Hospitals and Health Systems: The Best of Times and the Worst of Times - 2009

Hospitals and health systems, whether general acute care hospitals or specialty hospitals, are attempting to prosper in a challenging time. Last year and in 2007, the nation's hospitals, as a whole, recorded record profits. Many hospitals were examining a multitude of options for debt financing. Nearly 20 percent or more of the nation's hospitals were in the process of renovating, expanding or replacing their current hospitals.

As of 2009, the freezing of the financial markets, the loss of the value in hospital and related foundation portfolios, the underfunding of pension obligations, the movement in a negative direction of payor mix and the delaying of procedures are greatly changing the financial situation for hospitals. While the country's 1,000 healthiest hospitals remain stable, this remains a time of tremendous uncertainty and risk in the hospital industry. This article discusses five strategic and development issues facing hospitals.

1. The joint venturing of service lines
Joint ventures can provide substantial benefits to hospitals. There are also severe limitations involved in the use of joint ventures.

Jon O'Sullivan, senior principal and founding member of VMG Health, says, "Physician/hospital joint venture relationships will continue to be a very important part of the healthcare landscape. There are a number of market areas and strategic factors that will continue to drive these relationships."

Mike Lipomi, president of RMC Medstone, agrees that now is an excellent time for hospitals to look into joint ventures. "I think joint ventures will flourish in this difficult economic time," he says. "Joint venturing with a specialized organization supports the focused factory theory of 'faster, better, cheaper.' In addition, the joint venture should result in lower costs, higher efficiencies and increased profitability."

First, in terms of benefits to a hospital, a joint venture provides a means to develop congruent relationships with physicians. When both the hospital and the physicians have vested interests in a venture, it places the parties on the same page; both parties work together to control costs and achieve a profitable venture. It also avoids an employer-employee or boss-servant type of relationship.

Moreover, joint ventures are often less expensive alternatives for hospitals to pursue. Primary alternatives in the past have included, for example, attempting to control patient flow by employing significant numbers of primary care physicians and specialists. It has clearly proven expensive to employ and maintain a primary care–owned network. It is also proving difficult to maintain productive specialists as employees of hospitals or health systems.

A third key benefit to joint ventures is that a joint venture allows for greater freedom for both the hospital and the physician than the traditional employer-employee relationship allows. For example, in a typical joint venture, a majority of physicians maintain an independent practice outside of the joint venture. This type of arrangement allows for congruency in the joint venture between the hospital and physician yet offers the physician a certain amount of freedom outside the joint venture.

There are also challenges and limitations to the use of joint ventures. For example, due to a number of business and regulatory issues, once a hospital invests in a joint venture it is often difficult to modify the number of partners or terminate the joint venture without suffering substantial damages or losses.

Surgery centers may also see the benefits of a hospital joint venture. Mr. O'Sullivan notes that as it becomes difficult for freestanding surgery centers to maximize their revenue through an "out-of-network" approach, many of these centers will look to establishing relationships with their local hospitals. He says, "As more and more managed care payors change their policy towards out-of-network centers, these centers will seek to enter into contracts with those payors in order to continue to serve their patients. Unfortunately, many centers will find that these payors will either not contract with the center or offer a contract with very low reimbursement. These factors will spur many of these centers to joint venture with their local hospital partner who has both the ability to bring better reimbursement through their contracting ability as well as to bring more physicians who might increase the utilization of the center."

Second, in certain types of joint ventures, hospitals receive lower reimbursement if they choose to enter into a joint venture with physicians than they would otherwise. For example, hospitals receive lower reimbursement if they choose to joint venture an ambulatory surgery center with their physicians as opposed to simply receiving hospital-based reimbursement for an outpatient department. Thus, in addition to splitting the profits of the joint venture with the physicians, the venture as a whole will receive lower reimbursement then if operating as a unit owned solely by the hospital.

Third, true joint ventures are not permitted in certain specialties for certain types of services. For example, it is difficult to joint venture various imaging modalities with physicians who are not radiologists. The Stark Act, which prohibits physicians from referring to an entity with which they have a financial relationship, classifies radiology and other imaging services as "designated health services."1 A financial relationship is defined as any investment, ownership or compensation relationship. Therefore, subject to a rural exception, a non-radiologist physician owner (for example, an orthopedist, a primary care physician or a neurosurgeon) may not invest in a joint venture and generally may only "own" and provide imaging services pursuant to the in-office ancillary services exception, which is a restrictive exception.2 In addition, states are beginning to limit ownership in imaging by non-radiologists as well. The Maryland Attorney General interpreted the state physician self-referral bill, which is similar to the Stark Act, to specifically exclude magnetic resonance imaging services, radiation therapy services and computed tomography scan services from the in-office ancillary exception.3 The Centers for Medicare & Medicaid Services has expanded the list of Stark services to include nuclear medicine and positron emission tomography services. This would further limit the ability to enter into joint ventures for such services. There is also increasing scrutiny of imaging ventures set up as quasi-joint ventures as recently highlighted in national newspapers.4

