The biotechnology industry has grounds for complaint. The research pipeline is disgorging breathtaking new treatments for cancer, rheumatoid arthritis, multiple sclerosis, and other once-intractable diseases. But instead of praise, or in addition to praise, the industry finds itself subjected to ever-louder criticism of its prices and earnings. America again seems to demand the best health care someone else will pay for. Let’s cut the prices and worry about it later. And if the venture capitalists don’t get repaid for their efforts, so what?

HBR CartoonSticker shock on biotech prices should hardly be unexpected. Avastin is priced at $50,000 a year for colon cancer and twice that for lung cancer, although Genentech recently announced a $55,000 annual cap on total spending from all sources for patients below an as yet undetermined income level. Erbitux for colorectal cancer comes in at $120,000 per year (although patients don’t live a year), Nexavar for kidney cancer at $50,000, and Herceptin appears a bargain at $35,000 for breast cancer.

Biotech products typically are tested and marketed for one narrow clinical indication and then are expanded into broader patient populations with different severity levels, comorbidities, and primary conditions. This “indication expansion” is just what we want from breakthrough innovation, the application to new uses of core scientific insights, but, boy, does it add to the costs. Now, after enjoying two decades being too small to be noticed by payers, the biotechnology industry [two-week free access] finds itself very much on the budgetary radar screen [two-week free access].

The traditional industry response to accusations of excessive prices has been to emphasize the high cost of research and development, the years in the laboratory and the clinic, the innumerable failures for each successful product, and the imperative to reward investors’ high risks with commensurately high returns. But the cost-based justification for high biotech prices has two nontrivial problems. First and most simply, it is not valid as a description of pricing practices; biotech companies do not base prices on costs. Second, the industry is beginning to realize that it does not want the public to think that prices are based on costs, whatever might be the short-term appeal of such thinking.

Are prices based on cost, in biotechnology or anywhere else? No, and fortunately not. In research-intensive sectors such as biotech, the biggest costs are sunk. The price for a new product must cover the incremental expenditures on manufacturing and marketing, but there is no logic to quantifying past expenditures on research and development. Rather, prices are based on what the market will bear. These prices and revenues may or may not reimburse past efforts and investments, but their social purpose is to encourage future efforts and future investments. The prices for today’s products finance research for tomorrow’s products, either directly through the retained earnings of biotechnology firms or indirectly by enriching investors who then remain attached to the sector rather than moving their money elsewhere.

Justifications of biotech pricing based on research costs offer the industry protection in the short term, but over the long term they would foster public demands for data on actual research costs, debates over who should bear the cost of failed research initiatives, definitional contests over appropriate marketing expenditures, and a cost-plus mentality more befitting a slow-moving utility sector than the science-based, entrepreneurial, venture-funded culture of biotechnology.

So biotech insiders now promote the language of “value-based pricing” for their products, which offers the virtue of honesty (away from cost-based justifications) but the vice of obscurity. No one knows how to define value in health care (it’s certainly not what the patient would be willing to pay, because the patient is not the one paying), much less how to measure it. And it’s not obvious that the biotech industry should capture the full value of its innovations anyway, compared to, say, splitting that value with consumers and the citizenry at large.

But at least the industry in engaged in the right discussion. It’s about value, not about cost. Costs have to be covered, but only for products that we value enough to pay the expenses required. The challenge facing the biotech industry is to tell its story, to define value, and to articulate a product and pricing strategy based on it. The challenge facing those who pay for biologics, including governmental programs, private insurers, and individual consumers, is to develop the ability to define value and to push the industry to ensure that their products are only used in truly high-value settings. Value-based pricing needs to be matched with value-based purchasing, the relentless search for better data on clinical and comparative efficacy, more effective clinical programs incorporating new treatments, and prices bargained down to the lowest levels needed to sustain investment and innovation.

For more research and commentary on biotechnology, see Health Affairs’ current issue, “Biotech Drugs Come of Age.”

Tomorrow on the blog: Ian Spatz on biotech pricing.

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