Issues 2020: Drug Spending Is Reducing Health-Care Costs

The Narrative

"Prescription drug prices are out of control. The drug prices have gone through the roof."[1] — Donald Trump   "The greed of the pharmaceutical industry is a public health hazard to the American people."[2] — Bernie Sanders   "Millions and millions of Americans’ health and wellbeing is being put at risk by the outrageous and unjustifiably high cost of prescription drugs."[3] — Cory Booker

Reality

Prescription drugs are not the cause of America’s steadily rising health-care costs. Drug spending is a low and declining share of health-care spending, and even the most expensive new drugs can lower costs by reducing the need for costly hospital and physician services. While headlines have focused on eye-catching prices for new drugs, this is more than offset by price declines as patents expire and generic competition enters.

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1. Drugs are not what makes American health care expensive.

• Prescription drugs account for 12% of U.S. health-care spending—less than most other countries.[4]
• Out-of-pocket prescription drug spending accounts for 0.4% of  U.S. households spending, less than in any other major developed country.[5]
• Real per-capita spending on prescription drugs increased by $70 (9%) from 2007 to 2017, while real per-capita spending on hospital services increased by $627 (27%).[6]

2. Generics reduce drug spending more than twice as quickly as price hikes increase it.

• From 2014 to 2018, savings from patent expiry totaled $51 billion, more than offsetting the $22 billion increase in spending due to price increases. Overall drug spending did rise but only as a result of increased usage and availability of new drugs.[7]
• Spending on specialty drugs has been increasing, but overall real per-capita spending on traditional drugs fell from $738 in 2008 to $527 in 2018.[8]

3. Even initially expensive drugs save money in the long run.

• A new drug allowing treatment that wasn’t previously possible will add to health-care spending in the short run; but as its cost declines, it can deliver savings over the labor-intensive hospital and physician care otherwise necessary.
• The Congressional Budget Office estimates that a 1% increase in prescriptions filled by Medicare beneficiaries reduces spending on medical services by 0.2%.[9] This means that, on average, an extra $100 in prescription drug utilization (including products still covered by patents) by Medicare beneficiaries can be expected to reduce the program’s spending on other medical services by $95 while delivering better outcomes.[10]

On the Record "Financing new drugs is expensive, but developing new cures helps eliminate the costliest hospital and physician services over the long run." —Chris Pope, senior fellow, Manhattan Institute

Of the $457 billion spent in the U.S. on drugs in 2015, 72% went to retail (prescription and over-the-counter) drugs, with the remainder went to drugs purchased by hospitals or physicians.[11]

While costs for certain blockbuster drugs may be increasing rapidly, overall drug costs are not. Between 2007 to 2017, real per-capita hospital spending increased by 27%, from $2,297 to $2,924, but real per-capita spending on prescription drugs increased by only 9%, from $783 to $853. Real per-capita out-of-pocket spending on prescription drugs fell by 31%, from $173 to $120.[12]

U.S. health care is expensive primarily because it uses so much skilled labor, which costs more in the U.S. than in other nations.[13] As a share of health-care costs, U.S. drug spending is relatively low. Only 12% of health-care spending in the U.S. goes toward pharmaceuticals, compared with 15% in Australia, 17% in Canada, and 19% in Japan.[14]

As American insurers pay more for hospitalizations, so, too, are they willing to pay more for the new drugs that may prevent the need for hospitalization. Drug manufacturers know this and therefore develop new drugs on the expectation that they will be able to cover a disproportionate share of development costs with revenues from the United States. Thus, the U.S. accounts for 41% of global drug spending, compared with 13% by the five largest European nations and 11% by China.[15]

Prescription drug price negotiations by other countries ultimately depend on a refusal to purchase drugs priced above set amounts. In Canada, for instance, public programs cover only 23% of new drugs, while private insurance plans cover 84% of new drugs.[16] “Low prices” often simply mean “low reimbursement levels.” This limits the amount that drugmakers can realistically charge, but may leave individuals to bear most of the cost out-of-pocket to get access to the best therapies.[17] As a result, the share of household spending dedicated to out-of-pocket spending on prescription drugs in the U.S. (0.4%) was lower than in any other major developed country—and well below rates in Australia (1.2%), Canada (1.1%), and Japan (1.1%).[18]

Developing new drugs and demonstrating their safety and efficacy to the satisfaction of the Food and Drug Administration is enormously costly, with failures greatly outnumbering successes. The average cost of successfully bringing a new drug to market has been estimated at $2.9 billion.[19]

