On January 12, HCPF sponsored the 2021 Colorado Health Cabinet Health Policy Summit. As a part of the program, Commissioner of Insurance, Mike Conway, moderated a panel on prescription drug affordability. While informative, audience questions suggested that the discussion did not fully address factors affecting prescription drugs costs in the state of Colorado. At the risk of oversimplifying, I will make an attempt to do so here.
In an attempt to persuade, various stakeholders describe the pharmaceutical industry model in ways that do not accurately portray how drug manufacturers make money. Often, I will read about how companies spend twice as much on advertising as R&D, which is patently false. To set the record straight, I’ll do my best here to speak to what it costs to bring a drug to market and to develop and maintain the product once it has been approved.
Manufacturing. Loosely speaking, there are two types of drugs – pills and biologically-based drugs. Categorizing drugs this way is important, because pills are super-cheap to make and biologically-based drugs are not. Pills are often more expensive to develop, which is why the industry is increasingly trying to develop biologically-based drugs. When it comes to pills, there is a well-developed manufacturing model. Companies – often via chemical manufacturing plants in China and India – produce active drug through synthesis (i.e. they take a base substance and modify it several times chemically until they have an active drug someone can eat). They then make a pill out of it by blending it with inert ingredients and literally pounding it into a pill shape. This process yields pills that often cost 10-20 cents a unit. Let’s say you take two pills a day for a year; the math says your pills cost $73-146 for that year. On the biologically-based side, the manufacturing process is quite different. While technological improvements are impacting costs in a good way, the vast majority of biologically-based drugs are made by causing living cells to make the active substance in a giant steel vat. Once the manufacturer makes enough of the active substance, they filter out the impurities and freeze the drug in a specialized container. These drugs don’t work if simply swallowed, so manufacturers take the active substance and fill syringes with it for injection. This process yields injection systems that vary widely in terms of cost, but which might run several hundred dollars per unit. It is typical for manufacturers to pursue biologically-based drugs that can be administered once every month (or even less frequently), which suggests that a year’s worth of drug might cost several thousand dollars to produce. In sum – pills typically cost low hundreds of dollars for a year’s worth, while biologically-based drugs can run to several thousand dollars.
Sales, Advertising, Marketing, Administration. If you look at a pharmaceutical company profit-and-loss statement, you will find a line called “Sales, General & Administrative” or the equivalent. Different companies use different terms, but it’s all the same stuff. This line includes several discrete costs associated with a company’s attempts to maximize sales of a product. As a rule of thumb, roughly one-third of a company’s employees are associated with sales and marketing. Thus, in order to come up with the costs of promoting a drug, you might estimate what a “fully-loaded” employee costs (e.g. $200,000/yr.) and multiply that by the number of employees dedicated to this function. “Fully-loaded” refers to an employee’s salary and benefits load, plus travel expenses, information technology, etc. It is not clear that the industry needs as many sales and marketing employees as it has (a different topic for a different day), but this is where the industry has landed. On the advertising line, folks jawboning for affordability often get this figure wrong. It is rare for a company to support a product with a several hundred million dollar direct-to-consumer advertising campaign. More often, this figure is much smaller or non-existent, either owing to financial or operational considerations. Companies do advertise to prescribers, so most products receive advertising support, even if the direct-to-consumer component is modest. Overall, advertising spend is often a mid-to-high single digit percentage of sales. Finally, administration includes costs associated with non-promotional support. This can include human resources, finance, IT, etc. Best-of-breed figures for administrative expense run 4-5% of sales in the pharmaceutical industry, and rarely hit double-digits. Therefore, for a typical prescription drug company, total SG&A might reach 35% of sales, with G&A at 5-7%, advertising at 5–8%, and sales/marketing accounting for the remaining 20-25%. If you want to look at this another way, pull up the slides of any major pharmaceutical industry merger. You’ll see a cost savings figure that hovers around 7% of sales. That 7% is the elimination of nearly all G&A redundancies, a modest amount of manufacturing rationalization, nearly no net R&D spend (any savings are usually reinvested) and a modest amount of improved vendor contracts.
