Improving the financial performance of IDS-owned physician practices - Integrated Delivery Systems

Healthcare Financial Management, August, 1998 by Marc Benoff, Susan F. Dubow

Although physician practices acquired by integrated delivery systems (IDSs) have tended to show financial losses, these practices still offer IDSs considerable overall benefits, such as expanded market share and greater coordination of care. IDSs should not necessarily avoid acquiring practices. However, it is essential that IDSs take steps to improve the financial performance of acquired practices.

Over the past several years, integrated delivery systems (IDSs) and physician practice management companies (PPMCs) have been actively purchasing and affiliating with physicians. For many PPMCs, these relationships clearly have been profitable. By contrast, IDS-owned physician practices have tended to lose money. A 1997 survey by the Medical Group Management Association found that the median loss for hospital-owned physician practices was $47,000 per physician per year.(a) And some estimates have put these losses at $100,000 or more per physician per year.

Unlike PPMCs, IDSs focus on providing a broad continuum of services. They regard acquisition of physician practices as a means to support more traditional hospital-based care and facilitate greater integration of care, with the goal of improving the quality and cost-efficiency of care delivery. Moreover, not-for-profit IDSs see physician practice acquisition as a means to support their community service missions by maintaining or expanding access to care.

In addition, IDSs regard maintaining an active, vibrant, and diverse medical staff as a key to remaining competitive. Practice acquisition, therefore, often is used as a defensive strategy in reaction to acquisition initiatives by other IDSs and for-profit PPMCs.

Because Federal and state anti-kickback laws prohibit inducements to physicians to encourage patient referrals, IDSs should not consider referral income in their cost-benefit analyses of acquiring practices. Nonetheless, because forming physician affiliations often is an important component of a broader IDS strategic plan, even physician practices that are incurring operating deficits as stand-alone enterprises may make wise and successful investments. Viewed from the broader perspective of the health system, they may be considered successful business ventures because they offer considerable intangible benefits, expanded market share, and greater coordination of care.

By contrast, PPMCs typically cannot take advantage of the same synergies that physician practices offer IDSs because PPMCs are not engaged in providing services across the continuum of care. Moreover, publicly traded PPMCs normally need to focus on achieving short-term financial goals to meet the earnings objectives of their investors. Relationships between PPMCs and physicians, therefore, typically are structured to ensure a reasonable rate of return to the PPMC from the outset of the relationship.

Factors that Result in Losses

Although short-term losses on acquired physician practices may not be a reason for abandoning an acquisition strategy, it is important for IDSs to understand the factors that can lead to losses and take steps to make their physician practices profitable. In most instances, losses can be traced to: high purchase price, reduced productivity, ineffective compensation mechanisms, and/or inefficient operations.

High purchase price. Five to 10 years ago, prices for primary care practices often were 40 percent or less of the previous year's collections. Today, because the market for physician practices in many areas has become intensely competitive, prices range from 40 to 80 percent of collections, and can reach more than 100 percent, depending on the practice and area. Unlike PPMCs, which fund a significant portion of the purchase with equity, IDSs typically rely on cash payments. Thus, high purchase prices are a cash drain on the IDS in the year of the acquisition and lead to high levels of amortization in future years.

Reduced productivity. After acquisition, some physicians regard their new status as employees as an opportunity to slow down. Some physicians reduce their office hours, take longer vacations, and generally become less productive.

Ineffective compensation systems. IDSs often guarantee minimum levels of income based on historical compensation, and do not adjust these levels to account for changes in productivity and/or operating expenses. Moreover, even in instances in which compensation is productivity-based, the type of payment formula used can affect profitability. For example, a compensation system that pays 50 percent of collections to physicians may seem reasonable. However, even if overhead is 50 percent, a practice can show losses if physician benefits (including the employer portion of payroll taxes, as appropriate) also are paid. To provide the necessary incentives, compensation should be based on financial performance, including productivity and operating expenses.

Inefficient management. Instead of forming independent physician management organizations, IDSs often rely on existing hospital infrastructure, including staff and information systems, to support their acquired physician practices. This approach often leads to inefficient operations because hospital systems typically are designed to meet the specific requirements of hospital management, which differ from those of physician practice management. In addition, hospital staff may lack the expertise to manage practices.