Think your prescriptions cost too much? There's a new drug that just won approval from the Food and Drug Administration (FDA) that will run more than $2.1 million per patient, making it the most expensive drug ever. The price tag is so high that it will be paid for through what is essentially an installment plan.

Last week, the FDA gave the green light to Novartis (NYSE:NVS) subsidiary AveXis's gene therapy Zolgensma, which treats spinal muscular atrophy (SMA). Each patient will receive only a single dose of Zolgensma. But Novartis plans to charge $425,000 per year per patient over a five-year period. 

The American public and politicians from both major political parties were already riled up over sky-high drug prices. But before your blood boils about Novartis' pricing strategy for Zolgensma, there are a few things that you should know.

Capsule opened up with a stack of $100 bills in it

Image source: Getty Images.

The method behind this (apparent) madness

It might seem like pharmaceutical companies set drug prices by plucking a number out of thin air -- and in the case of Zolgensma, maybe the extremely rarefied air near the top of Mount Everest. However, drugmakers actually weigh several factors in establishing those prices. One of the most important of these is the addressable market size. In general, the fewer people who could benefit from the drug, the higher its price tag will be.

This concept isn't limited to drug prices, of course. A highly specialized tool used only on a few specific aircraft will cost a lot more than a regular screwdriver. Why? The company manufacturing it still has to cover all the infrastructure costs and related expenses involved, but it has to generate its profit on that investment from a far smaller number of sales.

Thus, the big reason why Novartis set the price for Zolgensma so high: Its addressable market is minuscule. Spinal muscular atrophy is a rare genetic neuromuscular disease: In the U.S., between 10,000 and 25,000 people have the condition. Further restricting the drug's potential, Zolgensma has been approved only for treating children under 2 years old. As such, Novartis estimates that there are only around 700 SMA patients in the U.S. today eligible for treatment with the gene therapy. Around 30 babies are born each month with SMA.  

Another key factor pharmaceutical companies use as a guide in setting prices is the value provided by the drug. SMA is the top genetic cause of death in infants and toddlers. Those with the condition who survive frequently rack up enormous medical bills over the course of several years. Zolgensma, on the other hand, is a one-time treatment that could potentially save their lives.

"We're talking about a lifetime of benefit being condensed down into a one-time treatment," AveXis President David Lennon said in an interview with NPR. "We're not used to thinking about this that way. We're used to a system of a chronic medication where we spread things out over years if not decades."

Like companies in any other industry, drugmakers must also consider the competition. There's only one other approved treatment for SMA, Biogen's Spinraza. The drug costs $750,000 in year one and $375,000 for every subsequent year. After five years of treatment, Spinraza's total cost exceeds that of Zolgensma. And based on clinical studies for both drugs, Zolgensma is arguably more effective. 

The long, uncertain road to approval

It's also helpful to understand the path that led to approval for Zolgensma. In 2010, a small company named Biolife Cell Bank was founded. It initially focused on the processing, storage, and preservation of fat (adipose tissue) and regenerative stem cells. By 2013, Biolife Cell Bank began working with Nationwide Children's Hospital (NCH) in Columbus, Ohio, on a gene therapy to treat SMA.

The company changed its name in January 2014 to AveXis, and began the first clinical trial in humans of a gene therapy targeting SMA a few months later. The risk of failure was very high. At the time, no gene therapies had been approved for any disease. 

By the end of 2017, AveXis had incurred cumulative losses of nearly $360 million. In the annual report it filed in early 2018, the biotech noted that it expected "to continue to incur significant expenses and increasing operating losses for the foreseeable future." But in April 2018, Novartis announced that it was acquiring AveXis for a whopping $8.7 billion

Why is all of this relevant to the high price tag for Zolgensma? The development of new drugs is all about risk and reward.

Although NCH played an instrumental role in the early research for a gene therapy to treat SMA, the hospital couldn't fund the effort required to advance an experimental drug through clinical testing and the regulatory approval process on its own. Instead, NCH licensed its SMA program to AveXis in exchange for stock.

The only way AveXis could afford to attempt to develop that SMA gene therapy was because investors were willing to buy its stock on the hope that the biotech would be successful. Later, Novartis paid billions of dollars to buy AveXis before the late-stage clinical studies of the gene therapy were complete, based on its estimation that the transaction would benefit its shareholders.

Along the way, all of these entities took on considerable financial risks, because of the potential for generating solid returns on their investment. And that's what will happen now that Zolgensma has been approved.

But the reality is that most candidate treatments fail. Fewer than 10% of all drugs that begin phase 1 clinical testing go on to win regulatory approval. The drugs that are successful must subsidize the development costs associated with the ones that aren't. The price tag for Zolgensma is high at least in part because Novartis and AveXis statistically aren't likely to achieve success with most of their future clinical programs.

The market rules

Ultimately, though, there's one simple reason why Zolgensma costs more than $2.1 million per patient: Payers won't balk at the price.

As Steven D. Pearson, president of independent drug pricing research group Institute for Clinical and Economic Review (ICER), told NPR, "Insurers were going to cover Zolgensma no matter the price."

That's almost certainly an overstatement. Drug prices can be so high that coverage providers refuse to cover them, especially when alternative treatments exist. Had Novartis priced Zolgensma much higher, say $20 million per patient, it seems likely that it would have encountered significant pushback, with insurers opting to cover only Biogen's Spinraza. 

But if you're still bothered by Zolgensma's extraordinary price tag, there's some good news. Both Novartis and Biogen could face a new rival in the not-too-distant future. Roche and PTC Therapeutics expect to file for approval of another SMA drug this year. Probably the best solution for controlling high drug prices is increased competition. And that's what the SMA market will likely soon have -- thanks to other biotechs and investors willing to take on risks in exchange for potential rewards.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.