Costs and Pricing
Within Europe there are as many pricing and reimbursement systems as there are countries. A low price in one country is undesirable not only because it reduces sales revenue but also because it may stimulate parallel importation and affect the price allowed in those countries where prices abroad are taken into account when setting local prices. If reimbursement status is not granted, it is unlikely to be worth marketing the product at all since patients will be unwilling to pay the full price.
–Sue Sullman. From Regulatory Affairs Journal (April 1992).
No country that has practiced cost containment in health care at the expense of its pharmaceutical industry has managed to nurture a pharmaceutical industry that can compete globally.
–Heinz Redwood, pharmaceutical consultant.
The literature is remarkably bereft of articles about how pharmaceutical companies price individual drugs. While many people would find it worthwhile to read detailed case studies, the companies have not felt it appropriate to present these in any detail. This information has been considered proprietary and not in a company’s interest to share. This chapter does not present specific case studies either. Rather, it describes the types of actual costs and considerations that go into the pricing of an individual drug. Theoretical discussions and composite evaluations of the pricing for groups of drugs have been published by economists, but the information in those articles does not really help a company to price the next drug it markets. Although some nonpharmaceutical companies use a single formula to establish a product’s price, this approach is not done in the pharmaceutical industry because many different factors are considered and weighed in arriving at a series of prices. In an attempt to estimate demand and elasticity (as well as other factors), some groups have used the approach of pricing a product at the point where the curves of marginal revenue and marginal costs intersect. Consideration of relevant market, social, competitive, and political factors as well as adherence to logic is a far better approach to pricing drugs than is adherence to one formula or another.
This chapter, therefore, focuses on costs and prices of individual drugs rather than on overall industry behavior and uses a descriptive rather than economic or statistical approach. It describes the concepts involved in establishing prices rather than the concepts underlying the equations that are purportedly used by some companies to derive price and to adjust those prices over time.
The industry prices its products to cover its costs, fund new research, return a profit to its investors, and promote healthcare. The act of pricing a drug is extremely complex and is interdependent with many other aspects of a pharmaceutical company including the involvement of private research facilities, risk capital, politicians, the public, media, and regulatory authorities.
COSTS ASSOCIATED WITH A DRUG
While many simplistic accusations levied at pharmaceutical companies state that drugs should be sold for their cost of manufacture plus 5%, 10%, or 15% for profit on that particular drug, this is an extraordinarily naive and incorrect view. This “cost-plus” approach that fills the newspapers and congressional speeches ignores a number of additional costs that virtually always must be considered as well. The general categories of costs associated with discovering, developing, and marketing a drug are listed in Table 98.1 and are described in the following sections.
Research Costs to Discover New Drugs
Although it is theoretically possible for chemists to rationally design the best structure for an organic molecule so that it performs a certain activity at the molecular level (e.g., inhibit an enzyme), this does not happen. Chapter 8 describes the “trial and error” approach used most commonly to discover new drugs. Hundreds of thousands of compounds may be screened and many hundreds or thousands may be synthesized in an attempt to improve on activity and decrease toxicity. This process is extremely expensive, and all compounds that never progress beyond screening must be paid for by the few drugs that are marketed and earn a profit.
Moreover, many thousands of newly synthesized and screened compounds generally do not turn up any interesting potential drugs or result in compounds that will be developed; most are terminated later during preclinical or clinical trials. These activities also have to be paid for by the few drugs that do emerge and reach the market.
Table 98.1 Costs associated with discovering, developing, and selling a drug a | ||||||||||||||||||||||||||||
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Development Costs
Of the 5,000 or so chemicals that are synthesized or tested in animal screens, or the large numbers put in high throughput screens (often 50,000 or more) for each drug that reaches the market, about a hundred compounds reach early preclinical development and are evaluated in numerous batteries of tests. Preclinical, clinical, and technical development activities discussed in many chapters of this book are expensive activities to conduct. Costs to develop a specific drug vary widely from approximately one million dollars (or even less) for obtaining case studies that demonstrate safety and efficacy (most often of a rare disease) up to approximately $400 million. When all costs were included (e.g., opportunity costs), as well as failures and other research, the total averaged $802 million (in 2000 dollars) plus an additional $95 million for postapproval research and development -mandated studies for a small molecule drug (DiMasi, Hansen, and Grabowski 2003) and $1.2 billion for a biologic (DiMasi and Grabowski 2006).
