A quick and dirty explanation of prescription drug costs...

For the last several years, health care reform has been a major emphasis of political conversation.  More recently, anytime healthcare gets brought up, the conversation goes straight to prescription drug costs.  This is a complicated issue.  It involves US gov't policies, public and private research, banking, investing, interest rates, foreign gov't policies, capitalism, socialism and ethics.  Here, I am going to do my best to boil it down to the essential elements. 

First, the reason this has been getting attention is a few recent high-profile cases of price gouging of life saving medicines by pharmaceutical companies.  I want to be completely clear, that this is NOT the reason for high drug prices.  It is a very good thing that drug prices are getting attention, but a very bad thing that the focus of media coverage has been a few outliers that lead people to believe that drug prices are totally arbitrary.

First, a little about the science of developing drugs.  As someone working in biotech, I can tell you that most ideas don't pan out.  If they did, disease wouldn't be much of a problem.  As it is, coming up with new drugs that eliminate suffering and help people lead longer healthier lives is not at all easy.  In fact, a recent study found that the likelihood of a drug that makes it to a phase I clinical trial ever achieving approval is 9.6%.  To be clear, only the very most promising laboratory work gets translated to a phase 1 clinical trial.  When you take that into account, WAY less than 1% of tested drugs will ever achieve approval.  For the sake of argument here, I will make a super generous estimate that 10% of drugs tested achieve approval.  I will assume there are zero R&D or time costs prior to beginning phase 1 trials. This is the first part.

The next piece of the equation is US Gov't policies.  In order to get a new drug approved in the US, it must go through the FDA approval process.  This process is designed to protect patients, but it is also time consuming.  The FDA estimates that from phase 1 clinical trials to approval is 5-7 years, plus additional post-market surveillance.  Again, I will use the very conservative estimate that a drug can go from phase I to market in 5 years.

Now we come to a cross-section of capitalism, banking, interest rates, and investing.  One universal truth, is that NOTHING is free.  As it turns out developing drugs is particularly expensive.  This is in part because so much specialized equipment and knowledge is necessary, and in part because when the stakes are human health, we want people investing adequate resources to ensure results.  Let's make another very conservative estimate that it will cost $100M to get a drug from phase 1 to approval.  Now we tie back in with everything else we've discussed.  Because in order for drugs to get developed it requires capital.  So let's say someone wants to develop a drug.  Let's assume they have to raise $100M up front to develop it.  Now,  at the very minimum in order to fund the project, returns have to be better than what you would expect investing in an index fund.  For simplicity, let's say 5% annually.  That means that in 5 years, returns would have to be $127M.  In a realistic scenario where the returns come over a long period rather than as a bulk sum upon reaching the market, that $127M becomes much larger.  But wait....Only 10% of drugs reach the market from phase 1 trials.  So now, to account for the risk.  The returns have to be $1.27B in order to be as good an investment as an index fund. Now, it may not be possible to invest in 10 different drugs, and even if you do, there is no guarantee that one of those will succeed, so the capital for investing in pharmaceuticals comes at a premium, because it has to compensate for the risk.  Now we are looking more in the range of $1.5-2B. 

Now, I hope at this point you see that developing drugs is incredibly time and resource intensive.  I hope you are also still skeptical about the prices we pay in the US.  They are TOO high.  Everything that I have said about drug development doesn't account for the prices we pay.  So the next conclusion most people assume is, "those lousy, greedy, pharma executives are screwing us".  However, you have probably also heard, "they have affordable drugs in (insert country with socialized medicine)."  Why then, are those greedy people not screwing the sick people in other countries?  Do they have a particular disdain for the US?  No.

This is where foreign gov't policies (especially those with single payer systems) come into play.  You can think about these governments like a really big insurance company.  The one big difference is that they are the only game in town so if you live in one of these countries they WILL be your insurance company.  In the US, the only thing we hate more than pharma companies charging ridiculously high prices for medication, is insurance companies refusing to cover those medications.  This is where we lose our leverage.  Countries with single payer systems tend to either have laws or official policies governing how much they are willing to pay for drugs, and often it is dependent on manufacturing costs.  So let's consider Drug A.  Drug A must make $1B in order to be a profitable drug.  Each pill costs $1 to make.  The company making drug A expects to sell 200M pills in the US, and 300M in countries with single payer systems.  This means we would expect the pills to cost roughly $2/each.  Instead the countries with the single payer systems say we will only pay $1.01/pill, because you shouldn't be charging us more than it costs you to make the pill.  Now they go to negotiate the drug price in the US, and they still need to make $1B, but they can only make that money in the US.  Additionally, they know that consumers in the US will demand that drug companies cover the cost, no matter what it is, so they tell US insurers that the pill will be $5/pill each.  Thus, a pill that costs $1 in Country B can be $5 in the US.  So in a less direct way, the US is paying for the healthcare of other nations the same way we have been paying for the defense of other nations.

What can be done about this?

For starters, we can be realistic.  This is one place where we should lower the cost of delivering healthcare in our country, but it is not by any means the only place.  We can't hope to fix this and suddenly have cheap healthcare.  Also, we have to do basic arithmetic.  We have to understand that if we pay the same thing here that places like Canada or New Zealand currently pay, new drugs simply will NOT get made.  There is a minimum amount of money that drugs have to make in order to incentivize the research and manufacture of new ones.  We can force drug companies to sell drugs in other develop nations at a similar price to what they sell them for in the US. This would likely cause our own drug prices to plummet, but it would also cause the drug prices in many friendly nations to skyrocket making their current health care systems untenable.

What makes the most sense to me is a piecemeal approach.  Let's not allow drug companies to use the US to subsidize other nations to the extent they currently do.  Lets also fund more translational research with public money, so that we can minimize risk and there fore the expect return on capital in drug development.  Lastly, what if we made the FDA work more like the CPSC in order to allow safe drugs to make it to the market substantially faster also lowering the expected returns.