Why prescription drug prices keep going up

Nicole Sinclair
Markets Correspondent

Drug pricing has become a key priority for President Trump. And it’s no surprise why.

Some drugs for cancer carry a price tag of over $100,000 per year with a big portion of costs falling on patients themselves. And drugs for rare diseases—made by companies like Alexion (ALXN) and Biomarin (BMRN)—can cost upwards of $500,000 per year.

The last year or two included major controversies over drug prices, including the price of Mylan’s (MYL) Epipen allergy treatment, which rose 500% from 2009 to 2016 before it introduced a lower-priced generic option. Before that, Martin Shkreli’s Turing Pharmaceuticals drew criticism for raising the price of an anti-parasite drug by 5,500%.  And beleaguered Valeant (VRX), which grew from a controversial acquisition strategy, came under fire for price hikes, including jacking up the price of two heart drugs by more than 500% and 200% after acquiring the rights to sell them.

These companies became the poster children for greed in the pharma space, bringing the sector’s drug-pricing practices into public view.

Prescription drug prices rose 6.2% in 2016, according to the pricing data provided by the Bureau of Labor Statistics. That’s about three times the overall rate of inflation. And many consumers without insurance face stratospheric costs if they need life-saving, brand-name drugs where there is no generic available.

Healthcare investment bank Leerink Swann analyzed nearly 1,000 branded drugs and found 10% of all drugs had seen price increases of 3x or higher between 2011 and 2016, and seven drugs saw increases above 5x, as shown below.

So what’s behind all of this? There are a few drivers.

First off, there is a complicated system of middlemen with different interests that puts upward pressure on pricing. Meanwhile, drug companies (which largely determine pricing) are motivated by profit and justify higher prices by pointing to high costs for research and development, including for failed studies. There is also minimal competition, given patent rules, FDA backlog for generic drugs, and restrictions on imports. Plus, Medicare, the biggest purchaser of drugs, isn’t allowed to negotiate prices.

‘It’s the system’

In interviews about the EpiPen price increase, Mylan CEO Heather Bresch deflected blame away from her company onto the healthcare system as a whole.

“I am hoping that this is an inflection point for this country,” Bresch told CNBC in an interview last summer about the Epipen outcry. “Our health care is in crisis. It’s no different than the mortgage financial crisis back in 2007.”

Bresch explained while the “list price” for EpiPens was $608, Mylan took $274 of that—with the remaining $334 going to intermediaries, including pharmacy benefit managers (PBMs), insurers, wholesalers, and pharmacy retailers. In other words, according to Bresch, much of the price increase is coming from “the system,” not the drugmaker specifically.

“This isn’t an EpiPen issue, this isn’t a Mylan issue. This is a health care issue… the system is broken,” she said.

Indeed, “the system” has received scrutiny, including names such as the nation’s largest PBM, Express Scripts (ESRX).

Insurance companies rely on PBMs to manage costs while drug manufacturers rely on PBMs to put their products in front of customers. PBMs negotiate with pharmacies and drug manufacturers to get discounts on drug prices that they pass to insurance companies. They also negotiate contracts with pharmacies to create a network of retail locations for drug distribution.

PBMs’ revenue comes primarily from rebates paid by drug manufacturers in order to be carried on a PBM’s system. This, according to some analysts, creates skewed incentives toward PBMs dispensing more expensive drugs (because the higher the price, the higher the rebate).

Meanwhile, the current pricing system reflects a reliance on insurance companies, which means that pricing is not based on consumer demand or ability to pay but instead on how much insurance companies will cover, as noted by Bloomberg View’s Matt Levine.

Plus, Medicare, the single biggest purchaser of drugs in the US, isn’t allowed to negotiate prices of drugs, contributing to higher costs.

Company responsibility: Research & development… and profits

At traditional biotech and pharma companies, increased drug pricing is at least purported to incorporate the cost of developing the drug and to incentivize companies to innovate and develop new ones.

