(FORTUNE Magazine) – PHARMACEUTICAL companies have long had the best deal in American business, a foolproof formula for turning chemical compounds into gold. The industry followed its own set of rules, raising prices at will, seemingly free from the market forces of supply and demand that weigh on the makers of computers, cars, and nearly every other consumer product. Drug companies apparently viewed cutting costs as beneath them, acting as though outsize profits were the market's reward for the special, research-intensive nature of their business. From 1988 to 1992 the earnings per share of the ten largest U.S.-owned drugmakers grew 18% a year, vs. 7% for the Standard & Poor's 500. Today a revolution is turning the sheltered world of pills and prescriptions into a tough, turbulent business. As part of a plan to transform the cost and delivery of health care, the Clinton Administration has launched a scalding attack on drugmakers, fanning public outrage over their high prices. The presidential task force, headed by Hillary Rodham Clinton, has threatened to shackle the industry with price controls and other onerous regulations. Why is Washington demonizing one of America's most revered businesses? The industry, after all, has turned out a stream of miraculous new products -- including treatments for heart disease, high blood pressure, and ulcers -- that have lengthened and improved the lives of millions and prevented billions of dollars in hospital stays. To take just one example, Merck's Proscar, the first drug to treat benign prostate enlargement, costs $600 a year. Surgery for the same condition might come to $3,000. But where credit is due, so is blame. The industry that has so improved patients' health has contributed mightily to rising health care bills. That, in a capsule, is the paradox of the drug industry. From 1985 to 1992, drug prices rose 80%, more than twice the rate of inflation. The increase was especially painful for America's biggest drug customers, the elderly. Because Medicare does not cover prescription drugs, most people over 65 pay from their own pockets. The cost of medication for chronic ailments is considerable. An elderly person with ulcers and angina would pay $800 a year to take both Pepcid and Vasotec, two medications from Merck. In 1987 the same drug combination cost $500 a year. The task force will not release its recommendations until later this spring. But the drug industry recently made a preemptive strike, announcing that it favors voluntary price controls for existing drugs. Ten companies, including Merck, Pfizer, and American Home Products, pledged to hold their average annual price increases to the rate of inflation, estimated at 3% for 1993. Merck CEO P. Roy Vagelos went even further, offering to refrain from raising the price of any one drug by more than the rate of inflation plus one point. The debate over health care reform will carry on well into next year. But no matter what happens in Washington, market forces are already bringing the lower drug prices that politicians and consumers seek. Two factors have converged to change the prognosis for the industry: The onset of managed care has altered demand, and a profusion of low-cost alternatives to high-priced drugs has increased supply. Managed care encourages the formation of large buying groups -- hospitals, HMOs, mail-order drug houses -- to drive the cost of pharmaceuticals lower. Under the Clinton Administration's prescription for health care reform, managed competition, that trend would accelerate. HMOs are under intense pressure to control drug costs for their clients -- U.S. corporations -- which pay 35% of America's $65-billion-a-year drug bill. Last year Ford spent $181 million on medicine, or $660 for every U.S. employee and retiree. Even though many Ford workers are in HMOs, its drug bill is growing 15% a year. To help corporations restrain drug costs, the HMOs and other large buyers are doing what is standard procedure in other businesses: In exchange for deep discounts, they are handing market share to one product at the expense of higher-priced competitors. They can do this because they have so many identical or similar drugs from which to choose. Pharmacy shelves teem with generics -- low-priced, exact copies of patented, brand-name drugs that appear when the patents expire. Why should an HMO allow its doctors to prescribe Eli Lilly's antibiotic Keflex, which costs $110 for a month's supply, when the generic copy cephalexin is available for just $14.93? Competition to the pioneering patented products also comes from so called me-too drugs. The me- toos are chemically different from the patented version but often treat the same ailment just as effectively and less expensively. Competitive pricing will force the drug industry to reformulate its lucrative chemistry. In the past, drug producers had three ways to generate earnings: introduce innovative, highly valued pharmaceuticals, launch me-too products, and