Money-Back Guarantee

HIGH DRUG PRICES HAVE BECOME A DOUBLE-EDGED SWORD. Pharmaceutical companies argue that they need high prices to allow them to continue R&D investment for helpful new drugs, which are increasingly difficult and costly to find. In response, payers implement formularies and other incentives to limit drug use and curtail costs. Unfortunately, this back-and-forth between pharma companies and payers hasn't optimized patient care. Rather, it's just refocused the discussion on cost. It used to be that we talked about prescribing the best drugs and treatments for the patient. Now, the refrain is different. Payers want to know: What is the least costly drug that adequately treats each patient?

Resolving this dilemma—and finally getting beyond the point where shrinking market share erodes any gains made by higher prices—requires companies and payers to change the way they buy and sell drugs. Companies and payers should seek common ground. In doing so, execs should move from focusing their negotiations on "price per unit of drug" to "price for value delivered."

The industry can start to rethink their approach by focusing on ways to drive volume without undermining value. Since the incremental cost to make most drugs is usually small, additional volume can add substantially to profit. The challenge is to develop strategies that enable companies to capture high prices for populations of patients for whom the drug delivers high value and therapeutic benefit, while simultaneously pricing lower to drive volume from populations that get less benefit or have less ability to pay.

Several other industries with similar cost structures—including the software, information products, and semiconductor industries—have solved this problem. They recognize that they are not in the business of selling products—rather, they are in the business of developing and selling access to intellectual property. As such, they have evolved highly effective models of pricing, such as pricing per application, per user, or per expected or actual effect.

Already, some pharma companies are experimenting with these pricing models. To date, that mostly has been in reaction to organized resistance—most notably, from the United Kingdom's National Institute for Health and Clinical Excellence (NICE). But by applying such models proactively, companies can increase market share, encourage faster uptake, and penetrate developing markets.

Let's look at three common models for pricing intellectual property that could help pharma win more volume and earn additional revenue to fund the growing cost of innovation.

Performance-Based Pricing

In any industry, whenever customers are uncertain if promised benefits will be realized in practice, they are reluctant to pay the asking price.

This is particularly true for new drugs, where payers balk at reimbursing for therapies until they see proof of sustainable benefits in actual practice. Frequently, this leads to a tug-of-war between payers, who are unwilling to pay a premium for an unproven value, and pharma companies, which don't want to get locked into a commodity price for a drug that may be worth much more. Meanwhile, the period of patent protection wastes away and patients lose out on new treatment options.

To overcome this problem, it is usually much cheaper for sellers to somehow guarantee outcomes than either to suffer the delay in adoption or to forgo the price premium that the innovation warrants. Honeywell used this model to drive adoption of its software-managed heating and cooling systems by tying payment for the product to the building owner's energy savings. In this way, it created a payment scheme based on the product's results in practice.

Pfizer implemented a version of this model in 2001. The company convinced the State of Florida to put all of Pfizer's drugs on the state's Medicaid formulary. In return, Pfizer agreed to payment based on the results of an independent audit of system-wide cost savings from patients using its drugs. If its drugs failed to generate long-term cost savings across the healthcare system, the company would rebate part of the drug cost. In doing so, Pfizer went beyond being a drug company to become a true healthcare company. And in the end, the performance-based approach worked, enabling Pfizer to avoid up-front discounts or back-end rebates, while saving the State of Florida $41.9 million in other healthcare costs.

Many companies have agreed to similar performance-based pricing agreements with the UK's National Health Service (NHS). In 2002, the three major suppliers of beta interferon drugs, Schering-Plough, Biogen Idec, and EMD Serono, created a "risk-sharing" agreement with the NHS under which payment for the drugs is linked to the sustainability of the clinical benefit. If a drug's effect on the patient condition diminishes over time, so does the cost of the drug. More recently, Janssen-Cilag tendered a money-back guarantee to NICE for its cancer treatment Velcade. At first, NICE ruled the drug was not cost-effective. But Janssen agreed to refund the cost of Velcade whenever a NHS patient fails to respond to it, and in so doing, convinced NICE to reverse its coverage decision.

