“What we are confronted with in the drug industry is the existence of prices which by any test and under any standard are excessive.”1 That brief remark, which appeared in a report from a U.S. congressional subcommittee, will come as no surprise to anyone who pays attention to the cost of health care. The timing of that statement, however, may indeed come as a surprise. It was published in 1959.
Fast forward exactly sixty years and, once again, senior executives of seven leading pharmaceutical companies—this time AbbVie, Merck, AstraZeneca, Bristol-Myers Squibb, Janssen, Pfizer, and Sanofi—faced a U.S. Senate committee to answer questions about the high and rising cost of health care. The topics for that session sounded familiar. As National Public Radio pointed out, “high drug prices and profits, limited price transparency, aggressive marketing, alleged patent abuse and mediocre ‘me too’ drugs … are identical to the issues senators investigated decades ago.”2
One of the most provocative comments in the 2019 testimony came from Merck Chairman and CEO Kenneth Frazier, who told the committee: “The people who can least afford it are paying the most. That’s the biggest problem we have as a country. We have a system where the poorest and the sickest are subsidizing others.”3 His comment echoed the sentiments of Heather Bresch, the CEO of the pharmaceutical company Mylan, who had testified before the U.S. House Oversight and Government Reform Committee in 2016 after her company’s substantial price increases for a popular pharmaceutical product ignited a major controversy. Mylan had raised the list price for a two-pack of Epipen—an injector that can administer a potentially life-saving dose of epinephrine to someone in allergic shock—from $100 to more than $600 over the course of nine years, starting in 2007.4 In a subsequent interview, Bresch shifted some of the blame for the high prices to other parts of the “system.” She singled out insurers for setting high deductibles and drug-benefit managers for negotiating high discounts off of the high list prices.5 “The irony is the system incentivizes high prices,” a spokeswoman for Bresch said at the time.6
Given that politicians have grilled pharmaceutical executives regarding the same broken system for the last six decades, one might think that the problem of high drug prices is intractable. But is there a better way? In the spirit of the Ends Game, we rephrase this question and ask: how much inefficiency is there in the system? The answer is staggering. One study has estimated the amount of waste in the health-care sector in the United States at roughly $1 trillion, or 30 percent of the country’s annual expenditure on health care.7 Leaving aside high administrative costs and alleged outright fraud, a significant portion of this waste stems from differences in standards of care across states (which leads to access waste), overtreatment (which leads to consumption waste), and failures in care or coordination (which leads to performance waste).8
High prices for drugs seem to have no end in sight. In 2019, for example, Novartis announced that its gene-therapy treatment for an inherited disease called spinal muscular atrophy will cost a record-setting $2.125 million.9 Given this outlook, how can medical systems address the inevitable waste that such high prices create? How can organizations, either individually or collectively, act in a way that makes them, their stakeholders (patients, insurance companies, other third parties), and society better off?
In our view, the path to answering this conundrum starts with the existential question What are we asking customers to pay for? Bill George, the former CEO of the medical technology giant Medtronic, hinted at one possible solution for the health-care sector in a commentary he wrote in response to Mylan CEO Bresch’s congressional testimony in 2016. George argued that “authentic health-care companies from Mayo to Merck understand they are in business to restore people’s health, and if they did that well, profits would follow.”10 In other words, success in the industry is the result of aligning financial performance with patient outcomes. In chapter 6, we described how some companies and institutions are already attempting to quantify patient well-being and make payments contingent on these measures. They are not alone. For example, another biotech firm, bluebird bio, plans to offer a gene-replacement therapy for an inherited blood disease on an installment plan tied to specific results. The company would get “as little as 20% of the product’s total cost upfront, and put the remaining 80% ‘at risk’ of nonpayment.”11 Payments of an additional 20 percent would follow in the ensuing years, but only if the treatment meets certain criteria, such as eliminating or reducing the number of transfusions. “We only get paid if we do what we said we’d do,” bluebird bio CEO Nick Leschly said.12
Nonetheless, many players within health-care systems continue to obsess over a different question. Instead of thinking hard about the merits of generating revenue by the pill, by the device, or by the treatment or procedure, these players think hard about the merits of a specific price point, and specifically about the opportunities to make products and services more affordable. Most other industries work the same way. It is as if the basic rules of the game in a given market, the nature of the revenue model, cannot be changed.
Why don’t organizations immediately leap at opportunities to play the Ends Game? Why doesn’t an organization, knowing that eliminating waste unlocks market potential, act proactively to shake up the prevailing revenue model in its industry, trying to reach a better alignment with the value customers actually derive in an exchange?
