What's Really Driving Costs?

May 1, 2003
Charles Beever

Pharmaceutical Executive

Pharmaceutical Executive, Pharmaceutical Executive-05-01-2003,

According to many legislators and the media, pharma companies, abetted by Madison Avenue, lead the corporate villain list, just below auditors and errant CEOs.

ccording to many legislators and the media, pharma companies, abetted by Madison Avenue, lead the corporate villain list, just below auditors and errant CEOs. The critics' complaint: Compelled by clever-and expensive-advertising, gullible consumers are pressuring physicians to write prescriptions, then rushing out to buy unnecessary drugs, thereby pushing pharmaceutical costs up at double-digit rates.

The numbers seem to support the accusation. Medications accounted for more than 10 percent of healthcare spending in 2001, up from about 6 percent in 1990. And the leap of logic that many critics make, as Michigan Senator Debbie Stabenow told the New York Times recently, is that "excessive advertising only leads to higher prices at the pharmacy."

Ah, if only healthcare costs were as simple to understand as accounting methods. But the truth is more complicated than a single, villainous industry scenario. It also includes an institutional force that is hard to reform or control: namely, third-party payment systems that erode personal accountability in healthcare consumption.

This article describes how that payment system has created the fertile ground in which insured consumers do not pay-or even know-the full cost of Rx therapies. Therefore, they are susceptible to the influence of pharma marketing through direct-to-consumer (DTC) advertising and physician detailing.

Third-Party Payments

In the early 1960s, according to the Department of Health and Human Services, pharmaceuticals accounted for more than 10 percent of total healthcare spending. Although that number fell to half that by the 1980s, it returned to 9 percent by 2000. During the next four decades, marketing spending as a percentage of sales remained roughly constant, 25–30 percent of sales for most companies, according to financial reports. So, although marketing spending has increased in absolute dollars as pharma sales have grown, it has been constant as a percentage of sales.

So what really accounts for the increase in Rx costs? A critical factor is the growing divide between who selects and uses the medicines and who pays the bills.

The evidence suggests that changes in third-party payments have had a significant impact on healthcare spending trends. Between 1960 and 1980, the proportion of total medical-care spending covered by third parties, including government programs, rose from 48 percent to almost 70 percent. During the same period, healthcare costs increased at almost twice the rate of the gross national product, rising from 5 to 9 percent of GNP, or from $27 billion to $246 billion (a $27 billion to $100 billion quadrupling calculated in constant 1960 dollars).

Although factors other than third-party reimbursement have contributed to the rise, they don't explain its magnitude. The US population grew by about 25 percent during the same period; the over- 65 age group grew by about 50 percent.

Even as Medicare and corporate health insurance programs became institutionalized during those decades, most US consumers paid for drugs out of their own pockets. That kept pharma spending growth in check while growth in medical spending exploded. As a result, the proportion of healthcare spending on pharmaceuticals fell by half.

During the 1990s, the situation made an about-face. Although the proportion of medical care spending reimbursed by third parties rose marginally-from 74 to 79 percent-there was a dramatic shift to third-party payment for pharmaceuticals. (See "Out-of-Pocket Nose Dive," page 74 and "Payment Shift," page 76.) In 1992, only 38 percent of full-time employees had Rx coverage. By 2001, that number had reached 88 percent. That increase in third-party payment, driven in large part by employers' desire to attract and retain talent in a competitive economy, clearly contributed to the rise in medicines' share of the nation's healthcare bill.

With third-party payment came a jump in drug spending. Between 1990 and 2000 it tripled, from $40 billion to $122 billion, growing from 6 to 9 percent of healthcare spending. During the same period, all other healthcare spending put together didn't even double, rising from $655 billion to $1,177 billion.

A Rand study recently published in the Journal of the American Medical Association (JAMA) gives further evidence of the impact of third-party payment on Rx spending. (See "Higher Co-Pays=Less Spend.") The study revealed that doubling patient co-payments from $5 to $10 per prescription cut spending by 22 percent-from $725 to $563 per year per person. The study included more than 400,000 employees in 25 large private companies, but regardless of whether it is representative, the impact of third-party payment on reimbursed Rx drug spending is clear: The more people must pay out of their own pockets per prescription, the less they spend overall. And that effect is independent of how much pharma companies spend on sales and marketing.

Some say the Rand study may have overestimated the decline in drug spending as third-party payment was reduced. That is because it failed to examine the extent to which patients switched to OTC alternatives when they were available. Pharmaceutical cost reimbursement-or the lack thereof-matters to patients, and they behave accordingly.

The Whole Story

Of course, the shift to third-party payment provides only a partial explanation of increases in Rx spending. Other factors play a role as well:

  • a rising incidence of disease in therapeutic areas like asthma and diabetes

  • innovative therapies for conditions such as osteoporosis and anemia, which had no satisfactory treatments until the late 1980s and '90s

  • growing evidence that increased spending on appropriate drug therapy can, for some patients with diseases such as diabetes and asthma, reduce overall healthcare costs

  • pharma industry practices such as DTC advertising, increases in the number of sales reps calling on doctors, price increases, and vigorous pursuit of patent life extensions.

Pharma's increase in marketing and sales spending is well documented. On an absolute dollar basis, the spending has increased significantly, tripling between 1990 and 2000, from about $10–$12 billion to $30–$35 billion in 2000. The increase reflects growth in the size of the pharma sales force-from roughly 50,000 in 1997 to more than 80,000 today-as well as increases in DTC advertising, which was essentially zero in 1990 and amounts to more than $2 billion a year today. Although those increases are significant, they also mirror increases in pharma industry sales growth, so the percentage spent on marketing and sales activities is no higher today than it was in 1990.