The objective of patent protection is to grant firms a period of exclusivity in which they might charge sufficiently high prices to recoup their investment. Adam Smith noted that this arrangement was preferable to state-administered prices or prizes, arguing that “if the legislature should appoint pecuniary rewards for the inventors of new machines, etc., they would hardly ever be so precisely proportiond to the merit of the invention as this is. For here, if the invention be good and such as is profitable to mankind, he will probably make a fortune by it; but if it be of no value he also will reap no benefit.”[20]

Once patents expire and drugmakers lose their market exclusivity, prices decline rapidly. After two years, generics cost only 41% what branded drugs do, and prices continue to fall as more competitors enter.[21] The generic statin atorvastatin is now available at 4% of the price for Lipitor, which had been America’s best-selling prescription drug before its patent expired in 2011.[22] Generic drugs account for 90% of prescriptions but only 23% of drug spending.[23]

Although a study of 49 top-selling branded drugs found that prices increased by an average of 76% from 2012 to 2017, the entry of generics reduces drug spending much faster than price hikes increase it.[24] From 2014 to 2018, price changes accounted for $22 billion in extra drug spending, which was more than offset by a $51 billion reduction in spending resulting from the loss of exclusivity that allowed generic drugs to enter the market. Spending increased slightly overall but not because of price increases. Increased usage of existing drugs led to $35 billion of additional spending while the introduction of new drugs accounted for another $75 billion.[25]

Prices for new drugs are least constrained when there are few close substitutes, meaning that they are highest where no treatment was previously possible. This is why specialty drugs, which serve small patient populations with rare diseases, often cost so much. These drugs require major up-front investments, which cannot be covered without high unit prices. Specialty drugs account for 2% of prescriptions but 49.5% of U.S. drug spending.[26] While real per-capita spending on traditional drugs fell substantially, from $738 in 2008 to $527 in 2018, real per-capita spending on specialty drugs increased from $262 to $517—more than offsetting the reduction.[27]

In 2012, 12 of 13 new cancer drugs entering the market cost over $100,000 per patient, annually, and usually with therapeutic benefits that fell well short of a cure.[28] At some stage, those paying for insurance will determine coverage of such therapies not worth the cost. But thus far, demand for them, even at very high prices, appears strong: the 87% support of seniors for reducing Medicare payments for drugs drops to 22% when they are told that the proposal would mean that “Medicare might not cover some prescription drugs.”[29] The Trump administration has struggled to develop proposals that would reduce Medicare’s drug costs by more than trivial amounts ($0.1 billion out of $113.7 billion spent on prescription drugs; and $0.1 billion out of $29.1 billion on physician-administered drugs).[30]

That is not to say that all prices need to be as high as they currently are. Even if benefits from new drugs outweigh the high costs of developing them, the prices borne by consumers may still be unnecessarily high relative to those costs. A third of drug spending is retained by pharmacies, drug plans, insurers, and other medical providers. In recent years, the largest drug manufacturers have spent more on administrative expenses than on research and development, and 78% of new patents have been attempts to extend protection for existing drugs, rather than for new products.[31]

This problem has become particularly significant for biologic drugs, which can involve a complex manufacturing process, generating numerous auxiliary patents, which may enable drugmakers to keep competitors off the market. Notoriously, this has allowed increases in the prices of insulin products that have been on the market for over a generation. However, the scale and pervasiveness of this are easy to exaggerate. After rebates and discounts, drugmakers often make no more from insulin than they did a decade ago.[32]

While drug costs may be increasing little overall, the uninsured and those in insurance plans with high deductibles or coinsurance for specialty drugs may be exposed to significant costs. Which is to say, we face a problem of gaps in insurance coverage, more than one of pricing as such. In 2017, 17.5% of prescription drug costs were borne out-of-pocket, as opposed to 3.4% of hospital costs.[33]

Even in a temporary period, market exclusivity provisions do not confer any monopoly for the treatment of any particular condition, but merely to the particular product employed—to which other drugs or non-drug therapies may serve as substitutes. Prices of new branded drugs therefore reflect the cost of alternative treatments. If a new drug offers no advance on other existing products that are available, it is unlikely to command a higher price.

