Innovation and Drug Pricing: A Conversation with Dr. Jonathan Darrow of Harvard Medical School

To begin, what are your thoughts on the claim that the U.S.'s friendly drug-pricing regulatory regime is the primary driver of innovation within the biopharma industry?

Certainly, having the ability to charge an unlimited amount of money would be an incentive for any business. There could as well be a number of other factors, such as the robust venture capital market in the United States that also contribute. The substantial amount of money that is funded through the National Institutes of Health and other government organizations provides basic research funding that can then be picked up by industry, as well as certain laws that allow private industry to patent and profit from inventions that at the early stage were originally funded by the government. Those are a few reasons that I might cite for why the U.S. has strong innovation in the biotech sector.

Do pharmaceutical companies have to pay any royalties to the U.S. government—and effectively the taxpayer—for the foundational research they leverage?

There is a law called the 1980 Bayh-Dole Act that governs the relationship between public funding and the ability of private entities to patent and profit from the research that was funded by that money. That does reserve some rights to the federal government, including the right to make and use the invention—although the government rarely, if ever, uses those rights. I think in part because they’re concerned that if the ability to profit is undermined by government use, it would deter collaboration or willingness to accept government funding in the future. But there are rights that the government has vis-à-vis the inventions that it funds.

So the government isn’t very aggressive in collecting fees that might be owed if it had been a private partner providing research?

In terms of an actual royalty paid to the government, that is something that had been proposed, but I don’t believe that’s ever been enacted into law. There is no obligation to pay the government royalties out of the profits that flow from government-funded inventions under the Bayh-Dole Act. Instead, the rights held by the government are in the form of a fully paid-up license for the federal government to use the invention, and also a “march-in right” to make sure the invention is being used if the company that has the rights is not adequately developing it and making it accessible to the public.

Regarding private funding—isn’t the robust U.S. venture capital landscape directly linked to the ability to charge high prices and cash out handsomely if a drug is approved?

I think that’s true. Venture capitalists certainly expect a high rate of return on average, although some of their investments fail to produce any return at all. The ones that do produce a return, they’re expecting quite a high return in order to justify their investment. One other important aspect is to what extent the U.S. market is separate from the rest of the world. To some extent, it is a single market; if you create a product, you can try to extract revenue around the world. I don’t know that all of the factors I mentioned fully explain why the U.S. market has been so robust. It could also depend on the presence of numerous institutes of higher education where foundational research occurs, combined with government funding, and the tradition of entrepreneurship—all in a context where people can profit through the patent system and generate revenues not only in the United States but globally. It is increasingly a single global market for pharmaceuticals.

A rule of thumb for some pharmaceutical companies is to project that 50% of profits will come from the U.S., despite it having only 5% of the global population. Doesn’t that make the U.S. the “golden goose” for drug companies?

I think that’s certainly true. The large share of profits comes from the United States, in part due to the lack of price caps on drugs. But again, you could be a company starting in China or India or any other country and choose to sell your product in the United States and still have access to that market. I don’t know that that fully explains why more companies originate in the United States. There has been increasing innovation in other regions of the world. China has become important particularly in the active pharmaceutical ingredient market. India has become increasingly important in creating finished drug products—especially since the 1995 TRIPS agreement, under which it created intellectual property rights. Latin America has also risen in importance. There is reason for increasing democratization of pharmaceutical innovation. It’s not clear that the United States will retain its number one spot, or for how long.

The Inflation Reduction Act allows the U.S. government to negotiate Medicare drug prices for the first time. What do you make of this change in policy?

I have not looked at that law in detail, so I can’t comment specifically on the language, but I can say a couple of things in general. Even prior to that law, individual plans under Medicare were already able to negotiate prices. The negotiation at the higher level of Medicare, in theory, will give it more leverage, and advocates hope that will allow the government to reduce expenditures. I think that may be overly optimistic, because whenever you negotiate, there has to be a basis for negotiation—there has to be an alternative. Having a large volume gives you a powerful position if you can walk away. However, under U.S. law, Medicare must cover certain prescription drugs across six categories regardless of cost. If you can’t walk away from the table, it’s not clear that negotiation will result in a lower price.