Mr. O'Sullivan says, "The dual impact of changes in federal legislation, such as the Stark Act, will prevent certain relationships and increase the need for certain hospitals to implement 'game-changing' strategies in order to remain viable. In many cases, this strategy will take the form of a whole hospital joint venture. Additionally, the prospect of a change in law which might prohibit future or additional whole hospital joint ventures is causing many hospitals to accelerate their thinking of this strategic alternative."

Fourth, a joint venture strategy is limited to certain physician specialists and is difficult to utilize for an entire medical staff. For example, the benefit of a joint venture — congruency between the hospital and physicians, controlled costs, vested interest in profits — becomes too diluted if too many physicians are involved in the joint venture. In short, a joint venture is useful to none if everyone is involved. This means that where a medical staff includes 200-300 physicians, a joint venture may ultimately be a useful option for a small minority of the whole staff.

Mr. O'Sullivan also mentions how some specialty physicians may find the benefit in a hospital joint venture. "Physicians in many specialty areas continue to see their earnings erode. As a result, a plethora of relationships from radiation therapy to co-management agreements are continuously being implemented to provide an ancillary form of income," he says.

The role of joint ventures is likely to continue to evolve over the next three to five years. In general, joint ventures can be expected to proliferate for smaller types of service lines and services facilities, including ambulatory surgery centers, cardiac catheterization facilities and imaging facilities, among a handful of other types of service lines and facilities. In contrast, joint venturing of many large scale projects is not expected. In essence, the development of joint venture specialty hospitals between hospitals and physicians is expected to some degree, and a smaller number of joint ventures of acute care general hospitals are expected between hospitals and physicians.

2. Landmines facing hospitals
Many of the key problems that hospitals may face in the near future have not yet surfaced in part because hospitals are currently experiencing a favorable revenue and business cycle. This favorable business cycle has left many hospital systems insufficiently prepared for dips or downturns in the revenue and reimbursement cycle. Large national payors are pushing back with respect to climbing reimbursement and pricing. On a national level, there is discussion regarding the need to cut back or to reign in Medicare costs and the amounts paid to hospitals. If possible, the government may attempt to limit costs by decreasing reimbursement in niche areas where there is not as much political strength. Hospitals still must be prepared for changes in the revenue cycle.

There are four specific concerns.

First, hospitals have overleveraged themselves. This reflects several different characteristics. On one hand, hospitals remain confident in development plans and are regularly expanding and renovating hospitals to capture or maintain certain types of service lines and revenues. Overall healthcare construction and commitments to construct increased dramatically from 2004-2008. Other entities are investing in information technology while others are pursing deals to merge. On the other hand, however, most hospitals, as not-for-profit, tax-exempt entities, are not forced to make distributions to shareholders. Because hospitals do not have to account to shareholders in that manner, it is easier to find opportunities to invest money in new programs and buildings, rather than prepare for the future by disciplined saving or repayment of loans.

Many hospitals seem to have compensated for the recent economic downturn by better managing their development plans. In a Jan. 2009 report on the financial health of U.S. hospitals and health systems, the Healthcare Financial Management Association (HFMA) reported that 72 percent of hospitals surveyed planned to cut expenditures on new construction projects over the next three to six months; 37 percent planned to put a hold on all new construction projects. In addition, 77 percent of respondents planned to cut back on information technology expenditures.

Second, a number of the nation's hospitals do not appear prepared for reductions and changes in reimbursement. Many hospitals have benefited from increased Medicare reimbursement and a lack of payor discipline over the last few years. Payors are returning to the zero sum game approach to negotiation efforts with hospitals. The health insurance industry is in a consolidation mode. This generally leads to greater power for the surviving payors and less negotiation leverage for providers. As noted above, all hospitals must be prepared for a slow down in Medicare reimbursement increases and potential reductions in payments from other payors.

Hospitals are also experiencing an upturn in patients seeking treatment who are not covered or covered by Medicaid or other public healthcare programs. A recent report from the American Hospital Association (AHA), The Economic Crisis: The Toll on the Patients and Communities Hospitals Serve, showed that 70 percent of the 1,078 hospitals surveyed reported an increase in uncompensated care. A further 46 percent reported an increase in patients on Medicaid or other public or low-income health programs.