A new drug like Sovaldi, a cure for Hepatitis C that costs $84,000 for a 12-week course of treatment, may seem expensive in the abstract, but it is a great value when compared with a liver transplant, which costs $577,000 on average, often falls short of a cure, and is prone to complications.[34] Indeed, the benefits to society of the best new drugs often far outweigh their costs. One study estimated the value of the increase in life expectancy resulting from the development of HIV/AIDS drugs at $1.3 trillion—20 times more than the profits on the investments that had been made in them.[35]

Five-year cancer survival rates increased from 49% in 1977 to 69% in 2013; and the largest improvements came in the types of cancer for which the most new drugs have been approved.[36] Between 2000 to 2009 alone, drug innovation reduced cancer mortality by 8%.[37] As a result of its more rapid uptake of new cancer drugs, the U.S. sees consistently longer average cancer survival (11.1 years) than European Union countries (9.3 years) across a range of conditions.[38]

Age-adjusted mortality per 100,000 from heart disease in the U.S. fell from 543 in 1965 to 169 in 2015, and for stroke from 166.4 to 37.6 over the same period.[39] Though lifestyle changes account for just under half this decline, medications such as statins, beta-blockers, and ACE inhibitors explain most of the decline in heart disease mortality resulting from better treatment over recent decades.[40]

In the short run, new drugs may increase overall spending, but they allow more to be done for patients who had previously gone untreated.[41] However, as a result of patent expiry, drugs will consistently save money over the long run by displacing labor-intensive hospital and physician care.[42] And according to some estimates, new drug development may even save money in the short term: a recent study found that “the newer the drugs prescribed in a census region are, the lower the total per capita health spending in that region” because newer, more effective drugs substituted for more expensive hospital stays. The authors estimate that for every one-year decrease in the average age of prescribed drugs, overall health spending declined by $45 per capita.[43]

While the introduction of Medicare coverage for hospital and physician services in 1965 made no discernible difference in the overall mortality rate of the elderly, the introduction of prescription drug coverage in 2006 reduced elderly mortality by 2.2%, with a significant relative drop in cardiovascular mortality in counties most affected by the coverage expansion.[44] Although 72% of seniors already had privately funded drug plans prior to its provision through Medicare, beneficiaries who were newly receiving drug coverage saw hospital admissions cut by 4% and inpatient expenditures fall by between 2%–5%.[45]

The Congressional Budget Office estimates that a 1% increase in prescriptions filled by beneficiaries reduces Medicare spending on medical services by 0.2%.[46] This means that, on average, an extra $100 in prescription drug utilization (including products still covered by patents) will reduce the program’s spending on other medical services by $95.[47] After associated patents expire, such utilization would generate net savings as well as improved medical outcomes.

