Big Hospitals vs. Big Pharma: Which industry is most to blame for soaring health care costs?

As talk of reform grows in D.C., the two sides are gearing up for an epic clash.

“It’s just appalling,” says Molly Smith, group vice president for public policy at the American Hospital Association. She’s talking about a new report from the Pharmaceutical Research and Manufacturers of America (PhRMA). “Hospitals’ Practices Increase Costs of Medicines for Patients & Employers,” the press release blared, further claiming “the system routinely rewards hospitals for extracting two to three times more revenue from the sale of a medicine than the company who discovered and made it” when administered under a government program for getting drugs to the most vulnerable patient populations.

Smith, steaming, is having none of it. “The program was solely created because of the high drug prices that [drugmakers] and they alone set,” she says. “And then when they’re upset that such a program got set up because of their egregious pricing practices, they come after it. They’re making hand over fist in profits. But, you know, anything that cuts into their bottom line …”

Subscribe to unlock this article and get full access to Fortune.com

“It’s just appalling,” says Molly Smith, group vice president for public policy at the American Hospital Association. She’s talking about a new report from the Pharmaceutical Research and Manufacturers of America (PhRMA). “Hospitals’ Practices Increase Costs of Medicines for Patients & Employers,” the press release blared, further claiming “the system routinely rewards hospitals for extracting two to three times more revenue from the sale of a medicine than the company who discovered and made it” when administered under a government program for getting drugs to the most vulnerable patient populations.

Smith, steaming, is having none of it. “The program was solely created because of the high drug prices that [drugmakers] and they alone set,” she says. “And then when they’re upset that such a program got set up because of their egregious pricing practices, they come after it. They’re making hand over fist in profits. But, you know, anything that cuts into their bottom line …”

America’s hospital industry and pharmaceutical industry—combined 2019 revenues: $1.6 trillion—are feuding more sharply and publicly than ever, and for good reason. One political party currently controls both the legislative and executive branches. And when that happens, especially in a new President’s first two years, big changes tend to follow. That’s how the Tax Cuts and Jobs Act became law under President Trump and how the Affordable Care Act got passed under President Obama. Now President Biden and the Democrats who control Congress have come to power with ambitious plans to reform U.S. health care and stem the ever-rising costs—and Big Hospitals and Big Pharma could be in the crosshairs.

This has set the stage for an epic showdown. Both Big Pharma and Big Hospitals know that reform in some guise is almost certainly coming out of Washington, D.C. The real questions are just how severe the crackdown will be, and, crucially in their eyes, which side gets hit hardest. So after a long period of relative détente, the two behemoths of the health care industry are circling each other like Godzilla vs. Kong—breathing fire, beating their chests, and pumping themselves up for a public relations and lobbying battle for the ages. Each side wants to make the other into legislative target No. 1. 

The public holds both sides about equally responsible for today’s health care problems. A Gallup poll finds that 76% of Americans think they’re paying too much for most care they receive, relative to its quality. The two main culprits, says a Kaiser Family Foundation poll, are drug costs (cited by 78%) and hospital costs (71%). Several polls show large percentages favoring government control of both drug and hospital charges.

It’s a propitious moment for Biden, who wants to go big on health care. The President wants to limit new-drug prices and price increases, allow Medicare to negotiate drug prices with pharma companies, and potentially break up some of the biggest hospital, drug, and health insurance companies.

Biden’s secretary of health and human services, Xavier Becerra, would go much further; he has long supported a single-payer health care system and has endorsed Sen. Bernie Sanders’ “Medicare for All” proposals. He can’t make those things happen on his own, of course. And Becerra said at a Senate committee meeting before his confirmation hearing that Biden’s agenda “will be my mission.” But his leanings are alarming to the industry.

