Harry Hooks served in the Vietnam War for one year and is long retired from the military, but he is still paying a high price for his service. The 66-year-old veteran, who lives in Pennsville, New Jersey, was diagnosed with hepatitis C in 2004 and has struggled with painful symptoms ever since.  

During the war, soldiers may have been infected with hepatitis C while getting vaccinations with rapid-fire tools known as jet injectors. If Hooks didn’t get the virus from those vaccinations, he says it probably was from the 40 units of blood he received in a transfusion after he was “blown up” on duty in 1969.

Decades later, the virus causes his hands and feet to throb in pain or go numb, a condition known as peripheral neuropathy. He often feels fatigued. When he heard about new hepatitis C drugs that were coming onto the market last year and promised a remarkable cure rate, he was eager for himself and fellow vets he had met through a support website called hcvets.com to receive treatment.

But he was also wary. Hooks started warning other veterans not to get their hopes up about receiving the drugs anytime soon -- it took but one look at the list price of these expensive new medicines for Hooks to suspect that the U.S. Department of Veterans Affairs would struggle to pay for them.

Today, Hooks has not yet received any of the new medications, but the Department of Veterans Affairs has stopped enrolling new hepatitis C patients for the drugs due to budget constraints. The VA initially reallocated $700 million to cover the costs for 20,000 veterans but asked Congress for another $400 million in a letter sent last week.

“They ran out of money,” Hooks says. “Anybody that was in line to get access will have to wait.”

Hooks is one of 3.2 million Americans who have hepatitis C, a viral infection that causes the liver to become inflamed. It is spread through contact with the blood of another infected person and over time, it can cause scarring of the liver known as cirrhosis or liver cancer, both of which can be fatal. 

A drug named Sovaldi cures more than 90 percent of patients with hepatitis C who take a daily pill for just 12 weeks with minor side effects. Those results made it the obvious choice for patients such as Hooks, who had already tried multiple drugs, including ribavirin and interferon, which only promise a 50 percent cure rate.

The Food and Drug Administration approved Sovaldi in December 2013, but when manufacturer Gilead Sciences Inc. announced the price -- $84,000 for 12 weeks of treatment, or $1,000 per 400 mg pill – patients and their insurance companies balked. Ribavirin had cost just $1,700 for a 48-week treatment.

Sovaldi 2 by Andrew Karpenko, University of Washington Sovaldi by Gilead Sciences costs $84,000 for a 12-week course of treatment. Despite a 90 percent cure rate, the high price of the drug has generated fierce backlash from insurers, patients and politicians since it debuted in December 2013. Photo: Andrew Karpenko, University of Washington

Over the last few years, this scenario has played out again and again: A company gets FDA approval for a drug, but when the company reveals the list price, patients who were hoping for a better life get hit with sticker shock. 

“What you have now is an onslaught of highly effective but very, very expensive drugs and vaccines,” noted Soeren Mattke, a public health policy expert at the nonprofit RAND Corporation.

The high cost of new drugs like Sovaldi has prompted patients, lawmakers, insurers and physicians to question the pricing tactics of drug companies.

Gilead is under particularly heavy scrutiny over Sovaldi, because unlike specialty medicines for rare conditions, Sovaldi could be prescribed to millions of patients. The magnitude of the drug’s total cost could overwhelm an insurer or an entire healthcare system.

Last year, U.S. senators demanded Gilead hand over all internal documents related to the price of Sovaldi for a federal investigation. The Southeastern Pennsylvania Transportation Authority, the Philadelphia area's mass transit system, has also filed a class-action suit against the company, claiming unjust enrichment and violations of the Affordable Care Act.

Still, the mechanisms that drug companies use to set prices remain a closely held trade secret. And despite the pushback, Gilead debuted another treatment for hepatitis C in 2014 named Harvoni which costs even more -- $94,500.

As the industry repeatedly demands extraordinary prices from patients, insurers and taxpayers, it prompts the question -- how, exactly, does a pharmaceutical company determine the price of a new medicine?

