States Go to Court in Effort To Rein In Costs of Medicine

The beleaguered pharmaceutical industry faces a new assault from a growing number of state prosecutors who are exploring action to bring down soaring drug costs.

The industry is already wrestling with a wide range of lawsuits and investigations by states reeling from the cost of Medicaid, the joint state-federal health-insurance program for the poor and disabled. Now more than 35 states are working together in hopes of repeating the success of the nationwide campaigns that led to the $208 billion tobacco-industry settlement and the pursuit of antitrust sanctions against software giant Microsoft Corp. Officials from the states have been exchanging tactics and took part in a conference call two weeks ago to organize a drug-pricing task force.

Mounting Pressures

The threat of a coordinated legal attack comes as the drug industry faces mounting pressures over prices. In Washington, a group of big companies and governors are lobbying Congress to help generic drug makers compete against brand-name rivals. In Boston and Philadelphia, federal prosecutors appear to be broadening investigations of pharmaceutical makers' pricing practices. The drug companies also face class-action suits from a coalition of consumer groups alleging that the companies engaged in deceptive and illegal acts to drive up medicine prices.

5th in a series: See previous articles in series1

Medicaid costs to states have shot up more than 25% over the last two years, partly because of drug-price increases. But the drug industry has mounted stiff resistance to any legislative effort to impose tighter cost controls.

That's why states collectively are looking more toward the courtroom. "Strength in numbers allows us to go toe to toe" with drug companies, says Ohio Attorney General Betty Montgomery, chairwoman of the new task force. "By the time we're done we will have an overwhelming majority of the states."

In a case scheduled for trial next year, Texas has charged three drug makers with falsely reporting wholesale prices to the state, leading to overcharges to Medicaid. California is contemplating similar legal action.

On another front, states are targeting efforts by brand-name makers to extend patents on their blockbuster drugs and keep generic versions off the market. In December, 29 states sued Bristol-Myers Squibb Co., alleging the company made false statements to federal regulators to extend its patent on the antianxiety drug Buspar. Bristol-Myers declined to comment.

Broader Aim

Earlier this year, Nevada and Montana took even broader aim at the industry. The two states, helped by a private law firm that successfully sued the tobacco industry, allege that at least 17 drug makers and their affiliates defrauded consumers by abusing a system designed to guarantee Medicaid the lowest drug prices available.

Wyeth, named in the Montana and Nevada suits, said it couldn't comment specifically on litigation but that it "will vigorously defend itself in these cases."

Many of the companies already targeted in lawsuits and investigations won't comment on specific legal matters, other than to say they will cooperate with the investigations and defend themselves against any charges that result.

In general, though, the industry has maintained that the government pricing rules that they are accused of violating are vague and that states hadn't previously contested their varying interpretations of these rules. If there are problems with the rules, says drug-industry defense lawyer Paul Kalb, the solution should be legislation, not legal action.

More cases are in the works. Pfizer Inc. last week disclosed that several state attorneys general are studying its marketing of a $1.75 billion epilepsy drug. Pfizer says it is cooperating with the investigation. Eli Lilly & Co. recently reported in a regulatory filing that Massachusetts had subpoenaed it in an investigation of alleged overcharging of the state's Medicaid program. Lilly says it is cooperating in the investigations and believes its practices have been lawful.

Much of the state prosecutors' interest can be traced to two cases brought by federal prosecutors. Early last year, Bayer Corp., the U.S. arm of Germany's Bayer AG, settled federal charges that the company falsely inflated the average wholesale prices, or so-called AWP, it reported to the government of drugs for hemophilia and immune disorders.

By inflating average wholesale prices and then selling drugs to doctors at a deep discount, prosecutors said, Bayer boosted the reimbursement doctors got from Medicaid and thereby encouraged them to use the company's medicines. The government alleged the actions caused Medicaid programs to overpay for medicines. Bayer also settled allegations that by failing to account for discounts made to some customers, the company underpaid Medicaid programs rebates they were owed.

Attention Getter

Bayer agreed to pay a $14 million fine, but the settlement caught the interest of attorneys general for another reason: The company agreed to change its pricing behavior. Bayer signed a five-year "corporate integrity agreement" under which the company pledged to report the actual average selling price of its drugs to help the government set fair reimbursement rates. At the time of the settlement, Bayer said it believed its pricing practices "were consistent with industry standards" and that its reporting of prices to the government were truthful and in compliance with the law.