Taken together, it sounds like a threatening outlook for hospitals and drugmakers, with one enormous countervailing factor: the pandemic. Over the past 13 months, hospital workers have been heroes in the truest sense, risking and sometimes giving their lives in the fight against the plague. Meanwhile, much-reviled Big Pharma has pulled off one of the great achievements in medical history—developing multiple effective COVID-19 vaccines in 10 months rather than 10 years, and rapidly manufacturing them in massive quantities. Says Niall Brennan, CEO of the Health Care Cost Institute, a nonprofit research organization: “They have gained the moral high ground.” Are these the businesses America wants to punish?

Win McNamee—Getty Images

This combination of pandemic and politics puts health care on the front burner like it hasn’t been since passage of the ACA 11 years ago. That landmark law has achieved a great deal; the portion of the population without health insurance has dropped from 15.5% when the ACA was enacted to 9.2% in 2019 (most recent data). But so far it has not bent the cost curve downward in the big picture. Total national health care spending per capita, in constant dollars, increased far faster in the six years after the ACA took effect in 2013 (18%) than in the six years before (7%). 

Understanding just why these costs have remained so maddeningly untamable is crucial as we enter into another bruising national debate on how to address the issue. And no one has a bigger stake in the outcome than hospitals and pharmaceutical companies—the largest players in the largest sector of the largest economy on earth.

The politics of health care are as closely interwoven with human psychology as they are driven by academic arguments. An economist may raise the alarm to assert that costs can’t keep growing faster than GDP. But politically, that’s not what counts. Voters tend to see those big macroeconomic trends merely as abstract numbers that don’t hit home. People care most about their own situation. It’s certainly true in health care—yet not quite in the way one might expect. 

Consider, for example, annual per capita out-of-pocket spending on prescription drugs. In theory, that’s what people ought to care about, the money coming from their own wallet. So they might be surprised to learn that the government’s National Health Expenditure data shows this expense being broadly flat for almost 20 years. On average, Americans are spending no more of their own money on drugs than they were in 2003; in fact, they spent less out-of-pocket in 2019 ($164) than they did in 2006 ($189). So why do large majorities of Americans rail against drug costs and want the government to control them?

The answer reflects an important truth about health care economics and especially about health care politics: Extremes are often more important than averages, and health care is a world of extremes. Among people with private health insurance, only 3% spend over $1,000 a year out-of-pocket on drugs, but they account for 40% of total out-of-pocket spending, reports the Kaiser Family Foundation. More broadly, in any given year, 5% of Americans account for about 50% of total health care spending. As KFF researcher Cynthia Cox observes, we all know that “at any given point in time, we might end up being in that 5%.”

1.6 trillion

Combined revenues in 2019 of the hospital industry and pharmaceutical industry, the two largest players in U.S. health care

Americans aren’t worried about averages. They’re terrified of being in the 5%. “A lot of this is about shifting anxiety from consumers up onto somebody else,” says Alan Scarrow, a neurosurgeon and former president of Mercy Health System in Springfield, Mo., who has written a book about the U.S. health care system called Hope Over Experience.

Consumers have read about people who have drained all their assets to pay for the drug that could save them or have been pushed into poverty by mammoth hospital charges. Says Vincent Rajkumar, a physician at Mayo Clinic who has written often on drug prices: “Someone can make $50,000 a year for 25 years and lose all they’ve got just like that once they get ill.”

Those are the anxieties that policymakers and legislators of both parties want to quell—or spin to their advantage.

What often tends to get lost amid all the blame-shifting and finger-pointing between Big Hospitals and Big Pharma is that there is something fundamentally wrong with the larger system: The U.S. health care sector operates at staggering costs without producing superior results. 

Consider that the U.S. spent 17.7% of its world-leading GDP on health care in 2019, says the Centers for Medicare & Medicaid Services (CMS). No other country came close. A group of 11 other wealthy countries averaged just 10.7%, says the Organization for Economic Cooperation and Development (OECD), yet many of those countries achieve better health outcomes by several measures, and in some cases the U.S. is the worst among them. For example, America’s all-cause age-adjusted mortality rates are the highest. Australia, which spends the least on health care in the group (9.3% of GDP, barely over half of America’s rate), reports the lowest mortality rates. U.S. premature death rates and pregnancy-related death rates are by far the worst.

