A Funny Thing About Drug Pricing

A University of Chicago law student with a prior career in the pharmaceutical industry whom I interviewed for a job the other day shared some knowledge regarding drug pricing that I thought quite interesting. It hadn’t occurred to me, though it seems perfectly obvious, that drug companies price drugs over which they possess a patent monopoly according to the avoided costs of the next best treatment for the diseases they address. If an insurer typically has a hundred heart attacks in its risk pool every year, and a new wonder-drug will prevent fifty of them, it will pay just under its cost for treating the fifty avoided heart attacks for a supply of the drug sufficient to achieve this result.

And it turns out, according to my source, that pharmaceutical companies do typically set the unit price of non-copycat patent drugs in relation to the avoided cost for insurers for on-label use.  But then a funny thing happens. The pharmaceutical manufacturer begins promoting down-label and off-label uses of the drug – i.e., use of the drug by patients who are not as at risk of the condition as those for whom the drug was approved to treat, and use of the drug to address other conditions than that for which it has been approved, respectively.

The avoided costs for treating down-label and off-label patients is typically less than for on-label patients, if it can be quantified at all. But at this point, the decision whether to administer the drug is within the hands of the doctor and the patient, and the insurer reimburses for the drug at the price that was negotiated based on the higher on-label rate of cost avoidance. Over time, the down-label and off-label use of a drug can and often does exceed the on-label use, often by a significant degree. As a result, an insurer will often find itself paying out significantly more in reimbursement for a patent drug than the cost of avoided medical treatment the drug achieves. Yet another hidden cost driver in the Freakonomics of our crazy health care system.

A comment from Austin Frakt follows.

Pharmaceutical manufacturers have so many ways to milk insurers. Co-pay rebates to policyholders being another (hat tip to recent Planet Money focus on this). These are just a few of the ways in which insurers really aren’t the big problem in health care. They’re played by providers.

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