Bayer added that it was "the only one of some two dozen pharmaceutical manufacturers under investigation to work cooperatively" with federal and state officials to "improve the Medicaid reimbursement system."

Another milestone came in October, when TAP Pharmaceuticals Products Inc. paid $875 million in federal fines for fraud and overcharges, mostly to Medicare, the federal health-care program for the elderly. The settlement by TAP, a joint venture of Abbott Laboratories and Takeda Chemical Industries Ltd. of Japan, was the largest ever for health-care fraud.

In that case, brought by the U.S. attorney in Boston, states saw how much money could be recouped: the $875 million in fines paid by the company, which involved just its cancer drug, Lupron, included $56.7 million to be divided among 50 states to compensate them for Medicaid overcharges. TAP also agreed to report actual average prices paid for its products rather than the AWP. At the time, TAP admitted it had wrongly given free drug samples to doctors knowing they would seek government reimbursement for them. But TAP officials said the company "consistently complied with pricing laws and regulations."

Both the Bayer and TAP cases involved tips from whistleblowers, who shared some of the proceeds from the settlements. Prosecutors say both exposed price manipulation by drug companies that now point the way for further investigation by state and federal law-enforcement officials.

James Sheehan, a federal health-care prosecutor in Philadelphia, says there's a lot more public data on drug-industry practices that "attorneys general could take a hard look at" than there were three or four years ago.

In March, Schering-Plough Corp. disclosed that Mr. Sheehan's office subpoenaed several employees to appear before a grand jury. The investigation, the company said in a regulatory filing, appears to focus on cut-rate services Schering-Plough provided to managed-care companies as inducements for them to keep certain drugs on their "preferred" lists. The investigation may be examining whether those inducements were really kickbacks or disguised discounts that led Medicaid to pay too much for drugs, the company said. Schering-Plough says it has been cooperating with the investigation. Mr. Sheehan declines to comment on the matter.

A case filed in September 2000 in state court in Travis County, Texas, provides a rough blueprint of how prosecutors believe this alleged price manipulation could work. As in the Bayer case, Texas lawyers claim three companies -- Dey Inc., Roxane Laboratories Inc., a unit of Germany's Boehringer Ingelheim GmbH, and Warrick Pharmaceutical Corp., a unit of Schering-Plough -- took advantage of complex Medicaid reimbursement rules to create a financial incentive for pharmacists to choose their asthma inhalers over competitors'.

Texas says the companies reported inflated average wholesale prices to Medicaid while charging other bulk purchasers of the inhalers considerably less. Since Texas Medicaid reimbursed based on the reported price, prosecutors say pharmacists pocketed the substantial difference. Texas alleges that that made it more lucrative for them to fill prescriptions with the three companies' products. The state is seeking a total of $78.3 million from the companies.

Sticker Price

Attorneys for the companies deny the charges. AWP is a "sticker price" subject to negotiations, says Warrick attorney C. Michael Moore. "Everyone in the industry knows that ... It's not a big secret, and it's not a big conspiracy."

Still, the case already has caused Warrick to lose business. After a state audit prompted by the affair, Texas cut Warrick's inhaler reimbursement rates to $6.26 from $16.79 per unit. The company's share of the state Medicaid market for a popular size of asthma inhalers dropped to 42% from 71% in less than two years, according to an affidavit by Martha McNeill, head of Texas Medicaid's drug program.

California is pursuing a similar case. In November, attorneys in the Texas case got a letter from California Deputy Attorney General William Schneider that said his state was "conducting an extensive investigation into possible fraud and other wrongdoing by various pharmaceutical companies through price manipulation." California officials decline to elaborate.

Earlier this year, in one of the broadest actions yet, Nevada filed two suits naming a total of 17 companies and affiliates and reserving space at the defendants' table for future targets, now known only as John Does "1 through 100." Nevada accuses the companies, which include such brand-name makers as GlaxoSmithKline PLC and AstraZeneca PLC, both based in Britain, of using the same illegal sales practices as in the Bayer and TAP cases.

A GlaxoSmithKline spokeswoman says the company's pricing practices are "legal" and have been "well-known and accepted" by the government, insurers and other private payers for years, and that the company will "defend against these charges." AstraZeneca officials weren't available for comment.

