Health Policy 102 (2011) 170–177

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Health Policy
journal homepage: www.elsevier.com/locate/healthpol

A new prize system for drug innovation

Afschin Gandjour ∗ , Nadja Chernyak
Department of Public Health, Faculty of Medicine, Heinrich-Heine University Düsseldorf, Düsseldorf, Germany

a r t i c l e i n f o a b s t r a c t

Keywords: We propose a new prize (reward) system for drug innovation which pays a price based
Drug innovation on the value of health benefits accrued over time. Willingness to pay for a unit of health
Prize system benefit is determined based on the cost-effectiveness ratio of palliative/nursing care. We
Value-based pricing
solve the problem of limited information on the value of health benefits by mathematically
relating reward size to the uncertainty of information including information on potential
drug overuse. The proposed prize system offers optimal incentives to invest in research
and development because it rewards the innovator for the social value of drug innovation.
The proposal is envisaged as a non-voluntary alternative to the current patent system and
reduces excessive marketing of innovators and generic drug producers.
© 2011 Elsevier Ireland Ltd. All rights reserved.

1. Introduction of asymmetric information about the costs and benefits

Pharmaceutical prices providing high profits under
patent protection has been the traditional incentive for
drug research and development (R&D) [48]. However, a
decreasing number of fundamentally new drugs in recent
years, despite high costs of prescription drugs, and lit-
tle incentive to invest in R&D of drugs for rare and other
“low-return” diseases demonstrate the shortcomings of
the current patent system [22,6,37]. As a result, efficiency
of patents to encourage medical innovation has been
questioned and a variety of approaches substituting or
complementing the patent system have been proposed.1,2
Several economic models have been developed to
explore the optimal design of patent systems and compare
patents to alternative incentives for R&D, e.g., contracts and
prizes/rewards.3 Ref. [57] was the first to analyze what
research incentives should be preferred under what con-
ditions and found that the range of situations in which a
patent system dominates other feasible alternatives may
be narrower than commonly believed. Only in the presence
∗ Corresponding author. Tel.: +49 0171 2195713.
E-mail address: gandjour@gmx.com (A. Gandjour).
1
For a current discussion see http://ccg.merit.unu.edu/prizefund/.
2 4
For the analysis of four alternatives to the patent system see [4].
3
For a review see Gallini and Scotchmer [58] as well as [31].
of research it might be better to offer patents. Hence, if
the value of health benefits becomes observable to pub-
lic authority, prizes rather than monopoly prices under
patents should be employed to reward medical innova-
tion [57,34,47,49]. Ref. [49] suggested determining the
social value of innovation based on the demand curve and
sales data. They argued that, if the public authority’s ex-
post sales-related information about demand is as good as
innovators’ ex-ante information, the innovators enjoy no
informational advantage that favors intellectual property
rights (patents).
When applying this insight to drug innovations, some
features of drug markets need to be considered. In many
countries drugs are consumed by patients, chosen by doc-
tors, and financed by third-party payers. Hence, third-party
payers are usually able to obtain significant information
about demand from drug sales. However, market demand
for drugs may poorly reflect social value of health benefits.
The reasons for this are following. First, pharmaceuti-
cal companies are not generally required to demonstrate
relative efficacy and safety compared to existing inter-
ventions for licensing.4 Second, patients or doctors are
Under the regulations operating in most jurisdictions, pharmaceutical
manufacturers have to demonstrate efficacy, safety, and quality of man-

0168-8510/$ – see front matter © 2011 Elsevier Ireland Ltd. All rights reserved.
doi:10.1016/j.healthpol.2011.06.001
 A. Gandjour, N. Chernyak / Health Policy 102 (2011) 170–177
not best placed to assess value, i.e., identify and synthe-
size all relevant evidence and undertake the computation
required [14]. Third, in countries such as the United States,
Switzerland, and Germany drug prices have, at least until
recently, been set with little or no regard to their relative
therapeutic value and cost-effectiveness.
