Why drug makers charge outrageous prices

By the time a drug reaches your medicine cabinet, it passes through a long series of intermediaries who each take a cut of money. It's part of an intricate, if not wasteful supply chain that pharmaceutical companies created more than 30 years ago. It's a scheme that's now working against their economic interest, and yours as well.

That system was on trial last week, when Mylan CEO Heather Bresch rebutted widespread criticism over the frequent price increases that her company has taken for its drug EpiPen — auto-injected form of epinephrine used in the treatment of severe allergic reactions. EpiPen can now cost $600 for a package of two pens.

Bresch said it's not Mylan's pricing policy that's corrupt, but the drug-distribution system. It compels Bresch to hike the list price of its medicine, she says, so that Mylan can then rebate money to a long series of drug-supply middlemen.

EpiPen has become the latest flashpoint in this opaque system. As more health plans shift to very skinny drug formularies and high deductibles, consumers are bearing more of the cost of their drugs. They are taking notice of the list price on their drugs.

But when drug makers hike the widely reported "list" prices on their drug, only a fraction of the additional money comes to them. Most gets paid as fees and rebates to a long series of drug-system middlemen. Some of these rebates eventually flow to consumers in the form of lower premiums. But not every patient benefits equally. Those without insurance can be forced to pay the full freight of the higher prices.

Here's how it works. Drug makers "sell" their drugs to pharmacies, which acquire them through drug wholesalers. When a pharmacy sells a prescription to a patient, the pharmacy-benefit manager (PBM) reimburses it for those costs. The PBM has a contract with the patient's health plan to cover different portions of the cost for different medicines. The PBMs offer purchasing efficiencies, and their large size let them negotiate lower prices.

Drug makers will then return some of the money they're paid to the PBM, in the form of a rebate. The PBM will, in turn, share some of these rebates with the health plan, reducing its drug costs. A rough estimate is that PBMs return to the health plans about 90 percent of their rebates. The PBMs earn more money by operating specialty pharmacies that distribute a lot of the costliest drugs. On average, this can net them another 1 percent on the drug's list price. For pricey drugs, this adds up.

Drug makers launched their own PBMs in the early 1990s as a way to process drug payments, but got out of the business in the 2000's. But they still liked contracting through the PBMs, because it was a pay-to-play arrangement. Drug makers paid rebates to get favorable placement on formularies, and access for their medicines.

But as the PBM's consolidated and began to exert more leverage, and as the drug market became more competitive (with many more "good enough" generics) the pharmaceutical companies had to start paying bigger rebates. To make headway for bigger rebates, they've been hiking the list prices on their medicines.

In Mylan's case, it took a 31-percent price increase on EpiPen in 2015, while selling 7 percent more pens that year, according to Evercore ISI's Umer Raffat. Yet Mylan's net revenue on EpiPen actually fell 1 percent during that year. Of course, Mylan wasn't a total loser. They converted more patients onto EpiPen. Some of those patients will stick with the Mylan product, even if FDA lets a new competitor enter the market.

The drug-sales model is a wasteful scheme. Policy makers are seeking legislative remedies like compulsory reporting of rebates, or even tacit price controls. But the system will game around whatever regulatory rituals Congress divines.

The scheme will end when drug makers realize that the current selling model is no longer in their economic interest, and when all of the system's players realize that they're losing their compact with patients. Then they'll find a more honest and transparent way to sell medicines, without all of the secreted strings and rebates.

Commentary by Scott Gottlieb, a physician and resident fellow at the American Enterprise Institute. He is a former FDA deputy commissioner and senior official at the Centers for Medicare and Medicaid Services. Dr. Gottlieb consults with drug makers. Follow him on Twitter @ScottGottliebMD.

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