Drug Prices: What's Fair?

How can we encourage research and still keep prices within reach...for Cipro and beyond?

For drugmakers, this fall's Cipro saga contains the germ of a potential nightmare. No, not because of worries that the antibiotic is scarce or that anthrax will bring America to its knees. The scary part for the industry was watching tough-talking Health & Human Services Secretary Tommy G. Thompson bully Cipro manufacturer Bayer (BAYZY ) into slashing its price by threatening to take away its patent-protected monopoly.

In one fell swoop, Thompson highlighted the fact that Cipro costs about 10 times as much as equally effective drugs, he emboldened Brazil and other countries to break patents to lower drug costs, and he set a worrisome precedent for future government meddling in the cost of medicines. If a free-market Republican Administration can force Bayer to cut its price, how will the government be able to resist stepping in when the soaring cost of a future Medicare drug benefit threatens to break the bank?

Make no mistake: In a few years, America's bill for drugs could well bust the health-care budget because of a triple whammy of expensive new medicines, a tremendous jump in the use of drugs, and the aging of the population. Already, there are drugs such as Pharmacia Corp.'s colon-cancer treatment, Camptosar, that can cost more than $60,000 per patient per year. And as today's gene wizardry becomes tomorrow's amazing new drugs, some of the price tags will be equally amazing.

The nation's drug bill has been rising at 14% to 18% a year, and for 2001 it will be between $160 billion and $170 billion, according to private sector estimates. The bill will climb even faster as seniors' ranks swell with aging baby boomers. The upshot: a clash between soaring costs and payers' ability to foot the bill. "The countdown has already started on the collision course," says Alan L. Hillman, director of the Center for Health Policy at the University of Pennsylvania's Wharton School. "We simply don't have enough money to pay for these future technologies."

The prospect of this collision is already prompting insurers, governments, and other payers to take direct aim at the pharmaceutical industry. To keep costs from soaring even higher, health maintenance organizations (HMOs) and pharmacy benefits managers (PBMs) are trying everything from pushing patients to use generics to demanding that drugmakers prove that their new medicines are cost-effective. States from Florida to Michigan are legislating discounts for residents, and companies like Chrysler (DCX ) are teaming up with others to negotiate lower prices. Meanwhile, a new World Trade Organization agreement gives other countries more leeway to make cheap knockoff drugs in times of medical need. All this comes at a bad time for Big Pharma, which is facing the imminent expiration of patents on many of its blockbusters and fewer-than-expected new drugs in the pipeline. "We are under enormous pressure," says Novartis (NVS ) Chairman and Chief Executive Daniel Vasella.

The industry is fighting back. In an advertising campaign, it is arguing that spending more on drugs actually saves money by reducing costly hospitalizations and other health-care expenses. Companies are also rushing to assure patients who cannot pay that they won't be left out. GlaxoSmithKline PLC (GSK ) announced in October that it would give discounts of 30% to 40% to needy elderly Americans, for instance. Novartis is providing its $28,000-per-year leukemia drug, Gleevec, free to those who can't afford it, as well as discounting other drugs for poor people. And the bioterrorism attack "gave the industry the opportunity to put its white hat back on," says Lehman Brothers Inc. analyst Nancy Myers. Glaxo, Bristol-Myers Squibb (BMY ), and others rushed to donate antibiotics and expertise to the government. "If industry doesn't make such an effort, we will face a backlash," says Vasella.

Big Pharma's do-gooders, however, can't paper over the underlying issue: Just how will the nation cope with the rising cost of drugs? It's a far from simple question. A close examination shows that this is not a black-and-white case of medical breakthroughs that bust the bank or of lifesaving drugs priced out of reach of ordinary citizens. Instead, the tale is replete with paradoxes and puzzlements. Take one classic example: Some expensive new drugs, such as Gleevec or cholesterol-lowering medicines, do save money by reducing the need for expensive bone-marrow transplants or bypass operations. Yet in terms of overall health-care costs, a quick death is cheap. By living longer, patients will get other diseases that require more costly care. On the other hand, premature deaths rob the economy of productive citizens and workers.