Patent Costs
Companies typically apply for patents in many countries (average of approximately 35). Costs for this activity include patent attorney fees in preparing these applications, filing fees in each country, and also the annual renewal fees to keep the patent application or patent itself alive. These facts raise questions such as, “When is it reasonable to allow a patent to lapse after a drug’s progress is terminated?” The nature of drug discovery and development is such that discontinued compounds or drugs are sometimes later found (often within a few years of project termination) to be potentially (or actually) useful in treating a different disease or the original disease in a different way. In addition, many drugs are not totally protected by a single patent but by a series of patents, and in the case of biologics, this is the general rule. There are also other patents designed to protect chemical analogues of the drug of interest so that similar “me-too” drugs cannot be easily patented by competitors. The story of how SmithKline and French failed to protect Tagamet from this type of competitor is described in Chapter 8.
Manufacturing Costs
To most people outside the pharmaceutical industry, production costs are the most obvious costs that should influence the price of a drug. It is this overall cost that is generally discussed in the greatest detail when the public tries to calculate what it believes a drug’s fair price should be. Manufacturing costs are in fact only a small portion of the financial risk taken on by the company and include the processes of obtaining raw materials, performing chemical syntheses, mixing the formulation, compressing the mixture into tablets (or producing other dosage forms), conducting quality assurance tests, and conducting many other activities described in Chapter 108. Costs often also involve purchasing expensive manufacturing equipment, hiring staff, building waste treatment facilities, and, in some cases, building an entire factory to manufacture the product, particularly biologics.
Manufacturing costs also include solving the difficulties involved in obtaining raw materials, synthesizing the active compound, preparing the formulated drug, packaging the drug, storing the drug, and shipping the drug. Ceredase (aglucerase injection) is an example of a drug for which the cost of obtaining the raw materials is very high. This extremely expensive drug is used to treat patients with Gaucher’s disease. It is estimated that a single year’s treatment for one patient may cost as much as $150,000 to $300,000 (US dollars). In the past, the drug was obtained from human placentas, and it reportedly required 22,000 placentas to provide one year’s supply of drug for a single patient. However, the product is now manufactured using recombinant techniques (Cerezyme, imiglucerase for injection), and the price has remained fairly stable.
Construction or Modification of Manufacturing Facilities
Certain drugs require the building of an entirely new manufacturing plant, which may have to be initiated several years before the drug is approved for sale. An extreme case is one where a plant is built (or at least begun) before it is known with certainty that the drug possesses adequate efficacy and safety for the drug to be marketed. Although it is easy to say that this situation should be avoided, it is not always easy or even possible to do so. For example, for a major breakthrough drug to be available after approval, the company may have to make a commitment to build the plant at an early stage of the drug’s development. However, if the profile of a drug is less exciting at the time of its marketing, sales will be less, and the need for the new plant may have disappeared. Associated costs with the start up of a new facility include plant validation expenses and meeting Good Manufacturing Practices in all areas of production. More than one company has lost this gamble.
Distribution Costs
Large-sized packages (e.g., gallon or even larger bottles of liquids for hemodialysis) cost far more to ship than do small packages or even cartons of drugs. Packages that must be stored in refrigeration due to their stability requirements are more difficult to handle and cost substantially more to transport (and store) than those that are stored at room temperature. Packages stored below freezing have separate problems that must be addressed. Each of these factors influences distribution costs and, ultimately, the prices charged.
Drugs taken out of inventory must be packaged and shipped to sites often in other parts of the world. Costs escalate dramatically when there is urgency in the drug’s delivery, whether it is on a compassionate plea basis or to fulfill a hospital, pharmacy, or physician’s emergency requirement. Other special drugs, such as radioactive drugs, have their own distribution requirements and costs.
The wholesaler who purchases the drug from the pharmaceutical company will mark up the price when it sells the drug to the retailer (e.g., hospital, pharmacy), and the retailer will mark up the price when it sells it to the customer/patient. Thus, the “price” of a drug that the customer sees is not usually the price set by the pharmaceutical company.
Marketing Costs
There is an adage stating that “drugs do not sell themselves.” Even breakthrough, life-saving drugs require significant marketing costs for educating physicians about their use and to launch them successfully. Marketing costs cover a multitude of activities that begin during the discovery period, intensify throughout the years of a drug’s development, and usually reach a peak during the prelaunch, launch, and first year or two of a product’s actual sales. These activities sometimes include a great deal of education of
physicians about certain diseases and treatments. Examples include Burroughs-Wellcome having to educate physicians that acyclovir (Zovirax) was a “safe” antiviral drug for treating herpes infections when the conventional wisdom was that all antiviral drugs were highly toxic. Another example was Merck playing a major role in educating physicians about differences between low-density lipoprotein (LDL) and high-density lipoprotein (HDL) cholesterol and the effects of lovastatin (Mevacor).
physicians about certain diseases and treatments. Examples include Burroughs-Wellcome having to educate physicians that acyclovir (Zovirax) was a “safe” antiviral drug for treating herpes infections when the conventional wisdom was that all antiviral drugs were highly toxic. Another example was Merck playing a major role in educating physicians about differences between low-density lipoprotein (LDL) and high-density lipoprotein (HDL) cholesterol and the effects of lovastatin (Mevacor).
