“Value-Pricing” of Drugs and Pharmaceutical Innovation

“Value-Pricing” of Drugs and Pharmaceutical Innovation


In a fascinating paper on drug pricing, Ana D. Vega and her five co-authors trace increases in the price of brand-name and generic drugs in the U.S. during the period 2012-15, using the national average drug acquisition costs (NADAC) data made public by the Centers for Medicare and Medicaid Services (CMS). These acquisition costs are the prices that retail community pharmacies pay to acquire medicines, usually from a wholesaler.

The tables in the paper show that the top 50 increases in the price of generic drugs over the three-year period ranged from a “low” of 448% to a high of 18,808%. For branded drugs the increases over the period ranged from a “low” of 63% to a high of 391%.

The paper also presents data on the wholesale acquisition costs (WAC) differences between first-in-class drugs and subsequent me-too-drugs, the latter usually costing much more than the first-in-class drugs, although they typically involve only small molecular changes. Here the price differentials varied from a low of -2.3% (the sole case me-too-drug actually being cheaper than the first-in-class drug) to a high of 61,259%.

It is rare to find such transparency on drug prices in this country, presumably because the data are in possession of a public agency, the CMS. By contrast, the private sector usually confronts both patients and researchers with contemptuous opacity. The pharmaceutical benefit management industry (PBMs) is particularly opaque on drug pricing, and private insurers and employers have gone along with it.

Price increases of the sort reported by Vera et al. usually are defended on two distinct grounds.

The first is what has come to be called “value pricing’ the idea that the price of a drug should be pegged on the value that drug has to patients or to society at large, in their eyes. For life-saving drugs or pain-killing drugs, that value can be very high.
Another defense of the ever rising prices of drugs is that they are needed to provide the incentives for new drug development.

Value Pricing

In my presentations on drug pricing, I often use the following metaphor to convey the central point of this concept.
Picture, then, a man somewhere in the Sahara desert close to dying of thirst.

Along comes a camel caravan for tourists, loaded with bottles of water. Assume the chap on the first camel is a private equity manager who knows a thing or two about “value creation” through “value pricing.” Assume the lady on the camel behind the first is a corporate lawyer.

Jumping off the camel, the private-equity chap approaches the dying man and, water bottle in hand, queries the dying man thus:

“How much would you pay me for this fresh bottle of water?”

“Everything I own,“ moans the dying man. “My house, my car, my bank account – all my possessions.”

“Done deal,” responds the private equity chap.

Swiftly the corporate lawyer jumps off her camel, draws up an airtight contract and presents it to the dying man, who promptly signs it.

He gets his water and gulps it down, thus purchasing a whole lot more “quality-adjusted life years” (QALYs).

The private equity chap and the lawyer are beaming.

End of story.

What should we call this transaction? What should we think of it?
The answer to the first question is “value pricing,” because the price for the life-saving water was pegged on the value that water had in the eyes of the dying man in the desert.

What to think of it is quite another matter.

Economists would call the deal “efficient” and unambiguously “social-welfare enhancing,” because both parties to the deal are better off consummating it than they would be if the transaction had not taken place.

Non-economists, however, may view the transaction as a form of price gouging and exploitation of a person in dire circumstances.
What do you, the reader, think?

The metaphor should be of interest to health-policy experts, because more than a few members of the pharmaceutical industry appear in recent years to have slouched more and more toward the Sahara model of “value pricing” their products.

Whatever economists might say in defense of this practice “value pricing” in health care, the general public and those who represent them, members of Congress, do not seem to buy into the economist’s rationale. It is by now well known that at the opening of his very first news conference, newly elected President Donald Trump stated that in their pricing policies drug companies are “getting away with murder.”

Incentives for R&D in Pharmaceuticals

On the surface, the arguments that high drug prices today pave the way for new-drug development by the pharmaceutical industry has intuitive appeal.

Pharmaceutical companies tend to spend anywhere between 15% to 20% of their revenues on R&D, a ratio that varies by company and over time. It is certainly less than is spent on marketing and administration.

So the argument may be that if increases bin drug prices raises revenues, some 15% to 20% of that increase may trickle down to R&D.

Perhaps so. An alternative hypothesis, however, might be that if it is so easy to raise drug prices, even for older generic drugs, why bother to sweat over the uncertainty surrounding R&D? On this theory, the great facility with which drug manufacturers can ram huge price increases down the throat of the health insurance industry and patients may actually be a barrier to more fervent search for truly innovative drugs.