These complexities make it extremely difficult to figure out whether any given drug increases or decreases health-care costs. Add in the larger picture, including productivity and quality-of-life measures, and the economics gets even murkier.

The whole debate is further muddied by the country's schizophrenic attitude toward drugs and drugmakers. Americans want powerful new medicines, along with smashing returns for stockholders. At the same time, people demand that drugmakers deliver their remedies at prices ordinary folks deem reasonable. If drug prices soar, Americans worry that medicines will have to be rationed by the patient's ability to pay, which wounds our sense of social equity.

So how is it possible to understand this complex situation? And more important, what can be done to soften the impact of the collision between soaring costs and ability to pay?

What follows is a step-by-step tour through some of the key questions and answers. The bottom line: The U.S. does spend more than it needs to on drugs, although in certain cases it should be spending more. Drugmakers need big profits to provide the innovative new medicines that the public demands--even though companies also need to boost research and development productivity. Market forces are already beginning to rein in the drug-cost monster, but there are steps the health-care system should take to speed the trend. BusinessWeek estimates that these steps could cut the nation's annual drug bill by as much as $15 billion and reduce other health-care costs as well.


One fact is crystal clear: The U.S. drug bill is higher than need be. Americans take more drugs than necessary, often popping expensive pills such as Cipro when cheaper ones will do. And because of overuse and misuse, studies estimate, the U.S. wastes an extra dollar for every dollar spent on drugs--fixing the ills medicines cause. Some patients don't get, or don't take, the right prescription, for instance, leading to lost work or unnecessary hospitalizations. Others suffer because of dangerous side effects or drug interactions. One famous 1998 study in the Journal of the American Medical Association estimates that adverse reactions to drugs in U.S. hospitals may cause more than 100,000 deaths a year. "When you see someone taking 14 drugs, the last seven are typically to treat the side effects of the first seven," observes Albert I. Wertheimer, director of Temple University's Center for Pharmaceutical Health Services Research.

Reduce these problems, and the savings are huge. If the estimated $150 billion spent each year to fix drug havoc could be cut to $50 billion, "we'd save enough to afford a Medicare drug benefit," says J. Lyle Bootman, dean of the University of Arizona's College of Pharmacy.

For each of these problems, there's plenty of blame to go around. Employers, doctors, and health insurers often fail to steer patients toward the drugs that offer the best value or to teach them to take the medicines properly, experts say. Meanwhile, Americans too readily seek pharmaceutical solutions to ailments that are better tackled through prevention. Public-health officials warn that we are on the cusp of a budget-busting diabetes epidemic, triggered by Americans' couch-potato habits. The incidence of the disease has jumped more than 33% since 1990, mirroring a similar rise in obesity.

Drugmakers are culpable, too--although not necessarily because of the prices they charge. Selling drugs is, after all, a business, and companies have a duty to shareholders to maximize profits, observes Dr. Alan M. Garber, professor of medicine and health policy at Stanford University. "It would be unfair to portray the industry as greedy or irresponsible if they charge what they can get," he says. But companies may cross an ethical line when they market expensive drugs to those who don't need them or manipulate the patent system to extend their patent-protected monopolies.

Today, the rise in drug spending is not being fueled by headline-grabbing, $15,000-a-year AIDS or cancer drugs, which are used by too few people to add up to megabucks. Instead, Merck-Medco (MRK ), a large PBM, figures that more than half of the projected doubling in its spending over the next five years will come from just two main types of drugs: cholesterol-lowering and other heart-related medications, and neurological medications, such as psychiatric drugs or painkillers, that are used by tens of millions of people.

When they develop new classes of drugs, companies typically price them far higher than the older medicines used for the same conditions--even if the extra benefits are small. Expensive drugs called calcium channel blockers, for example, are routinely prescribed for patients with high blood pressure, even though studies show that cheaper beta-blocker and diuretic drugs can work as well or better.