All too often, the remarkable explanation is that such a company is “blinded” by the quality of the products and services it proudly brings to market. This is what we refer to as the quality paradox. At some point, the relentless pursuit of quality makes it almost unimaginable to generate revenue from anything other than the sale of one’s offerings. Said differently, when a company obsessively directs its efforts toward continuously innovating its products and services, it risks becoming accountable to its offering rather than to its customers. In health care, for example, it implies that a pharmaceutical company, which spends considerable time, money, and effort developing new medications, focuses on pricing its own “outputs” rather than those that customers ultimately care about. Paradoxically, the better a company is at creating value for customers through its efforts at innovation, the more waste it generates in the exchange by continuing to adhere to the standard pay-to-own revenue model.
One probable cause of the quality paradox is surrogation, a concept made popular by Willie Choi, Gary Hecht, and William Tayler in a research article published in 2012.13 Put in its simplest terms, surrogation occurs when an individual or institution becomes so keenly focused on improving the measure of an underlying construct of interest that it reaches a point where the measure replaces the construct entirely. Surrogation warps the intent behind the old management cliché about “what gets measured, gets done” into something like “what gets measured is everything.” An often-cited example of surrogation is the 2018 credit card scandal involving Wells Fargo’s retail banking: “Driven by strict and unrealistic sales goals, employees in Wells Fargo’s Community Bank division engaged in fraudulent sales practices, including the opening of millions of fake deposit and credit card accounts without customers’ knowledge.”14 What happens in such cases is that “a company can easily lose sight of its strategy and instead focus strictly on the metrics that are meant to represent it.”15
Surrogation is likely to exist in the context of revenue models for two reasons. First, consider an organization that has a track record of innovation and invests constantly and heavily in research and development. This motivation may come from its desire to lead the market on quality and differentiation, or it may be a trait of the industry as a whole. Irrespective, the organization worships its products. However, similar to Gillette in chapter 4, and similar to many pharmaceutical or consumer electronics companies, such devotion reinforces attitudes and behaviors that are inherently inward-looking, making the organization less likely to consider—let alone accept—any metric for its revenue model other than the product or service itself. The deeper the roots in proprietary technologies or engineering and processes expertise, the more vulnerable is this organization to suffer from tunnel vision.
The second reason for surrogation in the context of revenue models is financial. Innovation is often an expensive exercise, and heavy investments tend to make organizations more conservative in any decision that involves revenue. Of the different models discussed in this book, the traditional ownership model is probably the simplest and “safest” to adopt, as it gives organizations a relatively clear sense of the costs involved in selling a product or service and, therefore, of the contribution they can expect from every transaction at a given price. This may not be the optimal contribution, but it is a less risky proposition.
In the spirit of the Ends Game, the creation of better outcomes for customers should go hand in hand with the creation of a better financial outcome for the organization. The tighter the alignment, the less waste occurs in the exchange between the two parties. If a company truly possesses a superior product or service, and especially when this company has the resources to innovate and maintain an advantage, then it does itself and its customers a disservice by stubbornly holding onto a revenue model based on ownership. An ownership model may prompt a dizzying price tag that reflects or validates the inherent quality of the offering. But this price tag may also deny access to potential customers and distort consumption patterns. Importantly, it offers no guarantee of performance.
In early 2019, the Boston Consulting Group cited an example of what would happen if a drug maker were to switch its revenue model for a cure from a per-treatment basis (a pay-to-own model) to a population-based payer licensing agreement analogous to the enterprise licensing model commonly used for software.16 The firm used a cure for the hepatitis C virus (HCV) as its example. According to the data cited, most of the world’s HCV-infected population remains uncured even though innovative medicines, introduced in 2013, can cure HCV in eight to twelve weeks.17 The Boston Consulting Group’s model of the HCV treatment showed that patients, payers, and pharmaceutical companies would do better under a payer licensing agreement agreement in every market they tested.18
As the Boston Consulting Group writes: “The advent of cures creates a true pricing dilemma for pharmaceutical companies and those that pay for medicines. If drugs were priced today to reflect only the value that accrues over time, the resulting (high) prices would strain payers, prompting some of them to limit patient access. Conversely, treating all patients as fast as possible—and in doing so, accelerating eradication—requires prices so low that developing certain cures would become far less economically attractive, particularly compared with the economics of drugs that treat chronic diseases.”19 In other words, amazing breakthrough cures do exists, but they cannot work their “magic” unless health-care systems adopt revenue models designed specifically to limit waste in the exchange between manufacturers and payers. The quality paradox hamstrings the consideration and adoption of such models.
We could recommend at this juncture that companies in an industry with a broken “system” forge ahead by applying the concepts we introduced and elaborated in parts I and II of this book. They would take customer focus to its logical conclusion, using today’s groundbreaking technologies to integrate impact data into their strategic calculus. They would seize growth opportunities in their markets, identifying where they can reduce the greatest amount of waste by aligning their revenue models with the desired outcomes customers achieve—or perhaps with value itself.
