Pharmaceutical R&D: Costs, Risks, and

Rewards

February 1993

OTA-H-522

NTIS order #PB93-163376

GPO stock #052-003-01315-1
Recommended Citation:

U.S. Congress, Office of Technology Assessment, PhurrnaceuficaZ R&D: Costs,

Ris/u and Rewards, OTA-H-522 (Washington, DC: U.S. Government Printing

Office, February 1993).

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ISBN 0-16 -041658-2
Foreword

P

harmaceutical costs are among the fastest growing components of health

care costs today. Although increases in the inflation-adjusted prices of

ethical drugs and perceived high prices of new drugs have been a concern of congressional committees for over 30 years, the growing Federal

role in paying for prescription drugs has increased the concern over the appropriateness of prices relative to the costs of bringing new drugs to market.

Specific policies of U.S. and other governments can alter the delicate balance

between costs and returns to pharmaceutical R&D, with ramifications for the

future health of Americans, for health care costs, and for the future of the U.S.

pharmaceutical industry.

OTA’s report focuses mainly on the economic side of the R&D process.

Pharmaceutical R&D is an investment, and the principal characteristic of an

investment is that money is spent today in the hopes of generating even more

money in the future. Pharmaceutical R&D is a risky investment; therefore, high

financial returns are necessary to induce companies to invest in researching new

chemical entities. Changes in Federal policy that affect the cost, uncertainty and

returns of pharmaceutical R&D may have dramatic effects on the investment

patterns of the industry. Given this sensitivity to policy changes, careful consideration of the effects on R&D is needed.

The specific request for this study came from the House Committee on

Energy and Commerce and its Subcommittee on Health and the Environment.

The Senate Committee on the Judiciary’s Subcommittee on Antitrust,

Monopolies, and Business Rights endorsed the study.

OTA was assisted in this study by an advisory panel of business, consumer, and academic leaders chaired by Frederick M. Scherer, Ph. D., Professor

of Economics, John F. Kennedy School of Government at Harvard University.

OTA gratefully acknowledges the contribution of each of these individuals. As with all OTA reports, the final responsibility for the content of the

assessment rests with OTA.

Roger Herdman, Acting Director

. . .

Ill
Advisory Panel

Frederick M. Scherer, Chair

Professor of Economics

John F. Kennedy School of

Government

Harvard University

Cambridge, MA

Jerome Avorn

Director

program for Analysis of Clinical

Strategies

School of Medicine

Harvard University

Boston, MA

Nancy L. Buc

Partner

Weil Gotshal & Manges

Washington, DC

Martin Neil Baily

Professor of Economics

University of Maryland

College Park, MD

William S. Comanor

Professor of Economics

University of California

Santa Barbara, CA

Lewis A. Engman

Partner

Winston & Strawn

Washington, DC

Thomas Q. Garvey, Ill

President

Garvey Associates Inc.

Potomac, MD

Frederic Greenberg

Partner

EGS Partners

New York, NY

Robert Helms

Resident Scholar

American Enterprise Institute

Washington, DC

Gene Kimmelman

Legislative Director

Consumer Federation of America

Washington, DC

Jeffrey Levi

Director of Government Affairs

AIDS Action Council

Washington, DC

Judy C. Lewent

Senior Vice President and Chief

Financial Officer

Merck & Company, Inc.

Whitehouse Station, NJ

George B. Rathmann

Chairman of the Board

ICOS

Bothell, WA

Shyam Sunder

Professor of Management and

Economics

School of Industrial Administration

Carnegie-Mellon University

Pittsburgh, PA

Jacob C. Stucki

Retired Vice President for

Pharmaceutical Research

The Upjohn Company

Kalamazoo, MI

W. Leigh Thompson

Executive Vice President

Eli Lilly & Company

Indianapolis, IN

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the advisory panel

members. The panel does not, however, necessarily approve, disapprove, or endorse this report. OTA assumes fill responsibility for the qort and the accuracy of its contents,

iv
Roger C. Herdman

Assistant Director

OTA Health and Life Sciences

Division

PRINCIPAL STAFF

JUDITH L. WAGNER

Project Director

Clyde J. Behney Michael E. Gluck

Health Program Manager Senior Analyst

Roseanne Altshuler

Rutgers University

William R. Baber

George Washington University

Lester Chadwick

University of Delaware

Robert Cook-Deegan

consultant

Joseph DIMasi

Tufts University

W. Gary Flamm

SRS International, Inc.

Penelope Pollard

Senior Analystl

Timothy W. Brogan

Research Assistant2

Lara Jakubowski

Research Assistant3

David J. Kaufman

Research Assistant

Arna M. Lane

Research Analyst

PRINCIPAL CONTRACTORS

Richard Frank

The Johns Hopkins University

Alan Garber

Palo Alto Department of Veteran Affairs

and Stanford University

Elizabeth Jensen

Hamilton College

Albert Link

University of North Carolina at Greensboro

Stewart C. Myers

Massachusetts Institute of Technology

Lynn Powers

Editorial Consultant

Project Staff

OTHER CONTRIBUTING STAFF

Jacqueline C. Corrigan

Senior Analyst

Philip T. Polishuk

Research Assistant

ADMINISTRATIVE STAFF

Beckie Erickson

Office Administrator

Eileen Murphy

P.C. Specialist

Carolyn Martin

Secretary

Stephen W. Schondelmeyer

University of Minnesota

Gordon Sick

University of Calgary

Ellen S. Smith

consultant

Steven J. Wiggins

Texas A&M University

1 From September 1989 to September 1991.

2 From Feb~q 1991 to Febw

3 From Auwst 1989 to JUIY 1991.

1992.

v
1 Summary, 1

Summary of Findings, 1

Introduction, 3

Origins and Scope of OTA’s Study, 3

Issues Beyond the Scope of This Study, 4

The Nature of Pharmaceutical R&D Investments, 4

R&D Costs: The Evidence, 10

Returns on R&D: The Evidence, 19

Total Pharmaceutical Industry Returns, 23

Industry Response: Increasing R&D, 24

Payment Policy and Returns on R&D, 26

The Regulation of Pharmaceutical R&D, 32

Federal Tax Policies Affecting Pharmaceutical

R&D, 33

Federal Support for Pharmaceutical R&D, 34

2 Research and Development

Expenditures, 39

How to Measure R&D Spending, 39

Trends in Domestic R&D Spending, 42

Trends in Worldwide Pharmaceutical R&D

Expenditures, 43

Directions of Pharmaceutical R&D, 44

Interpreting Aggregate Trends, 46

3 The Costs of Pharmaceutical R&D, 47

A Framework for Estimating R&D Costs, 47

Existing Studies of R&D Costs, 48

Validity of R&D Costs Estimates, 54

Other Factors Affecting Validity, 66

Tax Savings From R&D, 67

Recent Trends in the Cost of R&D, 69

Conclusions, 72

contents

4 ,

J

vii
4 Returns on Pharmaceutical R&D, 73

Returns on R&D: The Evidence, 76

Total Pharmaceutical Industry Returns, 95

Findings and Conclusions, 104

5 Trends in Science, Technology and Drug

Discovery, 105

Drugs and Receptors, 106

Protein Analysis and Proteins as Pharmaceutical

Agents, 113

Genetics in Biomedical Research, 119

DNA as a Therapeutic Agent, 127

Discovery Increasingly Driven by Biomedical

Research, 131

Implications for Future Pharmaceutical

R&D Cost, 132

6 Government Regulation and Pharmaceutical

R&D, 135

The Impact of Pharmaceutical Regulation on R&D

Costs and Output, 136

The U.S. Regulatory Review Process for New

Drugs, 138

Efforts to Expedite FDA New Product

Regulations, 151

Trends in the R&D and Regulatory Review

Processes, 158

Trends in the Regulation of Pharmaceuticals in

Other Countries, 163

Conclusions, 167

7 Product Liability and the Pharmaceutical

Industry, 169

Product Liability and Pharmaceutical R&D, 169

Pharmaceuticals and Product Liability Law, 170

Product Liability Insurance, 172

Product Liability Claims and R&D, 173

Government Policy and product Liability, 180

Conclusions, 182

. . . Vlll
89

Federal Tax Policy and Drug Research and

Development, 183

Analyzing Tax Policy, 183

Tax Deductions and Taxable Income, 184

Tax Credits, 186

Other Nations’ R&D Tax Incentives, 197

Conclusions, 198

Federal Support for Pharmaceutical

Research and Development, 201

Federal Support for Life Sciences, 203

Collaboration Between Pharmaceutical Firms and

Academia, 206

Targeted Federal Pharmaceutical R&D Programs, 210

Industry Collaboration With Federal Research

Laboratories, 217

Orphan Drugs, 225

Medicare and Medicaid Support for Clinical

Drug R&D, 232

Conclusions, 233

10 Trends in Payment for Prescription

Drugs, 237

Health Insurance for Prescription Drugs in the

United States, 238

Prescription Drug Benefits in Other Countries, 250

Conclusions, 262

APPENDIXES

A Method of Study, 265

B Acknowledgments, 269

C The Cost of Capital, 276

D Congressional Access to Proprietary

Pharmaceutical Industry Data, 284

ix
E

F

G

H

I

J

K

L

Patent Protection of Pharmaceuticals in the

United States, 290

Summary of Methods Used to Analyze Trends in

Postpatent Revenues, 294

Estimating the Cost of Producing and Selling

New Chemical Entities, 302

Methods of OTA’s Survey of Clinical

Trial Size, 308

Methods Used in OTA's Study of Success Rates for

New Molecular Entities, 309

Estimates by OTA and JCT of Federal

Tax Credits Attributable to Pharmaceuticals, 310

Federal Programs Dedicated to Pharmaceutical

R&D, 311

Acronyms and Glossary of Terms, 316

REFERENCES, 323

INDEX, 347
I

n this assessment, the Office of Technology Assessment

examined the costs of pharmaceutical research and

development (R&D), the economic rewards from that

investment, and the impact of public policies on both

costs and returns. Below is a brief synopsis of the study’s major

conclusions:

SUMMARY OF FINDINGS

. Pharmaceutical R&D is a costly and risky business, but in

recent years the financial rewards from R&D have more

than offset its costs and risks.

. The average aftertax R&D cash outlay for each new drug

that reached the market in the 1980s was about $65

million (in 1990 dollars). The R&D process took 12

years on average. The full aftertax cost of these outlays,

compounded to their value on the day of market

approval, was roughly $194 million (1990 dollars).

. The cost of bringing a new drug to market is very sensitive

to changes in science and technology, shifts in the kinds

of drugs under development and changes in the regulatory environment. All of these changes are occurring

fast. Consequently, it is impossible to predict the cost of

bringing a new drug to market today from estimated

costs for drugs whose development began more than a

decade ago.

● Each new drug introduced to the U.S. market between 1981

and 1983 returned, net of taxes, at least $36 million more

to its investors than was needed to pay off the R&D

investment. This surplus return amounts to about 4.3

percent of the price of each drug over its product life.
2 I Pharmaceutical R&D: Costs, Risks and Rewards

. Dollar returns on R&D are highly volatile

over time. Changes in R&D costs, tax

rates, and revenues from new drugs are

the most important factors influencing

net returns. Drugs approved for marketing in 1984-88 had much higher sales

revenues (in constant dollars) in the early

years after approval than did drugs approved in 1981-83. On the other hand,

R&D costs may be increasing and generic competition could be much stiffer

for these drugs after they lose patent

protection.

● Over a longer span of time, economic returns

to the pharmaceutical industry as whole

exceeded returns to corporations in other

industries by about 2 to 3 percentage

points per year from 1976 to 1987, after

adjusting for differences in risk among

industries. A risk-adjusted difference of

this magnitude is sufficient to induce

substantial new investment in the pharmaceutical industry.

. The rapid increase in revenues for new drugs

throughout the 1980s sent signals that

more investment would be rewarded

handsomely. The pharmaceutical industry responded as expected, by increasing

its investment in R&D. Industrywide

investment in R&D accelerated in the

1980s, rising at a rate of 10 percent per

year (in constant dollars).

. The rapid increase in new drug revenues was

made possible in part by expanding

health insurance coverage for prescription drugs in the United States through

most of the 1980s. Health insurance

makes patients and their prescribing physicians relatively insensitive to the price

of a drug. The number of people with

prescription drug coverage increased, and

the quality of coverage improved.

. Almost all private health insurance plans

covering prescription drugs are obligated

to pay their share of the price of virtually

any FDA-approved use of a prescription

drug. FDA approval acts as a de facto

coverage guideline for prescription drugs.

Most health insurers have almost no

power to influence prescribing behavior

or to control the prices they pay for

patented drugs.

● Manufacturers of drugs that are therapeutically similar to one another compete for

business primarily on quality factors,

such as ease of use, side-effect profiles

and therapeutic effect. With priceconscious buyers such as health maintenance organizations (HMOs) and hospitals, however, they have engaged in more

vigorous price competition.

. If price competition among therapeutically

similar compounds became more common, the directions of R&D would

change and the total amount of R&D

would probably decline. Whether a decrease in R&D would be good or bad for

the public interest is hard to judge. It is

impossible to know whether today level

of pharmaceutical R&D is unquestionably

worth its costs to society.

● The National Institutes of Health (NIH) and

other Public Health Service laboratories

have no mechanism to protect the public’s investment in drug discovery, development and evaluation. These agencies

lack the expertise and sufficient legal

authority to negotiate limits on prices to

be charged for drugs discovered or developed with Federal funds.
Chapter l-Summary I 3

INTRODUCTION

Pharmaceutical R&D is the process of discovering, developing, and bringing to market new

ethical drug products.1 Most pharmaceutical R&D

is undertaken by private industrial firms, and this

report is about how and why industrial pharmaceutical companies make decisions to undertake

R&D, what they stand to gain from such investments, and how they are helped or hindered by

public policies that influence the process.

Industrial R&D is a scientific and an economic

process. R&D decisions are always made with

both considerations in mind. Science defines the

opportunities and constraints, but economics

determines which opportunities and scientific

challenges will be addressed through industrial

research.

This report focuses mainly, but not entirely, on

the economic side of the R&D process. In this

perspective, pharmaceutical R&D is an investment. The principal characteristic of an investment is that money is spent today in the hope that

even more money will be returned to the investors

sometime in the future. If investors (or the

corporate R&D managers who act on their behalf)

believe that the potential profits from R&D are

worth the investment’s cost and risks, then they

will invest in it. Otherwise, they will not.

ORIGINS AND SCOPE OF OTA’s STUDY

OTA’s study of pharmaceutical R&D grew out

of a long-standing congressional debate over the

prices of ethical drugs. Increases in real (inflationadjusted) drug prices and perceived high prices

for new drugs have been a concern of congressional committees for more than 30 years.

The industry’s collective response to charges

that drug prices are too high or are increasing too

fast has been to point to the high and increasing

cost of pharmaceutical R&D and their need to

repay investors for their substantial and risky

investments (325,326,505). Industry representatives have pointed to academic studies of the

Photo cmdlt: ELI LILLY AND COMPANY

Pharmaceutical research and development is both a scientific

and an economic process. Personnel, equipment and facilities

come together in sophisticated organizations required for

R&D.

average cost of bringing a new pharmaceutical

compound to the market (324,326). One objective

of OTA’s report is to evaluate the accuracy of the

industry’s claims by examining the data and

methods used to reach such conclusions.

By itself, the average cost of pharmaceutical

R&D tells little about whether drug prices are too

high or are increasing too fast. A more important

question is whether the dollar returns on R&D

investments are higher or lower than what is

needed to induce investors to make these investments. The long-run persistence of higher dollar

returns in the industry as a whole than the amount

needed to justify the cost and risk of R&D is

evidence of unnecessary pricing power for ethical

pharmaceuticals (366). OTA examined the economic returns to investors in pharmaceutical

R&D.

The U.S. Federal Government is anything but

a passive observer of the industrial pharmaceutical R&D process. The Federal Government subsidizes private R&D, regulates the introduction and

] Ethical drugs arc biological and medicinal chemicals advmtiscd and promoted primarily to the medical, pharmacy, and allied professions.

Ethical drugs include products avallablc only by prescription as well as some over-the-counter drugs (320). Strictly speaking, ethical drugs

mcludc dutgnost]c i~~ WCII as therapeutic products, but this rcpor( concentrates on R&D for thcrapcut]c c(h]~iil drugs.
4 I Pharmaceutical R&D: Costs, Risks and Rewards

Box l-A–The Content of Pharmaceutical R&D

Synthesis and Extraction—The process of identifying new molecules with the potential to produce a

desired change in a biological system (e.g., to inhibitor stimulate an important enzyme, to alter a

metabolic pathway, or to change cellular structure). The process may require: 1) research on the

fundamental mechanisms of disease or biological processes; 2) research on the action of known

therapeutic agents; or 3) random selection and broad biological screening. New molecules can be

produced through artificial synthesis or extracted from natural sources (plant, mineral, or animal). The

number of compounds that can be produced based on the same general chemical structure runs into

the hundreds of millions.

Biological Screening and Pharmacological Testing--studies to explore the pharmacological activity and

therapeutic potential of compounds. These tests involve the use of animals, isolated cell cultures and

tissues, enzymes and cloned receptor sites as well as computer models. If the results of the tests suggest

potential beneficial activity, related compounds--each a unique structural modification of the

original-are tested to see which version of the molecule produces the highest level of

pharmacological activity and demonstrates the most therapeutic promise, with the smallest number

of potentially harmful biological properties.

Pharmaceutical Dosage Formulation and Stability Testing—The process of turning an active compound

into a form and strength suitable for human use. A pharmaceutical product can take any one of a

number of dosage forms (i.e., liquid, tablets, capsules, ointments, sprays, patches) and dosage

strengths (i.e., 50, 100, 250, 500 mg). The final formulation will include substances other than the

active ingredient, called excipients. Excipients are added to improve the taste of an oral product, to

allow the active ingredient to be compounded into stable tablets, to delay the drug’s absorption into

marketing of new drugs, and pays for many drugs in biotechnology-based drugs and vaccines. All

through Federal health care programs. Federal tax

policies also alter R&D costs and returns. OTA

assessed how Federal policies affect R&D costs

and returns and how well Federal agencies protect

the direct and indirect Federal investment in

pharmaceutical R&D.

ISSUES BEYOND THE SCOPE

OF THIS STUDY

OTA did not examine the implications for the

competitiveness of the U.S.-based pharmaceutical industry of Federal policies affecting pharmaceutical R&D. The U.S.-based industry is a leader

in the discovery and development of new drugs,

particularly important new drugs with global

markets. The U.S.-based industry has introduced

roughly one out of every four new compounds

introduced to the world market since 1961

(68,342) and is so far unchallenged as the leader

of the 15 biotechnology-based drugs and vaccines

approved in the United States as of August 1991

were developed by U.S.-based firms (453).

Federal policies affecting R&D obviously affect the U, S.-based industry, but their influence

on the relative competitiveness of the U.S.-based

industry is much more difficult to predict. Most of

the U.S. Federal policies in place today that affect

drug R&D are neutral with respect to the drug’s

country of origin. Whether the United States

should adopt policies that explicitly encourage

U.S.-based R&D or manufacturing is beyond the

scope of this project.2

THE NATURE OF PHARMACEUTICAL

R&D INVESTMENTS

H Pharmaceutical R&D’s Two Objectives:

New Drugs and New Markets

Pharmaceutical R&D includes many different

scientific and clinical activities (see box l-A).

2 For an examination of the competitiveness of U.S.-based dedicated biotechnology companies, see OTA’S recent report on the subject

(453).
Chapter 1--Summary 5

the body, or to prevent bacterial growth in liquid or cream preparations. The impact of each on the

human body must be tested

Toxicology and Safety Testing—Tests to determine the potential risk a compound poses to man and the

environment. These studies involve the use of animals, tissue cultures, and other test systems to

examine the relationship between factors such as dose level, frequency of administration, and duration

of exposure to both the short- and long-term survival of living organisms. Tests provide information

on the dose-response pattern of the compound and its toxic effects. Most toxicology and safety testing

is conducted on new molecular entities prior to their human introduction, but companies can choose

to delay long-term toxicity testing until after the therapeutic potential of the product is established.

Regulatory Review: Investigational New Drug (IND) Application—An application filed with the U.S.

FDA prior to human testing. The IND application is a compilation of all known information about the

compound. It also includes a description of the clinical research plan for the product and the specific

protocol for phase I study. Unless the FDA says no, the IND is automatically approved after 30 days

and clinical tests can begin.

Phase I Clinical Evaluation-The first testing of a new compound in human subjects, for the purpose of

establishing the tolerance of healthy human subjects at different doses, defining its pharmacologic

effects at anticipated therapeutic levels, and studying its absorption, distribution, metabolism, and

excretion patterns in humans.

Phase II Clinical Evaluation-Controlled clinical trials of a compound’s potential usefulness and short

term risks. A relatively small number of patients, usually no more than several hundred subjects,

enrolled in phase II studies.

Phase III Clinical Evaluation-Controlled and uncontrolled clinical trials of a drug’s safety and

effectiveness in hospital and outpatient settings. Phase III studies gather precise information on the

drug’s effectiveness for specific indications, determine whether the drug produces a broader range of

adverse effects than those exhibited in the smaller study populations of phase I and II studies, and

identify the best way of administering and using the drug for the purpose intended. If the drug is

approved, this information forms the basis for deciding the content of the product label. Phase III

studies can involve several hundred to several thousand subjects.

Process Development for Manufacturing and Quality Control—Engineering and manufacturing design

activities to establish a company’s capacity to produce a product in large volume and development

of procedures to ensure chemical stability, batch-to-batch uniformity, and overall product quality.

Bioavailability Studies: The use of healthy volunteers to document the rate of absorption and excretion

from the body of a compound’s active ingredients. Companies conduct bioavailability studies both at

the beginning of human testing and just prior to marketing to show that the formulation used to

demonstrate safety and efficacy in clinical trials is equivalent to the product that will be distributed

for sale. Companies also conduct bioavailability studies on marketed products whenever they change

the method used to administer the drug (e.g., from injection to oral dose form), the composition of the

drug, the concentration of the active ingredient, or the manufacturing process used to product the drug.

Regulatory Review: New Drug Application (NDA)—An application to the FDA for approval to market

a new drug. All information about the drug gathered during the drug discovery and development

process is assembled in the NDA. During the review period, the FDA may ask the company for

additional information about the product or seek clarification of the data contained in the application.

Postapproval Research--Experimental studies and surveillance activities undertaken after a drug is

approved for marketing. Clinical trials conducted after a drug is marketed (referred to as phase IV

Studies in the United States) are an important source of information on as yet undetected adverse

outcomes, especially in populations that may not have been involved in the premarketing trials (i.e.,

children, elderly, pregnant women) and the drug’s long-term morbidity and mortality profile.

Regulatory authorities can require companies to conduct Phase IV studies as a condition of market

approval. Companies often conduct post-marketing studies in the absence of a regulatory mandate.

SOURCE: OffIce of ‘Ikhnology Assessrnentj 1993; based on Pbarmaceutkxd Manufacturers Association Annual Swvey Reports.
6 I Pharmaceutical R&D: Costs, Risks and Rewards

Before any new therapeutic ethical pharmaceutical product can be introduced to the market in the

United States and most other industrialized countries, some R&D must be undertaken, but the

specific activities and required R&D expenditures vary enormously with the kind of product

under development. New therapeutic ethical pharmaceutical products fall into four broad categories:

●

●

●

●

New chemical entities (NCEs)--new therapeutic molecular compounds that have never

before been used or tested in humans.3

Drug delivery mechanisms--new approaches

to delivering therapeutic agents at the desired dose to the desired site in the body.

Follow-on products—new combinations,

formulations, dosing forms, or dosing

strengths of existing compounds that must

be tested in humans before market introduction.

Generic products--copies of drugs that are

not protected by patents or other exclusive

marketing rights.

R&D is needed to bring all of these products

to the market. National regulatory policies determine some of the required R&D, but some R&D

would be undertaken even if there were no new

drug regulation.

NCEs are discovered either through screening

existing compounds or designing new molecules;

once synthesized, they must undergo rigorous

preclinical testing in laboratories and animals and

clinical testing in humans to establish safety and

effectiveness. The same is true for novel drug

delivery mechanisms, such as monoclinal antibodies or implantable drug infusion pumps.

Follow-on products also must undergo preclinical

and clinical testing before they can be marketed,

but the amount of R&D required to prove safety

and effectiveness is usually less than for the

original compound.

Even after a new drug has been approved and

introduced to the market, clinical R&D may

continue. Some of this postapproval clinical

evaluation is required by regulatory agencies as a

condition of approval, but other clinical research

projects are designed to expand the market for the

drug. For example, much clinical research is done

to test new therapeutic uses for a drug already on

the market or to compare its

that of a competing product.

The research required on a

typically much less than on

pound it copies. In the United

effectiveness with

generic product is

the original comStates, the makers

of generic products must show the U.S. Food and

Drug Administration (FDA) that the drug is

therapeutically equivalent to the original compound, not that the compound itself is effective

against the disease. This involves much less R&D

than is necessary to introduce either NCEs or

follow-on products.

The discovery and development of NCEs is the

heart of pharmaceutical R&D, because the developers of follow-on or generic products build on

the knowledge produced in the course of developing them. The market for the compound and all its

follow-on products or generic copies in future

years rests on the R&D that led to its initial

introduction to the market. Most of the money

spent on pharmaceutical R&D goes to the discovery and development of NCEs. Companies responding to the Pharmaceutical Manufacturers

Association’s (PMA) annual survey estimated

that 83 percent of total U.S. R&D dollars in 1989

were spent in “the advancement of scientific

knowledge and development of new products”

versus “significant improvements and/or modifications of existing products” (320).4

3 Another term frequently used to refer to newly developed compounds is ‘‘new molecular entity” (NME). The U.S. Food and Drug

Administration (FDA) coined the term for use in its published statistical reports (474). The FDA includes some diagnostic agents and excludes

therapeutic biological in &ta they present on NMEs, whereas in this report the term NCE is used to refer to therapeutic drugs and biologkxds

but not to diagnostic products. OTA uses the term NME only when discussing work that specifically employs FDA’s defiition of that term.

4 How responding firms defined new products or moditlcations of existing products is unclear, however, and the accurac y or reliability of

these estimates cannot be verifkd.
Chapter 1--Summary 7

A patent on an NCE gives its owner the right to

invest in further R&D to test new therapeutic uses

or produce follow-on products. This continuing

R&D may extend the compound’s life in the

market or increase its market size. Therefore, a

complete analysis of returns on R&D for NCEs

should encompass the costs of and returns on

these subsequent investments as well.

NCEs comprise two poorly-defined subcategories: pioneer drugs and “me-too” drugs.

Pioneer NCEs have molecular structures or mechanisms of action that are very different from all

previously existing drugs in a therapeutic area.

The first compound to inhibit the action of a

specific enzyme, for example, is a pioneer drug.

Me-too drugs are introduced after the pioneer and

are similar but not identical to pioneer compounds in molecular structure and mechanism of

action. Many me-too drugs are developed through

deliberate imitation of the pioneer compound and

have a shorter and more certain discovery period

(158). But, the R&D cost advantage gained by

imitation is typically met by a reduction in

potential dollar returns from being a late entrant

to the market (55,158).

The distinction between pioneers and me-toos

is fuzzy, and not all me-too drugs are imitative.

Although it is rational for pharmaceutical firms to

imitate an existing product in order to share in a

potentially lucrative market (102,298,346,363,418),

much of the R&D on me-too drugs is not imitative

but competitive. Companies race to be first to the

market. The race has one winner and often a field

of followers. The R&D costs of those who lose the

race but manage ultimately to produce a product

may be as high as or even higher than the costs of

developing the pioneer compound,

For example, substantial R&D activity is

currently underway in several pharmaceutical

companies to develop new asthma therapies

based on leukotriene inhibitors (403). A total of

25 compounds are now under investigation. How

the research will proceed, which research programs will yield products that can be tested in

humans, and which of those products will ultimately meet the tests of efficacy and safety

required for market approval are anyone’s guess.

Already, research has been discontinued on at

least three such products because of unanticipated

safety problems in animal or clinical studies

(378,379).

H The Three Most Important Components

of R&D Investment: Money, Time, and Risk

Investors spend money today to make more

money in the future, The less money required for

the investment and the more that is expected in

the future, the better the investment is. But money

is only the first component of the R&D investment. Not only do investors care about how much

money is required and the potential dollar returns

that may result, but they also care about the

second component: the timing of money outflows

and inflows. The longer the investor must wait to

get money back, the more he or she expects to get.

Stated another way, money that will come in

tomorrow, even with complete certainty, is not

worth as much as the same amount in hand today.5

For risk-free investments, such as U.S. Treasury bills, the required return (as a percent of the

capital invested) is determined by supply and

demand in the money markets. If the going

risk-free interest rate is 5 percent per year, for

example, an investor who puts up $100 expects to

get at least $105 back next year. From another

point of view, $100 promised for delivery next

year is worth only $95.23 today, because the

investor could take that $95.23, invest it in a

risk-free security, and have the $100 a year hence.

Not having access to the $95.23 today essentially

deprives the investor of the opportunity to invest

at the going interest rate.

The interest rate required to induce the investor

to permit his or her money to be used is referred

to as the opportunity cost of capital. The value

today (e.g., $95.23) of money promised for

delivery sometime in the future (e.g., $100),

evaluated at the opportunity cost of capital (e.g.,

5 This principle lies behind the payment of interest on safe investments like insured bank deposits or U.S. Treasury bills.
8 I Pharmaceutical R&D: Costs, Risks and Rewards

5 percent), is referred to as the present value of

money.

Like all investments, R&D investments must

return enough money in the future so that the

present value of those returns (evaluated at the

investment’s cost of capital) is at least as great as

the amount of the investment.

Risk is the third component of the R&D

investment. Riskier investments require higher

dollar returns; otherwise investors would put their

money in safe investments like U.S. Treasury

bills. Thus, the opportunity cost of capital for

R&D investments must be higher than the cost of

capital for risk-free investments. And, the present

value of $100 that is expected next year but with

a great deal of uncertainty is even lower than the

present value of a risk-free investment. How

much higher the opportunity cost of capital for an

R&D investment is, and how much lower the

present value of future expected returns is,

depends on the riskiness of the R&D investment.

Pharmaceutical industry executives often emphasize the particular riskiness of R&D. Analogies to drilling for oil are common: R&D involves

many dry holes and a few gushers. According to

one industry executive, pharmaceutical R&D is

like “wildcatting in Texas (188). ” Data on the

dropout rate for drugs under development support

these notions that R&D is, indeed, an uncertain

and risky undertaking.

The risk that is accounted for in the opportunity

cost of capital is different from these conventional

notions about the risks of R&D. Modern finance

theory distinguishes between two different kinds

of investor risk: diversifiable risk and undiversifiable risk (59). The “wildcatting” risks of drug

R&D are diversifiable: the investor can invest in

a large diversified portfolio of R&D projects (or

firms undertaking such projects) and obtain, on

average, an expected dollar return that is very

predictable,

Photo credit: BRISTOL-MYERS SQUIBB COMFMIVY

Pharmaceutical R&D is risky business. Clinical testing of

thousands of patients can result in the failure of a new

compound to reach the market. Company scientists review

detailed clinical data on many patients to determine the

therapeutic benefit of a new agent.

For example, suppose the average NCE entering clinical testing has a l-in-5 chance of ultimately reaching the market. If it does, it will make

on average $100 million for the company. The

expected dollar return, then, is $20 million.6 If

investors diversify their portfolios across a large

enough number of R&D projects, they can be

fairly certain that they will make, on average,

about $20 million per project. Thus, the variation

in returns due to the low probability of successful

drug development can be eliminated by diversify6 The expected value is the avemge return weighted by the probability of each potential outcome: $100(0.20) + $0(0.80) = $20.
Chapter 1–Summary 9

ing the investment portfolio across a large number

of projects.7

Some kinds of risk cannot be diversified away.

Suppose, for example, prescription drug sales

were closely linked to the state of the economy,

perhaps because high unemployment produces

more people who are uninsured and cannot afford

prescription drugs. Pharmaceutical R&D would

then have a great deal of undiversifiable risk

because returns on R&D would depend on the

state of the economy as a whole, and investors

cannot diversify away these economywide risks.

The central finding of modern finance theory is

that the cost of capital for a given investment must

be adjusted only for the portion of risk that is

undiversifiable. (See appendix C for an explanation.) The technical risks of project failure that

weigh so heavily on the minds of R&D managers

and executives do not raise the opportunity cost of

capital.

OTA used standard financial techniques to

obtain estimates of the cost of capital in the

pharmaceutical industry as a whole and the cost

of capital for pharmaceutical R&D investments in

particular. We relied on techniques and data

provided in a contract report by Stuart Myers and

Lakshmi Shyam-Sunder (285). The cost of capital

varies over time and across firms, but over the

past 15 years the cost of capital in the pharmaceutical industry as a whole varied in the neighborhood of roughly 10 percent after adjusting for

investors’ inflation expectations (see appendix

c).

Pharmaceutical firms are collections of investments, some very risky and others much less so.

The undiversifiable risks of R&D projects are

higher than those of other investments that drug

companies must make, for reasons that are

outlined in appendix C. R&D investments are

riskier the earlier in the R&D process they are.

How much riskier is difficult to assess, but OTA

concluded that the cost of capital for the earliest

stages of R&D may be up to 4 percentage points

higher than the cost of capital for pharmaceutical

companies as a whole.

S Investors Look Ahead

In making R&D decisions, investors try to

predict the possible future outcomes as accurately

as they can. They assess the present value of their

investments based on these predictions, not on the

basis of past performance or profits.8 An industry’s past performance is informative to an

investor only to the extent that technology and

market conditions remain stable.

If investors always look ahead, then profits

from today’s drugs (which were developed with

yesterday’s R&D) do not determine how much

will be invested in R&D. R&D managers do not

invest in R&D simply because they have the cash

on hand; they invest when the prospects for future

returns look promising.

This conclusion seems to contradict the industry’s contention that today’s profits are needed to

fund today’s R&D (356). The success of the

health-care oriented biotechnology industry in

raising external capital proves that companies can

7 The portfolio diversitlcation need not occur within each individual company; investors can just as easily hold a diverse portfolio of

companies in the industry. Within-company diversification may be important for managers whose professional and financial futures may rest

with their own firm’s performance, however. To the extent that managers seek to diversify their company’s investments for their own purposes,

they are not representing the interests of the fii’s owners.

8 In interviews with executives and R&D directors of eight pharmaceutical firms, OTA learned that few companies do formal present value

analyses to select R&D projects or to determine how much R&D should be conducted in any year. What is true for the pharmaceutical industry

may be true more generally. Scherer surveyed executives of Fortune 100 companies about their investment decisions and found that only about

30 percent of the responding companies used present value analysis in decisions regarding R&D (364). The high level of technical uncertainty

may lead to other decision rules for R&D. Total R&D budgets appear to be based on current and recent earnin gs, managers’ intuitive

assessments of technical opportunities, and constraints on the rate of growth of R&D operations.

Despite the fact that formal investment analysis is infrequently used in R&D decisions, the present value of dollar returns to R&D across

the entire industry should approximate the present value of R&D costs. Although R&D managers may not follow strict rules, companies whose

investments do not return enough to cover the cost of capital will ultimately fail, while those whose investments return more than enough to

cover the cost of capital will gradually expand their investments.
10 I Pharmaceutical R&D: Costs, Risks and Rewards

raise substantial R&D capital in external capital

markets when future prospects look promising.

Between July 1990 and July 1991, over $2.6

billion was raised by the biotechnology industry

from external financing sources, almost all of it

for health care applications (65).9

Established pharmaceutical firms do fired almost all of their investment needs, not just R&D,

with internal cash flows from current operations

(285). Internal funds may carry a lower cost of

capital for complex investments like R&D, because outside investors are at a disadvantage in

being able to assess the potential returns on R&D

projects and will therefore demand a higher

expected return on their money to cover the risk

of being misled by company managers (170,189).

The more complex the R&D, the more these

information disparities are likely to raise the cost

of external sources of capital.

A higher cost of external capital than of internal

funds would explain companies’ clear preference

for internally generated cash flows when they

have access to them. If the effective cost of capital

is lower for firms that have high cash flows, more

R&D projects would pass the present value test

and be undertaken. Thus, the availability of

internally generated funds may increase the

amount of R&D that is performed over what the

R&D levels would be if all such funds had to be

raised in external capital markets.

How much more R&D is conducted because

established pharmaceutical firms use cash flows

to fund their investments depends on how much

higher the cost of capital for outside funds is. The

size of external capital market investments in the

biotechnology industry (which has low current

operating cash flows) suggests that much of the

R&D currently financed in established firms

through internally generated cash would be undertaken even if these cash flows were unavailable.

R&D COSTS: THE EVIDENCE

Although the investor always looks ahead in

making R&D decisions, R&D cost estimates are

retrospective. R&D costs can change quickly as

underlying scientific, technical or regulatory conditions change, so it is dangerous to predict much

about the future, or even about the costs of

projects under way today, from studies of past

R&D costs. OTA looked at the existing studies of

R&D costs and also at recent trends in some

critical components of the cost of bringing new

drugs to market.

The costs of bringing a new drug to market

rightly include those for projects that were

abandoned along the way. Since investors could

not have known beforehand which projects would

succeed and would not knowingly have invested

in the losers, these ‘dead-end’ costs are unavoidable costs of R&D.

The full cost of bringing a new drug to market

can be thought of as the minimal payoff required

from the drugs that successfully reach the market

required to induce investors to lay out the money

at each step of the way. To measure the full cost

of past R&D projects, all outlays required to

achieve the successes must be compounded (or

capitalized) to their present value on the day of

market approval at an interest rate equal to the

cost of capital.

The full cost of bringing a new drug to market

calculated in this way is much higher than the

amount of money companies must actually raise

to fund R&D projects. To pursue R&D, companies must raise only enough money to cover the

actual outlays for successful and unsuccessful

projects. Estimating the full cost of bringing a

new drug to market, by contrast, provides a way

of gauging how much money must be earned from

the successful drugs, once they reach the market,

to justify the research outlays.

g The sources of external fucing used by biotechnology fm change from year to year. In the pas~ R&D Limited Partnerships were an

attractive fucingmechanism, but changes in federal tax law took away their advantage. In 1991, initial public offerings were the major source

of funds. Venture capital was less important than in previous years. SrnaU biotednology companies look to strategic aIliances with traditional

pharmaceutical fm for sources of financing when other sources are unavailable (65).
The present value of full R&D costs has three

components:

●

●

●

Cash outlays required to produce the successes (and to pay for the abandoned projects along the way),

Timing of the cash outlays, and

Opportunity cost of capital for each specific

R&D investment. -

There is only one way to get information on

both the amount and timing of cash outlays

required to produce a successful NCE: take a

large and representative sample of R&D projects

and, for each project, record incurred costs

month-by-month until the project is either abandoned or approved for marketing. Then, outlays

over time can be converted to their present value

in a particular reference year at the appropriate

cost of capital. The present value of outlays per

approved NCE is the average cost of bringing an

NCE to market.

This project-level approach was used in a pair

of studies pioneered by Ronald Hansen (175) and

updated and extended by Joseph DiMasi and

colleagues (109). The frequent contention by

industry spokesmen that it costs $231 million (in

1987 constant dollars) to bring an NCE to market

(326) is the central result of the DiMasi study

(109). In 1990 constant dollars, the cost would be

$259 million. lo

The main problem with this approach is that

accurate data on the costs and time required to

reach specific milestones in the R&D process,

and rates of success or abandonment along the

way, are proprietary. Researchers must depend on

the ability and willingness of companies to supply

detailed data on R&D project costs and histories.

Hansen and DiMasi relied on surveys of 14 and 12

U.S.-based pharmaceutical fins, respectively,

that were willing to provide estimates of R&D

outlays and timing for the samples of newly

synthesized NCEs. The researchers could not

Chapter 1--Summary I II

audit these estimates for accuracy or consistency

across companies.

Early in this assessment, OTA determined that

it would be infeasible to mount an independent

project-level study of R&D costs. Although

Congress has the power to subpoena company

data, pharmaceutical companies have actively

resisted providing it to congressional agencies. In

the past, the U.S. General Accounting Office

(GAO) tried to obtain data on pharmaceutical

R&D (and other) costs but was ultimately foiled

after many years of effort that involved decisions

in the U.S. Supreme Court. (See appendix D for

a legal analysis of congressional access to financial data.) Although business confidentiality arguments are not sufficient to block a congressional subpoena (423), such arguments can result

in protracted negotiations over whether or not the

information will be kept confidential and the

scope of the documents that must be turned over.

The pursuit of data from a number of companies

would be very costly and take many years.

OTA’s approach to R&D cost assessment

relied on a detailed analysis of the validity of the

Hansen and DiMasi studies. First, OTA examined

the validity of the methods used to estimate each

component of R&D costs (cash outlays, project

time profiles, and success rates). Second, OTA

tested the consistency of the resulting estimates

with corroborative studies. Third, OTA examined

whether the rate of increase in real (i.e., inflationadjusted) R&D cost implied by the two studies is

consistent with data on trends in major cost

drivers, such as the number of subjects of clinical

trials, biomedical research personnel costs, and

animal research costs.

1 Cash Costs Per Success

Hansen examined a probability sample of

about 67 NCEs originated by U.S.-based pharmaceutical companies first entering human clinical

trials from 1963 through 1975. DiMasi and

colleagues studied a sample of 93 such NCEs first

entering human trials from 1970 through 1982.

IO ~ MS OTA repofi, dl e5timtes of R&D costs and returns are expressed in 1990 constant dollars md wme ~c~ated by OTA using tie

GNP implicit price deflator.
12 I Pharmaceutical R&D: Costs, Risks and Rewards

Total cash outlays per successful new NCE were

estimated at $65.5 million (in 1990 dollars) by

Hansen and at $127.2 million by DiMasi, a 94

percent increase in estimated outlays per successful new drug over the period of the two studies.

The two studies suggest that real (inflationadjusted) R&D cash outlays per successful NCE

increased at an annual rate of about 9.5 percent.

The increase in cash outlays per success was

moderated by an improvement in the success rate

of NCEs over time. Whereas Hansen projected

only 12.5 percent of the NCEs would ultimately

get FDA approval for marketing, DiMasi and

colleagues estimated that about 23 percent of the

projects would be successful. Without this improvement, the reported increase in cash outlays

per success would have been even higher.

OTA found two principal threats to validity of

the methods used to estimate cash outlays per

success: 1) the small number of NCEs in the

samples, especially in the Hansen study; and 2)

the reliance on unverifiable cost data that responding companies supplied. Although most

companies were capable of estimating the costs

associated with discovery and development of

particular NCEs with reasonable accuracy, inherent differences in the structure of cost-accounting

systems across companies introduce potential

inconsistency and bias. More importantly, any

company that understood the study methods and

the potential policy uses of the study’s conclusions could overestimate costs without any potential for discovery. Thus, the motivation to overestimate costs cannot be discounted.

Because of these threats to validity, OTA

looked for corroborative evidence on cash outlays

per success. Aggregate annual data on industry

R&D spending and NCE approvals in the United

States are readily available and reasonably verifiable. In a study using industry-level spending

data, Wiggins estimated R&D cash outlays per

successful NCE at $75 million (in 1990 dollars)

(520).

Wiggins’ sample of approved NCEs corresponds roughly in time to Hansen’s sample of

NCEs first entering clinical testing, but for

technical reasons Wiggins’ sample may be somewhat more recent and therefore more costly to

develop than the drugs in Hansen’s study. (See

chapter 3 for an explanation.) On the other hand,

Wiggins studied the costs of producing all NCEs,

not just those originated by U.S.-based firms.

NCEs licensed from other firms probably cost the

firm that acquires them less to develop. Thus,

Wiggins’ estimate of R&D costs maybe too low

for self-originated drugs. OTA concluded, therefore, that Hansen’s estimate of $65.5 million in

cash outlays per successful drug is reasonably

accurate and perhaps even slightly low.

A similar analysis was not available to cover

the time period of DiMasi’s study, but OTA

checked the results of the DiMasi study against

data on aggregate R&D spending by the U.S.

industry and the total number of self-originated

NCEs introduced by these companies. OTA’s

check revealed a substantial consistency between

aggregate R&D spending estimates and the cash

outlays per NCE estimated by DiMasi study (see

chapter 3 for details).

OTA also examined whether trends in three

R&D cost drivers-the costs of research personnel, the size of clinical trials, and the cost of

animal research-were consistent with the estimated increases in cash R&D outlays per successful NCE between the periods that Hansen and

DiMasi studied.

R&D PERSONNEL

The number of R&D personnel employed by

PMA-member firms remained fairly constant

throughout the 1970s but grew rapidly beginning

in 1980 (figure l-l). Most of this growth was in

scientific and professional personnel, which numbered about 12,000 in 1977, but increased to

almost 29,000 by 1989. At the same time,

inflation-adjusted salaries of biological scientists

did not increase.

How much of the increase in employment in

the 1980s reflects increased labor inputs per

successful NCE, versus adjustments for a larger

field of NCEs entering each phase of clinical

testing or a greater commitment to basic research,
Chapter l-Summary I 13

Figure l-l—Research and Development Personnel

in Pharmaceutical Companies, 1970-89

Number of R&D personnel (thousands)

50

45

40

35

30

25

20

15

10

5

0

1970 72 74 76 78 80 82 84 86 88

~ Scientists and U Technical- Support staff

professional staff

SOURCE: Office of TechnoiogyAssessme nt, 1993, basedon Pharrnixeutical Manufacturers Association Annual Survey Reports.

cannot be answered with available data. The most

that can be said is that trends in employment of

research personnel are consistent with a substantial increase in R&D cash outlays per NCE for

those NCEs first entering clinical research in the

late 1970s and early 1980s, the later part of the

period covered by the DiMasi study.

ANIMAL RESEARCH

Trends in the cost of animal research are even

more difficult to gauge. Some tentative evidence

suggests that the number of animals used in

pharmaceutical research may have declined between the 1970s and the 1980s, especially in the

earliest stages of pharmaceutical R&D, when

compounds are being screened for their pharmacologic activity. Any decline in the use of animals

was accompanied by a dramatic increase in the

cost of conducting animal tests, however. Table

1-1 shows the inflation-adjusted cost of conducting specific animal studies in 1980 and 1990 in

eight animal testing laboratories. The costs of

Virtually all kinds of animal studies increased

dramatically over the period. These data suggest

that the cost of studies involving animal subjects

has increased dramatically, but the ultimate

impact on the cash costs per successful NCE

cannot be gauged because of uncertainties about

trends in the volume of testing, about which there

is little information.

Table l-l—Price of Animal Studiesa ($ 1990 thousands)b

Number of Labs

Estimated price Price range Fold

Study

providing

in 1980 in 1990 Increase information

Acute rats. . . . . . . . . . . . . . . . . . . $0.8

28-day toxicity in rats. . . . . . . . . . 15

Subchronic rats. . . . . . . . . . . . . . . 38

2-year rat bioassay. . . . . . . . . . . . 384

Teratology rats.. . . . . . . . . . . . . . . 23

Acute monkey. . . . . . . . . . . . . . . . 14

Subchronic monkey. . . . . . . . . . . . 74

Acute dog. . . . . . . . . . . . . . . . . . . . 2.3

Subchronic dog. . . . . . . . . . . . . . . 46

$4- 5

30-65

55-143

250-575

52-70

39-62

108-184

22-51

72-147

5-6.25

2-4.3

1.4- 3.8

.7- 1.5

2.3- 3.0

2.8- 4.4

1.5- 2.5

9,6- 22.1

1.6- 3.2

8

6

8

5

5

6

6

7

7

a Each laboratory survey~ w= given an ident~al protocol on ~~h the p~ce is based. The “cost” iflctudes profit as

well as all direct and indirect costs. Laboratories surveyed were Hazleton, Bioresearch, I IT, TSI Mason, Biodynamics,

Pharmakon, PRI, and IRDC.

b All prices were adjustd to 1990 dollars using GNP implicit price deflator.

SOURCE: Office of Technology Assessment, 1993, basedon W.G. Flamm and M. Farrow, “Recent Trends in the Use

and Cost of Animals in the Pharmaceutical Industry,” contract report prepared for the Office of Technology

Assessment, DC, April 1991.
14 I Pharmaceutical R&D: Costs, Risks and Rewards

CLINICAL TRIAL SIZES

Pharmaceutical executives claim that the number of people enrolled in clinical trials has

increased dramatically over time. A rapid increase in trial sizes would be consistent with an

increase in the estimated cost of phase III clinical

trials from $5.7 million for each NCE entering the

phase in Hansen’s study to $14.3 million in

DiMasi’s study (in 1990 dollars). Part of the

explanation for such an increase may be a change

in the mix of drugs under testing from those for

acute illness to those for chronic illness. Drugs for

long-term use often require larger trial sizes.

Even within specific categories of drugs, however, the number of people enrolled in trials seems

to have increased. OTA surveyed pharmaceutical

companies for the size of clinical trials conducted

prior to FDA approval for NCEs in three classes

with a large number of approved drugs: antihy -

pertensives, antimicrobial, and nonsteroidal antiinflammatory drugs (NSAIDs). We compared

NCEs approved for marketing 1978-83 with those

approved between 1986 and 1990. Figure 1-2

shows the average number of subjects entered in

trials up to the point of NDA submission.

Although the time periods covered in the

clinical trial survey do not correspond exactly to

the Hansen and DiMasi research periods,ll the

survey results do show that the number of subjects

in clinical trials increased in the period between

the later years of the Hansen study and the later

years of the DiMasi study, even within reasonably

homogeneous therapeutic categories.

That the number of subjects in foreign countries increased faster than did the number of U.S.

subjects in two categories suggests that part of the

observed increase in research costs is due to the

globalization of research strategies over time.

Other industrialized countries increased their

requirements for premarket approval during the

1970s, and U.S. firms may have become more

aggressive in seeking early approval for NCEs in

other countries. These forces would gradually

Figure 1-2—Mean Number of Subjects Enrolled in

Clinical Trials Prior to Submission of NDA for NCEs

Approved in 1978-83 and 1986-90

Number of enrollees

4,000

3,000

2,000

1,000

0

I u!56Y0

2W0

1978-83 86-90 1978-83 86-90 1978-83 86-90

Antihypertensives Antimicrobial NSAIDs

_ Foreign enrollment n U.S. enrollment

KEY: NCE - new chemical entity; NDA D new drug application;

NSAIDS - nonsteroidal anti-inflammatory drugs

SOURCE: Office of Technology Assessment, 1993.

compress total R&D expenditures into the preNDA period.

The increase in clinical trial sizes within the

therapeutic categories that OTA studied is not big

enough to explain the almost three fold increase

in the average cash outlay for NCEs that entered

phase III clinical trials between the Hansen and

DiMasi studies. Trial sizes were not very different

across categories, even though antimicrobial drugs

are more frequently for acute conditions, while

antihypertensive drugs and NSAIDs are more

frequently for chronic conditions. The per-patient

cost of conducting trials must have increased

dramatically. OTA could not independently ver-

@ whether this cost increased as fast as the

Hansen and DiMasi studies imply.

OTA FINDINGS ON THE VALIDITY OF

ESTIMATED CASH COSTS

OTA concluded from the corroborative evidence available at the aggregate spending level

I I Hansen’s s~dy Yas (NCES f~st entering tesdng between 1963-75) correspond roughly with introductions in 197081. DiMasi md

colleagues’ study years (1970-82) correspond roughly with introductions in 1978-90.
that the estimates of cash outlays per successful

NCE made by DiMasi are reasonably accurate.

Hansen’s early estimate may have been too low,

suggesting that the rate of increase in costs

between the periods covered by the two studies

may have been overstated. Data on rates of

change in three illustrative components of R& D--

personnel, animal research costs, and clinical trial

size-are consistent with a substantial increase

over the period covered by the studies in the real

cash outlays required to bring a new drug to

market.

H Present Value of Cash Outlays

The present value of the R&D cost at the point

of market approval depends on the timing of R&D

expenditures over the life of projects and the cost

of capital for the investments over time. R&D

outlays occur over a long and, according to the

Hansen and DiMasi studies, lengthening period

of time. Hansen estimated the total R&D time was

9.6 years; DiMasi, 11.8 years.

OTA concluded from a review of study methods that the length of the clinical research and the

regulatory review periods estimated by Hansen

and DiMasi are very accurate. Estimates of the

length of the preclinical period (the time required

to discover and prepare a compound for testing in

humans) are much less precise and might even be

a bit too short, especially in DiMasi’s study.

Neither Hansen nor DiMasi adjusted the cost of

capital for the greater risk of R&D projects. Both

studies took the weighted average company cost

of capital in established pharmaceutical firms as

their basis for calculating the fully capitalized

cost of R&D. Hansen assumed a real cost of

capital of 8 percent; DiMasi, 9 percent. As

discussed above, the average inflation-adjusted

cost of capital for pharmaceutical firms as a whole

varied throughout the period but was probably

closer to 10 percent. The cost of capital for R&D

projects is even higher and increases the earlier

the stage of R&D.

Chapter l-Summary I 15

OTA estimated that the cost of capital for early

R&D may be up to 4 percent higher than the cost

of capital for manufacturing plant and equipment.

OTA recalculated the fully capitalized cost of

R&D at the point of market approval with a cost

of capital that decreases linearly from 14 to 10

percent from the beginning to the end of R&D

projects. 12 The estimate for the DiMasi study

increased from $259 million (in 1990 dollars) to

$359 million. Thus, a reasonable upper bound

on the fully capitalized cost of R&D per

successful NCE at the time of market approval

is $359 million.

1 After-Tax Costs of R&D

The effective cost to a company of bringing a

new drug to market is substantially less than the

cost estimates discussed above because they do

not account for the taxes the company is relieved

of paying when it invests in R&D. The net cost of

every dollar spent on research must be reduced by

the amount of tax avoided by that expenditure.

These tax savings result from both deductions and

tax credits. (When R&D is successful and produces marketable products, the company will pay

extra taxes as a result, and these dollar returns

must also be reduced by the amount of the extra

taxes.)

Like all business expenses, R&D is deductible

from a fro’s taxable income. This tax deduction

reduces the cost of R&D by the amount of the

company marginal tax rate. Because of the size

and sales of most major pharmaceutical fins, the

bulk of their taxable income would fall into the

highest tax bracket. This marginal tax rate fell

from 48 to 46 percent between 1971 and 1986. At

46 percent, every dollar spent on R&D would cost

the company only $0.54. With the passage of the

Tax Reform Act of 1986 (Public Law 99-514), the

marginal rate fell to 34 percent, thus effectively

raising the cost of each dollar of R&D to $0.66.

Corporations also pay State income taxes which

also can be reduced with business deductions.

12 Because 10 percent is ~ ~ei@ted ~v~~~~ ~~st of capi~ a~oss all of fie comp~y’s fives~ents, iIIVeSmCZltS h IIlaIIUfiiChMklg facilities

probably have a cost of capital below 10 percent. Therefore, this estimate may overestimate the cost of capital for R&D at each stage.
16 I Pharmaceutical R&D: Costs, Risks and Rewards

Pharmaceutical firms can also use special tax

credits available only for firms that perform

certain kinds of R&D. Since 1981, the tax code

has included a tax credit for increases in qualifying R&D expenses. This credit carried a statutory

rate of 25 percent until 1986, when it was reduced

to 20 percent. Quantifying the extent to which this

credit reduces the cost of R&D for pharmaceutical firms is impossible for two reasons: 1) the

credit depends on the amount that a firm increases

R&D expenditures, not on the level of those

expenses; and 2) expenditures on supervisory

activities or overhead do not qualify for the credit.

When it can be used, the most powerful tax

credit affecting pharmaceutical R&D is the Orphan Drug credit. The Orphan Drug Act of 1983

(Public Law 97-414) provides a 50-percent tax

credit for qualifying clinical R&D on drugs that

have received an orphan designation. An important limitation of the Orphan Drug credit, in

addition to its being limited only to clinical R&D

and orphan drugs, is that the credit cannot be

saved and used in future years if the company has

no current taxable income. Thus, small startup

companies, often the developers of orphan drugs,

cannot use it.

OTA recalculated DiMasi’s estimate of R&D

cost per NCE taking account of tax savings. The

sample of NCEs that DiMasi studied underwent

the great bulk of discovery and development at a

time when the marginal tax rate was 48 or 46

percent. Adjusting for tax savings (using a 46

percent rate) without any other changes reduces

the net cash outlays per NCE from $127.2 million

to $65.5 million, and adjusting for tax savings

reduces the total costs capitalized to the point of

market approval at a 10 percent cost of capital

from $259 million to $140 million (table 1-2).

When the cost of capital is permitted to decrease

linearly from 14 to 10 percent over the life of the

R&D projects, the net after tax cost is $194

million. OTA concluded that for NCEs whose

clinical research began in the period 1970-82—

the time period of the DiMasi study—the

upper bound on after-tax capitalized cost of

Table 1-2—After-Tax R&D Costs Estimated by

DiMasi Under Different Assumptions About the

Cost of Capitala ($ 1990 millions)

Before-tax After-tax savings

Cost of capital (%) savings (46%)

9 $258,650 $139,671

10 279,112 151,045

Variable (10 - 14) 359,313 194,029

a AII ~UrnptiOnS, given in 1990 dollars, were ad@ted for inflation

using GNP implicit price deflator.

SOURCE: Office of Technology Assessment, 1993, estimates adapted

from J.A, DiMasi, R.W. Hansen, H.G. Grabowski, et al.,

“The Cost of Innovation in the Pharmaceutical Industry,”

Journai of Health Ewnomkx 10:107-142, 1991.

R&D required to bring an NCE to market is

$194 million. The effect of the R&D tax credit,

the U.S. investment tax credit and the orphan drug

tax credit was not taken into account.

Had today’s marginal corporate tax rate (34

percent) been in effect at the time the NCEs in

DiMasi’s study were developed, the net after-tax

cash outlay per successful NCE would have been

no more than $80.1 million, and the full cost

capitalized at a 10 percent cost of capital would be

$171 million. At today’s tax rate, with a cost of

capital decreasing from 14 to 10 percent over

the life of the project, the average cost of

developing a new drug would be no more than

$237 million.

9 R&D Costs Today and in the Future

The fully capitalized cost of bringing a new

drug to market is very sensitive to four components of the R&D process:

1.

2.

3.

4.

The preclinical cash outlays required to

discover or design a potential therapeutic

compound and then to determine whether it

is worth testing in humans;

The success rate at which compounds move

from phase to phase of clinical research and

ultimately to the market;

The scope and size of clinical trials; and

The time a drug spends in regulatory

review.
Chapter l-Summary I 17

The studies of R&D costs that OTA reviewed were for compounds that entered human

clinical testing in the 1960s and 1970s. Much has

changed since then in the technical and regulatory

conditions governing pharmaceutical R&D, making inappropriate any extrapolation from the

experience of that generation of drugs to those

entering clinical testing today.

The technology of drug discovery and design

has changed enormously, Whereas researchers

used to screen a large number of chemicals for the

few that cause a desired chemical or biological

reaction, they now frequently engage in a more

deliberate process based on knowledge of biological function. (See chapter 5 for a description of

trends in the science and technology of drug

discovery.)

For example, many drugs are discovered today

through analysis of drug receptors, molecules that

bind with specific agents to change cellular

function. Agents that can bind with the receptor or

that inhibit the binding of a naturally occurring

substance become potential drug candidates. The

process of finding such molecules involves determining the shape of a receptor and designing the

agents that will affect its function.

Understanding the structure of receptor molecules has become the key to many areas of drug

discovery. Most receptors are large proteins with

multiple regions of interest. Expensive analytic

instruments and computers are necessary to

define the shape of these molecules. Companies

have justified investments in nuclear magnetic

resonance spectroscopy and x-ray crystallography, two techniques for analyzing the shape of

large molecules, as tools to determine the threedimensional structure of receptor sites, a process

that will improve the prospects for developing

drugs that fit into the desired sites. These and

other techniques of structure-activity analysis

require massive computer power to analyze data

and construct three-dimensional molecular images.

One outgrowth of the expanding base of

knowledge about disease mechanisms is the

endless supply of possible research directions that

Photo axf/t: BRISTOL-MYERS SQUIBB COMPANY

Computers facilitate the design of new enzyme inhibitors by

enabling scientists to graphically visualize the structure of

targeted molecules.

this knowledge creates. For example, drug receptors that reside on the surface of cells mediate

many of the most important functions in the body

and are extremely promising targets for future

drug development. Enzymes that mediate biochemical reactions and genetic materials also

offer up a plethora of drug development targets.

There are too many possible targets, however, for

scientists to understand the structure and function

of each. Thus, at the same time that new research

technology advances understanding, it expands

the choices and increases the chances of dry holes

in the discovery phase.

The impact of the rapid advances in the science

and technology of drug discovery on the costs of

R&D is impossible to predict. While investment

in instrumentation and computers has clearly

increased, the impact on the cost of R&D depends

largely on what these advances do to the productivity of the discovery phase of R&D. If, dollar-fordollar, the new drug discovery techniques produce more new drugs worthy of clinical testing,

and if these new drugs are more likely to

successfully jump the hurdles in each phase and
18 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 1-3—IND Applications Received by the

Center for Drug Evaluation and Research

Number of INDs

Figure 1-4--IND Applications Received by the

Center for Biologics Evaluation and Research

Number of INDs

90

500

400

2,000 4

—

-r- 1-

—

-r

87

—

—

200

100

1980 81 82 83 84 85 0 IIDIII

KEY: IND - investigational new drug. 1980 81 82 8384858 8 87 88 88 90 91

SOURCE: Office of Technology Assessment, SOURCE: Federal Coordinating Council for Science, Enaineerirxt, and 1993 based on U.S.

Technology, Office of Science and Technology policy,

Executive Office of the President, Biotwhndogyforthe 21sf

Century: A Report by the FCCSET Committee on Life

Sciences and Hea/th (Washington, DC: U.S. Government

Printing Office, February 1992), and data provided by the

Center for Biologies Evaluation and Research, U.S. Food

and Drug Administration.

came before, but without better data on clinical

trial sizes, regulatory delays, and other regulatory

requirements, it is impossible to say whether on

the whole the shift toward biotechnology-based

drugs will increase or decrease the costs of R&D.

The most recently available data on the success

rate from first filing of an IND application to FDA

approval shows an improvement over time. At

OTA’s request, the FDA compiled information on

INDs filed for new molecular entities (NMEs) in

the periods 1976-78 and 1984-86.13 The percent

of NMEs that reached the NDA filing stage within

54 months of the first filing of a commercial IND

increased from 6.8 to 11 percent, and although

few drugs filing INDs in the later period have yet

been approved, the percent reaching approval

within 54 months is also higher for drugs entering

testing in the later period. Improvements in

Department of Health and Human Services, Public Health

Service, Food and Drug Administration, Center for Drug

Evaluation and Research, Office of Drug Evacuation Statistic/ Report: 1991, U.S. Department of Health and Human

Service, Rockville, MD, 1992.

reach the market, then the costs of R&D per

successful drug could decline. On the other hand,

if the explosion of possible research avenues

makes the discovery process even more chancy,

then the cost of bringing a new drug to market

could increase. Both trends could occur at the

same time, with unpredictable consequences for

overall R&D costs.

The results of the changes under way in the

process of drug discovery are evident in the

number of investigational new drug (IND) applications submitted to the FDA in recent years.

INDs increased throughout the 1980s, with the

highest rate of growth coming in the investigation

of biological (biotechnology drugs and other

biological products) (figure 1-3 and figure 1-4).

The shift in drug development toward biotechnologybased drugs means that discovery and development costs may be very different from those that

13 FDA staff were very helpful to OTA and provided staff to collect and analyze IND data iiCCOKi@ to OTA’S SpeCifk@iODS. me mount

of effort that FDA staff were required to spend on this analysis revealed some of the limitations of FDA’s electronic databases for tracking trends

in drug development. FDA’s automated information system does not link applications for INDs with applications for NDAs, so any tracking

of drugs from IBID to approval, rejection or discontinuation of the project must be done by manual search of the IND and NDA fdes.
Chapter 1--Summary I 19

success rates can have a substantial moderating

effect on realized R&D costs per success, but the

data available so far are too limited to conclude

much about ultimate success rates for drugs that

recently entered testing.

OTA’s data on the length of the regulatory

period (from the NDA filing to approval) show no

improvement in recent years, but efforts to

harmonize the regulatory review process across

countries and recently passed legislation that will

increase FDA staff available for new drug review

in return for “user fees” from sponsors (Public

Law 102-571) could shorten the period overall. If

the ultimate success rate for NCEs does not

improve, getting successful drugs through the

FDA regulatory period faster will only modestly

reduce the capitalized cost of R&D.

In short, OTA cannot predict how R&D

costs will change in the future. The rapid

advances in science and technology, the shift in

the nature of drugs under development, and

the new FDA regulatory initiatives all promise

to influence R&D costs, but the net direction of

the effect of all of these influences together is

beyond predicting.

RETURNS ON R&D: THE EVIDENCE

The costs of R&D are most meaningful in

comparison with the dollar returns they produce.

Measuring dollar returns accurately is difficult

because the life of a new NCE maybe 20 years or

longer and the costs of producing, distributing

and marketing the NCE can be estimated only

imprecisely. Nevertheless, several authors have

tried to measure the present value on the day of

market approval of dollar returns on NCEs

(159,215,500). The studies produced widely differing findings, ranging from high present values

of dollar returns to present values that lie below

the fully capitalized cost of R&D. The studies

differ widely because they each examined NCEs

that came to market in different periods and made

different assumptions about the value of product

sales over the product life cycle and the cost of

manufacturing, distribution and marketing.

OTA conducted an independent analysis of the

dollar returns on R&D using recent data on annual

revenues from NCEs and the costs of producing,

marketing and distributing these products. OTA

analyzed the return on NCEs introduced to the

U.S. market in the years 1981-83. OTA chose this

relatively brief period for two reasons. First, the

period corresponds in time to the R&D period

studied by DiMasi and colleagues. Second, we

had access to data on drugstores and hospital sales

only for this particular set of NCEs (97).14

1 The Sales Curve

Figure 1-5 shows U.S. sales to hospitals and

drugstores in constant 1990 dollars in each year

after market introduction for NCEs introduced in

the years 1981-83 and, for the sake of comparison,

in earlier and later periods as well. Although OTA

had access to only 1 year of data on NCEs

introduced from 1984 through 1988, that one data

point suggests that, after adjusting for inflation,

U.S. sales of NCEs in the early years after

approval continued to steepen throughout the

1980s.

To predict the sales curve for the 1981-83

NCEs beyond the 9th year, OTA examined trends

in effective patent lives and in the loss of revenue

after patent expiration.

EFFECTIVE PATENT LIFE

The effective patent life is the elapsed time

between FDA approval for marketing of a new

drug and expiration of the last patent or market

exclusivity provision that effectively protects the

original compound from generic competition.

Two new Federal laws passed in the 1980s, the

14 Gaining access to sales dab On NCES was a major problem for OTA throughout the course of thiS study. Detailed data ~co~ected by

propnetaryorganizations onU.S. and worldwide sales of NCEs, and these data are sold to subscribers. IMS Americ% Inc. and IMS International,

Inc. are market research firms that, among other activities, conduct ongoing surveys of pharmaceutical product sales and prescriptions for sale

to subscribers. The cost to OTA would have been prohibitive, however. For example, IMS International, Inc. quoted a preliminary price to OZ4

for estimates of the total non-U.S. sales between 1981 and 1990 for NCES introduced between 1981-83 at $75,000 to $125,000 (339).
20 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 1-5-Average U.S. Sales of New

Chemical Entities Introduced in

1970-79, 1981-83, and 1984-88

$ million (1990 dollars)

150

120

90

60

30

0+’1,//’”1 I I I I I i I I I I I I I I I I I I I I I I I I 1 I I 1

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Years since introduction

+ 1970-1979 + 1981-1983 — 1984-1988

SOURCES: 1970-79: H.G. Grabowski and M. Vernon, “A New Look at

the Returns and Risks to Pharmaceutical R& D,” Managernent Sdence36(7’):804-82 1, July 1990. 1981-83: Coppinger, P., “Overview of the Competitiveness of the U.S.

Pharmaceutical Industry,” presentation to the Council in

Competitiveness Whking Group on the Drug Approval

Process, Washington, DC, Dec. 12, 1990. 1984-88: IMS

America, Inc., unpublished data prepared for the Office of

Technology Assessment, 1991.

Drug Price Competition and Patent Term Restoration Act of 1984 (Public Law 98-417) and the

Orphan Drug Act of 1983 (Public Law 97-414),

increased the effective patent life for new compounds.

Figure 1-6 shows recent trends in the average

effective patent life for NCEs. As expected, after

declining steadily throughout the 1970s and early

1980s, effective patent life rebounded somewhat

in the years since 1984.

The end of the effective patent life does not

always mark the end of exclusive marketing for

the NCE. Some compounds may not have generic

competitors for several years after the patent

expires, either because of delays in FDA approval

of generic versions or because the total market for

the drug is too small to induce generic manufacturers to enter the market. Occasionally a process

patent issued after the original patents will protect

a product for some time.

Product line extensions, such as new once-aday dosage forms, have become increasingly

important in protecting the original compound’s

market against generic competition. The 1984

Drug Price Competition and Patent Term Restoration Act (Public Law 98-417) granted a 3-year

period of market exclusivity, regardless of patent

status, to any product for which new clinical

research is required. Thus, if a new sustained

release formulation is developed and approved

for the originator compound, the new dosage form

has a 3-year period of market exclusivity from the

date of its FDA approval regardless of the patent

status of the compound itself.

Companies use the terms of the provision to

extend the effective exclusivity period by managing the introduction of new dosage forms to

coincide with the expiration of the patent on

earlier generations of the compound. Physicians

almost always prefer extended-release dosage

forms because they increase patients’ adherence

to the prescription. Increasing company incentives to develop products with these benefits is the

rationale for the 3-year exclusivity provision in

Figure 1-6-Effective Patent Life for

Drugs Approved, 1968-89

Number of years

12

10

8

6

4

2

0 ! -r- -r 1-

1968-72 1973-77 1978-82 1984-89

m Latest patent life ~ Product patent life

SOURCES: Office of Technology Assessment, 1993. Based on U.S.

Congress, House of Representatives, Committee on

Energy and Commerce, unpublished data, 1993; U.S.

Department of Health and Human services, Food and

Drug Administration, unpublished data, 1991; U.S. Department of timmerce, Patent and Trademark Office,

unpublished data, 1991.
the Drug Price Competition Act. Nevertheless,

the introduction of these new products can keep

the compound’s revenues high for years after the

effective patent life ends.

POSTPATENT REVENUES

The Drug Price Competition and Patent Term

Restoration Act made FDA approval relatively

easy for makers of generic copies of originator

drugs after patents or market exclusivities expire.

It is widely held that this law has led to rapid

decline in the originator drug’s market share

following patent expiration.

OTA analyzed changes in the U.S. market for

35 therapeutic compounds that lost patent protection in from 1984 through 1987 and found that the

sales decline is not nearly as steep as is commonly

thought-at least not yet. Figures 1-7 and 1-8

show how the compounds hospital and drugstore

sales (in 1990 dollars) and physical units changed

before and after the year in which patents expired.

Three years after patent expiration, the mean

annual dollar sales of the original compound were

83 percent of mean sales revenue in the year of

Figure 1-7-Originator Revenuea as a Percent of

Originator Revenue in Year of Patent Expiration

!

1oo80-

60-

-7 -6 -5 -4 -3 -2 -1 0 1 2345 6

Years in relation to patent expiration

a Based on 1990 dollars.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, “Economic Products,” contract paper prepared for Office of Tetinology Assessment, December

1991.

——

Chapter 1--Summary 21

Figure 1-8-Originator Unit Volume as a Percent

of Originator Volume in Year of Patent Expiration

Percent

120”

9 0

60

3(”

o- 1 I I 1 [

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Years in relation to patent expiration

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, “Econo,nic Products,” contract paper prepared for Office of Technology Assessment, December

1991.

patent expiration, while the mean sales volume in

physical units was 68 percent of its level in the

year of patent expiration.

OTA extended the sales curve beyond the 9th

year after U.S. market introduction based on these

trends and also made adjustments for sales to

other countries and to purchasers other than

hospitals and drugstores (see chapter 4 for details). Figure 1-9 shows the projected worldwide

sales for NCEs introduced in the United States

from 1981 through 1983. OTA assumed that the

originator compound would stay on the market

only 20 years and that the products are not sold in

other countries before they are approved in the

United States. Overall, then, the assumptions

used to build this projected sales curve were

conservative.

B Costs of Production

Sales revenues from new products must be

reduced to reflect the cash outlays required to

manufacture and sell them, and the ongoing R&D

costs required to produce follow-on products or to

justify new uses for the NCE. The net cash flows

induce additional tax liabilities as well. OTA

estimated these costs using data as available and
22 I Pharmaceutical R&D: Costs, Risks and Rewards

subtracted them from the net sales revenues over

the life of the compound. (See chapter 4 for details

of OTA’s method.)

~ Net Cash Flows

The 1981-83 NCEs deliver net cash flows of

$341 million per compound (discounted to their

present value in the year of FDA market approval

at 9.8 percent per year). The net after-tax value of

the cash flows projected for the 1981-83 cohort of

new drugs is $230 million.

I Net Return on Investment

These net postapproval cash flows must be

compared with the present value of the investment in R&D required to discover and develop

the compounds. An upper bound on the fully

capitalized R&D costs of drugs introduced in the

early 1980s is about $359 million before tax

savings, or $194 million after tax savings are

considered (table 1-2). Thus, OTA concluded

that the average NCE introduced to the U.S.

market in the period 1981-83 can be expected

to produce dollar returns whose present value

is about $36 million more (after taxes) than

would be required to bring forth the investment in the R&D.

Some of the revenue and cost assumptions

underlying this analysis were very uncertain, so

OTA analyzed the sensitivity of the estimated

returns to changes in critical assumptions. The

results are somewhat sensitive to the ratio of

global sales (about which we know relatively

little) to U.S. sales (about which we know much

more). If the ratio of global sales to U.S. sales is

much greater than 2, as we have reason to believe

it may be, the present value of the cash flows

would be even more (after taxes) than is necessary

to repay the R&D investment.

The results were not very sensitive to changes

in the speed with which originator brand sales

decline after patent expiration. If the average sales

per compound were to decline by 20 percent per

year after patent expiration, the present value of

the cash flows would be$311 million before taxes

and $209 million after taxes, still above the full

after-tax cost of R&D. Fully 6 years after the

Figure 1-9-Estimated Average Global Sales Profile

Per New Chemical Entity Introduced in the

United States, 1981-83

am $ millions (1990)

300-

250”

200-

150-

1oo50”

I I i

0 2 4 6 8 10 12 14 16 18 20 22 24

Years after market introduction

+ Global sales

— U.S. hospital and drug store sales

SOURCE: Office of Technology Assessment, 1993; based on data

from P. Coppinger, “Overviewof the Competitiveness of the

U.S. Pharmaceutical Industry,” presentation to the Council

on Competitiveness Working Group on the Drug Approval

Process, Washington, DC, December 12, 1990.

passage of the Drug Price Competition and Patent

Term Restoration Act there is no evidence that the

rate of sales decline for originator compounds

after patent expiration is approaching this rate.

What does it mean to have the average revenue

per compound deliver $36 million more in present

value than was needed to bring forth the research

on the drugs in the cohort? OTA estimated that

excess returns over R&D costs would be

eliminated if the annual revenue per compound was reduced by 4.3 percent over the

product’s life.

These estimates are rough predictions of the

actual returns that the 1981-83 cohort of NCE’s

will earn over their full product lives. OTA

attempted to be conservative in measuring returns, but the estimate is subject to measurement

error whose magnitude is not easily assessed.
Chapter 1--Summary 23

More importantly, the analysis illustrates how

volatile net returns can be for drugs introduced in

different time periods. This report documents

how rapidly both worldwide revenues and the

average cost of R&D for each new NCE can

change. The wide variation in R&D costs and

sales revenues across individual drugs means that

estimates of both average R&D costs and returns

could vary over short periods of time.

TOTAL PHARMACEUTICAL INDUSTRY

RETURNS

Another more indirect way to measure returns

on R&D is to estimate the profitability of

research-intensive pharmaceutical companies. Pharmaceutical firms invest in the discovery, development, production, marketing and distribution of

many products, including some that are not

ethical pharmaceuticals, The total profit or return

on a company’s investment in a given period is a

mixture of returns on past investments made over

many previous years on many different projects.

At the company level, the return on investment

is defined by the internal rate of return (IRR), the

interest rate at which the net present value of all

cash flows into and out of the firm equals zero, If

the IRR across all companies in an industry is

greater than the industry’s cost of capital, one

would expect to see increased investment in the

industry, including R&D, as investors enter to

reap the high rewards. In a dynamically competitive industry, IRRs much greater than the cost of

capital can not persist indefinitely. If abnormally

high profits persist for a long time, one would

suspect that barriers to entry or other forms of

monopoly power (perhaps obtained through patent protection) might exist in the industry (86),

On the other hand, a low IRR compared with the

cost of capital would lead to disinvestment in the

industry, including R&D.

The annual financial reports of public companies contain estimates of company profit rates

based on accounting records. For example, net

income as a percent of total ‘‘book value’ of

assets is a commonly used benchmark of firm

profitability (301). Companies themselves report

this ratio in their annual financial statements and

compare their return on assets in one year with

that in previous years. Other commonly used

profit ratios, such as net operating income as a

percent of sales, are also easily computed from

company financial statements.

It is not surprising, then, that analysts would

compare the accounting profit rates of firms in the

industry with those of firms in other industries

(301,457). The ready availability of publicly

reported and independently audited data and the

widespread use of these measures by companies

themselves invites such comparisons. By these

conventional accounting measures, the pharmaceutical industry looks very profitable compared

with other industries (301 ,457). But these comparisons are limited in two important ways.

First, accounting profits are poor measures of

true IRRs. Revenues and costs recognized in

accounting statements don’t correspond very well

to actual cash flows. And, because profits are

computed over a limited period, they don’t adjust

properly for the time profile of cash flows from

various investments made in previous times or for

payoffs that won’t occur until after the profit

measurement period.

Second, even if accounting profits are corrected to correspond more closely to IRRs,

differences in rates of return among industries

might reflect differences in their riskiness (and

hence in the cost of capital). Simple comparisons

that do not address differences in risk among

industries can be misleading.

OTA commissioned a study comparing the

IRR of 54 U.S.-based research-intensive pharmaceutical companies with the IRRs of two control

groups, each with 54 fins, selected to be most

similar to the pharmaceuticals on certain financial

characteristics (27) (see chapter 4 for details). The

accounting profit rate for the pharmaceutical

companies was 4 to 6 percentage points per year

higher in the study period (1976-87) than for the

control fins.

The contractors used a new technique that

adjusts accounting profits to obtain a closer

approximation of IRRs. IRRs cannot be measured

330-067 - 93 - 2 : QL 3
24 I Pharmaceutical R&D: Costs, Risks and Rewards

with precision, because assumptions are required

about the time profile of returns on investments,

but across a wide range of assumptions about

timing of cash flows, the estimated internal rate of

return in the pharmaceutical firms over the

12-year study period (1976-87) was on average 2

to 3 percentage points higher per year than the

internal rate of return in either control group.

The contractors did not address the question of

whether a 2 to 3 percentage point difference in

internal rates of return can be explained by

differences in the cost of capital between pharmaceuticals and control firms. If investment in the

pharmaceutical industry is riskier than in the

control firms, then the cost of capital will be

higher. OTA calculated the difference in the cost

of capital between the pharmaceutical industry

and each of the two control samples. OTA found

that the cost of capital for the pharmaceutical

industry was higher by 0.7 percentage points per

year than one of the control samples, but lower by

1.6 percentage points than the other.

The cost of capital can vary widely over time

with underlying interest rates and expected inflation, so precise measurement of each group’s cost

of capital over the study period is impossible. In

addition, OTA’s method may be subject to biases

in measurement. We used the same method

consistently across all samples, however, so the

biases would tend to cancel themselves out when

examining differences in the cost of capital

between pharmaceuticals and controls. Therefore,

OTA concluded that returns to the pharmaceutical industry as a whole over the 12-year

period from 1976 to 1987 were higher by 2 to

3 percentage points per year than returns to

nonpharmaceutical firms, after adjusting for

differences in risk.

INDUSTRY RESPONSE: INCREASING R&D

In an industry with a large number of active

competitors, high returns (compared with the cost

of capital) should attract new investment capital.

Data on aggregate domestic and worldwide pharmaceutical R&D reveal a rapid increase in real

R&D spending beginning in 1980 and continuing

today. Total R&D conducted by U.S.-based

pharmaceutical companies in 1975 was about

$1.1 billion; by 1990, this spending had grown to

between $7.9 billion and $8.1 billion (table 1-3).

After adjusting for inflation, U.S.-based companies’ foreign and domestic R&D spending

increased at about 9 percent per year between

1975 and 1990. The rate of increase accelerated

over the period. Before 1980, U.S. companies’

real worldwide R&D spending increased by

only 5 to 6 percent per year. Between 1985 and

Table 1-3--Aggregate Pharmaceutical Foreign and Domestic R&D, Selected Years ($ billions)

Annual percent rate of change

1975 1980 1985 1987 1990 1975-80 1980-85 1985-90

Compustat TMa

Current dollars. . . . . . . . . . . . . . . . . $1.10 $2,08 $4.20 $5.53 $7.90 13.60/o 15,1?40 13.5!/0

Constant 1990 dollarsb. . . . . . . . . . 2.44 3.19 4.98 6.19 7.90 5.5 9.3 9.7

Pharmaceutical Manufacturers Associationc

Current dollars. . . . . . . . . . . . . . . . . 1.06 1.98 4.08 5.51 8.13 13.2 15.6 14.8

Constant 1990 dollars. ., . . . . . . . . 2.36 3.03 4.83 6.17 8.13 5.2 9.8 10,9

a Figures are based on a total of 133 firms listed in the Compustat file under Standard Industrial Code (SIC) code 2834 in at least 1 year between

1971 and 1990. The number of firms vary from year to year due to firms’ entry and exit from SIC 2834.

b Adjusted by GNP implicit price deflator.

c R&D expenditures reported by Pharmacuetical Manufacturers Association member firms.

SOURCE: Office of Technology Assessment, 1993, based on unpublished data provided by S.H. Kang, School of Industrial Administration,

Carnegie-Mellon University, Pittsburgh, PA; Pharmaceutical Manufacturers Association, Annual Survey Reports, 197591 (Washington,

DC: PMA, 1976-91).
Chapter 1--Summary I 25

Table 1-4—HMG-CoA Reductase Inhibitors Currently or Formerly Under Development

Compound Sponsor Approval Status

Iovastatin

pravastatin

simvastatin

colestolone

fluvastatin

crilvastain

dalvastatin

BAYW6228

HR780

Cl 981

00-476

BMY-22566

SQ-33600

BMY-21950

GR-95030

SC-45355

L-659699

L-669262

CP-83101

Merck

Sankyo, Bristol-Myers Squibb

Merck

American Cyanamid

Sandoz

Pan Medica

Rhone-Poulenc Rorer

Bayer

Hoeschst

Warner-Lambert

British Bio-technology

Bristol-Myers Squibb

Bristol-Myers Squibb

Bristol-Myers Squibb

Glaxo

Searle

Merck

Merck

Pfizer

IND: April 1984. NDA: November 1986. Approval:

August 1987.

Launched in Canada, Europe, Japan, and Mexico. U.S. NDA:

January 31, 1989. U.S. approval: November 31, 1991.

Launched in at least 17 countries worldwide, including most of

Europe. U.S. NDA: November 1986. U.S. approval:

December 1991.

Entered U.S. clinical trials in 1987.

U.S. NDA filed March 1992.

Phase II clinical trials.

Phase Ill clinical trials.

Phase II clinical trials.

Phase II clinical trials.

Phase I clinical trials.

Series of compounds under development; preclinical.

Preclinical studies.

Preclinical studies, discontinued.

Phase I clinical trials.

Preclinical studies, discontinued.

Preclinical studies, discontinued.

Preclinical studies.

Preclinical studies.

Preclinical studies.

SOURCE: Office of Technology Assessment, 1993.

1990, they increased at about 10 percent per

year.

15 These data do not even fully reflect the

rapid increase in spending by small researchintensive biotechnology companies, a phenomenon that began in the early 1980s.

OTA’s findings on returns to pharmaceutical R&D and to the industry as a whole explain

why R&D expenditures have risen so fast

throughout the 1980s. Investors followed the

promise of high returns on future innovations.

Ultimately investment in research is determined

by expected revenues. The dramatic increase in

real revenues to new drugs throughout the 1980s

has sent signals to the industry that more investment will be rewarded handsomely. The industry

has responded as expected, by increasing its

commitment to investment, including R&D.

What will this increased investment mean for

pharmaceutical returns in the future? Some of the

research dollars are pursuing the development of

me-too NCEs that will compete with similar

products already on the market. For example, the

first HMG-CoA reductase inhibitor-a new class

of drugs that lowers cholesterol—was approved

for marketing by the FDA in 1987. Today, three

compounds are approved for marketing, one is

awaiting approval, and 12 others are under active

development (table 1-4). Over time, the entry of

new products should dampen the potential returns

on research into new NCEs in this class, as

companies spend more and more money developing competing products and fighting for a share of

the market.

Some research dollars are pursuing new classes

of drugs, which may supplant older therapies or

create new markets in areas where there was

before no effective therapy. Several companies

have current research programs on drugs for

Alzheimer’s disease, a major cause of dementia in

older people, but so far no drug can offer

substantial improvements in patient functioning.

(See chapter 5, box 5-E for more information on

15 Because spending iII VfiOUS COUIItrkS must be converted into a common currency, excbge rate Chges cm ~~t r~ort~ ‘~ntig”

The devaluation of the dollar after 1985 maybe responsible for some of the unusually high increase in total spending reported in recent years.
26 I Pharmaceutical R&D: Costs, Risks and Rewards

the status of research into drug therapies for

Alzheimer’s disease.) Successes in these areas

could mean a new cycle of high returns to the

pioneer and early me-too compounds but lower

returns to the later entrants who must compete for

market share in the class.

PAYMENT POLICY AND

RETURNS ON R&D

Future returns to the research-intensive pharmaceutical industry depend not only on the

opportunities created by scientific research, but

also on the regulatory and market conditions that

will govern the sale of pioneer and me-too

products. OTA examined recent trends in payment policies that affect the market for new

pharmaceuticals.

Sales of new ethical drugs depend on physicians’ decisions to prescribe them and on patients’ decisions to buy them. Physicians and

patients base these decisions on judgments about

a drug’s quality and price compared with the

quality and price of existing alternatives. The

tradeoff between perceived quality and price

depends on many factors, including the severity

of the disease or condition for which a drug is

intended, evidence of its effectiveness compared

with alternative courses of action, the availability

of close substitutes, and the effectiveness of

advertising and promotion in convincing doctors

the drug is the right choice for the patient (86).

I Importance of Health Insurance in

Determining Demand

When a patient’s health insurance plan covers

prescription drugs, the balance between perceived

quality and price tips in favor of quality. While it

protects consumers from uncontrollable and catastrophic expenses, health insurance also reduces

the effective price of health care services and

products. By reducing patients’ out-of-pocket

cost, health insurance makes them less sensitive

to price than they would otherwise be (516).

Insurance coverage for prescription drugs in

the United States changed during the 1980s in two

ways that made the demand for prescription drugs

Table 1-5--Percent of U.S Population With Outpatient Prescription Drug Coverage, 1979 and 1987a

1979 1987

People under 65. . . . . . . . . . . . . . . 71-73 73-77

People 65 and over. . . . . . . . . . . . 36 43-46

Total. . . . . . . . . . . . . . . . . . . . . . . . 67-69% 70-74%

a Adet~l~ memorandum deecdbing OTA’S methods in preparing thk

table is available upon request.

SOURCE: Office of T~nology Assessment, 1993; based on sources

listed in table 10-2.

even less sensitive to price than it was before.

First, the percent of Americans with outpatient

prescription drug benefits increased, albeit modestly, over the 1980s, from 67-69 percent in 1979

to 70-74 percent in 1987, the latest year for which

good data are available (see table 1-5). Although

few Americans had insurance plans that covered

outpatient drugs in full, the mere existence of

insurance coverage makes patients less sensitive

to price than they would be without such coverage

(294).

Second, the structure of outpatient prescription

drug benefits changed markedly over the period.

In the past, almost all nonelderly people with

outpatient drug benefits had “major medical”

plans with an overall annual deductible that had

to be met before insurance would help pay for any

services or drugs. By 1989, 30 percent of these

people had policies that required freed copayments for prescription drugs instead of including

them in the overall deductible (table 1-6). The

vast majority of people with freed copayments per

prescription in 1989 paid $5 or less per prescription (35). The insurance company picked up the

rest of the bill regardless of its amount.

The switch from overall deductibles to freed

copayments for prescription drugs means a richer

insurance benefit structure for prescription drugs.

For people whose annual medical expenses lie

below their plan’s annual deductible (commonly

$200 or $250 per year), a flat copayment for

prescription drugs means lower out-of-pocket

prescription drug costs than do major medical

restrictions. Even when patients do meet the

deductible in a year, many would have higher
Chapter l-Summary I 27

Table 1-6-Limitations of Prescription Drug

Benefits Among Nonelderly People With Private

Health Insurance Covering Prescription Drugs

1 977’ 1989/1990b

Full coverage . . . . . . . . . . . . . . . . . . . . . 3% 3%

Separate limits (copayments)c . . . . . . 9 30

Overall limits (major medical)d . . . . . . 88 61

Other Iimitse . . . . . . . . . . . . . . . . . . . . . . . 7

a Results b~gd cm 1977 National Medical Care Expenditure Study

Survey of employers and insurers of individuals under 65 years of

age.

b Results txKect on U.S. Bureau of Labor Statistics 1989 and 1990

surveys of employers.

c “separate limi~” refers to restrictions applicable only to prescription

drugs, such as a copayment for each prescription.

d “~erall limits” refers to restrictions applicable to a broader set of

medical services. For example, a major medieal policy may carry a

$100 deductible and 20-percent coinsurance rate that applies to all

covered services, not just prescription drugs.

e other limits i~ltie policies that combine fixed copayments ~th

overall limits.

SOURCE: Office of Technology Assessment, 1993, based on data

from P.J. Farley, Private Health Insurance in the U.S. Data

Preview#23, DHHS Publication No. (PHS) 86-3406, 1986.

U.S. Department of Health and Human Services, National

Center for Health Services Research and Health Care

Technology Assessment, September 1986; U.S. Department of Labor, Bureau of Labor Statistics, Ernp/oyee

Benefits in Medium and Large Firms, 1989, Bulletin 2363

(Washington, DC: U.S. Government Printing Office, June

1990); U.S. Department of Labor, Bureau of Labor Statistics, Employee Benefits in Small Private Establishments,

1990, Bulletin 2388 (Washington, DC: U.S. Government

Printing Office, September 1991); U.S. Department of

Labor, Bureau of Labor Statistics, Emp/oyee Benefits in

State andLoca/Governments, f990(Washington, DC: U.S.

Government Printing Office, February 1992).

out-of-pocket prescription drug costs under a

major medical plan than under a freed copayment. l6

The impact of these improvements in prescription drug insurance benefits shows up in insurance reimbursements. The percent of total outpatient prescription drug spending in the United

States paid for by insurance increased substantially, from 28 to 44 percent, between 1977 and

1987 (figure 1-10). The same trend holds among

elderly Americans, for whom private insurance

paid for about 36 percent of outpatient prescription drug expenses in 1987 compared with only

23 percent in 1977.

Most private and public health insurers have

little power to restrict physicians’ prescribing

decisions. Private insurers generally cover all

prescription drugs the FDA has licensed for sale

in the United States (35). Thus, FDA approval is

a de facto insurance coverage guideline. If the

physician orders a specific compound, the insurer

routinely pays its share of the costs.

Despite the fact that many compounds, though

protected from generic competition by patents or

other market exclusivity provisions, compete for

market share with similar compounds, that competition tends to focus on product characteristics,

such as ease of use, favorable side-effect profiles,

or therapeutic effects, and not on price .17 Companies spend a great deal on this product competition. One major U.S. pharmaceutical company

reported recently that about 28 percent of its sales

went for marketing (advertising and promotion)

expenses (1 19a).

Emphasizing product competition over price

competition is a rational strategy for companies

operating in a market that is not very sensitive to

price differentials among similar compounds. If

prescribing physicians will not be swayed by

lower prices, it would be foolhardy for firms to set

prices for their products much lower than those of

competitors. Unless or until the demand for

prescription drugs becomes more price sensitive,

the benefits of the competitive R&D on prices

will not be felt.

1 Different Buyers Pay Different Prices

Ethical drugs are sold through multiple distribution channels, and companies can set different

16 ~ most major medi~ p~, the insmed pe~on is responsible for sharing 20 percent or more of the cost of serviees above the deductible.

Under a 20 percent major-medical cost-sharing requirement, any prescription with a price greater than $25 would cost the insured person more

than it would a patient with the most frequent separate copayment rate. For example, a $30 prescription would cost someone with a major

medical policy and a 2@percent cost-sharing requirement $6, whereas the typical cost under a flat copayment would be only $5.

17 ~s i5 not t. say tit ~nce competition ~ong comp~g brand.name compounds is ent~ely absent, or tit priUN of pioneer tigs are

established without any concern for their effect on patient demand. Anecdotal reports suggest that new NCES are often launched at lower prices

compared with competing drugs, but the discounts are typically not high and they rarely lead the manufacturers of other compounds to meet

price reductions.
28 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure I-l O-Sources of Payment for Prescribed Medicines in the United States

5.9% 5.9%

13.9’YO

56.4%

27.7%

‘?/0

1977 1987

D family m Private D Medicaid ~ Other sources

insurance

a other sour~s incltie workmen’s Compensation, Medicare, other State and local programs, and any other source of payment.

SOURCE: Datafrom J.F. Moeller, Senior Projeet Director, U.S. Department of Health and Human Services, Public Health Service, Agency for Heaith

Care Policy and Researeh, Rockville, MD, personal communication, Mar. 12, 1991; J.A. Kasper, Prescribed Medicines: Use,

Expenditures, and Sources of Payment, Data Preview (Washington, DC: U.S. Department of Health and Human Services, National Center

for Health Serviees Research, April 1982).

prices to different kinds of buyers. For example,

companies can sell direct to HMOs18 or large

hospital chains and offer lower prices than they

charge for drugs sold to community pharmacies.

The ability to charge different prices to different

kinds of buyers is referred to as price discrimination. Price discrimination increases profits by

separating buyers who are price sensitive from

those who are not.

Price discrimination in pharmaceutical markets

takes its most extreme form when companies

offer expensive drugs free or at reduced charge to

people who cannot easily afford them because

they lack insurance and have low incomes. Many

pharmaceutical firms have developed such programs in recent years (327,458). In a separate

background study under this project, OTA examined CeredaseTM

, a new drug for a rare inherited

disease, whose high annual cost (at least $58,000

per year for the drug alone for the remainder of the

patient’s life) threatens to exhaust many patients’

lifetime insurance benefits (141).19 The company

that makes CeredaseTM provides the drug free to

patients who have exhausted their benefits or do

not have health insurance. Although these programs respond in a compassionate way to a real

need, they also separate the market into two

components--one with very high price sensitivity (uninsured people) and one with very low

price sensitivity (insured people). The CeredaseTM program is similar in its consequences to

offering a patient a lifetime supply of the drug in

exchange for the remaining value of his or her

insurance coverage plus associated premiums.

PRICE-SENSITIVE BUYERS

PAY LOWER PRICES

HMOs, particularly those with tight organizational structures, have both the incentive and the

18 Ufie ~~tio~ f=for.wnice~wmw PIW, HMos (some~es r~e~ to M “pr~~d hea.lthplw’ collect a set premium for each

member, but charge either nothing or a relatively small amount for each individual service. People enrolled in the HMO must receive their health

care from providers designated by the HMO.

19 Approfitely 71 percent of private insurance policy bene.tlciaries face a lifetime maximum benefit of $1 million or less (491).
Chapter 1-Summary ! 29

ability to influence physicians’ prescribing practices to take account of cost as well as quality .20

They can do this by establishing restrictive

‘‘formularies, lists of drugs that can be prescribed by participating physicians without special appeals or approvals. The power to impose

limitations on prescribing has given HMOs purchasing clout with manufacturers and, over the

past few years, has led manufacturers to offer

substantial price discounts to some of these

organizations. When there are several close substitutes in a therapeutic class, the HMO can use

the formulary as a bargaining chip to exact price

concessions from producers .21

Hospitals also have an incentive to establish

formularies for drugs administered to inpatients.

In 1983, Medicare adopted a new “prospective

payment system’ that pays hospitals on the basis

of the admission, not the specific services each

patient uses. 22 This system created incentives for

hospitals to reduce both length of stay and the cost

of services offered per stay, including drugs. The

incentive to develop restrictive formularies is

limited, however, because most insured nonelderly hospitalized people pay for hospital care on

the basis of charges for individual products and

services. Pharmacy charges are passed on to the

private insurance company. Nevertheless, the

number of hospital pharmacies adopting formularies increased steadily in the mid-1980s. The

percent of hospitals with a well-controlled formulary increased from 54 percent in 1985 to 58

percent in 1989 (101,412).

PRICE-SENSITIVE BUYERS GAIN FROM

PRICE COMPETITION

The success of some HMOs and hospitals in

getting price concessions from manufacturers of

single-source drugs (i.e., those with patent protection) attests to the potential for price competition

to lower the cost of drugs to patients or their

insurers. For price competition among close

therapeutic alternatives to be effective in a market

with price-sensitive buyers, enough similar competing products must exist to allow providers to

choose among alternatives on the basis of price as

well as quality. Me-too products, often derided as

not contributing to health care, are therefore

necessary to obtain the benefits of price competition in segments of the market that are price

sensitive.

Most of the new drugs entering the world

market in recent years have offered little therapeutic advantage over pre-existing competitors.

A 1990 European study of the therapeutic value

of new drugs first introduced in at least one of

seven industrialized countries23 between 1975

and 1989 found that only 30 percent of all NCEs

were classified by a group of experts as ‘‘adding

something to therapy’ compared with compounds already on the market (37).24 The rest fell

into categories that could be called me-toos.

About 42 percent of those NCEs originated in the

20 Enrollment in HMOS grew from 4 percent of the population in 1980 to 14 percent in 1990 (209). But, many HMOs do not give their doctors

incentives to economize in drug prescribing. A recent review of seven HMOS found the plain were structured so that the prescribing physician

never bore financial risk for prescription drug costs (5 15). These HMOS were all individual practice associations or networks. These kinds of

HMOS tend to have looser fiscal controls than staff-model HMOS, where physicians are either employees or partners in the organization. In

1990, pharmaceutical sales to staff-model HMOS made up 2.4 percent of the pharmaceutical market.

21 me power of ce~ Clmses of pUc~sem to exact discoun~ was recognized by the timers of the 1990 Medictid Rebate law ~b~ic

Law 101-508) which requires manufacturers to offer Medicaid the “best price” (i.e., lowest price) they offer to private purchasers if the

manufacturer wants to sell its products to the Medicaid patient. The strategy may have backfked, however, because manufacturers ehminated

many such discounts to HMOS and hospitals when they found that they would lose the amount of the discount on a large part of their total market

(431), (Medicaid makes up 10 to 15 percent of the market for outpatient drugs.)

M Medic~e ~ne~ci~es ac~~ted for 45.2 percent of inpatient hospital @S iII 1989 ~d for 33 Pmcent of the disc~ges (lM).

23 me seven Cowties were the France, Germany, Great Britain, Italy, Japa Swmmrland, ~d tie United States.

24 Emh product was ~v~~ted by severe] expefis, includ~g doctors, p~acisfi, chemists, and phMMWOIOgiStS, each WOddUg ~hkl the

therapeutic area of the new product. The study report contains little detail on the methods used to rate drugs, so the validity of the ratings has

not been vefiled. Over 65 percent of all compounds introduced in 1980-84 and rated as offering added therapeutic benefit were marketed in

at least four of the seven industrialized countries, compared with only 31 percent of the drugs judged to offer no additional benefits.
30 I Pharmaceutical R&D: Costs, Risks and Rewards

Table-l-7—New Chemical and Biological Entities Entering the World Market by

Therapeutic Category, 1975-89

1975-79 1980-84 1985-89

% with % with % with

Total therapeutic gain Total therapeutic gain Total therapeutic gain

Antibiotics

Anticancer

Antivirus

Cardiovascular

Nervous System

Anti-ulcer

Hormones

Anti-lnfIammatory

25

14

3

35

29

3

12

26

36%

64

33

43

35

67

17

23

27

16

2

36

32

7

13

30

44%

50

50

33

25

29

39

13

33

14

8

68

24

15

10

19

27%

36

75

27

17

20

50

5

SOURCE: P.E. Barral, “Fifteen Years of Pharmaceutical Research Results Throughout the Wortd 1975-1989,”

(Antony, France: Foundation Rhone-Poulenc Sante, August 1990).

United States were judged to offer therapeutic

benefits, so well over one-half of all drugs

introduced in the United States were judged to

offer no therapeutic benefit. Over the entire study

period, the majority of drugs in almost every

therapeutic category did not “add something to

therapy’ (see table 1-7). These results suggest the

supply of therapeutic competitors is large and the

potential for price competition in those segments

of the market with price-sensitive buyers is

potentially vast.

The problem with me-too drugs is not that they

are sometimes imitative or of modest therapeutic

benefit. Imitation is an important dimension of

competition, and the more choices consumers

have, the more intense will be the competition.

The personal computer industry provides a clear

illustration of how rapid improvements in quality

can coincide with steep price reductions (46). The

problem with me-too drugs is that a large part of

the market in the United States is very insensitive

to price and does not get the full benefits of price

competition that would be expected from the

availability of an array of similar products.

GENERIC COMPETITION GIVES INSURERS

MORE CONTROL OVER DRUG PRICES

Once a drug loses patent protection, it is

vulnerable to competition from copies whose

therapeutic equivalence is verified by the FDA.

These generic competitors compete largely on the

basis of price, since they can claim no quality

advantage over the brand-name drug.

Private and public health insurers have initiated programs to encourage dispensing of cheaper

versions of multisource compounds (those with

generic equivalents on the market). These strategies include using mail-order pharmacies, waiving beneficiaries cost-sharing requirements when

prescriptions are filled with generic versions, or

refusing to pay more than a certain amount for a

drug with a generic competitor. Medicaid, the

health insurance program for the poor, mandates

substitution with cheaper generic drugs unless the

prescribing physician specifically prohibits it in

writing on the prescription form.

These programs have substantially reduced

brand-name compounds’ unit sales and revenues,

but it takes several years after the compound’s

patent expires for the full brunt of generic

competition to be felt (see figures 1-7 and 1-8).

Indeed, OTA found that 6 years after patent

expiration, brand-name drugs still held over

50 percent of the market in physical units

(table 1-8).

PRICING SYSTEMS DIFFER

ACROSS COUNTRIES

Not only is the market for prescription drugs

segmented among different classes of buyers in

the United States, but it is also segmented

internationally. Pharmaceutical companies
Chapter 1-Summary 31

Table 1-8-Originator’s Market Share for 35

Compounds Losing Patent Protection 1984-87

Dollar Unit

Year Sales Salesb

- 7 100% 100%

- 6 99 100

- 5 99 100

- 4 99 100

- 3 99 100

- 2 99 100

-1 99 100

0 95 94

+1 86 73

+2 84 65

+3 84 57

+4 85 51

+5 83 44

+6 85 62

a year O i.s the year of patent expiration.

b unit sales are measured in defined daily dose.

SOURCE: Office of Technology Assessment, 1993, based on SW.

Schondelmeyer, “Economic Impact of Multiple Source

Competition on Originator Products,” contract paper prepared for office of Technology Assessment, U.S. Congress,

December 1991.

charge different prices for the same drug in

different countries (439a,457).

Most other industrialized countries have universal health insurance that includes prescription

drugs, so patients’ demand for drugs is not very

sensitive to the price charged. Nevertheless, the

prices paid tend to be more strictly controlled by

the third-party payers in these countries than in

the United States. Drug payment policy in each of

these other countries is governed by two potentially conflicting objectives: minimization of

health insurance prescription drug costs and

encouragement of the domestic pharmaceutical

industry. National prescription drug payment

policies represent a blend between these objectives. In other industrialized countries, drug

payment policy is generally developed with

explicit recognition of the two policy objectives.

Virtually all of the five countries whose

pharmaceutical reimbursement systems OTA

reviewed—Australia, Canada, France, Japan,

and the United Kingdom—use some mechanism for controlling the price of single-source

as well as multiple-source drugs. Four of the

five countries do so directly by setting payment

rates for new drugs based on the cost of existing

therapeutic alternatives. The pricing policies in

these countries reward pioneer, or ‘ ‘breakthrough,’ ‘

drugs with higher prices than me-too drugs,

although they accomplish this objective through

different mechanisms, and the prices of breakthrough drugs may still be low in comparison

with those obtained in the United States.

These countries obtain reduced prices for new

drugs through pricing systems that do not use

market mechanisms or price competition to determine the demand for prescription drugs. They use

price regulation or price control as a substitute for

price competition. The importance of politics in

determining g prices in countries with price controls is illustrated by the favorable prices explicitly granted to locally developed or manufactured

products in some of the countries whose pharmaceutical payment systems OTA examined. In

contrast, prices in the United States are determined in the market, but, because of the structure

of health insurance, a large part of the market

gives inadequate consideration to price in making

prescribing and purchasing decisions.

I Implications of Increasing Price

Competition for R&D

If the price-sensitive segment of the market for

health care services in the United States continues

to grow, either through natural evolution or

through a national health reform initiative, revenues from many existing and new drugs would

fall as price competition expands. The United

States accounts for 27 percent of total spending on

ethical pharmaceuticals among countries in the

Organization for Economic Cooperation and Development and is the largest single national

market. Changes in the U.S. market therefore can

have a major impact on worldwide pharmaceutical revenues.

A decline in expected revenues would reduce

a drug’s expected returns and would certainly

cause R&D on some new drug products to be

discontinued or reduced. The market may not

support as many close competitors in a therapeu-
32 I Pharmaceutical R&D: Costs, Risks and Rewards

tic class. R&D on me-too drugs could decline as

firms come to realize that the makers of pioneer

drugs will respond to competition with price

reductions of their own.

Research on pioneer drugs could also decline

as firms realize that the returns to the winner are

likely to be reduced by early price competition

from me-too drugs. Fewer competitors might

follow each specific line of research, and companies might choose to specialize in certain scientific or medical areas. How such dynamic changes

in the R&D environment might affect aggregate

R&D investment is impossible to predict with any

certainty. Much would depend on the supply of

technological opportunities, regulatory barriers to

new drugs, and the present availability of acceptable therapies for specific diseases. It is likely,

however, that industrywide investment in R&D

would grow more slowly or even decline.

Systems that control prices, especially those

that control the launch prices of new drugs, also

affect R&D, and it is even more difficult to predict

the directions or overall magnitude of their effect

on R&D. The effects would depend on how prices

were set and how high they are. For example, a

system that controlled only the prices of me-too

drugs could have effects on R&D that are very

different from a system that controlled all new

drug prices. Price regulation adds an additional

level of uncertainty to the process of R&D which,

as a new risk, lowers expected returns from R&D

investments,

Would a decline in R&D or a slowdown in its

rate of growth be a bad thing? A widely accepted

principle is that, left to its own devices, private

industry invests too little in R&D. The patent

system, which offers temporary monopolies over

new products, processes, and uses, is built on this

principle (366). The monopoly granted by patents

allows firms to charge more for inventions than

they could without such protection from competition. Other public policies, such as subsidies and

tax policies that favor R&D, are predicated on the

assumption that patents alone are insufficient to

bring forth the level of R&D that maximizes the

general welfare of society. The high direct

Federal subsidies of basic research and training of

scientific personnel are a result of the principle

that private industry has inadequate incentives to

engage in basic research.

Despite this general principle, there is no

theoretical basis for predicting that R&D is

always lower than the socially optimal level.

When R&D takes place under conditions of

rivalry, as it certainly does in pharmaceuticals,

that rivalry can lead to wasteful and duplicative

R&D efforts and lower returns to the public as a

whole than to private industry (102,170,222,

338,365,418). That is, the public can end up

paying too much for the benefits it receives from

the competitive R&D. The relationship between

private and social returns depends on many

factors, such as the cost of innovation, the

profitability of existing products the innovation

will replace, how easy it is for rivals to copy

innovations, how easy it is for a new company to

enter a particular field, and how rival companies

react to each others’ moves (222,365).

Statistical studies of the private and social rates

of return on R&D in other industries generally

find rates of return on R&D to the public as a

whole substantially greater than private rates of

return on R&D (166). Yet, in the pharmaceutical

industry health insurance weakens the role of

price competition, so findings from other industries are not germane to pharmaceuticals. Because the “appropriate” level of demand for

prescription drugs in the United States cannot

be inferred from the existing level of demand,

it is impossible to know whether on the whole

there is too much R&D or too little R&D on

new drugs.

THE REGULATION OF

PHARMACEUTICAL R&D

Numerous regulations at both the State and

Federal level in the United States control the

products of the pharmaceutical industry. But, the

Federal Food, Drug, and Cosmetic (FD&C) Act

has the greatest influence over the drug R&D

process. As the agency charged with implementing this body of law and regulation, the FDA has
Chapter 1–Summary 33

slowly grown in importance since its inception in

1938.

Regulatory requirements unquestionably increase the cost and time necessary to bring a new

drug to market. Because it is difficult to sort out

the effects of regulation from other factors that

could alter drug R&D time and costs, however,

the effect cannot be quantified. Most studies of

the impact of FDA regulation on the cost of

bringing new drugs to market examined the effect

of the 1962 Kefauver-Harris Amendments, which

added the requirement that drugs must be shown

to be effective as well as safe before they can be

approved for marketing, Little attention has been

paid to how more recent management and regulatory changes at the FDA altered the resources

required for the drug R&D process.

Since 1977, the FDA has undertaken a number

of initiatives to simplify and clarify the new drug

review process and to expedite the review of new

drugs identified by the agency as therapeutically

important. Most of the initiatives were implemented in the late 1980s, so their effects, if any,

on the cost or speed of the R&D process may not

yet be discernible.

One initiative designed to make important but

not-yet-approved drugs for life-threatening conditions available quickly to the public is the

Treatment Investigational New Drug (IND) program. Established in 1987, the Treatment IND

program codifies a long-standing agency practice

of releasing investigational drugs to practicing

physicians on a case-by-case basis for use in the

treatment of immediately life-threatening diseases where no immediate alternative treatment

exists. To date, 23 drugs have been made available under this program.

A unique feature of the Treatment IND program is that the sponsoring firm may sell the drug

to patients under the program at a price that covers

not only manufacturing and handling costs, but

R&D as well. Five Treatment INDs have so far

Photo credit’ NAT/ONAL /NST/TUTES OF HEALTH

Aerial view of the National Institutes of Health campus in

Bethesda, Maryland. Over $2 billion is spent each year on

intramural research in Federal biomedical laboratories.

been supplied by the sponsor at a price. In the case

of alglucerase, the drug’s manufacturer generated

$5 million in revenue through the Treatment IND

while the drug was still in the R&D process (141).

Selling investigational new drugs under the

Treatment IND program allows companies to

generate returns on their R&D investment before

the FDA has certified that the drug is safe and

effective. The FDA, the agency responsible for

reviewing companies’ requests to charge under a

Treatment IND, lacks the expertise and the

authority to determine whether cost data provided

by companies are accurate and justify the price

they wish to charge. In the case of CeredaseTM

,

the price charged under the Treatment IND ($3.00

per unit) was only slightly lower than the drug’s

price after the drug was approved for marketing

($3.06 per unit in 1991 net of free goods,

uncollected revenues and rebates to the Medicaid

program) (141),

FEDERAL TAX POLICIES AFFECTING

PHARMACEUTICAL R&D

In 1987, drug companies claimed $1.4 billion

in credits against their Federal income taxes.25 Of

‘s This docs not include over $9(XI million foreign tax credits. Unlike other tax crexhts which are designed to stirnula[c certain types of

behavior among taxpayers, foreign tax credits are simply a mechanism to prevent LT.S. firms from being taxed twice on income earned in another

country.
34 I Pharmaceutical R&D: Costs, Risks and Rewards

this amount, only about $90 million was for

credits whose specific purpose was to stimulate

R&D. The tax credit for conducting business

operations in U.S. possessions such as Puerto

Rico accounted for over $1.3 billion in foregone

taxes from the pharmaceutical industry in 1987.

Pharmaceutical companies are the main beneficiary of this tax provision, claimin g just over 50

percent of all dollars claimed under this credit in

1987. Overall, the tax credits reduced the amount

of taxes drug companies would have otherwise

owed the U.S. Government by 36 percent and

equaled 15 percent of the industry’s taxable U.S.

income.

Although the aggregate value of R&D-oriented

tax credits earned by the industry is relatively

small ($105 million), the pharmaceutical industry

is a major user of such credits (table 1-9). The

pharmaceutical industry earned almost 10 percent

of all R&D oriented tax credits in 1987. The

industry’s differential ability to use such credits

attests to its greater research orientation than

other industries and the rapid growth of its

research expenditures. These credits represent an

indirect subsidy to the industry for undertaking

activities deemed to be in the public interest.

FEDERAL SUPPORT FOR

PHARMACEUTICAL R&D

The Federal Government is the mainstay of the

country’s health sciences enterprise. Healthrelated R&D reached almost $10 billion in 1990.

Some of this money is spent in government

laboratories on intramural research ($2.6 billion

in 1990), but the vast majority of this federally

sponsored health-related R&D is awarded to

universities and private nonprofit laboratories

through extramural grants and contracts. The

money not only supports scientists but also has

paid for much of the infrastructure of health

research facilities in use today at American

universities. The Federal Government also provides the bulk of support for training scientific

personnel. Some of that training is paid for under

research grants and contracts, but in 1989 alone

Table 1-9—Research Tax Credits Earned by the Pharmaceutical Industry in 1987a

Aggregate credit Number of firms

claimed ($ thousands) claiming credit

Aggregate credit earned

as a percent of aggregate

earned by all Industries

Research and experimentation tax creditb

Firms with assets <$50 mill ion.. . . . . . . . . . . . . . . . . . $6,455 147

Firms with assets > $50 million and < $250 million. . 2,042 9

Firms with assets of $250 million or more. . . . . . . . . . 88,878 28

All firms. . . . . . . . . . . . . . . . . . . . . ., . . . . . . . . . . . . . . 97,375 184

University-based basic research tax credits

firms with assets < $50 million. . . . . . . . . . . . . . . . . . . 3 90

Firms with assets > $50 million and < $250 million. . . 0 39

Firms with assets of $250 million or more. . . . . . . . . . 2,257 43

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,260 990

Orphan drug tax credits

Firms with assets <$50 million. . . . . . . . . . . . . . . . . . . 0 0

Firms with assets > $50 million and< $250 million. . 0 0

Firms with assets of $250 million or more, . . . . . . . . . 5,358 8

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,358 8

3.10/0

2.0

12.6

9.6

17.3

0.0

10.7

6.4

—

—

84.3

84.3

a Estimates for tax year 1987 are from the LLS. Treasury’s Statistics of Income (SOI) sample weighted to reflect relevant populations.

Pharmaceutical industry is defined as SOI industry group 2830 minus firms with assets of $250 million or more and known not to be involved in

pharmaceuticals. Tax Credits earnedare notequivalentto taxcxedits claimed because the former does not reflect insuff icient tax liability in current

year, or carry-forwards from previous years.

b Research and experimentation credit estimates are net of university-based basic research Cdit.

SOURCE: Office of Technology Assessment, 1993. Estimates provided by U.S. Congress, Joint Committee on Taxation.
Chapter 1--Summary I 3 5

the NIH spent $256 million on 11,585 training

awards in the life sciences.

Although most of the research supported by the

NIH and other Federal health research organizations is aimed at understanding the basic mechanisms of health and disease, the Federal Government supports a substantial amount of research

directly targeted to the development of new

pharmaceuticals. OTA estimates that NIH and

other Public Health Service (PHS) research organizations spent approximately $400 million in

1988 for preclinical pharmaceutical research and

$250 million for clinical pharmaceutical R&D.

This spending includes 13 targeted drug development programs whose specific mission is to

develop new medications for particular diseases

or conditions.

The pharmaceutical industry is particularly

adept at mining the motherlode of knowledge

created by government-sponsored biomedical research and training. The pharmaceutical industry

benefits from the Federal investment in extramural and intramural research through its collaborations with universities and academic researchers

and through its contacts with intramural researchers at NIH and other Federal health research

laboratories. In the past decade, Federal technology transfer policies have provided new incentives for both federally supported academic researchers and government researchers to collaborate with private industry in bringing to the

market patentable inventions arising from federally supported research.

H Federal Technology Transfer Policy

Today, any inventions arising out of the

substantial Federal support to academic research

are essentially the property of those institutions.

The Bach-Dole Patent and Trademark Act of

1980 (Public Law 96-517) gave universities,

nonprofit organizations and small businesses the

rights to inventions resulting from research supported with Federal grants. This law was in part

the impetus for the creation in the 1980s of

university-sponsored enterprises whose purpose

is to commercialize biomedical research findings.

Universities and nonprofit organizations can license their valuable inventions to commercial

enterprises and share in the revenues the inventions generate.

Inventions arising from the $2.6 billion annual

investment in intramural Federal research have

also been encouraged by legislation whose purpose is to foster commercial innovation. The

Stevenson-Wydler Technology Innovation Act of

1980 (Public Law 96-480) made the transfer of

Federal technology to the private sector a national

policy and a duty of Federal laboratories. Among

its provisions, the act required that Federal

laboratories spend at least 0.5 percent of their

research budgets on efforts to transfer technology

from the laboratory to the marketplace. Additional legislation in 1984 directed the Department

of Commerce to issue regulations governing

licensing of technologies developed in Federal

laboratories (Public Law 98-620).

These initiatives proved insufficient to bring

about the desired amount of formal interaction

between government and industrial scientists.

The Federal Technology Transfer (FIT) Act of

1986 (Public Law 99-502) followed with financial and professional incentives to Federal scientists to actively pursue the commercialization of

their inventions. The act also requires Federal

agencies to share at least 15 percent of royalties

from any licensed invention with the inventing

scientists, and it directs agencies to establish cash

awards with other personnel involved in productive Federal technology transfer activities.

The legislation also permitted Federal laboratories to enter into formal cooperative research

and development agreements (CRADAs) in which

a Federal agency provides personnel, services,

facilities, equipment or resources (but not money)

and a private company provides money, personnel, services, facilities, equipment or other resources for R&D. The law leaves implementation

of CRADA policy up to the research agency, but

as part of a CRADA the Federal laboratory can

agree in advance to grant licenses to the collaborating partner on any inventions resulting from

research under the agreement.
36 I Pharmaceutical R&D: Costs, Risks and Rewards

250

200

150

100

50

0

Figure l-n-Public Health Service Patent

Applications and Patents Issued, 1987-90

Number of patents ———

T-- 1

1987 1988 1989 1990

~ Patent applications _ Patents issued

SOURCE: The Office of Technology Asse.ssment, 1993. Based on data

from U.S. Department of Health and Human Services,

Public Health &vice, National Institutes of Health, Office of

Technology Transfer, 1991.

Early data suggest that the FTT Act may be

successful in increasing the patenting of inventions created in Federal biomedical research

laboratories. The number of patents filed annually

by the Public Health Service (which includes

NIH) has grown dramatically since 1987, the first

year for which data on PHS patents are available.

The number of applications more than doubled

between 1987 and 1989 alone (figure 1-11).

1 Licensing Inventions from

Federal Laboratories

The Federal government has steadily increased

the number of licenses issued on its biomedical

patents throughout the 1980s (figure 1-12). Royalties paid to the inventing agency typically do

not exceed 5 to 8 percent of the resulting product

sales. The PHS policy is to grant exclusive

licenses only in cases where substantial additional risks, time and costs must be undertaken by

a licensee prior to commercialization (484,486).

Otherwise, PHS tries to negotiate nonexclusive

Figure l-12—Licenses Issued by the U.S.

Department of Health and Human Servicesj

Fiscal Years 1977-91

Number of license agreements

60 ]---––—— ------ —

40-

20-

01-q-lm 1

‘1977 78 79 80 81 82 83 84 85 86 87 88 89 90 91

Type of license

D Research/evaluation _ Exclusive

~ Nonexclusive

a Number in fi~al year 1991 annualized from the number of agreements reached during first 4 months of the year.

SOURCE: Office of Technology Assessment, 1993. Based on data

from U.S. Department of Health and Human Services,

Public Health Service, National Institutes of Health, Office of

Technology Transfer, 1991.

licenses. Firms collaborating with Federal health

laboratories under CRADAs, however, may have

built into the CRADA at its inception the right to

negotiate an exclusive license to any invention

arising out of the collaboration. The advent of

CRADAs in recent years26 may portend even

more exclusive licenses in the future.

Royalty income to PHS agencies from licenses

is a small fraction of the total PHS intramural

budget. In 1988, the total NIH royalty income was

just 0.03 percent of total NIH intramural spending. NIH takes the position that the purpose of

royalties is to stimulate technology transfer by

“offering an attractive incentive to encourage

[PHS] scientists to participate in collaborations

26109 Sepmate agreements were si~ed by the end of fiscdyear 1990.
Chapter 1--Summary ! 37

with industry. , .’ rather than to augment or

replace funds appropriated by Congress for research (75).

The net returns to both the NIH scientists and

the commercial firm rise and fall directly with the

ultimate price of the product to consumers

(individual patients and their private and public

health insurers). The PHS policy governing

exclusive licenses, including those granted under

CRADAs, requires that prices of commercial

products be commensurate with the extent of

‘ ‘public investment in the product, and the health

and safety needs of the public’ (486). The policy

further states that licensees may be required to

provide ‘ ‘reasonable evidence’ to support their

pricing decisions, To date, this policy has been

implemented only in one case—the antiviral ddI,

manufactured under an exclusive license by

Bristol-Myers Squibb.

At present, the PHS has no established

mechanism or standards for reviewing the

reasonableness of prices for products marketed under exclusive licenses and lacks the

legal authority to enforce its policy in cases

where prices would be deemed unreasonable.

The need for review of prices of drugs licensed

from public agencies results from the failure of

the market for prescription drugs to assign appropriate values to new technologies. Because most

patients have health insurance policies that pay

for a large fraction of the charges for covered

drugs and other health care products and services,

they may be willing to “purchase” such care

even when it is worth less to them that what the

seller charges. Insurers have little flexibility in

choosing what pharmaceuticals to cover and what

prices to pay.

Although the question of what is a “reasonable” price is subject to differing interpretations,

the term is commonly used to mean the price

charged does not greatly exceed the full cost of

researching, developing, manufacturing, marketing and distributing the drug, where cost includes

a return on the investment sufficient to cover

investors’ risks or failure and opportunity costs of

capital.

OTA’s contractor study of the costs of developing and manufacturing the drug CeredaseTM

demonstrated that determining such costs is a

difficult task. Expertise in cost analysis is critical

to such a review. Even the best and most

sophisticated efforts to assess costs will fall short

if they are not based on an audit of detailed cost

accounting data. Access to such data is possible

only with full cooperation of the company producing the drug.

Implementing PHS’s fair pricing clause for

exclusive licenses in more than a cursory way

could conflict with the Federal goals of technology transfer and the collaborative development of

new medicines with industry. When faced with

potential government scrutiny of their books and

manufacturing processes, some firms may opt not

to license drug technology developed at NIH.

Whether such reactions would be frequent enough

or universal enough to delay the availability of

new therapies can only be judged through experience. So far, NIH has been reluctant to take on the

task of demanding detailed cost information as

part of its technology transfer function.
Research and

Development Expenditures 2

T

his chapter summarizes trends in pharmaceutical research and development (R&D) spending and compares

estimates from available data sources. In short, the

pharmaceutical industry invests more intensively in

R&D than do most industries, and expenditures in constant

dollars have risen at an astonishing rate of roughly 10 percent per

year. Since 1980, pharmaceutical firms in the United States and

abroad have devoted an increasing proportion of total sales to

R&D. How much is spent? What does this record of increasing

real investment in R&D say about the costs and returns to

pharmaceutical R&D, both in the past and in the future? This

chapter addresses these questions.

HOW TO MEASURE R&D SPENDING

There is no single comprehensive source of data on worldwide

spending for pharmaceutical R&D. Because the researchintensive pharmaceutical industry is a mix of large multinational

companies and small research-oriented firms, it is difficult to

capture all R&D spending on human-use pharmaceuticals in one

data source. R&D data come from three main sources: industry

trade associations, governments, and companies themselves.

The Pharmaceutical Manufacturers Association (PMA) is the

main source of industry trade data on R&D conducted in the

United States by its member companies and abroad by its

U.S.-based businesses.1 PMA publishes an annual survey of its

60 corporate members, representing about 100 business entities.

* Domestic R&D data are for PMA members that are U.S.-based companies and U.S.

subsidiaries of foreign companies, Data on foreign R&D expenditures reflect only PMA

members that are U.S.-based companies.

39
40 I Pharmaceutical R&D: Costs, Risks and Rewards

In addition, in 1991, the Centre for Medicines

Research, an arm of the Association of the British

Pharmaceutical Industry, conducted a survey of

pharmaceutical industry trade associations in

nine European countries, Japan and the United

States (172).

U.S. Government data on domestic R&D

expenditures by industry are available from the

National Science Foundation (NSF) Survey of

Industrial Research and Development conducted

routinely since 1956. Each firm in the sample is

classified by a three-digit Standard Industrial

Classification (SIC) Code.2 The U.S. Census

Bureau on behalf of NSF collects data on total

companywide domestic R&D expenditures. The

estimates for drug companies (SIC 283) include

all R&D conducted in the United States in

company-owned and -operated facilities. Unfortunately, nonpharmaceutical R&D may be included in the estimates.

Also, the composition of firms in the pharmaceutical industry changes as mergers and acquisitions

alter SIC codes. For example, the acquisition in

1985 of G.D. Searle Company by Monsanto

Corporation, a chemical firm, probably caused

Searle’s spending on R&D to be counted in SIC

281 (chemicals) in subsequent years. Because the

SIC classifications change with merger and acquisition activity, NSF is probably a less reliable

source of industrywide R&D growth rates than is

PMA.

Company data are also available from annual

reports and filings with the Securities and Exchange Commission (SEC). CompustatTM 3 publishes audited company financial data for over

13,000 publicly traded companies in the United

States. The data are organized by four-digit SIC

code; firms are assigned to a primary SIC

category by CompustatTM staff using industry

definitions from the SIC manual, but there is no

guarantee that firms will be given the same SIC

code as the NSF survey (387). Like the NSF

survey, CompustatTM data on R&D spending

include companywide estimates, including both

pharmaceutical and nonpharmaceutical R&D.

The CompustatTM estimates include both foreign

and domestic R&D conducted by the reporting

companies. Between 1971 and 1990, 133 firms

were listed as pharmaceutical companies during

at least 1 year of that period.4

Estimates of total industry R&D expenditures

built from individual companies’ financial records (i.e., PMA and Compustat) may be overstated because of certain accounting practices that

can lead to double counting of such costs at the

industry level. The purchase of the right to further

develop a product is considered a purchase of

“in-process R&D” for accounting purposes. If

one company synthesizes a new drug, for example, and licenses it to another company for clinical

development and marketing, the company purchasing the right in exchange for an upfront cash

payment and future royalty payments may acPhoto credtt: ELI LILLY AND COMPANY

The pharmaceutical industry’s investment of approximately $6

billion on R&D is one of the most intensive of all the

R&D-oriented industries.

~ The Standard Industmd Classification system IS a method used to assign firms to industries according to the products or services they sell

( 126).

3 CompustatTM is a commercial on-line, time-series database service of Standard & Poor’s, publisher of business reference books.

4 Prior to 1975, uniform accounting standards did not exist for reporting R&D spending; hence, data arc reported in this study only for the

pcr]od begmnmg with 1975.
Chapter 2–Research and Development Expenditures 41

count for the upfront cash payment as the

purchase of ‘‘in-process R&D’ (144). This cash

payment may bear no relation to the actual

incurred research expenditures; it is the purchase

price of a valuable asset, whose cost of development was already accounted for (in earlier years)

in the R&D expenses of the first company. The

purchase price may include not only the payback

for R&D performed by the first company but also

a payment for the potential market value of the

drug in the future. (A drug with a large potential

market, for example, will have a high licensing

price, even if the R&D costs to date have been

low.)

Conservative accounting practices require that

such upfront payments be expensed, rather than

capitalized as investments, because unapproved

drugs are considered intangible assets of unproven values Some companies, particularly

small ones for which such payments are a

substantial part of their R&D expenses, may

separately identify such transactions as ‘ ‘purchase of in-process R&D.”6 Nevertheless, even

when such transactions are separately identified

in annual financial statements, it is unclear how

the transactions are treated when companies

report their expenditures through surveys such as

those conducted by PMA.

The potential magnitude of the overstatement

of industrywide R&D costs in databases using

company financial statements is illustrated by a

recently-announced strategic alliance between

Centocor, a biotechnology firm, and Eli Lilly and

Company, a large pharmaceutical company. Lilly

acquired the right to collaborate with Centocor on

the commercialization and marketing of Centocor’s promising anti-infective drug, CentoxinTM

in exchange for purchase of Centocor stock and

$50 million in cash (121). The $50-million cash

payment from Lilly to Centocor will probably be

recorded as an R&D expense on Lilly’s financial

statements because CentoxinTM is not yet approved for marketing.7 If Centocor uses the cash

to fund continued R&D on the product, it, too,

will report R&D expenses of $50 million. Then,

industrywide estimates of R&D expenditures that

include both firms recorded R&D expenses

would double count the actual R&D outlays

associated with Centoxin.

The overestimate of R&D costs may have

increased in the 1980s for two reasons. First, the

percent of new chemical entities (NCEs) under

development that are licensed from other companies increased in the 1980s (107). The increasing

frequency of strategic alliances between pharmaceutical firms and small biotechnology firms in

the late 1980s may have added to the trend.

Second, between 1981 and 1987, the R&D

limited partnership was an attractive financing

vehicle for small biotechnology fins. Since the

partnership actually owns the rights to the products of the research, purchase of in-process R&D

by the company would be one way for the

company to buy back the rights to products

developed through the partnership before they are

approved for marketing.

Despite these distortions, the Office of Technology Assessment believes that the overstatement

in estimates based on company financial reports

is still a small proportion of total industry R&D

and does not account for much of the increase in

the recorded rate of change of R&D in the 1980s,

especially domestic R&D. First, PMA’s membership does not include many small biotechnology

companies, so the potential for double counting of

R&D expenditures is reduced. (For example,

5 Once a product is approved for marketing, however, the purchase of rights to market it can be treated as an investment. For example, when

Genentec& Inc. purchased rights to market Protropin (its human growth hormone product) ffom the R&D limited partnership that owned rights,

it accounted for the transaction as a “purchase of product technology’ and amortized the cash outlay over a period of years (145).

s Forexarnple, when Genzyrne, Inc. purchased the rights to further develop the orphan product alglucerase from an R&D limited partnership,

it showed the $20-million price of buying out the partnership as a purchase of “in-process R&D’ (141).