What's more, drugmakers market many medicines directly to consumers, spending billions on ads that critics say are often misleading. "Pharmaceutical companies are coming out with these very expensive new drugs to replace existing drugs, sometimes in the absence of good evidence that their value is worth the extra costs," charges Dr. Sharon Levine, associate director of Kaiser Permanente's physician unit. For instance, the heavily advertised painkillers Celebrex and Vioxx, with combined worldwide sales of $5.6 billion, "are not more effective than Motrin, but they cost up to 60 times as much," Levine says. The new drugs do offer an important benefit for some patients: less stomach bleeding. But most people have no problem taking the older drugs. The Food & Drug Administration has cracked down on Pharmacia (PHA ) for painting too-rosy pictures of its drug's merits in consumer-focused ads.

Meanwhile, one study found that as many as two-thirds of people taking Schering-Plough Corp.'s (SGP ) heavily advertised Claritin and other allergy medicines don't even have allergies. Schering responds that patients wouldn't take Claritin if it didn't work. But "there's no doubt that the direct-to-consumer advertising increases drug consumption," says Barrett A. Toan, chairman and CEO of Express Scripts Inc. (ESRX ), a PBM. Claritin sales? About $2.2 billion per year.


Investors won't fault companies for persuading consumers to buy more products than they actually need. And the more money drug companies make, the more they can spend developing tomorrow's lifesaving medicines. Indeed, industry execs argue that if prices were squeezed, the world can forget about new and better drugs.

Many economists agree--up to a point. Consider today's protease-inhibitor drugs for AIDS, which have dramatically cut deaths and hospital costs for those with HIV. If Congress had put price controls in place back in the early 1990s when lawmakers were screaming about high prices, "there would be no protease inhibitors now," says Eugene M. Kolassa, professor of pharmacy at the University of Mississippi. While drugmakers would have tried to develop AIDS drugs anyway, they would not have moved as quickly as they did without the promise of blockbuster revenues.

On the other hand, drugmakers wouldn't need to charge such high prices if they could boost R&D productivity. Overall, the average tab for developing a new drug is $500 million to $880 million, the industry says. But the amount actually spent on any one marketable product is roughly one-quarter of that.

To understand why, just look at the drug-development process. In the past, scientists made many variations of existing chemicals and tested them to see which ones had the ability to fight a particular disease. Now, with the explosion of information about genes and biology, the process has gotten more complicated--and oddly enough, more difficult. Researchers try to identify the best target in a particular disease--for instance, a damaged gene that causes cancer--then they make a drug to hit the target and cure the disease.

That process can take 10 years or more. Such a long period means that about half of the calculated $500 million to $880 million total isn't actually spent at all. Instead, it's the opportunity cost--the measure of what the money tied up in the drug for so many years could have earned with alternative investments.

Moreover, there are pitfalls every step of the way. Making drugs from previously unexplored types of chemicals increases the chances of problematic side effects, explains John F. Niblack, R&D chief at Pfizer Inc. (PFE ) And new targets that look great in the test tube or in animals often don't pan out in humans. "If you develop a drug that hits one of those unvalidated targets, you are likely to spend a lot of money and find out that it doesn't work," says Niblack.

That's why, of the thousands of potential drugs that start development, only a tiny percentage make it into animal tests. Only a few of those will be given to people in so-called Phase I trials to test for safety. Then come Phase II trials for safety and the first hints that a drug works. And then Phase III: wide-scale tests to gather proof of safety and efficacy. Only about 1 in 10 of the drugs that enter human trials makes it through Phase III.

The high attrition rate means that about half of drugmakers' actual R&D spending represents the price of all the failed projects. The corollary, therefore, is that reducing the failure rate and the overall development time can dramatically cut total R&D costs. Pfizer's Niblack, for one, believes that new technologies for screening drugs, smarter clinical trials, and other measures will soon slash the attrition rate. But for now, industry productivity is going down and R&D costs are going up. With all the advances in biology, "we had expected a lot more [new drugs] by this time," admits Fred Hassan, chairman and CEO of Pharmacia. "The reason is that the new stuff is difficult to find."