The Nevada suits go well beyond Medicaid fraud and antitrust claims. The state contends the companies employed "deceptive practices" that constituted a consumer fraud that hurt all Nevada residents. Moreover, Nevada says the drug makers, through a pattern of behavior, operated a racketeering "enterprise."

"We're trying to assert every possible claim of relief," says Tim Terry, chief of the Nevada Medicaid fraud unit.

A broad legal attack by states would be difficult for drug makers to defend against. That's partly because the companies wouldn't be able to join forces as easily as their adversaries in state government because of antitrust strictures. The industry's powerful trade group, the Pharmaceutical Research and Manufacturers of America, which is orchestrating the industry's counterattack on its legislative foes, is forbidden from rising to its members' defense on pricing matters.

One defense would focus on the role of the AWP, which is calculated by the industry. Drug companies say it has been widely known for years that the AWP doesn't reflect the actual market price.

Mr. Kalb, a partner in the Washington office of law firm Sidley Austin Brown & Wood, who represented Bayer in its settlement with the government, says "government officials cannot credibly claim to be shocked" by the fact that a drug's AWP is typically much higher than the drug's market price.

But he adds: "The pressure from so many sources is significant," and says he envisions "an increasing number of manufacturers agreeing to work creatively with federal and state governments toward a reasonable solution."

Write to Andrew Caffrey at andrew.caffrey@wsj.com², Scott Hensley at scott.hensley@wsj.com³ and Russell Gold at russell.gold@wsj.com⁴

Updated May 21, 2002 12:38 a.m. EDT

Death of Pfizer's 'Youth Pill' Illustrates Drug Makers' Woes

NEW LONDON, Conn. -- William Landschulz, a Pfizer Inc. doctor, brimmed with anticipation as he strode through the company's research headquarters to a hastily called meeting last August.

Dr. Landschulz, a boyish 42-year-old endocrinologist, was leading the clinical trials for one of the most exciting drug candidates at Pfizer in years. Code-named CP-424,391, it was a once-a-day pill with the potential to be a fountain of youth.

By stimulating the pituitary gland, the experimental drug aimed to reverse the physical decline that comes with aging, to make old people feel young again and to keep legions out of nursing homes. The treatment, in which Pfizer had already invested tens of millions of dollars during nearly a decade of research, also had a shot at becoming the ultimate lifestyle drug for baby boomers by offering them vigor in old age instead of frailty.

Dr. Landschulz was optimistic about the early results of an ambitious clinical test. But the moment he entered the cramped, windowless conference room where several senior scientists had been analyzing the data, he knew the results were bad. "Only my boss looked at me," he recalls. "All the rest of them looked away."

What happened to Dr. Landschulz's frailty pill helps illuminate a big reason the price of drugs is surging: Despite the best science that money can buy, including the recently unlocked secrets of the human genome, discovering new medicines has become vastly harder. Researchers have unearthed many of the easiest cures and treatments, and drug makers have been largely unable to find replacements for familiar blockbusters that are losing their patent protection. Adding to the difficulty: the task of managing research operations that have ballooned after a wave of drug-industry mergers.

For Pfizer, the world's biggest drug company, the failure of the frailty drug was a deep disappointment. Even a thriving drug company counts on a small percentage of substances turning into spectacularly successful drugs to more than make up for the many costly busts.

Of the 18 major drugs that Pfizer markets for annual sales of $26 billion, eight bring in more than $1 billion each in sales annually and together account for 76% of total drug sales. They include the anticholesterol pill Lipitor, antidepressant Zoloft and the blood-pressure drug Norvasc. During the next five years, four of the eight will lose patent protection.

In the past three years, Pfizer has struggled to find replacements, launching only one new medicine on the U.S. market that was discovered by company researchers, a schizophrenia treatment called Geodon, with sales of $150 million in 2001. Its last blockbuster was Viagra, launched four years ago. Despite a strong first quarter, Pfizer warned last month of a sharp decline in profits for the current quarter. This year, the company expects to plow $5.3 billion into the hunt for new treatments, five times more than it did a decade ago. During the next five years, Pfizer expects to file for or receive U.S. marketing approval for 15 new medicines, 12 of which were discovered by Pfizer scientists.

The drug makers in the industry's main U.S. trade group as a whole spent $200 billion on research during the past decade, including more than $30 billion last year alone. Yet the 24 new drugs approved last year for marketing in the U.S. represented the lowest total since 1994, and very few of them, such as the novel cancer treatment Gleevec, appear to have blockbuster potential.