If only it were that easy. Before an organization can take these steps, it first needs to recognize that it faces the quality paradox. The organization needs to see that there is a tension between how it creates better outcomes for customers through its products and services (the solutions it brings to market) and how it creates better outcomes for itself (the revenue model). The stronger the solutions, the greater the tension if the organization blindly adheres to the same tried-and-true ownership model. Perhaps leaving aside industries such as luxury goods, where success is often closely tied to exclusivity, the organization must recognize that it makes no sense to improve an offering yet stick to a revenue model that blocks customers from purchasing, or one that dissuades customers from buying out of concern for inadequate consumption or performance.
Sticking to established revenue models leads to inertia, which can manifest itself as risk aversion, myopia, and a certain degree of hubris. The more companies are accustomed to perpetuating the past by projecting it into the future, the more likely they are to respond reactively to trends in their market instead of initiating them. An unwarranted commitment to an inferior revenue model is reinforced by efforts to win within the existing system—through cost cutting, process efficiency, and incremental innovation—instead of changing it. Recognition is the first step, because many managers are locked unnecessarily into a certain way of doing business.
The second step is to identify and appraise the opportunities and challenges that present themselves if the organization adopts a more efficient revenue model. The ease with which a company can make a change depends in part on the nature of the outcomes, as we described in chapter 7. For example, implementing a new revenue model grounded in complex outcomes is likely to require the participation of multiple players, which can be costly in terms of time, effort, and money. Having said that, companies that can consistently deliver best-in-class performance ultimately have the greatest incentive to play the Ends Game. Such organizations already focus their value proposition on superiority in one or more dimensions of quality, which suggests that they have a strong basis to implement a revenue model more closely aligned with the outcomes that result from this advantage. Depending on the dynamics of the market (the nature of the outcomes, the extent of competition, the existing level of transparency, etc.), implementing a revenue model that holds the firm accountable to its customers may in fact trigger a flight to quality. The irony, however, is that the companies most likely to benefit from implementing a better revenue model are those that are most likely to suffer from the quality paradox.
The impetus to make a change is unlikely to be strong among companies (or industries) that are currently performing well. This helps explain, for instance, the reluctance among many of the world’s best pharmaceutical companies to move toward outcome-based revenue models. There is no doubt that the products and services these organizations bring to market already generate tremendous value for them, for patients, and for society at large. Columbia University professor Frank Lichtenberg analyzed the benefits of drugs in twenty-two countries and estimated that drugs launched since 1982 are adding 150 million life-years to people’s life spans every year, at an average expenditure per life year of $2,837, an amount he considers to be a “bargain.”20 The pharmaceutical companies have clearly cashed in on this. One report from Bloomberg said that the top thirteen drug makers in the world earned over $100 billion in net income in 2018.21
However, a closer look tells a somewhat different story. The prices of many drugs are widely viewed as misaligned with the value they actually deliver. In a 2016 article appropriately titled “The Price-Quality Paradox in Health Care,” the Health Care Cost Institute concluded: “The relationship between state-level quality and price measures demonstrate[s] how price alone may not be sufficient for identifying quality. In some cases, it appears that higher prices are actually associated with lower quality.”22
The third and final step in overcoming the quality paradox is for the organization to persevere in search of the best possible answer to the question: What are we asking customers to pay for? Satisfaction with the current financial position should not distract the organization from this pursuit. As long as there is significant waste in the exchange with customers, there is room for improvement. More important, there is always the threat that the comfortable current position is “disrupted” by a bold competitor or new entrant that dares to look at the exchange and decides to offer customers a more efficient proposition.
We admit that answering this existential question is a grand, somewhat uncomfortable challenge. Frankly, it is tempting to skip the work and default to an answer that is familiar and “good enough.” This remains one of the main reasons why so many companies resort to generating revenue directly off of the products and services they make. But innovative companies that deliver solutions to customers that are truly superior can no longer afford such complacency. These companies have the most to gain from resolving the quality paradox, but they are missing the conviction that they can be more successful, or sustain their success for longer, if they take customer focus full circle and rethink their revenue model from the perspective of those they are working hard to serve.
1. M. Mintz, “Still Hard to Swallow,” Washington Post, February 11, 2001, https://www.washingtonpost.com/archive/opinions/2001/02/11/still-hard-to-swallow/013c5cb9-220e-451a-a327-852648342524/?utm_term=.d8b9e8dc0a30.