Since the value of new drugs might be unobservable
to patients, it seems reasonable to give an independent
assessment authority the responsibility for assessing the
value of new drugs and signaling the market demand curve
for drugs. Several authors [18,3,23,44] have proposed that
licensing authorities (e.g., the U. S. Food and Drug Adminis-
tration and the European Medicines Agency) should begin
to anticipate the needs of assessment authorities/third-
party payers when specifying their requirements and insist
on more demanding pre-marketing studies. That is, require
clinical trials which compare new drugs’ efficacy with that
of previously available alternatives rather than placebo;
use endpoints which are more related to indicators of clin-
ical benefit; and consider longer follow-up periods.
Pricing of drugs based on the value they provide is called
value-based pricing (VBP). Two much discussed proposals
that use VBP are the Health Impact Fund [5] and a model
developed by University of York health economists [15].
The Health Impact Fund [5] provides rewards for global
health improvements and considers overuse of drugs in the
assessment of health improvement. However, the Health
Impact Fund does not have a rational basis for the underly-
ing willingness to pay (WTP) per health gain and, instead,
uses an arbitrary figure such as 0.03% of the gross national
income. Furthermore, it assumes an arbitrary duration of
reward (e.g., 10 years) and does not adjust health gains for
equity concerns and uncertainty.
The proposal by York health economists [15] considers
drug overuse, uncertainty in cost-effectiveness, and equity
considerations in VBP. However, it does not appropriate
the full social value to the manufacturer and therefore
does not provide optimal incentives for R&D. Furthermore,
it acknowledges difficulties in determining the WTP per
health gain.
This paper proposes a new prize system based on the
VBP principle that deals with the shortcomings of alterna-
tive approaches as described above. The proposal rewards
the innovator for the full social surplus over product life-
time. Furthermore, it derives the WTP for health benefits
from the cost-effectiveness ratio of palliative or nursing
care. Additional features are presented and implications for
generic price competition are discussed.
The paper proceeds as follows. First, it outlines a VBP5
approach to rewarding medical innovation, shows how a
reward size can be linked to the value of health benefits,
and proposes a new prize system based on the VBP princi-
ple. Next, it discusses how to estimate the monetary value
ufacture for their products. Approval is frequently granted even if a new
drug is merely better than placebo at improving surrogate measures in
brief modest-sized clinical trials. Clinical trials comparing a new drug with
existing treatments are typically required only when placebo controls are
ethically unacceptable. See, e.g., [18].
5
We use the term “value-based pricing” following the terminology of
the UK Office for Fair Trading. See [41,14].
171
of health benefits and adjust it for equity considerations
and uncertainty (risk preferences). Finally, it summarizes
important advantages of the proposed prize system over
the current patent system.
2. Value-based pricing: formal approach
The fundamental principle of the VBP approach is that
costs of new medical technologies should not exceed their
health benefits. The prize system we propose builds on this
fundamental principle of VBP. Compared to existing pricing
proposals we make specific suggestions on how to adjust
health benefits for uncertainty in cost-effectiveness and
equity considerations. Furthermore, we derive the WTP for
health benefits from the cost-effectiveness ratio of pallia-
tive or nursing care, appropriate the full social value to
the innovator, and discuss implications for generic price
competition.
To further explain the VBP approach, consider that the
relative efficiency of medical intervention is traditionally
summarized as the incremental cost-effectiveness ratio
(ICER) and assessed with reference to a threshold value for
the WTP [33]:
C1 − C0 C
= (1)
E1 − E0 E < 
where C1 − C0 denotes incremental costs of the new ther-
apy, i.e., additional cost compared to the current treatment
pattern, E1 − E0 denotes incremental health benefit of
the new therapy, i.e., the difference in health outcomes
between the new therapy and the current treatment pat-
tern, and  is an acceptable price per unit of health outcome.
Current treatment pattern is the appropriate comparator
because this is the treatment being substituted in the real
world. That is, only incremental costs and benefits com-
pared to current treatment represent the real-world costs
and benefits of the new therapy.
Note that with current treatment pattern as a compara-
tor, a new therapy may be compared to several different
alternatives including no treatment. Hence, incremen-
tal costs and benefits represent weighted averages with
weights representing the current market share of the dif-
ferent comparators.
Traditionally, the price of a drug has been set by the
manufacturer and is an input to the calculation of the ICER.
