Detangling the Web of US Drug Pricing

When I was a sophomore in college, I was traveling in Marrakesh, Morocco, where there is a busy central plaza with flea markets, peddlers, street artists, and plenty of characters in between. As I walked through the plaza, I came across a group of individuals standing around watching a card game. The card dealer was playing a simple betting game. He had 3 cards—2 black ones and 1 red one. The game started with the dealer showing the participant all 3 cards face up. The dealer then flipped over the cards, scrambled them around, and the gambler had to choose which was the red card. As I stood there, I watched the card dealer play 3 iterations of the game. He showed the cards, flipped them over, and scrambled them around. Each time, the same gambler chose the red card and successfully doubled his money.

The card dealer then pointed to me and asked if I wanted to play. I naively thought to myself, “This is easy. Here’s my chance." I stepped up and he showed me the cards: 2 black ones and 1 red one. He flipped the cards over, and as he was scrambling them around, I watched the red card, surely I thought, fall right into the middle. I pointed to the middle card, and to my dismay, when the dealer flipped it over, the card was black. Again, my naivety kicked in: “This must be a mistake. I clearly saw the red card move to the middle. Let’s try this again." I went for another 2 rounds, and both times, I identified the red card move to the middle position but only to find the dealer revealing a black card. After losing $60, I walked away scratching my head. How could this happen? I saw the cards. I saw him scramble them around. I saw the red card fall right in the middle. And each time, I lost.

I went around the city and came back 2 hours later to see the same group of individuals crowded around the card dealer, and this time I saw another tourist naively watching the game. I stood a little farther back and examined it more closely. As the dealer scrambled the cards, when he went to flip over the red one, he quickly exchanged it for a black one. This was not a fair game; it was a hustle! And it was upon thinking about this hustle that has led me to understand drug pricing in the United States.

In this article, I hope to shed light on the fundamental question: How are drug prices determined in the United States? As we explore this question, I will emphasize 2 themes. First, why are stakeholders in the US supply chain ultimately incentivized to raise drug prices? And second, how is this drug pricing dynamic eerily similar to the 3-card hustle that I encountered in Marrakesh? Let’s flip the cards face up and detangle the web of US drug pricing.

How Are Drug Prices Determined?

A drug's life begins when it is produced by a drug manufacturer and culminates when the medication is prescribed by a provider to a patient. This is a straightforward model with which many providers are familiar. But maybe you have encountered some issues or questions in your practice, such as, “Which topical steroid can I get my patient on? Does the patient have to pay a copay or out of pocket?" Or “Do I have to put a patient on methotrexate or cyclosporine just to ultimately get them on dupilumab?" This is because in the drug pricing supply chain, there are middlemen. We will go into depth about each of these middlemen, what they do, and how they act in the supply chain. But first, let’s review the drug manufacturer (i.e., the pharmaceutical company).

Drug manufacturers set an initial drug price, also known as the list price or the wholesale acquisition cost. This is like an MSRP, the sticker price that sets the foundation for a complex series of negotiations to come. Brand name medications are introduced under exclusivity and/or patents, and it is the combination of exclusivity and/or patents that forms the monopoly period. During this monopoly period, companies can price the medication how ever they want, and no other company can introduce the same drug to undercut the price.

Let’s examine what these patents and exclusivities accomplish. Patents protect specific components of a drug, such as the formulas, delivery systems, or packaging. They are granted by the US Patent and Trademark Office and usually last for 20 years from the date of application filing. Exclusivity, on the other hand, grants rights for the drug itself and is conferred by the US Food and Drug Administration (FDA) upon drug approval. Standard brand name drugs receive 3 to 5 years of exclusivity, depending on the novelty of their ingredients; biologic drugs synthesized from living organisms receive 12 years of exclusivity. Orphan drugs receive exclusivity for 7 years. Dermatologic examples of orphan drugs include rituximab for pemphigus vulgaris and adalimumab for moderate to severe hidradenitis. The median length of postmarket approval exclusivity is 12.5 years for widely used drugs and 14.5 years for highly innovative first-in-class drugs. During this monopoly time, manufacturers often seek to maximize their profits.

Is the monopoly period markup justified by high research and development (R&D) costs? There are a couple of arguments that would suggest that this justification does not hold weight. First, most novel medications are initially funded by public sources such as the National Institutes of Health. Second, analyses have shown that companies invest just 10% to 20% of their revenue into R&D. There is little evidence of an association between R&D costs and drug prices. Rather, prescription drug prices in the United States are primarily based on what the market will bear.

Competition is the main mechanism for lowering drug prices. After the monopoly period ends, the introduction of competition from generic manufacturers generally achieves lower drug prices. Let's dive into a prime dermatologic example to illustrate this.

