Americans spend a little less than $1,000 annually per person on average for prescription drugs. That's the average, which means that many spend a lot more. Why are prescription costs so ridiculously high? You might not like the answers, but here they are.
1. You're paying for other drugs that you don't use.
When you put your money down at the pharmacy for Lyrica, the nerve and muscle pain drug from Pfizer (NYSE:PFE), you're really paying for your Lyrica prescription plus a whole host of other drugs. How's that possible? The answer lies in the realities of the drug development process.
Dr. Josh Bloom with the American Council on Science and Health estimates that it takes a drugmaker an average of 14 years to bring a drug to market -- at a total cost of around $1.3 billion. However, only one out of every 50 drugs that start down the development path actually make it to market. And, of those that do, typically only two out of 10 will make a profit.
Pfizer spent around $890 million on cholesterol drug torcetrapib, only to cancel the drug's development program in 2006 after serious safety concerns. The big pharmaceutical company wrote off $2.8 billion on inhalable insulin Exubera after consumers simply didn't like it.
How did Pfizer make up for those and other losses? Like all the other drugmakers, it added to the cost of the drugs that did succeed -- so Lyrica and others cost more than they would have otherwise.
2. You're paying for the world.
The weight of the world might not be on your shoulders, but the weight of subsidizing the world's drugs is. Prescription drug costs are higher in the U.S. than in any other country. Per-capita pharmaceutical spending in Canada, the second-highest nation, is a whopping 33% lower than in the U.S.
Two words explain why: price controls. Most other countries establish fixed price limits that they will pay for prescription drugs. What this means, though, is that pharmaceutical companies raise their prices for prescription drugs sold in the U.S. to make up for charging lower prices throughout the rest of the world.
You might think the simple solution is to implement price controls in the U.S., too. Such a move probably would lower prices for the drugs currently available.
The problem, though, is that it would provide financial disincentives for pharmaceutical companies to develop as many new drugs as they do now. If that happened, it could end up actually increasing overall health care costs, since taking prescription drugs is frequently much less expensive than other medical treatments.
3. You're paying for others to find out about the drug you use.
Marketing is king in the world of pharmaceuticals. And it demands a king's ransom. Unfortunately, you ultimately pay that ransom every time you buy a prescription drug.
Pfizer's advertising budget last year totaled more than $622 million. Over half of that budget was spent promoting three drugs -- Celebrex, Viagra, and Lyrica.Eli Lilly (NYSE:LLY) wasn't far behind with an ad budget topping $433 million. Nearly 94% of that amount was spent on only two drugs, in this case Cymbalta and Cialis.
Nielsen's tracking found that the top 10 pharmaceutical companies spent $2.7 billion last year on direct-to-consumer advertising. However, that figure doesn't include online advertising or physician promotions, so the actual marketing budgets for the big pharma companies is even larger. Research firm Cegedim estimates that total pharmaceutical industry spending on promoting drugs was around $28 billion in 2010.
You're also likely picking up part of the tab for the companies mistakes in how they promote their products. For example, Abbott Labs (NYSE:ABT) settled federal and state lawsuits accusing the company of inappropriate promotion practices for epilepsy drug Depakote for a cool $1.6 billion last year.
At the time of the settlement, the Justice Department said that the case demonstrated that "those who put profits ahead of patients will pay a hefty price." A hefty price was surely paid, but Abbott's profits for 2012 were more than 26% higher than either of the previous two years.
4. You're paying Uncle Sam.
Don't forget your good friends at the IRS. The passage of the Affordable Care Act brought new fees for large drugmakers totaling $80 billion. That amount is spread over multiple years, though. "Only" $2.8 billion was paid by pharmaceutical companies last year.
Technically, the big pharma companies pay these fees, which basically are excise taxes. However, those companies can't pay the IRS unless it first gets the money from its customers. Ultimately, you're paying Uncle Sam.
5. You're paying for profits.
Regardless of what product you purchase, you're paying for the maker of those products to make money. It's no different with prescription drugs. The concern is over whether prices paid by consumers contribute to excessive profits.
Most pharmaceutical companies generate nice profits. Despite Lilly's woes from losing patent protection for some of its big drugs, the company still had a profit margin of over 20%. Even though Abbott paid a steep fine last year for a legal settlement, its profit margin was 13% -- better than a lot of companies.
Pfizer ranks first among all Dow index stocks in terms of profit margin, with a margin of nearly 27%. The other two pharmaceutical companies in the Dow have profit margins higher than the average Dow company. However, of the top 10 Dow stocks ranked by profit margin, four are technology firms. Pharmaceutical companies generate high profit margins, but they're not always the highest among all industries.
A little good news
You're paying ridiculously high prices for prescriptions, but there is a little bit of good news. In 2012, Americans actually spent less on prescription drugs than the prior year for the first time on record. It was only 1% less -- but that's still better than spending more.
I figure this improvement amounts to maybe having an extra $10 in the wallet for the average American. You might want to hold on to that money. You'll probably need it soon enough.
Fool contributor Keith Speights has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.