The reason: Large pharmaceutical companies are nowhere near as important to real drug innovation as they purport to be. Furthermore, smart policy changes can sustain and increase the pace of life-changing breakthroughs in biomedicine through increased funding of the National Institutes of Health (NIH), cutting the costs and accelerating the speed of clinical trials, and reforming patent law to stop innovation-blocking abuses used by Big Pharma to prevent new drugs from entering the market.
How Pharma Companies Game the System to Keep Drugs Expensive
The 1984 Drug Price Competition and Patent Term Restoration Act gave pharmaceutical companies exclusive protections for innovating a new drug. If they brought a new therapy to life, they enjoyed patent protection to effectively monopolize the market. That was the payoff for shouldering the high risk and high costs of developing new drugs.
This decline can be partly explained by the transition from one-size-fits-all blockbuster drugs to niche therapies (which have smaller patient groups). However, it also reflects stronger pressures to lower medicine costs in traditional pharmaceutical markets. In just the last few months, President Trump made a commitment to bring down drug prices, high-ranking government ministers in the Netherlands published a strong call to develop alternative pharmaceutical business models, and the OECD released a report that recognized the need to rebalance the negotiating powers of payers and pharma companies.
Despite these taxpayer subsidies, prescription drug prices are nonetheless increasing at an alarming rate. In 2019, price increases from drug manufacturers affected more than 3,40026 drugs. For example, Allergan, a major pharmaceutical manufacturer, raised prices on 51 drugs, just more than half its portfolio. Some medications that Allergan manufactures saw a 9.5 percent jump in cost, while others saw a 4.9 percent increase in cost.27 Teva Pharmaceutical Industries Ltd., the largest generic drug manufacturer in the world, increased its drug prices by more than 9 percent.28 These sharp increases in price occur as companies continue to report millions of dollars in revenue. In 2018, Allergan reported $15.8 million29 in revenue, while Teva Pharmaceuticals reported $18.8 million30 in revenue.
Although the Trump administration keeps promising to lower drug prices, drug costs continue to climb as Americans suffer and pharmaceutical companies profit and their CEOs line their pockets. The government-funded research and major tax benefits that these pharmaceutical companies enjoy help them stay profitable. Meanwhile, they continue to hike up the costs of drugs, particularly life-sustaining drugs such as insulin.
As Americans are caught trying to decide whether to pay for rent or medicine, pharmaceutical companies continue to reap government benefits. Reducing drug prices and the costs that everyday people must pay is not possible without fixing the broken system in Washington.
The pharmaceutical industry devoted $83 billion to R&D expenditures in 2019. Those expenditures covered a variety of activities, including discovering and testing new drugs, developing incremental innovations such as product extensions, and clinical testing for safety-monitoring or marketing purposes. That amount is about 10 times what the industry spent per year in the 1980s, after adjusting for the effects of inflation. The share of revenues that drug companies devote to R&D has also grown: On average, pharmaceutical companies spent about one-quarter of their revenues (net of expenses and buyer rebates) on R&D expenses in 2019, which is almost twice as large a share of revenues as they spent in 2000. That revenue share is larger than that for other knowledge-based industries, such as semiconductors, technology hardware, and software.
Small drug companies (those with annual revenues of less than $500 million) now account for more than 70 percent of the nearly 3,000 drugs in phase III clinical trials.1 They are also responsible for a growing share of drugs already on the market: Since 2009, about one-third of the new drugs approved by the Food and Drug Administration have been developed by pharmaceutical firms with annual revenues of less than $100 million.2 Large drug companies (those with annual revenues of $1 billion or more) still account for more than half of new drugs approved since 2009 and an even greater share of revenues, but they have only initiated about 20 percent of drugs currently in phase III clinical trials.3
Information about the kinds of new drugs the pharmaceutical industry has introduced can be inferred from changes in retail spending across different therapeutic classes of drugs. When ranked by retail spending, therapeutic classes in which many expensive specialty drugs have been introduced over the past decade top the ranking, whereas classes in which the best-selling drugs are now available in generic form rank lower now than they did a decade ago.6 Information about the kinds of new drugs the pharmaceutical industry may introduce in the future can be inferred from clinical trials under way.