Alternatively, a cost-effective drug price can be derived
from a threshold analysis by setting the ICER equal to the
acceptable price per unit of health outcome () [54]:
C1 − C0 C
= = (2)
E1 − E0 E
Decomposing the price of the new drug from its total
costs yields:
C1 − C0 C1 − p + P − C0
= = (3)
E1 − E0 E
where P is the price of the new drug and C1−p denotes
costs induced by the new drug (i.e., costs of side effects,
savings from avoiding morbidity, and costs from avoiding
172 A. Gandjour, N. Chernyak / Health Policy 102 (2011) 170–177
premature death). Rearranging Eq. (3) yields the maximum
acceptable drug price:
P = E ·  − (C1 − p − C0 ) (4)
As price P is a function of , the acceptable price per unit
of health outcome is explicitly considered. The size of the
reward is thus placed into the broader context of societal
willingness/ability to pay for health improvements.
Independent of the threshold value  chosen, innovators
that develop drugs providing high incremental health ben-
efits are generally more highly rewarded than firms that
develop drugs offering only marginal improvements over
existing treatments. Drugs that yield a lower benefit but
demonstrate savings compared to existing treatments are
also priced based on Eq. (4). Hence, incentives are created to
develop cost saving therapies, which are equally or slightly
less effective compared to the common practice.
3. New prize system based on value-based pricing
As implied above and discussed by [32], cost-
effectiveness thresholds are not only a means to control
prices but also to reward innovation. Hence, reimburse-
ment prices derived from the cost-effectiveness threshold
could be considered a form of a monetary reward (prize)
for marginal health benefits created by the drug [11].
Our proposal is to determine the prize based on total
population health benefits. To determine the latter, we
propose using sales data but adjust them for treatment
overuse. Furthermore, sales data need to be combined with
information on incremental health benefits of a unit of sales
(i.e., the individual health benefit). To provide a real-world
estimate of the latter, the comparator of the new drug has
to be the current treatment pattern.
The approach we suggest sets a maximum WTP for
research activities based on the maximum WTP for a health
gain. Hence, we suggest rewarding an innovator for the full
social value which is in line with [52] as well as [32]. If drug
prices are increased beyond societal WTP, further research
activities may be stimulated, but these additional activi-
ties, even if they lead to great discoveries, are, by definition,
not acceptable pricewise. On the other hand, if drug prices
are reduced below societal WTP, it may decrease research
activities and may prevent discoveries that society is actu-
ally willing to pay for.
Varying WTP for R&D across industries (biomedical,
energy, agriculture, etc.) to provide differential incentives
and maximize overall research activities presupposes that
the public has more information on where research yields a
higher return for society than the market. Assuming that no
such information is available (on which areas of investment
yield a higher return) which corresponds to the assumption
that each field has the same return, WTP per health gain is
set equal across industries.
By pricing new drugs according to the outlined principle
the meaning of patents is changed. Patents would no more
reward medical innovation by profits from monopoly pric-
ing, but rather represent a claim for getting a prize based
on a monetary valuation of the incremental health benefits
created.
Since there is no patent protection in the current sense,
approval of bioequivalent drugs should be abolished to pre-
vent inefficiency due to free riding and excessive entry
of new firms. The possibility to license copycat drugs
(generics) would lead to the inability of the innovator to
appropriate full benefits and reduce the firm’s incentives
to invest in R&D. As long as the threshold value  reflects
real willingness/ability to pay for health gains, the VBP
approach would create no welfare losses due to restricted
access. Consequently, generic price competition, which is
usually assumed to improve access by reducing prices, is
not necessary under the proposed approach. Still, today’s
generic drug producers would have a role in the proposed
prize system as the innovator would be able to outsource
drug manufacturing. Hence, the license to produce iden-
tical drugs would be issued by the innovator and not the
government as under the current system. In any case, the
innovator would be rewarded with the same prize as if it
produced the drug itself.
However, the proposed prize system considers the
cumulative nature of medical innovation and does not
preclude approval of therapeutically similar innovations
(me-too drugs) if they offer additional health benefits or
cost savings. There have been concerns that therapeu-
tic substitutes might crowd out drastic innovations by
reducing the budget available for R&D. But different drug
versions are often innovated in so-called R&D races, imply-
ing that therapeutically similar innovations are already
in the ‘pipeline’ when the first drastic innovation enters
the market [10]. Thus, increased competition because of
the race to be the first might further stimulate innovation
and possibly speeds up commercialization. Moreover, even
drugs with the same effectiveness can provide incremental
benefits because of reduced side effects or improved com-
pliance [35]. In any case, the prize system considers as a
comparator of a new drug the current treatment, which
may be a recently approved drug or no treatment in case
of market expansion.