This has been the defense of Gilead (GILD), which has come under scrutiny for the high price of its Hepatitis C drug. (The cost to develop a new drug and win FDA marketing approval is pegged at about $2.6 billion, according to a 2014 report from the Tufts Center for the Study of Drug Development.)

So what should profit margins be? The gross profit margin for Mylan, for example, stands at about 40%, “normal” for the industry.

“For Mylan or any manufacturer, there is a grey area in what is viewed as appropriate versus aggressive price increases, especially on critical care drugs with near-monopoly positions that have large pediatric or elderly populations,” according to RBC’s Randall Stanicky.

In the end, it seems pharma and biotech CEOs have focused on enhancing shareholder value, which may conflict with consumers’ best interests.

And while Bresch was quick to blame the system, Mylan’s ability to respond to the outburst of criticism last year with a lower-priced alternative shows it could have done more earlier, according to analysts.

(Tetra images RF/Getty Images)

(At the end of last summer, Mylan responded to the pricing outcry, announcing it would cover up to $300 in out-of-pocket costs at the pharmacy, which would reduce what patients paid by 50% off Mylan’s list price. Then the company followed up with an announcement that it would launch a generic version of the EpiPen, for a list price of $300 for a two-pack carton.)

Given the choice, Mylan would probably have continued raising the price of the EpiPen before the media firestorm, according to analysts. Historically, Mylan has hiked the price on the EpiPen twice a year.

Minimal competition

Meanwhile, monopolies have built up for different drug categories, analysts say.

Specifically, in the last few years, backlog has built up at the Food and Drug Administration for approvals of generic alternatives.

Plus, there have been instances where companies that market branded drugs have paid generic drug makers to delay roll-out of generic options, a tactic known as “pay-for-delay.”

Now there are even some investigations into generic drug pricing. Generic drug maker Perrigo (PRGO) recently announced its offices were searched by the Department of Justice as part of an investigation into potential price collusion.

The importation of cheap drugs from Canada or other countries where prices are far lower is also not allowed.

In other countries, the health system is simpler with fewer organizations trying to buy drugs – so they have greater purchasing power. By contrast, in the US, insurance groups, hospitals and plans buy drugs for consumers, resulting in a wide variety of pricing.

What does this mean for the industry?

Political and consumer pressure does seem to be setting off changes at certain companies including Mylan, but the high cost of drugs across the industry remains a problem.

RBC’s Stanicky said the recent outcries will deter companies to some degree from boosting prices. “This will shift focus back to drug pricing and we have to think it will be another disincentive to companies to use price (brand or generic) as a mechanism to offset the potential gross margin pressure that we still see ahead for the generic/hybrid sector,” he wrote in a note.

In January, Trump met with pharmaceutical representatives, pushing them to to cut prices, which he said are “astronomical.” The CEOs of drug companies including Merck (MRK), Johnson & Johnson (JNJ), Eli Lilly (LLY) and Amgen (AMGN) are certainly in the crosshairs.

Trump, while saying “we have to get drug prices down. We have no choice” also struck a friendly tone, saying he will cut regulations on drugmakers and build a more favorable business climate. He’ll likely be met with resistance, though, because “big pharma” has powerful lobbyists in Washington.

Solutions?

Absent a specific plan from the Trump administration so far, many lawmakers have called for more scrutiny of pharmaceutical companies along with all the middlemen like pharmacy benefit managers.

Penalties for unjustified price increases (including fines and rebates) could also be rolled out. But this could prove difficult under an administration that has also promised to reduce regulations.

There has also been a push-back on consolidation. Aetna (AET) had proposed a merger with Humana (HUM) but that was shut down. And Anthem’s (ANTMpursuit of a merger with Cigna (CI) looks all but dead.

One oft-discussed way to control drug prices is to allow Medicare, the single-biggest purchaser of drugs in the US, to negotiate prices with providers. But federal law currently prevents this, with the likelihood of Congress changing that low.

Analysts have proposed making more generics and international branded drugs available to boost competition, but that may be difficult to institute, particularly for drugs under patent protection.

Nicole Sinclair is markets correspondent for Yahoo Finance.

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