Accelerating Generic Entry: A Proven Solution to the Problem of Prescription Drug Pricing

High prescription drug prices and their impact on costs borne by the government in Medicaid, Medicare Part D and other federal programs, is a front burner topic in Washington. The President has committed to reducing the price of prescription drugs, and pressured drug companies to hold the line. The Department of Health and Human Services (HHS) has proposed two regulatory initiatives—price disclosure in drug advertising and foreclosing rebates from manufacturers to pharmacy benefits managers (PBMs)—aimed at pushing prices down. Some Democrats have urged more sweeping actions, such as having the government negotiate Medicare drug pricing as a single buyer or regulating drug prices by reference to an international index based on government-negotiated drug prices abroad.

These proposals cannot solve the drug pricing problem. The Administration’s proposals merely tweak the status quo and put no effective restraint on new drug prices. Jawboning by the Executive has had a minimal impact. Disclosure of manufacturers’ list prices, unless accompanied by numerous and inherently confusing caveats highlighting the difference between those prices and the co-pay an insured consumer must bear at retail, is potentially misleading and, in any event, has no direct impact on prices. Eliminating rebates, as HHS’s rulemaking acknowledged, will inevitably raise health insurance costs now partly paid for by rebates while manufacturers’ pricing power remains unabated. The Democrats’ call for government power buying or price regulation would impact drug prices but also require politically sensitive government determinations about the “worth” of prescription drugs to patients—a significant step on the road to government-allocated health care.

A Proven Solution

So, do we have to settle for surrender, eyewash or non-market alternatives? Is drug pricing, as branded manufacturers claim, so complex in a largely insured world that any politically palatable initiative is bound to fail? No. In fact, there is a proven market-based solution that Congress could enable by recognizing that legally restraining competition is the foundation of current pricing excesses and confronting it directly. Ninety percent of the prescriptions filled in the United States today are sold under competitive market conditions at reasonable price levels because the market for those drugs has been opened to generic drugs and biosimilars, which are interchangeable copies of the branded drugs, making pre-entry single source branded prices unsustainable. But to incentivize new drug development, today’s legal system delays generic entry for many years after a new drug or biologic is first introduced. Drug developers are permitted to act as sole source providers of their innovative products for decades without any limitation on total cost recovery or reference to the actual cost of drug research and development.

Two legal constraints protect sole-source status. First, under the Federal Food, Drug, and Cosmetic Act (FDCA – governing new chemical entities and new uses of approved entities), the U.S. Food and Drug Administration (FDA) cannot approve an identical generic drug until at least five years after a new branded drug is approved. Under the Biologics Price Competition and Innovation Act (BPCIA – governing new biological producers) that period is stretched to at least 12 years. Statutory sole-source protection under the FDCA and BPCIA is comprehensive, including a ban on competing imports.

Second, drug manufacturers routinely secure one or more patents on new chemical and biological entities. Patent protection lasts 20 years or more from the date of filing and almost always past the end of statutory protection. Under both the FDCA and BPCIA, patent holders may sue potential competitors to foreclose entry or to impose crippling damages notwithstanding expiration of statutory exclusivity. To heighten entry deterrence, branded companies often seek, during the period of statutory exclusivity, to obtain additional patents that protect their drugs and extend sole source exclusivity in time, creating a veritable patent thicket for competitors to fight through to gain pre-patent-expiration entry.

With a sole source position legally secured, branded drug companies can price without fear of losing sales to generic competitors or inducing new entry. In addition, unlike most monopolists, branded companies benefit from drug insurance propping up patients’ ability to pay. Since the vast majority of potential patients are insured, the price they care about is their co-pay at the point of purchase. The difference between that co-pay and the cost to the dispensing retailer of the drug (driven by the manufacturer’s wholesale price) is borne by health insurance and recovered in premiums spread across the entire insured population. Where federal and state governments cover all or some of the difference, that cost is spread across all taxpayers. Branded drug companies use rebates as a means of securing favorable co-pay positions without regard to the wholesale price of their drugs.