raise prices on all drugs. Those strategies worked because the companies marketed almost exclusively to doctors, who had little concern for prices; after all, they weren't paying for the drugs. With competition, the second and third methods are becoming as useless as bleeding patients to banish evil humours. ''To make big profits, you need drugs that are totally different from anything else on the market,'' says Edward Bessey, vice chairman of Pfizer. THOSE all-important original drugs fall into two categories. The most important are the breakthroughs, usually the first effective treatments for a common ailment. They include Merck's $1-billion-a-year Mevacor, a cholesterol- lowering drug, and Cognex, Warner-Lambert's recently approved treatment for Alzheimer's disease. The second category comprises innovative drugs that follow the pioneer. These aren't me-toos. On the contrary, they have important new features. They might produce fewer side effects than the pioneer, or require lower dosages. An example is Pfizer's Procardia XL, a heart drug that gradually leaks medication into the bloodstream through a patented capsule. Procardia XL requires just one dose a day, vs. three for similar heart drugs. ''It used to be that almost everybody made money,'' says Jan Leschly, chief of the pharmaceutical division for SmithKline Beecham. ''From now on, it's the survival of the smartest.'' Among drug industry executives, the big worry is that the Clinton Administration might impose price restrictions on these new products. With the market paring prices anyway, controls on existing drugs would be painful though not disastrous. But industry executives worry that regulating new compounds could reduce the amount companies spend on research and development. ''Controls on new products would take the incentive out of doing the expensive, risky research needed for breakthrough drugs,'' says Kenneth Weg, head of the pharmaceuticals division at Bristol-Myers Squibb. Mitchell Daniels, who occupies the same post at Eli Lilly, is even more adamant: ''Price controls on new products would turn the industry into a regulated utility.'' Ronald Nordmann, an analyst at Paine Webber, has identified five U.S. companies he thinks will not only survive but also thrive in the drug industry's new world order -- and five others that will struggle. The haves, as he calls them, are Bristol-Myers Squibb, Merck, Pfizer, Schering-Plough, and Warner-Lambert. What sets them apart is fresh, original products and strong research. The five winners, Nordmann reckons, will raise earnings per share by 15% a year, on average, through 1997. Consider Pfizer. Nordmann expects its sales to grow 15% a year until 1997, even with minimal price increases. That's because Pfizer has introduced six important products since 1990, including Norvasc, the first heart drug likely to be approved to treat all three types of cardiovascular disease: high blood pressure, angina, and congestive heart failure. Another breakthrough is Diflucan, a medication for fungal infections common in AIDS patients and people on chemotherapy. Jack Lamberton of NatWest Securities predicts that the six products will generate more than $7.5 billion in sales by 1997. BY CONTRAST, Nordmann's have-nots -- American Home Products, Eli Lilly, Marion Merrell Dow, Syntex, and Upjohn -- count heavily on price increases to squeeze profits from their aging product line. Of Upjohn's 7% sales increase last year, five percentage points came from higher prices, and another one point from a foreign exchange windfall. The balance was a meager 1% increase in volume. Those price increases simply can't continue. ''From now on, companies that raise prices will just lose market share,'' says Neil Sweig, an analyst with Capital Institutional Services. Nordmann predicts the have-nots will raise earnings about 6% annually over the next five years, about average for the Standard & Poor's 500. While that's not bad, it's only one-third of their earnings growth over the past five years. Why have drug prices -- and profits -- stayed so high for so long? Contrary to the protestations of industry executives, expensive research isn't the main reason. Pharmaceutical companies do lavish money on research. In 1993 they will spend an estimated $11 billion, or 16% of sales, on R&D -- the highest share of any industry. But they pay even more to promote their products, as much as $14 billion a year, more than 20% of revenues, according to Stephen Schondelmeyer, a pharmaceutical economist at the University of Minnesota. They can afford heavy spending on promotion -- and research -- because their production costs are so low. Drugmakers spend as little as 10% of sales to make their product, vs. 40% or more for most manufacturing businesses. Traditionally, the drug companies aim their promotional dollars at the heart of the market: America's 550,000 physicians. The doctors, not the patients or the insurance companies, determine which drugs are sold