Drug companies point to the high rate of research failure as the reason why new drugs, particularly breakthrough medicines, are so expensive. With each step forward -- from first concept to test tubes, to animal experiments, then into human trials -- the cost of research increases astronomically. Failure late in the process, when investors are counting on a new product, can send a company's stock price plunging. That happened at Bristol-Myers Squibb Co. earlier this year when its much-anticipated blood-pressure drug Vanlev failed to live up to expectations in testing.

The challenges to developing Pfizer's frailty drug, which would have been a new class of medicine, were especially daunting. Last year, Pfizer Chairman Henry McKinnell cited the decade-long project as an example of the protracted, high-stakes research that only the biggest pharmaceutical companies can afford. The often-cited statistic, that only one in 10 drugs in clinical trials goes into production, actually understates the rate of failure: Pfizer says only one in many thousands of chemical compounds that its scientists discover make it to market.

The frailty-drug project began more than a decade ago when Pfizer decided to look for osteoporosis remedies, a new field for the company. Osteoporosis is a serious weakening of bones that comes with aging. Pfizer hired David Thompson, a seasoned researcher in the area from Merck & Co., to lead the effort with a multidisciplinary team of biologists, chemists and clinicians.

Early Brainstorming

In early brainstorming sessions, Dr. Thompson and his colleagues observed that bones become weaker when the muscles that pull on them atrophy because of age or injury. Some research suggested that muscles shrink in old age because the amount of natural hormone that triggers their growth and is produced by the pituitary gland declines steadily after age 35.

So Dr. Thompson's team began searching for a chemical that could prod the pituitary, the peanut-sized gland located deep inside the brain, to produce. It would be a pill -- far more convenient than an injection -- that would boost the amount of growth hormone the pituitary squirts into the bloodstream but wouldn't otherwise change how the hormone was released. The researchers believed the restoration of youthful levels of growth hormone would increase muscle mass, reduce fat and improve people's ability to perform everyday tasks.

The team searched for clues in scientific papers and talked with academics. When they started, no one knew the identity or structure of the switch, or receptor, on the pituitary cells. Industry scientists typically probe such receptors as a shortcut to designing new drugs.

University researchers had identified particular small protein fragments called peptides that could stimulate the pituitary, though the exact mechanism was unknown. Dr. Thompson's team looked for a stable chemical that could do the same thing. In less than a year, he says, "we found a molecule we really liked" in the library of compounds that Pfizer maintains for its researchers.

Lab tests at Pfizer showed the favored chemical raised growth-hormone levels in young and old rats. The finding proved that while the pituitary secreted less growth hormone in old age, that didn't mean it couldn't be coaxed into producing more with the right chemical nudge. This proof of the key principle behind the drug was crucial in convincing management to proceed from research into the development of medicine that could be tested in humans.

Pfizer pushes its researchers to put compounds to definitive early tests. If a compound proves promising, the research team can nominate it for classification as a formal "drug candidate." At Pfizer, this rite of passage from research to development is signaled officially by a "Candidate Alert Notice" entered into the company's tracking system. But everybody in research refers to it as being "canned," which in this instance is a good thing.

David Clark, an organic chemist, chairs a committee of scientists who decide whether to approve drugs for heart disease, stroke, diabetes and obesity. A canned drug has already become a star. Fewer than half of the compounds investigated by Pfizer's discovery scientists in earnest make it this far. These successes are anointed with millions of dollars in funding to support clinical tests of safety and effectiveness.

About a sixth of Pfizer's portfolio of drugs in development were approved by Dr. Clark and his colleagues, including the frailty drug, which got the green light in December 1995. He was confident the frailty compound would succeed, ranking it among the top third of candidates at the time.

But even among the fortunate drugs that pass muster initially with Dr. Clark's committee, the odds remain stacked against their ever making it to market. Dr. Clark's group also guides the researchers, funds interim studies and establishes milestones for judgment. And at any point Dr. Clark's committee can kill the very projects it has approved. Last year, the committee terminated research on five of seven promising medicines it had previously "canned."

The growth-hormone project quickly surpassed all the researchers' expectations. From the time the project was canned, it took only nine months to develop a drug that was safe enough to test in humans -- a speed record for the research center in Groton, Conn., across the river from administrative headquarters in New London. The drug "had no bumps or warts," marveled Gordon Gruetzmacher, project manager for the frailty drug.

