Updated: Mar 15, 2022
The objective of this comment is to illustrate a few of the underlying economic and behavioral forces that led to the first adoption of subscription-based pricing for pharmaceuticals.
In the interest of keeping the analysis relativ brief and relevant, I am limiting the empirical exploration to recent data and experience from the U.S. HCV market. As of May 2020, the few academic takes on the so-called Netflix approach in pharma have exclusively chosen public health perspective, hailing it as an innovation in allowing a health system to remove budget constraints as the barrier to universal medication access (e.g. Cherla et al. 2020).
I'll hope to illustrate how budgetary and population health considerations represented major demand factors shaping the context for today’s pricing dynamics. But the perspective of the analysis will remain on the supply side of the deal. With respect to the merits of the model’s adoption, the purpose here is thus not to discuss whether Netflix pricing may reduce the risks of severe budget impacts (payer’s financial exposure) or actuarial uncertainty (unpredictability of eligible beneficiaries in the insurance pool). Instead, I will draw on the competitive HCV market context to contemplate some of motivations and conditions for the selling manufacturers to embrace the approach, or to avoid it, if possible. Accepting different objective functions, we shall conclude by asking whether the model’s win-win proposition is as appealing to industry decision-makers, as it is to public health advocates.
The HCV Market Context
The negotiation of lump-sum reimbursement for entire populations has been pioneered for vaccinations in global health before. But the 2019 decisions by the Medicaid payers Louisiana and Washington to reimburse the manufacturers Gilead and AbbVie, respectively, based on fix amounts for multi-year-periods, makes for a remarkable case study: Figure 1 shows a truly unique market evolution reflecting the turbulent dynamics in HCV within five years after the debut of Sovaldi, the first safe and effective new direct-acting antiviral cure (DAAs).
Figure 1: Unique Dynamics in the HCV Market 
Analyzing the Pricing Problem
When Gilead launched Sovaldi at a list price of $84,000 for a standard 12-week course of the curative treatment, it triggered an investigation by the US Senate Financing committee. The 18-month audit uncovered “a calculated scheme for pricing and marketing its Hepatitis C drug based on one primary goal – maximizing revenue – regardless of the human consequences” (Senate Financing Committee 2015). The attention of policy makers and budget controllers to pharmaceutical pricing had been a matter of public debate for over thirty years. But recent rulemaking intensified in the US, and not a day went by without the words “drug costs” in the headlines of a major newspaper. A wave of novel high-cost therapies amplified affordability concerns among groups of payers, providers and patients now agreed that funding is insufficient to satisfy broad HCV patient access without ‘bankrupting the system’.
Protected by patent laws and guaranteed market exclusivity for their molecule, first entrants like Gilead would indeed raise the innovative drug’s list price towards the profit-maximizing level to the extent that payers would be limited in excluding from their formularies a superior therapy without alternative. Leveraging a wealth of health-economic data on the natural history and HCV disease burden, developers were able to show models that DAA cures were clinically superior and evidently cost-effective in over 80% of patients at commonly accepted willingness-to-pay thresholds. The manufacturers’ pricing rationale – that a better products provided good value money for the bulk of HCV patients – was confirmed by payer-funded studies (Najafzadeh et al 2015) as well as research at the National Institutes of Health (Chhatwal et al. 2015). Figure 2 illustrates visually the simplified value proposition the developer may have used for their argument that the high therapy price is cost offsetting given the reduced overall health care utilization expenditures alone.
