A version of this commentary first appeared in Discourse magazine.
The U.S. healthcare system is often criticized for its high costs, much of which are blamed on Big Pharma. In reality, pharmaceuticals account for only about 9% of total healthcare spending, yet Americans spend more than double the average per capita expenditure of other developed countries on prescription drugs.
The exorbitant prices that Americans pay for drugs relative to other countries are largely due to government policies that effectively subsidize other countries’ medications. Some policymakers see these high prices as a problem to fix, and they might be right. However, reducing prescription prices will inevitably reduce pharma profits, which will result in predictable and sometimes undesired tradeoffs.
Proponents of socialized medicine (e.g., government-funded universal healthcare) want America to embrace a system similar to that of Canada, Australia, and most European countries, which would increase government healthcare spending to broaden the size and scope of citizens’ medical coverage. However, the U.S. already outspends every other country on drugs on both an absolute and per capita basis, allowing its residents to consume the most and newest pharmaceuticals. Indeed, 65.2% of sales of new drugs released between 2013 and 2018 occurred in the United States, even though the U.S. only accounted for about 7.8% of world drug consumption in 2018. (Specifically, the U.S. consumed 225.4 billion defined daily doses out of the 2,876 billion consumed globally in that year.)
It is unclear whether this level of spending is necessary to foster innovation or whether it makes Americans healthier. Though pharmaceutical reform alone won’t fix America’s growing unfunded debt, simple adjustments could save taxpayers over $100 billion a year and force other countries to share the cost burden of innovation more equally.
Why Americans pay so much for drugs
The U.S. healthcare market subsidizes much of the world’s cutting-edge medical innovations, including a disproportionate amount of pharmaceutical developments. As a result, the socialized healthcare systems of other countries remain sustainable while their governments and taxpayers pay significantly less than they otherwise would for the same drugs consumed by Americans. This system also allows other countries to access drugs that likely wouldn’t exist if it weren’t for American-funded innovation. This status quo has helped make the U.S. a global leader in pharmaceutical development and innovation. However, given that 8 in 10 American adults believe that drugs are unreasonably expensive, stakeholders should consider how various reimbursement schemes affect the drug costs borne by patients and taxpayers.
Consider how the U.S. Medicaid and Medicare programs reimburse private insurers for drug purchases versus socialized healthcare systems in other countries. Under a true free market, patients or their insurers would privately negotiate prices with drug manufacturers to obtain drugs. Under socialized medical systems like the one in Australia, while private insurers purchase drugs through market-based price negotiations, the government programs often purchase drugs from manufacturers in bulk, using the fact that they are the primary buyer (a market condition known as monopsony) to negotiate lower prices. Public insurers often consider a range of market pricing data during negotiations to ensure the cost-effectiveness of their purchases, but there typically isn’t a rigid pricing formula that pharmaceutical companies can game. The U.S. Department of Veterans Affairs uses a similar model to purchase drugs for those it covers.
Conversely, the Centers for Medicare & Medicaid Services (CMS) in the U.S. are prohibited from negotiating prices directly with drug companies until the Inflation Reduction Act, which allows negotiations for a small but increasing number of drugs, takes effect in 2026. In most cases, Medicaid is legally required to pay the lowest price, Medicare Part B is required to pay the average sales price borne by the private market, and Medicare Part D subsidizes highly regulated private insurers to cover various prescription drugs.
According to the Government Accountability Office, since “federal prices are generally based on prices paid by nonfederal purchasers such as private health insurers, manufacturers would have to raise prices to those purchasers in order to raise the federal prices.” Indeed, since CMS is not allowed to negotiate down drug prices and instead pays prices pegged to what the American private market pays, pharmaceutical manufacturers have an incentive to raise the prices charged in the private market, even if this would result in fewer drugs being purchased in the private market and less profit from the private market for the manufacturers as a result.