Though increasingly optimistic, Pfizer scientists and managers were sober about the challenges the potential new medicine faced -- especially the elusive nature of the condition it was intended to treat. Frailty, which they came to define as an "age-related decline in physical performance," wasn't a recognized disease, like osteoporosis or Alzheimer's.

A drug to treat the chronic condition, like many the industry is now tackling, would require lengthy and especially expensive clinical studies because its effects might be subtle and take months or years to understand. To make sure that an experimental drug deserves such a sizable investment, Pfizer blends marketing with R&D early on. A marketing specialist works with each drug team to ascertain commercial merit. In particular, will the drug meet a compelling unmet medical need and will Pfizer be able to differentiate its medicines from those of its competitors?

For the frailty drug, researchers believed they would have to show that it could do more than boost hormone levels or even muscle growth. Early talks with the Food and Drug Administration confirmed the higher standard. Insurers, too, would need evidence that the frailty drug would be worth their expense.

To persuade regulators and insurers to embrace the drug, the Pfizer team aimed to prove beyond a doubt that elderly people who took it could walk faster and longer and avoid the kinds of falls that force many of them into nursing homes.

Such a drug also could appeal to a younger, healthier but worried market, people who might use the medicine as a lifestyle enhancer, like Viagra, decades before they faced a real danger of frailty. For Pfizer, a medicine to stave off the ravages of old age, unlike an antibiotic taken for a week, could provide a long-term revenue stream: "People will take it for 20 or 30 years -- it'll be like a vitamin," predicted John LaMattina, a senior research executive, early last year.

In late 1996, the frailty drug hit its first setback when an otherwise healthy man participating in a small safety study in the Netherlands developed a mysterious, mild rash. The test was halted while the team investigated. The cause was never found, though the leading theory remains that he had a reaction to laundry detergent or hand soap. After a few months, the team concluded that the drug was safe enough to continue.

Pfizer recognized the growth-hormone workers as the best research team of 1996 for their trail-blazing accomplishments. And they continued on the fast track, initiating in late 1997 a larger clinical test of the drug, involving 114 people who randomly received one of four different doses or a placebo for a month. At this stage, the researchers sought to substantiate the safety of the drug and to pinpoint the best dose to use in subsequent tests of effectiveness.

Happy Surprise

To their happy surprise, the scientists found that even a one-month regimen with the experimental drug produced measurable growth of muscle. "It was great," Dr. Gruetzmacher recalls, "We didn't expect an increase in less than six months."

Though encouraging, the results didn't prove the drug was working. The test could have been a fluke. Besides, increases in muscle mass, even if they were real, wouldn't convince regulators to approve the drug, everyone had previously agreed. After lengthy discussion, the team decided to propose a six-month trial of the drug to Dr. Clark and his committee for approval and funding.

But the scientists realized that showing that the drug halted or reversed aging would take months or even years. Dr. Clark pushed the research team to reconsider its time frame and "go for the home run" by pursuing a longer and much more expensive test that could detect subtle improvements in patients' ability to function.

The team took six months to design a trial that would provide a definitive answer on whether the drug worked. They eventually proposed a two-year study in elderly patients that would measure muscle and some biochemical markers in the bloodstream. They also would test the subjects' walking speed and endurance and their ability to get in and out of a chair.

Dr. Clark's management committee agreed to fund the study in about 350 patients, much larger than usual for such an early stage. To hedge the outsize bet and ensure that the project was on track, the study included interim analyses at six and 12 months.

Last summer, three senior managers unconnected to the project, including a statistician, were chosen to review the data after six months. As outsiders, they were expected to be unbiased, and they would share their findings with only a few senior managers.

In less than a week, they had reached their conclusion and called Dr. Clark. He decided to break the secrecy and inform the research team of the news.

The patients taking the frailty drug had gained some muscle mass -- but less than 3% more than the placebo group, which had also experienced muscle increases. There were no safety problems with the drug. But the study was stopped within a month because the drug appeared ineffective.

Nobody is quite sure why. One theory is that the patients selected for the study may have been too healthy, so there was less room for improvement in the treated group. Another idea is that the drug caused the pituitary gland to release growth hormone in a way that was out of tune with the body's system for using it.