Figure 2: Non drug cost of HCV-infected patients as evidence of the therapy cost-offsets
Source: Izaret & Matthews (2019)
We should note that the price points in the published cost-effectiveness analyses were based on wholesale acquisition costs, excluding discounts. Accounting for gross-to-net reductions – myriad concessions and rebates drug developers are expected to give in order to secure proper US distribution and formulary placement – the net price most insurers ultimately paid was much lower, falling at least on average below the overall cost of prior treatment regiments. In the US, net prices are kept secret as the outcome of a confidential negotiation between insurers and industry, but a rough analysis puts the average net price that Gilead initially realized around $45,000. In many ways, Hepatitis C medications were a prime example of what pharmaceutical marketers would see as a contextually negotiated but value-based price for a life-changing innovation. With its approach, Gilead realized over $50B in revenues between 2014-2017. Considering unmet need, lifetime treatment costs, disease progression, as well as non-health expenditures such as patient/caregiver time and productivity as evidence of economic value, the pricing approach made DAAs good value for money over the alternative current standard of care.
However, as we segment the demand side, complications arise. US state payers (Medicaid) could not negotiate their own discounts, but thanks to the so-called Medicaid best price regulation would automatically receive the lowest negotiated price that was registered between manufacturer and any private insurer across the country. This yielded an average drug cost-per cured patient of $35,000 in a Louisiana in 2018. This, one could argue, represents exceptionally great value. And yet, treating its entire HCV population would take a budget greater than the state’s annual expenses for K12 education, veterans and prison services combined (Gee 2019). Furthermore, cost-avoidance models also revealed that the expected 10-year savings did vary depending on the patient in question (age, genotype, gender etc.), leaving many budget holders unsatisfied about their ability to afford therapy and effectively cure infections (Izaret & Matthews 2019).
In view of classic economic theory, manufacturers were properly exploiting a low price-elasticity of demand. From a firm perspective, they would skim the market, a process “designed to capture superior margins, even at the expense of large sales volume” (Nagle & Mueller 2018, p. 138). The ‘take it or leave it’ approach to value extraction on a per unit-basis did indeed leave a large unserved market segment behind, a substantial population of untreated patients, as conceptually illustrated in Figure 3 (from the firm-level) and Figure 4 (from a market level).
Competition with AbbVie’s growing HPC franchise brought down net prices but not to a level to see Medicaid payers enter the market, and it did not change either of the companies’ approaches. While private insurers (which covered roughly half of the US population but a small percentage of the HCV market) could negotiate exclusion and formulary preference among clinically-equivalent therapies, Medicaid would have to cover all products as long as the manufacturers agreed to give states the best price paid in the commercial market. Pro-forma coverage but de-facto budget ceilings resulted in states’ imposing clinically unjustified access restrictions (Barua et al. 2015).
Figure 3: Price Setting Context from the Firm-level Perspective
Both dynamics – political contention and price skimming – would have been par for the course and a perhaps even lucrative business environment in other industries. But, here, they culminated in an embedded dynamic of psychological factors. The perception was that combatting the HCV epidemic in the US had failed. Despite the introduction of exceptional curative therapies, the public health threat was all but eliminated. Five years after launch, only 15% of the estimated 3M infected Americans had received therapy (Trusheim 2018). Louisiana, for example, managed to treat no more than 1,000 patients or roughly 1% of those living with HCV – a considerable deadweight loss. Of course, in reality many “non-drug-price” barriers to treatment existed – such as the lack of liver specialists whom state laws required to write prescriptions. But it widely appeared as if the unsavory pricing by the developers – targeting for-profit insurers – would make eliminating the epidemic impossible in many states, thus leaving the most disadvantaged in the Medicaid population untreated.
While the drug companies provided genuine value (i.e. a cure in 90-days) and priced fairly on per-unit value (i.e. at a discount to an inferior standard of care), they misjudged what Nagle & Mueller aptly called “the power of community-held norms of fairness in the decision and the resulting backlash against it … by an outraged public” (2018, 133). The experience illustrates the constraints of monetary value estimation in an emotionally charged market governed by budget ceilings. Proper segmentation likely had shown a much higher price sensitivity for the Medicaid states, yet the magnitude of estimated patient-level cost-savings had in fact little bearing on the WTP threshold for this payer archetype. The salient reference price was the economic cost of eliminating HCV among all of society. Against this backdrop, the disruptive Netflix alternative emerged with a win-win promise, and the call to disintermediate the classic promotion of individual product value and innovation attributes from per-unit pricing.