In 1997, imiquimod 5% cream was approved by the FDA for the treatment of external and perianal warts. At that time, the only other topical medication widely available for warts was 5-fluorouracil, but it was not approved by the FDA and was neither well tolerated nor particularly effective. Therefore, the introduction of imiquimod 5% cream represented an innovation to the dermatology market. When it was first introduced, the price of imiquimod 5% cream was $100 per month. If you equate that to 2023 dollars, it is about $190 per month. After the monopoly period ended, other generic manufacturers entered the market, which resulted in the price of imiquimod 5% cream dropping to about one-fifth of the original list price. Without insurance, the out-of-pocket cost for a 1-month supply of imiquimod today is about $20. In my opinion, this is an example of a successful story of exclusivity and competition.

Let's contrast this with another story of exclusivity. Adalimumab was approved by the FDA in 2002, at which time it was granted 1 patent for the tumor necrosis factor alpha blocking protein. Over the next decade and a half, the manufacturer increased that patent number to over 100 with very little meaningful innovation. With numerous patents essentially on the same product, adalimumab was effectively shielded from biosimilar competition in the United States. Even 18 years after its introduction, adalimumab remained on patent protection with a 1-month supply costing over $5000. Other companies tried to introduce generics to the market, but the manufacturer was able to persuade makers of biosimilar competitors to wait for a 2023 launch instead of engaging in costly legal battles. This is a pharmaceutical business strategy called evergreening (or product lifestyle management), which involves preventing generic competition through legal maneuvers and allowing companies to maintain high prices only guided by what the market will bear.

Although generic drugs are an important driver for lowering drug prices, even with the introduction of generics, prices can remain high. To this end, generic price increases can still occur in the setting of reduced competition. For example, if there is only one company producing the generic option, this company no longer needs to compete based on price. It is the presence of multiple generic manufacturers that is the most important factor for a competitive generic market.

Let's take a halftime break and summarize. How are drug prices initially determined? Initial prices are set by the drug manufacturer.

• The most important factor that allows manufacturers to set high drug prices is market exclusivity protected by monopoly rights awarded upon FDA approval and by patents.
• The availability of generic drugs produced by multiple manufacturers after this exclusivity period is a main means for reducing prices, but access to them may be delayed by numerous business and legal strategies.

How Do Supply Chain Stakeholders Influence Pricing?

Now, let’s dive deeper into the pharmaceutical drug supply chain. Although drug manufacturers set the initial price and certainly play a role in high drug prices, there are multiple stakeholders in the middle of the drug supply chain that also influence the price of a drug.

The first middleman is the distributor, which buys drugs from a manufacturer and then sells smaller quantities to pharmacies and providers. They supply the inventory; physically deliver products to locations around the country; and share the risks, costs, and logistical responsibilities of delivering the medication. Wholesalers are primarily compensated based on the list price of the drug and, thus, are incentivized to support high list prices.

Next, the drug arrives at the pharmacy. There, the pharmacy sets the price for these medications that are considerably or even astronomically higher than the original price. This is called the cash retail price, or what is sometimes called the usual and customary cost of the medication. The price may be neither usual nor customary, and it is not the price that the pharmacy expects to recoup on sales. Most patients do not pay the retail price of the medication at the pharmacy and instead rely on their insurance company and/or employer to cover most of the medication costs. Whether the insurance will cover the medication depends on how the formulary or drug tiering is arranged.

Most of us are probably familiar with what formulary drug tiering is, but let's illustrate it with a basic example. Let's say I am a patient with severe psoriasis, and I want to go to Dr X for treatment. Dr X indicates that topical medications are insufficient to control my severe psoriasis, so she looks to put me on a biologic. Which biologic my insurance will cover depends on how my insurance’s formulary or drug tiering is arranged. Is it going to be adalimumab? Guselkumab? Risankizumab? Unfortunately, that is not often determined by my provider, Dr X, or me, the patient. Rather, it is determined by how my formulary or drug tiering is designed. But how are these formularies designed?

Insurance companies pay pharmacy benefits managers (PBMs) to design and manage the formularies. PBMs are companies that manage prescription drug benefits on behalf of insurers, Medicare, and employers by negotiating with drug manufacturers and pharmacies to theoretically lower medication costs. PBMs have a significant behind-the-scenes impact on determining total drug cost for insurers and which medications patients can get access to. PBMs have become a major part of the pharmaceutical supply chain and are highly profitable, but to fully understand the function of the PBM, we need to define the important concept of a rebate. At their core, rebates are payments (some would say bribes) that are made by drug manufacturers to PBMs and used to incentivize the utilization of a pharmaceutical company’s drugs. In many cases, how high the rebate that a pharmaceutical company is willing to pay a PBM is the driver for determining which drugs are included in a formulary and on which tier a drug is prioritized. It’s like a parent paying the coach to get his or her child into the starting lineup.