Third, many hospitals do not maintain sufficient reserves. Hospital margins are relatively narrow. According to a MedPac report, there has been a decrease in hospital total margins. Total margin was measured by inclusion of all patient care services funded by payors, plus nonpatient revenues. In the aggregate, hospitals saw total margins decrease from 4.4 percent in 1991 to 3.4 percent in 2000. Given the small margins, insufficient reserves to cover losses can be problematic when a hospital faces a downturn in the revenue cycle.5 Many hospitals in this regard are facing large unfunded pension deficits.

Additionally, the April 2009 HFMA Healthcare Financial Pulse report found that 54 percent of all hospitals surveyed reported a negative total margin. In the previous Jan. 2009 study, HFMA found that large to mid-sized hospitals were the most pessimistic about total margins over the next three to six months (35 and 43 percent, respectively). In the April report, 80 percent of the large (more than 500 beds) hospitals reported negative margins.

Although the Jan. 2009 HFMA reported that hospitals were planning on cutting capital spending and considering service cuts if necessary, there was no indication for a long-term solution if margins continued to decrease.

The recent AHA report also showed that hospitals are experiencing a decrease in days cash on hand. Of the respondents, 59 percent experienced a decrease in the amount of days the hospital could continue to meet its financial obligations; of that number, 27 percent considered this decrease to be significant.

Hospitals are also experiencing an increase in days in accounts receivable, further diminishing any reserve funds they may have. According to the AHA report, 36 percent of hospitals reported an increase in days in A/R as compared with last year.

As a result of this loss of revenue, the report showed that nearly half of the 1,078 hospitals surveyed had reduced staff in response to the economic downturn. Eight of 10 had cut administrative expenses, and one in five had reduced services, including behavioral health, post acute care, clinics, patient education and other services that require subsidies.

Fourth, a number of hospitals consistently chase the "next big thing." For example, the "next big thing" a few years ago was an expensive cardiac program. In many situations, the open heart programs proved to be less profitable than expected. This is, in large part, due to improvements in technology and decreases in the number of open heart surgeries performed. Currently, many hospitals are aggressively investing in different types of cancer treatment technologies and new types of buildings and development related to orthopedics and spine. However, if the number of admissions and procedures does not meet expectations, or if reimbursement stagnates or decreases, chasing "the next big thing" may lead to situations where the results for certain programs sorely miss expectations.

In addition, hospitals are unprepared because the economic downturn is hitting them later than other industries. Mr. Lipomi says, "I think the problems facing hospitals are the same problems that all businesses are facing in today's economic crisis. The reason we are facing them later than most is that our industry is highly leveraged by insurance plans and managed care providers making us more of an economic anomaly. We face patients delaying procedures, resisting hospitalization and avoiding physicians' offices and the emergency room for fear of losing their jobs as well as inability to pay co-pays and deductibles. In addition, the co-pays and deductibles are increasing rapidly as the employers are trading premium dollars for higher deductibles."

Mr. O'Sullivan sees hospitals as capable of handling the changes in the market and as even accustomed to facing these challenges. "Unfortunately for weaker hospitals, these changes are part of an ongoing evolution of healthcare and often result in the demise of the weakest participants," he says. "The upside is that the market is often better served as a result of revenue consolidation, greater efficiency and rationalization of the delivery of care (two heart programs in a small market makes little sense). Hospitals will seek alternative mechanisms to survive and thrive in their markets. Some will sell, some will close and some will innovate. The difference will be the ability of management to face these challenges and propose solutions before it's too late."

Mr. Lipomi also sees government intervention as another potential hurdle for hospitals. "We face the threat of government intervention to an even higher level than currently exists," he says. "Threats of a national health plan and the elimination of privatized medicine are on the mind of all healthcare providers. We need to take a close look at countries with national health plans and not only look at outcomes but look at the quality and availability of healthcare."

3. Financing vehicles
Very healthy hospitals still face a plethora of options as to how to finance their investments in facilities and programs. For hospitals in good financial shape, the choice of lenders, from traditional commercial banks to private equity driven financing companies to publicly traded entities focusing on commercial and healthcare finance, is still significant. For a typical project, real estate or equipment driven, a hospital may choose to structure the project through either fixed or variable rate financing options, options not always available in the past. These options often involve captive finance programs from the vendors themselves who may include large equipment companies or real estate entities or middle market lenders that focus on loans ranging from $10-$150 million.

Mr. O'Sullivan says, "Financing is very difficult in the current environment. The inability to gain access to capital will result in hospital sales to those entities that have greater access to capital. In the absence of a strong credit rating and balance sheet, outside of a sale, there are relatively few options in the current environment."