Figure 4: Applying Economic Theory: Demand Function and Price Discrimination
Dissecting the Proposed Model
Although subscription pricing has been used for information products since the dawn of printed news media, it has seen a resurgence with business models in the digital economy (Fishburn 1999). Its current moniker derives from Netflix’ ‘disruption’ in entertainment pricing, the abandonment of consumer’s historical pay-per-view (consumption) model for movies and on-demand television, in favor of adopting a fixed subscription in exchange for unlimited content access. Following the analogy, the pharmaceutical adaptation has manufacturers sell a subscription to payors for an unlimited supply of drugs. Or, in buffet terms, “All you can eat” becomes “All you can treat”.
As figure 5 illustrates, the approach promises unquestionable public heath value as long as no further treatment innovation is to be expected in the category. By nature, this limits the model to indications and categories where continued R&D can be sacrificed for budget surety, such as curative therapies. Payer would not want to “lock in” products in areas like psoriasis or oncology.
Figure 5: Modeling Epidemiological Impact
Source: Izaret & Matthews (2019)
Australia’s public payer had set the precedent for the Netflix approach in 2015, when as a sole purchaser, the government leveraged its monopsony power to negotiate a license payment of $766M awarded to Gilead in exchange for an unlimited supply of DAA over a five year-period (Moon and Erickson, 2019).
The set-up of the governing contract follows a public ‘winner takes all’ auction in which the lowest bidder earns the right to supply “the buyer with unlimited product for the agreed-on fee” (Trusheim 2019). In the two US cases, the auction seemed to have resembled more of a confidential negotiation process led by the state payers with each of the three competing bidders. Price tenders remained unpublished, but our researched estimates of the accepted agreements in the US are provided in figure 6.
Figure 6: Agreed Model Parameters in the US
This licensing model falls in line with the alternative approach of de-linking innovation from price, the principle that the additionally treated patients does not represent a higher cost to payers who, in turn, would avoid entering limiting access restrictions (ibid.) The implications of de-linkage on the market- and patent-based system towards a public-sector mandate would go beyond the confines of a good PhD dissertation but from a developer perspective, the current model is widely seen as the only defensible model sustaining a high level of R&D intensity. Given insignificant marginal cost of production for small-molecule medicines, manufacturers aim to communicate their cost in terms of ‘fully-loaded’ development expenses (Gourville 1999). The messaging that one successful approval needs to compensate for various shots on goal in R&D is contentious though (Emanuel 2019), and there is underwhelming evidence of its effectiveness in motivating WTP in payer negotiations as state policy makers appear ready to dismiss the linkage (Berman et al. 2019).
In addition to the tactical benefits listed above, one could make the argument that rather than just an innovation in drug pricing modality, the subscription model represents an opportunity for product innovation at the same time. When Louisiana signed the dotted line, it did not purchase more drugs but a health solution for an entire population. Washington went further and required diagnostics and treatment support - a volume-hedge further de-risking the payer and engaging pharma to drive testing, care integration and treatment adherence.
Figure 7: Five Tactical Benefits Manufacturer May Realize
As Oklahoma, Michigan and Colorado are reported states next in line to evaluate subscription pricing, we should caution that a simple simulation (Figure 8) exposes that manufacturers should be wary about entering into these discussions without the proper due diligence. My review shows that it is most likely that the payer side benefits over-proportionally from the deal while a “win-win” may not be the automatic starting position.
Figure 8: How likely are manufacturers to see higher net sales revenues?
A few practical, context-dependent recommendations may offer strategic guidance to developers on how to approach the subscription question.
