Hospital Strategies for Newly Capitated Markets

Capitation is a market response to the long period of increasing prices of health insurance and government funded programs. Insurers confronted with customers (employers or taxpayers) unwilling to have higher costs passed through to them and unwilling to cut their own expenses or profits cut payments to providers and change the incentives of the fee for service system by paying actuarially determined fixed amounts for their insureds care.

For providers, capitation represents a form of social Darwinism where the strongest get the most. In capitated systems, providers must compete against one another for their share of the healthcare dollar. This is particularly true of primary care physicians, specialists and hospitals as separate and competitive classes. When a fixed payment is available, the larger that taken by one class, the smaller that available to the others.

Particularly in areas of the country where hospital utilization is high in terms of admissions and length of stay, e.g., the Northeast, the goal of capitated incentives is to reduce inpatient stays. At-risk providers will fail financially if they do not accomplish this. The reductions are accomplished through a variety of clinical modifications, including less reliance on procedures, use of outpatient settings, and transfer to sub-acute settings.

In order to claim a capitation payment associated with a particular patient, a provider unit must be somehow designated by the patient. This is typically accomplished through the selection of a primary care physician in so-called gatekeeper models. More advanced structures may permit a patient to select a system or network from which to obtain care, and the patient may or may not have to choose a PCP as well.

Capitation is therefore about both controlling the flow of dollars and determining who is worth what as well as determining where capitated patients go for services. The successful hospital must do both.

Strategic Responses

Hospitals have and choose to pursue a number of different strategies in responding to capitated markets, many of which are pursued simultaneously.

Acquisition of Physician Practices

A typical response is to purchase the medical practices of primary care physicians such as family practitioners, internists and pediatricians. Less frequent but not uncommon is the purchase of obstetrical practices and still less common those of various surgical and medical specialties.

In a gatekeeper style system it is easy to justify the purchase of PCP practices if a hospital desires to control the flow of dollars and patients in its service area. Absent the control of PCP practices, the control of dollars and patients will not be available. If the hospital truly intends to develop an integrated delivery system, purchase of pediatric and ob practices can also be justified as these are the two critical entry points into an insurer and/or delivery system. New parents tend to select their insurer and providers on the basis of access to obstetrics and pediatrics. This has the additional advantage of attracting younger healthier adults along with their children and lowering the overall risk of a capitated provider entity. This connection between pediatrics and obstetrics on the one hand and successful risk management often seems to escape many hospitals and integrated delivery systems. In some cases, insurers will even pay a flat capitated rate per enrollee, not adjusting for age and/or gender. It is not difficult to see in such a case that children and young adults will result in positive actuarial experience.

Beyond obtaining or retaining admissions, it is difficult to justify the purchase of surgical and many specialty practices. Though such providers are necessary for a delivery system, most areas transitioning to capitation have far more of such providers than they will need when the transition is complete. Therefore, supply will exceed demand and the 'price' will drop - both in terms of reimbursement for services on an ongoing basis as well as for the asset value of the practice. Under Stark II, paying for admissions is a violation of the law. There are, of course, some circumstances in which the purchase of a practice is warranted. Even less easily understood is the purchase of hospital-based practices such as radiology, anesthesia and pathology, where the physicians often serve under a contract and at the discretion of the hospital.

The valuation which must support the purchase of a physician practice cannot take into account indirect revenue that will result from the acquisition. In those markets where PCPs control the allocation of revenue, capitation profits are directly attributable to the PCP practice to the extent that the PCP could earn such profits as a freestanding entity, such as through membership in an IPA. Certain specialty practices, such as ophthalmology, which are commonly subcapitated may also serve as capitation profit points when the valuation is performed. The author is unfamiliar with such a strategy for general surgery, for example. Any valuation theory must reflect those structures utilized (preferably) or being developed in the marketplace and avoid including revenue streams which would be in violation of Stark.

Formation of Physician Hospital Organizations (PHO)

It is common for the very first response of a hospital to be establishment of a Physician Hospital Organization as a means of coordinating the contracting activities of the institution and the medical staff. For tax-exempt institutions, control of the PHO is problematic since it is typically funded by the hospital and 'equity' or voting control must be retained. Physicians generally will strenuously object to this structure, resulting in long and costly negotiations. Primary care physicians in particular, who have the least to gain from the constraints of such arrangements - since they can receive 'better deals' elsewhere, are particularly unlikely to participate. This leaves the PHO filled with specialists and little else.

Favorite Sons

If the PHO does not successfully attract sufficient PCPs to make it a viable contracting entity, the hospital may choose from among the most friendly PCPs 'favorite sons' as the target for special arrangements with enhanced income opportunities. One particularly clever and successful strategy employed is to create separate risk-sharing arrangements with the favorite sons where the hospital is reimbursed for services at lower rates than those available to other risk arrangements with less than favored sons. In risk arrangements based upon budgets rather than true full risk capitation, such a strategy may require the cooperation of the insurer. Many insurers do not permit two-tiered rate structures for services since it may adversely affect the treatment received by their insureds at the same institution. In fully capitated arrangements, the hospital may be free to charge the risk funds whatever rate it wants and 'artificially' create profits for one favored group. (Perhaps more insidious, it can receive these profits by charging the other group(s) correspondingly higher rates.)

This strategy is risky for all but the most financially and geographically strong hospitals, those that are certain of their market position. The offended members of the medical staff may take their business to a competitor if a viable one is located near by.

Vertical Integration

One of the most effective strategies for a hospital is to vertically integrate in its service area. Many institutions already have Transitional Care Units or TCUs and may have Sub-acute units or Skilled Nursing Facilities (SNFs). Since a principal goal of capitated systems is to reduce acute days by shifting those days to lower cost sub-acute days, a hospital can recover some of its lost revenue by controlling sub-acute settings.

Another goal of capitated systems is to move patients into home care settings. A well-integrated hospital can also acquire the local Visiting Nurse Association (VNA) to round out its vertical strategy. A by-product of successful vertical integration in a given geographic area is much greater negotiating strength with HMOs and at-risk physician groups for the various services along the continuum of care.

Contracting

As one line of business becomes less profitable - inpatient services - other lines may be made profitable. In some instances, contracting personnel for insurers and capitated providers are overly focused on obtaining lower inpatient per diems and lose sight of costs of outpatient services, such as ambulatory surgery and the emergency room. This type of give it up in one place and take it back in another approach can be effective for some hospitals.

Focus On Cost Control

Rarely done in any venue, controlling costs in order to become economically viable at lower operating levels is the key to success for many hospitals, aside from those with local geographic monopolies It would appear to be the only viable long-term strategy based upon present market trends in reimbursement. The 1997 Medicare+ Choice program assures that the trend will be ongoing as more and more Medicare recipients move into managed care, this program being the principal source of revenue for most hospitals.

Conclusion

Hospitals have a number of potential responses to the entry of capitated reimbursement systems and incentives into their market area. The actual responses chosen depend on a variety of factors, including the market share of the institution, the number, strength and proximity of competing institutions, the size and effectiveness of physician practice units, strength of HMOs and similar factors. Strategies based upon the 'divide and conquer' concept, while viable in the short-term for institutions with strong economic positions, generally backfire over the long-term.