Research and Development in the Pharmaceutical Industry

Research and Development in the Pharmaceutical Industry

Factors Influencing R&D Spending. The amount of money that drug companies devote to R&D is determined by the amount of revenue they expect to earn from a new drug, the expected cost of developing that drug, and policies that influence the supply of and demand for drugs.

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Spending on R&D and Its Results. Spending on R&D and the introduction of new drugs have both increased in the past two decades.

Overview

The U.S. pharmaceutical industry continually brings new, beneficial drugs to the market. However, these drugs often come with high costs, leading to increased healthcare expenses for both the private sector and the federal government. Policymakers have debated strategies to reduce drug prices and federal drug spending—such measures may also affect the pharmaceutical industry's motivation to develop new medications.

This report by the Congressional Budget Office (CBO) examines the trends in drug research and development (R&D) spending and the introduction of new drugs, alongside the factors that drive how much drug companies invest in R&D. This includes forecasting global revenues for new drugs, development costs, and federal policies impacting drug supply and demand.

Recent Trends in Pharmaceutical R&D and New Drug Approvals

In 2019, the pharmaceutical industry spent $83 billion on R&D, which consists of discovering and testing new drugs, developing incremental innovations, and conducting clinical trials for safety or marketing purposes. This sum marks a significant increase from the industry spending in the 1980s, even after accounting for inflation. On average, drug companies spent about one-quarter of their revenues on R&D by 2019, a notable rise from early 2000s levels, and more compared to other knowledge-intensive industries like semiconductors and technology hardware.

The number of new drug approvals has also steadily increased in the past decade. From 2010 to 2019, the FDA approved an average of 38 new drugs annually, with a peak of 59 in 2018—an uptick of 60% from the prior decade. Many of the recently approved drugs are categorized as "specialty drugs," which are aimed at treating chronic, complex, or rare conditions and often come with stringent handling or monitoring requirements.

What Factors Determine R&D Spending?

Key factors in a drug company’s R&D spending decisions include anticipated global revenues, expected development costs, and policies influencing drug supply and demand. Companies estimate a drug's revenue potential based on expected market prices, sales volumes, and competition. Expected costs include both the tangible expenses and capital costs incurred during the development process. Importantly, the sunk R&D costs do not influence drug pricing decisions, as companies price new drugs to maximize future revenues while covering manufacturing and distribution costs.

Developing new drugs is highly uncertain and expensive. Only about 12% of drugs entering clinical trials ultimately receive FDA approval. Estimates place the average R&D cost per new drug between $1 billion and $2 billion, including both successful and failed drug development efforts. The entire process often spans a decade or more, during which time companies do not see a financial return on their investments.

Federal policies also impact R&D through various mechanisms. Firstly, policies that subsidize prescription drug purchases increase demand and consequently stimulate new drug development. The federal government funds basic biomedical research, provides R&D tax credits, and enforces patent regulations to protect market exclusivity. Lastly, some policies influence both the supply and demand of new drugs, such as federal vaccine recommendations and regulatory or tax changes.

Trends in R&D Spending and New Drug Development

Both private R&D spending and new drug approvals have significantly risen in recent years. From 2015 to 2019, drug R&D expenditure increased by nearly 50%. New approvals in recent years have focused increasingly on high-cost specialty drugs for smaller patient populations, contrasting with the more universally applicable, lower-cost drugs of prior decades.

R&D Spending

Drug R&D encompasses several activities:

• Invention: Research and discovery of new drugs.
• Development: Clinical testing, FDA approval processes, and production design for new drugs.
• Incremental innovation: New dosages or delivery methods for existing drugs and testing drugs for additional indications.
• Product differentiation: Comparative testing to demonstrate a new drug’s superiority over an existing one.
• Safety monitoring: Post-market clinical trials to identify new side effects.

Investment in drug R&D has increased substantially, with PhRMA member firms spending around $83 billion in 2019, compared to $5 billion in 1980 and $38 billion in 2000. Smaller firms focus more on new drug development, often selling their innovations to larger companies who then conduct clinical trials and safety monitoring.

Box 1. Large and Small Drug Companies and the “Make or Buy” Decision

Smaller drug companies now contribute over 70% of the nearly 3,000 drugs in phase III clinical trials. Since 2009, they have been behind about one-third of FDA-approved drugs. Large companies, while accounting for more than half of new drug approvals, initiate fewer new drugs in phase III clinical trials. Large firms often acquire smaller companies to expand their drug portfolios and use their specialized knowledge to increase the value of their acquisitions.