VBP allows a more exact assessment of social value cre-
ated by the drug over time than one-time fixed prizes and
patent buyouts schemes. In the latter the government or
a wealthy non-profit foundation purchases patents and
turn over the rights to the public for free. However, it is
difficult for a purchasing agency to estimate all future ben-
efits ex-ante given changing market conditions (such as
the appearance of other innovative drugs), changing health
needs of the public [28], and new indications for the drug.
Hence, ex-ante inducement prizes and patent buyouts
can under/overestimate future benefits. When payment is
based on real sales, there is no need for the purchasing
agency to foresee at one moment all future benefits and
discount them to present value. The VBP approach allows
a refinement of the reward size as additional information
flows to the purchasing agency, e.g., from post-marketing
drug trials and observational studies.
VBP precludes reimbursing manufacturers for overuse
of a new drug, i.e., inappropriate prescribing which does
not add to health benefits. Thus, by monitoring drug
overuse excessive marketing expenses can be prevented.
The National Committee for Quality Assurance and other
organizations have developed, specified, and tested a
 A. Gandjour, N. Chernyak / Health Policy 102 (2011) 170–177
variety of overuse measures. An example is prescription
of antibiotics for upper respiratory infections which are
caused by a virus and are not effectively treated with antibi-
otics [38]. Still, in other cases there might be some effort
involved in finding out about a patient’s history and deter-
mining whether treatment has been appropriate or not. On
the other hand, information technology has great potential
to facilitate this type of data collection. Furthermore, any
uncertainty in the degree of overuse can be reflected in the
price, by downward adjustment.
Furthermore, if a drug causes more harm than bene-
fit in some patient populations, then the resulting negative
health benefits will be subtracted from the total gain, effec-
tively resulting in a punishment for the manufacturer.
The reward mechanism based on the VBP principle also
enables to adjust a reward size downward for uncertainty
surrounding health benefits, including uncertainty related
to drug overuse (see Section 7).
4. Measuring health outcomes
For the rest of the paper we use quality-adjusted life
years (QALYs) as a currency in which to express health out-
comes. QALYs are the product of life years and a measure of
the strength of preference for different health states (see,
e.g., [53]). They enable comparisons of drugs producing
different types of health outcomes (e.g., survival or health-
related quality of life) and are increasingly being used to
measure health benefits of medical interventions [29,39].
A discussion of the limitations of the QALY model goes far
beyond the scope of this paper; in particular, we would
like to point out that under expected utility theory QALYs
are valid representations of the preferences of individuals
only under a set of restrictive assumptions [43]. Further-
more, there is the question whose preference assessment
for the calculation of QALYs should count (patients vs the
general public). Moreover, QALYs may not be applicable
in acute diseases of short duration [21] as well as chronic
severe disease [51]. The new prize system outlined in this
paper is not limited to the use of QALYs, however. Other
measures of health outcomes (e.g., life years saved, disabil-
ity adjusted life years, healthy years equivalents, or WTP)
could be similarly used to assess the performance of a new
medical therapy.
5. Monetary valuation of health benefits
Clearly, the reward size for the innovation depends on
the value of . The value of  is specific to time, place, per-
spective, available medical technologies, population needs,
and budgetary restrictions [25,29].  can be defined as a
value function over health and money [1]. In case of a fixed
budget, the value of  is a function of the size of the bud-
get and the incremental cost-effectiveness ratios of existing
medical interventions, where  represents the opportunity
cost of health care resources at the margin or equivalently
the shadow price of the budget constraint [56]. If the bud-
get is set by a socially legitimate process, then the threshold
value represents the implicit social valuation of health [13].
In practice, full information about the cost-effectiveness
of existing medical interventions is not available [24].
173
However, it has been argued recently that threshold cost-
effectiveness can be thought of as the cost-effectiveness of
the medical technologies which would be displaced by the
new ones and empirical estimates are feasible [13]. As more
benefits are produced we might expect that the value of 
increases at a slower rate.