Research and Development. Beyond advertising, R&D is the topic most debated by proponents and critics of the pharmaceutical industry. It is also the topic where folks deliberately or inadvertently spread the most mis-information. In most developed nations, there exists a regulatory body that determines whether a prescription drug can be sold and under what conditions. In the United States, that body is the Food and Drug Administration (FDA). The FDA requires that drugs are tested exhaustively before they are made available for commercial sale. Companies have to test new drugs in mice and rats and dogs and monkeys; they then have to test new drugs in small handfuls of people for an initial look at safety, then larger groups of people for a look at both safety and efficacy. There are two reasons why this is very, very expensive. First, drugs fail. For every ten drugs that get tested in a person, one makes it to market. Second, running trials in people is (too) expensive. Drug companies deal with specialized organizations that carry out the trial protocols. They hire the doctors, run the tests and track the outcomes. If the trial uses a comparator drug, they have to pay for that drug (at full price). When thinking about the R&D cost of doing business as a drug company, these expenses are largely out of the industry’s control. It is fruitless to complain about this expense on an individual project basis. What is in the industry’s control is the number of projects to pursue. Using comparative effectiveness data and accepted thresholds for what developed countries are willing to pay for improved health, the pharmaceutical industry overspends on R&D. In other words, for the amount of sales and sales growth the industry generates, it delivers too many failures and too many approved drugs of questionable value. On another day, I’ll walk through the numbers, but I believe that prescription drug companies ought to be able to spend about 12% of sales on R&D and achieve growth and returns in line with historical averages. Instead, the average company spends about 20% of sales on R&D.
Generics. Advocates for improved drug affordability often suggest we need to speed generics to market as a solution. This is a heavy lift. Without changes to patent law, specifically related to prescription drug regulation, widespread relief is tremendously unlikely. Prescription drug companies do aggressively participate in patent “evergreening” activities in order to maximize the period generics are not available. However, they do so legally. The second way prescription drug companies maximize the period generics are not available is by settling litigation in a way that benefits the litigants to the detriment of consumers. Say a drug isn’t supposed to come off patent until 2030, but the patent is questionable and might be invalidated. The brand company might settle with the generic challenger and allow that company to introduce a generic product in 2028 in exchange for ceasing its attempts to invalidate the patent. Supporters of the status quo would assert that the two-year earlier introduction benefits consumers, while detractors would assert that the patent was going to fall anyway, so the generic is “delayed”. As a practical matter, each case is different, and it would be very difficult to have a broad and material impact on drug affordability by pursuing this matter outside of legislation. Finally, it is worth noting that only a handful of generic companies have the ability to manufacture biologically-based drugs at scale. With the industry increasingly marketing these types of drugs, it will take time for generics to impact affordability in this area.
Importation and Reference Pricing. For a long time, many have highlighted the fact that other countries pay less for drugs than does the United States. In order to improve prescription drug affordability, advocates have pursued two models that rely on overseas prices – importation and reference pricing. Importation involves the purchase and physical delivery of overseas drugs, while reference pricing simply involves capping prices or reimbursement at a level tied to overseas prices. First, let’s get past the quality issue. Drugs marketed in developed countries are every bit as safe as those marketed in the United States. The plants are just as clean, the personnel are just as ethical, and the doses and schedules are typically comparable if not equivalent, thanks to the globalization of clinical development programs. Drugs marketed in under-developed countries can be less safe than those marketed in the U.S., so it is important that any importation program involve a rigorous track and trace protocol. The issue with importation rests with logistics and supply. Countries like Canada and France negotiate directly with manufacturers over what price they pay for prescription drugs. They then have laws in place that govern the degree to which prices decrease over time. While manufacturers do make drugs available at these prices, they do so because they make enough money in the United States and selected other markets to more than compensate for the reduced profits they make in places like Canada and France. If the United States attempted to engage in a widespread drug importation program, the industry would probably make some very difficult and unappealing decisions around restricting supply. When it comes to reference pricing, there is less the pharmaceutical industry can do beyond lobbying and litigation. Thus, this is a theoretically tractable solution in the same way that permitting the government to negotiate directly on behalf of the Medicare program is a tractable solution. From the point of view of the state of Colorado, however, there are probably some other items to consider.
Colorado has expressed interest in capping permitted reimbursement for prescription drugs as a way of improving affordability. Pharmaceutical companies would still theoretically have the ability to set their own prices, but insurance companies and retail pharmacies, among others, would not be permitted to engage in commerce at levels that exceeded state-established thresholds. Think of it this way. It would be as if Mercedes Benz set the price of its E-Class at $60,000, but the local dealership wasn’t permitted to sell it to you for more than $30,000. Something would have to give. The state might use overseas pharmaceutical prices as a reference point for the thresholds, but exactly how is an important element in the impact such a stratagem might have on affordability and the industry’s response.