Money-back guarantees and other performance-based pricing models, when used proactively, should help pharma companies achieve higher prices and more volume. As the Pfizer example and others show, it justifies a higher price per treatment and communicates confidence in superior outcomes that the company may not yet have the hard data to claim outright. If the competitive alternative works only half the time, a price twice as high for a drug is no more costly per successful treatment.

Performance-based pricing encourages use of the drug in populations for which it might not otherwise be cost justified. In effect, a performance-based rebate enables the company to give a discount when payers allow the drug to be used in populations with a high risk of failure, while still enabling the company to capture full value from populations where failures are less likely. Most importantly, performance-based pricing can get a drug approved more quickly for reimbursement, resulting in higher earning over the patent life.

Capitation Pricing

Compuserve and Prodigy came to the market in the 1980s and made some headway by offering online data information services. Users could access those services by paying by the minute or for each data download. But in the mid-1990s, AOL became the market leader by offering a new model—monthly subscriptions for unlimited access. Even though AOL's revenue per minute was less, its value per user, and the number of users, was greater, leading to an increase in overall revenue.

The pharmaceutical industry could use a similar model when negotiating with public or private payers. In particular, a pharma company could offer a per-member per-month price for access rather than a price per unit of drug. In doing so, it could completely reverse a payer's incentive to discourage use of its drug, without having to match the lowest prices in the category. In fact, the more often doctors prescribed the capitated drug in preference to an alternative, the more a payer's total cost within a therapeutic category would decline.

To illustrate the power of capitation, imagine that a leading-edge drug commands a 30 percent share within a plan despite costing $5.00 per day. Two other drugs sell for $4.00 and $3.00 and have 15 percent share each. The largest share of the plan's patients get less-efficacious generics that cost only $1.50 a day. The weighted average cost of treatment for this population is $3.15 a day. For 12,000 patients per day under treatment, the plan's annual cost for all brands is around $13.8 million.

In this case, the leading-edge brand might offer the payer a capitation-pricing plan as low as $2.10 per diagnosed subscriber. Certainly, this is much lower than the $5.00 it typically charges. But after negotiating access for these 12,000 patients, the company would increase its revenue by 40 percent. Certainly, it costs more to manufacture and ship the increased number of drugs. But even if the incremental cost of goods is 50 cents per daily dose, its annual profit contribution would increase by more than $1 million.

The incentives are equally strong for payers and patients. They benefit from capitation because it eliminates the need to limit access to clinically preferred drugs. The plan has an incentive to encourage scrips to be written for the capitated drug which, after payment of the capitation fee, becomes essentially free. In the example above, the plan breaks even if only the patients currently taking generics are shifted to the capitated brand. If patients on higher-cost drugs are induced to shift as well, the plan can substantially reduce its total expenditure in the category while patients get access to a more effective, branded drug. A capitation pricing scheme also minimizes the upside budget uncertainty that leads payers to delay or restrict reimbursement for higher-priced new drugs since unexpected volume would not create unexpected cost within the current contract period.

Details of implementation need to be negotiated to consider the contribution of co-pays, the medical appropriateness of using other brands for some patients, management of risk, and the potential for new indications. Capitation fees would need to adjust up or down based upon competitive conditions, like when a drug in a class goes generic. (But those issues are as much a challenge when pricing per unit as when pricing per subscriber.) Still, an offer of capitation pricing creates potential for the payer, the patient, and the pharma company to gain.

Segmented Pricing

Intel and Microsoft have successfully overcome in their industries one of the biggest challenges that face pharmaceutical companies: charging different amounts for essentially the same product when used across different applications or markets. Take computer chips. Intel prices these chips differently if they are sold to drive the processing speed of video games rather than to drive complex logistics systems. Microsoft charges different prices for essentially the same software across different markets based on ability to pay.

