Updated: Feb 24, 2021
If you're curious and want to read more, here are the business model posts so far:
2. Big Pharma
Now, moving onto #8 in the series...
Ever had a hip replacement? Or know someone who has? What about a catheter? Maybe an insulin pump? In this business model breakdown, we'll take a look at the lucrative, medical device industry.
Laying the Foundation
Medical devices, like pharmaceutical drugs, are regulated by the FDA (Food and Drug Administration). However, not all devices need to be approved before companies can market them. Some low-risk devices don't even require an FDA sign-off.
Here's how it breaks down.
Medical devices are classified in three ways: Class I, Class II, and Class III
Class I devices make up 35% of all medical devices and 93% of these don't even require 501(k) pre-market notification, which is the least rigorous FDA review.
Class II devices, which make up 53% of devices, do require 501(k) clearance.
This is less strict than Class III devices, which must go through pre-market approval (PMA). These devices "sustain or support life, are implanted, or present potential high risk of illness or injury."
Put another way, medical devices aren't regulated as strictly as drugs, which makes sense. Drugs are ingestible and some medical devices, such as surgical gloves, don't need to be rigorously tested. Drugs are all required to receive pre-market approval. Whereas only Class III medical devices need to pass PMA. It is a higher bar because the law mandates "safety and effectiveness."
Naturally, the "safety" part is expected, but in medical devices, the "effectiveness" part is the difference between 501(k) and PMA. The former, less stringent of the two, only requires a device to be "substantially equivalent" to a product already on the market. Whereas, a PMA needs to be more effective or a completely new device.
To put it in perspective, each year, the FDA receives about 50-70 PMAs and over 4,000 501(k)s for medical devices.
Further, just like drugs, the gig doesn't stop at manufacturing. You actually need to market and sell the new product.
And here's where is gets even trickier.
Medical devices are typically broken up into two categories, which line up nicely with the three classifications. Conventional devices are made up of Class I and some Class II devices. These are low-risk like surgical dressings where suppliers have no real pricing power. The differentiation is scale. A medical device company selling conventional devices needs to sell a ton to make any money. In other words, the margins are low. The key here is getting long-term relationships with hospitals.
The other category is high-technology devices. These are made up of Class II and Class III devices. It is more difficult to get the corresponding clearance and approval and therefore, the competition is lower. For instance, there are only four main companies that make up about 95% of hip and knee replacements; the four are Stryker, Zimmer, Smith&Nephew, and Johnson and Johnson.
There is more differentiation in this category. Some physicians are already trained with certain devices and don't want to learn a new implantation technique. And obviously, doctors have influence with respect to the equipment that the hospital buys.
Last year, excluding research, 59% of physicians' compensation came from medical device companies. That's even higher than from drug reps. This just shows how lucrative the medical device industry is.
But another important question we must address is: how and who pays for all of these devices?
It's a nuanced question, so let's start with Medicare, the health insurance government agency. If you have paid into Medicare through taxes and are over 65, then you can qualify for Medicare. It is a giant and if it approves a certain device for reimbursement, then most private payors follow along.
To be clear, Medicare reimburses hospitals which bill patients.
This flow is important to the business model because it is all about who has leverage.
Hospitals buy from the medical device companies. So if the devices aren't differentiated, hospitals have the leverage to buy in-bulk. This is the case for conventional products and it is why the margins are low.
However, if a high-technology device comes along that will allow hospitals to save time and money, the device companies have the leverage and will therefore, have higher margins.
This is why Intuitive Surgical, a company that is a giant in the robotic-surgery space has done so well. Through the precision of the robotic arm and physician-assisted surgeries, recovery times decreased which allow hospitals to get more patients in and out. This means more revenue for the hospitals.
The tough part is making sure that insurance companies will provide the reimbursement though. If Intuitive Surgical came along and no insurance companies covered its robotic procedures, the hospitals would have no incentive to give it a shot. Plus, as mentioned previously, doctors have a huge influence in the buying process. If they must be re-trained, it sure as heck must be worth it!
So the real competitive advantage of a medical device company is making sure the device benefits a hospital while also having large coverage from insurance companies.
If a company can do that, it has a great shot of being a winner since switching costs are high and specifically, in Medicare, the payment rates are only updated every two years.
But this a hugely difficult proposition. Typically, high-technology devices need premarket approval, which is not a small task. Then, you need to get an NCD (national coverage determination). This is the part of the process where you get Medicare to cover your new product. Or, in the meantime, you can try to get a LCD (local coverage determination) where Medicare contractors can make a decision before the lumbering Medicare makes a call.
Next, you must reveal your value proposition to hospitals and that will probably take a decent-sized team of sales reps. And finally, once you have done all that, you need to make sure a competitor doesn't come in and make a better product than you. Granted, if you have done everything up until this point, the switching costs are high so the product has to a lot better which is fairly unusual.
Phew! That was a lot. Good job.
It is no wonder the some medical devices are extremely profitable and most go out of business or get swallowed up by the big players.
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