In the end, Dr. Clark's committee "took pity on us," Dr. Landschulz says, and allowed the team one last chance to salvage the medicine. They were permitted to collect and analyze data on the group of early patients in the study who had taken the drug for a year -- just in case its effectiveness emerged later than six months.

That was a long shot, everyone agreed, but worth the modest incremental expense. The final analysis was completed this spring, and the results were the same.

Later this month, Dr. Clark's committee will review the file one last time and officially lay to rest the frailty drug, which Pfizer says cost the company $71 million to research and develop.

Write to Scott Hensley at scott.hensley@wsj.com³

Updated May 2, 2002

Why Drug Makers Are Failing In Quest for New Blockbusters

In laboratories around the world, scientists on the hunt for new drugs are coming up dry. Patents on one blockbuster drug after another are expiring. Managed-care companies are successfully pushing patients away from high-priced new drugs and toward cheap generics.

The $400 billion-a-year drug industry is suddenly in serious trouble. After nearly a decade of double-digit growth, highflying stocks, and some of the world's loftiest profit margins, one big company after another is taking a beating. Analysts estimate that combined profits at the nation's top nine drug makers grew by less than 1% in the first quarter of 2002.

Victims include industry giants Bristol-Myers Squibb Co., Merck & Co., Eli Lilly & Co., Schering-Plough Corp. and Bayer AG, nearly all of which have lost sales of many of their old standbys to low-cost generic drug manufacturers. Merck has seen its shares slide more than 40% since the start of 2001. Lilly reported this week that its profits dropped 22% in the first quarter. Schering-Plough is facing the loss at the end of this year of most of the sales of Claritin, which last year provided more than half of its high-profit U.S. drug sales. GlaxoSmithKline PLC could be the next to feel the pinch: It is expected to lose patent protection next year on four drugs with nearly $3.9 billion in annual U.S. sales.

Consumers stand to benefit in the short term, as best-selling drugs such as heart-burn remedy Prilosec, allergy treatment Claritin and antibiotic Cipro become available in cheaper generic versions. But, in the longer term, the newest treatments promise to get more expensive, as the industry invests more in research and development and gets less out of it. Meanwhile it will continue routine price hikes on its existing drugs.

The likely outcome is worsening battles among the drug industry, managed-care companies, and federal and state governments over drug prices. Increasingly, the newest drugs are only slightly better than older, much cheaper medicines. Nonetheless, the industry's growing blitz of consumer advertisements drives patients to demand them.

The industry's latest flare of distress is coming from Bristol-Myers, which has spent $16.5 billion on R&D since 1990, without producing a single new star of its own. In the past few months, three of the New York-based company's biggest-selling drugs -- Taxol for cancer, BuSpar for anxiety and Glucophage for diabetes -- have lost most of their sales to generic competitors. Bristol-Myers thought it had lined up potential replacements, but so far it's had nothing but disappointment.

Days before Christmas, federal regulators refused even to consider the application to market a cancer drug produced by Bristol-Myers's partner, ImClone Systems Inc. And last month, Bristol-Myers researchers reported that their studies of the company's new blood-pressure pill, now under review by the Food and Drug Administration, found the drug less effective than expected.

Partly as a result, Bristol-Myers has warned that its earnings this year will be only about half those of last year, when it reported income from continuing operations of $4.74 billion on revenue of $19.09 billion. Since 1999, Bristol-Myers shares, which trade at around $32, have lost about two-thirds of their value. This week, Bristol-Myers fired its chief financial officer, and its CEO is on notice from the board that he has to shape up.

The industry is caught in a gap between an old way of developing drugs that's increasingly tapped out, and a new way that isn't yet bearing a lot of fruit. For decades, drug makers have focused their R&D efforts on enzymes, chemicals that serve as catalysts for most of the body's functions. Cholesterol drugs Lipitor, Zocor and Pravachol, for instance, work by inhibiting an enzyme in the liver that the body needs to make cholesterol.

But there is a growing sense among researchers that many of the body's major enzymes have already been fully exploited. "I think there are a limited number of enzymes that you can target in some systems, and many of those targets have already been dealt with," says Peter Kim, deputy chief of Merck's research operations.

For long-term relief, industry executives are looking to gene hunting. They hope to discover the genetic roots of most chronic diseases and use that knowledge to devise novel treatments. But they generally don't expect to see any big payoffs from the new technology until the end of the decade.