7 The Office of lkchnology Assessment requested Eli Lilly and Company to confirm or correct this interpretation but the company declined

to respond to OTA’S inquiry.
42 I Pharmaceutical R&D: Costs, Risks and Rewards

Centocor is not a member of PMA and is also not

included as a pharmaceutical firm in the Compustat database.) Second, although the R&D limited

partnership grew in use over the 1980s, it

represented a small proportion of the overall

funding of pharmaceutical R&D, and few biotechnology based pharmaceutical products were actually marketed in the 1980s; therefore, few buyouts would have occurred in the period. Third, a

review of annual reports of nine large U.S.

pharmaceutical companies over the period 1978-

89 found no disclosure of unusual R&D expenditures (such as those involving a large cash

payment to another firm), suggesting that such

expenses were not material in these firms (29).

Nevertheless, the overestimation bias could

grow in the 1990s as cross-licensing and strategic

alliances among pharmaceutical companies increase in frequency. The NSF survey does not

suffer from the double counting problem, although its estimates are sensitive to mergers and

acquisitions that change industry classifications.

Because the magnitude of the effect of the

limitations of each database on the resulting

estimates is unclear, it is best to examine all such

estimates together.

TRENDS IN DOMESTIC R&D SPENDING

PMA and NSF each report on R&D performed

by pharmaceutical firms in the United States.

Between 1977 and 1990, domestic R&D spending increased at an annual rate of 13.3 percent in

the NSF survey and 15.1 percent in the PMA

series (see figure 2-1). After adjusting for inflation, the annual increases were 7.6 percent for the

NSF series and 9.4 percent for the PMA series.

Table 2-1 shows the estimated domestic expenditures from 1975 through 1990. R&D spending

increased from $1.1 billion in 1977 to between

$5.7 billion (NSF) and $6.6 billion (PMA) in

1990.

Until 1986, the NSF estimates were higher than

those of PMA. Because the NSF survey measures

total company R&D, including R&D on both

ethical pharmaceuticals and other lines of business, the difference is to be expected. Since 1986,

however, the PMA estimates have exceeded the

NSF estimates. One possibility for this shift is the

impact of mergers and acquisitions in the rnid1980s on industry classification in the NSF series.

Although the two data sources are not completely comparable, both reveal a shift in the

speed of growth in domestic R&D spending by

pharmaceutical companies beginningin the early

1980s. For example, according to NSF, inflationadjusted R&D spending increased at about 7.7

percent per year between 1977 and 1980; between

1980 and 1985 it increased at 8.6 percent per year.

However, between 1985 and 1990 real R&D

spending in the NSF survey increased at only 6.5

percent. PMA data show more striking trends:

between 1975 and 1980 real domestic R&D

spending increased at a rate of 3.5 percent per

year; between 1980 and 1985 it averaged 11

percent and between 1985 and 1990 it averaged

10.7 percent.

Figure 2-1—Domestic Pharmaceutical

R&D Expenditures, 1977-90

$ billions

‘~~

o

I I ( I I I I I I I I I I I

197778 79 80 81 82 83 84 85 86 87 88 89 90

— — NSF — PM A

KEY: NSF = National Science Foundation; PMA = Pharmaceutical

Manufacturers Association.

SOURCES: Pharmaceutical Manufacturers Association, Annual Survey Reports, 1975-91 (Washington, DC: PMA, 1978-91).

National Science Foundation, Surveys of Science Resources Series, Research and Development in Industry:

1987-7988, Detailed Statistical Tables, NSF 89-323 (Washington, DC: NSF, 1989, 1990). National Sdence Foundation, Selected Data on Resear& and Development in

Mustry: 1990, NSF 92-317, Selected Data Tables (Washington, DC: NSF, 1992).
Chapter 2—Research and Development Expenditures 143

Table 2-l—Aggregate Domestic R&D Expenditures,a 1975-90 ($ billions)

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990b

a Includes company, Federal and other funds for R&D.

b Budgeted amounts.

c Federal sources of R&D funds to campanies are excluded in this year.

d Adjusted by GNP implicit price deflator.

KEY: NA - not available.

SOURCE: Office of Technology Assessment, 1993, based on Pharmaceutical Manufacturers Association, Annua/ Survey Reports, 1975-91

(Washington, DC: PMA, 1976-91). National Science Foundation, Surveys of Science Resources Series, Research and Deve/oprnentirr

Musky: 1987-1988, Detailed Statistical Tables, NSF 89-323 (Washington, DC: National Science Foundation, 1989, 1990).

TRENDS IN WORLDWIDE

PHARMACEUTICAL R&D EXPENDITURES

Data on worldwide R&D expenditures by

U.S.-based firms are available both from Compustat TM and PMA. Despite the difference between the two sources in coverage of R&D

expenditures, total R&D conducted by U. S,-

based pharmaceutical companies in 1975 was

estimated at $1.1 billion by both PMA and

Compustat TM (table 2-2). By 1990, this spending

had grown to between $7.9 billion (CompustatTM)

and $8.1 billion (PMA). These data suggest that

after adjusting for inflation, foreign and domestic

R&D spending by U.S.-based companies increased at approximately 8 to 8.5 percent per year

between 1975 and 1990. The rate of increase

appears to have accelerated, however. Before

1980, real worldwide R&D expenditures of U.S.

firms increased only by 5 to 6 percent per year

(table 2-2). Between 1985 and 1990, PMA data

show a 10.9 percent annual rate of increase in real

spending. 7 Compustat TM data show a rate of

Table 2-2—Aggregate Pharmaceutical Foreign and Domestic R&D, Selected Years ($ billions)

Annual percent rate of change

1975 1980 1985 1987 1990 1975-80 1980-85 1985-90

Compustat TMa

Current dollars. . . . . . . . . . . . . . . . . $1.10 $2.08 $4.20 $5.53 $7.90 13.6% 15.1% 13.5%

Constant 1990 dollarsb

. . . . . . . . . . 2.44 3.19 4.98 6.19 7.90 5.5 9.3 9.7

Pharmaceutical Manufacturers Associationc

Current dollars. . . . . . . . . . . . . . . . . 1.06 1.98 4.08 5.51 8.13 13.2 15.6 14.8

Constant 1990 dollars. . . . . . . . . . . 2.36 3.03 4.83 6.17 8.13 5.2 9.8 10.9

a Figures are based on a total of 133 firms listed in the Compustat file under Standard industrial Code (SIC) code 2834 in at least 1 year between

1971 and 1990. The number of firms vary from year to year due to firms’ entry and exit from SIC 2834.

b Adjusted by GNP implicit price deflator.

c R&D expenditures reported by Pharmacuetieal Manufacturers Association member firms.

SOURCE: Office of Technology Assessment, 1993, based on unpublished data provided by S.H. Kang, School of Industrial Administration,

Carnegie-Mellon University, Pittsburgh, PA; Pharmaceutical Manufacturers Association, Anrrua/Swvey Reports, 197S91 (Washington,

DC: PMA, 1976-91).

T Because spending in various countries must be converted into a common currency, exchange rate changes can affect reported spending.

The devaluation of the dollar after 1985 maybe responsible for some of the unusuaUy high increase in total spending reported in recent years.
44 I Pharmaceutical R&D: Costs, Risks and Rewards

growth in real spending of 9.2 percent per year

between 1985 and 1990.

The Centre for Medicines Research estimates

total expenditure on pharmaceutical R&D in 11

industrialized countries increased from $5.4 billion in 1981 to $15 billion in 1988 (172).

Estimated spending (in current dollars) accelerated after 1985, increasing 22 percent per year

between 1985 and 1988, compared with 10.5

percent per year between 1981 and 1985.

Thus, although a comprehensive source of data

on worldwide R&D spending is unavailable, the

existing data sources point to an accelerating rate

of increase in real spending on R&D throughout

the 1980s.

DIRECTIONS OF PHARMACEUTICAL R&D

Where have the increasing funds devoted to

pharmaceutical R&D been applied? Have they

been used increasingly for the advancement of

scientific knowledge within companies? Have

they been increasingly targeted to discovery and

development of drugs that treat diseases through

entirely new modes of action (“breakthrough”

drugs) or have they been targeted to new drugs

similar in structure and mode of action to products

already on the market (so-called “me-too’ drugs)?

To what extent have they been used to support the

development of product extensions or to research

new uses of existing drugs?

The data available on trends in R&D do not

provide answers to these questions. PMA is the

only source of data on the allocation of R&D

across different kinds of functions, and the PMA

fictional classification system is not germane to

these questions (table 2-3). Unfortunately, these

categories cut across all kinds of research and

cannot even be used very accurately to estimate

the proportion of R&D that is for drug discovery

versus clinical testing. Spending by fictional

category has remained relatively stable over time.

Companies reporting to PMA also provide estimates of the percent of R&D devoted to “the

advancement of scientific knowledge and development of new products” versus “significant

improvements and/or modifications of existing

Table 2-3-Distribution of R&D Expenditures by Function, Selected Years 1976-89a ($ millions)

Function 1976 1977 1978 1980 1982 1985 1987 1988 1989

Clinical evaluation: phases 1,11,111 ... ..$20.2

Biological screening and

pharmacological testing. . .........19.5

Synthesis and extraction. . . . . . . . . .. .16.6

Pharmaceutical dosage formulation

and stability testing. . . . . . . . . . . . . . . 9.1

Toxicology and safety testing. . . . . . . . . 8.9

Process development for manufacturing and quality control. . . . . . . . . . 9.5

Clinical evaluation: phase IV. . . . . . . . . . 3.2

Regulatory, IND and NDA preparation, submission and processing. . . . 3.3

Bioavailability studies. ... , . . . . . . . . . . 2.2

Other. ... , , . . . . . . . . . . . . . . . . . . . . . . . 7.5

Percent of pharmaceutical R&D devoted developing new products. . . . . 79%

$17.8

18.7

17.2

9.7

9.2

8.8

4.7

3.3

2.3

8.3

80%

$16.5 $19.8 $19.9 $21.0 $24.0 $26.4 $26.7

18.8 18.6 17.9 16.6 16.8 16.7 16.9

16.3 15.4 11.6 11.6 10.3 10.3 9.8

10.1 9.2 10.4 9.3 9.1 9.1 9.4

10.0 9.7 8.9 8.9 8.3 7.8 7.0

9.2 9.0 9.5 9.4 9.4 9.1 7.3

4.8 3.7 3.2 5.0 4.4 3.5 4.0

3.6 4.1 3.9 4.4 3.6 3.0 3.3

2.2 2.1 2.8 2.9 3.0 2.8 2.6

8.5 8,4 11.9 10,9 11.1 11.3 13.0

80% 81% 79% 82% 83% 82% 82%

a Bas~ on R&D conducted in the United States by all PMA members.

KEY: IND - investigational new drug application; NA = not available; NDA - new drug appiimtion.

SOURCE: Pharmaceutical Manufacturers Association, Annua/ Survey Reports, 1975-91 (Washington, DC: PMA, 1976-91).
Chapter 2—Research and Development Expenditures ! 45

products" (320). How firms define new products

or modifications of existing products is unclear,

however, and the reliability of these estimates

cannot be verified. Nevertheless, the data do

suggest a relatively stable mix of R&D ove r

time—about 80 percent devoted to new-product

R&D (table 2-3).

There is only sketchy information on trends in

the allocation of new-product R&D between

discovery research and clinical trials. DiMasi and

colleagues asked 12 U.S. companies to estimate

R&D expenditures for clinical and preclinical

research on self-originated NCEs for the period

1970-86 ( 107). Over the entire period, 66.1

percent of research on self-originated drugs was

reported as devoted to the preclinical phase. No

clear trends were evident in the ratio over time

(106), suggesting the allocation of R&D dollars

has remained stable over time.

Early signs are emerging that the output of

R&D--new products—is increasing modestly.

Though the number of new molecular entities

(NMEs) 9 approved by the U.S. Food and Drug

Administration (FDA) remained fairly constant

throughout the 1980s—at a mean of 22.5 per year,

the number of commercial investigational new

drug (IND) applications for initiation of clinical

testing of NMEs has increased over the decade.

From 1980 to 1982, the Center for Drug Evaluation and Research (CDER) of the FDA issued an

average of 271 commercial INDs annually while

during the 1988-90 period, the average rose to 349

per year (475). Because more than one IND can be

filed for each compound, a better indicator of

trends in productivity of research, especially early

research, is the number of NCEs entering testing.

Data from a sample of over 40 companies indicate

that the number of INDs for NCEs increased from

210 per year between 1975 and 1978 to 299 per

year between 1983 and 1986 (107).10 The total

Photo credit ELI LILLY AND COMPANY

The introduction of biotechnology-derived drugs has

increased rapidly since the first FDA approval in 1982 of Lilly’s

recombinant DNA product, Humlin.

number of NCEs entering human testing in

U.S.-based firms grew from 58 per year in the late

1970s to 67 per year between 1983 and 1986.

Although INDs for NCEs originated in U. S.-

based firms grew by 25 percent between the

periods, the percent of all NCE INDs for selforiginated U.S. drugs declined from 60 to 53

percent between the two periods. Licensed-in

drugs and INDs submitted by foreign firms grew

as a proportion of total NCE INDs submitted to

the FDA.

The number of biotechnology drugs in development increased dramatically over the period.

Between 1982—the year the FDA approved the

first biotechnology-derived drug (Eli Lilly’s recombinant human insulin j-and 1991, the FDA

had approved a total of seven biotechnology

drugs; however, as of October 199121 biotechnology drugs were awaiting FDA marketing

approval (146). Chapter 6 discusses the potential

backlog of approvals for biotechnology drugs in

greater detail.

g The terms ‘ ‘new chemical entity’ (NCE) and “new molecular entity’ (NME) both refer to new drugs, although their precise definitions

arc somewhat different. DiMmi ct al, define NC% as ‘‘a ncw molecular compound not previously tested in humans. ’ NME is a term USed by

the FDA that, unlike NCE, includes some diagnostic agents and excludes therapeutic biological t109,474). In keeping with DiMasi’s

definition, this report uscs the term NCE to refer to both therapeutic drugs ,and biological. OTA uses the lerm NME only when discussing work

that specifically employs FDA’s definition of that term.

I(J DIMa~l ~d ~ollcaWcs ~so ~ivc infomatlon on the 1979.~~ pcrio(f, SCC Chptcr (5 for more detail,
46 I Pharmaceutical R&D: Costs, Risks and Rewards

INTERPRETING AGGREGATE TRENDS

Each new dollar spent on pharmaceutical R&D

is an investment in a potential stream of future

revenues. Although investors make mistakes,

their decisions are a true reflection of expectations about the future. The rapid increase in total

industrywide pharmaceutical R&D in constant

dollars in the 1980s means that investors expected

aggregate net revenues over the lifetimes of the

new products would be sufficient to justify the

additional investment with its attendant risks.

Little more can be concluded from an examination of R&D spending trends. For example,

investors might or might not expect the number of

drugs approved for marketing to increase in the

future. The R&D could be directed toward fewer

products with more lucrative markets, or it could

be directed to the introduction of a large number

of products, each with more modest market

potential.

Some of the R&D might be directed to the

development of “me-too” drugs that do not

substantially enlarge the overall market but share

an existing market with close therapeutic substitutes. The pursuit of “me-too” drugs is an

attempt by rival firms to shave off part of the

monopoly profits enjoyed by the maker of the

pioneer drug in a therapeutic class.ll The higher

the initial monopoly profits, the more incentive

rivals have to develop a similar competing drug

(102,346,363,418). Thus, the increased R&D in

the 1980s could in part be a response to high

returns to pioneer drugs developed in the 1970s.

R&D dollars pursue returns, and the risks

investors will take to obtain those returns depend

on how great they promise to be. To understand

the drivers behind the pharmaceutical R&D

phenomenon of the 1980s, it is necessary to

examine closely how the returns to these investments have been changing over time. Subsequent

chapters of this report examine trends in the

average cost of discovering and developing new

ethical pharmaceuticals and the net returns to

bringing these products to market.

1 I Pionea ~d “me-t~’ &ugs m granted monopolies by the United States and other countries’ p~~t SYStCmS, which Protit pa~~

pharmaceutical compounds (or their manufacturing processes or uses) from copy for spezitlc periods from the date of application or issue. Even

with a strong paten~ the monopoly may be limited by the availability of similar drugs in the therapeutic class, of competing classes of drugs,

or of nonpharrnaceutical therapies.
T

The Costs of

Pharmaceutical R&D 3

his chapter brings together existing evidence on the cost

of bringing new pharmaceuticals to market. It begins

with background on how to measure such costs and then

moves to an assessment of existing studies of research

and development (R&D) costs. These studies are retrospective:

they estimate the costs of R&D for pharmaceutical products

developed and brought to market in the past. R&D costs can

change quickly as underlying scientific, technical, or regulatory

conditions change, so it is dangerous to predict much about the

future, or even about today’s R&D costs, from studies of past

costs. In the last part of the chapter, the Office of Technology

Assessment (OTA) examines recent trends in some critical

components of the cost of bringing new drugs to market.

A FRAMEWORK FOR ESTIMATING R&D COSTS

R&D is an investment in a potential future stream of revenues

from the sale of successful new drugs. Unlike other kinds of

investments, such as a new manufacturing plant, the success of

a pharmaceutical R&D investment is highly uncertain and may

take many years to be realized. The investors in pharmaceutical

R&D must be able to “expect” not only to recoup their actual

cash outlays for R&D but also to be compensated for the risk they

took of losing their investment altogether and for the time they

spent waiting for the investment to pay off. Without such an

expectation, no investor would put his or her money on the line.

The full cost of the R&D investment can be thought of as the

minimal ‘expected’ payoff required to induce the investor to lay

out the money at each step of the research project. The

‘ ‘expected’ payoff does not mean an assured payoff; rather, it

means the minimal payoff required from the drugs that successfully reach the market after taking into account the chances of

success and failure and the expected development time involved.

47
48 I Pharmaceutical R&D: Costs, Risks and Rewards

The full cost of bringing a new drug to market,

as defined above, is clearly higher than the cash

outlays spent to discover and develop successful

new drugs. It also includes the cash outlays spent

on projects that fail.l And, it must include the

opportunity cost of capital, the rate of interest that

dollars invested at a given level of risk must earn

in exchange for being tied up in the investment

(59,285).

The opportunity cost of capital for pharmaceutical R&D is higher than the interest rate on safe

investments, such as insured bank deposits or

government bonds, but just how high the cost of

capital for pharmaceutical R&D projects is depends on how investors evaluate the risks of these

investments, (See appendix C for a detailed

discussion of the cost of capital.) The risk and,

therefore, the cost of capital varies across different projects and even within the same R&D

project at different stages of development. The

cost of capital for any investment also varies from

year to year with underlying changes in the

risk-free rate of interest (e.g., on bank deposits).

Thus, the full cost of R&D varies widely over

time and across projects.

To measure the full cost of bringing a new drug

to market, all outlays required to achieve the

successes (including spending on projects that

fail) must be compounded (or capitalized) at an

interest rate equal to the cost of capital, to their

present value (or capitalized value) at the date

of market approval. For example, $1 million

invested 1 year ago should be worth $1.1 million

today if the cost of capital for that investment was

10 percent per year.

Note again that the full cost of bringing a new

drug to market is much higher than the amount of

money companies must actually raise to fund

R&D projects. To pursue R&D, companies must

raise only enough cash to cover the actual outlays

associated with the successful and unsuccessful

Photo cmdIt: THE UPJOHN COMPANY

R&D expenditures include substantial investment in research

facilities and equipment. The Upjohn Company recently built

this new addition to its research facilities, the ‘(white” building

located at the top of the photograph. It encompasses more

than 700,000 square feet, was constructed at a cost of

$120,000 million, and will house more than 500 scientists.

projects. Estimating the full cost of bringing a

new drug to market, by contrast, provides a way

of gauging ho w much money must be earned from

the successful drugs, once they reach the market,

to justify the research outlays.

EXISTING STUDIES OF R&D COSTS

Two major approaches have been used to

estimate the cost of bringing new drugs to market.

One approach examines project-level data acquired from pharmaceutical firms. The second

approach analyzes R&D expenditures and new

products at the industry level. Table 3-1 contains

a summary of selected pharmaceutical R&D cost

studies of both kinds—project-level and industrylevel—listed in the order of the R&D period

studied.

Project-level studies try to measure costs incurred at each stage of development and the

percent of drugs that will successfully pass each

stage, and then use these calculations to arrive at

a final cost estimate. The key advantage of the

project-level approach is that, if sufficiently

] when the full cost of R&D is estimated with historical data, averaging of outlays across wimers and losers must take place across the

entire industry, or at least a good part of it, because individual companies may have unusuat experiences. For example, a company could have

rmsmanaged its research, leading to relatively few successes and high outlays per success. Though investors in that company might have lost

money, they need not be rewarde.i for their bad judgment. The experience of the industry as a whole is a good basis for estimatmg the true (and

uncontrollable) probability of success and failure of R&D projects.
Table 3-l—Summary of Selected Pharmaceutical R&D Cost Studies

Constant Opportunist y

Sample

Treatment of

Estimated R&D dollar cost of Preclinical unsuccessful

Study years Estimation method Data source costs year capital costs projects

Project-level studies

Schnee, 1972 1950-67 (market

introductions)

R&D project cost NCEs:$534,000. Current dollars 0% Not included Not included

data reported by

one firm.

Average development

cost and time for 75

P

rejects marketed in one

 large firm.

NCE sample and $54 million

R&D project

expenditures

from 14-firm

survey.

1976 8% Assumed to be

530/’ (allocated

over 3 years

f

nor to IND

iling).

Estimated

12.5% NCE

success rate.

Hansen, 1979 1963-75 (projects

entering human

testing)

9% Estimates from

reported preclinical and clinical

period expenditures.

Estimated

success rate by

phase for

sample NC ES.

NCE sample and $231 million

R&D project

expenditures

from 12-firm survey.

DiMasi et al.,1991 1970-82 (projects 1987

entering human

testing)

R&D expenditure profile

built for sample of 93 selforiginated NCEs, not all

successful.

Industry-level studies

Baily, 1972 1949-69 (market

introductions)

Total R&D data: Pre-1962: $2.5

PMA survey. million. Post-1962:

New drug intro- $6 million.

ductions: Paul de

Haen, Inc.

Regression of total U.S. 1958 o% Implicit Implicit

drug introductions in U.S.

firms 1949-69 on total

research expenditures

(lagged 5 years), FDA

regulation stringency,

and a measure of depletion of research opportunities.

0% Assumed to be Implicit

50%

8% Implicit Implicit

Allocation of total R&D

expenditures (lagged 5

years) to NCEs introduced

in 1966-72.

R&D expenditures: $24.4 million

PMA survey.

Sctwartzman, 1966-72

1976 (NCE approvals)

1973

Regression of NCE 1986

introductions on total R&D

expenditures (lagged 4

years); FDA approval

times, by therapeutic

class. Adjuste for d

Hansen’s time profile.

NCEs: FDA. R&D $108 milliona

expenditures:

PMA surveys.

Wiggins, 1987 1970-85

(NCE approvals)

Analysis of industry R&D

x

production. R&D time

Grabowski & 1970-79 9% Implicit Implicit

Vernon, 1989 (NCE approvals)

NCEs: FDA. $125 million

Total R&D

expenditures:

PMA surveys.

1986

profiles modified from

regression estimates.

a Wiggins ~nginally rep~~ $125 million; adjustment for technical error changes the number to $108 million (DiMasi et al; 1991). =

KEY: NCE - new chemical entity; IND

z

= investigational new drug; FDA - U.S. Food and Drug Administration; PMA = Pharmaceutical Manufacturers Assceiation. P

SOURCES: J.E. Schnee, “Development Cost: Determinants and Overruns,” Journal of Business 45(3):347-374, 1972. M.N. Baily, “Research and Development Costs and Returns: The U.S. a

Pharmaceutical Industry,” Journal of PolMca/ Economy 80(l) :70-85, 1972. D. %hwarfzman, The Expecfed Return From Pharmaceutical Research (Washington, DC: American ~

Enterprise Institute, 1975). R. Hansen, “The Pharmaceutical Development Prcxx.ss: Estimates of Development Costs and Times and the Effect of Proposed Regulatory Changes,”

Issues in Pharmaceutical Economics, R.A. Chien (cd.) (Lexington, MA: D.C. Heath and Co., 1979). S.N. Wiggins, The Cost of Devdop”ng a New Drug (Washington, DC: @

Pharmaceutical Manufacturers Association, 1987). H.G. Grabowski and J.M. Vernon, “A New Look at the Returns and Risks to Pharmaceutical R& D,” Management %“ence

38(7):804-821, July 1990. J.A. DiMasi, R.W. Hansen, H.G. Gratmwski, et al., “The Cost of Innovation in the Pharmaceutical Industry,” Journal of Health Economics 10:107-142, 1991.
50 I Pharmaceutical R&D: Costs, Risks and Rewards

reliable data can be obtained, it provides the most

detailed view of the costs of particular projects

and overall development costs. These studies

look at a sample of new product introductions

(virtually always new chemical entities (NCES)

2

)

and use project cost data obtained from companies to estimate the average cost of bringing a

product to market. Although Clymer (79) and

Schnee (367) took this project-level approach in

early studies, they calculated only the cash R&D

outlays of a single firm, and Schnee did not

consider the cost of failures. These studies are

therefore not considered further.

The prototype of project-level R&D cost estimation is a pair of studies published by Hansen in

1979 and DiMasi and colleagues in 1991 (109,175).

They used very similar methods and data sources

to estimate the present value in the year of U.S.

market approval of the costs of discovering and

developing NCEs. The results of these studies

have been used to estimate net returns to R&D

and to estimate recent changes in the cost of

developing new drugs.

Industry-level studies examine the relationship

between new product introductions and industry

research expenditures. An estimated regression

equation that predicts NCE introductions as a

function of R&D expenditures in previous years

as well as other external factors (such as regulatory controls) is then solved for the R&D expenditures required to bring one additional NCE to

market. 3

The advantage of these industry-level studies is

that data on product introductions and research

expenditures are verifiable and readily available

at the industry level. The disadvantage is that the

introduction of NCEs in any year must be related

to a pattern of past R&D expenditures that is

complex and often beyond estimation with the

limited number of years of data available. This

approach was pioneered by Baily (32), but the

cost estimate from that study is based on very old

data that are not converted to present values.

A recent estimate based on a study by Wiggins

(520) is the most comprehensive analysis using

this approach. Wiggins followed the general

method first used by Baily, but Wiggins had more

data at hand and used less restrictive assumptions

about the nature of the relationship between

expenditures and new drug production. Therefore, this chapter focuses on the Wiggins study.

Grabowski and Vernon (159) also used published aggregate R&D expenditure data to estimate the cost of successful drug development.

Though Grabowski and Vernon did not estimate

development time profiles with statistical analysis, their estimate provides another point of

reference for comparison among methods, and it

is also summarized here.

1 The Hansen and DiMasi Studies

METHODS

The two studies by Hansen (175) and DiMasi

(109) are based on samples of NCEs frost entering

human testing in specified time periods. The

sample of NCEs for each study was selected from

a set of data on NCEs constructed and maintained

by the Tufts University Center for the Study of

Drug Development (CSDD) from an ongoing

triennial survey of over 40 pharmaceutical fins.

The early study ex amined approximately 67

NCEs, discovered and developed by 14 U.S.

pharmaceutical firms that first entered human

trials between 1963 and 1975. The second study

2 D-i defimes “NCE” M ‘‘a new molecular compound not previously teSted b humans ” (107). In keeping with DiMasi’s definition

this report uses the term NCE to refer to both therapeutic drugs and biological.

3 Industry-level analyses me therefore estimates of rmuginal costs of NCE production. As DiMasi observed, marginal costs and average

costs are not likely to be equal unless R&D is subject to constant returns to scale (109). IrI an R&D-intensive pharmaceutical fq there may

be substantial economies of scale,, particularly at low levels of expenditure. However, from the standpoint of the industry as a whole, marginal

costs may more closely approximate average costs. A more important criticism of the marginal cost measure is that the marginal NCE (i.e.,

the next one that would be brought forth by an infusion of new R&D expenditures) is not determined by costs alone but by the present value

of net returns. The marginal NCE might be a low-cost project with low revenue prospects. Therefore, marginal research cost does not have much

meaning from the standpoint of R&D decisions.
Chapter 3--The Costs of Pharmaceutical R&D I 51

examined 93 NCEs, discovered and developed by

12 U.S. fins, that were first tested in humans

between 1970 and 1982 (109).

Both studies looked only at NCEs that were

actually discovered by the firms themselves (i.e.,

self-originated), not licensed from other companies, and the samples in both studies included

unsuccessful as well as successful NCEs. Products acquired through joint ventures or licenses

were excluded because part of the costs of these

R&D projects would have been borne by other

firms and could not be measured easily.

The study authors surveyed the firms sponsoring the sampled NCEs for information about the

costs incurred from year to year as each NCE

traveled through the drug development process.

Many of the sampled products were abandoned

during the clinical testing phase, and the costs

were adjusted for these abandonments. With

year-by-year estimates of spending for each

project, the authors could build a time profile of

expenditures throughout the development period.

These time profiles were then combined with

information about the survival experience of the

NCEs under study to estimate the average cash

outlays 4 for clinical research.

A portion of R&D cost is devoted to the

discovery of NCEs. These basic and preclinical

research activities cannot be allocated to specific

NCEs, so the authors of each study asked firms to

report information that would allow estimation of

preclinical research expenditures. In the early

study, firms were asked to report total NCE R&D

expenditures in the United States between 1962

and 1975 as well as “basic research” expenditures. 5 Overall, firms reported that 51 percent of

all NCE R&D expenditures were for basic research, so Hansen assumed an amount equal to

the total average development period cost went to

basic research in the preclinical period, spread

equally over 3 years prior to the initiation of

clinical testing.

DiMasi used a more involved methodology to

estimate both the amount of preclinical cost and

the timing of those costs. Firms reported total

self-originated NCE R&D expenditures and

preclinical research expenditures between 1970

and 1986. Preclinical expenses averaged 66

percent of total self-originated NCE research.

This estimate was revised to 58 percent to account

for trends in the data over the time period on

which the estimate was based.6 These estimated

preclinical costs were spread evenly over 42.6

months prior to the initiation of the clinical

period.7

The estimated cash outflows, spread over the

discovery and development periods according to

the time profile reported by companies, were

converted to their present value in the year of

market approval. The early study used a real

(inflation-adjusted) cost of capital of 8 percent;

the later study used 9 percent.

RESULTS

Table 3-2 shows how the actual estimated cash

expenditures (in 1990 constant dollars) changed

between the two studies. Total cash outlays per

successful new NCE were estimated at $65.5

million (1990 dollars) by Hansen and at $127.2

million by DiMasi, a 94 percent increase in

estimated real (inflation-adjusted) outlays per

successful new drug over the period of the two

studies. If the midpoint of the study years is used

to calculate the rate of increase in cash outlays,

4 The reported expenditures don’t correspond exactly to cash outlays because charges for indirect costs, overhead, or capital equipment and

facilities may be made using allocation or depreciation methods that don’t correspond in time to actual cash outlays. The term “cash costs”

is used here to differentiate the reported expenditures from their present values in the year of market approval.

5 Develo~ment ~os~ included clini~ cos~ and shofl.tem predinied * ShldieS.

s Since clinical period expenditures occur later than preclinical expenditures, the ratio of preclinical period red R&D to total real R&D

expenditures overestimates the true preclinical period contribution when total expenditures are rising (109).

7 The length of the preclincial period was estimated from data in the CSDD database on NCES approved for marketing by the U.S. Food

and Drug A&mm‘ “stration (FDA) in the years of the study. The preclinical period is defined in that database as the length of time from synthesis

of a drug to the beginning of human clinical studies.
52 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 3-2-Cash Outlays per Successful New Chemical Entity:

Hansen and DiMasi ($ 1990 millions)a

Preclinical/discovery

Study years Clinical As percent Total cash outlays

Study (midpolnt) cost cost of total cost per success

Hansen, 1979. ...., . . 1963-75 $29.9 $35.6 54% $65.5

(1969)

DiMasi et al., 1991 . . . . 1970-82 53.8 73.4 58 127.2

(1976)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .......... .................. ........

Rate of increase (%). . . 79 106 94

a All estimates were adjusted for inflation using the GNP implicit price deflator.

SOURCE: Office of Technology Assessment, 1993, adapted from R. Hansen, “The Pharmaceutical Development

Process: Estimates of Development Costs and Times and the Effect of Proposed Regulatory Changes,”

/ssues in Pharmaceutkxd Economics, R.A. Chien (cd.) (Lexington, MA: D.C. Heath and Co., 1979); J.A.

DiMasi, F{.W. Hansen, H.G. Grabowski, et al., “The Cost of Innovation in the Pharmaceutical Industry,”

Journal clf Hea/th Economics 10:107-142, 1991.

this pair of studies suggests that real R&D cash

outlays per successful NCE increased at an annual

rate of about 9.5 percent in the study years.8

The increase in cash outlays per success is

moderated by an improvement in the success rate

of the drugs in the two study cohorts. Whereas

Hansen projected an ultimate success rate from

human testing to approval by the U.S. Food and

Drug Administration (FDA) of 12.5 percent,

DiMasi and colleagues estimated about 23 percent of the projects would be successful. Without

this improvement, the increase in cash outlays per

success would be even higher.

Because the estimated ratio of preclinical costs

to clinical costs was higher in the later study than

in the early study, the increase in real cash outlays

is somewhat greater for preclinical costs than for

clinical period costs, but the annual rates of

increase were not very different-10.3 percent

per year for preclinical costs compared with 8.3

percent per year for clinical period costs.

Total R&D costs capitalized to the date of

approval for marketing increased from $108

million to $259 million (in 1990 dollars) over the

course of the two study periods, an inflationadjusted increase of 139 percent, or 12.4 percent

per year from the midpoint of the early study

(1969) to the midpoint of the later study (1976).

The even more rapid increase in fully capitalized

costs was due to cost-increasing changes in two

components of the estimates:

An increase in the estimated cost of capital

from 8 percent in the early study to 9 percent

in the later study.

An increase in the total development time

from 9.6 to 11.8 years, led by a longer

preclinical period in the later study (42.6

months, compared with 36 months) and a

longer period of regulatory review once a

new drug application (NDA) is filed with the

FDA (30.3 months compared with 24

months).

The change in the assumed cost of capital alone

would account for little of the increase in total

capitalized costs. OTA reconstructed Hansen’s

cost analysis using a 9 percent cost of capital. This

change, in the absence of any others, increascd

Hansen’s total cost estimate by only 5 percent to

8 Comparison of the midpoints of the study years may understate the true difference in time between the studies and may therefore overstate

the rate of change over the time period. Although the database from which the sample of NCES in each study was drawn shows the median

years for self-originated NCES receiving investigational new drugs in the two studies were 7 years apart (107), the cost estimates in the early

study were based more heavily on the older NCES in the sample than were the cost estimates in the second study (176). If a steady upward trend

in the real cost of R&D was occurring throughout the decades of the two studies, the cost estimates of the early study would be biased downward.
Chapter 3-The Costs of Pharmaceutical R&D! 53

approximately $114.8 million (in 1990 dollars).

Increasing the discovery/development period to

match that of the DiMasi study without any other

changes would increase Hansen’s total cost estimate to $122.7 million (13 percent higher than the

baseline estimate). Together, a higher cost of

capital and a longer R&D time profile (in the

absence of any other changes) increased Hansens

estimated cost to $132.9 million (in 1990 dollars),

only 23 percent higher than the baseline estimate.

Thus, without the very large changes in estimated

cash outlays over the two periods, the inflationadjusted rise between the two periods in R&D

costs per success would have been relatively

modest.

H The Wiggins Study

Wiggins regressed the total number of NCEs

that the FDA approved between 1970 and 1985 on

the estimated total NCE-oriented research spending in previous years9 and on the average delay in

NDA approval times for drugs approved 5 years

earlier. The regression equation was then transformed into an estimate of the extra cash research

outlay required to bring forth one additional NCE.

This estimate of marginal R&D cash outlay per

additional NCE was $75 million in 1990 dollars.

Wiggins’ analysis is based on NCE approvals

for marketing, not NCEs entering human testing.

If the average time from the filing of an investigational new drug (IND) application to approval of

the drug by the FDA was 6.5 years (as Hansen’s

early survey indicated), then Wiggins’ sample

corresponds to NCEs first entering clinical testing

between roughly 1963 and 1979, a period that

overlaps substantially with the Hansen study

(1963 to 1975). Thus, Wiggins’ estimate of $75

million in cash costs is roughly in line with

Hansen’s estimate of $65.5 million, especially

when one considers Wiggins’ analysis probably

covers a somewhat more recent population of

NCEs than does Hansen’s.

Wiggins’ NCE sample is different from

Hansen’s, however, because it includes licensedin products as well as self-originated NCEs. It is

unknown how the full costs of discovery and

development for licensed-in products compare

with those of self-originated drugs. Though the

cost of developing licensed-in products is likely

to be lower for the licensee, if the licenser is a

Pharmaceutical Manufacturers Association (PMA)-

member company, then Wiggins’ method would

have captured the early costs.

Although Wiggins converted cash R&D costs

to their present value at the time of market

approval, he did so by assuming the cash costs

followed Hansen’s estimated time profile.10 Like

Hansen, Wiggins used an 8 percent cost of capital.

Starting with higher out-of-pocket expenses, Wiggins necessarily concluded the full cost of bringing an NCE to market is higher than Hansen

predicted. In 1990 dollars, Wiggins’ estimated

cost of discovery and development of a new NCE

is $123.4 millionll compared with $108 million

estimated by Hansen (175).

1 The Grabowski and Vernon Study

Grabowski and Vernon (160) also used annual

aggregate R&D data reported by PMA to estimate

the average cost of developing new NCEs approved by the FDA for marketing during the

1970s. Like Wiggins, Grabowski and Vernon

estimated the cost per NCE for both selforiginated and licensed-in drugs. They assigned

g The average research expenditures for NCES in the third, fourth, and fifth year prior to FDA market approval as reported to the

Pharmaceutical Manufacturers Association was used as the measure of research expenditure.

10 Since wl=~s’ ~]yslsincluded llccm~.~ as well as self-originated ~gs, he should have used a differen~ ad probably shorter, time

profile for the licensed-in drugs. Data on development times for approved licensed-in drugs suggest they are substantially shorter than the

development times for approved self-originated products (107), which suggests lower costs to the licensee. Had Wiggins applied a different

profile to the licensed-in drugs, his estimate of total capitalized cost would have been lower.

11 ~s value dlsa=~s with Wigglm’ estimate, $144 mllllon in 199o dol]ars. AS discussed by WOltmaII (524) ad DiMasi et al. (109),

Wiggim made an error in calculating the totat capitalimd cost. OTA’S re-estimate, $123.4 million, is slightly lower than DiMasi’s reealculatiom

$124.7 million in 1990 dollars, because of differences in price indexes used.
54 I Pharmaceutical R&D: Costs, Risks and Rewards

R&D expenditures in each year between 1962 and

1978 to product introductions in the years 1970-

79 using assumptions about the application of

each year’s expenditures to the future years’

introductions. For example, Grabowski and Vernon assumed that in 1965, 10 percent of R&D

expenditures for NCEs was spent on drugs

introduced in 1970, 10 percent on drugs introduced in 1971, etc.12

This weighting scheme was then used to

estimate the cost of introductions in each year.

Compounding these values to the date of market

introduction at 9 percent, Grabowski and Vernon

estimated the mean cost per successful NCE

approved by the FDA between 1970 and 1979

was $142 million in 1990 dollars. Because the

weighting scheme assumes a total discovery/

development period of 8 to 12 years (lengthening

over the period of study), this estimate corresponds to NCEs first entering human testing in

the period roughly bounded by 1965 and 1972.

This period falls within the bounds of Hansen’s

study years.

Whereas Hansen’s total estimated cost in 1990

dollars with a 9-percent discount rate is $114.8

million for drugs entering testing in the period,

Grabowski and Vernon estimated an average cost

of $142 million. For NCEs approved in 1975,

Grabowski and Vernon estimated cash R&D

outlays of $86.7 million in 1990 dollars compared

with $65.5 million estimated by Hansen.

1 Comparison of Estimates

The studies discussed above are best compared

by standardizing for constant dollar year and cost

of capital, chosen here to be 1990 and 9 percent.

Table 3-3 shows the estimates from each reviewed study.

The three studies of research conducted on

NCEs frost entering clinical testing in the 1960s

and early 1970s use different methods and arrive

Table 3-3-Estimates oft he Full Cost of Bringing a

New Chemical Entity to Marketa ($ 1990 millions)

First year of clinical testing

(midpoint)

1963-75 1970-82

Study (1969) (1976)

Hansen, 1979. . . . . . . . . . . . . . . . $114.8 —

DiMasi et al., 1991 . . . . . . . . . . . . . — $259

Wiggins, 1987. . . . . . . . . . . . . . . . 131.5 —

Grabowski and Vernon, 1990... . 142 —

a All ~timates were adjusted for inflation using the GNP implicit price

deflator and were calculated at 9 percent cost of capital.

SOURCE: Office of Technology Assessment, 1993.

at estimates differing by up to 25 percent. Since

the methods used in each study are not completely

independent,13 more congruence might have been

expected.

Because neither Wiggins nor Grabowski and

Vernon differentiated between licensed-in and

self-originated drugs, their estimates should be

lower, or at least no higher, than those of Hansen.

Yet the cash outlays estimated in both industrylevel studies are higher than those of Hansen.

Hansen estimated cash outlays per successful

NCE of $65 million; Wiggins estimated $75

million; and Grabowski and Vernon estimated

$86.7 million.

VALIDITY OF R&D COST ESTIMATES

All of the R&D cost studies described above

begin with estimates of R&D cash outlays in each

phase of development, the time required to

complete each phase, and the success rate for

projects in each phase of the process. These

estimated cash flows are then capitalized with a

cost of capital that differs among studies. The

validity of the studies rests ultimately on the

accuracy of the estimates of cash outlays and the

timing of those outlays. In this section, OTA

analyzes the validity of the estimates of cash

12 ~ese assumptions were based in part on a regression estimate Thomas made in 1986 (421).

13 Hmen used he s~ple firms’ se~.rewfied data on R&D ex~n~~es to es~ate b~ic mseuch ~sts to their pre!XXlt Vdle; Wiggh,$

used Hansen’s time profde generated from a survey of companies’ NCE introductions to capitalize costs, and Grabowski and Vernon’s time

profdes were based largely on data supplied by the CSDD NCE database, the same database from which Hansen’s sample was drawn and from

which estimates of Hansen’s R&D time profile were partially drawn.
Chapter *The Costs of Pharmaceutical R&D 55

outlays, their timing, and the success rates

stage to stage in the development process.

from

Are the estimates of cash outlays accurate?

OTA addressed this question in two ways. First,

we critically assessed the validity of the methods

and data sources used to arrive at the estimates

and the potential importance of departures from

full validity. Second, we attempted to corroborate

the findings with data from independent or

semi-independent sources.

The assessment of validity of the methods

concentrates on the project-level studies of

Hansen (175) and DiMasi (109) for two reasons.

First, the DiMasi study offers the most recent

estimate which industry representatives and others have quoted widely as the definitive estimate

of research costs (325). Second, the other studies

based on aggregate R&D expenditures draw from

the project-level analyses of Hansen and DiMasi

for estimates of the time profile of development

and are therefore partially dependent on them.

I Validity of Study Methods

The validity of the project-level studies depends on three aspects of the study methods:

● Sample of fins;

● Sample of NCEs; and

● Accuracy of survey responses regarding:

1. clinical period cash outlays,

2. preclinical period cash outlays,

3. phase-specific development times, and

4. phase-specific success rates.

THE SAMPLE OF FIRMS

Both Hansen and DiMasi examined NCEs

originated at U.S .-owned, research-intensive pharmaceutical fins. Hansen’s early study included

14 firms willing to respond to the survey;

DiMasi’s later study included 12. Because the

samples were predominantly large wellestablished companies in both surveys, the reported R&D costs may not reflect the cost

experience of small and relatively young firms,14

although the direction of potential biases between

large and small firms is unknown. 15 Even if

systematic differences in R&D costs by firm size

or total R&D commitment do exist, they should

not survive for long, for the industry would

gradually reorganize to operate at the most

efficient level. The responding firms in the

DiMasi study represented 40 percent of domestic

R&D, as measured by PMA, and the distribution

of R&D by therapeutic class in these firms was

virtually identical to the distribution of R&D in

the U.S. pharmaceutical industry as a whole.16

Thus, the sample of firms appears to pose no

serious threat to the validity of the study.

THE SAMPLE OF NCES

Both studies selected a sample of NCEs that

originated within the company’s U.S. research

organizations. NCEs were selected from a database maintained by CSDD of new products under

development. Probability samples were drawn

from the universe of NCEs in the CSDD database,

but some nonresponding companies could have

biased the sample. Furthermore, neither study

reported the within-fro response rate. If firms

failed to provide data on some NCEs for which

data were poor, or if they selectively reported on

NCEs for some other reason, the sample of NCEs

could be biased. Again, the effect of such

potential biases on cost estimates cannot be

judged.

The adequacy of the sample size to reliably

predict costs is determined by the underlying

variation in the costs to be measured. The sample

size in the Hansen study was 65 to 70 NCEs. The

precise NCE sample size was not reported.

DiMasi examined 93 NCEs. The higher the

14 me emergence of d~zem of ~m~I biotec~olo~ firms perfo~g pharmaceutic~ research k the 1980s would make hS pOhM 11101’e

salient for periods later tban those studied by Hansen and DiMasi.

15 phceutiml f~~may ~xp~ence d~r~m@~e~t.s~e of R&D at ]CJW levels of R&IJ (213). (2011M.uor fomd the ~@d

productivity of research persomel is inversely related to the size of the firm (85), but after controlling for R&D levels, Jensen did not find such

a relationship (213).

16 H-en did not provide e5~ates of the proportion of domestic R&D accounted for by the 14 f~s ~ his samPle.

330-067 - 93 - 3 : QL 3
56 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 3-4-Confidence Intervals for Clinical Period Cash Outlays in DiMasi Study

($ 1987 millions)

Probability that true

Standard 95% confidence mean is within 10

Phase Mean costs deviation Interval for mean percent of estimated mean

i . . . . . $2,134 $4,519 $1,184- 3,084 0.34

ii.”.”.”.”.”.”.”.-.”.”.”. : : . . . . . 3,954 5,230 1,729- 4,179 0.36

Iii. . . . . . . . . . . . . . . . . . 12,801 13,974 8,236-17,366 0.41

Long-term animal. . . . . 2,155 2,411 1,480- 2,830 0.46

Other animal. . . . . . . . . 648 1,183 49 - 1246 0.17

a Calculated for all new chemical entities entering the phase.

SOURCE: Office of Technology Assessment, 1993, based on data provided in J.A. DiMasi, R.W. Hansen, H.G.

Grabowsld, et al., “The Cost of Innovation in the Pharmaceutical Industry,” Journal of Hea/th Economics

10:107-142, 1991.

underlying variation in costs, the larger the

sample size must be to meet any required level of

precision. Hansen did not report on the observed

variation in costs among NCEs, so there is no way

to evaluate the precision of his estimate,

DiMasi did report the sample standard deviation of cash outlays in each phase of the clinical

period. Table 3-4 shows the standard deviations,

the 95-percent confidence intervals17 for the true

mean cash outlay in each clinical phase, and the

estimated probability that the true mean cash

outlay in each phase lies within 10 percent of the

estimated mean. The chance that the true mean

cost is no more than 10 percent greater or less than

the estimated cost of each phase ranges from 17

to 46 percent over the different clinical phases. To

have a higher chance of estimating the mean costs

with no more than a 10-percent error in either

direction, the sample size must be bigger.

Because the cost of one phase may be correlated with the cost of another, the precision of the

estimate of total cash costs cannot be computed

with the existing data (106). Thus, the precision

of the total cost estimate is unknown.

ACCURACY OF SURVEY RESPONSES

The project-level studies depend on data supplied by responding companies that are unavailable from other sources. The accuracy of such data

depends on two factors: the ability of firms to

provide accurate data (i.e., does the company

have access to accurate information?), and the

motivation of firms to provide accurate data.

Clinical Period Cash Outlays--OTA’s interviews with pharmaceutical company managers

indicated that, once projects reach the clinical

stage, virtually all companies have project-level

cost accounting systems that keep track of funds

spent on speckle projects, generally identified by

the chemical or biological compound. Therefore,

most firms have the ability to report data on

overall clinical period outlays.

OTA was unable to obtain much information

about the structure of such accounting systems;

hence, the ability of firms to identify expenditures

by clinical phase is unclear. All companies would

have an accurate picture of monthly charges to

individual project accounts, however, and the

dates at which phase I, phase II, and phase III

trials began are available to companies, so allocation of costs by date is a reasonable approach to

estimating the distribution of costs by phase. If

companies responded to survey questions with

this approach, the phase-specific estimates would

be reasonably accurate.

Companies responding to either survey may

have handled indirect, overhead, and capital costs

18 For example, in in inconsistent or biased ways.

some companies the costs of a central computer

may be billed to specific projects based on actual

use; in others, these costs are charged to projects

based on a predetermined allocation formula. &
Chapter 3-The Costs of Pharmaceutical R&D I 57

Such differences in cost allocation conventions

may explain part of the high variation in reported

phase-specific costs among NCEs.

The money spent to acquire capital equipment

and facilities used in research (referred to as

capital expenditures) sometimes is not allocated

to project-level management cost accounts. How

companies allocated these expenses to specific

NCEs for the purpose of the survey is unknown.

If a responding company estimated only direct

expenditures in its clinical period R&D, but

included R&D capital expenditures in its total

R&D expenditures, the costs in the clinical period

would be underestimated, but the ratio of preclinical period costs to total R&D costs would be

overestimated. Because clinical period costs occur

later, the total capitalized cost would appear

higher using this method. On the other hand, plant

and equipment costs are always accounted for

with depreciation formulas, which spread costs

out for a number of years subsequent to the actual

19 Because a proper cost capital expenditure.

estimate should be based on actual cash outlays,

the delay in accounting for capital costs will skew

expenditures toward the end of the period and will

cause the total costs of R&D capitalized to the

point of market introduction to be underestimated.

One hypothetical scenario that a pharmaceutical firm presented to OTA estimated that total

costs capitalized to the point of market introduction could be underestimated by as much as 12

percent because of depreciation methods, but the

size of the underestimate depends critically on

assumptions about the initial cost of facilities and

equipment, their useful life, the length of time

such assets are used for the project, their remainPhoto cred/t: THE UPJOHN COMPANY

The cost of testing NCEs in humans has risen rapidly in recent

years. New diagnostic tests make for more expensive and

larger clinical trials.

ing value at the end of the project, and the extent

of shared use among different research projects.

Preclinical Cash Outlay--Both of the projectlevel studies estimated the preclinical cash outlays for each sampled NCE from company survey

responses to similar (but not identical) questions

about annual expenditures for total NCE-oriented

R&D and preclinical NCE-oriented R&D.20 In

DiMasi’s study the reported ratio of preclinical to

total expenditures was 66 percent, but DiMasi

adjusted this estimate to 58 percent to account for

trends in total spending over time. In Hansen’s

study the reported ratio of basic to total NCE

.

Is A]~ough tie Sumey ~uestlonnaires did contain queshms about the methods of estimating overhead, indirect, and capital costs msociated

with research projects, the qucstlons were structured broadly and the study authors have provided no details about how such costing methods

may have varred ( 109, 175).

1~ If ~ ~lcce of ~ulpmcnl, bought new, has a 10-yew hfc, for example, the company might charge tiis expendimre off at 10 Percent of ‘ts

mlt~al COS[ each year over the nex( IO years. T’hIs annual depreciation charge would then be allocated across the projects that shared in use of

the capital equipment.

20 DIMasI asked compames to report total expenditures for self-origuu~tcd NCE R&D and prccluucal expenditures for self-originated NCE

R&D m the pcrrod 1970-86. Hansen asked comparues to provide estimates of total and ‘ ‘basic” NCE-oriented R&D conducted in the Umtcd

States m the years 1962-75.
58 I Pharmaceutical R&D: Costs, Risks and Rewards

research was 51 percent. When basic research is

combined with short-term preclinical animal

research (estimated separately in Hansen’s study)

to obtain an estimate of the percent of preclinical

expenditures (i.e., comparable to DiMasi), the

resulting ratio is 54 percent.

The accuracy of these estimates depends both

on the capability of firms to separate preclinical

expenditures for NCEs from those of other

products (such as combination drugs, new formulations, new drug delivery systems, etc.) and on

their motivation to report such expenditures

accurately.

The capability of firms to identify such preclinical expenditures would depend on the structure of

their cost accounting systems. Although OTA did

not have access to information on the structure of

these systems in any firm, virtually all companies

of reasonable size have in place project-level cost

accounting systems. Projects to extend product

lines of existing NCEs are probably separately

identified. Any project to develop a licensed-in

drug is also likely to have its own account.

Separating projects among the categories required to estimate the preclinical ratio would

require categorizing these projects, which can be

done with a reasonable level of effort by knowledgeable personnel. Thus, it is reasonable to

assume companies can slot R&D expenditures

into the detailed categories needed for the estimate.

Motivation is another matter. Because the

estimated ratio of preclinical cost to total R&D

cost cannot be verified without an independent

audit of cost accounting information, a company

that understood the use to which the data would

be put and with a strategic incentive to overestimate the preclinical ratio could do so without

potential for discovery.

Although the firms responding to the early

study may not have been aware of the potential

policy uses of the study’s conclusions, those

responding to the later study would surely have

been aware of the use to which the data would be

put and its potential use in political debates. A

brief review of the methods and findings of the

early study could alert respondents to the importance of preclinical costs to the final full cost

estimate. Thus, the motivation to overestimate

this percentage cannot be discounted, especially

in DiMasi’s later study.

If companies responding to the DiMasi survey

overestimated the percent of self-originated U.S.

R&D expenditures devoted to preclinical research by 5 percentage points, so that the true

percent was 53, as in Hansen’s study, the estimated total cost of developing anew NCE would

be $228 million in 1990 dollars, 12 percent less

than the $259 million estimated by DiMasi et al.

Phase-Specific Development Times—The

studies used identical methods to estimate a

typical development time profile for NCEs in

their sample. Responding companies reported the

start date and ending date for each NCE entering

a phase. The study researchers then calculated the

mean phase length for all NCEs entering the

phase.

21 Not only do companies have accurate

archival records to provide these dates, but

companies also must report on the start and

progress of clinical testing to the FDA. Although

data reported to the FDA are not in the public

domain unless an NCE is ultimately approved for

marketing, it is unlikely companies would deliberately misreport such data in survey responses.

The length of the period from submission of a

new drug application to FDA approval was not

estimated from the company survey; rather, the

authors estimated average new drug application

review times from the CSDD NCE database. In

the early study, Hansen used the reported mean

time from NDA submission to approval of all

approved NCEs in the database, 24 months.

DiMasi used the reported mean NDA review time

for approved self-originated NCEs first tested in

humans between 1970 and 1982, 30.2 months.

OTA re-estimated the NDA review period for

all self-originated U.S. NCEs in the CSDD

21 me ~e~ p~5e len~ ~em weigh[~ to talce accoun[ of sampling probabilities.
—

Chapter 3-The Costs of Pharmaceutical R&D 59

database approved between 1967 and 1979, the

time corresponding to Hansen’s sample of NCEs

(107). 22 The estimated approval time was 26

months. Thus, Hansen may have slightly underestimated the review time in the early study. The

effect on total costs is negligible, however.

Hansen’s estimate would increase from $108

million to $110 million.

Companies also did not report the length of the

preclinical period, but the studies’ authors estimated it through other means. DiMasi used the

CSDD database on approved NCEs which contains company reports on the date of first synthesis of a compound and the date of first human

clinical testing. Because NCEs can be identified

as self-originated or licensed-in, DiMasi was able

to estimate the preclinical period for the large

sample in the CSDD database of approved

self-originated NCEs that U.S. firms developed

during the study period. The mean estimated

length of the preclinical period was 42.7

months .23

Hansen had no information at hand with which

to estimate the length of the preclinical period. He

simply assumed that the period was 36 months in

length. OTA analyzed published CSDD data on

NCEs approved between 1969 and 1982 and

found the mean reported preclinical period was

about 30 months. (107). A shorter preclinical

period would reduce Hansen’s estimated costs

slightly (see table 3-5).

The preclinical period as defined by DiMasi

(107) begins at the point of synthesis of a

compound. Since firms must screen multiple

products to obtain a lead compound (399) and

engage in basic research to understand disease

pathways before synthesizing a new product, this

period could understate the length of the true

preclinical period. If the true mean preclinical

Table 3-5--Effects of R&D Time Profile on Costs of

R&D in Project-Level Studiesa ($ 1990 millions)

Percent increase

Capitalized (decrease)

Study cost from baseline

Hansen (1979)b

● Baseline estimate $108 —

● NDA review time

26 months 109 0).9%

● Preclinical time

30 months 106 (1.8)

43 months 109 0.9

60 months 114 5.5

. NDA review time/preclinical time

26 months/30 months 108 0

26 months/43 months 110 1.8

26 months/60 months 115 6.4

DiMasi et al. (1991)c

● Baseline estimate 259 —

● Preclinical time

60 months 270 4.2

a Estimates were adjusted for inflation using the GNP implicit priCO

deflator.

b Cost of capital is 8 percent.

c Cost of capital is 9 peroent.

KEY: NDA - new drug application.

SOURCE: Office of Technology Assessment, 1993, based on data

provided in J.A. DiMasi, R.W. Hansen, H.G. Grabowsld, et

al., “The Cost of Innovation in the Pharmaceutical industry,” Journa/ of Hea/th Ewnomics 10:107-142, 1991; R.

Hansen, “The Pharmaceutical Development Process: Estimates of Development Costs and Times and the Effeet of

Proposed Regulatory Changes,” Issuesin Pharmaceutkal

Economics, R.A. Chien (cd.) (Lexington, MA: D.C. Heath

and Co., 1979).

period was 5 years, the cost estimates would

increase modestly (see table 3-5).

The combined impact on total capitalized costs

of potential changes in the NDA review times in

the Hansen study and a longer preclinical period

is shown in table 3-5. The estimated capitalized

costs increase modestly—by about 4 to 6 percent

in both studies-as a result of these potential

errors in timing.

22 H~~~ ~~tfiat~ ~ mea 4.5-yem Iag ~~eenwand ~A submissionand a z-year period from NDA submission to approval.

Therefore, the Hansen study period for NCES f~st entering human trials in 1963-75 would correspond roughly to NCES reaching approval

between 1969 and 1982.

23 Al~Ou@ tie preClfiC~ ~.i~ for ~gs tit were ~~ately not approved may have been different from the period for dIUgS that Were,

OTA is unaware of any potential systematic differences that would suggest a bias in the estimate.
60 I Pharmaceutical R&D: Costs, Risks and Rewards

Success Rates—The estimated probability of

reaching each clinical phase was based on survey

responses. These data are both available and

likely to have been reported accurately by survey

respondents. Both studies predicted final approval rates not from the study sample, but from

a large sample of NCEs in the CSDD database.

DiMasi estimated the ultimate approval rate—23

percent—for the population of survey firm NCEs

in the CSDD database that met the survey

inclusion criteria. Hansen’s estimated approval

rate—12.5 percent—was based on all NCEs in

the CSDD database covering the years of his

study .24

Recently published data from the CSDD database suggest that Hansen’s predicted success rate

for his cohort of NCEs may have been slightly

low. After 17 years of experience, approximately

14 percent of self-originated U.S. NCEs first

investigated in humans between 1964 and 1975

had been approved, and further approvals were

obtained later (107). A 14 percent success rate

(rather than a 12.5 percent rate) would reduce

Hansen’s estimated capitalized cost per successful NCE by 11 percent, from $108 million to

$96.2 million in 1990 dollars.

It is too early to tell whether DiMasi’s predicted overall success rate will be borne out by

history. The effect of the 1.5 percentage point

difference in success rate on the estimated cost of

Hansen’s NCE sample reflects the importance of

small errors either way in success rates on the

ultimate cost of R&D.

1 Corroborating Evidence

The estimates of R&D cash outlays and capitalized costs in the project-level studies are imprecise and potentially biased, but the magnitude and

net direction of these errors cannot be predicted.

Therefore, OTA looked for estimates of R&D

costs from independent data sources to provide

additional confidence about the accuracy of the

estimates from the project-level studies.

Occasionally anecdotal data come to light on

the cash outlays required for the development of

specific NCEs. For example, in depositions filed

for a patent infringement lawsuit, Genentech

claimed it had spent $45 million to develop

Protropin TM, its human growth hormone product,

(494) and Eli Lilly certified that it had spent $16

million between 1980 and 1987 on its effort to

develop its version of the drug (495). In another

example, a 1980 report of the development cost of

an oral systemic drug for chronic use estimated

$21 million in outlays in the clinical period (226).

Unfortunately, anecdotal estimates of this kind do

not help verify industrywide costs, because they

are self-selected and do not reflect the cost of

failures or basic research.

OTA attempted to corroborate the estimates of

R&D costs with two approaches. First, the

industry-level studies reviewed in the previous

section produced independent estimates of R&D

cash outlays per success. The consistency of these

studies’ findings on cash outlays with those of the

project-level studies is examined below. Second,

data on trends in important components of R&D

costs are examined to determine whether they are

consistent with the rapid rise in real cash outlays

implied by the two project-level studies of R&D

costs.

INDUSTRY-LEVEL STUDIES

The industry-level studies help to verify the

reasonableness of total cash outlays required to

produce an NCE. These studies begin with

aggregate R&D spending reported to PMA by its

member companies (320). Because Wiggins’

estimate of cash outlays per successful NCE is

completely independent of data obtained in the

project-level study, Wiggins is a good corroborative source.25

~ Bc@ s~dies usti Kapl~-~cier smivd cme analysis (2 19,225) to estimate the ultimate success rate b the NCE cohofi udm smdy.

25 Gm~ws~ ~d ve~on’~ ,:~~te of R&D cash ~s~ is less usefil for ~fiobo~ive pqOS~ ~ Wiggins’ eSh@e kaUW &

estimated cash outlays are built horn an assumed relationship between NCE approvals in 1 year and R&D expenditures in previous years.
Chapter 3-The Costs of Pharmaceutical R&D 61

Wiggins estimated cash outlays per successful

NCE at $75 million (in 1990 dollars) compared

with Hansen’s estimate of $65.5 million (in 1990

dollars). Because Wiggins was estimating the

cost of developing all NCEs, not just selforiginated NCEs, his cost estimate should be

conservative. The population of NCEs entering

testing was somewhat more recent than Hansen’s,

however, and Hansen’s cost estimates are based

more heavily on drugs entering human testing in

the earlier years of his sample. Overall, then,

Wiggins’ study suggests Hansen’s estimated cash

outlays are not out of line with the true costs and

may even be slightly underestimated.

However, before one can conclude that

Hansen’s estimate of cash outlays is too low, it is

necessary to assess the validity of the aggregate

R&D data reported to and compiled by PMA and

used by Wiggins in his analysis, Are these

company-generated estimates accurate? PMA

does not audit its member companies’ reported

R&D expenditures, but comparison of PMA data

with publicly available financial statements suggests that R&D spending reported to PMA has

increased at rates very similar to those recorded in

companies’ financial statements. (See chapter 2.)

Although OTA cannot rule out the possibility that

PMA-member firms systematically overestimate

human pharmaceutical research by the same

percent each year, this congruence in rates of

change with audited financial records suggests

the PMA aggregate R&D data are reasonably

sound estimates of total R&D spending.

The total R&D spending reported to PMA

includes spending not only on new drug products

but also on modifications and extensions of

existing products. PMA publishes the firms’

reported percent of R&D devoted to new products

in most years. Between 1973 and 1987 this

reported percentage varied in the range of 79 to

82. Wiggins used 80 percent as an estimate of the

proportion of total PMA spending devoted to

NCE R&D. The accuracy of the reported expenditures cannot be verified. How companies define

‘‘new products’ is unclear; if they include

follow-on products such as new formulations, the

estimate could be inflated for the purpose of

estimating NCE expenditures. If it is too high,

then the cash outlays estimated by Wiggins would

be slightly high.26

Although there are no industry-level studies

available to corroborate DiMasi’s project-level

analysis, DiMasi conducted his own check on his

estimates using aggregate PMA data. He allocated a portion of U.S. fins’ aggregate NCE

R&D costs in each year of the period 1967 to 1987

to the production of NCEs in subsequent years.

Using this approach he estimated the cash outlays

per successful new drug at $155 million (in 1990

dollars) compared with the survey-based method

of $127.2 million. This allocation technique

assumed that the production of self-originated

successful NCEs would continue into future years

at an average rate of 7.9 per year, despite the fact

that real R&D spending rose rapidly over the

period. The validity of this assumption is tenuous.

OTA did a quasi-independent check of the

results of the DiMasi study using data on aggregate R&D spending by the U.S. pharmaceutical

industry and the total number of self-originated

NCEs introduced by pharmaceutical companies.

OTA used DiMasi’s estimates (109) of aggregate

R&D spending on self-originated NCEs by the

U.S.-based industry between 1967 and 1987,

which were obtained from PMA. The total cash

R&D outlays estimated in the DiMasi study

($127 million in 1990 dollars) were attributed to

each self-originated NCE approved between 1979

and 1989, spread out over the time profile

estimated in DiMasi’s study. Total self-originated

R&D expenditures for the U.S. pharmaceutical

industry in 197727 calculated in this way were just

‘s Followup R&D conducted on existing products that have already been approved for marketing represents a real R&D cost that is not

included in any of the empirical studies but which affect the company’s net returns. This issue will be discussed in the next chapter on measuring

returns.

‘7 The year 1977 was the only one in which all self-originated NCE research would be for NCES approved in the 1979-89 period.
62 I Pharmaceutical R&D: Costs, Risks and Rewards

5 percent less than PMA’s aggregate spending

estimates for that year. This result would suggest

the costs, time profiles, and ratios of selforiginated to total R&D found in the DiMasi

project-level study are at least internally consistent with one another.

UNDERLYING COMPONENTS OF

OUT-OF-POCKET COSTS

The Hansen/DiMasi studies imply that real

cash outlays per successful NCE almost doubled

in the 7-year period separating the midpoints of

their study years, from $65.5 million to $127.2

million (in 1990 dollars). The increase would

have been even greater had the ultimate success

rate not improved markedly. The two surveys

cover NCEs first entering human testing in

1963-75 and 1970-82. Is there any evidence to

support such a rapid increase in the real costs of

conducting research between the two periods?

OTA examined data on three inputs to pharmaceutical R&D--research personnel, animal research subjects, and human research subjects—to

learn more about the factors driving the increase

in costs per successful NCE.

Research Personnel-The number of R &D

personnel that PMA member firms employ remained fairly stable throughout the 1970s but

began to grow rapidly in 1980 (figure 3-l). Most

of this growth was in scientific and professional

personnel, which numbered about 12,000 in 1977,

but increased to almost 29,000 by 1989. Greater

detail is unavailable 011 the kinds of jobs these

new employees performed.

As the R&D workforce grew, so grew the

salaries of biomedical research personnel employed by industry (figure 3-2); however, after

adjusting for general inflation,

28 salaries actually

decreased a bit. From 1973 to 1979, the median

annual salary of biological scientists employed by

business and industry decreased from $59,961 to

$52,545 (in 1990 dollars), and from 1981 to 1989

it rebounded from a low of $49,176 to $56,600.

Figure 3-1—Research and Development Personnel

in Pharmaceutical Companies, 1970-89

Number of R&D personnel (thousands)

50

45 r 7m

1970 72 74 76 78 80 82 84 86 88

~ Scientists and ~ Technical _ Support staff

professionals staff

SOURCE: Office of Technology Assessment 1993, basedon Pharrnacwtical Manufacturers Association Annual Survey Reports.

If labor costs boosted the cost of bringing new

drugs to market, it was largely due to the

increased labor input per NCE, not wages.29 How

much of the increase in employment in the 1980s

reflects increased labor inputs per successful

NCE, versus adjustments for a larger field of

NCEs entering each phase of clinical testing, or a

greater commitment to basic research, is unknown. The most that can be said is that the trends

in research personnel are not inconsistent with a

substantial increase in R&D cash outlays per

NCE for those NCEs frost entering clinical

research in the late 1970s and early 1980s.

Animal Research—Although data indicate the

number of some types of animals used in pharmaceutical R&D may have decreased over the last

decade, other evidence is consistent with increases in the per unit costs of animal testing.

One drug company, Hoffman-La Roche, reported that the number of animals it used fell from

1 million in 1979 to just under 250,000 in 1988

(204). Data collected by the U.S. Department of

Agriculture (USDA) also shows a significant

28 ~atlon adjustments were made using the GNP implicit price deilator.

29 me S~W data d. not ~fl=t be costs Of employ~ &nefits, however, which IIMy bve increased in red terms Ova the ptiod.
Chapter 3-The Costs of Pharmaceutical R&D 63

Figure 3-2—Median Annual Salary of

Doctoral Biological Scientistsa

Median annual salary ($ thousands)

60

\

~-—-”

40 -:

1

20 “

-- ”- ““”-- ”--” “-

”

- “--””-””- ‘“- -”------”

o~,

I

1973 75 77 79 81 83 85 87 89

-- current doll~s -+- constant doll~s

a Emp[oyed in business and industry.

SOURCE: National Science Foundation, Surveys of Science Resource Series, Research and Development in Industry:

1987, Detailed Statistical Tables, NSF 89-323 (Washington, DC: U.S. Government Printing Office, 1989). National

Science Foundation, Surveys of Science Resource Series,

Research and Development in Industry, 1988, Detailed

Statistical Tables, NSF 90-319 (Washington, DC: U.S.

Government Printing Office, 1990).

decline in absolute and relative use of animals for

experimentation between 1975 and 1988 in States

with a disproportionate number of industrial

pharmaceutical R&D laboratories (459,460). However, these data are not definitive, since many

pharmaceutical firms contract with other facilities

to conduct their animal tests in other States. In

addition, the USDA numbers do not include

rodents, which make up the bulk of all animals

employed in drug R&D, especially in the early

efficacy and safety testing of potential drug

candidates that companies ultimately abandon

(133).

Beyond these few facts, several forces have

been at work over the last 10 years to both

increase and decrease the use of animals in

pharmaceutical research. Because early testing

involves the greatest number of animals, it also

has the greatest potential for reduction. HoffmanLa Roche said most of its reduction in the use of

animals came from these early phases of the R&D

process. Also, improvements in in-vitro testing

and other innovations like computer modeling

(described in chapter 5) may decrease some of the

demand for rodents (133),

On the other hand, an earlier OTA report

concluded that alternatives to many types of

animal testing are limited (447). Also, pharmaceutical executives interviewed by OTA suggested any efficiencies brought about by such

innovations in the R&D process are counterbalanced by the increased number of compounds to

be tested for pharmaceutical activity. In addition,

the number of animals used in later safety testing

is largely governed by regulatory standards.30

Any possible decline in the number of animals

used in drug R&D in the past decade was met by

significant increases in the cost of acquiring

animals and conducting tests in animals. An OTA

contractor surveyed 3 major commercial breeders

of animals used in drug R&D and 11 laboratories

that perform such research for pharmaceutical

fins. Table 3-6 shows trends in the costs of

Table 3-6—Trends in the Cost of Acquiring

Research Animals ($ 1990)

Cost per animal Fold

Species 1977 1980 1987 1990 increase

Rats. . . . . . . . . . — 5.29 — 8.45 1,6

Mice. . . . . . . . . . — 0.92 — 1.35 1.5

Guinea pigs. . . . — — — 25.30 —

Rabbits. . . . . . . . 8 — 33.6 — 4.2

Dogs. . . . . . . . . . 195 — — 300-500 1.5-2.6

Monkeys. . . . . . . 391 — — 1,000 2.6

NOTE: All crests were adjusted using the GNP implicit price deflator.

Facilities surveyed were Charles River, Taconic Farms, and

Hazieton. These faciliti- focus on breeding only. Although

Hazelton conducts testing, it is carried out in a separate

division.

SOURCE: Office of Technology Assessment, 1993, based on W.G.

Flammand M. Farrow, “Recent Trends in the Use and Cost

of Animals in the Pharmaceutical Industry,” contract report

prepared for the Office of Technology Assessment, April

1991.

so See table 6-1 in Chapter G for estimates of the number of animals typically used in each category of phmXXWiCd safety testing.
64 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 3-7—Price of Animal Studiesa ($ 1990 thousands)b

Number of Labs

Estimated price Price range Fold providing

Study in 1980 In 1990 increase information

Acute rats. . . . . . . . . . . . . . . . . . . $0.8

28-day toxicity in rats. . . . . . . . . . 15

Subchronic rats. . . . . . . . . . . . . . . 38

2-year rat bioassay. . . . . . . . . . . . 384

Teratology rats. . . . . . . . . . . . . . . . 23

Acute monkey. . . . . . . . . . . . . . . . 14

Subchronic monkey. . . . . . . . . . . . 74

Acute dog. ... , . . . . . . . . . . . . . . . 2.3

Subchronic dog. . . . . . . . . . . . . . . 46

$4- 5

30-65

55-143

250-575

52-70

39-62

108-184

22-51

72-147

5-6.25

2 -4.3

1.4 -3.8

.7- 1.5

2.3 -3.0

2.8 -4.4

1.5 -2.5

9.6 -22.1

1.6 -3.2

8

6

8

5

5

6

6

7

7

a Each laboratory survey~ was given an identical protocol on which the price is based. The “cost” includes profit as

well as all direct and indirect costs. Laboratories surveyed were Hazleton, Bioresearch, IIT, TSI Mason, E3io/dynamics,

Pharmakon, PRI, and IRDC.

b All ~ria~ were adjust~ to 1990 dollars using GNP implicit prim deflator.

SOURCE: Office of Technology Assessment, 1993, based on W.G. Flamm and M. Farrow, “Recent Trends in the Use

and Ccst of Animals in the Pharmaceutical Industry,” contract report prepared for the Office of Technology

Assessment, DC, April 1991.

commonly used species.31 The data indicate a

significant upward trend in the real cost of

acquiring all species of animals ex amined, with

especially large increases in the costs of nonrodents.

OTA’s contractor also surveyed eight facilities

that conduct toxicological animals studies about

the increases in their fees for tests involving

various species. The results (shown in table 3-7)

suggest the total costs of testing, which implicitly

includes the cost of the animals’ breeding, has

also risen significantly over the last 10 years.

Another indicator of the potential increase in

animal costs is PMA member fins’ spending for

safety and toxicological tests, R&D functions that

use animals heavily. Between 1980 and 1989,

spending for these functions went from $102

million to $565 million in 1989 dollars. Spending

for safety testing increased from 7 to 10 percent

of all R&D spending on human pharmaceuticals

over the same 1980-89 period (321,324). However, these measures are imperfect, since not all

animal testing is for safety and toxicology and not

all safety and toxicology testing involves animals. The increase could reflect the increase in the

number of NMEs tested for safety and toxicological effects during the 1980s.

Among the suggested reasons for animal cost

increases in the OTA survey of animal research

facilities are: 1) increased demands that animals

be healthy and virus-free, largely eliminating the

use of pound animals and explaining the particularly large increase in costs of some studies

involving dogs; 2) stricter regulation of animals’

living conditions under the Animal Welfare Act

(most recently amended by Public Law 99-198),

other government guidelines, and professional

standards set by the American Association for

Accreditation of Laboratory Animal Care; and 3)

increased security for facilities housing animal

research (133).

Research on Human Subjects—Pharmaceutical executives claim that the size of ‘human

clinical trials has increased dramatically over

time. A rapid increase in trial sizes is consistent

with an increase in the estimated cost of phase III

clinical trials from $5.7 million (in 1990 dollars)

for each new chemical entity (NCE) entering the

phase in Hansen’s study to $14.3 million (in 1990

dollars) in DiMasi’s study. Part of the explanation

31 Because ~ch ~weyed la~)rat~~ ~p~cifi~s in p~c~ar sp~ies, cost data for ~ch type of - are &WVIl frOIIl OIdy One klbOratOry

(except for dogs, which are represented by &ta from two breeders).
Chapter 3-The Costs of Pharmaceutical R&D ! 65

for such a large increase may be a change in the

mix of drugs being tested from those for acute

illness to those for chronic illness. Drugs for

chronic use often require larger trial sizes.

Even within specific categories of drugs, however, the size of trials appears to have increased.

OTA surveyed pharmaceutical companies for the

size of clinical trials conducted prior to FDA

approval for NCEs in three classes: antihypertensives, antimicrobials, and nonsteroidal antiinfl ammatory drugs (NSAIDs). (See chapter 6 for

a more detailed discussion of the survey and its

findings.) Drugs in each class approved for

marketing between 1978 and 1983 were compared with those approved between 1986 and

1990. 32 Table 3-8 shows the total number of

subjects entered in trials up to the point of NDA

submission. The average number of subjects

increased between the two periods, with the

largest increase occurring in research conducted

outside the United States.

Although the drugs examined in the clinical

trial survey do not correspond very well to the

Hansen/DiMasi research periods (only the later

years of the Hansen study correspond to the

approved drugs in the 1978-83 period), they do

Table 3-8-Mean Enrollment in Clinical Trials Prior

to New Drug Application, 1978-83 and 1986-90

(number of drugs in parentheses)

Ratio of

period 2 to

1978-83 1986-90 period 1

Antihypertension drugs, . . 1,791 (9) 2,485 (9)

U.S. studies. . . . . . . . . . 1,126 (8) 1,355 (9)

Foreign studies. . . . . . . 665 (8) 1,150 (9)

Antimicrobial. . . . . . . . ..1,885 (15) 3,461 (12)

U.S. studies. . . . . . . . . .1,248 (15) 2,049 (11)

Foreign studies. . . . . . . 637 (15) 1,412 (11)

Nonsteroidal antiflammatory

drugs. . . . . . . . . . . . . . . . 3,036 (4) 3,575 (4)

U.S. studies. . . . . . . . . . 1,698 (4) 2,745 (4)

Foreign studies. . . . . . . 1,338 (4) 830 (4)

1,39

1.19

1.73

1.84

1.64

2.22

1,18

1.62

0.62

SOURCE: Office of Technology Assessment, 1993.

show convincingly that the number of subjects in

clinical trials increased in the period between the

later years of the Hansen study and the later years

of the DiMasi study.

The rapid increase in the number of foreign

subjects suggests that the rising cost of preapproval research may be explained in part by the

globalization of research strategies over time. If

U.S. firms began to prepare self-originated NCEs

for entry into foreign markets earlier, and if

foreign governments increased their requirements

for premarket approval over time, as they did

during the 1970s, the estimated cost of developing NCEs in the IND-NDA period would increase

even though part of the cost increase was for

approval in other markets.

1 Conclusions About Validity of

Existing Estimates

Although the cost estimates of bringing an

NCE to market are imprecise and potentially

biased, corroborative evidence from the aggregate studies suggests they are not grossly overestimated. The Hansen/DiMasi studies suggest: 1)

the cost of developing NCEs rose rapidly in the

1970s and 1980s, and 2) increases in the numbers

of employed research personnel, the size of

clinical trials and the cost of animals are potentially important causes of this rise.

Some of the observed cost increase maybe due

to the restructuring of R&D into an integrated

global process in the 1970s and early 1980s.

U.S.-based firms became more aggressive in

conducting the development required for approval of NCEs in other countries, thus compressing R&D expenditures into the pre-NDA approval phase. Nevertheless, these R&D costs,

which may have been undercounted in the earlier

studies because they occurred after the FDA

approval date, are justifiable R&D outlays. Although the actual cash outlays required to bring a

new drug to all of its potential markets may not

have increased as rapidly as the studies suggest,

32 Hmen~~ ~~udy ~w~ @c+ flr~t ~ntefig ~c~ting &twMn 1963 ~d 1975) ~ome~ponds roughly wi~ in~oductio~ between 19’70 and

1981. DiMasi and colleagues’ study years (1970-82) corresponds roughly with introductions between 1978 and 1990.
66 I Pharmaceutical R&D: Costs, Risks and Rewards

the recent estimates of DiMasi and colleagues of

the pre-FDA approval cash outlays are reasonably

accurate.

Can more or different kinds of studies improve

on the existing estimates? More careful analysis

of project cost accounts and adjustment of estimates for different cost allocation rules would

give a more consistent estimate across firms, but

it is unlikely the resulting estimates of cash

outlays would be very different, and probably not

lower.

Gaining access to proprietary company management cost accounts in a large enough number

of companies would be very costly and would

take many years. Although Congress has the

power to subpoena financial data, pharmaceutical

companies have demonstrated a willingness to

actively resist providing access to this proprietary

data. Past efforts of the U.S. General Accounting

Office to obtain data on pharmaceutical costs

were ultimately unsuccessful after many years of

effort that ultimately involved decisions in the

U.S. Supreme Court. (See appendix D for a

history of the court cases and a legal analysis of

congressional access to pharmaceutical companies’ financial data.)

T o summarize, the estimates by DiMasi and

colleagues of the cash outlays required to bring a

new drug to market and the time profile of those

costs provide a reasonably accurate picture of the

mean R&D cash outlays for NCEs first tested in

humans between 1970 and 1982. The rapid

increase in inflation-adjusted R&D cash outlays

over the relatively short observed time span

separating Hansen’s and DiMasi’s studies illustrates how quickly such costs can change and how

sensitive such costs are to changes in R&D

success rates over time.

OTHER FACTORS AFFECTING VALIDITY

1 The Cost of Capital

Capitalizing costs to their present value in the

year of market approval more than doubles the

cost of R&D as estimated by DiMasi and colleagues, from $127 million (in 1990 dollars) for

cash R&D outlays per successful drug to $259

million (at a 9 percent interest rate). While the

practice of capitalizing costs to their present value

in the year of market approval is a valid approach

to measuring R&D costs, little is known about the

appropriate cost of capital for R&D projects.

A completely accurate measurement of capitalized cost would require the analyst to know, for

each dollar spent on the particular sample of

NCEs studied by DiMasi, the cost of capital that

pertained to that investment at the time it was

made. Even though these are retrospective studies, the cost of capital that should be assigned is

the cost the investors actually faced at the time

they made their investments.

The cost of capital varies widely across types

of research projects and with successive investments as the project progresses toward the market. (See appendix C for an explanation.) It also

changes from day to day as the risk-free interest

rate changes. But detailed data on the actual

riskiness of particular projects invested at specific

times simply do not exist. Consequently, the fully

capitalized cost of R&D associated with the

NCEs entering testing in DiMasi’s study can be

only crudely approximated.

All of the R&D cost studies reviewed in this

chapter assumed the cost of capital for R&D

investments was constant across all projects and

over the entire period during which the R&D

spending on the sampled NCEs was taking place.

Myers and Shyam-Sunder estimated for OTA the

inflation-adjusted weighted average cost of capital for a sample of pharmaceutical firms at three

points in time, January 1, 1980, January 1, 1985,

and January 1, 1990, at 9.9, 10.7 and 10.2 percent

respectively (285). For pharmaceutical companies as a whole, then, a reasonably rough approximation for the cost of capital over the period of

DiMasi’s study would be 9 to 10 percent. (The

higher the cost of capital, the higher would be the

estimated R&D cost, so DiMasi’s choice of 9

percent is conservative in that regard.)

Pharmaceutical firms can be thought of as

collections of investments, some with high risk

and some with low risk. R&D investments are
—

Chapter 3--The Costs of Pharmaceutical R&D I 67

riskier than other investments pharmaceutical

companies make, but for reasons that are different

from conventional ideas about risk (see appendix

C for explanation). The earlier in the R&D

process the investment is (e.g., at the preclinical

phase of research), the higher its cost of capital is

likely to be. How much riskier R&D investments

are than the other investments of the firm cannot

be precisely estimated with existing data, however. The best that can be done to get a quantitative estimate of the cost of capital for pharmaceutical R&D projects is to examine the cost of

capital for firms investing largely in R&D and

having relatively little investment in ongoing

operations.

Myers and Shyam-Sunder estimated the real

cost of capital for seven small pharmaceutical

fins, three of which were biotechnology fins, at

14 percent, 4 percentage points higher than the

cost of capital for 15 large pharmaceutical companies. In an unrelated study, Stewart (409) estimated the cost of capital for business risk for

1,000 publicly traded companies in the United

States and Canada. Companies whose main

business was providing R&D services (R&D

laboratories) had a cost of capital for business risk

approximately 4.5 percentage points higher than

the cost of capital for business risk for the drug

companies in Myers and Shyam-Sunder’s sample. Shyam-Sunder’s recent update of the Myers

and Shyam-Sunder paper found a 2.6 percent

difference in the net cost of capital between 30

biotechnology firms and 19 large pharmaceutical

firms (390).33 The results of these studies suggest

that a 4 percent differential in the cost of capital

from the beginning to the end of the research

process is a reasonable upper bound for the

capitalized costs of early R&D.

The weighted average cost of capital for

pharmaceutical firms with ongoing operations

(after adjusting for inflation expectations) was

roughly 9 to 10 percent over the past 15 years.

Investments in manufacturing capacity should

therefore be below that value, while R&D investments should be above it. A reasonable upper

bound on the true cost of capital for early

pharmaceutical R&D can be constructed by

assuming investments in a manufacturing plant

have a 10 percent cost of capital (a high estimate).

Applying the 4 percent spread (a relatively high

estimate) to the 10 percent cost of capital, the real

cost of capital for early R&D would be no greater

than 14 percent.

OTA recalculated DiMasi’s study with a cost

of capital that decreases linearly over the life of

R&D projects from 14 to 10 percent. The

resulting capitalized cost in DiMasi’s study

increases from $259 million to $359 million (in

1990 dollars). Thus, an upper bound on the full

cost of bringing NCEs to market in the 1970s is

roughly $359 million. These calculations highlight the sensitivity of the estimate of fully

capitalized R&D costs to assumptions about the

cost of capital for R&D.

TAX SAVINGS FROM R&D

A company’s effective cost of bringing a new

drug to market is substantially reduced by tax

savings the company (or its investors) receives

when it invests in R&D. The net cost of every

dollar spent on research must be reduced by the

amount of tax avoided by that expenditure. These

tax savings from R&D come about both from

deductions and from tax credits that reduce a

company’s tax liability when it spends money on

R&D. 34

33 A 1989 ~umey of ~PP~Oxi~t~lY 145 blotec~ology f~engaged in ~erapeutic h~~ ~kets reportecl R&D expenses accounted fOr

67 percent of product sales (64).

34 Compties get~br&from a n~ber of provisio~ ~the Fe&r~ IM code tit eff~tively reduce the mount of taxes they owe On

earned income. (See chapter 8 for details.) Some of these tax savings are not influenced by the amount of money the company invests in R&D.

For example, companies that manufacture products in Puerto Rico and other U.S. possessions can take advantage of a tax credit on income

from those operations (see chapter 8). The amount of the possessions tax credit that can be claimed is unaffected by how much R&D the

company performs. Thus, the effect of taxes on the cost of R&D must be computed as if the possessions tax credit did not exist. Only those

w savings that come about from conduct of R&D should be included in the analysis.
68 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 3-9--U.S. Corporate Marginal Tax Rates, 1971-91

Taxable Income ($) 1971-74 1975-78 1979-81 1982 1983 1984-86 1987” 1988-91

0-25,000 . . . . . . . . . . . . 22 20 17 16 15 15 15.0 16

25,000 -50,000 ..,.... 48 22 20 19 18 18 16.5 16

50,000 -75,000 . . . . . . . 48 48 30 30 30 30 27.5 25

75,000-100,000 . . . . . . . 48 48 40 40 40 40 37.0 34

100,00-335,000 . . . . . . . 48 48 48 46 46 46 42.5 39

335,000-1,000,000. . . . 48 48 48 46 46 46 40.0 34

1,000,000-1,405,000. . 48 48 48 46 46 51 42.5 34

1,405,000+. . . . . . . . . . 48 48 48 46 46 47 40.0 34

a1987t~rat~ were based on averagerates pati in1986and 1988. Figures shown arethe average orrates paidby

allfirmsin 1987.

SOURCE: U.S. House of Representatives, U.S. Congress, ‘The Overview of the Federal Tax System,” 102d Congress

(Washington, DC: U.S. Government Printing Office, April 10, 1991).

Under section 174 of the Federal tax code,

qualifying R&D expenses are deductible from

taxable income. This tax deduction reduces the

cost of qualifying R&D by the amount of the

company marginal tax rate.35 Table 3-9 presents

the U.S. corporate marginal tax rates for the years

1971 to 1991. Because of the size and sales of

most major pharmaceutical firms, the bulk of their

taxable income would fall into the highest tax

bracket. 36 Hence, in the simplest analysis, the cost

of R&D spending should be reduced by the top

tax rate.37 Between 1971 and 1991, this marginal

tax rate fell from 48 to 34 percent, thus effectively

raising the cost of R&D. (It also raised the

after-tax revenues from products resulting from

the R&D, so the importance of taxes is not nearly

as great when measuring net R&D returns, rather

than R&D costs in isolation.)

In the R&D period covered by DiMasi (1970-

87), the rate declined from 48 to 46 percent. With

a 46-percent tax rate, the after-tax cost of $1.00 of

R&D undertaken at the time of DiMasi’s study

would be: $1.00-$0.46 = $0.54.38 Today, the net

cost of a dollar of R&D undertaken by an

established company with positive net income

would be $0.66.39

During the 1980s two tax credits were put into

effect that reduce the cost of pharmaceutical

R&D. In 1981, Federal tax law was amended to

include a tax credit for any firm when it increases

“qualifying” R&D expenses. This credit carried

a statutory credit rate of 25 percent of qualifying

35 E a fm conducts R&D in Oher Countries that allow R&D to be deducted from taxable income but have tax rates that differ from tiose

in the United States, the company may realize a different net rate of reduction in the cost of its R&D.

36 since tie firms Stu&ed by Hansen and DiMasi made up 40 percent of domestic RtlcD, they were probably cOmpOWd ~gely of well

established pharmaceutical firms.

37 Uwe o~er R&D expe~;es that are &xlwM in the year they are made, capital expenditures for R&D, such as new MD equipment or

facilities, are depreciated from taxable income over several years. The shorter the period of depreciation the greater will be the effect of tax

savings on the cost of R&D. Prior to 1981, Federal law required firms to deduct R&D capital expenditures in equal amounts over the useful

life of the equipment or building, which could be 10 years or more. Beginning in 1981, fm could fully depreciate R&D capital expenditures

within 3 years, although in 1986 Congress raised the period to 5 years. Not much is known about the depreciation schedules used to estimate

R&D costs in the Hansen and IMMasi studies. Depreciation schedules on tax returns maybe different from those for fmcial statements, and

without more detailed information it is impossible to know whether the net tax savings for R&D capital expenditures are higher or lower than

the statutory marginal rate. OTA assumed for the analyses here that R&D capital expenditures are taxed at the marginal tax rate.

38 As explfied~c~pter g, not ~1 R&r) exwmesmeet he definition of ‘q~ifying’ laid Out in section 174 of the tax code. This definition

becomes important for calculating the orphan and R&D tax credits discussed below. However, it is not important here for calculating the

deductio% because R&D expenses not deductible under section 174 are nonetheless deductible as other business expenses.

39 sm~ls-pbiotec~olov fm may ~ve lltfle or n. taxab]e irlcome, but tax losses can be carried foward irlto future yWS. Stm some

fii may never become profitable, and the value of future tax benefits is less than those that can be used immediately. Therefore, the net cost

of research to such small firms may be higher than for established pharmaceutical fins.
Chapter 3-The Costs of Pharmaceutical. R&D! 69

expenses until 1986, when the rate was reduced to

20 percent. The credit pertains only to increases

in R&D, not to actual expenditure levels, so the

extent to which it actually reduces the cost of

R&D would depend on research spending trends

in firms themselves. Because pharmaceutical

R&D grew rapidly in the 1980s, the pharmaceutical industry may have benefited more than other

industries from the R&D tax credit.

The Orphan Drug Act of 1983 (Public Law

97-414) provided a 50-percent tax credit for

qualifying clinical R&D on investigational drugs

that have been granted orphan status by the FDA.

The credit is available only for “qualifying”

clinical research, not for animal or laboratory

research and not for supervisory or other kinds of

R&D expenditures typically disallowed by the

Internal Revenue Service. Also, when the credit is

applied, the expenses cannot be deducted, so the

net cost of a dollar of qualifying research under

this credit is effectively $0.50. Companies without current taxable income cannot save the credit

for use in future years, however, so startup

research-based firms may not have access to this

credit.

Because these credits are of recent vintage and

would not apply to the vast part of the research

undertaken in the time periods studied by Hansen

and DiMasi, they would not affect the net costs of

that research. Chapter 8 contains estimates of the

extent to which these credits have been claimed in

recent years.

To illustrate how important tax savings are to

net R&D costs, OTA recalculated the R&D cost

per new chemical entity from DiMasi’s estimates

(table 3-10). The sample of NCEs that DiMasi

studied underwent the great bulk of discovery and

development at a time when the marginal tax rate

was 46 to 48 percent. Adjusting for tax savings

(using a 46-percent rate) without any other

changes reduces the net cash outlays per NCE

from $127.2 million to $65.5 million, and it

reduces the total costs capitalized to the point of

market introduction from $259 million to $140

million. When the cost of capital was permitted to

decrease linearly from 14 to 10 percent over the

Table 3-10-After-Tax R&D Costs Estimated by

DiMasi Under Different Assumptions About the

Cost of Capital” ($ 1990 millions)

Before-tax After-tax savings

Cost of capital (%) savings (46%)

9 $258,650 $139,671

10 279,112 151,045

Variable (10 - 14) 359,313 194,029

a AH a~umptions, given in 1990 dollars, were adjusted fOr inflation

using GNP implicit price deflator.

SOURCE: Office of Technology Assessment, 1993, estimates adapted

from J.A. DiMasi, R.W. Hansen, H.G. Grabowski, et al.,

“The Cost of Innovation in the Pharmaceutical Industry,”

Journal of Health Ewnomics 10:107-14°, 1991.

life of the R&D projects, the net after-tax cost was

$194 million. This estimate is an upper bound on

the cost of bringing new drugs to market for

products that frost entered human testing in the

1970s.

Lower tax rates in the 1980s would raise the net

costs of research, all other things being equal, to

as much as $237 million in after-tax dollars, but

because R&D outlays per successful drug are

extremely sensitive to changes in technical and

regulatory conditions, it is impossible to predict

the cost of R&D for projects beginning today. The

rising number of biotechnology-based drugs under

investigation in recent years (see below) may

radically alter the time and expenditure profile in

ways that can not be predicted from the DiMasi

study.

RECENT TRENDS IN THE COST OF R&D

The studies of R&D costs reviewed in this

chapter examined NCEs that entered testing in the

1960s and 1970s. There are few data sources,

outside of aggregate R&D expenditures, to establish trends for drugs that entered clinical research

in the 1980s. As the previous chapter described,

R&D spending climbed dramatically in real terms

throughout the 1980s, but the ultimate impact of

these spending increases on the cost of developing NCEs will depend on the productivity of the

research in bringing promising NCEs into clinical

testing and ultimately to market.

OTA compared recent data (from the 1980s) on

the outputs of pharmaceutical research, the length
70 I Pharmaceutical R&D: Costs, Risks and Rewards

of the development period and success rates for

NCEs with data from the 1970s. overall, the data

suggest the output of preclinical research-the

submission of investigational new drug applications for new molecular entities—has increased in

the 1980s. Moreover, the rate of success in

reaching the NDA stage or market approval has

improved for NCEs introduced in the 1980s.

However, the higher success rates for NCEs may

be partly driven by an increase in the proportion

of INDs for licensed-in drugs.

1 Trends in Commercial INDs for NCEs

Data published by the FDA Center for Drug

Evaluation and Research show the total number

of commercial INDs handled by the Center

increased from an average of 253 per year

between 1975 and 1980 to 334 per year between

1981 and 1990.40 (See chapter 6 for more detail.)

Because the same NCE, may have multiple INDs,

and new uses or formulations of existing drugs

also require INDs, the total number of INDs is not

a perfect indicator of increases in the number of

NCEs entering clinical development. Data from

CSDD’S NCE survey of over 40 companies

indicate the number of INDs for NCEs increased

from 210 per year in 1975-78 to 299 per year in

1983-86 (107).41 Although INDs for U.S. selforiginated NCEs grew by 25 percent between the

periods, the percent of all NCE INDs that was for

self-originated drugs declined from 60 to 53

percent between the two periods. Licensed-in

drugs and INDs submitted by foreign firms grew

as a proportion of total NCE INDs submitted to

the FDA.

Not only did the number of INDs increase

rapidly throughout the 1980s, but the makeup of

the drugs shifted from chemically synthesized

compounds to biotechnology drugs (see figure

3-3) (66). This substantial shift means that the

technologic and regulatory conditions that influence drug R&D costs have changed in the decade

Figure 3-3-Biologic Applications for

Investigational New Drugs,

Fiscal Years 1980-91

Number of INDs

300~ I

200

I

1980 81 82 83 84 85 86 87 88 89 90 91

~ Biotechnology INDs _ Nonbiotechnology INDs

SOURCE: Federal Coordinating Council for Soience, Engineering,

and Technology, Office of Science and Technology Policy,

Executive Office of the President, Biokchrdogy for the

21st Centwy:A Report by the FCCS~Convnitbe on Life

Sdences and Hea/th (Washington, DC: U.S. Government

Printing Office, February 1992).

of the 1980s. Success rates, regulatory delays, the

length of the preclinical and clinical period, and

costs of clinical research may be vastly different

for these new drugs. Prediction of today’s cost of

bringing a new drug to market on the basis of the

kinds of drugs that were being tested in the 1970s

—the period of DiMasi’s study-is bound to be

inaccurate.

I Trends in Success Rates

Data CSDD supplied on NCEs developed by

companies responding to its ongoing survey

indicate the probability of reaching the NDA

stage was higher for NCEs first entering clinical

testing between 1980 and 1982 than it was for

NCEs first entering clinical testing in the 1970s.

40 me ~ubli~hed ~~Ubem do not include biologic~s, ~cau~ tie Center for Bio]ogics d~s not compile such dab. Biological prOdUCtS

under development were few in the 1970s, but grew rapidly in the 1980s.

41 D~si ~d co~ea~es also give information on the 1979-82 period. See chapter 6 for more detail.
Chapter 3-The Costs of Pharmaceutical R&D 71

Table 3-11 shows the proportion of NCEs in the

CSDD sample for which an NDA was filed within

48 or 60 months of IND filing for four cohorts of

NCEs first entering clinical testing.42 In addition,

the FDA supplied OTA with more recent data on

a sample of NCEs whose frost commercial INDs

were filed in the 1984-86 period that were

compared with an earlier published FDA analysis

of a similar group of INDs first filed 1976-78.

INDs reaching the NDA filing stage within 54

months increased from 6.8 to 11 percent. (Though

few NMEs were approved from the 1984-86

cohort, the overall approval rate was also higher.

See chapter 6 for more detail.)

Although overall success rates have improved

in the recent past, the improvement may be due in

part to a shift in NCEs from self-originated to

licensed-in. Licensed-in drugs have higher success rates than do self-originated drugs, probably

because they are self-selected for success. For

example, of NCEs entering testing between 1970

and 1982, an NDA was submitted within 48

months for 7 percent of self-originated drugs,

compared with 21 percent of licensed-in drugs

(427). At 60 months, 28 percent of licensed-in

NCEs had reached NDA submission compared

with 9 percent of self-originated drugs. Of NCEs

entering human testing among U.S. companies,

those licensed-in grew from about 21 percent in

1975-78 to 27 percent in 1983-86 (107). Thus, the

improvement in success rates for drugs first

entering testing in the 1980s is at least partly due

to the changing source of NCEs.

I Recent Development of Orphan Drugs

Since 1983, Federal law has stimulated the

development of orphan products through a series

of incentives and subsidies, including the tax

credit for clinical research on designated orphans

drugs. (See chapters 8 and 9 for more detail.)

These products may have a very different cost

Table 3-n-Percent of NCEs Reaching NDA/PLA

Submission in Given Time Intervals

Year in which NCE

Percent flllng NDA/PLA within:

entered clinical trials 48 months 60 months

1965 -69. . . . . . . . . . . . . . . . . 4.6% 7.O%

1970 -74. . . . . . . . . . . . . . . . . 8.0 12.0

1975 -79. . . . . . . . . . . . . . . . . 10.0 13.0

1980 -82....., . . . . . . . . . . . 12.0 17.0

KEY: NCE. new chemical entity; NDA. new drug application; PLA -

product license application.

SOURCE: Office of Technology Assessment, 1993, based on data

supplied by Tufts University Center for the Study of Drug

Development from its database of NCES reported by 41

pharmaceutical firms.

structure from other NCEs, not only because of

the tax credit but also because they may involve

smaller and shorter clinical trials than other drugs.

Although FDA approval standards are no different for this class of drugs than for others, orphan

drugs are likely to have smaller and quicker

clinical research studies than other studies because of the relative rarity of the diseases studied.

The FDA provided OTA with confidential data

on new molecular entities (NMEs) whose first

commercial IND was filed in the years 1984-86.

(See chapter 6 for more detail on this sample of

drugs.) Within 54 months of the IND filing, an

NDA had been filed for 11 percent of all INDs,

and 3.8 percent had been approved (see chapter

6), whereas for NMEs that had orphan designations, an NDA had been filed within 54 months

for 33 percent, and 11 percent had been approved. 43

Regulatory approval times also appear to be

shorter for orphan drugs. For example, during the

period 1985-90, the average approval time for

approved drugs without orphan designation was

29.3 months, while for approved orphan drugs it

was 27.4 drugs (168). For products classified as

“A” by the FDA, the approval time for nonorphans was 25.7 months, while for orphans it

42 A ~eae~sion of ~A f~g ~ate~ on tfie ~dicated the ficma~e ~ho~ in the table was statistically si~lcat at the 1(I percent level Of

significance for both the 48-month and 60-month success rates.

43 Ow identified fine -s for which tie first ~ommerci~ ~h~ been fid~ in 1984-86, md which tid been gllUlted ~ O~hilIl

desigmtion. An additional four NMEs in the IND cohort had orphan designations, but data on the sponsoring company were inconsistent and

they were not used. (Exclusion of the four NMEs did not change the results materially.)
72 I Pharmaceutical R&D: Costs, Risks and Rewards

was 18.1 months (168). Although it is impossible

to know whether the ultimate success rate for

orphan products will be higher or lower than for

nonorphans, the sensitivity of development costs

to success rates suggests orphan drugs may have

a substantial cost advantage.

CONCLUSIONS

The increase in the inflation-adjusted cost of

developing anew drug from the early 1970s to the

late 1970s is dramatic. Real cash outlays per

successful NCE increased by almost 100 percent

in the period. The evidence suggests that, in 1990

dollars, the mean cash outlay required to bring a

new drug to market (including the costs of failures

along the way) was in the neighborhood of $127

million for drugs first entering human testing in

the 1970s. The size of this required cash investment depends on the rate of success at each stage

of development and the ultimate productivity of

the research enterprise. Small differences in the

ultimate success rate can make a big difference in

the cost per approved NCE. Other factors, such as

changes in R&D technology and regulatory

conditions, can also have dramatic and rapid

impacts on costs. Thus, the estimates of the R&D

cost per successful product are inherently unstable over time.

The fully capitalized cost of bringing a new

drug to market cannot be measured with great

accuracy because the cost of capital for R&D

investments is unknown. The best evidence

suggests, however, that for drugs first entering

human testing in 1970-82, the after-tax cost per

successful drug, capitalized to the point of FDA

approval for market, was somewhere between

$140 million and $194 million (in 1990 dollars).
—.

T

Returns on

Pharmaceutical R&D 4

he cash outlays spent in bringing a new product to the

point of approval for marketing in the United States

increased in the 1970s and early 1980s. These cash

outlays occurred over a substantial period of time, an

average of 12 or more years.

A company makes these investments expecting that the

financial returns from successful drugs will be high enough to

justify the money, time, and risk involved. If the expected

financial returns are too low to repay investors, then research and

development (R&D) will decline as fewer projects are pursued.

On the other hand, if overall returns on drugs introduced in the

past are more than enough to repay investors for the cost, time,

and risk involved, then consumers are paying too much.

Evidence of long-run persistence of higher returns for new drugs

over what is necessary to justify the cost and risk of R&D would

imply unnecessary pricing power for new drugs [366). 1

In an industry with active competition, pharmaceutical R&D

investment will follow expected returns on new products. The

introduction of a ‘‘pioneer’ drug, the first product introduced

within a family of compounds, should and often does lead to

R&D by rival firms intent on introducing a similar therapeutic

alternative, or ‘ ‘me-too’ drug (158, 298), which can share the

market with the leader. Box 4-A describes the intense competition among rival firms for the development of compounds in an

important new class of drugs for the treatment of high cholesterol.

] The ra[ionaIc for p~fcrrt pro[cction N basccl orI the need for provi~lng a return on the

R&D ncccssary to bring an innovation to the market (366). In the absence of patent

protection (or some other form of protection from imitation), competitors would copy the

innovation tit a fraction of the cost to the innovator and sell [he product at prices that arc

insufficient to recover the imtial R&D investment. Thus, incentives to invest in

mnovatlon would bc comprormscd (242).

73
74 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 4-A--HMG-CoA Reductase Inhibitors

In August 1987, the first of a newly discovered class of cholesterol-lowering drug compounds known

as HMG-CoA reductase inhibitors was approved for marketing in the United States. The drug, lovastatin,

developed by Merck & Company, generated higher first-year sales than any previously introduced

prescription medicine. Today, lovastatin has annual sales exceeding $1 billion and maintains a 60 percent

share of the U.S. market for all cholesterol-lowering drugs.

The competitive drive to bring the first HMG-CoA reductase inhibitor to market highlights the intense

research and development (R&D) rivalry that frequently precedes the debut of an innovative new drug.

Although Merck was the first company to win U.S. marketing approval for a drug in that class, Merck was

not the first to synthesize and clinically test such an agent. The prototype HMG-CoA reductase inhibitor,

mevastatin, was isolated in 1976 by researchers at Japan’s Sankyo. Mevastatin entered phase I clinical trials

in Japan and other countries in 1978. At that time, Mevastatin showed much promise in significantly

reducing low-density lipoprotein (LDL) cholesterol levels with few side effects. Meanwhile, scientists at

Merck isolated a related compound, lovastatin, early in 1979. Merck filed for a U.S. patent on lovastatin just

months after Sankyo filed for a Japanese patent on mevastatin.

Foreign clinical trials with lovastatin began in April 1980 but were suspended just 5 months later

because, according to a Merck spokesman, “a similar compound had caused a toxic reaction in animals at

another lab. ” Although it was not announced at the time, the “similar compound” was Sankyo’s

mevastatin, which had been quickly withdrawn after intestinal lymphomas were found in 50 percent of

laboratory dogs undergoing tests with the drug.

In 1982, Merck allowed several clinicians to file individually sponsored investigational new drug

applications (INDs) for lovastatin in order to treat patients with severely high cholesterol unresponsive to

existing therapies. The drug dramatically lowered LDL cholesterol with very few observed side effects. The

results prompted Merck to reinstitute animal studies, and in May 1984 the company filed a commercial IND,

allowing lovastatin to enter phase I clinical trials.

HMG-CoA reductase inhibitors drew more attention in 1985, as Dr. Michael S. Brown and Dr. Joseph

S. Goldstein of the University of Texas won the Nobel prize for medicine for their work on LDL receptors.

By November 14, 1986, Merck had finished its clinical and long-term animal studies and sent its new drug

application (NDA) to the Food and Drug Administration (FDA). Lovastatin, with a IND/NDA classification

of 1A, was approved within 9 months, bringing its total review time (from IND to NDA approval) to 1,204

days, making it one of the most rapidly approved drugs in the history of the FDA.

Meanwhile, the industry’s R&D race produced additional HMG-CoA reductase agents. Sankyo’s

second HMG-CoA reductase inhibitor, pravastatin, licensed to Bristol-Myers Squibb, entered phase III

clinical trials in Japan at the same time lovastatin entered phase III clinical trials in the United States. In

October 1990, 21 months after Bristol-Myers Squibb submitted the NDA on January 31, 1989, FDA’s

Endocrinologic and Metabolic Advisory Committee unanimously recommended pravastatin be approved

On October 31, 1991, 3 years after approval in Japan, the FDA approved pravastatin with a “lC” rating,

a new molecular entity (NME) with little or no therapeutic gain over existing therapies. Bristol-Myers

Squibb initially offered pravastatin at a direct price discount of 5 percent and a 10 percent discount to

wholesalers of lovastatin. By 1993, pravastatin’s sales are estimated to reach $500 million.

Simvastatin, Merck’s successor product to lovastatin, was recommended for approval by FDA’s

Endocrinologic and Metabolic Advisory Committee in February 1991 and was approved for marketing on

December 21, 1991. As with pravastatin, the FDA gave simvastatin a “ 1C” rating, and it has been offered

at a 5 to 10 percent discount to lovastatin. Unlike the breakthrough compound lovastatin, simvastatin has

worldwide patent protection. Marketed outside the United States since 1988, simvastatin has been prescribed

to over 1 million patients in 30 countries, and already ranks among the world’s 50 top-selling drugs.
.—— —

Chapter 4--Returns on Pharmaceutical R&D 75

A list of HMG-CoA reductase inhibitors currently or formerly under development follows.

Compound Sponsor Approval Status

lovastatin

pravastatin

simvastatin

colestolone

fluvastatin

Crilvastain

dalvastatin

BAYW6228

HR780

CI 981

BB-476

BMY-22566

SQ-33600

BMY-21950

GR-95030

SC-45355

L-659699

L-669262

CP-83101

Merck

Sankyo, Bristol-Myers Squibb

Merck

American Cyanamid

Sandoz

Pan Medica

Rhone-Poulenc Rorer

Bayer

Hoeschst

Warner-Lambert

British Bio-technology

Bristol-Myers Squibb

Bristol-Myers Squibb

Bristol-Myers Squibb

Glaxo

Searle

Merck

Merck

Pfizer

IND: April 1984. NDA: November 1986. Approval: August 1987.

Launched in Canada, Europe, Japan, and Mexico. U.S. NDA:

January 31,1989. U.S. approval: November 31, 1991.

Launched in at least 17 countries worldwide, including most of Europe.

U.S. NDA: November 1986. U.S. approval: December 1991.

Entered U.S. clinical trials in 1987.

U.S. NDA filed March 1992.

Phase II clinical trials.

Phase III clinical trials.

Phase II clinical trials.

Phase II clinical trials.

Phase I clinical trials.

Series of compounds under development; preclinical.

Preclinical Studies.

Preclinical studies, discontinued

Phase I clinical trials.

Preclinical studies, discontinued

Preclinical studies, discontinued

Preclinical studies,

Preclinical studies.

Preclinical Studies.

Safety issues may lengthen the review period for successor products. As it considered pravastatin, the

FDA’s Endocrinologic and Metabolic Advisory Committee weighed increasing general concerns over the

potential carcinogenicity of HMG-CoA reductase inhibitors against the need to maintain equitable review

criteria for competing products. One FDA reviewer noted that too much emphasis on carcinogenicity data

in pravastatin’s review would “prevent a level playing field” with lovastatin. The approval of pravastatin

and simvastatin suggest that comparable safety criteria continue to be used for successor HMG-CoA

reductase agents.

The market potential for HMG-CoA reductase inhibitors is vast. In the United States alone, as many

as 60 million people are estimated to have high cholesterol, but fewer than 1 million people currently receive

drug therapy. As a result, the pharmaceutical industry continues to devote substantial R&D expenditures

toward cholesterol-lowering drugs.

SOURCES: J. De Pass, ‘The World’s lbp 50 Prescription Drugs,” Medical Marketing &Media, 26:21, August 1991. F-D-C Reports:

Health News Daily, “Bristol-Myers Squibb Launching Pravachol in Mid-November,” F-D-C Reports: Health News

Daily, Nov. 4, 1991, p. 4-5. F-D-C Reports: Prescription and OTC Pharmaceuticals, ‘T@. Weiss’ Subcommittee

Investigating Regulation of Merck’s Mevacor, Roche’s Verse4 W-L’s THA; Dec. 1 Subpoena Deadline Set for FDA,

OMB Documents,” F-D-C Reports: Prescription and OTC Pharmaceuticals, Nov. 23, 1987, p. 6-7. F-D-C Reports:

Prescription and OTC Pharmaceuticals, “FDA Approves 15 of 21 New Molecular Entities in DecembeL Commissioner

Young Says Approvals Will Be More Evenly Distributed in Coming Years,” F-D-C Reports: Prescription and OTC

Pharmaceuticals, Jan. 11, 1988, p. 10-13. F-D-C Reports: Prescription and OTC Pharmaceuticals, “Bristol-Myers

Squibb Pravachol (Pravastatin) Recommended for Approval by FDA Advisory Committee,” F-D-C Reports: Prescription

and OTC Pharmaceuticals, Oct. 29, 1990, p. 8-10. F-D-C Reports: Prescn”ption and OTC Phannaceufi”cals,

“Cholesterol-Lowering Trials for New Classes of Drugs Should Include Clinical Endpoints,” F-D-C Repom:

Prescription and OTC Pharmaceuticals, Mar. 11, 1991, p. 7. F-D-C Reports: Prescription and OTC Pharmaceuticals,

“Merck’s Zocor (Simvastatin) Will Be Promoted by 1,230 Sales Reps Jointly With Smithkline Beecm” F-D-C

Reports: Prescription and OTC Pharmaceuticals, Jan. 6, 1992, A. Garber, Assistant Professor, School of Medicine,

Stanford University, Palo Alto, CA, personal communication% Jan. 5, 1993. N. Ishi~ Finance Manager, Sankyo USA,

New York NY, personal communication, Oct. 17, 1991. M. Malk@ Merck & Company@c., Rahway, NJ, personal

comrnunicatiom Oct. 21, 1991, Pharmaprojects (Surrey, United Kingdom: PJ.B. Publications Ltd., 1991). R.L. Pierce,

Food and Drug A&mm“ “stratiom Public Health Service, U.S. Department of Health and Human Services, Rockville, MD,

pcrsonat communication% Jul. 18, 1991. Scrip World Pharmaceutical News, ‘‘Sankyo’s Compaction Effective in FamiIiaI

Hypercholesterolaemia,” Scrip World Pharmaceutical News 624:13, 1981. Scn”p World Pharmaceutical News,

“Blockbusters in R&D,” Scrip World Pharmaceutical News 1104:24, 1986. Scrip World Pharmaceutical News, “Merck

& Co. Products had World Markets,” Scrip World Pharmaceutical News 1397:16-17, 1989. P.R. Vagelos, “Are

Prescription Drug Prices High?” Science 252:1080-1084, 1991. M. Waldholz, “FDA Clears Sale of Bristol-Myers

Cholesterol Drug,’ New York Times, Nov. 4, 1991, p. B5.
76 I Pharmaceutical R&D: Costs, Risks and Rewards

New drugs need not be very similar in molecular structure to compete in a therapeutic category.

For example, new medicinal approaches to the

treatment of hypertension proliferated during the

1980s, as calcium channel blockers and angiotensin converting enzyme inhibitors have competed

with beta-blockers and diuretics (4). Thus, the

opportunities for competitive R&D are numerous,

and in an industry with a large number of

competing research-intensive fins, this competition should reduce industrywide returns on pharmaceutical R&D as competing products are

introduced to share existing markets.

This chapter examines the returns on pharmaceutical R&D. It provides two kinds of evidence on

returns: the present value of dollar returns on new

chemical entities (NCEs) introduced during a

selected time interval (which can be compared

with the present value of the R&D costs required

to produce the NCEs); and the net internal rate of

return (IRR), or economic profit, from all business activities of firms whose primary line of

business is the development, manufacture, and

sale of ethical pharmaceuticals.

RETURNS ON R&D: THE EVIDENCE

1 Overview of Methods

In chapter 3, the Office of Technology Assessment (OTA) reviewed the evidence on the full (or

capitalized) cost of R&D at the point of market

approval for drugs first entering clinical testing in

the 1970s and early 1980s. The full cost of R&D

can be thought of as the average value on the day

the products are launched that successful drugs

must have if they are to provide investors an

adequate payback for the cash outlays, risk, and

time spent in bringing the drugs to market.

The value of the potential income from successful drugs on the day of product launch

depends on the complete product life cycle

expected for these compounds. Figure 4-1 shows

a hypothetical life cycle of R&D investment and

revenues for an industry.

Suppose the industry starts from scratch with

new companies 15 years before marketable products can be expected. The firms build or rent

Figure 4-l-Cash-Flow Profile of

100 Drug Candidates

$ millions

80

60-

40-

20-

0

4

20 launched

-20-

100 enter human testing

-40 I I IA I I I I I 1 I I I I I I I ( ( I I I I I I I I I I I I

-Iol’ -5 0 5 10 15 20

Time in years (year O. market approval)

SOURCE: Office of Technology Assessment, 1993.

research facilities, then embark on programs to

discover a group of candidate compounds for

further research. Further laboratory and animal

testing of these lead compounds over the next 3 to

4 years results in, say, 100 drug candidates that

merit clinical testing. These 100 candidates then

undergo rigorous testing to determine their safety

and effectiveness in humans. More money is

invested to fund the testing required to bring these

drug candidates to market. As the testing process

continues over the next 9 years, some compounds

are found to be unsafe or ineffective and are

abandoned. Ultimately, suppose only 20 of the

100 candidates jump all the hurdles and reach the

market.

As the originators of the winning 20 compounds prepare for market entry, the firms developing them must invest again, this time in plant

and equipment to manufacture the products. Once

they are approved and launched, the new drugs

start earning revenues (minus the costs of producing, marketing, and distributing them). Net revenues grow over the next few years and then flatten

out. After 10 years or so, patents expire, and net

revenues begin to decline as generic copies of the

drugs are introduced. Ultimately, perhaps after 20
—-—

Chapter 4-Returns on Pharmaceutical R&D I 77

years, new generations of medical technology

render the products obsolete, and they are removed from the market,

As figure 4-1 illustrates, in the early years of

industry operation, cash flows out of the firms in

the industry in the form of expenditures on R&D

and manufacturing capacity. Years later, cash

flows back into the firms as some of the investments paid off. Whether the NCEs pay off enough

in revenues to justify the investment requires a

comparison of the outflows of cash with their

inflows, taking into account the timing of those

cash flows.

The issue for this section is how to measure the

net cash flows from the point of market approval

to the end of the product’s life cycle, taking

account of the fact that revenues are uncertain,

that costs must be incurred to manufacture,

market and distribute the products, and that

income delayed is worth less to investors than

income today. Once the net income from the sale

of successful drugs over their lifetime is appropriately measured, it must be compared with the

fully capitalized cost of the R&D spent to bring

them to market.

Just as the R&D investments in various years

were compounded to their full net present value

(NPV) in the year of market approval at an

interest rate equal to the opportunity cost of

capital, the future revenues (net of costs) must be

discounted back to their NPV at the time of

market approval, using an appropriate opportunity cost of capital. After that is done, the NPV of

the fully capitalized costs of R&D can be

subtracted from the NPV of the net revenues. If

the difference is greater than zero, then the overall

investment in R&D returned more than was

necessary to repay the investors for the time their

money was tied up and the risk they took. If the

NPV of the investment as a whole was less than

zero, then investors did not, on average, recover

their cost of capital and could have done better by

investing their funds in other industries.

Ideally, analysis of NPV should be based on

actual cash flows, not on what financial accounting statements report. For example, when it builds

a $50-million manufacturing facility, a company

spends the money at the time of construction, but

the fro’s income statements will recognize the

expense only gradually through depreciation

charges. The actual investment in the facility was

made at the time it was built, not as it was

recognized in depreciation expenses. At the end

of the product’s life, the firm may “sell’ the

facility to a new group of projects at its current (or

salvage) value. The salvage value of the facility

should be reflected as a positive cash flow at the

end of the product’s life.

The analysis should also reflect the effect of

taxes on cash flows. R&D expenses result in tax

deductions and other credits that reduce taxes,

while the net revenues from sales must be reduced

by the taxes they cause to be paid.

Sales are highly uneven across drugs, with a

few very successful drugs providing the bulk of

the revenues (160). Some firms in the industry

may not have any winners; others may be highly

successful. At the industry level, analysis of

returns on R&D is blind to the distribution of

revenues across R&D projects or firms. Indeed,

investors in startup firms or R&D projects expect

many ventures to fail. It is the promise of the

occasional big success that attracts the investment

dollars. Nevertheless, across a large number of

R&D projects, when winners and losers are

averaged together, the NPV of the investment, at

the appropriate cost of capital, should be in the

neighborhood of zero.

1 Past Studies

Several researchers have tried to measure the

net returns on R&D for new chemical entities by

predicting the shape of the cash-flow profile (as

illustrated in figure 4-1) for a group of drugs

reaching the market in a given period. The

researchers piece together information from a

variety of sources about R&D outlays, the shape

of the cash flow curve for new drugs, and the costs

of producing and selling the products over the

course of their life in the market.

These estimates are necessarily imprecise,

because information on the full life cycle of a
78 I Pharmaceutical R&D: Costs, Risks and Rewards

group of drugs introduced in the study period may

not yet be available, and data on production,

marketing, and distribution costs are typically

available only for the company as a whole, not for

individual products or even lines of business.

Three such studies are reviewed here.2 Joglekar

and Paterson (215), Grabowski and Vernon (160)

and Virts and Weston (500) estimated the NPV of

returns on R&D investment in different samples

of NCEs. Table 4-1 summarizes the main assumptions and findings of each study.

Joglekar and Paterson used the sales histories

of 218 NCEs introduced in the United States

between 1962 and 1977 (adjusted for inflation) as

the basis for predicting the revenues to an

“average” NCE expected to be introduced in

1988. The researchers made assumptions about

the cost of producing and distributing the NCEs

over their product lives. R&D cash outlays were

based on Hansen’s study of R&D costs (175),

adjusted for inflation.3 Joglekar and Paterson

calculated the NPV of the investment using a 6

percent cost of capital; the estimated average

after-tax NPV was $75 million per NCE (in 1976

dollars).

Grabowski and Vernon used the sales history

of NCEs introduced between 1970 and 1979 to

estimate the returns on this group of NCEs. The

researchers estimated the total R&D cost (capitalized to the point of market approval at 9 percent)

for this group of NCEs at $125 million (in 1986

dollars). Grabowski and Vernon’s assumptions

about production and distribution costs are similar in many respects to those of Joglekar and

Paterson’s, but Grabowski and Vernon included

substantial extra costs in the early years of

product life to cover expenditures for facilities,

equipment, advertising, and promotion associated

with the launch of a new product. Using a 9

percent cost of capital, the estimated after-tax

NPV of overall investment in NCEs was just $1.3

million (in 1986 dollars).

Virts and Weston (500) multiplied U.S. hospital and drugstore prescription volume data on 119

NCEs introduced between 1967 and 1976, by the

average selling price of the drugs and a prescription volume growth factor of 2 percent per year to

estimate the revenue curve for these drugs. The

market life was assumed to be 10 years, after

which revenues would decline immediately to

zero. Tax effects were not considered. The costs

of R&D were based on Hansen’s study (175), and

all costs and revenues were discounted at 8

percent per year. The pretax NPV of the investment was negative: -$16 million per drug (in 1978

dollars).

The differences among the three studies in net

returns on R&D illustrate the importance of

assumptions about the level and the timing of

revenues and expenditures as well as the cost of

capital. Table 4-1 summarizes the main assumptions and finding of each study.

The Virts and Weston study underestimated

lifetime revenues by limiting the product life to

10 years, clearly much below the actual experience of drugs introduced throughout the period

covered by their study. Grabowski and Vernon

used more realistic estimates of revenues for the

cohort of drugs introduced in the 1970s, but they

assumed revenues would decline sharply after the

loss of patent protection and foreign sales of new

drugs would be in the same ratio to U.S. sales as

are foreign sales of all pharmaceuticals. Joglekar

and Paterson, on the other hand, may have

overestimated worldwide revenues and underestimated the cost of capital.

2 Earlier studies by Baily (32), Schwartzrnan (372), and Statman (401) also e xamined returns on R&D, but these studies used industry-level

data on R&D expenditures, production of NCES, and sales. These studies also cover an earlier periot consequently, they are not reviewed in

this report. Another study by Grabowski and Vernon (157) is essentially an early version of their study reviewed here.

3 Joglekar and Paterson spread the total R&D period out longer than Hansen’s analysis projected. Between the discovery phase and the

clinical testing phase, Joglekar and Paterson inserted time for preclinical animal tests and Investigational New Drug application fding time (a

total of 14 months), Hansen had included the cost of preclinical animal tests, but his analysis assumed such tests would be undertaken

concumently with the last part of the discovery phase. Thus, Joglekar’s and Paterson’s capitalized R&D costs are higher than Hansen’s study

implied.
Table 4-l—Three Studies of Returns on Pharmaceutical R&D

G rabowski & Vernon (1990) Joglekar & Paterson (1986) Virts & Weston (1980)

Assumptions

Revenues

U.S. revenues

Worldwide sales (as a multiple

of U.S. hospital and drugstore

sales)

Tax rate

Production and distribution costs

Contribution margin (operating

profit + R&D as a percent of

sales)b

Plant and equipment expenditures

Working capital

inventories

Promotion & advertising costs

R&D costs

■ IMS8 drugstore and hospital sales

for NCEs introduced 1970-79

■ Postpatent loss of sales 600/0 over 5

years.

1.9

3 5 %

(see below)

Varied: 33%-40% (400/. in 1980s) + 4%

adjustment for depreciation.

50% of 10th year Sales, 2/3 spent

evenly in 2 years prior to product

launch. Remainder spent evenly over

years 2 to 10 after product launch.

12.5% of annual sales, recovered in

final year of product life.

41.6% of annual sales, valued at manufacturing cost.

1OO% of year 1 sales

50% of year 2 sales

25% of year 3 sales

$125 million (1986 dollars)

IMSa drugstore and hospital sales for

218 NCEs introduced in U.S. 1962-77—

extrapolated with regression out to 24

years after introduction; expressed in

1976 dollars.

increasing from 1.86 to 2.44 over the life

of the drug (extrapolated from PMA

data for 1954 -78.)

(see below)

45% (excludes depreciation and interest on working capital).

240/. of 5th year sales, spent evenly 4,

3, and 2 years prior to market launch.

(investment depreciates over time and

remaining book value is written off in the

last year of analysis.)

24% of fifth year sales, invested evenly

3,2, and 1 years prior to market launch.

Withdrawn in last year of analysis.

[included in working capital]

[included in contribution margin]

$32 million (1976 dollars) distributed

according to Hansen, 1979.

■ IMSa outpatient prescriptions for 119

NCE’s introduced 1967-76. Muitiplied

by average selling price.

■ Revenues = O after year 10.

■ 6% per year inflation in drug price

over cost.

1.6

0

Cost per unit = 60% of selling price.

[included in cost percentage]

$59 million (1978 dollars) based on

Hansen, 1979

(Continued on next page) u

—

8
Table 4-l—Three Studies of Returns on Pharmaceutical R&D--(Continued)

Grabowski & Vernon (1990) Joglekar & Paterson (1986) Virts & Weston (1980)

Discount rate: (cost of capital) 90/o 6% 8%

Results

NPV of investment + $1.5 million (1986 dollars) + $75 million (1976 dollars) -$16 million (1978 dollars)

+ $1.73 million (1990 dollars) + $168 million (1990 dollars) -$29 million (1990 dollars)

a IMS Amen=, Ire., is ~ ~a~et ~e~ear~h firm that ~~uc~ ~ngolng surveys of hospital and drugstore purchases of pharrn~euti~ls in the Lhlitd S!atfX.

b variable ~sts: 1 -ntnbution margin. The contribution margin as defined in these studies ~uais operating profit and R&D as a percent of Sd3S.

KEY: NCES = new chemical entities; NPV = net present value.

SOURCE: Office of Technology Assessment, 1993. Based on data from H.G. Grabowski and J.M. Vernon, “ANew lmokatthe Returns and Risks to Pharmaceutical R& D,” Management %“ence

36(7):804821, July 1990; P. Joglekar and M.L. Paterson, “A Closer Look at the Returns and Risks of Pharmaceutical R& D,” Journa/ otHea/th Economics 5:1 53-177, 1986; J.R.

Virts and J.F. Weston, “Returns to Research and Development in the U.S. Pharmaceutical Industry,” kfanageria/and D-”sion Economics 1 (3):103-1 11, 1980.
Chapter 4--Returns on Pharmaceutical R&D 81

Assumptions about the cost of production,

distribution, and marketing differed widely among

the studies. Virts and Weston simply assumed

that on average the full cost of producing and

selling the drugs in any year is 60 percent of their

selling price. Grabowski and Vernon and Joglekar

and Patterson used a modified ‘ ‘contribution

margin’ to estimate these costs. The ‘ ‘contribution margin’ is formally defined as the percent of

a company’s sales that contributes to paying off

the fixed costs (such as investments in facilities,

plant and equipment) and profits of the enterprise

after the direct costs of producing, marketing and

distributing the product are deducted (205). Fixed

costs do not vary with the amount of drug that is

sold. The contribution margin is the percent of

sales left over after the direct variable costs have

been deducted. The direct cost of production and

distribution as a percent of sales (the estimate

required to determine net cash flows) is therefore

one minus the contribution margin.4

The fro’s operating profit is calculated net of

the costs of advertising and promotion, but these

costs reflect the full line of products that the firm

sells. Expenditures for promotion and advertising

are heavier in the years immediately following

product launch, so the contribution margin based

on pharmaceutical companies’ operating profits

underestimates new products’ share of advertising and promotion expenses and overestimates

such expenditures for products as they age.

Joglekar and Paterson did not account for the

difference in timing of this major component of

expenses but assumed the contribution margin

was an accurate reflection of the expenses for new

NCEs. Grabowski and Vernon, on the other hand,

added a substantial expense in the first 3 years of

product sales to cover the additional advertising

and promotion expenditures associated with product launch, but adjusted the contribution margin

to reflect lower expenses in later years (154).

Finally, assumptions about actual cash outlays

for manufacturing plant and equipment vary

widely among the studies. Grabowski and Vernon

effectively assumed a much higher total investment than did the authors of either of the other

studies.

1 OTA Analysis of Returns on R&D

OTA estimated the return on R&D for NCEs

approved for marketing in the United States in the

years 1981-83. OTA chose this relatively brief

period for analysis because we had access to U.S.

sales data only for these years. These NCEs

include all newly introduced compounds regardless of their country of origin or licensing status

within the sponsoring company.

OTA’s approach is similar to Grabowski and

Vernon’s (160), but OTA’s assumptions vary in

important respects. Where the available data are

imprecise or scant, OTA used a range of estimates

reflecting the best available evidence. In addition,

when uncertainty was high, OTA used conservative assumptions that would tend to understate

returns on R&D.