Drug development also occurs in university research labs. In addition to grants funded by the National Institutes of Health (NIH) that many universities receive for performing basic biomedical research, universities may collaborate with (and be funded by) private drug companies to perform applied research toward the development of new drugs.12 The funding for that R&D may come predominantly from revenues, as the collaborations typically involve established pharmaceutical companies.13
Tax Incentives. The research and experimentation tax credit, available to all types of companies for certain qualifying R&D expenditures, directly reduces the amount of income tax a company owes.46 That tax credit has been modified over time and was made permanent by the Consolidated Appropriations Act, 2016 (Public Law 114-113).47 Some of the increase in R&D spending by pharmaceutical industries over the past several decades might have been a response to changes in that credit. In addition, the Orphan Drug Act (P.L. 97-414), enacted in 1983, created a tax credit to encourage the development of drugs to treat relatively uncommon diseases. Companies can also choose to deduct the cost of R&D investments immediately rather than over the life of the investment. Many companies use both tax credits and the ability to accelerate their deductions for investments in R&D, although only one tax preference may be used for any particular investment expense.
US spending on prescription drugs has been growing rapidly, prompting calls for government intervention to slow the upward trend. But any intervention should be predicated on a clear understanding of the economic forces that drive price increases, and the parties responsible for them. We collect gross and net profit data from the 2015 US Securities Exchange Commission regulatory filings of the largest publicly traded companies in the pharmaceutical distribution system, and use them to describe the flow of funds across the drug distribution system to understand how much each sector profits from its transactions. Gross (net) margins average 71% (26%) for manufacturers, 22% (3%) for insurers, 20% (4%) for pharmacies, 6% (2%) for pharmacy benefit managers and 4% (0.5%) for wholesalers. These margins imply that for every $100 spent at retail pharmacies, about $17 compensates for direct production costs, $41 accrues to the manufacturer ($15 of which is net profit), and $41 accrues to intermediaries in the distribution system: wholesalers, pharmacies, pharmacy benefit managers and insurers (with $8 of net profit split among them). The allocations differ depending on whether the drug is generic or branded. Manufacturers have higher gross profit margins for branded drugs and intermediaries have higher gross profit margins for generic drugs. Gross margins on generic drugs are lower for manufacturers (50%), and much higher for pharmacies (43%). More than $1 in every $5 in spending on prescription drugs goes towards profits of firms in the pharmaceutical distribution system. While the current analysis cannot say definitively whether any sectors make excessive profits, greater scrutiny of pricing policies of each sector and more competition throughout the distribution system is warranted.
To illustrate the implications of our estimates, we explore a hypothetical scenario in which $100 is spent on prescription drugs acquired at a retail pharmacy using commercial insurance. We apply the average sector gross margins to the incoming funds to each sector to identify how much is retained in each sector, and apply the average sector net margins to identify the funds that are kept as net profits. This process was applied throughout the distribution system, as detailed in Section D of the Appendix. The funds passed through the last step are assumed to be production costs to manufacture the drugs.
Finally, we compare the average net margins estimated for pharmaceutical distribution system participants to the average net margins of public companies in similar industries, which are published annually.16 Drug manufacturers are compared to other consumer and business product manufacturers, drug wholesalers are compared to food wholesalers, health insurers to other types of insurance companies, and pharmacies to other retail businesses. PBMs are compared to the category of real estate operations and services, which includes real estate agents and brokers, who also negotiate and act as intermediaries in transactions between third parties.
Average US sales-weighted gross and net margins for each sector in the distribution system are reported in Table 2, as are gross margins for the branded and generic markets separately. For all drugs combined, gross margins are highest for manufacturers at 71.1%, followed by insurers (22.2%), pharmacies (20.1%), PBMs (6.3%) and wholesalers (3.7%). Net margins are significantly lower for all parties, ranging from 26.3% for manufacturers to 0.5% for wholesalers. In the branded market, gross margins are higher for manufacturers (76.3%) and lower for the other distribution system parties (except for insurers, for whom drug-type-specific margins could not be estimated), while in the generic drug market, the opposite is true: margins are lower for manufacturers (49.8%), and higher for all other distribution system participants (again, excepting insurers), including pharmacies, with generic gross margins of 42.7%. Net margins by drug type are only available for manufacturers, falling significantly below their gross margins, at 28.1% for brand drugs and 18.2% for generics. 2ff7e9595c
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