Sometimes Drug Prices Are Too Low
Washington’s efforts to keep medications affordable have had unintended consequences.
When Americans talk about drug prices, the conversation is dominated by the eye-popping sticker prices of certain new drugs. We’re all aware of how sky-high prices can make it hard for some patients to afford the drugs they need. Yet few appreciate how patients also lose access to treatments when prices are too low.
The federal government’s attempts to keep prices low have created a chain of unintended consequences. Start with the “best price” law of 1990, which mandated that manufacturers offer drugs to state Medicaid programs at the lowest price available to any other buyer.
The unintended—but predictable—consequence was to hurt many small clinics and hospitals. Drug companies often gave discounts to clinics and hospitals that treated a large number of low-income and uninsured patients, but the best-price law put them in a dilemma. They couldn’t keep offering those low prices unless they did so for all of Medicaid. So manufacturers stopped the discounts, causing prices to increase by more than 30% at some hospitals and clinics.
Congress tried to compensate in 1992 with the 340B Drug Pricing Program, which mandates that manufacturers offer discounts to certain hospitals, but provides for Medicare to reimburse these hospitals for the full list price of the drugs. The hospitals love this profitable arrangement, and though Congress intended it to apply only to hospitals with a high percentage of low-income and underinsured patients, hospitals can apply for the discounts at their own discretion. This causes manufacturers to sell countless drugs well below their list price.
Hospitals and clinics have gained from these discounts, to the tune of $6 billion in 2015. Taxpayers gain nothing, because Medicare still pays the full price. And according to the New England Journal of Medicine, the discounts haven’t expanded care or reduced mortality of low-income patients. Because both the 340B program and the Medicaid best price law keep prices low, drug companies underinvest in the next generation of hospital outpatient drugs.
Another set of regulations further discourages hospitals from offering some drugs. For drugs administered in a hospital setting, Medicare Part B mandates that the facility can charge an administrative fee plus 4.3% on top of the drug’s “average selling price” across all manufacturers. That means that when a particular drug company raises its price, hospitals’ retail price remains pegged to the industrywide average, potentially forcing them to sell the drug at a loss.
If a hospital has a drug that costs $100 and gets a few patients a day, it stocks and replenishes the drug daily, earning $4.30 plus an administration fee on each patient. That makes mild financial sense. But what if the drug costs $10,000, demand is sporadic, and the shelf life is limited? The hospital might not even stock the drug.
The fixed 4.3% margin results from the government’s using its monopsony power to decide how much it will pay providers. In the drug arena, government is an 800-pound gorilla. Health-care providers and pharmaceutical companies are paying attention. The drug they don’t develop and the drug you aren’t administered might have been the one that got you out of the hospital a day earlier or even saved your life.
Washington also discourages drug development through its self-contradicting regulation of generics. The 1984 Hatch-Waxman Act fast-tracked the approval process for generics, yet the same law forbids manufacturers from telling doctors or customers if their generic drug is better than their competitors’. Why invest in a superior drug if you have to keep it secret?
Consider Merck’s Mevacor, now sold generically as lovastatin. As long as manufacturers produce a product that meets the minimum standard to be classified lovastatin, they can market it as identical to every competitor’s version. Hatch-Waxman effectively eliminates any incentive to make lovastatin better, to guarantee safety or reliability of supply, to discover new uses, or even to do something as simple as develop new tablet sizes.
Once a number of generics enter the market, profit margins decrease. Then sometimes it takes only a production problem or other small cost increase for a manufacturer to cease production. As the number of manufacturers declines, supply can slip below demand. Currently, as many as 260 drugs are unavailable or in short supply in the U.S.
The supply problem isn’t new. In 2011 President Obama directed the Food and Drug Administration to resolve and prevent critical shortages of vital medicines. One administration official stated, “We can’t wait anymore.” Unfortunately, yes, we can.
And patients are dying. A shortage of norepinephrine in 2011 hampered hospitals’ ability to treat septic shock. A study in the Journal of the American Medical Association concluded: “Patients admitted to these hospitals during times of shortage had higher in-hospital mortality.”
Citing such shortages, the Federal Aviation Administration has exempted airlines from having to stock their airplanes with five key drugs. Those drugs form the core of an emergency medical kit during flights. Dr. Sherif Badawy, an expert on in-flight medical emergencies, told the New York Times “To think you could fly without epinephrine is crazy.”
This is a race to the bottom. Companies that can’t effectively price and promote the advantages of their products sometimes decide not to make them in the first place. Americans are being denied needed drugs because some prices are too low.
Mr. Henderson is a research fellow with the Hoover Institution. Mr. Hooper is president of Objective Insights Inc., which consults for life-science companies. This article is based on a report for the Goodman Institute for Public Policy Research.