Suppliers who choose not to negotiate face a severe tax penalty. Doesn’t that force them to the table and give the government the upper hand—more a forced hybrid than a true private-sector negotiation?

If there’s a tax penalty, it sounds like that would force them to the table to negotiate—but it doesn’t sound like that would necessarily produce any particular result, which is really the important part from a price standpoint.

The industry worries this is a slippery slope toward a system like Canada’s, where government negotiation guarantees lower prices for patients but reduces profits and potentially stifles innovation.

If a company is generating the majority of its revenue from the United States, and the potential revenue and profits drop, that certainly could affect willingness to invest and the number and types of products that result. No one knows exactly how big that impact would be, but there is a concern that there would be a reduction in innovation. Right now, although the U.S. funds much of that innovation through higher prices, the benefits redound to the world as a whole. In some sense, the world is free-riding on the profits of the United States. A more level playing field could be considered more equitable—either by increasing companies’ ability to generate profits in other countries, or reducing their ability in the United States.

Let me also say, related to high drug prices in the U.S., we have a system that is internally inconsistent. On the one hand, we view healthcare as a right, so we have insurance that helps pay for drugs to ensure access. From the company’s perspective, that guarantees volume won’t decrease. In business, if you know you can raise the price and volume won’t decrease, you will raise the price. We have this free-market system of pricing and a socialist system of paying for drugs. We’re straddling these positions trying to make everyone happy, and the result is entirely predictable: prices will continue to rise. Increased negotiation by Medicare may be a small step away from the free market toward the socialist side. The other way would be an entirely free-market system. I won’t take a position on which is better—but if we continue straddling, I predict prices will continue to skyrocket.

Pharmaceutical companies often argue the net price paid by consumers is much lower than the gross price, blaming Pharmacy Benefit Managers for pocketing the difference. What is your view?

One of the challenges of the U.S. system is that it is so complicated it is difficult for the free market to work. You don’t know how much drugs actually cost. You often see claims about drug-price trends using list prices instead of actual prices, so you have to take those conclusions with a grain of salt. At the same time, the benefits of the drug are not clearly disclosed or frequently discussed. Imagine going to a gas station and saying, “Give me some gas, I don’t care how much it costs or how big the benefit is.” It’s very difficult for a free market to function in that context. Drug prices haven’t risen as dramatically as some headlines state, exactly because of rebates and disguised discounts. To me, this is an issue of transparency. Without transparency, how can a market function? I would love to see legislators mandate increased price transparency.

Didn’t the Trump administration make an effort to require hospital price transparency?

Yes—a regulation required hospitals to disclose their charge master, the list of prices they charge. Unfortunately, when we looked at this six months after implementation, a large share of hospitals had not complied. It’s a step in the right direction. Hospitals are one place where high drug prices are especially non-transparent, because you don’t know how much of the price was from the manufacturer and how much was a hospital markup. An industry-funded study claims that more than half the cost of hospital-administered drugs are hospital markups. And the increasing use of biologics, which generally have to be administered in a healthcare setting, means a larger share of the drug market is administered in hospitals—potentially with these steep markups.

Unlike buying a car or an iPhone, we can’t easily price-compare healthcare. Tools like GoodRx have helped with prescription transparency—why did it take so long for something like GoodRx to emerge?

I don’t know the answer to that, or where they get their data on prices. GoodRx is a substantial advance in transparency for cash drug prices, though it’s more complicated if you have insurance, and it doesn’t work for hospital-administered drugs. One limitation is that it isn’t very good at helping you discover lower-priced alternative medicines. A solution we’ve proposed is for state legislators to grant greater authority to pharmacists to substitute alternative drugs. Pharmacists have tremendous knowledge of drugs and often know the prices patients face. It would be great to see legislators grant pharmacists greater discretion to substitute—like swapping a very expensive combination product for its identical, cheap generic components as two separate pills. That could save quite a lot of money.

That’s an interesting idea. In the interest of time, Jonathan—it’s been a pleasure. Thank you for sharing your expertise.

Thank you.

Interviewed by Henri Mattila, September 2022. Originally published by Merion West. Lightly edited for length and clarity.