The U.S. performs well by certain other measures. For example, its cancer death rates are among the lowest in the group. But in light of the vastly greater share of our wealth that we spend on health care, shouldn’t all our outcomes be the envy of the world? The hospital and pharma industries are sniping at each other because an uncomfortable question hangs over the whole health care sector: Who’s to blame for this?

Assorted analysts and interest groups offer varying answers. Some say the U.S. actually has the world’s best health care system; when billionaires and monarchs need serious medical care, they often point their private jets to the U.S. But that fact can’t explain why so many outcomes are poor. A more substantive answer is that many poor health outcomes arise from causes outside the health care system’s control. Some 75% of U.S. spending goes to treat so-called lifestyle diseases—cardiovascular disease, diabetes, some cancers. America is the fattest nation in the OECD, and that isn’t the health care system’s fault.

But while other wealthy countries are less obese than the U.S., most of them smoke more and drink more, often a lot more, while spending much less on health care and achieving better outcomes on the whole. So yes, there’s a problem. Who’s to blame?

If we frame the question as hospitals vs. pharma, we find first that the U.S. spent about $11,000 per capita on health care in 2019, almost twice as much as the 11 comparable countries. Hospitals are by far the largest cost in the U.S. and the others. Prescription drugs are the second-largest cost in the U.S. but only third in the comparable countries, where long-term care is the No. 2 cost.

So it appears that hospitals-vs.-pharma is the right framing of the U.S. cost problem. The verdict of KFF analyst Cynthia Cox: While hospital care is 33% of total U.S. health spending, “retail prescription drugs are only about 10% of our health spending, so even if we slice those drug costs in half, it still wouldn’t bring down our total costs nearly as much as if we did something about hospital costs, which are the bulk of the difference between U.S. spending and other countries’ spending.”

It may seem unfair to blame hospitals. By the nature of modern health care they’re the largest cost across countries, so even a small percentage increase can easily outweigh a larger percentage increase in any other component of the system. But a closer look shows that the percentage increases in U.S. hospital costs aren’t small. While congressional committees and the media focus heavily on rising drug costs, CMS reports that hospital spending grew at faster rates than drug spending in four of the six years through 2018 (the most recent year for which it has data) and is expected to keep growing at faster rates in five of the six following years. 

Or think of it this way. CMS expects hospital costs to grow not just faster than drug costs, but also faster than overall health expenditures in five of those six following years. It expects drug costs to grow faster in only two of those years. Hospitals look like the locomotive that’s pulling health care costs up. 

But wait, hospitals have identified a culprit for their rising costs: It’s pharmaceutical companies! Asked if hospitals are unfairly blamed for increases in overall health care costs, the AHA’s Molly Smith replies, “I think that’s probably a fair way of stating it.” She says hospitals’ drug costs “have been rising exponentially” and “when a hospital purchases a drug to use in patient care, that cost gets reported nationally as a hospital cost. It’s not reported as spending on drugs.”

She’s right. The government’s National Health Expenditure numbers break out only retail prescription drug costs; drugs sold to hospitals are bundled in with total hospital costs. But the AHA has never reported how much U.S. hospitals actually spend on drugs, and that data cannot be found anywhere in publicly available government statistics. “It’s a big black box,” says KFF’s Cox. “We put out this analysis, and shortly thereafter I heard from a consultant for the hospital industry who was making exactly this point—‘Prescription drugs are driving up our costs.’ I said, ‘Well, if you’re able to share any data with us that accounts for the discounts you get on prescription drugs and any markups you make, we’ll gladly account for that in our analysis.’ I didn’t hear back.”