Under a true free market, charging a price for private patients and insurers that is above the market price would not be a profit-maximizing strategy for pharmaceutical companies, since the quantity supplied and total revenue raised by drug sales would fall. However, under a quasi-public system that includes CMS, increasing prices above market rates can still be profit-maximizing because the reduced gains in the private market can be offset by CMS: Manufacturers receive the average and lowest private sales price for every drug that these government agencies purchase.
The Medicaid pricing model is especially perverse because it reduces the incentive for a drug company to offer a discount to any patient, especially patients with lower socioeconomic status, as this would automatically lower the price that the company would receive for every drug reimbursed by Medicaid. Since new pharmaceuticals are patent-protected, which establishes a monopoly, pharma would otherwise price-discriminate to the benefit of poorer consumers and the detriment of the wealthy. But under the status quo, pharma benefits from charging every American higher prices to preserve higher CMS reimbursements. Moreover, the larger the market-share proportion of a patent-protected drug that is reimbursed by CMS, the larger the incentive to inflate private prices above market rates.
Costs of a cure
For pharmaceutical manufacturers, the vast majority of their production costs come from navigating the expensive research and development and uncertain regulatory approval process for drugs, with actual manufacturing costs remaining relatively low. Drug patents confer an exclusive production license with a shelf life that allows developers and innovators to recoup research costs without fear that “free rider” manufacturers will simply copy their drugs and sell them at close to marginal production costs. This system maintains pharmaceutical companies’ incentive to invest vast sums of money into developing new cures amid current regulations.
It takes about 12 years, however, before a pharmaceutical company can begin recouping the R&D costs of a newly patented drug after initial discovery. Since a dollar of revenue in 12 years is worth less than a dollar of revenue earned today, future sales do not offset up-front R&D costs one-to-one. And given that the majority of pharmaceutical research projects won’t yield a commercially viable product, drug developers must also cover sunk costs from failed projects, using commercial returns from successful projects to justify funding future research. A 2018 Congressional Budget Office study found that a drug company must obtain a profit margin of 62.2% from products that succeed to allow for just a 4.8% return on all its assets overall. These costs have risen even further in recent years due to increased research costs and higher failure rates.
Expectations of future profits not only provide a reward incentive for innovative research and development (R&D), but also lower R&D financing costs for cash-strapped pharma firms. To cover the costs of R&D and regulatory approval, manufacturers must sell a large volume at prices well above marginal costs to either their public or private insurer customers. And since CMS cannot negotiate down prices on an exceptionally large volume of drugs they purchase, manufacturers expect to rely on it and its subsidiaries for disproportionately large sources of revenue to justify their R&D costs, thereby reducing the need for revenue from non-U.S. public insurers.
These gains from the U.S. market, which are disproportionately driven by government purchases, also provide companies with a greater incentive to research and develop drugs for the U.S. market. This has made the U.S. approval process the global leader in pharmaceutical innovation and home to more cutting-edge drugs and therapies that eventually reach the rest of the world. For instance, the Information Technology and Innovation Foundation (ITIF) reports that “[f]rom 2014 to 2018, U.S.-headquartered enterprises produced almost twice as many new chemical or biological entities as European ones, and nearly four times as many as Japan.”
The foundation also notes that “private research [into developing] new drugs in the United States [accounts for] a significantly higher percentage of GDP than in the rest of the world.” Even the next-highest investing countries, such as Japan, provide only a small fraction of U.S. investment in absolute terms. Other favorable factors, such as high federal government research investment, R&D tax credits, laws that better incentivize public-private pharma research projects, and a disproportionate share of the world’s top research universities, also benefit the U.S. However, pharmaceutical companies’ windfall gains from drug sales to the U.S. government remain significant.