Drug companies operate largely outside of traditional market forces, and experts suggest that one variable has an outsized influence in setting the price for most medicines in the U.S. – how much patients and their insurers are willing to pay.

These Rules Don’t Apply

The story of how drugs came to carry the eye-popping price tags seen today dates back at least 30 years. Glaxo Holdings Inc., now part of GlaxoSmithKline, introduced Zantac to treat ulcers as a competitor to SmithKline’s Tagamet in 1983. Despite the fact that the medications were nearly identical, Glaxo priced Zantac 56 percent above Tagamet. The company’s then-chairman, Sir Paul Girolami, believed that a high price could persuade consumers to pay for the marginal value of the drug over Tagamet. And it worked -- Zantac soon overtook Tagamet to become the world’s best-selling medicine. By 1989, Zantac had captured 53 percent of the American market as compared to Tagamet’s 28 percent.

Drug executives often say prices reflect the fact that companies lay out an average of $2.6 billion and spend 10 to 15 years to bring a single drug to market. The industry’s trade group, Pharmaceutical Researchers and Manufacturers of America (PhRMA), says that only 20 percent of drugs earn back research and development costs, and a recent MIT study showed that companies lost about $26 million on each new drug they developed from 2005 to 2009.

But Andrew Witty, the CEO of GlaxoSmithKline, has called these billion-dollar R&D figures “one of the great myths of the industry" because they include the cost of failed experiments as well as successes. And the analysts at the Tufts Center for the Study of Drug Development who reported the $2.6 billion figure last fall were criticized for failing to disclose their methods. 

There’s no doubt that pharmaceutical companies spend vast sums to develop drugs, but to Rena Conti, a health economist at the University of Chicago, the argument that a drug’s price is based primarily on these costs doesn’t ring true -- particularly in the case of Sovaldi.

Gilead acquired the rights to Sovaldi when it purchased a company called Pharmasset, just a year before the medicine got FDA approval. By that time, Pharmasset had already completed much of the research and showed that it could sell the drug at a profit for $36,000 per treatment cycle, according to documents filed with the Securities and Exchange Commission.

Gilead purchased Pharmasset for $11 billion in 2011. In 2014, Sovaldi’s first year on the market, the drug generated $10.3 billion in sales.

Conti says even if a drug's price did reflect costs, that price should be close to the variable cost of production, or the expense that goes into making the next bottle of pills, rather than a company’s entire research budget. Production costs are certainly not zero, but on average, generic drugs – which offer the best approximation of variable costs -- are priced at 80 to 85 percent below brand-name medicines.

For example, the price of Lipitor to treat high cholesterol dropped from more than $5 per pill to 31 cents– a 95 percent reduction -- once it faced generic competition beginning in 2011. In the case of Sovaldi, an analysis led by the University of Liverpool in England showed that a 12-week course of the drug could be manufactured for just $68 to $136.

Uwe Reinhardt, a health economist at Princeton University, points out that price only reflects costs when competition between manufacturers brings a price within close range of the costs it took to produce a good. The FDA protects pharmaceutical companies from competition by prohibiting rival products from coming onto the market for five to seven years after a drug is approved.

“In drug companies, you do not have perfect competition -- you have artificial monopolies,” he says.

In another twist, the cost of a drug is largely divorced from a patient’s pocketbook. Therefore, drug companies worry less about whether a single person can afford the product than whether a major insurance company or healthcare system will pay for it.

Taken together, these exceptions mean the price of medicine is not limited by two of the primary forces that keep the costs of most U.S. consumer goods in check -- competition and affordability.

“I believe in economics as a way of explaining why things happen, but nearly every assumption that is based on a normal economic market is not present in this market,” said Stephen Schondelmeyer, an expert in pharmaceutical pricing at the University of Minnesota.

That leaves one remaining force that Reinhardt says is largely responsible for shaping drug prices – willingness to pay. To set a price for a new drug, pharmaceutical companies work backward from the highest possible amount that consumers, insurers or healthcare systems will pay to have it.

