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A recent study showed that in 1975, it cost about $100 million in 2005 dollars to develop one drug from the lab to FDA approval. By 2005, that figure was up to $1.3 billion.

What explains such a rapid rise? Mostly the approval process. Drug companies are now required to study the effect of their products on bigger and more diverse populations. The FDA has higher expectations and requirements for approval. Big drug companies are using larger, more complex studies to de-risk the approval process, and insurers are demanding studies that are more thorough.

Meanwhile, only about 20% of drugs that start Phase 1 trials ultimately see approval. Those that make it to Phase 3 incur as much as 90% of the development spending. Almost 70% of drugs that make it this far fail Phase 3 testing, after costs averaging hundreds of millions of dollars.

Drugs not only have to pay for themselves, but they must subsidize the company’s failures and still leave something for shareholders. When you factor in profit margins and the length of time an approved drug will generate revenue, it takes about one-third of the productive life of a typical drug to pay for the cost of development. A company with a portfolio of 10 drug candidates can expect to produce an internal rate of return of about 13.25%.

Any analysis of drug pricing comes down to a question of fairness for both the patients and the drug companies. An occasional blockbuster can generate big profits for a drug company, but dry spells and late-stage failures lead to poor returns.

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