"People got way too excited about the genome being unlocked," says Fred Hassan, chairman and chief executive of Pharmacia Corp. "Five to 10 years from now, it might help our product flow. In the meantime, the industry is going to go through rough times."

Growing Desperation

One sign of the industry's growing desperation for new products is the rising price drug makers are willing to pay for discoveries made outside their labs. In 1992, Bristol-Myers licensed the best cancer drug of the day, Taxol, for a 0.5% royalty. Last year, it licensed Erbitux, one of many good cancer prospects, for an upfront investment of $2 billion, plus a 60% royalty. (Erbitux is the drug that federal regulators later refused to consider.)

The pharmaceutical industry has survived hard times before. And while its fortunes have declined, it is still producing profits. Moreover, the nation's demographics continue to favor the industry's long-term growth. Prescription-drug spending by Americans tends to increase sharply with age. But much of that growing market is likely to be served by cheap generics.

Brand-name drug makers have come under increasing pressure from generics since 1984, when Congress passed the Hatch-Waxman Act, creating the modern generic-drug industry. The law reduced the amount of testing generic-drug makers had to do in order to market their products. Those requirements previously had presented such a hurdle to generics that branded drugs often continued to post strong sales for decades after their patents expired.

But within a year of the bill's passage, nine of the industry's 10 best-selling drugs had new generic rivals. Suddenly, pharmaceutical giants found themselves facing precipitous sales declines after their drugs lost patent protection, rather than a long, slow tapering off.

The Hatch-Waxman law put the drug industry on an innovation treadmill. If its labs didn't produce new products, the companies would eventually collapse, as generics snatched away their sales.

At first, the industry adjusted to this new reality with one of its most well-worn tools: price increases. Since there were few large medicine buyers back then, the industry could raise prices almost at will. If a patent expired on one of a company's drug, it could jack up prices on its others.

"All through the 1980s, a lot of the industry's growth came from price increases," says Raymond V. Gilmartin, chairman and chief executive of Merck.

The rise of managed health care in the early 1990s changed all that. In 1990, most drugs were bought with consumers' out-of-pocket money. Now, most drugs are bought by huge purchasers like managed-care health plans. If drug companies don't offer discounts, they lose sales to a competitor's pills; hefty price increases have become less common. As the decade progressed, managed-care companies became increasingly adept at holding down costs by promoting generics. Many hired pharmaceutical-benefit managers, such as Merck's Merck-Medco unit, who used their phone banks to press doctors to approve switches from name-brand drugs to their generic equivalents.

In August 2000, when Merck lost its patent on Vasotec, a blood-pressure drug, the drug's sales dropped two-thirds within three months. When Lilly's antidepressant Prozac lost its patent in August 2001, generics stole 80% of the drug's new prescription sales within two months, according to Atlanta-based market researcher NDC Health. Lilly was surprised by the drug's breathtaking collapse. Merck-Medco, meanwhile, boasted of its success in switching patients to generic Prozac.

The collapse of Prozac was a landmark for another reason. Through the 1980s and 1990s, when a branded drug lost its patent, sales of branded competitors often improved. When Tagamet lost its patent in 1993, for example, sales of other branded heartburn pills soared, even though they cost many times the price of generic Tagamet.

The reason: doctors get most of their information about drugs from drug-company salespeople and used to prescribe the pills that are pitched to them. By contrast, generic companies, which operate on razor-thin margins, can't afford to send legions of salespeople to doctors' offices.

Now, doctors largely prescribe drugs approved by patients' insurers to avoid patient complaints and harassing calls from managed-care pharmacists. As a result, the balance has shifted to generics. In 1986, less than a quarter of prescriptions were filled by generic pills. Last year, it was nearly half. Prozac's main competitors are Pfizer Inc.'s Zoloft, GlaxoSmithKline's Paxil and Forest Laboratories Inc.'s Celexa. Each drug works in a similar way. With a generic version of Prozac available for pennies per pill, there is little scientific reason for doctors to prescribe Zoloft, Paxil or Celexa unless the patient is already on one of those drugs or has tried Prozac and found it didn't work. Marketers for each company nonetheless are fighting for their drugs, but managed-care formularies favor generic Prozac.