THE SALES CURVE

Figure 4-2 shows U.S. sales to hospitals and

drugstores in constant 1990 dollars for NCEs

introduced in 1981-83 and, for the sake of

4 In theory, the contribution margin should be calculated gross of charges for depreciation on facilities and equipment R&D and other

investments. These investments should be recognized separately at the time they are made. Information on product-speci13c direct productio%

distribution and marketing costs is hard to come by, however, and the closest approximation to the contribution margin that is available from

companies’ financial statemerms is operating profit plus R&D expenditures. Joglekar and Paterson explicitly recognized expenditures for plant

and equipment as cash outlays in the year they would be expended and adjusted the contribution margin accordingly (215). Grabowski and

Vernon also adjusted after-tax income for depreciation expenses, which had the effect of raising the contribution margin by about 4 percentage

points (154).
82 I Pharmaceutical R&D: Costs, Risks and Rewards

150

120

90

60

30

Figure 4-2—Average Sales of New

Chemical Entities Introduced,

1970-79, 1981-83, and 1984-88

$ million (1990 dollars)

O 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Years since introduction

+-- 1970-1979 +- 1981-1983 –* 1984-1988

SOURCES: 1970-79: H.G. Grabowski and M. Vernon, “A New Look at

the Returns and Risks to Pharmaceutical R& D,” hfanagefnent %“@?ce36(7):804-821, July 1990.1981 -83: Coppinger, P., “Overview of the Competitiveness of the U.S.

Pharmaceutical lnd~stry,” presentation to the Council in

Competitiveness Mkwking Group on the Drug Approval

Process, Washington, DC, Dec. 12, 1990. 1984-88: IMS

America, Inc., unpublished data prepared for the Office of

Technology Assessment, 1991.

comparison, in earlier and later years as wells

Although OTA had only 1 year of data for NCEs

introduced in 1984-88, that one data point suggests that, after adjusting for inflation, U.S. sales

of new NCEs in the early years after approval

continued to steepen throughout the 1980s.

Sales to hospitals and drugstores account for

the majority of, but not all, ethical pharmaceutical

sales in the United States. Staff-model health

maintenance organizations (HMOs) and mailorder pharmacies account for a growing proportion (2.4 percent and 5.9 percent in 1991 respectively) of total pharmaceutical sales. Sales to

clinics and nursing homes account for another 6

percent of pharmaceutical sales (128). Together,

sales to these other distribution channels were 14

percent of total sales, or 19 percent of sales to

drugstores and hospitals.6 Therefore, OTA increased domestic hospital and drugstore sales in

each year by 19 percent to account for these

additional channels of distribution.

Hospital and drugstore sales data are based on

retail invoices and therefore do not reflect the

amount manufacturers actually receive. About 71

percent of ethical pharmaceutical sales were

distributed through wholesalers in 1991 (320).

For these drugs, the manufacturer received approximately 6.3 percent less revenue than the

invoice price. 7 OTA therefore reduced the sales

estimates by 4.5 percent to reflect the difference

between sales at the wholesale level and manufacturers’ revenues.

OTA had access to data on U.S. sales revenue

only for the first 9 years of marketing for the

1981-83 drugs. To predict the revenue curve

beyond those years, OTA examined trends in

effective patent lives and in the loss of revenue

after patent expiration.

Effective Patent Life--The effective patent

life is defined here as the elapsed time between

the U.S. Food and Drug Administration (FDA)

approval for marketing of a new drug and the

expiration of the last patentor market exclusivity

provision that effectively protects the original

compound from competition from bioequivalent

5 Data on mean annuai hospital and drugstore sales per NCE introduced in 1981-83 were supplied by the Food and Drug AdmmI “ ‘stration

(97). Data for the 1970s m taken from Grabowski’s and Vernon’s study (159), and OTA obtained 1 year’s worth of data for the 1984-88 NCES

from IMS America Inc., a market research firm that conducts ongoing surveys of hospital and drugstore sales.

The data on sales for the 1984-88 cohort of drugs are for NCES approved in the period, not necessarily introduced; the data for the 1970s

cohort are for NCES both approved and introduced in the period; and the data for the 1981-83 cohort are for NCES introduced in the period.

Of the 60 therapeutic NMEs first introduced to the U.S. market in 1981-83, 54 were approved during the same period. Three others were

approved in 1979 arid 1980 and are included in the analysis. Six therapeutic NMEs approved during 1981-83 were excluded from the analysis

because one was never marketed and the other five were not introduced to the market until at least 5 years tier 1983.

6 Data supplied to OTA by Medco Containment Services, Inc., showed that new drugs constituted the same percentage of total sales (in

physical units) in the mail-order business as in community pharmacies (255),

7 The 1991 average wholesalers’ gross margins were approximately 6.8 percent of net sales. Income obtained from interest, payment for

direct services to retailers, and c~ther sources accounted for 0.63 percent of sales (362).
Chapter 4-Returns on Pharmaceutical R&D I 8 3

generic products.8 The longer this period, the

more years the firm has a monopoly over its

product. Though this monopoly is imperfect

because close substitutes exist for many patented

drug products, generic competition has the potential for rapidly transformingg the originating company’s brand-name product into a standardized

commodity with consequent rapid declines in

market revenues.

The greatest threat to the effective U.S. patent

life of a new compound is the delay between

patent issuance and FDA’s approval to market the

product, Since the passage of the Drug Price

Competition and Patent Term Restoration Act of

1984 (Public Law 98-417), new drugs have been

eligible to receive patent term extensions of up to

5 years (with total patent life not to exceed 14

years as a result of the extensions) to compensate

for regulatory delays. In addition, the Orphan

Drug Act of 1983 (Public Law 97-414) granted 7

years of exclusive marketing rights for new drug

products designed to treat rare conditions.

OTA analyzed the effective patent life of NCEs

approved for marketing between 1984 and 1989

and compared the results with an analysis of

effective patent life conducted in 1983 for the

U.S. House of Representatives as part of the

legislative debate over the Drug Price Competition and Patent Term Restoration Act (440). OTA

calculated two measures of effective patent life:

the life of the patent protecting the product itself,

and the longest period of protection indicated by

any exclusivity provision or any patent covering

a drug and listed in FDA’s “Orange Book”

(473). 9 Data from the U.S. Patent Office were

used to update patent extension information not

yet published in the most recent supplement to the

Orange Book. The results are shown in figure 4-3.

Figure 4-3—Effective Patent Life for

Drugs Approved, 1968-89

Number of years

14~--—-–--—

I

-r- 1 -

1968-72 1973-77 1978-82 1984-89

_ Latest patent life ~ Product patent life

SOURCES: Office of Technology Assessment, 1993. Based on U.S.

Congress, House of Representatives, Committee on

Energy and Commerce, unpublished data, 1993; U.S.

Department of Health and Human Services, Food and

Drug Administration, unpublished data, 1991; U.S. Department of Commerce, Patent and Trademark Office,

unpublished data, 1991.

After declining steadily throughout the 1970s and

early 1980s, effective patent life has rebounded

somewhat in the years since 1984.

The simple average patent life data shown in

figure 4-3 may actually understate the effective

period of market exclusivity for originator compounds first marketed in 1981-83 and beyond.

Firms may manage the patent period more carefully when the potential revenues from a drug are

greater.10

To test this hypothesis, OTA obtained data on

hospital and community pharmacy sales of all

1984-88 NCEs 2 calendar years after the calendar

year of FDA approval (201). Table 4-2 shows the

relationship between sales and effective patent

life for NCEs by sales volume in the second year

8 The term “effective patent life’ may be a misnomer, since it refers to all kinds of market exclusivities. In this report it is used merely

to indicate how long after entry to the market the compound in its original dosage form is formally protected from generic competition.

9 My patent fisted ~me Ormge B~k series as a barrier to the approval of a generic v~sion Of the listed Prtiuct. Under tie ’984 ‘~

a generic manufacturer must provide a certifkation of patent invalidity or noninfringement as to any listed patent. The cost of researching such

claims is high, and litigation is always a threat for a potential generic competitor (124).

10 patent terns ~ o~er ~dus~l~ed Counrnes ~ for 20 yews from tie date of appfi~tion. h he Utited States, patent teITIIS 11111 fOr 17

years horn the date of issuance. Firms have substantial opportunities to delay the date of issuance, and anecdotal evidence suggests

pharmaceutical firms have taken advantage of those opportunities in the past (123).
84 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 4-2—Mean and Median Effective Patent

Life as a Function 01 Sales for New Chemical

Entities Approved 1985-89

Latest NCE

patent patent

Mean, total sample (113 drugs). . . . . . . . 10.6 9.6

Mean, nonorphans (94 drugs). . . . . . . . . 10.7 9.5

Breakdown by salesa

Mean for drugs with sales data

available (69 drugs). . . . . . . . . . . . . . . 10.5 9.2

Standard deviation. . . . . . . . . . . . . . 4.0 3.8

$0-20 million (43 drugs). . . . . . . . . . . . 9.8 8.4

Standard deviation. . . . . . . . . . . . . . 4.0 3.6

$20-$50 million (9 drugs) . . . . . . . . . . . 10.6 8.4

Standard deviation. . . . . . . . . . . . . . 2.9 3.2

$50-$100 million (8 drugs). . . . . . . . . . 11.9 11.2

Standard deviation. . . . . . . . . . . . . . 3.4 2.7

>$100 million (9 drugs). ., . . . . . . . . 13.1 11.7

Standard deviation. . . . . . . . . . . . . . 4.0 4.2

Median effective patent life. . . . . . . . . . . . 10.7 10.0

a Sal= are measured in the second calender year afler the ca!endi3r

year of approval. Sales data are in 1989 dollars, converted using

GNP implicit price deflator.

KEY: NCE - new chemieal entity.

SOURCE: Office of Technology Assessment, 1993. Sales data obtained from IMS America, Inc.

after approval (in 1989 dollars). A pattern of

longer patent life for drugs with higher sales is

evident in the table and was found to be statistically significant in a regression analysis.11 This

analysis suggests that, on average, each additional $100 million in sales is associated with 400

additional days of effective patent life.

The estimated period. of effective patent protection reflects only the period during which the

original compound is formally protected from

competition by patent or other laws. The expiration of patent protection on the original compound may not mark the end of exclusive

marketing, however. Some compounds may not

experience generic competition for several years

after the patent expires, either because of delays

in FDA approval of generic copies or because the

total market for the drug is too small to induce

generic manufacturers to enter the market. Even

more important, process patents that are issued

after the original patents sometimes may be

effective in keeping generic products out of the

market (see box 4-B). And, other product-line

extensions occurring late in the original patent

life may partly protect the originator compound

from competition. The 1984 Drug Price Competition and Patent Term Restoration Act granted a

3-year period of exclusivity, regardless of patent

status, to any existing product for which an

additional full NDA or supplemental NDA requiring new clinical research is approved by the

FDA12 (83). Thus, if a new dosage form, such as

a sustained release formulation, is developed and

approved for the originator product, the new

dosage form has a 3-year period of market

exclusivity from the date of its FDA approval

regardless of the patent status of the product

itself. 13

As box 4-C illustrates, companies can and do

use the terms of the provision to extend the

effective period of exclusivity for the compound

by managing the introduction of new dosage

forms to coincide with the expiration of patents on

earlier generations of a compound. Originator

companies have a natural advantage in developing new dosage forms prior to the expiration of

the original compound patents, because the patent

1 I me estfite(j regression model is = 3684.589+ .000004S1

, where PI is effective patent life for drug i expressed in days and S1 is sales

for drug i expressed in dollars, The estimated coefficient on sales has a t-statistic of 2.0 with 67 degrees of freedom which is signiilcant at the

5-percent level in a two-tailed test. The proportion of variation in effective patent life explained by this model (R2) is .05.

12 Genefic ~omp~escm apply for a fi~ ~A (~de-g ~1 of &e pr~~cal ~d C~C~ ~se~ch r-d of the originator company)

to avoid the exclusivity provisioq provided the patent on the originator drug has expired, but they cannot receive approval under abbreviated

new drug applications (ANDAs) to market the drug. The time and cost involved with full NDA submission effectively eliminates this avenue

of competition.

13 supplemen~~A~~so~:m~submitt~ for new fi~catiom or new dosing ~gime~, res~thg in anew label for the originator produc~

but under FDA’s current interpretation of the law, the sponsor of a generic drug can still submit an ANDA for the original label. Some legal

experts claim this interpretation is potentially subject to court challenge, because FDA would be treating the generic drug and the newly Iabelled

originator drug as completely interchangeable, thus impairing the exclusivity right (83).
Chapter 4—Returns on Pharmaceutical R&D I 85

Box 4-B–Postpatent Generic Competition: Opportunities and Obstacles

“Generic Erosion for Ceclor?”

“When Lilly’s Ceclor (cefaclor) comes off patent in the U.S. in 1992, unit sales of the antibiotic, which

account for roughly 15 percent of the company’s total sales, could be eroded by 70-80 percent by generic

competition in the first 18 months, according to Kidder, Peabody analyst James Flynn.

This erosion will take place despite the fact that Lilly holds process patent for Ceclor which expire between

1994 and 2006, and plans to introduce a sustained-release formulation, Ceclor AF, the analyst predicts.

Recent legal action in Japan, where Lilly has filed suit against ten companies for alleged infringement of

its cefaclor patent, suggests that the company intends to defend its patents vigorously... However, Mr. Flynn

argues that Lilly’s process patents will not be recognized in a number of countries (e.g. Italy) which are likely

to be used as manufacturing sites for generic companies planning to import formulations of cefaclor on expiration

of the product patent.

Barr and Biocraft, which have valid cephalosporin manufacturing facilities in the U. S., may also try to

‘‘skirt’ Lilly’s process patents, Mr. Flynn says. Such a strategy would give these companies a‘ ‘meaningful cost

advantage” over importing firms, he adds.

Ceclor AF is unlikely to be introduced in the United States much before the cefaclor product patent expires,

Mr. Flynn says. A preferred dosing regimen is the only benefit he is aware Ceclor AF would have over generic

competition. The analyst notes that Lilly’s Keftabs formulation of Keflex (cefalexin) gained less than 15 percent

of Keflex’ sales after the 1987 product patent expire. ’

‘

6Ceclor Market Dominance Will Continue Past Dec. 1992 Patent Expiration, Lilly Contends: Process

Protection Thru 1994”

‘ ‘Lilly’s dominant position in the oral antibiotic market will survive the expiration of the U.S. patent on

Ceclor in December 1992, the company maintained at a meeting with financial analysts in New York on Feb.

28. Based on a process protection for cefaclor and a pending NDA application for the follow-up compound

loracarbef, Lilly is forcefully declaring its intention to hold its place in the oral antibiotic field...

Asked to comment on the impact of the upcoming patent expiration on Ceclor sales, Lilly Pharmaceutical

President Gene Step said the relevant questions should be what will be Lilly’s overall position in the oral

antibiotic market and what is the likelihood of generic versions of cefaclor reaching the market.

‘‘You really have to [ask] what is our participation in the oral antibiotic market and to what extent will that

be affected” by generic cefaclor or “by other products that we mayor may not be selling” in the future, Step

said.

Lilly is emphasizing the de facto protection of a difficult production process and a patent position on a late-stage

intermediate . . . Step declared that when all factors are considered Ceclor should ‘‘remain a viable product for

Eli Lilly beyond expiration of the patent. ”

As the company often has been pointing out recently, Step told the Feb. 28 meeting that Ceclor has yet to

face generic competition outside the U. S., even in markets where there is no patent protection. ‘ ‘While we cannot

know what the actions of everybody else in the world will be,” Step said, ‘‘it is very interesting to observe that

while there isn’t patent coverage in a large part of the world for Ceclor, there isn’t any generic Ceclor. ”

Lilly Research Labs President Mel Perelman, Phd, explained the process protection during question-andanswer. “The Ceclor synthetic route is so long and so complex,” that it will be difficult to duplicate, Perelman

said...

A producer of cefaclor can take a number of different routes to get to the intermediate, Perelman explained,

“but they can’t go through it without violating our patent. So an ethical or legal end-run seems extremely

improbable. The patent on the intermediate runs until December 1994. Step further pointed out that

establishing a cefaclor manufacturing process ‘‘will require very considerable capital investment...we have

haven’t seen that yet ‘.,,

SOURCES: Generic erosion: Quote from “Generic Erosion for Ceder, ” Scrip World Pharmaceutical News 1594:25, 1991. Ceclor

market: Quoted from “Ceclor Market Dominance Will Continue Past Dec. 1992 Patent Expiratio% Lilly Contends:

Process Protection Tim 1994, Lorabid NDA Filed as Backup, ” F-D-C Reports: Prescription and OTC PAarmceuticaIs,

Mar. 4, 1991, p. 15.
86 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 4-C--Cardizem QD 1991 Approval Is Key to Successful Cardizem

Switch Before Patent Expiry in 1992”

“Marion Merrell Dow is counting on a late 1991 approval of Cardizem QD to give it time to convert

patents from the immediate-release form of the diltiazem calcium channel blocker before the patent expires

Nov. 5,1992, company management indicated at a Feb. 27 meeting with securities analysts in Kansas City,

Missouri.

Calling the approval of Cardizem QD Marion Merrel1 Dow’s “number one new product priority,”

MMD President Fred Lyons said: “I think it’s possible that QD could be approved this year and introduced

by the first of next year.”

The Cardizem QD NDA for hypertension was filed in February 1990 and is scheduled to go before

FDA’s Cardiovascular and Renal Drugs Advisory Committee on March 14.

To protect its $745 roil. Cardizem franchise, Marion Merrell Dow apparently intends to follow a

strategy similar to the one Pfizer used to protect its nifedipine franchise from generics with sustained-release

Procardia XL. Pfizer’s strategy called for discounting the new generation product by 25 percent and

promoting the price savings directly to consumers. Pfizer told analysts last fail that Procardia XL accounted

for nearly two-thirds of all Procardia scripts one year after its launch in October 1989 (“The Pink Sheet”

Nov. 5, p. 8).

Marion Merrell Dow Prescription Products Division President David Roche outlined his company’s

strategy to convert patents from immediate-release Cardizem to the once-a-day formulation by pointing to

his own experience in Canada as head of MMD’s Nordic Labs subsidiary. Cardizem went off-patent in July

1988, the same time that Cardizem SR twice-a-day was approved. By discounting the sustained-release

product by 5 percent and aggressively promoting it, Roche said, Nordic was able to maintain the total

Roche also said that like Pfizer, Marion Merrell Dow would seek to “build patent brand loyalty” to

combined 1,100-person sales force’s detail time in 1991.

Cardizem QD initially will be indicated only for hypertension, while Cardizem is approved for both

hypertension and angina. However, Cardizem SR, which has been available since early 1989, is

indicated for angina only, so the two products combined may replace the original.. "

SOURCE: Quotcdffom “(krdizem QD 1991 A~vid Is my to Successful ~ Switch Before Patent Expiry in 199~” F-D-C

Reports: Prescription and OX Pharmaceuticals, Mar. 4, 1991, p. 12.

laws prohibit other companies from conducting exclusivity provision of the Drug Price Competiresearch with commercial value using a patented

product. (Appendix E contains a summary of the

patent protection available to pharmaceutical

products, including biotechnology drugs.)

New dosage forms typically offer important

medical benefits to patients by making compliance easier or making dosing more convenient

and sometimes less uncomfortable. Increasing

company incentives to develop products with

these benefits is the rationale for the 3-year

tion and Patent Term Restoration Act (Public Law

98-417). The issue raised here is not whether such

provisions are good public policy, but what the

magnitude of their potential impact on the complete life cycle of revenues may be for an

originator NCE.

For NCEs approved in the 1981-83 period,

OTA assumed that the average effective patent

life is 9 years. As figure 4-3 shows, the simple

average effective patent life for drugs approved in
Chapter 4-Returns on Pharmaceutical R&D I 87

the period 1978-82 was between 8 and 9 years.

Because patent life is positively correlated with

sales revenue, it is appropriate to slightly increase

the patent life for total revenues from the new

drugs approved between 1981 and 1983. This

estimate of patent life does not include any

additional market exclusivity granted for new

dosage forms.

Postpatent Revenues-After a drug loses

patent protection, it becomes vulnerable to competition from generic copies. The Drug Price

Competition and Patent Term Restoration Act of

1984 made FDA approval relatively easy for

makers of generic copies of originator drugs.14 It

is widely held that this law has led to rapid decline

in the originator drug’s market share following

patent expiration. In their analysis of returns on

R&D for NCEs approved between 1970 and

1979, Grabowski and Vernon assumed that the

originator drug would hold only 40 percent of

total revenue in the market 5 years after patent

expiration, but they predicted that increased

generic competition in future years could reduce

the originator’s market share to 20 percent of the

total domestic market revenue within 6 years of

loss of patent or exclusive marketing protection

(160).

OTA analyzed changes in the U.S. market for

therapeutic compounds losing patent protection

in the years 1984-87. An OTA contractor obtained data for the years 1980-90 on hospital and

drugstore sales for 35 noninjectable, noninfusible, therapeutic molecular compounds that lost

patent protection in the period 1984-87 (368,369).

Details of sample selection, methods, and results

are presented in appendix F. Sales (in revenue and

Figure 4-4-Originator Revenuea as a Percent of

Originator Revenue in Year of Patent Expiration

Percent

1oo-

““~

80-

4

)

60-

40-

20-

0 { I I 1 I I I I I I I

-7 -6 -5 -4 -3 -2 -1 0 1 2345 6

Years in relation to patent expiration

a Based on 1990 dollars.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

%hondelmeyer, “Economic Products,” contract paper prepared for Office of Technology Assessment, December

1991.

physical units) were recorded for all strengths and

dosage forms of the compound. (Sales volume for

each form of the compound was converted into a

standardized physical volume measure, the defined daily dose (DDD)).

Figures 4-4 and 4-5 show how the annual sales

in 1990 dollars and in physical units of the

originator compound changed before and after the

year in which the patent expired. Three years after

patent expiration, the originator’s annual dollar

sales (in 1990 dollars) were 83 percent of sales in

the year of patent expiration, while the originator’s unit sales were 68 percent of its sales in the

year of patent expiration.15

14 ~~ac.wen~ee~g tO -et ~ generic version of ~ o~~ator product co~d file MI NA, showing only bioequivalence with the

originator product and not needing to prove anew that the generic copy is effective.

15 A recent ~ysis Ofgenenc Comwtition by ~a~ws~ ~d Vernon repofied ~ferent res~ts (161). Grabowski ~d Vernon examined 18

compounds with annual sales of $50 miUion dotlars or more, 16 of whose patents expired in the 1984-87 period. (Two drugs had patent

expiration dates in the early 1980s.) They then examined the originator product’s market share for the most convnonlyprescn”bed dosageforrn.

They did not report market share data on revenues, but they did report on market shares unphysical units of the most frequently prescribed dosage

form. Within 2 years of the first generic entry, the originator’s market share in physical units had fallen to 49 percent. @n OTA’S sample of

compounds, the originator’s market share in physical units 2 years afterpatent expiration was 65 percent.) The difference in market shares can

be explained in part by: 1) the inclusion in OZ4’S sample of compounds with lower annual sales, which may draw less competition from

generics; 2) OTA’S inclusion of sales of all strengths and dosage forms; and 3) delays between patent expiration and the entry of generic

competition during which the originator product maintains an exclusive marketing position.

330-067 - 93 - 4 : QL 3
88 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 4-5-Originator Unit Volume as a Percent

of Originator Volume in Year of Patent Expiration

Percent

1 20”

90

60

30

0

\

“w

-/ -6 -5 -4 -3 -2 -1 0 1 2345 6

Years in relation to patent expiration

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, “Economic Products,” contract paper prepared for Office of Technology Assessment, December

1991.

The slower decline of the originator’s dollar

sales than of physical units following patent

expiration means that the price of originator

products increased after patents expired. This

finding is surprising to many people who would

expect brand-name prices to decline in the face of

active competition from generic competitors. Yet

it makes sense for the manufacturer of an originator product to raise its price as generic competitors enter if a high enough proportion of the

people who prescribe and buy the drug do not care

very much about price when they choose between

brand-name and generic products (136).

The sample excluded drugs not generally

distributed through drugstores. Products sold

exclusively to hospitals or other institutional

settings, such as infusible or injectable drugs,

would be likely to lose revenue more quickly after

entry by generic competitors than products offered through drugstores (158), (See chapter 10

for a discussion.) OTA estimated that these drugs

constitute roughly 14 percent of market sales (in

dollars) in the year of patent expiration (see

appendix F).

The data on the U.S. postpatent sales decline

also do not include sales made to several kinds of

purchasers that can be expected to switch to

generic versions of drugs very soon after they are

available. First, sales made through mail-order

pharmacies, a small but growing channel of

distribution comprising 5.9 percent of domestic

pharmaceutical sales in 1991 (128) are not

included. Generic versions of multisource drugs16

constitute a somewhat higher proportion of dollar

sales to mail-order pharmacies than to communitybased pharmacies (see appendix F).

Second, sales to Federal Government purchasers, such as the Department of Veterans Affairs

and the Military, are not included in these data.

These purchasers can be expected to switch to

generic versions of compounds soon after they are

available. The Department of Veterans Affairs

spent approximately $500 million for outpatient

prescription drugs in 1991 (312). This sum is

approximately 1 percent of total domestic pharmaceutical sales (128,320).

Third, staff-model HMOs, which represented

about 2.4 percent of ethical pharmaceutical sales

in 1991, switch to generics relatively quickly

(5 15). Thus, the rate of decline in revenues after

patent expiration is understated in these data.

OTA adjusted the rate of decline in sales after

patent expiration to take account of these and

other limitations of the data (see appendix F for

details).

For the analysis of the returns on NCEs

approved in the 1981-83 period, OTA assumed

that the originator drug’s revenues would decline

after patent expiration at annual rates shown in

table 4-3. The generics data available to OTA

gave no guidance on losses after the 6th year

following patent expiration. OTA assumed that

revenues would fall by 20 percent per year in the

8th to 1lth year after patent expiration. Sales

would fall to zero after 12 years following patent

expiration or after 20 years following the original

approval of the NCE.

lb Multisomce tigs are those with generic competition on the market.
Table 4-3-OTA’S Assumptions About

Changes in Sales of Originator Drugs

After Patent Expiration

—.

Chapter 4-Returns on Pharmaceutical R&D 89

Yea r after Percent change

patent expiration in dollar sales

1

2

3

4

5

6

7

8

9

10

-18%

-8.5

-6.0

-6.0

-5.0

-5.0

-5.0

-20.0

-20.0

-100.0

SOURCE: Office of Technology Assessment, 1993; based on sources

and assumptions outlined in appendix F.

Future changes in the health care system may

increase the speed with which purchasers switch

to generic products.

17 For illustrative purposes,

OTA examined the sensitivity of measured returns on R&D to a decline in revenues at an

annual rate of 20 percent from the date of patent

expiration until the 20th year following approval

of the drug.

Worldwide Sales—Revenues come from sales

in other countries as well as in the United States,

so the revenue curve must be adjusted accordingly. Although data on worldwide sales of

pharmaceutical products are collected by IMS

International, Inc., OTA did not have access to its

data.

18 The only data available to OTA are

aggregate estimates of the U.S. and foreign

markets for all ethical pharmaceuticals (or for all

pharmaceuticals). These aggregate estimates are

available from industry trade organizations and

from the annual reports of individual Fins.

Glaxo, a British pharmaceutical company,

estimates the total world market and the share of

each country in its annual report. Glaxo bases its

estimates on data from IMS International and

other sources. According to Glaxo the United

States accounts for 27 percent of world sales, and

10 other industrialized and newly industrialized

countries account for 54 percent of world sales.

The rest of the world accounts for 19 percent.

Japan comprises the second largest national

market, with an 18-percent share. These aggregate industry sales figures suggest a ratio of total

world sales to U.S. sales of approximately 3.7 to

1. If only the top 10 countries are included (on the

assumption that the ‘‘rest of the world’ does not

constitute a large market for new chemical

entities), the ratio of total to U.S. sales is 3 to 1.

Many of the drugs sold in other countries are

never launched in the United States, so it is

difficult to draw conclusions from these worldwide aggregate sales figures about how new

chemical entities that are medically important

enough to seek and receive U.S. FDA approval

would fare.

The Pharmaceutical Manufacturers Association (PMA) collects sales data of its member firms

in an annual survey. U.S.-owned PMA member

firms reported that the ratio of total worldwide

sales to domestic sales was 1.765 to 1 in 1990

(317). These companies are likely to have a lower

percent of sales outside the United States than are

foreign-owned firms that launch new products in

the United States, and the ratio is based on drugs

that have lost patent protection as well as those

that are covered by patents. Thus, this ratio is too

conservative.

Grabowski and Vernon, using estimates based

on IMS International data, assumed that the ratio

of total world revenues to U.S. revenues for drugs

introduced in the 1970s, was 1.9 to 1 throughout

the life of the NCE (160). Joglekar and Paterson

estimated the trend in the global sales ratio over

the period 1954-78 based on IMS data and

predicted that the ratio for drugs introduced

17 For example, HMOS and other managed care plans with comprehensive pharmaceutical benefits typically either mandate generic

prescribing or offer incentives to users for purchase of generic brands (5 15). If managed care grows in the United States in the future, tbe speed

with which generic substitution occurs may increase. See chapter 10 for a discussion of trends in insurance and payment.

18 IMS ~temtio~, ~c, indicat~ the cost to o~ of obtig worldwide s~es ~~ for th~e drugs would be between $75,~ and

$150,000 (339).
90 I Pharmaceutical R&D: Costs, Risks and Rewards

between 1962 and 1977 would increase from 1.86

to 1 to 2.44 to 1 between 1985 and 2044.

Lacking more detailed data on the ratio of total

world sales for specific NCEs over their product

life cycle, OTA assumed that the ratio is 2 to 1.

OTA has reason to believe that this ratio is on the

low side, based on informal discussions with

researchers who have access to unpublished data.

Application of a worldwide sales ratio beginning with FDA approval ignores the revenues that

accrue when products are launched in other

countries before the FDA approves them.19 Figure 4-6 charts the frequency of early approval in

other countries for the NCEs approved by FDA in

1981-83. Over 25 percent of drugs approved in

the United States in this period were first approved at least 5 years earlier in another country.

The revenues realized in the years before FDA

approval are potentially very significant in terms

of the present value of revenues, but without

access to foreign sales data it is impossible to

estimate their size. To be conservative, OTA

excluded early foreign sales from the analysis.

COST OF MANUFACTURING, MARKETING,

AND DISTRIBUTING NCES

Sales revenues from new products must be

reduced by the cash outlays required to make and

sell them. Accurate measurement of productspecific costs of manufacture, marketing, distribution, and administration is difficult for multiproduct companies, and publicly available financial statements offer only rough estimates of the

magnitude of these costs.

OTA estimated manufacturing, distribution,

marketing and administrative costs from a variety

of sources, including the existing literature and

annual reports of six U.S.-owned companies with

pharmaceutical sales comprising at least 65 perFigure 4-6--Year of First Entry to the Market for

New Molecular Entities Approved in the

United States, 1981-83

“~

Number of compounds

I n

20-

lo-

~

0 I 1 I I I 1 1 1

-5(+) -4 -3 -2 -1 0 1 2 3

Years before and after U.S. approval

SOURCE: Office of Technology Assessment, 1993, based on unpub

Iished data from the Office of Planning and Evaluation,

Office of the Commissioner, U.S Food and Drug Administration.

cent of total company sales.20 The method and

estimates are described in detail in appendix G.

Marketing costs were assumed to be higher in

the early years of product life and low after patent

expiration, but over the lifetime of the product

they average 22.5 percent of total sales.

OTA also accounted for high initial cash

outlays for capital expenditures on manufacturing

capacity as well as ongoing manufacturing costs.

Initial expenditures for plant and equipment for

each compound were assumed to be $25 million,

spread evenly across the 2 years before and the

year of product approval.21 The sensitivity of the

results to an increase in this cost to $35 million

was also tested.

OTA assumed that the full value of plant and

equipment would be consumed in the production

of the single product and that at the end of the 20

years of product life, the salvage value would be

19 o~’s ~ysis also ignorl% the revenues ffom products tit remained unapproved in the United States but were accepted and launched

in other countries. The foreign revenues from these drugs that are never approved in the United Staks help offset the R&D costs associated

with each successful U.S. entry,

m me Sk fjj we Merck, Eli Lilly, Syntex, Schering-Plou~ UpJo~ ad -r,

21 k addition to this initi capi~ ~~ndi~e, OTA included all ongoing depreciation expense-s for manufacturing fSCfiitieS (which ~

embedded in cost-of-sales mtios) in excess of the depreciation that could be taken on the $25-million capital expenditure.
Chapter 4-Returns on Pharmaceutical R&D 91

Table 4-4-Cost Assumptions in OTA’s Analysis of Returns on R&D

Cost component Year after product launch Base case

Capital expenditures for plant

and equipment

Manufacturing and distribution

(as a percent of sales)

General and administrative

costs as percent of sates

Marketing costs as percent of

sales

Value of inventory as percent

of sales

Working capital as percent of

sales

Ongoing R&D rests

Total over life cycle

2 years before approval

1 year before approval

Year of approval

1-20

1-20

Average over life cycle

1

2

3-9

10-20

1-20

1-20

Total over life cycle

1-9

$25 million

$8.33 million

$6.33 million

$6.33 million

25.5% of sales less adjustment for

depreciation charges on plant and

equipment (20-year life)

11.1% of sales

22.6% of sales

1 OO.OO/’ of sales

50.0% of sales

40.9% of sales

6.5% of sales

12.7% of sales

1 7.0% of sales

$31.2 million

$3.46 million

SOURCE: Office of Technology Assessment, 1993.

zero, also a conservative assumption. Table 4-4

contains a summary of OTA’s base case assumptions regarding costs of production, distribution,

administration and marketing.

R&D COSTS

The NCEs introduced in the period from 1981

to 1983 began clinical testing roughly 8 years

earlier (1973-75), the midpoint of the study years

in DiMasi’s R&D cost study (109). OTA assumed

that DiMasi’s cash outlays (in constant 1990

dollars), success rates, and development time

profile represent the experience of the NCEs

approved between 1981 and 1983.

In addition to the costs required to bring a

compound to market, OTA’s analysis also explicitly recognized ongoing R&D costs after the

product is launched. These R&D expenditures

may be intended to explore the usefulness of the

drug in new conditions or to develop new dosing

strengths, formulations, or dosage forms. OTA’s

method for estimating the ongoing costs of R&D

is outlined in appendix G. Total ongoing R&D

expenditure was assumed to be $31.7 million per

compound (in 1990 dollars), evenly distributed

over the first 9 years of product life.

TAXES

To measure the net after-tax returns on R&D,

the cash flows generated by the sale of each

product in the years following market launch

must be reduced by the amount of taxes they

cause to be paid. Ideally, the reduction in cash

flows would be equal to the extra tax paid in each

year of the product’s life as a direct result of

manufacturing and selling the product.

Precise measurement of these extra tax payments is difficult for three reasons. First, taxes

owed or payable are based not only on cash flows

from the product but on rules in tax codes

governing what can be deducted, and when.

Expenditures to build manufacturing facilities,

for example, cannot be deducted in full in the year

they are made for U.S. income tax purposes; they

must be depreciated over a specified number of

years. (OTA assumed that investments in plant
92 I Pharmaceutical R&D: Costs, Risks and Rewards

and equipment would be depreciated for tax

purposes on a straight-line basis over 10 years.)

Second, taxes owed or payable depend not only

on what is manufactured and sold but also on

where it is manufactured. Drug companies can

and do make decisions to manufacture products in

jurisdictions that will afford them the best profile

of after-tax cash flows. The availability of tax

credits for locating manufacturing operations in

U.S. possessions, such as Puerto Rico, substantially reduces the tax liability of pharmaceutical

companies. (See chapter 8 for more detail.) Thus,

the opportunity to make a new product in a

low-tax jurisdiction means that the extra taxes

incurred as a result of the introduction of a new

group of products will certainly fall short of the

statutory marginal corporate tax rate.

Third, tax payments in any year depend not

only on taxable income in that year but also on the

profit and loss history of the company. Some

current tax liabilities can be applied to previous

years if the company lost money in the past.

Similarly, payment of some taxes can be deferred

to future years. Income tax expenses can remain

higher or lower than actual payments over a long

period of time if an industry as a whole is, or has

been, in a period of eligibility for tax deferments.

Taken together, these measurement problems

imply that the U.S. marginal corporate tax rate is

too high a rate to apply to the cash flows

associated with a new product after it is introduced to the market. A better approximation of

the tax burden would be based on the ratio of taxes

paid to income from ongoing pharmaceutical

operations. 22

Three estimates of this ratio are available for

the pharmaceutical industry. All of them were

made at the firm level and therefore include

nonpharmaceutical operations. Also, each estimate is based on: 1) a different sample of fins,

2) a different definition of tax liability, and 3) a

different definition of income.

●

●

The General Accounting Office and the

congressional Joint Committee on Taxation

calculated taxes payable each year as a

percent of firms’ pretax net income (net of

extraordinary income) in that year. (Tax

liabilities that are deferred to future years

were not included, but payments made as a

result of past deferments were.) For five

U.S.-based pharmaceutical firms in the sample, the effective worldwide tax rate on

worldwide income was 34.3 percent in 1987

(438). The rate varied between 1981 and

1987, starting higher (41.3 percent) in 1981

and reaching a low in 1983 (32.1 percent),

but climbing again to a high of 37.1 percent

in 1986.

Baber and Kang calculated worldwide income taxes paid as a percent of net income

before depreciation and taxes (as reported in

financial statements) between 1975 and

1987 for 54 U.S. pharmaceutical firms with

R&D expenses greater than 5 percent of

sales (24,224). Table 4-5 shows the income

tax rates from 1981-87. Taxes paid for this

sample of firms was in the range of 29 to 34

percent of income until 1987, when taxes

paid jumped to 39.7 percent of income.

Table 4-5-Taxes Paid as a Percent of Net Income

for 54 R&D-Intensive Pharmaceutical Companies

Year Tax rate (percent)

1981 31 .8%

1982 31.0

1983 31.7

1984 32.5

1985 29.1

1986 33.7

1987 39.1

SOURCE: The Office of Technology Assessment, 1993, based on

unpublished computations by S-H. Kang forpharmaeeutlcal

firms in W.R. Baber and S.-H. Kang, “Aecmunting-Based

Measure as Estimates of Economic Rates of Return: An

Empirical Study of the U.S. Pharmaceutical Industry 1976-

87, draft report prepared for the Office of Technology

Assessment, Mar& 1991.

22 ~s mrio is also referr~ tc~ as the effective tax rate (see chapter 8 for dews).
Chapter 4–Returns on Pharmaceutical R&D I 93

● Tax Analysts, Inc., a tax research group,

calculated current taxes payable, not including paybacks of past deferments but including a proportion of incurred tax liability that

will be paid in future years,23 as a percent of

income from ongoing operations (257). The

effective worldwide tax rate for 15 U. S.-

based pharmaceutical firms under these

criteria was 32 percent in 1987 (257,258).

The average effective tax rate for the industry

after 1987 is likely to decline because the Tax

Reform Act of 1986 reduced the U.S. corporate

marginal tax rate after 1986. In 1987, the top

Federal statutory marginal tax rate was 40 percent, compared with 46 percent in 1986, and it

dropped to 34 percent in 1988. Therefore, when

the effect of tax credits and deferments is taken

into account, the average effective tax rate is

likely to be even lower than 32 percent in years

after 1987. For the drugs approved in 1981-83, the

lower tax rate would have gone into effect in the

4th to 7th year after product launch.24

After taking into account the information

summarized above, OTA assumed that taxes

would constitute 32 percent of net pretax cash

flows throughout the life of new drugs introduced

between 1981 and 1983.

THE COST OF CAPITAL

The real (inflation-adjusted) weighted average

company cost of capital for pharmaceutical firms

varied roughly in the neighborhood of 10 percent

in the 1980s (285). OTA assumed that the real

cost of capital for investments made after product

approval is 9.8 percent, because 10 percent is too

high for investments made on existing products.

The cost of capital for investments in ongoing

operations is lower than the cost of capital for

investments in R&D (285), and the weighted

average cost of capital for the firm as a whole

strikes a balance among different kinds of investments. OTA therefore adjusted the cost of capital

for investments in ongoing operations slightly

downward from 10 percent.

RESULTS

Table 4-6 shows the NPV of the net returns in

the years following market approval (in 1990

dollars) under the base case. The NCEs of

1981-83 deliver cash flows equal to net present

value of $341 million per compound. After taxes,

the present value in the year of FDA approval of

this net revenue is reduced to approximately $230

million. These net revenues must be compared

with the present value of the investment in R&D

required to discover and develop the compounds.

An upper bound on the fully capitalized R&D

costs is about $359 million before tax savings, or

$194 million after tax savings are considered (see

table 3-10 in chapter 3). Thus, under the base-case

scenario, on average, each compound can be

expected to return a net present value of at least

$36 million more (after taxes) than would be

required to bring forth the investment in the R&D.

The results are somewhat sensitive to the

global sales multiplier, which is in turn very

uncertain but likely to be higher than the ratio

used in the base case. If the ratio were much

higher than 2 to 1, the net present value of the

Table 4-6-Net Present Valuea of Postlaunch

Returns to R&D for NCEs Approved 1981-83

(1990 $ millions)

Pretax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $341

After tax. . . . . . . . . . . . . . . . . . . . . . . . . . . $230

a Net present value is calculated with a 9.9 percent cost of capital.

KEY: NCE - new chemical entity.

SOURCE: Office of Technology Assessment, 1993.

23 AccOrd~g t. T’= A~~ly~ts, InC,, ~ ~ropo~lon of dcfc~ed t~cs MC never likely to bc paid. This portion of deferred taxeS iS nOt COUllted

in the tax rate.

24 The reduction in U.S. corporate income taxes resulting from the Thx Reform Act represents a one-time windfall for returns on drugs

discovered and developed before 1987. While taxes on net income from the manufacture and sale of new products will continue to stay as they

are unless a ncw law changes thcm, the after-tax cost of R&D conducted after 1987 increased from approximately 54 percent of cash R&D

outlays to 66 pcrccnt. Thus in the future the increased after-m income from successful new drugs resulting from the Tax Reform Act of 1986

will be offset to some extent by increased after-tax costs of R&D.
94 I Pharmaceutical R&D: Costs, Risks and Rewards

investment would be even greater than the base

case indicates.

Changes in the initial investment in plant and

equipment slightly affect estimated returns. A

$35-million investment in plant and equipment

reduces the net present value of pretax net

revenues to $336 million and the NPV of after-tax

net revenues to $225 million.25 The average

capital expenditures for plant and equipment

would have to be as high as $100 million for the

NPV of after-tax cash flows to equal the NPV of

after-tax R&D costs.

The results are not very sensitive to changes in

the speed with which the originator’s brand sales

decline after patent expiration. If the average sales

per compound were to decline by 20 percent per

year beginning with the year of patent expiration

(instead of according to the schedule shown in

table 4-3), the present value of dollar returns

would be $311 million before taxes and $209

million after taxes. The after-tax return still lies

above the upper bound on R&D costs.

A decline of 20 percent per year in originator

revenues from the date of patent loss would mean

that within 3 years tier patent expiration, originator sales revenue would be just51 percent of its

sales in the year of patent expiration. Fully 6 years

after the passage of the Drug Price Competition

and Patent Term Restoration Act of 1984 (Public

Law 98-417) there is no evidence that the rate of

revenue loss for originator compounds is approaching this rate. For the NPV of returns on

R&D to equal zero, the postpatent decline in

revenues would have to be over 30 percent per

year from the year of patent expiration.

What does it mean to have the average revenue

per compound deliver $36 million more in NPV

than was needed to bring forth the research on the

drugs introduced in 1981-83? This excess would

be eliminated if the annual revenue per compound

was reduced by 4.3 percent. If demand for the

drugs is totally insensitive to changes in price,

then the average price could be reduced throughout the product life cycle by 4.3 percent without

reducing returns below the amounts necessary to

repay R&D investors. To the extent that demand

for a compound increases as its price decreases,

prices could have been reduced more than 4.3

percent in each year.

These estimates are rough approximations of

the actual returns that the 1981-83 class of NCEs

will earn. OTA attempted to be conservative in

measuring returns, but the estimate is subject to

measurement error whose magnitude is not easily

assessed. They illustrate how volatile net returns

can be over time and how sensitive they are to:

1.

2.

The cost of R&D, which in turn depends on

the assumed cost of capital and the productivity of the research process; and

The worldwide revenues that can be expected from the drugs that result from that

process.

As this and other chapters in this report

illustrate, both worldwide revenues and the cost

of R&D for each new NCE can change rapidly. If

firms devote increasing resources to basic research, then the cost per success can increase

dramatically, not only because of the actual

outlays, but also because these expenditures are

made early in the process and carry a high cost of

capital. At the same time, worldwide revenues per

NCE can also change dramatically over short

periods of time, as figure 4-2 clearly demonstrates. The second-year U.S. sales of compounds

that the FDA approved in the period 1984-88

were substantially higher than the sales of the

drugs introduced in the 1981-83 period. Yet,

future changes in methods of paying for prescription drugs, brought about by health insurance

reform or health care cost containment in the

United States and abroad, could adversely affect

the sales curve for drugs introduced in the 1990s.

2s me ~rem net ~~ flows am ~duud by ordy $5 million because higher initial capital expenditure meu ~ a hi@r PmPofion of ~

cost of sales is devoted to depreciation expenses, which are subtracted fmm the estimate of direct manufacturing cost.%
—

Chapter 4-Returns on Pharmaceutical R&D 95

TOTAL PHARMACEUTICAL

INDUSTRY RETURNS

The previous section described an analysis of

investments in a specific group of new drugs,

from their very beginning as R&D projects to

their ultimate obsolescence and removal from the

market. Although the analyses reviewed and

presented above are imprecise, because some data

on revenues and costs can be estimated only

roughly, within the limits of data accuracy the

analyses appropriately measure the net present

value of investments in R&D.

Another more indirect way to assess returns on

R&D is to estimate the profitability of researchintensive pharmaceutical companies. Audited financial data are available to estimate profitability

at the company level for public corporations.

Pharmaceutical firms invest in the discovery,

development, production, marketing, and distribution of many products, including some that are

not ethical pharmaceuticals. The total profit or

return on a company’s investment in a given

period is a mixture of returns on past investments

made over many previous years on many different

projects.

At the company level, the return on investment

is defined by the internal rate of return (RR), the

interest rate at which the net present value of all

cashflows into and out of the firm equals zero. If

the IRR across all companies in an industry is

greater than the industry’s cost of capital, then the

industry returned more to its investors than was

necessary to bring forth the investment dollars,

and one would suspect that barriers to entry or

other forms of monopoly power (perhaps obtained through patent protection) might exist in

the industry (86). On the other hand, a low IRR

relative to the cost of capital would, if companies

invest efficiently, lead to disinvestment in the

industry, including R&D.26 Over the entire life of

the industry (from its start to its dissolution), the

IRR should be in the neighborhood of its cost of

capital.

The annual financial reports of public companies contain estimates of total firm profit rates

based on accounting records. For example, the net

income as a percent of the total ‘‘book value’ of

assets27 is a commonly used benchmark of firm

profitability (301). Companies themselves report

this ratio in their annual financial statements and

compare their performance in specific years with

that in previous years. Other commonly used

profit ratios, such as net income as a percent of

sales, are also easily computed from company

financial statements.

It is not surprising, then, that analysts would

compare the accounting profit rates of firms in the

pharmaceutical industry with those of firms in

other industries (301 ,457).28 The ready availability of publicly reported and independently audited data, and the widespread use of these

measures by companies themselves, invites such

comparisons. But they are limited in two important ways. First, accounting-based profit measures can be poor approximations of firms true

IRRs. Second, comparing returns of the pharmaceutical industry with those of other industries is

not a perfect substitute for comparing its returns

with the industry’s cost of capital. Risk differs

among industries, so even if accounting-based

profits were good proxies for IRRs, simple

interindustry comparisons, without consideration

of the riskiness of industries, would be misleading.

Accounting profits are poor measures of IRR

for several reasons:

26 ~other possible explanation for persMently low IR.Rs irl m tidwtry is tittie managers of fii in the industry do not adequately

represent the interests of their shareholders (39,155,282).

27 Book v~ue refers to the end-of-~e-y~ value of capital assets after depreciation expenses. Strict accounting convention detebe wht

kinds of investments create a capital asset. R&D, for example, is not recorded as an investment but is fully expensed in the year in which

expenditures are made. This accounting convention required since 1975 by the Federal Accounting Standards Board, is equivalent to

depreciating the investment 100 percent in the year it is made.

28 By ~ese conventio~ mem~es the pharmaceutical industry would appear to be substantially more profitable motier ~dustri~.
96 I Pharmaceutical R&D: Costs, Risks and Rewards

● Accounting standards require firms to record

as current expenditures all outlays for R&D,

advertising, and promotion when in reality

these expenditures are investments whose

payoffs may be delayed or extended into

future accounting periods. The value of the

‘‘intangible assets’ produced by these investments is too uncertain for use in accounting statements. Thus, the book value of

assets in a company’s financial statement

underestimates the true value of assets,

especially when these investments are important components of the company’s activities, as in the pharmaceutical industry

(62,78,80).

. Financial statements often report income

and expenses as they are accrued in accounting records, not as they are actually realized

in cash flows. These differences between

accrual accounting and cash flows can

distort the timing of investments and revenues and therefore misrepresent the rate of

return in a given period (27)

. Even if the above distortions are corrected,

the accounting rate of return could still

depart from the IRR because accounting

profits do not adjust properly for the time

profile of cash flows from various investments and are further distorted by growth or

decline in investment overtime (132,398,402).

E Past Studies

OTA found six studies of pharmaceutical

industry profits in which accounting rates of

return to pharmaceutical firms were corrected by

treating R&D (and sometimes advertising) as

investments rather than as current expenditures.

Each study makes assumptions about the useful

life of these intangible investments and the rate at

which their value depreciates. See table 4-7 for a

summary of these studies. These studies are

limited by small numbers of fins, virtually all

successful and therefore likely to be more profitable than the industry as a whole, and few years of

data. Nevertheless, they consistently find that

correcting pharmaceutical industry profit rates for

investment in intangible capital reduces rates of

return by roughly 20 to 25 percent (214).

Three research studies compared adjusted pharmaceutical industry profits with similarly adjusted profits in other industries. Table 4-8

summarizes the methods and results of these

studies. Once again, these studies include a small

number of pharmaceutical and nonpharmaceutical firms, virtually all successful, and examine a

short time period. Nevertheless, these studies

show that adjusting accounting rates of return for

investments in R&D and advertising does not

completely erase differences in computed profits

between pharmaceuticals and the comparison

industries.

Even if the corrections to accounting rates of

return in these studies were sufficient to approximate IRRs (which they do only imperfectly), the

differences in the rates of return might reflect

differences in the riskiness (and, hence, the cost

of capital) among industries. Thus, little can be

said about the rate of return on investments in the

pharmaceutical industry from these studies.

H OTA’s Contractor Report on

Comparative Profits

OTA asked William Baber and Sok-Hyon

Kang to compare the IRR of a sample of firms in

the pharmaceutical industry with IRRs of nonpharmaceutical companies using a new technique

that adjusts accounting data to obtain a closer

approximation of IRRs. (27). The method, pioneered by Ijiri (199,200) and Salamon (359,360),

calculates a “cash flow recovery rate’ from

accounting data, which can then be combined

with assumptions about the time profile of cash

flows to imply an IRR for the industry.

The time profile of cash flows (including the

total life of investments and the shape of cash

flows over time) is itself an unknown both for the

pharmaceutical industry and for other firms.

Consequently, Baber and Kang examined several

alternative assumptions about the life of investments (including R&D as well as tangible capital

facilities and equipment) and the shape of the cash

flow curve in both pharmaceutical and nonphar-
Table 4-7—Accounting Rates of Return Corrected for Investment in R&D and Advertising

Accounting Corrected Corrected ROR+

Researcher(s) Sample Time period Data source(s) Major assumptions rate of return rate of return Accounting ROR

Stauffer, 1975 6 major Varying across Compustat

pharmaceutical firms from 1953-

firms 72 to 1963-72

Clarkson, 1977 1 pharmaceutical 1965-74

firm (Eli Lilly and

Co.) (out of 69

firms in crosssectional sample)

Grabowski and 7 pharmaceutical 1968

Mueller, 1978 firms (out of 86

firms in crosssectional sample)

Bloch, 1973

Ayanian, 1975

Eli Lilly and Co.

Annual Reports

Compustat; previously collected

R&D data for 1959-

69; advertising

expenditures for

five major media

“from individual

media information

sources. ”

4 pharmaceuti- 1969 Annual reports

cal firms

6 major 1973 (for ROR) Data on advertispharmaceutical ing and R&D

firms expenditures provided by firms;

Moody’s Industrial

Reports.

1. No correction for inflation.

2. 4-year R&D gestation period

with constant expenditures

per unit of time.

3. Product sales reach constant

level first year after introduction, remaining at that level for

15 years.

4. Sales decay rate = 0.7.

1. Corrected for inflation using

wholesale price index.

2. 3-year life for advertising.

3. Basic research = 16% of total

R&D.

4. Basic research accumulates

at 10?40 per year for 11 years

and depreciates for 15 years.

5. Development accumulates at

10% per year for 6 years and

depreciates for 11 years.

1. Corrected for inflation using

GNP price index.

2. Removed cyclical effects and

financing effects.

3. R&D depreciates at constant

proportional rate of either 5 or

10?40.

4. Advertising depredates at constant proportional rate of 30%

1. R&D depreciation schedule

estimated by regression of

sales on lagged R&D.

2. Advertising not capitalized.

3. After-tax returns.

1. No correction for inflation.

2. R&D and advertising depreciated at same rate, assumed

at either 9 or 13% per year.

Varied across Varied across

firms firms; less than

accounting rate of

return for 5 out of

6 firms

17.3% (average 11 .lO/O (average

over time) over time)

14.1 % (average 10.80/0 (using 1OO/.

over firms) R&D depreciation

rate)

10.5% (using 5%

R&D depreciation

rate)

Varied across 7.6-16.1 ‘/o

firms 9.7-22.1%

17.7°/0 (average 14.060/’ (average)

over firms) (using 13“/. depreciation rate)

13.690/. (using 9%

depreciation rate)

Ranged from

0.72-1.23

0.64

0.77

0.74

Ranged from

0.70-0.80

0.79

0.77

o—

(Continued on next page) a

4
Table 4-7—Accounting Rates of Return Corrected for Investment in R&D and Advertising--(Continued)

Accounting Corrected Corrected ROR+

Researcher(s) Sample Time period Data source(s) Major assumptions rate of return rate of return Accounting ROR

Megna and 10 major 1975-85 Compustat 1. No correction for inflation. 14.81% 12.1 5% (average 0.82

Mueller, 1991 pharmaceutical 2. Estimated firm-specific rates over time)

firms of depreciation of R&D and

advertising by regression of

sales on lagged R&D and advertising expenditures (assumed

binomial lag functions).

KEY: ROR = rate of return.

SOURCE: Office of Technology Assessment, 1993, based on E.J. Jensen, “Rates of Return to Investment in the Pharmaceutical Industry: A Survey,” contract paper prepared for the Office

of Technology Assessment, September 1990.
Table-4-8--Results of Studies Comparing Adjusted Pharmaceutical Industry Profits With Profits in Other Industries

Other R&D capitalization Advertising capitalization

Pharmaceutical industries assumptions met hod Results

Study industry sample sample Pharmaceuticals Other Pharmaceuticals Others Pharmaceuticals Other firms Comments

Grabowski 7 companies 79 firms in a na- R&D depreciates R&D depreciates Depreciates at Depreciatesat 10.8% 7.2% ■ 1968 profits

and Mueller, 1968 tional sample in value at con- at constant pro- 30% per year 30% per year

1978

smoothed for

of industries stant proportion- portional rate of cyclical effects

performing R&D. al rate of 5%. 1 o%. ~ After-tax

profits

■ Inflation

adjusted

Clarkson, 1 company 68 firms in a

1977 1959-73 national

sample.

Megna and 10 major firms Selected firms in

Mueller, 1991 1975-88 advertising or

R&D-intensive

industries.

6 firms in toy industry; 4 distilled

beverage firms;

9 cosmetic

firms.

‘Basic’’research:

16% of R&D. Basic research has

26-year life, accumulatesfor11

years (growing in

value at 10 0/0

per year); then

depreciates for

15 years.

Development

84% of R&D. Development has a

17-year life, accumulates for 6

years (growing in

value at 10 0/0

per year) then

depreciates for

15 years.

R&D depreciation rates estimated for each

firm by regressing sales on

lagged R&D.

Maximum 8-

year life.

12.9% 9.6% n After-tax

profits

■ Inflation

adjusted

Development 3-year life 3-year life

life and depreciation schedule

estimated from

industry sources.

Varies across industries. Basic

research as- g

sumed to accumulate for the ~

development m

life plus 5 years. A

*

R&D deprecia- Same deprecia- Same depre- 12.15% ■ Toys = 6.66°/0.

tion rates tion estimation ciation esti- ~ Distilled

estimated for technique as mation tech- beverages =

each firm by R&D with a max- nique as R&D 11.44%.

regressing imum 4 year life. with a ● Cosmetics =

sales on lagged maximum 11.51%.

R&D. Maximum 4 year life.

8-year life.

■ After-tax q

profits

■ Not inflation 3

adjusted mo

m

-.

SOURCE: Office of TechnobQy Assessment, 1993.

CQ

co
100 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 4-7—Cash-Flow Profiles Used in Internal Rate of Return

Profile: Q(1) Profile: Q(2)

$

$

r c

Computations

‘LaN 2N N 2N N

i 3 3

Profile: Q(3)

I

N N

3

Profile: Q(4)

L–--– ”—T-–—+———

N

KEY: N = Life of investment project; Q = Cash flow profile

KEY: N - Life of Investment Pro~ect; Q - Cash-flow profile.

SOURCE: W.R. Baber and S-H. Kang, “Accounting-Based Measure as Estimates of Economic Rates of Return: An Empirical Study of the U.S.

Pharmaceutical Industry 1976-87, draft report prepared for the Office of Technology Assessment, March 1991.

maceutical firms, Figure 4-7 shows four different

cash flow profiles. Q1, an inverted v-shape profile

with a substantial delay before revenues begin to

accrue from an investment, has often been viewed

as the most appropriate shape for an R&Dintensive industry like pharmaceuticals (160).

(This profile is similar to the cashflow profile for

new drugs shown in figure 4-1, ) Other profiles

may be more realistic for nonpharmaceutical

fins. Because the productive life of investments

may also be longer in the pharmaceutical industry, the contractors estimated IRRs for 20-year

and 30-year investment lives.29

The contractors compared 54 researchintensive pharmaceutical firms listed at least once

in the CompustatTM database between 1975 and

198730 with two ‘‘control’ samples, each with 54

firms having financial characteristics similar to

29 other, ~hofler, ~ve~~ent11ve5 were ~50 co~idered, but the res~~g c~c~ted ~were unrealistically low for all samples ad are

not reproduced here. The difference in IRRs between pharmaceutical and nonpharmaceuticd fw is even greater for shorter investment lives

(27).

30 CJtudy of YWS Pfior t. 1$176 is infeasible ~cause acco~ting practi~s for R&D were not s~~ized UIItil 1975 with the publication

of a Federal Accounting Standards Board rule on the treatment of R&D (29,74).

31 me fkst con~ol Smple was obtained by matching nonpharmaceutical firms with pharmaceutical firms on the basis of sales and sales

growdy the second control sample was obtained by matching nonpharrnaceutical firms with p harrnaceutical fms on the basis of sales and R&D

intensity.
Chapter 4-Returns on Pharmaceutical R&D I 101

the pharmaceutical firms.31 Table 4-9 shows the

weighted mean IRRs between 1976 and 1987 for

the pharmaceutical firms and each of the control

samples under alternative assumptions about

investment life and cash-flow profiles.

Differences in weighted mean annual IRRs

between pharmaceutical and nonpharmaceutical

firms of about 2 to 3 percentage points per year

persist and were statistically significant regardless of assumptions made about investment life or

cash-flow profile.32 The same analysis for a

sample of 88 pharmaceutical firms (including

firms with ratios of R&D to sales lower than 5

percent) and their matched control firms showed

differences of the same magnitude (27). Thus,

while the differences in uncorrected accounting

profits between research-intensive pharmaceutical companies and non-pharmaceutical companies over the period were as high as 4 to 6

percentage points per year, the IRRs implied by

the contractors’ study differ by much less, 2 to 3

percentage points per year.33

Baber and Kang’s method for estimating industrylevel IRRs is itself subject to measurement error,

so the reliability of the measured rates of return

for each industry group (pharmaceuticals and

controls) is uncertain. Nevertheless, Baber and

Kang applied the estimation method consistently

across all firms in the three groups, so the

differences in profit rates between pharmaceuticals and controls, which were stable across a wide

range assumptions about their investments, are, in

OTA’s judgment, reliably estimated.

The contractor’s comparative profit study is

silent on the question of whether a 2 to 3

percentage point difference in rates of return is

due to differences in the cost of capital between

Table 4-9—Mean Estimated Internal

Rates of Return for Pharmaceutical Industry

and Control Groupsa

Investment Iife (years)

30 20

Pharmaceuticals

Mean accounting return on assets. .. 0.1432

Implied IRRb

Q(I). . . . . . . . . . . . . . . . . . . . . . ...0.1382

Q(2). . . . . . . . . . . . . . . . . . . . . . ...0.1413

Q(3). . . . . . . . . . . . . . . . . . . . . . ...0.1434

Q(4). . . . . . . . . . . . . . . . . . . . . . ...0.1460

Control Group I (sales)c

Mean accounting return on assets. .. 0.1029

Implied IRRb

Q(l). . . . . . . . . . . . . . . . . . . . . . ...0.1143

Q(2). . . . . . . . . . . . . . . . . . . . . . ...0.1147

Q(3). . . . . . . . . . . . . . . . . . . . . . ...0.1150

Q(4). . . . . . . . . . . . . . . . . . . . . . ...0.1155

Control Group II (R&D)d

Mean accounting return on assets. .. 0.0875

Implied IRRb

Q(l). . . . . . . . . . . . . . . . . . . . . . ...0.1163

Q(2). . . . . . . . . . . . . . . . . . . . . . ...0.1178

Q(3). . . . . . . . . . . . . . . . . . . . . . ...0.1190

Q(4). . . . . . . . . . . . . . . . . . . . . . ...0.1200

a

b

c

d

0.1432

0.1361

0.1374

0.1389

0.1393

0.1029

0.1076

0.1058

0.1036

0.1041

0.0875

0.1117

0.1113

0.1109

0.1111

Based on a sample of 54 pharmaceutical companies listed in

CompustatTM database at least once in the period 1975-87 with

R&D-to-sales ratios of 5% or more. Constant growth rates of invested

capital equal to the geometric mean sample growth rates from

1975-87 were used to calculate IRR estimates. Estimates based on

actual growth rates in each sample are comparable.

Cash flow Profiles, Q1 through Q4, are shown in figure 4-7.

Firms matched with pharmaceuticals on the basis of sales and sales

growth,

Firms matched with pharmaceutics on the basis of sales and R&D

intensity.

KEY: IRR - internal rate of return; Q - cash flow profile.

SOURCE: Office of Technology Assessment, 1993, based on W.R.

Baber and S.-H. Kang, 4Accounting-Based Measures as

Estimates of Economic Rates of Return: An Empirical Study

of the U.S. Pharmaceutical Industry 1976-87,” contract

paper prepared for the Office of Technology Assessment,

March 1991.

n me ~~tfiate~ ~hom ~ ~ble 49 UC based on constant growth rates. In an eXteIISiOn of their study, Ba~r ~d ~g estited ‘i*

actual investment growth rates. The results were substantially the same (28).

33 Because tie s~dy used new ~~yti~ tec~lques tit me ~fill~ to my @ysK, OTA solicited independent review ad COmfnent

on the validity of its methods and findings from both its advisory panel and a selected group of academic experts in economics and accounting.

The paper evoked considerable criticism from one outside reviewer, who questioned the validity of assumptions underlying the use of the

method. OTA then submitted the detailed critique to the study authors, and both the critique and the authors’ response were sent to two

independent outside experts for further review. The results of the review process reinforced the conclusion that pharmaceutical industry IRRs

were 2 to 3 percent higher than the returns on the control samples in the 12-year period under study. (A copy of the history of written reviews

and comments is available upon request from OTA.)
102 I Pharmaceutical R&D: Costs, Risks and Rewards

pharmaceuticals and the control firms. If investment in the pharmaceutical industry is riskier than

in the control fins, then the cost of capital will

be higher. OTA examined differences in the cost

of capital between the pharmaceutical industry

and the two control samples.

The cost of capital is the rate of return investors

require to induce them to invest in a company

with a given level of risk. The weighted average

cost of capital is the blended cost of the fro’s

debt and equity capital (285,409).

OTA estimated the weighted average cost of

capital for the pharmaceutical industry and the

two control groups. The cost of capital varies over

time with changes in underlying interest rates;

consequently, precise measurement of the cost of

capital over the 12-year period of this study is

impossible. In addition, OTA’s method may be

subject to biases in measurement. We used the

same approach consistently across all samples,

however, so the biases would tend to cancel

themselves out when examinin g differences in

the cost of capital between pharmaceuticals and

controls. OTA is therefore confident that the

measured differences in the cost of capital among

the samples are reasonably precise. (The method

and assumptions underlying the estimates are

described in appendix C.)

The cost of capital for the pharmaceutical

industry was slightly higher than that for control

sample I (matched by sales and sales growth) but

lower than that for the control sample II (matched

by sales and R&D). (See table 4-10). Thus, it

appears that the higher estimated IRRs of the

research-intensive pharmaceutical industry cannot be explained by a higher cost of capital in the

pharmaceutical industry.

Another possible explanation for the difference

in estimated IRRs is the investment character of

advertising and promotion. Baber and Kang did

not convert advertising expenditures to investTable 4-10-Cost of Capital Difference Between

Pharmaceutical Industry and Control Firms

(15 Largest Pharmaceutical Firms)

Pharmaceuticals - Control 1. . . . . . . . . . . . . . . . . . . . . +.007

Pharmaceuticals - Control Il. . . . . . . . . . . . . . . . . . . . -.016

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Control I: Firms similar to pharmaceutical industry in sales and sales

growth.

Control II: Firms similar to pharmaceutical industry in sales and R&D

intensity.

SOURCE: Office of Technology Assessment, 1993, based on data

provided by S.-H. Kang, unpublished computations for firms

listed in W.R. Baber and S.-H. Kang, “Aewunting-Based

Measure as Estimates of Ecrmomie Rates of Return: An

Empirical Study of the U.S. Pharmacautieal Industry 1976-

87,” contract paper prepared for the Office of Technology

Assessment, March 1991.

ments, but the pharmaceutical industry is characterized by high advertising and promotional

expenditures that generate intangible capital. The

life of these investments may be longer than the

life of advertising in other industries, and longer

than 1 year, although there is virtually no

evidence to support this contention and some

evidence against it (87,280).34 In preliminary

analyses, the contractors investigated the effect of

capitalizing advertising expenses over a 3-year

period for all fins; this action widened even

further the gap in implied IRR between the

pharmaceutical industry and the control firms

(26).35

~ Other Studies

Another way of examining returns on pharmaceutical firms is to study the response of companies’ stock and bond values to investments in

tangible and intangible (i.e., R&D and marketing)

assets. If the securities markets are efficient and

accurately predict the future value of firms (at

least over a long time frame), then the potential

returns from new investments by a firm should,

with random error, immediately be reflected in

the market value of the firm.

Two unpublished research studies have used

the relationship between investments and compa-

~ I-Iurwitz md caves (195)1 have suggested that advertising and promotion outlays may serve to redi.Ze the goodwi~ inhment in ~

innovation. The value lies in the innovation itself; promotio~ like production and distribution is necessary to unlock that value.

35 Gmssly longer inves~enlt lives for advertising in the pharmaceutical industry, such as 10 years or more wodd & r~titi for b

differences in implied HUG between pharmaceuticals and the control fms to disappear.
Chapter 4-Returns on Pharmaceutical R&D I 103

nies’ market values to estimate returns on different kinds of investments across industries. Results pertaining only to the pharmaceutical industry are reported here.

Thomas (422) estimated the relationship between market values and R&D, advertising, and

working capital in 23 large pharmaceutical firms

in 1984. Pharmaceutical industry stock market

values rose with higher ratios of R&D to investment in plant and equipment, but pharmaceutical

industry market values were unrelated to advertising expenditures.36 Thomas used the estimated

relationship between R&D intensity and the

fro’s market value to correct accounting rates of

return for the value of the intangible capital built

up from past R&D investments. The accounting

rate of return declined from 20 to about 11 percent

when the estimated value of the intangible R&D

capital is added to the asset base.

As Comanor has observed, studies of stock

market rates of return ‘‘indicate little about

competition or monopoly in the pharmaceutical

industry, [because] stock market values typically

capitalize future returns into the value of the firm,

which includes any prospective effects of monopoly power as well as other factors’ (86). Thus, a

high value of intangible R&D capital may reflect

the monopoly-creating effect of R&D in an

industry with relatively strong patent protection.

Mueller and Reardon (282) estimated the

excess market rate of return for a sample of 21

pharmaceutical firms over their cost of capital in

the period 1971-88. Mueller and Reardon observed changes in market prices from one period

to the next can be related to changes in different

kinds of investment. They found that investments

in pharmaceutical R&D led to changes in market

value that were more than twice as high as the cost

of capital, while advertising did not raise market

values at all, and investments in plant and

equipment raised market values less than the cost

of capital. High market returns on R&D relative

to the cost of capital suggest that over the 18-year

period of the study, pharmaceutical R&D paid off

in the aggregate more than was necessary to bring

forth the investment.

Mueller’s and Reardon’s conclusion that returns on R&D are well above the cost of capital

in the pharmaceutical industry must be considered suggestive at best, because the method for

estimating changes in market values required the

researchers to estimate a rate of depreciation on

existing assets (both tangible and intangible) that

is the same across all kinds of assets. Yet, plant

and equipment are likely to depreciate according

to rates that differ greatly from those governing

R&D and other intangible investments.

Other problems also cloud Mueller’s and

Reardon’s findings. The benefits of R&D cannot

be obtained without investments in plant and

equipment that produce the products and, in the

current market, without the advertising and promotion necessary to sell them. While R&D may

be a necessary condition for obtainin g high

returns, firms must invest in those seemingly less

profitable activities as well. Analysis of the

market returns on investment as a whole in the

seven largest pharmaceutical companies in Mueller’s

and Reardon’s study found only three of the

companies with stock market returns greater than

the cost of capital.37

To summarize, studies of the impact of pharmaceutical investments on returns in the stock

and bond markets do not prove, but are consistent

with, the finding that R&D drives profitability in

the industry and has produced returns over

reasonably long periods of time that may exceed

the cost of capital.

36 Mmket ~a]ue~ ~c~]]yd~~ed~~he ratio of advefiis~g expendi~es to ~ves~ent iII plant and equipmen~ but the relatiO~p Was

statistically insignit3cant. The failure to find a signitlcant relationship coutd be due to very small variation among pharmaceutical fms in the

advertisinglplant and equipment ratio, but the paper did not provide information necessary to test this possibility.

37 T. ~c~ate these re~, however, tie au~ors had to assume hat tie market value of tie firm’s capital would decline at a l%lte Of 10

percent per year in the absence of new investment. The validity of this assumption is questionable.
104 I Pharmaceutical R&D: Costs, Risks and Rewards

FINDINGS AND CONCLUSIONS

OTA’s review of the evidence on the returns on

R&D indicates that these returns were higher than

was required to reward investors for the time and

risks incurred. The net returns on NCEs introduced to the U.S. market between 1981 and 1983

are likely to exceed the cost of capital by an

amount that would allow annual revenues from

these drugs to be reduced across the board by

about 4.3 percent.

These results conflict with findings of earlier

studies, largely because the realized revenues

from this cohort of new drugs were so much

higher in real terms than the revenues from new

drugs introduced in previous years. Very preliminary sales data on drugs approved between 1984

and 1988 suggest that the revenue curve from new

drugs continues to steepen in real terms. OTA’s

assumptions about other key elements of revenues and costs also differed from those of

previous studies but not consistently in ways that

would increase returns. For example, OTA assumed a much higher cost of capital for R&D than

did other studies and therefore used a relatively

high cost of R&D against which to judge returns.

Estimates of returns on R&D are highly sensitive to changes in market conditions for drugs

throughout their product life cycle. Actions by

governments or insurers to control prices paid for

new drugs or to encourage price competition

among different drugs with similar therapeutic

effects could rapidly reduce worldwide sales

revenues. (See chapter 10 for a description of

prescription drug pricing policies in the United

States and selected foreign countries.) There is,

however, no evidence that these effects have yet

occurred at a scale that would seriously jeopardize the market for new drugs.

Evidence on the economic rate of return to the

pharmaceutical industry as a whole over a relatively long period (1976-87) shows returns that

were higher than returns on nonpharmaceutical

firms by about 2 to 3 percentage points per year

after adjustment for differences in risk among

fins. This is a much lower differential than is

suggested by conventional comparisons of profit

ratios, but it is still high enough to have made the

industry a relatively lucrative investment.

Together, the findings on returns on pharmaceutical R&D and to the industry as a whole

explain why R&D expenditures have risen so

dramatically in real terms throughout the 1980s.

Investors have followed the promise of high

returns on future innovations. Ultimately investment in research is determined by expected

revenues. The dramatic increase in real revenues

to new drugs throughout the 1980s has sent

signals to the industry that more investment will

be rewarded handsomely. The industry has responded as expected, by increasing its commitment to investment, including investment in

R&D. The resulting rise in R&D investment may

have dampened internal rates of return as more

money is poured into projects that, if successful,

must share revenues with other competing products on the market.
Trends in Science, Technology

and Drug Discovery1 5

s

cience undergirds the growth of the pharmaceutical

industry over the past century. The industry has long

been highly research intensive. Its roots trace to the

advances in physiology and organic chemistry at the end

of the last century. In recent years, however, the investment in

research and development (R&D) has reached new heights. Drug

treatments have transformed medical practice; biomedical research has transformed the discovery and development of drugs.

The expanding science base for drug discovery has implications for the cost of developing new agents. Two implications of

the rapid advance of science for the overall costs of discovery are

the need to keep abreast of the expanding base of knowledge

about disease mechanisms and the need to keep abreast of other

competitors in the industry. Pharmaceutical firms compete on

several fronts. Science and technology form one basis for

competition. This chapter describes the process of pharmaceutical research, particularly the discovery of new drugs. It centers

on research more than development and assesses how science

and technology might change the process and its costs over the .L

next decade. This chapter explains how a new agent is

discovered, particularly how drug discovery is changing in the

face of new developments in science and technology. .*

The focus is on changes in the discovery of new therapeutic

drugs brought about by the explosion of knowledge about

molecular biology and human genetics. The potential effects of

new methods, materials, and instruments for diagnosis are not

discussed here. The first fruits of many lines of research,

including protein analysis and study of DNA (deoxyribonucleic

acid) emphasized in this chapter, are likely to be new diagnostic

tests.

l~lS ~~pter was prcp~cd for the Office of Technology Asscssmen~ by Ro~fi

Mullan Cook-Dccgan, M.D.

105
106 I Pharmaceutical R&D: Costs, Risks and Rewards

Improved diagnosis generally advances before

treatment, often leading by a decade or more.

Advances in body imaging, for example, have

obvious implications not only for diagnosis, but

also for measuring the efficacy of treatment (281).

Also not discussed in this chapter are new

methods of drug delivery currently subject to

extensive research efforts (218,333) and research

on new assays to predict how the body responds

to new agents. These and other topics are central

to future directions in pharmaceutical R&D. Each

has a rich literature. The discussion emphasizes

molecular biology, however, because this best

illustrates the shifting scientific foundations of

drug discovery. This tack was chosen not because

other topics are less important, or will have less

impact, on future directions in pharmaceutical

R&D. Rather, it was chosen as the most promising way to highlight the widening gulf between

current and traditional research methods.

Finally, the emphasis on human genetics is

only illustrative. Molecular biology has come to

dominate other areas of research equally relevant

to drug discovery. Molecular approaches to combat viral infections, to control the immune response, to understand cancer, to penetrate the

brain and spinal cord, and to modulate responses

to hormones and growth factors are all extremely

active fields. A chapter of equal or greater length

could be written for each field. The focus on

human genetics was chosen in part because it

touches on all these other fields, and because it

also more starkly contrasts with more traditional

approaches and thus emphasizes how the scientific foundations are shifting beneath biomedical

research.

This chapter begins with a description of drugs

and drug receptors. Next it considers proteins, the

workhorses of biology that form structural elements within cells and that mediate biochemical

reactions. The next section deals with DNA, the

chemical basis of inheritance.

The study of DNA and proteins marks the

advance of molecular biology. Pharmaceutical

research increasingly relies on molecular biology,

and it is here that science most directly joins drug

discovery. Protein pharmaceuticals constitute an

important new therapeutic class. Several protein

drugs have had a dramatic impact on clinical

practice in recent years, and many more are being

prepared for the market. Novel protein drugs

have, for example, constituted roughly half the

new major introductions in the last few years;

indeed the wealth of new prospects has raised

concern that the regulatory pipeline may be

overwhelmed by the flow of new biotechnology

products (146,341). The direct use of DNA as a

treatment constitutes the next logical step. This is

currently a frontier of biomedical research, and

this section is necessarily more speculative, and

illustrates the uncertainty regarding a new treatment modality. A final section draws lessons

from the various case histories, focusing on those

elements most likely to influence the future costs

of drug discovery.

DRUGS AND RECEPTORS

The notion of specific drug action is most often

described by a lock-and- key analogy. The drug is

seen as the key that acts specifically on a narrow

range of locks. The lock is a drug receptor. A drug

is a substance that causes a physiological response; the receptor is the molecule through

which it works.

Paul Ehrlich formulated the idea of drugreceptor interactions in the first decade of this

century. A.V. Hill modified the interaction as the

binding of a drug to its receptor in mathematical

terms early in this century. This was embellished

in the late 1920s by A.J. Clark who forwarded the

idea of a drug “occupying” a receptor site,

competing with natural agents that bound the

receptor at the same site. Drugs were thereafter

termed “agonists,” those that caused the normal

response (simulating the body’s own action), or

‘‘antagonists, ’ those that blocked normal action

(105).

The model, in its simplest form, is that the drug

binds to a receptor. The receptor has a binding

domain that is specific for the drug, typically the

same site sought by compounds normally found

in the cell. Binding causes the receptor to respond,
—-

Chapter 5-Trends in Science, Technology and Drug Discovery I 107

causing a cellular change. The receptor may open

a gate for the influx or efflux of charged

molecules through the cell membrane, for example, or it may catalyze a biochemical reaction.

Many receptors act by causing the formation of

‘‘second messengers, ’ compounds that provoke

cellular events such as the secretion of insulin or

the synthesis of specific proteins. The site causing

a cellular change is separate from, but signaled

by, the binding site.

Many enzymes are drug receptors. Enzymes

are proteins that mediate biochemical reactions.

They build cellular structures, degrade cellular

byproducts, metabolize sugars, and perform the

myriad chemical tasks that transpire in cells.

Many drugs discovered in the 1970s and 1980s

originated from understanding a metabolic pathway, finding the enzyme associated with a

particular reaction, and studying how to inhibit its

activity. The drug captopril, for example, was

developed by tracing the biochemical pathway to

produce angiotensin, a short protein (a polypeptide) that raised blood pressure. By slowing

production of angiotensin, captopril helped treat

high blood pressure (see box 5-A) (300).

Box 5-A--The Discovery of Captopril

I

Hypertension, or high blood pressure, is a highly prevalent condition. It predisposes to heart attack and

stroke, and is a major cause of death and disability. A “hypertensive principle’ was discovered in the kidney

late in the last century. A theoretical model of hypertension was elaborated in the 1930s and 1940s. In this

model, the kidney was a central actor. Blood volume and the resistance to blood flow, caused by contraction

of smooth muscles in small arteries, were the main determinants of blood pressure. The kidney controlled

blood volume by regulating how much water was retained in the body, in turn determined by how much salt

was excreted.

The kidney also produced substances that directly caused contraction of smooth muscles in small

arteries. These findings led to several treatment strategies. One long-standing approach entailed diuretics

to reduce blood volume. Another involved relaxing smooth muscles in blood vessel walls by blocking the

action of epinephrine and other chemicals present in blood. Drug researchers at Squibb discovered a wholly

new class of antihypertensive agents through a logical set of steps that began early in the 1960s with the

elucidation of one physiological pathway leading to high blood pressure. This line of research culminated

in the discovery of captopril. The process was a prototype of rational drug design.

The physiological pathway began when a short protein, or peptide, angiotensin II was formed in the

blood stream. Angiotensin II stimulatedthe release of a hormone, aldosterone, from the adrenal gland, which

in turn caused the kidney to retain sodium. With more sodium in the blood, the body retained more water.

Angiotensin also directly stimulated contraction of smooth muscles in blood vessels. By blocking the

fen-nation of angiotensin, one could pursue both paths to antihypertensive therapy in a single stroke.

Angiotensin II, the most active natural agent, consists of a short peptide--a chain of eight amino-acids.

These 8 are cleaved from angiotensin I, which has 10 amino-acids. The enzyme that cleaves angiotensin I

to II is Angiotensin Converting Enzyme (ACE). The path to captopril started by trying to inhibit the action

of ACE.

Researchers at Squibb took several approaches. They started from the natural angiotensin I molecule

and fashioned molecules that might have similar shapes but were more difficult to cleave. They also worked

with a snake venom that inhibited ACE. The active components in the venom included several peptides,

including one chain of 9 amino acids and another of 5 amino acids. These natural peptides were ACE

inhibitors, but they had to be injected. The effort centered on finding an agent that could be administered

(Continued on next page)
108 \ Pharmaceutical R&D: Costs, Risks and Rewards

Box 5-A–The Discovery of Captopril--(Continued)

orally, and would find its way into the bloodstream after surviving the brutal transit through stomach and

intestines. The team screened a myriad of chemical compounds similar to the natural precursor and to the

snake venom. They devised modifications of the venom peptides and the natural precursor. They altered the

backbone of the five amino-acid venom peptide thinking that it might retain activity while resisting

degradation. Of 2,000 compounds screened, only a few inhibited ACE and only one was specific to it. That

one was a metal-binding molecule that promised to be toxic. Another approach was more successful.

The Squibb team also worked back from their conception of the receptor’s shape, based on their

knowledge of details of the cleavage reaction it performed. Since the ACE protein had not itself been

structurally defined, they developed a hypothetical model based on the active site of another enzyme that

performed a similar cleavage reaction, and whose structure was known from x-ray crystallography. The

research team crafted compounds to fit into the hypothetical active site of ACE and discovered a compound

with inhibitory activity that was similar in shape to two amino-acids in tandem. They performed further

chemical modifications of this molecule and eventually found a chemical amenable to oral administration

that was 1,000 times more potent than their initial “lead” molecule. The synthetic drug had greater activity

than the nine-amino-acid venom peptide.

This new agent was named captopril. Squibb submitted a new drug application for captopril in 1979.

Two years later, captopril was approved by the U.S. Food and Drug Administration for marketing under the

brand-name of “Capoten.” Captopril soon became a standard drug to treat hypertension, and also found

clinical use in combating heart failure and other cardiovascular conditions. Its sales in 1988 exceeded $1.1

billion, joining only three other compounds with sales over $1 billion in a year. It also became the starting

point for a round of new antihypertensive agents pursued by Squibb and other firms.

SOURCES: M.A. Ondetti, D.W. CushrnarL and B. Rub@ “Captoril,” Chronicles of Drug Discovery, J.S. Bindra and D. Miniger

(eds.)(New York: Wiley, 1983). M.R. Ziai and B. Beer, “MakingBusiness Sense of Science with Rational Drug Design,”

Pharmaceutical Executive 10:40-46, October 1990.

9 Identifying a Receptor Expedites early example of a strategy that prevailed for

Drug Design - “

The first drugs were typically found by looking

for chemicals that caused a particular clinical

reaction. Extracts from the foxglove plant were

long used to treat “dropsy” (congestive heart

failure) and other ills. Digitalis was discovered by

purifying chemicals out of those extracts and

looking for the compounds that produced clinical

improvement. Aspirin (acetylsalicylate) was found

by testing chemical modifications of salicylate, a

traditional remedy for fever and pain. Although

aspirin had been synthesized in 1853, its clinical

effects were not discovered until 40 years later. It

has become one of the most commonly used drugs

since the firm Bayer began making it on a large

scale in the late 1890s (396). Screening compounds chemically similar to salicylate was an

many years, starting from chance observations of

clinical effects of a known compound, with little

or no knowledge of mechanism. This approach

was refined until the synthesis of new compounds

became a high art and screening tests a centerpiece of pharmacology. One pharmaceutical researcher described drug research in the early

1960s thus:

There was a prevalent attitude in many places that

the conduct of research should be of the man-anda-boy type in which chemists would create

molecules by the pound and send them to

pharmacologists who would screen them for their

activity in the hopes that luck would strike. It’s

what I characterize as ‘research untouched by the

human brain’ (394).
Chapter 5—Trends in Science, Technology and Drug Discovery I 109

.

Photo cred(t’ NATIONAL CANCER INSTITUTE

The first drugs were typically found by extracting chemicals

from natural products and screening them for pharmaceutical

activity. Though other methods of drug discovery have

evolved, extraction remains an important ingredient of drug

discovery even today.

Finding new drugs was not ‘‘irrational, ’ but

the rationale was not based in chemistry or

knowledge of biological function. The purification and screening of natural products for antibiotics, for example, followed a reasonable strategy, but did not rest on knowledge of how the

drugs worked. As attention turned to chronic

diseases such as atherosclerosis, cancer, and

neurological and psychiatric conditions, the development of drugs depended more on knowledge

of the disease process. Rational drug design

reversed the traditional process, working backward from a known receptor target. Rather than

screening agents to serve specific functions, the

molecular mechanism underlying a biological

function was used to direct a search strategy.

Rational drug design is a general term that

covers a broad range of approaches, but the

underlying theme is a reliance on structural

analysis of target molecules and deliberate design

of agents to affect their function. One of the

prototype successes was the development of

cimetidine to treat peptic ulcer disease (see box

5-B). In this case, the first critical step was to

define a class of receptors, The next step was to

search for a compound that could at least partially

block the action of histamine on these receptors.

Once an initial “lead” antagonist compound was

found, then chemical modifications of nearby

atoms led to more potent and less toxic new

compounds that could be tested for clinical effect.

One of these proved effective in blocking acid

secretion, dramatically tipping the scales in favor

of medical management, as opposed to surgery,

for most cases of peptic ulcer disease ( 140,394).

Characterizing the H-2 receptor was a critical first

step.

9 Structure-Activity Relationships

Having found a receptor, and compounds that

act on it, the next step is to search for more potent

chemical analogs, drugs that have a similar effect

at lower concentrations. The standard way to do

this is to synthesize compounds chemically similar to the ‘ ‘lead compound, ’ altering one or a few

key sites on the molecule by adding or taking

away chemical groups, or by deforming its shape.

Newly synthesized compounds are then screened

for drug effect. The underlying premise is that the

structure of the drug affects its activity. The

process of chemical modification and searching

for functional effects is called structure-activity

relationships, or SAR (190).

In recent years, quantitative methods augmented SAR, and earned the name quantitative

SAR, or QSAR. The refinements grew in part
110 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 5-B-The Discovery of Cimetidine

In 1964, histamine was well studied for its role in allergic reactions, whose effects could be partially

blocked by a group of antihistamine compounds still used in many over-the-counter cold remedies. James

Black worked at the British pharmaceutical and chemical firm ICI, where he focused on drugs that affect

the response to epinephrine (adrenaline), itself a large class of drugs now used to treat high blood pressure,

disturbances of heart rhythms, diabetes, and many other conditions. The target molecule, the beta-receptor

molecule, responded to epinephrine specifically, although its function varied in heart cells, blood vessels,

and pancreatic cells, and other tissues.

Black moved to Welwyn laboratories, the British research arm of Smith, Kline& French. He worked

to show the existence of a different class of histamine receptors, dubbed H-2 receptors, that caused stomach

acid secretion. The task began by refining ways to measure H-2 receptor effects so that compounds could

be screened rapidly. Initial tests were insufficiently sensitive; only improved screening procedures and

higher doses of histamine enabled work to progress. Once the screening tests were in place, the search

focused on finding antagonists, compounds that could block the action of histamine. The compound

buriamide blocked H-2 activity.

In the late 1960s, administrators at Welwyn were ordered to stop working on the project to block acid

secretion, as it duplicated work going on near corporate headquarters in Philadelphia. The British group

persisted by finding a new name for their project, renamed the H-2 receptor program. Research administrator

William Duncan resorted to subterfuge, adopting an “arm’s length, isolationist policy in relation to

headquarters R&D. ” Early in 1968, the new president of the company, Thomas Rauch, directly ordered that

the project be preserved from drastic budget cuts “one more year,” just long enough for success to squeeze

through the door. He later reflected, “It’s terrifying to think about it today. ”

In 1972, Black and other colleagues at Smith Kline& French published their data demonstrating the

existence of H-2 receptors. They then searched for more potent antagonists, synthesizing and screening

chemical modifications of buriamide, their ‘lead’ compound. This led to metiamide and then to cimetidine.

Metiamide was used in initial clinical trials, and showed promising results. In two patients, however, it

suppressed production of neutrophils, white blood cells involved in inflammation. Cimetidine was already

in early clinical testing, and work on it intensified. Cimetidine was approved for the market in November

1976, in the United Kingdom, and in August 1977 in the United States. Within a year, it was distributed to

90 countries, becoming king of the “blockbuster” drugs of the 1970s, and revolutionizing the treatment of

peptic ulcer disease. Smith Kline & French’s moribund stepchild became a robust prince.

SOURCES: C.R. GanelliiL ‘Cimetidine,” Chronicles of Drug Discovery, J.S. Bindra and D. Ledniger (eds.) (New York, NY: Wiley,

1982). SmithKline a French International, The Discovery of Histam”ne H2-Receptors and Their Antagonists

(Philadelpl@ PA: SmithKline & French 1982).

from the increased power and reduced cost of might fit into receptor sites, and high-resolution

computers. Faster and better computers encouraged use of more complex but more accurate

computational methods to predict the threedimensional structure of small molecules, to

display the shape of receptors and ligands using

computer graphics, and to study the structure of

large molecules including drug receptors. Quantitative methods also enabled simulations of chemical synthesis pathways, the design of agents that

analysis of protein shape—all inputs to the QSAR

process.

When multiple agents all work on the same

receptor, their common features can serve as a

core for seeking new agents to perform the same

function. The process of defining entirely new

drug agents, however, has no assured computational solution. A generic approach involving

structural chemistry and biochemistry has emerged
Chapter 5–Trends in Science, Technology and Drug Discovery ! 111

as a usually successful strategy. The process is far

from a simple matter of defining the structure of

a receptor, drawing a chemical that fits into it, and

testing the result in a laboratory. Indeed, the

process has become more complex rather than

simpler. As one practitioner of QSAR noted:

The incredibly rapid advances in biochemistry,

molecular biology, theoretical chemistry, and

computers along with the accumulated experience of the past 100 years must give drug research

directors sleepless nights (179).

Indeed, even the technical advances are far

from providing a cookbook to produce new drugs.

The process remains too qualitative for precise

predictions, and is better at finding agents similar

to those discovered by others than in producing

real innovation in the form of entirely new classes

of agents. At a 1984 symposium called ‘‘Drug

Design: Fact or Fantasy, ” G. Jones noted:

The critical area of pharmaceutical innovation,

the de novo lead generation, is unfortunately the

area in which fantasy remains preponderant (217).

1 Frontiers of Rational Drug Design

Discovering drugs by design is a relatively new

phenomenon, but it dominates the pursuit of new

agents today. The logical strategy used to develop

captopril is held up as a prototype of the new

approach. The approach in its most refined form

can be applied only to enzymes, however, and

then only when the chemical reaction is well

understood. The structure of the enzyme itself, or

that of some enzyme with similar function, must

first be determined by x-ray crystallography or

nuclear magnetic resonance (NMR) spectroscopy

(explained below).

Drug research is pushing back the frontiers of

rational drug design in several directions. One

direction is the structural analysis of receptor

molecules. Most receptors are large proteins with

multiple regions of interest. Determining their

shape can be a first step to homing in on parts of

the molecule that bind prospective drugs. Until

recent years, the only hope of defining the shape

of a molecule was x-ray crystallography. Crystallography reconstructs the shape of molecules by

analyzing how they deflect x-rays. This entails

shooting x-rays through a crystal of a substance,

and analyzing where they come out, in a process

much like determining the shape of a sculpture by

shooting balls off it and backing where they

bounce. One limitation of the technique is the

necessity for a crystal.

Crystallizing large molecules, such as proteins,

is a difficult art, and many molecules have proven

refractory to crystallography for this reason. Even

for the molecules that can be crystallized, the

analysis of x-ray deflection patterns requires

massive calculations. Defining a crystal structure

can take years. The development of very highintensity synchrotrons radiation has given x-ray

methods a new boost, with a particularly hightechnology twist (183).

In recent years, a new technique of NMR has

been applied to increasingly large molecules,

permitting spatial resolution of small molecules,

short peptides (small proteins), and regions of

macromolecules (58,82). NMR spectroscopy reconstructs shape by analyzing the effects of very

Photo credit: BRISTOL-MYERS SQUIBB COMPANY

Dr. David W. Cushman (left) and Dr. Miguel Ondetti (right)

developed captopril using a new approach to drug discovery.

The captopril team was able to design a molecule with the

structure needed to block the active site of the converting

angiotensin enzyme (see box 5-A).
112 I Pharmaceutical R&D: Costs, Risks and Rewards

high magnetic fields on the nuclei of atoms in the

molecule.

Both NMR and x-ray crystallography require

large investments in analytical instruments and

computers to analyze the data, entailing multimillion dollar investments just to analyze the structure of potential drug receptors. The justification

for such investments, made by many firms in

recent years, is that defining the threedimensional structure of receptor sites will improve the prospects for developing drugs that fit

into those sites. The wisdom of the investments

will only become clear in several years, if this

approach bears fruit.

A second frontier is the analysis of molecules

that are joined to proteins to give them distinctive

shape, adhesive properties, or other attributes.

Chains of sugars, called polysaccharides, project

out from the surface of many proteins, for

example, acting as antennae for chemical signals

or providing structural stability on the outer

surface of the cell. These polysaccharides often

confer specificity to the receptor. The process of

altering sugars, or attaching them to proteins,

provides a possible mechanism to affect receptor

function, but the chemistry and the biochemical

pathways are far from being fully described, and

the process of describing them is tedious and

difficult.

Progress is nonetheless forthcoming. Modifying polysaccharide structure is a promising avenue to treating inflammation, autoimmune disease, and other disorders. It seems especially

promising for diseases such as arthritis, diabetes,

multiple sclerosis, and others that involve an

inflammatory response that induces tissue destruction by the bodies' own defense mechanisms. As one of many possible examples, the

molecule that attracts neutrophils (common white

blood cells involved early in an inflammatory

response to injury and some tumors) was recently

shown to be a sugar chain (329,506). Drugs to

control the production of the sugar chain, or to

break it down, might temper the destruction by

neutrophils, suggesting a path for drug developCell surface molecules are the points at which

cell-to-cell communication takes place. The process starts with binding of a molecule to the surface

receptor. This entails specific binding, or recognition, that transmits a signal to alter cellular

processes. The binding of a hormone from the

bloodstream triggers the proliferation of cells, or

the binding of a neurotransmitter causes an

electrical signal to propagate along a nerve cell. A

muscle contracts in response to a transmitter, or

the immune system primes itself to fight a nascent

infection. Viruses and other infectious agents also

take advantage of cell surface receptors. The

rabies virus homes in on nerve cells by binding to

specific neurotransmitter receptors, for example,

and the human immunodeficiency virus attacks

cells bearing CD4, a molecule that projects from

the surface of certain white blood cells. Cell

surface receptors thus mediate many of the most

physiologically important functions in the body

and are extremely promising targets for future

drug development. One serious problem is that

there are so many cell surface receptors, and thus

too many paths to follow for scientists to understand the structure and function of each.

Another major obstacle is that the methods of

predicting three-dimensional structures are simply not up to the task for large molecules. New

techniques to deduce the structure of large molecules are powerful but slow and not always

successful. The ultimate solution would be predictive tools of sufficient power to predict shape

from knowing the order of the building blocks,

the amino acids in proteins and nucleotides in

DNA. How long strings of amino acids emerge

into shapely proteins is termed the ‘‘folding

problem, ’ and constitutes one of the most vexing

and important fields in structural biochemistry

today. Computational algorithms and theoretical

chemistry are not yet powerful enough to make

such robust predictions. All is not lost, however,

as the structures determined for one protein can

serve as a first approximation of the shape of

another with similar function, as in the development of captopril described in box 5-A.

ment.
Chapter 5-Trends in Science, Technology and Drug Discovery I 113

Cell surface receptors are clearly of great

importance in understanding the function of the

nervous system, the endocrine system, the immune system, cell proliferation, and targets for

infection. The major chronic diseases such as

cancer, diabetes, heart disease, arthritis, autoimmune disease, necrologic and psychiatric disorders, and endocrine dysfunction involve interactions with cell surface receptors. Understanding

the structure and function of surface receptors has

grown into one of the great thrusts of pharmaceutical R&D, pursued in the belief it will uncover as

yet unknown approaches to treatment of diseases

hitherto intractable.

9 Organizing to Discover New Drugs

The wealth of new knowledge derived from

basic biomedical research and the new power of

rational drug design recast the drug discovery

process, but there is no prototypical process that

can be simply described. Pharmaceutical firms

track research by talking to scientists and reading

the scientific literature. They maintain in-house

research teams, often doing research parallel to

that performed in academic centers. New ideas

may originate in corporate research efforts or in

the academic ones; examples of both abound.

This industrial research base is a source of new

leads, and the stalking grounds for corporate

‘‘champions’ of new drug ideas. Each firm has a

somewhat different process to decide which leads

to pursue. Some organize according to treatment

category, assembling teams to focus on finding

drugs to treat a disease or organ system; for

example, entire firms are dedicated to research on

cardiovascular drugs. Some firms make researchtargeting decisions in committees, others delegate

great authority to research directors who informally circulate in the firm and among academic

groups, and still others have strong central

direction. All attempt to manage innovation by

balancing an endless supply of possible research

directions against a need to produce salable

products.

PROTEIN ANALYSIS AND PROTEINS AS

PHARMACEUTICAL AGENTS

1 Essentials of Protein Structure

and Function

Proteins form structural elements in cells and

perform a wealth of functions, including the

catalysis of most biochemical reactions. Proteins

are composed of linear chains of amino acids.

There are 20 common amino acids in cells, each

with a common chemical unit called the peptide

group. The peptide group enables each amino acid

to form a chemical bond with any other. Each

amino acid in a protein serves as a chemical

module: the peptide units confer structural stability and link the modules together, while chemical

groups attached to the peptide backbone confer

the distinctive structural and fictional properties. The 20 amino acids have different chemical

groups attached to the peptide core. The amino

acid proline, for example, introduces turns into

the protein backbone, while cysteine can form

bridges with other cysteines located on different

protein chains or remote parts of the same chain.

Some amino acids prefer lipid (fatty) environments, providing stability in cell membranes,

while others are highly soluble in water. Some are

acidic and others basic.

Some proteins can be transported outside cells

to lay down a matrix, such as the collagen that

constitutes the bulk of bone and cartilage. Others

act as enzymes to carry out the biochemical

reactions taking place in cells at every moment.

The enormous diversity that is possible when

hundreds of amino acids are strung together

produces a correspondingly large range of functions in the proteins they form, despite the

simplicity of the constituent amino acid components.

1 Proteins as Receptors

The vast majority of drug receptors in the body

are proteins. Many are enzymes or cell surface

receptors. Proteins are involved in virtually every

cellular process and are components in most
114 I Pharmaceutical R&D: Costs, Risks and Rewards

cellular structures. Protein chemistry is thus a

dominant theme in current drug research.

Proteins have been a major preoccupation of

biochemistry and molecular biology since the

inception of those scientific fields. There are

several ways to study proteins. Analysis of

three-dimensional structure has been briefly described above. Biochemists have devised many

ways to study enzyme function. One classic

technique is to isolate an enzyme to near purity,

then to attempt to study the chemical reaction it

mediates in great detail. This is a key strategy in

dissecting the biochemical pathways of energy

metabolism, biosynthesis, and degradation. Another technique is made possible by modem

molecular genetics.

The order of amino acids in a protein chain is

specified by the genetic code laid down in DNA.

DNA is composed of very long chains of four

chemical bases linked through a sugar-phosphatebackbone. The information from DNA is “transcribed’ and spliced in the cell’s nucleus into a

similar polymer, but in a somewhat less stable

form called ribonucleic acid (RNA). RNA is

transported from the nucleus to the cytoplasm,

where it is translated to amino acids. The order of

bases in DNA specifies the order of bases in RNA

which in turn specifies the order of amino acids in

the protein. A gene consists of a stretch of DNA

that produces a functional product, either RNA

alone or RNA that is subsequently translated into

protein. The path from code to product thus

typically involves three major steps: DNA, RNA

and protein, with the possibility of modifications

at each step. The linear order of DNA bases in a

gene, modified by splicing out stretches of RNA

and adding caps and tails to the message, thus

directly determines the order of amino acids in the

corresponding protein, In its simplest formulation, the cell translates a linear DNA code into a

linear string of amino acids in proteins. The

diverse shapes and chemical constituents that

result from the chain of amino acids become

proteins that form the structural supports and

perform the biological functions for cells and

tissues.

Through recombinant DNA technology, genes

that produce a specific protein can be spliced into

bacterial DNA. Large amounts of the protein can

be produced in the bacteria, yielding enough

DNA to precisely define the DNA sequence for

the expressed part of the gene, from which the

amino acid sequence for the resulting protein can

be derived. Producing large amounts of the

protein in bacterial cells is a boon to prospects of

crystallizing proteins for crystallographic analysis; it also produces ample supplies for further

biochemical analysis. One disadvantage of the

process is that bacterial cells may not process the

protein in exactly the same way as the cells in

which the gene normally resides. Polysaccharides

may not be added appropriately, for example, or

the protein may fold somewhat differently because processing enzymes are not present in

bacteria. The strategy nonetheless works for

many proteins.

Manipulating the DNA code alters the order of

amino acids in a protein. Scientists can exploit

this effect by introducing a gene into bacteria or

yeast by recombinant DNA with exquisite precision. They may thus introduce changes (mutations) in the native gene into the whole animal,

where the mutation’s effect can be observed. By

introducing such mutations at specified sites, one

amino acid can substitute for another at specific

points in the protein peptide chain. To study the

binding site of a receptor molecule, for example,

the amino acids at that site can be replaced by

those with similar, or with vastly different,

chemical properties to assess the impact on ligand

binding. The active sites for enzyme activity can

be similarly studied by targeting just those amino

acids thought to be important.

1 Proteins as Therapeutic Agents

Proteins also serve as chemical signals in the

body. At the level of organ systems, proteins

regulate immune responses, cell growth cycles,

hormone responses, and many other functions.

Blood proteins are involved in coagulation and

dissolution of blood clots. Several hormones are

short proteins, or polypeptides. Many polypep-
—. .-

Chapter 5-Trends in Science, Technology and Drug Discovery I 115

tides appear to be involved in modulating digestion, regulation of blood pressure, and other

functions involved in many normal metabolic and

disease processes. These proteins involved in

cellular communication are prominent targets as

drug receptors in many cases, but they can also be

therapeutic agents in their own right. Proteins are

thus of great interest to drug researchers, not only

as drug receptors but also as drugs themselves.

As the tools to study proteins and proteinprotein interactions have advanced, the importance of proteins and polypeptides has become

increasingly clear. The production of large quantities of proteins became feasible with the advent

of recombinant DNA techniques. Many companies were founded to exploit the potential of

biotechnology and most established pharmaceutical firms have many projects underway to develop and market protein drugs. Michael Venuti

of Genentech lists over 100 peptide products

under development in 1991 (498). The first Food

and Drug Administration approval to market a

protein derived from recombinant DNA was

granted on October 29, 1982, for human insulin

(see box 5-C) (171). In 1985, the second approval

was granted for human growth hormone, followed by various interferon beginning in 1986,

tissue plasminogen activator in 1987, and erythropoietin in 1989. A recombinant DNA-derived

hepatitis B vaccine was approved in 1986, and for

Hemophilus B in 1988. A large number of protein

pharmaceuticals have been recently approved, or

are under active review (146,148).

Many of the products already on the market,

and many yet to be approved, perform functions

not achieved by other drugs. They represent

Box 5-C--Insulin

Charles Edouard Brown-Sequard postulated the existence of circulating factors whose absence caused

disease in the late 1880s. William Bayliss and Ernest Starling worked on pancreatic secretions during the

first decade of this century. In 1905, Starling proposed the term “hormone” for substances secreted into the

blood by one organ to produce a response in another. In the period 1889 to 1920, many groups, most of them

European, established the connection between cells in the pancreas, in the Islets of Langerhans, and the

clinical presence of diabetes. The seminal work leading to the discovery of insulin began under Frederick

Banting and his colleagues at the University of Toronto in May 1921.

Banting worked with physiologist John Macleod and Macleod’s student Charles Best to tie off

pancreatic ducts in dogs, to remove the pancreas, and to treat the resultant diabetes with pancreatic extracts.

They quickly found a substance they called “isletin,” because it was derived from cells in the Islets of

Langerhans. The name was later changed to insulin. James Collip, a biochemist, joined the team to improve

the extraction procedures, improving the potency and consistency of isletin. The University of Toronto’s

Connaught laboratories were brought in to scale up production of the substance, which met with strong

clinical demand soon after the promising initial results were known. G.H.A. Clowes of Eli Lilly & Co. of

Indianapolis then got involved. Lilly was already producing other glandular extracts, and Clowes had an

excellent scientific reputation. Clowes met with Banting and Best after they presented preliminary results

at a meeting in December 1921, and expressed interest in their work. He offered Lilly’s services to scale up

production.

In May 1922, the University of Toronto filed a patent on insulin for no other reason “than to prevent

the taking out of a patent by other persons. When the details of the method of preparation are published

anyone would be free to prepare the extract, but no one could secure a profitable monopoly. ” Soon

thereafter, the University of Toronto and Lilly began a collaboration, sometimes rocky, to produce insulin

for wider clinical use. George Walden, a chemist at Lilly, developed novel production methods that

simplified production and further improved lot-to-lot consistency by the Fall of 1922. Lilly began to market

(Continued on nexfpage)
116 [ Pharmaceutical R&D: Costs, Risks and Rewards

Box 5-C–lnsulin--(Continued)

its insulin as “Iletin,’” hearkening back to the original Banting and Best coinage, but with the dropping of

a silent “s.”

Insulin remains the main treatment for the most severe form of diabetes. Indeed, in current terminology

this form is called insulin-dependent diabetes mellitus. Lilly remains the largest U.S. producer of insulin,

and shares the U.S. market with Squibb. Outside North America, Novo of Copenhagen is the dominant

producer. But the insulin story did not end with the production of insulin extracts. Insulin also became the

target for assaults by molecular biology.

The importance of insulin made it the focus of Frederick Sanger’s work in structural chemistry. Sanger

applied chemist Emil Fisher’s philosophy, using chemical principles to explicate protein structure and

function. Sanger eventually established the order of amino acids that made up insulin, the first protein for

which the amino acid sequence was determined. Knowing the sequence enabled comparison between

insulins from different species, and discovery of the slight differences between them.

Recombinant DNA ushered in new hope for production of peptide hormones. As soon as recombinant

DNA was discovered in the mid-1970s, the insulin gene became an early target. The gene for insulin was

the first ever cloned from a mammal. Work on insulin emerged as the focus for product development at

Biogen and Genentech, two prominent new biotechnology companies established during the late 1970s. The

human insulin gene was introduced into bacteria by recombinant DNA, and the bacteria produced insulin.

The City of Hope Medical Center synthesized DNA sequences for the gene that Genentech used to produce

insulin in bacteria, Genentech licensed insulin produced through recombinant DNA to Lilly for large-scale

manufacturing, marketing, and regulatory approval. In 1980, insulin was the first recombinant DNA product

tested in humans. In October 1982, Humulin, trade name of the human insulin marketed by Lilly, became

the first recombinant DNA drug approved for marketing.

SOURCES: S.S. HalI, Invisible Frontiers: The Race to Synthesize a Human Gene (New YoriL NY: Atlantic Monthly Press, 1987). F.

Sanger, “Sequences, Sequences, and Sequences,’ Annual Reviews of Biochemistry 57: 1-28, 1988. J.P. Swanq Academic

Scientists and the Pharmaceun”cal Industry: Cooperative Research in Twentieth Century America (IWixnore, MD: The

Johns Hopkins University Press, 1988). U.S. Congress, Office of Technology Assessment, Commercial Biotechnology:

An International Analysis (OTA-BA-218) (Washingto& D.C.: U.S. Government Printing Oflke, 1984).

entirely new classes of therapeutic agents. Erythro- Proteins pose several problems as drugs, howpoietin, for example, stimulates the replenishment of red blood cells. It was approved in 1989

to treat the anemia that attends long-term renal

dialysis (451). In the future, it could be used for

many other purposes as well, and many are under

investigation. A series of growth factors stimulates the proliferation of different kinds of white

blood cells, and could be used to replenish them

after cancer chemotherapy or in response to

adverse drug reactions. A class of blood enzymes

dissolve blood clots after heart attacks. Interferon and interleukins are promising in the treatment of cancer and infections, particularly viral

infections for which there are relatively few

effective treatments.

ever. The necessity for parenteral, as opposed to

oral, drug delivery is foremost among the limitations. Parenteral administration refers to techniques that break the skin surface, by injecting

into veins, into muscles, under the skin, or

elsewhere. These are more invasive and require

sterile preparations. Proteins are readily degraded

in the stomach and intestines, so that simple oral

administration is impractical-the agent is destroyed before it can be absorbed. Insulin, the

prototype of protein drugs, is still injected or

administered by pumps installed in the body. It

has been used as a mainstay of diabetes treatment

since the 1920s, and has never been replaced by

a smaller molecule. Decades of research have
Chapter 5—Trends in Science, Technology and Drug Discovery ! 117

failed to uncover an oral formulation as effective

as injectable insulin. The need for parenteral

administration is nonetheless an immense impediment to widespread use of a protein drug.

The problems with parenteral administration

include the pain of injections, immune reactions

against the agent, local inflammation and scarring

from repeated injections, the need for sterile

preparations, and strong resistance from patients,

Parenteral administration includes intravenous

injection, intramuscular injection, subcutaneous

injection, implantable pumps, and slow- release

formulations placed just under the skin. Research

along each of these avenues is proceeding apace.

Research to introduce drugs through less invasive

routes is also moving forward.

Coating peptide drugs with a shell to prevent

digestion in the stomach, adding carrier molecules to permit rapid absorption, or formulating

drugs with surfactants to promote absorption are

all being pursued. Some peptide drugs can

already be administered as suspensions for nasal

inhalation for absorption by the rich network of

blood vessels that can transport agents directly

into the brain. Yet another line of research

attempts to redesign peptide drugs into small

organic molecules that can be administered orally

rather than parenterally, making them much more

attractive for general use.

For some applications, parenteral administration is not a major obstacle. Clot-dissolving

agents, for example, are used mainly in the period

immediately after a heart attack. The patient is

typically in the hospital receiving intravenous

fluids in any event, so that intravenous delivery is

not a problem. This same feature will be shared by

treatments for anemia from dialysis, cancer chemotherapy, and a few other uses. The clinical

benefits of parenteral drugs must be significantly

higher than oral drugs to overcome the inconvenience of parenteral administration for long periods.

Many potential drugs must be highly targeted

to be useful. Highly potent cellular poisons, for

example, would be useful if they could be induced

to attack only cancer cells. One novel treatment

approach is to affix poisons such as ricin, tumor

necrosis factor, or diphtheria toxin to proteins

recognized primarily by cancer cells. The recognition function can be served by antibodies raised

against the target cells, or ligands that bind

specifically to surface receptors on target cells.

Antibodies have also been studied experimentally

to coat lipid sacs containing anticancer drugs, as

a means of delivering the drugs specifically to

regions containing cancer cells (428). These

developments are novel uses of proteins as means

to target specific cells, but they remain limited by

the range of specific recognition molecules, the

need for parenteral administration, and a relatively narrow range of therapeutic applications.

Pharmaceutical research scientists are divided

about the future significance of proteins as

therapeutic agents. In interviews, they formed

two camps with differing visions of the future of

drug therapy. One camp believes that the problems of drug delivery will diminish over time as

technological improvements overcome technical

obstacles. They note that many of the promising

protein agents have no small molecular counterparts-no small organic compounds have been

found to serve the same function, Insulin is cited

as a prototype. It is still used as a drug almost 70

years after its discovery (see box 5-C). The

clot-dissolving enzymes, growth factors, and

hormones approved for use in recent years are

cited as other examples of new life-saving protein

drugs that flowed straight out of molecular

biological research. This group believes that

many of the new proteins are so entirely novel in

their action that small molecules may never be

found to replace most of them, and at least for the

foreseeable future proteins alone will be available. This group believes further that small

biotechnology companies can grow into pharmaceutical giants through their successes in manufacturing protein drugs. They see protein pharmaceuticals as the technology that mediates a

transformation of drug therapy and the pharmaceutical industry. Firms that fail to move aggressively toward protein drugs will lose out on many
118 I Pharmaceutical R&D: Costs, Risks and Rewards

of the major drug innovations over the next few

decades.

The other camp points to the immense difficulties of marketing drugs that must be administered

parenterally. They acknowledge the importance

of the new protein growth factors, hormones, and

blood products, but believe that the markets for

many protein drugs will be relatively small,

seldom achieving the ‘‘blockbuster’ status needed

to sustain a pharmaceutical firm over the long run.

The confinement to narrow therapeutic niches

and a need for high prices because of a limited

number of doses will limit the impact of protein

drugs. This group maintains that protein drugs

will be extremely important in a few therapeutic

categories such as cancer or organ transportation, but will rarely be commonly used outside the

Photo cradit: ELI LILLY AND COMPANY

Protein drugs accounted for over half of the major new drug

introductions in the last few years. Insulin, the prototype for this

class, remains in use 70 years after its discovery. Insulin was

introduced to the medical profession in December 1922 in a

Journal of the American Medical Association article illustrated

with this photo of a mother holding her 3-year-old diabetic son

before the child was treated with insulin. The photo on the right

shows the same boy after treatment with insulin.

hospital setting. In cases where proteins are the

only available means to achieve a treatment goal,

companies will concentrate their efforts to find a

small organic molecule with the same function,

developing drugs that do not require parenteral

administration. This camp cites captopril (box

5-A) as the prototype. Here, a peptide drug was

replaced by a small molecule that could be orally

administered. While this model is only broadly

possible today for enzyme drug receptors, the

same principles could prove applicable to the full

range of peptide drugs. Morphine itself appears to

be a nonpeptide mimic of enkephalin, a naturally

occurring peptide that modulates pain perception.

Drug firms have recently discovered nonpeptide

blocking agents for several other natural peptide

hormones, such as cholecystokinin (which regu-
— —.

Chapter 5-Trends in Science, Technology and Drug Discovery I 119

lates function in the gastrointestinal tract and gall

bladder), substance P (involved in pain sensation), and others. Drug firms may indeed pursue

protein drugs, but mainly as stepping stones

toward small molecules. Proteins will often serve

merely as a research way station en route to more

widely marketable drugs. These observers see the

future pharmaceutical industry as an incremental

extension of today’s, with many of the same firms

continuing to dominate the pharmaceutical market by incorporating new biological technologies.

Biology will provide insights, but organic chemistry and the production of small molecules to

substitute for the function of larger proteins will

become the norm.

Disagreements about the importance of proteins as therapeutic agents does not extend to

research. Here, all the experts agree that studying

proteins is now central to developing new drugs.

Rather, the disagreement among researchers centers on which problem will be solved first—

finding small molecules to do what proteins do or

finding ways to formulate proteins drugs for

easier drug delivery.

Most large firms are hedging their bets, making

substantial research investments and pursuing

exploratory projects toward protein drug products. Other fins, generally smaller biotechnology companies, are betting a large proportion of

their companies’ assets on the success of protein

drugs. Both strategies are being carried out, so the

question will have an empirical answer in the next

decade. Small companies may grow large, large

companies may engulf them before they get large,

or some instances of each may occur. These

differing strategies exemplify the difficulties of

making resource allocation decisions in pharmaceutical R&D. Both strategies are reasonable, and

their success depends critically on factors that

cannot be predicted: how many patients suffering

from which conditions can benefit from a growth

factor or immune modulator? Is it too soon to

invest directly in developing a drug agent, based

on current research results? Will it be possible to

find small molecules to replace protein drugs?

Can problems of drug delivery be solved? “There

are so many expensive avenues to explore that

even with budgets in hundreds of millions of

dollars it is no easy task placing bets” (179).

GENETICS IN BIOMEDICAL RESEARCH

The study of DNA has been the second main

thrust of molecular biology, paralleling analysis

of protein structure and function. Proteins make

up most cellular components; DNA contains the

instruction set for when and how to make them.

The other important function of DNA is to serve

as the structural basis of inheritance.

1 DNA as the Structural Basis of

Inheritance

The DNA base pairs described earlier in this

chapter are linked together in long chains. There

are four nucleotide bases linked together in

extremely long chains, coiled up and bound with

proteins to form chromosomes. The information

content of DNA is mainly contained in the order

of these base pairs, the DNA sequence. DNA is

the structure by which individual traits are

transmitted from generation to generation. The

linear code of four letters is analogous in some

ways to the linear code of O’s and 1‘s in computer

software, which also instruct hardware to carry

out functions and can be copied faithfully for

transmission.

Classical genetics, the study of inheritance,

dates back to the 19th century. William Bateson’s

original definition of genetics presumed genes to

be the hereditary “elements” discovered by

Gregor Mendel in 1865 (230,261,336). Genes

were units of inheritance, transmitting specific

traits. The discovery of the structure of DNA by

Watson and Crick in 1953 (509), spawned a field

called molecular genetics. Classical genetics and

molecular genetics came together in the study of

DNA function, but this required some wobble in

the exact meaning of the term “gene.’ The

simple idea of a gene, an element of inheritance

(in classical genetics) that coded for a protein had

to be modified

genetics. Genes

absent, but also

under assault from molecular

were not merely present or

subject to regulatory control.

330-067 - 93 - 5 : QL 3
120 I Pharmaceutical

Genes were expressed

only at certain times,

R&D: Costs, Risks and Rewards

(i.e., produced a product)

in certain tissues, and in

certain amounts. Uncovering such complexities

made it difficult to directly map inheritance, with

its discrete particles of” inheritance, to the exquisitely complex processes governing expression of

genes. The complexity of molecular genetics was

reflected in the changing face of human genetics.

1 Genetic Approaches to Disease

Human geneticist and physician Victor McKusick maintains a catalog of human genes, called

Mendelian Inheritance in Man. The frost edition

in 1966 listed 574 well-characterized traits, and

913 partially validated. ones; most were genetic

diseases identified through inheritance patterns in

human family pedigree studies. By the ninth

edition in 1990, there were 2,656 well characterized traits and another 2,281 partially validated

ones (266). This growth in knowledge of human

genetics, already significant, understated the

growth of knowledge about the contribution of

genes to human disease. During this same period,

human genetics moved from the backwater to the

cutting edge of biomedical research. (Genetics in

other organisms has been a central thrust of

biology throughout the century, but its full

application to humans awaited technologies developed in the 1970s and 1980s.) The genetic

factors underlying the most common diseases,

such as heart disease, cancer, Alzheimer’s disease, diabetes, hypertension, and many others

were becoming better delineated. Genetic approaches to understanding such illnesses emerged

as a dominant research strategy. Entering the

1990s, genetics was poised to dissect complex

diseases because of the growing power of genetic

maps.

8 The Importance of Genetic Maps

Geneticists have been constructing maps of

chromosomes since 191.3, when Alfred Sturtevant

found traits that were inherited together and

inferred their corresponding genes were therefore

located on the same chromosome. Geneticists

labored for decades to construct maps of the

chromosomes of fruit flies, yeast, bacteria, plants,

mice, and other organisms (414). These efforts

were greatly aided by controlled matings, an

option obviously not available in humans. Constructing similar maps for humans relied on

finding genes through indirect methods, a slow,

uncertain, and tedious process. A global approach

to genetic mapping in humans comparable to that

enjoyed by geneticists for other organisms was

greatly aided by the emergence of recombinant

DNA techniques.

The first step toward isolating genetic factors

for human traits is to find informative families.

These are typically large families with a welldefined genetic character (trait), such as a genetic

disease. The way in which the character is

inherited provides a great deal of information

about whether it stems from a single gene or

many. Even single-gene defects vary in their

inheritance pattern. A genetic disease may be

dominant, expressed if an affected gene is inherited from either parent, or recessive, requiring

affected genes from both parents. If affected

fathers never transmit the character to sons, and

women are only rarely affected, it is good

evidence that the character is a recessive gene on

the X chromosome (since males have only one

copy of the X chromosome, inherited only from

the mother). The inheritance pattern for multigenic diseases is even more complex. Yet another

layer of complexity is added by genes that express

themselves only in combination with environmental factors.

A genetic linkage map is the bridge from the

study of inheritance in a family to establishing a

gene’s chromosomal location. Different individuals have, on average, over a million” DNA

differences in their genomes (a genome is defined

as a complete set of chromosomes, one of each

pair). Most variations have no clinical significance, but they can be used as markers on the

chromosomes. The idea of a genetic linkage map

is to find chromosomal sites that frequently vary

among individuals, and to verify where on the

chromosomes these common variations originate.

Once this is done, the inheritance of bits of
Chapter 5-Trends in Science, Technology and Drug Discovery I 121

chromosomes can be tracked through families by

tracing the fate of markers. The markers vary

among individuals, so they are likely to differ

between parents in each family. But the variations

are present only at a specific site on the chromosomes. If markers from the same region of

chromosome 7 are consistently inherited along

with cystic fibrosis (CF) in different families,

then this is strong statistical evidence the gene

causing CF comes from that region (see box 5-D).

The way to construct a robust genetic linkage

map in humans was first proposed in 1978 and

published in 1980 (56). The first genetic linkage

map of the human genome was published in 1987

(1 10). Other groups constructed genetic linkage

maps of individual chromosomes, and the 1990s

should see a major push to refine such maps

sufficiently to find almost any gene, once family

resources are good enough and the genetic

character is well enough defined. (These are,

however, significant limitations.)

Once the approximate chromosomal location

of a gene is known, the next step is to obtain the

DNA from that chromosomal region in hopes of

finding the gene itself. A physical map is needed

for this purpose. The order of genes or markers

will always be the same between genetic linkage

and physical maps, but the measure of distance is

quite different. Genetic linkage maps measure

how often markers stay together or separate

during inheritance. This is a measure of the

probability of being separated by genetic recombination, a DNA exchange process that occurs in

the production of egg and sperm cells. The

measure of distances in physical maps is the size

of DNA fragments, ultimately translating to the

number of DNA base pairs. The most useful

physical map is a collection of cloned DNA

fragments that span the chromosomal region in

question and are arranged in order. With such a

map, one can go from one end of the region to the

other by picking out different clones of known

orientation. Since the clones contain many copies

of the DNA from that area, this allows direct study

of DNA in search of a gene. Physical mapping

was pioneered in viruses and bacteria. Groups

working on yeast (whose chromosomes are over

12 million base pairs in length) and the nematode

Caenorhabditis elegans (100 million base pairs)

scaled up to more complex organisms with larger

genomes (99,299). Similar strategies are now

being applied to individual human chromosomes

(488).

I Ways to Find and Study Genes

Once a region of DNA thought to contain a

gene is in hand, then the hunt begins for a gene

amidst the long string of DNA base pairs. There

are many indirect methods to select DNA regions

likely to contain “candidate genes. ’ All strategies ultimately entail extensive amounts of DNA

sequencing from the region, and comparison of

sequence differences among individuals.

In the hunt for the cystic fibrosis gene, for

example, consistent sequence differences were

found in affected children. The CF gene was

located on chromosome 7 by genetic linkage in

1985 (425,504,518). Each parent of every CF

child had to have ‘normal, ’ non-CF gene on one

chromosome 7 and a CF mutation on the other, (If

both copies were normal, parents would not have

a CF child; if both were mutations, the parent

would be affected.) Using genetic markers, scientists could trace which copy of chromosome 7 was

passed on to the CF child from each parent, and

this had to be the one with the CF mutation.

Comparing ‘‘normal’ to ‘‘mutation’ sequences

in DNA from this part of chromosome 7, taken

from many affected children and their parents,

revealed a consistent abnormality, the loss of

three base pairs (229,351,353). This constituted

the most common mutation causing CF. Once a

small piece of a gene was identified, it was a

straightforward matter to find the rest of the gene

and the protein that it produced. Having found the

gene, more than a hundred additional mutations

causing CF were identified. The successful research strategy was thus: genetic linkage analysis

of many families to find the gene’s location,

physical mapping of the region, DNA sequence

analysis to identify the most common mutation

(and thus the gene), and further analysis of
122 ! Pharmaceutical R&D: Costs, Risks and Rewards

Box 5-D-The Search for the Cystic Fibrosis Gene

The search for the gene causing cystic fibrosis (CF) is a recent triumph of human genetics. The

symptoms of CF are poor digestion of foods and recurrent lung infections. The main effects of the disease

trace to the accumulation of thick mucus plugs in the duct systems of organs throughout the body. The organs

most affected are the lungs and the pancreas. Proper lung function depends on clear airways. In CF, airways

become obstructed, and pockets of infection develop. Pancreatic ducts normally drain digestive enzymes

into the small intestine. When viscid mucus blocks pancreatic ducts, the enzymes are not delivered, and

digestion is less effective. The digestive symptoms can be treated by enzyme supplements. Treatments for

lung symptoms are primarily careful monitoring, efforts to physically dislodge mucus plugs, and frequent

administration of antibiotics to stave off infections.

CF is the most common seriously disabling single gene defect among Caucasian populations. It is a

recessive condition, present only when a child inherits defective copies of a gene on chromosome 7 from

both parents. CF affects approximately 1 in 3,500 live births in the United States; 1 in 30 Americans has

one copy of a CF mutation gene, but most are unaffected because it takes both copies of the gene to cause

disease.

Until 1985, the main facts known about CF were its symptoms and its pattern of inheritance. That year,

a group led by Lap-Chee Tsui at the University of Toronto found that CF was genetically linked to, i.e.,

frequently inherited with, a marker on chromosome 7. The marker was contributed by Collaborative

Research, Inc., a small biotechnology company located near Boston. Other groups quickly confirmed the

linkage.

Finding the gene itself took another 4 years. The process involved studying cloned DNA fragments

from that region of chromosome 7, meticulously assembling a map, and then searching for differences in

DNA structure that correlated with the presence of CF in patients. A large group of collaborators at several

centers, led by Francis Collins, finally identified a common DNA defect, the loss of three DNA base pairs.

Seventy percent of patients with CF had this mutation, which served to identify the gene. Once the DNA

sequence surrounding this mutation was known, it could be used to find the rest of the gene, and to find the

protein produced by the gene. With the gene in hand, it was possible to confirm that its dysfunction caused

CF by introducing the normal gene into cells in tissue culture and reversing a molecular defect.

The molecular defect underlying CF involves the transport of chloride ions across cell membranes.

Poor chloride transport leads to thick, sticky mucus. The CF protein now serves as a target for drug

development. The fact that the CF protein regulates chloride ion flow raises hopes that a drug might

successfully replace its function. Another possibility in the long run is to introduce the normal gene into the

cells that line lung ducts (see gene therapy section in text), permitting production of normal mucus. This is

technically difficult and will take years at best, although investigators took their first steps down this path

in 1992 with the first CF gene therapy protocol. In the meantime, a wealth of other treatment possibilities

center on increasing chloride flow by drug treatment, or on modulating the inflammation that actually causes

tissue damage. Discovery of the gene has rekindled hope among CF families, and has renewed interest in

clinical trials of new agents.

SOURCES: K. Davies, ‘The Search for the Cystic Fibrosis Gene, “New Scientist 124:54-58, 1989. M. Deaq “Molecular and Genetic

Amlysis of Cystic Fibrosis,’ Genom”cs 3:93-99, 1988. E.D. Green, and M.V. Olsoq “Chromosomal Region of Cystic

Fibrosis Gene in Yeast ArtMcial Chromosomes: A Model for Human Genome Mapping,” Science 250:94-98, 1990. B.-S.

Kereq J.M. Rcmmens, J.A, Buchanan+ et al., “Identi.tlcation of the Cystic Fibrosis Gene: Genetic Analysis,” Science

245:1073-1080, 1990. S.T Reeders, M.H. Breunig, K.E. Davies, et al., “A Highly Polymorphic DNA Marker Linked to

Adult Polycystic Kidney Disease on Chromosome 16,” Nature 317:542-544, 1985. D.P. Riclq M.P. Andersoq RJ.

Grego~, et al., “Expression of Cystic Fibrosis Transmembrane Conductance Regulator Corrects Defective Chloride

Channel Regulation in Cystic Fibrosis Airway Epithelial Cells,” Nature 347:358, 1990. J.R. Riordan, J.M. Rommem

B.-S. Kererq et al., “Identi.f3cation of the Cystic Fibrosis Gene: Cloning and Characterization of Complimentary DNA,”

Science 245:1066-1072, 1989. L. Roberts, “The Race for the Cystic Fibrosis Gene,” Science UO:141-144, 1988. J.M.

Rommens, M.C. Iamuzi, B.-S. Kerem, et al., “IdentMcation of the Cystic Fibrosis Ckne: Chromosome Walking and

Jumping,” Science 245:1059-1065, 1989. L.-C. Tsui, M. Buchwalq D. Barkes, et al., “Cystic Fibrosis Imcus Defiied by

a Genetically Linked Polymorphic DNA Marker,” Science 230:1054-1057, 1985. BJ. WainwrighL P.J. Scambler, J.

Schmidtke, et al., “Localization of Cystic Fibrosis Locus to Human Chromosome 7cenq22,” Nature 322:467470, 1985.

R.L. White, S. Woodward, M. Uppen et al., “A Closely Linked Genetic Marker for Cystic Fibrosis,” Nature

318:382-384, 1985.
.——.— —.—

Chapter 5–Trends in Science, Technology and Drug Discovery I 123

pedigrees to find additional mutations of the same

gene.