READER COMMENTS
Alan Goldhammer
Dec 1 2019 at 6:27pm
David – I’m sorry to say that your commentary is misleading. As you know I spent most of my working career in the pharma industry on the regulatory side. I’ve also looked at the pricing practices of many companies since retiring. I currently serve on a non-profit board that provides health insurance and drug coverage to a significant number of fellows at a major research institution.
As we have looked at the insurance landscape it is clear that pricing of drugs is indeed very complex and there are rebates and discounts at many points along the way. It continues to get complicated when you look at various federal programs and also consider formularies and co-pays. Hardly anyone has any idea about how much they pay for prescriptions and what discounts and mark ups are in place. You use the example of hospitals but don’t mention the huge mark ups on Rx and OTC drugs for patients who are not covered by Medicare and Medicaid. Hospitals view this as a profit center.
I don’t understand your comment on Hatch-Waxman at all (not to mention that while Mevacor was one of the first statins it was also one of the weakest and was quickly eclipsed in the marketplace). Yes, Hatch-Waxman encourages generics which are a huge cost saver to patients. I think currently 85% of all Rx filled are for generic drugs. It not only lowers overall drug costs but encourages innovations as patent life expiration means the loss of a huge profit stream for the innovator. Isn’t this what the patent system was designed to do? Generics have to meet clear standards so that they are bioequivalent to the branded drug. the brand companies have a number of ways to innovate around this. They can come up with a new formulation (controlled release) which starts the patent clock running again. Taking one pill a day rather than two is more convenient but it’s also more expensive. I don’t know that changing the size of a pill represents any benefit.
You mention shortages of some generics. When I was working at PhRMA this was one of the issues I was frequently interviewed on. The majority of these shortages are for sterile injectables whose manufacturing is far more complex than the pills most of us are familiar with. The cost of manufacturing is higher and there are fewer companies capable of making such drugs. When there are impurities in the process and it has to be shut down and remedied, there may not be a secondary manufacturer of that product. The best source for drug shortages is the database maintained by the American Society of Health System Pharmacists. I looked up to see what the status of epinepherine autoinjectors is (the epi-pen). There does not see to be a problem as several new manufacturers are making these.
dylan
Dec 2 2019 at 8:18am
I’m also confused about the complaints against Hatch-Waxman, since if the follow-on drug is somehow superior to the reference drug, then it is by definition not a generic. Part of the point of exact bioequivalence is for substitutability, so that a doctor can write down the branded name of the drug, and your pharmacist is allowed to substitute in the generic version. If the generic version was different in some important regard, then the pharmacist wouldn’t be able to do that.
However, Hatch-Waxman did include a provision to encourage drug manufacturers to come up with improvements on generic drugs. Known as the 505(b)(2) pathway, it is a cross between a generic drug and a new, innovative drug. Say you are able to reformulate a generic drug so that you only have to take a pill once a day, instead of 3x a day. You can do a 505(b)(2) study where you rely on the data from the reference drug for most of your studies, and only have to do limited trials to show that it works the same way in your once a day formulation. This is a much, much cheaper way to get a drug to market, yet you can usually still get a period of market exclusivity between 3 and 7 years, longer for some drugs where you can still have patent protection.
Charley Hooper
Dec 5 2019 at 8:03pm
Good points. We can make a distinction between a different and better product (something that can be generated through a 505(b)(2) application) and a different and better manufacturing system—one that is more reliable, for instance.
In the first case, that better product can generate a premium price. In the second case, even though the product is arguably better, because it is available today and will be available tomorrow, the market does not allow for a premium price.
Generic drug companies, aware that they can’t charge a premium price for a more reliable manufacturing process, choose not to invest in that area.
Dylan
Dec 8 2019 at 9:15am
Mr. Hooper,
Thanks for the response and the clarification. I’ll admit this isn’t exactly my area of expertise, but your comments still have me a bit confused. I’m having trouble of thinking of any area where the end consumer will pay more for the exact same product, just because it has a more reliable or efficient manufacturing process? Companies still have plenty of incentive to improve that process for other reasons. One of the most obvious being, that by improving reliability or efficiency, they bring down unit costs and improves margins.
I’ve worked with a number of generic drug manufacturers over the years and they were pretty proud of their manufacturing efficiencies. I wasn’t really involved deeply on that side of the business for small molecules, so I can’t dive more deeply than that. I have however done a fair amount of work with biosimilar companies, and investing and optimizing manufacturing is seen as a key competitive advantage, but again, not because that would command higher prices directly, but because that increases your yield. I’ve helped some of our clients to acquire biotech companies because they felt they had technology that could help them improve yields by 10%.
