Gilead Is Undercutting Its Own Drugs: Here's Why

The U.S. drug pricing system is a mess. It's an absolute disaster. Just about every entity involved, from drug companies to consumers to insurers to the government, agrees that offering discounts off the list price is a convoluted way to sell a life-saving product.

The government has plans to try and fix it, but now Gilead Sciences (NASDAQ: GILD) apparently can't wait that long -- or figures a fix might never come to fruition --and is taking matters into its own hands, disrupting the system with a pair of authorized generics of its hepatitis C drugs, Epclusa and Harvoni, which will be launched through a new subsidiary, Asegua Therapeutics.

Authorized generics aren't all that novel. Many large drugmakers launch them -- either on their own or with a generic partner -- after their drug goes off patent to eke out a few more dollars from the drug. The authorized generic competes with their branded version, but since there are already generic competitors, sales of the branded product are already headed toward zero as patients switch to generics.

But Epclusa and Harvoni aren't off patent. Gilead claims to have U.S. patent protection until 2032 and 2030, respectively.

Rather than competing with generics -- that don't exist yet -- Gilead appears to be trying to manipulate the convoluted pricing system in its favor. The generic versions, which will be available in January, will cost $24,000, which is a substantially lower than Epclusa's list prices around $75,000, but fairly close to what the company actually gets after offering discounts.

So why not just lower the price of the branded drugs and be done with it? Here are a couple of reasons Gilead is probably taking this approach with a branded generic:

1. Cutting out the middleman

Discounts off the list price vary widely from disease to disease, but they're largely tied to how many competitors there are in the space. If pharmacy benefit managers (PBMs) can pit companies against one another, as they have with Gilead and rival AbbVie (NYSE: ABBV), which sells Mavyret and Viekira Pak, they can get steeper discounts than if there's only one superior medication to treat a disease. A few years ago, in protest to the lack of negotiation, PBM Express Scripts (NASDAQ: ESRX) was only covering AbbVie's drug for a while, and Express Scripts has removed drugs in other diseases from its formulary for playing hardball on negotiations.

Discounts result in lower price, but the entire discount doesn't go to the PBMs' clients (typically companies offering health insurance to their employees). The PBMs take a cut of the discount for negotiating on behalf of their clients.

By offering a generic version at the same price the PBMs have already negotiated, Gilead appears to be cutting the PBMs out of the equation.

2. Medicare/Medicaid patient preference

Many government drug plans, including Medicare, have wonky rules about negotiating with drug companies over price. By offering a generic version at a lower price, Gilead estimates that seniors using Medicare Part D can save up to $2,500 in out-of-pocket costs per course of therapy.

Arguably, the discounts for people on government plans will result in lower revenue for Gilead, but the company should be able to make up the difference -- and then some -- through higher volume. For example, because of the high cost they have to pay, some state Medicaid programs have limited the use of Gilead's drugs to the most advanced hepatitis C patients. By lowering the cost, the plans can afford to treat more patients.

And the lower actual cost to government plans could result in Gilead's drugs becoming the preferred drug over AbbVie's competing drugs. Of course, AbbVie isn't likely to just sit on its hands and could make a move of its own, potentially offering an authorized generic of its own.

Game changer?

The launch of authorized generics seems like a decent Band-Aid for the drug pricing system, but it certainly isn't a cure-all. They could work for other diseases where there are multiple players resulting in large negotiated discounts -- diabetes comes to mind -- but authorized generics won't solve the overall problem of high drug costs.

The best-case scenario, if enough companies started doing it, is that PMBs would need to change their business model toward a fee-based system, passing on all discounts to clients, which would better align their interests.

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Brian Orelli has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Gilead Sciences. The Motley Fool has a disclosure policy.