As a result of this difficult economic environment, hospitals may consider utilizing some of these new financing vehicles.

Certain of these new types of financing choices are intended to improve hospital/physician relationships. For example, the use of participating bonds allows physicians and local community members to hold a part of the debt used by a hospital or a hospital project. It may also include, as noted earlier, the use of joint venture projects which enable participating physicians to share in the capital needs of a venture. In these situations, the cost of these alternative sources of capital can be high in terms of the transaction efforts and fees. At the same time, these options offer a tangible benefit by helping to solidify relationships between physicians and hospitals. Accordingly, hospitals will often utilize a joint venture approach to financing projects even if it may be more expensive in terms of transaction costs and other types of challenges than doing the project alone. Participating bonds are used less often as the transaction costs for such products have proven to be so expensive that many hospitals choose not to use participating bonds unless the project is of such size and scope that the cost will be relatively reasonable in comparison to the total amount being raised. Over the next few years, financing options are expected to continue to proliferate until hospitals, once again, are faced with challenges relating to the financial performance of projects.

The number of the nation's hospitals that are not in strong or even good financial shape has increased significantly in the last 12 months. Whether these hospitals are semi-rural or located in difficult urban environments, these entities face a very significant increased struggle to find financing on any level. According to the Jan. 2009 HFMA report, both hospitals with limited and broad access to capital saw increases in their debt (38 percent of all respondents) and increased difficultly securing other types of financing.  Often when financing is available, it is available only at high rates and can be developed only to the extent that there are tangible assets available to serve as collateral for the financing. In contrast, healthy hospital systems can utilize their traditional cash flows and projected cash flows to help obtain financing.

Overall, even though it is becoming more difficult, hospitals are still able to access capital. In the AHA report, 45 percent of respondents said that their ability to access capital was getting worse; however, 51 percent reported that their access to capital was about the same. The report found that most hospitals could gain some type of capital, although they reported that it was somewhat to significantly harder to get.

4. Hospital strategy for the next few years
Hospital planning over the next few years should be driven by three conceptual strategic approaches — an offensive approach, a defensive approach and an allocation method or approach. First, hospitals must play offense. This means constantly seeking new revenue lines. These can be "home run" profit lines, such as the efforts by many hospitals to develop oncology programs or leadership in orthopedics or spine. In contrast, investing smaller amounts in a number of service lines as a way to increase profits and revenues has also benefited hospitals. This may include simply reinvesting in the three to five key programs the hospital sees as its most profitable or to add a few service lines.

Second, hospitals must aggressively play defense. This means not over leveraging the hospital through excessive debt financing or overstaffing of certain programs. It also means preventing erosion of the hospital's revenue base by aggressively challenging or preempting joint venture efforts and market encroachment efforts by other hospitals and health systems.

Finally, hospitals must adopt the concept of allocation as an overriding strategy. Too often, hospitals are significantly over-invested in one service line or one service category. Over the last few years, hospitals that have over-invested in certain types of service lines, such as surgical, imaging, oncology, orthopedic or neurosurgical, have performed very well. However, hospitals are better off allocating their risk by investing in several different service lines. In addition, hospitals must develop a service line or a specialty where they can become known and recognized as a key provider in their community and become the distinct provider of choice. In essence, they must develop some specific reason for existence as revenue lines change and competition unfolds.

Mr. O'Sullivan notes some of the issues when considering developing a specialty hospital. "Migrating services to a specialized facility from an acute care setting is very difficult and can take years," he says. "Importantly, if the opportunity for specialization exists, it will probably take form in a physician driving specialty strategy (heart hospital, short stay hospital, rehab, etc.). The most viable strategy for hospitals in the next five years is to capture market share through enhances relationships with physicians. As such, hospitals are employing physicians at greater numbers, entering into co-management relationships and initiating joint venture strategies. The mix of these varies by market and market conditions."

5. Legal issues, congressional attack and class action suits
Not-for-profit hospitals are facing distinct attacks on several different levels. First, Congress has opened up an investigation as to whether hospitals are actually doing enough to earn and maintain their tax-exempt status. The Senate Finance Committee has delivered extensive questionnaires to ten tax-exempt hospitals and health systems, seeking details on activities ranging from travel to compensation to charity care.6 In addition, the House of Representatives Ways and Means Committee has held a series of public hearings focusing on the tax-exempt sector, with particular focus on the not-for-profit, tax-exempt hospital.7 Second, many states and local communities are making efforts to try to reduce or erode tax exemption.