Figure 9: Setting up for Success with the Approach
To put matters simply, manufacturers should model the agreement before they sign. They need to make sure to have a superior understanding of the prevalence within the state population and gauge the price accordingly. If the increase in volume reduces a defined contribution margin (driving up COGS), at a decreasing net price, and the resulting decline in profitability for the entire market appears to be greater than forgoing sales in that state’s Medicaid segment, they should re-consider. If they proceed, they must define what share of the delta they can claim to take home given the products value delivered to the entire patient population. As with any non-traditional pricing agreement, successful manufacturers are supported by a multi-disciplinary pricing steering committee and have provisioned for monitoring and adjudication systems.
Outlook: Caught between Netflix and aggressive share-based pricing
We should conclude that Netflix is not the only path to garner Medicaid customers. Other than through confidential discounts derived from the private market, the US system presents no fences to allow for differential pricing for individual state payers. Some deadweight loss thus remains – until generic entry that is. Last year, Gilead made an unprecedented move and effectively switched to a strategy of price penetrating of whatever is left of the HIV market. Well before patents would run out, the company launched authorized generics to their own blockbuster – priced roughly at the same effective net level (a 60% discount from the brand’s official launch price) (Liu 2019). While self-cannibalizing for the branded franchise in terms of script counts, the expected gain in cumulative market share at the equivalent level of net sales aims to put a grip on the price-sensitive Medicaid customers.
Given the public nature of these new generic prices, Gilead and Abbvie are now effectively in a market-share driven pricing in Medicaid (with obvious erosion effects for the smaller commercial HCV markets). This is resulting in an effective race-to the lowest price at whatever speed is required to secure the remaining share points of the (naturally) diminishing patient pool ahead of the competitor. With treatment-naïve patients being one-time end users, brand attachment matters only at the physician level for making the initial prescription decision. This puts even more upfront resources into marketing and education. The approach could nonetheless be profitable as long as selling, delivering and maintaining treatment and adherence (avoidable cost) are carefully monitored. Since these are incremental to the gain in volume, they are margin reducing in downward price spiral. At the pace the market is moving, there may well be a point where a certain level of return falls below the required cost of capital – of course, this is all depending on how the companies financing attributes the required rate of return on its R&D. However, it is more than an exercise in cost accounting and requires the attention of executives.
Following this case study, everything about HCV cures is engulfed in a story about pricing challenges – and the rapid escalation from value- to volume- to shared-based pricing raises questions about profit sustainability of commercializing future curative therapies. From the US manufacturer’s strategic pricing position, the Netflix model is unfortunately less of an innovative way forward, and more so a ‘last resort’ response mechanism providing optimal policy under a particularly narrow set of circumstances.
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 Federally administered and state run, Medicaid is a government insurance program covering 21% of US the population with low-income. With an annual spend of $592.7B, it is providing health and long-term care coverage to “over 70 million children, pregnant women, adults, seniors, and people with disabilities” (http://files.kff.org/attachment/fact-sheet-medicaid-state-US)  Build from annual financial statements of the companies (difference to 100% 2016/17 are others). Size of the hills as indicators of a rapidly shrinking market in dollar terms. As their generic names would indicate, product of Gilead and Abbvie are largely follow-on agents around key active ingredients of their DAA with improved efficacy or safety for additional genotypes.  A 2017 systematic review of 24 studies found a consensus that DAAs are cost-effective in the most prevalent genotype when priced under $227,200, adding that studies show that they "produced cost savings at current discounts" (Chhatwa et al. 2017).  Calculated from Gilead Q2 2017 earnings of U.S. HCV revenue of $1.909B across 42,000 treatment initiations.  Washington State declined publication of price negotiations, but reviewing the arrangements’ non-redacted details, as well as confirmation from public officials allows for estimate based on 2018 treated numbers as a comparison. https://www.scientificamerican.com/article/pharma-sells-states-on-netflix-model-to-wipe-out-hep-c/  A literature review suggests that economic studies tend to see a robust relationship between expected profitability of products and markets investments in R&D innovation (Kennedy 2019).