"The drug company is saying -- ‘We invented something that saves lives. What is it worth to you?’” Reinhardt says.

To his point, a recent analysis by the National Institutes of Health published in the journal JAMA Oncology found no connection between the effectiveness and price of 51 cancer drugs, and concluded that drug prices “simply reflect what the market will bear.” Physicians at the Mayo Clinic in Minnesota reinforced that point in a recent paper in Mayo Clinic Proceedings that also refuted four of the pharmaceutical industry’s main arguments for why drug prices are so high.

To determine the highest possible list price for a new drug, companies calculate what patients and insurers currently pay for competing drugs or surgery. If there are no other medicines or surgical treatments for a given disease, the company will evaluate the cost of allowing that disease to remain untreated – a calculation that can drive a drug price to astronomical heights.

“In the last couple of decades, drug companies have set their prices on the cost of not having their product,” Schondelmeyer says.

The calculation might capture the cost of a lifetime of hospital visits or lost productivity for patients and their caregivers. Heart disease, for example, costs the nation $273 billion in direct medical costs each year and $172 billion in lost productivity, as stated in a 2011 study by the American Heart Association. For an uninsured patient, recovering from a heart attack may cost as much as $92,000 in hospital bills, and the average lifetime cost of suffering a stroke is $100,000.

Such costs can quickly add up and present a convincing case to insurers and the federal government that these medicines are ultimately worth the high price tag. 

PhRMA likes to point out that drugs account for only about 10 percent of U.S. healthcare costs. But at the same time, the pharmaceutical industry is directly benefiting from the high costs of hospital and physician care by charging the highest possible drug prices based on the avoided value of these services.

Reinhardt says Gilead probably used such a formula to set Sovaldi’s price tag. As a drug that cures patients of an often-lethal disease, Gilead could claim lifetime cost savings on behalf of its many potential patients to entice a healthcare system or insurance company to pay handsomely for it.

John Castellani, CEO of PhRMA, argues that new hepatitis C drugs such as Sovaldi could save the U.S. healthcare system up to $9 billion a year by preventing liver transplants that cost $500,000 apiece.

“So they said, ‘If we charge $1,000, how could we turn that down?’ And they were right -- people pay it,” Reinhardt says.

However, a recent study published in Annals of Internal Medicine suggests that hepatitis C drugs would cost the healthcare system about $65 billion more than former treatments and offset only $16 billion in additional costs over the next five years.

A Flexible Rate

Choosing a price for a drug is only the first step, and only one kind of customer winds up paying full price – uninsured patients. For everyone else, the list price is a starting point for negotiations. Government and insurers can often leverage the number of patients they cover or claim rights under special laws to bring the price of a drug down.

"No one is paying $84,000 for the treatment course of Sovaldi," Conti says.

Administrators at Medicaid, which provides insurance for low-income people, have a “best price” rule that entitles them to the lowest negotiated price that a drug company has offered private insurers. The agency typically earns at least a 15 percent discount off the list price of any drug. In addition, the 340 B Drug Pricing Program gives discounts of 25 to 50 percent to hospitals that serve low-income populations. The Department of Veterans Affairs is entitled to discounts of 25 to 50 percent based on federal law, and the Federal Bureau of Prisons has secured a 44 percent discount on Sovaldi for inmates.

Medicare, however, as the national insurance program for seniors, with 54 million enrollees, is not allowed to negotiate with drug companies pursuant to the rules of the 2003 Medicare Modernization Act. That restriction turns out to be a lucrative one for drug companies. Without the power to negotiate, Medicare is paying far more for drugs than other U.S. agencies.

One report showed that Medicare pays 58 percent more on average than the Department of Veterans Affairs for the same medicines. Last year, Medicare spent $4.7 billion on drugs for hepatitis C, which represents a more than 16-fold jump from the $286 million it spent the year before, while Medicaid spent $1.2 billion in the first nine months of 2014 on the same drugs -- despite the fact that Medicaid covers roughly 16 million more patients than Medicare.

