How Are Drug Prices Determined?

A lot goes into getting a drug into a patient's hands, but the complexity of the distribution channel is only one reason why drug prices are high. As drugs get increasingly intricate, they're becoming more costly to develop, and that has an impact on prices, too. How can you determine if a drug price is fair?

In this episode of The Motley Fool's Industry Focus: Healthcare podcast, Kristine Harjes is joined by contributor Todd Campbell to discuss the factors that contribute to a drug's price and how payers attempt to measure the value that a medicine provides to a patient.

Also, the two explain why dollar-cost averaging into the stock market can be the single best way to build wealth over time, and they suggest some investments that you may want to consider for dollar-cost averaging if you're interested in healthcare. 

A full transcript follows the video.

This podcast was recorded on March 1, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your Healthcare show host, Kristine Harjes, and it's March 1. I'm in Alexandria, Virginia, at Fool HQ, and I have healthcare contributor Todd Campbell on the line. Todd, welcome to another week of Industry Focus!

Todd Campbell: Hi, Kristine! It's a pleasure to be here. How are you today?

Harjes: Doing great, I'm excited for today's episode. We want to tackle a pretty important question, which is, why are prescription drugs so darn expensive? We will attempt to answer that on this show. Then, after that, we wanted to give you some specific, actionable advice that we think can improve all of our listeners' investing immediately. It should be a good one. Let's dive in. We'll start with the drug question. Why are drugs priced the way they are? If you have been reading the news lately, you've seen headlines about price gouging and healthcare reform. This is a hot-button issue, and it affects the vast majority of our wallets directly. There's a lot of political attention being given to it as well. We've had some listeners write in, expressing concern about drug pricing and asking us questions, so we figured we would try to boil it down and have a conversation about what exactly goes into a drug price. What do you think, Todd?

Campbell: Kristine, I blame biologics.

Harjes: That's fair. For a background, biologics are these big, complicated drugs. They're relatively new compared to the type of basic drug, which is a small-molecule drug. And since they're so big and tricky, they're expensive, too.

Campbell: Yeah. Let's go back 20 years or whatever, when we were just talking about small-molecule-chemical produced drugs. Those are relatively easily produced, easy to duplicate, and the rate of inflation associated with drug prices 20 years ago was much less than it is today. I really think that a lot of it has to do with the complexity that's associated with building out these new, next-generation therapies. They work better. But they're also more complex to build. And there's a lot of failure that goes into developing drugs. When you combine the complexity plus the failure rates, you end up with higher cost to produce, and those costs obviously getting translated into higher costs that payers have to pay.

Harjes: Right. So, that's the most obvious argument that you hear from drugmakers about their drug prices, "We need to recoup our investment. We spent 10 years trying to develop this drug, and not only that, but we also had years and years before that of trying and failing on other drugs." It's very expensive to run trials, and the majority of trials end up failing and are never commercialized at all.

Campbell: Right. I think investors have to remember, too, that this isn't a free market. It's a regulatory controlled market because of patents. It's not like you're going out, you're developing this drug, and then you're competing instantaneously with 10 other people that are going to drive down the price. No, you have a monopoly to recoup the expense that you incurred over the course of that 10-year period. So, there's a lot of different things that are going into this. I think over the past couple years, you really saw the whole conversation blow up, if you will, because of these revelations that people were going out and buying drugs that have been around for a while and jacking up the price 200% or 300%. But it's not just those one-time price increases. It's much more systematic than that. You know, Kristine, that I like to put you on the spot.

Harjes: [laughs] Oh, boy, here we go.

Campbell: I'm going to put you and the listeners on the spot, here. In researching background for the show, I always turn to Express Scripts (ESRX) -- a pharmacy benefit manager -- and we'll get to that part in a minute. But every year, they put together a report that basically dives into the nuts and bolts of the figures behind drug costs. And one of the things they do, that I think is really interesting, Kristine, is back in 2008, they created a basket of commonly used brand-name drugs, and they set that basket at a base price of $100. They also decided to evaluate how that price changed over time, or, contrast it against a basket of typical household goods also costing $100 back in 2008. The question that I have for you, Kristine, and for the listeners, is to guess, how much do you think that $100 basket of goods for the drugs now goes for? I'm going to give you a hint, or, something to compare it to. That's that the household goods basket is $114.38 now. So, it went from $100 to $114.38. Any guess where we stand on that drug basket?

Harjes: Remind me of the initial year where it was $100?

Campbell: 2008. So, 2008 to now -- household basket has gone up around 14.4% over that whole period to $114.38.

Harjes: I would definitely guess it would be a lot more. I would say $180.

Campbell: $307.

Harjes: Oh my gosh!