That's why drugmakers are increasingly letting others take the big risks. More and more, they're filling their pipelines by picking up drugs from biotech corporations and startups--after the medicines have already shown promise in clinical trials. Case in point: Bristol-Myers Squibb's $1 billion investment in ImClone Systems' promising cancer drug, C225.

Although drugmakers spend billions on R&D, they also rake in huge profits. Too big, some analysts believe. Since 1988, the return on equity of the five biggest U.S.-based drugmakers--Merck (MRK ), Eli Lilly (LLY ), Pfizer, Pharmacia, and Schering-Plough--has averaged 30% a year. Last year, it was 36%, compared with 27% for Microsoft Corp. (MSFT ) and 21% for companies in the Standard & Poor's 500-stock index.

Industry execs say that the high returns are justified on the basis of the high risks they take to develop drugs. But economists point out that such risks ought to translate into variable returns--and drugmakers show a consistent high return on equity compared with companies in other sectors. Merck's return, for example, has not fallen below 28% since 1988. "If you went to Vegas with $1,000 and routinely came back with $1,400, could your family accuse you of gambling?" asks Alan Sager, co-director of the Health Reform Program at Boston University.

By this analysis, Big Pharma's prices are higher than needed to cover R&D costs and risks. But that's not surprising, because the price set for a drug typically has little to do with its development cost. Instead, pharmaceuticals are just like any other product: The producers charge what the market will bear. The usual price calculation includes an assessment of the medical benefits the drug brings and how much competition it faces.

If a new drug offers a lifesaving treatment where none existed before, or if it helps avoid costly hospital procedures, the price can be astronomical. An example is Genzyme's (GENZ ) drug Cerezyme for the rare Gaucher disease, which has an average price tag of $170,000 a year. The alternative, after all, is severe disability or death. "In reality, if a drug is going to save a life, we will find a way to afford it," says C. Daniel Mullins, associate director of the Center on Drugs & Public Policy at the University of Maryland School of Pharmacy.

And when it comes to new painkillers or other drugs, Big Pharma has been able to get away with charging high prices because most consumers, shielded by their insurance coverage, have little or no incentive to pick cheaper options, explains Kenneth L. Sperling, head of health-care analysis at Hewitt Associates LLC. That, however, is beginning to change, as the health-care system takes a harder look at the value of drugs.



Despite the concern over drug costs, pharmaceuticals represent only about 9.5% of the nation's $1.4 trillion health-care bill. In the U.S., drug spending is less, per person, than it is in many European countries, which have lower per capita medical bills. To economist H.E. Frech III of the University of California at Santa Barbara, the conclusion is clear: If the U.S. spent more on drugs, health-care costs would be lower. Argues the University of Mississippi's Kolassa: "We should be happy that pharmaceuticals are the fastest-growing component of the health-care budget, because it means that other components aren't growing as fast."

There's some merit to the argument. Health experts can point to case after case in which a new drug or a boost in drug use replaces hospital outlays. The advent of stomach-acid blockers, for instance, dramatically slashed the number of ulcer surgeries. Even at $28,000 per year, the leukemia drug Gleevec is cheaper than a bone-marrow transplant. And a newly updated study by Columbia University economist Frank R. Lichtenberg finds that for every extra dollar spent replacing many older drugs with new, costlier ones, four dollars are saved in medical costs.

Even WellPoint Health Networks Inc. (WLP ) in California, which has been particularly aggressive at trying to curtail drug spending, has learned that additional drug use sometimes can save money. In 1998, WellPoint became concerned about rising emergency-room and hospitalization costs for its asthma patients. For help, the company turned to Kathleen A. Johnson, a pharmaceutical economist at the University of Southern California. She helped set up a program to identify patients at risk and train them to monitor their symptoms and use drug inhalers when needed. "We found that even though drug costs went up [about 20%], hospital admissions and emergency-room visits went down by 80%--and overall costs by 48%," says Johnson.

