Myth: Drug prices accurately reflect their costs for development

The third in the series “The 10 Biggest Myths about the U.S. Health System.” For the previous reports, go to

On just about every topic in healthcare, the nation’s divided. But on the issue of drug prices, there is almost universal agreement. They think prices are too high, drug manufacturers are to blame and the federal government needs to step in. This sentiment is widely felt and cuts across party lines, demographic cohorts and health status.

The U.S. prescription drug industry is a $400 billion juggernaut dominated by 38 major manufacturers whose operations span the globe along with hundreds of early-stage start-ups. The U.S, market is the industry’s most important, representing almost 40% of global sales ($1.1 trillion) and 53% of revenue growth anticipated in the next five years. It’s a big industry representing 11% of total U.S. health spending ($3.3 trillion) and it’s profitable. According to the U.S. Government Accountability Office, two-thirds of drug companies saw their profit margins increase in the past three years averaging 17.1%.

The impact of the industry goes far beyond its U.S. workforce (4.7 million), R&D investments ($75 billion annually) and ubiquitous impact on patient care. It is a major factor in rising health insurance premiums, hospital costs, expenditures by Medicaid and Medicare and out-of-pocket health costs in most households.

Surveys indicate consumers believe their meds are safe and effective but suspect the manufacturers are motivated more by profits than patient care. It’s a conundrum for the industry: consumers like their products but not the organizations that produce them.

  • Over half of our population take at least one prescription drug and one in five takes at least four. (CDC)
  • Three in four Americans consider think the cost of drugs unreasonable (Kaiser Family Foundation Tracking Poll)
  • 29.6% of Americans say they have not filled a prescription because of cost. (Zogby Poll February 2017)
  • The majority in the U.S. believe the development of new drugs has improved their lives but three in four think drug manufacturers put their profits before patients (Kaiser Family Foundation).
  • The majority think the federal government should play a bigger role in controlling drug prices: 75.5% agree that the “drug companies are getting away with murder”, 92% think the federal government should negotiate directly with manufacturers on behalf of Medicare and Medicaid, and 72% think importation from Canada should be legalized. (STAT-Harvard Poll, November 2015, Zogby Poll February 2017).

Against this backdrop, the industry has effectively advanced its belief that its costs for their new drugs reflect the actual costs for development. Based on a sophisticated analysis by the Tufts Center for the Study of Drug Development in 2016, it concluded that the total cost for a new drug is $2.87 billion over a 10 to 15-year approval process that’s highly regulated and risky to manufacturers. Approximately 60% of these costs are direct with indirect costs including their cost of capital (imputed at 10.5%) representing the rest.

Looking forward, QuntilesIMS Holding estimates the U.S. prescription drug market will grow 4-7% annually through 2021 as fewer brand name patents expire and new drugs gain market approval. The Express Scripts 2016 Drug Trend Report reported that the 2013-14 spike in spending was as an anomaly due to new blockbuster drugs for Hepatitis C and others but spending growth going forward will be steady.

The supply of medicines is increasing, the media spotlight is on drug prices and legislators seem determined to do “something” especially at the state level. But to date, the jury’s out on how these might impact drug prices:

  • Drug Supply: The FDA approved 46 new molecular entities (versus 22 in 2016) and 3 gene therapies last year as FDA Administrator Scott Gottlieb streamlines its approval processes. It was a 21-year high. In addition, in 2017, the FDA recorded the highest annual total of generic drug approvals (1,027 generic drug approvals: 843 full approvals and 184 tentative approvals) to stimulate competition.
  • Bad actors: Widely reported price gauging by Mylan, Valeant, Turing and others fueled public suspicion that drug prices might not be a proxy for their underlying development costs.
  • Legislative Focus: Per the National Conference of State Legislatures, at least 176 bills on pharma pricing were introduced in 2017 in 36 states.

All things considered, the assumption that drug prices accurately represent their cost is not completely plausible. This is not to discount the development risks by manufacturers nor to discredit the studies by academics. It is reflective of the industry’s track record in setting its prices. The reality is this: the industry sets its prices on its own terms because it can. Patent laws, data exclusivity and its fiercely competitive and fast-consolidating marketplace lend to transparency avoidance.

Drug manufacturers, their distributors and pharmacy benefits managers operate in virtual obscurity, protecting their intellectual properties, business processes and costs of operating from public scrutiny.  When spending heavily to promote their drugs to consumers and prescribers and curry favor with elected officials, they invite greater scrutiny of their prices. (iSpot Data, ZS Data, Kanter Media).

The industry’s leading trade group, the Pharmaceutical Research and Manufacturers (PhRMA) offers four strategies that are necessary to address changes in the U.S. health market:

  • Modernizing Drug Discovery, Development and Approval: We need to modernize the FDA to keep pace with scientific discovery and to enable a more competitive, innovative and sustainable ecosystem.
  • Promoting Value-Driven Health Care: We need to encourage value-driven payment models, and to remove the hurdles making it difficult for innovative, sensible payer/manufacturer arrangements to emerge.
  • Engaging and Empowering Consumers: We need to make more information on health care out-of-pocket costs and quality available to patients.
  • Addressing Market Distortions: We need to address market distortions like the rapidly growing 340B program or the risk adjuster for commercial insurance that does not account for prescription drug costs.

Perhaps a fifth might be timely, given growing public disdain for their pricing practices: Make drug pricing decisions in the sunshine. Provide data detailing all underlying costs including discounts, coupons, incentives and distribution. Make the case credibly.

The U.S. represents 5% of the world’s population but almost 40% the drug manufacturing industry’s global revenues. It’s the most lucrative market on the planet for manufacturers.

The good news is that the public believes our drugs are safe and effective. The bad news is that the industry’s prices are increasingly unaffordable to the rest of the system, and the public’s trust in the industry is slipping.

That drug prices are a reflection of their costs is a myth until and unless the industry’s manufacturers come clean.