Middle-Men. I include both insurance companies and pharmacy benefits managers (PBMs) in my definition of middle–men. I could include retail pharmacies and wholesalers, which are certainly actors in the pharmaceutical supply chain, but these entities don’t make much money and aren’t really the problem (beyond being complicit). Manufacturers and consumers should hate PBMs (and their siblings, the insurance companies). The PBMs business model is to “save” consumers money on the cost of prescription drugs, but their value proposition is tied inherently to higher prices and price increases. Rather than focus on whether the net price a consumer pays for a drug is fair, PBMs focus on how much of a discount they are able to negotiate off an arguably inflated list price. I have a friend in the investment world who calls this the $95 burrito coupon. Would it make any sense if Chipotle charged $100 for a burrito, but you could get a $95-off coupon from a group purchasing cooperative you belonged to? I bring this up because folks who talk about drug price inflation conflate a number of drug price definitions and confuse those who are trying to learn what’s really going on. In short:
- List prices are meaningless to all but two groups —
a. Those paying cash because they don’t have insurance and the discounts insurance provides. GoodRx (you’ve seen the commercials) has built an entire business around this problem.
b. Those who have a co-insurance obligation tied to the list price of a drug (often those on Medicare).
2. There is a tremendous amount of disparity and cross subsidization inherent in our delivery system. Some of this is due to our reliance on a fragmented and free market approach to negotiating best prices, while some is due to the complex nature of how our governments regulate prices and reimbursement on behalf of programs like Medicaid and Medicare. For example, HCPF director Kim Bimestefer talks about how Colorado Medicaid realizes rebates that keep drug price inflation under control for the state — that’s simply the law. Prescription drugs aren’t permitted to increase prices ahead of CPI-U (about 1-2%) without rebating the difference. The Kaiser Family Foundation goes over the details here: https://www.kff.org/medicaid/issue-brief/understanding-the-medicaid-prescription-drug-rebate-program/.
3. There isn’t just one culprit behind lack of drug affordability in the U.S., but two stand out from the crowd:
a. Consumers are asked to pay too much of the bill. Free market theorists love to talk about “skin in the game” and “moral hazard” when it comes to health insurance, but it is pretty short–sighted to ask a Type I diabetic to make a co-payment for a drug he/she can’t live without. Affordability reforms should center on applying a little more sophistication here.
b. Drug companies are free to set price and determine price increases. This is a stickier wicket from a policy point of view. In countries like Canada and France, drug companies are also “free” to determine prices, but whether they’ll be reimbursed is highly centralized and not assured: hence, the air quotes. This is not the case in the U.S. PBMs do have exclusionary lists tied to their formularies, but this is a relatively recent trend and there’s almost always a strong alternative available. Again, because drug companies can cross subsidize lower overseas prices with higher U.S. prices, they usually agree to a lower price in Canada, France, etc. In 2011, Eli Lilly and partner Boehringer Ingelheim did refrain from launching the diabetes drug Tradjenta in Germany because the authorized price was too low. This represents a rare exception.
WHAT DOES THIS IMPLY?
- Drug companies do make too much money, but reformers are chasing too many ghosts.
a. Most pharmaceutical companies’ profit and loss statements are “legit”, if not slightly wasteful. The model of pursuing high-priced, specialty pharmaceutical markets has left the industry earning margins above 40%!
b. The Colorado debate focuses on pharmaceutical pricing and costs quite broadly, but mostly misses the real issues. Most people in Colorado have drug coverage through their employer and these are the people 1) most likely to be happy with their insurance, 2) most able to afford their medications and 3) out of reach of the state in terms of regulations (they are more likely than not to be covered by ERISA plans). Putting out 200-page reports and citing statistics selectively distracts from what problems really need to be addressed (benefit designs, inefficiencies) and what can be accomplished at the state level.
2. Direct-to-Consumer advertising is not the problem. Stop griping about it.
3. Generic substitution is not the solution. Focus elsewhere.
4. Slashing sales and marketing while boosting R&D won’t get us anywhere.
5. Similarly, calling for transparency around costs is pointless; there is no scope to regulate this, and costs are largely unrelated to price, but for short-term budgetary challenges.
6. Getting tough on price can help, but just how matters.
a. The Medicaid inflation-linked rebate has been immensely helpful. Establishing such a mechanism for other populations (e.g. commercial risk and managed Medicare) could be helpful if it were to survive legal challenges.
b. Rudimentary approaches to price-setting invite unanticipated knock-on effects. For example, using another country’s price, where circumstances are much different, is much more likely to invite a legal challenge or non-compliance than is a price determined through a rigorous and informed return-on-investment approach. It is also more likely to pressure ancillary industry participants in unanticipated and undesirable ways.
c. There may be simpler ways to improve affordability without attacking the industry’s pricing structure, which is considered sacrosanct. One possibility would be to impose a luxury tax used to fund patient assistance programs. Products subject to taxation could be determined by a pharmaceutical affordability board.