The polymerase chain reaction (PCR) is a

simple technique that enormously expedites the

study of DNA (283,358). It is, in essence, a way

to make many copies of short stretches of DNA

without having to clone it. PCR can be used to

generate a DNA sequence directly, or as a

“probe” to identify clones or cells that contain

the sequence copied by PCR. It requires only a

mix of chemicals, a DNA-synthesizing enzyme

extracted from bacteria, and short stretches of

DNA that define the starting points for DNA

copying. PCR was first described in 1985 by

investigators at the biotechnology company Cetus.

By 1989, PCR was referenced in 860 publications, used in dozens of ways for a multitude of

purposes (316). In searching for genes, and as an

adjunct to use genes to study proteins, PCR

replaces slower and more expensive processes

and opens entirely new avenues for exploration.

The story of CF (box 5-D) is one of the most

straightforward that can be expected, but it

nonetheless required enormous effort. From 1985

to 1989, laboratories throughout the world labored to find the gene. One reason for the

protracted search was that the physical maps and

regional sequencing had to be done de novo. Once

complete maps of the human genome are constructed, similar searches should be much faster

and less costly.

Other diseases are much more confusing, and

tracking them down may prove far more difficult.

The gene causing Huntington’s disease, for example, was mapped in 1983, but its gene (and

consequently, its protein product) remained elusive after a decade. Even when a gene and a gene

product are identified, however, it may not be

obvious what the protein product does. To understand function, other methods from cellular biology and physiology are needed.

When a gene is found, it is often not readily

apparent what it does. A newly discovered protein

may be likewise inscrutable-merely a dot on a

piece of filter paper or a product derived from

DNA sequence. The most reliable tools of molecular biology and protein chemistry produce information about structure, but knowing structure

does not guarantee an understanding of function.

Genetics does provide tools to determine the

function of a gene or protein, but the tools cannot

crack open every lock. Genes can be introduced

into bacteria, yeast, or animals to study the effects

of a gene. As noted above, mutations can be made

in the gene coding for a protein, in hopes that

“breaking” the protein will clarify what it does

when not broken.

The first step is to compare a new gene or

protein to others already known, using databases

that store the collected knowledge of researchers

from around the world. There are databases for

many kinds of structural information—

crystallographic structure, protein structure, gene

map positions, DNA sequence, and others (100).

If a match is found—a protein that has a similar

sequence of amino acids, for example-the matching protein may give clues to the function of the

newly discovered one. Indeed, the ‘‘new” gene

may not be new at all. Russell Doolittle and

colleagues shocked the research community in

1983, for example, when they found an unsuspected similarity between a cancer-associated

gene (a so-called oncogene) and a molecule that

promoted cell growth (1 11).

To study the function of a disease-associated

protein, such as the variant protein of cystic

fibrosis, the abnormal gene can be introduced into

cells in tissue culture, allowing much more

precise experiments to be done quickly. The gene

may also be introduced into another animal by

recombinant DNA, making a transgenic animal.

The effects of a gene mutation can thus be directly

observed in the whole animal. This is a direct

route to creating an animal model of a human

genetic disease, with many of the complexities

introduced by multiple organ systems, immune

reaction, and other factors that are difficult to

study in bacteria, yeast, or tissue culture cells.

Until the advent of transgenic animal research,

one had to hope that scientists had discovered an

animal with an appropriate genetic defect similar

to a human disease. Many human genetic dis-
124 I Pharmaceutical R&D: Costs, Risks and Rewards

eases, however, had no animal counterpart, and

for these, transgenic techniques were a godsend.

The technique has obvious implications for

drug research. Most drug receptors are proteins

with corresponding genes that can be introduced

into animals to explore their functions and

dysfunctions. Alterations of the drug receptor can

be introduced, and their effects observed in

animals, without having to put human subjects at

risk.

~ Genetics as a Tool to Dissect

Complex Disorders

Genetics may aid drug development by defining specific subpopulations of patients, thus

simplifying the process of ascertaining the efficacy of new agents. Alzheimer’s disease is an

example of how genetics may help advance

understanding of a disease by identifying subtypes (see box 5-E). Alzheimer’s disease is the

most common cause of dementia—loss of thinking ability. Symptoms typically begin only in

middle age or later. It affects millions of Americans today, and is expected to afflict tens of

millions early in the next century as the population ages (448). Alzheimer’s disease is inherited

as a single-gene dominant trait in some families,

so that children of an affected parent in these

families stand a 50-50 chance of developing it if

they live long enough. The wide variation in

symptoms and in age of onset have puzzled those

studying the illness since it was first described in

1907. Indeed, only a small group of specialists

were even aware that it could be inherited until

recent years. Since 1987, studies of families

affected by the familial form of Alzheimer’s

disease have revealed a genetic heterogeneity

obscured by clinical and anatomical diagnosis.

Even before the different genes in these families

are found, it may be possible to categorize

patients into subtypes, thus making it more likely

to find effective drugs and other treatments (see

box 5-E).

Genetics is but one of many approaches to

disease. Following the trail down to a mutation in

DNA cannot fully explain even most genetic

diseases, and clearly genetic factors are only a

part of most major diseases. The attraction of

genetic approaches to disease, however, is that the

tools are becoming so powerful. Most important

diseases have been studied for decades. Those

that could be easily explained by more traditional

approaches have yielded; molecular genetics

offers a strategy to crack those that have not.

1 The Implications of the Human

Genome Project

The genetic approach dissects the genetic

factors that conspire to cause disease. The basic

tools needed to pursue the approach are genetic

linkage maps, physical maps, and DNA sequencing capacity. These are complemented by an

Q

CELL

The basic unit of life,

these tiny sacs contain

chromosomes and protein ,,

,.

. .

factories, among other

‘. elements. :x] CHROMOSOME

Strands in cells containing

DNA. Humans have 23 pairs,

one chromosome each from ‘. ‘. the father and the mother.

‘. ‘. ‘.

DNA

The blueprint for producing all

the proteins and chemicals

that carry out the innumerable

functions crucial for life.

,’

❑

,.,. .“ .’ .,. ., :.’

, ,

. . . . . , , ..,

.,, ..’ ..’

,’” ,.’ ‘.,

,., .,,, ., ’...,. -.’

. . . . . ,,. ... ”

GENE

A stretch of DNA that contains

the instructions for making

proteins. A damaged gene can

lead to disease.

Reprinted from the May 28, 1990 issue of Business Wbek by

permission. @!I 1990 by McGraw-Hill, Inc.
Chapter 5–Trends in Science, Technology and Drug Discovery I 125

Box 5-E—The Complex Genetics of Alzheimer’s Disease

Alzheimer’s disease typically begins insidiously with loss of memory for recent events. It then

progresses to more pronounced forgetfulness, loss of cognitive abilities, and frequently to behavioral

symptoms such as irritability or depression. The course of the disease can extend for many years, even

decades. Disease can begin to show as early as age 40, but most commonly begins after age 70. In 1907,

Alois Alzheimer first described a 51-year-old woman with progressive loss of memory and distinctive

microscopic changes in her brain. In the 1930s, many groups began to describe families in which many

members developed Alzheimer’s disease. By 1980, more than 80 such families were in the published

literature, but the familial form of Alzheimer’s disease was still not widely appreciated.

In some families, the disease travels as an autosomal dominant trait, so that the child of an affected

parent has a 50-50 chance of developing it. In such families, a single gene best explains the pattern of

inheritance. Getting the Alzheimer’s copy of the gene from the affected parent translates to a very high

probability of eventually developing Alzheimer’s disease. Inheriting the normal copy means that one will

not get Alzheimer’s disease, or at least not the genetic form, and future progeny likewise will be spared.

Several groups throughout the world attempted through the 1970s and 1980s to characterize the genetics of

Alzheimer’s disease. A picture began to take shape, but it was more complicated than a simple Mendelian

disease caused by the same gene in all families.

The first breakthrough came from studies led by Peter Saint George-Hyslop. A large collaborative

group studied several families with Alzheimer’s disease, and in 1987 linked the disease to a genetic marker

on chromosome 21. Another group in Europe confirmed the linkage. Over the next two years, however, other

groups found families that seemed to have the same disease but did not show linkage to chromosome 21,

even using the same markers. In 1991, a different group of families showed evidence of an Alzheimer’s gene

on a different chromosome, number 19; in 1992, another international collaboration found most familial

Alzheimer families showed linkage to a region on chromosome 14. The story on chromosome 21 also

became more complicated. Two groups found patients with a particular DNA mutation on chromosome 21

that correlated with the disease. Other families that showed linkage to chromosome 21 lacked this mutation,

making it likely there were two or more causes of chromosome 21-linked Alzheimer’s disease. A consensus

emerged that more than two genes on chromosome 21 could cause the disease in different families. There

was likely another gene on chromosome 19; and a set of families, called the Volga German families for their

geographic origin in prerevolutionary Russia, that seemed to have a gene that did not map to either

chromosome. There might thus be four or more subtypes: beta-amyloid mutant Alzheimer's disease, a

distinct chromosome 21 Alzheimer’s disease, chromosome 19 Alzheimer’s disease; chromosome 14

Alzheimer’s disease, and an unlinked (Volga German) familial Alzheimer’s disease.

Time-honored clinical and anatomic classifications obscured the heterogeneity revealed by genetics.

The hope was to find the genes, define their protein products, and use these to search for functional clues

as to why nerve cells in the brain died prematurely. A similarly complex picture was beginning to emerge

in complex diseases such as heart disease, schizophrenia, arthritis, diabetes, various types of cancer, and

other disorders. Genetics, with its unique power to break diseases into precise subtypes directly correlated

to molecular diversity, was likely to have implications for drug development. If different genes caused

clinically similar diseases, different proteins were involved (or, perhaps, RNA products that regulated DNA

expression).

All these different gene products are potential targets for drug development. If their function can be

restored by drugs, then there is hope for therapy. Finding the gene maybe the first step to finding the right

target at which to aim. If the Alzheimer’s gene produced a toxic product, for example, it might be possible

to inhibit its production. If it resulted from lack of a growth factor, then agents to replace that factor might

be synthesized.

(Continued on next page)
126 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 5-E–-The Complex Genetics of Alzheimer’s Disease--(Continued)

The genetic factors involved in Alzheimer’s disease underscore how little is known about its causes.

The discovery of unsuspected subtypes of disease starkly points out how far medicine remains from a

detailed understanding. Genetics is being pursued in hopes of getting a molecular “handle” on conditions

for which little is known beyond the fact that they “run in families.”

At the very least, being able to distinguish molecular subtypes can direct drug development for defined

subpopulations. This could permit advances for diseases such as Alzheimer’s that have to date proved

refractory. Disease subtyping might also conceivably reduce drug testing costs. If it were possible to select

in advance those subpopulations of patients likely to respond to a given drug, then it would be much easier

to demonstrate efficacy. Proving efficacy is a major problem in developing drugs for complex chronic

diseases. Drug effects apparent in only 20 percent of patients, for example, could easily be lost in the

‘‘noise’—random statistical variations in the other 80 percent. If genetic typing could select out only the

20 percent likely to respond, the effect would pop to the surface. Testing a small, molecularly defined

population would amplify drug effects, lower testing costs, and speed regulatory approval.

PRINCIPAL SOURCES: A.M. Goate, A.R. Haynes, M.J. Owen, et al., “Predisposing hxus for Alzheimer’s Disease on Chromosome

21,” Luncet 1(8634):352-355, 1989. P.H. Saint Georg&Hyslop, J.L. Haines, L.A. Farrer, et al., “Genetic

Lirkage Studies Suggest That Alzheimex’s Disease Is Not a Single Homogeneous Disorder,” Nature

34:?:19~197, 1990. p.Ho Sxt GcOrgc-HySIOp, R.E. -i, R.J. Polins@, et al., ‘The Genetic Defect

Causing Familial Alzheimer’s Disease Maps on Chromosome 21,” Science 235:885-890, 1987. G.D.

Schellenberg, T.D. Bird, E.M WijsU et al., “Absence of Linkage of Chromosome 21q21 Markers to

Familial Alzheimer’s Disease,” Science 241:1507-1510, 1988. G.D. Schellenlwrg,T.D. Bird, ELM. Wi~

et. al., “Genetic Linkage Evidence for a Familial Alzheimer’s Disease Locus on Chromosome 14,” Science

258:668-671, October 23, 1992.

ADDITIONAL SOURCES: J, Constantinidis, G. Garrone, R. Tisso~ et al., “ L’incidence famiale des alterations neusofibrillaires

corticales d’Alzheimer,” Psychia~”e et Neurologie 150:235-247, 1965. W.H. Engli~ “Alzheimer’s

Disease,” Psychiatric Quarterly 16:98, 1942. E. Essen-Moller, “A Family with Alzheimer’s Disease,”

Acta Neurological Scandinavia 21:233-244, 1946, R.G. Feldman, K.A. Chandler, L.L. Levy, et al.,

“Farniliai Alzheimer’s Disease,” Neurology 13:811-824, 1963. F.E. Flugel, “Zur Diagnostic der

Alzheimerschen Krankheit,” Gesamte Psychiatric 120:783-787, 1929. R.L. Friede, K.R. Magee,

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enormous diversity of ways to understand the evolved into a concerted effort to build the

function of genes, by introducing mutations in infrastructure for large-scale mapping, sequenccultured cells, or by creating yeast models or ing, and technology development which, in turn,

transgenic animal models of a human disease. were intended to lay the foundation for genetic

The Human Genome Project emerged in 1985 and explorations in biomedical research.
———. ———.—— —

Chapter 5–Trends in Science, Technology and Drug Discovery I 127

The underlying story was a convergence of

technologies to analyze DNA, to clone large DNA

fragments, to construct genetic linkage and physical maps, and to determine DNA sequences.

These developments paralleled developments in

computers that lowered costs and added computational power and flexibility. From these technological shifts, several individuals independently

struck on the audacious idea of determining the

sequence of all 3 billion base pairs in the human

genome. The idea provoked considerable controversy, and the genome project was ultimately

redefined to include genetic linkage mapping,

physical mapping, as well as DNA sequencing.

The goal of the Human Genome Project slowly

and almost imperceptibly shifted from a complete

DNA sequence of the genome to a complete

structural catalog of human genes, which may not

prove to be the same thing (91).

Work on model organisms is essential to

interpret human gene maps, and has been incorporated into the project’s goals (488). To accomplish its goals, the human genome project must

develop new technologies to make mapping and

DNA sequencing faster, less costly, and more

accurate. These technologies will themselves be

a boon to other investigations, as the analysis of

DNA is central to biomedical research of almost

every variety.

The objective is ambitious. An estimated

50,000 to 150,000 genes are dispersed through the

human chromosomes, of which McKusick’s catalog lists just over 2,000 that have been well

characterized. The genome project should provide a molecular catalog for tens of thousands of

genes that are as yet unknown. Genetic linkage

maps with severalfold more markers are needed to

locate genes known only by their pattern of

inheritance. Most regions of the genome lack

physical maps, and less than one percent of the

genome has been sequenced as of 1991. The

human gene map is only in its infancy (3 13,405).

The physical and genetic linkage maps are slated

to be near completion by mid-decade, with

massive amounts of sequence data to be available

in 15 years (488). The elaboration of these various

maps, when combined with techniques to catalog

the large mass of currently unknown genes, will

undoubtedly reveal many genes that influence

disease. Even in well studied organisms such as

yeast and nematode worms, the direct approach of

DNA structural analysis has uncovered many

more genes than were known to exist. Each new

protein is a potential drug receptor target; many

will provide promising new leads for drug development.

DNA AS A THERAPEUTIC AGENT

1 Gene Therapy Is Just Beginning

One promising treatment strategy is

ately to introduce genes into human

delibercells to

compensate for aberrant genes that cause genetic

disease. The process is called human gene therapy. Gene therapy as a theoretical possibility was

discussed widely for decades. In 1989, the first

genes were introduced into the cells of cancer

patients in order to monitor a novel anticancer

treatment (354). The first gene insertion to treat

a genetic disease, bona fide gene therapy, was

per-formed in 1990.

Gene therapy falls into two major categories. It

can be aimed at cells of the body, or somatic cells,

so that it affects only that patient. The other, more

controversial, alternative is to treat cells of an

early embryo, egg cells, sperm cells, or their

precursors. Any genes introduced into such cells

would not only be present in the individual, but

would also be passed on. Treatment of egg cells,

sperm, or their precursors would lead to inherited

changes in any babies resulting from fertilization.

Treating an early embryo would affect not only

somatic cells but also those giving rise to eggs and

sperm. In each case, some fraction of future

generations would carry the altered genes. This

variety of gene therapy is termed germ line gene

therapy.

The treatments approved to date, and anticipated in the near future, will involve bone marrow

cells, white blood cells, skin cells, liver cells, lung

cells, pancreatic cells or others that can be

extracted from the body, treated, and reintroduced
128 I Pharmaceutical R&D: Costs, Risks and Rewards

back into the patient. The first approved gene

therapy clinical trial aimed to treat a rare genetic

disease caused by a deficiency of the enzyme

adenosine deaminase (ADA) known as “BubbleBoy Syndrome. ” This is a recessive disorder, so

both copies of the gene coding for the enzyme are

abnormal. The result is that the enzyme fails to

degrade the chemical adenosine. Adenosine accumulates, most notably in white blood cells, and

the white cells responsible for fending off infections consequently function poorly. Untreated

patients completely bereft of enzyme function

generally die of infection before age 2. In an

example of a protein used directly as a drug agent,

the ADA enzyme has been chemically linked to

polyethylene glycol and injected directly into

patients. Patients have improved under this treatment. Another approach is to take white blood

cells from such patients, insert the gene that

produces ADA, and insert the cells back into the

patient. This is the protocol approved as the first

instance of human gene therapy (16,49). The frost

patient, a four-year-old girl, began treatment in

September 1990; by the end of June 1992, there

were 14 approved clinical protocols (with 35

patients) involving gene transfer in humans (15,194).

The original notion of human gene therapy was

to treat single gene defects. The concept has since

broadened considerably. Viewing gene therapy

only as a way to compensate for defective genes

in the patient’s body has given way to seeing it as

a way to introduce useful genes into cells that can

act as drug delivery devices. This opens a far more

diverse set of possibilities. Cells treated with

inserted genes could conceivably be used to treat

acquired immunodeficiency syndrome (AIDS),

heart attacks, diabetes, and cancer (14). Several

recent protocols approved or in preparation already illustrate the broader possibilities (305).

Several technical obstacles face gene therapy

before it can be used as a standard treatment

modality. First, the range of cells that can be

targeted for gene insertion must be expanded

considerably. Only white blood cells and certain

types of bone marrow cells have been successfully treated to date. These cells die off over a

period of months, and the treatment expires with

them. The next step may be to get genes into the

so-called ‘‘stem” cells that continually divide to

produce whole populations of cells. If the gene

were inserted into stem cells of the bone marrow,

for example, then the treatment might not have to

be repeated-there would be a steady stream of

new cells expressing the gene, derived from stem

cells. Second, the expression of the inserted gene

must be sufficient to produce a clinical benefit

and not too much as to cause toxicity. The amount

of protein produced from artificially inserted

genes is, in general, significantly lower than

normal amounts. Third, for many applications it

will be necessary to “aim’ the gene insertion at

specific organs or tissues.

For now, this problem is solved by extracting

cells from the body before inserting the gene. This

severely limits the types of cells that can be

treated. It is not practical to remove cells from

most organs before treating them. The ability to

reliably insert genes only into nerve or muscle

cells, for example, would greatly enhance prospects of treatment for intractable neuromuscular

diseases. Those hoping to treat Duchenne muscular dystrophy have raised this possibility, and are

working to fabricate DNA elements that express

genes only in muscle cells (355). Finally, it would

be a great boon to gene therapy if genes were not

merely inserted, but instead new DNA sequences

replaced old ones in the same gene. Current

methods of introducing genes into cells insert

whole new genes (attached to other genes and

regulatory sequences). The chromosome.1 site of

insertion is not predictable or controllable. The

ideal treatment would instead excise ‘bad’ DNA

sequences while replacing them with “good”

ones. This would require that the corrective

sequence recognize the gene it was to replace with

great specificity. This process is possible in yeast

and bacteria, and is a standard tool of genetics. It

has even been done in manmals; the problem is

that it is successful only very infrequently. Before

such techniques were clinically applicable, they

would have to be much more reliable.
Chapter 5-Trends in Science, Technology and Drug Discovery I 129

1 Prospects for Germ Line Treatments

Are Remote

The prospects for germ line gene therapy are

quite remote at present, for both ethical and

technical reasons. Germ line gene therapy would

be directly analogous to transgenic animal methods, in that a heritable gene would be introduced

into a human. Changes could be inherited by

subsequent generations. The technique is thus

technically feasible, but there are extremely

important differences between clinical application in humans and transgenic animal research.

First, most transgenic animal experiments involve hundreds of animals, only a small fraction

of which acquire the desired new gene (a percent

or so at best). In many experiments, a fraction of

animals become sterile or suffer genetic damage

because of the new DNA inserts into critically

important sites, disrupting another gene. To be

clinically useful, the technique would have to

successfully insert a gene almost all of the time

and only very rarely cause adverse consequences.

Clinical trials of germ line therapy would have to

demonstrate, moreover, that the inserted gene had

no demonstrable effect during embryonic and

fetal development. Even contemplating how to

demonstrate this in humans is a major task.

Providing evidence of safety in humans without

being able to target gene insertion is difficult to

imagine.

Germ line gene therapy might be useful for

conditions where damage accumulated during

embryonic or fetal development, or if multiple

organ systems had to be corrected. Germ line

therapy would require techniques to insert genes

into sperm or egg cells that currently do not exist

(or into cells that produce them), or use of in vitro

fertilization followed by treatment of early embryos. Prospective parents could more simply and

safely choose to implant embryos that would not

develop a disease, rather than treating embryos

destined to do so. This alternative would not be

available in one very unusual situation-if both

parents had a recessive genetic disease. Both

parents would carry double copies of a defective

gene in this case, and so every embryo would

likewise have a double dose of a gene defect and

would thus be affected. This clinical situation is

not impossible, but it would be quite rare. These

technical factors combine with a lack of consensus that germ line therapy is ethically acceptable

to make germ line gene therapy unlikely in the

foreseeable future, although it might resurface in

the more distant future.

1 Uncertain Prospects for Gene Therapy

as a New Treatment Modality

Those surveyed by the Office of Technology

Assessment disagreed markedly about whether

gene therapy would emerge as a major treatment

modality over the next 10 to 20 years, Some saw

gene therapy as the coming wave of therapeutics.

They cited several advantages. First was that it

could attack diseases that other methods could

not. Most genetic diseases have only palliative

treatments, or only partially effective ones. The

optimists foresaw that the problem of getting cells

into specific target cells and in specified chromosomal locations would be solved. If so, many

single gene defects could be treated.

The most devastating symptoms of CF are due

to lung problems. The cells that line lung ducts,

for example, are constantly turning over. It might

be possible to introduce normal genes into CF

cells if the stem cells giving rise to them could be

treated by gene therapy. But to treat a sufficient

quantity, this would most likely have to be done

without removing lung cells from the patient’s

body. A tamed virus, perhaps inhaled or injected,

would have to home in on those stem cells. In

addition, the introduction would have to be

sufficiently controlled 50 that when many millions of cells were treated, the gene insertion did

not induce mutations leading to cancer or cause

other unwanted side effects. Gene therapy for CF

is nonetheless being vigorously pursued, with the

first clinical protocol approved in 1992.

Another advantage of gene therapy is that it

might require many fewer treatments. Once stem

cells were treated, it might not be necessary to

continually administer drugs. In this sense, it

would be more akin to organ transplantation or
130 I Pharmaceutical R&D: Costs, Risks and Rewards

vaccination than to most drug treatments. Onetime treatment is an appealing prospect for

diseases such as diabetes, where it would obviate

daily injections of insulin. Gene therapy also

might restore the body’s own feedback controls.

Fluctuations in drug levels often fail to synchronize with normal regulatory controls. This is

particularly important for hormones and other

substances produced in response to environmental changes. Cells treated by gene therapy

might be brought back into feedback control,

either by including a gene’s natural regulatory

elements, or by repairing a defective gene in its

natural chromosomal site.

Skeptics note the technical difficulties in targeting specific cell types, in getting genes into

identified chromosomal sites, and in the high

costs of clinical trials and safety testing. The

range of diseases that can be attacked with current

methods seems narrow. Gene therapy might be

useful for cancer therapy, fatal genetic diseases of

childhood, and other extremely serious conditions lacking better therapy. Some of those

surveyed acknowledged that these revolutionary

treatments were imminent, but questioned whether

they would prove economically viable on a grand

scale. If the number of affected individuals is

small and the treatment is expensive to develop

and to administer, the clinical advantages of a

one-time treatment could prove a commercial

disadvantage. The costs of R&D might fall on a

small number of patients and single doses,

limiting access and boosting the unit price. The

range of disorders that can be approached by gene

therapy will not broaden appreciably until better

cell targeting and chromosome-site targeting are

possible, and these make well take a decade of

research to develop, if they develop at all. The

unknown safety issues also raise concern that

liability costs could be high.

Those working to develop gene therapy tend to

be optimists. They view current protocols as

analogous to Henry Ford’s first primitive internal

combustion engine, with prospects so revolutionary they cannot be predicted. The Federal Government is, for now, the main investor in gene

therapy. The cost of the clinical trials has to date

been funded directly by the National Institutes of

Health, although this may change as more firms

become involved in gene therapy development.

At least three small biotechnology companies

were founded with gene therapy as part of their

business plan, but these are viewed as long-term

investments and the companies are now concentrating on research and new methods. They aspire

to turn a profit from marketable therapeutic

products in the next several years. These small

startup companies have been joined by eight or

more larger pharmaceutical firms pursuing gene

therapy technology. Even if they cannot sell gene

therapy itself, however, they may be able to sell

reagents for gene transfer to other researchers.

Gene transfer methods are widely applicable

beyond gene therapy, and so this market, while

not comparable to a major therapeutic agent,

might nonetheless sustain a small firm during its

formative years. Current work includes collaborative agreements with larger pharmaceutical firms,

that fired small exploratory research efforts. For

now, gene therapy is in its early exploratory

phase.

E Alternative Uses of DNA and RNA

In the future, DNA itself could serve as a

therapeutic agent. There are several possible

routes by which DNA (or RNA) could be used as

drugs. The transcription of DNA into RNA can be

blocked, for example, by proteins designed to

bind to DNA. Short stretches of DNA introduced

directly into the blood stream can last for hours,

are actively taken into cells, and can also block

the process of transcribing DNA into RNA. Short

stretches of DNA or RNA can also inhibit the

process of translating RNA into protein. This

strategy of making “antisense” sequences to

block the production of proteins is being explored

by several pharmaceutical companies for its

possible therapeutic value. These efforts closely

parallel other drug discovery efforts, the main

difference being that the physiological target is

DNA or RNA rather than proteins. Like gene

therapy, these alternative uses of DNA and RNA
—

Chapter 5-Trends in Science, Technology and Drug Discovery 1131

as therapeutic agents are in their preliminary

research phase.

DISCOVERY INCREASINGLY DRIVEN BY

BIOMEDICAL RESEARCH

An increasing reliance of drug discovery on

biomedical research stands out as a salient theme

of this chapter. Drugs uncovered by chance

clinical observations or systematic refinement of

folk remedies early in the century have given way

to pharmaceutical firms with thousands of scientific workers pursuing drug research. The teams

of organic chemists, specialists in pharmacological screening, and clinical experts have not been

abandoned; they are still just as essential as they

have always been. Rather, biologists have been

added onto the front end of the drug discovery

process.

1 The Foundation of Drug Discovery Is

Biomedical Research

The first step along the pathway to discovering

a major new drug is the understanding of what

causes a disease. Many of the drugs that could be

discovered by clinical happenstance have been

developed in this first century of the pharmaceutical industry. Screening of microbes and plants is

still important, but many of the classes of agents

that can be discovered have already been. There

are undoubtedly many clinically useful natural

products yet to be found, but the process of

discovering them has reached a point of diminishing returns. Pharmaceutical firms have turned

their attention to understanding the mechanism of

disease as a guide to discovering truly novel

drugs.

The development of cimetidine and captopril

illustrate the new approach. Dozens of other drugs

could have served as equally valid examples.

These drugs are already well established in the

market. Many of the agents under investigation

now will only come to market after the turn of the

century. The differences of opinion belie an

underlying, widely shared philosophy:

‘‘Successful management of industrial research is

dependent on rapid access to the latest discoveries

in academic laboratories, the ability to recognize

the importance of a given discovery, the ability to

integrate the information into research programs

within an industrial laboratory, and the ability to

focus effort to allow maximum chance that the

idea will bear practical fruit. It is vital for an

industrial laboratory to have its own cutting edge

basic research program at early stages of newly

evolving fields” (373).

The dominant strategy of modern pharmaceutical firms is to invest heavily in R&D, to form

collaborations with academic laboratories and

small specialized biotechnology companies, and

to pursue the most promising leads with in-house

research teams. Drug discovery research thus

rests on a broad base of publicly funded basic

biomedical research. It picks the fruits of basic

research as new ideas emerge about disease

mechanisms that suggest potential drug receptor

targets.

9 Biomedical Research Turning to Larger

Scale and More Complexity

Biomedical research is itself changing. The

scale and complexity of problems are increasing.

This is in part due to the massive accumulation of

knowledge in the postwar era. Many of the simple

problems have been solved, the simplest diseases

understood. What remain are the conditions that

could not be understood with past methods.

Research methods grow more powerful at the

same time as harder problems come into view.

Structural understanding of proteins and DNA are

at the forefront of innovative research methods

and pose many of today’s most tantalizing

problems.

Genetics progressed from the study of viruses

whose genomes are thousands of bases in length

to those with hundreds of thousands, then to

bacteria with millions of bases in their genomes.

Only in the 1980s did DNA pioneers venture into

genomes of tens or hundreds of millions of base

pairs. As the 1990s began, they. were poised to

take on the human genome.
132 I Pharmaceutical R&D: Costs, Risks and Rewards

1 The Increasing Role of Instruments

and Computers in Drug Research

A person picking up a scientific journal will

open its pages to many advertisements aimed at

biologists. In these advertisements, the stereotypical biochemist or molecular biologist holds a test

tube in one hand and pipette in the other, focusing

intently on transferring a fluid containingprotein,

DNA, or chemicals used to study such molecules.

The image of biomedical research conjures up

thousands of test tubes and hours spent moving

reagents into and out of them,mixing them, and

then analyzing the results. The image is accurate,

but changing. In many advanced academic and

industrial laboratories the test tubes have not gone

away, but the person has been replaced by a robot

or automated instrument. Sanger’s work from

1945 to 1955 to determine the sequence of amino

acids in insulin (see box 5-C) took almost a

decade of intensive effort by a scientist who

ultimately earned two Nobel prizes. Today, this

can be done in days by a technician and a

machine. The first 24 nucleotides of DNA sequence took many years effort in the early 1970s;

today a single automated DNA sequenator can

generate a thousand times as many in a day.

Extraordinary leaps in technological capacity

open up new approaches to problems of larger

scale. Instrumentation and automation thus dramatically increase the efficiency of doing the

same experiments. In the 1970s, every well-to-do

molecular biology laboratory had its own ultracentrifuge, used to spin test tubes very fast and

enabling separation of proteins and DNA fragments according to weight, and a spectrophotometer, used to measure the color of liquids to

determine the concentration of chemicals. These

instruments cost tens of thousands of dollars each.

Now, a laboratory must have not only these

instruments, but others even more complex and

expensive. To stay on the cutting edge of DNA or

protein research, there are robots to do microchemical reactions, instruments to determine the

sequence of amino acids in proteins and bases in

DNA, machines to synthesize short proteins and

stretches of DNA with specified sequence. Some

of these instruments edge over $100,000 in price.

The percent of total Federal funding going to

equipment has remained relatively stable over the

past decade, indeed dropping somewhat from 6.2

percent in 1979 to 5.6 percent in 1988 (481).

Within this stable base, however, there has been

a shift from centrifuges and tissue culture needs

to instruments that synthesize or sequence protein

and DNA. Requests for preparative equipment,

including centrifuges, dropped from 33 percent of

requests in 1984 to 25 percent in 1988, while

sequences and synthesizers increased from 11 to

14 percent (480).

Those surveyed by the Office of Technology

Assessment agreed that the need for instruments

had increased dramatically, and many offered the

example of multimillion dollar investments in

crystallography and computers as examples. These

not only involve investments in instruments but

also entail sustained commitments to specialized

personnel to run the machines and cadres of

support personnel to develop software and to

analyze the data. Supercomputers are used and in

the process of QSAR to analyze all the data

emanating from protein structure studies. Virtually every firm has invested heavily in computers

with sophisticated graphics displays for structural

chemistry studies. Computer networks maintain

and analyze the massive amounts of data flowing

out of clinical studies. Many firms lease time on

supercomputers. At least one drug company has

purchased one outright, representing a several

million dollar hardware investment, and has spent

millions each year in personnel, software, operating, and maintenance costs.

IMPLICATIONS FOR FUTURE

PHARMACEUTICAL R&D COST

~ Knowledge Better Specifies Targets for

Drug Design, but Multiplies the Number

The large public investment in biomedical

research since World War II has amply demonstrated how investment in research can translate

to knowledge about disease and normal biology.
Chapter 5-Trends in Science, Technology and Drug Discovery! 133

The mushrooming mass of medical facts has two

major impacts on pharmaceutical R&D. Refined

models of disease mechanism offer new insights

into lines of research that might produce a new

drug. Work can concentrate on the molecules that

form the links in a causal chain leading to disease.

Just as the targets become more precise, however,

they proliferate in number.

Drugs to treat heart disease, for example, were

until recent decades restricted to a few drugs that

strengthened cardiac contraction (such as digitalis), sped heart rate (epinephrine), or constricted

or relaxed small arteries (vasodilators and vasoconstrictors). These agents still exist, but drugs

that modulate the flow of ions through cell

membranes have been added to the list, including

agents for calcium channels, potassium channels,

sodium channels, and chloride channels. A wealth

of drugs inhibit or stimulate cardiac muscle

receptors selectively. Understanding diverse mechanisms that influence the contraction of heart

muscle and blood vessels has uncovered a plethora of new drug receptor targets.

In general, each project undertaken now is far

more precise and the mechanisms are better

understood individually, but there are far too

many avenues to pursue. This is perhaps the most

significant change in drug discovery research

over the past decade, and the trend is likely to

continue.

1 Uncovering Disease Subtypes May

Make Clinical Testing More Precise

As illustrated in box 5-E (on Alzheimer’s

disease) genetics may prove useful in identifying

groups of patients more likely to respond to a

given agent. If so, the process of demonstrating a

drug’s effect would be simplified and the drug

approval process expedited. Refinements of drug

receptor studies will frequently uncover tests for

function that are more precise, capable of improving screening tests used to identifying promising

chemical compounds for physiological effects.

Narrowing the population that needs to be clinically assessed could dramatically cut costs of

clinical trials.

The flip side of this coin is that tests of efficacy

and safety could continue to proliferate. The

number of tests that regulators could wish to see

performed may increase to provide better evidence of safety and efficacy. If more population

subtyping leads to an increased demand for

studies of more refined groups that could not be

distinguished before, then costs could go up

rather than down. Here again, scientific advance

is a two-edged sword. Each experiment or trial

can be more precise, but the number and cost of

experiments may go up as well. It is difficult to

predict which effect will be greater.

9 Automation and Advances in

Analytical Methods Can Make Research

More Powerful

Some technologies clearly make essential steps

faster and cheaper. The polymerase chain reaction

(PCR) described above is a good case in point.

PCR will have direct applications for diagnosis,

and it also shortens or eliminates many steps in

DNA research. This is a technology that clearly

saves costs. The growing power of computers

similarly makes old procedures practical for a

much broader range of experiments. Dropping

computer costs and improved instruments have

enabled several drug firms to invest in facilities to

do their own x-ray crystallography and high-field

NMR analysis of proteins, for example.

fl Will New Technologies Speed the

Discovery of New Drugs?

The new technologies of biomedical research

clearly presage the development of new drugs.

Whether the new approaches to drug discovery

increase or reduce R&D costs depends in large

part on whether the drug development cycle is

shorter or longer as a result of the new technologies. A large fraction of the cost of any researchintensive enterprise, and especially drug development, is the cost of capital (see chapter 3). A

dollar invested in drug discovery cannot be

invested elsewhere, and its return can be known

only many years later. The length of time from
134 I Pharmaceutical R&D: Costs, Risks and Rewards

first investment to payback is a critical variable,

since the costs compound each year.

Developing new therapeutic drugs will likely

become more difficult over time, as the easiest to

discover give way to more and more difficult

tasks. Unless the new technologies expedite drug

discovery sufficiently to compensate for the

increasing difficulty of finding new agents, costs

will rise. Most of the new investments in molecular biology appear to have been added to the

‘‘Iiont end’ of drug discovery, and thus represent

an increased investment at the earliest stages of

research, where the time-cost of capital is greatest.

As drugs move from discovery to clinical

testing, the new technologies may make it easier

to demonstrate efficacy. If the number of safety an

efficacy tests increases at the same time, however,

or if the testing process becomes slower, then

costs will again rise. The critical factor is again

how long trials take, how many new ones are

added as a result of new technologies, how much

the testing costs, and the duration of regulatory

review. Molecular biology clearly promises to

dramatically expand the repertoire of drug therapy in the coming decades. The prospects for cost

reduction or cost escalation, however, are extremely difficult to gauge. Faster and cheaper

methods may be offset by longer product development cycles and a need for more and better

clinical trials.
T

Government Regulation and

Pharmaceutical R&D 6

he pharmaceutical industry is one of the most highly

regulated industries. Virtually all countries have established schemes to require the registration of products

before they are offered for sale. The information

companies are called upon to produce and registration mechanisms vary widely, but some form of evidence that the drug is

safe, effective, of good quality, and suitable for the national

market is typically required (302). The production of this

information and the time required for regulatory authorities to

review it contribute to the cost of bringing a new drug to market.

What are the origins of pharmaceutical regulation? Societal

concern over the quality, safety, and value of medicinal therapies

is not a new phenomenon. Documents dating to the Middle Ages

contain the first recorded evidence of an organized community

system to protect people from unsafe or adulterated medicines.

The earliest systems focused on the local apothecary, the person

who, throughout most of history, was responsible for the

preparation of medicinal therapies. With the advent of commercial production and large-scale promotion of medicinal products

during the 17th century, the focus of government interventions

shifted to the control of quackery and fraud (1 14).

The next major change came roughly three centuries later as

governments slowly began to recognize the value of premarket

clearance programs. The early years of the 20th century produced

a rapid expansion in the number of synthetic drugs available.

Many of these products represented real and significant therapeutic advances, but many did not. Many posed a serious risk to the

health of those who used them. Lacking the means to effectively

police a large and rapidly growing market, governments set about

to establish the administrative mechanisms necessary to identify

unsafe or poor quality products prior to their being offered for

sale.

135
136 I Pharmaceutical R&D: Costs, Risks and Rewards

Government concern over the effectiveness of

pharmaceutical products is a relatively recent

phenomenon. The emergence of clinical pharmacology as a scientific discipline, along with the

growing acceptance of controlled clinical trials,

provided the tools necessary for governments to

include proof of efficacy as a criterion for market

approval decisions. In the United States, the

Kefauver-Harris Amendments (Public Law 87-

781) to the Federal Food, Drug, and Cosmetic

(FD&C) Act (21 U.S.C. 301 et seq.) were passed

in 1962. By the end of the 1970s most industrialized countries had added an effectiveness standard to their regulatory requirements for new

pharmaceutical products (1 14).

In the United States, numerous laws and

regulations at both the State and Federal level

control the products of the pharmaceutical industry. But, within the patchwork of programs and

policies, the FD&C Act has the greatest influence

over the drug research and development (R&D)

process. The agency responsible for implementing this body of law and. regulation, the U.S. Food

and Drug Administration (FDA), has slowly

grown in importance since its inception in 1938.

Every time Congress has amended the FD&C

Act, the agency’s control over the manner in

which pharmaceutical products are developed

and used has increased.

This chapter describes how compliance with

Federal regulation has affected the cost of bringing a new drug to market. The first section

provides a brief overview of studies on the impact

of pharmaceutical regulation in the United States

on the production of new drugs and the cost of

development. The second describes the drug

R&D process from point at which a firm has

identified a potential drug compound. The third

section describes the regulatory review process.

The fourth section describes FDA’s recent efforts

to improve the quality and timing of the review

process. The fifth section reviews recent trends in

rates of success and the timing of new drug

development, and the last section briefly reviews

recent trends in pharmaceutical regulation in

Europe and Japan.

THE IMPACT OF PHARMACEUTICAL

REGULATION ON R&D COSTS AND

OUTPUT

Since the enactment of the 1962 amendments

to the FD&C Act, researchers have studied the

extent to which the regulation stifles, delays, or

raises the cost of innovation in the pharmaceutical

market. Many of these studies examined the

impact of the 1962 event itself on the amount of

time required for new drugs to receive approval,

the cost of drug R&D, the rate of pharmaceutical

innovation, and the level of competition among

drug firms.

In the earliest estimate of the impact of the

1962 law on pharmaceutical R&D, Baily found

that the law added significantly to the cost of

bringing new drugs to market (32). Peltzman

(315) used data on new drug introductions, prices,

and quantities dispensed before 1962 to estimate

what the demand for pharmaceuticals would have

been in the absence of the 1962 law. By comparing these data with actual data on the post-1962

period, he concluded that the new regulation

resulted in 50 percent fewer new drug introductions each year, increases in old drug prices, a

doubling of the cost of bringing new drugs to

market, but no decrease in ‘‘waste’ on drugs that

were not effective. In total, he estimated that the

1962 law was equivalent to a $300 million

per-year tax on the users of pharmaceuticals.

Grabowski and colleagues (162) noted that

Peltzman did not control for independent factors

that may have affected the introduction of new

1 Pharmacology is “the science of detection and measurement of the effects of drugs or other chemicals on biological systems (264).

2 The terms ‘‘new chemical entity’ (NCE) and “new molecular entity’ (NME) both refer to new drugs, although their precise definitions

are somewhat different. DiMasi and colleagues defiie NCE as “a new molecular compound not previously tested in humans” (109). NME

is a term used by the FDA that unlike NCE, includes some diagnostic agents and excludes thempeutic biological (109,474). In keeping with

DiMasi’s deftition, this report uses the term NCE to refer to both therapeutic drugs and biological. OTA uses the term NME only when

discussing work that speciilcally employs FDA’s definition of that term.
Chapter 6–Government Regulation and Pharmaceutical R&D I 137

chemical entities (NCES)

2 after 1962, such as

depletion of research opportunities, industry and

physician restraint in the wake of the thalidomide

disaster, or improvements in the science of safety

testing. They compared the pre- and post-1962

NCE introductions in the United States and the

United Kingdom, which did not have an efficacy

standard in 1962. The United Kingdom had a

threefold decrease in annual drug introductions

between 1960-61 and 1966-70 compared with a

sixfold decrease in the United States. Hence, they

attributed about one-half of the U.S. decrease to

the 1962 changes. They also suggested the 1962

law at least doubled the R&D costs of an NCE

(162).

Wiggins (519) measured the longer-term effects of the 1962 amendments on the number of

new drugs introduced to the U.S. market. He

concluded that the 1962 law was associated with

about 60 percent fewer new product introductions—

but not until the 1970s—both directly as a result

of the new regulatory requirements and indirectly

as a result of company decisions not to proceed

with R&D projects expected to be unprofitable.

Other researchers examined FDA regulation

more broadly. In 1981, the Pharmaceutical Manufacturers Association (PMA) and nine of its

member firms documented the costs associated

with U.S. regulation by commissioning three

studies, two of which were loosely related. Arthur

Anderson and Company estimated the incremental financial and labor costs of complying

with a series of FDA regulations that the PMA

and its member firms labeled as ‘‘unnecessary”

(20). These regulations cost the nine firms $117

million in 1978, including 1,600 person-hours of

labor and 1 million pages of paperwork. Hansen

estimated that these particular regulations were

further associated with a 20 to 30 percent

reduction in R&D productivity, or three to five

fewer new drug introductions each year (177).

The third PMA-sponsored study, by Eisman

and Wardell, compared the nine PMA-member

companies’ drug introductions in the United

States with their introduction in other countries

with ‘‘comparable regulatory standards. ” They

concluded that, on average, FDA regulation is

associated with a 14-month delay in the introduction of new products with no evidence of greater

safety or effectiveness (1 18).

Parker (307), however, came to a different set

of conclusions. He studied the impact of regulation in 18 countries (including the United States)

on the length of time between first and subsequent

marketing application and introduction of 192

drugs in those countries. He found intercountry

delays in product introductions decreased between 1954 and 1978 and countries with tougher

regulation were not associated with longer lags in

product introductions. However, the time between first and subsequent market applications

increased over time. Because countries with

tougher regulations tend to have larger markets,

companies may take extra care in preparing those

applications, thus accounting for the lack of a lag

in ultimate introductions but more delay in filing

applications (307).

Other authors examined the effect of regulation

on competition in the pharmaceutical industry.

Temin (420) studied the development of the

industry in the 1950s and 1960s. Noting increased

regulation usually acts as a‘ ‘barrier to entry’ for

new fins, he argued that regulation in the drug

industry should result in fewer larger firms with

higher profits. Finding substantial growth in firm

size but little consolidation or increased profitability over the period, Temin concluded that a

variety of factors, especially technological opportunity and imperfect patent protection within

particular classes of drugs, help explain the

structure and performance of this industry.

In a 1990 study comparing the United States

with the United Kingdom, Thomas concluded

that additions to regulation between 1960 and

1980 (including the 1962 law) reduced innovation

in small U.S. firms, but innovation in the larger

U.S. firms largely mirrored that among U.K.

fins. In addition, sales of NCEs introduced by

large U.S. firms increased substantially while

those of NCEs from all other U.S. and U.K.

companies increased little or not at all. Thomas
138 I Pharmaceutical R&D: Costs, Risks and Rewards

concluded regulation tended to reduce competition in the pharmaceutical industry (422).

Dranove and Meltzer (112) recently found that

among all NCEs approved in the United States

between 1950 and 1986, those of greater therapeutic importance (as measured by a variety of

scientific and market-based indicators) progressed

from first worldwide patent to U.S. approval more

quickly than other drugs. (This finding is consistent with Office of Technology Assessment’s

(OTA) conclusion that higher U.S. sales revenues

are associated with longer effective patient lives

(see chapter 4)). They also found that almost all

of the increase in the speed of drug development

occurred prior to filing a marketing application.

They concluded the acceleration in the speed of

development was probably due to efforts of the

firms rather than to efforts of the FDA to expedite

review of important drugs.

One limitation of this conclusion is that the

authors attribute to the FDA full responsibility for

the length of time from submission of a marketing

application until approval. In reality, the length of

time necessary to review a marketing application

may reflect the firm’s earlier research efforts, its

business decisions regarding when in the clinical

research period to file an application to market the

drug, the quality of its application, and the speed

with which a firm responds to queries from the

FDA as much as it reflects the FDA’s own delays

in reviewing applications.

Taken together, this literature indicates that

increases in regulatory requirements and stringency increase the cost and time necessary to

bring a new drug to market. However, because it

is difficult to sort out effects of regulation from

other factors that could affect drug R&D, the

extent of such increases remains unclear. Also,

most of the work to-date has focused on the

impact of the 1962 amendments; little attention

had been paid to more recent management and

regulatory changes at the FDA. For example,

recent attempts to identify and expedite the

review of new drugs deemed therapeutically

important may reduce the cost of developing

some drugs but increase the cost of R&D on

others. Increases in the variation in FDA review

time for new drugs would lead to greater uncertainty and risk for drug sponsors.

THE U.S. REGULATORY REVIEW

PROCESS FOR NEW DRUGS

Once a company identifies a compound or

molecule with pharmaceutical potential, it enters

a highly structured period of scientific inquiry

that, if the agent is of value, culminates in the

market launch of a new pharmaceutical product.

Federal regulatory requirements act as a major

organizing framework for these research activities, since they define a series of hurdles that

companies must clear in order to gain access to

the marketplace.

Because each pharmaceutical agent is different, there is much variation and uncertainty in the

amount of data required to obtain FDA approval

to begin clinical trials or to market new drugs

(275). The company must wait until the FDA

begins to review an application to find out if it

offered enough information. Filing with too little

information available about a drug may ultimately lead to a longer R&D process as the FDA

tries to interpret the inadequate application and

ultimately requests additional data.

On the other hand, some companies may

collect more data than the FDA would require

either because they are overly cautious or because

the firm needs the data for other reasons (e.g.,

approval in another country or to market the drug

more effectively) such firms spend money to

pursue research questions not germane to the

regulatory review process. Thus, the costs of

clinical research in the regulatory phase cannot be

attributed in its entirely to regulations.

Regardless of a company’s decision about

when to approach the FDA for authority to test a

drug in humans or to market it, responsibility for

reviewing the relevant documentation falls to one

of two organizational units within the FDA: the

Center for Drug Evaluation and Research (CDER)

and the Center for Biologics Evaluation and

Research (CBER).
..-. ——. .

Chapter 6–Government Regulation and Pharmaceutical R&D I 139

1 Center for Drug Evaluation and

Research

CDER is responsible for the premarket review

and approval of all chemical pharmaceuticals,

antibiotics, generic and over-the-counter drugs

sold in the United States, as well as most

hormones and enzymes. Once a drug is approved

for marketing, the Center monitors companies to

ensure their marketing claims comply with the

drug’s approved labeling, to guarantee the quality

of manufactured drugs and to identify medications with unforeseen adverse reactions (471).

The work of CDER is divided among seven

offices. The bulk of the work relating to the

premarket review and approval of new drug

products is carried out by two offices (Drug

Evaluation I and Drug Evaluation II), each of

which is divided into several review divisions

with responsibility for different therapeutic classes.

Although the other offices within CDER focus

largely on the agency’s post-approval regulatory

responsibilities, several provide support for specific elements of the premarket review process as

well as the statistical and manufacturing sections

of a drug sponsor’s application.

1 Center for Biologics Evaluation and

Research

CBER is responsible for regulating ‘‘any virus,

therapeutic serum, toxin, antitoxin, vaccine, allergenic product, or analogous product applicable to

the prevention, treatment, or cure of disease or

injuries of man, ’ as well as blood, products

derived from blood, and diagnostic reagents that

use biotechnology-derived products.3 In addition

to monitoring the marketing and safety of approved products, CBER maintains closer surveillance of manufacturing processes for biological

than does CDER for drugs, requiring manufacturers to provide detailed documentation of production processes and regular samples of products

that CBER can compare with reference standards

kept at the FDA (40).

CBER has three offices: the Office of Compliance, the Office of Biological Product Review,

and the Office of Biologics Research. The Office

of Biological Product Review oversees the review

of all applications to test investigational products

in humans and to market new products, but staff

in all three offices actually conduct the reviews.

1 Regulatory Review of Investigational

New Drugs

To conduct clinical research on a drug (that is,

to test the drug in humans), a sponsor must file an

Investigational New Drug (IND) application with

the FDA.4 Federal law has required firms to file

an IND application since 1962 (Public Law

87-781). Prior to 1962, sponsors could begin

clinical investigations whenever they felt ready to

do so, as long as they clearly labeled their new

drug as an investigational product and limited its

availability to qualified researchers who in turn

guaranteed that they would use the drug solely for

investigational purposes. Sponsors frequently submit more than one IND for the same investigational product if they hope to market more than

one dosage form of the drug or claim the drug has

more than one therapeutic benefit.

The IND process serves three purposes. First,

it provides the Federal Government the opportunity to identify and bar from human use any

investigational product that poses an undue risk.

Second, the IND provides a mechanism for

monitoring the actions of clinical investigators to

ensure they protect the rights, safety, and welfare

of individuals participating in any clinical investi3 The CBER broadly defines a biotechnology-derived product as any product derived from a living source (h- animal, plant, or

microorganism), made up of a complex mixture of proteins that are not easily identified or characterized; sensitive to heat, and susceptible to

microbial contamination (40).

4 In addition to commercial firms, individual researchers (such as those in academia) as well as noncommercial groups may seek and receive

investigatioti new drug status to test investigational drugs in h umans. Commercial and noncommercial INDs foUow the same requirements

and procedures outlined here.
140 I Pharmaceutical R&D: Costs, Risks and Rewards

gation involving the new product.5 Third, the IND

allows regulators to examine each clinical study

a company plans to conduct and determine

whether it is likely to produce the scientific and

statistical information necessary to demonstrate

the safety and effectiveness of the product when

used as intended (21 C.F.R. 312.22). This review

provides companies with an opportunity to revise

their clinical research plans before spending

money and time on inappropriate or inadequate

trials, and it helps the FDA avoid tying up its staff

with a flawed market approval application while

products with strong scientific evidence await

consideration.

CONTENT OF AN IND APPLICATION

An IND application contains the drug sponsor’s clinical research plans, details of manufacturing processes, and the results of laboratory and

animal tests to-date. The ‘‘clinical section”

contains a detailed description of the initially

planned clinical trials and a general overview of

the studies that will follow; the “manufacturing

section” describes the facilities, equipment, and

techniques the sponsor will use to produce the

drug (21 C.F.R. 312.23 (A)(7)). The “manufacturing section’ of the IND for biological products

is more important than for drugs, because biologicals tend to be molecularly more complex and

more difficult to produce in quantity than are

synthetic chemicals (40,399).

Although the laboratory and animal data the

FDA requires in the IND varies, the R&D

necessary to begin human clinical testing falls

into

●

●

four general categories (152,424):

Laboratory tests to determine how the molecule reacts physiologically (in isolation

from the rest of a human or animal) with the

target disease or affected organ systems;

Pharmacological animal tests using rodents

to document what happens once the drug

enters the body;

●

●

Acute toxicological animal tests to determine the highest doses that two species of

animals (including one nonrodent) can receive without risking overt toxic reactions

and death; and

Subacute and subchronic toxicological animal tests to determine whether repeated

exposure to the drug changes any toxic

effects discovered in the acute tests.

For toxicological tests requiring nonrodents, researchers choose species in which the organ

systems of interest closely resemble those of

humans. While the number of animals required

also varies with each drug according to statistical

principles (516a), table 6-1 shows the usual

number for each type of toxicological test.

For biological, product integrity may be

influenced by changes in temperature, equipment,

handling, and other factors, so CBER encourages

sponsors to produce the product for clinical

testing in the same facility in which it will be

manufactured once marketed. When this is not

possible, the sponsor must validate the process

and product following a physical change (40).

Hence, the IND process for biological may, in

essence, include approval of the manufacturing

facility (43).

Once an IND goes into effect, drug sponsors

must inform the FDA of modifications in clinical

protocols, the drug’s composition, or the processes used to produce it. The sponsor must submit

new safety information to the FDA in a timely

fashion, with data on serious adverse events sent

to the agency immediately. Other information

required of IND recipients by the FDA include the

protocols for clinical trials not included in the

original application, notification of the end of

each phase of clinical research and of its key

findings, and an annual progress report (21 C.F.R.

sec. 312.22). An IND remains in effect until one

of four events occurs: 1) the sponsor notifies the

FDA it is no longer conducting clinical research

s Institutional Review Boards (IRBs) in each institution participating in a clinical trial must review and approve the study before it begins.

Investigators must fully inform study participants about the purpose and nature of the researc~ the risks involved, the availability of alternative

therapies, and their right to refuse to participate or withdraw from the study at any time.
Chapter 6–Government Regulation and Pharmaceutical R&D ! 141

Table 6-l—Toxicological Tests Used in the U.S. Regulatory Process

Type Species Number used Measured outcome

Acute toxicity

Subacute toxicity

Subchronic toxicity

Reproductive toxicity

Segment I

Segment II

(teratology)

Segment Ill

Cancer bioassay

Mutagenicity

Dominant lethal

Rats

Dogs

50 per sex

10 per sex

Death

Morbidity

50 per sex Morbidity, histopathology, blood

chemistry, body weight, organ

weights, hematology

Rats

Rats

Dogs

Monkeys

100 per sex

20 per sex

12 per sex

Same as subacute

Same as rats

Same as dogs

Rats

Rabbits

50 per sex

50 per sex

Fertility and reproductive

Performance

Rats

Rabbits

50 per sex

50 per sex

Malformed

offspring

Rats

Rabbits

50 per sex

50 per sex

Growth of

offspring

Mice

Rats

250 per sex

250 per sex

Tumors

Tumors

Rats 40 males Dead implants

(embryos)

SOURCE: G. flamm, “Recent Trends in the Use of Animals in the Pharmaceutical Industry,” mntract report prepared

for the Office of Technology Assessment, 1991.

using the drug; 2) the FDA approves the drug for

marketing in the United States; 3) the FDA finds

the sponsor has violated regulations governing

investigational products; or 4) the FDA finds the

product is unsafe for human use.6

FDA REVIEW OF IND APPLICATIONS

A company may begin clinical testing 30 days

after the FDA receives the IND application,

unless the firm receives notification from CDER

orCBERofa‘‘clinical hold’ (21 C.F.R. 312.40).

The FDA imposes clinical holds if the drug or trial

design poses a significant health risk to participants, the clinical investigators named in the IND

are not qualified to conduct the trials, the information the sponsor plans to provide to investigators

conducting the trials is inadequate, the sponsor’s

research plan is not scientifically sound or would

not meet the sponsor’s stated research objectives,7 or the IND application lacks sufficient

information for the FDA to evaluate the study’s

risks to participants. CDER and CBER also use

clinical holds to suspend ongoing clinical trials if

new evidence suggests unforeseen risks to study

participants or if the trials are not being conducted

in accordance with Federal regulation (21 C.F.R.

312.42).8

To help it prioritize its work, CDER rates each

drug for which an IND is received according to

the drug’s novelty and the agency’s subjective

judgment of the drug’s therapeutic potential. Box

6-A describes these ratings schemes, which have

recently changed.

6 ~~~i~, ~w~rding t.~A~~f, ~omp~ti often do not fo~~ly inform the ~A of their decisio~ to end clinical research on an ~.

The agency only learns of the company’s decision upon pursuing tardy annual reports on the drug (269).

7 This provision applies only to Phase II and Phase III studies.

8 The FDA maintains administrative mechanisms for a sponsor to appeal a reviewer’s decision to impose a clinical hold with which the

sponsor disagrees.
142 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 6-A-The Center for Drug Evaluation and Research’s

Classification of New Drugs

Between 1975 and 1992, the FDA assigned two ratings to each investigational new drug (IND) and new

drug application (NDA) to determine the drug’s place in the queue of applications to be reviewed. The

agency introduced this system to identify and expedite the review of important new drugs. The first rating,

which FDA continues to assign to INDs and NDAs, identities the newness of the entity according to one

of seven possible categories:l

Type 1: New Molecular Entity

The active moiety has not been previously marketed in the United States for use in a drug product, either

as a single ingredient or as part of a combination product.

Type 2: New Ester, New Salt, or Other Derivative

The active moiety has been previously marketed in the United States, but this particular ester, salt, or

other derivate has not been marketed, either as a single ingredient or as part of a combination product.

Type 3: New Formulation

The drug is marketed in the United States by the same or another manufacturer, but this particular

dosage form or formulation has not.

Type 4: New Combination

The product contains two or more compounds which have not been previously marketed together in

a drug product in the United States by any manufacturer.

Type 5: Already Marketed Product--Different Firm

The product duplicates a drug product already marketed in the United States by another firm.

Type 6: Already Marketed Product--Same Firm

A new use for a drug product already marketed in the United States by the same firm.

Type 7: Already Marketed Product, Without an Approved NDA

The product has received the first approved NDA for a drug product which has or is being marketed

without an approved NDA.

The second rating, identified with letters, indicates the FDA’s best guess of the drug’s therapeutic

potential. Since January 1992, the FDA has used a rating scheme consisting of only two categories:

“P” or “priority” for the most important drugs, and

“S” or “standard” for all other drugs.

Between 1975 and 1992, the FDA used a five-category rating scheme of therapeutic importance:

Type AA: Acquired Immune Deficiency Syndrome (AIDS) Designation

Drug is for the treatment of AIDS or AIDS related disease.

Type A: Important Therapeutic Gain

The drug is an effective treatment for a disease not adequately treated by any marketed drug, or

represents a therapeutic advance over existing treatments for the target illness because it is more

effective or safer.

1 fi=e categories are not mutually exclusive. A new formulation ~ 3) or a new combination ~A) @@t *cona new molecular entity (T’@ 1) or a new salt me 2). In such cases, both numks would be included in the classifkation.
—

Chapter 6–Government Regulation and Pharmaceutical R&D I 143

Type B: Modest Therapeutic Gain

The drug offers a modest, but real, advantage over other drugs currently available to treat the same

disease or condition. (FDA gave a drug a “B” rating if it expected the drug to improve patient

compliance, eliminate annoying but not dangerous adverse reactions, reduce the cost of therapy, or be

useful in the treatment of a specific subpopulation of those with the target disease, such as individuals

who are allergic to currently available drugs.)

Type C: Little or No Therapeutic Gain

The drug essentially duplicates in medical importance and therapeutic usage one or more drugs already

marketed in the United States.

Type V: Designated Orphan Drugs

The sponsor of the drug has officially requested and received orphan designation under the Orphan

Drug Act (Public Law 97414).2

Although made available publicly at the time of NDA approval, the subjective judgment of a drug’s

future therapeutic potential implicit in this earlier rating scheme had limitations when used for purposes

other than the prioritization of the FDA’s workload. First, ratings for investigational drugs could changeover

the course of their development. Because the FDA sometimes made early ratings on the basis of little or

incorrect information, the agency often changed the drug’s rating as it received subsequent research results.

The FDA also lowered a drug initially rated as an “A” if another drug for the same indication received

approval first or was shown to be safer or more effective.

Second, the FDA tended to be conservative in its allocation of “A’ designations, reserving it for drugs

that represented a major therapeutic advance, embodied an exciting pharmacologic concept that served as

a prototype for still greater therapeutic advances, and those that offered a unique delivery system. Because

of this conservative approach and the limited data available to the FDA, drugs that represented a real

improvement over existing therapies could have received a “B’ or “C’ designation.

And finally, the agency based its final rating at the time of NDA approval on limited use of the drug

during clinical trials, other investigational use, and any foreign use of the drug. Hence, drugs released to the

market with a ‘‘1B’ or ‘‘ 1C’ designation might later have been found to be clinically much more valuable

or more widely used than the agency’s final rating would indicate. Despite these limitations, however, these

ratings represented the only available measure of a drug’s therapeutic importance and were often used in

research trying to understand the effects of drug regulation in the United States between 1975 and 1992.3

2 “A,” “B,” and “C” are mutually exclusive designations. Only one of these letters maybe used to class@ a drug. The other

designations are not mutually exclusive. For example, an orphan drug maybe classified as “1 B-V. ”

3 See, for ex~ple, Wiggins (1981) and several analyses done by OTA and presenttxl later in tis chpter.

SOURCE: OffIce of Twlmology Assessment, 1993, based on F-D-C Reports: HeaM News Daily, “FDA changes Rating System for

Drugs,” F-D-C Reports: Health News Daily, p. 3, Jan. 7, 1991. M. Finkel, “The FDA’s Classii3cation System for New

Drugs: An Evaluation of Therapeutic Ga@” New England Journal of Medicine 302(3): 181-183, 1980.

H Regulatory Review of new drug application (NDA) and win approval of

New Product Applications the FDA to market the drug in the United States.

Once a drug sponsor gains permission to test an In addition to beginning the human clinical trials

investigational drug in humans, it begins its authorized by the IND, the sponsor also compiles

clinical research. The principal goal of the re- laboratory data about a drug’s chemical propersearch it to obtain evidence sufficient to submit a ties, descriptions of the facilities and methods the
144 I Pharmaceutical R&D: Costs, Risks and Rewards

sponsor will use to produce, package, and distribute the drug, and evidence from additional animal

tests. 9

CLINICAL RESEARCH NECESSARY FOR

NEW PRODUCT APPROVAL

Although drugs that enter testing in humans

have all exhibited some potential as safe and

effective therapies, there is a high chance of

failure at some point in the clinical research

period. Some drugs prove to be of limited or no

clinical use, while others drop out because they

are too poorly tolerated by patients. The FDA

requires clinical trials be conducted according to

formal protocols that the drug sponsor submits as

part of the IND application. Pharmaceutical

researchers commonly distinguish among three

largely sequential phases of clinical trials necessary

●

●

●

for regulatory approval:

Phase I studies are small trials usually

involving only healthy volunteers to map

how the body absorbs and eliminates the

drugs and to document the response it

produces.

Phase II studies test the drug’s therapeutic

effectiveness and note any adverse reactions

in individuals affected by the target disease

or condition.

Phase III studies assess the drug’s medical

benefits and risks among a large number of

patients under conditions of ordinary use.

They often take more than 1 year.

Size of Clinical Trials--The number of people

exposed to a drug during each phase varies

widely. In interviews with OTA staff, pharmaceutical industry managers repeatedly emphasized

the resource intensity of clinical trials and

claimed regulatory demands have increased the

size of clinical trials. OTA surveyed pharmaceutical firms that sponsored drugs approved for

marketing by the FDA in two periods (1978-83

Photo wed: U.S. FOOD AND DRUG ADMINISTRATION

Drug sponsors submit to the FDA new drug applications to

market new drugs. An NDA may contain many volumes of

data. FDA staff review this complex array of data to make a

recommendation for marketing approval.

and 1986-90) in three therapeutic classes: antihy -

pertensives, antimicrobial, and nonsteroidial antiinfl ammatory drugs (NSAIDs). For each drug, we

obtained data from companies on the size and

location of clinical trials conducted prior to FDA

approval. Within each class of drug, we compared

the size of trials in the earlier period with the size

of those in the later period. Appendix H provides

greater detail about the methods of this survey.

Table 6-2 summarizes the results.

We found substantial increases between the

early and later period in the number of clinical

trial participants and number of studies per drug

conducted to support the drug’s first NDA. This

g Animal tests conducted concurrent with human trials usually include chronic toxicity tests designed to identify the drug’s impact on living

tissue when administered repeatedly for anywhere from 6 months to the lifetime of the animal; tests to determine whether the drug adversely

affects the reproductive process over two successive generations of anirn als, whether it causes cancer, and whether it produces genetic changes

that trigger tumors, other illness, and congenital deformities in offspring; and, for some drugs, tests to determine whether the intended dose

form or route of administration causes any toxic effects.
Chapter 6-Government Regulation and Pharmaceutical R&D ! 145

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146 I Pharmaceutical R&D: Costs, Risks and Rewards

difference existed across all three therapeutic

classes, although the magnitude of the differences

was usually greater for NSAIDs than for the other

two categories. The most dramatic increases

occurred in clinical trials conducted outside the

United States and in trials completed after the

sponsor first submitted its NDA.

The apparent trend. toward more and larger

clinical trails could reflect both industrial business strategies and regulatory expectations.10 The

available data provide only a limited ability to

distinguish among the potential explanations.

One potential explanation, for the increase

often cited by industry managers in interviews

with OTA staff, is that regulatory authorities have

come to expect larger trials (i.e., greater statistical

confidence in the results) or just more types of

studies to support the marketing of new drugs in

the United States. New guidelines for drug

sponsors that the FDA adopted during the latter

period could have led to a growth in studies by

recommending sponsors study drugs’ effects in

special populations or potential interactions with

foods or other drugs (48,499).

There are other possible explanations as well.

First, the data are consistent with an increasingly

global marketplace for pharmaceuticals. If firms

have over time tried to market new drugs in more

countries, one would expect to see an increase in

the number of foreign trials, because foreign

governments often expect marketing applications

will be supported at least partly by clinical

research conducted in their countries.

Furthermore, rewritten FDA regulations that

went into effect in 1987 strongly emphasized the

importance of worldwide safety data in the initial

U.S. NDA and made it clear that an NDA could

be based solely on foreign data (48). In addition,

the FDA requires firms to file all clinical research

data on a drug related to its safety, regardless of

where the research was conducted or whether or

not it was completed before the firm filed its NDA

in the United States. The increase in clinical trial

data provided to the FDA after the filing of the

initial NDA could also reflect an increased

tendency on the part of sponsors to file an NDA

as early as possible.

Another possibility is that the later clinical

trials were designed to support applications for

indications other than those contained in the

initial NDA. Even though the firm would file data

on the efficacy of the drug for the additional

indications in subsequent NDAs, the FDA would

still expect the sponsor to file safety data from all

completed trials for consideration of the first

NDA. This explanation is consistent with the

observation that in two of the therapeutic classes

examined, the average number of indications

contained in the initial NDA declined over time.

In an effort to market the drug as early as possible,

sponsors may be reducing the number of uses for

which it seeks initial FDA approval.

Finally, it is possible that the work completed

after the filing of the initial NDA reflects trials

conducted to ‘‘seed the market’ for the drug once

it is approved by the FDA. ‘‘Seeding the market’

means that the drug’s sponsor attempts to enlist a

large number of physicians into trial participation

to acquaint them with the drug and its potential

indications for use. Although such work may

legitimately add to knowledge about the drug’s

safety and efficacy, its primary purpose may be to

make physicians, especially those influential in

specialties likely to prescribe the medication,

familiar with its expected availability and therapeutic potential. Again, such data would appear in

OTA’s survey results as supporting the initial

NDA because the FDA requires the sponsor to

supply it with all available safety data.

10 we om c~ot mle ollt tie ~tenti~ presence of some measurement error in these data reflecting different interpretations by diffant

companies of the deftition of a clinical trial supporting their U.S. marketing applications, there is no reason to believe that such error could

explain the observed increases between the two periods; any such measurement error should be present to a similar extent in both the early and

later periods.
—

Chapter 6—Government Regulation and Pharmaceutical R&D I 147

APPLICATIONS FOR MARKETING

NEW DRUG PRODUCTS

When a drug sponsor seeks marketing approval, it files a formal application with the FDA.

Sponsors seeking to market a new chemical,

antibiotic, hormone, or enzyme drug product file

a NDA with CDER. Companies with biotechnologyderived products file two applications with CBER,

a product license application (PLA) covering the

drug, and an establishment license application

(ELA) covering the facilities manufacturing the

product.

CDER Review of NDAS--CDER has 60 days

from the date a company submits an NDA to

decide if it contains sufficient information for the

agency to conduct a substantive review. It refuses

inadequate applications. Once CDER accepts an

NDA, it logs the application into its management

tracking system and refers it to the appropriate

review division based on its intended use. This

review division has primary responsibility for the

application, but staff in other offices participate as

well.

Each reviewer summarizes his or her findings

in writing which the review division staff then

compile for the division director together with a

summary of the company’s application and the

proposed regulatory action (314). For nearly half

of all NDAs the review goes no further than the

division level. If the Division Director and review

staff disagree on the strength of the scientific

evidence and the appropriate regulatory action,

the NDA moves up one level to the Office

Director for consideration. If disagreements still

remain, the director of CDER will review the

application and proposed FDA decision (47 1).

Some divisions routinely refer some or all NDAs

to a standing advisory panel comprising outside

experts. The decision of whether to approve a

drug remains an FDA authority, however.

Once the agency reaches agreement, the review

division director sends a letter to the company

explaining its decision. The letter can either: 1)

approve the product for market, 2) declare that the

FDA would approve the drug once the company

allays lingering concerns about effectiveness or

safety (called an ‘‘approvable letter’ ‘), or 3) state

that the drug is “unapprovable.”

The sponsor must respond within 10 days to an

‘‘approvable’ or ‘‘unapprovable” letter by providing information identified by the FDA as

missing, stating its intent to provide such information at a future date, requesting a formal

hearing on the matter, or asking that the FDA

remove the application from further consideration.

If the sponsor does not respond within 10 days,

the FDA automatically withdraws the NDA (21

C.F.R. sec 314.105,314.110,314.120, and 312.125).

By law, FDA must complete its review of an

NDA within 180 days,

11 but this deadline does

not include time when the FDA is awaiting

additional information from the company (467).

Most NDAs require at least one such amendment

by the company, and a recent analysis by CDER

revealed that for the 68 NDAs for new molecular

entities submitted to the FDA in 1984 and 1985,

the sponsoring companies had filed a total of

1,141 amendments (496). Under law, each amendment allows CDER to extend its review time by

an additional 180 days to ensure the agency can

adequately consider the new information (21

C.F.R. 314.60).

Even with these extensions, however, actual

review time of some drugs exceeds the statutory

allowances (467). Data from the FDA do indicate

that the 23 NDAs for new molecular entities

approved in 1990 took an average of 30 months

to approve with a median approval time of 26

months; however, these numbers do not indicate

how many of the drugs had amendments filed to

the original NDA, thus extending the statutory

6-month approval time. Data available from the

FDA and other sources do not indicate the exact

percentage of NDAs that violate statutory allowances.

11 nc IaW measures tie start of this 6-mcmth period from the day the FDA agrees tO accept the application
148 I Pharmaceutical R&D: Costs, Risks and Rewards

In interviews and informal discussions with

company regulatory personnel and clinical researchers, OTA learned that many people involved in the process believe at least some

reviewers in CDER use the ‘‘application not

complete notice to manage workloads. These

sources claim that CDER staff can always find

some additional information is necessary, so the

agency can manipulate the starting date of its

statutory time limit. To investigate this claim is

beyond the scope of the study, but the very

existence of this rather widespread belief suggests

it is almost impossible to separate out delays in

the approval process due to companies’ inadequate applications from those due to the regulatory process.

CBER Review of PLAs and ELAs--The CBER

review process for new products places added

emphasis on the safety and quality of the processes and facilities used to produce a biological

drug.12 Also, in contrast to CDER’s NDA process, there are no statutory limits on the amount of

time CBER reviewers may take to complete their

review of PLAs and ELAs (40). As with the

CDER process, reviewers may refer the applications to a relevant FDA advisory committee

before reaching a final decision.

In contrast to CDER, CBER does not routinely

compile and publish statistical information on its

workload, output, and review times for applications to market new products, OTA attempted

unsuccessfully over the full course of this project

to obtain such data from CBER. According to

CBER staff, these statistics would be of limited

value to the Center and potentially misleading to

outside analysts because there is substantial

variation in the products it reviews and the

amount of time required for the FDA to ensure

their safety and effectiveness (40).

Other published sources do shed some light on

product approvals by CBER. According to data

.

Photo wedit: U.S. FOOD AND DRUG ADMINISTRATION

As part of the new drug approval process of biologicals, FDA

reviewers must inspect and approve the facilities to ensure

the safety and quality of the processes that will be used in

production.

recently compiled by the PMA, firms report 21

new biotechnology drugs awaiting PLA and ELA

approval with another 111 currently in clinical

trials (323).13

In a recent press account, one FDA official

noted the review of biotechnology drugs has been

relatively fast compared with synthetic chemical

drugs, with a mean review time of 21,4 months,

10 months faster than the average CDER review

time (146). However, the author also suggested

that as the number of PLAs and ELAs grows14 and

the molecular complexity of these drugs increases, CBER’s speed of review and approval

will decrease substantially, For example, monoclonal antibodies are already experiencing significant delays. CBER has not approved any new

monoclinal antibody products since 1986, and as

1 z me ELA ~cvlew includes ~pwtlon and tcs[~g of tie facility that will manufacture the tig and its component biological ‘tetids.

1 S pm ~t[emptcd t. ~WeJl all fm t~t might have biotechnology-based ~gs iII deve]oprnent, not just companies belonging to PMA.

However, they may have missed some smaller biotechnology firms with drugs in various (probably preclinical) stages of the R&D process.

l.1 A toml of 14 blotec~ololu-ba~ed ~eraWutic ~gs were approved through Oclober 1991, half of which had been approved since 1989.
Chapter 6–Government Regulation and Pharmaceutical R&D I 149

Table 6-3—U.S. Food and Drug Administration Advisory

Committees on Pharmaceuticals

Number of Number of Year

Organization unit Committee members meetings per yeara established

Center for Biologics

Evacuation and Research Allergenic Products

Biological Response

Modifiers

Blood Products

Vaccines and Related

Biological Products

Center for Drug

Evacuation and Research Anesthesia and Life

Support Drugs

Anti-infective Drugs

Antiviral Drugs

Arthritis

Cardiovascular and

Renal Drugs

Dermatologic Drugs

Drug Abuse

Endocrine and

Metabolic Drugs

Fertility and Maternal

Health Drugs

Gastrointestinal Drugs

Oncologic Drugs

Peripheral and Central

Nervous System Drugs

Psychopharmacologic

Drugs

Pulmonary-Allergy

Drugs

Radiopharmaceutical

Drugs

9 3 1984

9

11

3

4

1984

1980

11 4 1979

13

13

13

11

2

2

2

2

1978

1980

1989

1974

11

11

15

11

3

2

2

2

1970

1980

1978

1970

11

11

11

2

2

2

1965

1974

1973

11 2 1974

11 2 1974

11 2 1972

11 2 1967

a Number is approximate. Committees meet only when the Director of the relevant center calls the members together.

Some committees may not meet during the course of the year and others may meet more frequently than indicated

in the table.

SOURCE: Office of Technology Assessment, 1993.

of October 1991, 58 drugs were awaiting FDA and CDER staff on drug approval decisions (see

approval for marketing or for approval to enter table 6-3). Each committee advises a specific

various clinical testing phases (146). review group within CDER or CBER. Although

ADVISORY COMMITTEES the FDA has used outside experts since 1964, the

FDA has 19 separate panels of 9 to 15 outside number of committees has grown steadily over

the last 20 years, from 5 in 1972 to 13 in 1979, to experts each that it can convene to advise CBER
150 I Pharmaceutical R&D: Costs, Risks and Rewards

19 in 1991,15 While some review divisions refer

every NDA to an advisory committee before

making a final determination, others refer only

‘‘problem’ applications (173). Some divisions

also involve advisory committees in the review of

INDs, the surveillance of approved products, and

the development of regulatory guidelines (467).

Topics for discussion at advisory committee

meetings can run from technical questions about

study methodology, to interpretation or adequacy

of data, to potential changes in proposed labeling,

to an overall assessment of a potentially controversial drug’s net benefits (221 ,467). Committees

may recommend approval, re-analysis of the data,

further studies, or rejection of the application,

Because these committees’ reviews are purely

advisory and not mandated by law, FDA staff

need not follow their recommendations. To date,

however, they almost always have done so.

Proponents of the advisory committee system

see it as an important check on the thoroughness

and quality of FDA reviews (467). However, the

wide variation in the composition, operation, and

questions considered by the committees have

made observers of the agency skeptical that they

achieve this objective. Critics suggest that they

delay the approval of new drugs while adding

little to the review process that the FDA does not

provide on its own.

A recent study of 95 NCEs approved by the

FDA between January 1983 and December 1987

compared NDA review times for drugs subjected

to advisory committee review with those approved without such review (221). The researchers found that advisory committee review is

associated with small delay (4.5 months).16 The

delay may reflect systematic differences between

the drugs submitted to committees and those not

submitted, For example, as shown in figure 6-1,

there was substantial disparity among review

divisions in the extent of their use of advisory

committees (221). The researchers also noted on

average it took the FDA 19 months to approve an

NDA after an advisory committee recommended

such approval (22 1). The FDA has commented

that this delay reflects the need to respond to

advisory committee recommendations for additional data or revised labeling and to give senior

FDA management a last opportunity to review the

application (471).

B Post-Approval Research and

Reporting Requirements

PHASE IV STUDIES

Because proapproval testing affords only a

limited view of a drug’s benefits and risks, the

research process usually does not stop at the point

of market approval, Post-approval research can

involve both clinical trials, referred to as Phase IV

studies, and new animal toxicity studies (21

C.F.R. 310.303).

One recent analysis of post-approval studies

required by the FDA of drugs approved from 1970

through 1986 found the frequency of postapproval studies has increased significantly over

the 1980s, with only 17 percent of approved drugs

including FDA requests for post-approval research in 1983 compared with 45 percent in

1985-86 (350).

Most post-approval studies are less than a year

in length and involve relatively small numbers of

subjects. The Richard study found differences

across therapeutic classes in the frequency of

FDA requests for post-approval studies and the

number of studies requested per drug.

The purpose of post-approval research has also

changed over time. Fewer studies required in the

more recent period examined additional uses or

uses in children than did studies in the earlier

years, while the number of post-approval studies

of drug interactions has increased. Finally, the

study found no evidence that postapproval reIS me 1972 passage of tie I~~er~ Adviso~ Committee Act (Public Law 92-463), enabled the Federal government to tie use of oukide

experts more easily tban in earlier years (221).

IS me p v~ue for MS difference was .054. The actual mean for the 45 drugs submitted to advisory committees WaS 36.9 months (medi~:

34.6), while the mean for the 55 not submitted to advisory committees was 32.4 months (median: 24.5).
Chapter 6—Government Regulation and Pharmaceutical R&D I 151

Figure 6-l—Average Approval Times for NCE-NDA, by Therapeutic Category 1983-87:

Reviewed by Advisory Committee Versus Unreviewed

All drugs 40

J

Surgical/dental ~“/’’/’//’//fl///’////~/’’’”/~ 7

I

Anti-infective

Oncology/radiopharmacology 3

Cardio-renal 5

I 21

5 Metabolic/endocrine

b’

Neuropharmacologic ~“’’’/~/’’’”/V6

] 7

[ ( 1 t 1 1

0 12 24 36 48 60 72

Months

ml Unreviewed m AC reviewed

NOTE: Vertical lines across bars for AC reviewed drugs indi-te point during the NDA review period when the AC, on average, made its

recommendation to the appropriate FDA review division. Numerals at the end of bars represent the number of NDAs in each category.

KEY: AC - advisory committee; NCE = new chemical entity; NDA - new drug application.

SOURCE: Kaitin et al., “FDA Advisory Committees and the New Drug Approval Process,” Journal of Clinical Pharmawlogy29: 888-890, 1989.

search is associated with faster approval of NCEs,

a commonly cited rationale for such requests

(350).

POST-MARKETING SURVEILLANCE

Federal regulation requires manufacturers selling in the United States periodically to notify the

FDA about the performance of their products.

This surveillance is designed to detect uncommon, yet serious, adverse reactions typically not

revealed during premarket testing. Manufacturers

immediately notify the FDA of serious or unexpected side effects and annually send the agency

data on all adverse reactions. 17 For frequent or

serious side effects, the agency may seek additional animal or clinical research or use the

sponsor’s surveillance data to revise the drug’s

approved conditions of use or notify medical

practitioners of precautions they should take

when prescribing. Sponsors can hold new information about the drug’s therapeutic benefits

gathered through surveillance until they file their

annual report with the agency (21 C.F.R. 310.305,

312.85; 128a) .18

EFFORTS TO EXPEDITE FDA NEW

PRODUCT REGULATIONS

The regulatory system has been under almost

constant attack since its inception in 1938.

Numerous commissions, hearings, and studies

conducted over the years questioned how the

FDA enforces laws and regulations governing the

17 During tie fnt 3 yCWS after market approval, the company provides this information quarterly tO h ~A.

1ST. ~prove its ~bili~ ~ ~Weil ~keted ~gs,~~A~r~nflyconduct~asuccessful ~uctio~ &monstrationprogrsm in Rhode

Island to eneourage physicians voluntarily to report suspected adverse reactions directly to the FDA or to the manufacturer. At the end of the

2-year projec4 adverse drug reports from this State were 17 times greater than the national average (374).

330-067 - 93 - 6 : QL 3
152 I Pharmaceutical R&D: Costs, Risks and Rewards

development and marketing of pharmaceutical

products in the United States. There is some

consistency to their themes and recommendations. Critics frequently cite the FDA for providing inadequate or untimely information about the

processes and standards used by agency staff to

judge the merits of an application (196,407). Poor

working conditions within the agency, inadequate

staffing, and low salaries are perennial criticisms,

as is the need for better management. The agency

is also regularly criticized for being slow to accept

new scientific methods or to incorporate the latest

advance in biomedical knowledge into the drug

review process (196,197).

Against this backdrop of public debate over the

appropriate role and effectiveness of government

regulation of pharmaceuticals, the FDA has

demonstrated its capacity to change when presented with opportunity, challenge, or mandate by

modifying its programs and policies, issuing new

regulations, or working with consumer groups or

industry representatives to identify ways in which

the drug development and regulatory review

process might be made more efficient.

This section reviews these initiatives, including efforts to improve the conduct of research and

regulatory review and to broaden or hasten the

availability of important new pharmaceutical

therapies. The review is purely descriptive, as an

evaluation of how well these various programs

have worked is beyond the scope of this report.

S Guidelines and “Points to Consider”

New drug regulation process is a labor-and

document-intensive process. The typical IND is

several hundred pages long and grows as researchers submit protocols for later clinical studies and other supplementary information. The

typical NDA consists of 30 separate volumes of

technical information totaling 100,000 pages of

text, data tabulations, statistical analyses, and

patient case report forms (469). For the drug

development and regulatory review process to

work efficiently, sponsors need to know what

information the FDA expects to see in these

applications and what standards reviewers will

use to evaluate the evidence submitted. Sponsors

also need to understand how to organize and

present the information. Reviews based on inadequate or poorly organized applications can be

prolonged or unsuccessful, thus wasting both

Federal and private sector resources (399).

Since 1977, CDER has periodically issued

guidelines containing general information on

preclinical and clinical testing procedures, manufacturing practices, product standards, ingredient

standards, statistical methods, and product labeling. Although these guidelines are not legally

binding, they represent the agency’s official

position about the nature and variety of information required by agency staff in judging the merits

of new drug products. The agency maintains that

a drug sponsor following the guidelines substantially increases its chances of producing an

acceptable IND or NDA (assuming the firm

conducts its scientific studies properly and the

results are statistically significant). However,

following the guidelines does not guarantee a

favorable outcome. The FDA advises sponsors

wishing to deviate from the R&D strategies laid

out in these guidelines to meet with appropriate

FDA review staff before acting on their plans.

FDA describes these meetings as an opportunity

for the drug’s sponsor to describe and just@ the

alternative approach to the FDA staff who will

later be responsible for reviewing the NDA and to

discuss the strengths and limitations of the

substitution (469).

Rather than issuing guidelines, CBER has

written a series of memos, known as ‘‘points to

consider, ’ on subjects relevant to the R&D of

biological products. CBER treats its “points” as

more informal than CDER’s guidelines, but they

do allow CBER to react quickly to the rapid

evolution of the science underpinning the biotechnology industry.

The “points to consider” memos do not

represent official agency positions, nor do they

require the agency to automatically accept manufacturing methods and research conducted according to the ideas laid out in the “points.’

Because they have no official standing within the
Chapter 6–Government Regulation and Pharmaceutical R&D \ 153

agency, CBER can easily revise its ‘‘points to

consider’ to incorporate new knowledge and

approaches to the development of biological

products (116).

1 Rewrite of the IND and NDA Regulations

Because the Federal administrative rulemaking

process, is cumbersome, the FDA rarely seeks to

change the formal regulations that govern the

review of INDs, NDAs, PLAs, and ELAs. After

1962, the agency changed these regulations only

to implement new legislation and to make technical alterations that remedy deficiencies in language or modify specific requirements (274). By

1979, however, the FDA concluded that these

changes had cumulatively rendered the agency’s

IND and NDA regulations inconsistent, unclear,

and out of step with current scientific thinking.

The agency began a review that resulted in new

NDA regulations in 1985 and new IND regulations in 1987 (173). Among the changes instituted, the new regulations:

●

●

●

●

●

Eliminated or simplified some prior regulatory requirements;

Opened the door for improved communication between the agency and pharmaceutical

sponsors;

Established specific time limits for industry

and agency action at various points in the

regulatory review process;19

Altered the format and content of the NDA

and IND applications to facilitate review by

the FDA; and

Clarified or codified other FDA policies and

practices (such as the conditions under

which the agency issues approval and approvable letters and administrative procedures sponsors may use to resolve scientific

disputes with FDA review staff).

Of particular importance is the increasing

communication between the sponsor and the FDA

throughout the course of the process. The revised

regulations offer sponsors the option of meeting

with FDA staff twice during the clinical research

period to discuss scientific and medical issues

pertaining to the development of the drug. Drug

sponsors can request a meeting with FDA staff at

the end of Phase 11 on the organization and

content of Phase III testing, and to discuss any

additional clinical or nonclinical information the

agency may want to see in the NDA (52 FR 8798).

FDA staff are responsible for keeping minutes of

the “end-of-Phase II’ meetings and any agreements reached, The minutes along with a copy of

any written material the FDA provides to the

sponsor serve as a permanent record of the

meeting.

Sponsors may also elect to meet with agency

staff at the conclusion of Phase III studies to

discuss the organization and content of the NDA.

The primary purpose of this meeting is to acquaint

FDA reviewers with the information a sponsor

plans to include in the NDA, to discuss appropriate methods for statistical analysis of the data, and

to uncover any major unresolved research questions that may delay or preclude a favorable

regulatory decision (21 C.F.R. 3 12.47).

M Acceptance of Data From

Other Countries

The FDA has permitted drug sponsors to

include data from clinical trials conducted in

other countries as part of a U.S. NDA since the

early 1970s. Despite this stated policy, sponsors

tended to use foreign data only to demonstrate

product safety and to corroborate the outcome of

U.S. effectiveness studies. FDA staff maintained

that NDAs may include some foreign trial data,

but there must beat least one U.S. trial conducted

by a competent investigator in order to validate

the foreign trial data (400). The FDA pointed to

differences between the United States and other

countries in preferred trial designs, a general lack

of adherence to clinical protocols among foreign

investigators, and difficulty in reviewing and

19 Mmy @ysN have suggested tit be FDA does not necessarily adhere to some of these standards, such m tie 18@ day limit on the review

and disposition of new drug applications (260).
154 I Pharmaceutical R&D: Costs, Risks and Rewards

verifying clinical records from foreign trials. In

addition, the FDA argued that without the U.S.

data it might approve a drug for the U.S. market

based on a safety and effectiveness profile that

had more to do with fundamental differences in

population characteristics, diagnostic criteria, and

therapeutic practices than the pharmacological

potential of the drug. Although pharmaceutical

sponsors believed they could control for such

differences when designing foreign studies (399),

they tended to interpret the FDA’s position to

mean that agency reviewers preferred U.S. data in

making regulatory decisions (314).

European governments made efforts during the

1970s and 1980s to improve the quality of clinical

studies and established pan-European standards

for clinical research to support the move to a

common market. These actions eliminated many

of FDA’s historical objections to the use of

clinical trial data from the European Community

(400).

FDA used the 1987 rewrite of the NDA

regulations to indicate it was now willing to

accept NDAs based solely on foreign data.

Because there is still considerable variation in

medical practice standards and the quality of

clinical investigations throughout the world, the

FDA still requires sponsors to prove that each

foreign study used in an NDA was conducted by

a qualified investigator in accordance with the

U.S. regulatory requirements for the conduct of

clinical trials and that the data are accurate and the

findings apply to the U.S. population (21 C.F.R.

312.20).

S FDA Ratings of Drugs Under Review

CDER introduced a classification scheme in

1975, for new drugs based on their molecular

novelty and therapeutic potential as an attempt to

prioritize CDER’s workload so that potentially

important therapies might reach the marketplace

more quickly than they had in the past. Box 6-A

describes these ratings. In January 1992, CDER

announced that, effective immediately, it would

simplify this prioritization scheme to identify

only two categories of therapeutic importance for

drugs: “priority” for the most important drugs,

and “standard” for all other drugs (127).

I The “NDA Day”

CDER is experimenting with the use of daylong meetings referred to as the “NDA Day,” to

forge an agreement among the FDA, drug companies, and advisory committee members on the

final labeling of a new drug product. The “NDA

Day” is usually faster than the traditional approach to approval of new drug product labels.

Although scheduling difficulties and the preparation required by both the sponsor and the FDA

somewhat limit their feasibility, CDER is considering use of similar meetings to speed up its

review of INDs, clinical trial protocols, and

technical sections of the NDA.

I Computerized Applications

In the late 1970s and early 1980s, drug

companies developed computer systems to manage and analyze the large clinical research databases and began to explore the potential of

computers to streamline the submission and

review of NDAs, PLA/ELAs, and other aspects of

the regulatory process. The FDA entered the

computer age when it received the first computerized new drug approval application in 1985.

CDER has since received over 40 computerized

new drug applications (CANDAs) from over 20

sponsors, resulting in 12 approved drugs.20

The primary reason drug sponsors and the FDA

agreed to experiment with computerized submissions was their potential for speeding up the

review process. CANDAs do introduce a number

of important efficiencies into the review process,

but the agency has completed too few reviews

involving CANDAs to determine whether their

use actually results in shortened review times.

The major advantage of CANDAs noted to date is

that they allow review staff to search the application quickly for needed information using key

words. CANDAs also facilitate comparison of

m Becau~ CBER has had very limited experience with computer-assisted ~rCViewS, this discussion focuses On ~~
Chapter 6-Government Regulation and Pharmaceutical R&D I 155

information across clinical trials and the search of

individual patient records for specific data (376).

Industry views FDA’s ability to do its own

computations using data files and patient records

as something of a double-edged sword. Some see

this capability as a net benefit to companies,

because it saves agency reviewers time when they

have a question about information contained in

the application (70). Other industry people are

concerned that unfettered access to raw clinical

research data gives FDA reviewers an opportunity to reprocess and analyze data in any way they

see fit. Without the usual contact between sponsor

and agency in interpreting each NDA, the sponsor

may not know until very late that its application

is in danger of rejection (399).

So far, the FDA has not established any

standards for the organization of CANDAs or the

hardware and software systems used in their

preparation and review. To cope with the wide

variation in computer literacy within the agency,

each of the 20 sponsors submitting a CANDA met

with the FDA reviewers prior to submitting their

application so that they could tailor each CANDA

to the computer skill and review requirements of

the individual reviewers. This haphazard approach has produced a proliferation of hardware

and software systems within the agency and

general confusion among drug sponsors as to

what the FDA will expect in the future.

B Subpart E Regulations: Expedited

Approval of Important New Therapies

Largely in response to the AIDS epidemic and

the regulatory reform movement of the 1980s, the

FDA issued new regulations, in 1988, known as

‘ ‘Subpart E,’ ‘ that substantially alter the research

and regulatory review process for drugs to treat

life-threatening and severely-debilitating illness.

21

Subpart E is an attempt to expedite approval by

encouraging close communication between the

FDA and sponsors. Usually before filing an IND,

the drug’s sponsor requests an expedited review

designation. Once granted, the FDA and the

sponsor meet to plan the animal studies necessary

to initiate each phase of human testing, to discuss

the organization and content of the IND, and to

design the Phase I trials. Although traditional

Phase I studies use only healthy volunteers, Phase

I studies of expedited drugs may include individuals with the target disease, thus giving the sponsor

some information on the drug’s effectiveness

early in the clinical research process.

At the end of Phase I trials, the FDA and the

sponsor meet again to plan for Phase II studies.

Data accumulated by the end of Phase II trials that

are usually sufficient for an NDA. Although the

Phase II trials may be bigger than usual in order

to accomplish this goal, the total number of

research subjects and amount of time involved in

clinical testing should still be lower than for the

combination of Phase II and Phase III trials under

a traditional development scheme.

In reviewing a Subpart E NDA, the FDA

considers the drug’s benefits in relation to its

known and potential risks, the severity of the

disease, and the availability of alternative therapies. If the FDA believes important questions

about the drug remain unanswered, it may opt to

require Phase III studies before approval, or it

may mandate Phase III tests to be done following

market approval (21 C.F.R. (E)).

The FDA estimates that the Subpart E regulations are capable of cutting the time and money

needed to develop and market a drug by one-third

to one-half (258a). As of February 1992,24 drugs

with Subpart E designation had been approved, 3

others had NDAs under review, and 23 had active

INDs (47).

9 Treatment INDs and Parallel Track:

Expanded Access to Experimental Drugs

Although Subpart E regulations shorten the

amount of time it takes to bring a select group of

drugs to market, access to these drugs prior to

21 me su~p~E ~e@tiom, def~ ~ life.~te~g dim or ~ndition ~ one wh~e “tie Weltid of d~ti is h@l Udt3SS he COIIXW

of the disease is interrupted’ or a disease or condition with a potentially fatal outcome, where the endpoint of clinical trial analysis is survival.

Severely- debilitating illness is defined as a disease or condition tbat “causes major irreversible morbidity.’
156 I Pharmaceutical R&D: Costs, Risks and Rewards

market approval continues to be limited to people

enrolled in clinical trials. The FDA established

the Treatment IND program in 1987 in response

to continuing demands of consumer groups for

early access to potentially important new drugs.

It followed 3-years later with the parallel-track

program in order to provide access to promising

experimental HIV-related therapies even earlier

than was possible with a Treatment IND (55 F.R.

20656). 22

Treatment INDs--The Treatment IND regulation essentially codifies a long-standing agency

practice of releasing investigational drugs to

general practitioners, on a case-by-case basis, for

use in the treatment of immediately lifethreatening diseases in instances where no satisfactory alternative treatment exists.23 While the

Treatment IND is most closely associated with

the AIDS epidemic, it is available to any sponsor

developing a drug for the treatment of a serious or

life-threatening disease, Under a Treatment IND,

sponsors can release experimental therapies to

health care providers to treat people with lifethreatening disease who are either too sick to

qualify for a clinical trial or live too far from a trial

site to be included (95,528).

A unique aspect of the Treatment IND is

sponsors have the option of charging for drugs

supplied under the protocol. A sponsor must

notify the FDA of its intent to charge for a

Treatment IND drug. This notice must include a

justification for the amount to be charged, 24

tangible evidence the sponsor is well on its way

toward securing market approval for the drug, and

written assurance that the sponsor has no intention of creating a commercial market for the drug

under the Treatment IND. Unless the FDA objects

Photo cmdtt: NATIONAL CANCER INSTITUTE

The regulatory review of drugs used in the treatment of

life-threatening diseases such as AIDS has been expedited in

recent years.

within 30 days, the sponsor may proceed to

charge for the drug. The FDA can withdraw the

authorization to charge if it believes the sponsor

has failed to show due diligence in its pursuit of

market approval, is using the Treatment IND to

market its product, or the conditions underlying

the Treatment IND no longer apply (21 C.F.R.

312.7(d)(2); 340).

So far, out of 23 drugs with Treatment INDs,

only 5 have been supplied by the sponsor at a

price (98). 25 This may reflect the industry’s

tradition of not charging for experimental therapies or a fear that sponsors who charge for their

products are more likely to be sued should the

drug be found to be associated with severe

adverse effects. Or, drug sponsors might prefer

giving up any revenue for these drugs to providing the Federal Government with data on research

and manufacturing costs.

‘z The parallel-track program is limited to people with acquired irnmunodeficiency syndrome or Human Immunodeficiency Virus-related

ilLness who have no therapeutic zdternatives and cannot participate in conventional clinicat trails. The Public Health Service announced it may

extend the program to other life-threatening diseases in the future.

‘s The FDA has rekxised investigational drugs for ‘‘compassionate use’ purposes since the mid- 1970s.

24 The regulations specify the price charged cannot be more than the amount ncccssary to recover the ‘‘costs of manufacture, researck

development, and handling of the investigatioml drug. ’ The sponsor is required to supply the FDA with detailed information on these expenses

to support the amount it plans to charge for the drug.

‘s All five of these pharmaceuticals are atso designated as orphan drugs.
Chapter 6—Government Regulation and Pharmaceutical R&D I 157

Between 1987 and 1991, the FDA received

Treatment IND petitions for 37 drugs, allowed

distribution to patients in 23 of these cases, and

approved 14 NDAs or PLAs/ELAs for drugs with

Treatment IND status (98). The modest number of

Treatment INDs is partially explained by the few

drugs under development at any time for the

treatment of serious or life-threatening diseases

and the even smaller number meeting the criteria

set forth in the regulations. Furthermore, even if

a drug potentially qualifies for Treatment IND

status, the sponsor may decide that participation

is not in its best interest.

Critics of the treatment IND program fear that

making investigational drugs broadly available

may decrease patients’ willingness to participate

in clinical trials. Others are afraid that because

Treatment IND drugs are unproven, participating

sponsors may subject themselves to a significant

risk of product liability claims (95,232,279,340).

Parallel-Track Program—The parallel-track

program, proposed in 1990 but not yet finalized,

is designed to make experimental treatments for

conditions related to Human Immunodeficiency

Virus (HIV) available even if the evidence of their

effectiveness is less than that required to receive

Treatment IND status (55 F.R. 20656). Under this

program, a drug sponsor would pursue two

clinical research tracks for its investigational

HIV-related therapies. The ‘‘scientific’ track

would comprise traditional Phase II and Phase III

controlled clinical trails. The ‘‘parallel’ track

would comprise more open, loosely monitored

studies. A sponsor could ask the FDA for

permission to release a drug through a paralleltrack program immediately following the completion of Phase I studies,

Physicians who provide patients with an investigational drug under a parallel-track program

would be expected to function in a manner similar

to clinical investigators in the scientific-track.

They would provide the drug according to a

protocol written by the sponsor, and they would

provide the sponsor with data on adverse reactions and, if requested, evidence on the drug’s

effectiveness. The sponsor could use information

from the parallel-track studies to support its

petition for market approval of the new drug once

the clinical trials are complete, but the FDA has

stated it would continue to base its market

approval decisions on data from the controlled

clinical trails in the scientific track.

Critics of the proposed parallel-track program

have cited potential liability, delayed market

approval, and potentially higher R&D costs for

drugs in the parallel-track programs. Because of

the limited treatment options for the large number

of HIV-infected people, participation in the paralleltrack program might force sponsors to increase

their production, distribution, and administrative

capacities earlier than they otherwise would.

Unlike the Treatment IND program, the FDA

does not expect sponsors to charge for drugs made

available under a parallel-track protocol. Consequently, if a parallel-track drug ultimately proves

to be unsafe or ineffective, the sponsor would face

a larger loss on the project than it would under a

traditional research program. However, sponsors

facing economic hardship would be able to

petition the FDA for permission to recover part of

the cost associated with making the drug broadly

available to those who need it (95,232).

Although the FDA has only issued proposed

regulations governing the parallel-track program,

drugs for HIV-related treatments already have

made up a significant portion of the Treatment

IND program. Of the 23 drugs receiving Treatment IND status by the end of 1991, 8 were for

HIV or HIV-related infections, and 5 of these

drugs have received NDA or PLA/ELA approval

(98).

B Recent Initiatives to Expedite

Drug Approvals

In November 1991, the White House Council

on Competitiveness and the FDA proposed several initiatives aimed at further reducing the time

required to move a drug from clinical testing
158 I Pharmaceutical R&D: Costs, Risks and Rewards

through marketing approval.26 Under these proposals:

●

●

●

●

Drug sponsors could begin phase I clinical

testing without receiving IND status from

the FDA. Instead, Institutional Review

Boards (IRBs) at hospitals or other medical

institutions that administer the trials would

review and monitor them.

The FDA could approve drugs for lifethreatening diseases and diseases for which

no alternative therapy exists on the basis of

limited evidence of safety and efficacy.

Sponsors could collect and provide the full

complement of such evidence after the drug

is approved.

The FDA would contract with outside experts in academic and other institutions to

review pieces of NDAs submitted for antibiotics, allergy drugs, analgesics, and antiinflammatory drugs, four therapeutic categories in which many drugs have already

been approved and the FDA expects little

scientific controversies.

The FDA would look for foreign drug

approval systems with sufficient high standards to warrant U.S. approval on the basis of

an approval in these other countries.

Two of these proposals appear to be grounded

in existing policy. Drugs for AIDS and other

life-threatening illnesses reach patients through

several programs prior to approval and through

expedited approval. It is not clear how the new

proposals would alter the substance or outcomes

of these programs. As described later in this

chapter, the FDA is already engaged in talks with

other countries exploring the potential for some

international harmonization of drug approval

standards (380). But whether or not the search

will result in the agency identifying acceptable

drug approval systems remains to been seen

(147).

Proponents of external review of some NDAs

suggest it is a natural extension of the FDA’s

current use of advisory committees and other

outside experts and the agency still retains the

actual approval decision. The FDA Commissioner has also said the agency would initially

limit external review from 8 to 12 applications.

Critics inside and outside the FDA claim that

finding outside reviewers without conflicts of

interests arising from financial stakes in the

pharmaceutical industry may be difficult and

scientists outside the FDA may lack the expertise

found within the agency to provide a review in

line with regulatory scientific standards (148,187).

Proponents of the proposal to allow phase I

testing prior to IND status argue current policy

needlessly requires double oversight of these

clinical trials by both the IRBs at the institutions

conducting the trials and the FDA. Critics argue

that IRBs focus largely on the rights and safety of

human subjects and lack the expertise or desire to

oversee all FDA regulatory standards for investigational drugs receiving their first test in humans

(147,187,203).

TRENDS IN THE R&D AND

REGULATORY REVIEW PROCESSES

The time required to bring a new pharmaceutical to market depends both on the R&D strategy

and competence of the drug’s sponsor and on the

efficiency and competence of FDA’s review

process. It is impossible to isolate the effect of

each of these factors on the time it takes to

develop an approved drug. It is also inappropriate

to assign full responsibility or credit to the FDA

for changes in the observed time from the first

filing of an NDA to the approval decision.

Changing company R&D development strategies

can result in earlier or later submission of NDAs.

~ k Iw() and 1991, two groups appointed by the Presiden4 the National Committee to Review Current procedures for &PfOVd of New

Drugs for Cancer and AIDS (known as the Lasagna Committee) and the Advisory Committce on the Food and Drug Adnums “ “ tration (known

as the Edwards Committee), issued final reports suggesting changes in FDA policies qdating drugs for Iifdmatdng “~ and FDA

rnanagemat procedures, respectively (462,467). Although the November 1991 initiative by the White HOW and the FDA was not a formal

response to the reco mmcndations of these two groups, the initiative does contain some proposals embodied in the committees’ reports.
Chapter 6–Government Regulation and Pharmaceutical R&D I 159

With these limitations in mind, OTA analyzed

trends in the number of new drug candidates

under development, their attrition rates, the amount

of time they spend in the clinical R&D and

regulatory processes, and the potential contributions of company actions and FDA actions in

explaining these trends.

1 Trends in INDs and NDAs

Among the most basic measures of activity in

the research and regulatory processes are the

numbers of INDs issued, NDAs or PLAs received, and NDAs or PLAs approved by the FDA.

These snapshots of the number of drugs in the

development pipeline are of limited value in

understanding the dynamics of the regulatory

process. For example, they say little about trends

in the probability of successfully bringing a new

drug to market, the time required to do so, or the

reasons for these trends. However, they do

provide a window into the workload of the FDA

and the output of companies’ R&D efforts.

Figure 6-2 presents data compiled by Tufts

University’s Center for the Study of Drug Development (CSDD) on commercial INDs for NCEs

filed in six different 4-year periods (107).27 These

data suggest that after declining through the

1970s, the number of NCEs entering clinical

testing increased somewhat during the 1980s. For

NCEs from U.S. sponsors, the number of selforiginated drugs increased modestly in the late

1980s.28

Figure 6-3 shows NDAs received by the FDA

in each year since 1975 (468,472,474). For the

1980s, the figure breaks out NDAs for new

molecular entities (NMEs) from the total. NDAs

submitted for NMEs have ranged fairly consistFigure 6-2—IND Applications for NCEs Received

by the FDA in 4-Year Periods, 1963-66

Number of INDs for NCEs

‘~I

1963-66 1967-70 1971-74 1975-78 1979-82 1983-86

a Licensed-in IND applications from U.S. sponsors

~ Self-originated IND applications from U.S. sponsors

_ IND applications from foreign sponsors

KEY: IND _ investigational new drug; NCE - new chemical entity.

SOURCE: Office of Technology Assessment, 1993, based on data

from J.A. DiMasi, N.R. Bryant, L. Lasagna, “New Drug

Development on the United States,” 1963-1990, C/in&/

Pharmaeo/ogyand Therapeutics 50(5):471-486, 1991.

ently between 23 and 37 per year over the last

decade with some decline in the last 3 years. By

contrast, the total number of NDAs submitted

peaked in the early 1980s and has declined fairly

steadily since. Similar trends are apparent in data

in NDAs approved each year (figure 6-4). A

steady number of NMEs were approved, but the

total number of NDA approvals declined. The

decline in non-NME applications may reflect a

tendency on the part of sponsors to forgo applications for new uses of drugs already on the market.

27 ~e~e dam come from 31 u,s,-o~ed and 10 foreign-owned fmns. Aeeording to CSDD the dz@ ~clude 78 Pement of Ws from

U.S.-owned firms and 63 percent of NMEs from foreign-owned fm that ultimately obtained FDA approval between 1963 and 1990 (107).

Since the mid- 1980s, CSDD has sought to include therapeutic biologieals in its surveys (106).

28 A se~.ongfit~ NCE is defm~ as one that was s~~es~ed ad developed by the spo~oring f~. ne alternative 1S fOr I.he fkm tO

‘‘license in’ or otherwise acquire a.nexisting compound from another company or researcher. By the time sponsoring firms acquired licensed-in

drugs, some R&D has already been done, so they should have a higher probability of approval and a shorter development time. CSDD does

not give a breakdowm between self-originated and licensed-in drugs for NCES from foreign-owned firms beeause CSDD believes some of them

to behave like lieenstxt-in drugs. CSDD expects firms to file INDs in the United States onty for drugs that have already shown a high potential

for success in foreign research (107).
160 I Pharmaceutical R&D: Costs, Risks and Rewards

9 Trends in Time to Marketing Approval

for New Clinical Entities29

A more revealing view of trends in the research

and regulatory processes is obtained from analyses of drugs entering testing in specific periods.

Because the FDA’s automated management

information system does not permit tracking of

NMEs from the point of first IND to market

approval, all such data gathering must be done by

hand. The FDA’s Office of Planning and Evaluation (OPE) had compiled such data in 1988 for an

analysis of NMEs whose INDs were first filed in

Figure 6-3-Original NDAs Received by the FDA

for Review, 1975-90

Number of NDAs

“r

—

n

1975767778798081 82838485868788899 0

_ All NDAs ~] NMEs ~ Other NDAs

NOTE: Breakdown of NMEs versus other NDAs not available prior to

1980.

KEY: NDA = new drug application; NME E new molecular entity.

SOURCE: Office of Technology Assessment, 1993, based on data

from U.S. Department of Health and Human Services,

Public Health Service, Food and Drug Administration,

Center for Drug Evaluation and Research, Offke of Drug

Eva/uafion Stafistka/ Report, U.S. Department of Health

and Human Services, Rockville, MD, 1984, 1987, 1991,

1992.

Figure 6-4--NDA Approvals by Year, 1975-90

Number of approvals

150 ,

i

120-1

1975 76 7778798081 8283 84858687888990

~ Other NDAs _ NMEs only

KEY: NCE = new chemical entity; NME _ new molecular entity.

SOURCE: Office of Technology Assessment, 1993, based on data

from U.S. Department of Health and Human Services,

Public Health Service, Food and Drug Administration,

Center for Drug Evaluation and Research, Office of Drug

Eva/uatkm Statistic/ Report, U.S. Department of Health

and Human Services, Rockville, MD 1984, 1987, 1991,

1992.

the period 1976-78 (426). At OTA’s request, OPE

and CDER staff compiled similar data for the

period 1984-86 (Appendix I describes methods

used to compile these data). Figures 6-5 and 6-6

present the results of these analysis.

Figure 6-5 shows the cumulative percent of

NMEs that result in an NDA in each period.

Figure 6-6 shows the cumulative percent that

resulted in a marketed product. The figures

display data for the early cohort for 144 months

and for later cohort for 54 months, the maximum

amount of time elapsed after IND issuance for all

drugs in the cohort over the time periods measured. More drugs in the 1984-86 group reached

NDA submission and market approval than did

drugs in the 1976-78 cohort at each month after

clinical testing began. If these trends continue to

Z9 In @yses presented in this Swtiow data on the outcomes of more recent cohorts of drugs were available for shorter periods of tieh

were data onearliercohorts. Hence, conclusions presented in this section about the lengthening or shortening of the time required for each cohort

to achieve approval refer only to the amount of time necessary for a given percentage of drugs in each cohort to result in an NDA submission

(or approval). For example, it may take 24 months for the first 20 percent of one cohort of NDAs to be approved, while it takes 36 months for

a comparable percentage of another cohort of NDAs to receive approval. One cannot draw any conclusions about changes in the average time

to approval for all ultimately approved drugs since the ultimate success of many drugs in the later cohorts is unlmown.
Chapter 6–Government Regulation and Pharmaceutical R&D I 161

Figure 6-5—Percent of IND for NMEs Entering

Clinical Trials Resulting in NDA or PLA,

1976-78 and 1984-86

Cumulative percent

25 —------ —————

1

)

20-

11°/. of 1984-86 INDs

15- resulted in a

NDA or PLA within

54 months

1 0

5“

0“ I I I I I I I I I I I

12 24 36 54 60 72 84 96 108120132144

Months to NDA or PLA

+-- INDs entering clinical trials, 1976-78

- +-- INDs entering clinical trials, 1984-86

KEY: IND=investigational new drug; NM E=newmolecularentity; NDA

= new drug application; PLA = product I icense application.

SOURCE: Office of Technology Assessment, 1993, based on data

supplied by FDA (see appendix l).

hold as time goes by, more NMEs that entered

testing in 1984-86 may ultimately result in NDAs

and marketed products than those in 1976-78.

Data supplied by CSDD to OTA permitted

further analysis of trends in success rates and

times from IND to market approval. Figure 6-7

shows the cumulative probability that an IND

resulted in an NDA and that an NDA resulted in

an approved product within a certain number of

months after the first IND was filed. While the

success of the IND to NDA submission phase for

NCEs improved over successive IND periods, the

opposite trend holds once those drug candidates

made it to the NDA review phase. Because the

CSDD database could track the latest cohort of

drugs during NDA review for only 36 months, it

is not clear whether the trends observed to date

will continue over the remainder of the cohort’s

experience.

Another way of interpreting these data is to say

that for any given percentage of approved NDAs,

the amount of time from NDA submission to

approval lengthened. This observed lengthening

of the NDA review time is found among the

Figure 6-6-Percent of INDs for NMEs Entering Clinical Trials Resulting in Approved Products,

1976-78 and 1984-86

Cumulative percent

16

14-

12-

10-

8 -

6-

4-

2 -

1

01~i 1 I I I [ I I I I I I I I 1 I I 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102 108 114 120 126 132 138 144

Months to approval

— INDs entering clinical trials, 1976-78 -t INDs entering clinical trials, 1984-86

KEY: IND - investigational new drug; NME - new molecular entity; FDA = Food and Drug Administration.

SOURCE: Office of Technology Assessment, 1993, based on data supplied by FDA (see appendix l).
162 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 6-7-Percent of INDs for NCEs Resulting in an NDA/PLA and NDAs/PLAs for NCEs

Resulting in Approved Products, 1965-82

Cumulative percent

loo~

90

{

IND to NDA/PLA

50

40

30 /

L;, ‘,,,,,,

—-

20 —/ -“ - -

10 -.> -“s .9

0

NDA to approval

,,, !,,

O 12 24 36 48 60 72 84 96 108 120 132 144 156 168 180 192 0 12 24 36 48 60 72 84

Number of months

Drugs first entering clinical trials between: 1965-69 — — - 1970-75 ------- 1976-82

KEY: IND = investigational new drug; NCE - new chemieal entity; NDA - new dtug application; PtA = product license application.

SOURCE: Office of Technology Assessment, 1993, based on data supplied by the Center for the Study of Drug Development, Tufts University.

licensed-in NCEs, but not among self-originated

drugs.

OTA also analyzed the FDA’s published data

on trends in the NDA review period. This analysis

is similar to that of the CSDD data except that the

cohorts of NMEs examined are defined according

to the year in which their NDAs were submitted

to the FDA rather than according to the year their

INDs were first issued.30 Figure 6-8 presents the

cumulative probability of approval over time for

all NMEs. Time to approval has increased for any

given percentage of approved drugs, and the

probability of approval within specified time

intervals for all drugs reaching NDA submission

has declined over time. Although the limited

experience of the most recent NDAs (i.e., those

submitted to the FDA between 1985 and 1988)

suggests a possible increase in approvals compared with earlier cohorts, a breakdown of these

cumulative probabilities according to the FDA’s

rating of drugs’ therapeutic potential (figures 6-9

through 6-11) shows all of the trend toward faster

and higher approval rates among the most recent

cohort appears attributable to drugs the FDA

expected to be of modest or little therapeutic

importance. Drugs with a rating of ‘‘A’ show

decreasing rates of success over time.31 Additional experience with the most recent cohort of

NDAs is needed to determine whether this trend

will continue.

Reasons for the apparent decline in approval

rates for drugs the FDA rated as having the

highest therapeutic potential are not clear. Sponsoring firms may be submitting less complete or

lower quality NDAs over time, or the FDA’s

expectations may have increased. It is also

possible that increases in the FDA’s responsibilities and the greater constraints on its resources

30 ~ew&m ~xClu& p~~du~tliceme appficatiom/es~blis~ent lice~e appficatio~ mview~ by mER (most of which wotid appear ixI

the most recent period).

31 me tipofimm of this time trend is tempered somewhat by the fact that even with this decline over time, the approval of ‘A’ tigs has

been consistently higher and faster than those rated “B” or “C.”
. . . .

Chapter 6-Government Regulation and Pharmaceutical R&D I 163

Figure 6-8-Approval Times for NME-NDAs

Submitted in Three Periods

Cumulative percent

‘“~

60

40

201 M I

“L&L—_—J 6 12 18 24 36 48 60 72 84 96 108120132

Months to approval

-+ 1975-79 –k 1980-84 + 1985-88

KEY: NDA = new drug application; NME = new molecular entity.

SOURCE: Office of Technology Assessment, 1993, based on data

from U.S. Department of Health and Human Services,

Public Health Service, Food and Drug Administration,

Center for Drug Evaluation and Research, Offke of Drug

Eva/uafion Statistic/ Report, U.S. Department of Health

and Human Services, Rockville, MD 1984, 1987, 1991,

1992.

documented elsewhere (436,462) have led to

longer review times. Regardless of the reasons for

this trend in the NDA phase, it still holds true that

over time, greater proportions of drugs entering

clinical research have reached the market in less

time and that, on average, NMEs with a rating of

“A” reach the market more quickly than other

NMEs.

To summarize the above analyses:

●

●

The percent of NCE drug candidates entering human trials that resulted in an approved

NDA within 54 months increased during the

1980s compared with the 1970s.

This improvement was confined largely to

the pre-NDA period. Success rates once the

NDA is submitted have actually declined.

The lengthening of the NDA review period

appears to be concentrated in NCEs acquired

by license.

●

●

Although the most recent group of submitted

NDAs shows some improvement, drugs for

which the FDA has tried to expedite approval times (category “A” drugs) actually

showed a decline in approval rates and a

lengthening of the NDA review period.

Despite this disturbing trend, drugs designated by the FDA as category ‘‘A’ are still

associated with higher approval rates than

others.

TRENDS IN THE REGULATION OF

PHARMACEUTICALS IN OTHER

COUNTRIES

Pharmaceutical industry representatives have

stressed in both interviews with OTA and in

public forums that because U.S. approval standards are the strictest, companies tend to establish

clinical research strategies according to requirements of the U.S. FDA. Yet, drug sponsors must

Figure 6-9—Approval Times for NME-NDAs Rated A

in Three Periods

Cumulative percent

100

80-

60-

40-

1 Zv’ I

2kL--J

6 12 18 24 36 48 60 72

Months to approval

+ 1975-79 + 1980-84 + 1985-88

NOTES: NMEs rated “A” were deemed by the FDA to represent

“important therapeutic gains.”

KEY: NDA - new drug application; NME - new molecular entity.

SOURCE: Office of Technology Assessment, 1993, based on data

from U.S. Department of Health and Human Services,

Public Health Service, Food and Drug Administration,

Center for Drug Evaluation and Research, Office of Drug

Evacuation Statistim/ Report, U.S. Department of Health

and Human Services, Rockville, MD, 1984, 1987, 1991,

1992.
164 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 6-10—Approval Times for NME-NDAs Rated

“B” in Three Periods

Cumulative percent

‘:r ‘“-”--”sl

60 I

40

$

20-

0 I I I I

6 12 18 24 36 48 60 72

Months to approval

-* 1975-79 A--- 1980-84 + 1985-88

NOTES: NMEs rated “B” were deemed by FDA to represent “modest

therapeutic gains.”

KEY: NDA - new drug application; NME - new molecular entity.

SOURCE: Office of Technology Assessment, 1993, based on data

U.S. Department of Health and Human Services, Public

Health Service, Food and Drug Administration, Center for

Drug Evaluation and F;esearch, Office of Drug Evaluation

Statisfica/ Report U.S. Department of Health and Human

Services, Rockville, M[), 1984, 1987, 1991, 1992.

also negotiate the regulatory approval processes

of other countries to sell their drugs. OTA

reviewed two major industrialized markets: Japan

and the European Community. Europe, Japan,

and the United States together account for 80

percent of the world’s pharmaceutical sales.

Hence, the size of these markets make them most

important for the U.S. pharmaceutical industry’s

R&D activities and, potentially, for U.S. regulatory practices in the future.

Q Drug Approval in Japan

The Japanese pharmaceutical industry traditionally was largely domestic. Japanese firms did

little innovative R&D and thus did not produce

many new drugs for potential introduction into

other countries, nor did foreign companies market

their own drugs in Japan. This situation, now

changing, reflected Japanese trade policies, the

.

organization of Japanese medicine, and principles

governing Japan’s clinical research requirements.

Figure 6-1 l—Approval Times for NME-NDAs Rated

“C” in Three Periods

Cumulative percent

100 ‘ -

–—-– ‘-

80-

60-

40-

20-

0

6 12 18 24 36 48 60 72

Months to approval

+ 1975-79 ~ 1980-84 + 1985-88

NOTE: NMEs rated “C” were deemed by the FDA to represent “little or

no therapeutic gains.”

KEY: NDA - new drug application; NME - new molecular entity.

SOURCE: Office of Technology Assessment, 1993, based on data

from U.S. Department of Health and Human Services,

Public Health Service, Food and Drug Administration,

Center for Drug Evaluation and Research, Office of Drug

Evacuation Statistika/ Report, U.S. Department of Health

and Human Services, Rockville, MD, 1984, 1987, 1991,

1992.

Until 1967, Japan did not require its own firms

to conduct clinical trials for safety or efficacy in

Japan for drugs licensed from foreign sponsors

and already approved elsewhere. In contrast, until

the 1980s, foreign sponsors were required to

conduct trials on Japanese citizens and could not

apply for marketing approval without entering

into an agreement with a Japanese sponsor. These

policies had the effect of encouraging Japanese

sponsors to license foreign drugs rather than

investing in their own R&D, and they effectively

kept the foreign presence in the Japanese market

to a minimum (344).

Other characteristics of the Japanese medical

care system have affected its drug approval

process and help explain the traditional isolation

of the Japanese pharmaceutical market from the

rest of the world. Among the significant features

of this system are the primary role of the

physicians in clinical practice and research and
Chapter 6–Government Regulation and Pharmaceutical R&D ! 165

the deference shown them by patients and government. Until recently, the Japanese Government

did not require researchers to obtain informed

consent from research subjects, which made data

from such studies unacceptable to the regulatory

authorities in other countries (523).

In addition, physicians in Japan tend to own or

have other financial stakes in the facilities that

dispense drugs to their own patients. Because

governmental approval of new drugs in Japan

relies heavily on committees of outside physicians (with the government maintaining only a

small staff to provide support for this process),

individual physicians charged with review of new

drug applications as well as the profession in

general may face a conflict of interest by potentially benefiting financially from regulatory decisions they make or influence. This potential

conflict of interest is compounded by the fact that

committees charged with new drug review comprise leading researchers who may have conducted the clinical trials of pharmaceuticals under

consideration for approval. Japan has relatively

loose efficacy requirements for drugs to treat

cancer and other life-threatening illnesses, leading to the availability of many treatments with no

proven value. These practices have limited the

acceptability of Japanese R&D results in other

nations (523).

Regulation and approval of investigational

pharmaceuticals falls to the Ministry of Health

and Welfare’s Pharmaceutical Affairs Bureau

(PAB). Since the early 1980s, Japan has sought to

establish tighter government control of the clinical use and investigation of new drugs to conform

with R&D practices in other countries. PAB

requires sponsors to receive approval to begin

clinical testing, although the government does not

review the drugs safety, the drug sponsor’s

research plans, or interim results in the same way

the FDA does through its IND process. Since

1983 Japan has required investigators to comply

with internationally accepted Good Laboratory

Practices (GLP), and since 1990, with Good

Clinical Practices (GCP). This latter group of

guidelines include avoidance of potential conflicts of interest, an impartial review of research

plans prior to beginning trials, and a requirement

for informed consent (21 1). Although PAB is

charged with auditing clinical trial records at the

time the sponsor files an application to market the

drug, early indications suggest that enforcement

may be difficult because of the strength of

traditional practices (21 1,523).32

When a sponsor files a new drug application,

PAB refers it to the Central Pharmaceutical

Affairs Council (CPAC), which is made up of

outside medical and scientific experts. A subcommittee of CPAC’s Committee on Drugs performs

the bulk of the review, although the full Committee as well as CPAC’s Executive Committee also

approve the subcommittee’s findings. CPAC

sends its recommendation to the Minister of

Health who formally grants approvals.33

The standard processing time for complete,

sound new drug applications is 18 months. Once

approved, Kosheibo’s Health Insurance Board

(HIB) enters price negotiations with the manufacturer (21 1).34

1 Drug Approval in the

European Community

The decision by member countries of the

European Community (EC) to create a single

economic market by the end of 1992 has significant implications for the approval of new drugs

sz 1n ~ddltlon t. ~culmal ~~ag~t government audits of physician records, physicians have cfitic~~ tie ~o~~ Cement ‘~ukement

arguing that it goes against the Japanese practice of not fully explaining to patients the nature of their illness and treatment for fear any related

anxiety will adversely affect patient and family. Critics also argue that adherence to these guidelines lowers patient willingness to participate

in trials, thus raising development times and costs (523).

33 Two o~er agencies, tie Natlo~ ~titutes of Hy@e~c Sciences @~S) and the Natio~ I~ti~tes of Heatth (NfH), must ako validate

the manufacturing quality of new drug products as well as validate the laboratory systems used in testing the drug. While NELS tests drugs

containing new chemicat entities, NIH has charge of new biologics and antibiotics.

34 Chapter 10 descrihs price regulation in other counties.
166 I Pharmaceutical R&D: Costs, Risks and Rewards

within the EC.35 Currently, each national government has its own approval standards and process

for allowing the marketing of new drugs within its

borders. Beginningin 1979 (with modification in

1986), however, the EC established a process by

which drug companies may apply for reciprocal

approval in multiple EC countries once it has

received formal approval for the drug within at

least one EC nation. The other countries then have

4 months to either grant approval or state their

grounds for not doing so. The Committee for

Proprietary Medicinal Products (CPMP), made

up of individuals from EC countries as well as

members of its governing body, the European

Commission, reviews individual nations’ objections to reciprocal approval. The CPMP then

issues a recommendation to the individual countries who still reserve the right to make a final

decision on approval within 2 months (67).

Because of differences in national standards and

philosophies for new drug approval, this process

has not led to timely reciprocal approvals (67).

Only one drug has been approved without objection from individual countries, and few countries

have made a final approval within the statutory 2

months following the CPMP’s recommendation.

In 1988, the EC began to consider new options

to streamline European drug approvals. Directives to be published in the next several years are

expected to represent a compromise between

those countries preferring a system of binding

reciprocal approval and those preferring a single

European regulatory body for drug approvals.

Recent drafts suggest that the EC will adopt a

three-tiered approval system:

●

●

Companies could apply to a central Medical

Evaluation Agency (MEA) to receive approval to market new drugs throughout the

EC.36

Alternatively, sponsors could apply to any

single EC nation whose approval all other

member countries would be required to

accept. The MEA would arbitrate any disagreements or objections, and its findings

would also be binding throughout the EC.

For drugs of limited geographic interest and

for all generics, companies would continue

to apply to national regulatory authorities

for approval to market only within that

country (67,210).

The net effects of these changes on the time and

cost of bringing new drugs to market throughout

the EC are not clear. On the one hand, standardization and centralization of the drug approval

process will likely reduce the administrative and

scientific effort currently necessary for sponsors

to gain entry to 12 different national markets. On

the other hand, the need to assure all member

states of the quality of drug approval reviews

throughout the EC may lead to an approval

process (whether the central MEA or those in

individual countries) that is more cautious, deliberate, and time-consuming than those currently

employed in some of the individual EC members.

In essence, a centralized MEA and binding

mutual recognition may lead countries with

relatively less burdensome regulatory reviews to

bring their standards and processes up to the level

of the more burdensome states, rather than the

other way around. European observers expect this

new process to go into effect sometime between

1993 and 1996 (210).

1 Attempts to Harmonize International Drug

Approval Regulation

In November 1991, representatives of the

United States, the EC, and Japan met in Brussels

for the frost International Conference on Harmonization (ICH1) to formalize agreements reached

during 18 months of negotiation. International

harmonization of drug approval standards seeks

to cut the cost of drug development by identifying

duplicative studies required by multiple regulatory authorities. The results of ICH1 suggest

35 ne EC cuentiy comprises Belgi~ Denmark France, Germany, Greeee, Ireland, Italy, Luxembourg, the Netherlands, pofiug~, Sp@

and the United Kingdom.

36 me MEA would auto~ti~y regulate all biotechnology tigs.
Chapter 6–Government Regulation and Pharmaceutical R&D I 167

safety and quality-control studies are the most

promising area for harmonization (63). In Brussels, the conferees agreed to reduce certain

toxicity tests currently required in some countries

and to adopt uniform guidelines for determining

the shelf-life of pharmaceuticals, functions that

are not the most costly R&D activities for drug

sponsors. According to DiMasi’s estimates, all

animal toxicity testing represented 12 percent of

all expected out-of-pocket expenditures for the

R&D of a new drug in 1987 (109). Data from the

PMA indicate that its member sponsors spent 7

percent of their total R&D expenditures in 1990

on toxicology and safety testing, another 7

percent on process development and quality

control, and 9 percent on dosage formulation and

stability testing (320). Less progress was made in

harmonizing requirements for the more expensive

clinical testing,37 for which individual countries

have been more reluctant to accept data from

other countries. For example, Japan has traditionally argued that differences in diet, climate, and

race make clinical results from Europe or the

United States inappropriate for generalizing to

Japanese patients (1 13,202,380). The three conferees will meet again in 1993 and 1995.

CONCLUSIONS

The time needed to establish the safety and

effectiveness of a new drug represents a significant component of its R&D costs. The data

presented in this chapter indicate that in recent

years, the percent of drugs entering human

clinical trials that can be expected to receive

marketing approval in the United States has gone

up. Furthermore, those approved at the time of

OTA’s analysis had moved from IND application

to NDA approval faster than those that entered

clinical trials in the 1970s. Most of this improvement came during the clinical research phase,

because the time from NDA submission to

approval has actually lengthened during the

1980s.

While these trends seem clear, their causes do

not. The FDA’s expectations of and actual advice

to drug sponsors can determine the length of the

clinical research period as much as drug sponsors’

own decisions and research efforts. Likewise, the

length of time required by the FDA to review and

approve an NDA can reflect the completeness and

quality of the sponsor’s application as much as it

reflects the FDA’s resources and efficiency. As

the literature reviewed in this chapter indicates,

other market and scientific factors can also affect

the amount of time required to move a drug into

the marketplace.