Costs to develop line extensions (e.g., new dosage strengths), new formulations, new indications, and new packaging of an already marketed drug may be considered as costs incurred during the marketing period. However, many of these costs begin during the development period prior to marketing and often are shared among manufacturing, research and development, and other groups within the company. Other costs include clinical trials to compare the new drug with established treatments, which are sometimes referred to as promotional trials and yield information of importance to treating physicians, formularies, insurers, and other groups.
Many marketing activities influence how well a new drug does commercially after it is launched. Most of these activities cost a great deal of money (e.g., promotion to increase awareness, education), and this money usually comes from sales of the drug. All research-based companies that develop important new therapies spend a large amount of money to educate physicians about the benefits and appropriate ways to prescribe and use these new treatments. Some of the major marketing activities that require significant sums of money to launch a new drug and to keep it afloat are discussed briefly in the following two sections.
Advertising and Promotion Costs
Although marketing promotion and advertising are only a small percentage of the total activities conducted by marketing groups, they represent a significant portion of the total money spent on marketing by pharmaceutical companies. In addition, these two activities receive a great deal of attention by the public, legislators, and regulators.
Practicing physicians and other healthcare professionals usually focus on the content as well as the nature of advertisements and promotional practices. These activities serve an important function in disseminating information about a drug, and it is legitimate to spend money on them. Advertisements and promotions provide information about new and established drugs and are an effective, albeit expensive, method for getting information to those targeted by the manufacturer. Companies without sales forces are typically unable to compete in the marketplace with their new drugs and usually join forces with a larger company in a copromoting or licensing arrangement.
Education Costs
There are numerous constituencies who must be educated before a drug can be used safely and with optimal efficacy in the marketplace. These include pharmacists, physicians, nurses, formulary committees, compendial committees, hospital administrators, medical press, professional societies, patient advocacy groups, patient medical groups, and many other groups. If the drug has anything unusual about it (e.g., patients must inject themselves, patients must use a spinhaler, hospital pharmacists must follow relatively complex procedures to prepare a parenteral drug), then additional educational activities must be conducted.
Educational costs include developing symposia and journal articles, supplements, lecture series, and other appropriate activities. Even advertisements have educational value. The more novel the drug, the greater is the need for education, and the greater are the costs. There is a fine line between education and promotion, and some activities could fulfill both functions depending on how they are performed. Either function could be served by teaching:
What the new drug is designed for
How it differs from other treatment(s)
What its disadvantages are
How it is used
What its advantages are
Its mechanism of action
Special issues, including economic considerations
It is obvious that a company’s discussions with patient advocacy groups about these seven categories will differ from its discussions and materials directed to physicians or the media. This means that a company must prepare separate educational programs for different audiences, even though some specific elements, as well as the overall approach and theme, may be the same for all groups.
Licensing and Royalty Costs
Not all drugs have royalty costs, but a significant number do. Royalty fees usually vary between 3% and 10% of sales. These are paid to the owner of the property from whom the drug is licensed. While licensing costs usually include consideration of royalty fees, there are often additional costs involved in licensing. These include up-front costs and milestone costs, which are lump sums paid as the drug achieves specific development milestones (e.g., completes Phase 1, files a New Drug Application).
Legal Costs
Certain drugs are introduced into therapeutic or disease areas that have a history of significant litigation. Because liability insurance is no longer available to most pharmaceutical companies, companies are generally forced to be self-insured in the United States. Some companies are putting money aside to defend potential or even anticipated legal cases, even before (or shortly after) a new drug is introduced. The extent to which this is done, if at all, depends on the specific drug and specific countries in which it is sold. Some types of drugs for which litigation can be anticipated include: anticoagulants, contraceptives, vaccines, and anti-drug abuse drugs. Nonetheless, a certain number of legal cases can be expected to arise for most widely used drugs. Whether or not there is any merit to these cases, a pharmaceutical company must financially be able to defend itself and to pay often extremely high costs if it is found guilty. The only way that a company receives money to pay for litigation is through sales of its products and related fees (e.g., royalties).