But as usual, the story is more complex than it seems. Many drugs don't replace costly procedures. Glaxo's new flu drug, Relenza, simply shortens flu symptoms by a day or so. Other drugs may cut some costs but raise others. Do AIDS drugs save money, for instance? "The jury is still out," answers Maryland's Mullins. Yes, AIDS-related hospitalizations and deaths are down. But the drugs also have serious side effects. HIV-infected patients are now getting cancer, heart disease, and other diseases that are costly to treat.

Even drugs that help prevent hospitalizations or surgeries may increase health-care costs--because so many people take them. Cholesterol-lowering "statin" drugs reduce the need for bypass and other heart operations. But they are now used by millions of Americans, and scientists estimate that only a minority would have needed operations without the drugs. The total statin bill: $15.5 billion this year, rising to $24.6 billion by 2005, predicts SG Cowen Securities Corp. Economists say it's not clear whether the health-care savings would be greater than that.

The problem of paying will grow even more complicated. Companies are experimenting with genes that help build new blood vessels to the heart, for instance, or cancer treatments where patients' own tumor cells are used to boost the immune system's ability to fight the disease. These approaches, some customized for each individual, will be hugely expensive. Yet if they work, Americans will demand them. "The limiting factor will be affordability," says Dr. August M. Watanabe, executive vice-president for science and technology at Eli Lilly & Co. "Can society afford them for its citizens?"

The nation can easily pay the tab, economists generally agree. "We're a long ways from reaching any limit," says Harvard University economist David Cutler. After all, he points out, GDP is rising faster than total health-care costs. That leaves a bigger and bigger piece of the pie to pay for drugs.

But while a rich nation like the U.S. can foot the bill, many Americans will be left out. In fact, de facto rationing is already common. Look at two of the latest drugs for rheumatoid arthritis, Immunex Corp.'s (IMNX ) Enbrel and Johnson & Johnson's (JNJ ) Remicade, both of which cost $10,000 to $12,000 a year. The companies do offer some assistance to poor patients. But, says Dr. John H. Klippel, medical director of the Arthritis Foundation, "just because of the expense, they are largely limited to people who have insurance plans that pay for them."

Overall, when it comes to health care, "we're moving to a three-tier system: the haves, the have-littles, and the have-nots," says Wharton's Hillman. "The more technology we have and the more that it costs, the more we have to ration it."


For Americans worried that they will be among the have-nots, the good news is that the market has begun to rein in drug costs. Insurers and payers will also get a break because blockbuster drug after blockbuster drug, from Claritin to stomach drug Prilosec, is coming off patent or other monopoly protection. Overall, drugs that are now worth $35 billion per year in U.S. sales could face competition from generics by 2005.

Large employers such as General Motors Corp. (GM ) stand to reap windfalls. "If you take a look at three of the drugs that will lose exclusivity--Prilosec, Claritin, and Glucophage--we are talking about $75 million in potential savings for GM over a three-year period," says Cynthia Kirman, GM's director of pharmacy. That's why insurers and PBMs are already pushing generic drugs hard. When Prozac went off patent recently, Merck-Medco was able to convert 80% of mail-order customers within a week--an amazingly quick substitution. The savings from the coming flood of generics? Up to $3 billion per year.

Drugmakers are responding as many other companies would--by protecting their profits. For example, they're doing everything in their power to delay competition from generics, sometimes using tactics that even some drug company execs call "brazen" and "embarrassing". Generic competition is not the only threat, however. In the past couple of years, the market has also begun to generate another set of checks and balances on drug prices, called pharmaco-economics. In essence, experts scrutinize the value of individual drugs, aiming to get more bang for the buck.

Pharmaco-economics is already slowing the rise in drug costs for insurers and other payers. In Britain, for instance, a government panel made the controversial recommendation that Glaxo's Relenza not be made available to the public through the National Health Service. The benefits didn't justify the cost, the panel said. Similarly, U.S. military pharmacists have decided that all new patients with allergies will be put on only one allergy drug, Allegra. The government has negotiated a price of 60 cents per daily dose for Allegra, less than half the cost of competing Claritin. The savings: $7 million in fiscal 2001.