Clinical trials are an especially resourceintensive component of drug R&D. OTA found

that the number of people enrolled in clinical

trials conducted prior to U.S. market approval has

increased over time. This increase is especially

large for trials conducted outside the United

States and those completed after the filing of an

NDA. While these increases could reflect increased regulatory expectations, there are also

several other potential explanations including an

increasingly global approach to drug R&D.

Since the mid-1970s, the FDA has tried to

prioritize its review of NDAs so that drugs

deemed therapeutically important may reach the

market as quickly as possible. While drugs rated

with the highest therapeutic importance have, on

average, received the fastest NDA approvals

when compared with other drugs, FDA’s review

of all drugs, no matter what the therapeutic

importance rating, has become longer over time.

In recent years, the FDA has intensified its

efforts to speed approval through programs to

provide drugs for life-threatening illnesses to

patients. While the Subpart E program attempts to

speed actual NDA approval, the Treatment IND

and proposed parallel-track programs allow expanded access to experimental treatments before

approval. These efforts have resulted in greater or

faster access to certain drugs, but it is possible the

oversight they require may have slowed the

37 Clfical testing represented 31 percent of PMA R&D expenditures in 1990(320).
168 I Pharmaceutical R&D: Costs, Risks and Rewards

FDA’s review of drugs not receiving high priority.

Recent anecdotal evidence raises some concern

over a potential significant lengthening in the

review of PLA/ELAs by CBER. Although there

have been relatively few biological drugs to-date,

the number of biological therapeutics expected to

seek marketing approval from the FDA over the

next few years is expected to grow substantially.

OTA was unable to conduct quantitative analysis

of recent trends in the review of biological drugs

because CBER could not provide management

data to OTA as CDER provided for OTA’s

analysis of the NDA review process.

Another initiative recently approved by Congress, the imposition of user fees on drug sponsors for the review of their drug marketing

applications (Public Law 102-571) may offer

additional opportunities to shorten regulatory

review times. In exchange for fees of $100,000 for

each NDA or PLA/ELA (rising to $233,000 in 5

years) and other fees, Congress and the FDA have

agreed to augment the agency’s staff of reviewers

to speed the approval process. Whether the

agency faster approvals will justify the fees paid

by sponsors can only be determined with time and

experience.

Given the globalization of the marketplace for

pharmaceuticals, regulation in other countries

also can affect the cost of developing new drugs.

To the extent that regulatory and scientific

standards are roughly the same across countries

and countries accept data gathered outside their

borders, drug sponsors do not have to duplicate

research to market their products in different

countries. The two major marketplaces for drugs

outside of the United States—Japan and Europe--

have either changed or are in the process of

changing their regulation of drug safety and

effectiveness. While Japan has attempted to

remove barriers to the marketing of drugs by

sponsors from other countries and to improve

standards for the conduct of scientific research

including informed consent, significant differences appear to remain between Japan and the

Western developed countries.

Across the Atlantic, the members of the European Community are in the process of consolidating and harmonizing their own drug approval

processes. While a 1991 conference among the

United States, the European Community, and

Japan made some progress in harmonizing safety

and quality-control testing, the development of

mutually acceptable standards for effectiveness

of new drugs remains a significant challenge for

future conferences scheduled in 1993 and 1995.
Product Liability and

the Pharmaceutical Industry 7

hat are the implications of product liability-the

legal liability of a producer or seller for harm caused

by a product—for the pharmaceutical research and

development (R&D) process? Observers claim that

over the past 20 years, the courts have broadened the circumstances in which injured parties may collect from manufacturers,

a trend particularly cited regarding the pharmaceutical industry

(250). They have also suggested that the frequency of large jury

awards has increased for cases proceeding to trial, raising the

degree of uncertainty surrounding expected liability losses for a

manufacturer or its insurer (184).

While some argue that in the pharmaceutical sector these

changes successfully protect the public from unsafe drugs (522),

others suggest that increased liability, losses, and uncertainty

affect R&D in two other ways:

Costs associated with bringing a new pharmaceutical to

market may rise as a result of additional research that firms

may conduct to ensure the safety of new drugs (239).

Firms may decide not to pursue areas of research or product

development where they fear excessive liability costs will

critically lower the potential return for a particular drug

(236).

This chapter focuses largely on the second hypothesis,

examining how product liability rules in the United States may

affect the drug projects in which manufacturers choose to invest.

PRODUCT LIABILITY AND PHARMACEUTICAL R&D

The greatest impediment to understanding the effects of

product liability on the drug R&D process is the lack of evidence

on trends in pharmaceutical liability cases. Data on court cases

are limited because the legal system adjudicates only a small

fraction of all product liability claims and because there is no

169

— —

4
170 I Pharmaceutical R&D: Costs, Risks and Rewards

centralized database of” all product liability cases

filed and decided and no centralized record of

settled claims.

The liability insurance industry is a poor source

of information on the drug industry’s product

liability experiences because companies now

largely self-insure for all but the highest liability

losses. The best source of information on the costs

and implications of product liability law in this

industry are drug companies themselves. The

Office of Technology Assessment (OTA) found

no published data summarizing industry experience.

1

Despite the lack of data, it is possible to sketch

a rough picture of product liability trends in the

research-based pharmaceutical industry from a

variety of sources that are incomplete by themselves, including trends in law and insurance

markets, a few in-depth studies of product liability litigation in particular jurisdictions, and anecdotal accounts of products particularly vulnerable

to liability claims:

●

●

Over the past 15 years, product liability

claims and litigation against pharmaceutical

manufacturers appear to have increased as

measured by numbers of cases and changes

in liability insurance. The legal circumstances under which courts hold pharmaceutical manufacturers responsible for injuries

to consumers also broadened in recent years.

The increase in liability claims is not uniform across all pharmaceutical products.

Contraceptives, vaccines, and drugs taken

during pregnancy appear to be particularly

susceptible to liability claims. The vast

majority of all product liability litigation in

the health care sector over the past two

decades is attributable to two products—the

Dalkon Shield contraceptive and Bendectin,

●

●

●

a drug used to treat pregnancy-related nausea.

While data suggest the average award per

liability claim has increased substantially

for pharmaceuticals, a very small number of

cases with very large punitive damage

awards explains the bulk of these increases.

However, even excluding these very large

cases, there has been a general increase in

awards over time.

Assessing the impact of increased product

liability on pharmaceutical firms is difficult.

No data exist to measure R&D and other

business costs attributable to product liability. The little systematic research done to

date on whether product liability affects the

rate of pharmaceutical innovation has yielded

inconclusive results. Evidence drawn from

the experiences of particular products or

from interviews with industry executives

indicates liability may inhibit or preclude

R&D or marketing of reproductive-related

vaccines and products.

Although the Federal Government has not

adopted product liability reforms for therapeutic pharmaceuticals, several States have,

and the Federal Government has adopted

no-fault compensation schemes for swine

flu and childhood vaccines that could offer

potential models for Federal underwriting of

other product liability risks. The U.S. Congress has also considered several proposals

to adopt a Federal product liability law that

would supersede current State law.

PHARMACEUTICALS AND

PRODUCT LIABILITY LAW2

1 Establishing Legal Liability

Liability law in this country draws more from

the common law precedents of previously deI A recent htitute of Medicine study of contraceptive R&D, however, conducted an informal survey of companies Currenfly or formerly

involved in researching new metl!mls of birth control. The committee surveyed the companies about the implications of product liability on

contraceptive business, but the committee report did not provide a wide range of survey results or any information about the representativeness

of the sample (207).

2 This section provides only a rough outline of some of the more important concepts of relevance to product liability for pharmaceuticals.

These legal concepts have been ~escribed more fully elsewhere (250,371,413).
Chapter 7—Product Liability and the Pharmaceutical Industry I 171

cided cases than from statute. Rather than having

a single, uniform product liability system, the

United States really has 51-one for each State

and one for the Federal court system. The Federal

system has jurisdiction only over product liability

cases in which the parties reside in different States

and one requests that the case be heard in Federal

court (28 U.S.C, 1332). Hence, cases heard in

different jurisdictions may operate under different theories and standards for establishing a

pharmaceutical manufacturer’s liability (265,443).

Even with these complexities, there are some

common elements in pharmaceutical liability

law. In determining whether the manufacturer is

indeed liable for any injuries caused by the

product in question, the courts tend to establish

liability for pharmaceuticals in one of two ways:

1. The courts may consider whether a design

defect makes the product unreasonably

dangerous-i. e., whether the risk of a drug’s

use outweighs its utility. Although the

American Law Institute (ALI)3 recognized

in its 1965 Restatement (Second) of Torts

(Section 402A, Comment K) that pharmaceuticals have social value despite their

potential to cause adverse reactions even

when used as directed, some courts have

applied the notion of strict liability to cases

of injury associated with pharmaceuticals

where there was no established negligence

or malicious intent in the design and production of the drug4 (247).

According to this idea, liability lies with the

party best able to prevent injury or absorb its

costs—usually the manufacturer---even if

that party was not responsible for causing

the injury through negligence or intent

(250). The courts may make this judgment

independent of the U.S. Food and Drug

Administration’s (FDA) evaluation of the

drug’s safety and efficacy, although there is

a great deal of uncertainty in how one

establishes design defects in pharmaceuticals (142,413,416).

2. A more common means of claiming liability

is to show a drug is ‘‘unreasonably dangerous as marketed’ because the manufacturer

has given inadequate warning of the drug’s

risks (413,416). Determination of a failure

to warn focuses on information about the

drug that the manufacturer targets to prescribing physicians. A warning may be

inadequate because it is factually wrong or

incomplete or because it is not conveyed in

an effective way.

Even though the FDA must approve a

drug’s labeling, packaging materials, and

advertising claims, courts have often found

firms liable for adverse events that the FDA

determined lacked a scientific basis for

inclusion among the drug’s warnings.

Courts have also found inappropriate promotion can render warnings ineffective and

the failure of a physician to consult materials describing a drug’s risk (such as the

Physician’s Desk Reference) does not absolve the manufacturer of liability (413).

Once a court has determined that a manufacturer is liable for any injuries resulting from a

pharmaceutical’s use, the court must decide

whether the product caused the specific injury in

question. In cases where a class of plaintiffs (i.e.,

injured parties) cannot identify the specific manufacturer because of the passage of time, the courts

of some States have adopted a “market share’

theory to determine causality. Under this theory,

plaintiffs may receive damage from all manufacturers of product in proportion to their market

share (243,263).

3 The ALI is a nonprofit membership association of judges, legal academicians, and lawyers. The institute’s purpose is the “clfilcation

and simplification of the law and its better adaptation to social needs. ’

4 There have been relatively few cases where injured parties have established negligence in the munu~acture of pharmaceuticals. Observers

have suggested the FDA’s tight regulation of Good Manufacturing Practices and quality conhol are the reason (416).
172 I Pharmaceutical R&D: Costs, Risks and Rewards

I Jury Awards

Across all types of liability (product, malpractice, and personal injury), in an average year only

2 percent of all insurance claims are resolved

through litigation (i.e.,, a court case). Of these,

only 5 percent (or 0.1 percent of all liability

insurance claims) result in a trial verdict. The

remainder are settled by the parties (247). Despite

the relative infrequency of litigation, however,

changes in judicial rules, decisions, and outcomes

are important barometers of the total climate in

which the U.S. product liability system exists.

In cases where courts establish a manufacturer’s liability, juries’ awards to the injured party

have increased well in excess of the rate of

inflation during recent years. While these verdicts

comprise both compensatory and punitive awards,

the bulk of the increase is attributable to punitive

actions (192). A study by the Rand Corporation

using data drawn from Cook County (Chicago)

and San Francisco found substantial growth in the

size of jury awards for all types of product

liability suits.5 From the 1960-64 to the 1980-84

period, the mean award for all product liability

cases (not just pharmaceuticals) in San Francisco

grew 1,116 percent in real terms and 312 percent

in Cook County (318). In each city, the mean

awards were substantially greater than the median, reflecting the small number of very large

awards. The probability of actually winning a

case that goes to court did not change over this

period (318).

PRODUCT LIABILITY INSURANCE

Manufacturers traditionally protect themselves

against the financial risk of product liability

damage awards by buying insurance. Changes in

pharmaceutical manufacturers’ liability premiums, claims, and uninsured expenses provide a

measure of the financial impact of product

liability on a firm’s cost of doing business and

presumably reflect the changes in risk or expected

losses posed by product liability claims.

Through the 1970s, most pharmaceutical firms

protected themselves against liability losses with

insurance that consisted of three pieces:

●

●

●

The manufacturer paid a deductible for the

first portion of each claim.

Once the deductible was met, the basic

insurance policy paid claims up to specified

limits.

Most companies also held excess insurance

to pay claims above the basic policy up to

another specified limit (443).

For the manufacturer, the total costs attributable to product liability include deductibles, any

other losses not covered by insurance, any legal or

administrative costs borne by the firm, and

insurance policy premiums.

Most of the pharmaceutical firms interviewed

by OTA indicated they can no longer get any

basic insurance coverage in the traditional liability insurance market. The policies available today

carry higher deductibles and premiums, with

lower limits on how much they will pay per claim

and in aggregate than did past policies (510),

Some policies have excluded specific products or

types of products thought to carry a higher than

average risk of product liability loss. Consequently, pharmaceutical manufacturers have increasingly self-insured to compensate for lost

basic insurance coverage by setting aside reserves

to cover expected losses, establishing special

lines of credit to cover unanticipated liability

losses, and establishing “captured” insurance

companies that are wholly or primarily owned by

the insured pharmaceutical firm and have no other

policyholders. 6

Some companies also transfer a portion of their

liability risk to insurance companies established

in consortia with other manufacturers. Two exarn5 This research is limited. Mriation between Cook County and San Francisco and between San Francisco and other California communities

calls into question the representrdiveness of trends observed in these particular areas for product liability claims, suits, and awards to the country

as a whole.

6 Insurance industry observers have suggested that one reason for setting up a captured insurance company is some excess insurers require

fii to have basic insurance in order to get an excess policy (5 10).
Chapter 7–Product Liability and the Pharmaceutical Industry I 173

pies of such insurers mentioned to OTA by drug

manufacturers are the American Casualty Excess,

Ltd. (A. C. E.) and X.L. Insurance Company, Ltd.

X.L. provides coverage below A, C. E., and A.C.E.

insures against the highest losses suffered by a

firm. Both insurers were established in the 1980s

and are funded through premiums paid by manufacturers (243,490 ).7

PRODUCT LIABILITY CLAIMS AND R&D

Systematic attempts to determine product liability costs borne by the pharmaceutical industry,

and the impact of product liability on fins’ R&D

decisions, innovation, and drug safety would

require data from several sources, much of which

is currently unavailable. Firms do not routinely

report to the public on liability claims made on

their products or settlements made by the firm or

their insurers. Insurance companies collect data

on claims made under their policies but do not

report on claims associated with particular companies or products. For the minority of claims

proceeding to litigation, court records exist but

are not centralized across different State and local

jurisdictions.

1 Overall Trends in Pharmaceutical

Product Liability Litigation

TRENDS IN NUMBERS OF CASES

In 1988, researchers at the Rand Corporation

analyzed product liability cases filed in the

Federal District Courts between 1974 and 1986 to

identify trends in the number of cases over time

and their concentration within particular industries and products (1 15). They focused on the

Federal court system because of the availability of

a single computerized data system. However,

these data have several limitations:

●

●

●

●

Most product liability cases are heard in

State courts, making the Rand analysis

potentially unrepresentative of all litigation.

The analysis is unrepresentative of product

liability claims and settlements not resulting

in litigation, which constitute the vast majority of all claims.

The database records only the first named

defendant in cases with more than one

defendant.8

Because this database does not mention the

product involved in each suit, the Rand

researchers classified defendants by the

company’s Standard Industrial C1assification (SIC) code (which reflects the company’s primary area of business activity).

However, since many companies have diversified product lines, a suit against a firm

with a pharmaceutical SIC code does not

necessarily mean the suit itself concerns a

pharmaceutical product.

The analysis found 85,694 different Federal

product liability cases involving a total of 19,456

lead defendants. Pharmaceuticals and health care

products represented 13.5 percent of the total

cases but only 2.2 percent of the total number of

defendants. Of the 11,292 suits for pharmaceutical and other health products filed, 72 percent are

attributable to five fins, and 60 percent are

attributable to two companies--A.H. Robins and

Merrell Dow Pharmaceuticals.9 Figures 7-1 and

7-2 show trends in these cases over time.

The Rand researchers concluded that A.H.

Robins’s Dalkon Shield contraceptive intrauterine device (IUD) and Merrell Dow’s Bendectin

antinausea medicine for pregnant women explained the bulk of liability cases for these two

7 The Federal Government has tied to facilitate risk pooling by erasing barriers to firms or other organimations to form “risk retention

groups” (RRGs) that write product and general liability insurance policies and collect premiums or “purchasing groups” (PG) that pool risk

in order 10 get additional coverage or cheaper premiums than if they were purchasing insurance alone (Public Laws 97-45,98-193, and 99-563).

To date, firms have not made much use of these options (489,5 10), and pharmaceutical executives interviewed by OTA did not mention F2RGs

as part of their insurance protection against liability.

g The Rand researchers conducted a separate analysis of paper records of Federal product liability cases filed in California between 1977

and 1986. They found, on average, each case had 2.2 defendants, and codefendants (i.e., other than the lead defendant mentioned in the

computerized Integrated Federal Courts Database) are sued infrequently in the Federal courts.

s A.H. Robins WaS tie defendant in almost 5,700 cases, and Merrell Dow in just under 1,300.
174 I Pharmaceutical R&D: Costs, Risks and Rewards

firms. The dropoff in numbers of new cases

involving these firms in 1985 and 1986 is

attributable to a cutoff for new claims against the

Dalkon Shield on April 30, 1986 (following A.H.

Robins’s bankruptcy in August 1985) and a

district court ruling in favor of Merrell Dow in a

February 1985 judgment involving 800 consolidated Bendectin suits. The Dalkon Shield and

Bendectin cases are discussed further in the

section that follows on products involving reproductive health.

Despite the overwhelming number of cases

probably attributable to two products, the researchers noted a significant increase in the

number attributable to other defendants during

the 1980s and a contemporaneous increase in the

number of defendants. The number of cases more

Figure 7-l—Filing Patterns of Federal

Pharmaceutical Product Liability Cases, 1974-86

Number of suits filed

2,200

2,000

1,800

1,600

1,400

1,200

1,000

800{

/,

/,

/

N

/ ‘, /,/

—J

/

197475 76 77 78 79 80 81 82 83 84 85 86

— — Major defendants Other

SOURCE: T. Dungworth, Producf Liabi/ity and the Business Sector:

Litigation Trends in FederalCourts(Santa Monica, CA: The

Rand Corporation, 1988).

than doubled between 1981 and 1986, of a rate of

increase greater than that for all Federal product

liability cases during the same period.

In 1988, the U.S. General Accounting Office

(GAO) published a study of its own examining

trends in Federal product liability filings between

Figure 7-2—Federal Pharmaceutical Product

Liability Patterns for Major Defendants, 1974-86

Number of suits filed

1,600

J

1,400

1,200

1,000

I

/--J/t\

o

1974 75 76 77 78 79 80 81 82 83 84 85 86

--m-- A.H. Robins + Merrell Dow —— Other major

defendants

SOURCE: T. Dungworth, Prtict Liabi/ify and the Business Sealx:

Litigation Trends in Federa/Covrts(Santa Moniea, CA: The

Rand Corporation, 1988).

1974 and 1985 (432). Although GAO did not

examine cases involving pharmaceuticals separately, it found that a few products—including the

Dalkon Shield and Bendectin--were responsible

for the bulk of the growth in filings during this

period (432).

TRENDS IN JURY AWARDS AND JUDGMENTS

AGAINST MANUFACTURERS

OTA found no systematic attempts to examine

the monetary awards resulting from pharmaceutical product liability litigation. The Rand analysis

of jury awards for all product liability cases (not

just those involving drug companies) in San

Francisco and Cook County showed that once

sued, the number of claimants and the total

amount claimed tended to be large and to have

increased over time (318,388). Increases in the

magnitude of the largest awards and in the

probability of a plaintiff winning indicated manufacturers may have faced a greater expected loss

if they allowed claims to proceed to trial.10

10 Although there is no systematic analysis to date of jury awards speci.flcally involving the pharmaceutical fidustry, tie md Corporation

is currently examiniog how product liability affects company decisionmalun“ g and industrial economic performan ce (142),
. .

Chapter 7—Product Liability and the Pharmaceutical Industry I 175

S Liability Claims Involving

Reproductive Health Products

THE DALKON SHIELD AND

OTHER CONTRACEPTIVES

The Dalkon Shield and Bendectin are both

products intended to affect the reproductive

health of women in childbearing years. A.H.

Robins acquired the rights to the Dalkon Shield in

1970. Claims of the device’s effectiveness as a

contraceptive were based on a l-year study of 640

women, which showed a 1.1-percent pregnancy

rate during the trial period (103). At that time,

Federal law did not require FDA approval of

medical devices such as the Dalkon Shield.11

A.H. Robins began to market the contraceptive

device in the United States in January 1971

despite questions among the fro’s medical staff

about the validity of conclusions drawn from the

single effectiveness study (288).

During the first 3 years of marketing, A.H.

Robins received evidence the Dalkon Shield

could and did cause uterine infections and septic

abortions, but it did not change the product or its

labeling. In June 1974, A.H. Robins withdrew the

device from the market after the U.S. Centers for

Disease Control (CDC) had reported complications among 62 percent of women who became

pregnant while wearing the Dalkon Shield (288).12

After the Dalkon Shield suits forced A.H.

Robins into bankruptcy, the courts imposed an

April 1986 filing deadline for new claims. By that

time, about 320,000 claims had been filed against

the firm for injury caused by the Dalkon Shield

(206). Of the 4,400 claims resulting in litigation,

A.H. Robins paid $250 million in out-of-court

settlements and another $25 million in punitive

awards imposed by 11 juries. As part of its

bankruptcy plan, the courts required A.H. Robins

set aside another $2.475 billion for unsettled

claims (288).

Although the Dalkon Shield is not a pharmaceutical product, some observers have suggested

that claims made against it have led to successful

claims made against pharmaceutical products,

including oral contraceptives (9, 192). However,

the data do not exist to measure whether there has

been a significant increase in liability losses for

contraceptives other than the Dalkon Shield. As

measured in terms of decided court cases (i.e., not

including those settled or otherwise resolved

before completion of a trial), oral contraceptives

show cyclical variation in numbers of cases over

time, but the average number of cases within each

cycle remained relatively constant between 1971

and 1988 (see figure 7-3).

BENDECTIN

First sold in the United States in 1956, Bendectin is a combination drug consisting of a

vitamin, an antispasmodic, and a sedative. It is the

only pharmaceutical ever approved in this country for the treatment of “morning sickness”

Figure 7-3—Yearly Reported Oral Contraceptive

and IUD Liability Cases

Number of reported cases

9 -

6 -

3 ’

0+ A A

1971 73 75 77 79 81 63 85 87

+ Oral contraceptives --o-- Dalkon Shield IUD

--i-- Non-Dalkon IUD

SOURCE: L. Mastroianni, P.J. Donaldson, and T.T. Kane (ads.),

Developing New Contraceptives: CMstades and @pOrtunitk (Washington, DC: National Academy Press, 1990).
176 I Pharmaceutical R&D: Costs, Risks and Rewards

associated with pregnancy.

1 3

Beginning in 1969,

the medical literature reported cases of congenital

defects in babies born to women who had taken

Bendectin during pregnancy. Because the number

of deformities attributable to Bendectin was

expected to be small if it did cause birth defects,

establishing this relationship with any degree of

statistical confidence was problematic.

Although the FDA concluded in 1980 that there

was not enough evidence to ban Bendectin from

the marketplace, it required the drug’s manufacturer, Merrell Dow, to change its package insert to

indicate while the drug had been carefully studied, it was impossible to prove it was without risk

if taken as indicated (45 F.R. 80740).

As mentioned earlier, litigation proliferated

despite the FDA’s willingness to allow the drug’s

use. In the early 1980s, the courts consolidated

1,100 claims into a single, class-action suit that

Merrell Dow offered to settle for $120 million.

The plaintiffs rejected the offer, and the manufacturer successfully defended itself in a jury trial. Of

the 17 Bendectin cases that had gone to trial by

July 1987, Merrell Dow had prevailed in 12 (192).

According to one source, total costs to Merrell

Dow of defending itself against Bendectin’s

liability suits exceeded the $13 million in annual

revenues the company received from sales of the

drug, prompting the firm in 1985 to remove it

voluntarily from the marketplace (61).

DES

First discovered in 1937, the synthetic form of

estrogen called diethylstilbestrol (DES) was marketed as a generic product by over 300 manufacturers worldwide, especially during the 1950s, as

a means of preventing miscarriages. However,

research completed in 1971 showed a statistically

significant association between DES use and

clear-cell adenocarcinoma, a cancer of the glands,

among daughters of women who had used the

drug. This finding resulted in a large number of

product liability suits against the drug’s manufacturers. 14 Because of the large number of manufacturers involved and the long period between use

of the drug and development of the cancer, the

courts were unable to determine directly which

manufacturer had caused each injury. The case of

DES led the California Supreme Court to be the

frost to adopt the “market share” theory in

attributing causality among drug manufacturers

(142,192,263).

1 Liability Claims Involving Vaccines

Vaccines are another type of health care

product frequently cited as prone to liability

claims (9,239). Although they are usually not

considered to be therapeutic pharmaceuticals—

the type of health care product on which this

report largely focuses-they are appropriately

discussed in this chapter for several reasons:

. Because most vaccine manufacturers also

produce pharmaceuticals, the behavior of

firms responding to vaccine liability claims

may be similar to their likely behavior in the

face of pharmaceutical liability claims.

● The distinctions between vaccines and pharmaceuticals in terms of their underlying

science and their R&D processes can be

murky, particularly as more therapeutic

pharmaceuticals rely on biotechnological

techniques to replicate substances naturally

found in living organisms as many vaccines

traditionally have done.

. The Federal Government has attempted to

absorb some of the product liability faced by

vaccine manufacturers, potentially offering

13 In 1972, ~~~of ~ ~eview of ~gs approved by tie FDA before tie imposition of tie requirement that drugs show effectiveness to be

marketed in the United States, the National Research Council and the National Academy of Sciences concluded there was no clinical evidence

the antispasmodic contributed to the drug’s therapeutic effect, and the manufacturer dropped this agent from the drug. This finding was

unrelated to the claims that resulted in product liability litigation involving Bendectin (239).

14 DES is not identified as a major product in the Rand analyses of Federal court cases described earlier in this chapter. ~S could reflect

the fact that few DES cases were filed in Federal court (263). Alternatively, the number of DES cases in the Federal courts maybe obscured

because of a large number of DES manufactmers; the Rand analysis only identifies each case according to its “lead” defendant rather than

by the product name or all codefendants (142).
Chapter 7–Product Liability and the Pharmaceutical Industry I 177

w“

Photo cred(t BRISTOL MYERS SQUIBB COMPANY

Although vaccines can bean effective and cost-saving means

of preventing diseases, manufacturers of these drugs have

been the subject of many liability cases.

lessons and insights for policy makers considering greater Federal involvement in

pharmaceutical liability.

All vaccines introduce some component of an

organism that causes disease into the body in

order to stimulate the immunized person’s own

system to produce antibodies against that disease.

15 For reasons not completely understood.

some individuals exhibit reactions after receiving

immunizations ranging from soreness in the arm

to paralysis or brain damage (444). Determining

the actual risk of serious harm for a given patient

is difficult for two reasons: 1) they are rare; and

2) it is difficult to determine whether such harm

would have occurred even if the patient had not

received the vaccine (206).

The vaccine that has evoked the greatest

liability concern to date is the pertussis component of the diphtheria-tetanus-pertussis (DTP)

vaccine. The risk of encephalitic brain damage

was estimated in a 1981 British Medical Journal

article as 3.2 per million injections (9), although

more recent U.S. epidemiological research has

suggested the risk is actually much lower (165).

Risks of serious complications from other vaccines appear to be even lower than that of DTP

(9,444). Furthermore, vaccines are not mentioned

as frequent subjects of lawsuits (115,432).

Why, then, are vaccines frequently cited as

products bearing a heavy liability burden? The

answer may lie in the nature of vaccine products

and their differences from therapeutic pharmaceuticals, rather than in the risks or the absolute

liability burden associated with vaccines. Vaccines are an effective and cost-saving means of

preventing disease. Not only do the States require

children to be immunized against the most serious

childhood diseases, but the Federal Government

supports vaccination activities for children and

adults through a variety of grants and Medicare

and Medicaid reimbursement (443,449). At the

same time, however, some observers suggest

vaccines have relatively low profit margins (239).

The legal burden for vaccine manufacturers

also rests on somewhat different grounds than it

does for drug manufacturers. While courts have

found in most drug and contraceptive cases that

companies have fulfilled their duty to warn of

adverse reactions by adequately informing physicians of risks,16 some courts have ruled that

because there is no personalized relationship

between physician and patient in mass immunization programs manufacturers must provide warn-

] 5 ThCre :ire four main s~a[egi~s vaccines can adop[ in producing immunity:

1 ) ‘‘ KIllcd’ or ‘‘ Inactlva(cd vaccines contain deird cells of the bacteria or virus that causes the disease to be prevented. Examples

lncludc the Salk polio vacclrre and the pcrtussIs vaccmc.

2) ‘‘L]\’c u[[cnuatcd ” vaccmcs contain living version.s of a dlscasc-causing virus Um[ have been weakened m the laboratory. The

Sabln polio vaccine and tbc vaccines agaims[ mumps, mcmlcs, and rubella arc IIVC attenuated.

3) ‘ ‘Toxoid” ~accmcs, such as those thut pre~cnt d]phthcma and tetanus, contain weakened versions of poisonous Ioxrns produced

by [k d]scasc-causrng bactcrur (206).

4) Newer, ‘‘ iic~lld~r’ ~’accmc~, wh]ch contain only pIcccs of the d] s~~s~-~iiuslng bacter]a, htive been dcvcloptd in Ihe search for

a safer means of immunizing ilgtinSt pcrtussis (239).

1 h Th, s ,$ SOrnc[inlcs referred to :M the ‘‘ learned intermcdlag’ mlc.
178 I Pharmaceutical R&D: Costs, Risks and Rewards

ings directly to patients.17 Finally, many vaccines, especially the DPT immunizations, have

relatively common, nonserious, but disquieting

adverse reactions such as fever, inconsolable

crying, localized soreness, rashes, and malaise

(444). Such side effects may create the perception

among health care consumers that the risk of

serious injury is greater than it really is; patients

may be more likely to claim that health problems

occurring subsequent to vaccination occurred

because of the vaccination.

E Evidence Concerning Product

Liability and Innovation

Given the discernible patterns of product liability claims and costs described above, what is

known about their effects on the pharmaceutical

R&D process? There are at least two hypotheses

one could attempt to test:

Product liability could increase R&D costs

and lengthen the R&D process as firms

perform ‘‘defensive studies’ to help protect

themselves from subsequent negligence

claims and as they absorb the costs of

liability for a drug administered during the

clinical R&D phase.

Product liability burdens could lead firms

not to fund R&D in certain areas or ultimately not market certain products.

OTA found no studies or other evidence that

allow one to test the first of these hypotheses. In

addition, it was not cited by pharmaceutical

industry officials in any of OTA’s interviews at

eight drug fins. Hence, OTA is unable to shed

any additional light on this possible corporate

response to product liability. However, there is

evidence (albeit largely anecdotal) that bears on

the second hypothesis.

PRODUCT LIABILITY AND FIRMS’

WILLINGNESS TO CONDUCT R&D

OTA found only one attempt to bring together

industrywide data to determine if product liability

inhibits pharmaceutical innovation. In a 1991

study, Viscusi and Moore compiled data for

pharmaceuticals and several other manufacturing

industries for the frost half of the 1980s on both

product liability insurance experience and innovation (501). They concluded that during the

period examined pharmaceuticals were both relatively innovative and subject to a volatile liability

burden-that do not lend support to the hypothesis that product liability inhibits innovation.

However, their study does not control for other

factors that might have affected innovation.18 In

addition, their examination of industrywide data

may obscure differences in access to various

types of pharmaceuticals.

Much of the remaining evidence on product

liability and pharmaceutical innovation is anecIT ~epr=~at.=~ case wmD~is v. W’ye~hfubomr~fie~, 399 F.2d 121 (9th Cir. 1%8), which dealt with a polio vaccine administered

inamassimmunization clinic. Reyes v. Wyeth L.uborutory, 498 F.2d 1264 (5th Cir. 1974), reinforced this decision by ruling the manufacturer

was liable because of inadequate warning even though it had manufactured the vaccine properly with printed warnings and there was good

evidence the plaintiffs polio was caused by a virus not found in the vaccine. In this latter case, the court indicated f- should bear the cost

of a potential vaccine-induced injury as a predictable business expense, passing the cost on to consumers in the price of the vaccine ratlm than

placing the loss on the injured party (443). However, in another Federal case decided this year, Mazur v. Merck, the court actually ruled a

manufacturer was nor liable for an injury that occurred in a 1982 mass immunization program because a Federal agency, the U.S. Centers for

Disease Control, had agreed to convey warnings to the patient (404).

18 my point out WXd other limitations of the data they present:

1) The statistics on innovation are measured at the beginning of the pcaiod examin cd (1980), and almost no firm changed its

responses in the suhsequemt annual surveys conducted. Hence, there is no measured variation in innovation over time in this

database or any way to determine if innovation would have been different with lessor more product liability burden.

2) The statistics on product liability are likely not to bean accurate reflection of product liability activity in the pharmaceutical

indusby because the authors depend on insurance data and much of the transition to self-insumnc e for drug manufacturers owmrred

before 1980.

3) The largest number of liability cases (as suggested in the Rand and GAO data) and the greatest amount of attention to product

liability occurred during 1985 and 1986-after the collection of the data that Viscusi and Moore examine.
. —— -= -

Chapter 7–Product Liability and the Pharmaceutical Industry I 179

dotal and tends to fall into one of two lines of

argument. One line of argument cites the discontinuation of products associated with high liability costs as evidence of how product liability

directly limits the availability of products to

consumers and as an indirect indication that

liability could inhibit R&D for similar types of

products. Among the products cited are the

Dalkon Shield, Bendectin,19 thalidomide as a

sedative for nonpregnant women (239), and

vaccines against DPT, Japanese encephalitis (254),

and swine flu (293).

The second line of argument directly attributes

certain changes in fins’ R&D portfolios to

product liability. The examples to support this

argument are somewhat more general than those

given above, perhaps because of the confidential

nature of most fins’ R&D portfolios.20 Among

the examples encountered by OTA:

●

●

Contraceptive R&D-The number of large,

U.S. research-based pharmaceutical firms

engaged in contraceptive R&D has dropped

in recent years from nine to two.21 Product

liability is the most-often cited reason for the

decision to end such research programs

(89).22

Pharmaceuticals Taken During PregnancyMembers of the legal staff at several pharmaceutical firms interviewed by OTA for

this report indicated they would raise concerns about any potential product to be given

to pregnant women. The lawyers tied their

concerns specifically to the Bendectin expe-

●

rience. Other analysts have made similar

findings (348).

Vaccines Against Human Immunodeficiency

Virus (HIV)--Legal staff at a firm engaged

in R&D to develop a vaccine against HIV

told OTA that liability was a significant

consideration each time the company decided to continue this research. Furthermore,

the firm’s insurer was reluctant to provide

any coverage for a potential product. Legal

staff at two other companies indicated their

liability insurers23 asked the firms to inform

them if they decided to engage in HIV

vaccine R&D. In a recent case, Abbott

Laboratories withdrew its participation in a

planned NIH clinical trial that would have

tested vaccine to ensure pregnant HIV positive women from passing the virus to their

unborn children. Abbott cited fear of liability in its decision not to provide NIH with

the vaccine, called HIV hyperimmune globulin (HIVIG) (81). Other groups have also

cited potential liability problems surrounding the search for a product to prevent HIV

infection (9,231).

Some observers suggest the impact of liability

can be inferred from the complexity and extent of

safety testing necessary to receive FDA marketing approval. According to this line of argument,

these regulatory requirements are largely driven

by public concerns that products not cause injury,

the basis for liability (243).

19 me l~bill~ ~x@mm of this ~g~d its withdrawal from the market hasac~y led one author to suggest that no COIllpiiIly wdl ever

again seek to market a drug to treat nausea associated with pregnancy (239).

Zo ~ OTA*s fiterviews at eight re-h-based pharmaceutical fins, company OfflCialS Off~t?d SpeC~lC mamples of MD pmj~ts

abandoned or forgone because of liability concerns, but all fm asked that they not be identifkd by name with these decisions.

21 Ortho Pharmaceuticals, a subsidiary of Johnson & Johnsou has had an ongoing contraceptive R&D program. Eight companies that have

discontinued such R&D are: Syntex, Searle, Parke-Davis, Merck, Upjo~ Mead Johnson, Wyeth-Ayers4 and Eli Lilly (207). Wyeth-Ayerst,

a subsidiary of American Home products, has renewed its contraceptive R&D program in recent years, focusing on new forms of oral

contraceptives (8,25 1). In additioa a relatively new, small f~, Gynco-Pharma, cunently markets a copper IUD. Non-U.S. f- as well as

universities and nonprofit foundations also carry on R&D on new forms of birth control (207).

22 However, pr~uct liabfi~ is not the o~y r-on cited. Others irl~lude lfitatio~ on patents that make poten~ products possibly

unprofitable and perceived public pressure not to engage in contraceptive R&D (89).

23 ~ each case, the f~s had only excess product liability insurance and 5elf- insured against lesser claims.
180 I Pharmaceutical R&D: Costs, Risks and Rewards

GOVERNMENT POLICY AND

PRODUCT LIABILITY

To what extent has government intervened in

recent years to alter product liability rules or to

affect the outcomes of liability claims? This

section reviews recent policy initiatives of potential relevance to pharmaceutical liability,

0 Tort Reform

As States have developed different case law,

some have also enacted statutes designed to alter

liability law, usually in response to the perceived

ill effects of court decisions. Although some

attempts at changing liability law have been

found in most States, a Federal review of statutes

adopted by State legislatures during 1986 alone

revealed the actual provisions adopted vary greatly.

The most common reform (enacted by 16 States)

altered the doctrine of ‘‘joint and several liability’ which allows multiple defendants named in

a lawsuit all to be held responsible. Observers

have suggested under this doctrine the wealthiest

defendant often pays all or most of the damages

whatever the defendant actual degree of responsibility for causing the injury (265). Other provisions adopted by States include limitations on

noneconomic and punitive damages, limitations

on attorney’s contingency fees, allowance for

periodic payment of damage awards instead of

requiring a lump sum, and modification of the

‘‘collateral source rune,’ which prohibits courts

from considering other sources of compensation

(such as personal health insurance benefits) a

plaintiff may receive (490).

Over the past decade, Congress has considered

several Federal product liability statutes that

would supersede any relevant State statute or case

law. The 101st Congress considered, but did not

adopt, “The Product Liability Reform Act” (S.

101-1400). 24 Of particular importance to the

pharmaceutical industry, the bill would bar punitive damages for drugs or medical devices receiving approval from the FDA unless the manufacturer had withheld or misrepresented relevant

information from the agency. Among other provisions of the bill were limitations on punitive

damages, limits on the amount of time in which

a plaintiff can bring a claim, a limitation of joint

and several liability25 to compensatory (nonpunitive) damages only, and incentives for parties to

settle the case prior to trial (442).26

One recent study suggests case law as well may

be moving away from the expansion of liability

and damages, In a quantitative analysis of recent

State court decisions in product liability cases,

Henderson and Eisenberg suggest that since the

early to mid-1980s, courtroom decisions have

subtly begun to favor manufacturers by placing

limitations on injured parties’ ability to receive

damages. They show this change predates many

of the statutory reforms described above. While

such tendencies are becoming evident, the authors point out it still may be too early to assess

their ultimate impact (182).

~ Federal Compensation for Injuries

Associated With Health Care Products

To date, the Federal Government has not

established any alternative or additional remedy

for injuries associated with therapeutic pharmaceuticals. 27 However, on two separate occasions,

Congress has adopted compensation schemes for

vaccine-related injuries.

24 SeMte Bill IWO (lolst Conwess) was vev similar to seve~ earlier product liability reform bills: S. 666 (100th Congress) md S. 2790

(99th Congress).

25 “Joint and several liability” refers to the liability of each defendant for all damages even if more than one defendant is found liable.

‘s Introduced by Senator R:obert W. Kasten in July 1989, the bill reached was reported out of committee (Senate Report 101-356), but not

debated on the floor before the end of the session. Senator Kasten reintroduced this legislation in the 102d Congress (S. 640).

’27 AS mention~ ealier in this chapter, Congress has considered adopting national tort law standards, hdlldillg propods to Prot~t

manufacturers from punitive damage awards for products approved by the FDA unless the manufacturer has acted fraudulently.

~g In January 1976, several soldiers at Fort Dix (New Jersey) became sick with influenza found by the CDC to be caused by the swine flu

virus responsible for the worldwide influenza epidemic in 1918-19 that killed 20 million (293).
Chapter 7—Product Liability and the Pharmaceutical Industry ! 181

THE SWINE FLU IMMUNIZATION PROGRAM

In August 1976, in the face of an epidemic of

swine flu expected during the winter of 1976-

77,28 Congress established a national immunization program (Public Law 94-380). As part of this

legislation, the Federal Government agreed to

accept liability for vaccine-related injuries. Because insurers had excluded the vaccine from

product liability policies, manufacturers were

unwilling to supply it without Federal intervention. Under this law, people who believed themselves to have been injured could not sue, but

were permitted to make claims against the United

States within 2 years of the vaccination according

to the theories of liability in practice in the State

where the injury took place (169).

The U.S. Department of Health, Education, and

Welfare (DHEW) (now the U.S. Department of

Health and Human Services (DHHS)) halted the

immunization program in December 1976 after

several vaccinated individuals contracted GuillainBark syndrome, a condition that leads to paralysis.29 About 40 million people had received the

vaccine. In June 1978, DHEW announced that

because the vaccine label and consent form did

not warn recipients about the possibility of

Guillain-Barre, those claiming injury did not need

to prove fault (i.e., negligence by the government)

in order to receive compensation. Out of the 4,179

claims and 1,604 lawsuits filed against the

government under the swine flu program, the

government paid a total of $90.1 million in 709

settled claims, 391 settled suits, and 105 judgments in favor of the claimants (169).30

THE NATIONAL CHILDHOOD VACCINE

INJURY ACT OF 1986

In response to concern over the ability of the

dwindling number of vaccine manufacturers to

provide adequate supplies of vaccine for childhood immunization during the 1980s, Congress

adopted a no-fault alternative to product liability

litigation for people seeking compensation for

injuries related to childhood vaccines administered up to 8 years prior to the enactment of the

legislation (Public Law 99-660, Title III). Under

the act, Congress determines which vaccines are

included, and the Secretary of DHHS determines

what types of injuries are eligible for compensation through regulation.31

Although claimants may still choose to pursue

compensation, this statute essentially constitutes

Federal tort reform for eligible childhood vaccinerelated injuries. By establishing a no-fault compensation scheme as the first form of redress for

injuries and limiting liability for manufacturers

who have met FDA requirements, Congress has,

in essence, nullified case law that had previously

allowed liability findings based on theories of

29 In addition, tie epidemic of swine flu nCVCr oCCUrred.

~~ According t. Hag~, at fie tlmc ~cSc data were gathered in January 1989, 2 claims ad 17 lawsuits were still to ~ resolved (169).

s 1 Cumcnt]y, the pro~~ includes vaccines for measles, mumps, polio, rubella, and diptheria/pertussls/tetanus (DW. me law prohibits

anyone from seeking awards of more than $1,000 or for an unspecified amount though civil litigation without frost filing a petition for

compensation with the U.S. Claims Court and the Sccremry of DHHS.

Compensation can include nonlegal expenses incurred as a result of the injury, lost camings, and death up to $250,000. The program allows

compensation for attorneys’ fees regardless of the outcome of the petition.

‘fhe compensation mechanism is ‘‘nonexclusive’ in that claimants may choose to pursue remedies through the courts rather than accepting

an award through the no-fault process. However, if a claimant sues, the law tries to protect manufacturers from claims of design defect if they

have complied with all relevant FDA regulations in establishing a drug’s safety and efficacy.

Compensation for vaccines administered before October 1, 1988 comes from appropriated funds which have averaged $80 million per year

since Congress first funded the program in fiscal year 1989 (Public Law 100-436). A tax added to the cost of each vaccine funds a National

Mccine Injury Compensation Trust Fund, which pays damages awarded for vaccines administered after October 1, 1988. The tax rate is set

according 10 evidence about the frequency and expected damages msociated with each type of vaccine (169).

As of June 18, 1991, the U.S. Health Rcsourccs Scswiccs Adminis&ation, which is charged with implementing the compensation program

within DHHS, had rcccivcd 4,095 petitions for pre-October 1988 injuries and 127 for injuries on or after October 1, 1988. Of the 306 petitions

acted on as of June 18, 1991, 66 were withdrawn or dismissed before being adjudicated, 188 were deemed compensable, and the remaining

were ruled not compensable. The government has paid a total of $122.4 million in awards that individually ranged from $48,510 to $2.9 million.

The average award for pre-1988 cases is $1.2 million (465).
182 I Pharmaceutical R&D: Costs, Risks and Rewards

strict liability and a failure to warn. The experience of this program could offer insights into the

potential effects of adopting a similar no-fault

compensation system for acquired immunodeficiency syndrome (AIDS) vaccines, as suggested

by the Keystone AIDS Vaccine Liability Project

(231), or into the implications of other product

liability reform proposals like those mentioned

earlier in this chapter.

CONCLUSIONS

Despite a lack of systematic data, it is possible

to piece together the major implications of

product liability on pharmaceutical R&D. Although health care products appear to be a part, if

not a significant part, of the increase in product

liability litigation over the last 20 years, the vast

majority of health-care-related cases have involved only certain types of products, contraceptives, and other pharmaceuticals that affect reproductive health, and vaccines. Although some

firms continue to pursue R&D in these areas,

anecdotal evidence suggests liability concerns

may significantly inhibit the overall level of

industrial R&D effort in these areas. Both industry and government have implemented novel

forms of underwriting health-care product liability risks, although no systematic evidence exists

to evaluate the extent to which these programs

enhance firms’ willingness to conduct R&D for

vaccines and reproductive health products. As

suggested by recent experience, fear of product

liability may be a particularly significant barrier

to industry’s willingness to develop, test, and

market potential

become a major

Government.

vaccines against HIV and may

policy concern for the Federal
—..

T

Federal Tax Policy

and Drug Research

and Development

he taxes paid by pharmaceutical companies alter both the

net cost of pharmaceutical research and development

(R&D) and the ultimate returns on R&D investments.

This chapter examines U.S. tax code provisions that

directly affect R&D or are of particular relevance to the

pharmaceutical industry. It describes the incentives for taxpaying

companies to alter their R&D behavior, and it estimates the

actual impact of these provisions on the Federal Treasury and on

drug companies.

ANALYZING TAX POLICY

Federal corporate income tax policy comprises laws and

regulations that define income subject to taxation, adjustments to

taxable income (deductions), tax rates, and adjustments to tax

payments (tax credits and minimum tax payments). Tax code

provisions are not just intended to raise revenue; they are also

structured to provide taxpayers with incentives to spend or invest

in desirable ways. Most of these incentives are either deductions

from taxable income or credits against tax liability. For example,

the tax code contains tax credits to encourage firms to perform

more R&D and to make the United States competitive with other

nations as a place to locate business. Similar tax deductions exist

for some R&D expenses not eligible for these tax credits.

Because each of these provisions reduces the taxes that the

Federal Government collects from firms, they are sometimes

referred to as ‘ ‘tax expenditures’ (241). While any taxpayer

theoretically could take advantage of any of these incentives, in

reality many provisions have requirements that preclude their use

except by certain types of taxpayers. This review focuses on

components of the tax code that either directly affect industrial

# - ‘“

1 This chapter is based in part on two papers prepa.rcd under contract for the Office

of Technolo~r Assessment (7,245).

183

330-067 - 93 - 7 : QL 3
184 I Pharmaceutical R&D: Costs, Risks and Rewards

R&D expenditures or are used by the pharmaceutical industry more (in terms of Federal tax

expenditures) than by other industries.

A common measure of the impact of tax policy

on a firm’s or industry’s operation is the average

effective tax rate, the ratio of actual income tax

paid to the pretax income of a taxpayer or a group

of taxpayers (such as the whole pharmaceutical

industry). This measure: of tax burden assesses the

equity of taxes paid across different kinds of

taxpayers or in examinations of corporate profits

and profit rates.

Because the average effective tax rate combines the effects of all provisions of the tax code,

it obscures differences in the tax rate that apply to

different kinds of assets or across different firms

within an industry (7). This chapter does not

contain estimates of average effective tax rates in

the pharmaceutical industry, but it does contain

estimates of each tax credit in the U.S. Federal

Tax Code as a percent of the pharmaceutical

industry’s taxable income. This measure is the

difference between two average effective tax

rates: the average rate without a credit minus the

average rate with the credit.

To examine the effects of particular tax credits

on pharmaceutical R&D investment, a more

useful measure is the marginal incentive effect or

marginal credit rate (5). This rate is the number

of cents that a tax credit reduces the ‘‘cost’ of an

additional dollar that the taxpayer decides to

spend on R&D. The “credit rate” is a negative

tax rate. Because of limitations on particular tax

credits, the effective marginal credit rate can be

different from the “statutory rate. ’ This chapter

reviews what is known about the marginal credit

rate associated with each of the several tax credit

provisions affecting pharmaceutical operations.

The aggregate impact of a tax credit is the

extent to which it achieves its policy goal. For

example, the goal of a tax credit is to increase

corporate investment in R&D. The Office of

Technology Assessment (OTA) did not measure

policy impacts of the tax provisions affecting the

pharmaceutical industry.3

Finally, a measure of the Federal Treasury’s

cost is the net subsidy of a tax credit or deduction.

The value of tax credits claimed by taxpayers

represents a dollar-for-dollar cost to the Federal

Treasury. OTA estimated Federal tax subsidies

associated with tax credits claimed by the pharmaceutical industry.

TAX DEDUCTIONS AND

TAXABLE INCOME

1 Deductions of R&D Expenses

From Taxable Income

Section 174 of the Internal Revenue Code

permits businesses to fully deduct R&D expenditures in the year incurred-a practice referred to

as ‘‘expensing. ’ In contrast, Federal income tax

law does not permit expensing of outlays made on

other kinds of investments such as machinery,

equipment, or facilities that remain useful for a

number of years. 5 The immediate expensing of

R&D creates an incentive for a taxpaying firm to

conduct R&D, because a tax deduction taken

today is worth more than one that must be taken

in the future. Firms do have the option to deduct

R&D expenditures made in a particular year over

a period of at least 5 years beginning with the

month in which revenues first flow into the firm

from the R&D. The deferral option is meant to

benefit small or newer firms with little or no

taxable income during their early years.

When it was written in 1954, section 174 gave

little indication of what activities qualified as

z me sta~tory rate is the rate written into the internal revenue code.

s Analyses of the impact of the R&D tax credit on aggregate R&D investment, see (33,437).

4 R&D is referred to in the tax code as research and experimentation (R&E). In this chapter OTA uses the term R&D to refer to R&E

expenses covered under five tax code provisions.

s The cost of other investments is recognized overtime through “depreciationallowances. The term ‘depreciation’ refers to the allocation

of the cost of a long-lived asset over its useful life.
Chapter 8-Federal Tax Policy and Drug Research and Development I 185

R&D. Subsequent regulations, first adopted in

1957, provided more detailed guidelines (26 CFR

1.174). According to these regulations, the deduction is for ‘research and development costs in the

experimental or laboratory sense, ’ including all

expenditures incident to the development of an

experimental or pilot model, a plant process, a

product, a formula, an invention or similar

property, and improvements to existing property

similar to these types. It also includes the cost of

obtaining a patent.

Specifically excluded from the definition of

qualifying R&D expenditures are those for testing

quality control, management studies, advertising

and promotion, market research, sales promotion,

sales service, research in the social sciences or

psychology, and other nontechnological activities

or routine technical services. In interviews with

executives at eight research-intensive pharmaceutical firms and with Internal Revenue Service

(IRS) examiners responsible for auditing R&D

deductions, OTA found that the IRS interprets

these regulations to exclude the cost of developing software used in the R&D process as well as

all management functions except the direct supervision of scientists and technicians. The regulations do permit firms to deduct the expense of

qualifying R&D that the firm has commissioned

and paid another organization to perform on its

behalf.

In regulations proposed in 1989 (54 FR 21224),

the IRS specifically discussed the application of

section 174 to pharmaceutical R&D. The proposed regulations included the following very

specific example:

Example (9): C, a biotechnology firm developed

a new drug that substantially lowers blood

pressure. Prior to marketing the drug, C incurs

costs to test the product and obtain U.S. Food and

Drug Administration (FDA) approval of the drug.

The costs incurred by C to develop, test, and

receive government approval of the drug are

research and experimental expenditures within

the meaning of section 174.

Although this interpretation has not yet been

adopted as a final regulation, the IRS is currently

interpreting the rules in this way.

If expenditures are disallowed by the IRS as

qualifying R&D expenses under section 174, they

can still be deducted as ordinary business expenses. However, the definition of R&D is the

basis for allowing research expenses to count for

a Federal R&D tax credit, which is discussed later

in this chapter.

FOREIGN SALES AND DEDUCTION OF

US. R&D EXPENSES

One provision of the tax code, currently

suspended by congressional action,6 could serve

as a disincentive for multinational firms to locate

R&D in the United States. A 1977 Treasury

Department regulation (CFR 1.861-8) would

limit the extent to which multinational firms

could deduct expenses for qualified R&D conducted in the United States (CFR 1.861-8). The

rationale for the regulation is that if a firm spends

money for R&D in the United States and the

resulting products or processes are sold abroad,

then a portion of these R&D costs should be

allocated against foreign sales. As discussed later

in the section on foreign tax credits, foreign sales

are subject to special U.S. tax provisions designed

to provide some allowances for income taxes paid

abroad. Because the U.S. tax rules governing

income from foreign sources lead to higher

effective tax rates on foreign income than on

domestic income,7 this regulation may provide an

incentive for multinational firms to export a

portion of R&D overseas (245). Because the

research-intensive segment of the pharmaceutical

industry is multinational, the incentive to locate

6 In 1981, Congress passed a 2-year moratorium of U.S. Treasury regulation 1.861-8 (Public Law 97-34). Although Congress has never

made the moratorium permanen4 it has renewed the moratorium for a temporary period at each expiration. Most recently, the Omnibus Budget

Reconciliation Act of 1990 extended the moratorium through the 1991 tax year (Public Law 101-508).

7 Most other mtions with provisions permitting the deduction of R&D expenses from taxable income do not disallow part of this deduction

for foreign sales.
186 I Pharmaceutical R&D: Costs, Risks and Rewards

R&D outside the United States is especially

important for the pharmaceutical industry.

1 Deduction for Contributions to

Scientific Organizations

The internal revenue code allows corporations

to deduct up to 5 percent of their taxable income

for contributions to educational and scientific

organizations held to be operating in the public

interest (section 170a,). The income of these

scientific and educational organizations operated

in the public interest is exempt from Federal

income tax (section 501a-c). The operating standard for research in the public interest is that the

work must result in information ‘‘published in a

treatise, thesis, trade publication, or in any other

form that is available to the interested public.’ If

met, the research-performing institution qualifies

for the tax exemption, even if the research is

performed under ‘‘a contract or agreement under

which the sponsor or sponsors of the research

have the right to obtain ownership or control of

any patents, copyrights, processes, or formulae

resulting from such research.’ Under this provision, pharmaceutical firms that contract with

academic institutions or donate R&D resources to

such institutions can reap the commercial benefits

of sponsored research at a cost that is net of taxes.

1 Depreciation of Capital Assets

Used for R&D

In addition to resources that qualify for the

section 174 deduction discussed earlier (such as

salaries and depletable supplies), pharmaceutical

R&D also requires the use of capital assets such

as machinery, equipment, and facilities. The tax

code requires companies to depreciate these costs

instead of deducting the total investment in the

year it was made.

Prior to 1981, firms were required to depreciate

equal portions of a capital expenditure used in

R&D (as well as assets used in other activities)

each year over its whole useful life (which could

be 10 or more years). The Economic Recovery

Tax Act of 1981, or ERTA (Public Law 97-34),

altered this practice by establishing an “accelerated cost recovery system” (ACRS). Under

ACRS, firms can depreciate all capital expenditures for R&D over a 3-year period regardless of

their useful lives.9 Congress further enhanced this

provision by giving companies a 6-percent tax

credit for all new capital investment for tax years

1982 through 1986.10 The Tax Reform Act of

1986 (Public Law 99-514) required firms to

depreciate such investments over 5 years instead

of 3.

Because tax savings realized sooner are worth

more to pharmaceutical companies than those

realized later, ACRS represents a net decrease in

the cost of R&D-related capital investment and

therefore an incentive for firms to expand their

U.S. R&D efforts.

TAX CREDITS

9 R&D-Related Tax Credits

TAX CREDIT FOR INCREASING RESEARCH

EXPENSES

A significant change in the tax treatment of

R&D occurred with the enactment of ERTA in

1981. Among four major provisions related to

8 As noted earlier, the section 174 deduction for qualifying R&D also permits f- to deduct the cost of R&D conducted by another

organiza tion. How then does the section 170(a) deduction differ from section 174 deduction? While it is possible that for a fm in the position

of providing funds to another org anization for research the two deductions are, in practice, indistinguishable, it is also possible that the

particular provisions of each deduction noted in the text may limit its usefulness to the fmn. To use the section 174 deductio~ the research

performed must meet the deftition of qual@ing R&D discussed earlier in this chapter, whereas section 170(1) is less restrictive. Hence, the

R&D expenses deductible under 170(a) may be greater than under 174. To use the section 170(a) deduction, however, the results of the research

must be openly published, thus eliminating the possibility of trade secrets. Furthermore, for corporations the total amount of all 170(a)

deductions must be less than 5 percent of taxable income.

g Capital expenditures for non-R&D assets are depreciated over 3 years or longer periods under ACRS (335). Hence R&D assets were

advantaged by the system put in place in 1981 when compared with all non-R&D assets as a group.

10 ~sfives~ent tax credit was not renewed when it expired in 1986.
Chapter 8-Federal Tax Policy and Drug Research and Development I 187

Photo cred~t NATIONAL INSTITUTES OF HEALTH

The Economic Recovery Tax Act of 1981 allowed

pharmaceutical companies to depreciate all expenditures for

R&D facilities and equipment over a 3-year period. The Tax

Reform Act of 1986 lengthened this depreciation period to 5

years.

R&D in ERTA was a new tax credit for increases

in R&D expenditures.

10 The credit was originally

equal to 25 percent of’ the difference between

qualified R&D expenses in the current tax year

and the average amount spent during the previous

3 taxable years, or 50 percent of current year

expenditures, whichever is greater. Qualifying

expenditures include company-financed expenditures for R&D wages and supplies, 65 percent of

the amount paid for contracted research, and 65

percent of corporate grants to universities and

scientific research organizations for basic research. Expenses must be paid by the taxable year

and must pertain to the carrying on of a trade or

business. Thus, the credit was originally not

available to startup companies, certain joint

ventures, or existing firms entering into anew line

of business,

The credit has several important limitations.

The requirement for ‘ ‘carrying on a trade or

business’ means that expenses incurred in connection with trade or business but not pertaining

to the development of potentially marketable

goods and services failed to qualify. For example,

development of new business accounting software would not qualify. Perhaps as important, the

courts have interpreted this limitation to exclude

research expenditures paid or incurred prior to

commencing a trade or business (29). Only wages

paid for doing actual research work qualified for

the credit. Thus, wages for laboratory scientists

and engineers and their immediate supervisors

qualified, but wages for general administrative

personnel or other auxiliary personnel (such as

computer technicians working in a multipurpose

computer and information-processing department)

did not. Research done outside of the United

States was also excluded.

Companies with insufficient tax liabilities to

use credits in the year they are earned may

‘ ‘ carry back’ ‘ these credits for up to 3 years to

offset past tax liabilities, or they may ‘‘carryforward’ for up to 15 years to offset future tax

obligations (26 CFR 38-39). Credits carried

forward in time do not earn interest, making them

less valuable than those that can be used in the

year they are earned.

Since its enactment in 1981, the provisions of

the R&D tax credit have changed several times.

The Tax Reform Act of 1986 (Public Law 99-5 14)

reduced the statutory credit rate from 25 to 20

percent. The law also narrowed the definition of

qualified research to emphasize the discovery and

experimentation stages of the innovation process,

thus eliminating expenditures for product modifications after they reach their functional specifications (441). The legislative history of the Tax

Reform Act clearly states that all R&D necessary

to obtain approval from the FDA to market a

pharmaceutical in the United States for one or

more indications qualifies for the tax credit

(Public Law 99-514, L.H. II-75).

Further changes in the tax credit enacted in the

1988 Technical and Miscellaneous Revenue Act

(TAMRA) (Public Law 100-647) reduced the

10 The ~~cr three Prov IsIons ~erc: ] ) ~ ~low:~nc~ for faster depreciation of R&D assets (discussed e~licr in the text), 2) ~ incrc~e ‘n

the deduct]on for newly manufactured research equipment donated to umvcrsitics, and 3) a 2-year suspension of a 1977 Treasury Department

regulation (FR 1.861-8) requiring a portion of R&D expenses for products or proccsscs sold abroad to be allocated against foreign sales, thus

reducing the value of the R&D deduction for U.S. taxes (also discussed earlier m the chapter) (357).
188 I Pharmaceutical R&D: Costs, Risks and Rewards

effective credit rate from 20 percent before

TAMRA to 16.6 percent (233). The Omnibus

Budget Reconciliation Act of 1989 (Public Law

101-239) extended the tax credit through September 1990 but also made changes that had

important effects on its value to firms (33,233). In

addition, as a company’s rate of R&D growth

(i.e., the annual percentage increase in R&D from

one year to the next) goes up, so too does the

probability that the credit will be subject to

limitations. Baily and Lawrence (33) showed that

a company first faces the limitations in the credit

at growth rates above 36 percent. This provision

of the law limited the ability of fast growing but

small research intensive R&D firms (such as

many biotechnology fins) to claim high credits.

Congress twice extended the version of the

R&D tax credit as adopted in 1989 (Public Law

101-508; Public Law 102-227), although it expired in June 1992. Congress passed another

extension as part of the Revenue Act of 1992

(H.R. 102-11) which President Bush vetoed

November 1992.

A number of researchers have estimated the

effective marginal credit rate (the percent reduction in the cost of R&D) implicit in the several

incarnations of this tax credit using a variety of

methods and assumptions; they have found effective credit rates that are substantially less than the

statutory rates of 20 or 25 percent. The divergence

between the effective and statutory rates stems

from the way in which the credit is calculated, the

interaction of the credit with other provisions of

the internal revenue code,ll the rate at which

future savings are discounted to their present

value, and the fact that not all firms have

sufficient tax liability to use credits in the year

they are earned.

Baily and Lawrence (33) estimated marginal

effective credit rates for the R&D tax credit as it

changed over the course of the 1980s. Assuming

that a firm could take full advantage of the credit

beginnin g in the first year it was available and

assuming a (before-tax) interest rate of 12 percent, they calculated that the 1981 credit reduced

the cost of qualified R&D by 9.3 percent. The

1986 changes in the credit and in corporate tax

rates reduced this effective rate to 6.1 percent by

1988; alterations made in 1988 further reduced

the marginal effective credit rate to 4 percent.

These calculations do not take into account the

fact that not all firms could use the credit. Some

were not expanding their R&D, making them

ineligible for the credit since it was based on

increases in research spending, while others did

not have sufficient tax liability to use the credits.

Other firms may have increased R&D spending

so rapidly that they were subject to upper limits

on the credit. To correct for these instances, Baily

and Lawrence reduced the calculated rate by 30

percent, based on estimates that 30 percent of

company-financed research expenditures across

all industries from 1981 to 1985 did not qualify

for the credit (437). After this correction, the

marginal effective credit rate declined from 6.5 to

2.8 percent between 1981 and 1989. This marginal effective rate is an average across all firms

in all industries. The pharmaceutical industry

might have a higher effective credit because

pharmaceutical R&D expenditures increased faster

than R&D in most other industries in the 1980s

(290). Individual pharmaceutical companies probably vary greatly in their marginal effective credit

rate depending on their R&D expenditures.

Altshuler used a different approach to estimate

marginal credit rates (5). Using data from the IRS,

she modeled the extent to which any particular

type of firm was able to use the R&D tax credit

between 1981 and 1984. This model accounted

for the carryforward and carrybacks of unused

credits. Altshuler estimated the marginal effective credit rate for firms with different levels of

R&D and different tax liabilities. Assuming an

(after-tax) interest rate of 7 percent, she found a

marginal credit rate of 1.3 percent for 1981 across

all industries. When weighted by qualified re11 For ~xmple, ~ven ~~out a m cmdi4 when the corporate tax rate was 46 pereent, an additional dolhr of R&D cost the f~o~Y $0.54

because these expenses are deductible.
Chapter 8-Federal Tax Policy and Drug Research and Development 189

search expenditures,

12 this rate increases to 2.3

percent, a figure that is less than 10 percent of the

statutory 25 percent credit rate in effect in 1981.

For some types of firms that expand their R&D

quickly and move from a nontaxable to taxable

state, she found a negative credit rate, which

suggests that the credit may create a counterintuitive disincentive to expand R&D. (An earlier

study by Eisner, Albert and Sullivan (119) that

also used IRS data for the 1981-84 period but did

not correct for carry forwards and carrybacks also

found instances in which the incentive created by

the credit to increase R&D is zero or negative.) A

third study by Wozny (525) that uses similar data

for the period and also accounts for the inability

of some firms to claim credits in the year they are

earned found marginal effective credit rates

consistently below 6 percent. Taken together,

these studies suggest that during the 1980s, this

tax credit lowered the price of each extra dollar

spent on R&D to a much smaller degree than the

25- and 20-percent statutory rates. However, none

of these studies provide estimates of effective

rates particular to pharmaceutical companies.

To date, only Baily and Lawrence have attempted to estimate the marginal effective credit

rates of the 1989 version of the R&D tax credit,

although this work also lacks any industryspecific estimates. Baily and Lawrence estimated

that the marginal effective credit rate for firms

able to fully utilize the credit is the statutory 20

percent, but for firms limited in using the credit,

it may be as low as 10 percent. Assuming that 70

percent of company -financed R&D qualifies for

the credit and no more than 10 to 20 percent of

R&D is in firms that face limitation, Bailey and

Lawrence estimated that, on average, the marginal effective credit rate of the latest version of

the credit is 12 to 13.5 percent. Regardless of the

exact marginal rate, their calculations indicate

that the 1989 version of the R&D credit provides

incentives to increase R&D spending substantially greater than those of earlier versions.

THE BASIC RESEARCH TAX CREDIT

The Tax Reform Act of 1986 established a tax

credit for support of university-based and nonprofitbased basic research. Like the R&D tax credit, its

statutory rate is 20 percent, and it is given for

increases in corporate cash payments to universities or nonprofit organizations for basic research

over abase amount.13 Basic research is defined as

“original investigation’ (in any area except the

social sciences, arts, or humanities) undertaken

“for scientific advance without commercial objective” (26 U.S.C. 41(e)).

OTA found no attempts to analyze the marginal

effective credit rate of the basic research tax

credit. Because of the complex structure of this

credit, the marginal effective rate faced by any

particular firm is lower than the statutory 20

percent and depends on the fro’s overall qualified R&D expenditures during the tax year and

previous years, its qualified basic research payments during the tax year, and its undesignated

university contributions during both the base

period and the tax year.

The IRS does not prohibit universities that

perform basic research under this credit from

assigning intellectual property rights (such as

12 BeC~u~~he -p~m~t “~e~~~the rate at whicha f~ is increasing its R&D over tie, ~tsh~er (unlike Baily and Lawrence)

weights research expenditures at the level of individual fms according to whether they were taxable in each of the 4 years she examined and

according to whether their qualifkd R&D expenditures were growing at a low, normal or high rate. Baily and Lawrence weight at the level

of dlfm together, using the estimate that 70 percent of all R&D expenditures in the whole economy from 1981 to 1989 qtiled for the

credit. Using her method, Altshuler estimated that for the period 1981-84, 62 percent of all R&D expenditures qualifkxl.

13 me b~e ~omt is spcific t. Czh corporation ~d is the sum of two ~mponen~. The f~s~ Cornponen[ Is (he gt@eSt C)f lhKX CtdCllkikd

amounts: 1) 1 percent of the average annual total qualitled research expenses (as calculated for the R&D tax credit) during a 3-year base period;

2) all contract research payments made by the taxpayer during the base period; 3) 50 percent of the qualifkd basic research payments to

universities and nonprofit organizations during the tax year. The second component is defined as the excess of the average annual nondesignated

contribution to universities during the base period (updated for inflation) over nondesignated university contributions during the tax year. This

second component is designed to reflect any decrease in nonresewh giving to universities during the tax year as compared with the base period.

If this amount turns out to be negative, it is assumed to be zero in calculating the base amount.
190 I Pharmaceutical R&D: Costs, Risks and Rewards

patent ownership) resulting from such research to

other parties, including the corporation that pays

for the research. Because the pharmaceutical

company may realize exclusive benefits from

basic research it supports in universities, the basic

research tax credit has created a new economic

incentive for pharmaceutical companies to support research conducted in universities. However,

such a decision is likely to depend on other factors

in addition to the after-tax cost of such research,

including where the scientific expertise resides,

whether it is desirable to maintain secrecy of

ongoing research, and what the firm’s philanthropic policy is.

THE ORPHAN DRUG TAX CREDIT

The third tax credit designed to promote R&D

is specific to the pharmaceutical industry. It is one

of several incentives included in the 1983 Orphan

Drug Act (Public Law 97-414) to encourage firms

to develop new treatments for commercially

unviable therapies in the United States.14 Firms

are entitled to a tax credit equal to 50 percent of

qualified R&D expenditures for human clinical

trials on therapies that have received official

orphan drug status by the FDA. Firms can receive

such status for drugs that treat diseases or

conditions affecting less than 200,000 people in

the United States.15

Clinical research expenditures for designated

orphan drugs qualify for the orphan tax credit

only if they otherwise meet the test for qualifying

R&D expenditures under the R&D tax credit (26

U.S.C. 41(a-d)). This test excludes several types

of expenses, including software development and

management of R&D activities (except for direct

supervision of R&D).

Is this tax credit an important incentive for

pharmaceutical firms to engage in additional

orphan drug R&D? Because it depends only on

the amount of qualified clinical testing that a

company does on a drug with orphan drug status,

not on increases in R&D, 16 the cost of an

additional dollar of qualifying orphan R&D is

$0.50 for the company, a 24 percent reduction

from the cost of the qualifying R&D without the

tax credit.17 However, not all firms can take

advantage of this credit. To benefit, companies

must have taxable income in the same year they

make these clinical research expenditures, because there is no carryforward or carryback

provision in the orphan drug tax credit. In

addition, since some expenses associated with

additional clinical orphan drug R&D do not

qualify for the credit, the actual cost of additional

clinical R&D for qualifying drugs is somewhat

more than $0.50 on the dollar (but less than

$0.66).18 Even so, this analysis suggests that for

14 See Chapter g for a review of other kCentiveS in the OI_pk drUg law.

15 Fi~s may also rewive o@an drug status for therapies whose expected costs are high enough that no single kwould otiewise develop

the pharmaceutical. However, since 1985 no fm has yet applied for orphan status under this provision. See chapter 9 for more information

about how drugs receive designation as orphan drugs.

16 mere i5 one exception t.t~gener~mtion. me oq~@gcr~it c~ot r~uce tie taxes a f~ owes below a calculated uum

amount (referred to as the ‘‘alternative minimum tax’ ‘).

17 Because t=payers c~ot deduct expenses eligib]e for tie orphan ~g cr~it from taxable ~come, one cm figure the effeCtiVe m~ghld

rate as follows: Without the credit, the after-tax cost of a dollar of research is ($1.00 - 0.34) = $0.66 when the marginal tax rate is 34 percent.

with the tax credit, the cost is ($1.00 - $0.50)= $0.50. Hence the tax cr~it lowers tie Cost Of tie exm dou~ Of clfic~ O@~ ~Se~Ch fiorn

$0.66 to $0.50, a drop of 24.2 pcreent.

18 OT_ feud n. ~~ on tie Peruntage of Pticeutical R&D spen~ tit ac~ally qual~les for the various tax credits. However, One

study by the U.S. General Accounting Office (GAO) suggested that across all industries, qualifying R&D represented 70 percent of all R&D

spending (437). l~this figure applied to clinical orphan drug R&D as well, then the tax credit would reduce the cost of an additional dollar of

such research (for a fm in the position to expand its clinical orphan R&D) by 17 percent. This figure is arrived at as follows:

Assuming a 34-percent tax rate, the cost of an additional dollar of clinical orphan R&D without the tax credit would be ($1.00 - $0.34) =

$0.66. With the 5@percent tax credit and assuming that 70percent of R&D expenses qualify for the credit, the cost would be 0.7($1.00 - $0.50)

+ 0.3($1.00 - $0.34) = $0.55. Hence, the tax credit would lower net cost per dollar of research from $0.66 to $0.55, a reduction of 17 percent.

However, there is no evidence other than the single GAO study mentioned to indicate that 70 percent of clinical orphan R&D qualify for the

credit.
—

Chapter 8-Federal Tax Policy and Drug Research and Development I 191

a firm with a high percentage of its clinical orphan

R&D qualifying for the credit, the potential tax

savings may be substantial and potentially pivotal

in the decision about whether to begin or continue

clinical testing of an orphan drug.

1 Other Tax Credits

Among other tax credits of the Federal Tax

Code, two provisions are of particular relevance

to the pharmaceutical industry: the foreign tax

credit system and the possessions tax credit.

While these credits do not represent direct subsidies to the firm’s R&D costs, there are at least two

reasons to consider their importance for pharmaceutical R&D. First, they indirectly affect the

location and amount of R&D. These credits affect

the after-tax cost of doing business in political

jurisdictions outside the United States. Second,

they affect pharmaceutical firms’ returns to R&D.

FOREIGN TAX CREDITS

All major U.S. pharmaceutical firms are multinational and are taxed under the U.S. tax code on

the basis of their worldwide income. 19 This

creates the potential for double taxation of foreign

source income. Because most other nations have

mechanisms to prevent double taxation, the

United States would beat a competitive disadvantage without a similar policy here as well. For this

reason, the United States has adopted a foreign

tax credit system allowing multinational corporations to credit tax payments they make to foreign

treasuries against their domestic income tax

obligations (26 U.S.C. 861). Because the credit is

limited to the amount of U.S. taxes a firm would

owe on income derived from foreign sources,

multinational firms would not receive the full

credit if the taxes paid abroad are greater than the

U.S. tax owed.20

Revenues from foreign sales (perhaps of a

product resulting from foreign R&D) may be

subject to both foreign and U.S. taxes. When the

revenues are repatriated to the U.S. parent corporation, they are subject to U.S. taxes. Parent firms

that already have excess foreign tax credits

generate no additional U.S. tax liability, and

parent firms without such an excess pay the

difference between the rates at home and abroad.

In the final analysis, both the former and latter

parent corporations pay at least the U.S. tax on

foreign income. However, for a firm that cannot

use all of the credits earned on foreign income

from a country whose effective tax rate is higher

than the U.S. tax rate, the after-tax cost of

business in the foreign country is higher than the

cost of business in the United States. To the extent

that firms are sensitive to such discrepancies

between locations in the net price of investing,

firms may be less likely to invest in the country

with a higher effective tax rate. As suggested

above, such considerations may influence the

location, level, and financing of a firm’s R&D

investments. However, OTA’s interviews with

corporate and financial managers at eight U.S.

research-based pharmaceutical firms indicated

that tax considerations are much less important in

determining where they locate R&D than are

regulatory, marketing, and scientific considera19 ~S system is Called a < ‘residence approach’ to tiaxation and is not found in all countries. For example, many European Counties use

a ‘ ‘territorial” approach under which taxes are owed only on income earned within national borders. Mixtures of the two systems are also

common.

In the United States, a multinational firm may organizx an overseas operation as a branch or a subsidiary. The choice of legal form determines

when it must pay U.S. taxes on income from foreign sources. Branches, which are not separately incorporated in foreign countries, are taxed

when income (positive or negative) is earned, Subsidies, which are separately incorporated, pay taxes only when income is repatriated. This

feature of the U.S. international tax system, called “deferral,” creates a strong incentive to delay repatriations of subsidiary earnings

indefinitely, In 1962, Congress enacted the Subpart F provisions that restrict deferral of certain types of unrepatriated income (Public Law

87-834). The Tax Reform Act of 1986 (Public Law 99-5 14) extended the classes of income subject to the Subpart F provisions. Within these

limitations, a subsidiary may repatriate income from foreign sources in a variety of forms, each of which have different tax consequences.

Although multimtional firms arc largely free to choose repatriation strategies that minimize their global tax liabilities, both the United States

and foreign countries have passed laws that limit the scope of this activity.

ZO A firm’s excess foreign MX credits may be carried back to offset tax obligations for up to 2 prior years or carried forward to offset fut~e

tax obligations for up to 5 years. However, unused credits do not earn interest over time.
192 I Pharmaceutical R&D: Costs, Risks and Rewards

tions. Like other multinational firms, pharmaceutical companies have an incentive to allocate their

expenses among their international subsidiaries

and divisions to the extent allowable by law to

minimize their global tax liability.

THE POSSESSIONS TAX CREDIT

(SECTION 936)

In an effort to encourage firms to locate

operations in Puerto Rico, the United States

altered the tax code to exempt qualifying income

generated in Puerto Rico from U.S. taxation (7).

In addition, Puerto Rico has designed its tax code

to benefit U.S. firms that locate in the Commonwealth .21 Section 936 of the U.S. tax code contains

provisions that exempt qualifying corporations

from U.S. taxes on Puerto Rico income. Corporations qualifying for this credit are called possessions corporations. U.S. companies are considered possessions corporations if they derive at

least 80 percent of gross income from U.S.

possessions such as Puerto Rico. Possessions

corporations must earn at least 75 percent of their

income from active business operations (such as

manufacturing), and thus no more than 25 percent

of income may be derived from financial mechanisms such as interest on bank investments.22 The

“possessions tax credit” is equal to 100 percent

of the U.S. tax on income from Puerto Rico for

subsidiaries or branches that meet the definition

of a possessions corporation (6).

The pharmaceutical industry is a prime beneficiary of the possessions credit because of both

the extent of its taxable revenues and its "intangible assets. ” Intangible assets include patents,

licenses, trademarks, and corporate or brand

names. Unlike tangible assets including buildings

and machinery, intangible assets are not tied to

any particular physical location. Hence, ownership of intangible assets such as patents may be

transferred to subsidiaries or branches that qualify

as possessions corporations according to guidelines established by the Federal Government. 23

County NatWest’s Washington Analysis Corporation (WAC) estimated the net tax savings

from the possessions credit in 1989 for several

companies using data from annual reports (248).24

Table 8-1 summarizes the results of this analysis

for eight research-based U.S. pharmaceutical

firms. These are only rough estimates of net tax

savings from the possessions tax credit, because

the net income in that study was defined according to standard accounting practice and differs

from taxable income as defined by the internal

revenue code.

Because effective corporate tax rates in Puerto

Rico are substantially lower than in the United

States, this tax credit represents a major form of

Federal tax expenditure for pharmaceutical firms.

Although little actual pharmaceutical R&D is

done in Puerto Rican locations (245), the credit

may lead to more manufacturing jobs in the

21 ~e~o Mco ~pm~xing j-ction over income earned within its borders. Although Puerto RiCO bsstitutory CO~Or~e M ~~s

that range from 22 to 44 percent (and will drop to a maximum rate of 35 percent by 1993), the effective tax rates fhced by most fm are much

lower due to extremely generous tax exemptions. Corporations that engage in manufacturing or export services in Puerto Rico receive an

exemption of current income of up to 90 percent. These exemptions take the form of grants and gradually expire over a 10- to 25-year period

depending on the location of the plant. The Commonwealth usually grants extensions before expiration.

Structures and equipment located in Puerto Rico are also treated preferentially. Depreciation deductions are “flexible” which means that

as long as the deduction does net make taxable income negative and the total amount depreciated does not exceed the value of the asset, any

amount of depreciation may be claimed in any year.

Income repatriated to parent corporations in the form of dividends are subject to aPuerto Rican tax of IOpercent. However, ifhalfthe earnings

from Puerto Rican investment are held in Puerto Rico for at least 5 years, the taxis reduced by one-half. In additiou interest generated from

Puerto Rican fwcial instruments such as from bonds or banks is not subject to Puerto Rican uixes.

z For f~cl~ income to qual@ for the credit it must be obtained frOfU i.nV@rII@S tie in PI.Ierto MCO.

23 Poswssiom Cowmtiom ~nust use one of sev=~ methods to ~OCa~ income derived from products protected t)y Such patents IXXwtXXI

the U.S. possession and the U.S. mairdand business. The most common method, called “profit splitting, ” allocates to Puerto Rico half the

revenues generated from transferred intangibles (7,243).

24 s~eh~ for fie~o Wco would lad t. tie re~~ of the possessio~ ~C!r~t ~ause the U.S. Constitution requires tit Federal law

apply uniformly across all States (430).
Chapter 8-Federal Tax Policy and Drug Research and Development I 193

Table 8-l—Tax Savings for Selected Pharmaceutical Firms Attributable to U.S.

Possessions Credit for Businesses in Puerto Rico, 1989a

Estimated tax

savings attributable Tax savings as

to possessions Net income a percent of

Firm credit ($ millions) ($ millions) net income

American Home Products. . . . . . . . . . . . .

Bristol-Myers. . . . . . . . . . . . . . . . . . . . . . .

Eli Lilly. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Merck. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pfizer Inc.. . . . . . . . . . . . . . . . . . . . . . . . .

Schering-Plough. . . . . . . . . . . . . . . . . . . .

Upjohn. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Warner-Lambert. . . . . . . , , , . . . . . . . . . .

$81

64

54

105

106

49

46

40

$1,102

747

940

1,430

681

399

176

413

7.3%

8.6

5.7

7.4

15.6

12.3

25.9

9.6

a Data for Schering-Plough are for 1988.

SOURCE: Office of Technology Assessment, 1993. Based on data from 1.S. Loss and A.D. Morgenstern,

Pharmaceuticals/Tax Polky:A Success fulPuerto Rican Statehood Initiative WillResultin HigherCorporate

Tax Rates for Many Companies (Washington, DC: The NatWast Investment Banking Group, 1990).

commonwealth (430). In addition, the net tax

savings improves pharmaceutical companies’ aftertax returns.

1 Estimates of Federal Tax Credit

Expenditures

At OTA’s request the congressional Joint

Committee on Taxation (JCT) estimated the size

of all tax credits affecting the pharmaceutical

industry in tax year 1987. These estimates come

from the Statistics of Income (SOI) Database

compiled by the IRS.25

The results of the analysis are presented in

tables 8-2 and 8-3.

Table 8-2 shows the tax credits actually

claimed by the pharmaceutical industry in 1987.

In addition to the total dollar value of each credit,

the estimated number of firms claiming them, and

the pharmaceutical industry’s credit as a percent

of the credit’s total dollar value for all industries,

the table also estimates the credit as a percent of

the industry’s tax liability in the absence of any

credits26 as well as the credit as a percent of the

industry’s taxable income (a ‘‘negative tax rate’

on taxable income). As noted earlier, foreign tax

credits differ somewhat from the other tax credits

examined in this chapter in that they are a means

to prevent double taxation of foreign source

income rather than a provision to encourage

certain types of taxpayer behavior. However, we

include estimates of this credit here to underscore

the multinational nature of the pharmaceutical

industry and to show the size of foreign tax credits

relative to the credits.

For the pharmaceutical industry, however, the

possessions tax credit may be more important

than the foreign tax credit.27 More than half of the

total credit was claimed by firms in the pharmaceutical industry, and, on average, it reduced each

fro’s tax liability by more than a third. The

percentage deduction in tax liability was greater

for smaller companies (those with assets $250

million) than for larger companies, which suggests size may not be a barrier to establishing a

subsidiary in Puerto Rico.

The orphan drug credit had relatively little

impact on either the Federal Treasury or the

industry’s tax obligations in 1987. As one would

25 Appendix J de~fibes how OTA and the JCT identitled research-based pharmaceutical f~sin tie SOI.

26 ~ss~tistic measmes the extent to which the credit reduces the indush-y’s ~ obligations.

27 Es~tes of & ~ossessiom ~r~it here represent t= expen~~es for tie F~er~ Treas~ oxlly md do not comt taxes that fktrls mUSt

pay to the Commonwealth of Puerto Rico. Hence, the actual total tax savings to the industry is smaller than the subsidy provided by the Federal

Government. As indicated earlier, however, effective tax rates in Puerto Rico are much lower than on the U.S. mainland.
Table 8-2—Tax Credits Claimed by the Pharmaceutical Industry in 1987a

Aggregate credit Aggregate credit Aggregate credit claimed

Aggregate credit Number of claimed as a claimed as a percent as a percent of

claimed by firms percent of of taxes pharmaceutical aggregate pharmaceutical

pharmaceutical claiming aggregate claimed industry would industry income

industry ($ thousands) credit by all industries pay with no credits subject to taxes

Foreign tax credit

Firms with assets less than $50 million $469 2 0.1% 0.4% 0.2%

Firms with assets between $50 million and

$250 million. . . . . . . . . . . . . . . . . . . . . . . . . . . 287 6 0.1 0.1 0.0

Firms with assets of $250 million or more. . . . . 928,089 20 4.6 26.6 10.7

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 928,843 28 4.5 23.4 9.4

Possessions tax credits

Firms with assets less than $50 million. . . . . . . 66,947 22 14.5 64.1 24.8

Firms with assets between $50 million and

$250 million . . . . . . . . . . . . . . . . . . . . . . . . . . . 313,536 20 40.3 81.9 33.0

Firms with assets of $250 million or more. . . . . 958,100 11 67.8 27.5 11.1

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,338,800 53 50.4 33.7 13.6

Orphan drug tax credits

Firms with assets less than $50 million. . . .

Firms with assets between $50 million and

$250 million . . . . . . . . . . . . . . . . . . . . . . . .

Firms with assets of $250 million or more. .

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . 0 0 0.0 — —

. . . 0 0 0.0 — —

. . . 4,665 6 90.5 0.1 0.1

. . . 4,665 6 90.5 0.1 0.0

General business tax credits

Firms with assets less than $50 million. . . . . . . 4,053 221 0.5 3.9 1.5

firms with assets between $50 million and

$250 million. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,355 7 0.7 0.6 0.2

Firms with assets of $250 million or more. . . . . 79,240 20 1.2 2.3 0.9

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,648 248 1.1 2.2 0.9

a~timat= are fortm y~r 1987 from the U.S. Treasury’s Statistics of Income (SOI) sample weighted to reflect relevant populations. Pharmaceutical industry k defined as SOI industv 9muP

2830 minus firms with assets of $250 million or more and known not to be involved in pharmaceuticals.

SOURCE: Office of Technology Assessment, 1993. Estimates provided by U.S. Congress, Joint Committee on Taxation.
Chapter 8-Federal Tax Policy and Drug Research and Development I 195

Table 8-3—Research Tax Credits Earned by the Pharmaceutical Industry in 1987a

Aggregate credit earned

Aggregate credit Number of firms as a percent of aggregate

claimed ($ thousands) claiming credit earned by all industries

Research and experimentation tax creditb

Firms with assets <$50 million. . . . . . . . . . . . . . . . . . . $6,455 147 3.10/0

Firms with assets > $50 million and < $250 million. . 2,042 9 2.0

Firms with assets of $250 million or more. . . . . . . . . . 88,878 28 12.6

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,375 184 9.6

University-based basic research tax credits

Firms with assets < $50 million. . . . . . . . . . . . . . . . . . . 3 90 17.3

Firms with assets > $50 million and <$250 million. . . 0 39 0.0

Firms with assets of $250 million or more. . . . . . . . . . 2,257 43 10.7

Ail firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,260 990 6.4

Orphan drug tax credits

Firms with assets <$50 million. . . . . . . . . . . . . . . . . . . 0 0 —

Firms with assets > $50 million and < $250 million. . 0 0 —

Firms with assets of $250 million or more. . . . . . . . . . 5,358 8 84.3

All firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,358 8 84.3

a Estimates for tax year 1987 are from the U.S. Treasury’s Statistics of Income (SOI) sample weighted to reflect relevant populations.

Pharmaceutical industry is defined as SOI industry group 2830 minus firms with assets of $250 million or more and known not to be involved in

pharmaceutm.als. Tax credits earnedare not equivalent to tax credits chimed because the former does not reflect insufficient tax Iiabilit y in current

year, or carry -fonvards from previous years.

b Research and experimentation credit estimates are net of university-based basic research credit.

SOURCE: Off Ice of Technology Assessment, 1993. Estimates provided by U.S. Congress, Joint Committee on Taxation.

expect, virtually all (91 percent) of this credit was

claimed by firms whose primary activity is

pharmaceuticals.

Estimates of the R&D and university basic

research credits claimed by the pharmaceutical

industry are included in the ‘‘general business

credit. ’ In addition to these two research-related

credits, the general business credit includes other

tax credits potentially available to corporations: a

credit for newly created jobs, one for certain types

of special investment, one for the use of alcohol

as a fuel, and a credit for the provision of

low-income housing. Because carrybacks and

carry forwards are calculated on the general business credit as a whole, it is not possible to produce

separate estimates of the R&D and university

basic research credits actually claimed.

General business credits were claimed by firms

of all sizes in this industry and reduced the taxes

owed by the smallest companies (those with

assets under $50 million) by almost 4 percent

more than for larger fins. Although genera-1

business credits for drug companies cost the

Treasury 17 times more than the orphan drug

credit in 1987, it still totaled less than 10 percent

of the foreign tax credit and only 6 percent of the

possessions credit claimed by this industry.

Estimates of the R&D tax credit, the basic

research credits and orphan drug tax credits

earned by the pharmaceutical industry in 1987,

are shown in table 8-3.28

Only eight companies, all large fins, earned

an orphan drug credit in 1987.29 Two-thirds of all

orphan drug designations granted by the FDA

28 For he R&D ad ba~lc ~e~cmch ~r~it~, ~c~omt of Cah Credit Curnedby ap~cul~ compmy is defiied as 20 pement Of the difference

between quali~ing expenses in the current year and the base amount. The amount of credit actually claimed, however, adds in credits earned

in earlier years that are carried forward to the current year or subtracts credits earned in the current year but unused due to insufficient tax

liability.

29 The fact tit ~~ysix flm~ ~l~med his Crc(fit (sm table ~.z) indicates that two of tie ftisthat actually had qti~g expenses iII 1987

were unable to use it due to insufficient tax liabilities.
196 I Pharmaceutical R&D: Costs, Risks and Rewards

went to firms that are not members of the

Pharmaceutical Manufacturers Association (generally the smallest companies in the pharmaceutical industry). Thus, the developers of most orphan

drugs may not have been in a position to claim a

tax credit or may not yet have reached the clinical

stage of the R&D process.

The fluidity of tax laws during the latter half of

the 1980s may make these 1987 estimates unrepresentative of the late 1980s. The Tax Reform

Act of 1986 lowered the maximum corporate tax

rate from 46 to 34 percent over a period of several

years beginning in 1987. And, the structure of the

R&D tax credit also changed substantially over

time. Although the resources necessary to conduct the analysis presented in tables 8-2 and 8-3

limited OTA to examining a single tax year, the

IRS publishes some summary statistics from the

SOI database for Principal Activity Classification

(PAC) codes, groups of firms organized according to the activity earning them the greatest

proportion of their total receipts.

Table 8-4 presents estimates of tax credits

claimed by firms in pharmaceutical firms (PAC

2830) in the 1984-87 period.30 Whereas all of the

credits increased in the 1984-86 period, the

possessions, orphan drug, and general business

credits dropped between 1986 and 1987, the first

year after tax reform. Of these three, only the

general business credit registered a major decline

(48 percent). It is likely that the dramatic decline

between 1986 and 1987 in this set of credits is

attributable to the elimination of the Investment

Tax Credit in the 1986 Tax Reform Act (297). The

foreign tax credit actually increased between

1986 and 1987. Despite the evident trends, the

numbers indicate that the relative magnitude of

these credits remained roughly steady between

1984 and 1987.

In sum, the estimates in tables 8-2,8-3, and 8-4

indicate that, in an effort to achieve a variety of

Table 8-4-Tax Credits Claimed by Firms in

Statistics of Income Industry Group 2830,1984-87

($ millions)

1984 1985 1986 1987

Foreign tax credit. . . . . . . . . . . . . $621 $632 $747 $929

Possessions credit. . . . . . . . . . . . 839 903 1,463 1,399

Orphan drug credit. . . . . . . . . . . . 0 0 6 5

Research & experimentation

tax credita. . . . . . . . . . . . . . . . . 86 88 — —

General business creditsa. ... , . . 135 125 180 86a

a ~ginning in 1986, statistics of income (SOI) data subsumed the

researeh and experimental tax credit within “general business

eradits” which also includes low-income housing, investment, jobs,

alcohol fuel, and employee stock ownership credits.

SOURCE: Office of Technology Assessment, 1983. Sased on Statistics of Income Division, Internal Revenue Service, U.S.

Department of Treasury, Soume Books, Statlstkx of

Inwme, 1984-198Z Cotporate Tax Returns (Washington,

DC: U.S. Government Printing Office, 1984-87).

public policy objectives, the Federal Government

makes substantial tax expenditures through credits claimed by the pharmaceutical industry. In

1987, not including over $900,000 for foreign tax

credits, the Federal Treasury spent a total of $1.4

billion in tax credits for these firms (table 8-4).

Taken together, they reduced the Federal taxes the

pharmaceutical industry would have otherwise

owed by over 36 percent.31 The largest of these

tax code provisions, the possessions credit, is also

significant because the pharmaceutical industry

makes more use of it than does any other industry,

accounting for half of all the dollars claimed in

1987. Although this credit along with the foreign

tax credit was designed to enhance the economic

development of a U.S. possession and to avoid

double taxation of foreign income, respectively,

rather than to subsidize pharmaceutical R&D,

they nevertheless do effectively reduce the tax

liability of pharmaceutical fins. Hence, they

raise net after-tax income achievable from pharmaceutical operations, including those arising

from the development of new products.

30 me dam for pAC 2830 ~oll~ some l~ge fi~~ m~tiple lirles of b~iness (~d, hence, overestite the illdus~’S true SSSetS ~d

tax credits). Nevertheless, the summary statistics are useful for e~trends in the use of tax credits over time.

31 Adding foreign tax credits raises this to 59 percent.
Chapter 8--Federal Tax Policy and Drug Research and Development! 197

H Firm Characteristics and the

Use of Tax Credits

The tax credits available to businesses engaging in pharmaceutical R&D are of greater or less

value to fins, depending on their specific financial and operating characteristics. The following

stylized examples show how companies in various situations would stand to benefit from the

various tax credits. Consider three types of

research-based pharmaceutical companies:32

. A startup firm with no products or processes

on the market, and hence, no income, but

with a growing R&D budget financed by

investment from sources outside the firm.

. An emerging firm with a few products on the

market (either in the U.S. or abroad), some

income, a growing R&D budget, and a very

high ratio of R&D expenses to sales.

● An established, large, multinational firm

with multiple products on the market and

R&D expenditures that equal between 12

and 16 percent of sales (the same as that

found among almost all existing large pharmaceutical fins).

For the startup firm, tax credits are not particularly useful since it usually does not pay income

taxes. Such a firm is intent on identifying or

moving a product or process to the point that

investors may realize a return. To the extent that

it can anticipate taxable income in the future, it

can carry forward R&D tax credits to subsequent

years, but the value of these potential future

credits is diminished because of the time value of

money. While the possessions and foreign tax

credits can also theoretically be carried forward,

a firm can earn these credits only by generating

income (either abroad or in a U.S. possession).

The orphan drug credit has no carryforward or

carryback provision at all. In practical terms, then,

these credits are not useful to the startup firm.

The established firm cares most about the tax

provisions having the greatest impact on its tax

liability-the possessions and foreign tax credits.

Although the established company will claim any

R&D or orphan drug credit to which it is due,

these have a smaller impact on taxes it pays: the

total general business and orphan drug credits

claimed by the largest pharmaceutical firms

represented only 4 percent of the amounts

claimed for possessions and foreign tax credits. In

addition, the fact that the R&D credit is limited to

expenses for research done in the United States

diminishes its appeal for an established firm with

multinational R&D facilities.

For the emerging firm, the R&D tax credit can

be particularly important. Because the credit is for

increases in R&D expenditures, its dollar value is

higher for firms with relatively high annual rates

of growth of qualifying research expenses. The

higher the company’s R&D-to-sales ratio, the

more likely that tax subsidies from the R&D

credit will reduce the company’s Federal tax

liabilities. 33

OTHER NATIONS’ R&D TAX INCENTIVES

To the extent pharmaceutical firms earn income in other countries, they are subject to the tax

laws of the foreign countries in which they

conduct business. While a full review of all

foreign tax laws of relevance to the pharmaceutical industry and their implicit incentives is

beyond the scope of this report, this section

provides a brief examination of how other nations

treat corporate R&D.

32 me ~mceutic~ fm~ “i~lt~ by OTA ~~over tie co~se of ~s assessment hcluded compties that resemble each of the three ~S

described above. The perspectives of relevant corporate managers interviewed at these f- about the value of various tax subsidies closely

fit these three generalizations.

33 Al~Ough not ~~id~red~~sC~pter,OTA’s ~terviews at ph~~eutic~ Cornpties ~dica[ed tit startup ~d emer@Ilg f~S may

care as much or more about the tax treatment of income generated for their investors as they do about taxes on their own income. Because such

companies are likely to fwce their R&D with funds from outside sources using novel mechanisms such as the R&D limited partnership,

favorable tax treatment of investment income (particularly from high risk/high return fuckil instruments) may make it easier for firms to

attract needed capital.
198 I Pharmaceutical R&D: Costs, Risks and Rewards

In a review of national tax policies in 23

developed or emerging high-technology countries,34 OTA found that most nations permit R&D

spending to be deducted from taxable income in

the year incurred (245). In addition, most tax

codes provide some mechanism to carry unused

deductions forward into future years. Countries

vary a great deal in the provision of tax credits tied

to R&D spending. Currently, Brazil, China,

Denmark, Hong Kong., Italy, South Africa, and

Switzerland lack any R&D tax credits or other

special allowances for R&D beyond the deduction of current expenses. Among other countries

examined, Canada, France, Japan, Spain, Sweden, and Taiwan all provide a tax credit on

increases in R&D spending similar to the United

States. As shown in table 8-5, the statutory credit

varies considerably but does not exceed 50

percent in any country. Remaining nations provide other incentives for R&D, including more

specific types of tax subsidies as well as direct

grants, These policies are also briefly summarized

in table 8-5.

Although a complete understanding of particular tax subsidies and incentives faced by the

pharmaceutical industry in other countries would

require a more detailed analysis, this review

suggests that most countries use some mechanism

to subsidize private spending for R&D. In many

cases, these mechanisms are similar to those

employed by the U.S. Government. This general

comparability of U.S. and international tax codes

is reinforced by the recent trend in other countries

to reduce corporate tax rates to levels near the

maximum 34 percent rate adopted by the United

States in its Tax Reform Act of 1986 (303).

Corporate managers at the research-based pharmaceutical firms interviewed by OTA said that

marketing and scientific considerations were

much more important in deciding the location and

level of R&D investment than were tax incentives. While specific research projects and programs may differ considerably in their tax implications, this perspective is consistent with an

overall general comparability of national taxes

across different countries.

CONCLUSIONS

Taxes paid by corporations are determined by

numerous provisions of the tax code, each designed to achieve particular policy goals. Whether

or not such provisions achieve their public policy

goals, many lead to lower taxes for firms and to

lower after-tax costs of R&D and higher after-tax

returns to R&D.

In actual Federal dollars spent, Federal tax

credits constitute one of the most substantial

forms of government involvement in the operations of the pharmaceutical industry. In 1987, not

including over $900,000 in foreign tax credits, the

Federal Treasury made $1.4 billion in tax expenditures through credits to drug companies. Of this,

only about $90 million was for credits whose

specific policy purpose is to stimulate R&D. The

major part, $1.3 billion, of the lost tax revenue

was due to the foreign and possessions tax credits.

Overall, tax credits reduced the amount of taxes

pharmaceutical firms would have otherwise owed

the U.S. Government by 36 percent and equaled

15 percent of the industry’s taxable U.S. income.

Adding foreign tax credits raises these figures to

59 percent and 24 percent, respectively.

The relative importance of each credit varies

among firms according to their financial characteristics. The incentives in the R&D tax credit

may be stronger for emerging biotechnology

companies who have some income on which to

pay taxes but whose R&D budgets are growing

more rapidly than they are for larger, more

established fins. For the largest, most estab34 me com~e5 me Austrda,Belgi~ Brazil, Canad~ China, Denmark Germany, France, Hong Kong, Ireland, Italy, Jwm, Ne~erl~h

Norway, Singapore, South Africa, South Kore~ Spain, Swedeq Switzerland, Taiwq United Kingdom, and United States. The information

gathered in this review does not capture tax policies at the regional or local level, which can be as important or more important than those at

the national level. For example. in Switzerland, the individual cantons into which the country is divided have primary responsibility for

collecting government revenue (334,335). Some countries, like Italy, may also have special incentives in their mtional tax codes that apply

only to particular geographic regions where they wish to stimulate economic development.
Chapter 8-Federal Tax Policy and Drug Research and Development I 199

Table 8-5-Research and Development Tax Incentives in Other Nations:

Summary of Policies

Country R&D tax credits Other subsidies”

Australia

Belgium

Canada

France

Germany

Ireland

Japan

Netherlands

● 20% incremental

● 50% incremental

. Tax credits on R&D

equipment

Norway

Singapore

South Korea

Spain

Sweden

Taiwan

United States

●

●

●

●

●

●

●

United Kingdom

Q 20% incremental

15%

30%

3070

20%

20%

20%

of R&D

of R&D equipment

incremental

incremental

incremental on R&D

incremental on

● 150% expensing of R&D

● R&D tax “grants”

● Special deductions for R&D

personnel

● Exemptions from tax of

distributed profits

● R&D grants in selected

industriesb

● Tax grants on capital investment

● Tax exemption for royalty

income from patent R&D done in

Ireland

● Trade policies beneficial to R&D

equipmenta

● R&D grants for selected

technologies

● Special allowances for R&D

capital and labor

● Deductions for future R&D

● 200% expensing of R&D

● Deductions for future R&D

● Special allowances for R&D

salaries

university-based basic R&D

50 percent of clinical

orphan drug R&D

● Deduction of R&D facilities

and machinery

a Beyond expensing of current R&D expenditures.

b The~e subsidies ~re provid~ direCtly to the qualifying firms; they are not administer through the t~ Code.

SOURCE: office of Technology Assessment, 1993.

lished companies, the possessions and foreign tax

credits are most Likely more important. For the

very newest startup firms, corporate tax credits

may be of negligible value.

Quite apart from tax credits, the immediate

deductibility of R&D expenditures reduces the

cost of a dollars worth of research performed

today from $1.00 to about $0.66.

To summarize, the tax code includes numerous

credits and deductions tied to firms’ expenditures

for R&D as well as several other tax code

provisions that are especially important for drug

companies and their profits. These tax policies are

major avenues of U.S. Federal assistance to the

research activities of the pharmaceutical industry.

Although they were designed to achieve a variety

of policy goals (most of which are not specific to

the pharmaceutical industry), the tax policies

reviewed here result in a substantial Federal

investment in the industry in terms of foregone

tax revenues.
Federal Support for

Pharmaceutical Research and

Development 9

E

conomic theory suggests that without help from the

government, the private sector alone will underinvest in

research (19,5 13). It makes sense for a firm to invest in

research whose results lend competitive advantage to

the company. But, much research creates knowledge that the firm

cannot keep to itself. The patent system and the legal protections

afforded trade secrecy are attempts by governments to confer

exclusive ownership rights to knowledge, but not all discoveries

can make use of these privileges. Basic research increases the

storehouse of fundamental scientific understanding and is often

necessary for commercial applications. Yet, a private industrial

firm lacks the incentive to adequately support basic research

because the firm cannot ensure it will capture all the benefits of

such support. To realize the benefits of basic research and

research training, the public sector must participate in its

funding.

Underwritten largely by Federal and State Governments,

research-intensive universities serve as the public sector’s

principal agents in the conduct of both biomedical research and

training of biomedical researchers. The goal of this support is to

realize the economic and public health benefits that can follow

from the commercialization of research results (131).

The pharmaceutical industry is particularly adept at mining the

motherlode of knowledge created by government-sponsored

biomedical research and training. In a recent survey of firms in

seven research-based industries, Mansfield (253) found over

one-quarter of products and processes in use in the pharmaceutical industry could not have been developed without substantial

delay in the absence of recent academic research (figure 9-l).

,/

/“

201
202 I Pharmaceutical R&D: Costs, Risks and Rewards

Photo crodtf: NATIONAL INSTITUTES OF HEALTH

The National Institutes of Health conducts targeted drug

discovery and testing programs. The transfer of the scientific

knowledge with commercial value from this agency to the

pharmaceutical industry is one of the ways that

pharmaceutical companies directly benefit from Federal

research support.

Respondents to a survey of biotechnology

firms conducted by Blumenthal and colleagues

(52) reported that collaboration with academic

institutions helped keep firms current with impor30

20

10

0

tant research (83 percent) and that it reduced the

cost of mounting research and development

(R&D) programs in new fields (60 percent).

Indeed, most of the biotechnological techniques

developed during the early 1980s, upon which the

pharmaceutical industry now depends, came from

academic laboratories (445).

The Federal Government provides even more

direct subsidies to industrial pharmaceutical R&D

than general support for biomedical research and

training. The National Institutes of Health (NIH)

and other Federal laboratories themselves conduct targeted drug discovery and testing in

disease areas deemed particularly important. In

addition, the Federal Government offers a series

of subsidies specifically designed to encourage

the development of orphan drugs, treatments that

might not otherwise be commercially viable. And

finally, the Federal Government may unintentionally defray some of the cost of clinical research

through its Medicare and Medicaid programs.

Figure 9-l—Percent of New Products and Processes Based on Recent Academic Research, 1975-85

Percent

.

— — —. — — —

IE-- —

Information Electrical Chemical Instruments Drugs Metals Oil Industry mean

processing

Could not have been developed without academic research Products L’~ Processes

Otherwise benefited from academic research [-] Products LX’ Processes

SOURCE: Office of Technology Assessment, 1993. Based on data from E. Mansfield, “Academic Research and Industrial

Po/icy 20:1 -12, 1991.

Innovation,” Research
—.

Chapter 9–Federal Support for Pharmaceutical Research and Development 1203

Figure 9-2—Sources of Support for Health-Related R&D in the United States, 1960-90

MAGNITUDE OF SUPPORT

-- Billions of dollars

23

20

15

10

5

0

_ Federal Government

~ Industry

~ Other

I

1960 63 66 69 72 75 78 81 84 87

- ------- . .. .. . - - ,., ,----- D15 I Hlt5U I IUN Ut SUYF’WH I

Percent of total

100

80

60

40

20

0

90 1960 63 66 69 72 75 78 81 84 87 90

NOTE: Other sources of support include State and local government, private, and nonprofit support.

SOURCE: Office of Technology Assessment, 1993. Based on data from U.S. Department of Health and Human Services, Public Health Service,

National Institutes-of Health, Data Book 1989 (Washington, DC: U.S. Government Printing Offioe, 1989).

This chapter describes direct Federal contributions to the pharmaceutical knowledge base as

well as indirect support through its funding of the

biomedical research and trainin g infrastructure.

In addition to assessing the extent of such Federal

subsidies, this chapter describes how federally

funded knowledge produced in academic institutes and government laboratories is transferred

to pharmaceutical companies.

The transfer of scientific knowledge with

commercial value to private companies that can

develop and commercialize the resulting products

or services unquestionably has benefits. This

chapter describes powerful financial incentives

recently put in place through Federal legislation

to transfer technologies to the private sector.

Whether the public pays too much for the

resulting products, however, is a question that

needs more attention from public policymakers.

FEDERAL SUPPORT FOR

THE LIFE SCIENCES

In 1990, the Federal Government and industry

each funded approximately 45 percent ($9.9

billion) of health R&D undertaken in the United

States (483). Of the Federal portion, 75 percent

came from NIH. In the post-World War II period

as a whole, the contribution of the Federal

Government to biomedical R&D has been much

greater than that of industry. Figure 9-2 shows the

Federal portion of health R&D conducted in the

United States was consistently over twice that of

industry throughout the 1960s and 1970s. NIH’s

investment in biomedical research continued to

increase at 2.6 percent per year between 1981 and

1991, after adjusting for inflation. But, the

dramatic spurt in industrial pharmaceutical R&D

spending beginning in the early 1980s is responsible for the increase in industry’s share of total

biomedical R&D since 1980.
204 I Pharmaceutical R&D: Costs, Risks and Rewards

The Federal investment in R&D over the

postwar period has created a physical and organizational infrastructure that continues to be productive today. Over 60 percent of all healthrelated academic and nonprofit research facilities

built between 1958 and 1968 were financed with

50-50 matching funds available through the

Federal Health Facilities Research Act (Ch. 779,

70 Stat 717).1 The National Science Foundation

(NSF) and several NIH institutes also had their

own authority and appropriations to support

building and renovation. Although Federal support for construction has fallen since the 1960s,

the Federal Government’s contribution over the

entire period provided the necessary capacity to

conduct subsequent research funded by government, industry and the nonprofit sector.

Industry, on the other hand, has never been a

significant contributor of research facilities other

than its own in-house laboratories (207).2 When

industry has provided research grants or contracts

to academic institutions, its support for indirect

and overhead expenses (which pay for facilities

and administration) has generally been below the

standard Federal contribution for such costs.

Dollars devoted to research and facilities do not

fully reflect the importance of Federal support for

the academic research infrastructure upon which

industry depends. Not only did institutions of

higher education receive 62 percent of NIH R&D

funds and 53 percent of all Federal health R&D

money, but colleges and universities receive

virtually all Federal funds for research training

(482). 3 Academia, in turn, has used these resources to produce one of the most important

components of the R&D infrastructure—

scientific talent. The Federal investment in training includes not only scholarship and fellowship

support, but also research support to principal

investigators who employ trainees in their laboratories, thus giving them a vital part of their

education, a research apprenticeship.

Although data limitations preclude comprehensive measurement of Federal support for

training, 4 the Office of Technology Assessment

(OTA) estimates that in 1989 the Federal Government spent over $325 million on training support

for over 14,000 postgraduate trainees in the

biological sciences (see table 9-1).5 (This does not

include the billions of dollars spent on general

training support for undergraduate and graduate

education through the Federal student financial

aid programs administered by the U.S. Department of Education.) About 25 percent of graduate

students pursuing a doctoral degree in the

biomedical sciences receive a training grant from

NIH (207).

Over the last 10 years, the number of doctorallevel biomedical research jobs in industry has

grown about 12 to 13 percent per year compared

with an average 4.9 percent increase for biomedical research jobs in all sectors (207). Pharmaceutical companies make more intensive use of

trained scientific personnel than do firms in other

industries. While all industries together employ

27 trained scientists or engineers per 1,000

employees, the pharmaceutical industry hires 62

per 1,000 employees (figure 9-3).

1 The other most common sources of funding for biomedical research facilities are State and local government and debt fmcing by the

research institution itself (207).

2 Well-publicized agreements between universities and industry in the health sciences that include the construction of new facilities are

noteworthy for their size, but they have been limited to a few of the most research-intensive universities.

3 Remainin g Federal and NM reseamh money went to industry, Federal, State and local govexnrn ents, and private nonprofit org “ amz.ations

not engaged in higher education.

4 OTA published a more detailed discussion in 1991 of the strengths and limitations of data on scientific research andtraining in the united

States (452).

s Most awards for training biomedical researchers are funded as National Research Service Awards (NRSAS). Most NRSA traineeships go

to educational institutions that in turn award them to predoctoral trainees for up to 5 years and postdoctoral for up to 3 years. After completing

their training, awardees must conduct biomedical research for 1 month for every month they received support. Those who do not provide this

research ‘‘payback’ must reimburse the government for their awards.
Chapter 9-Federal Support for Pharmaceutical Research and Development 205

Table 9-l—Federal Research Training Support Targeted for the Life Sciences In 1989

Number of trainees supported Funds for research

Agency Predoctoral Postdoctoral Total training ($ millions) Other characteristics

National Institutes of Health 6,216 5,369 11,585 $256.0 For both NIH and ADAMHA, all

(NIH) but 1,150 awards require recipients to conduct research 1 month

for each month supported after

completing training.

Alcohol, Drug Abuse, and 720

Mental Health Administration

(ADAMHA)a

National Science Foundation NA

(NSF)

567

NA

1,287

1,361

27.1 Includes approximately 630

awards for behavioral research

training

U.S. Department of Energy 200 10 210 30.7

(DOE)

Totals 14,443 $326.6

12.8 Training support is provided

through research funds to principal investigator who hire

trainees.

a In 1992, the resear~ institutes acfrnhisbring ADAMHA’s training awards were made part of NIH under Public Law 102-321. The remainder of

ADAM HA became the Substance Abuse and Mental Health Services Administration.

KEY: NA - not available.

SOURCE: Office of Technology Assessment, 1993.

Figure 9-3-Number of Trained Scientists and

Engineers Per 1,000 U.S. Employees

80

60

40

20

0

27

41

I

62

—

All industries Chemical industry Pharmaceutical

overall firms

SOURCE: Office of Technology Assessment, 1993. Based on data

from J.P. Swarm, A~emic Scientists and the Pharmaceutical Industry: Cooperative Research in Twentieth Century

America (Baltimore, MD: The Johns Hopkins University

Press, 1988).

Training support for graduate students and

postdoctoral fellows comes not only through

formal training grants, but also through employment as research assistants (RAs) on grants or

contracts supported by Federal funds. About 52

percent of all graduate students with training

support from DHHS in 1988 reported their work

as RAs was the major form of such aid (289)

compared with only 31 percent in 1981.

The Federal investment in R&D infrastructure

outlined above made possible the fundamental

knowledge and techniques upon which current

drug discovery depends. The advances in molecular biology, which form the core of biotechnology

(445), include recombinant DNA processes,

monoclinal antibodies, and gene synthesis and

splicing. Chapter 5 discusses the importance of

these techniques in today’s pharmaceutical R&D

process. These advances were made, for the most

part, in university laboratories and relied heavily

on Federal support.

Private industrial firms also provide predoctora1 or postdoctoral training in the life sciences
206 I Pharmaceutical R&D: Costs, Risks and Rewards

through scholarships, fellowships, and other training grants as well as other research support in

universities. About 6 percent of life science

trainees (advanced graduate students and postdoctoral fellows) at six research-intensive universities surveyed by Blumenthal and colleagues in

1985 received training grants or scholarship

support from industry (151).6 Other types of

involvement with industry also provided financial benefit to trainees. In all, about 19 percent of

life science trainees in the six universities studied

by Blumenthal and colleagues reported receiving

research salary, training grants, or scholarships

directly from industry; another 15 percent worked

in the laboratories of faculty advisers who received industrial research support.

Industry support appears to be more restrictive

than that of government. Of students and fellows

reporting scholarships or training grants from

industry, about 35 percent were required to

perform some activity of direct benefit to the

sponsoring firm, such as working for the company

(151). And, while the average research training

award at NIH in 1984 was $12,385 for graduate

students and $22,425 for postdoctoral fellows, the

mean award for training grants or scholarships

from firms involved in biotechnology ranged

from approximately $4,551 to $9,181 per award

(150). Thus even when industry has provided

training support for universities in the life sciences, the support is more restrictive than is

Federal support.

COLLABORATION BETWEEN

PHARMACEUTICAL FIRMS AND

ACADEMIA

Collaborative arrangements between academic

researchers and pharmaceutical firms represent an

implicit transfer of federally supported research

and knowledge to the private sector. As opportunities to commercialize; research findings in the

life sciences have grown, so too has interest in

commercial relationships designed to make use of

these results in the marketplace (445).

The pharmaceutical industry has a long tradition of cooperation with academia (415). When

World War I eliminated the supply of pharmaceuticals from Germany, American drug companies

realized the need to develop their own products.

They established ties with universities in order to

recruit scientific manpower and to capitalize on

academic research with pharmaceutical potential.

Academics were receptive to such cooperation

(415). During the postwar period, U.S. pharmaceutical firms established multifaceted strategies

for cooperation with universities. They built ties

with academic scientists by attending scientific

meetings in force, visiting academic laboratories

on a regular basis, sponsoring lectures by academic scientists at company facilities, sponsoring

awards through academic societies, and developing lists of leading scientists within relevant fields

to receive regular written updates on advances

occurring within industrial laboratories. They

also began to sponsor fellowships and trainees in

universities. Between 1925 and 1930, for example, Squibb spent a seventh of its research budget

on such fellowships (415).

Collaboration between academia and the pharmaceutical industry on basic research diminished

steadily between 1940 and the 1970s as alternative sources of support for university research

(mainly the government) increased and as the

growth in industrial research laboratories reduced

firms’ reliance on academia (415). Yet, the

amount of clinical research sponsored by the

industry and conducted by academia grew significantly over this period, particularly after the 1962

amendments to the Food, Drug and Cosmetic Act

(21 U.S.C. 301 et seq.) required drug sponsors to

establish effectiveness as well as safety of new

products.

Clinical research requires collaboration with

academic medical centers that have the physician6 Although these six universities are not representative of all institutions that train young biomedical researchers, the survey does provide

insight into the role of industty in the trainin g of students and fellows in very research-intensive universities. Such young researchers are Likely

to constitute the next generation of scientific leadership (151).
— —

Chapter 9—Federal Support for Pharmaceutical Research and Development I 207

researchers, the patients, and the infrastructure to

test new drugs. Hence, even as universityindustry relationships revolving around laboratory research diminished in the 1950s to 1970s,

pharmaceutical firms maintained formal and informal clinical relationships with academia.

Beginning in the late 1970s, the number of

collaborations with universities during the discovery phase of research began to expand once

more. Most observers have tied this trend to the

development of biotechnology techniques in university laboratories (228,415,445). Large pharmaceutical firms turned to academia to learn these

techniques. In many instances, the principal

founders of new biotechnology companies came

from academia and attempted to keep their

university affiliations. In the 1980s academic

scientists and venture capitalists, recognizing the

value of these advances in the life sciences,

sought to commercialize university research

through startup firms that also maintained close

relationships with academic laboratories (228).

Today’s collaborations take place against a

backdrop of pervasive government funding for

biomedical research in academia. Even within the

individual academic research laboratory, financial support from industry coexists with more

extensive government support. As figure 9-4

indicates, in 1984 less than one-quarter of principal investigators in the life sciences who used

biotechnological techniques at 40 of the 50 most

research-intensive universities received any support from industry (53). In addition, the vast

majority of those faculty who received any

research support from industry still get most of

their research support from government and the

nonprofit sector; only 10 percent of principal

investigators receive more than 25 percent of their

research support from industry. In comparison,

faculty members in chemistry and engineering

receive industrial funds almost twice as frequently.

1 Four Kinds of University-Industry

Collaborations

There are at least four kinds of collaboration

between academia and the pharmaceutical industry. The two most common are project-specific

research support and consulting arrangements

with pharmaceutical firms. Two less common

forms of collaboration-large-scale, multiyear,

investments in academic research centers by

private companies and ownership or control of

industrial firms by a university or its faculty—

have received much more popular attention in

recent years, perhaps because of their novelty in

the life sciences and their potential impact on

traditional academic values and norms of behavior (228).

Figure 9-4—Proportion of Faculty Receiving a

Given Percent or More of Research Budgets

From Industry, 1984

Proportion of faculty

1

T ‘1

0.8

1

0.6

I

0.4

h

I

o 10 20 30 40 50 60 70 80 90 100

Percent of research budget

+ Biotechnology -+- Chemistry and engineering faculty

SOURCE: Reprinted with permission from D.B. Blumenthal, M.E.

Gluck, K.S. Imuis, et al., “University-Industry Relationships

in Biotechnology Implications for the University, ” Sa”ence

232:1361-1 366, 1986.

7 The data also indicate that the vast majority of life scientists responding to the survey (81 percent) used biotechnological techniques.
208 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 9-2—Large-Scale Pharmaceutical R&D Agreements Between Universities and Industry

Funds Duration Year

Partners (university/firm) ($ millions) (years) established Area

Harvard University Medical School/Monsanto . . . . . . . . . . $ 23.5

Leicester University/lCl . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2

Massachusetts General Hospital/Hoechst . . . . . . . . . . . . . 70.0

Scripps Institute/Johnson & Johnson . . . . . . . . . . . . . . . . . . 30.0

Washington University/Mallink . . . . . . . . . . . . . . . . . . . . . . . 3.8

Harvard University Medical School/Dupont . . . . . . . . . . . . 6.0

Yale University/Celanese . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1

Johns Hopkins University/Johnson & Johnson . . . . . . . . . 1.0

Rockefeller University/Monsanto . . . . . . . . . . . . . . . . . . . . . 4.0

Washington University/Monsanto . . . . . . . . . . . . . . . . . . . . . 100.0

Yale University/Bristol Myers. . . . . . . . . . . . . . . . . . . . . . . . . 3.0

Cold Spring Laboratory/Exxon . . . . . . . . . . . . . . . . . . . . . . . 7.5

Rochester University/Kodak (Sterling) . . . . . . . . . . . . . . . . . 0.5

Columbia University/Bristol-Myers . . . . . . . . . . . . . . . . . . . . 2.3

Oxford University/Monsanto . . . . . . . . . . . . . . . . . . . . . . . . . 20.0

Georgetown University/Fidia . . . . . . . . . . . . . . . . . . . . . . . . . . 62.0

Harvard Medical School/Takeda . . . . . . . . . . . . . . . . . . . . . . 1.Oa

Oxford University/Squibb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.0

Johns Hopkins University/SmithKline Beckman. . . . . . . . 2.2

Cambridge University/SmithKline French . . . . . . . . . . . . . 4.0

Oxford University/Beecham . . . . . . . . . . . . . . . . . . . . . . . . . . 8.0

University of London P/Squibb . . . . . . . . . . . . . . . . . . . . . . . . 47.0

Massachusetts General Hospital/Shiseido . . . . . . . . . . . . . 85.0

University College London/Eisai . . . . . . . . . . . . . . . . . . . . . . 75.0

Harvard University Medical School/Hoffman-LaRoche. . 10.0

Massachusetts General Hospital/Bristol-Myers Squibb . 37.0

University of California at San Diego/Ciba Ceigy ..,,... 20.0

12

12

12

Open-ended

5

5

5

Open-ended

5

12

5

5

Open-ended

6

5

Open-ended

Open-ended

7

5

5

10

7

1

15

5

5

6

1974

1978

1981

1981

1981

1981

1981

1982

1982

1982

1982

1982

1983

1983

1983

1985

1986

1987

1988

1988

1989

1989

1989

1990

1990

1990

1990

Cancer angiogenesis

Genetics

Molecular biology

Synthetic vaccine

Hybridomas

Genetics

Enzymes

Biology

Photosynthesis

Biomedical research

Anticancer drugs

Molecular genetic

DNA

Gene structure

Glycoproteins

Neuroscience

Angiogenesis factors

Pharmacology (central nervous system)

Respiratory disease

Molecular medicine

Neuropsychobiology

Molecular biology: proteins

Dermatology

Neuroscience

Medicinal chemistry

Cardiovascular

Rheumatoid and osteoarthritis

a Harvard Medical School/Takeda contract is $1 million per annum (open-ended).

SOURCE: A.J. Webster and H. Etzkowitz, Amdemic-industry Relations: The Secimd Academb Revolution: A Framework Paper for a Proposed

Workshop on Academb-/ndustry Re/ations (London, England, Scienee Policy Support Group, 1991).

Support for specific research projects by firms percent of such faculty had consulted with

that use the techniques of biotechnology in their industry for money at least once over the 3-year

R&D totaled between $85 and $135 million in period ending in 1984 (53).

1984, or between 8 and 24 percent of all funds Large-scale collaborations between pharmaavailable for biomedical research in academia ceutical companies and academia are largely a

(51), 8 Spending per project was less than the phenomenon of biology and pharmacology (5 11).

average size of NIH grants, and they were Although these agreements may represent extentypically of a shorter duration suggesting indus- sive support and collaborative opportunities for

trially supported research can be more focused the faculty involved, they are relatively infreand applied in nature than that funded by govern- quent. Table 9-2 lists the bulk of such relationment (51,483). ships of direct or indirect relevance to the

Life science faculty at major research-intensive pharmaceutical industry. In some cases, the

universities also receive support through consult- industrial partner may create an entire physical

ing arrangements with private firms. About 40 structure in which industrially-supported work

8 Because biotechnology has applications beyond biology and medicine, some of this estimated industrial support of academic research went

for work in fields such as agrieultwe.
Chapter 9-Federal Support for Pharmaceutical Research and Development 209

takes place; in others the company may support

research in an existing academic facility.

Among other potential benefits to the industrial

partner, some collaborations allow the placement

of company scientists in university laboratories.

Table 9-2 shows the industrial commitment in

these relationships is often for a longer period

than is industrial project-specific support.

Though some systematic research about the

structure, workings, and scientific or commercial

outcomes of these large collaborations is currently underway, little is known about them today

(228,512).

Private industrial ventures begun by universities or their faculty have created controversy

about the appropriate limits of commercial activities on campus. Such startup ventures come in

two main varieties: 1) commercial ventures established directly by the university to commercialize

academic research and to benefit the school

financially; and 2) firms founded by individual

faculty members to commercialize their own

research, usually for the financial benefit of the

founders and other stockholders.

One of the earliest universities to try to capture

the commercial benefits of its faculty’s research

is the University of Wisconsin, whose Wisconsin

Alumni Research Foundation (WARF) dates

from the 1920s. All faculty at the University of

Wisconsin are required to assign the rights to

patents arising from their work to the independent

WARF, which then attempts to license the

technology. Proceeds are shared by the university

and the inventing faculty member. The vast

majority of all its income is attributable to a single

early patent of importance to the dairy industry,

which suggests that such enterprises may be

unable to generate much patent income for the

university (50).

Despite the mixed success of the WARF

example, during the 1980s a number of other

research-intensive universities created similar

institutions to commercialize campus research.

The growth of these arrangements is partly due to

the increasing opportunities to commercialize

academic life science research and partly to a

1980 change in law that gave universities sole

ownership of patents arising from governmentsponsored research (Public Law 96-517)9 (228).

An important feature of almost all these

enterprises is that they are organizationally independent of the universities that own them. The

separation is intended to prevent commercial

considerations from perverting the traditional

academic values of the university.

Critics of these arrangements have questioned

whether true organizational separation is possible

given the frequent involvement of individuals

with strong ties to the parent university in the

decisions of the commercial enterprise (50,228).

Indeed, Harvard University soundly rejected a

1980 proposal to establish a firm to commercialize research because it was considered incompatible with the university’s central missions of

learning and the pursuit of knowledge (54). By

1988, the attitude had changed; the university

reversed itself by establishing Medical Science

Partners, an enterprise designed to commercialize

biomedical research findings in a manner similar

to WARF. In doing so, the university faced little

of the faculty questioning or media attention that

accompanied the 1980 proposal (514). To date, no

evidence is available on whether these enterprises

have in fact stimulated commercialization of

research findings or whether the earlier fears of

the critics were justified.

In the 1980s, many faculty in the life sciences

founded companies with products or services

based on their own research (445,450). Some

early products based on biotechnology (such as

diagnostic tests using monoclinal antibody technology) had a relatively fast R&D period, thus

g The Bach-Dole Patent and Trademark Act of 1980 (Public Law 96-517) gave universities, nonprofit organizations, and small businesses

the rights to inventions resulting from research supported with Federal grants. It also required these institutions to share any royalty income

from patents with the individuals responsible for the invention. Congress extended these patent rights in 1984 to Federal laboratories operated

by universities and nonprofit corporations (Public Law 98-620).
210 I Pharmaceutical R&D: Costs, Risks and Rewards

generating early revenues and increasing interest

in such enterprises among other faculty and the

investment community (419).

Faculty-founded companies led universities to

question how deeply involved in the commercial

enterprise a faculty member should become while

maintaining his or her university affiliations

(228,415,5 11). In recent years, some universities

have banned faculty equity holding in firms that

support the faculty members’ own research, while

others have relied on faculty disclosure of such

financial interests and a case-by-case consideration of their appropriateness (51,331).

Although individual cases have been controversial, the scanty evidence that exists suggests

the phenomenon of faculty equity-holding in

commercial enterprises is actually very infrequent. In 1985 only 8 percent of faculty involved

in biotechnology at universities reported holding

equity in a firm whose products or services were

based on their research (53). In addition, only 0.5

percent held equity in firms from whom they also

received support for their university research.

Although responding faculty may have underreported these activities, the 8 percent no doubt

includes equity ownership in nonstartup fins.

1 Issues in Current University-Industry

Collaborations

During the early 1980s, as the frequency of

industrial collaborations grew, so did questions

about their ethical implications for the university

and the appropriate balance between the potential

risks and the benefits gained by the transfer of

academic research to productive industrial applications (54,234). Among the most oftenmentioned potential risks of university-industry

collaboration are conflicts over faculty time

commitments to the university, conflicts of interest for faculty who are in a position to benefit

financially from their university laboratory research, and increased secrecy or other restrictions

on the dissemination of industrial research results.

There is little evidence that the behaviors

associated with these risks are at all widespread.

Although one survey found that a minority of

faculty has done some research in which the

results could not be published without consent of

the sponsor, the faculty who collaborate with

industry tend to be among the most productive

(53). They publish and teach more than their

colleagues, so commitment to the academic

institution appears not to be a big problem.10 As

indicated earlier, the potential for conflicts of

interest arising from faculty involvement in

startup firms appears to exist in only a very small

minority of cases. Furthermore, in the last 2 years,

the Federal Government and the research community itself have taken steps to prevent researchers

from having any financial interest in the outcome

of research they conduct.11

TARGETED FEDERAL PHARMACEUTICAL

R&D PROGRAMS

In addition to the general research and training

support that makes up the life science research

infrastructure, NIH and other parts of the Federal

Government have established 13 programs specifically targeted to fund pharmaceutical R&D.

