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Drug Pricing Mayhem


By this point you have likely heard of Martin Shkreli, the entrepreneur who thought he could make a killing by buying the rights to an anti-parasite drug and jacking the price up 5000%. While he eventually relented and promised to lower the price, the PR damage had been done: he and his company, Turing Pharmaceuticals, became pariahs overnight.

A little outrage feels good now and then, of course, but it’s important to realize that this was not an isolated case, nor is drug pricing in the US carried out in a sensible fashion. It’s a complex, even byzantine world of contracts, rebates, and secret prices. Notably, the United States government is one of the few in the industrialized world that is not permitted to negotiate drug prices in order to keep costs low. Indeed, that was part of the devil’s bargain that produced the Medicare Part D program–easily the largest money grab by the insurance industry up until the passage of the Affordable Care Act.

By no means am I being especially critical of the ACA here: it is not a single-payer program and it is not a public option, which are serious shortcomings, but it is easily a great improvement over the pre-ACA environment. Nevertheless, the healthcare reforms championed by President Obama do little to address prescription drug costs, which remain one of the biggest drivers of healthcare costs overall. To understand why, it helps to delve into where those prices come from and what that money is spent on.

No Free Market

The extent to which the healthcare industry functions as a free market is limited due to a variety of factors. Some are regulatory, but many are a consequence of healthcare itself: it is difficult to negotiate fair prices on something you urgently need to live. Unlike food, which is cheap by virtue of strong competition and subsidies, if you are critically injured and there’s only one emergency room within 30 miles, you have exactly one place to go. You can’t shop around and compare prices–your life depends on getting care urgently, not cheaply. The situation with many medications is not terribly different. First off, new drugs first come to market as patented brand-name drugs. Such drugs may only be produced by a single manufacturer (or any manufacturer who has licensed the patent), up until the patent expires, which takes several years. In that time, the manufacturer seeks to maximize their revenue, paying off both research and development costs, generating income for further research, and extracting enough of a profit to keep shareholders happy. The profits aren’t small: 10-40% or more, depending on the company and the drugs involved. That’s a better profit margin than banks, car makers, and energy companies can expect. Those profits primarily come from brand-name drugs, as generic drugs tend not to be nearly as profitable.

For a number of important drugs, there are no suitable generic equivalents. And while generic drugs are required to be pharmacologically equivalent to brands, they are not always as effective as the brand name. Cheaper inactive ingredients can cause allergic reactions and other issues–for some people, generic drugs are simply not an option.

And while the pipeline of drugs becoming generic is slowing, meaning fewer brand drugs will be coming to market as generics in the near future, the generic market itself is seeing an increase in profiteering behavior. Manufacturers are abandoning generics to pursue higher-margin drugs they can patent, resulting in less competition in the generic sector and offering more opportunities for individual companies to corner the market on specific generic drugs.

In other words, the extent to which the drug market is expected to behave like a free market is quickly eroding. This is good news for the Martin Shkrelis of the world, but bad news for the rest of us.

No Transparency

Another issue with drug costs is a lack of transparency. How much does a course of Amoxicillin cost? Good question! According to HealthTrans’ price calculator, 150mL of 250mg/5mL suspension–a typical dosage and quantity for a course of treatment–runs $11.81 in my area (northern New Jersey.) But that’s the price taking HealthTrans’ drug discount card into account–it is by no means a standard market price, because there isn’t one. Rather, drug prices are influenced at many levels before you ever see a final price or copay. Those factors include:

  * Average wholesale price or wholesale acquisition cost. These are proprietary, published values produced by a handful of companies whom insurers and other firms pay for the data. The methodology used to acquire this data is secret and, in fact, [has been gamed to fix prices.](
  * Drug manufacturer rebates. Rebate programs are commonplace in the industry yet virtually unknown to patients, as patients do not directly benefit from them. Manufacturers offer rebates to insurers as a way of attracting them, but the actual rebate values tend to be estimates. Insurers bake those estimates into the premiums paid by patients, but if they underestimate the value of the rebates, those benefits are not shared with the insured. Rebates amount to approximately 10% of the drug price, with 90% of that typically going to an employer, in the case of employer-provided insurance, though the amount varies--larger companies negotiate larger rebate shares; smaller companies receive less or even no rebate funds. It's a complex system that is not well-regulated nor well-understood outside the pharmaceutical and insurance industries.
  * Pricing formulae. When you take a prescription to your local pharmacy, the pharmacist likely enters it into a computer system, along with your insurance information. The pharmacist then also submits a requested price. The insurer's drug claim processing system then undertakes what can be very sophisticated calculations to determine a final price, or even to reject the claim outright if the pharmacy is asking too much. It is not uncommon for a pharmacy to engage in trial-and-error to find the highest amount that the insurance system is willing to pay. Indeed, some pharmacy systems come with tools to automate this profit maximization process. In the end, however, the insurance system returns any applicable copay and coinsurance amounts, along with the amount the pharmacy will actually be reimbursed by the insurer. This can have little or no relation to what the pharmacy paid for the drug, nor what it cost to make.
  * Medicare reimbursement rates. While the government has no power to set drug prices, it must base its reimbursement rates on something. It is typically some percentage (~80% or so) of the average wholesale price or the wholesale acquisition cost--but, as mentioned above, these amounts are have no independent verification or control. In practice, Medicare can be charged up to 175% of the average manufacturer's price--this is the "federal upper limit." Suffice it to say, that doesn't amount to much of a price control.

This system is complicated and messy and, obviously, not conducive to helping people make informed choices about their prescription drug purchases. In many cases, if your insurance doesn’t give you an affordable price (or doesn’t cover the drug at all), you are left investigating one of the many drug discount card programs, or applying to the drug manufacturer for free or low-cost supplies based on financial hardship. Either way, it’s a crapshoot, and gating essential drugs behind such complex rigmarole is effectively denying access.

No Federal Pricing Authority

It would make sense that, in the absence of a free market with healthy competition, there is a central authority governing prices and behavior. Not so in the US. Free market competition is untenable in a special market such as prescription drugs, and yet regulation to keep it functioning fairly and toward its intended purpose is scattered, at best. The FDA too readily approves some drugs, while holding back others which have been proven effective in other countries. Medicare represents a huge amount of spending, yet fraud is rampant and cost control proves difficult given the lack of authority to manage drug prices. This results in a situation where drug prices are controlled almost entirely by manufacturers rather than any real market or regulatory mechanism. Insurers keep up with the costs by jacking up premiums and copays, but their negotiating power to bring down overall prices is limited by their own size. The only entity with the leverage to effectively manage prices is the federal government: it spends more on prescription drugs than any insurer, and backed by statutory authority, it could ensure that pharmaceutical companies maintain healthy (but reasonable) profit margins while not being permitted to charge outlandish prices.

This is hardly a novel concept, Indeed, this is exactly how it works in Canada and most of Europe, and it functions quite well–at the least, people are not denied necessary drugs for lack of money or insurance to pay for them. But it is also not generally legal to advertise prescription drugs directly to consumers outside the US, either. In fact, it wasn’t legal in the US until 1997, and now drug manufacturers spend $4 billion a year marketing drugs directly to patients. That’s more than they spend on basic research, where that money would be better invested.

That particular point connects well into one of my overall narratives, that chasing short-term profits over long-term viability and social benefits is dangerous to the sustainability of a society. There is little need for the government to heavily regulate, say, boutique mattress delivery startups–those are not essential for people to survive. But when it comes to lifesaving medications, expecting the “free market” to sort it out, when the market is hopelessly distorted from the getgo, is a foolish fantasy. There is room for profit in the world of pharmaceuticals, but it must not be allowed to come at the expense of public health, nor is permitting uncontrolled cost growth a sustainable regulatory strategy. Change must come, either through direct reform, or because the system has caved in on itself. The latter would be bad medicine for all of us.