simply by scribbling prescriptions. They hardly risk losing customers by prescribing expensive ones: Frequently their patients not only don't know much about the medication, but also barely notice the price. That's because insured patients are reimbursed for a large portion of their costs or pay a fixed ''co-pay'' of $5 to $7 per prescription, regardless of price. Gaining market share means winning over physicians one at a time. In the medical version of door-to-door selling, drugmakers dispatch an army of ''detailers,'' salespeople who travel to physicians' offices with a bag of samples, often waiting hours for an appointment. Drug companies employ 30,000 detailers, one for every 18 physicians. Since price is not usually a primary concern, salesmen play up a drug's therapeutic advantages, often crowing about tiny differences with competing brands. They blitz doctors with scientific literature, office supplies, and other gifts. Hosting ''educational'' dinners at fancy spots like New York City's Plaza hotel is still a popular sales tool. Doctors' choices are heavily influenced by detailers. ''Doctors learn most % of what they know about drugs from professional salespeople,'' says Dr. Jerry Avorn, a professor at Harvard Medical School who advises companies on how to reduce pharmaceutical costs. Once doctors prescribe a drug, especially a chronic medication, they usually remain loyal to the brand. Says Dr. Alan Hillman, an internist who teaches at the University of Pennsylvania medical school and the Wharton School: ''Until recently doctors would choose drugs from the nicest salesmen. They got used to a small group of products that they prescribed over and over.'' THE FIRST CRACK in this cozy, protected market came from generic drugs. Their sales started growing rapidly in 1985 after the Food and Drug Administration allowed companies to clone off-patent, brand-name drugs without repeating expensive, time-consuming clinical trials. To win FDA approval, a generic must satisfy two criteria: It must contain exactly the same active drug ingredient as the equivalent brand, and it must be absorbed into the body at precisely the same rate. There is one profound difference: Generics are cheap, cheap, cheap. As a rule, they sell for about half the price of brand-name drugs. But sometimes the discrepancy is much greater. The wholesale price for 100 tablets of Valium, the anti-anxiety drug sold by Swiss-owned Hoffmann-La Roche, is $55.62, vs. $9.14 for diazepam, the generic version from Mylan Laboratories. Generics, produced by no-frills companies like Mylan, Rugby-Darby, and Barr Laboratories, have the potential to turn a huge segment of the drug business into a commodity market. They already compete directly with brands for $29 billion in sales, or 62% of the market. Of that total, however, they now take only 50% of the prescriptions and 14% of the revenues. The main reason the cheap clones haven't grabbed more is the reimbursement policy of Medicaid, the government's health insurance program for low-income Americans. Medicaid is administered by the states, and most states adhere to the extravagant policy of fully reimbursing either the costly name brand or the cheap generic. Medicaid pays $67.36 for 100 tablets of Inderal, a heart drug produced by American Home Products. For generic propranolol it pays $2.33. In some states, other laws do favor generics. Pharmacists in New York and Massachusetts must sell patients generic products even if the doctor prescribes the brand name. Doctors can block generic substitution only by writing ''brand medically necessary'' or another disclaimer on the & prescription form, which they hesitate to do. But in other states -- including Texas, New Jersey, and Arizona -- a doctor can require the brand name simply by signing a line on the prescription pad. The big drug companies also do their part to thwart the clones. For example, they refuse to allow generic rivals to duplicate the appearance of a branded drug, which is protected by a trademark. The generic can't come in capsules of the same size, shape, or color. Worried that the new blue oval (generic) tablet might not provide the same relief as the familiar white round (branded) pill, many elderly patients on long-term medication refuse to switch. Despite the snags, generics challenge brands the instant they go off patent, and can steal 50% of their unit sales within a year. Take Pfizer's arthritis drug, Feldene. Since its patent expired last June and its generic equivalent, piroxicam, arrived, Feldene's annual sales have dropped from $350 million to a current rate of $175 million. Generics have tremendous room to grow, both against today's off-patent brands and against a large group of blockbuster drugs that will soon lose protection. Between now and 1995, the patents for 60 important drugs with more than $10 billion in sales will expire, including half of America's ten best- selling products. ''Prices in many big, protected categories