In this way, the United States subsidizes socialized medicine for the world. For example, the U.S. public and private markets account for 70% of patented biopharmaceutical profits, despite only accounting for about 34% of GDP at purchasing power parity among Organisation for Economic Co-operation and Development countries. Therefore, it’s no surprise that the U.S. pharmaceutical industry allocates more of its profits toward R&D than other industries do. In 2014, pharmaceutical companies contributed about 43.8% of their total value added to R&D, a greater percentage than other high-value-added U.S. industries such as aerospace and electronics. Only the U.S. semiconductor and scientific research industries contribute a greater proportion of their sales toward R&D, which is not common in other countries.
Moreover, such economic activity is the consequence of unique profit opportunities in the U.S., but it comes at an equally unique high cost. Various policy interventions can be employed to reduce spending in the U.S., but each approach will reduce pharma profits in its way and, consequently, reduce global investment to find new cures.
Solution 1: Negotiation model
If CMS were allowed to negotiate drug purchase prices the way socialized systems in other countries do, even for just a small number of drugs, American taxpayers would save billions of dollars each year. CMS’s bargaining power as a monopsonistic bulk buyer is significantly greater than that of all other countries, so these cost savings are likely to be high. Simultaneously, Americans dependent on private insurance, such as that provided through employers, would also likely benefit from lower prices since the incentive to charge above-market prices to private insurers, to artificially boost the price of each drug purchased by CMS under the current system, would be eliminated. However, CMS’s price negotiations wouldn’t necessarily affect price negotiations with public insurers in other countries, since changes in U.S. pharma revenues don’t affect the profit-maximizing strategy for foreign buyers in their negotiations with pharma, all other things being equal.
Moreover, if CMS began negotiating down drug prices, pharmaceutical companies would have less funding to create new cures and bring them to market. One way to mitigate reductions in research funding would be to allow CMS to negotiate down prices for new drugs only after a certain number of years have elapsed. The Inflation Reduction Act’s CMS negotiation reform already utilizes a similar approach for some drugs. However, the world would still likely see less future revenue to incentivize pharmaceutical innovation. Foreign countries might respond by increasing their own research funding to service global demand that is no longer being subsidized by the United States. However, these new ventures would not fully account for the loss in worldwide pharmaceutical research investment caused by the decline in U.S. public purchases.
Conversely, as current levels of innovation would no longer be subsidized by the artificially inflated prices that pharmaceutical companies receive for drugs through CMS purchases under the status quo, pharmaceutical companies would shrink their research portfolios to prioritize the projects most likely to yield profits. Such projects would increasingly target the private insurance market, due to increased profits in this sector from lowering prices.
However, shifting a chunk of the burden of funding pharmaceutical research from the public healthcare market to the private insurer market could also mean less incentive to address issues that disproportionately affect Americans who are more likely to rely on CMS, including people who are poor and elderly. For example, we might expect less research investment in drugs that address illnesses that worsen with age—such as Alzheimer’s, arthritis, heart disease, type 2 diabetes, and many types of cancer—since these illnesses are more likely to affect CMS recipients than privately insured patients. However, shifting pharma’s focus to relatively younger, privately insured individuals might lead to healthier geriatric ages and reduce the need for investment in conditions that are the accumulation of chronic inflammation. Moreover, it’s not clear whether the superior R&D investment due to government subsidies makes the U.S. healthier.
Solution 2: “Most favored nations” model
An alternative to the negotiation model is the “most favored mations” (MFN) rule, which pegs CMS reimbursements to the prices paid by one or more foreign governments. The rule was first proposed under the Trump administration in 2018 but was later scrapped by the Biden administration. Like direct negotiations, the MFN model would lead to both taxpayers and private buyers in the U.S. paying less for prescription drugs, while pharmaceutical companies would be incentivized to charge higher prices to foreign public insurers. However, since these buyers cannot match the bulk purchasing power of the U.S., foreign reference prices would be lower than current CMS reimbursements that reference the U.S. private market, which would likely reduce pharma profits from both CMS and abroad.