"I would argue that the prices that we have in the U.S. are not set by the market because we don’t really have the conditions of a market,” Schondelmeyer says. “They're not set by the government because they can't negotiate the price. Essentially, we've chosen to let pharmaceutical companies write blank checks for their prices."

National healthcare systems elsewhere often negotiate a discount below what patients, insurers and government agencies pay in the U.S. Canada has a federal rule that says the national healthcare system -- which covers everyone, unlike in the U.S. -- may pay no more for a drug than the median price paid by seven other industrialized nations. European cancer drug prices are typically 20 to 40 percent lower than the price of the same medicines sold in the U.S.

Pharmasset had expected to sell Sovaldi in the European Union for about $24,000, or 67 percent of the price it would have charged in the U.S. Earlier this year, a generic drug maker began selling a version of Sovaldi in India for just $10 and Gilead has sold Sovaldi in Egypt for $999 for the course of treatment – which is 1.2 percent of what it charges in the U.S.

Hooks, the Vietnam veteran, understands that pharmaceutical companies must make a profit in order to keep developing new drugs, but he is upset by the fact that the U.S. seems to be largely responsible for contributing to the industry’s bottom line. “We seem to pay for it and in other areas, they get it for a cheaper price,” he says.

Group purchasing organizations and pharmacy benefit managers that oversee U.S. insurance plans may also negotiate deals and discounts for the patients they cover. These groups often earn a 15 to 20 percent discount from the list price and can receive additional rebates if they sell enough of a drug.

Typically, the public has no way of knowing how much of a discount a private insurer is receiving because the negotiations take place behind closed doors. But these discussions became very public in the case of Sovaldi.

Managers at Express Scripts, the nation’s largest pharmacy benefit manager, were deeply unnerved by the price that Gilead had set for Sovaldi when it debuted. They struck a deal with rival drug company AbbVie to exclusively cover a comparable hepatitis C medicine named Viekira Pak that cost $83,000 in exchange for a steep discount. After the deal was announced, several other large pharmacy benefit managers scrambled to secure their own exclusive deals with either Gilead or AbbVie.

After that back-and-forth, Gilead executives admitted to shareholders that a year after debuting at $84,000, Sovaldi would be sold at an average discount of 46 percent in 2015, which would put the price at $45,360. The price had dropped to nearly the same price which Pharmasset had set for the medicine in the first place -- $36,000 -- though the former company's original list price surely would have been still lower after rebates and discounts.

If a pharmaceutical company knows it must offer steep discounts to insurers and governments, it may inflate the list price. Combine this tendency with the inability of one of the nation’s largest insurers to negotiate while the FDA restricts all competition for highly coveted products – and the U.S. ends up with the most expensive drug prices in the world.   Sovaldi by Andrew Karpenko, University of Washington The $84,000 price tag for Sovaldi has been hotly disputed, but that price doesn't even place Sovaldi within the top 10 most expensive drugs sold in the U.S. The treatment lasts only 12 weeks before the vast majority of hepatitis C patients are cured -- unlike high-priced medicines for chronic diseases which must be taken for life. Photo: Andrew Karpenko, University of Washington

Reining In Costs

America has endured high drug prices for decades – a 1989 editorial in the New York Times decried the “extraordinary cost” of AZT, an early and extremely toxic AIDS treatment, which sold for $8,000 a year. That editorial pointed out that the federal government underwrote much of the research and development for AZT, and complained that manufacturers refused to reveal their true costs.

So what can be done to grant access for patients like Hooks to the medicines they need? 

“The only thing we can really do is contact Congress and tell them to get with it,” Hooks says.

As a first step, U.S. Sen. Bernie Sanders of Vermont, who is running for president, sent a letter to the secretary of veterans affairs earlier this month requesting that the department break the patents for hepatitis C drugs to allow for competition.

