Why Does Medicine Cost So Much? Here’s How Drug Prices Are Set

From 2007 to 2016, Mylan raised the list price of its EpiPen about 500%, from just under $100 to more than $600. From 2002 to 2013, insulin prices more than tripled. From 2012 to 2019, the average price of AbbVie’s rheumatoid-arthritis drug Humira climbed from $19,000 a year to $60,000 a year—and that’s after rebates. These are dramatic examples of a systemwide problem: prices for brand-name drugs are rising at a rate that far outstrips inflation.

What’s behind these rapid price hikes? It’s a simple question with a complicated answer that involves three central entities: drug manufacturers, pharmacy benefit managers (PBMs) and insurers. Together, they create a complicated supply chain that helps drive drug prices aggressively upward. “We have a system that is all engine and no brake,” said Michelle Mello, a professor at Stanford Law School and a professor of health research and policy at Stanford Medicine.

The amount you pay for a brand-name drug will depend on your insurance plan; the plan’s formulary, or list of drugs it prefers and covers; the size of your deductible; and the deal your insurance company has worked out with the drug’s manufacturer, among dozens of other variables. How such discounts are negotiated is proprietary, carefully guarded by the system’s various players.

There’s a lot of finger-pointing over who is to blame for rising prices, particularly between drug companies and PBMs, or the middlemen that negotiate rebates and discounts for health plans.

It all starts with the manufacturers: companies that develop new treatments and conduct clinical trials. There are essentially no regulations governing how drugs are priced. Instead, pharmaceutical companies select a price based on a drug’s estimated value, which typically translates into what they “believe the market will bear,” said Dr. Aaron Kesselheim, an associate professor of medicine at Harvard Medical School. Blockbuster first-in-class treatments, therefore, command stratospheric prices. When Gilead Sciences received Food and Drug Administration (FDA) approval for its hepatitis medication Sovaldi in 2013, the company priced it at $1,000 a pill, or $84,000 for the full course of treatment. The price was possible because the drug worked and, for a time, was the most convenient and effective treatment on the market.

For drugs entering a crowded disease category with multiple other options, the calculus is different. In such cases, a new treatment will typically be priced similarly to its competitors.

The dollar amount a manufacturer assigns a drug is the list price, and functions “like a sticker price on a car,” said Mello. The pharmaceutical company will, depending on the drug and buyer, provide a variety of discounts off the list price.

Rebates for commercial, employer-sponsored or self-insured health plans, negotiated by PBMs on behalf of the insurers, can get confusing, but the process broadly goes like this: Say a manufacturer offers a drug with a list price of $1,000 for a month’s supply. Wholesalers pay the manufacturer the full or close to the full price and make it available to pharmacies. From the manufacturers’ point of view, that’s as far as things would need to go: they’ve put a drug on the market and gotten paid for it. But there would be little demand for the drug if insurance companies didn’t make it available to consumers by listing it on their formularies, and employer-sponsors weren’t making the insurance available to their employees.

It’s the PBMs that negotiate with the manufacturers and insurers to get drugs listed and to establish prices. For that work, the manufacturers pay a fee in the form of a rebate—say, $400 off that $1,000 drug. One of two things then happens to that $400: Either the PBM takes a share of it, say $40, and passes the rest of the savings on to the insurance plan’s employer-sponsor. Or the PBM pays the entire $400 to the sponsor, but raises the fee it charges the insurer to conduct the price negotiations in the first place.

Either way, the drug now has a net price of $600, or the amount the manufacturer actually makes on its sale. The consumer with health insurance pays an amount that ranges from a fixed co-pay to some percentage of the full list price, depending on the terms of the plan and whether deductibles have been met. For many patients, out-of-pocket costs can be cut further by coupons the manufacturer distributes through doctors or online, which can make patients likelier to ask for a certain drug by name.

When the buyer is the government, discounts are typically standardized. The price Medicare pays for a branded drug that is self-administered (taken at home instead of administered in a clinical setting, like chemotherapy) is based on the average sales price of that drug across different health plans, taking into consideration all discounts and rebates. Medicaid gets a better deal: the government insurance program is entitled by law to receive either 23.1% off the manufacturer’s list price or the drug’s largest commercial discount, whichever is lower. In the case of the $1,000 drug, a 23.1% discount would mean a $769 net price, compared with the $600 price negotiated by PBMs and insurers, so Medicaid pays the $600.

This complex system becomes even more so, thanks mostly to the power of the PBMs. Not only do they wrangle rebates and discounts from the manufacturers in exchange for getting their drugs placed on the insurance companies’ formularies, they also help determine where on the formulary hierarchy any drug will be. An insurance plan may cover, for example, three psoriasis drugs, but they are on different tiers. A drug on a preferred tier will have a larger rebate, making it cheaper for patients. Ideally, drugs would be tiered only according to their effectiveness, and there is certainly an element of that in the mix, especially for patients with Medicare. But a lot of it has to do with which manufacturers are willing to offer the greatest discounts.