will collapse,'' says Max Ferm, a consultant who advises the brand manufacturers on strategic planning and marketing. In December, Syntex will lose the patent on its $1-billion-a-year arthritis drugs, Naprosyn and Anaprox, which account for almost 50% of the company's sales. The day Naprosyn's patent expires, Copley's copycat version could be in pharmacies at a fraction of Naprosyn's price. Even brands with no generic rivals must compete on price with patented me- toos. Me-toos used to sell at the same price as the market pioneer, or sometimes at a premium. Even if the me-too captured only 5% or 10% of the market, it could be highly profitable. ICI's Zestril had almost exactly the same qualities as other drugs on the market when it was introduced in 1988. It sold for about the same price as Merck's pioneering heart drug, Vasotec, and proved very profitable with a sliver of less than 10% of the market. But now there are eight copycat drugs for lowering blood pressure. To win market share companies must introduce their me-toos at a substantial discount to established brands. The Swiss company Ciba-Geigy is pursuing just such a strategy with its high blood pressure drug, Lotensin, which sells at a 28% discount to Vasotec and for half the price of Capoten. The downward pressure on prices from generics and me-toos seems certain to build. ''If the federal government mandates prescribing generics, a big part of the drug industry will look like computer clones,'' says John Klein, president of the generic manufacturer Zenith Laboratories. Additional pressure is coming as the main pharmaceutical market changes from thousands of doctors who ignore prices to HMOs, mail-order companies, and other providers that make price a top priority. Steven Gerber, a security analyst with Oppenheimer & Co., predicts that managed-care companies will account for two-thirds of the drug industry's sales by the year 2000, vs. one-third today. Two of the most influential buyers are Kaiser Permanente, America's largest HMO, and Medco Containment Services, the mail-order prescription drug company. Kaiser serves 6.6 million patients with a staff of 9,000 full-time physicians. Because the doctors work for Kaiser, it has considerable power over what they prescribe. Kaiser guides the doctors' choices by establishing a ''formulary,'' a list of high-quality, mostly low-cost drugs it wants them to prescribe. A staff of Kaiser physicians sorts out the safest, most effective products in each category, including heart, ulcer, and cholesterol medication. When several excellent drugs treat the same ailment with nearly identical results, Kaiser asks the manufacturers to bid for spots on the formulary. It usually chooses the two or three least expensive drugs from a field of as many as eight. Its clout is extraordinary: Kaiser spent $670 million on drugs last year and accounted for 3% of the market's total unit sales. Kaiser even encourages competition among drugs on the formulary. For example, in exchange for further discounts, it has steered market share to Upjohn's arthritis drug Motrin at the expense of Syntex's Naprosyn. It also avidly uses generics. Kaiser was spending $15 million a year for ICI's Tenormin before the heart drug went off patent in 1991. It now pays $1.5 million a year for the same volume of the generic, atenolol. Kaiser isn't the only HMO that treats drug companies less like paragons of science and more like bidders at an auction. Says Paul O'Connor, director of pharmacy for Harvard Community Health Plan, a Boston HMO: ''If there are five or six good- quality products in a category, we'll drive 90% of the sales to the one that offers the lowest price. The rest get to divide up the crumbs.'' To sway doctors on its choices -- and to counteract the influence of drug company salesmen -- Kaiser uses a technique sometimes called counter- detailing. About 50 full-time pharmacists educate Kaiser's doctors about drugs on the formulary. Kaiser still allows drug company salesmen to see its doctors. But the detailers must wonder whether it's worth showing up. They have to wear special ID buttons when they visit a Kaiser doctor. ''They are not allowed to wander around shaking hands,'' says Francis Crosson, an associate medical director at Kaiser. They can't recommend a product if it is not on the Kaiser formulary, and all gifts -- down to pens and coffee mugs -- are verboten. If a drugmaker commits three offenses in a year, its salesmen are banned from visiting Kaiser for six months. Counter-detailing is a rousing success. Fully 96% of Kaiser's prescriptions come from the formulary, and 75% are for generics. MEDCO ACHIEVES similar ends through different means. The mail-order company, headquartered in Montvale, New Jersey, specializes in lowering drug costs for big companies, including General Motors and General Electric. Medco mails medications to patients with chronic conditions, saving them the trek to the pharmacy and cutting costs to corporate