In these circumstances, branded manufacturers not surprisingly price far in excess of the variable manufacturing cost of their drugs. They realize many multiples of even the most robust estimates of new drug development costs while they and generic manufacturers alike can sell drugs profitably in competitive markets at 10% to 20% of sole source branded prices. It may resonate politically to demonize branded drug manufacturers for high prices, but their actions are consistent with their obligations to maximize investor returns as permitted by the legal regime. Until that regime changes, blame fairly belongs to lawmakers.

Free Market-Friendly and Effective

How then could the regulatory regime be enhanced without injecting the government into health care purchasing or unduly limiting incentives for new drug development? Tinkering with the existing sole source regime for new drugs—­with or without browbeating or shaming through price disclosure—will not work. Eliminating rebates may strike at PBMs that absorb them as income rather than passing them through to reduce insurance premiums, but is likely to have minimal impact, if any, on drug prices. But reviewing the limits on competitive entry could be both consistent with a free market economy and demonstrably effective.

While today’s extended sole source status is a useful reward for innovation, there is no limit on how much operating profit an innovator can extract from a new drug or biological product. Apart from costs of discovery and securing regulatory approval of safety and effectiveness, the enormous margins over manufacturing costs being extracted in the sole-source period are returning multiples of development and approval costs to innovators. The critical questions are: 1) how much of this sole source return is actually necessary to stimulate drug innovation? and 2) whether generic/biosimilar entry opportunities and market competition can be keyed to the achievement of an adequate return.

One simple approach to the issue would be to limit sole-source protection to the exclusivity periods now established in the FDCA and BPCIA and foreclose the double dip extension of these periods through injunctive relief or lost profits damages under patent law. Today, the expiration of statutory exclusivity permits the FDA to begin approving competitive generic drugs and biosimilars but does not shield potential entrants from claims of patent infringement that can lead to entry-barring injunctions or accountability for lost profits on sole source sales in amounts that threaten the viability of a losing prospective entrant. The result is often a multi-year extension of the sole source period Congress deemed adequate to stimulate innovation, the creation of “patent thickets” prospective entrants must traverse before competition begins, and the substitution of expensive and burdensome patent litigation for rational determination of competitive entry dates.

To be fair, the patent system does promote disclosure of the formulation of new drugs and biologicals and facilitates their imitation by competitors. Moreover, the patent clause of the Constitution requires providing some benefit to patent holders. But there is no economic or legal compulsion to preserve today’s specific patent benefits to the detriment of the public health. Congress could limit those benefits by foreclosing entry-barring patent injunctions and capping total patent royalties at a reasonable percentage of revenues achieved by infringing generic competitors—e.g., 10-15%–to be apportioned between holders of all infringed patents. That limitation would permit innovators to be rewarded throughout the patent period but provide economically realistic opportunity for new entrants. It would incentivize innovators to litigate only their strongest patents and greatly reduce the incentive for creating patent thickets.

Innovators may claim, understandably, that existing statutory exclusivity periods were established in the context of full-scale exercise of patent rights and should be extended if patent remedies are curtailed. That need, however, can be tested by determining whether sole source recoveries during current statutory periods are sufficient to support necessary innovation. This is both an empirical question—how have returns in the statutory period compared to discovery and FDA approval costs?—and a policy issue—what is the appropriate balance between stimulating innovation and price competition?—that our system of government entrusts to Congress. In addition, Congress could create an escape valve to permit innovators to seek administrative extension of a statutory exclusivity period by demonstrating that unusual circumstances had unduly limited sole source returns on specific drugs.

In sum, there is a proven avenue available for permitting market competition to alleviate the drug-pricing crisis. Modifying the current regulatory regime to produce that result may not be easy politically, but it is much preferable to ineffective tweaking, a wholesale surrender, or direct, pervasive drug-price regulation.

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