Drug Pricing, Demystified (Part I: The Basics)

One in a Series of Commentaries on the US Healthcare System

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Why do prescription drugs cost so much? Or do they?

The never-ending debate over prescription drug prices suggests how little most of us know about drug industry pricing practices. The pricing process, and what a drug ultimately costs, is hidden under a mountain of technical jargon, corporate anti-competitive secrecy and government law and policy — some created with beneficial intent; some not. However, our collective ignorance is not going to help us have realistic debates nor aid us in developing more equitable solutions.

There has been much focus on the high prices of newly available brand name drugs for decades and, recently, it has intensified. There is also the seemingly counter-intuitive drug company practice of raising prices at least annually on existing brand drugs. After all, shouldn’t the price of an older drug go down? Especially if a new drug that treats the same condition is approved? Or if a drug’s patent expires and generic forms of the drug become available?

The logical answer would seem to be “yes,” if the brand drug industry business model were comparable, for example, to the automotive industry. Like automakers, drug makers are for-profit businesses. As such, the driving motivation for both is to make profits and provide returns to shareholders. Beyond this basic fact, further comparisons are difficult.

Let’s get some insight into pricing practices that are common across the brand drug industry:

  • A company has a potentially promising drug candidate. This candidate must pass through a series of clinical trials; these are designed to evaluate the drug’s optimal dosage, safety profile, side effects, and how effectively it treats a specific disease. Typically, well-designed trials include hundreds of patients, and compare the candidate drug to an already tested and proven product. Ultimately, the goal is that the US Food and Drug Administration (FDA) approve the drug so it can be legally marketed and sold. This process takes several years and is costly and financially risky — most drug candidates fail to deliver on their promise, and further testing is abandoned. Money invested in a failed drug candidate goes down the drain.
  • Early on in a candidate drug’s life, companies start running the numbers on its potential profitability at different price points. The starting comparison point is usually close to drugs already on the market that treat the same or similar conditions. Companies also consider important demographic and financial factors: How many people have the disease the candidate drug may treat? In which countries do they reside? Who will be paying for the drug: government programs, private insurance or individual consumers (i.e., “self-pay”)? What is the expected duration of treatment (a week, month, lifetime)? Are other companies developing similar drugs, and how far along are they in the process? All these factors impact potential profitability.
  • Whether the candidate drug is a “me-too” (i.e., very similar to an existing drug), the first of its kind or somewhere in between, companies give significant weight to what public (e.g., Medicare, Veterans Administration) and private insurers will be willing to pay. The companies determine this by confidentially (and legally) sharing basic information about the drug with insurers; the insurers in turn indicate, within a range, what they’ll be willing to pay.
  • Companies do consider the actual cost of the materials, the physical plant, equipment and people needed to make a high-quality product. However, to the surprise and consternation of many of us, this “cost of goods” has little bearing on a drug’s ultimate price.
  • Companies tend to set the initial list price of a drug at the upper range of what insurers will ultimately pay, and often close — if not higher — than the prices of existing competitor drugs. Critics of the industry decry this practice as “pricing at what the market will bear” — basically as high as possible.
  • Many companies suggest that they set initial prices at least in part according to the value that a drug will bring to consumers and the healthcare system. This includes the very real impact drugs may have on reducing costs in other parts of the healthcare system, e.g., preventing hospitalization. There is also the potential to extend life and reduce human suffering. However, companies have difficulty quantifying these values in ways that are uniformly accepted by payers — or in ways that directly support their pricing decisions.
  • For the drug company, a drug’s job is to remain as profitable as possible for as long as possible — certainly until the drug’s patent expires. Hence, the fact that a brand drug’s price tends to increase over time instead of going down. Companies bake price increases into a drug’s annual and longer-term economic forecasts. They plow profits back into the company to support the drug’s marketing costs, research and development of future drugs, and to cover the myriad of other expenses common to most large businesses — including financially rewarding shareholders.

It’s important to note that a drug’s price is just the starting point for that drug’s cost: what your insurance and/or you ultimately pay for the drug. After all, none of us walks into a prescription drug manufacturing plant and buys a bottle of pills off the assembly line. In between the point that a drug company establishes a drug’s price and the point where the drug ends up in your medicine cabinet, an opaque process unfolds that determines a drug’s final cost.

At this point, an array of other players enters the equation. The players include drug wholesalers, pharmacy benefit managers (PBMs), pharmacies, health insurance companies, government agencies— and sometimes doctors and hospitals if the drug must be administered by a healthcare professional. Drug companies make separate, confidential discount or rebate agreements with many of these middlemen.

How and why these negotiations occur figures centrally in the drug pricing and cost story that I’ll delve into in Part II of this commentary. For now, let’s just say that the lack of transparency around these discount and rebate negotiations draws the ire, speculation and investigation of politicians and public citizens alike. It’s just another piece of the story that makes drug pricing such a challenging component of our expensive and inefficient US healthcare system.