Also, like direct negotiations, MFN would prevent pharma from artificially inflating private market prices in the U.S. and would shift the proportion of total innovation costs from the U.S. to other countries. Furthermore, since U.S. insurance companies will pay a lower price for drugs and thus theoretically buy a greater quantity than they currently do, private market demand and increased profit from this sector would replace some of pharma’s current research investment incentives from domestic and foreign government purchases.
One major problem with MFN is that it could reduce profit for pharma from foreign countries relative to price negotiations. If prices do inevitably increase to secure higher CMS reimbursements, foreign governments might reduce their purchasing volumes. Much like the status quo, when U.S. public insurers would purchase drugs under MFN, pharma would forgo higher profits from foreign public insurers by charging them above-market prices to secure higher rates of return from higher-volume CMS purchases. However, unlike private insurers, foreign public insurers operate under political pressure to secure medicines for their constituents. If the U.S. were to implement MFN, evolving political pressures might motivate foreign governments to purchase similar quantities despite price hikes on drugs.
Indeed, raising public debt, cutting other public expenditures, and raising taxes are easier tasks for foreign governments relative to private insurers charging higher premiums, since insurers’ customers may voluntarily stop purchasing their products. Under this scenario, pharma might increase its profits from some countries under MFN. However, if pharmaceutical companies were capable of charging foreign governments higher prices to increase profit, they would theoretically have done so already. Keep in mind that if foreign governments do substantially reduce the number of drugs they purchase, you may see more of their citizens turn to the private market to purchase drugs.
Considering the tradeoffs
When price negotiations and MFN were first proposed, they attracted substantial backlash from the pharmaceutical industry and even from some libertarian groups who argued that they amounted to “price controls” on drugs and would “import socialism.” However, these claims could not be further from the truth. Price controls are government intrusions into negotiations between private parties, not restrictions on the government’s spending. Under a free market, government entities ought to exercise good stewardship of taxpayer resources by behaving more like a private party by reducing the prices they pay. By increasing pricing pressure on countries with socialized medicine, price negotiations, and MFN wouldn’t import socialism—they would export capitalism by making the U.S. and other countries more reliant on their private markets.
However, the tradeoff of lower drug prices and a significantly lower drug bill for U.S. taxpayers, from either price negotiations or MFN, could lead to a long-term decline in new drug discovery due to less incentive for R&D. According to ITIF, mental illnesses alone impose a $1.5 trillion penalty on the U.S. GDP every year, highlighting the societal benefits that discovering new drugs might bring. For example, the Alzheimer’s Association claims that discovering a new drug for treating dementia by 2025 would lower treatment costs by a third while delaying its onset by five years. If true, these benefits may be delayed if new government purchasing models significantly reduce pharma revenue and profit margins from Alzheimer’s patients.
Basic economics suggests that Americans would be better off shifting their resources to industries they find valuable, versus policymakers trying to centrally plan incentives to bolster medical innovation. However, some studies find that the vast majority of social benefits provided by pharmaceutical research are not internalized or captured by profits from drug sales, even under the status quo.
Many other policies are worthy of attention when it comes to supporting medical research and thus incentivizing new drug discovery—for instance, reforming the patent process, reducing the costs of drug approvals, and eschewing recent government moves to “march in” and fix the prices for taxpayer-funded innovations in public-private partnerships. Regardless, the way that taxpayer-funded U.S. agencies pay for drugs has important implications for global and U.S. innovation, the sustainability of public budgets and debt, and the affordability of drugs.
Moving toward more market-based negotiations or MFN models would increase the per-dollar value of research investment by better aligning it with market demand while making drugs more affordable for Americans. However, these reforms would also reduce total funding available for research and could disincentivize research into new treatments affecting some of society’s most vulnerable individuals, especially the poor and elderly. The reforms may or may not be worth the consequences, but we shouldn’t ignore the tradeoffs altogether by insisting that the U.S. should embrace a European-style single-payer healthcare system. Their “free” healthcare is a myth—Americans are paying for it.