To force a manufacturer’s hand, PBMs may also practice formulary exclusion, in which they remove one of the medications in a disease category altogether. If a drug is not on a formulary, patients are usually on the hook for the full list price—which most won’t pay if there is a competing drug available. Price pressure intensifies as companies scramble not to get cut.

When the system is working, PBMs do perform a service, getting manufacturers to lower costs. “If you didn’t have an entity called a PBM, you would want to create one,” said Geoffrey Joyce, chair of the department of pharmaceutical and health economics at the University of Southern California School of Pharmacy.

But as it exists today, the system isn’t designed to prioritize savings for patients. A big reason for this is that PBMs are not incentivized to negotiate for lower list prices as much as they are for higher rebates, since the share of those refunds they keep is a part of how they make their money. Manufacturers, competing to secure high formulary tiers, know PBMs want juicy rebates. And so they have two options: offer a larger discount and make less money on the drug, or offer a larger discount while also raising the list price of the drug, therefore keeping the net price level. If you’re a manufacturer, you’re going to pick the latter option. Little of this is evident to the average consumer.

Let’s return to that $1,000 drug. If the manufacturer raises the rebate it is offering the PBM from $400 to $500, it will likely also raise the list price by at least $100 to avoid taking a hit on the drug’s net price. That’s good for the PBM; neutral for patients with good health insurance; and bad for those who pay co-insurance, are on high-deductible plans or are uninsured, as the list price is now $1,100.

“There is a lot of concern that those incentives are somewhat perverse,” said Rachel Sachs, an associate professor of law at Washington University in St. Louis.

Insulin pricing is an especially cautionary example. The drug’s average cost has nearly doubled since 2012. “The increase in the list price has been stunning,” said Karen Van Nuys, a research assistant professor at the USC Price School of Public Policy. Today, insulin is so expensive that some people are rationing their supplies, which comes with serious, potentially deadly risks.

In a 2018 article published in Diabetes Care, Van Nuys and colleagues tracked the list prices for insulin against the net prices, or the amount manufacturers actually received. They found that from 2002 to 2013, list prices for insulin nearly tripled��while increases in net prices during that period were far less significant. (In some cases, those net prices even went down.) The reason: most of the increase went to rebates that the PBMs and plan sponsors got to keep. Many insured patients paying only the net price might not have noticed the difference, but uninsured patients, or those with insurance but with deductibles still to meet, were stuck with the soaring list prices.

On top of secretive agreements with manufacturers, PBMs have separate, confidential contracts with health insurers and employers. Large employer-sponsors, because of their size, can demand favorable terms, said Richard Evans, general manager of SSR’s health practice, such as stipulating that they receive all rebates. But like PBMs, insurers are feeling public heat for holding on to rebates. Last year, Aetna and UnitedHealthcare announced they would start passing rebates down to patients—at least ones in higher-end insurance plans.

Manufacturers argue that the public’s focus on list prices is misplaced, since drug costs are discounted as they move through the supply chain. While this is technically true, the list prices do matter. Not only do uninsured patients and those who haven’t met their deductibles have to pay that amount in full, patients with co-insurance often face out-of-pocket expenses that are based on a percentage of the list price, not on the discounted price.

What can be done to stop or slow the rate at which drug prices are increasing? As of yet, there are virtually no regulations preventing manufacturers from setting and raising prices as high as the market will bear, nor are there policies preventing PBMs from keeping a percentage of the discounts they negotiate.

Public anger, however, is reaching a boiling point. The Trump Administration has floated the idea of eliminating Medicare rebates, essentially forcing PBMs to pass negotiated discounts down to patients. (While this would lower the out-of-pocket expense for patients on high-cost brand drugs, it might increase overall costs in the form of higher premiums.)

In late February, seven pharmaceutical executives testified before Congress about rising drug prices. Their showdown with lawmakers was more muted than expected, but many experts believe the groundwork is being laid for substantive legislative action, if not in the next couple years, then in the next half a dozen.

Changing the system won’t be easy. There’s a lot of money on the line, and the health care industry is preparing for a fight: PhRMA, the pharmaceutical industry’s most powerful influence arm, spent nearly $28 million in lobbying efforts last year, a record-breaking total for the group. (PCMA, the lobbying group for PBMs, spent a far smaller, but not insignificant, amount in the low seven figures.)

Those lobbying efforts are going into overdrive because the drug-supply chain is facing real pressure as health care costs have become a rare bipartisan issue. “Over the last two years there has been increasing recognition by state and federal legislatures that something needs to be done,” Kesselheim said.

Consumers and patients—it’s worth remembering—are also voters. That makes them one link in the supply chain that Washington ignores at its peril.