Campbell: Yeah. 208% [sic] increase since 2008. I think that's really what's brought us to this breaking point where it's now become part of our common conversation. We had it over Thanksgiving or Christmas, everyone's talking about drug prices, right?

Harjes: Yes, absolutely. But I think another part to that that's really important to mention, and I assume this is true of the Express Scripts report, but that's list prices, yes?

Campbell: Correct, it's list prices. And what's interesting is, there's a lot of players in how a drug gets produced and delivered and put in your hand. There's all sorts of middle people.

Harjes: Right. When I say list price, I mean, that's what the company says is the sticker price. But that's not really what ends up getting paid. Like you said, there are all these middle men. You mentioned Express Scripts is a PBM, a pharmacy benefits manager, that's somebody that negotiates between the payers and the drug makers for these prices. You have insurers trying to take a cut. So, you have all of these different people that are getting in the way of it. There's the distributor who sends the drugs themselves to the pharmacy. Everybody needs to make their little bit of profit. So, there ends up being a pretty substantial discount to that list price. For example, I was reading a report from IMS Health, which is a research firm. They say that even though list prices for drugs rose 12% in 2015 alone, net prices grew only 2.8%.

Campbell: Right. And that's backed up, Kristine, by Express Scripts' report this year, which showed that last year, the list price on average climbed 10.7%. But after rebates and discounts, the net price was only up 2.5%. So, yeah, you're right, there's a very big difference between that manufacturer suggested retail price -- we're talking about cars here, whatever the true car value would be, maybe, of what people are actually paying for it. But you're still talking about, over time, growth that is significantly in excess of the typical inflation measure, Consumer Price Index.

Harjes: Exactly. And while, on one hand, I think you could argue that these drugs are getting better and better, so they're adding years to people's lives, so it's not really comparable to the type of medicine that people were paying for years ago, this is still a problem, and it's been a strain on a lot of people's pockets, particularly in the United States. In this country, the way that we do healthcare is pretty different from the rest of the world, and because of these elements and because the standard of living is so high, drug makers can effectively get away with this kind of pricing. I think when you boil it all down, the drug makers are just trying to figure out what they can get away with, how much money can they make for this drug, and that's the price they set. And often, that involves seeing what insurers are paying for competing drugs and evaluating how your new drug compares to some of the existing ones on the market. Ultimately, it's kind of a repeating cycle, where if you have expensive drug prices, and you have a small improvement on it, and you know that insurers are willing to pay X, and you have an even better drug, then you're going to add to that price.

Campbell: Right. And there's not a lot of price transparency. You have the list price, people know that. But the net discount, that's a trade secret. Gilead (GILD -2.70%) isn't going to tell AbbVie what it is that they're willing to discount their hepatitis C drug for. They're going to try to negotiate those deals the best they can with each one of these participants. In the U.S., you talked about globally, the U.S. is a different system. We don't give Medicare the ability to go out and negotiate prices directly with drug makers. We have each one of these individual payers, so, UnitedHealth Group or Cigna or Aetna or whatever going out and sitting down and saying, "Give me your best price." And of course, that's going to depend a lot on how many patients they represent. "If I can get an exclusivity deal, maybe I give them a better discount," or, "If I can't get an exclusivity deal, maybe I don't give them as big a discount." And that's different than other countries. For example, the United Kingdom we like to talk about a lot, because that's probably the biggest difference between the two in the way that they approve drugs for use among the patient population in relation to pricing.

Harjes: Yeah. I really do find their system absolutely fascinating. They have this concept in the EU that's called quality-adjusted life years, QALYs. This is a concept that tries to put the value of a drug in terms of the quality of life achieved after taking the drug. So, essentially, if the drug adds a year to your life at complete, total health, 100% quality, that's one QALY. Or, say, it adds two years to your life, but you're only at 50% of your well-being and your health -- and I have no idea how you actually measure quality of life, but say it's half of a quality of life measurement -- that would be 0.5X2, which is, again, one QALY.

Campbell: Exactly. You go from zero being death, not much quality of life there, up until the full one, and that would be living a perfectly normal, healthy happy life. And you're right, you touched on probably one of the biggest drawbacks or knocks against using QALY, which is the subjectivity. How do you determine between zero and one what that quality of life is? You can look at statistics and say, "If this drug added one year in overall survival, I know that's one year." But then, you get subjective when you start asking people to self-report, "Would you trade five years at 0.05 health for two years at one health?" Those subjective measurements make QALY a little bit of a moving target. NICE, which is the watchdog for the U.K. drug system, uses QALY as a leveraging tool. They can go out and say to the drug maker, "Listen, if I take the cost and divide it by the QALY," and say it's a $100,000 drug and it's one year of life at perfect health, that's $100,000 QALY, "That's too pricey for us. You're going to have to bring that down to $50,000 for us to approve it." So, for them, they use it as a negotiating tactic. It's much harder, obviously, as investors to try to figure out, if we're going to try and determine, because we know there's so much price uncertainty, how are we going to figure out whether or not a drug is going to be approved in other markets? Or, how are we going to find out whether or not that's a fair price to charge for a drug here in the U.S.? It's very hard for us as investors. We either eyeball it, and we say, "Other drugs are selling for this, and this one's a little bit safer, so maybe it gets a little bit of a premium," or we try and compute QALY on our own, which is impossible, because we can't go out and talk to the people who participated in the trials and figure out just how much their quality of life improved. We can guess some estimates, and say, "Let's map it out at 0.5 and one," or whatever. But for investors, it makes for a lot of uncertainty and difficulty in valuing what these drugs could face.