Schondelmeyer says a truly effective overhaul would require a fundamental restructuring of the way pharmaceutical companies are allowed to do business in the U.S. “This isn’t a market in an economic sense like most consumer goods,” he says. “We keep closing our eyes as a society and as policy makers and pretending that it is.”

In February, President Barack Obama announced that he would request authority from Congress for Medicare to negotiate drug prices on behalf of the 54 million people enrolled in the program. This move would slash the amount Medicare must spend to cover these drugs for enrollees. Obama pitched a 2016 budget based on the assumption that Sylvia Burwell, U.S. secretary for health and human services, would assume this responsibility and set a more reasonable rate.  

However, that proposal isn’t likely to go over well with a Republican-dominated Congress. If it fails, Medicare could take another approach and only agree to cover the most expensive medicines for the sickest of patients. Conti says “coverage is essentially guaranteed” in the program today.

But states that have tried to set limits on patients' access to drugs have been heavily criticized. Arizona’s Medicaid office initially refused to cover a $311,000 treatment by Vertex Pharmaceuticals for cystic fibrosis called Kalydeco in some eligible patients, partly for fear that it would bankrupt the state agency’s budget. The decision prompted three patients to file a federal lawsuit.

For fear of similar backlash, private payers are often reluctant to refuse coverage for a life-changing treatment. Instead, insurance companies might nudge patients toward cheaper drugs by placing pricier ones at a coverage level that requires a higher co-pay. However, Conti says both methods are imperfect solutions to a systemic problem.

“Command and control strategies -- for restricting supply or making patients more cost-sensitive to cost of drug, don’t really work in markets where there's not much choice,” she says.

Such challenges have prompted Dr. Steve Miller, chief medical officer for Express Scripts who led the group’s AbbVie negotiations, to pledge to continue his crusade against high drug prices. He alluded to a coming payer-led effort to restrain prices on cancer drugs when speaking to investors in late April, with the goal of “influencing the market by 2016.” 

To some extent, public advocacy and finger-pointing seems to work. Physicians at Memorial Sloan-Kettering Cancer Center in New York, the nation's most-renowned cancer hopsital, wrote a letter to the editor stating that they refused to prescribe a medicine called Zaltrap by Sanofi to treat patients with colorectal cancer because the price was more than twice that of another drug which worked just as well. Soon after the letter was published in the New York Times in 2012, Sanofi slashed the price in half.

An Expensive Pipeline

Americans already spend $300 billion a year filling their prescriptions. With no reason to stop, pharmaceutical companies will continue to price drugs based on the highest possible amount they believe insurers and governments will pay for those medicines – and negotiate discounts to grant some payers better terms than others.

When it comes to painfully high prices, hepatitis C drugs may only be the tip of the iceberg. Today, there are more than 900 cancer drugs in development. Though many will prove to be failures and won't make it through all three stages of clinical research, those that do could be the most expensive the world has ever seen. The FDA approved a dozen cancer drugs in 2012, and 11 of them cost more than $100,000 per year.

Michael Rosenblatt, the chief medical officer of Merck, warned in a post in the Harvard Business Review that recent enthusiasm for precision and specialty medicines to treat ever-smaller subsets of patients could raise prices ever higher without changes in drug regulation and development. Though he urged countries to raise drug prices in accordance with “the true value of medicines,” his broader point about the need for regulation is one on which many can agree.

As payers apply growing pressure to drug companies including Gilead for the exorbitant prices they have set, and outrage within Congress swells over the national burden of paying for these medicines, major pharmaceutical companies may soon find that the very terms on which such favorable drug pricing is based are suddenly up for negotiation.

Meanwhile, Hooks will continue to wait for access to the medicines that could cure him. He says he’s in no rush. He’s more concerned about the hundreds of veterans who have visited hcvets.com over the past year to ask how they can obtain these drugs – many of whom seem far more desperate for treatment as the disease progresses. “I'd much rather see them get it before me,” he says.