1. Tae Kim, “Biotech, Pharma Shares Drop After Trump Says ‘Drug Prices Are Out of Control,’ ” CNBC, Oct. 16, 2017.
2. Bernie Sanders, Twitter post, Oct. 9, 2019.
3. SocialSecurityWorks, Twitter post, Jan. 11, 2019.
4. OECD, “Pharmaceutical Spending: Total, % of Health Spending, 2018 or Latest Available.”
5. OECD, “Out-of-Pocket Medical Expenditure,” Health at a Glance 2017; Centers for Medicare & Medicaid Services (CMS), “National Health Expenditure Data.”
6. CMS, “National Health Expenditure Data”; Bureau of Labor Statistics (BLS), “CPI Inflation Calculator.”
7. IQVIA Institute, “Medicine Use and Spending in the U.S.,” IQVIA Institute Report, May 9, 2019.
8. Ibid.
9. Congressional Budget Office (CBO), “Offsetting Effects of Prescription Drug Use on Medicare’s Spending for Medical Services,” Nov. 29, 2012.
10. CMS, “National Health Expenditure Data”; in 2017, Medicare spent $100.9 billion on prescription drugs and $481.0 billion on other medical services.
11. Department of Health and Human Services, Office of the Assistant Secretary for Planning and Evaluation, “Observations on Trends in Prescription Drug Spending,” Mar. 8, 2016.
12. CMS, “National Health Expenditure Data”; BLS, “CPI Inflation Calculator.”
13. Eric Helland and Alex Tabarrok, “Why Are the Prices So Damn High?” Mercatus Center, May 22, 2019.
14. OECD, “Health Spending: Total, % of GDP, 2016.”
15. Ibid.
16. Mark Rovere and Brett J. Skinner, “Access Delayed, Access Denied,” Fraser Institute, Apr. 4, 2012.
17. Tsung-Mei Cheng and Uwe E. Reinhardt, “Shepherding Major Health System Reforms: A Conversation with German Health Minister Ulla Schmidt,” Health Affairs web exclusive 27, no.1 (April 2008); Karine Chevreul et al., “France: Health System Review,” Health Systems in Transition 17, no. 3 (2015).
18. OECD, “Out-of-Pocket Medical Expenditure”; CMS, “National Health Expenditure Data.”
19. Joseph A. DiMasia, Henry G. Grabowski, and Ronald W. Hansen, “Innovation in the Pharmaceutical Industry: New Estimates of R&D Costs,” Journal of Health Economics, 47 (May 2016): 20–33.
20. Adam Smith, Lectures on Jurisprudence, ed. R. L. Meek, D. D. Raphael, and P. G. Stein, vol. 5 of The Glasgow Edition of the Works and Correspondence of Adam Smith (Indianapolis: Liberty Fund, 1982), 103.
21. Atanu Saha et al., “Generic Competition in the US Pharmaceutical Industry,” International Journal of the Economics of Business 13, no. 1 (Feb. 2006): 15–38.
22. Ed Lamb, “Top 200 Drugs of 2008,” Pharmacy Times, May 15, 2009; Todd Hixon, “The High Stakes Games Around Generic Lipitor,” Forbes, Dec. 7, 2011; Costco pharmacy online, Lipitor: Price for Lipitor, 30 tablets, 40 mg., $488.55; price for generic alternative (atorvastatin), 30 tablets, 40 mg., $18.98, as of Oct. 12, 2019.
23. Association for Accessible Medicines, “Generic Drug Access & Savings in the U.S.,” 2018.
24. Nathan E. Wineinger, Yunyue Zhang, and Eric J. Topol, “Trends in Prices of Popular Brand-Name Prescription Drugs in the United States,” JAMA Network Open (May 2019).
25. IQVIA, “Medicine Use and Spending in the U.S.”
26. Ibid.
27. Ibid.
28. Donald W. Light and Hagop Kantarjian, “Market Spiral Pricing of Cancer Drugs,” Cancer 119, no. 22 (Nov. 15, 2013): 3900–3902.
29. Ashley Kirzinger et al., “KFF Health Tracking Poll,” Kaiser Family Foundation, Mar. 1, 2019.
30. Modernizing Part D and Medicare Advantage to Lower Drug Prices and Reduce Out-of-Pocket Expenses, 42 C.F.R. § 422 & 423 (2018); Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, “2018 Annual Report,” June 5, 2018; Medicare Payment Advisory Commission (MedPAC), Databook, “Chart 10-1: Medicare Spending for Part B Drugs,” June 2018.
31. CMS, “National Health Expenditure Data.”
32. Ibid.
33. Ibid.
34. F. Jason Harris, “Sovaldi Costs Less than Other Treatments,” Modern Healthcare, May 1, 2014.
35. Tomas J. Philipson and Anupam B. Jena, “Who Benefits from New Medical Technologies?” NBER Working Paper #11810 (December 2005).
36. Max Roser and Hannah Richie, “Cancer,” Our World in Data, 2017; Frank R. Lichtenberg, “The Effect of New Cancer Drug Approvals on the Life Expectancy of American Cancer Patients, 1978–2004,” Economics of Innovation and New Technology 18, no. 5 (2009): 407–28.
37. Frank R. Lichtenberg, “Has Medical Innovation Reduced Cancer Mortality?” NBER Working Paper #15880 (April 2010).
38. Tomas Philipson et al., “An Analysis of Whether Higher Health Care Spending in the United States Versus Europe Is ‘Worth It’ in the Case of Cancer,” Health Affairs 31, no. 4 (April 2012) 667-75.
39. “Mortality Trends in the United States, 1900–2015,” CDC: National Center for Health Statistics.
40. Earl S. Ford, “Explaining the Decrease in U.S. Deaths from Coronary Disease, 1980–2000,” New England Journal of Medicine 356 (June 7, 2007): 2388–98.
41. David M. Cutler and Mark McClellan, “Is Technological Change in Medicine Worth It?” Health Affairs 20, no. 5 (September/October 2001).
42. Peter W. Huber, “Of Pills and Profits: In Defense of Big Pharma,” Commentary, July 1, 2006.
43. Abdülkadi̇r Ci̇van and Bülent Köksal, “The Effect of Newer Drugs on Health Spending,” Health Economics 19, no. 5 (May 2010).
44. Amy Finkelstein and Robin McKnight, “What Did Medicare Do (and Was It Worth It)?” NBER Working Paper #11609 (September 2005); Abe Dunn and Adam Hale Shapiro, “Does Medicare Part D Save Lives?” American Journal of Health Economics 5, no. 1 (Winter 2019): 126–64; Jason Huh and Julian Reif, “Did Medicare Part D Reduce Mortality?” Journal of Health Economics 53 (May 2017): 17–37.
45. Robert Kaestner, Cuping Schiman, and G. Caleb Alexander, “Effects of Prescription Drug Insurance on Hospitalization and Mortality: Evidence from Medicare Part D,” Journal of Risk and Insurance 86, no. 3 (September 2019): 595–628.
46. CBO, “Offsetting Effects of Prescription Drug Use on Medicare’s Spending for Medical Services.”
47. CMS, “National Health Expenditure Data”; 2017 Medicare spending: prescription drugs, $100.9 billion; other medical services $481.0 billion.