An alternative approach suggested in this paper is to
define a minimum WTP based on the cost of palliative or
nursing care, which in Germany, e.g., is up to D 23,000 per
life year [30]. Palliative and nursing care provide a use-
ful benchmark because they are generally accepted and
uncontroversial (i.e., we would not displace these services).
We suggest using a uniform baseline WTP value across all
diseases. The benchmark may also consider quality of life of
patients receiving palliative or nursing care, by calculating
QALYs. Calculation of QALYs does not require comparing
different types of palliative treatments in terms of QALYs
(such nuances may be difficult to capture) but to compare
the quality of life of a person in palliative care with that of
a person in full health.
The minimum WTP can be easily adjusted over time, by
simply following changes in the WTP for palliative/nursing
care. In addition, the threshold value may be adjusted
upward based on the reduced health-related quality of
life of nursing home inhabitants. It may also be adjusted
upward based on the severity of disease and urgency of
treatment. This is formalized below. The latter two fac-
tors are the most important equity criteria to be considered
along with cost-effectiveness [17].
6. Incorporating equity considerations in the
willingness to pay
We propose to set drug prices based on the social value
of health outcomes after adjustment for severity of dis-
ease and urgency of treatment. Thus, industry priorities
are “pulled” towards actual health needs of the public. To
consider urgency of treatment and severity of disease we
suggest measuring the expected number of future QALYs
without treatment and the expected number of future
QALYs without disease. While the first parameter is a
measure of treatment urgency (patients who die without
treatment have zero future QALYs), the difference between
the two parameters indicates severity of disease. If we con-
sider both parameters in a power model, we obtain the
following formalization of the social value (SV) of a health
gain:
SV (E, r, n, m) = E · (1 + r)n−m (5)
where r = inequality aversion parameter, n = expected
health gain if the individual did not have the disease, and
m = expected health gain without treatment. Thus, an indi-
vidual with a life threatening disease obtains a large power
factor and the reward size is adjusted upward accordingly.
Parameter n can be derived from a life table of the general
population. Parameter m may be more difficult to estimate.
However, in clinical areas where there has been no effec-
tive treatment so far, the comparator of the new drug is
no treatment and conventional cost-effectiveness analysis
would need to estimate this parameter.
174 A. Gandjour, N. Chernyak / Health Policy 102 (2011) 170–177
With this model, rare diseases also receive priority: if
industry neglects rare diseases, the value of health bene-
fits and hence the reward size increases relative to more
prevalent diseases (as n − m in Eq. (5) increases). Thus, it
becomes more attractive to invest in drug R&D for rare dis-
eases. Furthermore, if competitors neglect rare diseases,
the manufacturer of an orphan drug will be able to reap
benefits for a longer period of time than manufacturers
for more prevalent diseases. Still, the private sector may
not fully account for all the future benefits and returns
from developing treatments for rare/neglected diseases in
its investment decisions if it discounts the future bene-
fits more highly than society or if it irrationally fears that
returns may be recouped by subsequent superior market
entrants. In these cases public sector need to provide push
incentives for innovation, e.g., by directly funding research
or providing tax incentives. Since direct funding offsets
some of R&D costs, the threshold value  and thus the max-
imum drug price needs to be corrected for the amount of
initial funding when calculating a reward size. For exam-
ple, if 50% of drug R&D is financed by the public sector,
the firm will be later paid half the drug price. Otherwise,
costs to society exceed the value it places on the health gain
produced.
7. Incorporating uncertainty
It is never possible to know the true incremental costs
and effects of a new technology with certainty. Usually,
mean point estimates of incremental costs and effects
(C̄ and Ē) are reported in conjunction with bounds (e.g.,
95% confidence limits) within which the mean cost and
effects can be expected to lie. Thus, the expected cost-
effectiveness of the new technology under uncertainty can
be expressed as:
C̄ C̄1 − C̄0
= (6)
Ē Ē1 − Ē0
Accordingly, a cost-effective drug price is calculated as
follows:
P = Ē ·  − (C̄1−p − C̄0 ) (7)
Calculating the price solely on the basis of mean point
estimates only makes sense if we assume a linear util-
ity function, i.e., risk neutrality with regard to money and
health effects. For a discussion on whether this assumption
is reasonable and whether risk aversion for health out-
comes, costs, or both should be incorporated in the analysis
see, e.g., [7,12,40,26].