10 Data from tie smeys conducted by Blurnentil and colleagues (52) suggest that while fins’ expectations of thekacadernlc collaborators

may vary, there is a general consensus about what constitutes acceptable behavior for academics who collaborate with fins. For example,

patent rights arising from industrially supported research are expected to be owned by the university, although firms sometimes may have the

right of fust refusal for exclusive licensing for some period of time. Researchers have a right to publish and are usually not expected to protect

trade secrets for a fm (52). A recent survey of graduate school deans suggests there has been increasing administrative attention to these ethical

issues on campus as measured by the adoption and revision of university policies governing student and faculty communication of research

results, teaching commitments, and interactions with industry (249).

11 For example, iKI 1989, tie ,Vew Eng/adJourna/ of Medicine (NEJM) adopted a policy that required authors to Sign a Statement tiat tiey

had no personal financial interest in a firm that could benefit from the outcome of research reported in articles submitted to the journal for review

and possible publication (347). The American Medical Association House of Delegates has considered the issue, and the Journal of (he

American Medicu/Association has adopted policies similar to those of NEJM (10). NIH is spearheading an effort for the Public Health Service

to develop similar guidelines for the recipients of Federal health research funds. In April 1989, NH-I solicited comments on proposed regulations

(54 FR 17828), but has not yet ]ssued a revised set of guidelines.
Chapter 9—Federal Support for Pharmaceutical Research and Development 211

There are also cases in which federally supported This mixing of basic research with more

research projects incidentally, but directly, influ- applied efforts that directly advance the developence pharmaceutical R&D, even though the ment of new drug therapies makes it difficult to

government is pursuing research goals far re- sort out the exact nature of any implied subsidy of

moved from the discovery and development of private pharmaceutical R&D. OTA’s discussions

new therapies. Consider a hypothetical research with Public Health Service (PHS) officials and its

project: reviews of federally supported biomedical rein an effort to understand the physiology of a

particular disease, researchers test the hypothesis

that the absence of a substance naturally produced

by the body (such as an enzyme or protein), but

largely lacking in patients suffering from the

condition, actually causes the disease. The research involves administering to people with the

disease a pharmaceutical compound that is used

to treat another disease but is known to stimulate

the body’s production of the missing substance.

The researchers’ main objective is to understand

whether providing the substance alleviates the

disease, However, the research may also benefit

the makers of the drug or biological who now

have a potential new indication for which they

may seek Food and Drug Administration (FDA)

approval.

search projects suggest the use of potential

pharmaceutical compounds in projects aimed at

increasing basic understanding of diseases can be

a common form of such hybrid work. Thus, it is

difficult to assess how much of a research project

represents targeted drug R&D as the private

sector would perform it, how much merely aids

such private efforts but does not mimic it, and

how much is clearly unrelated to the drug R&D

process. Box 9-A provides several examples of

the link between federally supported basic research and the development of new drugs.

OTA identified 13 programs within the Federal

Government whose specific mission is to conduct

R&D involving actual or potential pharmaceutical products. There is no ambiguity in these

Box 9-A–Examples of the Link Between Basic Federal Biomedical Research and the

Development of New Drugs

All basic research supported through the disease-oriented institutes of NIH and ADAMHA contributes

to the ability to research and develop new pharmaceuticals by increasing fundamental understanding of

normal and diseased functioning of living organisms. The line where untargeted basic research ends and

targeted drug discovery begins is hazy at best. About $4.4 billion of the $6.9 billion appropriated for R&D

at the Public Health Service in 1989 was for basic research.1 The results of this public funding for basic

research provide a necessary foundation for subsequent pharmaceutical R&D. The following three examples

show how basic research in the biological sciences ultimately affects the introduction of new pharmaceutical

products.

. In the early 1960s, scientists at the National Eye Institute (NEI) showed that cataracts (an obstruction

of the lens of the eye) in animals with diabetes were due to the formation and accumulation of polyols

(sugar alcohols). They discovered that an enzyme, aldose reductase, converts blood sugars (which

are found in high levels in diabetics) into polyols. The sugar alcohols accumulate in cells, weaken

the cell membrane, and eventually leak out of the cell, causing the cataracts. The discovery of aldose

I &cOr@ to NatiO~ Science Foundation deftitions, “in basic researc& the objective of the sponsoring agency is to gain

fuller knowledge or understanding of the fundamental aspects of phenomena and of observable facts without speciilc applications

toward processes or products in mind. ” Hence, this would exclude any research where the goal is to iden@, characterize, or test an

actual, potential pharmaceutical product.

(Continued on next page)
212 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 9-A–Examples of the Link Between Basic Federal Biomedical Research and the

Development of New Drugs--(Continued)

●

●

reductase and its role in diabetic cataracts led scientists to search for therapies that block the

enzyme's action. The resulting class of drugs, aldose reductase inhibitors (ARIs), became the first

therapies for diabetic complications that are unaffected by other treatments for diabetes itself (i.e.,

insulin used to lower blood sugar levels).2 Current NEI research is intended to understand the role

of aldose reductase and polyols in causing other complications of diabetes, including nerve and

kidney damage.

Since 1987, the National Institute of Allergies and Infectious Diseases (NIAID) has provided just

under $3 million in grant support to three projects of research on the structure, functioning, and

replication of rhinoviruses, which are estimated to cause 50 percent of common colds. The purpose

of this support is to provide enough fundamental understanding of these viruses that pharmaceutical

companies will be willing to invest in the development of preventive or therapeutic drugs.

Laboratory analysis funded by NIAID has identified unique features of all rhinoviruses and has led

to the development of drugs (called WIN compounds) that block viral replication in animals. Study

of these drugs in animals (funded by NIAID) in turn increased fundamental scientific understanding

of how the viruses behave in the body. At the same time, Sterling Winthrop pharmaceuticals has

recently received investigational new drug (IND) status to test WIN compounds in humans.3

Over the last 15 years, the National Institute on Drug Abuse (NIDA) provided sustained support for

basic research to understand the specific mechanisms by which opiates affect brain cells and cause

pain relief, addiction, and various side effects. In particular, NIDA-supported scientists have found

that different opiate compounds attach themselves to brain cells at different places. This

understanding has provided researchers with leads with which to seek medications to treat drug

addictions. The NIDA-supported discovery of how opiates affect brain cells also provided scientists

with a technique for rapidly screening potential pharmaceuticals that may act upon brain cells;

researchers can determine if the pharmaceutical candidate ‘binds’ to a desired ‘binding site’ found

on brain cells, and whether or not it also binds to undesired sites. This screening technique has been

used by academic and industrial researchers in the development of new pain relievers and

antipsychotic drugs among other types of pharmaceuticals.

2 ~~~~y~ a ~~r ~~ k cw~ tes~ of these therapies by jointly ddgthg,_~conduc~ ~~-r

Pharmaceuticals a 5-year mukiamter, randomized clinical trial of Pfizer’s investigational ~Sorbinilw, in patients with diabetes.

This Soribinil Retinopathy ‘hid (SRT) showed tbat this particular ARI compound was not significantly ei%xtive and caused adverse

reactions in some patients.

3 Nei~w Or my Obr research agency of the Federal Governmen t has provided support for these clinical studies.

SOURCE: Office of ‘Ikdmology Assess- 1993. Based on data fkom: Dvomik D., Simard-Dqueane N., Kraml M., et al.,

“Inhibition of Aldosc Reductase in Vivo,” Science 182:1146-1147, 1973; Gr@ S., Acting Director, Office of Science

Policy and Legislation National Institutes of Heal@ Public Health Sefice, U.S. Deparbncnt of Health and Human

Services, Bethm@ MD, personal communicatiom February 8, 1991; He@ B.A., Ruecherg R., Shepar& D.A., et al.,

“Genetics and Molecular Analyses of Spontaneous Rahino Virus #14 Mutants of H- Cells that are Resistant to an

Antiviral CompouI@” Journal of Virology 63:2476-2485, 198% Kirmh@ J.H., “Cataracts in Galactoscmitq”

Investigative Ophthafmololgy and Visual Sciences 5:786-789, 1965; Kinoshi& J.H., Dvornilq D., Draml, M., et al., “The

Effect of an AMose Reductase Inbibitor on the Galactoso-Exposed IMbit Lem” Biochinu”ca et Bwphys”cu Acta

158:472-475, 1968; KinoshI‘a J.H., “Mechamam“ InitiatiugCataractForrmm“orq” Investigative Ophthalmology and Visual

Sciences 13:713-724, 1974; National Sciawe Boar& Science and Engineering Iw.ll”cators-1989, NSB Pub. No. 89-1

(w@@@& DC: Us. GoVemrmnt Printing Office, 1989); Pevear, D.C., Fancher, MJ., FeloclG P.J. et al,,

“cmfirmah“end Change in the Floor of Human Rahino Virus Canyon Blocks Adsorption to HeLa Cell Receptor, ’’~owwa/

~ Virology 63:20(X2-2(X17, 1989; Ro_ M.G., “The Stmcture of Antiviral Agents that Inhibit uDcoating when

Complexed witb Viral Capsi@” Am#viral Research 11(1):3-13, 198% Sakamoto, N., Kinoslu“Q J.H., Kador, Pi:, and

Hotta N (eds.), Polyol Pathnuy and its Role in Dhzbetic Complications: Proceedings of the International Symposium on

Polyol Pathways and their Role in Didbetic Complications (New York NY: Bxcapta Mediq 1988); Science, “The

Microchip Microbe Hunters,” Science 247:804-806, 1~, Wn Heyningen+ R., “Formation of Polyols by the Lena of the

Rat witb Sugar Cataract, “ Na@re 184:194-1%, 1959.
Chapter 9-Federal Support for Pharmaceutical Research and Development 213

programs. They are intended to make new therapies available through public funding of R&D.

Together, these 13 programs accounted for $387

million in spending in fiscal year 1989, about 55

percent of the total (preclinical and clinical)

government-sponsored drug R&D estimated by

OTA in the next two sections. It is impossible to

estimate the proportion of these funds devoted to

preclinical research, because most of the 13

programs support both clinical and laboratory

research.

One program--National Cancer Institute’s (NCI)

Cancer Therapy Evaluation program, which accounts for 78 percent of the $387 million fiscal

year 1989 funding-is devoted exclusively to

clinical testing of cancer drugs. The NCI drug

development programs together accounted for

roughly 80 percent of all funds for Federal

dedicated drug development programs in fiscal

year 1989 (see table K-1 in appendix K). All but

one of these programs, the Department of the

Army’s Antimalarial Program, are at NIH.12

The 13 programs vary in size, purpose, and

methods of operation. Some have significant

intramural laboratory programs; others are extramural grant and contract programs. Appendix K

contains a summary of the 13 Federal dedicated

pharmaceutical R&D programs.

What is the justification for direct public

spending on targeted drug discovery? In certain

cases, public health authorities have determined

that national priorities necessitate public investment to speed the process of developing new

therapies. Illnesses related to human immunodeficiency virus (HIV) is one example. There may

also be barriers to private-sector involvement.

The orphan drug programs exist because some

conditions affect so few patients that the private

sector might otherwise find investment in potential treatments financially unprofitable.

In another example, the National Institute on

Drug Abuse suggested to OTA that private

pharmaceutical firms have traditionally shown

little interest in medications to treat substance

abuse because of difficulties in getting clinical

research subjects to comply with research protocols (343). It is also possible that firms perceive

products for substance abuse treatment to represent relatively low potential returns, perhaps

because of limited third-party coverage of such

services.

Another reason the Federal Government conducts or supports targeted drug discovery is the

difficulty of distinguishing basic from applied

investigation. At least one long-time observer of

science policy, Donald E. Stokes, has noted that

most research projects have at once basic and

applied qualities (410). Another observer has

suggested that making such separations in the life

sciences has become more difficult in the last 15

years as the development of new biotechnological

techniques has ‘‘collapsed” the amount of time

traditionally needed to move from basic scientific

understanding to potential products, including

drugs (306).13

~ Federal Support for

Preclinical Drug R&D

OTA asked NIH and the former Alcohol, Drug

Abuse and Mental Health Administration

(ADAMHA), which together makeup the bulk of

Federal health-related R&D, to estimate all of

their expenditures for preclinical drug discovery,

whether or not such expenditures were made as

part of one of the targeted drug development

programs described above.

The results must be considered rough estimates, because the institutes did not uniformly

follow OTA’s guidelines for classifying research

projects, and some institutes were unable to

12 one of ~c~rogm, me ~gAbu~Mc&~ti~~ D~~~@~~~t~~~, is auster~ by he NatiO~ ~timte 011 Drug Abuse (_NDA)

which Was part Of ~~until 1992. Recent legislation has moved this institute to NIH (Public IAw 102-321).

]3 T. tietie ~vi~ion of ~~r ~~mn tie Fcde~ Government ~d pfivate ~d~&y even less tidy, most indust.rid scientists interviewed

by O’IA during our visits to eight pharmaceutical fms stressed that while their primary mission is to bring new drugs to rnarke~ their work

can also produce advances in basic scientific understanding. Such industrial contributions to the scientific Litemture are borne out by analyses

of bibliographic and citation databases (286).
214 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 9-3--Estimates of NIH and ADAMHA

Research Support for Preclinical Pharmaceutical

Screening, Synthesis, Evacuation and Development

Activities, Fiscal Years 1988-90($ thousands)

Fiscal year Fiscal year Fiscal year

1988 1989 1990

NIH

NCI . . . . . . . . . . . . . . . $283,576 $308,851 $316,729

NHLBl a . . . . . . . . . . . 28,324 31,983 28,350

NIAIDb

. . . . . . . . . . . . 46,603 52,358 64,897

NIDDKC . . . . . . . . . . . 8,500 9,417 9,700

NICHDd 

. . . . . . . . . . .

NIAa . . . . . . . . . . . . . . 1,265 0 955

NINDSe . . . . . . . . . . . 4,812 6,168 5,079

NIDRf . . . . . . . . . . . . . 14,165 14,918 11,056

NCRR g . . . . . . . . . . . . 10,502 12,296 11,485

NIAMS C 

. . . . . . . . . . . 284 275 618

NEI . . . . . . . . . . . . . . . 6,420 8,557

ADAMHAh

NIMH . . . . . . . . . . . . . N/A N/A N/A

NIDA . . . . . . . . . . . . . N/A N/A 28,843

NIAAA . . . . . . . . . . . . N/A 6,286 13,261

Total’ . . . . . . . . . . . . . . 398,031 448,972 499,530

a NHLBI, NIA: Data are institut~l~’ ~st estimates.

b NIAID: %s4 on narrow definition of drug development; may differ

from earlier NIAID reports.

C NIDDK: ~timat~ in~iu~ ~lin~al research.

d NICHD: National drug development and clinical research cannot be

separated; both included in clinical estimates (table 9-5).

e NINDS.: Estimates prior to fiscal year 1990 with approximately I o

percent variance.

f NIDR: Fi~l year 1990 is the most accurate; others are likely

overestimates.

9 NCRR: Includes clinical research involving pharmaceutical development.

h ADAMHA: Data not availabkl for following institutes and years:

NIMH-fiscal years 1988 and 1989; NIDA-fiscal year 1988; NiAAAfiscal years 1988, 1989, and 1990.

i Totals are only an approximation since data for several institutes are

missing (counted as zero) and data for others indude clinical activities.

KEY: ADAM HA = Alcohol, Drug Abuse and Mental Health Administration. NCl=National Cancer Institute. NCRR=National Center for

Research Resources. NEI - National Eye Institute. NHLBI -

National Heart, Lung and Blood Institute. NIA - National Institutes

on Aging. NIAAA . National Institute on Alcohol Abuse and

Alcoholism. NIAID = National Institute of Allergy and Infectious

Diseases. NIAMS = National Institute of Arthritis and MuscuIoskeletal and Skin Diseases. NICHD - National Institute of Child

Health and Human Development. NIDA = National Institute on

Drug Abuse. NIDDK - National institute of Diabetes and Digestive and Kidney Diseases, NIDR = National Institute of Dental

Research. NIH - National Institutes of Health. NIMH E National

Institute of Mental Health. NINDS = National Institute of Neurological Disorders and Stroke.

SOURCE: Office of Technology Assessment, 1993. Based on data

provided by individual institutes of the Public Health Service,

U.S. Department of Health and Human Services.

provide any estimates at all. Total estimated

preclinical pharmaceutical R&D constituted approximately $450 million in 1988 (table 9-3),

about 6 percent of the overall combined research

budgets of NIH and ADAMHA. Such activity is

highly concentrated at NIH, with a majority

falling within the National Cancer Institute. OTA

also estimated that NIH and ADAMHA’s 1988

preclinical drug research spending of $400 million represented roughly 14 percent of the amount

spent by private pharmaceutical firms for similar

R&D functions (table 9-4).

Table 9-4-Estimates of NIH and ADAMHA

Preclinical Pharmaceutical Research Support

as a Percentage of PMA Firms’ Expenditures for

Preclinical R&D Activities, Fiscal Year 1988

Estimate

A. PMA firms’ R&D for human ethical

pharmaceuticals $6.31 billion

B. Percent preclinicalb44%.

C. PMA firms’ preclinical R&D

(A multiplied by B) $2.77 billion

D. NIH/ADAMHA preclinical

pharmaceutical R&Dc

$ .40 billion

E. NIH/ADAMHA as a percent of PMA

(D divided by C) 14%

a From Annual PMA Survey Reports, 1988-90.

b R&D functions included: ‘{biological screening and pharmacological

testing,” “synthesisand extraction, pharmaceutical dosage, formulation, and stability testing,” and ‘Ioxicdogy and safety testing.”

Excluded functions: “process development for manufacturing and

quality control,” all “clinical evaluation, “ “regulatory, investigational

new drug and new drug approval preparation, submission and

processing,” and “other.”

c Assumption for middle estimate is a rough approximation bSd on

data from individual institutes of the Public Health Service, U.S.

Department of Health and Human Services (presented in table 9-3);

assumption of high and Iowestimates are 50 percent hlgherand lower

than middle estimate.

KEY: ADAM HA - Alcohol, Drug Abuse and Mental Health Administration; NIH - National Institutes of Health; PMA = Pharmaceutical

Manufacturers Association.

SOURCE: Office of Technology Assessment, 1993.
Chapter 9–Federal Support for Pharmaceutical Research and Development I 215

Support for Clinical Drug R&D

OTA also requested NIH and ADAMHA to

provide estimates of clinical research involving

pharmaceuticals. Table 9-5 presents estimates

Table 9-5—Estimates of NIH and ADAMHA Support

for Clinical Research Involving Pharmaceuticals,

Fiscal Years 1988-90 ($ thousands)

Fiscal year Fiscal year Fiscal year

1988 1989 1990

NIH

NCI . . . . . . . . . . . . . . . $51,991

NHLBI . . . . . . . . . . . . 22,555

NIAID a 

. . . . . . . . . . . . 61,394

NIDDK . . . . . . . . . . . .

NICHD b 

. . . . . . . . . . . 11,252

NIA C 

. . . . . . . . . . . . . . 2,686

NINDS d 

. . . . . . . . . . . 23,324

NIDRe 

. . . . . . . . . . . . . 9,193

NCRR . . . . . . . . . . . . 6,502

NEI . . . . . . . . . . . . . . . 6,523

ADAMHAf

NIMH . . . . . . . . . . . . . 7,782

NIDA . . . . . . . . . . . . .

NIAAA . . . . . . . . . . . .

Totalg . . . . . . . . . . . . . 203,202

$55,072

30,292

80,236

12,512

1,934

25,060

8,127

6,762

6,849

6,661

16,500

$57,889

26,540

96,304

11,107

3,380

5,246

5,246

5,877

6,293

17,500

1,227

250,005 237,977

aNIAID: Fiscal year 1990 is rough estimate,

bN]DDKand NICHD: Clinical and drug development activities could

not be separated. NIDDK estimates were reported as preclinical

(table 9-3) NICHD figureswere reported here (as clinical research)

CN\A: Data are best estimates; not based on CRISP search.

dNIDS: Fiscal year 1990 unavailable; fiscal year 1989 based on

examination of abstracts from CRISP search; estimates for earlier

years based on fiscal year 1989.

e NIDR: Figure for fiscal year 1990 is most accurate, based On review

of abstracts; others are rough estimates.

f ADAMHA: Data not available for following institutes and years:

NIDA—fiscal year 1988; NIAAA-fiscal years 1988 and 1989.

9 Totals are approximation since data for some institutes are missing

(counted as zero) and data for others include nonclinical activities.

KEY: ADAM HA = Akmhol, Drug Abuse and Mental Health Administration. NCI = National Cancer Institute. NCRR = National Center for

Research Resources. NEI = National Eye Institute. NHLBI -

National Heart, Lung and Blood Institute. NIA = National Institute

on Aging. NIAAA - National Institute on Alcohol Abuse and

Alcoholism. NIAID = National Institute of Allergy and Infectious

Diseases. NICHD = National Institute of Child Health and Human

Development. NIDA == National Institute on Drug Abuse. NIDDK

= National Institute of Diabetes and Digestive and Kidney

Diseases. NIDR = National Institute of Dental Research. NIH =

National Institutes of Health. NIMH = National Institute of Mental

Health, NINDS = National institute of Neurological Disorders and

Stroke,

SOURCE: Office of Technology Assessment, 1993; based on data

provided by individual institutes of the Public Health Service,

U.S. Department of Health and Human Services.

provided by NIH and ADAMHA. The participating institutes estimated that between $200 million

and $250 million per year was spent on research

involving clinical pharmaceutical investigation in

the fiscal years 1987-90. Together NIH and

ADAMHA clinical research in 1988 represented

roughly 11 percent of clinical research conducted

by Pharmaceutical Manufacturers Association

(PMA) firms in that year (table 9-6).

These estimates by themselves divulge little

about the nature of clinical pharmaceutical research directly supported by the Federal Government. OTA reviewed federally funded clinical

research projects for four drugs approved for

marketing in the United States by the FDA in

1987—lovastatin, fluoxetine, zuidovidine (AZT),

and tissue plasmiogen activator (TPA). The

results indicated that the clinical projects supported by NIH and ADAMHA institutes span the

pre- and post-FDA-approval periods. Projects

involving drugs already approved for marketing

include attempts to better understand the efficacy

or safety of the drug as well as investigations into

potential new indications for its use. PharmaceuTable 9-6-Estimates of NIH/ADAMHA Support

for Clinical Pharmaceutical R&D as a Percentage

of PMA Firms’ Expenditures for Clinical R&D

Activities, Fiscal Year 1988

Estimate

A. PMA firms’ R&D for human ethical

pharmaceuticals $6.31 billion

B. Percent clinicalb

30°A

C. PMA firms’ clinical R&D

(A multiplied by B) $1.89 billion

D. NIH/ADAMHA clinical

pharmaceutical R&Dc $ .20 billion

E. NIH/ADAMHA as a percent of PMA

(D divided by C) 11“A

a From Annual PMA Survey Reports, 1988-90.

b Clinical evaluation = phases 1, 11, Ill, and IV

c Estimate is based on data from indiwdua! institutes of the Public

Health Service, U.S. Department of Health and Human Services (see

table 9-5).

KEY: ADAM HA = Alcohol, Drug Abuse and Mental Health Administration; NIH = National Institute of Health; PMA - Pharmaceutical

Manufacturers Association.

SOURCE: Office of Technology Assessment, 1993.

330-067 - 93 - 8 : QL 3
216 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 9-B--NIH Clinical Trials Involving Cholesterol-Lowering Drugs

The class of cholesterol lowering drugs called HMG-CoA reductase inhibitors whose discovery and

development is described in box 4-A has also been the subject of clinical research at NIH. In 1987, an

advisory committee of the National Heart, Lung and Blood Institute (NHLBI) recommended that the

institute fund a large-scale, multiyear trial to evaluate the long-term effectiveness and safety of this class of

drug as a means of preventing fatal and nonfatal heart attacks among the elderly. Because the three drugs

in this class currently on the U.S. market were approved on the basis of the short-term, ‘surrogate’ measure

of effectiveness-whether or not they lowered levels of cholesterol in blood-there was no available

empirical evidence as to whether these drugs actually prevented death, particularly among the elderly. Given

that as many as 60 million people are estimated to have high cholesterol, but fewer than 1 million people

currently receive drug therapy, the results of this investment by NIH could have inportant scientific and

economic implications. On the one hand, the trial could reinforce the effectiveness of this drug, thus

maintaining or brightening their market prospects. On the other hand, if the research suggests the drugs are

not effective or carry unforeseen risks for patients, the market for these drugs could evaporate.

Although funds were not available to mount a full-scale trial, which was expected to cost at least $60

million and involve 5,500 research subjects at 16 to 20 locations, NHLBI did fund a 2-year, $2.5-million

pilot study to estimate the cost of the full-scale trial and to identify potential problems in carrying it out. The

pilot study, called the Cholesterol Reduction in Seniors Program (CRISP), began in July 1990 at five sites

(chosen by NHLBI through a competitive process) and involved 400 research subjects. In addition to

measuring the rate at which potential subjects agree to participate in the trial and their compliance with the

trial’s protocol, the pilot study also collected data on side effects, the extent of cholesterol reduction

observed, and a number of other measures of the drug’s efficacy and long-term toxicity in elderly patients.

The three HMG-CoA reductase inhibitors currently available in the United States are manufactured by

two firms: lovastatin and simvastatin by Merck, and pravastatin by Bristol-Myers Squibb. NHLBI invited

each of the manufacturers to submit proposals to NIH for the use of their drugs in the trial. Because NHLBI

considered the two companies’ proposals to be equivalent, it suggested using both companies’ products.

(Continued on next page)

tical firms typically provide the Federal Govern- ine, that is already marketed as a treatment for

ment with drugs used in federally supported trials

at no cost; but the other costs of the trial are

funded by the government.

The National Heart, Lung and Blood Institute’s

(NHLBI) potential support of a trial comparing

the use of different HMG-CoA reductase inhibitors in treating high levels of serum cholesterol,

described in greater detail in box 9-B, is an

example of Federal support for clinical research

on a drug--lovastatin--that is already marketed.

Several other examples of federally supported

investigations into new indications for drugs

already marketed came from the National Institute of Mental Health (NIMH), which has supported trials testing new uses of a drug, fluoxetdepression.

As in the case of AZT, a drug whose use in

treating HIV was demonstrated in research at NCI

during the 1980s, the Federal Government also

supports trials whose results ultimately yield

evidence of efficacy and safety necessary for an

FDA marketing application. NCI’s involvement

with AZT was the result of an urgent, specific

Federal initiative to find therapies for HIV and its

related illnesses (276,493). Because of data limitations, OTA was unable to make any better

estimate of how frequently the Federal Government funds clinical work that later becomes part

of a fro’s new drug application.

When NIH supports clinical research, part of

the total health care expenses incurred by patients
— —.——— .—.

Chapter 9–Federal Support for Pharmaceutical Research and Development ! 217

When one of the companies rejected this proposal, NHLBI chose to use Merck’s lovastatin because it had

received FDA marketing approval first and had experienced a low rate of serious side effects during its, by

then, 3 years on the market. The pilot study’s protocol involved two different doses of the drug and a placebo.

Merck bore the costs providing both the drug and placebo, including its distribution. All remaining

costs associated with establishing the trial, administering the drug, diagnostic tests, related patient care, data

collection, and analysis ($2,5 million) were paid by the Federal Government through NHLBI. According

to NHLBI, industry scientists were not directly involved in planning the clinical trial or developing its

protocol. They have participated in a steering committee for the pilot study convened by NHLBI, although

they had no access to the study’s data until its completion.

The pilot study ended in June 1992, and investigators expect to publish results in the medical literature

during 1993. Plans are currently underway to make the full cholesterol-lowering trial part of a large

Antihypertensive and Lipid-Lowering Treatment for the Prevention of Heart Attack Trial, which will begin

in the fall of 1993, Of the 30,000 research subjects that will participate in this trial, 12,000 will meet

researchers’ criteria to receive an HMG-CoA reductase inhibitor. The study will follow these patients for

5 to 7 1/z years, measuring heart attacks and long-term toxicity associated with the drugs. The researchers

may also have sufficient statistical power to measure the potential effects of cholesterol reduction on overall

mortality.

NHLBI has budgeted $78.3 million for the whole trial over 9 years, A protocol committee will convene

in early 1993 to determine which drugs and what doses will be part of the trial. As of December 1992, NHLBI

had entered into discussions with the relevant pharmaceutical manufacturers about their contributions to this

effort. At a minimum, NHLBI hopes to receive drugs and placebos from the companies, but it may try to

receive additional financial contribution as well in light of the importance of this research for the companies’

markets. The role of pharmaceutical scientists (if any) in the design and administration of the trial is also

yet to be determined.

SOURCE: Office of Technology Assessment, 1993. Based on information provided in personal communications from: S. Groft, NH

Office of Science Policy and hgislatio~ Feb. 8, 1991; C. Ro@ OffIce of Policy and bgislation, National Heart Lung and

Blood Institute, Dec. 22, 1992; J. Cutler, Nationat Heart, Lung and Blood Institute, Dec. 22, 1992; David Gordo~ National

HearL Lung and Blood Institute, Dec. 22, 1992; A. Garber, Assistant Professor of Internal Medicine, Stanford University,

January 6, 1993.

enrolled in such trials is paid by the Federal professional) are typically paid by the patient or

Government. For those clinical trials conducted at

the NIH clinical center, all services provided to

patients are paid by the Federal Government

(476). At other institutions, the cost of care

associated with the research protocol is paid for

by the Federal Government through research

patient care rates established by the Department

of Health and Human Services (DHHS). ‘‘Usual

patient care’ (e.g., items and services furnished

ordinarily to patients by providers under the

supervision of a physician or other certified health

the patient’s health insurer.

INDUSTRY COLLABORATION WITH

FEDERAL RESEARCH LABORATORIES

The Federal investment in biomedical research

includes a substantial amount of intramural research conducted in Federal Government laboratories. In 1990, about $2.6 billion was spent on

intramural health research at laboratories operated by the Federal Government (483).14

Over the last 10 years, Congress and the

Executive Branch have paid increasing attention

IA In addition to in-house research, this includcsprogram management and direct operations attributable to health R&D. A total of $1.4 billion

of this amount is for R&D that was performed at NIH, The remainder was performed at ADAMHA, FDA, CDC, Department of Defense, the

Department of Veterans Affairs, the Environmental Protection Agency, the Department of Energy, and the Natioml Aeronautical and Space

AdmlnisK~tion.
218 I Pharmaceutical R&D: Costs, Risks and Rewards

to the role of these Federal research laboratories

in fostering commercial innovation. Legislation

was enacted to encourage the transfer of research

results from Federal laboratories to private firms

when commercial applications are feasible. This

section reviews Federal. technology transfer activities within the Public Health Service, which

contains NIH and other health research agencies.

1 Legislative History of Federal

Technology Transfer Activities

Since 1950, the Federal Government has explicitly required Federal employees to report

inventions created during the course of their work

to the Federal Government (Executive Order

10096; 15 FR 389). Beyond this requirement,

however, there was no uniform patent and licensing policy for ail Federal agencies until 1980

when Congress passed the Stevenson-Wydler

Technology Innovation Act (Public Law 96-480).

The Stevenson-Wydler Act made the transfer

of Federal technology to the private sector a

national policy and duty of Federal laboratories.

Among its provisions, the act required that

Federal laboratories spend at least 0.5 percent of

their research budgets on “Federal technology

transfer activities. ” Additional legislation in

1984 directed the Department of Commerce to

issue regulations governing licensing of technologies developed in Federal laboratories (Public

Law 98-620; 50 FR 9801; 37 CFR 404).

These actions proved insufficient to bring

about the intended level of formal interaction

between government and industrial scientists

(456), so Congress passed the Federal Technology Transfer (FIT) Act of 1986 (Public Law

99-502).

The FTT Act gives the Federal employee the

right to his or her invention if the government

determines the invention has no commercial

value and does not intend to license it. The FTT

Act also requires Federal agencies share at least

15 percent of royalties from any licensed inventions with the inventing scientists, and it directs

agencies to establish cash awards for other

personnel involved in productive Federal technology transfer activities.15

Most importantly, the legislation permits the

establishment of formal cooperative research and

development agreements (CRADAs) in which a

Federal laboratory provides personnel, services,

facilities, equipment or resources (but not funds),

and a non-Federal party (e.g., a private company)

provides finds, personnel, services, facilities,

equipment or other resources for R&D.

The legislation does not provide any greater

detail about the form or amount of resources each

party must bring to a CRADA. It leaves implementation of a CRADA policy up to the relevant

agency. As part of a CRADA, the Federal

Government can agree in advance to grant licenses to the collaborating partner on any inventions resulting from research under the agreement. The use of CRADAs within the Public

Health Service is discussed in greater detail later

in this chapter.

S Technology Transfer in the

Public Health Service

NIH has taken the lead in implementing

Federal technology transfer activities for PHS.

Most of this responsibility has fallen to the Patent

Policy Board (PPB), which recommends NIH

policy, and to NIH’s Office of Technology

Transfer (OTT), which reports to the Board and

carries on the administrative functions associated

with technology transfer.16 Federal technology

transfer activities involving PHS laboratories and

the private sector fall into three related areas:

patenting policy, licensing policy, and CRADAs.

15 The l~@~l~tive histol-y of ~(~ ~~ts(resses that it was not intended to alter any of the conflict-of-titerest re~ations tit prevent c~ent

or former Federat employees from improperly benefiting from their government affiliation. At NIH, this includes limitations and prohibitions

against renumeration from any outside source that has any formal agreement with an employee’s laboratory or institute branch (478).

16 me b~ of pHS tw~o]ogy ~mfer activi~ o~~s at ~. Al(hou@ tie patent policy Bo~d and on are located at ~, they now

also recommend policy and administer CRADAS, patents, and licenses for ADAMHA and the Centers for Disease Control (CDC), the other

PHS agencies with technology tmnsfer activities.
Chapter 9–Federal Support for Pharmaceutical Research and Development 219

PATENTING INVENTIONS OF FEDERAL

BIOMEDICAL RESEARCH LABORATORIES

When an invention is created in a PHS laboratory or under a CRADA the Federal employee

involved must report it to a technology development coordinator located in his or her institute so

that patent applications may be filed before the

discovery is published or discussed at scientific

meetings. The coordinator determines whether

the invention is patentable.

The number of patents filed annually by PHS

has grown dramatically since 1987, the frost year

for which data on PHS patents are available. The

number of applications more than doubled between 1987 and 1989 alone (figure 9-5). The

number of patents awarded to PHS by the U.S.

Patent and Trademark Office (PTO) in the same

period did not increase, however, because of the

substantial lag between application and award.17

These trends indicate the financial incentives and

organizational structure for patenting of inventions introduced in the FTT Act of 1986 had the

desired effect.

LICENSING INVENTIONS FROM FEDERAL

BIOMEDICAL RESEARCH LABORATORIES

Outside parties who want to use patented PHS

inventions must obtain a license from the Federal

Government. Under all PHS licensure agreements, the licensee must agree to make all efforts

to develop a commercial product with the licensed invention. PHS monitors progress toward

commercialization and can revoke the license

under certain circumstances.

Royalties paid to the inventing PHS agency

typically do not exceed 5 to 8 percent of the

resulting product sales. The kinds of licenses

available and the conditions under which they are

given depend on the nature of the invention and

whether or not it was developed as part of a

CRADA (484,486). PHS grants exclusive commercialization licenses ‘ ‘in cases where substantial additional risks, time and costs must be

undertaken by a licensee prior to commercializaFigure 9-5—Public Health Service Patent

Applications and Patents Issued, 1987-90

Number of patents

250~-—–———

200-

l!x100 “

50-

0-‘ ——T——

1987 1988 1989 1990

~ Patent applications m Patents issued

SOURCE: The Office of Technology Assessment, 1993. Based on data

from U.S. Department of Health and Human Services,

Public Health Service, National Institutes of Health, Office of

Technology Transfer, 1991.

tion” (484,486). Under CRADAs, collaborating

firms may have the right to negotiate exclusive

licenses to such inventions as part of the agreement itself.

Unless it receives a request for an exclusive

license, PHS tries to negotiate nonexclusive

commercialization licenses for inventions developed in its laboratories. Under such an agreement, PHS can license a single invention to more

than one party. For both exclusive and nonexclusive licenses, PHS has developed a model agreement that is the basis for negotiations between it

and the potential licensee.

PHS grants nonexclusive research/evaluation

licenses to facilitate further research on the

invention itself, but not for commercial production or as a substitute for commercially available

research materials that the researcher could otherwise purchase. Research licenses are available

even for inventions developed under a CRADA or

17 me Genera] Accounting Office f~ud tittie ~veragc time betw~n patent application ad issu~ce in 1988 was 21.0 IIIOnth.S fOr tdl

patents and 29.4 months for those involving biotechnology (433).
220 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure 9-6—Licenses Issued by the U.S.

Department of Health and Human Services,

Fiscal Years 1977-91

Number of license agreements

60 q-—---- -

‘— ‘

—-— ---- -

40-1

I

I m

20

0 -1

n

1977 78 79 80 81 82 83 84 85 86 87 88 89 90 91a

Type of license

➤✽ Research/evaluation _ Exclusive

~~ Nonexclusive

a Number in fiscal year 1991 annualized from the nUmkr of

agreements reached during first 4 months of the year.

SOURCE: Office of Technology Assessment, 1993. Based on data

from U.S. Department of Health and Human Services,

Public Health Service, National Institutes of Health, office of

Technology Transfer, 11991.

already the subject of an exclusive commercial

license by another party.18

Figure 9-6 shows the number of licenses issued

by the DHHS through 1991.19 These data indicate

a fairly steady growth in licensing that predates

the implementation of the FTT Act and CRADAs.

Given the lag between patent application and

issuance, the licensing data displayed in this

figure do not capture any additional growth that

might result from PHS’s efforts since 1986 to

promote technology transfer.

Pharmaceutical firms that license inventions

from PHS laboratories receive economic benefits

when the inventions are commercialized and lead

to product sales. Private firms pay royalties to

PHS (and its employees) that offset these economic benefits somewhat. Data on royalty income to PHS agencies suggest the royalties

obtained by PHS are a small fraction of the total

PHS intramural budget. In 1988, the total NIH

royalty income (figure 9-7) was just 0.03 percent

of total NIH intramural spending (76). Furthermore, the vast majority of all NIH royalty income

in 1988 is attributable to a single institute and a

single technology: NCI’s HIV-antibody test kit,

for which 12 nonexclusive licenses have been

negotiated since 1984 (3,143). The patents on this

Figure 9-7--NlH/ADAMHA License Royalty Income,

Fiscal Years 1987-90

$ thousands

3,000 -]

—

1987 1988 1989 1990

KEY: ADAM HA-Alcohol, Drug Abuse, and Mental Health Adm inistration; NIH _ National Institute of Health.

SOURCE: Office of Technology Assessment, 1993. Based on data

from U.S. Department of Health and Human Services,

Public Health Service, National Institutes of Health, Office of

Technology Transfer, 1991.

18 1n ~ddition t. li~eme~, the pHS also enters into materials transfer agreements, the most common fo~ relationships ~tween a ‘HS

laboratory and a private firm (3). Under such agreements (479) PHS provides biological research materials (such as a type of cell) not covered

by a patent in return for a fee (479). The agreement also limits the scope the materials use, r~uires an acknowledgement of the PHS contribution

in reporting research results, and iibsolves the government of liability associated with its use (Model MTA Agreement). PHS laboratories use

the same agreement to obtain research materials from outside paroles (3).

19 Most ll1311s patentable invsnticms, and hence licenses, are from NIH, ~~, and CDC (72).
—

Chapter 9—Federal Support for Pharmaceutical Research and Development [ 221

Figure 9-8—Distribution of NIH/ADAMHA Royalty Collections for Fiscal Year 1988

OTT program costs

17.2% ADAMHA Institute/Lab

33.30/o

NIH Institute/Lab

NTIS charges 1 3.7%

37.4%

NTIS charges

42.9 %

enter awards

tor awards 23.80/0

31 .7%

NIH ADAMHA

(Total royalties =$1 ,989,000) (Total royalties = $22,000)

a Net of $3.4 million in royalties from NCI’S HIVantibody test kit licenses paid to private foundation as part of agreement with the French government.

Inventor awards are calculated from gross revenue.

KEY: ADAMHA -Alcohol, Drug Abuse, and Mental Health Administration; NCI - National Cancer Institute; NIH - National Institute of Health; NTIS

= National Technical Information Service; OTT= NIH Office of Technology Transfer; PHS = Public Health Service.

SOURCE: The Office of Technology Assessment, 1993, Based on data provided by the U.S. Department of Health and Human Services, Public

Health Service, National institutes of Health, Office of Technology Transfer, 1991.

one technology brought $1.76 million to NIH in

fiscal year 1988, which represents 89 percent of

all NIH royalties for that year.20

NIH takes the position that the purpose of

royalties is to stimulate technology transfer by

‘‘offering an attractive incentive to encourage

[PHS] scientists to participate in collaborations

with industry . . .’ rather than to augment or

replace funds appropriated by Congress for research (75). The distribution of royalties received

by NIH and ADAMHA is consistent with this

policy (figure 9-8). Almost one-third of NIH

royalty income in 1988 went to the scientists

responsible for the invention.

21 About 55 percent

of royalty income went to reimburse the government for the costs of negotiating and administer- 22 Only 14 percent (or ing licenses themselves.

$272,000) went back to the PHS division responsible for the invention.

The net returns to the licensee rise and fall

directly with the ultimate cost to consumers of

obtaining the product. The PHS policy governing

exclusive licenses and licenses granted under

CRADAs requires that prices of commercial

products be commensurate with the extent of

“public investment in the product, and the health

and safety needs of the public’ (486). The policy

further states that licensees may be required to

‘“ Royalties from licenses on these NCI patents actually totaled $5.16 million. However, under an agreement with the French Government

settling a dispute over the discovery of HIV, $3.40 million was paid in 1988 to the nonprofit French-American AIDS Foundation to fund future

work. A similar percentage of royalties from these licenses was paid in each of the other years, and is not reflected in the data.

21 pHs ~ollcy d~w~ inventing emPloyeeS t. get 25 percent of the fkst $50,~ of royalty income, 20 percent of the next $50,000, ad 15

percent of the remainder up to $100,000 per employee per year from all patents for which they are inventors. NIH policy also allows some

awards to go to noninventing employees that nonetheless contributed to the invention. After other expenses, the remainder is returned to the

budget of the organizatioml unit responsible for the award (486).

In recent years (including 1988 as shown in figure 9-9), the amount of income to inventors for NCI’S HIV-antibody test kit patents was

calculated on the basis of gross revenues prior to the $3.4 rnilllon distribution to the French-American AIDS Foundation. Hence, final inventor

awards in fiscal year 1988 totaled 32 percent of royalties actually turned over to the NIH.

‘z Untd recently, the National Technical Information Service (NTIS) was charged with this function and received more than one-third of

NIH royalties. The Office of Invention Development (now OTT) received about 17 percent to cover its costs. On has taken over the

responsibilities previously carried out by NTIS.
222 I Pharmaceutical R&D: Costs, Risks and Rewards

-

.

.

%.

Photo credit: NATIONAL GAUCHER FOUNDATION

After several years of treatment, this girl shows few visible signs of the Gaucher disease that afflicts her. The drug used in her

treatment--Ceredase TM--was originally discovered and developed by Federal scientists.

provide ‘‘reasonable evidence’ to support their

pricing decisions.

To date, PHS has implemented this pricing

clause in only one case-the antiviral drug ddI

manufactured under exclusive license by BristolMyer Squibb.23

Health consumers and activists have publicly

questioned pharmaceutical pricing decisions for

other products that have been developed at least

in part through public investment (337). AS

mentioned earlier, the role of Federal laboratories

in the development of one such drug, AZT, an

antiviral drug used to treat HIV, has been the

subject of public controversy and litigation stemming, in part, from its price to consumers

(276,493).

The case of CeredaseTM, a treatment for the rare

hereditary disorder Gaucher disease, also raises

questions about the Federal Government’s ability

to protect the public’s research investment in new

drugs that come from our national laboratories.

This drug, which is manufactured by Genzyme,

Inc. of Massachusetts, was discovered in the early

1970s by NIH scientists and received FDA

approval in 1991 on the basis of NIH designed,

funded, and conducted clinical trials. An analysis

by OTA24 indicates that at Genzyme’s current

price and under accepted doses, this drug costs

23 In a public hearing, rcprescntativcs of patient groups at NIH in 1992 voiced no objections to Bristol-Myer Squibb’s proposai price, which

included a plan to give the drug ‘free to those who could not otherwise afford it (3).

‘~ OTA’S analysis of the R&D leading to the Ccrcdase TM ad tic ~p~catlom of ~e drug’s costs is contained iII a separately publish~ OTA

background paper prepared as part of this assessment (141).
—— ——.

Chapter 9–Federal Support for Pharmaceutical Research and Development I 223

patients between $71,000 and $550,000 per year,

thus threatening the lifetime maximum insurance

benefit of those with private insurance within a

few years (455). Gaucher patients require this

therapy for life. Because CeredaseTM is also a

federally-designated orphan drug (as discussed

later in this chapter), Genzyme has the right to

market it without competition for 7 years.

While the pivotal discoveries for this drug

predate current NIH technology transfer policies

and procedures, it does suggest that the current

mechanism of enforcing NIH's fair pricing policy

alone might not be sufficient to protect the

public’s interest and ensure adequate compensation for the government’s research investment.

Even though OTA was able to infer a great deal

about Genzyme’s production costs and its own

TM from data pro- R&D investment in Ceredase

vialed by Genzyme, the company did not give

sufficient information for OTA to determine

independently the drug’s ultimate profitability in

the course of our year-long study of the drug

(455). The Federal Government is likely to be

faced with the same difficulties in gathering data

upon which to make a confident judgment about

the fair pricing of other drugs that come from its

laboratories.

1 CRADAs

CRADAs give Federal laboratories the flexibility to accept industrial resources, including

funds, and to provide Federal resources (except

funds) for collaborative research. PHS encourages the use of CRADAs by Federal scientists

who want to engage in collaborative R&D

activities with outside parties (486). The disposition of intellectual property resulting from a

CRADA follows the general PHS patenting and

licensing guidelines described in previous sections of this chapter with the exception that the

agreement may include a company’s option to

negotiate an exclusive license to any invention

resulting from research under the CRADA.

Between fiscal years 1987 and 1990, 109

CRADAs were established within NIH and

Table 9-7--CRADAs Established by NIH and

ADAMHA, Fiscal Years 1987-90

Number of

Year CRADAs established

1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1988 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

1990 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Total CRADAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

KEY: ADAM HA - Alcohol Drug Abuse and Mental Health Administration; CRADAS - cooperative research and development agreements; NIH = National Institutes of Health.

SOURCE: Office of Technology Assessment, 1993. Based on data

provided by U.S. Department of Health and Human Services, Public Health Service, National Institutes of Health,

Office of Technology Transfer, 1991.

ADAMHA (table 9-7). An OTA analysis of

CRADAs in effect in October 1990 in PHS (NIH,

ADAMHA, CDC, and FDA) shows that CRADAs were heavily concentrated in the National

Cancer Institute, which had 26 percent of all such

agreements at that time (table 9-8).

Table 9-8—PHS CRADAs in Effect October 1990

CRADAs: Percent a

in which the private collaborator is a PMA

member . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370/o

in which NCI is the PHS collaborator. . . . . . . . . 26

that are HIV- or AIDS-related . . . . . . . . . . . . . . . . 18

that involve the R&D of vaccines or other

prophylactics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

that involve the R&D of diagnostics . . . . . . . . . . 8

in which the private collaborator is a university

or nonprofit institution . . . . . . . . . . . . . . . . . . . . . 5

a catego~es are not mutually exclusive or collectively exhaustive, and

hence, do not add to 1.00.

KEY: AIDS = acquired immunodeficiency syndrome. CRADAS . cooperative research and development agreements; HIV - human

immunodeficiency virus. NCI - National Cancer Institute. PHS -

Public Health Service. PMA - Pharmaceutical Manufacturer

Association.

SOURCE: Office of Technology Assessment, 1993. Based on data

compiled from the U.S. Department of Health and Human

Services, Public Health Service, National Institutes of

Health, Office of Technology Transfer, PHS 7bchrIo/ogy

Transfer Directory, October 1990.
224 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 9-C-Examples of Two CRADAs at NIH

Thomas Kindt of the National Institute of Allergy and Infectious Diseases has been working with

the gene for CD4--the protein that regulates the entry of HIV (human immunodeficiency virus) into

cells-and wanted a good animal model for studying CD4 gene expression in lymphoid tissue. After reading

one of Kindt’s early papers, people from a Massachusetts company that makes transgenic animals called to

propose a collaboration. They would make rabbits with the human CD4 gene, using their expertise at

creating transgenic animals. Kindt would have the animal model he needed.

Says Kindt, “This is a nice, focused collaboration and provides my lab with resources we needed. I

don’t have the facilities for making rabbits.” It does not cost Kindt a thing-the company pays for the

breeding and care of the animals. And what does it get in return? The possibility that the rabbit will, in fact,

turn out to be a good model for studying AIDS. Then, the company could make money selling these

genetically special animals to people studying AIDS or testing AIDS drugs.

What would Kindt have done 3 years ago, before CRADA fever? He would have gone “hat in hand”

to colleagues in academia who do research with transgenic animals. “I would have been asking for a favor,”

Kindt says, “and even if someone agreed, making animals for me would not necessarily be atop priority.

With a CRADA I have a true collaboration.”

Richard Jed Wyatt of the National Institute of Mental Health is another investigator who has made

use of a CRADA to get needed research rabbits. A neuroscientist interested in how the AIDS virus gets into

the brain, Wyatt began collaborating with a colleague at NIH who had developed an animal model. But the

colleague did not have facilities for breeding and keeping rabbits. Neither did Wyatt. The solution: find

investors to form a company that make rabbits. Wyatt did and RRI of McLean, Virginia, was formed. Then

Wyatt and his colleagues signed a CRADA with RRI. The researchers have their rabbits, the company has

a possible product. Another good idea.

But traditionalists worry. If CRADAs become common, will they really be true collaborations with

intellectual, scientific input from both sides? Or will they just be another form of cent.ract+e in which

NIH benefits without having to pay?

Conversely, could CRADAs eventually turn NIH into little more than a giant contract lab if companies

lure NIH scientists into cooperative agreements that serve the companies’ need for NIH brain power at the

expense of basic research?

SOURCE: Reprinted with permission tim B.J, CullitioU “MH Inc: The CRADA Boow” Science 245:1034-1036, 1989.

Although the idea for a CRADA can come from CRADA subcommittee of the Patent Policy

a variety of sources,25 the first stage in establish- Board must approve the CRADA before it is

ing the arrangement is a research plan that signed by the institute director and the private

includes the goals and activities of the CRADA, collaborator. Preference is given to CRADAs

the respective contributions of each party, an involving small businesses arid firms that ‘‘agree

abstract for public release, and identification of to manufacture substantially in the United

relevant patents and other NIH technology trans- States” any inventions developed through CRAfer agreements related to the CRADA (484). After DAs. Box 9-C describes two recent CRADAs.

review by legal counsel within the agency, a

M me office of T&-~ol~~ T1-~fm ~~en steps to tie tie private s~tor more aw~e of opportunities for collaboration tith PHS

agencies by sponsoring an annual conference for the past 3 years highlighting PHS research with potential commercial value. More recently,

PHS has established an electronic bulletin board providing outside parties with information about speci.tlc collaborative oppotities.

According to the PHS Policy Statement on CRADAS and intellectual property licensing, “In certain areas of research, e.g., where the

Government has the intellectual lead or where both scient.iflc and commercialization capabilities are deemed essential at the outset

NIH/ADAMHA may competitively seek a collaborator through Federal Register notiilcation. The Patent Policy Board has left to eztch institute

the decision of when to publish in the Federal Register” (486).
Chapter 9—Federal Support for Pharmaceutical Research and Development 2 2 5

As shown in table 9-8, the bulk of all CRADAs

in 1990 (82 percent) are related either directly or

indirectly to R&D on new human therapies, with

vaccine or other prophylaxis research accounting

for another 10 percent, and R&D on diagnostic

tests accounting for the remaining 8 percent. At

least 18 percent of all CRADAs are related to

acquired immunodeficiency syndrome (AIDS)

and HIV therapies or vaccines. This statistic

reflects both a general emphasis on HIV-related

research at NIH and an urgent interest in transferring knowledge about HIV into treatments or

other products.

To what extent do private firms participating in

CRADAs provide funds to the collaborating

Federal research agency? All but 1 of the 14 NIH

and ADAMHA institutes, centers, and divisions

with CRADAs in fiscal year 1989 received some

financial resources from their collaborations (table

9-9). At NIH, CRADA collaborators provided

$1.8 million, of which $1.2 million went to

support the salaries of 47 personnel. Over onehalf of all support was centered in NCI. At

ADAMHA, total financial support in 1989 under

CRADAs was $187,000 with all but $10,000

going to support salaries of nine scientists at the

National Institute of Mental Health. Even though

the money received was only 0.2 percent of

overall institute budgets for research within NIH

and ADAMHA laboratories,26 such support may

be a catalyst for successful research. Furthermore,

the data in table 9-4 are based on one of the

earliest years of the CRADA program. Data for

subsequent years may show more extensive

financial support to Federal laboratories that have

CRADAs.

ORPHAN DRUGS

Congress passed the Orphan Drug Act (Public

Law 97-414) in 1983, providing strong incentives

for private firms to discover and develop treatments for rare diseases and conditions. Amended

Table 9-9—Financial Resources Provided to NIH

and ADAMHA Through CRADAs, Fiscal Year 1989

Institute Personnel a Program supportb

NIH

cc . . . . . . . . . . . . . . . . . . $ 0 $ 5,000

DRS . . . . . . . . . . . . . . . . . 0 0

NCI . . . . . . . . . . . . . . . . . . 623,288 (24) 325,635

NEI . . . . . . . . . . . . . . . . . . 0 0

NHLBI . . . . . . . . . . . . . . . . 0 2,625

NIA . . . . . . . . . . . . . . . . . . 25,000

NIAID . . . . . . . . . . . . . . . . 34,327 (1) 74,000

NIAMS . . . . . . . . . . . . . . . 30,000 (1) o

NICHD . . . . . . . . . . . . . . . 127,028 (5) 20,000

NIDDK . . . . . . . . . . . . . . . 57,000 (2) o

NIDR . . . . . . . . . . . . . . . . 174,000 (7) 103,050

NINDS . . . . . . . . . . . . . . . 177,500 (7) 20,000

Total . . . . . . . . . . . . . . . . . $1,223,143 (47) $575,310

ADAMHA

NIAAA . . . . . . . . . . . . . . . . $ $ 10,000

NIMH . . . . . . . . . . . . . . . . . 177,250 (9) o

Total . . . . . . . . . . . . . . . . . $ 177,250 (9) $ 10,000

a Support for personnel; numbers in parentheses are numbers of

persons supported.

b Travel, equipment, or supplies, used in conducting any part of the

research effort.

KEY: ADAM HA - Alcohol, Drug Abuse and Mental Health Administration. CC - Warren Grant Magnuson Clinical Center. CRADA -

Cooperative Researc+and DevelopmentAgreements Collaborators.

DRS - Division of Research Services. NCI - National Cancer

Institute. NEI - National Eye Institute. NHLBI - National Heart,

Lung and Biood Institute. NIA = National Institute on Aging.

NIAAA - National Institute on Alcohol Abuse and Alcoholism.

NIAID - National Institute of Allergy and Infectious Diseases.

NIAMS - National Institute of Arthritis and Musculoskeletal and

Skin Diseases. NICHD = National Institute of Child Health and

Human Development. NIDDK - National Institute of Diabetes and

Digestive and Kidney Diseases. NIDR = National Institute of

Dental Research. NIH = National Institutes of Health. NIMH -

National Institute of Mental Health. NINDS =National Institute of

Neurological Disorders and Stroke.

SOURCE: U.S. Department of Health and Human Serviees, Public

Health Service, National Institutes of Health, Office of

Technology Transfer, 1989.

three times since its initial enactment (Public Law

98-551, Public Law 99-91, Public Law 100-290),

the law has three provisions (in addition to a tax

credit described in chapter 8) designed to subsidize R&D costs or to remove other disincentives

to developing drugs of limited commercial value:27

26 ~Eaual (le., t~g P]ace on tie PHS laboratories campus) research SUppOrt totaled $782 million ~ fisc~ year 1989 (482) ~d $103

million at ADAMHA in tbe same year (485).

27 me Owti Dmg ~t as first adopted excluded ~tibiotics from eligibili~ for orp~ designation. Congress eliminated thiS reS~CtiOn

in August 1985 (Public bW 99-9 1).
226 I Pharmaceutical R&D: Costs, Risks and Rewards

●

●

●

Food and Drug Administration assistance to

orphan drug developers in protocol design

for new drug approval (NDA) or product

license approval (PLA) applications;28

Research grants for clinical and preclinical

studies of orphan products; and

A grant of 7 years of exclusive U.S. marketing rights to the first firm that receives NDA

approval for an orphan drug.

The FDA first published proposed regulations

to implement the law in January 1991 (FR

1/29/91) (56 FR 3334). Prior to these proposed

regulations, the FDA relied on interim guidelines

that differed from the proposed regulations in

important ways described later. Though the

proposed regulations have not been adopted

officially as final, the FDA has operated under

these rules since they were published.

E Designation of Orphan Drugs

The first step in a request for orphan drug

subsidies is to apply for official orphan drug

status from the FDA’s Office of Orphan Products

Development (OPD) (468). Drug sponsors may

seek this designation at any time between the

granting of an investigational new drug (IND)

exemption and the submission of an NDA.29 In

making such a request, the applicant must show

the disease or condition that the drug is intended

to treat:

. “Affects less than 200,000 persons in the

United States; or

. Affects more than 200,000 persons in the

United States and. . . there is no reasonable

expectation that the cost of developing and

making [the drug] available in the United

States will be recovered from sales in the

United States of such drug” (468).

Since 1985, virtually all orphan designations

have met the frost criterion. The exact interpretation of this provision has been subject to dispute.

For example, the number of AIDS patients in this

country has climbed above 200,000, but several

AIDS drugs were designated as orphans early in

the epidemic, when the prevalence of the disease

was much lower (21).

In its recent proposed regulations (adopted as

final in December 1992, the FDA makes clear that

“the 200,000 prevalence figure means 200,000

affected persons in the United States at the time

that the orphan-drug designation request is made

(not 200,000 new cases annually)” and that a

“drug would remain an orphan drug even if the

disease or condition ceases to an orphan disease

or condition because of increased prevalence’ in

order to ‘‘protect a sponsor’s good-faith investment” (56 FR 3339);

More than one sponsor can receive orphan

designation for the same drug for a single

indication. For example, by December 1989,

Biogen, Genentech, and SmithKline Beecham

had all received orphan drug status for a single

drug undergoing clinical research, human recombinant soluble CD4 for the treatment of AIDS

(470). At most, only one of the three companies

will ultimately be granted approval to market the

drug for its orphan use.

Between January 1984 and the end of September 1992, the FDA granted orphan status to 494

drugs and biological (table 9-10). Of all the

orphan designations ever given, 16 percent were

granted during 1991 alone. Almost two-thirds of

orphan designations (63 percent) went to sponsors who were not members of the U.S. Pharmaceutical Manufacturers Association. Because PMA

membership is available only to companies marketing an FDA-approved pharmaceutical in the

United States, this statistic suggests that a high

28 NDAs ~d PL.4s ~e formal applications made to the FDA by pharmaceutical sponsors to manufacture and market therapeutic hgs ~

the United StaIes. ~As are for synthetic chemical drugs and PLAs are for biological products. ~s chapter uses the term “NDA” to refer

to both types of applications. See chapter 6 for additionat discussion of the drug approval process in the United States.

29 fior to 1988, tie orphan drug law did not specify exactly at what stage in the regulatory process the sponsor of ~ hvestigational tig

fora rare disease or condition could seek an orpha.n designation from the FDA. Public Law 10029O, adopted April 18, 1988, clarillxl that this

designation could be granted only prior to the submission of an NDA or PLA.
Chapter 9—Federal Support for Pharmaceutical Research and Development I 227

Table 9-10-Orphan Designationsa Granted

January 1984 Through September 1992

Number of Percent of

designations total

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 100

Given in 1991only . . . . . . . . . . . . . 81 16

Given to PMA members . . . . . . . . 183 37

Given to Non-PMA members . . . 311 63

a As prov~~ under section 526 of the Federal Food, Drugs and

Cosmetic Act (21 U. S.C30 et seq.) and amended by the Orphan Drug

Act (Public Law 97-41 4).

b Inc[u@s both drugs and biological.

SOURCE: Office of Technology Assessment, 1993. Based on data

supplied by the U.S. Department of Health and Human

Services, Food and Drug Administration, Office of Orphan

Product Development, 1992.

percentage of all orphan drug research is being

sponsored by new (and probably small) firms or

other organizations with little previous experience in researching and marketing drugs in the

United States.30

An analysis of all orphan designations granted

through November 1990 revealed that about 23

percent of all compounds granted orphan status

by that date had more than one designation (table

9-1 1). Different sponsors can receive orphan

designations for the same indication when they

are simultaneously developing the same drug. As

of November 1990, 66 compounds had orphan

designations by at least two competing fins. A

single sponsor may also receive multiple designators for a single drug, but for different potential

uses of the compound. As of November 1990, 59

compounds had multiple designations by same

sponsor.

1 Protocol Assistance

The FDA is required by law to provide written

assistance upon request about the design of

studies to support an NDA for an orphan drug. So

far, the total number of such requests has been

small compared with the total number of orphan

drug designations issued (227). In 1985, FDA

Table 9-1 l—Multiple Orphan Designations” for

the Same Generic Compound, January 1984

Through November 1990

A. Number of distinct generic compounds with

orphan status 227

Percent of orphan compounds with multiple

designations 23%

B. Multiple orphan designations for a given generic

compound

Number of compounds

receiving that number

Number of designations given of designations

2 45

3 8

4 4

5 4

6 2

7 1

9 1

10 1

Total 66

C. Multiple orphan designations for a given generic

compound received by a single sponsor

Number of compounds

receiving that number

Number of designations given of designations

2 44

3 8

4 4

5 1

7 1

10 1

Total 59

a AS provided under section 526 of the Federal Food, Dregs and

Cosmetic Act (21 U. S.C30 et seq.) and amended by the Orphan Drug

Act (Public Law 97-41 4).

SOURCE: Office of Technology Assessment, 1993. Based on data

supplied by the U.S. Department of Health and Human

Services, Food and Drug Administration, Office of Orphan

Product Development, 1992.

received nine such requests; they have virtually

disappeared in recent years.

The sponsor of any drug or biological has the

option of requesting protocol advice directly from

the FDA’s Center for Drug Evaluation and

Research (CDER) or the Center for Biological

30 ~~ ~~tl~tic may ~de~~stfi~te he ~ercen~ge of ow~ ~gs being rese~ch~ at tie fitiative of PMA members since somk academic

or nonprofit ‘sponsors’ may receive research funding from PMA firms. As discussed earlier in this chapter, the fm that supports such research

may have the rights to market the drug if its succeeds.
228 I Pharmaceutical R&D: Costs, Risks and Rewards

Evaluation and Research (CBER). Because such

meetings need not be requested formally and can

involve iterative questioning and discussion,

sponsors probably perceive this type of assistance

as more flexible and useful than the formal

interchanges mandated under the Orphan Drug

Act (227). Some observers have suggested the

FDA may actually discourage written requests for

assistance (270).

1 Grants for Clinical Research

The Orphan Drug Act authorized grants for

clinical research on potential orphan products,

and one of its more recent amendments (Public

Law 100-290) extended this authority to preclinical studies. These grants represent a direct subsidy for orphan drug R&D.31 The Office of Orphan

Products Development administers the program

in a manner parallel to other Public Health

Service grants.

Grants are given for single, discrete studies and

are available to for-profit, nonprofit, and government organizations. In almost all cases, the grants

have been limited to a maximum of $100,000 in

direct costs per year for up to 3 years. Although

recipients are not required to possess official

orphan drug status for the drug or biological under

study, the grants are designed for treatment of

conditions affecting less than 200,000 patients in

the United States.32

The orphan products grants program has grown

steadily since 1983. In 1990, the Office of Orphan

Products Development allocated a total of $7.6

million among 65 recipients (table 9-12).33 Forprofit organizations represent a very small part of

the total grant program (table 9-12). The average

size of each award each year (annual direct plus

indirect costs for new and continuing grants) has

increased from $79,000 in 1987 to $111,000 in

1990. This represents an increase of 6.5 percent

per year in constant dollars.

1 Market Exclusivity

The first drug sponsor to receive NDA approval for a drug and indication with orphan

status may market it exclusively for a 7-year

period beginning on the day the FDA approves

the drug .34 This exclusivity prevents the FDA from

approving an NDA for a drug for which another

sponsor has already received marketing approval

for the same indication.35 Any patent protection

covering the drug runs contemporaneously with

the market exclusivity. Two or more sponsors

may receive FDA approval for a single orphan

drug if their approvals are for different indications

and if they do not violate any patent protections.

ORPHAN EXCLUSIVITY VERSUS

PATENT PROTECTION

In practice, the exclusivity clause is the strongest incentive in the orphan drug law, and for some

drugs it may be more important than patent

protection in effecting market exclusivity36

:

● For some drugs orphan market exclusivity

may extend beyond the expiration of the

s I Because tie @pMDmg Act’s grant authori~ has never received funding from Congress, the FDA has funded this program using money

appropriated for orphan drug research under a general grants program of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 30 et seq.).

sz Gmts ~dcr ~s Progm me acm~ly not limited to drugs and biological but are also available for mdiCd devices ~d medic~ foods

for rare diseases and conditions. In practice, almost all grants are for drugs and biological. For example, none of the new awards given in fiscal

year 1989 were for medical devices or foods.

33 ~ese 65 rwlplen~do not ~clude 10 supplemental awards given to r~ipien~ of f~ gr~ts h 1990 or earlier years who requested

additional funds to cover unanticipated costs. In 1990, supplemental awards represented $388,332 of the total $7.6 million program.

34 As fU5t emt~ ~ 1983, the Orpha Drug Act (~blic ~w97.414) permitted market exclusivity ordy for O@Ml phaM3.aCeUtiCalS tit

were ineligible for a U.S. patent at the time of marketing approval. In August 1985, Congress removed this limitation making all orphan drugs

eligible for the 7-year exclusive marketing period if no other sponsor has received approval for that therapy for that indication (Public Law

99-91).

35 Becau5e o~~ dmg s~~[5 is given for a p~cular indicatio~ m~ket excluslvl~ is ~SO limited tO p~CUhU iIldiCatiOnS.

36 In addition t. patents ~d ~}q~ ~g market exclusivi~ for a specific ~di~tio~ ~o~er potenti~ barrier tO Competition fOr a13 OrphaIl

drug is FDA’s regulatory approval process itself. A potential competitor must conduct R&D and receive FDA approval of an NDA or PLA

for each indication for which it would like to market the drug (21).
9—Federal Support for Pharmaceutical Research and Development 2 2 9

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230 I Pharmaceutical R&D: Costs, Risks and Rewards

relevant patents. Because manufacturers usually receive their 17-year patents on potential new drugs early in the development

process (220), the amount of time remaining

on the patent at the time of FDA approval

may be less than the 7 years guaranteed by

the orphan drug exclusivity (21).

. Some drugs duplicate substances that naturally occur in the body (e.g., ‘‘biological’ ‘),

For these, the state of patent law is currently

so murky that the 7-year market exclusivity

is a more certain means of protecting the

product from competition (45 1).

Problems in Awarding Orphan Market Exclusivity Rights--Controversy has arisen over how

different the molecular structure of two drugs

must be in order for both to receive market

exclusivity. Because biological pharmaceuticals

tend to have relatively large and complex molecular structures, scientists can alter their makeup

slightly without changing their clinical effects. If

the Federal Government interprets any small

clinically insignificant change as the creation of

a “different” orphan drug eligible for its own

market exclusivity, it effectively eliminates the

incentives of the exclusivity clause for many

biotechnology drugs. Since the orphan drug law

was enacted, competitors have challenged the

exclusivity of two approved orphan drugs by

seeking approval of slightly different versions of

the same pharmaceuticals.

Human Growth Hormone-In 1985, Genentech received FDA approval and exclusive marketing as an orphan drug for a human growth

hormone (HGH) product to treat children whose

bodies do not naturally produce enough of the

hormone to ensure normal growth. Genentech’s

HGH product, ProtropinTM, contains one more

amino acid than is found in the version usually

produced by the body’s pituitary gland, but this

particular amino acid does not appear to alter the

hormone’s activity in the body.

Eli Lilly independently developed its own

HGH product HumantropeTM, with a molecular

structure that is identical to the HGH produced by

the human body. Eli Lilly applied for orphan drug

status and marketing approval for Humantrope,

arguing that because of the additional amino acid

on Protropin, the Eli Lilly drug was ‘‘different’

from Protropin. In 1986 the FDA agreed, giving

orphan status to Humantrope.

Genentech subsequently challenged the FDA’s

decisions in court by arguing the FDA did not

have the authority to grant orphan status to Eli

Lilly. The courts ruled against Genentech. Currently, each manufacturer has orphan status for its

version of HGH, and each drug is sold on the

market .37

The results of the HGH case established that

the FDA has the authority to determine when two

therapies are sufficiently different from one

another that each can receive its own orphan

designation (240).

Recombinant Erythropoietin38--In June 1989,

Amgen received approval to market its version of

recombinant erythropoietin (rEPO) for the treatment of anemia in patients with chronic renal

failure. EPO is a protein usually produced by the

kidneys and necessary for the production of red

blood cells. Amgen had first produced the drug in

1983 and had received orphan status for it in

1986. In September 1988, Chugai Pharmaceuticals of Japan, in a joint venture with Upjohn

Pharmaceuticals, filed a PLA with the FDA to

market its own version of rEPO in competition

with Amgen.

37 me~T~protection prohibitsCach ~ufac~er fmm mmketing a version of HGH bat is molec~ly identicd to the version produced

by the other firm. For example, Genentech developed a new HGH that was identical to the HGH produced naturally by the body. However,

because this new Genentech HGIH was also identical to Lilly’s Humantrope ‘, the FDA prohibited Genentech from marketing it (240).

38 For a more comp]ete discussion see chapter 3 of OT4’S study on recombinant erythropoietin (45 1).

39 Because ~ino Kids me the building blocks of proteins, and because rEPO is designed to fulfill the function of the missing Mtil_id EPO,

the drug’s amino-acid sequence can be important in the effectiveness of the rEPO.
—

Chapter 9–Federal Support for Pharmaceutical Research and Development ! 231

Although the Chugai/Upjohn drug has an

amino-acid structure39 identical to that found in

the Amgen version, Chugai/Upjohn argued that

the two drugs differed in glycosylation, the

linkages of carbohydrates to the molecule, and

that their version was therefore eligible for its

own orphan designation and marketing approval.

Although the FDA had not yet acted on the

Chugai/Upjohn application for orphan drug designation at the time of the Amgen approval, then-FDA

commissioner Frank Young stated publicly that

the Chugai/Upjohn version appeared ‘‘different’

from the Amgen drug (240). In October 1989,

Amgen requested that the FDA develop regulations to determine the circumstances under which

two molecularly similar orphans are eligible for

shared exclusivity .40

Proposed Regulations—The FDA recently

attempted to set forth general criteria for determining when two drugs are sufficiently different

to warrant orphan status and exclusivity for both.

In proposed regulations published on January 29,

1991 (56 FR 3338) and adopted as final in

December 1992, the FDA would presume two

orphan drugs to be the same ‘‘if the principal, but

not necessarily all, structural features of the two

drugs were the same, unless the subsequent drug

were shown to be clinically superior. According

to these guidelines, different glycosylation patterns in two protein drugs, the difference suggested to have been found in the two versions of

rEPO, would not be sufficient to find the Upjohn/

Chugai drug different from the Amgen drug. The

proposed regulations identify three circumstances

under which a subsequent drug could be deemed

‘‘clinically superior’ to an already approved

orphan, and hence, approvable:

● The subsequent drug is more effective than

the first drug as shown in comparative

clinical trials.

● The subsequent drug is safer than the first for

a ‘‘substantial portion of the target population, ’ including the case where the two

●

drugs have about the same therapeutic

effect, the frost drug has significant side

effects, and the subsequent drug achieves its

effect at a lower dose.

The subsequent drug ‘‘makes a major contribution to health” as in the development of

an oral dose form where the drug had only

been available by parenteral administration.

While awaiting approval from the White House

Office of Management and Budget to adopt a final

version of the regulations, the FDA operated

according to the draft regulations (227).

~ Impact of orphan Drug Subsidies

The clinical research tax credit (discussed in

chapter 8), protocol assistance, and clinical research grants theoretically lower the cost of

orphan drug R&D; the market exclusivity provision increases the expected revenues to such

R&D. In practice, the protocol assistance has had

little effect, especially in recent years, and the tax

credit and grants program represent, overall, a

relatively small commitment of Federal funds to

orphan products. This commitment may be critical for certain drugs, however, so it should not be

discounted.

The 79 biological and drug applications approved for marketing by the FDA with orphan

status as of September 1992 represent broad and

extensive R&D efforts for rare diseases. The test

of the Orphan Drug Act’s effectiveness, however,

is whether it has led to the approval and marketing

of drugs for orphan conditions that would otherwise have been unavailable to patients. If pharmaceutical companies would have developed and

marketed orphan drugs even without these subsidies, then their true effectiveness would be nil.

It is impossible to estimate how many of the

new orphan drugs would have been made available since 1983 in the absence of these subsidies.

Simple comparison of the number of such drugs

approved and marketed before the passage of the

act with those made available since its passage is

@ .4ppend]X E @CnbeS a controversy over patent rights for rEPO that took place at the same time as this dispute over OWk d@@iOn.
232 I Pharmaceutical R&D: Costs, Risks and Rewards

inappropriate because, many other factors, especially the state of scientific knowledge, may

affect pharmaceutical innovation.

A recent analysis of the Orphan Drug Law’s

first 8 years concluded that while most orphan

incentives have gone to the type of drugs Congress intended to subsidize, there is evidence that

some drugs with orphan status would have been

commercially viable without Federal help. Furthermore, the authors concluded there might have

been sufficient information for the FDA to

determine the drug’s commercial viability in

granting orphan status had the Orphan Drug Law

permitted such consideration in awarding orphan

drug incentives (389).

Concerns that the Orphan Drug Law has

subsidized the development of commercially

successful drugs which did not really need help

from the Federal Government led to legislation in

the 102d Congress that would have removed an

orphan drug’s exclusivity once cumulative net

sales in the United States surpassed $200 million

(S. 102-2060). Another piece of legislation (H.R.

102-1713) would tax ‘ ‘profits” on orphan drugs

that exceed certain levels.41

Another measure of the law’s effectiveness

may be the extent to which orphan drugs have

been sponsored by relatively small startup fins.

As drug R&D costs go up, smaller firms may have

a harder time mustering enough resources to bring

new products to the market. By lowering barriers

for such fins, the orphan drug subsidies may

encourage competition in the industry and provide a new mechanism to realize the commercial

benefits of biotechnological and other scientific

discoveries, especially those originating in academia. As shown earlier, almost two-thirds of

orphan designations have gone to drug sponsors

that are not PMA members, a characteristic

commonly found among startup fins.

MEDICARE AND MEDICAID SUPPORT FOR

CLINICAL DRUG R&D

The Medicare and Medicaid programs are the

sources of the vast majority of Federal spending

for health services. Medicare and Medicaid payment for patient care rendered in association with

clinical research on a pharmaceutical agent therefore constitutes a potential subsidy of pharmaceutical R&D. Nevertheless, there are no good

estimates of clinical-trial-related health care costs

paid for by Medicare and Medicaid (395).

By law, Medicare does not cover any drugs

administered outside of the hospital or a physician’s office, and the program does not pay for

clinical research (487). Furthermore, to be covered by Medicare, drugs must be ‘reasonable and

necessary, ’ a criterion that the Health Care

Financing Administration (HCFA) “has interpreted . . . to exclude . . . those medical and health

care services that are not demonstrated to be safe

and effective by clinical evidence’ (487). HCFA

has taken this to mean that “experimental” and

‘‘investigational’ drugs are not covered.

“Group C“ cancer drugs42 represent the one

exception to the statutory and regulatory exclusion of unapproved drug therapies from Medicare

payment. Because Medicare does pay the costs

associated with the administration of Group C

drugs,

43 some patients have requested that Medi--

41 mere ~ve ken ~~er ~onWe~slo~ attempts t. bit re~xtively tie use of orp~ subsides. ~ legislation passed by Congress k 1990,

but later pocket-vetoed by the FresidenL manufacturers would lose their exclusivity if disease prevalence grew more that 200,000. In additiom

the legislation would have allowed more than one manufacturer to share an orphan market exclusivity if each reached certain regulatory hurdles

contemporaneously (HR. 101-4638).

42 ‘‘Group C’ cancer drugs are pharmaceuticals for which significant data on safety and efficacy are already available. These drugs are

usually in phase III trials. NCI and the FDA jointly developed the concept of Group C drugs in 1976, although DHHS has never formalized

the definition in regulations (NCI, 1990). Only physicians registered with NCI as clinical investigations can administer the drugs. Some of the

drugs in the Group C category may never receive fti FDA approval to market because fmns consider them to be commercially unviable.

43 N~ provides the Group C drugs free of c~ge.
Chapter 9-Federal Support for Pharmaceutical Research and Development 2 3 3

care cover all drugs with Treatment INDs as well

(69). 44

In practice, there are other exclusions from

Medicare coverage, particularly for drugs administered as part of a clinical research protocol. Prior

to 1983 Medicare paid hospitals for the individual

services they provided to patients. Anecdotal

evidence suggests that Medicare’s payment for

clinical research was common in that period

(446),

Since 1983, Medicare has paid hospitals a fixed

amount per admission for a package of services

based on a patient’s primary diagnosis and major

treatments. Medicare will now cover attendant

hospital costs for patients receiving an experimental drug if the admission was not solely for the

experiment. Some observers have suggested that

adjustments to hospital payments allowed by

Medicare to cover costs associated with medical

education also underwrite some of the patient and

faculty costs associated with clinical research.

Medicare contractors, the companies that administer the Medicare program under contract with

HCFA, interpret these policies differently in

different parts of the country (395).

Although Medicare contractors screen claims

submitted by hospitals to determine whether they

are appropriate, and utilization and quality control peer review organizations (PROS) may screen

and refuse payment for inappropriate services

given Medicare beneficiaries by hospitals, it is

likely that a great deal of patient care associated

with pharmaceutical trials is paid for by Medicare

because of the difficulty of screening claims to

detect such services.

Because the Medicaid program, which pays for

health services for individuals who are lowincome, is administered by the States, decisions

about coverage of pharmaceuticals (whether investigational or approved) are up to each State.

Medicaid is one of the biggest payers for prescription drugs in the United States, accounting for 10

to 15 percent of total spending.45

A recent informal DHHS survey of Medicaid

drug program administrators found that while

many States do not cover investigational drugs

under any circumstances, some are willing to

provide payment for investigational therapies

under specific circumstances (487). Policy varies

by State: a few States pay for investigational

pharmaceuticals on a case-by-case basis; one

State covered treatment IND drugs for treatment

of AIDS, and the State legislature was considering codifying this practice. Another State requires

prior approval for use of an investigational drug.

The results of this survey suggest it is possible

(perhaps likely) that Medicaid is paying for some

investigational pharmaceuticals and the attendant

medical care costs of persons enrolled in clinical

trials. However, the tremendous variation in

Medicaid policies among States makes such

subsidies impossible to estimate.

CONCLUSIONS

The Federal Government is the mainstay of

support for the scientific infrastructure upon

which advances in medical technology depend.

The pharmaceutical industry makes use of this

infrastructure through its hiring of scientists, its

formal and informal interactions with federallysupported scientists in universities and in Federal

laboratories, and informational resources that

document research and its results. In addition, the

government provides even more direct support to

industry R&D through drug development programs in Federal laboratories, orphan drug policies, and Medicare and Medicaid reimbursements.

The public sector has been the major source of

funds for training scientific personnel. Over the

44 me Trea~ent fND pro~, es~b]ish~ in 1987 and administered by the FDA, allows tie release of ~vestigatio~ ~gs ‘0 ‘edicd

practitioners on a case-by-case basis for use in the treatment of immediately life-threatening diseases for which no satisfactory alternative

treatment exists. Under this progr% described in greater detail in chapter 6, the drug must be under investigation in controlled clinical trials

and the sponsor must be actively pursuing maxketing approval. With the permission of the FDA, sponsors may charge patients for Treatment

IND drugs in order to recover production and R&D costs (21 CRF 312.34.(a)).

45 See ~ble 10-1 h chapt~ 10.
234 I Pharmaceutical R&D: Costs, Risks and Rewards

past decade, industrial demands for biomedical

scientists have grown much faster than demands

for biomedical scientists as a whole (12 to 13

percent per year versus 5 percent).

Collaborations with academic scientists have

historically been an important component of the

drug industry’s R&D efforts and continue to be so

today. Of all U.S. industries, innovation within

the pharmaceutical industry is the most dependent on academic research and the Federal funds

that support it. In recent years, advances in

biotechnology that occurred within academic

research laboratories added to the task of transferring basic scientific knowledge from academia

and government to industrial applications.

The pharmaceutical industry’s support for university scientists include consulting arrangements, funds for specific research projects, and to

a lesser extent long-term support for entire

laboratories or university research programs. The

bulk of shorter-term research support from industry goes to laboratories that receive most of their

support from the Federal Government.

A more direct form of Federal support for

pharmaceutical R&D comes through the Federal

Government’s funding of research targeted to

drug discovery and development. The Federal

Government has 11 research programs devoted

solely to the encouragement, finding, and coordination of nonclinical pharmaceutical R&D. At

three institutes, these programs include the screening and characterization of potential medications

submitted by outside researchers including pharmaceutical fins.

OTA’s ability to measure the precise extent of

different types of federally supported drug R&D

is limited both by problems with defining relevant

R&D and a lack of adequate data. But, a

conservative estimate of research involving nonclinical drug discovery functions funded just by

NIH and ADAMHA in 1988 is $400 million; this

estimate represents 14 percent of the amount

spent by firms in the PMA for the same R&D

functions.

A conservative, likely underestimate of NIHand ADAMHA-funded research in 1988 specifically involving clinical R&D is $200 million,

which represents 11 percent of industry’s expenditures for phases I, II, III, and IV clinical

research. The Federal Government also indirectly

supports clinical research by paying a portion of

the health care bills of Medicare and Medicaid

beneficiaries who are also enrolled in clinical

trials. No data exist to measure the exact extent of

this support.

In recent years, the innovation of the CRADA

has allowed companies and Federal laboratories

greater latitude for productive interactions. Although a comprehensive assessment of the benefits and risks of such arrangements for both

parties is yet to be taken, the terms of such

collaborations offer some preliminary indications. Through 109 CRADAs signed between

1987 and 1990, PHS gave pharmaceutical industry collaborators access to Federal research laboratories and potentially exclusive property rights

for patentable commercial applications arising

from the research. In return for such rights, PHS

received just under $2 million in research resources from industrial and other CRADA partners in 1989.

In another form of technology transfer, DHHS

issued 44 licenses (17 exclusive) for Federal

patents in 1988. Income from licenses in 1988

netted NIH and ADAMHA research laboratories

just $272,000 after expenses (.004 percent of NIH

budget), the majority of which is attributable to a

single technology (the HIV antibody test).

In the Orphan Drug Act, the Federal Government has created several potentially strong incentives for firms to pursue the R&D and marketing

of pharmaceuticals for relatively rare conditions.

In particular, designated orphan drugs are eligible

for a 7-year exclusivity covering their approved

indications and a 50-percent tax credit for clinical

R&D that lowers the cost of qualifying clinical

trial expenses by 76 percent. Researchers also

received $7.6 million in grants from the Federal

Government for 75 phase I and II clinical trials

studying potential orphan drugs.

The policies and programs laid out in this

chapter (and the one that precedes it) suggest that
——... —

Chapter 9—Federal Support for Pharmaceutical Research and Development 235

Federal involvement can substantially lower the

private sector’s costs of bringing some new drug

products to market. Furthermore, because this

report does not examine any incentives provided

by State and local governments to pharmaceutical

firms located in their jurisdictions, actual publicsector involvement may be greater than that

implied here.

Industry provides some compensation for its

access to these resources, although such compensation is relatively limited. The true cost of

pharmaceutical R&D is greater than just the

private funds invested in this enterprise, and the

Federal Government’s support of the country’s

research infrastructure is critical to industry’s

ability to bring forth new drugs.

In the case of orphan drugs, some of the

pharmaceuticals receiving help from the Federal

Government might have been commercially viable anyway. Various proposals debated by Congress have attempted to target orphan drug

subsidies more precisely on only those drugs that

would not otherwise be available to patients.

When the fruits of Federal pharmaceutical

research are transferred to the private sector for

development and marketing, the Federal Government currently has neither sufficient incentive nor

expertise to negotiate compensation or limits on

prices that reflect the Federal investment in

dollars or the technical risk of failure absorbed by

the government during the R&D process. As the

case of the drug Ceredase TM illustrates, this

failure, along with extensive insurance coverage

of pharmaceuticals described in the next chapter,

creates the potential for the Federal Government

to pay for such drugs twice--once through

support of the R&D process and once again as a

health insurer.
Trends in Payment for

Prescription Drugs 10

A

s soon as a new ethical pharmaceutical compound hits

the market, revenues begin to flow to the drug manufacturer. These revenues depend on the decision of the

physician to prescribe the drug and the decision of the

patient to buy it, based on physicians’ and patients’ judgments of

the drug’s quality and price compared with those of other

possible therapies.

The importance of price versus perceived quality depends on

many factors, including the severity of the disease or condition

for which the drug is intended, the availability of close

substitutes, and the effectiveness of advertising and promotion in

convincing doctors (and sometimes patients) that the drug is the

right choice for the patient (86), Most important in tipping the

balance between perceived quality and price, however, is health

insurance. l When a medical service or product is covered under

a patient’s health insurance plan, the patient pays less and is less

sensitive to price (5 16).

Like other medical services, pharmaceuticals are marketed in

a world with a complex structure of health insurance. Health

insurers offer different levels of insurance coverage for different

kinds of services and products, Payment restrictions and

regulations are as important as covered benefits in determining

the demand for health care. As health care costs have increased,

health insurers worldwide have adopted new methods to

influence or control the use of health care products and services.

I C&# I

1 Although eth]cal pharmaceuticals include some nonprescriptioms items, health

msurancc covcragc is typIcallY Ilmi[ed only 10 prescrip[]on drugs. Consequently, the

rcmmnder of thl.s chapter refers to prescription drugs.

237
238 I Pharmaceutical R&D: Costs, Risks and Rewards

This chapter documents recent trends in health

insurance for prescription drugs beginning with a

review of insurance coverage and payment controls for prescription drugs in the United States.

The United States is not only the largest single

national market for prescription drugs in the

world, but it also has the world’s most complex

patchwork of insurance mechanisms. Americans

are almost alone in the industrialized world in not

having universal health insurance.

Virtually all other industrialized countries have

national health insurance programs that include

prescription drug benefits. Good examples, later

in this chapter, are Australia, Canada, France,

Japan, and the United Kingdom, which illustrate

what other nations are currently doing to control

expenditures for prescription drugs and what

these controls mean for revenues from new drugs

yet to be developed.

HEALTH INSURANCE FOR PRESCRIPTION

DRUGS IN THE UNITED STATES

1 The Structure of Coverage

All public and private health insurers in the

United States distinguish between inpatient, outpatient, and home health insurance benefits. So,

whether or not an individual has insurance

coverage for a prescription drug depends not only

on whether he or she has health insurance but also

on the setting in which the drug is prescribed and

administered. Inpatient benefits cover services

and products used in hospitals and sometimes in

nursing homes. Outpatient benefits are for services or products obtained in clinics or offices of

health professionals; home health care benefits

are for services or products provided by certified

personnel to patients at home.2

Figure 10-1—Pharmaceutical Sales in the United

States by Trade Channel, 1991

Other ($3.78M) HMOS (staff model) ($1.2M)

MaJ

Hospitals ($

230/.

\

Community pharmacies ($30.2M)

61%

SOURCE: IMS America, Inc., as cited in F-D-C-Reports: Prescription

and OTC Pharrnaceuticzds, “Mail Order Grew 37% to $2.9

Bil. in 1991 IMS Survey; Growth May Slow Soon,” p. 11,

Mar. 16, 1992.

HOSPITAL COVERAGE

Most Americans-86 percent-have public or

private health insurance, continuing a steady

trend over the last decade (292). Virtually all

health insurance plans cover hospital care, including drugs dispensed to hospitalized patients.

Sales to hospitals made up about 23 percent of

total U.S. pharmaceutical sales in 1991 (128), a

decline from about 29 percent in 1983 (291,320).

(See figure 10-1 for a breakdown of pharmaceutical sales by type of buyer at the wholesale level.)

A growing proportion of these sales represent

drugs sold through hospital-based outpatient pharmacies, 3 so the inpatient hospital share of the

pharmaceutical market today is actually below 23

percent.

2 Insurance for health semices provided in the home generally does not affect prescription drugs, because most drugs administered at home

would be covered under outpatient prescription drug benefits. Home health benefits sometimes cover the professional care and device costs

associated with administering i~ intravenous drug to patients at home, thereby making a dministration of such drugs at home (rather than in

a hospital or clinic) a viable option (454). Sometimes Medicare will extend coverage for certain intravenous drugs as part of its durable medical

equipment benefit to patients in the home even though the program lacks outpatient prescription drug benefits. Other insure~ may also

occasionally permit such ‘back door’ coverage. Because such cases of extended coverage are relatively rare, however, they are not discussed

in this report. See the OffIce of Wchnology Assessment’s study of home intravenous drugs for more information (454).

s Virtuatly unheard of 10 yeus ago (369), this practice was carried on for profit by appro ximately 17 percent of U.S. hospitals in 1990 (120).
Chapter 10–Trends in Payment for Prescription Drugs ! 239

One reason for the decline in the inpatient

hospital share of the overall pharmaceutical

market is the major restructuring of hospital

payment systems in the past decade. When

Medicare adopted in 1983 a prospective payment

system that pays by admission and not by specific

service, Medicare created incentives for hospitals

to reduce the services offered per stay and to

reduce the length of stay for Medicare patients.4

For drugs dispensed during the hospital stay in the

1980s, hospitals adopted stricter formularies,5

aggressively used the cheapest generic drugs

available, and closely scrutinized doctors’ prescribing practices (41 1,412). Hospital use declined dramatically as well. Some of the shift

from inpatient care to outpatient care means that

medications that would have been prescribed on

an inpatient basis are now prescribed to outpatients.

NURSING HOME COVERAGE

Pharmaceutical sales to nursing homes made

up just 2.9 percent of total U.S. pharmaceutical

sales in 1991 (128). Private insurance for nursing

home care is very limited, but drugs dispensed to

nursing home patients are typically covered under

outpatient drug benefits if the patient has outpatient drug coverage. Medicare covers its beneficiaries for limited skilled care in a nursing home

and covers drugs dispensed as part of a Medicarecovered stay as they would be in a hospital. If

Medicare doesn’t cover a patient’s stay in a

nursing home, Medicare would still pay for

certain drugs that would be covered were the

patient living at home (454).

Medicaid is a payer of last resort for nursing

home residents whose personal funds are depleted, and virtually all State Medicaid agencies

cover drugs as part of nursing home stays.

Nursing home residents have a high probability

(30 to 50 percent according to several studies) of

becoming eligible for Medicaid while institutionalized, which then covers them for prescription

drugs (137).

OUTPATIENT COVERAGE

Although fewer Americans have outpatient

prescription drug coverage than hospital coverage, outpatient drug coverage grew in the 1980s.

Most (67 percent) ethical pharmaceuticals in

1991 were dispensed through retail or mail-order

pharmacies (128,324), so this growth in coverage

has been an important stimulus to the demand for

prescription drugs in the United States.

The proportion of outpatient prescription drug

purchases paid for by insurance increased substantially, from 27 to 43 percent, between 1977

and 1987 (table 10-1 ).6 The average expenditure

for prescription drugs by individuals with any

prescription drug costs increased 135 percent

between 1977 and 1987 (from $69 to $162 in

1987 dollars) (277). Although Medicare does not

pay for most outpatient prescription drugs, these

same trends hold among elderly Americans, for

whom private insurance paid for 36 percent of

outpatient prescription drug expenses in 1987

compared with only 23 percent in 197’?. People 65

and over are relatively heavy users of prescription

drugs?

4 Medicare beneficiaries accounted for 45.2 percent of inpatient hospital days in 1989 and for 33 percent of the discharges (164).

5 Formularics arc lists of drugs that either include or exclude drugs that may be prescribed by physicians without special exceptions. The

number of hospital pharmacies adopting formularies has steadily increased. Studies conducted by the American Society of Hospital Pharmacists

show the percent of hospitals adopting a well-controlled formulary system increased from 53.9 percent in 1985 to 58.4 pexcent in 1989

(101,412).

6 In 1977, and again in 1987, the Agency for Health Care Policy and Research (AHCPR), known until 1990 as the National Center for Health

Services Research collected data in a mtional survey of health care expenditures, payments, and insurance coverage. Both the 1977 study,

called the Natioml Mediczd Care Expenditure Survey (NMCES) and the 1987 study, referred to as the National Medical Expenditure Suwey

(NMES), included a household survey of expenditures and health care coverage for different types of health care products and semices. Data

on expenditures are available from both surveys. Data on coverage are not yet available from the 1987 NMES survey.

7 In 1987, people 65 and over made up 12 percent of the U.S. populatio~ but were responsible for 34 percent of the country’s total

expenditures on prescription drugs. Elderly Americans’ per capita expenditure on prescription drugs in 1987 was $331, about twice that for

the population as a whole (277).
240 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 10-1—Sources of Payment for Prescribed

Medicines in the United States

Percent of expenditures

1977 1987

All prescribed medicines

Family . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73%

Private insurance . . . . . . . . . . . . . . . . . . 14

Medicaid . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Other sourcesa . . . . . . . . . . . . . . . . . . . . . 6

Prescribed medicines for persons

over 65 only

Family . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

Private insurance . . . . . . . . . . . . . . . . . . 10

Medicaid . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Other sourcesa . . . . . . . . . . . . . . . . . . . . . 3

57%

28

10

6

64

22

9

5

a other sources include Workmen’s Compensation, Medicare, other

State and local programs, and any other source of payment.

SOURCE: Data from J.F. Moeller, Senior Project Director, U.S. Department of Health and Human Services, Publ’ic Health Service,

Agency for Health Care Policy and Research, Rockville, MD,

personal communication, Mar. 12, 1991; J.A. Kasper,

Prescribed Medicines: Use, Expenditures, and Sources of

Payment, Data Prewew (Washington, DC: U.S. Department

of Health and Human Services, National Center for Health

Services Research, April 1982).

Insurance reimbursements alone do not reflect

the full impact of outpatient insurance coverage

on the use of prescription drugs. Coverage itself,

though limited by deductible and copayment

requirements, makes patients less sensitive to the

cost of medical care than they would be without

such coverage (294). Prescription drug costs

frequently contribute to annual deductible amounts,

and most privately insured people are protected

from high expenditures by annual catastrophic

limits on out-of-pocket costs. 8 Hence, people

with health insurance, particularly those with

chronic diseases or conditions requiring longterm medical treatment and medication, have

relatively little incentive to minimize the cost of

medical care, including drugs.

The Office of Technology Assessment (OTA)

estimates private and public health insurance

programs together provided at least some outpatient drug coverage for 67 to 69 percent of the

total noninstitutionalized civilian population in

1979. By 1987, this figure had increased to

between 70 and 74 percent (table 10-2). Among

people 65 and older, the proportion with outpatient drug coverage increased more dramatically,

from 36 percent in 1979 to between 43 and 46

percent in 1987.

Not only has insurance coverage for outpatient

prescription drugs increased over the past decade,

but these benefits have become more generous

over time, as insurance plans have moved toward

policies with flat copayments for prescription

drugs (see below). On the other hand, all thirdparty payers have tried to contain the costs of

prescription drugs.

~ Private Health Insurance Benefits for

Outpatient Prescription Drugs

EXTENT OF OUTPATIENT COVERAGE

Very few private outpatient prescription drug

benefit plans pay for 100 percent of the allowed

cost of drugs. Table 10-3 shows that only about 3

percent of employed people with prescription

drug coverage had full coverage throughout the

1980s. Full coverage is most common in health

maintenance organizations (HMOs),9 whose enrollment grew from 4 percent of the population in

1980 to 14 percent in 1990 (209). In 1989, 10

percent of employees of medium and large firms

who were enrolled in HMOs had full coverage,

compared with only 1 percent of those enrolled in

fee-for-service plans (35).

Limitations of coverage vary across plans and

include restrictions applying specifically to prescription drug expenditures (e.g., copayments for

each prescription) and restrictions affecting overall health expenditures (e.g., a single annual

deductible for all covered medical services in a

“major medical” policy). Policies with specific

copayments for prescriptions increased substan8 Most insurance plans (8(1 percent) have both an annual deductible and an annual maximum limit on out-of-pocket expenses (491).

g Unlike traditional fee-for -semice insurance plans, HMOS (sometimes referred to as ‘prepaid health plans’ collect a set premium for each

member, but charge either nothing or a relatively small amount for each individual service. People enrolled in the HMO must receive their health

care from providers desigmted by the HMO.
Chapter 10-Trends in Payment for Prescription Drugs I 241

Table 10-2-Percent of U.S. Population With Outpatient Prescription Drug Coverage, 1979 and 1987a

1. ASSUMPTIONS

A. Total noninstitutionalized population Number of people (thousands)b

1979 1987

People under 65 198,966 212,700

People 65 and over 24,194 28,487

Total 223,160 241,187

B. Health insurance among people under age 65 1979 1987

Number of Percent with Number of Percent with

people prescription people prescription

(thousands) b drug coverage (thousands)b drug coverage

Group private health insurance 133,555 95’ 140,909 9 5 ’

Other health insurance 35,765 41-54 d

41,071 53-75”

C. Health insurance among people age 65 and over 1979 1987

Number of Percent with Number of Percent with

people prescription people prescription

(thousands) drug coverage (thousands) drug coverage

Medicare only (with no supplemental health insurance) 4,645f

o 5,877g

0

Group supplemental private health insurance 1,706b 71 h

8,830b

45-531

Other supplemental private health insurance 17,543b 43j

13,474’J 61-67k

Il. RESULTS

1979 1987

Percent of total noninstitutionalized civilian population with

outpatient prescription drug coverage

People under 65 71-73 73-77

People 65 and over 36 43-46

Total 67-69% 70-74%

a A detailed memorandum describing OTA’S methods in preparing this table iS available upon request.

b From the Current population survey, c, Nelson, Census Bureau, us. Department of Commerce, Washington, DC, personal communication, Mar.

26, 1991; K. Short, Census Bureau, U.S. Department of Commerce, Washington, DC, personal communication, Nov. 15, 1991.

C From the U,S, Department of La~r, Bureau of Labor Statisti=, su~eys of employers; A. Blostin, U, S. Department of Labor, Bureau Of Labor

Statistics, Washington, DC, personal commurucation, Aug. 15, 1991.

d weighted averages of percent of each type of “other health insurance” with outpatient prescription drug coverage: Medicare--OO/.;

Champu+l OOO/.; nongroup private health insurancW-24°/’ (maximum 240/. estimate from G.L. Cafferata, Private Health hrsurance of the

Medicare Population, Data Preview 18, Publication No. (PHS) 84-3362 (Washington, DC: U.S. Government Printing Office, 1984));

Medicaid-1 OOO/..

e weighted averages of following percents: MediCarHO/o; Champu~l OOO/.; Medicaid-100%; nongroup private health insuranc~-530/0

(maximum 53”J’o from Market Facts, Inc. Consumer Awareness of Medigap Insurance: Findings of a National Survey of Older Ametin.s

(Washington, DC: American Associations of Retired Persons, 1990)).

f &s~ on estimates of Medicare only population in Cafferata, 1964 (footnote d).

9 Based on estimates of Medicare only population in J. O’Sullivan, and D. Koitz, Hea/th Insurance That Supplements Medicare: i3ackground Materials

and Data, 89-421 EPW (Washington, DC: Congressional Research Service, 1989).

h From Cafferata, 1984 (footnote d).

i From Market Facts, Inc., 1990.

J Weighted averages of percent of each t ype of “other health insurance” with prescription drug coverage: Mecticaic&l OOO/~; Champu+l OOO/.; Stale

pharmaceutical assistance programs—lOOO/’; nongroup private health insurance-240/’ (from Cafferata, 1984 (footnote d)).

k Weightd averages of following percents: Champu-1 OOO/O; State pharmaceut~al assistance programs—lOOO

/o; nongroup priVate health

insuranc+5-53°/’ (from Market Facts, Inc., 1990).

SOURCE: Office of Technology Assessment, 1993.
242 I Pharmaceutical R&D: Costs, Risks and Rewards

Table 10-3-Limitations of Prescription Drug

Benefits Among Nonelderly People With Private

Health Insurance Covering Prescription Drugs

1977’ 1989/1990b

Full coverage . . . . . . . . . . . . . . . . . . . . . 3% 3%

Separate limits (Copayments)c . . . . . . 9 30

Overall limits (major medical)d . . . . . . 88 61

Other Iimitse . . . . . . . . . . . . . . . . . . . . . . . 7

a R~~ults ~Sed on 1977 National Medical Care Expenditure Study

Survey of employers and insurers of individuals under 65 years of

b ~~~~lts b~ed on U.S. Bureau of Labor Statistics 1989 and 1990

surveys of employers.

c “separate limits” refers to restrictions applicable only to prescription

drugs, such es a copayment for each prescription.

d “overall limits” refers to restrictions applicable to a broader set of

medical services. For exampl,s, a major medical policy may carry a

$100 deductible and 20-percent coinsurance rate that applies to all

covered services, not just prescription drugs.

e other limits include policies that combine fixed copayments with

overall limits.

SOURCE: Office of Technology Assessment, 1993, based on data

from P.J. Farley, Private Health Insurance in the U.S. Data

Preview#23, DHHS Publication No. (PHS) 86-3406, 1986.

U.S. Department of Health and Human Services, National

Center for Health Services Research and Health Care

Technology Assessment, September 1986; U.S. Department of Labor, Bureau of Labor Statistics, Emp/oyee

Benefits in Medium and Large Frrms, 1989, Bulletin 2363

(Washington, DC: U.S. Government Printing Office, June

1990); U.S. Department of Labor, Bureau of Labor Statistics, Employee Ben6fits in Small Private Establishments,

1990, Bulletin 2388 (Washington, DC: U.S. Government

Printing Office, September 1991); U.S. Department of

Labor, Bureau of Labor Statistics, Emp/oyee Benefits in

State andLoca/Governments, 1990( Washington, DC: U.S.

Government Printing Office, February 1992).

tially between 1977 and 1989, roughly from 9 to

30 percent of the insured population. Copayments

have substituted for other types of restrictions,

such as the inclusion of drugs within the deductible and coinsurance framework of the major

medical policy.

The trend in the 1980s away from inclusion of

prescription drug benefits in major medical policies toward separate limits on drug benefits

themselves represents a move toward a richer

benefit structure for prescription drugs. The vast

majority (95 percent) of employees facing fixed

copayments per prescription in 1989 had a

copayment of $5 or less (35). For people whose

overall medical expenses lie below the deductible, a flat copayment for prescriptions means

lower out-of-pocket prescription drug expenses

than do the major medical restrictions. Even after

a beneficiary covered under a major medical plan

meets the deductible, he or she may be responsible for a 20 percent or higher coinsurance

payment. For example, a $30 prescription would

cost the employee covered under a major medical

policy with a 20-percent coinsurance rate $6,

whereas the typical cost under a flat copayment

would be only $5.

REIMBURSABLE AMOUNTS

For policies providing prescription drug benefits, the actual insurance benefit depends on the

allowed reimbursement level. The reimbursable

amount is not necessarily equal to the price

charged by a pharmacy for the prescribed medication, although it is usually tied to the drug’s price.

In 1977, 76 percent of those with outpatient

prescription drug coverage had policies that based

reimbursement rates for a given drug on the

amount usually charged by the dispensing pharmacy or by other pharmacies in the geographic

area (130). More recent data are not yet available,

but informal OTA discussions with insurance

plan administrators suggest the reimbursement

base may have shifted during the 1980s to average

wholesale prices (AWP). In either case, if the drug

is a ‘‘single-source’ drug, 10 the insurer essentially pays the manufacturer’s price plus a retail

markup.

REIMBURSABLE DRUGS

Private insurers generally cover all prescription

drugs licensed for sale in the United States by the

U.S. Food and Drug Administration (FDA) (35).11

Thus, FDA approval is in essence a de facto

coverage guideline for insurers. Indeed, pharmaceuticals are spared the additional insurance

coverage hurdles that new medical devices must

10A ~ingle-sowce ~g is a moleculw entity that is marketed under a single brand name. After the patent on a dmg exP~es, genefic coPies

may be approved by the FDA, and the compound becomes a multiple-source drug.

11 Most ~Wmce plm d. not cover nonpres~ption drugs, vitamins, medical supplies, dietary supplements, diabetic suPPfies o~er *

insulin, and non-oral contraceptives (35).
Chapter 10—Trends in Payment for Prescription Drugs 243

often clear.12 For drug manufacturers, the relatively uniform coverage of pharmaceuticals reduces the company’s uncertainty about the expected returns from a drug once it has been

approved by the FDA.

There is at least one exception to predictable

coverage that may become more important in the

future. Although virtually every prescription drug

that the FDA approves is covered by private

insurers, a pharmaceutical may not be covered if

a doctor prescribes it for a use other than the one

the FDA has approved. Insurers are typically not

contractually obligated to provide coverage in

these instances (278). Although some of these

prescriptions are clearly experimental, others are

standard therapies. Pharmaceutical manufacturers often do not seek approval to sell a drug for

additional indications once it is initially licensed,

because the process can be costly and time

consuming (238). The practice of prescribing for

unapproved indications, known as off-label prescribing, occurs in many branches of medicine.

There is little published data to show how

many claims for off-label prescriptions are denied, but cancer patients report they have found it

increasingly difficult to get reimbursement for

off-label prescriptions and their associated costs

(e.g., hospital stay) as insurers have begun to

examine the prescriptions, mainly to control costs

(395). About 33 percent of cancer chemotherapy

prescriptions are off-label and about 56 percent of

all cancer patients receive at least one off-label

prescription in their drug regimen (238). Insurers

are generally willing to reimburse for off-label

uses that have been documented as effective in

one of three major medical compendia13 or in

multiple independent published studies. Physicians have complained that there are often long

delays between proof of effectiveness and approval in the compendia or other literature (278).

RECENT COST-CONTAINMENT TRENDS

In the past 5 years, many private health

insurance plans have begun cost-containment

measures that either directly or indirectly control

or influence the use of, and prices paid for,

prescription drugs. Chief among such provisions

are incentives to purchase generic drugs, drug

utilization review programs, and mail-order pharmaceutical programs. These provisions may represent a ‘‘second-tier barrier’ to access to drugs

beyond FDA licensing requirements (515). In

addition, the rapid growth of HMOs over the past

decade has added an indirect incentive to control

the utilization of all services, including prescription drugs.

Incentives to Use Generic Drugs—The percent of enrollees in employer-based plans that

encourage the use of generic drugs by reducing

copayments when a generic is dispensed increased dramatically from 3 to 14 percent between 1985 and 1989 (35). The most common

incentive is a lower copayment when a generic

drug is purchased. In HMOs, where mandatory

generic substitution can be enforced, the use of

differential copayments appears to be just as

effective as mandatory substitution in increasing

the use of generics (515).

Formularies—A formulary restricts the doctor’s choice of drugs to drugs on a list (or to those

not on a list of excluded drugs) when more than

one therapeutically similar compound is available

to treat a condition, Except for HMOs, formularies do not exist in private health insurance plans.

Recent surveys of HMOs indicate that between 28

and 55 percent of all plans have some type of

formulary, but the nature and effectiveness of

these restrictions have not been documented

(515).

12 some Pfivate i~urcrs subject m~ic~ devices and procedures to a rigorous review that can include Cost Or COSt-effectiveness crite~a ~

their coverage decisions. For example, the Blue Cross/Blue Shield Association of America has a Ikchnology Management Prcgram that

undertakes such studies in order to make coverage recommendations to its individual insurance plans (12).

13 ~1e5c ~omces ~clude tie ~enca Hospital Fo~ul~ se~i~’s Drug ~n~o~~tion, the I-J.S. Pharmacopoeia’s Drug z?r~or~afion, ~d

the American Medical Association Drug E\wZuutions. None of these sources are published with the intent that they should be used as guides

for insurance coverage; they are references for doctors and hospitats concerning drug options and activities (395).
244 I Pharmaceutical R&D: Costs, Risks and Rewards

Photo credit” U S FOOD AND DRUG ADMINISTRATION

The use of generic drugs is growing as health insurers give

both patients and pharmacists incentives to substitute generic

versions for brand-name versions of prescription drugs.

Drug Utilization Review (DUR)—DUR is the

review of drugs prescribed or prescriptions filled

to verify the drug’s appropriateness, to identify

potential interactions with other medications, or

to identify alternative effective or cost-effective

therapies for the patient (35,1 38,434,515).14

Data on the extent of DUR programs or their

impact on the use of pharmaceuticals are limited.

Among HMOs, about 70 percent report having a

DUR program (5 15). OTA found no similar

profile of DUR programs among fee-for-service

insurance plans. A recent General Accounting

Office (GAO) study described eight DUR programs, including some at retail chain pharmacies,

one at a U.S. Department of Defense pharmacy,

and one at a mail-order pharmacy (434). GAO

found that the identification of potential adverse

drug reactions or adverse interactions with other

drugs that a patient is using are the most common

features of DUR programs, but the report also

stresses that these systems could be linked

relatively easily to insurance claims systems.

Thus, although there is little evidence DUR is

currently a major tool in attempting to control the

use of, or total expenditures for, prescription

drugs, insurers or others concerned with costs

may try to use DUR more extensively for such

purposes in the future.

Mail-Order Pharmacies--Another way in which

insurers try to constrain prescription drug costs is

by contracting with a ‘‘mail-order’ pharmacy for

drugs that patients need refilled on a regular basis.

Unlike other cost-containment mechanisms, mailorder pharmacies do not necessarily restrict

access to drugs or attempt to constrain use. These

programs achieve cost savings through the economies of scale of a centralized mail-order operation

and by providing incentives (usually through

lower copayments) for patients to buy their

medications in large quantities.

Mail-order pharmacy programs are also more

effective than retail pharmacies in substituting

less expensive generic versions of brand-name

drugs when generic versions are available. One

prescription drug insurance administrator with a

large mail-order operation reported to OTA that

between January and March, 1992, 44 percent of

its mail-order sales of multisource drugs were for

generic products. In contrast, only 31 percent of

sales of maintenance multisource drugs purchased through the company’s community pharmacy system were for generic products (255).

Thus, the increasing use of mail-order pharmacies

may appreciably reduce revenues for brand-name

products that have lost patent protection.

[J The now repealed Mcdic:we cat~strophic Coverage Act (Public Law 100-360) included a mandated DUR program for tic outpatient

prescription drug benefit provided by that legislation. In 1990, the Congress required each State Medicaid program with a prescription drug

bencflt begin a DUR program by January 1, 1993 (Public Law 101-508). With the expectation that DUR may be a growing part of outpatient

prescription drug dispensing, the Pharmaceutical Manufacturers Association (PMA), the American Pharmaceutical Association (APhA), and

the American Medical Association recently adopted joint “principles” for DUR programs. This document stresses the importance of DUR

m enhancing ‘‘the quality of patient care, ’ but docs not address its potential usc by health insurers to constrain prescription drug costs (138).
Chapter 10-Trends in Payment for Prescription Drugs 245

Mail-order pharmacy programs appear to be

growing rapidly among employer-based health

care benefit plans. In 1989, about 13 percent of

U.S. employees had a mail-order drug benefit; by

1990, 20 percent of employees had such a plan

(135).

HMOs—The rapid growth in HMO enrollment

over the past decade, from 3 to 14 percent of the

population, means that incentives to economize

on medical services are increasing dramatically.

But, many HMOs do not give their doctors

incentives to economize in drug prescribing. A

recent review of seven HMOs found the plans

were structured so that the prescribing physician

never bore financial risk for prescription drug

costs (515).15 Rates of use of prescription drugs

were actually higher in the seven HMOs studied

than in traditional insurance plans (5 15). And, the

enrollees in the HMOs used newly approved

drugs at the same rate as did those in traditional

fee-for-service plans.

Because HMOs are more suited than traditional

fee-for-service plans to develop and enforce

formularies, HMOs also are more able to negotiate discounts with makers of brand-name drugs,

Some large HMOs have achieved substantial

discounts on specific drugs for which close

therapeutic alternatives exist.16 Thus, the growth

of HMOs has surely expanded price competition

among single-source drugs and has reduced,

though modestly overall so far, the returns to

research and development (R&D).

1 Medicaid Prescription Drug Benefits

Medicaid, funded jointly by the States and the

Federal Government, provides health insurance to

people of limited financial means.17 Coverage of

outpatient prescriptions is an optional Medicaid

benefit offered by 49 States and the District of

Columbia. Medicaid enrollees get their prescribed medications from a retail pharmacy usually at little or no charge to them. The pharmacy,

in turn, is reimbursed by the State Medicaid

agency according to payment limits and established dispensing fees set by Federal Medicaid

regulations. Medicaid is responsible for about 10

to 15 percent of the Nation’s outpatient prescription drug expenditures.18

EXTENT OF OUTPATIENT COVERAGE

To get a prescribed medicine from a pharmacy,

a Medicaid beneficiary usually presents a Medicaid card verifying his or her enrollment, along

with the doctor’s written prescription. A total of

22 States require Medicaid enrollees to pay apart

of the cost of medications (287). In most States

with this provision, the copayment ranges from

$0.50 to $3.00 (287). Federal law prohibits States

from requiring copayments from important

groups of beneficiaries: children under 18, pregnant women, residents of long-term care and

hospice institutions, some HMO enrollees, and

15 mese HMOS were all Individud Practice Associations or Networks, These kinds of HMOS tend to have looser fiscal COntrOh Mst~f

model HMOS, where physicians are either employees or partners in the organization.

lb me ~g~tude of such dlsco~~ MS declined s~ce 1990, when tie Medicaid Rebate ~WI (Wblic hW 1(31-508) made it COSlly for

pharmaceutical firms to offer such discounts (431).

IT At a mlnlmum, States must provide certain health scrviccs under Medicaid to the recipients of certain kinds of Federal financi~ assist~ce.

In particular, recipients of Supplemental Security Income (SS1), Aid to Families of Dependent Children (AFDC), and several other groups of

pregnant women and children meeting specific criteria are considered ‘ ‘categorically’ eligible for Medicaid. States may also decide to provide

these services to other low-income individuals without health insurance (sometimes referred to as ‘‘medically needy’ individuals). States may

also provide other services, including prescription drug coverage, to the categorically eligible only or to both the categorically and medically

needy populations. In 1991, 17 States and the District of CoIumbia provided prescription drug covemge 10 the categorically needy only, while

the rcmaining 34 States provided drug benefits to both the categorically and medically needy, Of the 17 States having no prescription drug

benefits for the “medically needy, ” 16 offer Medicaid only to categorically eligible people (463).

18 As shown in table 10-1, tic 1987 Natio~l Medical Expenditure Survey of nonlnstitutiomllim=d Americans indicated Medicaid accounted

for about 10 percent of expenditures for prescription drugs in 1987. Tbc National Health Expenditures Series, which estimates national spending

on health care based on a variety of data sources, estimates the Medicaid share of pharmaceutical expenditures was 15 percent in 1990 (464).
246 I Pharmaceutical R&D: Costs, Risks and Rewards

recipients of emergency and family planning

services (287).

REIMBURSABLE AMOUNTS

State Medicaid programs reimburse the pharmacist after a drug is dispensed to a Medicaid

enrollee (235). States pay a freed dispensing fee

and an amount to cover the cost to the pharmacy

of the prescribed drug. The median dispensing fee

in 1990 was $4.10 (287).

Federal requirements for reimbursement of

prescribed drug costs differ for single-source and

multiple-source drugs. Until 1991, when a new

Medicaid rebate law went into effect, State

Medicaid agencies were required to pay no more

for a single-source drug than either the pharmacy’s estimated acquisition cost plus a reasonable dispensing fee, or the pharmacy’s usual and

customary charge to the general public (134).

State Medicaid agencies generally discounted the

published average wholesale price for the drug by

a fixed percent (ranging from 5 to 11) to obtain the

estimated acquisition cost (134). Since published

wholesale prices are generally higher than the

actual wholesale prices paid by retailers, Medicaid essentially paid the manufacturer’s price plus

a retail markup for single-source drugs.

Since the mid-1970s the Federal Government

has tried to reap savings from price competition

for multiple-source drugs by requiring that in the

aggregate (i.e., across all multiple-source drugs)

the State reimburse no more than 150 percent of

the published price for the least costly product

(134). States themselves have every incentive to

pay as little as possible for multiple-source drugs.

A big loophole in this regulation has been the

exemption of any prescription from the upper

limits if the physician has written by hand that a

specific brand is medically necessary. When such

an override occurs, the prescription is treated as a

single-source drug even when generic competitors are available.19

REIMBURSABLE DRUGS

Until 1991, State Medicaid agencies had the

authority to restrict the drugs that Medicaid

covers. In 1990, about 22 States had restrictive

formularies, which limited reimbursable drugs to

a defined list. Another 28 States had ‘‘open

formularies," under which all drugs are reimbursable except for those explicitly identified as

ineligible.

The use of restrictive formularies can add a

measure of uncertainty and delay to the drug

development process and could affect manufacturers’ returns to R&D. In the past, there were

reports of long delays in the adoption of new

drugs into Medicaid formularies after FDA approval. A study of delays in Medicaid formulary

approvals for new drugs introduced between 1975

and 1982 in six States with restrictive formularies

found the average delays in approval time for

drugs eventually accepted ranged from about 1 to

4 years after approval by the FDA (153). An

update of that study, which examined nine States

over the period 1979 to 1984, found similar

delays (156).

OTA examined the status of three newly

approved drugs in States with restrictive formularies. Two of the drugs, AZT and gancyclovir,

were approved in 1987 and 1989 respectively for

treating AIDS patients. The third drug, fluoxetine, the first compound in a new class of

antidepressants, was approved in December 1987.

By September 1990, virtually all States had

approved the three drugs for Medicaid reimbursement, although it had taken almost 2 years for

some States to approve AZT. In addition, several

States required prior authorization to fill prescriptions for these drugs (503).

Many State Medicaid programs restrict payment for off-label uses of prescription drugs;

however, the restrictions are applied only to a few

very costly drugs. Therefore, the overall impact of

such Medicaid restrictions is minor.

19 A ~~dy ~OnduCted ~ ~Cln&in 198$) fo~d most 40 percent Of prescriptions for rn~tiple-so~~ tigs were written With a physician’s

brand override and were filled with the originator’s brand. In 1990, Florida issued a rule mandating the use of available generics and essentially

refusing to pay for brand-name drugs regardless of the physician override when generic equivalents exist (517).
.——-

Chapter 10-Trends in Payment for Prescription Drugs 247

RECENT COST-CONTAINMENT EFFORTS:

THE MEDICAID REBATE LAW

A new Federal Medicaid law enacted in 1990

rendered much of previous Medicaid prescription

drug policy inoperative. The Omnibus Budget

Reconciliation Act of 1990 (Public Law 101-508)

required manufacturers selling prescription drugs

to Medicaid patients to give States a rebate on

their Medicaid purchases. In exchange, the law

prohibited States from using formularies to restrict Medicaid patients’ access to any FDAapproved drug in the manufacturer’s product line.

States may require doctors to get prior authorization for a drug but not for the first 6 months after

FDA approval.

The required rebate on brand-name drugs20 has

two main components. The first is the Basic

Rebate, which requires the manufacturer to effectively discount the price of each drug it sells to

Medicaid by a specified amount. The second

component is an Additional Rebate, which requires the manufacturer to pay money to Medicaid whenever the prices of its brand-name drugs

increase more rapidly than price inflation. The

Congressional Budget Office projected a total

rebate for brand-name drugs (single-source and

innovator multiple-source drugs) to the Federal

Government of $637 million in fiscal year 1992

(431). Including the States’ share brings this total

to about $1.1 billion (317), or about 2 percent of

total domestic manufacturer sales.

The Basic Rebate has two components—a flat

discount off the average manufacturer’s price21

and a‘ ‘best-price’ discount that would equate the

net Medicaid price with the lowest price offered

by the company to any buyer. The required rebate

is the higher of these two components. The flat

discount increases over time as the law is phased

in.22

The Additional Rebate operates one way until

1994, when it is slated to change in a manner that

is potentially important for returns on new drugs.

Through 1993, the average manufacturer’s price

of each brand-name drug product in any calendar

quarter is compared with the price of the drug in

the quarter ending October 1990. If the product’s

price has increased faster than inflation (as

measured by the consumer price index (CPI)),

then the manufacturer must give back to Medicaid

the difference for each unit of the drug it sells to

Medicaid. If a drug product is introduced after

October 1990, then the price in the calendar

quarter in which it was launched on the market

becomes its baseline price.23 Thus, while price

increases to Medicaid are controlled, the launch

price to Medicaid of a new drug is virtually

unrestrained.

After 1993, the Additional Rebate for each

drug is tied not to the pricing history of that drug

alone but to the average manufacturer’s price

across the manufacturer’s complete product line,

weighted by the number of units of each product

sold to Medicaid. The manufacturer’s current

weighted average price is compared with the

manufacturer’s weighted average price across its

entire product line as it existed in October 1990.

If the average price across drugs sold in a period

after 1993 is higher than the average price as of

October 1990, after accounting for general inflation, then the manufacturer must give back the

20 Brad.me ~g~ ~e hose av~able from o~y one m~~~~r (i.e., single-so~ce @gs) or, if generiC competitors exist, the innovator

company’s brand-name product. The law also requires a rebate from generic manufacturers equal to 10 percent of the average manufacturer’s

price (increasing to 11 percent in 1994).

21 me Aver~g~ ~~ac~er’~ pn@(~)is he average price Chage(t by wholes~ers for products distributed to the m@ Ch.SS of trade.

The best price originally excluded depot prices and single-award contracts given any Federal agency. In subsequent legislation passed in 1992,

prices paid by the Department of Veterans Affairs, the Department of Defense, Public Health Service Hospitals and other federally funded health

providers, and certain hospitals that serve a disproportiomte share of poor people were also excluded ffom the best price (Public Law

102-585).

22 ~ tie fkst 2 Yws, here Me upper limi~ on the required rebate.

23 me law d~s not specific~ly indicate w~t should be done about ~gs in~~uced titer October 1990, but the law k been implemented

so far in this way.

330-067 - 93 - 9 : QL 3
248 I Pharmaceutical R&D: Costs, Risks and Rewards

Box 10-A–Medicaid’s Additional Rebate After 1993: An Example

Suppose a company had two drugs on the market in 1990, with unit sales over the quarter ending

October 30 and average manufacturer's prices as given below:

Drug Price Unit sales

x 10 100

Y 30 100

Suppose the consumer price index increased by a total of 10 percent between 1990 and 1995. Then,

the inflation-adjusted baseline weighted average manufacturer’s price in 1995 would be:

[(10(100) + 30(100)]/200] * 1.10= $22.00

Now, suppose in 1995 the firm introduces a new drug and its total sales now are as follows:

Drug Price Quantity

x 11 100

Y 33 100

z 25 100

The weighted average price in 1995 for this manufacturer is now $23.

For every unit of each product it sells, the manufacturer must give back to the Medicaid program $1, the

difference between the current weighted average manufacturer’s price and the inflation-adjusted baseline

weighted average manufacturer’s price. This manufacturer would owe Medicaid $300 in additional rebate.

Without the new drug, the manufacturer would have owed Medicaid nothing, so the new drug pays a

penalty of $3 per unit to Medicaid for having been introduced at a relatively high price.

SOURCE: OffIce of lkclmology Assessment, 1993.

difference for every unit of each drug it sells to payable for each unit of the new product sold to

Medicaid.

The baseline average weighted manufacturer’s

price as of 1990 would not contain any drugs

introduced after that period, so as the law is

currently written new drugs introduced to the

market at high prices relative to pre-existing

drugs will face additional rebates. (See box 10-A

for an example of how this works.) At the same

time, the law states that the Secretary of Health

and Human Services (HHS) may exclude from the

calculation of today’s weighted average price any

new drug that effectively would lower the rebate

manufacturers must give to Medicaid. (A new

drug product entering the market at a very low

price, for example, might be excluded from the

calculation of the weighted average manufacturer’s price, but the per unit rebate would still be

Medicaid.)

The law does allow the Secretary of HHS to

exclude from the weighted average price calculation, new products that increase the rebate to

Medicaid, but only if their inclusion would

impose “undue hardship’ upon the manufacturer. The law also gives the Secretary the power

to impose an alternative mechanism for calculating the Additional Rebate. No such alternative

approaches have been published to date.

In the short term, the Additional Rebate gives

firms the incentive to introduce new products at

high prices. While a company’s price increases

for existing products are controlled, launch prices

are not. And, the prohibition of restrictive formularies for participating manufacturers increases
. .

Chapter 10–Trends in Payment for Prescription Drugs I 249

the potential for higher earnings in the early years

after product launch.24

After 1993 the situation changes. If the Additional Rebate is implemented as designed, the

effective launch price to Medicaid of a new drug

will be constrained at or even below the inflationadjusted weighted average price for 1990, Thus,

new drug products launched at high prices will

effectively face high Medicaid rebates, thus

substantially reducing the revenues on this segment of the market.

The Post-1993 Additional Rebate as it is

currently outlined in the law has implementation

problems. Detailed data on the quantity of Medicaid drugs sold from June to October, 1990,

necessary to compute the weighted average price

of the manufacturer’s products as of October

1990, do not exist in a usable form in most State

Medicaid agencies. One technical solution to this

problem would be to use a calendar quarter in late

1993 as the baseline date for quantity weights,

because by that time Medicaid agencies would

have better data on quantities of each drug

product sold to their agency.

In the fall of 1992, technical amendments were

introduced (but not passed) to change the post1993 Additional Rebate (S.3274). Under the

amendments, the baseline weighted average manufacturer’s price would be calculated using the

1990 price for drugs already on the market in

1990 and the launch price of drugs introduced

after that period. Importantly, it would weight

those prices by unit sales in the current rebate

period. This new rebate would not penalize firms

when they introduce a new product at a relatively

high price, although it would still control increases in prices to Medicaid after the introduction.25 Thus, the effect on revenues obtained from

newly introduced drugs would be less severe than

under current law, which would effectively control the prices of new drugs to Medicaid.

1 State Pharmaceutical

Assistance Programs

During the past 15 years, 10 States have

established State Pharmaceutical Assistance Programs (SPAPs) that extend pharmaceutical benefits mainly to people 65 years of age and older

who do not qualify for Medicaid but cannot afford

to purchase private health insurance. Four of these

SPAPs also cover the permanently disabled.

Together these programs currently spend about

$500 million annually on prescription drugs

(34,38,181,191,237,246,252,256,259). Eligibility

in a SPAP is limited by personal income ceilings

that each State determines and that usually fall

between one and two times the Federal poverty

line. In 1977, the first year of the programs,

43,000 people participated. By 1991, this figure

had grown to approximately 936,000 people

representing about 3 percent of the population age

65 and older. Five of the programs cover nearly all

FDA-approved prescription drugs; the other five

limit the classes of prescription drugs for which

they will pay.26

Virtually all of the State programs have policies encouraging the use of cheaper generic drugs.

Five States require dispensing generics if they

exist, unless the physician specifically specifies

the brand-name drug. Two of these States have

also adopted other incentives to promote the use

of generics. In Pennsylvania, a pharmacist who

convinces a physician to change a prescription

~ me -~eutic~ mufac~ers Association (PMA) has complained that States are using the prior aut.hOtitiOn ties as de~ac~o

formularies (37 la), thereby undercutting the positive aspeets for the industry of the restriction on formula.ries. Such tactics are illegal for only

the first 6 months of a product’s life.

25 ne tWtiC~ amendmen~ would also have removed the discretion of the Seeretary of Health ~d H~ Services to exclude new drugs

from the weighted average price when such an action would lower the amount of the rebate. The Secretary also loses the discretionary power

to change the overall approach.

‘b For example, Illinois, Maine, Vermont, and Rhode Island cover pharmaceuticals only for the treatment of chronic conditions including

heart disease, diabetes, hypertension, and arthritis, Rhode Island also covers cholesterol-lowering drugs as well as treatments for cancer,

glaucoma, and Parkinson’s disease. Since 1991, Maryland has limited the drugs its SPAP covers to chronic disease treatments, anti-infectives,

and drugs for a limited number of other diagnoses. None of the programs cover over-the-counter drugs.
250 I Pharmaceutical R&D: Costs, Risks and Rewards

from brand-name to generic receives an extra

dollar of reimbursement from the State, while in

Maine the patient pays a higher copayment for a

brand-name prescription if a generic is available.

The five States without a generic substitution

requirement do require higher copayments from

beneficiaries for prescriptions filled with a brandname drug.27

i Medicare Prescription Drug Benefits

Although Medicare generally does not cover

outpatient drugs,28 it does cover drugs that only a

doctor or someone under a doctor’s supervision

can administer. Many drugs given by injection or

intravenous (IV) administration fall into this

category. Ordinarily, Medicare leaves it to its

carriers29 to determine whether specific drugs will

be covered under this provision. If the drug is

usually self-injectable or self-administered, the

carrier can deny coverage (88).

Biotechnology drugs are frequently large molecules that must be administered by IV or

injection. Thus, these drugs are more likely to be

covered under Medicare than are other drugs.

Nevertheless, at least two recently approved

biotechnology drugs, ActimmuneTM and Protropin TM, were denied Medicare coverage by

certain carriers because they were classified as

self-injectables (43).

When Medicare does pay for outpatient prescription drugs, the carriers determine pricing

policies. There is no official Medicare cost

control strategy pertaining to the few outpatient

drugs covered by Medicare.

PRESCRIPTION DRUG BENEFITS

IN OTHER COUNTRIES

The existence of universal health insurance in

other industrialized countries means patient demand for such drugs is not much affected by

prices. Nevertheless, insurers in universal health

systems more strictly control the use of drugs and

the prices paid. Although data on drug utilization

and prices paid in other countries for drugs are not

generally available,30 special studies conducted

in recent years suggest some European countries

pay less for drugs than do consumers in the United

States (457).

OTA reviewed recent trends in payment methods for prescription drugs in five countries:

Australia, Canada, France, Japan, and the United

Kingdom. To a greater or lesser extent in each of

these countries, drug payment policy is governed

by two potentially conflicting objectives: to

minimize health insurance prescription drug costs

and to help the country’s domestic pharmaceutical industry. Payment policies represent a blend

between these objectives.

