Drug Prices Are Unrelated to Research and Development Costs

Merrill Goozner

The prices and escalating overall cost of prescription drugs have once again risen to the top of the health care policy agenda. Nearly every major health care lobbying group in the nation’s capital – representing hospitals, insurers, physicians, seniors, and consumers – have banded together in a Campaign for Sustainable Rx Pricing. ¹ About the only thing both presidential candidates in the 2016 race for the White House agreed on was the need to take action to curb drug prices. ² The concern encompasses both brand name drugs, which are still on patent and command premium prices, and generics, whose makers have substantially raised prices by flagrantly exploiting regulatory and market failures. ³ While generic drug abuses involving Turing, Mylan, and Valeant Pharmaceuticals have generated headlines and Congressional hearings, it is the rising price and costs of the latest branded drugs to win approval from the Food and Drug Administration that are most worrisome to patients, payers, and providers.

It’s easy to understand why. While brand drugs were only 11.3% of the 4.37 billion prescriptions filled in the U.S. in 2015, they accounted for 73.3% of the $424.8 billion in total sales and drove nearly three-fourths of the overall 12.2% increase in total costs. Spending on the branded specialty drugs that combat cancers, hepatitis C, and a handful of rare diseases are rising the fastest. Spending on this class of medicines rose more than 20% in 2015, and now account for 36% of total drug spending. ⁴

Because of the rising outrage over high prices and costs, the Pharmaceutical Research and Manufacturers Association (PhRMA) for the first time since passage of Medicare’s prescription drug benefit in 2003 faces a political threat to its current pricing model. It is responding today the way it responded then – by claiming the high cost and uncertainty of research and development requires higher prices.

“On average, it takes more than 10 years and $2.6 billion to research and develop a new medicine,” it said in a recent report that cites that finding from the Tufts Center for the Study of Drug Development, which receives more than one-third of its funding from the pharmaceutical industry. ⁶ And in a relatively new twist, the industry trade group also argues that the value delivered by these new medicines justifies high prices. ⁵

There are several methodological flaws in the Tufts study, whose authors have updated its findings several times over the past two decades. It’s a survey of selected manufacturers, who provide data on total costs, failure rates, and research timelines for the experimental drugs in their development pipelines. The total investment is then discounted – at a 10.5% annual discount rate in the latest study – so that fully 38% of the $2.6 billion of alleged costs come from time value of money invested over the 10-year average course of development.

The problem with that method of accounting is that research and development is not an investment. It is a current expense, and it is paid for and deducted dollar for dollar from current revenue. In addition, the government provides special tax credits, thus further reducing the current cost of R&D.

The methodology also doesn’t take into account the value of the drugs that make it through the pipeline (the companies involved in the survey are not named and do not release the data). For instance, it is unknown whether the drugs in the survey are given a priority review status by the FDA, which indicates it is a significant medical advance, or a standard review, which means the drug has no promise of being any better than existing drugs on the market.

These so-called “me-too” drugs may give firms a competitive entry in an existing therapeutic class, but they add little or nothing to physicians’ armamentarium for fighting disease. In 2015, 40% of the 40 new FDA-approved drugs received a standard review. ⁷ A comprehensive review of the past several decades’ approvals at U.S., Canadian, and European regulatory agencies found “most of the new drugs are relatively minor modifications of existing treatments.” ⁸

The logic behind the idea that drug companies are pegging prices to capitalized R&D costs is also flawed. If the research costs of all failed efforts are recouped by the prices charged for the relatively small handful of successful drugs that make it to market, then there is no risk. There are only guaranteed returns. The only question becomes how those returns are distributed – with winners taking all and losers taking nothing.

For the winners, those returns have been substantial. The financial filings of the major pharmaceutical companies, who continue to fund the vast bulk of R&D or buy drugs in the late stages of their development from start-ups and experienced drug development firms that make up the biotechnology industry, are the envy of Wall Street. In fact, they are consistently higher than banking and other financial institutions.

While total industry spending on R&D equaled nearly 20% of sales in 2015 and averaged between 16% and 18% for most of the past two decades, ⁹ profits have been even higher. The pharmaceutical and biotechnology industries are projected to post profit margins around 25% in 2016. The only sectors earning higher margins, according to a recent analysis in Forbes Magazine, were investment managers, the tobacco industry and, highest of all, generic drug makers at a 30% margin. ¹⁰

Despite the industry’s substantial spending on R&D, which grows or shrinks in lockstep with total sales, there is rising concern about declining return from research. One study projected falling, even negative returns and predicted the “rewards for innovation” would be insufficient “to sustain biomedical innovation.” ¹¹

Yet the real concern ought to be for the declining health returns from the industry’s spending on R&D. If one looks beyond the hype around personalized medicine and cancer moonshots, the reality is that the 71 cancer drugs approved between 2002 and 2014 had a median survival rate of 2.1 months. ¹²

One possible reason for that is that the U.S. has been systematically starving basic research, which provides the scientific insights necessary for a successful drug development program. ¹³ Scientists’ ability to decode the genetic make-up of cancer and other diseases has provided a mother lode of potential drug targets. But the basic research required to validate those targets – usually performed by university-based scientists – remains an underfunded work in progress. The National Institutes of Health budget has shrunk in real terms by about 20% over the past decade.

The saga of how the hepatitis C drug Sovaldi came to market with an initial price tag of $84,000 for a three-month course of treatment reveals the moral and financial bankruptcy of the current drug development model. ¹⁴ An Emory University researcher using NIH grants identified the target for killing the virus and began work on developing the drug. He began a company called Pharmasset that took that drug through its early stages of development, spending, according to its financial filings, about $315 million.

With the drug about to go in its final stage human testing with all signals looking promising for a breakthrough therapy – which it turned out to be – Gilead Pharmaceuticals, a successful AIDS drug manufacturer, purchased the biotech start-up for $11 billion. The price eventually charged for Sovaldi was necessary to provide a return on that investment, and had nothing to with the cost of its R&D.

About the Author

Merrill Goozner, M.S. is editor of Modern Healthcare, a weekly trade journal and daily news website for industry leaders and professionals. A former economics correspondent for the Chicago Tribune and other publications, he is author of “The $800 Million Pill: The Truth Behind the Cost of New Drugs.”

Acknowledgements

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13. This is the theme of The $800 Million Pill.
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