Harjes: When you go to try and figure out a peak sales estimate, that's got to be the hardest part of it, trying to nail down exactly what price not only that the drugmaker will set, but that they'll actually end up receiving both in the U.S. and abroad. Because both systems clearly are very complex.

Campbell: Right. You had talked earlier about the cost to develop these drugs. Do you know, Kristine, what the latest average cost was for a drug development that's cited?

Harjes: I believe it's $2.6 billion for a single drug.

Campbell: Yeah, in the last few years, I think it's gone from $1.4 billion over to over $2 billion, like you said. But again, you have to take all those things with a grain of salt. That's an average, that includes all of the failed trials, too. You could have a company that does extremely well, it is very efficient, and they get one drug on the market, maybe it costs them a fraction, a couple hundred million dollars. You could assume that maybe the innovation over time will reduce the number of drug failures in clinical trials, because it will be determined earlier on that these will fail, and that they'll never enter the clinical, and maybe that brings pricing down somehow. This is not going to go away. It's certainly not an easy problem to solve, either from a policy standpoint or as investors, trying to figure out the sweet spot for pricing for a particular drug that might get rolled out.

Harjes: Exactly. I know we're only scratching the surface of truly understanding this tangled web of the reimbursement models and drugmakers margins and everything that makes drug prices as high as they are. But I also want to leave some time in the episode to give our listeners an investing strategy that minimizes your risk and is actually very likely to increase your return over a long period of time, which kind of sounds like it's a miracle strategy. But it's something pretty simple. It's called dollar-cost averaging. Todd, I'm going to toss it over to you to explain what exactly that is.

Campbell: This is probably one of the most powerful ways of investing, and it's also one of the absolute simplest. All you have to do is say, "I'm going to commit to investing a specific amount of money every month for some specific interval." For example, you could say, "I'm going to invest $100 a month regardless of whether or not stocks rise or fall. $100 a month every month from now until the end of time."

Harjes: Right. The whole point of this is, once you commit to that, and you're setting a fixed dollar amount, you end up buying more shares of whatever the security is when prices are low, and fewer shares when prices are high. So, I'm going to run through an example of how exactly that works. Take a stock, we mentioned Gilead Sciences earlier, we'll go with Gilead. Say Gilead is trading at $100 right now. [laughs] I wish. Anyway, you want to invest $30,000. That would give you 300 shares. Say, instead, you're interested in dollar-cost averaging into that position over three months. You still have your $30,000, and you're going to do $10,000 worth every month. Initially, Gilead is still trading at $100, so you buy 100 shares. Let's say next month, it's up to $110, so you buy another $10,000 worth and you wind up with 91 shares. Then, next month, it's down to $90, so that same $10,000 gets you 111 shares. Add that all up after those three months, and the dollar-cost averaging strategy gives you 302 shares, which is two extra shares when you compare it to buying all at once $30,000 at $100. And if you look at your cost basis on those shares, it's $99 instead of $100. That doesn't sound like a lot, but if you extend this example over a long period of time, the difference is more pronounced. That's also something that we have academic studies confirming.

Campbell: But, Kristine, can't I just put it all to work at one point in time and make more money?

Harjes: That would be the buying in $30,000 worth at $100. You would have 300 shares, your cost basis would be $100. If you run through the math in my example it's just not as good of a strategy.

Campbell: The major advantage of dollar-cost averaging that Kristine just beautifully walked through is that it smooths out your risk in your return. It helps to reduce the volatility in your returns. Now, there's no getting around the fact that if you're in a skyrocketing market, say, for example, coming out of the Great Recession up through now, if you had timed it perfectly and bought in March 2009, you would have done better by putting all of the money to work all at once, because it's been a pretty straight line up. But the reality is that markets rise and they fall, and the vast majority of people, even some of the most talented investors of our generation, recognize that trying to time the market is highly unlikely that you're going to be able to do that consistently over and over again.