All the drivers of drug spending increases mentioned previously are important. They are reflected in the rising number of patients on drug therapy, an increasing number of prescriptions, and more days of therapy per patient. They are also reflected in higher prices for innovative new therapies.

Without those factors, drug spending would not have increased as quickly as it has. Nonetheless, third-party reimbursement is a critical underlying driver that has provided the financial "grease" for other engines of drug spending growth.

What To Do

The list of factors contributing to Rx price increases suggests several ways to reduce pharmaceutical spending, many of which have already been attempted. Increasing patient co-pays can result in reduced third-party reimbursement. Limiting sales reps' access to doctors can lower pharma marketing spend. DTC advertising can be controlled-or outlawed, as it is in many countries. The government, too, can control prices.

What's the right mix of interventions? They all "work," if success is measured by reduced drug spending, but they do so in very different ways. Two basic factors account for lower expenditures:

  • who makes the decisions about how much to spend on medicines, including the trade-off between pharmaceutical spending and spending on other types of healthcare interventions

  • the relative impact of the number of prescriptions.

Who Decides

The design of current third-party reimbursement plans distorts the choices patients and physicians make about pharmaceutical and other treatment options. In plans without co-pays, for instance, patients and doctors are insulated from the economic consequences of their choices.

Shifting costs back to patients through co-pays theoretically puts spending decisions in the hands of patients and physicians. But in practice the design of most co-pay programs preclude that. Employer-sponsored Rx benefit plans typically sort co-pay amounts into "tiers"-often three tiers with co-pay amounts of roughly $10, $15, and $20 per prescription for medications in each tier. A drug's tier and its co-pay depend on where it falls in the formulary: generic, preferred, or non-preferred brand-name medicines, respectively. To qualify products for "preferred" low co-pays, pharma companies provide discounts to benefit plan sponsors or their agents. More than 70 percent of Rx benefit plans-up from 38 percent in 1996-feature such arrangements.

So, in today's typical tiered co-pay plan, the third party or its agent is still distorting choices about Rx selection by altering the economics of patient and physician choices. The term "third party" encompasses a combination of payers, including employers, state and federal governments, providers, physicians, and others. But all strive to serve their own best interests as well as the interests of individuals or patient groups. Those third parties, primarily insurance companies responding to employer demands for cost controls and managed care products, make most of the choices about how much healthcare is "enough," about the relative value of treatment options, and about the structure of co-pay programs.

Moreover, co-pay programs are designed to put more pressure on unit volume than on prices, as patients have a fixed co-pay no matter what the Rx price, giving them no incentive to select a cheaper alternative. Although theoretically it is in payers' interest to push pharma companies for lower prices, the incentive to do so is attenuated, because payers do business through agents such as health plans or pharmacy benefit managers (PBMs), which make money by capturing part of the discounts pharma companies offer in exchange for preferred status. And because higher-priced drugs often have higher discounts, such a financial structure results in "perverse" incentives to find the highest absolute discount rather than the lowest absolute price.

So, although benefits with tiered co-pays are a step in the right direction, they are a halting step. Through price negotiations with manufacturers, third parties decide which products merit low co-pays and thus the greatest use. The national discourse rages on, to the detriment of the industry's reputation.

The central question remains: Is the price for a new treatment too high, or is it a bargain relative to the hospitalization consequences of not paying for it? More often than not, it is neither pharma companies nor those whose lives hang in the balance-patients-who wage that debate, but rather third-party payers and health plans working on behalf of those payers.

Many people advocate direct interventions, such as re-establishing the ban on DTC advertising, because the evidence shows that it increases pharmaceutical use. Critics argue two points: Advertising provides inadequate or misleading information, and even if it is truthful, it drives "unnecessary" or inappropriate use of medications.

To the first point, a ban on DTC advertising hardly seems necessary, because regulatory mechanisms ensure accuracy. As for the second point, the issue again is who decides how much pharmaceutical use is too high or inappropriate-third parties or financially accountable patients and their doctors?

Another Way

How do companies that want to provide prescription benefits to their employees give them a more direct stake in the decisions affecting their healthcare? Some are examining a "defined contribution" plan, also known as a consumer or self-directed health plan. Rather than pay for healthcare on a prescription-by-prescription or physician-visit basis, employers contribute a fixed amount of money that beneficiaries can spend as they see fit. That approach, which can assure coverage of catastrophic costs, puts decisions about medication selection and about the "value" of those medications back in the hands of those who benefit.

Some argue that individual decision makers lack the power of large health plans or PBMs to "push back" pharmaceutical price increases or marketing spend, but the evidence suggests otherwise. Booz Allen surveys of health plans show little or no correlation between health plan size and the level of discounts they receive from pharma companies. Instead, the plan's ability to affect patients' Rx choices and to move market share from one medication to another is what triggers discounts. Most pharma companies structure their discounts to plans as "pay for performance" deals, offering discounts only for share movement, often against a reference point such as last year's share or national average market share.

If defined contribution plans become more widespread and patients begin to vote with their wallets and select medicines based on price as well as performance, pharma companies will respond. As companies compete to make their case to patients and physicians based on performance and price, there will be market pressure on price as well as indirect pressure on marketing and ad spend. Debates about whether DTC advertising is appropriate will continue, but patients will retain the power to select products from companies that build a lower advertising margin into their prices.

Consumer-directed health plans put the decision about the "right" level of pharma spending where it belongs: in the hands of patients and physicians. They also put the onus on pharma companies to make their case to the right audience: patients and their doctors. Pharmaceutical spending may or may not drop as a result, but at least patients will have more choices.

Related Content:

News