Acquisitions can provide efficiencies by allowing smaller firms to focus on research while larger companies manage trials and marketing. There is some evidence suggesting that large firms acquire smaller ones to limit competition, particularly for drugs that might compete with their existing products.

The PhRMA data shows R&D intensity—increasing from about 13% of net revenues in the early 2000s to over 25% in 2018 and 2019, higher than in other research-intensive industries.

New Drug Development

The pharmaceutical industry has steadily launched more new drugs in the past decade, with an average of 38 approvals per year between 2010 and 2019—a 60% increase from the previous decade. These approvals peaked in 2018, mirroring late-1990s levels.

This growth in drug approvals and spending on R&D does not always indicate more innovative new drugs; some approvals are for incremental improvements. Industry trends suggest a shift toward high-value specialty drugs in fields like cancer and nervous system disorders.

The approval process is complex; it can take over a decade of R&D to develop a new drug, meaning approvals lag behind the actual R&D spending. Additionally, R&D spending doesn’t always lead to more new drugs, as it may reflect rising costs in labor and technology.

Figure 2.

Average Annual Approvals of New Drugs by the FDA

Number of Drugs

From 2015 to 2019, the FDA approved about twice as many new drugs as it did a decade earlier. Biologic drugs make up a growing share of FDA approvals.

Data source: Congressional Budget Office, using data from the FDA's Center for Drug Evaluation and Research and the FDA's Center for Biologics Evaluation and Research. See www.cbo.gov/publication/57025#data.

Until the 1990s, the FDA did not count biologics as a separate category; they were counted with NMEs.

Factors That Drive R&D Spending

Pharmaceutical companies invest in R&D in pursuit of future profits, driven by factors like anticipated global revenues, developmental costs, and policies influencing drug demand and supply. Higher expectations of future profits lead to increased R&D investments, resulting in more new drugs from a higher investment in research and development. Lower expectations yield the opposite effect.

Box 3. Effects of Changes in Expected Profitability on the Introduction of New Drugs

If expected profitability of new drugs drops—due to policy changes, shifts in market demand or supply, or changes in power dynamics between drug companies and buyers—the expected returns on R&D investments also decline, resulting in fewer new drugs. The reverse happens if profitability expectations rise. CBO’s analysis of H.R. 3 during the 116th Congress highlights this relationship.

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Revenue Expectations and R&D Spending

Companies base their R&D investments on anticipated future revenues, formed by evaluating potential market prices and sales volumes. Expectations are influenced by current revenues from existing products, market conditions, and sales performances. Established companies generally prefer financing R&D with current revenues rather than external sources like venture capital due to transaction and monitoring costs.

The pharmaceutical industry's R&D intensity—R&D spending as a share of net revenues—has risen significantly, driven by small firms focusing on research and larger firms on clinical trials and product improvement.

R&D Costs for a New Drug

Developing a new drug involves substantial R&D costs, including preclinical research, clinical trials, and capital costs due to the funds tied up over many years. Approximately 12% of drugs entering clinical trials make it to market, with average development costs ranging from $1 billion to $2 billion per new drug.

Preclinical Phase

The preclinical phase, lasting around 31 months, comprises a significant portion of total R&D spending despite its shorter duration compared to clinical trials. Many drugs developed in preclinical stages never advance to clinical trials.

Clinical Trials Phase

Clinical trials, divided into four phases, are costlier and longer due to the involvement of many participants.

• Phase I trials assess safety in a small group of healthy volunteers.
• Phase II trials involve people with the targeted medical condition to evaluate biological activity and side effects.
• Phase III trials test the drug's clinical effectiveness in larger groups for years.
• Phase IV trials monitor side effects and efficacy after the drug reaches the market.

Most drugs undergoing clinical trials are not ultimately approved. Companies spend significant amounts on clinical trials, covering costs for failed drugs as well.

In the sample mentioned, companies spent an average of $1,065 million per approved new drug in clinical trials. Costs escalate through successive phases, with phase III trials being the most expensive.

Capital Costs of R&D

Besides the direct R&D expenses, drug companies incur capital costs due to the long lag between investment and the return on investment. These capital costs can be nearly equal to the actual R&D expenditures.

Policies Impacting R&D Costs

The federal government influences pharmaceutical R&D costs through various policies, including funding for biomedical research, tax incentives, and regulations affecting market exclusivity, generic and biosimilar drugs, and clinical trials.

Vaccine Development

The federal government also plays a crucial role in vaccine development, both by creating demand through programs like Vaccines for Children and by compensating manufacturers for adverse reactions under the Vaccine Injury Compensation Fund. Recent substantial investments in COVID-19 vaccine development highlight this support.

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