Harjes: Exactly, and something that we talk a lot about, here at The Motley Fool, is taking the emotion out of your of investing. It's important that even when the market is dipping and prices are low, you need to still make that key purchase of those same dollar amount of shares at the low purchase point to make this equation work out.

Campbell: Right, because the emotional component of that -- "The market is too expensive, the market's going to go to zero." As soon as you start adjusting or messing with how much money you're going to put in or whatever, you run the risk of shooting yourself in the foot on this strategy. Set it and forget it. You can adjust it up over time as you're making more money or whatever. But have a certain amount of money, go in, don't get too cute with it. Over time, studies have shown -- as a matter of fact, I don't remember which firm did it, I just read it recently, I have to look it up, Kristine, but it's stuck in my head that, the study showed that people who sold in the Great Recession to try and protect themselves didn't get back into the market in time, and as a result, people who just held through the whole Great Recession are way ahead of these people who tried to market-time and reduce the risk by selling and trying to buy back in at a different time. Or, you could look at it a different way -- Warren Buffett made a great bet where he basically said, nine years ago, "I think if you just buy passively managed low-cost index funds, it would outperform the best stock pickers out there, actively managed funds, hedge funds." And someone took the other side of that bet, and sure enough, in his annual report to investors, he just updated the results, and the passive investing strategy has returned 7% compounded annually, where the active investment has only returned 2.2% compounded annually. I think what that shows you is, if you just use a dollar-cost averaging type strategy and continue and commit to it, and don't try to get too cute with it, you'll probably come out far better off than you would otherwise.

Harjes: Exactly. As you mentioned a little bit ago, you can set it and forget it. I imagine that most interfaces have this option. I personally use Capital One investing, which was formerly ShareBuilder. I know for a fact that they offer, actually, a smaller trade commission when you do this, if you set up a regularly scheduled trade. You can plug in, "I want to buy this dollar amount at this frequency at this time, and here's exactly what I want it to go to." When you were talking about the Buffett bet, Todd, it reminded me that we should probably hit on what exactly people should be putting their money into. We talk a lot about individual stocks. But it's kind of tough to commit to buying, say, $1,000 of Gilead at regular intervals over the next indefinite time period, because then you should probably be keeping up in doing your own due diligence on Gilead every single month. But one really good way to employ this strategy without the stress of having to hand-pick stocks to employ it with is going with an ETF.

Campbell: Yeah, absolutely. We talk about this over and over on this show -- diversification is very important, especially when you're talking about the healthcare sector. By using ETFs, you can get exposure to a lot of different stocks within specific subsets of healthcare. So, you can, for example, buy the XLV, which is a broader ETF of healthcare stocks. Or, if you want just biotech, you can buy the IBB, which is a portfolio comprising of some of the biggest biotech stocks. By focusing on these ETFs, which, typically, by the way, are a little bit less expensive as far as management fees, you can avoid some of that risk you just alluded to of buying a stock where something changes dynamically over a course of a 10-year period, and you no longer want to be investing in that. Polaroid jumps to mind, as an example of that.

Harjes: Exactly. This is a strategy that clearly has a lot of upside to it. I do want to point out, I think a lot of people listening to this show are actually already doing this maybe without even knowing it in their 401(k)s. That's essentially what your 401(k) is -- you're committing to a certain amount of money at a regular interval, and it invests that money regardless of the market conditions. So, give yourself a pat on the back if you're already dollar-cost averaging into your 401(k).

Campbell: Oh jeez, Kristine, that just reminded me of something else. If you're a listener out there and you happen to have a 401(k) plan and you're doing your dollar-cost averaging from having the money invested every month out of your paycheck, a lot of these 401(k) plans are now offering auto-escalating features where you can go in and sit down and talk to your human resources department and have them increase your contribution by 1% or 2% every year. That's a fantastic way to increase the amount that you're dollar-cost averaging over time, theoretically, to build yourself an even bigger nest egg for retirement.

Harjes: And I do find that when you do those types of set-it-and-forget-it types of strategies, where it just automatically takes money from your paycheck and funnels it somewhere productive, you don't miss the money. You never see it, so you can't spend it.

Campbell: Right. And if you're doing it automatically, even with the increases, you don't have to worry so much about busting your budget, having to play catch-up and making these large contributions later on in your working career to try and make up for the years that you didn't do as much earlier on. That's so important, because if investing becomes hard, and you have to choose between how many groceries you can buy this week versus putting money into your retirement account, the retirement account just going to end up losing.

Harjes: Yep, absolutely. That is a fantastic strategy. Thank you for sharing that. And thank you for being on the show in general today.

Campbell: It's my pleasure to be here.

Harjes: As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against them, so don't buy or sell stocks based solely on what you hear, regardless of whether you're dollar-cost averaging into them or not. For Todd Campbell, I'm Kristine Harjes, thanks for listening and Fool on!