Administration Costs
This category includes all of the costs of the entire company that are not included in the activities listed in the previous sections. Salary and overhead costs of the entire organization must be considered in establishing the price of a drug. Companies have groups to conduct the activities described as well as staff in human resources, engineering, public affairs, service groups, and so forth whose salaries and benefits must be considered. Some companies are much more staff heavy than others. Being too lean, however, can be expensive if one has to contract out many activities at high prices.
Other administrative costs include the costs of registering the drug and adhering to regulations in all areas of a company.
Lost Opportunity Costs
Money invested in drug discovery and in investigational drug development is not being invested in any financial instrument (e.g., stocks, bank accounts, bonds) and, therefore, is not earning interest or dividends. The money also is not placed in real estate, precious metals, or antiques where it might appreciate in value. The loss of income from this money is referred to as lost opportunity costs. Of course, the investment is made in the hope that it will yield future profits if an important drug is discovered, developed, and successfully marketed. If the cost of capital is 10% or more, it causes opportunity costs to become large, particularly if development times are long.
Transfer Costs
A company that manufactures a drug in one country and sells it in others must ship the drug to those countries. The company site that ships a drug charges the foreign offices of the same company a price for the drug. This price is called the transfer price. The countries receiving the drug establish a price or are assigned a price by the government at which to sell the drug. The selling price often is influenced by the transfer price.
Many factors and methods used to calculate the transfer price influence its value. These factors primarily center on:
Taxes paid to customs for import/export goods
Regulatory authority practices in establishing a drug’s price (e.g., it may be related to the stated value on the customs declaration)
The need for the company to show a larger profit in one country versus another
The specific countries involved
Whether the product requires additional procedures as part of its manufacture (e.g., purification, filling into vials, labeling) and possibly retransfer back to the original site
In these circumstances, it is important to consider whether pricing decisions should be based on maximizing the transfer price for the headquarters or doing what is best for the balance sheet worldwide. A high transfer price to a subsidiary makes sense if it is a means of getting money out of a country that places severe limitations on this. A high transfer price to a subsidiary usually makes little sense if it prices the drug above the competition and hurts sales.
The Organization for Economic Cooperation and Development (OECD) has published guidelines on how transfer prices are to be assessed (Transfer Pricing and Multilateral Enterprises). Most countries have tax laws that are based on these OECD guidelines. The major principle underlying the OECD guidelines is “arm’s length prices.” This means that the transfer prices that should be established are those that would be charged between two groups that are not related. Transfers include not only the transfer of drugs, but also technology, services, trademarks, and so forth.
The arm’s length price may be established by several methods. The comparable uncontrolled price method uses a reference to other comparable transactions. Another method, the resale price method, assesses the price charged an independent group or person for the object. A third method is cost plus a fair mark up for the item. See Pradhan (1983) for a further discussion.
PRICING OBJECTIVES AND STRATEGIES
Most companies orient their pricing objectives toward either profit or sales, although a combination of both also can be used. Profit-related objectives establish a money amount for each product or product line or, alternatively, establish a return on investment number. Sales objectives usually are based on a percentage of growth from year to year, although this objective could be expressed in terms of market share.
Whether a company uses sales or profits as their primary goal depends on the medical value of the product, the amount of competition, years of patent life remaining, and other factors.
Cost-plus Pricing
Cost-plus pricing is sometimes used by generic drug manufacturers who have no research costs and only minimal development costs. It is determined by adding a predetermined profit to the sum of all costs (i.e., fixed and variable) of the product and dividing by the number of units produced. This approach is not suitable for research-based companies and is rarely used because most costs cannot be allocated to specific products and because the other approaches make more sense. This approach would generally be followed for low-cost generic drugs (e.g., aspirin) because generic prices of expensive brand name drugs are priced based on the price of the innovator’s drug. The generic price also depends, in that situation, on whether the generic is first, second, or later to the market. Often the costs for the expensive generics are 20% to 30% below that of the brand name drug.
Competition-based Pricing
Companies often use the prices of their competitors’ products as the basis for establishing their own prices. Depending on a large number of factors, they may set their prices above, below, or equal to those of most of their competitors or to that of a particular competitor’s product. The price is based on the estimation of claims that will be allowed versus that of the competition. Thus, if a drug is more effective than an available competitor, it will usually be more expensive (and vice versa). Using this method, reactions to the prices chosen for a new product may be reasonably accurately guessed in advance.
