Owning Physician Practices: A Viable Strategy?
By John A. Deane
Now that the frenzy of physician practice acquisitions has calmed, it's time to examine what has been achieved through such acquisitions by hospitals, health plans, physician practice management companies (PPMs) and some academic medical centers. More importantly for health systems, hospitals and academic medical centers that have acquired practices, where do we go from here?Some would argue that the recent past represents a grand failed experiment and that "disintegration" and divestiture is the only logical course. After all, according to the MGMA, institutionally acquired practices incurred average operating losses of $80,819 per physician in 1997, while a significant number has losses exceeding $125,000 (1). For an institution owning and operating 200 primary care physicians, the annual losses can be as high as $25 million.
Why Institutionally Acquired Practices Lose Money
Practices acquired by health systems, hospitals and academic medical centers lose money for a number of reasons. Zachary Gerbarg, M.D., in a recent article in New Medicine underscores several key reasons which are summarized as follows:
- Increase in overhead costs and capital improvements;
- Decreased physician productivity;
- Reduced collections;
- Inability to secure global risk contracts while fee-for-service discounts exacerbate;
- Functioning as a group of independent practices as opposed to a group practice; and
- Ineffective governance structure with weak physician leadership (2).
Perhaps the most important lesson of the recent physician acquisition phase is that purchasing practices is only the first step in a long journey toward optimizing the delivery of physician services. Competitive pressures and misaligned motives put a premium on the "purchase price" instead of the future focused financial needs of the physician organization going forward. In the future, acquired practices will not be turning to the luxury car dealership after the deal is done, but rather toward the significant investment decisions required in order to transform acquired practices into a fully functioning, integrated, and innovative health care delivery system.
The Capitation Bogeyman
Clearly one of the biggest threats facing health care during the past decade has been the "capitation bogeyman." Conventional wisdom was that by the year 2000, half of the payors in the United States would contract with health systems on a capitated basis. In such a system, primary care physician capacity was king, fueling the trend toward practice acquisition.
Of course, the capitation bogeyman did not come. Current trends toward the patients' freedom of choice have driven the industry away from tightly controlled health systems responsible for managing population wellness. A discernible slowing in the growth rate of health care expenditures took the pressure off the accelerator of managed care growth. Specialty providers have had some success with specialty carve outs and package pricing which goes against the grain of global capitation.
Nevertheless, for a significant but still minority of many local markets, global capitation arrangements are in place and direct millions of dollars in health care spending. Where physician practices have been acquired with the specific intent to acquire covered lives, market share has shifted to the acquiring institution. Tragically, this shift in some cases has been achieved through unrealistically low percent of premium contracts as a part of the bargain.
Defense Against Competitors
A major motivating force behind physician practice acquisitions is that competitors were using this strategy to steal loyal primary care physicians. Examples of such acquisitions demonstrate that the loss in referrals to the institution can be significant, from $2-4 million in lost revenues per primary care physician.
The Need to Integrate In Order to Innovate
In the face of declining hospital admissions and length of stay, institutions have sought to expand the scope of services they provide in order to preserve their marketplace position. Accordingly, health systems have brought the full scope of outpatient services under their umbrella, including physician services. If these health systems fail to innovate new ways of delivering care, the benefit of integration will be lost. Having primary and specialist physicians, the hospital and the full spectrum of outpatient care under one roof creates an environment ripe for innovation.
Where Do We Go From Here?
The recent past has taught practice management companies, hospitals and academic medical centers much about purchasing practices. The following lessons are most worth noting:
Invest in the Practice, Not the Up Front Purchase Price
The notion of purchasing a physician practice, including a significant value associated with good will or other intangibles is flawed. Inasmuch as the physician continues to earn income from the practice post transaction, the goal should not be to "cash out" but to "cash in." What this means for the physician is to secure a commitment from the acquirer to invest significant capital into the practice going forward at a very efficient cost of capital.
From the perspective of the institution acquiring physician practices, this means offering book value for tangible assets (including furniture, fixtures, equipment and accounts receivable) up front, and offering to invest capital and management along with the other intangible assets that come with an institutional affiliation in the future. In this way, everyone's motivations are future focused and performance oriented rather than deal focused and transaction oriented.
Align Financial Incentives
A major mistake that many institutions have made is to pay acquired physicians based on a "market" base salary plus incentive. This notion fails to recognize that the historical motivating force behind physician productivity has been the entrepreneurial imperative physicians face in the economics of their private practices - "they eat what they kill." To remove this imperative is to subject the practice to built in operating losses.
In many cases, some form of guaranteed compensation is necessary in order to attract physicians. However, in no event should this base compensation exceed 70 percent of the target compensation. Why? The current operating losses of institutionally based practices are filled with physicians who are happy to earn 80 percent of their former compensation in order to work 20 percent less. The problem is rooted in the fact that, with fixed overhead structures, physician practices generate 40-50 percent of a physician's income from the last, incremental 20 percent of production.