2. J. Hancock, “Senate Inquiry on Drug Prices Echoes Landmark Hearings Held 60 Years Ago,” Shots: Health News from NPR, February 22, 2019, https://www.npr.org/sections/health-shots/2019/02/22/696967037/senate-inquiry-on-drug-prices-echoes-landmark-hearings-held-60-years-ago.
3. L. A. Caldwell, “In Senate Testimony, Pharma Executive Admits Drug Prices Hit Poor the Hardest,” NBC News, February 26, 2019, https://www.nbcnews.com/politics/congress/senate-testimony-pharma-executive-admits-drug-prices-hit-poor-hardest-n976346.
4. A. Pollack, “Mylan Raised Epipen’s Price before the Expected Arrival of a Generic,” New York Times, August 25, 2016, https://www.nytimes.com/2016/08/25/business/mylan-raised-epipens-price-before-the-expected-arrival-of-a-generic.html.
5. J. Rockoff, “Mylan Reacts to Epipen Backlash,” Wall Street Journal, August 26, 2016, https://www.wsj.com/articles/mylans-epipen-price-increases-highlight-its-grip-on-the-market-1472154769?mod=article_inline.
6. Rockoff, “Mylan Reacts to Epipen Backlash.”
7. D. O’Neill and D. Scheinker, “Wasted Health Spending: Who’s Picking Up the Tab?,” Health Affairs (blog), May 31, 2018, https://www.healthaffairs.org/do/10.1377/hblog20180530.245587/full/.
8. O’Neill and Scheinker, “Wasted Health Spending.”; National Academies of Sciences, Engineering and Medicine, “Transformation of Health System Needed to Improve Care and Reduce Costs,” news release, September 6, 2012, http://www8.nationalacademies.org/onpinews/newsitem.aspx?RecordID=13444.
9. D. Roland, “At $2 Million, New Novartis Drug Is Priciest Ever,” Wall Street Journal, May 24, 2019, https://www.wsj.com/articles/at-2-million-new-novartis-drug-is-priciest-ever-11558731506?mod=article_inline.
10. B. George, “Mylan CEO’s Testimony Was a Huge Blow to the Entire Pharma Industry,” Biotech and Pharmaceuticals, CNBC, September 27, 2016, https://www.cnbc.com/2016/09/27/mylan-ceos-testimony-was-a-huge-blow-to-the-entire-pharma-industry-commentary.html.
11. J. Walker, “Biotech Proposes Paying for Pricey Drugs by Installment,” Wall Street Journal, January 8, 2019, https://www.wsj.com/articles/biotech-proposes-paying-for-pricey-drugs-by-installment-11546952520?mod=article_inline.
12. Walker, “Biotech Proposes Paying for Pricey Drugs by Installment.”
13. J. Choi, G. W. Hecht, and W. B. Tayler, “Lost in Translation: The Effects of Incentive Compensation on Strategy Surrogation,” Accounting Review 87, no. 4 (July 2012): 1135–1163.
14. M. Levine, “Fake Accounts Still Haunt Wells Fargo,” Bloomberg Opinion, October 23, 2018, https://www.bloomberg.com/opinion/articles/2018-10-23/fake-accounts-still-haunt-wells-fargo.
15. M. Harris and B. Tayler, “Don’t Let Metrics Undermine Your Business,” Harvard Business Review, September–October 2019, https://hbr.org/2019/09/dont-let-metrics-undermine-your-business; emphasis in original.
16. J. M. Izaret, D. Matthews, and M. Lubkeman, “Aligning Economic Incentives to Eradicate Diseases,” BCG, January 7, 2019, https://www.bcg.com/publications/2019/aligning-economic-incentives-to-eradicate-diseases.aspx.
17. Izaret, Matthews, and Lubkeman, “Aligning Economic Incentives to Eradicate Diseases.”
18. BCG, “An Innovative Approach to Pricing Drugs Can Accelerate the Eradication of Diseases,” news release, January 14, 2019, https://www.bcg.com/d/press/14january2019-an-innovative-approach-to-pricing-drugs-accelerate-eradication-disease-211735.
19. Izaret, Matthews, and Lubkeman, “Aligning Economic Incentives to Eradicate Diseases.”
20. S. Kurczy, “Calculating the Benefits of Drugs,” Ideas and Insights, Columbia Business School, February 12, 2019, https://www8.gsb.columbia.edu/articles/ideas-work/calculating-benefits-drugs.
21. M. Nisen, “Why Big Pharma’s Case to Congress Comes Up Short,” Bloomberg, February 26, 2019, https://
22. E. Barrette and K. Kennedy, “The Price-Quality Paradox in Healthcare,” data brief, IssueLab, March 31, 2016, https://www.issuelab.org/resource/the-price-quality-paradox-in-healthcare.html.