Spending on prescription drugs increased by 3.8% in 2016, according to pharmacy benefit manager Express Scripts. While that's slower growth than the 5.2% year-over-year increase experienced in 2015, spending is still headed in the wrong direction. Using data from 2014, America's Health Insurance Plans (AHIP) -- the trade group for health insurers -- estimates that over 22% of health insurance premium goes to paying for prescription drugs.
Here are seven reasons why prescription drugs are so expensive.
1. High research and development costs
Researching drugs isn't cheap, but it's the development costs once a drug candidate is discovered that really rack up the bills. The Food and Drug Administration generally requires companies to run at least one phase 1 and phase 2 trial, and then requires at least two independent phase 3 trials (except in cases where the drug treats a disease with a high unmet need).
For many diseases where drugs are making modest improvements, companies have to run many large phase 3 trials to demonstrate efficacy and safety in different types of patients. For example, AbbVie's (NYSE:ABBV) phase 3 program for its rheumatoid arthritis drug upadacitinib is testing the drug in more than 4,000 patients.
Equally important, the drugs that work have to indirectly pay for all the drug candidates that fail to show an effect or have side effects that keep them from being approvable. Companies will only invest in development if they know the potential rewards justify the sunk costs if the drug fails.
Unlike most countries, the U.S. allows drugmakers to market directly to consumers. Nielsen estimates that drugmakers spent a whopping $5.6 billion hawking their drugs to patients in 2016, a 9% increase over the previous year. Pfizer (NYSE:PFE) was the biggest spender, shelling out $1.19 billion. Bristol-Myers Squibb (NYSE:BMY), AbbVie (NYSE:ABBV), and Eli Lilly (NYSE:LLY) rounded out the top four with spending of $458 million, $433 million, and $414 million, respectively.
Those marketing costs are recouped by -- you guessed it -- higher drug prices.
The marketing also results in increased use of the drugs, which can allow companies to increase prices through the standard economic principle of supply and demand.
Generic drugs can reduce drug costs dramatically through increased competition, but most drugs gain regulatory approval with a decade or more left on their patents. And companies can extend their exclusivity by an additional six months for running clinical trials to see if their drugs work on children.
Once patents expire, the speed at which the FDA approves generic competitors greatly affects the price. An FDA study found that when a drug has three generic manufacturers, the average price was 44% of the branded drug price, but that drops to 23% when there are seven manufacturers and all the way down to 6% of the branded price if there are 19 generic manufacturers.
Exclusivity can also be broken when other branded drugs are approved with essentially the same efficacy and safety profiles. We've seen this recently with insulin and hepatitis C drugs, where insurers have been able to demand lower prices for them to stay on the insurers' lists of preferred drugs.
4. Small markets
Drugmakers try to earn a certain amount of revenue from each drug. For mass-market drugs, such as statins that lower cholesterol, companies can offer reasonable prices and make up for it with volume. Conversely, when drugmakers develop drugs that treat orphan diseases that affect a relatively small number of Americans, they have to charge more to generate the same revenue from the drug.
BioMarin Pharmaceuticals (NASDAQ:BMRN), for example, priced its recently approved drug Brineura, which treats Batten disease, an ultra-rare pediatric brain disorder, at $702,000 per year. BioMarin estimates that about 20 infants are born with the disease each year.
Because a small number of patients are affected, insurers can afford to pay the high price, which is ultimately shared by all the insured members. And government programs, such as Medicaid, typically get substantial discounts off the list price. In the case of BioMarin's Brineura, the price drops to a-still-quite-staggering $486,000 per year.
5. Insurance companies accept it
Insurers try to negotiate lower costs to reduce member premiums as they compete with each other, but unless an insurer wants to refuse to cover a drug, it has limited negotiating power. When there aren't equivalent drugs on the market, drugmakers can offer a price and say: take it or leave it.
And the price of prescription drugs doesn't actually matter for health insurance companies' profits since they're really just middlemen that are agnostic to the price. They add up all the expected costs for their members, tack on a little for profit, and divide the cost by the members to get the premium they charge. The high price of drugs is just passed on to members.
6. We're subsidizing other parts of the world
Other countries have lower costs for prescription drugs because their governments institute price controls or because they have single-payer systems that refuse to pay for medications that they believe aren't worth the costs. For the most part, drugmakers are still willing to sell their drugs in those countries at the lower costs because some revenue is better than no revenue at all.
But imagine an alternative universe where patients in every country paid the same amount for any given drug; U.S. patients could pay less, others could pay more, and drugmakers would generate the same revenue. Since decisions about whether to develop a drug or not are based on expected revenue, the same drugs would be developed in this alternate universe with the rest of the world picking up their fair share.