Prescription Drug Pricing Pathfinder
Pharmaceutical Industry's Costs

The pharmaceutical industry incurs tremendous costs in bringing a new drug product to market. These costs generally fall into four areas:

- Research & Development (R & D)
- The FDA Approval Process
- Manufacturing
- Advertising

Each of these is discussed briefly below, with sources for more in-depth information listed. The best source of information on the Pharmaceutical Industry's costs is PhRMA, the industry's main trade association. The PhRMA site is chock-full of reports, facts, and figures on industry costs, especially R&D.

See also the Pathfinder page on the Pharmaceutical Industry.

1. R & D

1a. R&D Overview
Research and Development is far and away the most costly aspect of drug development. The topic is complicated, but for a good introduction (though a slightly dated one), see a February, 1993 report published by the federal Office of Technology Assessment, "Pharmaceutical R&D: Costs, Risks, and Rewards." (Click on the alphabet index in the lower left-hand corner of the site to get to the P's.) Although the Office of Technology Assessment shut down in 1995, copies of all of its publications are archived on the web at the Government Printing Office (GPO) and Princeton University. The Princeton site has a much nicer interface and is much easier to use. The link to the report given here is to the Princeton site.

See also PhRMA's "Facts & Figures" page.

1b. Government Assistance
Although R & D costs are extreme, the federal government offers a number of incentives and assistance programs to pharmaceutical companies:

• Tax Benefits
  R& D costs are treated favorably by the tax system, in that a pharmaceutical company can deduct the expenses currently, rather than depreciating them over time. For a discussion of the pros (and some cons) of this system, see W. Kip Viscusi, et al., Economics of Regulation and Antitrust, M.I.T. Press (2nd Ed., 1995), Chapter 24.
  

• Government-funded basic research
  The federal Department of Health and Human Services (DHHS) is the largest grant-making agency in the federal government. The National Institute of Health (NIH), a DHHS agency, funds basic research in labs across the country, much of which eventually evolves into a component of a new, commercial drug (or occasionally, the drug itself). Interestingly, the cost of this government-funded research--which is really taxpayer-funded research--is never recouped when it leads to a commercial product. Look for this issue to play a prominent role in the ongoing debate about why drug manufacturers should lower their prices.
  
  For a good overview of the government-funded research issue, see: Jeff Gerth & Sheryl Gay Stolbert, "Drug Makers Reap Profits on Tax-Backed Research," The New York Times, April 23, 2000, Page 1.
  
  
• The Orphan Drug Act of 1983
  The Act provides a tax credit of 50% for R & D expenses incurred in clinical trials of so-called "Orphan Drugs." Orphan Drugs are those for which the market is very small, because the drug is targeted at a malady affecting only a small number of people. The Act provides that the first firm to receive FDA approval for an Orphan Drug may market the drug exclusively for seven years (concurrently with the patent term).
  The Orphan Drug Act was P.L. 97-414, 96 Stat. 2049.
  

2. FDA Approval

The FDA approval process can take 12 years by some estimations--see W. Kip Viscusi, et al., Economics of Regulation and Antitrust, MIT Press (2nd Ed., 1995), Chapter 24. Also see Jeff Gerth & Sheryl Gay Stolbert, "Drug Makers Reap Profits on Tax-Backed Research," The New York Times, April 23, 2000, Page 1. Drug manufacturers cannot recoup any costs during the approval process, because the drug is still being tested.

See also the Pathfinder page on Drug Regulation.

2a. Prescription Drug User Fee Act

The Prescription Drug User Fee Act, P.L. 102-571, 106 Stat. 4491, passed in 1992, authorizes the FDA to collect fees, payable by the drug companies, for applications for approval of human drugs. While the fee is small compared to the total amount a drug company spends on developing a drug to the point of FDA application, the fees are not cheap; in 1997 the application fee was $233,000. The law provides for a 50% reduction for companies with fewer than 500 employees.

3. Manufacturing

Actual manufacturing and packaging costs are very small compared to other costs. A prescription that is priced at $50 may only contain 50 cents worth of ingredients. But drug companies stress that efforts to link prices to manufacturing costs are misguided, because of the extreme R&D costs.

4. Advertising

In addition to the billions of dollars pharmaceutical companies spend on sales and marketing to physicians, pharmaceutical companies spent an estimated $1.9 billion on direct-to-consumer (DTC) advertising in 1999. Prior to the 1990s, DTC advertisements of prescription drugs was severely restricted; prior to 1997, advertising had to be accompanied by all of the fine print that would normally go on a label and package insert. But in August, 1997, the FDA relaxed restrictions on DTC advertising, leading to a boom in television and radio ads (and advertising spending).

For rules governing DTC advertising of pharmaceuticals, see the FDA's regulations in 21 C.F.R. Sec. 202.1. The link will take you (slowly) to the on-line version of the Code of Federal Regulations (CFR) at the free, on-line government site for the full CFR.

For recent statistics on DTC advertising, see the National Institute for Health Care Management (NIHCM)'s recent publication entitled "Factors Affecting the Growth of Prescription Drug Expenditures." The report and an addendum issued shortly after the completed report is available on NIHCM's publication page.

In addition to adding directly to pharmaceutical company costs, direct-to-Consumer advertising is a significant reason America's drug spending has increased. Consumers either try a drug where they would have used nothing (such as allergy medicines), or consumers ask for more expensive drugs by name, rather than purchasing a less expensive drug. For a discussion, see Thomas M. Burton, "Hard to Swallow--America's Soaring Drug Costs--Bested Interests: Why Generic Drugs Often Can't Compete Against Brand Names--Lower Prices Aren't Enough to Overcome Demand for 'New and Improved,'" The Wall Street Journal, Nov. 18, 1998, p. A1.

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