For pharma, this type of segmented pricing is particularly difficult to do when negotiating outside of a centralized payer, because drugs intended for one application are easily diverted for another unintended one. To overcome this, companies must create "fences" that hinder purchase for high-value-per-unit applications from being met at a price intended for lower-value applications. The most effective fence—a different product for each application—is also the most costly, but it does work.

For example, while studying Proscar (finasteride) for benign prostatic hyperplasia (BPH), Merck realized that the drug also had an effect on hair loss. The maximum effective dose for male pattern baldness was only one-fifth the dose for treating BPH, a larger and more lucrative market. At the price per milligram for BPH, potential revenue from the male pattern baldness market would have been too small to make them worth pursuing. To enable charging a higher price per unit for male pattern baldness, Merck manufactured a difficult-to-divide 5-milligram tablet for BPH priced at $3.48. It then created an entirely different brand name (Propecia), product appearance, and packaging to support its pricing of the hair-loss drug at $2.38 for a 1-milligram tablet containing the same active ingredient.

Occasionally, pharma companies use similar tactics to make drugs, or licenses, available to aid agencies serving those least able to pay. For example, Pfizer has created a distinctive appearance for Diflucan (fluconazole), which it donates free of charge in many countries in Africa. There is a growing commercial opportunity to use similar tactics for sales in large, developing markets where many people can pay profitable—albeit not the highest—prices. Indeed, different product variations can be used to penetrate developing markets while minimizing the chance that these drugs will be reimported back into markets where higher prices are charged.

By codeveloping local formulations and combinations to ensure no adverse effects, a Western pharma company could supply an active ingredient and a license to a local supplier to manufacture drugs at prices that patients in developing countries could afford. Software companies very often grant licenses to local partners that limit the geographic area within which they can sell. They do so by licensing only a few distributors and using state-of-the-art product tracking codes and counterfeit protections on their products and packaging. Any product that shows up where it does not belong can easily be tracked back to the local authorized distributor, who has a lucrative franchise to lose. Pharma companies could adopt similar tactics in partnering with local manufacturers and distributors and, in so doing, maximize their product's sales around the world.

Above All Else, Price is a Negotiation

The success of innovative drugs will depend increasingly on how well the companies that make them can structure prices to cover different applications and abilities to pay, can align pricing with performance to overcome uncertainty, and can negotiate win-win deals with powerful buyers. Above all else, pharma executives must realize that pricing today is not about setting an optimal number for price takers. It is about creating a strategy for successful negotiations with payers and institutions that are pursuing strategies to reduce their costs. There is no right price in a negotiation—only a range of possible outcomes between what the seller is willing to accept and the buyer is willing to pay. Success in negotiation depends largely on having good information and using it to make viable offers that are attractive to both parties.

One necessary piece of insight for structuring offers is an estimate of how payer restrictions and disincentives impact sales. Knowing that two payers each could put your drug into the highest co-pay category does not mean that each should be offered the same deal. The highest co-pay category for one may involve much more restriction of volume than for another because the actual co-pay levels or the economic circumstances of the patients are different. In addition, the increasing transparency of discounts requires sellers to consider the impact of a deal on the demands that will be made by similar buyers.

Equally important to a successful negotiation is understanding the drivers of and barriers to brand choice within each payment system. Who is the economic decision maker: the payer, the physician, or the patient? Is the decision maker concerned entirely about keeping the cost of care within a budget, or is she willing to expand the budget if the incremental clinical benefits represent "good value" relative to the incremental cost? What are the criteria used to determine the economic value of clinical benefits? Beyond value, what are the decision maker's expectations about fairness in the negotiation?

Structuring offers that payers will accept is not about winning the highest prices per unit, but about maximizing the return on the IP. Pricing models must encourage broad use of the drug, while still capturing differences in value across applications. To win acceptance, pharma will need to educate stakeholders regarding the social value in replacing product-based with value-based pricing models. The industry's success in implementing this will affect not only its well-being, but also the well-being of the healthcare systems and patients it serves.

Thomas Nagle is a partner in The Monitor Group who specializes in strategic pricing. He can be reached at tom_nagle@monitor.com