clients. It has become expert at changing the way doctors in private practice prescribe drugs. Its staff of 1,100 pharmacists make 100,000 telephone calls a month to doctors, asking them to change prescriptions from expensive drugs to less costly brands or generics. Nearly half the time the physician agrees to switch. ''The drug companies were initially skeptical about working with us,'' says Medco CEO Martin Wygod. ''But they were amazed at our ability to drive business to the lowest-cost drugs.'' Because Medco buys $2 billion of drugs each year directly from manufacturers, it gets significant discounts. But it generates even deeper reductions by persuading drug companies to lower their prices to beat their competition. SmithKline Beecham's ulcer drug Tagamet had been losing share to Glaxo's Zantac. In return for lower prices, Medco agreed to favor Tagamet over Zantac. Since 1991, Tagamet's portion of Medco's ulcer drug sales has risen from 21% to 31%. The more expensive Zantac's has fallen from almost 60% to 47%. No doubt about it: Life is changing drastically for the drugmakers. Profits ! that used to be a cinch will now be a struggle. Pharmaceutical companies will have to make the same wrenching changes that tested -- then rejuvenated -- manufacturing companies in the 1980s. Drugmakers need to cut costs, find new ways to sell their products, and focus research dollars on original products. No company knows this better than Merck, the industry's leader for the past five years. Even while he defends his business, Merck's Vagelos, 63, is crafting a plan to help the company withstand the ravages of price competition. Merck's immediate prospects are less than rosy. A rising dollar and plummeting sales in Germany will slow profit growth this year to about 10%. But Vagelos's three-part strategy, echoed by other strong manufacturers, should produce strong results by the mid- to late 1990s. Merck is emphasizing new products, new businesses, and far lower costs. The company will concentrate on developing breakthrough drugs to treat chronic diseases of the elderly, including Alzheimer's and osteoporosis. ''That's the market of the future,'' says Vagelos. ''In the year 2000, one out of every five people will be eligible for Medicare.'' Merck has a promising drug for osteoporosis called Fosamax, due for introduction in 1996. By slowing the loss of bone mass, Fosamax could be the first medication to reduce hip fractures in the elderly. Merck will also try to patent improved versions of existing drugs Next year the company plans to introduce Timoptic- XE, a spinoff on its popular Timoptic, used to treat glaucoma. Timoptic-XE requires just one dose a day, vs. two for its predecessor. MERCK IS already exploring new businesses, including some that are definitely down-market. In 1989 it formed a joint venture with Johnson & Johnson, an experienced marketer of over-the-counter drugs. Next year the joint venture will introduce an OTC version of Pepcid, Merck's popular ulcer drug. Merck's intention is to avoid the ferocious price competition that overtakes off-patent drugs by building some strong consumer brands. To learn more about marketing consumer goods, Vagelos joined the board of PepsiCo last year. Like SmithKline Beecham and other rivals, Merck is also entering the generic melee. A plant in West Point, Pennsylvania, produces the same compound for Merck's branded arthritis drug, Dolobid, and its generic copy diflunisal. Making generics will allow Merck to maintain high production volumes, thus reducing unit costs for both brands and generics. Finally, Vagelos is adamant about lowering costs. Flush with profits, the drug industry added layers of fat in the 1980s while the rest of corporate America slimmed down. This year Merck -- already one of the industry's leaner competitors -- will shrink its work force by 1,000, or 3%. According to Vagelos, the rise of HMOs and other managed-care companies presents an opportunity to reduce Merck's $3-billion-a-year marketing and administrative expenses. ''In the future the industry will need fewer sales representatives,'' says Vagelos. ''At Merck we've already reduced the size of our sales force. Now we have a new, centralized buyer without a great deal of medical knowledge, but with a strong focus on costs.'' Increasingly, it will be that demanding new customer who blesses the drug industry's winners and dooms the losers.

CHART: NOT AVAILABLE CREDIT: FORTUNE TABLE/SOURCE: MED AD NEWS CAPTION: TOP-SELLING DRUGS

CHART: NOT AVAILABLE CREDIT: FORTUNE TABLE/SOURCE: RONALD NORDMANN, MANAGING DIRECTOR, PAIN WEBBER CAPTION: HOW U.S. DRUG COMPANIES STACK UP Drug analyst Nordmann sorts the industry according to projected growth in earnings per share.

CHART: NOT AVAILABLE CREDIT: FORTUNE TABLE/SOURCE: NYC DEPARTMENT OF CONSUMER AFFAIRS CAPTION: HOW PRICES COMPARE. . .

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: HEMANT K. SHAH, PHARMACEUTICAL ANALYST, HKS. & CO. CAPTION: AND GENERICS RISE