Are Drug Companies Ripping Us Off?

AbbVie sells Humira, which treats multiple immunological diseases, at prices above $26,000 per patient-year. Gilead Sciences launched Harvoni in 2014 for hepatitis C with a list price of $94,500 per 12-week treatment. Bristol-Myers Squib launched Yervoy and Opdivo combination treatment in 2015 for melanoma with a list price at $250,000 per patient for the first year.

Are the drug companies ripping off the U.S. health care system and ultimately us?

With eye-popping price tags on life-saving drugs like the ones mentioned, many feel that they are. But, let’s look behind the numbers before we jump to any conclusions.

Costs: An Unsustainable White Lie

In the past, many pundits and pharmaceutical industry leaders have claimed that the price of a drug represents the costs to identify and produce that drug. To support their pricing policies, these pundits point to the costs of research and development, FDA approvals, and many other factors. And these costs are extremely high. 2014 research by Joseph DiMasi at Tufts Center for the Study of Drug Development claimed the average pre-tax industry cost per new prescription drug approval was $2.5 billion.

Yet, as a researcher and practitioner of value-based pricing, I know full well that costs and prices are often uncorrelated. Costs and prices should be factors in determining if a product or service is offered, but price should not be a direct function of costs.

In other words, those pundits have misled us with what was once accepted as a polite white lie.

The public accepted this white lie because we want to think that prices reflect costs and are willing to accept higher prices when costs increase. This is a well-known sociological and psychological behavior and forms the basis for standard advice with respect to public relations and price announcements.

Yet, with prices for pharmaceutical treatments reaching the tens- to hundred-of-thousands, recent pressure has shed light on the standard white lie. Many other researchers have argued that the price for creating new drugs is much lower than the number reported by Mr. DiMasi. But perhaps that number is irrelevant.

A decreasing number of large medical solutions firms actually design and develop their own new therapies. Instead, they wait for an upstart firm to develop a solution then purchase the license to produce that solution. When a large medical solutions firm, be it pharmaceutical or equipment, purchases the rights to produce a product, the costs required to develop that solution do not determine the price they are willing to pay for the license to produce the solution. Rather, the size of the market for that solution, the potential price of that solution, and the risk-adjusted cost to complete the FDA approval process are key factors determining the price a medical solutions firm should be willing to pay for the license.

If Not Costs, Then What?

Pharmaceutical formularies, like other medical solutions, are best priced according to the value they deliver relative to the alternative treatment for the target disease. If the new solution provides more value, it should have a proportionately higher price. If it provides less value, it should have a proportionately lower price. This is the concept behind value-based price: price to reflect the prices of alternatives adjusted for their differential value for the target customer.

Hence, when evaluating the U.S. price of Humira for Crohn’s Disease, we should consider the U.S. price of Remicade at $1,300 to $2,500 per infusion. When evaluating the U.S. price of Harvoni, we may want to consider the U.S. price of a liver transplant at $100,000 to $575,000. And, when evaluating the price of Yervoy and Opdivo combination treatment, one may want to consider the costs of chemotherapy and radiation therapy.

Given the proper context, the prices of these new pharmaceutical formularies do not seem entirely off. In fact, they appear to be approximately appropriate.

Yes, But They Are High!

The U.S. prices identified through value-based pricing for a new pharmaceutical treatment are often criticized as being too high for three different reasons: (1) They are higher than the prices paid by foreign countries with single payer systems. (2) They force the proportion of dollars spent on pharmaceuticals higher than historical average. (3) They are too high for the value they deliver.

Let’s address these claims individually.

U.S. Prices Are Higher than Other Country Prices

I accept the general truth that the price paid to a pharmaceutical company per pill in the U.S. is higher than what is paid outside of the U.S.

This fact is often blamed on the negotiating power of single-payer systems versus the competitive system used in the U.S. Yet, such attribution would imply that a small country like Greece with a population of 10 million is a much better negotiator than a huge firm like Aetna with a patient pool of 22 million. This begs credibility.

Rather, the disparity in prices of pharmaceutical formularies can mostly be attributed to the disparity in the costs of the alternatives in foreign countries and the budgetary constraints enforced through using Quality Adjusted Life Years.

Costs of hospital stays, nursing care, and other factors are higher in the U.S. than in most other countries. As such, the costs of the alternatives to a pharmaceutical treatment is usually higher in the U.S. than in other countries. Therefore, the price of the pharmaceutical treatment should be higher in the U.S. than in other countries according to the principles of value-based pricing.

As for the use of Quality Adjusted Life Years (QALY) to restrain prices, the U.S. barely has a rational mechanism for rationing health care dollars. Indeed, when it was QALYs a remote possibility, it was improperly branded as a “Death Panel” by some politicians. The U.S. chose against it. To discuss it further in this article would hit too many political hot buttons for this type of decision-maker oriented article.

The Proportion Spent On Drugs is Increasing

Drugs expenditures are growing faster than other health care costs. U.S. government economist found that prescription drug prices are increased by 12.2% while overall health care spending increased by only 5.3% in 2014.

This phenomenon is a natural impact of value-based pricing applied to drugs. When a new drug displaces the need for a hospital stay, doctor’s visit, or surgery, then that new drug will increase the portion of the budget spent on drugs and reduce the budget spent on many other health care costs. That is a goal of new drugs: to displace the need of more expensive treatments with a cost effective drug.

The portion of our budget spent on different things increase and decrease in other categories too. For instance, Americans now spend more money on mobile phones and less on cameras. Businesses spend more money on cloud innovation and less on servers and software. And, we quickly flip our purchases from cars to SUVs depending on the price of gas.

Changes in budgets are a normal part evolving solutions and industries. It is not a health care industry issue alone.

Are the Prices Too High for the Value Delivered?

Some doctors have notably claimed that the price of one new pharmaceutical treatment or another is too high for the value it delivers. Now this argument may have some merit.

When a pharmaceutical company prices a new product with value-based pricing, they have to make assumptions and estimates regarding several questions: Which diseases will the new drug address? What disease severity level will be addressed? How many people suffer from that disease at each severity level? By disease and severity, what is the cost of the nearest comparable alternative and what is the differential value of the new drug? How is that differential value calculated?

These assumptions and estimates are used to create the model and inform the model parameters of the value delivered. While research is conducted to narrow the uncertainty in the parameters and clarify the differential value, no research effort is perfect. As such, the outcome price is sometimes off.

Hence, when doctors point to evidence that a drug is priced too high for the value it delivers, they are quibbling about the parameters used in calculating the price, not in the value-based pricing method used to price the drug. And, they are using information gathered from direct experience with the new drug, information which did not exist at the time of setting the drug’s launch price. The doctor’s evidence is the basis of a good negotiating stance, one which can and is used by insurers to reduce the price they pay pharmaceutical companies for a drug, and can and is used by pharmaceutical companies to update their prices after entering the market.

They Are High, and for Good Reason

Some new pharmaceutical treatments are priced very high. Others, less so. In both cases, value-based pricing leads to prices which, overall, reduce the per-patient cost of treating a disease—not raise it. The higher prices reflect both better treatments and displaced costs in other areas. It is for good reason that drug companies can get such high prices: they offer a better solution.