The warring industry-funded studies and talking points are endless, but for anyone interested in actually solving the cost problem, bashing any one group doesn’t get us very far. The U.S. health care system is incomprehensible to the casual observer. Voters tend to view issues at a high level and like to think in terms of heroes and villains, so that’s how lobbyists characterize the players. 

Down on the ground where business gets done, there are indeed heroes, like vaccine scientists and frontline hospital workers. And there are a few villains, too, like notorious pharma price-hiker Martin Shkreli (now in federal prison). But mostly there are just businesspeople responding rationally to the incentives they face. 

That’s where we need to look. If we want to understand the roles of hospitals and pharma companies in this mess, and what potential new laws and regulations might mean for them, it’s necessary to examine how the system really works for its two biggest players—and thus for everyone else. 

When experts begin explaining America’s world-record health care costs to the uninitiated, a phrase that recurs quite often is “perverse incentives.” 

Let’s start with a typical (though not universal) type of transaction between a pharma company and a hospital—the kind that sparked PhRMA’s complaint about hospitals jacking up prices and the AHA’s complaint about rising drug costs. First, a drug manufacturer sells a drug to a wholesaler for what is known as the list price. This might be a chemotherapy drug or some other medication administered in a hospital outpatient department. Unlike wholesalers in other industries, the drug wholesaler may then sell the drug to a hospital for a price that’s lower than the list price. This price was negotiated with the manufacturer by a group purchasing organization (GPO), which represents several hospitals and other purchasers. The manufacturer then reimburses the wholesaler for the loss it took on the drug, plus a small fee. The manufacturer also pays the GPO a fee, maybe 3% of the negotiated price.

76%

Portion of Americans who think they’re paying too much for the health care they receive based on its quality, according to a Gallup poll

These payments begin to chip away at the healthy profit margin built into the drugmaker’s list price—and there are more to come.

The hospital then administers the drug to a patient and bills the patient’s insurer at a pre-negotiated rate for the procedure. Depending on the plan, the insurer might pay the hospital for part of the cost, say 80%, and the patient might pay coinsurance of 20%. Finally, and significantly, the manufacturer pays the insurer a rebate on the cost of the drug used in the procedure, which may be substantial, perhaps 20% of the list price or in some cases more. Unlike most rebates, this one isn’t paid to the consumer. 

Feel free to take a break and apply cold compresses to your forehead.

At the end of this tortured process, the hospital may indeed get more money than the drug company gets, as PhRMA claims, though PhRMA glosses over the fact that the hospital provides a facility, equipment, and personnel to administer the drug. In its counterblast, the AHA doesn’t dispute PhRMA’s numbers but notes that they apply only to patients with commercial insurance, not those with Medicare or Medicaid, on whom hospitals typically lose money.

Here’s the larger question: Why is the drug distribution system so insanely complex? The answer, once again, is incentives. In the retail distribution system, which is even more complex than the example above, drugmakers pay substantial rebates to pharmacy benefit managers (such as Caremark, Express Scripts, and OptumRx), who pass the rebates (minus a fee) to the insurers who eventually pay for the drugs. In return, the insurers put the drugs in their formularies’ most affordable tiers—incentivizing patients to prefer those drugs. 

Al Seib—Los Angeles Times via Getty Images

But wouldn’t it be simpler for the drugmaker just to discount the price to the insurer rather than going through the charade of setting a high list price and then paying a rebate? Maybe, but it doesn’t happen because other parts of the system are wired to the list price. At the retail pharmacy, patients with high-deductible insurance plans—a fast-growing number of people—pay list price for drugs until the deductible has been met. The fees collected by pharmacy benefit managers and group purchasing organizations are often based on the amount of the rebate they negotiate. 