After Prozac lost its patent protection last year, the growth of new prescriptions for each of its branded competitors fell by at least half, according to NDC Health. Kaiser Permanente, the big California health-maintenance organization, says that its 11,345 doctors now prescribe generic Prozac to about two-thirds of patients who need an antidepressant for the first time, twice the proportion who took branded Prozac a year ago.

None of that would matter so much if drug companies' labs were producing innovative new therapies. But, these days, launches of breakthrough drugs -- such as Novartis's Gleevec, brought out last year to wide acclaim because it led to the recovery of some near-death leukemia patients -- are few and far between.

Last year, the drug industry spent $30 billion on research, more than three times what it spent in 1991, according to the Pharmaceutical Research and Manufacturers of America, a Washington-based trade group. But the industry launched just 24 new drugs last year -- half the number it did in 1996. According to a 2001 study by Tufts University, it now costs about $802 million to discover and develop a new drug, two and a half times what it did in 1987, in inflation-adjusted terms.

One of the subtler causes of the major drug labs' slowing productivity is that there are already so many good drugs on the market. Heart disease, for example, is the nation's biggest killer and a potentially profitable area for drug discovery because patients typically take the same heart drugs for years. But cholesterol pills already available -- Lipitor, Zocor, Pravachol, Lescol -- can safely cut a patient's cholesterol levels by as much as 45%, a remarkable accomplishment.

Similarly, to treat high blood pressure, doctors have an entire arsenal at their disposal -- diuretics, beta blockers, angiotensin-converting enzyme inhibitors, angiotensin II receptor antagonists and calcium-channel blockers. All attack the condition in a different way. Many of them are available in generic versions. That means a new drug would have to be extraordinarily effective in order to find a market, especially at a premium price.

Many of the industry's most productive labs have managed to remain so by frequently launching drugs that are only slightly better than those already on the market. Then they charge a premium for these incremental improvements.

AstraZeneca PLC is among the drug makers pursuing that strategy. The London-based company will soon lose U.S. patent protection on its huge-selling heartburn drug, Prilosec. Last year, in an attempt to hang on to some of Prilosec's $6 billion in annual sales, AstraZeneca launched Nexium.

Now, it is feverishly trying to convert Prilosec users to the new medication. But Nexium is at best 3% better than Prilosec in curing one form of heartburn, according to a company-sponsored test. That means managed-care companies will have to decide whether to pay a lot more for Nexium's small measure of superiority once generic versions of Prilosec hit the market in coming months.

New Cholesterol Pill

This year AstraZeneca says it plans to launch a new cholesterol pill called Crestor that may be slightly more effective than those already available. Whether managed care will pay a premium for the pill once generic versions of competitors' Pravachol and Zocor reach the market in 2006 is uncertain.

"Drugs like Nexium are a desperate attempt to save sales from nearly identical drugs losing patents," says Sharon Levine, associate executive director of Kaiser Permanente. "Generics are a real value."

AstraZeneca declined to comment.

Many executives and industry watchers believe the dearth of big new drugs will force the industry to consolidate further. But Robert Temple, a top FDA official who oversees many new drug applications, says consolidation has been one of the chief causes of the industry's diminishing lab productivity. "I can't believe that when you take two or three companies all frantically producing drugs and put them together that they produce as many drugs," he says.

Pfizer may be a case in point. Two years ago, it absorbed Warner-Lambert Co. in a hostile takeover, and it is now one of the few healthy drug companies. The takeover left Pfizer with more than $32 billion in annual revenue. To ensure that its double-digit sales-growth continues, Pfizer would need to launch at least two or three billion-dollar drugs every year. But Pfizer, despite annual research spending that this year will likely amount to $5.3 billion, hasn't introduced a big seller of its own since Viagra, in April 1998.

At GlaxoSmithKline, which has undergone three big mergers in the past decade, Chairman and Chief Executive Jean-Pierre Garnier was concerned that his company's vast size might impede its lab productivity. So, he recently split the company's research operations into six largely independent labs, each targeting different diseases. "The industry is spending 15 times what it did 20 years ago on research, but our organizational structures haven't changed much at all," says Mr. Garnier. "You want creativity. You don't want layers."

At the very least, large drug companies are loosening their ties. "Trying to to industrialize research and assuming that if you regiment people they will deliver is just not true," says Novartis's Dr. Vasella. "You can't be corporate in discovery."

Write to Gardiner Harris at gardiner.harris@wsj.com³

Updated April 18, 2002 11:59 p.m. EDT