1 Australia

Australia’s domestic pharmaceutical industry

is very small, and the country represents a small

proportion of the world market for prescription

drugs. 31 Consequently, Australia has not had a

major economic stake in promoting pharmaceutical R&D. Instead, the main objective of Australia’s pharmaceutical payment policies has been to

minimize the cost of drugs, both to the government and to its citizens. Recently, though, the

government has made efforts to promote the

27A r~ent in-house study conducted by New York’s SPAP suggests this type of consumer-based PriCe incentive may kve o~y rn~est

effects. The study found that in New York the lower copayment for generics led to the dispensing of generics for only 27 percent of prescriptions

ffled compared with 24 percent for dl prescriptions filled nationwide (34).

M Me&cWc covers ~uosllppresslves after organ transplants, antigens, blood-dotting factors for h~op~~s, and di~Ysis ~gs such

as eglhropoeitin.

29 Me~c~e ~~ers we fisc~[ agents (typically Blue s~el~lue Cross plans or Otier private iII.sur~LX. Companies) ud~ CO13&tlCt tO the

Health Care Financing A&mm“ “stration (under the Department of Health and HumaLI Semices) for administration of specitlc Medicare tasks.

These tasks include determiningg reasonable costs for covered items and services, making payments, and guarding against unnecessary use of

covered services.

so me U.S. General Accounting Office iS Currentiy engaged in m e xarnination of European prescription drug price mechanisms to determine

their applicability to the United States.

31 Dmg5subsidi~dby beAu~@~ianGove~ent,w~chaccount for 75 ~rcent of ~ pr~criptions, were WOlih A$l .32 billion in 1990-91,
Chapter 10--Trends in Payment for Prescription Drugs 251

Australian domestic pharmaceutical industry

through its pricing policies.

The Pharmaceutical Benefits Scheme (PBS) of

Australia, adopted in 1950, originally made 139

life-saving and disease-preventing drugs available at no cost to patients. These drugs were

supplied because the cost of treatment could be

‘‘most burdensome’ to people in life-threatening

situations (308). However, as this program grew

to cover hundreds of drugs and 105 million

prescriptions annually (75 percent of all Australian prescriptions), the government began to

consider options for cost control.

One primary approach to controlling the government’s pharmaceutical bill has been to enact

copayment requirements, determined annually

according to the Australian consumer price index

(125,178). In August 1992, the patient copayment

per prescription was A$15.90 for general beneficiaries (to a maximum per year of A$30, then

A$2.60 to a maximum of an additional A$51.60

that year), and A$2.60 for retirees32 (up to a

maximum per year of A$135.20) (178).

Since 1963, the government has negotiated

prices with manufacturers for any new chemical

entity to be reimbursed by the PBS. After a drug

is approved for efficacy and safety it must be

admitted onto the list of products covered by the

PBS. Legislation passed in 1987 requires the

Pharmaceutical Benefits Advisory Committee

(PBAC), the body responsible for recommending

whether anew chemical entity should be listed for

federal reimbursement, to consider not only

effectiveness but also cost.

Guidelines implementing this legislation were

not drafted until 1990; since then the rules have

been subject to extensive debate. Revised guidelines were released in August 1992 and will be

followed for all major submissions to the PBAC

as of January 1993. The guidelines recommend

the use of final outcome measures, such as cost

per year of life saved, cost per death prevented, or

cost per quality-adjusted year of life, to evaluate

a drug’s cost-effectiveness compared with alternative therapies. Because these measurements are

difficult to make in many cases, estimated costeffectiveness analysis may be based on intermediate outcome indicators such as the number of

patients achieving a target blood pressure for a

new antihypertensive agent.

Once a new chemical entity is admitted to the

PBS list, manufacturers undergo price negotiations with the Pharmaceutical Benefits Pricing

Authority (PBPA) (formerly the Pharmaceutical

Benefits Pricing Bureau) to determine the PBS

price for the product. Price negotiations were

originally applied to multiple-source as well as

single-source drugs entering the market; however, since 1990, only drugs identified as being

without generic equivalents must enter price

negotiations (see below).

The PBPA presently considers the following

factors in the pricing negotiations: the prices of

drugs in the same therapeutic group, cost information supplied by the manufacturer or estimated by

the Authority, prescription volumes, economies

of scale, product stability, special manufacturing

requirements, prices of the drug in other comparable countries, the level of activity being undertaken by the company in Australia (see below),

other relevant factors presented by the company,

and other directions by the Health Minister of the

Authority.

In 1988, as part of an Industry Development

Plan, the government declared it would consider

“the level of activity being undertaken by the

company in Australia including new investment,

production, research and development” in determining a company price (308).33 This provision,

known as Factor-(f), granted further price increases ‘‘where a company can demonstrate that

it is making a significant contribution to internationally competitive production in Australia”

(308).

To enter the Factor-(f) scheme, companies are

expected to increase their Australian production
252 I Pharmaceutical R&D: Costs, Risks and Rewards

and R&D activities by 3 percent. The actual price

increase is based on the increase in local value

added for a company’s manufacturing, exports,

and R&D. Companies receiving a pricing dividend under the Factor-(f) provision can apply it to

any drug in their product line. The government

has confirmed its commitment to expanding the

drug industry in Australia by announcing an

extension of the Factor-(f) policy through the year

1999.

Until 1990, drugs with generic equivalent

competitors on the market underwent the same

pricing negotiations as new chemical entities.

Since then, drugs with generic equivalents are no

longer subjected to the PBPA pricing process.

Today companies may set their own prices for any

drug having a generic equivalent on the market,

but the government sets a benchmark reimbursement rate for each chemical entity equal to the

lowest priced generic alternative (178). When a

consumer purchases a drug, the PBS reimburses

the pharmacist only up to the benchmark rate; if

the doctor prescribes a more expensive brand, the

consumer must pay not only the copayment but

also the difference between the price and the

benchmark. Patients can ask the pharmacist to

substitute the benchmark product for a more

expensive prescribed brand, but the pharmacist

must contact the prescribing physician for approval (178).

The current benchmark pricing scheme was

adopted to give consumers incentives to economize on the use of prescription drugs for which

generic equivalents are available (178,408) and to

make the marketplace more price competitive.

Drug prices were freed subject to the benchmark

pricing scheme late in 1990. In early 1991,of651

brands subject to benchmark pricing, 131 (including the 65 most prescribed in Australia) have a

price higher than the benchmark level (178). The

government reports that market shares decreased

slightly for drugs priced above the benchmark

level, while there has been an increase in market

share for benchmark priced drugs and an increase

in generic prescribing (408). However, it is likely

that manufacturers would not price their drug

above the benchmark price if they do not expect

total revenues from the sale of the drug to be

higher than they would be with a benchmark

price. Thus, the fleeing of prices means a potential shift of the burden of payment from the

government to the consumer. Whether the consumer (or the physician) becomes more price

conscious as the generic pricing system matures

remains to be seen.

I Canada

Like other countries OTA reviewed, Canada

has sought a compromise between the two goals

of pharmaceutical cost containment and development of a domestic pharmaceutical industry.

Unlike other countries, Canada’s national pharmaceutical cost control policy has used legislation that weakened the impact of patent protection

on pharmaceutical sales in Canada.34 This approach led to widespread penetration of generic

products in the Canadian market, which in turn

stimulated price competition among brand-name

drugs in Canada. However, legislation passed in

1987 has restored a measure of patent protection

to pharmaceutical products in exchange for the

cooperation of multinational pharmaceutical companies in keeping pharmaceutical prices from

increasing sharply and investing in R&D performed in Canada.

In the 1960s Canadian federal and provincial

health programs did not yet include pharmaceutical benefits, so patients paid for nearly all drugs

themselves. The early 1960s saw rapid increases

in Canadian drug expenditures, which alarmed

the public and created a national demand for price

34 c~di~ provinces ope~te independent programs to control the costs of pharmaceuticals. Control methods VW widely, USing

combinations of incentives for generics, restrictive drug lists, copayments, etc. Although this section focuses mainly on measures of the national

government to control prescription drug expendi~es, it should be recognized that provincial control over the prices of prescriptions sold

through provincial drug plans (which make up 40 to 100 percent of drugs sold in individual provinces) gives Canada added leverage overrnarket

prices. One way most of the provinces exert downward pressure on prices is via a restricted benefits lisc the manufacturers must negotiate prices

with the provincial government to have a drug admitted to the list of those eligible for reimbursement in the province.
Chapter 10-Trends in Payment for Prescription Drugs I 253

control. Three separate federal government studies conducted between 1963 and 1966 found drug

companies had undue market power, allowing

them to set unnecessarily high prices (90). The

studies also concluded such market power would

not exist if there were competition for many of the

drugs protected by patents.

The legal right to bypass patent protection for

pharmaceuticals has existed in Canada for quite

some time. A statute enacted in 1923 permitted

Canadian companies to apply for compulsory

licenses to produce generic equivalents of drugs

already protected by patents in Canada. This

statute was not invoked often; since the Canadian

market was small, it could not support a domestic

manufacturing industry for generic drugs (244).

However, in 1969, the Canadian Government

extended the compulsory licensing provision to

allow for import of generics from other countries.

In some Eastern European and South American

countries, drug patent laws are either weak or

nonexistent (90). Thus, when a company launches

a new drug, manufacturers in these countries can

reproduce the active ingredient and market the

drug within about 2 years. The 1969 Canadian

law allowed Canadian companies to apply for

compulsory licenses to import and market these

readily available generic products.

The government took other actions to support

the growth of generic competition such as lowering the tariff on pharmaceutical imports, awarding large grants and loans to support domestic

generic drug packagers and distributors, and

setting up education programs for physicians

(90).

By the early 1980s, generic drugs accounted for

10 percent of pharmaceutical sales. In 1968, the

year before the law was enacted, Canadians paid,

on average, 9 percent more than did Americans

for 43 patented drugs. By 1976, Canadian prices

for these drugs were, on average, 21 percent

cheaper than in the United States (90). Imported

generics generally entered the Canadian market at

prices 10 to 20 percent below their patented

counterparts and maintained this margin if the

price of the patented versions were reduced in

response (30). When multiple generic products

were available to compete with a single brandname drug, the generics were sold at prices as low

as 40 percent below the brand-name price (244).

In 1983, savings of $211 million in a $1.6-billion

market were realized as a result of compulsory

licensing (244).

As the provinces adopted their own pharmaceutical benefits plans, they took advantage of the

savings that generics offered. By the middle of the

1980s, most of the provinces had enacted measures to ensure generics would be used more

frequently. All 11 provincial or territorial governments now have provisions encouraging or requiring pharmacists to substitute generics on

reimbursed prescriptions whenever possible (30),

unless the physician states otherwise.

The pharmaceutical companies selling patented products in Canada claimed that costcontrol via compulsory licensing put an unfair

burden on the most innovative companies (90).

Although the ratio of Canadian R&D to sales

increased moderately from 3.6 percent in 1960 to

about 5 percent in 1980, manufacturers claimed

Canada was punishing innovation because it

lacked patent protection. In 1985, the United

States put additional pressure on Canada to

restore patent protection for drugs as part of

negotiations on free trade (244).

Canada responded in 1987 with Bill C-22, a

law that gives 7 or 10 years of conditional

protection from compulsory licensing after a drug

is approved for marketing in Canada.35 If a new

drug is invented in Canada, the protection lasts for

the full 20 years of the patent (309). In exchange

for this lengthened period of exclusive marketing,

the multinational companies publicly committed

35 M he ~ene-ic ~ulv~ent of a patented tig is produced in Canada, the period of market exclusivity extends 7 Years from tie tie o

f

approval. Generics imported into Canada must wait 10 years after approval (244).
254 I Pharmaceutical R&D: Costs, Risks and Rewards

themselves to increase the ratio of Canadian R&D

to Canadian sales to 10 percent by 1996 (244). 36

The new law also created an independent

quasi-judicial body, the Patented Medicines Pricing Review Board (PMPRB), whose main charge

is to ensure prices of patented medicines are not

excessive. The PMPRB does not set or approve

prices; it monitors manufacturers’ prices, evalu -

ates whether those prices are excessive, an d

negotiates with companies to lower prices when

they are considered too high. The Board has

authority across all the provinces; in its ow n

words, it is “investigator, prosecutor, and judge”

(309), with the power to remove the marke t

exclusivity of every patented drug .

The Board developed its own guidelines t o

determine what constitutes excessive pricing .

Patented medicines are broken down by the Board

into two categories: existing drugs and new drugs.

Existing drugs are those sold in Canada before

Bill C-22 was enacted and those whose introductory prices have been approved by the Board since

Bill C-22 was enacted. The PMPRB will assume

an existing drug’s price is excessive if its rate of

price inflation exceeds the cumulative change in

the Canadian consumer price index over the same

period .

To review the prices of new drugs entering the

market, the PMPRB categorizes them into three

subgroups, each with its own criteria for excessive pricing. Category (IL), known as line extension

drugs, includes product line extensions (such as

new dosage forms). Line extension prices are

judged excessive if the average price per kilogram

does not bear a reasonable relationship to that of

some other medicine or form of the same medicine with a comparable strength or dosage.

Category (ii), breakthrough drugs, are deemed to

have excessive prices if the price is greater than

both all other Canadian drug products in the

therapeutic class and the median price of the

medicine in seven selected industrialized nations.

Category (iii), “other” drugs, includes those that

provide little improvement over their predecessors. Their prices will be judged excessive if they

exceed the prices of other drugs in the same

therapeutic class (309).

The Board has strong remedial powers at its

command when a drug is found to have an

excessive price. Although these powers have not

been invoked since its inception, the PMPRB can

order a drug’s price lowered, or it can revoke the

market exclusivity on both the drug in question

and another of the manufacturer’s patented drugs

(the Board’s choice) by granting compulsory

licenses for the production of a generic equivalent

of the patented medicine.

Both the price review measures and the efforts

to stimulate R&D appear to have been successful

in moderating price increases so far. From January 1987 to December 1991, patented drug prices

increased at a rate of 2.9 percent annually,

compared with an annual increase of 4.7 percent

in the Canadian consumer price index.37 The

PMPRB reported that in its first 18 months of

operation, compliance with the pricing limits was

around 70 percent. Most of the cases where prices

were deemed excessive were resolved, with a few

exceptions where complicated circumstances delayed a solution. As of June 1992, the Board had

not reported any incidents in which a patent was

revoked in favor of compulsory licenses (31 1).

The Board also reported that in the “existing

drug” category, prices actually increased less

rapidly than general inflation (309,310,31 1).

The PMPRB also monitors R&D conducted in

Canada by firms selling drugs in Canada. The

Board reported that by 1991 the ratio of R&D

performed in Canada to sales in Canada had

increased to 9.7 percent, up from around 5 percent

in 1987 (311). Basic and applied research in36 ~~OmpfiSOm ~ 1989, sv,~~, ~~ united Kingd~~ ad tie ufit~ s~tes ~d domestic R&r) pr S&X ratios Of 21.8,20.9, ad 14.2

percent, respectively (71).

37 HOwever, tie 3+ 1 ~~entfitwe is forpatent~ rn~ic~es o~y. ~en~ c~~p~~eutic~s we includ~, the iUUIUtd rate of increase

in pharmaceutical prices becomes 5.1 percent (244),
.. . . .

Chapter 10-Trends in Payment for Prescription Drugs 255

creased by 20 and 22 percent, respectively, from

1990 to 1991 (PMPRB 1992).

In January 1992, Canada proposed a bill to

eliminate compulsory licensing as a punitive

measure to further promote industrial growth as

well as to maintain consistency with the draft text

of a General Agreement on Tariffs and Trade

released in December 1991.

Bill C-91, which was in the early stages of

consideration by the Canadian legislature in the

fall of 1992, proposes to amend the Patent Act to

eliminate compulsory licensing during the entire

course of a drug’s standard 20-year patent life.

The bill offsets the effects of this measure by

enhancing the role of the PMPRB with extended

judicial and punitive powers.

Under Bill C-91, PMPRB would have increased control over the introductory prices of

new drugs entering the market. In the case of

excessive pricing by manufacturers, the Board

could essentially force manufacturers to roll back

prices. If a manufacturer is found to be making a

regular practice of continually pricing pharmaceuticals excessively, all frees and penalties could

be doubled. Executives of pharmaceutical companies refusing to submit pricing and sales information or not willing to comply with the pricing

orders of the Board would be subject to imprisonment for up to 1 year under the bill.

PMPRB has the authority to examine the prices

of drugs being sold in all Canadian markets,

public and private. The extended protection from

compulsory licensing in Bill C-91 would essentially guarantee exclusivity for new drugs for a

substantial period of time within a regime that

monitors and, at least in principle, has the power

to regulate excessive pricing of pharmaceuticals

in all sectors of the market.

1 France

French Social Security Funds subsidize about

74 percent of the prescriptions filled in France

(381). When a French patient buys a drug, he or

she generally pays up front for the medicine and

then applies for reimbursement to the national

insurance fund that covers all but the required

patient copayments.

There are three different levels of reimbursement to the patient for different classes of drugs:

“mainstream drugs, ” prescribed for common

chronic and acute illnesses, are reimbursed at a

rate of 70 percent. Medications ‘intended for the

treatment of troubles and diseases usually not

serious’ ’38 are generally reimbursed at a rate of 40

percent (386). The third category, single-source

products for serious illnesses, is reimbursed at a

rate of 100 percent.

Despite the seemingly high copayment requirements, the French have very low unreimbursed

expenses. Numerous classes of people and chronic

treatments are exempted from copayments. About

80 percent of the population belongs to supplementary insurance funds, or mutuelles, which pay

for the bulk of the patient’s drug costs, leaving

only minimal copayments. Although 56 percent

of prescriptions in France required some copayment in 1991 (381), most were very low. Thus,

French consumers have little price sensitivity

(67,174).

France boasts the highest per capita pharmaceutical consumption by volume in Europe (67)

and the second highest per capita pharmaceutical

expenditures among Organization for Economic

Corporation and Development countries in 1990

(304). The high drug consumption rates at least

partially explain why the French Government has

found it necessary to regulate relatively strictly

the price of pharmaceuticals. In 1990, the prices

of medicines in France were the second lowest in

the European Community (304). The government

has focused its cost control measures on manufacturers’ prices of the drugs that national insurance

reimburses. 39 Although government efforts at

38 some ~mplti Me ~tfiusem[5, antipfitics, wei@t 10SS ~gs, antispasmodic, antivaricose drugs, hormonotherapy dlllgS, hlXlitiveS,

urological, and counter-irritants. There are a good number of other similar therapeutic categories included (386).

39 me ~tio~y reimb~sed pres~ptiom me up 80 percent of ~gs sold in France. About 11 percent are ac~~td for by hospitals,

which negotiate prices on their own. The remaining 9 percent are sold privately, without any price constraints (386).
256 I Pharmaceutical R&D: Costs, Risks and Rewards

price control have been described as “piecemeal’ and ‘fragmented’ (174), they have clearly

been successful in keeping drug prices comparatively low.

Any drug to be sold and reimbursed by national

health insurance must work its way through a

maze of French ministries and commissions

(174,386). To reach the French market, a manufacturer must see its drug through a three-step

process. First, the drug must win the French

equivalent of U.S. FDA approval. Second, the

drug must be approved for addition to the list of

reimbursable drugs. Third, it must go through

price negotiations to determine what the reimbursement price for the drug will be and whether

national insurance will pay 40, 70, or 100 percent

of this price when a patient receives the drug.

Through each of these steps, the drug is

evaluated for its efficacy, safety, and risk/benefit

ratio (406). The French equivalent of the U.S.

FDA reviews drugs for marketing approval. This

process is completed relatively quickly; the

government has 120 days to make a decision after

an application for marketing authorization is

filed, with a 90-day extension available (406).

Once a drug gains marketing authorization, the

manufacturer seeks the approval of the Transparency Commission, which decides whether to

admit the drug onto a list of drugs approved for

reimbursement by the national insurance funds.

Although a drug can be prescribed without

approval of the Transparency Commission, physicians rarely do so (406). The Transparency

Commission is empowered to compare the drug’s

cost with that of alternative existing treatments.

The Transparency Commission tries to keep the

market clear of too many ‘‘me-too’ drugs offering no real medical or economic advance (386).

Once a product is admitted to the list of drugs

approved for reimbursement, its manufacturers

must again document its benefits for a Pricing

Committee, which negotiates both the price of the

drug and its level of reimbursement (40, 70, or

100 percent). The Committee, made up of representatives from the Directorate of Pharmacy and

Drugs, and the Ministries of Social Security,

Industry, and Competition, enters into a two-step

evaluation process. First, a “technical price” is

set based on the effectiveness and economic

efficiency of the drug. This price is set in relation

to reimbursement rates for therapeutically similar

drugs. “Me-too” drugs for which therapeutic

equivalents are already on the market cannot

receive a technical price higher than 90 percent of

the price of existing therapeutic equivalents.40 For

breakthrough drugs with no close competitors,

the price of the drug is compared with prices paid

in other countries.

Second, the technical price is adjusted to an

‘‘economic price, ’ the ultimate selling price. A

bonus is added if the raw materials used to make

the drug were produced domestically. Similar

additions are awarded if the drug provides a

positive French trade balance or creates French

jobs. Finally, if the drug is a result of French

research efforts, it may also receive price increases. Because these kinds of national incentives are banned under the European Commission’s Transparency Directive, they no longer

officially exist.

The price increases available in the Committee’s adjustment of the technical price to the

economic price are incentives to promote an

active French pharmaceutical industry. But the

magnitude of such incentives may not be great

enough to spur research, especially when there are

countries nearby that offer greater financial re40 ~S ~]e ~So h~ldS for ge~[~ric quiv~ents of drugs &eady~keted.M~ufaC@rshave ach,dy USed t.hi!l % percent bit tO S1OW b

penetration of the French market by generics. When a brand-name manufacturer gets wind of a generic drug being developed for introduction

into France, the manufacturer can quickly release a generic equivalent of its own. Multiple generic equivalents may be released by different

subsidiaries of the company. With each generic accepted into the marke~ the price awarded decreases by another 10 percent. These generic

copies are not marketed, but they ensure a competitor’s generic entering the market will be granted a very low price, possibly not worth the

trouble of importing or distributing. Lmw-priced generics may also be boycotted by pharmacists, whose profit margin is figured as a percentage

of the drug’s cost (174).
Chapter 10–Trends in Payment for Prescription Drugs ! 257

wards for R&D conducted within their borders.

Between 1961 and 1970, France had the second

highest rate of discovery of new chemical entities

in the world; by 1981, France had slipped into

fifth place (174). Although it is not at all clear

what caused this decline, the French pharmaceutical industry blames the drop on 30 years of strict

governmental price controls (174).

1 Japan

To be sold on the Japanese market, a drug must

be approved by the Japanese Pharmaceutical

Affairs Bureau (PAB), an equivalent of the U.S.

FDA. Once the PAB approves a drug, the

Japanese Health Insurance Bureau (HIB), a

branch of Japan’s Ministry of Health and Welfare

(MI-W), must consider whether or not to add the

drug to a national list of drugs that may be

prescribed by Japanese doctors. Since the 1980s,

the HIB has updated this list quarterly. Once a

drug is admitted to the list, the HIB settles on the

price that will be paid when the drug is prescribed. 41 Virtually the entire Japanese population is covered by some form of health insurance

that adopts the HIB reimbursement rates, so these

rates are applied to almost every prescription

written throughout the country.

‘‘Me-too drugs entering the market are generally granted a price similar to those already held

by therapeutic equivalents, although there has

been no explicit policy to mandate or formalize

this procedure (527). “Me-too’ drugs in Japan

include generics as well as drugs chemically

different from ones already on the market but not

considered medical advances.

Drugs without any therapeutic equivalent or

chemical predecessor (known in Japan as ‘‘shining new drugs’ are evaluated for their therapeutic usefulness and priced accordingly: drugs

already on the market that are viewed as equally

innovative may be used as guidelines for setting

the reimbursement rate.

All changes in reimbursement rates go through

the HIB, which revises them once every 2 years.

Pharmaceutical companies that want to participate in Japan’s $35-billion domestic drug market

must accept the HIB reimbursement rate as the

final price their product will fetch when a doctor

prescribes it.

Despite their virtually universal control over

prescription reimbursement rates, the Japanese

ranked first and second in per-capita pharmaceutical spending in 1987 and 1988, respectively

(139,361). This spending seems odd because

Japanese drug prices were drastically cut by a

total of 52 percent from 1981 to 1990. To explain

such high pharmaceutical expenditures in the face

of the price cuts of the 1980s, one must look at

how drugs are delivered in Japan.

Most drugs are dispensed to patients directly

by the physicians who prescribe them. In fact,

only 10 percent (by value) of drugs in Japan were

sold by independent pharmacists in 1985; the rest

were purchased from independent doctors or

hospital pharmacies.

42 Most drugs are sold by

manufacturers to hospitals and clinics (139,163,344),

usually through wholesalers, at a discount off the

rate set by the HIB; wholesalers receive similar

discounts from the manufacturers.43 Therefore,

when the doctor or hospital pharmacy is reimbursed for dispensing a drug at the HIB rate, he or

she (or the hospital) makes a profit. Discounts

vary widely but typically run from 10 to 30

41 ~wmR~ener~ypays ~~wnTO ad 100” Perwnt of ~s ~te; tie patient ties up my &fference. I-lU3 reimbursement decisions me

guided by policies drafted by the Chu-Ikyo, or Central Sociat Insurance Medical Council, an independent governmental advisory board.

42 Doctors me fo~d tiyfi ~ee set~gs ~ Jap~. fivate p~ctices ~ by ~dependent doctors me knowrl as clirlics ~ IOng as alley hWe

20 or fewer beds. Private hospitals have more than 30 beds, but are also owned and managed by the doctors who work at tie facility. The

remaining doctors work in hospitals run by universities or the government. Hospitat-based physicians are salaried, while independent doctors

are reimbursed on a fee-for-service basis, with fees determined by the government (163).

43 wholes~ers formaly were Mowed to set heir sell~g prices ~ collaboration wi~ ~ufac~ers, in exckge for price ~~teeS fTOm

the manufacturers. This allowd wholesalers to adequately gauge what discount they could offer hospitals and doctors without risking

discounting at rates higher than the manufacturers’ rebates. However, the Japanese Fair Trade Commission has ruled wholesalers can no longer

enter into these collaborative agreements with the manufacturers, and must set their prices independently.
258 I Pharmaceutical R&D: Costs, Risks and Rewards

percent of the reimbursement rate. In certain

therapeutic categories, such as antibiotics where

product competition is relatively strong, discounts have traditionally run even deeper.

In a medical system where the reimbursement

rate is set above the actual cost of drugs while

reimbursement rates for physicians’ services,

which are also set by the MHW, are set below cost

(344), doctors and hospitals have depended on the

sale of pharmaceuticals to make money. Profits

from drug sales made up about 37 percent of the

independent doctor’s wages in 1987 (344). Since

the Japanese health system offers few additional

subsidies (outside the doctor’s salaries or fees) to

help clinics and private hospitals purchase equipment or maintain facilities, the sale of pharmaceuticals has become a primary source of revenue to

ensure the normal functioning of nongovernmental medical facilities. With no formal method to

keep track of physicians’ prescription habits,44

the incentive is strong for doctors to prescribe

unnecessary and excessive medications (139,

163,344).

The Japanese Government has struggled to

combat physician-income subsidization by high

drug price margins. Although the government has

shown some support for “bungyo,” the separation of drug prescribing from dispensing duties,

most cost reduction measures have used pricing

policies to try to erode or eliminate the industry’s

ability to grant discounts to doctors. The drastic

reimbursement rate reductions that took place in

the 1980s were enacted partially for this purpose.

Products with the largest discounts had their

prices cut the most. Ostensibly, these cuts would

reduce the reimbursement rate of heavily discounted products to the point where manufacturers would no longer be willing to undercut the

HIB price to grant doctors their margins. Despite

these strong efforts, discounts were still reported

as prevalent in 1991, with many pharmaceutical

companies granting doctors margins of 20 percent

or higher (163).

Just as doctors have seized upon the sale of

discounted drugs as a way to gain some control

over their own incomes, so too have pharmaceutical companies. In a market where manufacturers

have little control over the reimbursement rate,

discounts to physicians have become an important tool in the competition to get one’s product

to those who prescribe drugs. Since drugs with

higher profit margins are often more heavily

favored by doctors, the ability to offer a large

discount remains a significant factor in determining use. Although the discounts may have diminished somewhat in magnitude, drug companies

continue to view discounts as apart of the normal

cost of doing business.

A new landmark pricing policy took effect in

April 1992 to limit doctors’ discounts. Rather

than trying to eliminate pricing discounts and the

overuse of drugs that may accompany them, the

regulations aim to reduce the discounts to a

‘‘reasonable level. This level, known in Japan as

the “R-zone,” would be effectively equal to 15

percent of the HIB price. When reimbursement

rates are reviewed every 2 years, an average

wholesale price of the drug over the past 2 years

is calculated by dividing total sales for the drug by

the number of units sold. The new reimbursement

rate will be calculated by adding this AWP to 15

percent of the previous HIB rate for the drug.45

This means that drug prices can be discounted at

an average of 15 percent of the reimbursement

u The Japanese Governrnenl has tict access to detailed information regarding each doctor’s prescribing history. Doctors must fide claim

forms describing exactly what dosage of what drugs were prescribed in order to receive reimbursement for medications provided to patients.

However, the government does not frequently review or rebuke doctors for their prescription habits or overuse of drugs. According to one

observer (527), only about a half dozen doctors in Japan are censured each year because of their drug prescribing habits.

45 Here is ~ Cxmple of hov~ t.hi5 wor~o A drug has a current reimbursement rate of 100 Yen. However, the Aw of the ~t3 is so Yew

leaving a 2@yen margin for the doctors. When the lm.1 recalculates the new rate for this drug, it adds the A~ (80 yen) to 15 percent of the

old HIB price (or 15 percent of 100 yen=15 yen), giving a new HIB rate of 80+15 or 95 yen.

Now suppose the AWP for the drug is 90 yen. The new rate would be the AWP, 90 yen, plus 15 percent of 100 yen, or 105 yen. The policy

requires that the new HIB rate cannot be higher than the old HIB rate; thus in this instance, the new rate would remain at 100 yem
Chapter 10-Trends in Payment for Prescription Drugs 259

rate without suffering further price reductions

(417). If a manufacturer discounts less than 15

percent on average, the revised HIB rate will

remain the same.

The HIB plans to gradually reduce the R-zone

rate from 15 to 13, 11, and 10 percent over the

next 6 years (319). The gradual reduction of the

R-zone is intended to ease companies into a

system in which doctors’ margins are reduced to

a certain (arbitrary) level.

The plan will probably benefit newer products

that have relatively little history of discounting;

older products, which tend to be more heavily

discounted to compete with newer drugs, will

probably suffer as they are either forced to reduce

the amounts of their discounts or to have their

prices continually lowered until it is no longer

profitable for the manufacturer to market them. It

is not clear how this change will affect prescribing

habits or overall pharmaceutical spending (345).

It is possible that reduced profit margins could

lead to even more excessive drug dispensation as

doctors try to compensate for income no longer

received from larger discounts.

There are also stipulations in the new scheme

that extend beyond the reduction of doctors’

margins and overall costs. These rules establish a

consistent policy for increasing the reimbursement rates of so-called innovative or ‘ ‘shining

new drugs’ which are defined by the MHW as

new chemical entities that are therapeutically as

well as chemically innovative (2). In the rate

revisions of “shining new drugs, ” a 20 percent

R-zone will be added to the AWP instead of the

normal 15 percent. This percentage will not

decrease over time, so by 1998 innovative drugs

will be granted an R-zone rate twice that of

generic and “me-too” drugs that show no improvement in side effects or effectiveness.

Orphan drugs and “me-too’ drugs demonstrating an improvement in efficacy or side effects

over their predecessors and deemed “relatively

useful’ will be given prices 3 percent above the

normal rate. With competition through discounting as strong as it is, these additional rate

increases translate into a significant advantage for

the “shining new” new chemical entities entering the Japanese market. The pricing policies

encourage R&D in Japan. Although innovative

new chemical entities were often spared to some

degree in the price cuts of the 1980s, the new

approach marks the first definitive policy to

extend benefits to these products (345).

It appears the main objective of Japanese

pro-innovation policy is health-related: to increase treatments for the diseases that the growing

elderly population will face in increasing numbers. The development of the Japanese pharmaceutical industry is a secondary goal.46 A proposed measure increasing the R-zone for Japaneseoriginated drugs was dropped, apparently to

facilitate the import of significant new drugs from

other countries (417). However, some Japanese

policymakers and industry representatives believe the new directives will indeed foster a strong

Japanese industry steeped in innovative R&D

(319).

H United Kingdom

In the United Kingdom, the government controls the cost of pharmaceuticals not by limiting

individual product prices, but by setting a cap on

the profit that individual pharmaceutical companies can enjoy from their business with the

National Health Service. Each company negotiates with the Secretariat of Pharmaceutical Price

Regulation Scheme (PPRS) a total rate of return

on the capital employed in generating its sales to

the British National Health Service (NHS).

46 H1~tOn~allY, ~~ Ja~~esc ~bceutical fid~stry was not very active ~ developtig tigs for tie world market. ht~d, Japanese dlllg

fm grew mostly by serving a domestic market with generally high reimbursement rates for pharmaceuticals (508) and by the relative ease

of government approval for marketing of domestically produced drugs (139,212). Between 1960 and 1980, only 10 Japanese drugs were

approved as new chemical entities by the U.S. FDA (180). Only three ‘breakthrough” drugs developed in Japan between 1960 and 1990 were

licensed for marketing in the United States (180). Finally, out of 1,234 globally marketed new chemical entities developed between 1940 and

1977,46 (3.7 percent) were produced in Japan (332).
260 I Pharmaceutical R&D: Costs, Risks and Rewards

The PPRS is a nonstatutory arrangement in

which confidential profit negotiations are held

between individual companies and the PPRS

Secretariat on behalf of the Ministry of Health.

This plan, which has existed in various forms

since 1957, was designed for two purposes: 1) to

“ensure that safe and effective medicines are

available to the NHS on reasonable terms’ and 2)

to ‘‘ensure that the Department of Health and

Social Security acts as a sponsor for the drug

companies’ to maintain the industry as one of the

United Kingdom’s healthiest and most profitable

(84).

The U.K. pharmaceutical industry is the fourth

largest exporter of drugs in the world and the third

leading export industry in the United Kingdom

(22). How much of this success is due to the PPRS

is a matter of conjecture, but the results are at least

consistent with the second goal of the scheme.

Whether British drug prices have been controlled

by the system is also unclear. The Association of

the British Pharmaceutical Industry reports that

the U.K. retail price index increased by 29 percent

between 1984 and 1989, while the pharmaceutical price index increased by only 22 percent.

However, the Economist reported that drug prices

outpaced the national inflation rate by more than

4 percent for the same time period (1 17).

All pharmaceutical companies with NHS brandname drug sales over £500,000 are included in the

Scheme, but only firms with sales over £4 million

must submit financial records for a yearly assessment of their allowable profit rates (44). These 65

or so companies provide audited annual financial

reports that document their total sales to the NHS

including expenses for manufacturing, distribution, promotion, and R&D associated with those

sales, and the capital employed in generating the

NHS sales. At most, 9 percent of a company’s

total NHS sales may be claimed for promotional

expenses, but an additional allowance is made for

informational activities (386). The PPRS attempts to pay for its share of R&D by allowing

firms to apply their worldwide ratio of R&D

expenses to sales to their sales in the United

Kingdom.47

An annual rate of return as a percent of capital

employed is compared with the actual sales of

brand-name drugs to the NHS. If revenues do not

exceed cost plus an allowed profit rate, the firm’s

prices are deemed acceptable to NHS.

The procedure is different for multinational

companies with scarcely more than an importing

or marketing subsidiary in the United Kingdom.

The PPRS attempts to apply the same standards to

these companies; however, much of the information regarding a multinational company’s expenses would not be applicable to the United

Kingdom, so an allowed rate of return on sales is

used instead of a return on capital employed

(44,84).

The allowed profit rate has generally hovered

between 17 and 21 percent of the allowed capital

employed (386), though this range is by no means

freed. If a company exceeds the profit margin

assigned by PPRS, it may attempt to justify the

excess profits. Additional profits of up to 50

percent of the original rate can be awarded for

expenses directed to innovation, new drug launches,

improved drug efficiency, significant investment

in the U.K. industry, and increased exports from

the United Kingdom (44,84). Companies may

attempt to justify profit rates outside of the limits

on one or all of these grounds; they may also

apply for future profit rate increases based on

these criteria. These potential increases in profit

rates are generally known as the ‘‘Grey Zone’ of

PPRS pricing. The final allowed profit remains

confidential.

Both critics and proponents of the Scheme

claim the PPRS provides many other opportunities for increased profits (84,1 17,174). The fact

that the government must rely completely on the

pharmaceutical company’s own information on

capital employed allows the industry a great deal

of latitude (174). For example, in the past, many

companies mutually agreed to sell each other

ingredients at artificially high prices to make it

47 ~ ~ddltioq my ~ves~ents in R&D facilities md equipment in the United Kingdom are added tO tie es-ted ~piM em@oY~.
Chapter 10-Trends in Payment for Prescription Drugs I 261

appear as though manufacturing costs were much

higher than they actually were (84). Although

some observers have suggested the close ties

between industry and government have made for

a fairly open relationship between the two (84),

others believe the PPRS has no real power to

question or investigate the claims of the drug

companies (1 17,174).

The profit targets that the PPRS approves may

become more difficult to attain in a market

currently experiencing increased price competition with parallel imports and generic equivalents. A parallel import a brand-name drug

purchased by a middleman in a country where the

price is relatively cheap and then is imported to

other countries (possibly including the country of

manufacture) where the drug’s price is normally

higher. The middleman sells the drug at a profit

but undercuts the higher price. This practice is

legal in Europe and is actually endorsed by the

European Community. It is also growing in

prevalence in Europe due to both wide variations

in individual drug prices from country to country

and the geographical proximity of the various

markets (67). The United Kingdom is one of the

largest targets for parallel imports, which currently hold about 8 percent of the British market

(377). In addition, statistics for generics show

they account for about 30 percent of British

prescriptions and 9 percent of total sales (295).

Some experts claim the PPRS is responsible for

the relatively successful containment of drug

spending in the United Kingdom (17,376a). Low

per capita spending (especially compared with

countries such as Belgium, France, Germany,

Italy, and the United States) is cited as an

indicator that the PPRS is effectively managing

pharmaceutical costs in the United Kingdom

(304). However, data collected by Burstall indicate much of the cost reduction realized in the

United Kingdom is due to the control of prescription volume, not prices (67). The per-person cost

of drugs in the United Kingdom is the fifth

highest in the European Community, 18 percent

above the European Community average, and 170

percent higher than in France. Conversely, the

consumption of drugs in the United Kingdom is

quite low: two-thirds of the average European

Community rate and one-third of the rate in

France.

Because drugs bought through the NHS are

paid for almost completely by the British Government, there has been almost no consumer-driven

price competition in the U.K. market. Although

there is a £3.75 copayment on each prescription a

patient purchases through the NHS, so many

classes of people are exempted from this charge

that almost 80 percent of NHS ambulatory care

prescriptions have this fee waived. Many of the

poor in England are exempted from copayments;

however, there is no formal method in existence

to ascertain a patient’s level of income. Tax

records are confidential, and doctors have reportedly been unwilling to question patients on this

matter (149). Thus, in practice, hardly anyone

pays the prescription copayment. With no serious

consumer interest in low market prices, pharmaceutical companies generally charge the NHS at

least up to the limit of their allowed profits,

assuring companies of the returns the PPRS has

determined are acceptable (174).

Recently, new measures to influence prescribing and dispensing habits have been adopted as

supplements to the PPRS. In 1988, the Department of Health formulated a list of drugs in

therapeutic categories for which there are cheaper

and/or more effective treatments. The NHS no

longer pays for many of the most expensive

brands. The therapeutic categories include antacids, cough and cold preparations, laxatives, vitamins, tranquilizers, sedatives, and analgesics.

This effort may have saved as much as £70

million (117).

A more significant move was the exemption in

1985 of generics from the PPRS profit limits.

Manufacturers were encouraged to promote generic drugs, since profits made from generics

would no longer count toward a manufacturer’s

profit limit. To stimulate the prescription of

generics by British practitioners, beginning in

1989 the NHS assigned each doctor an “indicative drug account’ that monitors the cost of drugs
262 I Pharmaceutical R&D: Costs, Risks and Rewards

he or she prescribes. A suggested per capita limit

is a guideline for further action. Doctors who

surpass their limit must defend their practices to

a locally employed medical advisor to the Family

Health Service Authority. If the case is not

resolved, the doctor must appear in front of a

specially convened three-person council. Physicians who consistently exceed the limit without

justification are penalized48 (117). Doctors may

begin to favor cheaper generic alternatives if they

believe the penalties (or the inconvenience of

justifying overspending) are worth avoiding.

Although it is too early to judge how effective this

plan will be in the long run, the aggressiveness

with which per capita spending is monitored will

probably determine the success of this initiative

in reducing the cost of prescribed drugs.

The current version of the PPRS policy expired

in October 1992. In late October 1992, negotiations were underway between the National Health

Service and the Association of the British Pharmaceutical Industry to reformulate and reauthorize the PPRS. It is expected that the PPRS will be

reauthorized without any major structural changes

(45). However, the future direction of the program

is still unclear in light of potential changes

occurring in the European Community with the

advent of Europe 1992 (377).

CONCLUSIONS

In the United States insurance coverage for

prescription drugs broadened over the 1980s, with

almost three-quarters of the U.S. population

having some private or public insurance coverage

for prescription drugs.49 These benefits have

improved substantially in quality throughout the

1980s, as plans requiring a flat copayment for

drugs replaced plans covering drugs only after a

deductible amount has been spent. Today, roughly

30 percent of people with private prescription

drug insurance plans have freed copayments,

compared with 9 percent in 1977.

The improvement in insurance coverage for

prescription drugs in the United States has led to

attempts to control prescription drug costs

through a variety of mechanisms. Different kinds

of payers have different avenues open for cost

control. These mechanisms, which include incentives to use cheaper generic drugs as well as

attempts to control utilization directly through

formularies, are most common in hospitals, HMOs

and the Medicaid program. Traditional private

health insurance plans have also used incentives

for generic drug prescribing, but they have little

power to restrict the availability of FDAapproved drugs and generally must pay their

share of the manufacturer’s price for singlesource drugs.

The most effective cost-control mechanisms

are available to those private-sector plans that can

control prescribing through formularies. Hospitals and staff-model HMOs have used this power

to exact price discounts from manufacturers even

when the manufacturers are single-source producers of a specific compound. Some HMOs not only

have a measure of control over drug prescribing

through formularies, but they also can encourage

price competition by encouraging (or even requiring) physicians to consider costs as well as

effectiveness in the prescribing decision.

The power of certain classes of purchasers to

exact discounts was recognized by the framers of

the 1990 Medicaid Rebate Law, which attempts

to piggyback on the negotiating power of HMOs

and large hospital groups to obtain the same

discounts for Medicaid. The strategy may have

backfired, however, because manufacturers become unwilling to give discounts to HMOs if, by

so doing, they stand to lose the amount of the

discount on 10 to 15 percent of the total market for

48 pe~ties my tie the form of fines, or the doctor maybe asked to reduce his or her list of patients in order to reduce NHS expenses bi~~

to that doctor.

49 SW, rou~y 16 ~~on ~{lple 65 Yas of age ad Older ad 53 million people ~der 65 y= of age hck any inSU.IWKX for prescription

drugs (see table 10-2). For these people, many of whom have chronic illnesses, prescriptions drug expenditures can be a severe economic

burden. Several pharmaceutical companies have recently announced programs in which certain expensive drugs will be made available without

charge to people unable to pay for them (296,327,458).
.—

Chapter 10-Trends in Payment for Prescription Drugs 263

outpatient prescription drugs. A coalition of large

pharmaceutical purchasing groups recently called

for the repeal of ‘best price’ provisions because

of the elimination of such discounts after the

Medicaid rebate law went into effect (381a).

Trends in U.S. health insurance in the past

decade have, on balance, provided an increasing

potential market for prescription drugs, through

more and richer third-party coverage, with modest downward pressure on the demand for such

drugs or the price payers are willing to pay. The

most comprehensive approach to prescription

drug cost containment among third-party payers

has been to encourage generic price competition

for multiple-source drugs. Even there, the physician override provisions in both private and

public insurance plans appear to have limited the

loss of market share for originators. (See chapter

4 for recent trends in market shares for multiplesource, brand-name drugs.)

Under the universal health insurance found in

other industrialized nations, the demand for drugs

is not much affected by the price charged.

Nevertheless, the utilization of specific drugs and

the prices paid tend to be more strictly controlled

by the insurers. To a greater or lesser extent, drug

payment policy in other countries is governed by

two potentially conflicting objectives: minimization of prescription drug costs and encouragement

of the domestic pharmaceutical industry. National prescription drug payment policies are a

blend of these objectives.

In the United States, there is no single coherent

drug payment policy. To the extent costcontainment efforts exist, they are applied without regard to the country of manufacture or origin

of a drug. Abroad, drug payment policy is

generally developed with the two purposes mentioned above in mind.

Virtually all of the five foreign countries that

OTA reviewed-Australia, Canada, France, Japan,

and the United Kingdom-use some mechanism

for controlling the price of single-source drugs as

well as multiple-source drugs. Four of the five

nations do so directly by setting payment rates for

new drugs on the basis of the cost of existing

therapeutic alternatives. The pricing policies in

these countries do reward “breakthrough” drugs

at a higher rate than ‘me-too’ drugs, though they

accomplish this result in different ways. The

resulting prices of breakthrough drugs may still

be low compared with those in the United States.
Appendix A

T

his assessment grew out of the continuing

political debate over rising pharmaceutical

prices in the United States. The House

Committee on Energy and Commerce and

its Subcommittee on Health and Environment requested in 1988 that the Office of Technology

Assessment (OTA) provide an independent estimate of

the “average” cost of bringing a new drug to market,

in response to industry claims that the estimated cost

of bringing a new drug to market was $125 million.

The request was later endorsed by the Subcommittee

on Antitrust and Monopolies of the Senate Committee

on the Judiciary.

In preparing for a project proposal to OTA’s

Technology Assessment Board, OTA management

concluded that focusing on research and development

(R&D) costs alone would be too narrow and that these

costs should be studied in the context of the financial

returns that investors receive from pharmaceutical

R&D. OTA also concluded that the study should

examine how Federal policies affect both the costs of

and returns on R&D. OTA submitted a proposal to the

Technology Assessment Board in June 1989, which

the Board approved for initiation in September 1989.

(The project was not fully staffed until January 1990.)

The project had four components:

Analysis of the cost of discovering and developing a new drug;

Analysis of the financial returns on drug discovery and development;

Analysis of financial returns in the researchintensive ethical pharmaceutical industry as a

whole; and

Review of the effect of external factors on costs

and returns on pharmaceutical R&D, including

new drug regulation, tax policy, product liability

law, direct R&D subsidies by the National

Institutes of Health (NIH) and other government

research bodies, and reimbursement policies

(both private and public) for prescription drugs.

Method of Study

~ Advisory Panel

Every major OTA assessment is advised by a panel

of outside experts and representatives of relevant

interest groups. The role of the Advisory Panel is to

provide guidance in project planning and review of

OTA’s findings. The panel is not responsible for the

final contents of an OTA assessment. OTA chose a

16-member Advisory panel comprising industrial

pharmaceutical R&D managers, pharmaceutical industry executives, consumer advocates, physicians,

accountants, economists and lawyers. Frederick M.

Scherer, Professor of Economics at the John F.

Kennedy School of Government at Harvard University

served as panel chair. The Panel convened twice during

the project, once early in 1990 to give advice about

research priorities and directions for the project, and

again in May 1991 to review a preliminary draft of the

study. Six members of the Panel also participated in a

workshop (discussed below), and the Panel was

involved in every round of project review throughout

the course of the study.

I Site Visits

Early in the project, OTA visited eight pharmaceutical companies (listed in table A-1) to interview

senior-level corporate and R&D managers about the

R&D process and the economics of pharmaceutical

R&D. These interviews were extremely useful in

providing a qualitative appreciation for the complexity

and cost of pharmaceutical R&D as well as an

understanding of how companies track their R&D

costs in internal management cost accounting systems.

The meetings were not intended to, nor did they,

produce actual cost data on new drug development.

I Workshop on the Economics of

Pharmaceutical R&D

To explore relevant economic methods and data,

OTA engaged in intramural research and also contracted for several papers that were presented at a

workshop held in September 1990 at the University of

265
266 I Pharmaceutical R&D: Costs, Risks and Rewards

Table A-l-Sites and Dates of OTA Visits to

Selected Pharmaceutical Companies

Cetus Corporation

Emeryville, CA

July 19, 1990

Genentech, Inc.

San Francisco, CA

July 18, 1990

Eli Lilly and Company

Indianapolis, IN

April 17 and 18, 1990

Merck & Company

Rahway, NJ

June 19 and 20, 1990

Schering-Plough Corporation

Madison, NJ

February 12, 1990

SmithKline Beecham Corporation

Philadelphia, PA

June 15, 1990

Syntex Corporation

Palo Alto, CA

July 17, 1990

The Upjohn Company

Kalamazoo , M l

April 19, 1990

California, Santa Barbara. Workshop participants included paper authors, six members of the Advisory

Panel with economic or financial expertise, and a small

number of outside experts who reviewed and critiqued

the papers for revision. (See table A-2 for a list of

workshop attendees.) This review greatly enhanced the

quality and clarity of the contract papers, some of

which became essential pieces of the R&D assessment.

H Review and Revision of Profitability

Study

One contract paper, a comparative study of profitability of firms in the pharmaceutical industry with

firms in other industries, utilized new methods for

analyzing publicly available accounting data to infer

economic profits. This study generated a great deal of

discussion and critique at the workshop. Because of the

potential policy importance of the subject matter and

the technical nature of the methods and critiques, OTA

initiated a thorough process of revision and review in

collaboration with the contractors, William Baber

(George Washington University) and Sok Hyon Kang

(Carnegie Mellon University).

Baber and Kang submitted a second draft of their

contract report to OTA in January 1991, based on the

criticisms raised at the ‘workshop. OTA contracted

with two of the country’s foremost experts on profit

measurement, Franklin Fisher (Massachusetts Institute

of Technology) and Gerald Salamon (Indiana University), as well as the panel chairman, to provide a

thorough review and critique of the second draft. These

two reviews formed the basis for a third revised draft

of the profit study in March 1991, which was then

submitted for further review not only to the Advisory

Panel but also to Professors Fisher and Salamon and a

small number of outside economists who specialize in

the pharmaceutical industry.

One outside economist who specializes in the

pharmaceutical industry submitted a detailed critique

of the third draft of the profit study in July 1991. OTA

asked Baber and Kang to reply to the critique. The

entire file of comments and replies was then sent back

to the two contract reviewers and the panel chair for a

final review. These reviews convinced OTA that the

methods employed by Baber and Kang to measure

profitability in the industry are sound and represent an

important advance over previous methods. OTA compiled the entire history of review for the profit study

into a single document that is available upon request to

interested parties.

i Other Research Activities

In addition to contracting for research on the

pharmaceutical R&D process, OTA sought out other

sources of data bearing on costs of R&D and returns to

the industry from these activities. Data availability was

a major problem, particularly data on domestic and

worldwide sales of new drugs introduced to the U.S.

market during specific time intervals. OTA was able to

purchase limited data on domestic sales from IMS

America, Inc., a market research firm specializing in

surveys of pharmaceutical purchases and prescriptions, but was required to rely mainly on a sales data

analysis conducted for other purposes by the Food and

DrugA d ministration. OTA was also able to contract

with Stephen Schondelmeyer of Purdue University to

provide a report on pharmaceutical sales for drugs that

have recently lost patent protection based on IMS

America data.

OTA was never able to gain access to IMS data on

worldwide sales. IMS International, Inc., quoted OTA

a price of over $100,000 for specific data on the ratio

of worldwide sales to domestic sales for drugs

introduced to the market between 1981 and 1983. OTA

used what data were available from existing literature

and the sources available to us to conduct an independent analysis of returns on R&D.

OTA was assisted throughout the course of the study

by contract papers on specific research issues and

topics. Table A-3 contains a list of the major contract

papers prepared under the assessment. Papers marked

with an asterisk were presented and reviewed at the

September 1990 Santa Barbara workshop. Other

contract reports were reviewed as appropriate by

outside experts and panel members.
Appendix A—Method of Study 267

Table A-2—Participants in the OTA Workshop on the Economics of Pharmaceutical R&D,

Santa Barbara, California, September 1990

Rosanne Altshulera

Assistant Professor of Economics

Rutgers University

New Brunswick, NJ

William R. Baberb

Associate Professor

George Washington University

Washington, DC

William S. Comanor

Professor Economics

University of California

Santa Barbara CA

Paul Coppinger

Deputy Associate Commissioner for

Planning and Evaluation

Food and Drug Administration

Rockville, MD

Richard Frank

Associate Professor of Health Policy

and Management

Johns Hopkins University

Baltimore, MD

Ronald W. Hansen

Associate Dean for Academic Affairs

University of Rochester

Rochester, NY

Sok-Hyon Kang

Assistant Professor of Industrial

Administration

Carnegie Mellon University

Pittsburgh, PA

Judy C. Lewent

Chief Financial Officer

Merck & Co. Inc.

Whitehouse Station, NJ

Albert Link

Professor of Economics

University of North Carolina

Greensboro, NC

Robert B. Helms, Workshop Chair

Resident Scholar

American Enterprise Institute

Washington, DC

Alison Masson Keithc

Assistant Director for Economic Analysis

Pfizer, Inc.

New York, NY 10017

David Salkever

Professor of Economics

Johns Hopkins University

Baltimore, MD

Frederick M. Scherer

Professor of Economics

Harvard University

Cambridge, MA

Stuart O. Schweitzer

Professor and Chair, Department

of Health Services

University of California

Los Angeles, CA

Jacob Stucki

Vice President for Pharmaceutical

Research (retired)

The Upjohn Company

Kalamazoo, Ml 49008

Lakshmi Shyam-Sunder

Assistant Professor of Business

Administration

Dartmouth College

Hanover, NH

Shyam Sunder

Professor of Accounting

Carnegie-Mellon University

Pittsburgh, PA

Steven N. Wiggins

Texas A & M University

College Station, TX

a Dr. Altshuler was with Columbia University at the time of the workshop.

b Dr. Ba~r WaS with Georgetown University at the time of the workshop.

C Dr. Keith WX with the F~eral Tra& Commission at the time of the workshop.
268 I Pharmaceutical R&D: Costs, Risks and Rewards

Table A-3-Major Contract Papers Prepared for the Pharmaceutical R&D: Costs, Risks and Rewards Project

●

●

●

●

●

Roseanne Altshuler, Ph. D., Rutgers University, New Brunswick, New Jersey and Henrl Chaoul, Ph. D., Columbia University,

New York, New York. The Effect of T= Po/icy on Returns to R&Din the Pharmaceutical Industry: A Methodo/ogica/ Review,

November 1990.

Wllllam R. Baber, Ph. D., IC.P.A., George Washington University, Washington, DC and Sok-Hyon Kang, Ph. D., CarnegieMellon University, Pittsburgh, Pennsylvania. Accounting-Based Measure as Estimates of Economic Rates of Return: An

Empirical Study of the U.S. Pharmaceutical/ Industry 1976-87, March 1991.

Will lam R. Baber, Ph. D., IC.P.A., George Washington University, Washington, DC, Ronald Ross, Ph. D., and J. Raymond

Apple, M. B.A., Georgetown University, Washington, DC. Research and Development Accounting /ssues With Specific

Reference to the U.S. Pharmaceutica// ndustry, December 1990.

Lester W. Chadwick, C. P.A., Ph. D., University of Delaware, Newark, Delaware. Pharmaceutical/ R&D Study, Accounting for

R&D.

Robert Mullan Cook-Deegan, M. D., Consultant, Rockville, Maryland, Trends in Sciences, Technology, and Drug Discovery,

(incorporated in edited form as chapter 5 of the final report) October 1991.

W. Gary Flamm, Ph. D., F. A.C.T., and Michael Farrow, Ph. D., SRS International, Inc., Washington, DC. Recent Trends in the

Use and Cost of Anima/s in the Pharmaceutkx/ /ndustry, April 1991.

Richard G. Frank, Ph. D., and David S. Salkever, Ph.D, Johns Hopkins University, Baltimore, Maryland. Pnch?g, Patent Loss

and the Market for Pharmaceuticals, December 1990.

Alan M. Garber, Ph. D., M. D., Palo Alto Department of Veterans Affairs Medical Center and Stanford University, Pato Alto,

California, Ann E. Clarke, M. D., Dana Goldman, B. A., Stanford University, Pato Alto, and Michael E. Gluck, Ph. D., Office of

Technology Assessment, U.S. Congress, Washington, DC. Federa/ and Pr/vate Ro/es in the Development and Provision of

A/g/ucerase Therapy for Gaucher Disease, OTA-BP-H-1O4 (Washington, DC: U.S. Government Printing Office, October 1992).

Elizabeth J. Jensen, Ph. D., Hamilton College, Clinton, New York. Rates of Return to /nvestmentin the Pharmaceutical/ /ndustry:

A Survey, September 1990.

Albert Link, Ph. D., University of North Carolina, Greensboro, North Carolina. T= Incentives and the U.S. Pharmaceutka/

/ndustry, November 1990.

Stewart C. Myers, Ph. D., Massachusetts Institute of Technology, Cambridge, Massachusetts and Lakshmi Shyam-Sunder,

Ph. D., Dartmouth College, Hanover, New Hampshire. Costof Capita/Estimates for/nvestmentin Pharma@utica/Research and

Development, January 1991.

Stephen W. Schondelrneyor, Pharm.D., Ph. D., University of Minnesota, Minneapolis, Minnesota Ewnomic /mpact of Mu/tip/e

Source Competition on Orilginator Products, February 1992.

Gordon Sick, Ph. D., University of Calgary, Calgary, Alberta Canada Pharmaceutical/ /ndustry R&Dand the Cost of Capita/,

February 1992.

Ellen S. Smith, M. B.A., Wcmdcliff, New Jersey. Third Party Payment for Unapproved Uses of Approved Drugs and for Medid

Care Associated With Drug C/inica/ Tria/s, January 1991.

Steven Wiggins, Ph. D., Texas A&M University, college Station, Texas. Pharmaceutical R&D Costs and Returns, December 1989.

NOTE: Contract papers marked with an asterisk were presented and reviewed at the September 1990 wotkshop held in Santa Barbara, CA.

In addition to other data collection and analysis

tasks, OTA conducted a survey of clinical trial sizes for

drugs approved in the late 1970s versus the mid-1980s.

B Report Review Process

A preliminary draft of OTA’s report was submitted

for review and critique to the Advisory Committee in

April 1991. The Panel meeting in May 1991 was

devoted to a discussion and critique of that draft and

suggestions for further research. OTA spent the next

year continuing the research process outlined above,

searching for data, verifying the accuracy of data, and

conducting analyses. Sections of the draft were submitted for special review to selected panel members

and outside reviewers throughout the spring of 1992,

and revisions were made in the draft before it

underwent the general review. (A total of 43 people

reviewed targeted sections of the report throughout this

period.)

The full second draft of OTA’s report was distributed for review to the Advisory Panel and a group of

outside experts and interested parties in August 1992.

A total of 122 people were sent the second draft, and

63 separate replies were received. OTA reviewed and

revised the draft as appropriate in response to these

comments,
—

Appendix B

Acknowledgments

o

TA wishes to thank the Pharmaceutical R&D: Costs, Risks and Rewards Advisory Panel, its workshop

participants, contractors, and the individuals and organizations listed below for their assistance over

the course of this study. OTA also wishes to express appreciation to those who provided advice and

information for its background paper, Federal and Private Roles in the Development and Provision

of Algucerase Therapy for Gaucher Disease. These individuals and organizations do not necessarily approve,

disapprove, or endorse this report. OTA assumes full responsibility for the report and the accuracy of its content.

Lois Adams

Office of Legislative Affairs

U.S. Food and Drug Administration

Rockville, MD

Reid Adler

Office of Technology Transfer

U.S. National Institutes of Health

Bethesda, MD

Gwynn C, Akin

Public Policy

Syntex (USA) Inc.

Palo Alto, CA

Fredrik Andersson

Battelle MEDTAP Europe

Battelle Institute, Ltd.

London, England

Naomi Aronson

Technology Evaluation

Blue Cross Blue Shield Association

Chicago, IL

Carolyn Asbury

Health and Human Services

The Pew Charitable Trusts

Philadelphia, PA

Wade M. Aubrey

Blue Cross Blue Shield of California

San Francisco. CA

Wiltse Bailey

Washington, DC

P. Etienne Barral

Rhone-Poulenc Rorer

Antony, France

Norman Barton

Clinical Investigation Section

National Institute of Neurological Disorders

and Strokes

Bethesda, MD

Michael Beatrice

Center for Biologics Evaluation and Research

U.S. Food and Drug Administration

Rockville, MD

David W. Beier

Government Affairs

Genentech, Inc.

Washington, DC

269
270 I Pharmaceutical R&D: Costs, Risks and Rewards

Leslie Z. Benet

Department of Pharmacy

University of California

San Francisco, CA

Ernst Beutler

Department of Molecular and

Experimental Medicine

Scripps Research Institute

La Jolla, CA

Douglas W. Bitz

Sandoz Research Institute:

Sandoz Pharmaceuticals Corporation

East Hanover, NJ

Carla Bodaghi

U.S. Health Care Financing Administration

Washington, DC

Charles Booth

Office Payment Policy

U.S. Health Care Financing Administration

Baltimore, MD

Alan Blostin

Bureau of Labor Statistics

U.S. Department of Labor

Washington, DC

David Blumenthal

Medical Practices Evaluation Center

Massachusetts General Hospital

Boston, MA

Lawrence Brenkus

Arthur D. Little, Inc.

Cambridge, MA

John Brosan

Office of General Counsel

U.S. General Accounting Office

Washington, DC

Julie Cantor

Human Resources Division

U.S. General Accounting Office

Washington, DC

Douglas L. Cocks

Corporate Affairs

Eli Lilly and Company

Indianapolis, IN

Karen Cohen

National Gaucher’s Foundation

Gaithersburg, MD

Joseph Collier

Department of Pharmacology and

Clinical Pharmacology

St. Georges Hospital Medical School

London, England

Paul Coppinger

Office of Planning and Evaluation

U.S. Food and Drug Administration

Rockville, MD

Pedro Cuatrecasas

Pharmaceutical Research Division

Warner-Lambert Company

Ann Arbor, MI

Joan M. Curran

Merck and Company, Inc.

Rahway, NJ

Bruce Cwalina

Springfield, VA

Patricia M. Danzon

School of Business

University of Pennsylvania

Philadelphia, PA

Alfred B. Engleberg

Greenwich, CT

Alain Enthoven

School of Business

Stanford University

Palo Alto, CA

David Evans

World Health Organization

Geneva, Switzerland
Appendix B—Acknowledgments I 271

Dee Fensterer

Generic Pharmaceutical Industry Association

New York, NY

Franklin Fisher

School of Management

Massachusetts Institute of Technology

Cambridge, MA

Scott D. Freedman

Pharmaceutical Division

Miles, Inc.

West Haven, CT

Jesse Friedman

Chevy Chase, MD

Steven Garber

Rand Corporation

Santa Monica, CA

Kevin Gaynor

Price Waterhouse, Inc.

New York, NY

William Glaser

School of Management and Urban Policy

New School for Social Research

New York, NY

Sarah Glavin

Human Resources Division

U.S. General Accounting Office

Washington, DC

Martin Glick

Genentech, Inc.

San Francisco, CA

Gregory Grabowski

Children’s Hospital Medical Center

University of Cincinnati Medical Center

Cincinnati, OH

Henry G. Grabowski

Department of Economics

Duke University

Durham, NC

Stephen C. Groft

Office of Science Policy and Legislation

U.S. National Institutes of Health

Bethesda, MD

David Gross

Human Resources Division

U.S. General Accounting Office

Washington, DC

Charles Grudzinskas

Medications Development Division

U.S. National Institute on Drug Abuse

Rockville, MD

Marlene E. Haffner

Orphan Products Development

U.S. Food and Drug Administration

Rockville, MD

Ronald Hansen

School of Business Administration

University of Rochester

Rochester, NY

Edward Haas

Office of Planning and Evaluation

U.S. Food and Drug Administration

Rockville, MD

Jody Hessen

Pharmacy, Policy, and Education

Aetna

Minneapolis, MN

Michelle Hiltebeitel

IMS America

Plymouth Meeting, PA

Peter Barton Hutt

Covington & Burling

Washington, DC

David Jackson

Janssen Pharmaceuticals, Inc.

Piscataway, NJ

David C. Jones

Chapel Hill, NC
272 ! Pharmaceutical R&D: Costs, Risks and Rewards

Robert Kaplan

School of Business Administration

Harvard University

Boston, MA

David Karlin

Institute of Clinical Medicine

Syntex Research

Palo Alto, CA

Alison Keith

U.S. Pharmaceuticals

Pfizer, Inc.

New York, NY

John V. Kelsey

Office of Orphan Products Development

U.S. Food and Drug Administration

Rockville, MD

William Kennedy

Drug Regulatory Affairs

ICI Pharmaceuticals Group

Wilmington, DE

Christian L. Khung

Policy Research and Development

Blue Cross and Blue Shield of Massachusetts

North Quincy, MA

Richard Kinny

Legislative Affairs

Schering-Plough Corporation

Washington, DC

Mary C. Knipmeyer

Office of Women Services

U.S. Substance Abuse and Mental

Health Administration

Rockville, MD

Neil Kran

Internal Revenue Service

U.S. Department of the Treasury

New York, NY

Jacques Krasny

Bogart, Delafield, and Ferrier, Inc.

Morristown, NJ

Nancy J.W. Lewis

Institute for Pharmaceutical Economics

Philadelphia College of Pharmacy and Science

Philadelphia, PA

Harold S. Luft

Institute for Health Policy Studies

University of California

San Francisco, CA

Evan Marks

MEDCO Containment Services

Montvale, NJ

Kathleen McAvoy

Office of Planning and Evaluation

U.S. Food and Drug Administration

Rockville, MD

Jack McConnell

Hilton Head Island, SC

Robert T. McDonough

Public Policy Planning

The Upjohn Company

Kalamazoo, MI

Peter Merrill

Washington National Tax Service

Price Waterhouse, Inc.

Washington, DC

Gerald Meyer

Center for Drug Evaluation and Research

U.S. Food and Drug Administration

Rockville, MD

Abbey Meyers

National Organization for Rare Disorders

New Fairfield, CT

Ann Meyers

Center for Drug Evaluation and Research

U.S. Food and Drug Administration

Rockville, MD

Dann M. Michols

National Pharmaceutical Strategy

Ottawa, Ontario
Appendix B—Acknowledgments 273

Robert R. Miller

International Finance Corporation

Washington, DC

Andrew Mitchell

Pharmaceutical Evaluation

Department of Health Housing and

Community Services

Canberra, Australia

John Moeller

Center for General Health Services

Intramural Research

U.S. Agency for Health Care Policy and Research

Rockville, MD

Melissa Moncavage

Center for Drug Evaluation and Research

U.S. Food and Drug Administration

Rockville, MD

Lee Mortenson

Association of Community Cancer Centers

Rockville, MD

Dennis Mueller

Department of Economics

University of Maryland

College Park, MD

Michael Murray

Office of the General Counsel

U.S. House of Representatives

Washington, DC

Jane S. Myers

Patent and Trademark Office

U.S. Department of Commerce

Washington, DC

Maven Myers

Department of Pharmacy

Philadelphia College of Pharmacy and Science

Philadelphia, PA

John O’Hare

Joint Committee on Taxation

U.S. Congress

Washington, DC

Jonathan Peck

Institute for Alternative Futures

Alexandria, VA

Gary Persinger

Health Care Systems Division

Pharmaceutical Manufacturers Association

Washington, DC

Tim Proctor

Office of General Counsel

Merck & Company, Inc.

Rahway, NJ

Lisa Raines

Government Relations

Industrial Biotechnology Association

Washington, DC

Jonathan Ratner

Human Resources Division

U.S. General Accounting Office

Washington, DC

James W. Rayburn

Regulatory Affairs

Bristol-Myers Squibb Company

Evansville, IN

Larry Reed

Medicaid Non-Institutional Payment Policy Branch

U.S. Health Care Financing Administration

Baltimore, MD

Heinz Redwood

Suffolk, England

Michael R. Reich

School of Public Health

Harvard University

Boston, MA

Bryan G. Reuben

Department of Chemical Engineering

Southbank Polytechnic

London, England

Gerald Robertson

Department of Policy, Planning and Evaluation

Patented Medicine Prices Review Board

Ottawa, Ontario
274 I Pharmaceutical R&D: Costs, Risks and Rewards

Deborah Regal

Alpha Center

Washington, DC

James B. Russo

Government and Public Policy

Smithkline Beecham

Gerald L. Salamon

Department of Accounting

Indiana University

Bloomington, IN

Jeffrey Sanders

Office of Legislation and Policy

U.S. Health Care Financing Administration

Washington, DC

Alice Sapienza

School of Public Health

Harvard University

Boston, MA

Janet Scheren

National Wholesale Druggists Association

Alexandria, VA

Stuart Schweitzer

Department of Health Services

University of California

Los Angeles, CA

James Shuttinga

Office of the Director

U.S. National Institutes of Health

Bethesda, MD

Richard Sweeney

School of Business Administration

Georgetown University

Washington, DC

Max W. Talbott

Lilly Research Laboratories

Eli Lilly and Company

Indianapolis, IN

Alison Taunton-Rigby

Biotherapeutics

Genzyme Corporation

Cambridge, MA

Albert Teich

Directorate for Science and Policy Programs

American Association for the Advancement of Science

Washington, DC

Henri Termeer

Genzyme Corporation

Cambridge, MA

Charles E. Van Horn

Patent and Trademark Office

U.S. Department of Commerce

Washington, DC

Jon E. Villaume

Drug Regulatory Affairs

Roche Pharmaceuticals

Nutley, NJ

Stuart Walker

Centre for Medicines Research

Surrey, England

Andrew J. Webster, Ph.D.

Faculty of Humanities, Arts, and Education

Anglia University

Cambridge, England

Roy Widdus

National Commission on AIDS

Washington, DC

Sidney Wolfe

Health Research Group

Washington, DC

Robert Wren

Bureau of Eligibility, Coverage and Reimbursement

U.S. Health Care Financing Administration

Baltimore, MD

James P. Yee

Institute of Clinical Medicine

Syntex Research

Palo Alto, CA

Aki Yoshikawa

Stanford University

Palo Alto, CA
Appendix B—Acknowledgments I 275

OTA also acknowledges the assistance of individuals from the following pharmaceutical companies, without

whom neither the survey on the size of clinical trials nor OTA’s on-site interviews of pharmaceutical executives

would have been possible.

Abbott Laboratories Norwich Eaton Pharmaceuticals, Inc.

Abbott Park, IL Norwich, NY

Bristol-Myers Squibb Company Parke-Davis

Princeton, NJ Ann Arbor, MI

Cetus Corporation Pfizer, Inc.

Emeryville, CA New York, NY

Ciba-Geigy Corporation

Summit, NJ

Genentech, Inc.

San Francisco, CA

Hoffman-La Roche, Inc.

Nutley, NJ

Hoechst-Roussel Pharmaceuticals, Inc.

Somerville, NJ

ICI Pharmaceuticals Group

Wilmington, DE

Janssen Pharmaceutical, Inc.

Piscataway, NJ

Lederle Laboratories

Pearl River, NY

Eli Lilly and Company, Inc.

Indianapolis, IN

Mead Johnson & Company

Evansville, IN

The R.W. Johnson Pharmaceutical

Research Institute

Raritan, NJ

Sandoz Pharmaceuticals Corporation

Hanover, NJ

Schering-Plough Corporation

Kenilworth, NJ

SmithKline Beecham Corporation

Philadelphia, PA

Syntex (U.S.A.), Inc.

Palo Alto, CA

Takeda U. S. A., Inc.

New York, NY

TAP Pharmaceuticals, Inc.

Deerfield, IL

The Upjohn Company

Kalamazoo, MI

Wyeth-Ayerst Research

Philadelphia, PA

Merck and Company, Inc.

Rahway, NJ

Miles, Inc.

West Haven, CT
Appendix C

The Cost of Capital1

I

nvestors in pharmaceutical research and development (R&D) put up their money because they

expect, on average, to get returns that adequately compensate them for the time and risk

involved. Just as the interest rate on bank deposits is a

payment for the use of depositors’ money (or capital),

the return on an investment in R&D is a payment the

company or its investors get from the use of their

capital. Riskier investments require higher dollar

returns; otherwise, investors would put their money in

safe investments like U.S. Treasury bills or bank

certificates of deposit. The riskier the investment, the

higher the required return. The rate of return that

investors must be able to expect from money invested

with a given level of risk is referred to as the

investment’s ‘‘cost of capital. ’

9 Risk and the Cost of Capital

How does one measure the riskiness of an investment? This is the key question in estimating the cost of

capital for any project. Were there no risk the cost of

capital would be the same as the interest rate on U.S.

Treasury bills.

Pharmaceutical industry executives often emphasize

the particular riskiness of R&D. Analogies to drilling

for oil are common: R&D involves dry holes and a few

gushers. According to one industry executive, pharmaceutical R&D is like “wildcatting in Texas” (188).

Data on the dropout rate for drugs under development

support these notions that R&D is, indeed, an uncertain

and risky undertaking.

The risk that is accounted for in the cost of capital

is different from these conventional notions about the

riskiness of R&D. Modem finance theory differentiates between two different kinds of investor risk:

diversifiable risk and undiversifiable risk (59). The

‘‘wildcatting’ risks of drug R&D are diversifiable;

that is, the investor can diversify his or her portfolio

across a large number of such projects (or firms

undertaking such projects) and obtain, on average, an

expected cash flow that is very predictable. Thus, the

risk associated with low probabilities of successful

drug development can be eliminated by diversifying

the investment portfolio across a large number of

projects.

The undiversifiable, or systematic, risk is the risk

the investor cannot eliminate through diversification

of his or her portfolio of investments. Suppose, for

example, that prescription drug sales were closely

linked to the state of the economy, perhaps because

high unemployment produces more people without

health insurance. Then, investment in pharmaceutical

R&D would have a great deal of systematic risk

because returns on R&D would depend on the state of

the economy as a whole, and investors cannot diversify

away these economywide risks.

The cost of capital for a given investment reflects

only the portion of the investment’s risk that is

undiversifiable. The technical risks of project failure

do not affect the required rate of return for an

investment, though they do alter the potential cash

flow expected from an investment.3

1 This chapter draws heavily from a background paper on the cost of capital prepared by Stuart Myers and LakshmI “ Shyam-Sunder (285).

2 The cost of capital is also referred to as the “opportunity cost of capital,’ because the investor expects to get at least as much return as

he or she can get from other opportunities to invest at the same level of risk.

3 This concept of cost of capital is based on the Capital Asset Pricing Model (CAPM), which depends for its validity on the efflciemy of

capital markets. The validity of the CAPM theory is impossible to test (352a); consequently, the CAPM model has not been validated (96).

Recently, researchers have presented analyses that question whether the CAPM is an adequate predictor of returns in the market (129).

Nevertheless, the CAPM approach remains one of the most widely used models of expected returns, and no better practical alternatives to

estimating the cost of capital presently exist.

276
Appendix C—The Cost of Capital 277

AN EXAMPLE

Consider two hypothetical pharmaceutical R&D

projects. Each project involves a newly synthesized

compound with identical development costs and

probabilities of being approved for marketing by the

U.S. Food and Drug Administration (FDA). Clinical

testing on each will take 2 years and cost $10 million

(spent evenly over the 2-year testing period). Suppose

also that the company’s history with drug development

suggests each drug has a 24-percent chance of ultimately reaching the market. The technical risks and

R&D costs of the two drugs are therefore identical,

If either drug is successful in getting to market, it

will produce net cash inflows (revenues less the costs

of production, marketing, etc. ) whose value is not

known with certainty. To keep the example simple,

suppose that the product life for either drug is just 1

year-after the first year of marketing, a new product

replaces it and its revenues fall to zero. Each drug has

the possible net cash inflows shown in table C-1.

Although both drugs have identical average or

‘‘expected’ cash flows, the distribution of possible

outcomes is different. Suppose project A is for a drug

in a well-known family of analgesic products whose

potential revenues are relatively certain, On the other

hand, suppose project B is a very costly drug for

patients with end-stage renal disease. It will be

accepted and sold only if Medicare, which covers all

end-stage renal disease patients regardless of age,

agrees to pay for it. Once Medicare covers the drug,

however, its revenues are completely certain. Although the “expected” net cash inflows from each

drug are the same, the risk profile of the two drugs

differs dramatically. Project B’s cash flows are much

riskier than project A’s cash flows, because the firm

can win big or lose big with that project, whereas once

drug A is approved, its potential revenues vary in a

narrow band.

Despite the fact that project B’s expected cash flow

is riskier than that of project A, that risk is largely

diversifiable, because it is unique to the project and

depends only on the Medicare coverage decision

which, we can assume, is unaffected by the state of the

economy. Project A’s risk, on the other hand, may

reflect undiversifiable, or systematic, risk because

demand for analgesics may vary with the state of the

economy. Although the total risk of project B is much

Table C-l—Potential Net Cash flows From Two

Hypothetical R&D Projects

Project A Project B

Potential Potential

revenue revenue

Probability y ($ million) Probability ($million)

0.33 $25 0.50 $0

0.33 50 0.50 100

0.33 75

Expected net

cash flow 50 50

SOURCE: Office of Technology Assessment, 1993.

larger, the cost of capital for project B would actually

be lower than the cost of capital for project A.

How does the cost of capital affect decisions to

invest in R&D projects? To assess whether the

investment is worth its $10 million R&D cost,

company managers (on behalf of their investors)

would compute the net present value (NPV) of the

investment by converting all future expected cash

flows (both into and out of the firm) into their present

value at the time the investment decision is made using

the cost of capital appropriate to the project as the

discount rate.4 The algebraic sum of the present values

of all the expected cash flows is the NPV of the

investment. If the NPV is greater than zero, the

investment is worth it and will compensate investors at

a rate of return that exceeds the cost of capital.

Suppose we knew project A’s cost of capital was 13

percent, while Project B’s cost of capital was 10

percent. Then

N P VA = -$5-$5/(1+0.13) + 0.24[$50/(1+0.13)2

]

= -$0.03 million.

and

N P VB = -$5 -$5/(1+0.10) + 0.24[$50/(1+0.10)2

]

= $0.37 million.

The NPV of project A is less than zero, so the project

does not earn a high enough return to cover its cost of

capital. Project B, on the other hand, does earn enough

to repay its investment at its cost of capital. The

company would decide to go forward with project B

and forego project A, a result that would seem

4 The present value (i.e., the value today) of $1.00 that an investor expects to receive 1 year hence, for example, is $0,91 when the COSI of

capital is 10 percent ($1 .00/(1 +1. 10)).
278 I Pharmaceutical R&D: Costs, Risks and Rewards

counterintuitive to those who focus on total risks rather

than on undiversifiable risks.

MEASURING UNDIVERSIFIABLE RISK

If the cost of capital is determined by the undiversifiable part of a project’s risk, how can that risk be

measured? At the level of the company (which can be

considered a collection of investments), a standard

approach to measuring undiversifiable risk for equity

investors is to estimate the historical relationship

between the firm’s stock: market returns and the returns

from the stock market as a whole (59,96). If the firm’s

stock market returns are strongly associated with

returns in the stock market as a whole, the relationship

will be strong, and the firm has a high degree of

undiversifiable risk. A measure of the strength of this

relationship is refereed to as the firm’s “beta.” If beta

equals 1, the fro’s equity has a risk profile that is

average for the stock market. If beta is greater than 1,

the firm’s equity risk is higher than the average risk in

the stock market. (In that case, swings in market

returns are magnified in the company-when the

overall stock market goes up, the company’s stock

market value goes up even more; when the market goes

down, the company’s stock market value goes down

even more.) A beta of zero means that the firm has

virtually no undiversifiable risk: its returns are completely uncorrelated with the stock market.

Although the riskiness of a company depends on

how investors view its future performance, company

betas are estimated from the historic relationship of the

company’s stock to the overall stock market. The

assumption is that the systematic riskiness of a

company today is probably similar to its riskiness in

the recent past. Betas for individual firms and for

industries are computed. from stock market price and

returns data available in several databases for publicly

traded firms.

I The Cost of Capital for the

Pharmaceutical Industry

The cost of equity capital for a company as a whole

is given by the following formula:

r e = rf +ß(r m

-rf)

where rf is the rate of return to risk-free securities;

(rm

-rf) is the risk premium for the equity market as a

whole, and ß (beta) is the firm-specific risk premium

reflecting added or reduced risk of the firm’s security

in relation to a diversified market portfolio. The cost of

equity capital for an industry can be estimated with the

same formula, by weighting the individual firms’ betas

by the relative market value of each firm in the

industry.

In a contract paper for OTA, Myers and ShyamSunder estimated that the risk-free rate in January 1990

was 6.8 percent and the market risk premium over the

70-year long period ending in December 1990 was 8.7

percent (285).5 Myers and Shyam-Sunder also estimated market-value-weighted equity betas for a sample of 17 large U.S. pharmaceutical firms by regressing

excess returns (over the Treasury bill rate) for pharmaceuticals against the excess returns on Standard and

Poor’s 500 composite index for 60-month periods

ending in December 1979, December 1984, and

December 1989. The estimated betas at those three

points in time were 0.97,0.66, and 0.98, respectively

(285). Taken together, these estimates imply a nominal

(i.e., unadjusted for investors’ inflation expectations)

cost of equity capital of 18 percent, 16.4 percent and

15.4 percent at the beginning of 1980,1985, and 1990,

respectively. After adjusting for inflation expectations

at each time, the real cost of equity capital was 10.3,

10.9, and 10.4 percent.

Equity is only one kind of capital that companies

raise. Debt financing is also used, and the cost of debt

capital is generally lower than the cost of equity

capital, because bondholders must be paid before

stockholders are paid dividends.6 The weighted average cost of capital, r*, is the blended cost of the firm’s

debt and equity capital (285,409):

r* = rd

(l-tC) (D/V) + re(E/V)

where rd and re are the cost of capital for debt and

equity, respectively, D/V is the ratio of debt to market

value of the firm, E/V is the ratio of equity to the

market value of the firm, and tC is the marginal

corporate tax rate. The cost of debt is reduced by the

amount of the corporate income tax because interest is

S The market risk premium has declined over the past 70 years. M the premium is measured over the post-World War II em it is 8.3 percxm~

which would lower the cost of capital to the industry.

s The cost of equity capital increases as the fm takes on more debt (%). Empirical estimates of the cost of equity capital for an industry

are therefore based on the obsemed capital structure (i.e., the ratio of debt to equity) in the industry. This approach assumes that the capital

structure of firms in an industry is optimal.
Appendix C-The Cost of Capital! 279

deductible from business income and therefore costs

the company less than it would without taxes.7

Myers and Shyam-Sunder calculated the cost of debt

capital for a sample of 17 pharmaceutical companies.

In January 1990, the market value weighted cost of

debt for pharmaceuticals was 9.1 percent (285). The

January 1990 cost of debt net of taxes, with a marginal

tax rate of 34 percent, is therefore 6.0 percent. Before

the Tax Reform Act of 1986 lowered marginal tax

rates, the marginal tax rate was 46 to 48 percent, which

would imply a net after-tax cost of debt of 4.9 percent.

Pharmaceutical firms have little debt, so the total

cost of capital is close to the cost of equity capital.

Based on all of the information given above, Myers

and Shyam-Sunder estimated the real cost of capital for

17 pharmaceutical firms at the start of the year in 1980,

1985, and 1990 at 9.9, 10.7, and 10.2 percent

respectively.

1 The Cost of Capital for

Pharmaceutical R&D Projects

Companywide betas represent a weighted average

of betas for the different individual investments that

pharmaceutical companies make, including investments in R&D, manufacturing plant and equipment,

and marketing,8 Consequently, R&D investments are

likely to have betas that differ from the companywide

average. And, different projects will probably have

different betas, as the stylized example above demonstrated. It is impossible to estimate a precise beta for

each project, because historic data on returns to

projects that are similar to it do not exist. Thus, while

it is possible to make a reasonably accurate estimate of

the companywide beta at any point in time for a

pharmaceutical firm, it is not possible to directly

estimate the beta for R&D projects.

Some general statements can be made about the cost

of capital for R&D compared with the cost of capital

for manufacturing or financial investments. Spending

money on R&D can be thought of as buying an option,

or opportunity, to invest in manufacturing a drug.

Without the R&D, there would be no opportunity to

invest because a product would not exist. In order to

actually manufacture the drug that the R&D produces,

however, a company must make a fixed investment in

plant and equipment. This necessary fixed investment

is much like a fixed debt obligation-its claims must

be met before the firm can actually reap the benefits of

the R&D. Just as high fixed debts increase a company’s riskiness to stockholders, who are last in line to

be paid, so too does the fixed manufacturing investment increase the riskiness of the R&D investment.

Consequently, the R&D is riskier than investment in

plant and equipment (285).

Because the weighted average cost of capital for the

firm as a whole includes investments in manufacturing

and other operations as well as in R&D, the cost of

capital for R&D must be higher than the weighted

average cost of capital, while the cost of capital for

investments in manufacturing and marketing must be

less than the weighted average cost of capital.

R&D projects are in reality sequential investments

that buy opportunities for further R&D along the way.

Early in the R&D process there are high fixed

obligations to be met before the company can actually

begin to earn money, so the cost of capital is higher

(other things being equal) for money invested very

early in the process than for the money invested later,

as the project approaches market approval. Therefore,

early R&D projects are riskier than later projects and

have a higher cost of capital.

Not only does early R&D produce an option on

future investments and revenues, but it also produces

information that reduces the uncertainty about the

value of the project (96,330,352). Since R&D projects

can be abandoned at any point in the process (or at least

at certain project milestones), the investment in early

R&D can be viewed as an investment in information

that allows the firm to reduce the uncertainty of its later

investments.

Suppose, for example, a new compound stands one

chance in 100 of reaching the market, but $1 million

T Although debt interest is untaxed at the corporate level, it is fully taxed at the personal level. Equity returns, on the other hand, are taxed

fully at the corporate level and lightly at the personal level to the extent that much of the equity returns are in the form of capital gains, which

are taxed only when the gains are realized (391,392). At the investor level, the personal and corporate tax systems combine to largely eliminate

the overaIl tax advantage of debt (273). This impIies that at the fm level, the cost of equity should be lower than the cost of debt of comparable

risk (392). Together, these findings imply that the cost of equity capitat as calculated in the formulas given above may be overstated when beta

is less than one and understated when beta is greater than one (391). Since the beta for the pharmaceutical industry was slightly less than one,

the cost of equity capital in the pharmaceutical industry may be slightly overstated.

8 Although R&D and advertising and promotion are treated as current expenditures in firms’ accounting statements, if they lead to increases

in revenues in later years, they arc in principal investments, and stock prices would reflect this fact.

330-06 7 - 93 - 10 : QL 3
280 I Pharmaceutical R&D: Costs, Risks and Rewards

spent early on animal toxicology testing will either

show it to be too toxic and therefore not worth

additional R&D expenditures or increase its chances of

success to, say, 1 in 10. Any money spent after the

animal testing is completed would face vastly better

odds than would be the case if the firm were required

to commit to the full course of R&D at the very

beginning of the project. The information produced by

the $1-million expenditure is valuable and may justify

early speculative R&D projects whose NPV, viewed

from the beginning of the project, may appear to be

negative (352).

This “information-producing” function of R&D

essentially adds to the value of the R&D investment or,

stated another way, dampens the effective cost of

capital for R&D to more closely approximate the cost

of capital for investments in manufacturing capacity

for an approved drug. Although the betas and, therefore, the cost of capital for R&D projects are always

higher than those for investment in ongoing operations, how much higher depends on the interplay

between the information value of the investment and

the fixed investment required to realize the returns

from R&D.

To summarize, although the cost of capital for R&D

must be higher than that for manufacturing, and it is

higher the earlier in the research process the project is,

there is currently available no practical approach to

estimating just how high the cost of capital actually is

for any set of R&D investments. The best that can be

done to get a rough quantitative estimate of the cost of

capital for pharmaceutical R&D projects is to examine

the betas of firms that invest largely in R&D and that

have relatively little investment in ongoing operations.

Stewart (409) estimated the cost of capital for

business risk for 1,000 publicly traded companies in

the United States and Canada. Companies whose main

business was providing R&D services (R&D laboratories) had a cost of capital for business risk that was

approximately 4.5 percentage points higher than the

cost of capital for business risk for the drug companies

in his sample. A recent update of the Myers and

Shyam-Sunder paper by Shyam-Sunder found only a

2.7 percentage point difference in the net cost of capital

between 30 biotechnology firms and 19 large pharmaceutical firms as of December 1990 (285). The results

of these studies suggest that a 4-percentage point

differential in the cost of capital from the beginning to

the end of the research process provides a reasonable

outer boundary for calculation of the capitalized costs

of R&D.

1 Comparing Pharmaceutical and

Nonpharmaceutical Costs of Capital

This section describes OTA’s procedures for estimating the difference between the cost of capital for

the pharmaceutical industry and the cost of capital for

the comparison firms used in the Baber and Kang study

of pharmaceutical industry profitability (27).

At OTA’s request, Baber and Kang estimated the

internal rate of return (IRR) over a 12-year period

(1976-87) for a sample of pharmaceutical companies

and two comparison groups matched with the pharmaceutical companies according to sales, sales growth

and R&D intensity (27). The IRR is the compound

annual interest rate earned by investments in the

companies over the period of study. Baber and Kang

demonstrated that, after adjusting for distortions in

financial accounting data, the difference in IRR

between the pharmaceutical industry and the comparison groups over the period studied was 2 to 3

percentage points per year, a far smaller difference

than traditional profitability analyses tend to show

(27).

In their comparative profitability study, Baber and

Kang did not address the question of whether a 2 to 3

percentage point difference in IRRs can be explained

by a difference in risk (and, therefore, in costs of

capital) between the pharmaceutical industry and other

companies. To investigate this issue, OTA estimated

the relative riskiness and differences in the cost of

capital between the pharmaceutical firms and the

nonpharmaceutical firms studied by Baber and Kang.

OTA’s method for comparing the costs of capital is

based in large part on procedures and information

supplied by Myers and Shyam-Sunder in their OTA

contract report (285). Although Myers and ShyamSunder laid out general procedures for estimating betas

and weighted average costs of capital, they were asked

by OTA to supply specific estimates only for the

pharmaceutical industry. To estimate cost of capital

differences between the pharmaceutical industry and

the nonpharmaceutical firms sampled by Baber and

Kang, OTA pieced together information provided by

Myers and Shyam-Sunder as well as data provided by

Baber and Kang on the specific samples of firms

studied.

The Baber and Kang study examines nominal rates

of return without adjusting for inflation. Therefore,
Appendix C—The Cost of Capital 281

OTA’s estimates of the cost of capital for each sample

are nominal as well.

EVIDENCE ON BETAS

Estimation of beta, the correlation of a firm’s returns

with market returns, requires data that are available

only for publicly traded firms. Hence, beta can be

estimated only for a subsample of firms in the Baber

and Kang study, although these firms represent a high

proportion of total market values in these samples.

Betas also vary over time, so the period over which

they are estimated can affect the ultimate results.

OTA had two sources of evidence on pharmaceutical betas. First, as described earlier, Myers and

Shyam-Sunder estimated market value-weighted equity betas for a sample of 17 large U.S. pharmaceutical

firms by regressing excess returns (over the Treasury

bill rate) against excess returns on Standard and Poor’s

500 composite index for 60-month periods ending in

December 1979; December 1984; and December

1989. 9 Estimated betas were 0.97, 0.66, and 0.98

respectively (285).

Second, Baber and Kang calculated market-value

weighted betas for each year of the 12-year study

period by regressing total firm returns against total

market returns over the previous 240 months for

companies for which data were available (24,224).

Table C-2 shows the calculated betas and the number

of firms included in each year’s calculation. The

calculated weighted average betas change slightly

from year to year, as the sample of firms changes and

as the market value weights change, but they are very

stable. 10 The mean across all study years of the

weighted average betas is 0.90 for pharmaceuticals,

1.00 for control firms matched by sales, and 1.29 for

control firms matched by sales and R&D. OTA used

these estimates of beta for the sake of consistency

across samples.

EVIDENCE ON THE RISK-FREE RATE

Myers and Shyam-Sunder observed that the appropriate risk-free rate is the short-term Treasury bill rate,

but this must be adjusted for forecasts that will govern

the firm’s long-term investments (285). The short-term

Treasury bill rate averaged 5.76 percent in the period

1957-87 (23,223). Myers and Shyam-Sunder obtained

a risk-free rate by subtracting an historical term

premium (1.2 percent) from the 20-year Treasury bond

yield. In December 1989, the net rate was 6,81 percent

(285).

EVIDENCE ON THE MARKET RISK PREMIUM

The realized market risk premium (over the risk-free

rate) is highly volatile over time, while expected risks

are assumed to be stable over long periods. Therefore,

the market risk premium is typically estimated over a

long period of time (198). Myers and Shyam-Sunder

found an arithmetic mean of 8.7 percent for excess

market return over the Treasury bill rate for the period

1926-89 (285). The market risk premium declined in

the post-war period, however, and the premium for the

period 1947-88 was 8.3 percent (285).

In an unrelated study, Stewart estimated the market

risk premium by comparing Standard and Poor’s 500

stocks with long-term (20-year) U.S. Treasury bonds

from 1925 to 1989 (409). He found that the risk

premium was only 5.8 percent over the period. This

would imply a risk premium over the Treasury bill rate

(adjusted for long-term forecasts) of just 7.0 percent.

EVIDENCE ON THE AFTER-TAX

COST OF DEBT

Myers and Shyam-Sunder calculated the cost of debt

capital for a sample of 17 pharmaceutical companies

based on Moody’s industrial bond ratings. As of

December 1989, the market value weighted cost of

debt for pharmaceuticals was 9.1 percent (285).11 The

cost of debt net of taxes, with a marginal tax rate of 34

percent, was therefore 6.0 percent. At the pretaxreform marginal tax rate of 46 percent, the net after-tax

cost of debt would have been 4.9 percent.

At OTA’s request, Baber and Kang calculated the

mean ratio of after-tax interest payments to the book

value of long-term debt between 1975 and 1987 for the

15 largest firms in each of the three samples in this

9 All of the firms included in Myers and Shyam-Sunder’s analysis of the pharmaceutical industry are part of the Baber and Kang

pharmaceutical sample.

10 Bct&S ~stimated ~ver ~ long Pcfiod of ~bscma[ion tend [0 & more stable [~fllose based on shorter periods. For example, Myers ~d

Shytim-Sunder’s estimate of betas for the pharmaceutical indust~, which are based on 5 years’ worth of data, vary more widely than do the

estimates made by Baber and Kang. But, too long a period of historical observation can obscure the effects of changes in an industry’s riskiness

over time. Part of the variation in the estimates of Myers and Shyam-Sunder is probably random, but part may atso be due to changes from

the mid- 1970s through the late 1980s in the riskiness of the industry.

I I Ovcrdl, us, coTorate bond yields averaged 10.87 between 1973 and 1989 (1).
282 I Pharmaceutical R&D: Costs, Risks and Rewards

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OJCNCNNCVCNCNNCNOIOJNN

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. . . . . . . . . . . . .

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study. These ratios were 5,64 percent for pharmaceuticals, 4.92 percent for the control sample matched by

sales and 5.72 percent for the control sample matched

by R&D, Although these ratios area crude measure of

the cost of debt, the rate for the pharmaceutical sample

is close to the after-tax rate estimated by Myers and

Shyam-Sunder.

ESTIMATES OF COST OF CAPITAL

OTA estimated the weighted average cost of capital

for the three samples based on the evidence summarized above. Because the control firms have much

higher debt-to-equity ratios than do the pharmaceutical

companies, OTA used parameter estimates that would

tend to understate the cost of debt and overstate the

cost of equity. The computed costs of capital are

therefore biased in favor of a higher cost of capital in

the pharmaceutical industry.

Specifically, OTA assumed the pretax cost of debt

is 9 percent for all three samples, the risk-free rate is

—

Appendix C—The Cost of Capital 283

6.8 percent, and the market risk premium is 8.7

percent. These parameters are consistent with those of

Myers and Shyam-Sunder (285). Betas were assumed

to follow those calculated in table C-2. Table C-3

summarizes the calculations for the pharmaceutical

firms and the two control groups.

Because these estimates of the cost of capital are

based on high estimates of the risk-free rate and the

market premium, they should not be viewed as

accurate estimates of the actual cost of capital over the

period. Moreover, the cost of capital is a moving target

over time; a single estimate provides only a rough

approximation of its value. Yet, they do provide a

reasonably accurate (indeed, a conservative) test of

differences in the cost of capital among the samples of

firms examined by Baber and Kang.

Table C-3—Weighted Average Cost of Capital, 1976-87

Control Control

Pharmaceuticals sample I sample II

Characteristics of industrya

Market value of equity ($ million) $1,288 $453 $562

Value of debt ($ million) $ 85 $116 $129

Average firm value ($ million) $1,373 $569 $691

Assumptions

Beta 0,9 1.0 1.29

Cost of debt (pretax) 0.09 0.09 0.09

Marginal tax rate 0.46 0.46 0.46

Risk-free rate (r,) 0.068 0.068 0.068

Market risk premium (rm-rf) 0.087 0.087 0.087

Results

Cost of equity capital (re) 0.146 0.155 0.18

Cost of capital (r’) 0.14 0.133 0.155

a Based on 15 largest firms in each Sam@e.

KEY: Control sample 1: Firms similar to pharmaceutical in terms of sales and sales growth.

Control sample 11: Firms similar to pharmaceuticals in terms of sales and R&D industry.

SOURCE: Office of Technology Assessment, 1993.
Appendix D

Congressional Access to Proprietary

Pharmaceutical Industry Data

I

n the past, numerous congressional committees

have expressed an interest in the research,

development, and marketing costs of the pharmaceutical industry. While the industry is quite

willing to disclose its own estimates, it guards the

financial information that is used to derive these

estimates, especially the data needed to determine

overall industry profitability and profitability per

product.

Without voluntary disclosure, Congress must resort

to compulsory processes. Congress’ auditing body, the

U.S. General Accounting Office (GAO), which investigates “all matters relating to the receipt, disbursement, and application of public funds, "

1 is probably

best equipped to do a financial analysis of the

pharmaceutical industry, In addition, GAO is afforded

special power to audit the expenditure of public funds

through government contracts. Since 1951, almost all

government contracts must contain a clause authorizing GAO to:

. . .examine any directly pertinent books, documents, papers, and records of the contractor or

any of his subcontractors engaged in the performance of and involving transactions related to such

contracts or subcontracts.2

However, the pharmaceutical industry successfully

battled GAO for a decade to prevent GAO from using

these “access to records” clauses to obtain information about individual companies’ research, development, and marketing costs. The following discussion

outlines GAO’s unsuccessful attempt to obtain research, development, marketing, and promotional

costs from the industry, demonstrating the industry’s

willingness to fight disclosure.

Another avenue for obtaining this data would be

through a congressional subpoena. It is clearly within

congressional powers to subpoena this data; however,

it appears that Congress has been reluctant to use this

power against the pharmaceutical industry. The broad

scope of congressional subpoena power summarized

in this appendix demonstrates that legal constraints

have not prevented Congress from obtaining proprietary data.

1 GAO and the Pharmaceutical Industry

The controversy between GAO and several of the

largest U.S. pharmaceutical companies began in 1967

when the Senate Select Committee on Small Business,

Subcommittee on Monopoly, held a series of hearings

on all aspects of the pharmaceutical industry, including

its profitability and the amount of competition in the

industry.3 The intent of these hearings was to establish

] 31 U.S,C. Sec. 712.

2 See, e.g., 41 U.S.C. Sec. 254 (1992) (civilian contracts); 22 U.S.C. Sec. 2586 (1992) (arms control and disarmam ent); 22 U.S.C. Sec.

2206 (1992) (atomic energy); 50 U.S.C. Sees. 1431, 1433 (1992) (military/national defense). Harvard Law Review, “The Controller

General’s Authority To ExamirI e the Private Business Records of Government Contractors: Eli Lilly & Co. v. Sraats, Harvard Luw

Review 92: 1148-1159 (1979).

3 ~ fcomwtitive ~oblems ~ tile D~g Indus~:He~gs~fore tie Subcommittee on Monopoly of tie Semte Sehxt Committee on Stil

Business (pt. I) 90t13 Cong., 1st Sess, passim (1967), cited in note, “The General Accounting Office’s Access to Government Contractor’s

Records,” University of Chicago Law Review’ 49:1050 1075 (1982).

284
Appendix D—Congressional Access to Proprietary Pharmaceutical Industry Data 285

a record in preparation for possible legislative action.4

In 1971, the Comptroller General of the United States,

the head of GAO, testified at one of these hearings.5

The Subcommittee Chairman, Senator Gaylord Nelson, suggested that GAO use the ‘access-to- records’

clause, found in a number of government contracts

with the pharmaceutical companies, to ‘‘take a look at

the costs” of the pharmaceutical industry.6 After the

hearings Senator Nelson’s staff continued to urge

GAO to use its powers under these clauses to obtain

cost records ‘‘without any strings attached so that the

high profits’ of the drug industry could be made

public by product and firm.7

Following the hearings, in 1972 GAO approached

the Pharmaceutical Manufacturers Association (PMA)

about doing a comprehensive study on the industry,

including production process, efficiency, costs, and

profits. PMA-member companies rejected GAO’s

request because the confidentiality of their cost and

other data could not be protected.8 GAO revised its

plan and proposed a Phase I study that would examine

the characteristics and methods of the industry. Six

companies voluntarily cooperated with this initial

phase: SmithKline Corporation, Bristol Laboratories,

division of Bristol-Myers Company, Abbott Laboratories, Eli Lilly & Company, Merck& Company, Inc.,

and Hoffman La Roche.

In 1974, GAO published its Phase I findings9 and

proposed a second part to gather data that would

illuminate ‘‘salient economic and operational aspects

of the industry. "

10 GAO originally proposed that the

cost data from individual companies or drugs be kept

confidential; however, Senators Nelson’s and Edward

Kennedy’s staff insisted that the Committee’s objectives could only be met if the data were made public.11

The drug companies refused to cooperate, and in 1974

GAO decided to use its authority under the access to

records clause to obtain the data.

Each of the six pharmaceutical companies GAO

studied in Phase I had government contracts with the

U.S. Defense Department and the U.S. Veteran’s

Administration. Relying on the access to records

clauses in these contracts, GAO sent a letter to each

company requesting:

. . . all books, documents, papers, and other records directly pertinent to the contracts, which

include, but are not limited to (1) records of

experienced costs including costs of direct materials, direct labor, overhead, and other pertinent

corporate costs, (2) support for other information

as may be necessary for use to review the

reasonableness of the contract prices and the

adequacy of the protections accorded the Government interests.12

As would later become apparent, GAO was seeking

financial data that would allow it to estimate research,

development, marketing, promotion, and distribution

costs for individual products.

Each of the pharmaceutical companies’ contracts

was negotiated freed price and the prices were

therefore based on catalog prices, often with volume

4$ <Compe.ltlve pr~b]cms in [he Drug 1nduslv: Hearings before tic Subcommittee on Monopoly of tie Senate Selmt committee on Small

Business (pt. 1 ) 90th Cong , 1st Scss passim ( 1967) (remarks of Senator Gaylord Nelson) cited in note, ‘‘The General Accounting Office’s

Access to Government Contractor’s Records, Unz;ersity of Chicago LaH Re\’iew 49: 1050-1075 (1982).

5 $ ‘HcU1ngs on Competltlve probl~ms in the D~g Indus~ before ~c sc~~te Subcommittee on Monopoly of the senate SCIWt committee

on Small Business, ’ 92d Cong., 1st Sess., 8020 (1971) cited in note, ‘‘The General Accounting Office’s Access to Govemmenl Contractor’s

Records, ” Un~\er$/ry of C’h/cugo Law Re}iew 49: 1050-1075 (1982).

e Bon’sher v. Merck & Co , Inc., 103 S. Ct. 1587, 1591 n.4 (1983).

7 Bowsher v. Merck & Co , Inc , 103 S. Ct. 1587, 1591 n.4 (1983).

8 Elf Lill} & Co , v. Sfaa[s, 574 F,2d, 904, 923 (7th Cir. 1978), cerf. denied, 439 U.S. 959, 99 S. Ct. 362 ( 1978).

g Eli Lilly & Co. v. Staats, 574 F,2d. 904, 923 (7th Cir. 1978), cert. denied, 439 U.S. 959, 99 S. Ct. 362 (1978).

1~ BO~sher V. .~erck & CO,, fnc., 103 S. Ct. 1587, 1591 n.4 (1983).

] I GAO ]:~tcr ~~~eflcd tit i@ repo~ t. Congress would not ident~ p~lcul~ companies or produc~, but rather it would be ~ industr-ywide

report. E// Llfly & Co, v, Sfaats, 574 F.2d 904 (7th Cir, 1978), cert. denied, 439 U.S. 959, 99 S. Ct. 362 (1978).

II Harvard Law Review, ‘ ‘The Controller General’s Authority To Examine the Private Business Records of Govemmcnt Contractors: Eli

LI[l}I & CO v. .Staats”, Han’ard Lawt Re\iew 92: 1148-1159 ( 1979).
286 I Pharmaceutical R&D: Costs, Risks and Rewards

discounts. When the contracts were negotiated, the

reasonableness of the prices was assessed on the basis

of the contractor’s established catalog or market price;

no attempt was made to demand the manufacturer’s

actual costs. 13 A number of the companies believed

any data relating to costs of the products were

irrelevant to a fixed price contract, and to the extent any

financial data were relevant, only direct costs (e.g.,

materials and labor) apply. Furthermore, the companies believed GAO was not authorized under the

statute to conduct an audit for the sole purpose of doing

a congressional study. They argued that the access-torecords clause was meant only to prevent fraud and

abuse in government contracting and could not be used

unless there was a reasonable basis for GAO to suspect

fraud and abuse in pricing. Since the contract prices

were at or below the catalog prices and were not

negotiated, the companies claimed GAO should not be

allowed to investigate their prices. Therefore, in

answer to GAO’s request, five of the six companies

filed suit to prevent GAO from enforcing its demand.14

The fact that the catalog prices were not questioned

during the contractual negotiations did not prevent

GAO from auditing the prices paid. A previous case

involving a fixed-price defense industry contractor had

already established that GAO was not strictly limited

in its investigation of government contracts to those

items specifically negotiated. The word ‘contract, ’ as

used in the access-to-records statute, was interpreted to

not only include the specific terms, but also the general

subject matter of the contract which includes the

business arrangements of the contract.15 Faced with

this precedent, the courts in the pharmaceutical cases

were unwilling to narrowly limit GAO’s ability to use

access-to-records clauses to gather information on

prices even when the price was not specifically

negotiated and was less than a catalog price. Moreover,

although the courts recognized that GAO’s request was

motivated largely by the Senate Subcommittee on

Monopoly’s desire for a study on the pharmaceutical

industry, the courts concluded that such mixed motivations did not limit GAO’s stated statutory powers.16

After quickly disposing of these issues, the courts

struggled with what became the main issue: what

documents could GAO properly request? The only

precedent, Hewlett Packard v. United States, had

given GAO access to books and records related to the

direct cost of materials, labor, and overhead but had not

addressed the question of whether GAO’s access

extended beyond direct costs.17

The scope of GAO’s power turned on the phrase

“directly pertinent” in the statute authorizing GAO

access to documents under government contracts.

Interpreting the applicability of these two words

became the subject of litigation for nearly a decade. No

other court had interpreted this language, and the

legislative history was ambiguous. 18 The original

proposed bill allowed GAO access to all records that

were ‘pertinent. ‘‘ The adjective “directly’ was added

at the end of legislative debate to limit snooping’ that

may be carried out."19 This amendment revealed that

although Congress sought to give GAO broad enough

powers to obtain data that would enable it to evaluate

the reasonableness of Federal Government contracts

and deter impropriety and wastefulness, certain Members also expressed concern about giving GAO overly

broad access to private data.20

Between 1977 to 1983, 10 separate Federal court

decisions were handed down in the cases between

13 s.s. G~er, ‘6 GAO R@ of &cess and tie pharmaceutical Industry: Bowsher v. Merck,” Air Force fuw Review 24(2): 125-156 (1984).

14 Hoffmann LaRoche chose to settle with GAO. htter from Thornas G. Stayton to the HarvardLuw Review (Jan. 3, 1979) cited in “The

Controller General’s Authority To Examine the Private Business Records of Government Con@actors: Eli Lilly& Co. v. Smuts’ HarvardLuw

Review 92: 1148-1159 (1979). The terms of that settlement and the amount of information obtained from Hoffman La Roche do not appear to

have been made public.

15 Hewlett Pachrd company v. United ,$~ate~, 385 F. 2d, 1013 (9th Cfi. 1967), ce~. denied, 390 U.S. 988, 88 S.Ct. 1184 (1968).

16 S= e.g., Smit~~ine v. Staar~, 668 F.2d 201 (3rd c~. ]981), cert. denied, B~W~her v. Smirmline COrp., 461 U.S. 913, 103 S. Ct. 1891

(1983). For a more complete discussion of this issue, see Case Comments, “The Comptroller General’s Authority To Examine the Private

Business Records of Government Contractors: Efi Lilly & Co. v. Sfaafs, Harvard Luw Review 92: 1148-1159 (1979).

17 ~ew~ett pac~rd v. ~nitetj StafeS, 383 F.2d 1013 (9~ Cir. 1967), ce~. denied, 390 U.S. 988, 88 S.Ct. 1184 (1%8).

18 NO@ ‘ ‘me ~ne~ ACCOUU* office’s Access to Contractor’s Records,’ University ojChicago Luw Review 49:1050-1075 (1982).

1997 CongreSsionalRe~ord 13377 (1951) cit~ ~Merc& V. B~W~her, at 1~,me complete quote of Congressman Hoffma13, who supported

the amendment was that [t]he purpose is to limit ‘snooping’ that may be carried out under this bill which we do not have the votes to defeat.”

115 Congressional Record 258(KI (U.S. Senate - Sept. 17, 1969).

zo ~ows~er V. Merck & CO. Inc., 460 U.S. 824, 103 S.Ct. 1587 (1983).
Appendix D-Congressional Access to Proprietary Pharmaceutical Industry Data ! 287

GAO and the pharmaceutical companies.21 All of the

courts agreed that GAO had the authority to see cost

data even if the prices were not negotiated. The courts

also agreed that direct costs, such as manufacturing

costs, royalty costs, and delivery costs were relevant to

the contract and were therefore subject to GAO

review. 22 But, the courts were split on GAO’s right of

access to indirect costs (research and development

(R&D), marketing, promotion, distribution, and administration costs). In most cases, the companies successfully argued that indirect cost data were not directly

pertinent because only a small portion of indirect costs

could be allocated to the Federal Government’s

contracts, and GAO would have to examine a large

amount of data not related to the Government’s

contracts in order to discern this small amount.23 The

Government unsuccessfully argued that GAO would

not have to go on a fishing expedition through all the

company’s unallocated costs, because the companies

allocate costs to products and perform profitability

studies for their own purposes.

24 That argument fell on

deaf ears, and GAO was given access only to direct

cost data that the industry was willing to provide.25

From a practical point of view, these decisions left

GAO with little meaningful data, since direct costs

amounted to only about 9 percent of the cost of a

particular pharmaceutical product. The access granted

by these courts was, therefore, virtually useless as an

auditing tool.

GAO did find a sympathetic ear in one judicial

circuit. In Eli Lilly & Co. v. Staats,26 the Seventh

Circuit concluded that because R&D, marketing, and

promotion costs constituted a major portion of the total

price of the contracts, they were directly pertinent

under both “common and legal understandings.”

27

The court concluded that records were “directly

pertinent” to a contract if it is “a significant input in

the cost of the product purchased in the contract.”28

The conflict between the courts was finally resolved

by the U.S. Supreme Court, in Bowsher v. Merck & Co.

Inc.29 The Federal Government again argued that GAO

had the right to examine records pertaining to every

cost that the company used the Government’s payments to defray. 30 The decision to make such a broad

assertion of power may have been a strategic mistake

because it gave no apparent recognition to the statutory

limits imposed by the word “directly,” and the

Government’s interpretation, “carried to its logical

extreme. . . would dictate that few, if any, of private

contractor’s business records would be immune from

GAO scrutiny."31 Moreover, the Supreme Court cited

GAO internal decisions and a memorandum to ConZ1 Bristol Laboratories Div. of Bristo[-Myers Co. v, Staats, 428 F. Supp. 1388 (1977), @dper curium, 620 F. 2d 17 (2d CU. 1980), afld

mem. by e~’enly di~ided court, 451 U.S. 400 (198 1); SmithKline C’OT, v. Smuts, 483 F. Supp, 712 (E.D. Pa. 1980), affds 668 F.2d 201 (3d

Cir. 1981), cert. denied, Bow’sherv. SmithKline Corp., 461 U.S. 913 (1983); Eli Lilly & Co. v. Staats, 574 F.2d. 904 (7th Cir. 1977), cert. denied,

439 U.S. 959,99 S. Ct. 362 (1978); U.S. v. Abbott, 597 F,2d 672 (7th Cir. 1979). Merck& Co. v. Staars, 529 F. Supp. 1 (D.C.C. 1977); afld,

665 F.2d 1236 (D.C. Cir. 1981), afld., Bowsher v. Merck & Co,, 460 U.S. 824, 103 S. Ct. 1587 (1983).

z~ In one of the first cases decided, the Bristol-Myers Company offered to provide GAO with data on direct costs. This compromise position

proved to be a useful strategy because the courts concluded that the company’s offer reflected ‘a responsible and reasomble effort to distinguish

‘directly pertinent’ matter. ” Bristol Lub. Div. of Bristol-Myers Co. v. Staats, at 1391.

23 Bristo/ Lab, Div. of Bristof-iUyers Co. v. Staats, at 1391.

M SmirhKline Corp. v. Sfaafs, 668 F.2d 201 (1981), cert. denied, Bowsher v. SmithKline Corp., 461 U.S. 913, 103 S. Ct. 1891 (1983) “we

therefore adopt the standard formulated in Brittof, which for the most part relies on the distinction between direct and indirect costs’ Merck

& Co. v. Staafs, 665 F.2d 1236 (D.C. Cir. 1981), afld, Bowsher v. Merck & Co., 460 U.S. 824, 103 S. Ct. 1587 (1983).

25 Merck v. Staafs, at 1247 (Mikva, J., concurring in parL dissenting in part).

26574 F.2d 904 (7th Cir. 1978), cert. denied, 439 U.S. 959 (1978).

27574 F.2d 904 (7th Cir. 1978), cert. denied, 439 U.S. 959 (1978).

28574 F.2d 904 (7th Cir. 1978), cert. denied, 439 U.S. 959 (1978).

‘9 460 U.S. 824, 103 S. Ct. 1587 (1983).

so Bowsher V, Merck & CO. Inc., 460 U.S. 824, 843, 103 S. Ct. 1587,1598 (1983).

31 Bo~,s~er V. Merck & CO. Inc., 460 U.S. 824, 103 S. Ct. 1587 (1983).

JZ 1n a 1969 memoradum responding t. Congess’ interest in performing a profitability study of the defense industry, ‘AO ‘ote ‘it

‘ ‘While GAO’s legal authority would permit it to perform some to the work necessary in making a profit study. . . . to do a meaningful study

of profitability. . . . legislation should be enacted broadening [GAO’S] right of access to rword. .“ Part of GAO’s concern was that without

specific authority it would be drawn into protracted litigation. Memorandum on the Adequacy of the LegalAuthority of the General Accounting

Office To Conduct a Comprehensive Study of Profitability in the Pharmaceutical Industry, reprinted 115 Congressional Record 25,801 (Semte

1969).
288 I Pharmaceutical R&D: Costs, Risks and Rewards

gress in which GAO appeared to acknowledge more

limited authority .32

The Court followed the majority of the lower courts

and drew the line between direct and indirect costs. The

Court held that since Congress had drafted the limiting

language (’‘directly pertinent”), arguments for change

should be directed to Congress. The Court also noted

that in the past Congress had found it necessary to pass

legislation expanding GAO’s powers to conduct a

profit study of the defense industry .33 In that case,

Congress expressed its reservations about providing

GAO with the authority to conduct a “fishing expedition” and limited this expansion of GAO’s authority

to a single study .34 This past congressional action

weakened the Government’s argument that GAO had

such broad powers under the access-to-records clauses.

I The Availability of Congressional

Subpoena Power

Although the Federal Government was willing to

fight five separate cases through to the Supreme Court,

Congress was not willing to use its subpoena power to

obtain the data. A brief review of the scope of

congressional subpoena power demonstrates that since

the hearings were being carried out in anticipation of

legislation, a congressional subpoena would have been

a legal alternative, although perhaps not politically

feasible.

Congress’ power to legislate includes the power to

investigate, to compel witnesses to testify, and to

demand the production of documents. The power to

investigate and issue subpoenas is, however, limited to

the congressional committees.35 There are few’ limitations on the scope of a congressional subpoena,

provided it is carried out in the course of legitimate

congressional powers. As the Supreme Court cases in

this area demonstrate, legitimate congressional powers

are quite extensive and congressional subpoenas are

virtually immune from judicial challenge.36

The courts give congressional subpoenas deference

because they fall within the protections of the Speech

and Debate clause of the Constitution.37 The Speech

and Debate clause literally protects all Senators and

Representatives from “questioning in any other Place

for any Speech or Debate in either House. ” As

interpreted, this protects members of Congress from

judicial interference in legislative matters.

In Eastland v. United States Servicemen’s Fund,38

the Supreme Court reviewed a congressional subpoena

issued during the course of an investigation of the

United States Servicemen’s Fund, Inc. (USSF). The

USSF challenged the subpoena alleging it infringed

upon the USSF’s First Amendment rights.39 The Court

rejected the USSF claim, stating that since the congressional subpoena fell within the “sphere of legitimate

legislative activity,” the Committee’s actions could

not be questioned by the courts because the “prohibi33 ~fiwAppropriatio~ &t of 1970, ~blic J.AW 91-121, Sec. 408, 83 Stat, 204, cited itI MerCk V. Bowsher, a 1595, n. 12.

~ 115 co~essio~ Record 25795,25793 (statements of Senator Ribicoffand semtor~o-, respectively), cited in Merck v. Bowsher,

at 1595, n. 12.

M me power t. Mvestigate us~g comp~sow prmess is derived from the U.S. COUStitUtiO~ but Congress ime~ti limit~ Subpoem power

to the committees. Since 1946, each standing Senate Committee has had the power to issue subpoenas without obtaining speci.tlc permission

from the Senate. See The Legislative Reorganization Act of 1946 (Public Law 79-901), cited in Congressional Quarterly, Gu”de to Congress

(3rd Ed.) (Washingto% DC: Congressional Quarterly Inc., 1982). In 1974, House Committees were given general subpoena power; however,

each subpoena must be approvedl by the majority of the Committee or Subcommittee and can only be enforced by action of the fuU House.

Congressional Quarterly, Guide to Congress (3rd Ed.) (WashingtoXL DC: Congressional Quarterly Inc., 1982).

36 McGrain V. Daugher~, 273 U.S. 135 (1927) (establishing that Congress must be able to obtain kfo~tionto fulfill i~ Iegisktive duties

and may compel such disclosure). Watkins v. United States, 354 U.S. 178 (1957).

37 U.S. Constitutio~ Art.1, Sec. 6, clause 1.

38421 U.S. 491, 95 S. Ct. 1813 (1975).

39 me USSF published ~ ~dergro~d newspaper for America ~i~perso~ ~d estab~h~ ~ff~hous~ n= do~stic rllili~

installations which were admittedly a‘ ‘focus of dissent and expressions of opposition within the military toward the war in [Southeast Asia].’

Congress was concerned that the activities of the USSF were undermining the moral of American servicepersons and issued a subpoena

requesting all USSF documents and records to the bank in which USSF kept its account. ‘fhe USSF protested that Congress was attempting

to force the disclosureof4‘beliefs, opinions, expressions and associations of private citizens which may be unorthodox or unpopular,’ and that

the sole purpose of the subpoena was to ‘‘harass, chill, punish and deter wSSF and its membem] in their exercise of their” First Amendment

rights, particularly freedom of the press and freedom of association. Eusrland v. United Sfutes Servicemen’s Fund, 421 U.S. 491

(1974).
Appendix D—Congressional Access to Proprietary Pharmaceutical Industry Data 289

tions of the Speech and Debate Clause are absolute."40 

Even valid constitutional objections are overridden by

the absolute nature of the Speech and Debate clause.41

To be within the protections of the Speech and Debate

clause, the subpoena must be issued in ‘‘a session of

the House by one of its members in relation to the

business before it.”42 In addition, a court will not

examine the motives for the subpoena, provided it can

be related to possible legislative actions;43 “the

wisdom of congressional approach or methodology is

not open to judicial veto."44 The Supreme Court has

stated that a legislative inquiry is valid even if there is

‘‘no predictable end result. ’45

Given this broad subpoena power, it is likely that a

congressional committee could devise a legitimate

subpoena to obtain R&D costs from the pharmaceutical industry. For example, Congress might investigate whether discounts should be required for pharmaceuticals purchased for Medicaid, Medicare, or other

government programs, or look into whether current tax

subsidies for R&D costs are warranted. The industry

has cited its research costs in testimony during 1987

hearings on the consequences of the Drug Price

Competition and Patent Term Restoration Act of 1984

(Public Law 98-417) and, therefore, has arguably made

it a legitimate target for investigation.

Any subpoena directed at such data is likely to be

met by protests about the proprietary nature of the data.

Although business confidentiality arguments are not

sufficient to block the subpoena,46 such arguments can

result in protracted negotiations over whether the

information will be kept confidential and the scope of

the documents that must be turned over.

In summary, Congress has the power to request

R&D and marketing cost data from the industry. But,

given the past history of litigation on the issue it is safe

to predict that pharmaceutical companies are not likely

to make such a request easy, and Congress has so far

been unwilling to exercise this power.

40 Ea~f/and “ United Sfafe$ Semlcemen’s Fund, 421 U.S. 491, 95 S.C[. 1813 (1975) (additional cites Omitted).

41 East/a~”, ~nitedSfateS Semicemen’s Fund, 421 U.S. 491 ( 1975) (additio~ cites omitted), However, three Justices WrOte that h Certa.iIl

cases the constitutionality of a congressional subpoena may be reviewed by the Court, even if the subpoem is within the sphere of legitimate

legislative activity. Id. (concurrence of Justice Marshall, with whom Justices Brennan and White joined).

42 Kl]bourn v, Thomp~~n, 103 U.S. 168 (188 1), cited in Easdund v. United Sfufes Servicemen’s Fund, 421 U.S. 491 (1975).

43 Ea~f/and v. unitedsfa(e~sen,icemen’~ Fund, 121 us. 491 (1974): Watkins v. ~ni(ed Sra[es, 354 U.S. 178, 200, 93 S. Ct. 2018 (1957).

44 Doe V. MciVfilfan, 412 U.S. 306, 313, 93 S. Ct. 2018 (1973).

os Easf/and v, United Stares Sen,icemen’s Fund, 421 U.S. 491 ( 1974) (addition~ cites omitt~)

46 Conversation with c~les Tlefer, Offlce of the General Counsel, House of Representatives, I_J.S. Congress (September 4, 1991).
Appendix E

Patent Protection of Pharmaceuticals

in the United States

I

nventors have two mechanisms to protect the

commercial value of their inventions: secrecy or

patents. Trade secrets have legal protection if

inventors make efforts to prevent the sharing or

dissemination of their intellectual property (452).

Patents prohibit others from making, using or selling

the invention in the United States for 17 years after

issuance without the inventor’s permission.1 Because

of the relatively wide dissemination of pharmaceutical

research results and production techniques through

scientific literature and discussion, drug manufacturers

rely on patents to protect potential and marketed drug

products whenever possible. This appendix briefly

examines the nature and limitations of pharmaceutical

patent protection in the United States.

1 Pharmaceutical Patents and Products

Article I of the U.S. Constitution provides Congress

with the power “to promote the Progress of Science

and useful Arts, by securing for limited Times to

Authors and Inventors the exclusive Right to their

respective Writings and Discoveries, ’ which Congress has implemented by allowing the Federal Government to issue patents. In contrast to many inventions, pharmaceutical products typically do not have a

simple one-to-one correspondence with patents to

which they relate. Several drugs can share the same

patent, and some drugs may be protected by more than

one patent. Other drugs are not eligible for patents at

all.

According to Federal statute, art invention is patentable only if it is new, useful, and unobvious (35 U.S.C.

35101-103). The heart of a patent application is the

“claims” that the filer makes. The claims succinctly

define the subject matter that the inventor regards as

the novel contribution. A patent examiner compares

the claim against existing public information (“prior

art”) in deciding whether to award the patent. The

claim defines the scope of protection granted to the

patent owner and is the basis for future judgments of

whether the patent has been infringed (1 1).

For most newly discovered pharmaceutical chemical entities, a patent applicant can make four types of

claims:

A compound claim covers the chemical entity,

per se, including any and all formulations or uses

of the chemical entity.

A composition claim covers a chemical entity

formulated for use as a pharmaceutical. These

claims sometimes specify a particular dosage

form (e.g., oral tablet, injectable drug) or carrier2

although they rarely are limited to a particular

carrier, dosage form or treatment of a particular

ailment.

A method-of-use claim covers the use of a

chemical compound or composition in a specified way. For example, the applicant may claim

compound X as an antibiotic when administered

in an effective dose against bacterium Z.

A process claim, or method of manufacture

claim, covers the way in which a compound or

composition is produced (124,284). These claims

have been particularly important in recent years

for drugs that rely on recombinant DNA (deoxyribonucleic acid) technology, and because of

‘ Contrary to trade secrecy, the patent system actually contributes to the disse mination of scientific and technological advances through the

publication of inventions and their details at the time the Federal Government issues their patent.

z A pharmaceutical carrier is usually an inert substance which allows or facilitates the active compound to be absorbed by and act upon the

body (42).

290
—

Appendix E—Patent Protection of Pharmaceuticals in the United States I 291

a 1989 amendment to the patent laws that permits

the holder of a U.S. patent to stop the importation

of a product made outside the United States by

the patented process (35 U.S.C. 271(g)).

Currently in the United States, all four kinds of claims

are often found in a single patent. Prior to 1980, the

U.S. Patent and Trademark Office (PTO)3 usually

granted three patents for the four types of claims: one

for the compound claim, one for the composition and

method-of-use claim and one for the method of

manufacture claim. The transition to a single patent has

occurred gradually over the past 10 years and reflects

procedural changes within the PTO (284).

For a firm filing an application with a compound

claim, there are tradeoffs in deciding how broad the

claim should be. A broad claim may encompass

thousands of compounds which share common structural characteristics that are thought to be responsible

for providing a particular utility. However, the broader

the claim, the greater the chance a patent already exists

on some version of the compound, thereby defeating

the novelty of the broad claim. If a patent already exists

on a particular compound or composition, one can still

apply for and receive a composition or method-of-use

patent for a new use even though the proposed use

would infringe the pre-existing patent claiming the

compound. A patent, however, does not give its owner

the affirmative right to make, use, or sell the claimed

subject matter but rather only the right to exclude

others from doing so. In granting patents the PTO is

only concerned with the patentability of the claimed

subject matter and has no authority to consider whether

that subject matter infringes an earlier patent. Determination of whether or not art infringement has occurred

and enforcement of a patent must be left to the court

(124).4

Given the broadness with which an applicant can

make a compound claim, each patent, in reality, may

cover or protect multiple chemical compounds. The

PTO estimates that the average pharmaceutical patent

contains ten distinct chemical compounds (284).

Assuming a single compound may have more than one

composition or method-of-use claim, a single patent

could be associated with an unspecified number of

potential products. The ability to file new method-ofuse claims on existing compound or composition

patents (because of a newly discovered use or a new

dosage form) increases the likelihood that the intellectual property protection of a single marketed drug

product can rest on more than one patent (124,497).

Some drug products are not eligible for patent

protection. Most of these have existed so long that all

relevant patents have expired. A potential manufacturer can file a patent application for the new use of

such a drug. However, the characteristics and actions

of long available drugs (e.g., aspirin) may be so well

known that it is difficult to establish the novelty (or

lack of novelty) of a method-of-use claim. Even where

a patent is obtained on a new method of use for an old

drug with many shown uses, the patent may be difficult

to enforce (497).

Until the 1980s, drugs discovered and developed in

Federal laboratories rarely had patent protection because Federal policy dictated that they remain in the

public realm. As a result of a series of legislative and

policy initiatives developed during the 1980s, the

Federal Government now patents drugs discovered in

its laboratories and actively attempts to license them to

the private sector.5

1 Patent Protection of

Biotechnology Drugs

As discussed in chapters 5 and 6, major advances in

the life sciences over the past 15 years have led to an

increased number of biological drugs whose production is based on techniques of biotechnology. Biotechnology, particularly recombinant methods, allow manufacturers to produce sufficient quantities of these

medicinal preparations for therapeutic use. Although

the U.S. Supreme Court has held that living organisms

are patentable, naturally occurring compounds and

compositions themselves are not patentable because

they are not considered ‘novel. Products that exist in

nature may be considered patentable if they are given

a form, quality or function they do not possess in the

natural state or otherwise meet all other criteria for

s ~o is ~e ~gcncy ~1~ tie U.S. Comerce Department charged with examining patent applications and issuing Patents.

4 If one inventor receives a patent on an improvement to another inventor’s already patented invention, each inventor may find himself or

herself blocked from using his or her invention by the other’s patent. In such a situatiom not uncommon among pharmaceuticals, the two

inventors usually negotiate to cross-license their patents so both can use, produce, or sell their inventions (124).

5 Chapter 9 describes in greater detail patent and technology transfer policies in the U.S. Department of Health and Human Services and

their implications for pharmaceutical R&D.
292 I Pharmaceutical R&D: Costs, Risks and Rewards

patentability. Those who produce old drugs with the

new techniques of biotechnology tend to seek patent

protection for the methods by which they produce the

drug; the bases for these patents are referred to as

“process claims.

Because of the relative novelty of biotechnology

drugs and their patent claims, they have been the

subject of much legal uncertainty and dispute over the

past few years. The drug recombinant erythropoietin

(rEPO), which treats anemia by replacing a deficient

enzyme vital to red blood cell production, is a notable

example. In 1987, Amgen, Inc. and Genetics Institute

each received a patent related to rEPOs. Genetics

Institute received a patent on a method of purifying

human EPO from natural sources (i.e., not rEPO) and

applied for another patent covering the production of

a recombinant form of EPO. Amgen’s patent covered

an intermediate product in this process. Genetics

Institute also licensed its patent rights to Chugai

Pharmaceuticals for the Japanese market and to a

cooperative venture between Chugai and Upjohn

Company for the U.S. market.