Thus drugmakers are incentivized to set ever higher list prices and then offer ever larger rebates, which is exactly what they’ve been doing in recent years. “A lot of observers think there is no reward for any pharmaceutical manufacturer coming in at a lower price than their competitor,” says Jay Want, executive director of the Peterson Center on Healthcare, a think tank and research organization. “The win is when you come in at a higher price and then give a bigger rebate in order to be able to buy market share in that particular class.” Researchers Stacie B. Dusetzina of Vanderbilt University and Peter B. Bach of Memorial Sloan Kettering Cancer Center conclude: “The current rebate system contains perverse incentives within the supply chain and increases costs for patients and taxpayers.” Should we blame the drugmakers for that, or blame the incentives that guide them?

That’s Drug Pricing 101, but special situations sometimes demand Ph.D.-level expertise. In 2018 the makers of three hepatitis C drugs reversed the usual strategy; they stopped offering rebates and instead discounted list prices by 60% or more, which is almost unheard of. An abnormally large proportion of the prescriptions for those drugs are eligible for government discounts, which altered the incentives. An analysis of the mind-addling math by researchers at the Pew Charitable Trusts found that the drugmakers’ unusual strategy increased their revenues by $182 million and reduced revenues by the same amount at health care organizations serving vulnerable populations. Again, do we blame the pharma companies or the incentives they face? 

Such perverse incentives are everywhere in the system, often invisible to patients. David Whitrap, a vice president at the Institute for Clinical and Economic Review (ICER), points to autoimmune drugs such as AbbVie’s Humira, Amgen’s Enbrel, and Johnson & Johnson’s Remicade. They cover a wide range of inflammatory conditions—rheumatoid arthritis, plaque psoriasis, Crohn’s disease, colitis, and others. Because they’re so broadly indicated, he says, the maker of one of these drugs can “sit down in a negotiation with a health insurer and offer a rebate for their drug across this entire class, and it’s a meaty rebate. It could be 50% of the list price.” In return, the insurer will put the drug in the top tier of the formulary, where it’s most attractive to patients. But it may be that another drug is more effective or affordable for a specific condition, say, Crohn’s disease. Because that drug is so narrowly targeted, it can’t get “that preferred formulary treatment,” Whitrap says. “We’re creating a situation where patients can’t get access to the better or more affordable drug because there’s some rebate happening behind the scenes that’s really driven by the market for rheumatoid arthritis, which is a much broader indication. It’s not good for the health system.” 

All of which leads to a deeper question for pharmaceutical companies, hospitals, and the whole health care sector: How much is any treatment or device worth? In most other industries we let the market decide such matters, but “this is a case where the market is not going to answer the question for us,” says Want of the Peterson Center on Healthcare. That’s because health care deals uniquely in wellness, sickness, life, and death. Even in a largely market-based system like ours, we can’t avoid excruciating questions of what we’ll pay for and what we won’t. (See section below, “Putting a price on a miracle drug.”)

Carefully considering whether prices line up with benefits can help us evaluate not just drugs but all elements of health care, including the costliest. Organ transplants typically cost over $1 million, for example. A month in a top hospital’s intensive care unit can cost millions. Are they worth it? In judging prices, we must consider what we get and also what we give up—what we could have bought instead. It’s what economists call opportunity cost. Researchers from Pennsylvania State University and the U.K.’s University of York have calculated a health care opportunity cost, in dollars, for the U.S. 

We’re creating a situation where patients can’t get access to the better or more affordable drug because there’s some rebate happening behind the scenes.

David Whitrap, VP at the institute for clinical and economic review

It’s based on the concept of the quality-adjusted life year (QALY), which ICER also uses to evaluate if medications are worth their cost. Figure out how many years a treatment will extend life; multiply by a factor between 0 and 1, with 1 representing perfect health during those years and 0 representing death. Compare the result with the treatment’s price and you get the treatment’s cost-per-QALY. Health care economists call that number the incremental cost-effectiveness ratio (the acronym, not coincidentally, is ICER). Do a bit more math and you find a threshold—any treatment above that cost-per-QALY has too high an opportunity cost, and the money should be spent on other, more cost-effective treatments. The cost-per-QALY threshold in the U.S., the researchers find, is between $100,000 and $150,000.

