Even though US consumers spend 3 times more for hospital care than for medication, they are much angrier with pharmaceutical companies than hospitals for driving up the cost of health care. Drug companies raise this apparent inconsistency in an effort to defend their pricing practices. In so doing, however, they fail to appreciate why they’ve been targeted for so much opprobrium. Ironically, the industry’s biggest public relations problems may arise from its most effective and widely applicable innovations.

Austin B. Frakt, PhD (Image: Doug Levy)

Taking medications is the most common way US consumers use health care. Each year, patients are 8 times more likely take a prescription drug than to use hospital inpatient services (61% vs 7.3%). For every annual physical, a patient might visit her community pharmacy a dozen times. US patients are more upset about drug prices in part because they encounter them far more frequently than those of other health care products or services. They spend $50 billion per year out-of-pocket on prescription drugs—more than for any other health care service.

US patients are relatively underinsured for prescription drug expenses, further contributing to high out-of-pocket costs. Only 3.2% of inpatient care and 13% of physician visit spending is borne by patients compared with 16.5% of drug spending. The upward trajectory of cost sharing amplifies the effect of price increases on patients. As coverage erodes, the veil separating patients from drug prices lifts; fewer get such a clear view of hospital prices.

Outpacing Other Medical Costs

The rate of increase in drug prices has outpaced that of overall medical care every year since 2008. A recent survey found that retail prices of selected brand-name dermatological medications increased an average of 401% between 2009 and 2015 (363% in real terms, accounting for inflation), while prices of the generic medications increased an average of 279% between 2011 and 2014 (265% in real terms). These price increases for dermatological drugs are well above the national average for all drugs and payers—up 23% in real terms between 2009 and 2015. They do not reflect the possibilities that patients might switch to cheaper alternatives, or there may be slower growth in prices paid by insurers and public programs.

Retail prices have increased dramatically for other types of drugs, as well. The aggregate retail price of a basket of 477 widely used drugs doubled between 2006 and 2013, even though retail prices for generics decreased. Per life-year gained, new anticancer drugs prices have quadrupled in 2 decades and now exceed conventional levels of cost-effectiveness.

To be sure, many drugs are exceptionally valuable, but their high costs to patients can interfere with their usefulness. For instance, medications for patients with chronic conditions (like diabetes) are often cost-effective and, in some cases, cost saving, by offsetting downstream care. Nevertheless, the immediate out-of-pocket costs results in some patients skipping or delaying doses, splitting pills, and failing to fill prescriptions. Reducing out-of-pocket costs of highly advantageous drugs (like insulin) for chronic conditions—for example, by reducing prices and increasing their coverage through a value-based insurance design—would increase adherence to drug therapies and the value they deliver.

Constraining prices so more drugs are cost-effective—for example, below $100,000 per quality-adjusted life year—is one approach to managing drug price inflation. Although the political prospects for such a policy are poor, recent value-based contracts between manufacturers and insurers or pharmacy benefits management companies are similar in spirit. For example, Cigna’s payments to Novartis for the heart failure drug Entresto are linked to how effectively it reduces hospitalization.

Value-based drug payment approaches do not reflect unfair targeting of the pharmaceutical industry to justify drug prices. They are increasingly common for hospital and physician services as well. They are enshrined in Medicare policy through, for example, readmissions penalties, accountable care organizations, and bundled payments (for hospitals) and the Merit-Based Incentive Payment System (for physicians).

A focus on cost-effectiveness alone will not spare the pharmaceutical industry from public scorn, however. Even if every drug had a price considered cost-effective, aggregate spending could exceed what budgets can bear. A $1 million pill that extended life by 10 years would be considered cost-effective, but to provide it to every American would require an expenditure that is equivalent to more than 1000 years of US drug spending. It would be both painful and difficult to deny such a pill to patients who could not afford it. But alternative methods of rationing are perhaps even less palatable. Such are the financial, political, and cultural limits of our ability to manage spending for expensive, effective medicine.

Have We Reached a Limit?

In fact, we may have already have reached the point of confronting the fact that we cannot all have it all. New, expensive drugs for hepatitis C—Viekera Pak, Sovaldi, and Harvoni—severely stress budget-constrained programs like Medicaid and the Veterans Health Administration. Even at the steep discounts those programs receive, these treatments—though cost-effective—are indicated for such large populations that their aggregate cost would overwhelm budgeted resources. The day that life-extending $1 million “miracle” pill arrives (or the precision-medicine equivalent of a collection of drugs), we may look back on the current hepatitis C treatment funding problems nostalgically. As innovation continues, drug pricing and budgeting problems will only get worse.

For inspiration on how to moderate drug price growth, we could look overseas. In many European countries, the prices of drugs with similar therapeutic effects are pegged to that of one of the lower cost drugs in the class, or an average. The insurer pays one amount (called the reference price) for any drug in a class, an approach that penalizes high-cost drugs that are no better than less expensive but therapeutically similar alternatives. However, the approach only works across drugs that are reasonable substitutes. That is, they require a degree of competition, even if only across a few brand-name drugs.

Competition among generic drugs is one area where the United States offers success stories. When it is sufficiently robust—and it isn’t always so—generic competition can bring US generic drug prices below those paid in other developed nations. This is a remarkable feat, considering that US health care prices are generally several multiples of those overseas.

But competition is severely limited for some drugs. For new drugs, patent law and Federal Drug Administration (FDA) policy confer monopolies. For other drugs, the high cost of establishing manufacturing capacity and other barriers to market entry frustrate competition. As Martin Shkreli demonstrated—after acquiring the toxoplasmosis drug Daraprim and raising its price 5000%—when competition is low, the price of some generic drugs can be raised almost without limit. In some cases, potential competitors exist in other countries—including for Daraprim—but are denied entry to the US market. This is modifiable through FDA regulatory change.

Higher prices may help fuel drug innovation. Yet, at the current price trajectory, the rate of innovation will eventually exceed our ability to pay for it. Fostering valuable innovation with financial reward is the engine of much of American commerce, including in health care. It’s a fantastic model, responsible for tremendous gains in longevity, well-being, and satisfaction. We should keep that engine turning, but only as rapidly as we can afford.