Let us now assume risk neutrality with regard to costs
because following the Arrow–Lind theorem [2] the risk of
investments is spread across many taxpayers and the dis-
tribution of costs can be ignored in a collectively funded
health care system. The assumption of risk neutrality with
regard to health outcomes is less convincing, however.
Since it is not possible to compensate individuals for lost life
years it seems reasonable not only to consider the mean,
but also the distribution of health benefits in the valua-
tion of the medical technology. When using QALYs as a
measure of health outcome, preference-based instruments
might capture some degree of risk or loss aversion [9]. In
order to surely avoid double counting of risk aversion, one
may correct utility estimates for risk or loss aversion [8].
In order to consider risk aversion with respect to
health outcomes Eq. (4) needs to consider a risk aversion
parameter6 :
 r

P= Ē − · var(E) ·  − (C̄1−p − C̄0 ) (8)
2
where var(E) denotes the variance of incremental health
benefits and r is a risk aversion parameter. Thus, for given
Ē and var(E), we calculate the price of a new drug. Eq.
(8) implies that price increases with mean health bene-
fits and decreases with the variance of health benefits or
risk aversion. Thus, the presence of even modest degrees
of uncertainty may lead to a substantial decrease in price.
Uncertainty cannot only be considered with respect to
individual health gain, but also with respect to the number
of people are treated appropriately. This includes a consid-
eration for treatment overuse. Uncertainty in the degree of
overuse of the new drug would lead to downward adjust-
ment of the price.
Other formulations of utility functions for health bene-
fits and costs are possible [see, e.g., [1,20]]. We use a very
simple stylized model to demonstrate how drug prices can
be adjusted for risk preferences, thus trading off expected
returns to investment in health care and the variance of
those returns. As argued above, risk neutrality with regard
to health benefits is difficult to justify. An adjustment of the
reward size for uncertainty could be deemed unnecessary
only if the magnitude of uncertainty were equal across all
medical technologies.
Similar to our proposal, [13] as well as [27] suggest a
downward adjustment of drug prices in case of uncertainty
on cost-effectiveness. While their approach formally con-
siders the costs of decision uncertainty, it does not account
for risk aversion with respect to uncertainty in health.
Downward adjustment of a drug price because of
uncertainty and upward adjustment because of reduced
uncertainty create appropriate incentives to invest in clin-
ical trials early in the development of drugs and preserve
incentives for the manufacturer to conduct post-marketing
evaluative research. While additional placebo-controlled
trials may be considered unethical after drug approval,
there is still opportunity for head-to-head studies against
other interventions or evaluations of real-world data from
observational studies and patient registries.
8. Prize system vs current patent system
It is widely recognized that, left to itself, the market does
not support an adequate amount of biomedical research:
if consumers pay only the marginal cost of production,
revenues are insufficient to cover the cost of future drug
R&D. However, it does not automatically follow that patent
monopolies provide the best mechanism to encourage drug
R&D [4].
6
For a similar approach which applies the risk-aversion parameter to
the variance in cost-effectiveness see [26].
 A. Gandjour, N. Chernyak / Health Policy 102 (2011) 170–177
Monopoly profits from patent-protected prices are
often criticized for creating two types of inefficiency. On
the one hand, the gap between the competitive market
price and the patent protected price may reduce access
to drugs and generate inequality of drug use [34,4,6]. On
the other hand, monopoly profits may offer insufficient
incentives for R&D because they reward inventors with
less than the social value of their innovations—monopoly
advantages last for a limited number of years and inno-
vators cannot fully capture consumer surplus [50,34,49].7
This is especially true for drugs since their actual value can
be unobservable for consumers and prices may be held
below the profit-maximizing level if adverse public reac-
tion is feared [48]. Furthermore, once a drug is off-patent,
the innovator has little incentive to conduct trials on other
indications, as the drug price does not promise an adequate
return.
The outlined VBP approach to reward medical innova-
tion minimizes the failures of the patent system outlined
above. First, as long as threshold value  reflects real will-
ingness/ability to pay for health gains, the VBP approach
is superior to monopoly profits under patents because no
unrealized social benefits (deadweight loss) are created.
