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Reference Pricing: Implementing Value Based Payment in Prescription Drugs

September 10, 2018
Public outcry at the high price of prescription drugs has reached a fever pitch. Our national focus on prescription drug costs concentrates on eye-popping, seemingly random price increases on essential drugs, and the stories reporters tell outline a simplistic “villain/victim” narrative with evil drug company executives like Martin Shkreli on one side and hapless, ill consumers on the other. One such example is the public outcry from when manufacturers tripled the price of insulin in just over a decade.[1]  While these prices frighten consumers, insurers and providers alike, pharmaceutical companies argue that they do not reflect net prices of drugs after rebates, which are harder to find and vary from payer to payer. They further argue that high prescription drug costs are necessary to finance continued innovation. One thing is certain: US prescription drug spending in dollars per capita outpaces every other OECD country, with US consumers spending roughly triple their European counterparts.[2][3]

Meanwhile, in other health care sectors, the revolution of value-based payments and accountable care organizations has made tying payments to outcomes a real possibility.[4][5] We can extend these lessons to US pharmaceuticals through a system of reference pricing which would reward pharmaceutical companies for value rather than allow companies to set prices at almost random. The result would speed the development of breakthrough therapies and decrease costs, while preserving the United States’ continued subsidization of research and development in the pharmaceutical industry.[6]

Image: Pharmaceutical Spending, Source: https://data.oecd.org/healthres/pharmaceutical-spending.htmImage: Pharmaceutical Spending, Source: https://data.oecd.org/healthres/pharmaceutical-spending.htm

How we got here (where is here anyway?)

Since the Food and Drugs Act of 1906, the United States Federal Government has played an active role in certifying the safety and legitimacy of new drugs.[7] However, drug pricing has largely been regulated not through Congress, but through anticompetitive enforcement actions. Under this system, the federal government targets price fixing and collusion and forces companies to license out medicines to other manufacturers, as they did in 1958 after companies worked together to inflate the price of the antibiotic tetracycline.[8][9] This “golden era” of drug pricing helped reduce prices for drugs like penicillin, and the Justice Department aggressively pursued price-fixing cases from antibiotics to the polio vaccine. However, changes in patent law in the 1980s increased the so called “exclusivity protections” periods of drugs which extended the time these products were protected from generic copying.[10] These protections were designed to spur development and innovation by giving drug companies a hefty prize for the creation of new therapies. Drug companies will argue that prize is critical to incentivize new drug development and recoup the 800 million - 1.2 billion dollars required to pursue FDA approval, a weak argument given the lack of correlation between research, development costs, and prices.[11]

However, drug companies make between 64 to 78% of total profits in the United States market, indicating that, at some level, drug consumption in the US is supporting research and development and subsidizing cheaper drugs internationally.[12] To phrase the same idea differently, drug companies likely take into account the assumption that drugs can be sold profitably in the United States when investing large sums in research and development and calculated expected returns – removing that assuredness could have serious consequences in the advancement of medicine. Policy solutions therefore should focus on incentivizing drug development that improves health, and leverages transparency and clarity to increase drug pricing competition.

Reference Pricing

One mechanism that could help reduce prescription drug costs while maintaining an emphasis on improving medicine is tying drug pricing to the value that drugs create by improving health. Breakthrough drugs that significantly increase quality of life are developed all of the time, and some of these drugs are expensive. For example, a new class of hepatitis C drug called direct-acting antivirals posed significant costs but was significantly more impactful than existing therapies. However, these drugs are often far outnumbered by “Me Too” drugs which are chemically similar to existing therapies and treat the same ailments.

Companies pour billions into developing “Me Too” medicines because they are more likely to be approved by the FDA, with one study saying that submitting a “Me Too” drug for FDA approval, rather than a unique drug, doubled that drug’s likelihood of acceptance.[13] This incentive structure functions as a deterrent for breakthrough therapies. If we accept the premise that high drug prices translate into research dollars (an imprecise claim), then it follows that policymakers should pay more for breakthrough therapies at the expense of “Me Too” drugs. Then, hoping to snag a sliver of the market shares, companies waste even more patient dollars marketing these drugs to patients and providers; one ProPublica analysis found that top marketed drugs in five months of 2013 were not breakthroughs or top sellers, but were largely “Me Too” drugs where older and cheaper therapies were already available.

One tool which may reduce a firms’ interest in developing and marketing “Me Too” drugs is reference pricing, a strategy employed in many European countries to encourage substantive drug development and cut costs across the system.[14]

Reference pricing functions by requiring drug companies to submit clinical evaluations of drug effectiveness compared to existing therapies, proving not that drugs are safe and effective, but that they are more effective than therapies already on the market. If the drugs are not, in many countries such as Germany and Sweden, the payer (the government, a nonprofit insurance fund or similar) will only reimburse the cost of the new drug up to an average price (or other benchmark, such as lowest price of a drug with sufficient market share) of similar drugs. Drug companies can continue to charge whatever prices they choose to, but are forced to grapple with consumer demand if they choose to charge more than existing therapies that accomplish similar goals. In many countries, if a drug is uniquely effective, it negotiates with payers to reach an agreeable price. In Germany, in the few years after the policy launched, 63% of drugs reviewed were found to have some clinical benefit, leading to a reduction of new, expensive drugs on the market when existing therapies were just as effective.[15]

From Germany to Spain, reference pricing has been associated with significant reduction in pharmaceutical drug costs; one Harvard meta-analysis on reference pricing policies concludes, “that this strategy reduced drug prices, increased utilization of and adherence to targeted drugs, and promoted switching behavior from expensive products to alternatives at or below the reference price.” Between 2009 and 2013, German prices dropped -0.7% per year while US prices grew at 2.7% – and those very same US prices are growing at closer to five percent today. This difference between both countries amounts to tens of billions of dollars.

Image: US Drug Spending Estimates and Projections, Source: https://www.pewtrusts.org/en/research-and-analysis/fact-sheets/2018/02/a-look-at-drug-spending-in-the-usImage: US Drug Spending Estimates and Projections, Source: https://www.pewtrusts.org/en/research-and-analysis/fact-sheets/2018/02/a-look-at-drug-spending-in-the-us

Reference pricing also fits neatly into broader trends in American healthcare. By having private companies respond to market-based incentives, this rewards those companies for the value they provide and hopefully also improve efficiency in the pharmaceutical market. If lawmakers are serious about reducing prescription drug prices, they should leverage market-based incentives to cut waste and focus funds on patient wellbeing.

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Wharton Public Policy Initiative’s strategies, recommendations, or opinions.


  [1] https://www.pbs.org/newshour/health/whats-behind-skyrocketing-insulin-prices

  [2] https://data.oecd.org/healthres/pharmaceutical-spending.htm

  [3] https://healthpolicy.usc.edu/wp-content/uploads/2018/01/01.2018_Global20Burden20of20Medical20Innovation.pdf




  [7] https://www.fda.gov/AboutFDA/History/FOrgsHistory/EvolvingPowers/ucm054819.htm










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