What Goes into Determining the Cost of a Prescription Drug?

February 25, 2015

Prescription drug costs continue to be one of the fastest growing components of total health care costs. According to a 2008 report from the Kaiser Family Foundation, spending in the United States for prescription drugs in 2006 was $216.7 billion, more than five times what it was in 1990. Though spending for prescription drugs was one-third of that for hospitals and half of that for doctors' services, the annual rate of increase for spending on prescription drugs has exceeded that for these other services in all but one of the last 11 years.

Nearly half (44%) of spending for prescription drugs is paid for by private insurance, and since employers are the principal source of health insurance coverage in the United States, they fund a major portion of the spending for prescription drugs. Therefore, it's worthwhile for employers to understand the factors that go into the ultimate cost of the prescription drugs that are paid for, in part, by employee benefit plans.

When a new drug is first brought to market, the company that developed it enjoys some patent protection for the drug, which gives that company the exclusive right to sell that drug in the market for a certain period of time. This protection is intended to help pharmaceutical companies recover some of the cost of drug research and development, which can be substantial. By providing patent protection for a period of time, companies are encouraged to take the financial risk associated with new drug development. Only after the patent protection has expired can competitors bring lower-cost generic versions of the same drug to market.

When a company develops a new drug, it decides what price to charge for it, taking into account factors such as the research and development costs associated with the drug; whether other, different drugs with similar therapeutic effects are available; market demand; the current economic and competitive climate; and advertising costs and marketing strategy. While in some other countries governments play an active role in setting the prices for prescription drugs, this is not the case in the United States.

The price a drug manufacturer sets for its product is just the first piece of the equation that determines what the drug ultimately costs at the time it is dispensed to the consumer. Health plans and pharmacy benefits managers (PBMs) will negotiate with pharmaceutical manufacturers for discounts and rebates on their prescription drug products. The success of such negotiations and size of incentives achieved can vary significantly depending on a number of factors, including the utilization volume of the plan/PBM for the manufacturer's products, placement of the manufacturer's products on a plan formulary or preferred drug list, etc. Health plans and PBMs also can save costs by trying to achieve savings at the pharmacy level of the prescription drug distribution chain. This can be done by establishing networks of preferred pharmacies that agree to accept an established reimbursement rate in exchange for being included in the network, and by setting up or working with mail-order pharmacies.

Though these factors that establish the price of a prescription drug are out of an employer's hands, there are things that any company with a prescription drug benefit can do to have some impact on what prescription drugs will ultimately cost the plan. Effective plan designs that encourage the use of generics and other preferred medications and that succeed in getting employees to use preferred and mail-order pharmacies can dramatically lower plan spending on prescription drugs. Working with a PBM or health plan that is proven effective with these strategies can be key in getting the most for your prescription drug dollar.