How Drug Pricing Works
Part One: Market Burden
This is Part One of a short series of explainers on how drug pricing actually works once you get past the political rhetoric — insofar as things can exist outside of rhetoric and politics.
Perhaps only someone capable of earning the moniker “Pharma Bro” could have brought drug pricing into the realm of pop culture. Martin Shkreli gained national notoriety for raising prices on Daraprim, a treatment for toxoplasmosis and some AIDs-related diseases, by 5600 percent — or up from $13.50 to $750 per pill — in 2015. The pharmaceutical industry has been in the hot seat ever since.
Senate hearings from Republicans and Democrats, market-dropping tweets from Clinton and Trump, and enormous publicity over every move have forced the industry to be on the defensive as fingers are starting to point.
But how did we get here? Shkreli didn’t exist in a vacuum. So let’s start with how prices are set. (Later, I’ll focus on issues that have exacerbated the price-setting process, as well as ways to stymie this problem.)
One of the biggest pieces of misinformation around drug pricing is the idea that high costs make up for high research and development (i.e. R&D) costs. While the idea seems to make intuitive sense, the high cost of developing drugs, including covering failed developments, can’t actually influence how much people will pay. What the high cost of drug development does do is influence investment decisions and where to put R&D dollars. But claims that high drug prices are needed to recoup R&D are disconnected from the market considerations that really determine pricing.
Instead, it’s more an interaction between supply and demand that determines the prices of drugs; in other words, what a market will bear.
In most developed countries, the market is composed of payers, who range from the private insurers and pharmacy benefit managers (PBMs) in the US to government organizations in various countries around the world. While physicians decide what drugs to prescribe and patients usually face some cost-sharing in the form of copays, the primary market is whoever pays for most of the cost of therapy. In the US, it’s those insurers and PBMs.
So how do companies determine what the market will bear? In short, conversations and research. The Wall Street Journal covers how some of this is done in the US. Companies directly or indirectly (e.g. via consultants) discuss with payers how they perceive a certain disease category and how they would manage a new drug, depending on its price. Would they pay for a drug at all? Require it to be used after another drug? Demand a lower price? Depending on the country, different organizations have different elements of control. Many EU countries are very willing to play hardball and say no if the price isn’t right.
The drug’s therapeutic value relative to other treatments and its cost are the major considerations here, and you can consider this as part of the supply/demand element. If a company’s drug is not very good, demand will be low and it’s not going to be able to command a very high price. Likewise, if there are similarly effective drugs treating the same disease, companies will have to compete on price. Physicians and patients complicate this area further, but getting in the door with payers is typically one of the most important steps.
Another element? The size of the organizations negotiating. For countries with governments negotiating, like many in the EU, it is an entire country using its purchasing power to negotiate. In the US, there are some large organizations capable of negotiating, such as PBMs, but overall fragmentation, requirements, and market complexity reduce the ability to bring drug prices down. That said, the PBM Express Scripts (ESI) was able to reduce the price of a Hepatitis C cure from roughly $83,000 to a price comparable to what Germany and France pay ($66,000 and $51,000 respectively).
This last distinction with Express Scripts is important. In the US, drug companies are free to set a list price to whatever they want, but then negotiate a net price that payers will actually pay. In the case of ESI and Abbvie, that difference was around $20,000.
In Part Two, we’ll see how this distinction has helped to drive prices — along with other forces that have led to significant price increases and the overall higher costs of drugs in the US. We’ll also examine some of the influences that change the dynamics and exacerbate the US market in a way that does not happen as much elsewhere.
You can find Part 2 here.
David Chen is based in Boston.