Note that even if drug prices are higher than the marginal
costs of their production, a deadweight loss may not occur.
A deadweight loss does not occur as long as, from soci-
etal perspective, marginal costs equal marginal benefit (i.e.,
costs of a drug including downstream cost effects equal
societal WTP). Note that manufacturers may set the price
just below the level of the threshold ICER, which could
lead to higher prices than without a VBP system. Still, this
may not necessarily be an undesirable reaction as it may
increase future R&D activities. In any case, a threshold
based on the cost of palliative or nursing care, which in
Germany, e.g., is no more than D 23,000 per life year, does
not seem to allow for much upward shifting of prices.
Second, as long as the expected social benefits exceed
costs, private research incentives are in line with social
incentives. If a drug price is based on the threshold cost-
effectiveness ratio reflecting the social value of incremental
health benefits, the innovator will be rewarded for the
net health benefit actually created over time. Hence, the
innovator also has an incentive to conduct trials on new
indications for a drug that is already approved.
In addition, as the reward system does not provide for
licensing copycat drugs, it prevents welfare losses from free
riding and excessive market entry. This is in line with the
reasoning of [36], who argued that if an entrant causes
incumbent firms to reduce output, entry is more desir-
able to the entrant than to society. Further, there is no
need to subsidise start-up and production costs of generic
manufacturers. Litigation costs because of patent infringe-
ment lawsuits against generic manufacturers also vanish.
Finally, firms currently allocate substantial resources to
marketing8 in order to protect their profits. Restricting
7
Ref. [34] provided examples from the empirical literature suggesting
that the social rate of return on R&D is at least twice the private rate of
return, given the quantities consumed under monopolistic pricing.
8
According to publications by the pharmaceutical industry, promo-
tional costs including the value of samples amount to about 60% of the
175
excessive entry and competition for market share could
change the proportion between R&D and marketing expen-
ditures.
To provide sufficient incentives for innovation the terms
of any award must be fixed before the informational asym-
metry with regard to costs and benefits of research is
resolved [57]. The threshold value , which is used for mon-
etary valuation of health benefits under VBP, may offer
credible and time consistent incentives for medical innova-
tion, particularly if based on the cost of palliative or nursing
care. Of course, future WTP for health improvements may
change due to government budgetary pressures. However,
under current patent system there is also a risk of future
modifications of patent law as well as enforcement of dis-
counts by the government.
9. Global implementation issues
Differential pricing of drugs has been discussed as a
tool to increase affordability of on-patent drugs in devel-
oping countries while preserving incentives for innovation
(e.g., [19,16]). An important reason why manufacturers
are reluctant to charge lower prices in developing or low-
income countries is that they fear that this will undermine
the prices they charge to higher-income countries [45].
The proposed prize system might help to set and maintain
appropriate price differentials between countries based on
their ability or WTP for the surplus created. Since the abil-
ity or WTP for health benefits depends inter alia on the
per-capita income, a fair relationship between income and
prices is established. In addition, fair R&D cost sharing can
be achieved, as each country contributes according to its
economic capacity. Incentives to spill over too much costs
to low-income countries as well as incentives for each
country to free ride with regard to R&D paying only the
marginal cost of production and distribution and leaving
others to pay the joint fixed costs of R&D are eliminated. If
a certain country offers a price that is lower than suggested
by its willingness/ability to pay, pharmaceutical companies
will not be forced to sell at this price. Conversely, if the
manufacturer offers a price below the willingness to pay,
there will be no need to adjust the price upward. Further-
more, it might be the case that pharmaceutical companies
negotiate a higher price than suggested if the social value
in a given country is not adequately captured (i.e., there
are additional values). This would not mean, however, that
other countries could lower prices compensatory.
Still, differential pricing might be unsustainable due to
parallel trade and external referencing (the latter occurs
when governments or other purchasers use low foreign
drug prices as a benchmark for regulating their domestic
prices [16]). To prevent parallel trade and external refer-
encing, [16] suggest that manufacturers and purchasers
in low income countries use confidential rebates as part
of their procurement arrangements, such that low prices
research expenses. Other statistics suggest that for the 10 largest phar-
maceutical companies, 14% of revenue is devoted to R&D, while 34% goes
to marketing, general, and administrative costs [6].
