How Pharmaceutical Companies Price Their Drugs

Revenue generated from drug production by U.S. pharmaceutical companies both domestically and abroad is growing substantially, in part because of repetitive price increases.

Drug companies’ pricing is relatively unregulated, and they can often raise drug prices beyond inflation rates. This allows the drug companies to increase their revenues continually, even if demand for one or more drugs is not high. By 2024, worldwide sales of prescription drugs are predicted to reach $1.18 trillion by some estimates.

Exorbitant Drug Costs

The U.S. news media has put a great deal of focus on pharmaceutical companies that have released new drugs with sky-high prices. There has also been increased focus on previously released drugs under new ownership that have undergone abruptly increased prices. Drug companies do this, of course, to generate revenue.

However, the majority of a pharmaceutical company’s revenue comes from a pattern of steadily increasing prices of drugs that have been on the market for some time. The number of drugs that drug companies have in their pipelines will also affect each drug’s price.

The Inflation Reduction Act of 2022, signed into law on Aug. 16, 2022, for the first time includes provisions to help lower the costs and negotiate the price of prescription drugs for people with Medicare. This will start with 10 high-cost drugs in 2026 and expand to 20 high-cost drugs by 2029. Companies that refuse to negotiate with Medicare face a 95% tax penalty on that drug.

How Drugs Are Priced

Because of drug companies’ pricing power and their ability to increase prices without regulation, the worry about sluggish demand is far down on the list of concerns in relation to pricing. Pharmaceutical companies concern themselves with a variety of factors when pricing drugs.

Drug Uniqueness

The uniqueness of the drug must be considered—that is, how many other drugs are already available that treat the same condition. If the market is heavily saturated with drugs to treat a certain condition, new drugs for the same condition will likely be priced lower.

Competition

Competition is another factor that affects pricing. Drug companies must consider the popularity and success of the drug’s competition, and they must determine if new drugs have added benefits over competing drugs. Additional benefits lead to higher prices.

Drug Effectiveness

Drug companies must consider whether new drugs have the potential (or have proven through clinical trials) to change the current practice of medicine used to treat the conditions that the drugs target. The companies must also consider whether their drugs can prevent the need for certain medical treatments or the necessity for surgeries or other procedures.

Drugs that can cut down on expensive surgeries, hospital trips, and doctor visits are often priced higher because of the savings they offer customers on the back end. Drug companies also issue higher prices to drugs that can extend or even save lives.

Ultimately, the main objective of pharmaceutical companies when pricing drugs is to generate the most revenue. This often means facing competition, which serves to drive prices lower. However, drug companies have balanced pricing drugs too low with the ability to enact price increases at steady intervals.

Issue of Pricing

Pricing a drug incorrectly is a mistake that drug companies strive to avoid. Pricing a drug too low or too high has a great impact on its potential for success. If, for example, if a drug is priced too high, payers may be unwilling to reimburse for it or physicians may be disinclined to prescribe it.

They may believe the drug is not worth the high cost if it is likely that it will offer too little benefit to warrant the cost. On the other hand, if a drug is priced too low, physicians may conclude that it offers a discounted form of therapy, less effective than a more expensive drug that already exists.

The research and development (R&D) surrounding each drug is another monumentally important issue in regard to pricing. The amount of time, effort, and money that a pharmaceutical company invests in the R&D for each drug must be weighed when the drug is priced. This often leads to higher prices to ensure that the revenue generated will exceed the expenditures behind the drug’s development.

The Bottom Line

Pharmaceutical companies set their own prices when selling the products they have created. Without any competition for a newly created drug or one still under patent, pharma companies can set whatever price, knowing there are no alternatives. Under the Inflation Reduction Act of 2022, drug companies would have to negotiate with Medicare on the prices of some high-cost drugs that have been on the market for a certain number of years.

When considering how to price a drug, pharma companies take into consideration the uniqueness of the drug, competition, drug effectiveness, and research and development (R&D) costs.

Correction—April 26, 2023: This article has been amended to state that the Inflation Reduction Act of 2022 includes provisions to help lower the costs of prescription drugs for people with Medicare (not Medicaid).