In the long run it is expected that Congress will take little, if any, action to fundamentally change the way not-for-profit hospitals do business. As a business reality, not-for-profit hospitals are a huge employer in many places, and are vital to many communities. For example, in 2008, tax-exempt hospitals and healthcare organizations controlled approximately $490 billion in assets and received more than $500 billion in gross receipts.8 Further, the debt markets are extremely important to the national economy and provide great investment opportunities for a whole variety of participants. A challenge to the status of the tax-exempt entities that would result in a reduction of the supply of tax-exempt investments would have a substantial impact throughout the country. While Congressmen may enjoy the investigative aspects of the effort to examine the not-for-profit sector, any changes in tax exempt finance laws and how exempt hospitals function would have draconian and unexpected results throughout the healthcare economy and the national economy as a whole. It is expected, at some point, that politicians will use these types of investigations as a cover to wrestle with real and legitimate cost concerns of the Medicare program. In essence, certain of the negative aspects that come out of the Congressional investigations as to the tax-exempt sector may be used as tools and tactics to provide political cover and to ultimately reduce reimbursement to hospitals and health systems.

However, some believe that Congress should examine problems within Congress before addressing whether or not hospitals still meet tax-exempt status. "I think Congress should examine Congress first," says Mr. Lipomi. He mentions plans like the current stimulus plan could encourage more people to spend money that they don't have and continue this cycle of economic downturn. "This is a very dangerous situation that jeopardizes more than the future of healthcare," he says.

On the state side, there will continue to be state-to-state skirmishes over issues related to the state tax and local tax exemption. This is particularly true in small communities where the hospital has evolved into one of the biggest employers, if not the biggest employer, and particularly if the community has lost some of its tax paying businesses. For example, the Illinois Department of Revenue revoked the local property tax exemption for Provena Covenant Medical Center in Urbana, Ill., following a determination by the local tax board that Provena was not a charitable institution because of the way it treated needy patients.9 In essence, the manufacturing decreases in many communities and as the taxes are paid by such companies decrease as well, there will be more pressure on local communities to attempt to reap some tax benefits from their local hospitals.

This analysis examines five different issues that are facing hospitals and health systems throughout the country. If you would like further information on any of these issues, please contact Scott Becker at (312) 750-6016 or by e-mail at sbecker@mcguirewoods.com or Elissa Moore at (704) 343-2218 or by e-mail at emoore@mcguirewoods.com.

Notes
1. 42 U.S.C. § 1395nn.
2. 42 C.F.R. § 411.355(b). In order to satisfy the in-office services exception, a physician has to meet separate supervision, location and billing tests, each of which focus on whether such services are truly ancillary to the medical services being provided by the physician or group practice.
3. Md. Code Ann., Health Occ. § 1-301(k)(1) (2005). On Jan. 5, 2004, the Maryland Attorney General released a legal opinion stating that the law bars a non-radiologist physician from referring patients for tests on MRI machines or CT scanners owned by the physician or his or her practice. 89 Op. Att'y. 10 (Jan. 5, 2004).
4. Armstrong, David, MRI and CT Centers Offer Doctors Way to Profit on Scans, Wall Street Journal, May 2, 2005.
5. MedPac, "Data Book on Hospital Financial Performance," Appendix D. Table D-15 shows a decreasing trend in hospital total margins. Over the same time frame, urban hospitals saw a decrease in total margins from 4.3 percent to 3.3 percent while rural hospitals saw a decrease in total margins from 5.2 percent to 4.4 percent.
6. See http://finance.senate.gov/press/Gpress/2005/prg052505.pdf for the press release and full text of the detailed questionnaire.
7. See http://waysandmeans.house.gov/Hearings.asp?congress=17 for transcripts of the public hearings relating to the tax-exempt sector and hospitals.
8. Testimony of the Honorable Mark Everson, Commissioner, Internal Revenue Service, before the House Committee on Ways and Means, May 26, 2005.
9. The Champaign County Board of Review, responsible for property-tax assessments, argued that the hospital filed lawsuits and used aggressive debt-collection tactics against patients who didn't pay their bills. As a result of the decision, Provena had to pay $1 million in property taxes. Provena is currently appealing the decision of the Board of Review to the Illinois Department of Revenue.

Scott Becker is a partner based in the Chicago office of the McGuireWoods Health Care Department and serves as co-chair of the Health Care Department. Elissa Moore is an associate based in the Charlotte office of the McGuireWoods Health Care Department. McGuireWoods is the nation's sixth largest healthcare law firm as ranked by the American Health Lawyers Association.

Copyright © 2024 Becker's Healthcare. All Rights Reserved. Privacy Policy. Cookie Policy. Linking and Reprinting Policy.