176 A. Gandjour, N. Chernyak / Health Policy 102 (2011) 170–177
granted to one purchaser are unobservable to others and
cannot be copied.
Under the VBP approach prices can exceed marginal cost
of production and distribution only as long as the cost to
society does not exceed the value it places on the health
gains or savings produced. If forecasted prices from antici-
pated health benefits do not provide a return on investment
for the private sector, the development of drugs for diseases
that are prevalent in low income countries might not occur.
That is, there would be no R&D in the first place. In case the
WTP for health improvement in developing/low-income
countries are not sufficient to stimulate R&D, the incentives
to invest in the development of technologies beneficial for
poor countries will depend on the altruistic value placed on
expected health benefits in developing countries by high
income countries [42].
Calculating ICERs in each jurisdiction may require a
large effort. One may consider, as a second-best solution,
tying drug prices directly to health gains. This approach
would not consider downstream savings, however. On the
other hand, it would be in line with using the ICER of pal-
liative or nursing care as a benchmark, as palliative and
nursing care do not aim at changing progression of the dis-
ease and hence do not lead to downstream savings either.
In developing countries the outlined prize system can
be implemented by international organizations already
financing drug development for poor countries, such as the
International Financing Facility for Immunization, as well
as by drug purchasing organisations such as UNITAID. The
threshold value placed on health benefits can be used as
a benchmark to allocate available funds between “push”
and “pull” instruments, i.e., between targeted research to
develop drugs for specific diseases and commitments to
procure the developed drugs.
10. Discussion
In this paper we propose a new prize system for drug
innovation, where public authority (e.g., a third party
payer) is committed to pay a price based on the value of
health benefits accrued over time. We define a minimum
WTP for health benefits based on the cost-effectiveness
of palliative or nursing care and provide a formal method
to adjust the price upward based on the severity of dis-
ease. The proposed methodology allows us to overcome
the lack of a formal method to determine reward size
which is inherent in some other proposals linking prize
payment to the value of health benefits.9 Furthermore, we
suggest a formal method to adjust prizes downward for
imperfect information on health benefits, including infor-
mation on potential drug overuse. Therefore, our approach
does not presuppose perfect information on health bene-
fits. The proposed reward mechanism enables refinement
of a reward size by periodic reassessment of health bene-
fits of a drug on the basis of newly available information,
e.g., from post-marketing drug trials, pragmatic trials and
observational studies. The proposal is envisaged as a non-
9
See, e.g., the Medical Innovation Prize Act of 2005 (discussed by [55])
and the Health Impact Fund [5].
voluntary alternative to the current patent system. In this
system approval of bioequivalent drugs including generics
is abolished.
The proposed prize scheme can improve allocative effi-
ciency of drug spending compared to the current patent
system because no unrealized social benefits (deadweight
loss) are created, as long as the threshold value reflects
the real WTP for health gains. This prize system also
provides strong incentives for innovation because the inno-
vator reaps the full social surplus. Furthermore, the system
prevents welfare loss from excessive marketing of the inno-
vator and firms producing copycat drugs (me-too drugs
with no proven additional benefit and generics). While
generic drug producers may still market their production
capability to the innovator, the corresponding marketing
effort seems small compared to that for the general popu-
lation under the current system.
As a final notion, the proposed prize scheme could prin-
cipally also be applied to other types of medical products
such as medical devices and diagnostics. With such a sys-
tem in place there would be an incentive for more formal
evaluation of the effectiveness of medical devices or diag-
nostics.
11. Conclusions
Under our proposal monopoly profits are turned into
prizes linked to the social value of health benefits. If prop-
erly implemented, the proposed reward system
• allows to allocate available government spending on
pharmaceuticals in a more cost-effective way,
• directs innovative activity to drugs most valued by soci-
ety,
• ensures commercialization of innovations since prize
payments are conditional on sales,
• reduces incentives to promote drug overuse and
decreases related marketing costs,
• offers transparent and unambiguous incentives to invest,
• can stimulate research on drugs addressing
rare/neglected diseases,
• offers incentives for continuing development and follow-
up innovations, and
• makes generic price competition unnecessary.
Further refinement of the proposed prize system should
involve stakeholders as this would increase its acceptance
[46].
Acknowledgement
The paper did not receive funding. There is no conflict
of interest.
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