Kaiser Permanente is another believer in pharmaco-economics. Under its plans, only 6% of arthritis patients--those at higher risk for gastric bleeding--get expensive Cox-2 inhibitor painkillers like Vioxx. The rest take cheap ibuprofen. Nationwide, the ratio is 50-50. "If people can be switched from drugs of very little marginal benefit to drugs that are as good and a lot cheaper, there is an opportunity to save many millions of dollars," says Stanford emeritus professor Alain C. Enthoven. With seed money from BlueCross BlueShield, Enthoven is helping to set up an institute, RxIntelligence, to provide drug-effectiveness data that insurers can use to save money.

Meanwhile, insurers are giving patients incentives to choose cheaper drugs. According to a spring, 2001, survey by market researcher Scott-Levin, 50% of people enrolled in HMOs tracked by the firm were in three-tiered prescription drug plans, up from 5% just three years previously. In such plans, patients typically pay little or nothing for a generic drug. They have a bigger co-pay for the brand-name product, and a still higher co-pay for the most expensive drug.

Some cost-cutting tactics can be risky, leaving some patients with substandard treatments. Economists have shown that simpleminded measures, such as capping drug benefits, can actually raise overall costs since patients may not get the medicines that work best. But done correctly, with the emphasis on effective treatments instead of drug costs alone, this type of scrutiny can lead to better care.

One model, pharmacists say, is the approach used by Active Health Management for companies such as Merrill Lynch (MER ) and Sears, Roebuck & Co. (S ) The idea: Give people more medical attention, not less. When doctors find and treat diabetes, heart disease, or other illnesses early, hospitalizations decline, yielding savings of more than $100 per person per year, calculates Dr. Lonny Reisman, CEO of Active Health Management.

Inevitably, the nation's drug bill will continue to rise, fueled by the introduction of new drugs and by aging baby boomers, now reaching their prime prescription years. "I think we will pay more for drugs and we will have less available for other things," says Express Scripts' Toan. But it is within America's power to use those drugs more effectively.

Health-care experts say there are some simple remedies. The nation's doctors and hospitals should be able to trim scores of billions per year by avoiding health-care costs that occur when drugs are used incorrectly. Steps include computer systems to spot dangerous drug interactions and better patient education about the need to take medicines as prescribed. Health care must also harness market forces more effectively.

Back in the 1960s, when Americans paid out of their own pockets for drugs, consumers had a strong incentive to pick the medications that offered the best value. That incentive vanished when insurers began to pick up the tab. But it could be restored and boosted by expanding use of tiered co-pay plans, saving about $1 billion annually. Or for more savings, insurers could require patients to shoulder a specified percentage of each drug's cost; the percentage would increase for more expensive drugs.

The nation could also educate consumers, doctors, and payers about which drugs deliver the most for the money, by setting up an independent pharmaco-economic institute. The information it provides could shave $10 billion or more off the annual drug bill, economists estimate. In addition, Congress could close loopholes that drugmakers use to delay introduction of generics. Tightening rules for advertising drugs directly to consumers could reduce overuse of expensive drugs. And Big Pharma must learn to cope with the flood of new knowledge about biology to boost its productivity.

The future could get ugly--not just for have-nots. Maryland's Mullins, for instance, fears that the health-care system may decide not to pay as much for treatment for those who helped bring on their own illnesses, such as smokers. Medical progress, though, will clearly continue on its current fast track. "America is in love with innovation--and it wants new drugs," says Jean Paul Gagnon, director of public policy at Aventis Pharmaceuticals. Now, we need to figure out how to pay for those drugs without breaking the bank.

By John Carey and Amy Barrett

With Arlene Weintraub in Los Angeles, Catherine Arnst in New York, Kerry Capell in London, and Michael Arndt in Chicago

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