At the end of the day, this issue is about the needs of acquired physicians and their affiliate institutions to develop a trusting relationship based on each side doing the right thing and making adjustments in flawed compensation methodologies as lessons are learned in order to protect the viability of the enterprise.
Identify and Empower Physician Leadership
It is a myth in practice management that physicians can successfully affiliate with a competent strategic, management and capital partner and in doing so turn over the operations of the practice completely to management. Good physician leadership is essential to the success of acquired practices.
The optimal model for physician leadership is one in which the physician leaders are true partners with management at every level within the practice. Just as no large physician organization would be structured without a lay executive director or administrator, a chief financial officer (or equivalent) and a business office manager, there needs to be a physician executive to partner with the administrator, a physician led finance committee to work with the chief financial officer, and other key physician leaders.
The Mayo Clinic has demonstrated this model most effectively. For each non-physician administrative leader the Clinic has a physician leader counterpart. The two function as one in managing the operations of the Clinic. A key to this model is that both the lay administrator and the physician are jointly held accountable for operating and financial performance.
Involving physicians in leading and managing a physician organization is messy. It is antithetical to the traditional corporate hierarchy and can be frustrating for lay managers. Physician leaders may resist accountability for the organization's financial performance. However, successful physician organizations will be those that meet the challenge of accepting physician leadership, empowerment and accountability.
Focus on Developing a Group Culture
One of the key functions of physician leadership in partnership with management is to develop and maintain an effective group culture. This represents an unusually difficult challenge for organizations composed of acquired solo and small group practices where historical success was based on focusing on what's good for the individual physician as opposed to the group as a whole.
There is no magic pill which creates a group culture. Success in this endeavor requires strong physician leadership supported by strong management combined with aligned financial incentives. By placing a focus on external threats to the organization as opposed to how resources and compensation are divided internally, leadership can create a sense of group purpose which takes the spotlight off of individualism.
Invest in Financial Operations Management
Physician organizations have historically underinvested in financial operations. Institutions have often made the mistake of assuming that their traditional financial infrastructure can handle the additional burden of billing, collecting and accounting for physician practices. Both are fatal mistakes.
Physician practices, characterized by significant fixed expenses, large numbers of small transactions and very low operating margins require sophisticated financial operations management. They require infrastructure which will provide consistent, timely, accurate and useful financial information on a daily, weekly, and monthly basis.
A related issue is that the accrual accounting methodology of PPM companies and institutions fails to place the correct emphasis on cash collections. Since often the P&L financial statement reflects reasonable revenue activity (associated with billed charges less an "estimate" for contractual allowances and bad debt), management often is not focused on how much cash came in the door. Billing operations can deteriorate over many months which takes months to clean up and results in significant lost revenue.
Recruit highly qualified financial and business office talent with extensive physician practice management experience. Develop a dashboard of key indicators which focuses on cash as well as accrued performance.
Invest in Information Systems
Support the operations with a robust information system. There are hundreds of systems out there. For large group practices, however, there are only a handful of systems which provide the breadth and depth of capabilities required to optimize performance in a larger physician practice organization. For groups of 20-50 physicians, the investment could be as high as $400,000 - $600,000, higher for larger groups.
Invest in training so that the information system can be fully utilized. Often a powerful system is purchased but is not used to its fullest capability. System set up and design is key to ensuring that patient care operations and the billing process are effectively integrated.
When converting to a new system, plan well in advance. Once a system selection decision has been made, six months should be set aside for system set-up, design, training and installation. During this period, invest in additional staff resources so that the pre-existing billing, collections and accounts receivable operations can continue without deterioration while the new system is being implemented.
Finally, its important to "fix" broken billing organizations before converting them to a new system. Otherwise, the pre-existing dysfunctionality will simply become exacerbated and collections will deteriorate following conversion.
Benchmark Physician and Staff Productivity
The best way to determine how to improve physician practice operations is to measure and compare the little events that take place within the context of day to day operations. By focusing on these "microperformances" opportunities can be identified and improvements can be made which collectively will have a significant impact upon overall performance.
Summary
The strategic reasons for acquiring physician practices remain credible. While the temptation is to "throw the baby out with the bath water" by simply divesting failed transactions, the opportunity exists to correct the problems through improved contractual relationships with both the physicians and the payors, and to invest in practice management operations with systems and people to minimize the operating losses. Let's face it, most health systems have not managed physician practices well. We can do better.
The benefits of owning physician practices can be worth the effort of making it work well. Physicians need access to capital and management expertise which health systems can provide. Physicians bring referrals, the ability to manage the full continuum of care, and the opportunity to develop new and innovative ways in which to care for patients in the new millennium.
John A. Deane is President and Founder of Southwind, an interim health care management and consulting company specializing in working with troubled physician organizations. For more information call 615-986-3459.
A version of the above article was published in "Academic Clinical Practice," a publication of the Group on Faculty Practice of the American Association of Medical Colleges, Summer, 1999, Volume 12, Number 2.
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