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24 Comments on "“Value-Pricing” of Drugs and Pharmaceutical Innovation"

Apr 12, 2017

Barry I am not expert on pharma, but I do have two opinions that may be of value:

1. Some of the worst price gouging (albeit in smaller dollar amounts) has taken place in the last few years on older drugs –which are bought up if they have even a small population dependent upon them.

The gouging could be stopped tomorrow and not have the slightest impact on medical innovation.

America needs a Pharmacy Price Review Board like Canada’s, with veto power over monopoly gouging. We could also use less powers for the FDA, which slows up competition for these drugs.

2. The decisions on how much to spend on one life are agonizing, but more than drugs are involved. Friends of mine had a child born with a defective liver, and with all his treatments the cost has been over $3 million. Two health plans have had huge rate shocks, and the parents are divorced and bankrupt.

I have two ideas to relieve this horrible strain:

a. Price controls on drugs and hospitals, which does not remove the decision but kind of postpones it ….in the sense that a cost of $100,000 is easier to debate than a cost of $500,000.

b. My last idea will never happen, but here it is. Have insurers refuse to pay enormous sums, and turn the decision over to the doctors and hospitals.

If they want to devote their own time to the patient and save their life, wonderful.
If not, so it goes.

Barry Carol
Apr 13, 2017

Bob — I agree with your comment about price gouging on certain low volume generic drugs. My preferred solution is for the FDA to simplify its drug approval process to reduce costs and shrink the time needed to approve a new competitive offering. When the incumbent’s price rises beyond a defined threshold, a new competitor should be moved to the head of the line in the backlog so its application can be approved as quickly as possible. I’m uncomfortable with direct price control but I am comfortable with QALY metrics or other rational bases to exclude overpriced drugs from a formulary.

Barry Carol
Apr 12, 2017

When it comes to pricing brand name and specialty drugs, most drug companies think in terms of maximizing shareholder value which, I think, is unfortunate. While it’s necessary for investors to earn a satisfactory risk-adjusted return on their capital to sustain medical innovation, there is or at least should be such a thing as striking a reasonable balance among all stakeholders including patients and payers. Most drug companies want patients to pay little or nothing for their drugs but they want payers to pay through the nose. Too many drug companies raise prices well in excess of inflation year after year because they can but just because they can doesn’t mean that they should. I wonder how some of these folks who set drug prices would feel if they were on the receiving end of the bills.

Another thing that is unique to the drug industry is using per capita GDP as a proxy for ability to pay so they charge what the market will bear in the unfettered U.S. market and considerably less in other first world countries. Importing drugs into the U.S. from other countries is easier said than done even if there are no safety issues. It’s not like Canadian pharmacies, for example, can buy as much of a given drug as they want in order to export it back to the U.S. The manufacturers will place limits on how much they will sell based on prior patient demand within the country. If the U.S. tried to control prices like other first world countries do, there would likely be a significant adverse impact on medical innovation. Price controls work in other countries because drug companies can shift costs back to the U.S. just as Medicare and Medicaid can pay relatively low reimbursement rates because providers can shift costs to commercial insurers and self-funded employers.

In the end, society has to make some judgments as to how much it is prepared to pay to keep one person alive. That’s a mighty tough call when you’re dealing with a child or young adult. It should be a considerably easier call when you’re dealing with an older person who has already lived a normal lifespan and then some. People should always be free to spend their own money if they have it but most people don’t have it when it comes to very expensive specialty drugs especially. Specialty drugs account for only 1% of prescriptions written in any given year and only 2% of patients need them but they account for one-third of drug costs and that percentage continues to drift up. We have to draw the line somewhere.

Apr 11, 2017

I would rather defer to the philosopher Michael Walzer, whose book Spheres of Justice taught me about the repulsiveness of “desperate exchanges.”
In the aftermath of World War II, starving women sold themselves to GI’s. This was the classic ‘desparate exchange.’
The relevance to drug pricing is obvious….

see the attached


Apr 11, 2017

“I often use the following metaphor to convey the central point of this concept. Picture, then, a man somewhere in the Sahara desert close to dying of thirst….”

Uwe, one of the problems with healthcare policy is that such metaphors are frequently used, but they don’t lead to good policy formation. If Churchill during WW2 used that type of thinking WW2 could have been lost.

David Dranove rightly brings up liquidity constraint something that has been mentioned in various ways before. It demonstrates that the policy makers have created much of the problem they now intend to find solutions for.

I would like to add another aspect, contract law. There is such a thing as a contract of adhesion which this metaphor seems to create. The courts might later hold the contract to be unenforceable due to its unconscionability. Wouldn’t such an agreement “shock the conscience” (Rochin v. California)?