Formulary design is, therefore, not necessarily based on clinical data or cost effectiveness. Rather, PBMs and insurers may design their tiered formularies based on the rebates a drug manufacturer awards, which may lead to auctioning of formulary access. In extreme cases, a costly drug may be in a preferential tier when cheaper, safer, or more effective generic alternatives are available. Rebate reliance may also reduce the value proposition for cheaper drugs manufactured by smaller companies, which are less attractive to PBMs.

Let's walk through a hypothetical example of this dynamic, again using me as a patient with severe psoriasis. My insurance company has paid a PBM to design its formulary. The manufacturer offers my insurance company's PBM a very high rebate each time adalimumab is prescribed to a patient. Because a PBM receives a nice paycheck whenever a patient is put on adalimumab, my PBM decides to put adalimumab at the top of the formulary. So, when I, a patient with psoriasis needing a biologic, go to Dr X for treatment, the only option that she can prescribe to me without any prior authorization paperwork is adalimumab. Therefore, I end up on adalimumab, not because it is the best option for my disease or because it is the cheapest, but because that is how my formulary has been designed. But neither Dr X nor I as the patient have any insight into these rebates or formulary design since rebate details are often not disclosed to insurers and patients. Therefore, rebates, which are often instrumental drivers in drug tiering, drug pricing, and preferred formulary selection, carry a substantial lack of transparency. And, these drug rebates drive PBM revenue. They move retrospectively, are hard to track, and prevent final drug pricing from being accessible at the time of distribution or even when a drug is added to a formulary. Perhaps you are starting to see themes from that hustle in Marrakesh. The cards are face down in drug pricing, and they can switch without any of us knowing.

The average rebate is estimated to be 20% of the list price but may reach up to 60%. In competitive drug markets where there are many options, rebates are higher because pharmaceutical companies must pay a higher rebate to the PBMs to get their drug bumped up on the formulary. As such, the presence of multiple manufacturers with head-to-head competitors is associated with higher rebates.

PBMs may pass a part of this rebate to the insurer in the form of a discount, which, in turn, may theoretically result in a reduction of premium costs for patients. But, in reality, much of the rebate is retained by PBMs as profit, also known as the retained  rebate. Maximization of the retained rebate reduces neither insurance premiums nor copays and, in some situations, patients with high deductible plans may pay the full list price of that drug, allowing the PBM and, secondarily, the insurer to keep any pre-negotiated rebates.

In some cases, the PBM and insurer have now merged into a single entity and may pocket 50% of the price paid by the patient. The percentage-based rebate system incentivizes PBMs to favor a high list price and, therefore, PBMs grant formulary status to higher price drugs where the percentage rebate is greater. In some cases, this baseline drug price is cheaper than the drug price with insurance and patient copays, and it would be cheaper for the patient to just buy the drug outright without using insurance. However, if the patient still uses insurance in the scenario, the insurer may retain the difference, known as a clawback.

Let’s walk through one more example to illustrate the concept of a clawback. A provider has prescribed a particular topical steroid for a patient. The PBM has helped negotiate a $15 copay for this medication. The medication only costs $2 and the pharmacy, which dispenses the medication to the patient, is reimbursed $7, giving a profit of $5. Where does that rest of that profit go? Right back to the PBM, “clawing back” the remaining $7.78 from the pharmacy.

Before October 2018 when it became illegal, there was something called a gag clause in the contracts the pharmacies signed with the PBMs that would not allow pharmacists to tell patients, “It is actually cheaper for you to buy this out of pocket than use insurance with it.”

Now, what about providers? Unfortunately, providers have been implicated in raising prices occasionally, such as in the buy and bill model for Medicare Part B patients. For example, a provider can buy infliximab, administer the infusion to the patient, and then bill the patient directly. Clinicians have been implicated in profiting from the spread between what the medication is bought for and what the patient is billed for. Furthermore, it is challenging for providers at the point of prescription to be effective stewards of cost because it is almost impossible for them to know the cost of medications at the time of prescription. The current system is so complex that it is possible for the same patient, with the same insurance, with the same pharmacy chain, in the same city, on the same day, on the same generic drug, to pay different copays in different branches. This makes the prediction of copays nearly impossible.

Conclusion

To summarize the answer to the question that we posed at the beginning, drug prices in the United States are driven by a complex web of interconnected relationships, incentives, and payments among a multiplicity of stakeholders in the drug supply chain. The lack of transparency is a major barrier to physicians functioning as effective stewards of resources, which results in an increase in overall costs. We are still trapped in that 3-card hustle game I encountered in Marrakesh. What keeps us here is inertia. I hope we can move toward a system that is fair, balanced, and transparent. Perhaps, you can say, a system where the cards are face up.

Acknowledgments: The author would like to acknowledge the Oregon Health & Science University Frances J. Storrs, MD, Medical Dermatology Lectureship, from which this article was adapted, and Dr Peter Bach for his insightful discussions.

Disclosure: The author reports no relevant financial relationships.