Roger D McKinney
Dec 1 2019 at 9:47pm
Very informative! Thanks! Contrast the regulatory approach for drugs with the regulatory approach to doctor pay. The Center for Medicare and Medicaid merely takes a national average for all procedures and then adjusts for cost of living, whether you are a research or teaching facility, and a few other minor adjustments. As a result, they keep physician pay increasing much faster than cpi.
David Seltzer
Dec 2 2019 at 4:20pm
The 1984 Hatch-Waxman Act fast-tracked the approval process for generics, yet the same law forbids manufacturers from telling doctors or customers if their generic drug is better than their competitors’. Doesn’t this violate manufacturer’s First Amendment right? Who is yelling “FIRE” in a crowded theatre?
dylan
Dec 2 2019 at 7:38pm
Unless I’m greatly misunderstanding the act, this isn’t a speech issue, except perhaps in not allowing false marketing claims, because the whole point of generics is that they are exactly the same as the originator drug (OK, not exactly, but within a small margin of error difference). If your drug is better than the originator, then by definition it isn’t a generic. I know that Mr. Hooper is a consultant in the field, so I feel like something must have gotten lost in translation here, or I’m misunderstanding the point that is trying to be made.
Mark Brophy
Dec 3 2019 at 9:23am
The purpose of the FDA is to violate the First Amendment. The “label” of a drug, the instructions on how to use it that is included in the consumer package, is the result of a long expensive negotiation between the manufacturer and the FDA. If the manufacturer wrote whatever he wanted, the FDA would shut him down. In this way, a dissatisfied consumer isn’t forced to sue the manufacturer for fraud in the instructions. In the eyes of the FDA, speech restrictions are preferable to lawsuits.
David Seltzer
Dec 3 2019 at 4:28pm
Mark, I see your point. Commercial speech is a free speech exception wherein, there is “diminished protection”. False advertising and misleading advertising may be prohibited. But…in ‘Bates v. State Bar of Arizona,’ the Supreme Court held that a state’s prohibition of advertising by attorneys was unconstitutional as applied to newspaper advertisements. Restraints on advertising potentially violate the first amendment and the Sherman Act. Why wouldn’t this apply to to Hatch-Waxman? In terms of the Sherman act, doesn’t H-W prohibit competition in the marketplace?
dylan
Dec 3 2019 at 5:14pm
Once again, unless someone can point me to a specific passage in H-W that says otherwise, H-W doesn’t really say anything new regarding speech that isn’t already in the mandate of both the FDA and FTC. A couple of internet searches on the subject didn’t turn up anything either. Considering how good Prof. Henderson is at replying to comments to his posts, I’m surprised he hasn’t weighed in on this yet.
Regarding your last comment on competition in the marketplace, it might be useful to backup and show what H-W tried to do (fairly successfully in my estimation) Before the passage of this, generic drugs weren’t really possible, because each new manufacturer would be required to go through the same expensive trial procedure in order to get FDA approval. H-W allowed for an abbreviated pathway for approval on drugs whose patents had expired (or weren’t valid). A generic drug maker could rely on the data package for the original drug in terms of proving safety and efficacy, and instead just had to show that their drug was essentially identical to the reference drug.
H-W (eventually) unleashed a torrent of competition. The generic drug market, is one of the closest things we have to an economists idealized version of perfect competition, or at least as close as you’re going to see in the healthcare space. But the whole point is that the generic drugs are identical to the branded drug. I just don’t see how this becomes a freedom of speech issue, unless you’re talking about the freedom to make false advertising claims, which I don’t think is allowed in any industry. What am I missing?
David Seltzer
Dec 3 2019 at 6:02pm
“The generic drug market, is one of the closest things we have to an economists idealized version of perfect competition, or at least as close as you’re going to see in the healthcare space. But the whole point is that the generic drugs are identical to the branded drug.”
Dylan, If in fact there is a close approximation of perfect competition, as you state, then it obtains because perfect information is a feature or property of perfect competition, why is it necessary for H-W to restrict the FA rights of manufacturers when the market already has this information. What am I missing here? Thanks.
dylan
Dec 3 2019 at 6:13pm
David,
That is also what I’m trying to understand. I’m not aware of anything in H-W that restricts the rights of manufacturers, and my searches didn’t find anything either. Which is why I would love some clarification on this point from one of the authors that is making this claim, because as written it doesn’t even make sense within the context of the generic drug market.
dylan
Dec 3 2019 at 6:16pm
Sorry, that should have read: “not aware of anything in H-W that restricts the speech rights of manufacturers.”
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