In subsequent litigation, a Federal court in Boston

ruled that because Chugai produced its rEPO in Japan,

it did not violate Amgen’s patent; the court found that

Amgen’s protection of an intermediate product in the

manufacture of rEPO did not cover production in

another country. However, the judge did find that

Amgen and Genetics Institute had each violated parts

of the other’s patent. In 1990, the court ordered these

two firms to cross-license each other’s patents without

royalties (45 1). In March 1991, however, the Court of

Appeals for the Federal Circuit reversed this decision,

upheld Amgen’s patent, ruled that Genetics Institute

had infringed on Amgen’s patent, and barred Genetics

Institute from marketing rEPO in the United States

(12,452). 6 This action ensured only Amgen’s version

of rEPO would be available in the United States for the

duration of its patent protection.7

1 Length of Patent Protection

Although the Federal patent statute provides for 17

years of exclusive rights to an invention, the actual

amount of time a drug manufacturer is usually able to

market its drug without competition is substantially

less. Because firms usually seek patent protection once

a potential drug compound is identified (284), a large

portion of the patent period can be taken up by the

sponsor’s research and development (R&D) activities

and the U.S. Food and Drug Administration’s review

of the marketing application (507). In 1984, Congress

passed the Drug Price Competition and Patent Term

Restoration (DPCPTR) Act (Public Law 98-417),

which allowed PTO to add up to five years to the patent

term of drugs when the patent term was eroded by

regulatory review. 8 As of May 1992, the PTO had

issued 142 patent extensions most often for a period of

2 years beyond the statutory 17-year exclusivity (497).

From time to time Congress has passed special

legislation granting additional patent extensions for

individual drugs.9 In 1992 Congress considered, but

did not enact, a bill granting patent extensions for

Upjohn’s nonsteroidal anti-inflammatory drug flurbiprofen (AnsaidTM) (S. 102-1165) and U.S. Bioscience’s

antiradiation drug ethiofos or amifostine (EthyolTM)

(S. 102-526). The PTO had already issued a certificate

of patent term extension for 2 years though February

1993 under the DPCPTR Act on the patent for which

Upjohn seeks a further extension, but the company

claims that unwarranted delays by FDA in the approval

of its drug justify a further 4+ years. U.S. Bioscience

seeks a 10-year extension for ethiofos because of its

claim that the U.S. Army prevented the drug’s timely

development for the potential treatment of persons

with human immunodeficiency virus and cancer (439).

6 A.mgenreceived U.S Food and Drug A&mm‘stration approvat to market its rEFO for the treatment ofanemiaamong patients with end-stage

renal disease in June 1989.

7 In another suit brought by Arngem the U.S. International Trade Co remission ruled that it lacked jurisdiction and sent the case to the Federal

Circuit Court of Appeals which ruled in 1990 that Amgen’s patent did cover a process for producing rEPO (13).

8 This legislation represented a compromise that also allowed easier FDA approval for generic drugs after patent expiration. The law also

allows two types of exclusivity not related to patent status--a 5-year exclusivity for new chemical entities not eligible for a patent and a 3-yar

exclusivity for new uses of approved chemical entities. TMs appendix discusses the 3-year exclusivity in greater detail in the following section.

9 For example, in 1983, as part of the Federal Artti-’Ikmpering Act (Public Law 98-127), Congress extended two patent terms covering an

anesthetic drug to compensate for a delay in marketing approval while the fm conducted research at the request of the FDA that Congress

deemed unnecessary (497). In another case, Congress granted a patent term extension for the drug gernfibrozil to Warner-Lambert Company

after it was shown to have a new use in combating high cholesterol (Public Law 100-418).
Appendix E–Patent Protection of Pharmaceuticals in the United States \ 293

1 Patents and “Follow-On” Products

Once relevant patents protecting the exclusive

marketing rights of a drug expire, the manufacturer of

the original form of the drug often seeks to maintain its

market share by developing new, but related products.

These new products may include previously unmarketed dose forms of the drug such as one that might

require less frequent or easier administration. Once on

the market, physicians and patients may prefer such a

dose form over generic versions of the old dose form.

Alternatively, the originator firm may develop a new

(and patentable) drug product that is chemically related

to the first but offers some clinical superiority. For

example, the new drug may have fewer adverse

reactions than the frost generation product that is losing

its patent protection. Although all companies theoretically may attempt to develop ‘ ‘follow-on’ products to

drugs losing patent protection, Federal law may offer

the originator company an advantage in developing

them more quickly. In a series of legal decisions, the

Federal courts have determined that researchers may

use patented materials and processes for noncommercial scientific inquiry, but that any research related to

a possible commercial product constitutes a patent

infringement. Hence, the originator may conduct R&D

activities on follow-on products, while all other

competitors must wait until any relevant patents expire

before beginning to develop their own (452).

Furthermore, the DPCPTR Act (Public Law 98-417)

contains a provision that may reinforce the advantage

originator firms have in getting ‘‘follow-on’ products

to market. The law provides for 3 years of market

exclusivity for companies receiving approval of an

new drug application (NDA) that is not for a new

chemical entity, or of a supplemental NDA for a new

use of an already approved drug. 10 To be eligible, the

new or supplemental NDA must be based on new

clinical research (other than bioavailability studies)

conducted or paid for by the drug’s sponsor and

essential to FDA approval (83).

10 me ]aw ~So al]ows for a 5-Y= market exclusivity for new chemical entities not otherwise guaranteed a period of market exclusivity

through patent protection of their active ingredients (83).
Appendix F

Summary of Methods Used to Analyze

Trends in Postpatent Revenues

T

he Office of Technology Assessment (OTA)

contracted with Dr. Stephen Schondelmeyer

to report on trends in sales revenue and unit

sales volume for molecular compounds that

lost patent exclusivity during the 4-year interval

1984-87 (368). The period 1984-87 was chosen

because the Drug Price Competition and Patent Term

Restoration Act of 1984 (Public Law 98-417) significantly reduced the barriers to market entry for generic

manufacturers by allowing the U.S. Food and Drug

Administration (FDA) to expedite the approval process for generic versions of drugs already proved safe

and effective. Data were provided on sales of the

sampled compounds from 1980 to 1990.

Dr. Schondelmeyers report to OTA is based on data

from the IMS America, Inc. MIDAS system using the

United States Drugstore and United States Hospital

database. That database does not include sales made

directly to mail-order distributors, health maintenance

organizations, or Federal Government health purchasers (such as the U.S. Department of Veterans Affairs

and the military.) In 1986, IMS America claimed the

database reflected 98 percent of ethical pharmaceutical

sales in the United States (368), but this share may be

declining as mail-order pharmacies become more

important.

1 Sample Selection

OTA supplied the contractor with a list of 83

pharmaceutical compounds which came off patent in

the period 1984-87. This list was compiled from

sources that included the FDA (262), trade publications and market research surveys. Products approved

for over-the-counter sale during the period of study

were excluded from the sample. Combination products

were also excluded, except for two (methyldopa with

hydrochlorothiazide and triamcinolone acetonide with

nystatin). 1

Drug products that would not be marketed in

significant quantity through community-based pharmacies were also removed from the sample.2 These

included injectable, infusible, and diagnostic drug

products. Injectable and infusible drugs make up a

negligible part of the outpatient market but a larger

proportion of the hospital market. Informal discussions

with hospital pharmacists in a large voluntary hospital

chain suggest injectable and infusible drugs constitute

approximately 60 percent of dollar purchases of

inpatient drugs.

After eliminating products not meeting the criteria

for inclusion, 45 products were in the sample. The

drugs on OTA’s list also were compared with a

drugstore database held by Purdue University (based

on IMS data), and compounds with no recorded sales

in any of the study years were eliminated. After this

round, 41 drugs remained in the sample (see table F-l).

Further analysis of the IMS data showed some

products with substantial generic sales in years prior to

the assumed patent expiration date. We contacted the

company marketing the brand-name product and also

referred to a summary of patent issue dates produced

in 1988 by the Pharmaceutical Manufacturers Associations (PMA) (322). Four products were removed from

the list when the true patent expiration year was found

to be earlier than the year obtained from the FDA.

(These compounds are listed with a footnote in table

F-l.) Two additional drugs (enflurane and dimethyl

sulfoxide) met the selection criteria as noninjectable,

noncombination drug products but were dropped from

1 For these two products, only the combination products with specitlc ingredients identiled were included.

2 At the time the sample of drugs was selected, the contractor believed that data available from IMS included only drugstore sales. IMS

America ultimately provided the contractor with sales data for both drug stores and hospitals.

294
Appendix F-Summary of Methods Used to Analyze Trends in Postpatent Revenues 295

the analysis, because they are used almost exclusively

in hospitals. Enflurane is a general anesthetic and

dimethyl sulfoxide is a urinary tract diagnostic aid.

Table F-1 shows the final list of 35 products included

in OTA’s analysis.

The patent issue dates compiled by the PMA also

revealed a number of discrepancies with the FDA

patent expiration dates. Only 13 of the 35 drugs

showed no discrepancy between the FDA and PMA

sources. Of the remaining 22 compounds, 18 had PMA

patent expiration dates that were earlier than the FDA

patent expiration date. Choosing a later patent expiration date makes the rate of decline of originator

revenues immediately following expiration look higher.

Therefore, to be conservative, OTA took the FDA date

in these 18 cases.

In the remaining four cases, the earliest PMA patent

expiration date was either the same or earlier than the

FDA date, but the PMA source showed a second patent

that expired after the FDA year. (The earliest patent

typically covers the compound, while subsequent

patents often involve process or uses.) There were no

generic sales in the study years following the FDA

patent expiration date for two of the four drugs. OTA

chose the FDA patent expiration date as the year of

patent expiration in all of these four cases.

1 Data Analysis

The contractor provided OTA with a report containing unit and dollar sales for each compound in the

sample. Because a drug may be produced in different

strengths, dosage forms and package sizes, the contractor constructed a standardized measure of unit sales

(368). This measure of sales volume, the defined daily

dose (DDD), is based on the typical daily dose of a

given drug product for an adult patient being treated for

the drug’s primary indication.

Dollar and unit sales data were compiled for the

compound as a whole across all its dosage forms and

strengths. We selected this orientation to examining

generic competition because the returns to R&D

depend on the entire history of the compound,

including the exclusive opportunity to develop new

dosage forms before the patents on the original

compound expire. 3 Such product extensions bring with

them 3 additional years of exclusive marketing rights

from the FDA.4

Table F-1—Noninfusible Noninjectable New

Chemical Entities Losing Patent Protection,

1984-87

Year of

Drug entity patent expiration

acetohexamide 1984

amiloride 1984

baclofen 1986

beclomethasone 1984

carbamazepine 1986

cefadroxil 1987

cephalexin 1987

cephradine 1986

clindamycin 1987

clonidine 1986

clorazepate 1987

danazol 1984

desipramine 1986

diazepam 1985

dimethyl sulfoxidea

1987

disopyramide 1985

doxepin 1986

enflurane a

1986

fluocinonide b1986

flurazepam 1985

haloperidol 1986

Iactulose 1986

Iorazepam 1985

maprotiline 1986

meclofenamic acid 1985

mesoridazine 1985

methyldopa 1985

methyldopa hctz 1984

metoclopramide 1985

molindone 1987

oxazepam 1984

perphenazine 1986

propranolol 1985

sucralfate 1986

temazepam 1985

thiothixene 1984

tolazamide b 1985

trazodone 1985

triamcinolone b

trifluoperazine b 1985

verapamil 1986

a pa%~selection criteria a.snoninfusible, noninjectable, noncom bination drug products, but not typically used in an outpatient setting;

removed from analysis.

b patent expiration year found to be earlier than year obtained from the

FDA; removed from analysis.

SOURCE: 9ffice of Technology Assessment, 1993, based on S.W.

Schondelmeyer, “Economic Impact of Multiple Source

Competition on Originator Products,” contract paper prepared for Office of Technology Assessment, U.S. Congress,

December 1991.

3 Under this approach, the costs of R&D required to put the extended product on the market must also be included in an analysis of the returns

to R&D. OTA included an estimate of such costs in its analysis of returns to R&D.

4 The additional years of effective patent life obtained from new dosage forms were not reflected in OTA’s estimate of effective patent life.

That estimate is based on the effective patent life for the original compound.
296 I Pharmaceutical R&D: Costs, Risks and Rewards

Sales were reported to OTA in current dollars, but

OTA converted them to constant 1990 dollars using

the GNP implicit price deflator. OTA had 11 years of

data which allowed examination of sales over a

14-year period relative to the year of patent expiration.

Data on each compound were aligned according to the

year of patent expiration. For example, sales in the first

year after patent expiration for compounds whose

patents expired in 1984 were those reported in 1985,

whereas sales in the first year after patent expiration for

compounds whose patents expired in 1987 were those

reported in 1988. Thus, 1988 inflation-adjusted sales

for the 1987 drugs were combined with 1985 inflationadjusted sales of the 1984 drugs to obtain inflationadjusted sales 1 year after patent expiration for the

entire sample.

Data for the entire sample of 35 drugs were available

from 4 years prior to patent expiration to 3 years after

expiration. For earlier and later years, data were

available for only a part of the sample. For example,

data on dollar and unit sales in the sixth year after

patent expiration were available for only eight drugs:

those whose patents expired in 1984. The 6-year

postpatent estimate is based on 1990 sales and volume

data for these eight drugs. Also, 7 of the 35 drugs

received FDA marketing approval after 1980. A drug

was included in each year’s analysis only when the

product was marketed for the complete year.

H Summary of Results

Table F-2 shows the mean sales revenue (in constant

1990 dollars), and unit sales of originator products in

each year relative to the year of patent expiration (year

Table F-2-–Originator Sales of Compounds Losing Patent Protection, 1984-87

Year relative to Sample Revenue per drugb Unit volume per drugc

patent expiration” size (standard deviation) (standard deviation)

-7

-6

-5

-4

-3

-2

–1

o

+1

+2

+3

+4

+5

+6

5

14

22

32

34

35

35

35

35

35

35

30

18

8

$63,051

(79,645)

41,887

(52,518)

63,110

(86,663)

60,258

(78,034)

62,246

(77,934)

68,194

(83,229)

77,661

(91,620)

79,657

(84,010)

69,810

(61,392)

67,239

(66,448)

66,012

(79,686)

63,570

(94,340)

50,832

(52,217)

40,588

(59,995)

44,435

(45,950)

60,346

(61,989)

129,691

(195,887)

118,697

(166,164)

115,621

(156,440)

115,823

(152,824)

115,710

(143,258)

108,791

(126,585)

90,513

(95,021)

83,098

(98,475)

73,771

(100,104)

71,105

(108,036)

49,181

(48,448)

38,023

(51,406)

a year o is the year of patent expiration.

b Measured in thousands, constant 1990 dollars.

c Measured in defined daily dose, in thousands. See text for explanation.

SOURCE: Office of Technology Assessment, 1993, based on S.W. Schondelmeyer, “Economic Impact of Multiple

Source {competition on Originator Products, ’’contract paper prepared for Office of Twhnology Assessment,

U.S. Ckmgrees, December 1991.
Appendix F—Summary of Methods Used to Analyze Trends in Postpatent Revenues I 297

O). Note that in the early and late years, only a

subsample of drugs is included in the estimates.

Year-to-year changes in revenues, shown later in this

appendix, were calculated only for drugs for which

data were available in both years.

The originator brand’s market share in each year

relative to the year of patent expiration is shown in

table F-3. Originator products maintained almost 85

percent of the total market share (in dollars) as long as

6 years after patent expiration, but the originator

product’s market share in unit volume declined to 50

percent within 4 years of patent loss.

OTA examined changes in originators’ dollar and

unit sales over the years immediately preceding and

following the year of patient expiration (figures F-1

and F-2. ) Average year-to-year changes in revenues

and unit sales were calculated only for drugs for which

data were available in both years. Between the second

year prior to patent expiration and the third year after

patent expiration, all 35 drugs were in the sample. In

contrast, only eight drugs were used to calculate the

Figure F-l—Originator Dollar Sales as Percent of

Originator Dollar Salesa in Year of Patent Expiration

for Drugs Losing Patent Protection, 1984-87

Percent

120 ‘1 -

- ‘

--—— ‘–——-–

1 0 0

80

60-1w

21------ ! ,

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Year relative to patent expiration

KEY: Year O is year of patent expiration.

a Based on 1990 dollars.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

schondelmeyer, ‘Economic Impact of Multiple Source Competition on Originator Products,’ cent ract paper prepared for

Office of Technology Assessment, December 1991.

Table F-3—Originator’s Market Share

Dollar Unit

Year Sales Salesb

- 7

- 6

- 5

- 4

- 3

- 2

-1

0

+1

+2

+3

+4

+5

+6

100”/0

99

99

99

99

99

99

95

86

84

84

85

83

85

100% 

100

100

100

100

100

100

94

73

6 5

57

51

44

62

a ‘fear o is the year of patent expiration.

b Unit sales are measured in defined daily dose.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, “Economic Impact of Multiple Source

Competition on Originator Products,” cxmtract paper prepared for Office of Technology Assessment, U.S. Congress,

December 1991.

Figure F-2-Originator Unit Sales as Percent of

Originator Unit Sales in Year of Patent Expiration

for Drugs Losing Patent Protection, 1984-87

Percent

120

\

—

100 ~

80

/

60 -\

I

I

, r I 1 (

-7 -6 -5 -4 -3 -2 -1 0 1 2345 6

Year relative to patent expiration

KEY: Year O is year of patent expiration.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, ‘Economic Impact of Multiple Source Competition on Originator Products,’ contract paper prepared for

Office of Technology Assessment, December 1991.
298 I Pharmaceutical R&D: Costs, Risks and Rewards

average percentage sales loss between the fifth and

sixth year after patent loss.

The sharp decline experienced in year +5 revenue,

as shown in figure F-2, is due primarily to the loss of

data on verapamil, which came off-patent in 1986 and

had 1990 revenue approaching $500 million. The

originator market for verapamil actually grew after

patent expiration because of the introduction by its

manufacturer of a new sustained release dosage form

shortly before its patent expired. Its loss to the sample

in years 5 and 6 accounts for the substantial recorded

decline in originator revenues in the figure.

Data on the history of revenues and unit sales

volume for drugs coming off patent in each of the study

years are presented in figures F-3 and F-4. Substantial

differences were recorded in the pattern of revenue and

unit volume loss across these subsamples, although

originator sales and unit volume declined in all but one

cohort of drugs. The sales volume for the 1986 cohort

actually increased after patent loss. This was primarily

due to verapamil’s product line extension.

Figure F-3—Originator Dollar Sales for Drugs

Losing Protection, 1984-87

Sales per compound ($1990 thousands)

120

100

80

60

40

20

0

k

\-

-7 -6 -5 -4 -3 -2 -1 0 1 2345 6

Year relative to patent expiration

* 1984 + 1985 -o- 1986 h 1987

KEY: Year O is year of patent expiration.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

schondelmeyer, ‘Econc]m ic Impact of Multiple Source Competition on Originator Products, ’contract paper prepared for

Office of Technology Assessment, December 1991.

300

250

200

150

100

Figure F-4-Originator Unit Salesa for Drugs

Losing Protection, 1984-87 ($ 1990)

Sales

-7 -6 -5 -4 -3 -2 -1 0 1 2345 6

Year relative to patent expiration

*1~ + 1985 --0-- 1986 -A-- 1987

KEY: Year O is year of patent expiration.

a Unit sales are measured in defined daily dose.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, ‘Economic Impact of Multiple Source Competition on Originator Products, ’contract paper prepared for

Office of Technology Assessment, December 1991.

Some reviewers of OTA’s draft report argued

verapamil is an unusual case, both because it had anew

sustained release form and because the indications for

the drug were expanding over the period. Consequently, these reviewers believed OTA should remove

verapamil from the sample of drugs.

The presence of verapamil in the sample of drugs

does, indeed, have a large impact on the estimated rate

of decline in originator sales following patent expiration. Verapamil had the highest inflation-adjusted

dollar sales of all drugs in the sample by the third year

after patent expiration, and its sales revenue inconstant

dollars grew over the period.

That there is wide variation among different compounds in their sales history and product life cycle is

undisputed. In that sense, every drug is unusual.

Manufacturers do depend on a few “big winners” to

carry the fixed costs of R&D and marketing necessary

to develop and sell drugs in today’s market (159).

OTA’s analysis is at the industry level, however, and

an accurate representation of the pattern of loss of
Appendix F-Summary of Methods Used to Analyze Trends in Postpatent Revenues 299

revenues after patent expiration would be impossible

if the big winners were excluded from the analysis.

(The industry would appear to be losing great sums if

the high selling drugs were removed.)

The practice of managing patent life by timing the

introduction of new dosage forms is becoming more

common, not less common, in recent years, as new

drug delivery systems have become available. At least

4 of the 35 drugs in the sample had product line

extensions that lengthened their exclusive marketing

rights beyond the year in which the patent governing

the compound itself expired. The extraordinary sales

growth of verapamil’s originator brand after its patent

expired would probably have been substantially dampened without the extended release form.

One reviewer of OTA’s draft report pointed out that

one compound, chlorpropamide, whose patent expired

in 1985 and whose 1985 inflation-adjusted sales were

higher than all but four of the drugs in the sample, was

not included in OTA’s ultimate sample, even though

it meets the inclusion criteria. Upon re-reviewing the

selection process OTA discovered this drug had been

eliminated from the sample because preliminary analysis of Purdue University’s database had indicated

many generic companies were manufacturing the

product as early as 1981. This finding had suggested

to us that the patent was not effectively barring generic

competition and we therefore excluded it from the

sample. As part of the re-review of this issue, we

obtained rough estimates of sales of the originator’s

brand-name product, DiabeneseTM,and generic copies TM, ,

which showed the generic sales in 1985 of chlorpropamide, were very small. Therefore, excluding Diabenese from the sample was probably a mistake.

Although OTA does not have access to the full

history of sales of Diabenese and its generic competitors, we did obtain an estimate of its sales in 1985 and

1991. We assumed sales would decline at a constant

percentage rate between 1985 and 1991. Using the

resulting sales estimates for Diabenese, we recalculated the rate of decline in originators’ revenues in the

years after patent expiration. Table F-4 shows that the

year-to-year decline in revenues after patents expire

changes very little when Diabenese is included.

Because OTA did not have access to the actual sales

data for all years of the study, we did not recalculate

any of the other tables presented in this appendix, but

we did use the revised estimates of dollar sales declines

in the analysis of returns on R&D.

Table F-4—Decline in Originator Dollar Sales With

and Without DiabeneseTM in Sample

Rate of change Rate of change

excluding including

Yea r relative to Diabenese Diabenese

patent expirations

(percent) (percent)

o to +1 –12.0% –1 2.90/.

+1 to +2 –4.0 –4.6

+2 to +3 -2.0 -2.7

+3 to +4 -5.0 -5.5

+4 to +5 -5.0 -5.3

+5 to +6 +3.0 +3.4

a year 0 is the year of patent expiration.

SOURCE: Office of Technology Assessment, 1993.

The relatively slow postpatent decline in dollar sales

of originator brands is surprising to many observers of

the industry, because the impact of generic competition on the sales of some drugs and on the companies

that manufacture them can be severe. OTA’s analysis

begins with the point at which the patent governing

manufacture of the compound in its original form

expires, not the point at which generic products enter

the market. The entry of generics can be delayed by: 1)

FDA’s subsequent award of market exclusivity for

follow-on products (as in the extended release example); 2) delays in FDA approval of generic copies of

brand-name drugs; or 3) technical or market factors

that discourage generic companies from entering the

market at all. Drugs with small markets, or for which

bioequivalence is difficult to achieve or demonstrate,

may never have a generic competitor.

Another factor slowing down the decline in revenues is a steep increase in the price of the originator

drug after patent expiration. OTA developed a price

index for originator products using average sales per

DDD as a proxy. The average price of the originator

product increased steadily throughout most of the

period (figure F-5). It increased 69 percent in constant

dollars in the 6 years after patent expiration. At the

same time, the ratio of the average price of generic

products to originator products decreased rapidly over

the course of the study period (figure F-6). Four years

after patent expiration, the generic price was just 20

percent of the originator price.

Manufacturers continue to increase the real price of

their drugs as their share of the market in unit volume

falls. The real price increases dampen the rapid decline

in unit sales that follows generic competition. Even

with a very large price discrepancy between generic
300 I Pharmaceutical R&D: Costs, Risks and Rewards

Figure F-5-Price Index for Originator Drugsa

($ 1990)

Index

1

I

I

150;

ok-n-ll--r-

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Year relative to patent expiration

KEY: DDD - defined daily dose; Year O is year of patent expiration.

a p~e is measur~ as average revenue (revenue~DD).

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, ‘Economic Impact of Multiple Source Competition on Originator Products,’ contract paper prepared for

Office of Technology Assessment, December 1991.

product prices and the originator price, however, the

originator product still maintains roughly a 40-percent

market share in physical units 5 years after the patent

expires.

1 OTA Estimate of Decline in Originator

Sales Revenue

The data shown in figure F-1 are the backbone of the

estimate of the year-to-year rate of decline in dollar

sales to both hospitals and drugstores after patent

expiration. Because the sample of drugs did not

include injectable and infusible products, however, the

rate must be adjusted for the probable impact of these

hospital products on the rate of loss of sales.

Generic substitution is much more common in

hospitals, where strong formularies and centralized

pharmacies can control prescribing and dispensing

Figure F-6—Non-originator Price as a Percent of

Originator Pricea ($ 1990)

Percent

80

60

40

20

0

0 1 2 3 4 5 6

Years after originator patent expiration

a Average revenue ($ Sale.s/DDD), of nonoriginator drugs divided by

average revenue of originator drugs.

SOURCE: Office of Technology Assessment, 1993, based on S.W.

Schondelmeyer, ‘Economic Impact of Multiple Source Competition on Originator ProductS,’contract paper prepared for

Office of Technology Assessment, December 1991.

more thoroughly, and where the incentives are strong

to purchase the least expensive version of a drug for

hospitalized patients.

OTA estimates about 60 percent of dollar sales to

hospitals are for injectable and infusible products.

About 23 percent of all ethical pharmaceutical sales are

to hospitals, which would imply that about 14 percent

of sales overall are for these products. But a proportion

of sales to hospitals are made through hospitals’

outpatient pharmacies, which have no incentives to

encourage doctors to prescribe generics, so 14 percent

is an overestimate of the size of the injectable-infusible

market. 5 Nevertheless, OTA assumed 14 percent of

total sales are for these hospital products. OTA also

assumed that dollar sales of these products to hospitals

5 About 2.4 percent of the market is made up of staff-model health maintenance organizations (HMO), which probably switch to generics

much faster than the general community pharmacy market once generics are available. The overestimate of the injectable and infusible market

compensates to an unknown de;~ee for the failure of the IMS data to account for sales to these kinds of HMOS,
Appendix F—Summary of Methods Used to Analyze Trends in Postpatent Revenues ! 301

would decline at 50 percent per year from the year in OTA’s analysis of the returns to R&D for the 1981-83

which the patent expires. Table F-5 shows the resulting introductions of new chemical entities outlined in

estimates of year-to-year changes in sales relative to chapter 4.

the year of patent expiration. The year-to-year rates of

change in the fourth column of table F-4 were used in

Table F-5-Change in Originator Brand Revenues for Drugs Losing Patent Protection, 1984-87

Rate of change Rate of change

excluding injectable in injectable Blended rate of Rate of change

Year relative to and infusible drugsb

and infusible change d

in OTA’s analysisO

patent expirations(percent) drugsc (percent) (percent) (percent)

-7 to -6 . . . . . . . . . . . . . . . . . . . . .

-6 to -5 . . . . . . . . . . . . . . . . . . . . .

-5 to -4 . . . . . . . . . . . . . . . . . . . . .

-4 to -3 . . . . . . . . . . . . . . . . . . . . .

-3 to -2 . . . . . . . . . . . . . . . . . . . . .

–2 to –1 . . . . . . . . . . . . . . . . . . . . .

–1 to 0 ......, . . . . . . . . . . . . . . .

0 to +1 . . . . . . . . . . . . . . . . . . . . . .

+1 to +2 ., . . . . . . . . . . . . . . . . . . . .

+2 to +3 . . . . . . . . . . . . . . . . . . . . . .

+3 to +4 . . . . . . . . . ... , . . . . . . . . .

+4 to +5 . . . . . . . . . . . . . . . . . . . . . .

+5 to +6 . . . . . . . . . . . . . . . . . . . . . .

1 .70/0

4.0

6.6

8.2

12.7

13.9

2.6

-12.9

-4.6

-2.7

-5.5

-5.3

+3.4

1.7% 

4.0

6.6

85.2

12.7

13.9

2.6

-50.0

-50.0

-50.0

-50.0

-50.0

-50.0

1.7% 

4.0

6.6

8.2

12.7

13.9

2.6

-18.1

-8.5

--4.9

--6.6

-5.9

+3.1

1.7% 

4.0

6.6

8.2

12.7

13.9

2.6

-18.0

-8.5

-6.0

-6.0

-5.0

-5.0

a year O is the year of patent expiration.

b Rates based On figure F-5 and sources therein.

C OTA assumed the rate of growth would be the same as with other drugs until the year of patent expiration, when revenues would decline by 50

percent per year,

d Injectable and infusible drugs were assumed to make up 14 percent of the market in Year 0.

e see chapter 4 for OTA’s analysis of returns from R&D on drugs first introduced to the U.S. market in 1981-83.

SOURCE: Office of Technology Assessment, 1993.
Appendix G

Estimating the Cost of Producing and

Selling New Chemical Entities

T

o estimate the net returns on new chemical

entities (NCEs) introduced in the period

1981-83, the cost of manufacturing, marketing and distribution in each year following

market approval must be subtracted from net revenues.

Precise estimation of such costs is impossible from

published financial statements because companies

produce a variety of products but report costs on a

consolidated basis across all operations. 1 The Office of

Technology Assessment (OTA) made assumptions

about the costs of manufacture, distribution and

marketing based on a variety of sources of data,

including a review of the annual reports of six

research-intensive U.S.-owned pharmaceutical firms,2

as detailed below.

I Manufacturing and Distribution Costs

The reported annual cost of goods sold for the six

companies was used as an approximate estimate of the

manufacturing and distribution costs of pharmaceuticals. The sales-weighted average ratio of cost of goods

sold to total company sales for the sample of firms was

0.255. These costs include charges for depreciation on

facilities and equipment used to produce, store, and

distribute the firm’s products. OTA estimated the cash

outlays for construction of facilities and equipment

separately; consequently the estimated depreciation

charges associated with the cash outlays were deducted

from the cost of goods sold. (The estimated construction costs of $25 million per NCE, for example, were

assumed to generate depreciation charges over an

average 20-year time horizon. Thus, $1.25 million per

year was deducted from the cost of goods sold in each

of the 20 years of the product’s life.)

9 Plant and Equipment Costs

Firms make investments in plant and equipment

early in the product life cycle, typically before the drug

receives approval for marketing. Additional investments may be necessary as time goes on, especially if

the drug is one that has a high unit volume. OTA had

little specific information to go on to estimate average

expenditures for plant and equipment across all drugs.

Such investments may vary systematically among

types of drugs, especially between biological and

synthetic chemicals,

One difference between traditional synthetic compounds and biotechnology and other biological drugs

is the ease with which ‘‘campaign’ product manufacturing can be undertaken. Product campaigning refers

to the scheduling of production runs of different

products on the same equipment and using the same

facility. Campaign production generally reduces fixed

facility costs because it allows different products to

share the same facility and equipment and reduces

down time of equipment. Costs are incurred in

preparing the facility and equipment for new production runs, but the overall manufacturing process is

generally cheaper when dedicated facilities do not

have to be built.

The cost of sharing plant and equipment among

different biotechnology drugs is much higher because

of the more stringent U.S. Food and Drug Administration (FDA) requirements governing the manufacture of

biological products. Although the FDA regulates the

1 Companies themselves often have difilculty estimating the cost of producing and selling specific products or services (216). New methods

for assigning costs to different products have been proposed but are not fully diffused into company practice (92,93,94,95).

Z The six firms are Marion Merrell Dow (1989-90), Merck (1988-90), Schering-Plough (1989-91), Syntex (1989-91), Upjohn (1988-90),

and Eli Lilly (1987-89).

302
Appendix G—Estimating the Cost of Producing and Selling New Chemical Entities 303

manufacture of all kinds of pharmaceuticals, the

requirements for facilities that manufacture biological

products are more stringent (41). The potential for

contamination is greater with biological products than

with synthetic compounds, and containment areas may

be necessary. Although the FDA does not prohibit

biotechnology firms from manufacturing more than

one product in a facility, many companies elect to build

a dedicated facility to manufacture biotechnology

products because of the stringent requirements (186).

One biotechnology executive recently submitted a

statement in congressional hearings that a dedicated

bulk biopharmaceutical facility would cost approximately $25 million (31).

The drugs approved in the period 1981-83 included

only a very few biotechnology drugs, so the special

manufacturing problems with these products were not

present. Anecdotal evidence about costs of building

production facilities for two drugs, atenolol (Tenormin Tm) and loracarbef (LorabidTM) provides some

information on synthetic chemicals. A recent bulk

pharmaceutical plant for TenorminTm, an antihypertension drug, cost $60 million to construct (382). Tenormin had 1990 world sales of approximately $1.2

billion and was the fifth highest selling drug worldwide in 1991 (385). Eli Lilly and Company announced

a $65-million plant to manufacture Lorabid (383).

Although LorabidTm was approved in December 1991

and launched in 1992, Kidder Peabody analysts

forecast annual sales of at least $500 million for this

antibiotic (384), which would place LorabidTm near

the top 25 selling drugs in 1991 (385).

These high-volume drugs can be expected to have

higher capital expenditures for manufacturing plant

and equipment. OTA estimates the mean worldwide

sales of the drugs approved between 1981-83 in the

fifth year after product launch were $170 million (in

1990 dollars). The few big winners are accompanied

by many drugs with low sales. For example, if 1 out of

10 drugs is large enough to require $60-million

manufacturing facilities, and the other 9 out of 10

drugs require $20-million manufacturing facilities, the

average capital expenditure would be under $25

million.

OTA took the above information as a basis for

estimating the costs of constructing plant and equipment to manufacture 1981-83 drugs, We assumed such

facilities would cost $25 million, expended equally

over a 3-year period beginning 2 years before market

launch and ending in the year of market launch

approval. Because of the uncertainty associated with

this estimate we examined the impact on the estimated

returns on R&D of an average expenditure for plant

and equipment of $35 million. (The results are

presented in chapter 4.)

OTA’s analysis of returns on R&D also included

expenditures for capital facilities in other forms. The

administrative and marketing cost estimates include

charges for depreciation on facilities used in these

functions. In addition, the cost of sales includes any

charges for depreciation on manufacturing facilities in

excess of the depreciation that would be charged for

the $25-million facility. Also, manufacturers of drugs

in finished form often buy their bulk chemicals from

fine chemical producers. The cost of these materials to

the pharmaceutical companies is included in pharmaceutical companies’ financial statements as operating

costs of goods sold. Thus, the estimate of cost of goods

sold contains an implicit rental charge for the value of

the manufacturing facilities used to produce bulk

chemicals purchased from other producers. Therefore,

if the capital expenditures on plant and equipment were

in reality higher than $25 million, the extra costs would

be at least partially captured in residual depreciation

charges and cost of materials embedded in the

cost-of-sales estimates.

1 Administrative Costs

Administrative costs are typically reported together

with marketing costs in companies’ annual financial

statements. The marketing and administrative cost for

the six firms was 33.6 percent of total sales in the years

examined. One firm (Eli Lilly) reported over a 3-year

period that 67 percent of marketing and administrative

costs were for marketing. If this one firm is representative of the industry, administrative costs would be 11.1

percent of total sales. OTA used this estimate of

administrative costs and assumed the percent would

not vary over the life of the product. (A producer of

generic drug products, Barr Laboratories, reported its

annual general and administrative costs at 7.5 to 10.1

percent of sales in the period 1989-91.)

1 Marketing Costs

Marketing costs comprise promotion (advertising

and detailing), sponsorship of symposia and other

promotional events, and support functions such as

market research. Between 1987 and 1990, in the six

companies surveyed by OTA, 33.6 percent of sales

were devoted to marketing and administrative costs. If

Eli Lilly’s cost structure is typical of the research-
304 I Pharmaceutical R&D: Costs, Risks and Rewards

intensive industry, then 22.5 percent of pharmaceutical

companies’ total sales are devoted to marketing.

Another way of examining the ratio is to begin with

advertising expenses, which are reported by companies, and estimate the ratio of advertising to other

marketing expenses from published sources. Baber

and Kang reported the average ratio of advertising to

total sales for 88 pharmaceutical companies was 6.9

percent between 1975 and 1987, and the ratio for 54

research-intensive pharmaceutical companies was 4.5

percent (26).3 Among the six U.S.-owned companies

examined by OTA the ratio of advertising to sales

averaged 4.3 percent in 1989 and 1990. In 1989,

advertising comprised 26 percent and detailing activities comprised 74 percent of total promotional expenses for ethical pharmaceuticals (73). These facts

together imply total promotional expenditures comprise between roughly 17’ and 26 percent of sales.

OTA assumed 22,5 percent of pharmaceutical

companies’ total sales are devoted to marketing. These

expenditures vary over the life of a product, however,

and can be expected to be high in the early years of

marketing and relatively low after a product loses

patent protection. Caves, Whinston and Hurwitz reported on originator brand promotion expenses in the

year of patent expiration for a sample of 21 drugs that

lost patent protection between 1982 and 1987. Promotion comprised 6.5 percent of total sales in the year of

expiration (73). OTA therefore assumed marketing

expenses would be 6.5 percent of sales in the years

subsequent to patent expiration.

OTA assumed marketing expenses in the first year

after product approval would be equal to total worldwide sales; in the second year, they would be equal to

50 percent of worldwide sales (159). In the 3rd to 9th

year (when patents expire), OTA assumed marketing

costs would be equal to the percent that equates total

marketing costs over the product life cycle to 22.5

percent of total sales over the life cycle. This calculated

percent was 40.6.

I Inventory Costs and Working Capital

The cost of producing inventory was calculated by

assuming the company would build up inventory in

each year equal to 12.7 percent of sales in the year (the

average ratio of inventory to sales in the six U. S.-

owned companies examined by OTA). If inventories

are valued at the cost of goods sold, this percent is

equivalent to 4.8 months of sales held in inventory. As

sales decline at the end of the product life cycle,

inventories decline accordingly. Working capital to

finance accounts receivable was also charged against

revenues. Accounts receivable comprised 17.2 percent

of sales in the six pharmaceutical firms. This amount

was used to estimate the working capital required in

each year. As sales decline at the end of the product life

cycle, accounts receivable decline as well.

1 Cost of Ongoing R&D

Since the revenue curve for a typical NCE is based

on the total sales for the molecular compound for all

indications and formulations, it is appropriate to

include ongoing R&D that takes place after FDA

approval and marketing to support new indications,

new dosage forms, or routes of administration. Additional research may also be needed to obtain marketing

approval in other countries. OTA estimated the cash

outlays for ongoing R&D at $31.7 million (in 1990

dollars) per NCE over the product life cycle. This

estimate was made for OTA by Dr. Joseph DiMasi

from information obtained in his survey of R&D costs

(109). In that study, the 14 surveyed companies

reported that over the period from 1970 to 1986,

research on self-originated NCEs comprised 73.7

percent of all R&D; research on licensed-in NCEs

comprised 10 percent of all R&D; and existing product

research totaled 16.3 percent of all R&D. OTA

assumed existing product research is allocated proportionately between self-originated NCEs and licensedin NCEs. DiMasi and colleagues also estimated the

cash outlays associated with producing a selforiginated NCE were $127.2 million (in 1990 dollars).

Ongoing R&D costs associated with this expenditure

based on these figures would be $20.7 million.

Spending increased over the study period, however,

and DiMasi estimated the time between spending on

proapproval R&D and postapproval R&D requires an

adjustment of the ongoing R&D estimate to $31.7

million (106). OTA used this estimate in its analysis of

returns on new drugs.

1 Alternative Approach to Measuring

Manufacturing and Distribution Costs

Because the estimates of production and other costs

are imprecise, OTA compared the results of the above

analysis with production and distribution costs calculated using an alternative method. This second method

3 Pharmaceutical companies were identifkd as publicly traded U.S. registered companies reporting standard industrial classification (SIC)

code 2834 (pharmaceuticals) as tieir principal line of business. Research-intensive fm were a subsample of the p harmaceuticat fw whose

ratio of R&D to sales was 5 percent or greater.
Appendix G—Estimating the Cost of Producing and Selling New Chemical Entities I 305

Table G-l—Ratio of Generic Pricea to Originator Price by Year Relative to Patent

Expirationb (for 30 compounds whose patents expired 1984-87)

Year relative to patent expiration –3 –2 - 1 0 +0 +2 3

Ratio 0.49 0.46 0.41 0.38 0.39 0.37 0.32

a Generic price is the average nonoriginator price in year 3, or in year 4 if no generic sales were recorded in year 3.

b Average price weighted by originator drug’s physical volume as measured by defined daily dose.

SOURCE: Office of Technology Assessment, 1993, based on data from S.W. Schondelmeyer, “Economic Impact of

Multiple Source Competition on Originator Products,” contract paper prepared for Office of Technology

Assessment, December 1991,

uses information about the price of generic drugs to

infer the cost of manufacture and distribution of

originator products.

As several researchers have noted, when a large

number of generic suppliers have entered a market, the

average price of the generic version of a drug can be

taken as an upper bound on the long-run marginal cost

of producing and distributing the product and providing general and administrative services in the running

of the company (73,161). The pressures of price

competition will, with entry of new firms, drive

generic producers to charge prices that just cover the

cost required to stay in business. This cost includes the

required return on investment, or cost of capital. Thus,

a brand-name product markup over marginal production, distribution, and administrative cost cart be

roughly estimated by the difference between the

brand-name price and the generic price.

The ratio of generic to originator price serves as a

proxy for production, distribution, administrative,

inventory, and working capital costs. It also includes

the costs of facilities and equipment used to produce

the product. These costs are recognized in the generic

price as an effective rental or lease payment for such

facilities. 4

Generic companies also spend some funds to market

their products, and they incur substantial R&D costs

which also must be covered in the price they charge.5

However, marketing and R&D costs for originator

products are likely to be much higher than for generic

products; consequently, the generic price does not

fully cover these components of cost.

Although few if any of the compounds approved

between 1981 and 1983 have faced any generic

competition to date, OTA did have access to data on

the sales of 35 compounds that lost patent protection

in the period 1984-87 (368). For 30 of these compounds, 6 OTA calculated the ratio of the generic price

obtaining in the third year after patent expiration

(measured in 1990 dollars) to the originator’s price in

each year, from 3 years prior to patent expiration to 3

years after patent expiration.7 Table G-1 shows the

ratio of generic price (or marginal cost) to originator’s

price in the 7 years surrounding patent expiration for

the 30 drugs in the sample. As expected, the ratio of

generic price (marginal cost) to originator price

declines as time passes. These results are consistent

with the widely observed rise in average originator’s

price immediately before and after patent expiration

(see appendix F) (73,161,195,368).

To compare the cost estimates from financial

statements with those derived from the generic price

ratios, a ratio of cost to price is required for the entire

product life cycle. OTA had no data on originators’

transaction prices in the first 5 years of product life for

NCEs approved in the 1981-83 period. A review of

published wholesale list prices for these compounds

suggests that after adjusting for inflation, prices tended

to rise in real terms in the first few years after

introduction. (See table G-2, ) The simple average

annual rate of increase in price over the first 4 years of

4 Although generic firms may budd and own their own factories, the price they charge for the product must reflect the amount they must

pay their investors for the usc of the facility, This rental rate is implicit in the competitive price of the product and does not have to be explicitly

estimated.

5 ~ec ~cne.ic ~ompanles whose ~nu~ flwclal statements were examined by OTA incu~cd R&D COStS of 5 to 6 percent of sales in 1990.

In addition, marketing expenses by onc firm (that reported such expenses separately) amo-mted to 6.5 percent of sales, (36) the same as that

estimated for originator firms in the year of patent expiration (73).

6 Five of the drugs had no generic competitors in 1990, the last year of data collection.

7 The generic price is measured by the total revenue across all generic producers of the same drug divided by the estimated volume of defined

dally doses (DDDs) sold. The originator’s price is total originator’s revenue divided by the physical volume sold (measured in DDDs). The

overall ratio of gcncnc price to originator price in each year was calculated by weighting each drug’s ratio by the volume of DDDs sold.
306 I Pharmaceutical R&D: Costs, Risks and Rewards

Table G-2-Changes in List Price of New Chemical Entities Approved Between 1981 and 1983

NCE U.S. trade Rate of change in real priceb

Approval Dosage

name name year form Year 1-2 Year 2-3 Year 3-4 Year 4-5

albuterol

alprazolam

alprostadil

amiloride

atenolol

buprenorphine

captopril

cefotaxime

ceruletide

estramustine

flunisolide

gemfibrozil

halazepam

ketoconazole

Iatomoxef

mezlocillin

nifedipine

piperacillin

sucralfate

temazepam

trazodone

verapamil

aciclovir

azlocillin

cefoperazone

cellulose

ciclopirox

diflunisal

diltiazem

econazole

etomidate

gonadorelin

guanabenz

guanadrel

isotretinoin

malathion

niclosamide

pindolol

piroxicam

praziquantel

sodium phosphate

streptozocin

triazolam

acetohydroxamic

atracurium

bentriomide

bumetanide

ceftizoxime

cefuroxime

chenodiol

Proventil

Xanax

Prostin VR

Midamor

Tenormin

Buprenex

Capoten

Claforan

Tymtran

Emcyt

Nasalide

Lopid

Paxipam

Nizoral

Moxam

Mezlin

Procardia

Pipracil

Carafate

Restoril

Desyrel

Isoptin

Zovirax

Azlin

Cefobid

Calcibind

Loprox

Dolobid

Cardizem

Spectazole

Amidate

Factrel

Wytensin

Hylorel

Accutane

Prioderm

Niclocide

Visken

Feldene

Biltricide

Zanosar

Halcion

Lithostat

Tracrium

Chymex

Bumex

Cefizox

Zinacef

Chenix

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1981

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1982

1983

1983

1983

1983

1983

1983

1983

Inhaler, 90 mcgm

Tab, 0.25mg, 100s

Amp, 500 mcgm/1 ml, 5s

Tab, 5mg, 100s

Tab, 50mg, 100s

Amp, 0.3mg/1 ml, 10s

Tab, 25mg, 100s

Via, 1gm, 10s

Amp, 2ml, 5s

Cap, 140mg, 100s

Sol, 0.25%, 25ml

Cap, 300mg, 100s

Tab, 20mg, 100s

Tab, 60s

Via, 1gm/10ml, 10s

Via, 1gm/10ml, 10s

Cap, 10mg, 100s

Via, 2gm

Tab, 100s

Cap, 15mg, 25s

Tab, 50mg, 100s

Tab, 80mg, 100s

Oin, 5%, 15gm tube

Via, 2gm/30ml, 10s

Via, 1gm

Pow, 2.5gm, 90s

Cream, 1%, 15gmr tube

Tab, 250mg, 60s, uni

Tab, 30mg, 100s

Cream, 1%, 15gm, tube

Syr, 2mg/1 ml, 20gx1

Pow, 100mcgm

Tab, 4mg, 100s

Tab, 10mg, 100s

Cap, 10mg, 100s

Lotion, 20oz

Tab, 500mg, 4s

Tab, 5mg, 100s

Cap, 10mg, 100s

Tab, 600mg, 6s

Via, 1gm

Tab, 0.25mg, 100s

Tab, 250mg, 120s

Amp, 10mg/5ml, 10s

Sol, 500mg, 7.5ml

Amp, 0.25mg/2ml, 10s

Via, 1gm/28ml, 1s

Via, 750mg/1 ml

Tab, 250mg, 100s

0.08

0.14

0.06

-0.04

0.08

-0.04

-0.04

-0.04

0.02

0.24

-0.04

0.10

-0.04

0.07

-0.04

0.20

0.06

-0.04

-0.04

0.06

0.17

0.07

0.06

0.00

-0.04

-0.04

0.06

0.09

0.14

0.06

-0.04

-0.03

0.05

-0.04

0.06

0.10

0.22

0.07

0.05

0.13

0.06

0.01

0.07

0.03

0.12

0.07

0.10

0.07

0.22

0.08

0.07

-0.03

0.20

-0.03

-0.03

0.19

0.07

0.17

0.15

0.19

-0.17

0.09

0.20

0.29

-0.03

0.07

-0.03

0.07

0.06

0.11

-0.03

0.15

0.03

0.06

0.07

0.07

0.09

0.07

0.04

0.09

-0.03

0,12

0.05

-0.03

0.07

-0.03

0.07

-0.03

0.09

(Continued on next page)
Appendix G—Estimating the Cost of Producing and Selling New Chemical Entities I 307

Table G-2—Changes in List Price of New Chemical Entities Approved Between 1981 and 1983--(Continued)

Rate of change in real priceb

NCE U.S. trade Approval Dosage

name name year form Year 1-2 Year 2-3 Year 3-4 Year 4-5

ciclosporin Sandimmune 1983 Amp, IV, 50mg/5ml, 1s

indapamide Lozol 1983 Tab, 2.5mg, 100s 0.09

netilmicin Netromycin 1983 Syr, 150mg/1.5ml, 10s -0.27

ranitidine Zantac 1983 Tab, 60s

Z3 Real ~nce~ ~lculated“sing GNP implicit pr~e deflator; prices are retail or wholesale prims given in Dwg To@CS Rdbook.

b Entries are blank when data are unavailable.

KEY: Am~Ampoule; Ca@apsule, IV—intravenous; Oin-Ointment; Pow-Powder; Sol-Solution; Syr—Syringe; Tab-Tablet; Via—Vial.

SOURCE: Office of Technology Assessment, 1993, based on data from Drug Topics Redbook (Montvale, NJ: Medical Economics Company, Inc.,

1981-86).

product life was 5,5 percent for compounds in the

sample for which list prices were available. OTA

assumed this rate of increase in prices would continue

throughout the first 5 years of product life, culminating

in a ratio in year 6 of 0.49 (see table G-l).

For the last years of the product life cycle (4 and

more years after patent expiration), OTA assumed

originator prices would stabilize and the observed ratio

(0.32) in the third year of patent life would hold in

subsequent years.

This approach to estimating the marginal cost of the

1981-83 compounds (excluding marketing and R&D)

is itself imprecise. The ratios are based on an entirely

different set of drugs from the ones whose net returns

are being analyzed. The approach assumes the average

inflation-adjusted markup on a compound depends

only on its age relative to patent expiration; drugs

approved between 1981 and 1983 are assumed to have

markups over cost that mirror those for drugs whose

patents expired in 1984-87. Because this assumption is

arbitrary, OTA did not use the method as a primary

estimation procedure; rather, the cost estimates are

merely intended to corroborate the estimates taken

from companies’ financial reports.

Table G-3 compares costs of production, distribution, and administration as a percent of sales in each

year following market approval under the two methods

of cost estimation. The marginal cost estimate, which

represents an upper bound on actual costs, is higher

than the financial statement estimates in most years. It

is much higher (by up to 13 percentage points) in the

early years. The marginal cost estimate includes both

marketing costs for generic companies, which may be

as much as 6 percent of sales, and an implicit rental

cost of facilities and equipment, while the financial

statement estimates given in the table do not include

these costs. It also includes the cost of ongoing R&D

for generic companies, which comprise approximately

5 to 6 percent of sales. If marketing and R&D costs

were removed from the generic price ratio (at an

assumed rate of 11 percent of sales), the resulting

generic price ratio would be lower than the costs based

on financial statements in almost every year. This

comparison suggests cost estimates based on recent

financial statements of research-intensive pharmaceutical firms do not underestimate actual costs over the

product life cycle.

Table G-3—Cost of Production, Distribution,

Administration, Working Capital and Inventories

as Percent of Sales Under Different

Estimation Methods

Number of years Financial statement Generic price ratiob

after approval estimates (marginal cost)

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

60.8%

44.5

47.8

41.5

41.1

39.6

39.0

41.4

30.0

33.4

34.2

34.1

34.4

34.4

34.4

34.3

28.7

28.4

28.1

27.6

62.8%

57.0

57.0

54.3

51.7

49.1

45.7

41.0

38.5

39.0

37.2

32.1

32.1

32.1

32.1

32.1

32.1

32.1

32.1

32.1

a This estimate ~~~/udes expenditures for @pital facilities and eqUipment, marketing, and ongoing R&D costs.

b This ratio imlude~ implicit ~sts of rental of capital facilities and

equipment, ongoing R&D and marketing costs of generic producers,

and return to investors.

SOURCE: Office of Technology Assessment, 1993.
Appendix H

Methods of OTA’s Survey of

Clinical Trial Size

T

he Office of Technology Assessment (OTA)

conducted a survey of sponsors of new

molecular entities (NMEs) that received

U.S. Food and Drug Administration (FDA)

marketing approval during certain years to estimate

systematic changes over time in the number of

participants in clinical trials conducted before new

drug applications (NDA) approval.

To construct its sample, OTA began with 57 NMEs

that had a first NDA approved between 1978-83 or

1986-90. OTA chose drugs approved during these

periods to ensure the sample represented enough years

to detect any trend in trial size while also ensuring all

NMEs examined faced essentially the same regulatory

guidelines. Because OTA hypothesized that there

would be systematic variation in clinical trial size

across product classes, OTA chose to focus on three

very different therapeutic classes of drugs: antimicrobial, antihypertensives, and nonsteriodial antiinflammatories (NSAIDs) in order to provide diversity

in the analysis. (OTA analyzed data from each class

separately), Before arriving at its final sample, OTA

eliminated two NMEs from its sample because they

were qualitatively different from other drugs in the

class: one drug labeled by the FDA as an antihypertensive is not actually an antihypertensive, and

another antihypertensive is actually a diagnostic agent

rather than a therapeutic drug. This left a final sample

consisting of 18 antihypertensives (9 for 1978-83 and

9 for 1986-90),27 antimicrobials (15 for 1978-83 and

12 for 1986-90), and 8 NSAIDs (4 for 1978-83 and 4

for 1986-90).

OTA staff developed the survey instrument with the

assistance of OTA project advisory panel members and

Pharmaceutical Manufacturers Association (PMA)

senior management. It contained seven questions

pertaining to total clinical trial enrollment, total

number of therapeutic indications for which the

company sought FDA approval, the total number of

clinical studies completed (both pre-and post-NDA),

and the total number of trial sites. OTA asked

companies to provide these numbers broken down by

foreign and domestic research and by whether or not

the clinical studies were completed before or after first

FDA (NDA) marketing approval.

To ensure a timely response, OTA mailed identical

survey packages to two contacts at the company

manufacturing each drug, Each package contained a

cover letter, a description of OTA’s project and its

advisory panel membership, a project fact sheet, a

return envelope, and survey forms for each drug in the

sample developed by that company. OTA made two

followup calls to contacts that did not return their

surveys. OTA received usable responses for all but two

drugs-one antihypertensive and one NSAID (both

from the 1978-83 period) for an overall response rate

of 96 percent.

308
Appendix I

Methods Used in OTA's Study of Success

Rates for New Molecular Entities

A

s described in the text of chapter 6, OTA

used data from the U.S. Food and Drug

Administration (FDA) to compare development times for two cohorts of new molecular entities (NMEs) with their first commercial investigational new drug (IND) applications submitted during two 3-year intervals: 1976-78 and 1984-86. The

FDA had already compiled IND, new drug application

(NDA), and final approval data on the 1976-78 cohort

for their own previous analysis (426), For this analysis,

the FDA updated the 1976-78 database to record

approvals through July 1991. At OTA’s request, the

FDA compiled similar data for the 1984-86 cohort.

Because the FDA’s computer data systems do not link

IND and NDA records for the same N-ME, the agency

manually integrated these records.

Both cohorts exclude insulins, insecticides, sunscreens, vaccines and antitoxins from a biological

source, and veterinary products from the analysis

(426) For the 1984-86 cohort, the FDA added

therapeutic biological entities evaluated by it’s Center

for Biologics Evaluation and Research (CBER). This

step was not necessary for the 1976-78 cohort because

the FDA did not establish CBER until 1988; prior to

this date, all therapeutic drugs, no matter what their

source, were reviewed by the predecessor of the FDA’s

Center for Drug Evaluation and Research (CDER). A

total of 7 percent of the later cohort are biologics.

The FDA purged the 1984-86 cohort of INDs that

did not represent a first commercial filing for the NME.

Using available reference materials such as Pharmaprojects (328) and the Merck Index (267), the FDA

verified each IND sponsor was a commercial firm and

then checked the lngredient Dictionary, the Drug

Product Reference File microfiche, and its own management information system to confirm that no commercial INDs had been filed for a related compound

(salt or ester) prior to the 1984-86 interval.

During the 3-year period 1976-78, commercial

sponsors filed 174 first NME INDs. Of these 40

resulted in an NDA, and the FDA had approved 27 for

marketing as of July 1991. During the 1984-86 period,

commercial sponsors filed 344 NME INDs. By July

1991,53 of these also resulted in an NDA, and 27 had

received FDA marketing approval. All drugs in the

1984-86 cohort have at least 54 months experience

following IND submission recorded in the database

(the amount of time between December 1986 and July

1991).

309
Appendix J

Estimates by OTA and JCT of

Federal Tax Credits

Attributable to Pharmaceuticals

T

his appendix describes how the Office of

Technology Assessment and the congressional Joint Committee on Taxation (JCT)

identified pharmaceutical firms in the Internal Revenue Service’s (IRS) 1987 corporate Statistics

of Income (SOI) database and used these samples to

estimate Federal tax credits claimed by the drug

industry in that year.

The SOI database consists of most elements from

corporate tax returns. The sample is stratified by the

size of firms so that 100 percent of the corporations in

the United States with the greatest assets (approximately $50 million or more) are included. The bulk of

companies are randomly selected for inclusion in each

year’s sample with a probability inversely proportional

to their size as determined by several measures. The

SOI database classifies each corporation according to

a Principal Activity Classification (PAC) coding

scheme that reflects the activity from which the firm

derives the greatest proportion of total receipts (essentially gross income). Although similar in format to the

U.S. Census Bureau’s Standard Industrial Classification Codes (SIC), PAC and SIC codes are not

equivalent. Each firm indicates on its tax return the

PAC code it believes best describes its activities.

However, to ensure consistency over time for some

analyses that the IRS and other government agencies

conduct with the database, the IRS changes the PAC

grouping for some firms (297). PAC code 2830 is

described as “drugs.”

In an effort to refine this industrial grouping so that

OTA’s analysis of tax credits would reflect only those

parent firms and subsidiaries exclusively (or almost

exclusively) involved in pharmaceutical R&D or

production, l the JCT investigated each firm in PAC

2830 of the 1987 SOI sample with assets $50 million

or more. Of 99 such firms, the JCT concluded from its

research that 12 of them were not primarily drug

companies2 and should be dropped from the JCT/OTA

analysis. The JCT did not investigate and eliminate

nonpharmaceutical firms with assets of less than $50

million because these companies combined account

for only 3 percent of total assets in PAC 2830 and less

than 2 percent of the taxes paid by this industry group

in 19873 (492). Because the bulk of corporations

whose sales are diversified beyond pharmaceuticals

have tax-filing subsidiaries that do fall into PAC 2830

and whose business is almost exclusively in pharmaceuticals, OTA also concluded that relatively little

pharmaceutical business or tax payments fall outside

of PAC code 2830 (297). Hence, OTA believes its

analysis accurately and comprehensively captures the

tax activity of the pharmaceutical industry in 1987.

1 So called “generic manufacturers” of pharmaceuticals with relatively small research budgets are included in the analysis.

2 According to the JCT, most of these companies did relatively little work in pharmaceuticals. These companies included manufacturers

of medical devices, cosmetics, other chemical products, and nonpharmaceutical applications of biotechnology (297). OTA was unable to

investigate the nature of these firms itself because confidentiality of tax return data precludes OTA from knowing the identity of fms included

in the SOI database or the other information from the SOI database at the level of an individual flrrn.

3 Because of the large number of such fw, an investigation of each one would require a commitment of resources beyond its value to the

analysis.

310
Appendix K

Federal Programs Dedicated to

Pharmaceutical R&D1

A

s indicated in the text and summarized in

table K-1, the Federal Government maintains 13 targeted drug research and development (R&D) programs. Eleven of these

programs focus on drug discovery and testing, and two

are devoted solely to clinical R&D. All but one, an

antimalarial program run by the U.S. Walter Reed

Army Medical Center, are located within the U.S.

Department of Health and Human Services in its

National Institutes of Health (NIH). This appendix

describes the mission and organization of each program.

1 Targeted Drug Discovery Programs

Cancer Development Therapeutics Program

Located within the National Cancer Institute’s

(NCI) Division of Cancer Treatment, the Developmental Therapeutics Program (DTP) uses both intramural

and extramural funding to discover and develop new

anticancer and anti-human immunodeficiency virus

(HIV) agents. Under its current organization, DPT

includes: 1) the Laboratory of Drug Discovery Research and Development for the expeditious development of agents given high priority in the treatment of

cancer or HIV infection; 2) the Drug Synthesis and

Chemistry Branch which acquires, screens, and evaluates the therapeutic potential of new compounds

provided by outside researchers including pharmaceutical firms; and 3) an extramural program that supports

preclinical drug discovery and development.

Biological Response Modifiers Programs

Begun in 1972, the Biological Response Modifiers

Program supports intramural and extramural research

(including some clinical investigation) on agents or

approaches that alter the relationship between a tumor

and the “host” patient by modifying the host’s

biological response to tumor cells in order to realize

therapeutic benefits. In recent years, this program has

included among the research it supports the development of new approaches to modify the body’s response

to HIV.

National Sickle Cell Disease Program

This program seeks to develop pharmacological

agents that prevent or decrease the ‘‘sickling’ of red

blood cells in order to improve the quality and duration

of life for persons afflicted with sickle cell disease.

Because sickle cell disease is a hereditary disorder at

the molecular level, research supported by this program over the past 20 years has attempted to use the

developing tools of “rational drug development. ” In

particular, laboratory investigation has focused on

understanding the biochemical actions that underlie

the disease and molecules observed to inhibit those

actions. One particular approach, genetic modifiers

that increase hemoglobin in the fetus, has moved close

to clinical trials to determine efficacy.

Lung Surfactant Replacement Program

A component of the National Heart, Lung, and

Blood Institute’s (NHLBI) Specialized Center of

Research Program, “Respiratory Disorders in Infants

and Children, ’ this drug development program has

sought new therapies since 1979 for respiratory

distress syndrome (RDS), a breathing disorder that

affects about 40,000 infants per year in the United

States. Caused by a deficiency in surfactant, a substance produced within the lung during the final

trimester of pregnancy, research within the program

has produced a number of synthetic surfactants as well

1 Unless otherwise noted, the information on these programs were provided by the relevant agency (167,271,343).

3 1 1

330-067 - 93 - 11 : QL 3
312 I Pharmaceutical R&D: Costs, Risks and Rewards

Table K-1—Federal Targeted Pharmaceutical Development Programs

Fiscal year 1989 budget

Program Agency Component Year begun ($ thousands)

Cancer Developmental Therapeutics

Program. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cancer Therapy Evaluation Program. . . . . .

Biological Response Modifiers Program. . . .

National Sickle Cell Disease Program. . . . .

Lung Surfactant Replacement Program. . . .

National AIDS Drug Discovery Groups. . . . .

Antimicrobial Chemistry Program. . . . . . . . .

Antiviral Research Program (Non-AIDS).. .

Anticonvulsant Drug Development

Program. . . . . . . . . . . . . . . . . . . . . . , . . . . .

Contraceptive Development Program. . . . . .

Drug Abuse Medications Dovelopment

Division. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Antimalarial Experimental

Therapeutics Program. . . . . . . . . . . . . . . . . .

Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

NIH (DHHS)

U.S. Army (DOD)

NCI

NCI

NCI

NHLBI

NHLBI

NIAID

NIAID

NIAID

NINDS

NICHD

NIDA

Walter Reed

Army Institute

of Research

1 955’

1975

1972

1979

1987

1981

1969

1968

1971

1972

1963

$305,101 b

742

1,506

18,908

3,493

9,722

4,188

13,833

30,216

1,900

389,609

a ~~cancer therapies” programs -an in 1955. No separate dates given for Cancer Developmental Therapeutics Program and Cancer Therapy

Evaluation Program.

b AII thr~ NCI programs combined.

KEY: ADAMHA = Alcohol, Drug Abuse and Mental Health Administration; DHHS _ U.S. Department of Health and Human Serviees; DOD= U.S.

Department of Defense; NC1-National Caneerlnstitute; NHLBI - National Heart, Lung and Blood Institute; NIAID_National Institute of Allergy

and Infectious Diseases; NICHD - National Institute of Child Health and Human Development; NIDA = National Institute on Drug Abuse; NIH

- National Institutes of Health; NINDS - National Institutes of Neumlogieal Disorders and Stroke.

SOURCE: Office of Technology Assessment, 1993.

as some derived from animals. NHLBI research has

included testing of these compounds in both the

laboratory and in humans through regular extramural

grants and contracts as well as special grants to small

businesses.

National Cooperative Drug Discovery GroupsAIDS

The National Institute of Allergy and Infectious

Diseases (NIAID) set up its National Cooperative

Drug Discovery Groups on Acquired Immune Deficiency Syndrome (NCDDG-AIDS) in order to promote collaboration among academic, industrial, and

governmental scientists to increase the speed with

which new and better AIDS treatments are discovered

and developed. Although physically not centered in a

single location, each NCDDG brings together three to

seven senior scientists who represent expertise in

different disciplines. As of February 1991, NIAID had

established 34 NCDDGs with scientists drawn from 46

academic or nonprofit institutions and 27 for-profit

fins. While some of the groups focus on HIV itself,

others target their efforts toward treating opportunistic

infections (OIs) to which people with HIV are susceptible and which represent the major causes of illness

and death in this patient population.

These groups, which only conduct preclinical R&D,

are part of a larger, coordinated effort within NIAID

and other NIH institutes intended to bring about

therapeutic developments in the treatment of HIV

more rapidly than would otherwise occur.2 NIAID has

two clinical AIDS drug programs that are described in

greater detail in the section below on Federal clinical

drug R&D.

Antimicrobial Chemistry Program and the

Non-AIDS Antiviral Research Program

NIAID has established these two research programs

to develop new treatments for viral infections (other

than HIV). Because viruses are parasitic organisms

z A recent report of the institute of Medicine, The AIDS Research Program of the National Institutes of Health (208), describes the

continuum of HIV researeh effcmts within the NIH in much greater detail.
Appendix K–Federal Programs Dedicated to Pharmaceutical R&D I 313

that exist within cells and whose replication is closely

tied to that of the host cell, most antiviral agents have

profound toxic effects on the host cell. While the

Antimicrobial Chemistry Program focuses only on

drug discovery and preclinical evaluation (including

an intramural program to screen compounds submitted

by researchers outside the government as well as

research support for designing and testing new compounds), the Antiviral Research Program includes both

laboratory and clinical R&D. Among the recent

clinical trials supported by the Antiviral Research

Program are a Phase I/11 dose-response study of the

drug ganciclovir in treating congenital cytomeglovirus

infections in babies with central nervous system

symptoms, and a Phase I/II study of acyclovir as a

treatment for neonatal herpes simplex infections in

infants in whom the disease is limited to the skin, eye

and mouth.

Anticonvulsant Drug Development Program

The National Institute of Neurological Disorders

and Stroke’s (NINDS) Anticonvulsant (or Antiepileptic) Drug Development (ADD) Program supports both

preclinical and clinical investigations into new therapies for the treatment of seizures in the hopes of finding

drugs that are more effective and less toxic than

existing interventions. In addition to supporting intramural and extramural research, the ADD Program

serves as a clearinghouse for R&D efforts aimed at

treating seizure disorders. It monitors worldwide

patents on potential compounds, maintains regular

contacts with pharmaceutical firms doing central

nervous system (CNS) research, and facilitates collaborative arrangements between NINDS and commercial

suppliers to evaluate potential compounds for anticonvulsant activity. NINDS and an ad hoc advisory

committee meet to determine NINDS priorities for

promoting the development of promising compounds.

Contraceptive Development Program

Since 1971, the National Institute of Child Health

and Human Development (NICHD) has provided

support largely through contracts (currently at about

$1.3 million per year) for a Contraceptive Development Program to discover, develop, and clinically

evaluate new potential pharmaceuticals. Included among

the possible contraceptive strategies researched are

drugs that block the production of viable ova (eggs) in

women or spermatozoa in men or drugs that interfere

in the ability of ova and spermatozoa to undergo

fertilization. This latter strategy includes spermicides

for use in the female reproductive tract. Among the

pharmaceutical approaches to contraception pursued

by the NICHD are drugs that block the action of

gonadtropin-releasing hormone (GnRH), which is

necessary for the functioning of both the testis and the

ovary. Development of contraception within this

program may also provide advances in the treatment of

diseases such as precocious puberty, endometriosis,

and certain cancers that stem from improper GnRH

activity.

Drug Abuse Medications Development

Program

Although the National Institute on Drug Abuse

(NIDA) has supported research for the development of

medications to treat substance abuse since 1972, the

current incarnation of the Drug Abuse Medications

Development Program received its authorization from

Congress in the Anti-Drug Abuse Act of 1988 (Public

Law 100-690). The program draws a distinction

between drugs to treat opiate and cocaine addition,

although NIDA indicates the distinction may be

somewhat artificial for several reasons: 1) some opiate

compounds have shown promise in treating cocaine

addiction; 2) co-addiction to both types of substances

is not uncommon; and 3) many potential medications

may be useful in treating both types of dependence. As

mentioned earlier in Chapter 9, a major justification for

Federal support of this program cited by NIDA has

been the historical reluctance of pharmaceutical firms

to invest in R&D for medications to treat drug abuse.

In fiscal year 1989, this program funded $22.8 million

in R&D, about two-thirds designated for narcotics

dependence and one-third for cocaine. Of the total,

about $16.5 million was for clinical investigations.

Antimalarial Experimental Therapeutics

Program

Since the early 1960s, when U.S. military personnel

stationed in Southeast Asia became infected with

strains of malaria resistant to existing treatments, the

U.S. Army’s Walter Reed Army Research Institute has

supported antimalarial research in its Division of

Experimental Therapeutics (272). With an increase in

the number of Americans traveling and living in parts

of the world where such malarias are common, the

public health need for new drugs has increased while

pharmaceutical company interest in antimalarial R&D

has remained historically minimal. The Walter Reed
314 I Pharmaceutical R&D: Costs, Risks and Rewards

Program maintains an in-house capability to study the

malaria parasite itself, to discover, develop, and

evaluate new compounds, and to develop collaborative

agreements with other public organizations such as the

World Health Organization (WHO) and private pharmaceutical firms for clinical testing and potential

marketing successful compounds.

Among potential malarial treatments attributable to

the program are: 1) mefloquine, 2) halofantrine, 3)

artemisinin, and 4) a compound currently known as

WR238605. Mefloguine was developed jointly by

Walter Reed, WHO, and Hoffman-LaRoche, Inc., and

was recently approved for U.S. marketing by the U.S.

Food and Drug Administration (FDA). Halofantrine is

a potential prophylactic jointly developed by Walter

Reed and SmithKline Beecham that may be effective

in parts of the world where malarias are proven

resistant to mefloquine and is currently undergoing

studies of chronic toxicity. Artemisinin is a drug based

on traditional Chinese medicine and is in the early

stages of development in cooperation with WHO as a

treatment for severe forms of malaria. WR238605 will

soon go into Phase I clinical testing as a replacement

for the drug primaquine in treating malaria and

possible Pneumocystis carinii pneumonia (PCP), a

common opportunistic infection in HIV patients.

Pharmacological Research in the National

Institute of General Medical Sciences (NIGMS)

Because NIGMS’s sole research mission is to

support work ‘‘h the sciences basic to medicine"

(rather than to focus on a particular disease or organ

system), it plays a unique role among agencies in the

Federal Government supporting basic biomedical

investigation. It “helps supply new knowledge, theories, and concepts’ that can then be used in diseasespecific research undertaken by other parts of NIH3

(477). A large part of this fundamental scientific

research portfolio is relevant to pharmaceutical R&D.

Among the institute’s activities is the Pharmaceutical Sciences Program, which is charged with supporting ‘‘research and research training leading to increased understanding of the interactions of drugs with

living systems in order to produce new, safer, and more

efficacious therapeutic agents. ’ While the program’s

work is interdisciplinary, drawing on the fields of

genetics, molecular biology, chemistry, computer

science, and more traditional pharmacological investigation, most grants given by the Pharmaceutical

Sciences Program are in three areas: anesthesiology,

pharmacology, or bio-related chemistry (486a). The

Pharmaceutical Sciences Program’s extramural research budget totaled just under $86 million in fiscal

year 1989, representing 15 percent of the institute’s

total extramural research funds,

1 Clinical Evaluation Programs

NCI’s Cancer Therapy Evaluation Program

NCI is one of two NIH institutes that maintains

targeted drug development programs focused solely on

clinical testing. NCI’s Cancer Therapy Evaluation

Program is responsible for funding and coordinating

most extramural trials within the NCI’s Division of

Cancer Therapy, including those involving anticancer

and anti-HIV pharmaceuticals. Through a network of

clinical cooperative groups the program’s Investigational Drug Branch sponsors trials to determine the

efficacy and toxicity of new investigational drugs and

maintains close contact with the pharmaceutical industry to promote efficient, coordinated drug development.

The program also maintains a Regulatory Affairs

Branch that has responsibility for preparing and

submitting investigational new drug (IND) applications to the FDA for human trials (particularly for those

drugs lacking a commercial sponsor to fulfill that

function). The Branch also cooperates with pharmaceutical companies in providing data and other information needed for a pharmaceutical firm to receive

approval of new drug applications (NDAs).

NIAID’s AIDS Clinical Trials Groups Program

and the Community AIDS Program

Begun in 1986, the NIAID’s AIDS Clinical Trials

Groups (ACTGs) involves active trials of drugs at

every stage of clinical development at many research

sites around the country (208). Because of the intense

scrutiny of ACTG trial protocols by patient groups,

trials are designed through a process of consensus

coordinated by NIAID and involving NIAID staff,

AIDS advocates, and the potential investigators. Data

collection at multiple sites is similarly coordinated

with the help of an NIAID research contract.

3 NIGMS is also charged with supporting doctoral and postdoctoral training toward the same ends and coordinates many of the

NIH-administered training programs outlined in chapter 9.
Appendix K–Federal Programs Dedicated to Pharmaceutical R&D ! 315

A more recent initiative within NIAID is the

Community Programs for Clinical Research on AIDS

(CPCRA), launched in 1989 in an attempt to involve

a greater number and broader cross-section of people

with AIDS in the clinical research process than was the

case with the ACTGs alone. According to NIAID

comments to the trade press at the time the program

was begun, CPCRA also differs from the ACTG

program in that while “many of the [ATCG] trials

have clinical endpoints (e.g., development of opportunistic infection or death) and require stringent

monitoring of immune responses to experimental

drugs, CPCRA endpoints will include ‘indications of

drug efficacy that are relevant to and easily obtainable

in the day-to-day practice of medicine’ and which do

not require the “sophisticated viral or cell-culturing

capability or technically intense monitoring of typical

ACTG studies” (375). In fiscal year 1990, CPCRA

awarded $9 million to 18 community-based projects in

14 cities, leaving another $3 million to support

statistical analysis and administrative coordination of

the trials.
Appendix L

Acronyms and Glossary of Terms

Acronyms

AAALAC —American Association for

Accreditation of Laboratory Animal

Care

ACE —angiotensin conversion enzyme

ACRS —accelerated cost recovery system

ACTGs —AIDS Clinical Trials Groups (NIAID)

ADA —adenosine deaminase (enzyme)

ADAMHA —Alcohol, Drug Abuse, and Mental

ADD

AFDC

AHCPR

AIDS

ALI

ANDA

APhA

ARIs

AWP

BPS

CANDAs

CAPM

CBER

CDC

CDER

CF

CMBD

CNS

Health Administration (DHHS)

—Anticonvulsant (or Antiepileptic) Drug

Development Program

—Aid to Families of Dependent Children

—Agency for Health Care Policy and

Research

—acquired immunodeficiency syndrome

—American Law Institute

—American Medical Association

—average manufacturer price

—abbreviated new drug application

—American Pharmaceutical Association

—aldose reductase inhibitors

—average wholesale price

—Biophysics and Physiological Sciences

Program

—computerized new drug applications

—capital asset pricing model

—Center for Biologics Evaluation and

Research (FDA)

—U.S. Centers for Disease Control

—Center for Drug Evaluation and

Research (FDA)

—cystic fibrosis

—Cellular and Molecular Basis of

Disease Program

CPAC

CPCRA

CPMP

CRADAs

CRISP

CRR

CSDD

CSOs

DIS

DHEW

DHHS

DNA

DOE

DRG

DTP

DTP

DUR

EC

ED

EDCs

ELA

ERTA

FDA

FD&C

FEDRIP

GAO

GCP

—central nervous system

—Central Pharmaceutical Affairs

Council (Japan)

—Community Programs for Clinical

Research on AIDS

—Committee for Proprietary Medicinal

Products (EC)

—cooperative research and development

agreements

—Computer Retrieval of Information on

Scientific Projects system

—cash flow recovery rate

—Center for the Study of Drug

Development of Tufts University

—consumer safety officers

—Drug Information System

—U.S. Department of Health, Education,

and Welfare (now DHHS)

—U.S. Department of Health and Human

Services

—deoxyribonucleic acid

—U.S. Department of Energy

—Division of Research Grants (NIH)

—diphtheria-tetanus-pertussis (vaccine)

—Developmental Therapeutics Program

—Drug Utilization Review

—European Community

—U.S. Department of Education

—European Discovery Capability Units

—establishment license application

—The Economic Recovery Tax Act

—U.S. Food and Drug Administration

—Federal Food, Drug, and Cosmetic Act

—Federal Research in Progress database

—Federal Technology Transfer Act

—General Accounting Office

(U.S. Congress)

—good clinical practices

316
Appendix L—Acronyms and Glossary of Terms 317

GLP

GSL

HCFA

HGH

HMO

HRSA

ICH1

IOM

IPO

IRBs

IRC

IRS

IUD

IV

JCT

LI

MACS

MARC

MEA

—good laboratory practices

—Guaranteed Student Loan

—U.S. Health Care Financing

Administration

—human growth hormone

—Health Insurance Board (Japan)

—human immunodeficiency virus

—health maintenance organization

—U.S. Health Resources Services

Administration

—International Conference on

Harmonization

—investigational new drug

—Institute of Medicine

—initial public offering

—institutional review boards

—internal revenue code

— internal rate of return

—U.S. Internal Revenue Service

— intrauterine device

—intravenous

—Joint Committee on Taxation

(U.S. Congress)

—licensed-in

—Multiaxis Coding System

—Minority Access to Research Careers

program

—Medical Evaluation Agency (EC)

MEDLARS--Medical Literature Analysis and

MHW

MIDAS

MSP

MSTP

NCE

NCI

NCRR

NDA

NDSL

NEI

NEJM

NHLBI

NHS

NIAID

Retrieval System (NLM)

—Ministry of Health and Welfare (Japan)

—Molecular Interactive Display and

Simulation system,

—Medical Science Partners program

—Medical Scientists Training Program

—new chemical entity

—National Cancer Institute (DHHS)

—National Center for Research Resources

(DHHS)

—new drug application

—National Direct Student Loan program

—National Eye Institute (DHHS)

—New England Journal of Medicine

—National Heart, Lung and Blood

Institute (DHHS)

—National Health Service

(United Kingdom)

—National Institute of Allergy and

Infectious Diseases (DHHS)

NICHD)

NIDA

NIDDK

NIGMS

NIH

NIHS

NINDS

NLM

NMCES

NME

NMR

NPV

NRSA

NSAID

NSF

NTIS

OD

OECD

OIs

OMB

OPD

OPE

OTA

OTT

PAB

PAC

PBAC

PBPA

PBS

PCP

PCR

PG

PHS

PIs

—National Institute of Child Health and

Human Development (DHHS)

—National Institute on Drug Abuse (DHHS)

—National Institute of Diabetes and

Digestive and Kidney Diseases (DHHS)

—National Institute of General Medical

Sciences (DHHS)

—National Institutes of Health (DHHS)

—National Institute of Hygienic Sciences

(Japan)

—National Institute of Mental Health

(DHHS)

—National Institute of Neurological

Disorders and Stroke (DHHS)

—National Library of Medicine (NIH)

—National Medical Care Expenditure

Survey

—new molecular entity

—National Medical Expenditure Survey

—nuclear magnetic resonance

—net present value

—National Research Service Awards Act

—nonsteroidial antiinflammatory drug

—National Science Foundation

—U.S. National Technical Information

Service

—orphan drug

—Organization for Economic

Cooperation and Development

—opportunistic infections

—U.S. Office of Management and Budget

—Office of Orphan Products

Development (FDA)

—Office of Planning and Evaluation (FDA)

—Office of Technology Assessment (U.S.

Congress)

—Office of Technology Transfer (NIH)

—Pharmaceutical Affairs Bureau (Japan)

—principal activity classification (codes)

—Pharmaceutical Benefits Advisory

Committee (Australia)

—Pharmaceutical Benefits Pricing

Authority (Australia)

—Pharmaceutical Benefits Scheme

(Australia)

—Pneumocystis carinii pneumonia

—polymerase chain reaction

—purchasing groups

—U.S. Public Health Service

—principal investigators
318 I Pharmaceutical R&D: Costs, Risks and Rewards

PLA

PMA

PMPRB

PPB

PPRS

PROS

PS

PTO

PV

rEPO

RAs

R&D

R&E

RDS

RNA

RRGs

ROS

SATSU

SBID

SBIR

SEC

SEOG

SIC

SOI

SPAPs

SRT

SSI

TAMRA

TDC

TPA

UCSF

USDA

USSF

WACC

WARF

WHO

—product license application

—Pharmaceutical Manufacturers

Association

—Patented Medicine Prices Review Board

(Canada)

—Patent Policy Board (NIH)

—Pharmaceutical Price Regulation

Scheme (United Kingdom)

—peer review organizations

—Pharmaceutical Sciences program

—U.S. Patent and Trademark Office

—present value

—recombinant erythropoietin

—research assistants

—research and development

—research and experimental

—respiratory distress syndrome

—ribonucleic acid

—risk retention groups

—return-on-sales

—Science and Technology Studies Unit

of Anglia College (England)

—Small Business Innovation

Development Act

—Small Business Innovation Research

grants

—U.S. Security Exchange Commission

—Supplemental Educational Opportunity

Grants

—standard industrial classification

—Statistics of Income

—state pharmaceutical assistance

programs

—Soribinil Retinopathy Trial

—Supplemental Security Income

—Technical and Miscellaneous Revenue

Act

—Technology Development Coordinator

—tissue plasmiogen activator

—University of California at San

Francisco

—U.S. Department of Agriculture

—United States Servicemen’s Fund, Inc.

—weighted average cost of capital

—Wisconsin Alumni Research

Foundation

—World Health Organization

Glossary of Terms

Abbreviated new drug application (ANDA): A

simplified submission to the U.S. Food and Drug

Administration (FDA) for approval to market a copy

of an already approved drug. An ANDA must

contain evidence that the duplicate drug is bioequivalent (see “bioequivalence”) to the previously

approved drug.

Applied research: Research to gain knowledge or

understanding necessary for determining the means

by which a recognized and specific need may be

met. While there is no standard definition of applied

research for pharmaceuticals, it generally refers to

all investigation targeted to the development and

testing of actual pharmaceutical compounds.

Asset: Any owned physical object (tangible) or right

(intangible) having economic value to its owners; an

item or source of wealth with continuing benefits for

future periods, expressed for accounting purposes in

terms of its cost or other value (such as current

replacement cost).

Average manufacturer price: The average price paid

by wholesalers for products distributed to the retail

class of trade.

Average wholesale price: The average price charged

for a specific commodity to retailers by one or more

wholesalers.

Basic research: Research performed to gain fuller

knowledge or understanding of the fundamental

aspects of phenomena and of observable facts,

without specific applications towards products or

processes in mind. Basic pharmaceutical research is

aimed at understanding the underlying physiological causes, disease, or developing new techniques

for use in developing pharmaceuticals.

Beta: A measure of a company’s (or industry’s)

relative risk in capital markets. Beta measures the

correlation between stock market returns to a

company (or industry) and overall stock market

returns. A value of beta close to 1 means that the

company’s stock has a risk profile that is average for

the stock market. A beta higher than 1 means that the

firm’s risk is higher than the average risk of firms in

the stock market.

Bioequivalence: Scientific basis on which generic and

brand-name drugs are compared. To be considered

bioequivalent, the rates at which the active ingredient of two drugs are absorbed by the body must not
Appendix L—Acronyms and Glossary of Terms 1319

differ significantly when they are given at the same

dosage under similar conditions. Some drugs, however, are intended to have a different absorption rate,

FDA may consider one product bioequivalent to

another if the difference in absorption rate is noted

in the labeling but does not affect the drug’s safety

or effectiveness, or change its effect in a medically

significant way.

Biological drugs: Drug products made from living

organisms and their products, including viruses,

serums, toxins, antitoxins, vaccines, allergenic or

analogous products. Also included are blood, blood

derivatives, and diagnostic reagents that use biotechnologyderived products.

Biopharmaceuticals: Pharmaceutical products produced by the application of biotechnology.

Biotechnology: Any technique that uses living organisms, or substances from those organisms, to make

or modify a product, to improve plants or animals,

or to develop micro-organisms for specific uses.

Book value: The current values of capital assets

claimed by a company in its financial statements

after depreciation expenses. Strict accounting conventions determine what kinds of investments create

a capital asset.

Brand-name: The commercial name given to a drug

product by an individual company for marketing

and promotion purposes.

Breakthrough drug: A new therapeutic compound

whose therapeutic effects and/or mechanism of

action are substantially different from any previously marketed compound. Criteria for ‘ ‘substantially different” can vary among evaluators.

Capital asset: A tangible or intangible asset intended

for long-term use.

Capital asset pricing model: An economic model of

equilibrium in capital markets which predicts rates

of return on all risky assets as a function of their

correlation (or covariance) with the overall market

portfolio.

Capitalized cost: The present value on a particular

date of expenditures made in the past. The capitalized cost is measured by compounding the past

expenditure to its present value at an appropriate

interest rate.

Carry back: A tax provision that allows companies

with insufficient tax liabilities in a tax period to

apply credits earned during that period to tax

liabilities incurred in a past tax year.

Carry forward: A tax provision allowing companies

with insufficient tax liabilities in a tax period to save

credits earned during that period for use in a future

tax year.

Cash flow recovery rate: The rate of return on

realized cash flows into and out of a firm over a

defined time interval.

Clinical pharmacology: The study and evaluation of

the effects of drugs in humans.

Clinical trials: Experimental research in which preventive, diagnostic, or therapeutic agents, devices,

regimes, and procedures are given to human subjects under controlled conditions in order to define

their safety and effectiveness. (See also phase I, II,

III, and IV studies).

Constant dollars: Dollars expressed in terms of their

purchasing power in a base year. Constant dollars

adjust for changes in buying power due to inflation

or deflation between the base year and the year of

measurement.

Contribution margin: The percent of a company’s

sales that contributes to paying the fixed costs and

profits of the enterprise after the direct costs of

producing, marketing and distributing the product

are deducted.

Cooperative Research and Development Agreements (CRADA): A formal agreement between a

Federal laboratory and anon-Federal party (individual, university, or private firm) in which the

non-Federal party provides resources in exchange

for exclusive rights to license patents that result

from the collaboration. Congress gave Federal

laboratories the authority to enter into CRADAs as

part of the Federal Technology Transfer Act of 1986

(Public Law 99-502).

Copayment: In health insurance, a form of cost

sharing whereby the insured person pays a specified

amount for the service or pharmaceutical. The

copayment can be a fixed amount or a percentage of

the bill.

Cost of capital: The interest rate required to induce

investors to put up capital for an investment with a

given level of risk.

Current dollars: The value of dollars spent or

received at the time of the transaction, without

adjusting for inflation or deflation since the transaction date.

Depreciation: The process of allocating the cost of

tangible assets to operations over the expected life

of the asset. Depreciation represents the gradual
320 I Pharmaceutical R&D: Costs, Risks and Rewards

exhaustion of the service capacity of fixed assets. It

is the consequence of such factors as use, obsolescence, inadequacy, and wear.

Discount rate: The interest rate used to convert future

cash flows to their present value.

Drug: In this report, any chemical or biological

substance that may be applied to, ingested by, or

injected into humans to prevent, treat, or diagnose

disease or other medical conditions.

Drug receptor: A site or structure in or on the surface

of a cell which combines with a drug to produce a

specific alteration of a cell function. The vast

majority of drug receptors in the body are proteins.

Drug utilization review: A review system used by

health insurers to monitor the frequency and usage

of prescriptions by enrollees, to identify potential

interactions with other medications, or to identify

alternative effective or cost-effective therapies for

the patient.

Effective patent life: In this report, the length of time

during which a new chemical entity is formally

protected from generic competition by patent or

other statutory market exclusivity provision.

Effective tax rate: The ratio of actual income tax paid

to the pre-tax income of a particular taxpayer or a

group of taxpayers (such as the whole pharmaceutical industry).

Enzymes: Proteins that are produced by living cells

and that mediate and promote the chemical processes of life without themselves being altered or

destroyed.

Establishment license application: An application to

the FDA for a license to produce a biological

product at a given facility.

Ethical pharmaceuticals: In this report, biological

and medicinal products for use in humans and

promoted primarily to the medical, pharmacy and

allied professions.

Expensing: In accounting, the practice of recording an

expenditure in the period in which it occurs.

Fiscal year: Any accounting period of 12 successive

calendar months, or 52 weeks, or 365 days, used by

an organization for financial reporting.

Follow-on product: Any new combination, formulation, or dosing strength of existing therapeutic

molecular compounds that must be tested in humans

before market introduction.

Formulary: A list of selected pharmaceuticals and

their appropriate dosages judged to be the most

useful or cost-effective for patient care from which

physicians are required or encouraged to prescribe.

A formulary may also be a list of drugs that may not

be prescribed without special appeals.

Gene therapy: See human gene therapy.

Generic drug: A “copy” of an existing pharmaceutical compound.

Health maintenance organization: A health plan that

provides a full range of health benefits to a specified

group of subscribers for a fixed prepaid fee,

regardless of the expense of the care needed. The fee

can either be paid by the subscriber or by an

employer.

Human gene therapy: Treatment of disease by

insertion of new genetic material or permanent

modification of existing genes.

Innovator firm: A drug manufacturer that invents,

develops, and in most cases, markets new chemical

entities.

Internal rate of return: The interest rate at which the

present value of all net cash flows into and out of a

firm over a specified time interval equals zero.

Investigational new drug (IND) (application): An

application submitted by a sponsor to the FDA

before beginning human testing on an unapproved

drug or on an approved drug for an unapproved use.

Joint and several liability: A legal term that refers to

liability of each defendant for all damages even if

more than one defendant is found liable.

Licensed-in NCE: A new chemical entity acquired

from the originating company through a contractual

agreement.

Line extension drug: See follow-on product.

Medicaid: A government medical assistance program

that pays for medical expenses for the poor and

certain other classes of uninsured people, established by the Title XIX of the Social Security Act of

1965. Each State administers its own program.

Medicaid is funded by both the State and Federal

governments.

Medicare: A Federally administered health insurance

program covering the cost of services for people 65

years of age or older, receiving Social Security

Disability Insurance payments for at least two years,

or with end-stage renal disease. Medicare consists of

two separate but coordinated programs-hospital

insurance (Part A) and supplementary medical

insurance (Part B). Health insurance protection is

available to insured persons without regard to

income.
Appendix L–Acronyms and Glossary of Terms 321

Marginal credit rate: For tax credits, the percentage

reduction in the cost of an extra dollar of spending

for a taxpayer, holding everything else constant.

Marginal incentive effect: See marginal credit rate.

Me-too drug: A new chemical entity that is similar but

not identical in molecular structure and mechanism

of action to a pioneer NCE.

Molecular biology: The study of biology at the level

of individual molecules, such as proteins and DNA.

Multiple-source drug: A drug product not protected

by patents or other exclusive marketing rights and

marketed by more than one company.

Net present value: The difference between the present

value of all cash inflows from a project or investment and the present value of all cash outflows

required for the investment.

New chemical entity: In this report, a new therapeutic

molecular compound that has never before been

used or tested in humans. The term refers to both

drugs and biological. (See also new molecular

entity.)

New drug application: An application to the FDA for

approval to market a new chemical (nonbiological)

drug for human use in U.S. interstate commerce.

New molecular entity: A term used by FDA in its

published statistical reports to describe newly developed drug compounds. The FDA includes some

diagnostic agents and excludes therapeutic biologicals in the definition.

off-label use: The prescription or use of ethical

pharmaceuticals for indications other than those

specified in FDA approved labelling of the drug.

Opportunity cost of capital: The rate of interest that

dollars invested must earn in exchange for being tied

up in an investment with a given level of risk.

orphan drug: A drug product discovered and developed for the treatment of a rare disease.

overhead costs: Cost items that cannot be identified

specifically with any one project or activity.

over-the-counter drugs: Drugs available without a

physician’s prescription.

Parallel-track program: A FDA program, proposed

in 1990, that would allow release of investigational

drugs to medical practitioners, on a case-by-case

basis, for use in the treatment of AIDS or HIVrelated illness for which no satisfactory alternative

treatments exist or patient participation in conventional clinical trials is not possible.

Patented drugs: Brand-name drugs that are marketed

by a pharmaceutical company under exclusive

marketing rights.

Phase I, II, III, IV studies: Specific phases of the

clinical (human) testing of new drug products.

. Phase I studies are small trials usually involving

only healthy volunteers to map how the body

absorbs and eliminates the drugs and to document

the response it produces.

. Phase 11 studies test the drug’s therapeutic

effectiveness and note any adverse reactions in

individuals affected by the target disease or

condition.

. Phase III studies assess the drug’s medical

benefits and risks among a large number of

patients under conditions of ordinary use.

. Phase IV studies are clinical trials conducted

after a product is already approved for marketing.

Pioneer drug: A new chemical entity that has a

molecular structure and/or mechanism of action that

differs from all previously existing drugs in a

therapeutic area, such as the first therapeutic compound to inhibit the action of a specific disease or

condition.

Preclinical research: Laboratory and animal research

conducted prior to the clinical testing of a new

chemical entity. Preclinical research may include

basic research and applied non-clinical research.

Prescription drug: In the United States, a drug

dispensed by a licensed pharmacist or medical

practitioner on the written order (prescription) of a

medical practitioner licensed by law to administer

such drugs.

Present value: The economic value today (or at some

specific date) of an amount paid or received at a later

date discounted at an appropriate rate.

Protein: A type of molecule composed of linked

amino acids in particular sequences, which determine the structure, function, and regulation of the

various cells, tissues, and organs in the body.

Product license application: An application to the

FDA to market a biological product in the United

States.

Rational drug design: A process of drug research

focusing on the physiological basis of disease and

finding or creating new therapeutic agents that

interfere with the course of disease at the molecular

level. It is contrasted with random screening of

existing molecules in search of empirically observed

action against disease. A general term that covers a
322 I Pharmaceutical R&D: Costs, Risks and Rewards

broad range of approaches to the discovery of new

drugs that rely on structural analysis of target

molecules and deliberate design of agents to affect

their function.

Real dollars: See constant dollars.

Receptor: See drug receptor.

Research and development: In the pharmaceutical

industry, the process of discovering, and developing

for the market new drugs and related products.

Self-originated NCEs: A new chemical entity discovered, developed, and brought to market by a single

company.

Shining new drugs: A term used in Japan to refer to

drugs without any close therapeutic competition or

chemical predecessor.

Single-source drug: A drug marketed under one brand

name usually by one company,

Standard Industrial Classification (SIC) Code: A

numerical code used by the U.S. Department of

Commerce to classify firms according to their

primary line of business.

Strict liability: A legal concept that states liability lies

with the party best able to prevent injury or absorb

its costs even if that party was not responsible for

causing the specific injury in question through

negligence or intent.

Technology transfer: The process of converting

scientific knowledge into useful products. This most

often refers to the flow of information between

public and private sectors or between countries.

Therapeutic class: A group of drugs intended to treat

a particular disease or group of related diseases.

Third-party payers: Private insurance companies,

government agencies, and self-insured business that

pay medical providers for services given to a patient.

Treatment IND: An FDA program, established in

1987, that allows the release of investigational drugs

to medical practitioners, on a case-by-case basis, for

use in the treatment of immediately life-threatening

diseases in instances where no satisfactory alternative treatment exists.

Vaccine: A preparation of whole or parts of living,

attenuated, or killed bacteria or viruses, (or synthesized antigens identical or similar to those found in

the disease-causing organisms) designed to produce

or increase immunity to a particular disease.

Working capital: The excess of current assets over

current liabilities. Where current assets and liabilities are cash and short-term securities and current

liabilities are debts owed in the current accounting

period.
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Containment,’ Journal ofEconomicLiterature

29:523-552, June 1991.

Weissinger, J., Center for Drug Evaluation and

Research, Food and Drug Administration, Public Health Service, U.S. Department of Health

and Human Services, Rockville, MD, personal

communication, March 1991.

Wells, J., Pharmacy Program Manager, Division of Medicaid, Florida Department of Health

and Rehabilitative Services, Tallahassee, FL,

personal communication, 1990,

White, R. L., Woodward, S., hppert, M., et al.,

‘‘A Closely Linked Genetic Marker for Cystic

Fibrosis,” Nature 318:382-384, 1985.

Wiggins, S. N., “Product Quality Regulation

and New Drug Introductions: Some New Evidence From the 1970s,” The Review of Economics and Statistics 63(4):615-619, 1981.

Wiggins, S. N., The Cost of Developing a New

Drug (Washington, DC: Pharmaceutical Manufacturers Association, 1987).

Wilkes, M. S., Doblin, B., Shapiro, M., “Pharmaceutical Advertisements in Leading Medical

Journals: Experts’ Assessments,’” Annals of

Internal Medicine 116:912-919, 1992.

Wolfe, S. M., Director, Public Citizen Health

Research Group, Washington, DC, “Statement,” Product Liability Reform Act, hearing

before the Subcornmittte on the Consumer,

Committee on Commerce, Science, and Transportation, Senate, U.S. Congress, May 10,

1990, Serial No. 101-743 (Washington, DC:

U.S. Government Printing Office, 1990).

Wolski, K. P., remarks at “Drug Approvals in

the United States and Abroad, ” seminar sponsored by the Institute for Alternative Futures

Foresight, Washington, DC, October 7, 1991.

Woltman, R., “Reviewing the Bidding: R&D

Costs and Profitability of New Chemical Entities,” Journal of Research in Pharmaceutical

Economics 1(3):49-65, 1989.

Wozny, J. A., “The Research Tax Credit: New

Evidence on Its Effects,” Proceedings of the

Eighty-Second Anuual Conference of the National Ta Association-Tax Institute of America

1989, pp. 223-228.

Yoshikawa, A., Associate Director, Comparative Health Care Research Project, Stanford
346 I Pharmaceutical R&D: Costs, Risks and Rewards

University, Stanford, CA, personal cornmuni- 528. Young, F.E., Norris, J.A., Levitt, J.A., et al.,

cation, December 10, 1991. “The FDA’s New Procedures for the Use of

527. Yoshikawa, A., Hayase Fellow, Asia Pacific Investigational Drugs in Treatment,” JournaZ

Research Center, Stanford University, Palo of the American Medical Association 259(15):

Alto, CA, personal communication, March 5, 2267-2270, 1988.

1992.

U . S . GOVERNMENT PRINTING OFFICE : 1993 - 330-067 : QL 3
Index

Abbott Laboratories, HIV vaccine clinical trial, 179

Academia. See Universities

Accelerated cost recovery system, 186

Acquired immunodeficiency syndrome

CRADAs related to, 225

expedited approval of therapies, 155, 156, 158

gene therapy, 128

Medicaid support for clinical R&D, 233

orphan drug designation, 226

treatments, 246

vaccines for, 182

ADAMHA. See Alcohol, Drug Abuse and Mental Health

. .

Administration

Additional Rebate, Medicaid, 247-249

Advertising, 102

Advisory committees, FDA, 149-150

A.H. Robins, product liability litigation, 173-174, 175, 179

AIDS. See Acquired immunodeficiency syndrome

Alcohol, Drug Abuse and Mental Health Administration

CRADA examples, 35-37,223-225

pharmaceutical R&D support, 213-217,221

Alglucerase, see CeredaseT m

Altshuler, marginal credit rate study, 188-189

Alzheimer’s disease, 25, 120, 124-126

American Association for Accreditation of Laboratory

Animal care, 64

American Casualty Excess, 173

Amgen, 230-231

Angiotensin converting enzyme, 107-108

Angiotensin converting enzyme inhibitors, 76

Angiotensin II, 107

Animal research

necessary for INDs, 140

cost, 13, 58, 62-65

transgenic, 129

Animal Welfare Act, 64

Antidepressant drugs, 246

Antihist amine compounds, 110

Antihypertension drugs, 65,76, 86, 107-108

Antimicrobial drugs, 65

Antinausea drugs, 173-174, 175-176, 179

Arthur Anderson and Company, 137

Aspirin, 108

Association of the British Pharmaceutical Industry, Great

Britain, 260,262

Australia, prescription drug benefits, 250-252

Average effective tax rate, 184

AZT, 216, 222,246

Baber and Kang

IRR comparison study, 96, 100-102

worldwide tax calculation, 92

Bach-Dole Patent and Trademark Act, 35,209

Baily, R&D cost study, 50, 136

Baily and Lawrence, tax credit study, 188, 189

Basic Rebate, Medicaid, 247

Basic research

costs, 51, 58

Federal support relevant to pharmaceutical R&D, 34-35,

211-213

industry and academia collaboration, 206

tax credits for, 189-190, 195

Bateson, William, 119

Bayliss, William, 115

Benchmark pricing scheme, Australia, 252

Bendectin, 173-174, 175-176, 179

Best, Charles, 115

Beta blockers, 76

Biogen, 226

Biomedical research

complexity of, 131-132

DNA as a therapeutic agent, 127-131

drugs and drug receptors, 17, 106-113

genetics and, 119-127

implications for future R&D costs, 133-134

increasing role of instruments and computers, 132

link between basic Federal biomedical research and new

drug development, 211-213

personnel costs, 12-13,62,204-206

proteins, 113-119

Biotechnology drugs

Medicare coverage, 250

number in development, 18, 69, 70

orphan market exclusivity rights, 230-231

regulatory review process, 147-149

Biotechnology industry

cost studies, 67

347
348 I Pharmaceutical R&D: Costs, Risks and Rewards

raising external capital, 9-10

R&D spending estimates and, 41-42

Birth defects, 175-176

Black, James, 110

Blumenthal, surveys about industry and academia collaborations, academic research survey, 202, 206

Bristol-Myers Squibb, 37,74,216-217,222

Brown, Dr. Michael S., 74

Brown-Séquard, Charles Edouard, 115

“Bubble Boy Syndrome,” 128

Burstall, M. L., 261

Bush, George, veto of Revenue Act of 1992, 188

Calcium channel blockers, 76,86

Canada

Bill C-22, 253-254

Bill C-91, 255

prescription drug benefits, 252-255

Cancer

gene therapy, 127

Group C drugs, 232-233

off-label prescriptions and, 243

CANDAs. See Computerized new drug applications

Capitalized R&D costs

cost estimate validity, 57, 59, 66-67

cost estimates, 16-19, 60

definition, 10

estimating R&D costs framework, 48

existing cost studies, 52-5,3

measurement difficulties, ’72

Captopril, 107-108, 118, 131

Cardizem QD, 86

Cash flow profile, 76, 100

Cash outlays, R&D

cash costs per success, 11-15

clinical period, 56-57

components of out-of-pocket costs, 62-65

framework for estimating R&D costs, 48

industry-level cost studies,, 60-62

mean cash outlay to bring new drug to market, 72

preclinical period, 57-58

present value of, 15

project-level cost studies, 51-54, 69

validity of cost estimates, 55-56, 65-66

CBER. See Center for Biologics Evaluation and Research

CDER. See Center for Drug Evaluation and Research

Ceclor, 87-88

Cefaclor, 87-88

Cefalexin, 87

Cell surface molecules, 112-113

Census Bureau, 40

Center for Biologics Evaluation and Research

Investigational New Drug Applications, 18

new drug regulatory review process, 138-139, 141-143,

148-149

orphan drug assistance, 227-228

review process guidelines, 152-153

Center for Drug Evaluation and Research

cost studies, 70

efforts to expedite FDA new product regulations, 154-155

new drug classification, 142-143, 154

orphan drug assistance, 227-228

R&D spending estimates, 45

regulatory review process for new drugs, 138-139, 141-

143, 147-149, 160

Centers for Disease Control, 175

Centocor, 41

CentoxinTm, 41

Central Pharmaceutical Affairs Council, Japan, 165

Centre for Medicines Research, United Kingdom, 40,44

Ceredase TM, 28,33,37,222-223

CF. See Cystic fibrosis

Cholesterol-lowering drugs, 25,74-75,216-217

Chromosome maps. See Genetic maps

Chugai Pharmaceuticals, 230-231

Cimetidine, 109, 110, 131

Clark, A.J,, 106

clinical trials

expedited approval process, 155-158

expenditures, 51, 52, 56-57

Federal regulatory review process for new drugs, 140,

143-146

Federal support for pharmaceutical R&D, 206-207, 215-

217,228,232-233

foreign trials, 153-154

gene therapy, 130

survey of trial sizes, 14, 65

Clowes, G. H. A., 115

Clymer, R&D cost study, 50

Collip, James, 115

Comanor, William, 103

Commercialization licenses, 36,219

Committee for Proprietary Medicinal Products, European

community, 165-166

Compustat TM database, 100-101

as source of spending data, 40, 42, 43

Computer modeling, 63

Computerized new drug applications, 154-155

Computers, increasing role in biomedical research, 132

Contraceptive devices. See Dalkon Shield

Cooperative Research and Development agreements

examples, 35-37, 223-225

licensing inventions of Federal biomedical research labs,

36-37,219-223

patenting inventions of Federal biomedical research labs,

35-37,218

technology transfer activities, 35-37, 218

Copayments, insurance for prescription drugs, 26-27, 240,

242, 245,255, 261

Cost of capital, 9,93, 102

R&D cost estimates, 48,52-53,54,66-67

Costs of pharmaceutical R&D.

components of out-of-pocket costs, 62-65

cost studies’ approaches, 48-54

framework for estimating, 47-48

impact of regulations on, 33, 136-138

industry-level cost studies, 50, 60-62

summary, 10-19

tax savings from R&D, 15-16, 67-69
Index ! 349

trends in, 69-72

validity of cost estimates, 14-15, 54-67

CPAC. See Central Pharmaceutical Affairs Council

CPMP. See Committee for Proprietary Medicinal Products

CRADAs. See Cooperative Research and Development

agreements

Cross-licensing, 42

CSDD. See Tufts University Center for the Study of Drug

Development

Cystic fibrosis, 121-123, 129-130

Dalkon Shield, 173-174, 175, 179

ddI, 37,222

DES. See Diethylstilbestrol

DHHS. See U.S. Department of Health and Human Services

Diabetes, 115-117

Diethylstilbestrol, 176

Digitalis, 108

DiMasi, Joseph

R&D cost study, 11, 14-16,50-53,55-67,68-70, 91

R&D expenditures estimate, 11-12,45, 166

Diphtheria-tetanus-pertussis vaccine, 177-178

Diuretics, 76

DNA

alternative uses, 130-131

composition of, 114

gene therapy, 127-129

recombinant DNA, 115

Doolittle, Russell

oncogene and cell growth molecule similarity, 123

Dranove and Meltzer, regulation impact study, 138

Drug delivery mechanisms, 6

Drug discovery. See Biomedical research

Drug Price Competition and Patent Term Restoration Act,

21, 22,83, 84,86,87,94

Drug receptors, 106-113

Drug utilization review, 244

Drug receptors, 106-113

DTP vaccine. See Diphtheria-tetanus-pertussis vaccine

Duchene muscular dystrophy, 128

DURs. See Drug utilization reviews

EC. See European Community

Economic Recovery Tax Act of 1981, 186-187

Ehrlich, Paul, 106

Eisman and Warden, regulation output study, 137

Eisner, Albert and Sullivan, marginal tax credit rate study,

189

ELA. See Establishment license application

Eli Lilly and Company

Federal support for pharmaceutical R&D, 230

R&D costs, 60

R&D expenditures, 41

Equipment, increasing role in biomedical research, 132

ERTA. See Economic Recovery Tax Act of 1981

Erythropoietin (EPO), 116

Establishment license application, 147-149

Ethical pharmaceuticals, 3, 26-27,42

European Community, drug approval in, 165-167

Exclusivity period for patents, 20-21,84,86

Expenditures for pharmaceutical R&D.

allocation of funds, 44-45

data sources, 39-42, 166

domestic trends, 42

industry share of total biomedical R&D, 203

overstatement in estimates of, 40-42, 61

tax credits for, 68-69, 186-189

tax deductions for, 184-186

worldwide trends, 43-44

Factor-(f) scheme, Australia, 251-252

Faculty-founded companies, 209-210

Failure to warn determination, 171

FD&C Act. See Federal Food, Drug, and Cosmetic Act

Federal Food, Drug, and Cosmetic Act, 32, 136-138

Federal Health Facilities Research Act, 204

Federal research laboratories, 34-37,217-225

Federal support for pharmaceutical R&D. See Support for

pharmaceutical R&D

Federal Technology Transfer Act, 35,36,218,219, 220

Fisher, Emil, 116

Fluoxetine, 216, 246

Follow-on products, 6,61

Food, Drug, and Cosmetic Act, 206

Food and Drug Administration

clinical R&D support, 215

efforts to expedite FDA new product regulations, 33,

151-158

Endocrinologic and Metabolic Advisory Committee, 74

NCE approvals, 54,58, 65,71

NME approvals, 45

orphan drug support, 69, 226-232

post-approval research and reporting requirements, 150-

151

regulation impact on costs and output, 137

regulatory review process, 32-33, 52, 53, 138-151, 158-

164, 167-168

Foreign clinical trials, 65, 153-154

regulation trends, 164-167

regulatory review and foreign trials, 146

Foreign sales

deduction of U.S. R&D expenses and, 185-186

Foreign tax credits, 191-192, 193

Foreign tax laws, 197-198, 199

Formularies, 29, 243,246

France, prescription drug benefits, 255-257

French Social Security Funds, 255

FTT, See Federal Technology Transfer Act

Gancyclovir, 246

GAO. See General Accounting Office

G.D. Searle Company, 40

Gene therapy, 127-130

Genentech, 60, 116,226,230

General Accounting Office, 11,66

Federal product liability filings study, 174

tax calculation, 92

Generic drugs

competition, 30

description, 6
350 I Pharmaceutical R&D: Costs, Risks and Rewards

incentives to use, 30, 243

mail-order pharmacies, 244

market shares, 31

in the United Kingdom, 261

Genes. See also Genetics

composition of, 114

finding and studying, 119-120, 121, 123-124

mutations, 123-124

Genetic maps, 120-121

Genetics

DNA and, 119-120

gene therapy, 127-130

genetic factors of disease, 120

genetic maps, 120-121

history of, 119-120

Human Genome Project, 126-127

Genomes, 121, 126-127

Genzyme, Inc., 222-223

Germ line gene therapy, 127-129

Glaxo, worldwide sales estimates, 89

Goldstein, Dr. Joseph S., 74

Good Clinical Practices, 165

Good Laboratory Practices, 165

Government agencies. See specific agencies by name

Government regulation of R&D

efforts to expedite FDA new product regulations, 151-158

Federal regulatory review process for new drugs, 138-139

in foreign countries, 164-167

impact of regulation on costs and output, 136-138

origins of, 135-136

R&D and review process trends, 158-164, 167-168

summary, 32-33

Grabowski and colleagues, regulation impact study, 136-137

Grabowski and Vernon

cost study, 50, 53-54

returns on R&D study, 78-81, 87, 89

Group C cancer drugs, 232-233

Guillain-Barré syndrome, 181

H-2 receptors, 110

Hansen, Ronald

R&D cost study, 11-12, 14-15,50-53,54,55-67, 69,78

regulation impact, 137

Harvard University, 209

Health Care Financing Administration, 232,233

Health insurance in the United States. See also other

countries by name

extent of coverage, 26, 240-241

health maintenance organizations, 28-29,240, 244,245

hospital coverage, 238-239

importance in determining demand, 26-27

limitations on coverage, 26-27

Medicaid prescription drug benefits, 245-249

nursing home coverage, 239

outpatient coverage, 239-240

price-sensitive buyers, 28-30

state assistance, 249-250

Health maintenance organizations

drug prescribing practices and drug price competition,

28-29, 245

drug utilization review programs, 244

prescription drug coverage, 240

Henderson and Eisenberg, product liability study, 180

Hill, A.V., 106

HIV. See Human immunodeficiency virus

HIV-antibody test kit, 220-221

HIV hyperimmune globulin, 179

HMG-CoA reductase inhibitors, 25,74-75,216-217

HMOs, See Health maintenance organizations

Hoffman-La Roche, 62,63

Human Genome Project, 126-127

Human growth hormone, 230

Human immunodeficiency virus

action of, 112

AZT and, 216,222

CRADAs related to, 225

expedited approval of therapies, 156, 157

HIV-antibody test kit, 220-221

public spending on drug discovery, 213

vaccine for, 179

Human recombinant soluble CD4, 226

HumantropeTM, 230

Hun-din, 116

Huntington’s disease, 123

Iletin, 116

I-MS International, Inc., 19,89

In-process R&D, 40-41

In-vitro testing, 63

INDs. See Investigational new drug applications

Insulin, 115-117, 132

Internal rate of return, 23-24

comparative profits contractor report, 96, 100-102

definition, 95

past studies, 96

Internal Revenue Service, 69. See also Tax policies

International Conference on Harmonization, 166-167

Intrauterine device. See Dalkon Shield

Investigational new drug applications.

Federal regulatory review process for new drugs, 139-143

Medicaid support for clinical R&D, 233

number of, 18-19,45, 70-72

orphan drug designation, 226

R&D and regulatory review process trends, 158-159,

160-164

rewrite of regulations, 153

Investigational Review Boards, 158

Investment. See Returns on R&D

IRBs. See Investigational Review Boards

IRR. See Internal rate of return

Japan

drug approval in, 164-167

prescription drug benefits, 257-259

Japanese Health Insurance Bureau, 165, 257

Japanese Pharmaceutical Affairs Bureau, 257

Joglekar and Paterson, returns on R&D study, 78-81,89-90

Kang. See Baber and Kang

Kefauver-Harris Amendments, 33, 136
.

Index ! 351

Keflex, 87

Keystone AIDS Vaccine Liability Project, 182

Kindt, Thomas, 224

Liability. See Liability insurance; Product liability

Liability insurance, 172-173

Licensed-in drugs

existing cost studies, 53, 54

trends in cost of R&D, 71

validity of R&D cost estimates, 58, 59, 70

Licensing

Federal patent and licensing policy, 36-37,218

for inventions from Federal biomedical research labs,

219-223

Life sciences. See Biomedical research

Lilly Pharmaceutical, 87-88, 116. See also Eli Lilly and

Company

Lovastatin, 74, 216-217

Macleod, John, 115

Mail-order pharmacies, 244-245

Mansfield, academic research and commercial innovation

survey, 201-202

Manufacturing costs, 21-22,90-91

Marginal credit rate, 184, 188-189

Marginal incentive effect, 184

Market exclusivity, 228-231

Marketing applications. See Foreign markets; New drug

applications

Marketing costs, 90-91, 102

McKusick, Victor, 120

Me-too drugs, 7,30,46,73

in France, 256

in Japan, 257

Medicaid

clinical drug R&D support, 232-233

cost-cont ainment efforts, 247-249

outpatient coverage, 245-246

reimbursable amounts, 246

reimbursable drugs, 246

Medicaid Rebate Law, 247-249, 262-263

Medical Science Partners, 209

Medicare

biotechnology drug coverage, 250

clinical drug R&D support, 232-233

inpatient drug coverage, 29, 239

nursing home drug coverage, 239

outpatient drug coverage, 239

Meltzer. See Dranove and Meltzer

Mendel, Gregor, 119

Mendelian Inheritance in Man, 120

Merck & Co., 74, 216-217

Merrell Dow Pharmaceuticals, 86

product liability litigation, 173-174, 175-176, 179

Mevastatin, 74

Monsanto Corporation, 40

Mueller and Reardon, IRR study, 103

Mutuelles, France, 255

Myers and Shyam-Sunder, cost of capital study, 9, 66-67

National Cancer Institute, 213, 214, 216,225

National Childhood Vaccine Injury Act of 1986, 181-182

National Health Service, 259-262

National Heart, Lung and Blood Institute, 216

National Institute of Mental Health, 216, 225

National Institute on Drug Abuse, 213

National Institutes of Health

Ceredase TM discovery, 222-223

clinical trials involving cholesterol-lowering drugs, 216-

217

CRADAs examples, 223-225

drug discovery and testing, 202

gene therapy clinical trials funding, 130

support for biomedical research, 35-37, 203, 204, 206

targeted Federal pharmaceutical R&D programs, 210,

213-217

technology transfer in the PHS, 218-223

National Science Foundation, 40,42, 204

NCEs. See New chemical entities

NDAs. See New drug applications

Neutrophils, 112

New chemical entities

cost studies, 11-16, 49-67

cost trends, 69-72

description, 6-7

allocation R&D, 45

regulatory review process, 32-33, 150, 159, 160-164

returns on R&D and, 19-24, 73-104

sales, 19, 81-90

spending estimates and, 41

tax savings, 34, 69

worldwide sales, 89-90

New drug applications

approval times, 161-163

clinical trial survey, 65

cost studies, 52, 53, 58-59

cost trends, 18-19, 70, 71-72

foreign clinical trials, 153-154

number of, 160

orphan drug assistance, 226, 227, 228

regulatory review process, 32-33, 142-148, 158-159,

160-164

rewrite of IND and NDA regulations, 33, 153

New molecular entities

cost trends, 18-19, 70

funds allocation, 45

regulatory review process, 32-33, 159, 160-164

NIH. See National Institutes of Health

NMEs. See New molecular entities

NMR. See Nuclear magnetic resonance spectroscopy

Nonsteroidal antiinflammatory drugs, 14, 65

NSAID. See nonsteroidal antiinflammatory drugs

NSF, See National Science Foundation

Nuclear magnetic resonance spectroscopy, 111-113

Nursing home coverage for prescription drugs, 239

Off-label prescriptions, 243

Office of Management and Budget, 231

Office of Orphan Products Development, 226,228

Office of Planning and Evaluation, FDA, 160
352 I Pharmaceutical R&D: Costs, Risks and Rewards

Office of Technology Transfer, NIX-I, 218

Omnibus Budget Reconciliation Act of 1989, 188

Omnibus Budget Reconciliation Act of 1990,247

Opportunity cost of capital, See also Cost of Capital, 7-8,11,

48

Originator products, increase in price after patent expiration,

88

Orphan Drug Act of 1983

effectiveness, 231, 232

exclusive marketing rights, 83

pharmaceutical R&D support, 225,228

regulatory review process for new drugs, 143

tax savings from R&D, 16, 69

Orphan drugs

clinical research grants, 228

designation of, 226-227

impact of subsidies, 231-232

market exclusivity, 228-231

protocol assistance, 227-228

speed of approval, 71-72

tax credit policy, 190-191, 193, 195-196

Outpatient coverage for prescription drugs, 239-240

Parallel-track program, 155-156, 157

Parker, regulation impact study, 137

Patent and Trademark Office, 219

Patent Policy Board, NIH, 218

Patented Medicines Pricing Review Board, Canada, 254

Patents

effective patent life, 19-21, 82-87

exclusivity period, 84, 86

Federal patent and licensing policy, 36-37,218

for inventions of Federal biomedical research labs, 36-37,

219

licensing of technology by universities, 209

orphan exclusivity vs. patent protection, 228-231

postpatent revenues, 21, 87-89

Paterson, See Joglekar and Paterson

Payment for prescription drugs

in Australia, 31, 250-252

in Canada, 31, 252-255

in France, 31, 255-257

in Japan, 31, 257-259

Medicare and Medicaid support for clinical drug R&D,

232-233

under parallel-track program, 157

price discrimination, 27-28

sources of, 27-28

under Treatment IND, 156

in the United Kingdom, 31, 259-262

in the United States, 238-250

PBPA. See Pharmaceutical Benefits Pricing Authority

PCR. See Polymerase chain reaction

Peltzman, regulation impact study, 136-137

Peptic ulcer disease treatment, 109, 110

Peptide hormones, 114-119

Personnel costs, R&D, 12-13,62

Pertussis vaccine, 177-178

Pharmaceutical Benefits Advisory Committee, Australia,

251

Pharmaceutical Benefits Pricing Authority, Australia, 251-

252

Pharmaceutical Benefits Scheme, Australia, 251

Pharmaceutical Manufacturers Association

annual survey, 6

members’ spending on research, 64, 215

orphan drug assistance, 226-227, 232

R&D costs, 53,55,61, 166

sales data annual survey, 89

as source of spending data, 39,40,4142,43

studies of regulation’s impact, 137

Pharmaceutical Price Regulation Scheme, United Kingdom,

259-262

Pharmaceutical R&D

components, 7-9

content of, 4-5

costs, 17-19

Federal support for, 34-37,203-206,210-217, 234-235

investors and, 9-10

objectives, 4, 6-7

returns, 19-23, 73-105

spending, 39-46

Phase I studies, 5, 144

Phase II studies, 5, 144

Phase III studies, 5, 144

Phase IV studies, 5

Phase-specific development times, 58-59

Phases of clinical trials, 5, 144

PHS. See Public Health Service

Pioneer drugs, 7,32,46,73

PLA. See Product license application

PMA. See Pharmaceutical Manufacturers Association

Polymerase chain reaction, 123, 133

Polypeptides, 114-115

Polysaccharides, 112

Possessions tax credits, 34, 192-193

Pravastatin, 25,74

Preclinical research. See Preclinical trials

Preclinical trials

cost studies, 58-59, 67, 70

expenditures, 51, 52, 57-58

Federal support for pharmaceutical R&D, 213-214

Pregnant women, antinausea medicine, 173-174

Prescription drugs, 2, See also payment for prescription

drugs

Present value, 7-8, 15

Price competition, 29-32

Price discrimination, 27-28

Pricing, Federal policies affecting, 33,37,221-223

Private health insurance benefits for outpatient drugs

drug utilization review, 244

extent of coverage, 240, 242

formularies, 243

generic drugs, 243

health maintenance organizations, 245

mail-order pharmacies, 244-245

off-label prescriptions, 243

reimbursable amounts, 242

reimbursable drugs, 242-243
Index I 353

Product liability

data limitations, 169-170

failure to warn, 171

federal compensation for injuries, 180

government policy, 180-182

insurance for, 172-173

judgments against manufacturers, 174-178

jury awards, 172, 174-178

legal liability, 170-171

litigation trends, 173-174

market sham theory, 171

National Childhood Vaccine Injury Act of 1986, 181-182

strict liability, 171

swine flu immunization program, 181

tort reform, 180

trends, 170

willingness to conduct R&D and, 178-179

Product Liability Reform Act, 180

Product license application, 147-149, 226

Production costs, drugs, 21-22

Project-level cost studies

cost estimating approaches, 48-50

industry-level studies and, 60-62

sample of fins, 55

sample of NCEs, 55-56

study method validity, 54-55, 60

summary, 11-12

survey response accuracy, 56-60

Proteins

administration of, 116-118

as receptors, 113-114

structure and function, 113

as therapeutic agents, 114-119

Protropin TM,60,230

Public Health Service

pharmaceutical R&D support, 35-37,211, 228

technology transfer in, 218-223

Puerto Rico, corporate taxes, 34, 192-193

R-zone, Japan, 258-259

Rabies, action of, 112

Rand Corporation

jury awards study, 172, 174

litigation trends study, 173

Rational drug design

drug receptor identification and, 108-109

frontiers of, 111-113

Rebates, Medicaid, 247-249

Recombinant erythropoietin, 230-231

Regulation and R&D. See Government regulation and R&D

Regulatory review process. See Government regulation and

R&D; U.S. regulatory review process for new drugs

rEPO. See Recombinant erythropoietin

Reproductive health products. See Bendectin; Dalkon

Shield; Diethylstilbestrol

Research/evaluation licenses, 219

Research personnel, R&D costs and, 62

Returns on R&D

cost of capital, 9, 93, 102

costs of production, 21-22

increasing price competition implications, 31-32

internal rate of return, 23-24, 95-104

manufacturing, marketing, and distribution costs, 90-91

methodology of studies, 76-77

net after-tax returns, 91-93

net cash flows, 22

net return on investment, 22-23

past studies reviewed, 76-81

sales curve, 19, 81-90

study results, 93-95

Revenue Act of 1992, 188

Richard, regulation impact study, 150-151

Risks of pharmaceutical R&D, 7-9

high vs. low risk investment, 66-67

returns and risks, 46, 47-48

RNA

alternative uses, 130-131

composition of, 114

Royalty income, 36-37, 220-221

Safety testing, 63,64

Saint George-Hyslop, Peter, 125

Sales of New Chemical Entities

domestic sales, 19-20

effective patent life, 19-21, 82-87

postpatent revenues, 21,87-89

worldwide sales, 19, 89-90

Sanger, Frederick, 116, 132

Sankyo, 74

SAIL See Structure-activity relationships

Scherer, capital budgeting study, 9

Schnee, R&D cost study, 50 “

Self-originated drugs, description, 51

Shining new drugs, Japan, 257,259

Shyam-Sunder. See also Myers and Shyam-Sunder

cost of capital update, 67

Simvastatin, 74,216-217

SmithKline Beecham, 226

SOI. See Statistics of Income Database

SPAPs. See State Pharmaceutical Assistance Programs

Spending. See Expenditures for pharmaceutical R&D

Squibb, 206

Starling, Ernest, 115

startup firms

orphan drug sponsorship, 232

private industrial ventures by universities, 209-210

tax credits, 197

State Pharmaceutical Assistance Programs, 249-250

Statistics of Income Database, 193, 196

Stevenson-Wydler Technology Innovation Act, 35,218

Stewart, cost of capital study, 67

Stokes, Donald E., 213

Strategic alliances, 41,42

Strict liability concept, 171

Structure-activity relationships, 109-111

Sturtevant, Alfred, 120

Subpart E regulations, 155

Support for pharmaceutical R&D

conclusions, 34-37233-235
354 I Pharmaceutical R&D: Costs, Risks and Rewards

Federal support for biomedical research, 34-37,203-206,

232-233

Federal support for patient-care costs, 216-217

Federal support for R&D, facilities, 204,208-209

industry collaboration with academia, 206-210

industry collaboration with Federal research labs, 34-37,

217-225

industry vs. federal support for biomedical research,

203-206

orphan drugs, 225-232

overview, 34-37, 201-203

targeted Federal pharmaceutical R&D programs, 210-217

Swine flu immunization program, 181

TAMRA. See Technical and Miscellaneous Revenue Act of

1988

Tax Analysts, Inc., 93

Tax credits, 15-16, 33-34, 67

for basic research, 34, 189 -190, 195

estimated total amount, pharmaceutical industry, 34,

193-196

firm characteristics and, 197

foreign tax credits, 191-192, 193

for increases in R&D expenditures, 34,68-69, 186-189

for orphan drugs, 34,69, ’71, 190-191, 193, 195-196,231

possessions tax credit, 34, 192-193

relative importance, 33-34, 198-199

Tax deductions, 15-16,67-68

contributions to educational and scientific organizations,

186

foreign sales and, 185-186

qualifying R&D expenditures, 184-185

Tax policies, 33-34, 198-199. See also Tax credits; Tax

deductions

composition of, 33-34, 183-184

depreciation of capital assets used for R&D, 186

foreign tax laws compared with U.S. laws, 197-198, 199

net after-tax returns, 91-93

Tax Reform Act of 1986, 186, 187, 189, 196

Investment Tax Credit, 196

Technical and Miscellaneous Revenue Act of 1988, 187-188

Technology transfer

legislative history of activities, 218

in the Public Health Service, 35-37, 218-223

Temin, regulation impact study, 137

Thalidomide, 136, 179

Thomas, Lacy Glen

IRR study, 103

regulation impact study, 137-138

Toxicology testing, 140

Training of Biomedical research personnel, 204-206

Treatment INDs, 33, 155-15 ’7, 232-233

Tufts University Center for the Study of Drug Development

existing studies of R&D costs, 50

INDs for NCEs data, 71, 159, 160-162

R&D cost estimate, 55-56, 58-59,60, 70

United Kingdom, prescription drug benefits, 259-262

Universities

basic research tax credit, 189-190, 195

Federal support of research training, 204-206

industry and academia collaboration, 206-210

University of Wisconsin, 209

Upjohn Pharmaceuticals, 230-231

U.S. Congress

access to financial data, 11, 66

compensation for vaccine-related injuries, 180-182

Joint Committee on Taxation, 92, 193

U.S. Department of Agriculture, 62-63

U.S. Department of Commerce, 35,218

U.S. Department of Education, 204

U.S. Department of Health and Human Services, 36, 205,

217,220,233

U.S. Department of the Army, 213

U.S. regulatory review process for new drugs

FDA role, 138-139

guidelines, 32-33, 152-153

investigational new drugs, 139-143

new product applications, 143-150

post-approval requirements, 150-151

trends, 32-33

U.S. Securities and Exchange Commission, as source of

spending data, 40

U.S. Supreme Court, 11,66

U.S. Treasury Department, tax deductions for U.S. firms

sales abroad, 185-186

USDA. See U.S. Department of Agriculture

Vaccines, product liability, 176-178, 180-182

Venuti, Michael, 115

Vernon. See Grabowski and Vernon

Virts and Weston, returns on R&D study, 78-81

Viscusi and Moore, product liability insurance and innovation study, 178

Walden, George, 115

Warden. See Eisman and Warden

WARF. See Wisconsin Alumni Research Foundation

Washington Analysis Corporation, net tax savings from

possessions credit, 192

Watson and Crick, DNA structure, 119-120

Welwyn Laboratories, 110

Weston. See Virts and Weston

White House Council on Competitiveness, 157

Wiggins, Steven

R&D cost study, 12,50,53,54,60-61

regulation impact study 137, 143

Wisconsin Alumni Research Foundation, 209

Wozny, marginal tax credit rate study, 189

Wyatt, Richard Jed, 224

X-ray crystallography, rational drug design and, 111-113

X.L. Insurance Co., Ltd., 173

Young, Frank, 231