Market Penetration Pricing
Market penetration pricing means that a low price initially is chosen to obtain a larger share of the market. It is recognized that profits will be lower, but this consequence is accepted as a trade-off for achieving a high market share in a rapid manner. This pricing policy reduces the risk of failing to enter the market successfully and places great pressure (i.e., a greater barrier to entry) on present (and future) competitors.
Skimming Pricing
Skimming pricing establishes relatively high prices for a drug to obtain increased profits on (presumably) lower total sales. New breakthrough drugs are candidates for this strategy, as are novel drugs that are expected to have a limited life cycle because of new competitive products entering the market. It may be necessary to heavily promote such products. In some cases, where production is extremely difficult or the starting materials are extremely scarce, a high price may hold down the demand and, thus, decrease
pressures to make more product. A high-priced product in a competitive market segments the market and, assuming there is a basis for setting the price, allows the company to promote the product’s higher quality. This also leads to the perception of higher quality (or greater efficacy), even if it does not exist.
pressures to make more product. A high-priced product in a competitive market segments the market and, assuming there is a basis for setting the price, allows the company to promote the product’s higher quality. This also leads to the perception of higher quality (or greater efficacy), even if it does not exist.
An example is that of Empirin Compound, which was sold for many years by the Burroughs Wellcome Company. Emprin contained aspirin, plus caffeine and phenacetin, and had the “mystique” in many areas of being much more effective than aspirin and was priced significantly higher. When the phenacetin had to be removed from every marketed product, because some people took large quantities on a daily basis, which led to renal problems, the company faced the choice of whether to simply remove the phenacetin and maintain the caffeine or to drop the product. In hindsight, they made a poor choice and dropped the product. Had they kept it, they would have maintained most of the “mystique,” and in a few years, the presence of caffeine was shown to have analgesic value in combination with aspirin.
Value-based Pricing
A company may conduct economic studies to determine the value of a new drug for society. This approach evaluates all the benefits of a drug and the total money saved in a patient’s treatment or the ability to prolong life. Financial savings are usually calculated on an annual basis. Based on the amount of savings (e.g., fewer hospital stays, fewer physician visits, less nursing time), a price is established that still provides a substantial savings to society for purchasing and using the drug. For life-saving drugs, the value can be based on the patients’ having an increased life expectancy compared with not using the drug at all.
FACTORS INFLUENCING THE PRICE OF A NEW DRUG
Understanding all of the costs mentioned earlier as well as the strategies involved in pricing is not sufficient to establish a new drug’s price. First, aggregating all costs at the end of the investigational period does not consider that most of the overall development costs actually are spent after the drug is initially launched. These expenses are for postmarketing studies; for clinical trials on new indications, dosage forms, and routes of administration; and for trials in foreign countries to support regulatory submissions. Second, there are many factors apart from a drug’s cost that influence prices. The following discussion moves beyond the consideration of costs to a focus on other factors that influence the price of a drug.
Although all of the factors described in the following sections may influence the price of a new drug, some are not relevant to a particular company or to a regulatory authority that establishes the price.
Company Reliance on the Drug for Its Own Survival
A company may have a marked dependence on a specific product being introduced on the market for its economic well-being. This point does not mean that such a company will necessarily charge a higher price for a drug if its future is in jeopardy or is questionable, but it is a strategy that may be considered by a company. The opposite situation is also not necessarily true; that is, when a wealthy company has little dependence on a new product for its financial well being, this does not mean that the price charged will be relatively low.
Amount and Intensity of Competition
The degree of competition in the therapeutic area and the costs of competitive products are important influences on prices and usually provide a starting point for establishing a price. Most drugs are introduced into therapeutic areas where other treatments (i.e., drugs or nondrugs) exist. It is important to determine accurately how physicians and patients view the established treatment. For healthcare professionals to be persuaded to use the new treatment, there must be an advantage over older treatments. The extent of that advantage, in terms of safety, efficacy, convenience, quality of life, or other aspects, may influence the price that is charged. Another aspect of competition is the ease with which competitors will be able to imitate or improve on the drug and how long it will take them to do so.
The competition in the same class of drugs (i.e., those drugs working by the same mechanism of action) is particularly relevant because the prices of existing drugs that are similar to the new drug have a major influence on new drug prices. The prices of the first new treatments approved for acquired immunodeficiency syndrome (AIDS) after Retrovir (the first drug approved) were set close to the price for Retrovir. Often formulary committees will allow only one drug from a class to be on the formulary, so companies will usually price their drug at a lower price in the class to capture share for that category.
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