Is it barbaric to put a price on life? Or is it unavoidable? Under the terms of the Affordable Care Act it’s illegal for Medicare to use cost-per-QALY, but the Department of Veterans Affairs uses it in determining drug coverage and negotiating prices based on a threshold of $100,000 to $150,000 per QALY. Caremark has used it to decide which drugs get into its formulary, and the New York State Drug Utilization Review Board used it to evaluate a cystic fibrosis treatment. Other countries use it routinely and tend to be stingier than the U.S. In the U.K., for example, the National Institute for Health and Care Excellence recommends that treatments with a cost-per-QALY above £20,000 to £30,000 ($28,000 to $41,000) not be covered by the National Health Service in England and Wales. 

Most nations are forced into these math acrobatics because the usual method of determining price and value, the market, is largely out of the picture. Even in the U.S., a majority of people are almost entirely separated from the market mechanism. Most don’t buy their own insurance; they get it from their employer or the federal government. Out-of-pocket spending is only 13% of total health care expenditures; with someone else paying 87% of the bill, most people have little incentive to shop carefully. Economically, the real consumer, the patient, is a bit player in this drama.

I think we’re headed to some form of universal coverage. I think that’s consistent with our values as a nation.

Jay Want, executive director of the Peterson Center on Healthcare

That trend isn’t about to reverse, which raises the momentous issue of whether the U.S. is headed toward some kind of universal coverage system, with significant steps in that direction potentially during the Biden administration. “I do think we are drifting more and more toward a government-run health system,” says Alan Scarrow, the neurosurgeon and former hospital exec. Jay Want of the Peterson Center agrees. “I think we’re headed to some form of universal coverage,” he says. “I think that’s consistent with our values as a nation. I tend to believe that it’s likely to still involve insurance for multiple different venues, not a single kind of delivery system.” 

Benjamin Isgur, chief of PwC’s Health Research Institute, doesn’t buy it. “We’ve found our happy medium,” he says. “We have this very unique system, this intertwining of the public and the private, and it doesn’t always work out well. But for the American psyche, it satisfies everyone and dissatisfies everyone equally. And that’s why I think it’ll stay.”

As the debate continues, it’s worth remembering that Big Pharma and Big Hospitals are at each other’s throats because something’s wrong. Fixing it is the great challenge. It’s a lot harder than placing blame. 

Putting a price on a miracle drug

Why America’s most expensive medication is worth the money.

What is the net benefit to society of Zolgensma? It is America’s most expensive drug, at a price of $2.1 million for one course of treatment. Made by pharma giant Novartis, the gene therapy medication appears to cure a rare childhood disease called spinal muscular atrophy. In its worst form, “affected children never sit or stand,” says the National Institutes of Health, and “the vast majority usually die of respiratory failure before the age of 2 years.”

Now, with a one-time treatment of Zolgensma, doctors can envision those children growing to adulthood. “And not only that—those kids will walk,” says Jay Want, executive director of the Peterson Center on Healthcare. “At what price do you help a child walk and live a life they otherwise wouldn’t have had?” 

Such questions may seem unanswerable, but the Institute for Clinical and Economic Review (ICER) tries to answer them; it evaluates whether drugs are worth their costs. While it’s an independent nonprofit with no official authority, its analyses seem to have affected pricing decisions. David Whitrap, a vice president at ICER, says his organization judges only 25% to 30% of the drugs it analyzes to be worth their costs—and Zolgensma is one of them. “That price lines up with its benefits,” he says. “There are drugs out there that might seem much less expensive, but to us, they’re also less valuable to the system. And those prices might need to come down so we can afford the Zolgensmas of the world.

This article appears in the April/May issue of Fortune with the headline, “Big Hospitals vs. Big Pharma.” Correction: A previous version of this story misstated the name of the Department of Veterans Affairs.