A conflict of issues

Arguments on both sides of the specialty hospital debate have valid grounding in standard economic principles. Proponents claim that by focusing on a limited range of services, specialty hospitals can perform with greater efficiency, and that through the competitive process, can stimulate improved performance among local community hospitals (Greenwald et al., Reference Greenwald2006). Some analysts go so far as to suggest that full-service hospitals are outmoded, and that the solution to increasing health care quality while containing costs lies with the establishment of ‘focused factories’, a concept derived from classical economic arguments in support of specialization, dating back to the pin factory of Adam Smith. ‘Focused factories’ in this context would employ factors of production such that these organizations would range from those that perform only one procedure, like cataract surgery, to those that provide full panoply of care for a single disease such as cancer (Herzlinger, Reference Herzlinger1997).

Physician ownership of these new institutions also relates to other economic principles. Physician-owners are presumably motivated by greater opportunities for decision-making authority within health care delivery organizations and increasing personal income. While the former incentive is viewed largely with favor, the latter draws criticism in that self-interest of the physician is likely at odds with the interest of the patient. Yet in a market system, it is entrepreneurship that stimulates innovation, which in turn has the potential to make both physicians and patients better off. Through greater control over hospital operations, physician-owners may be able to improve their own productivity by, for example, reducing the frequency of disruptions to procedure room schedules and the amount of down time between procedures (MedPAC, 2005).

Another possible advantage of specialty hospitals is illustrated in the growing literature linking greater volume and higher quality of care (Dudley et al., Reference Dudley2000; Birkmeyer et al., Reference Birkmeyer2002). This applies particularly in the case of higher numbers of procedures, so that facilities specializing in cardiac and surgical care may be especially well-positioned to reap quality benefits associated with greater scale and smaller scope of activity.

At the same time, specialty hospitals raise serious policy concerns due to the opportunities they create for physician self-referral. In this vein, specialty hospitals do not necessarily exemplify the ‘focused factory’ model in that the employees of the enterprise are also the owners, whereas the factory model presumes a capitalist employing the factors of production. A better paradigm for these types of organizations might be the Pauly and Redisch (1973) model that emphasizes physicians exerting control through their referral power over the factors of production in a hospital. Two central issues for opponents of specialty hospitals pertain to (1) the total volume of services provided and (2) the distribution of types of services over the available service locations. The former raises the long-standing debate among health economists over supplier-induced demand (SID), questioning whether physicians can and do induce extra services among their patients, performing technically unnecessary procedures in order to augment their personal incomes. Empirical analysis has failed to resolve the SID hypothesis one way or the other in general, but physician ownership raises the SID stakes here in particular because, in addition to increasing earnings from fees for services provided, physicians also stand to gain a share in the hospital’s profits.

The latter issue is related to more frequently voiced concerns about the distribution or selection of patients across hospital sites, or what is more disparagingly labeled as ‘cherry-picking’. Critics maintain that physician-owners operate facilities that specialize in the most profitable services (viz. cardiac, orthopedic, and surgical). Selection may work through other channels as well. Since the same physician-owners frequently also have admitting privileges at the general hospitals, they may choose to admit to the hospitals they own the less sickly, less costly patients. Specialty hospitals also have been criticized for sidestepping relatively unprofitable services. A particular feature of interest is the absence of emergency department services, a major complaint of full-service hospital competitors, whose business models rely on cross-subsidization among relatively profitable services and those that chronically operate at a loss, including emergency departments.

Herein lies an impasse. The efficiency and quality benefits of physician-owned hospitals are predicated on a design of specialization around particular services, and consumer satisfaction with the new specialty facilities appears to stem in part from their smaller size. Yet inherent in the nature of an enterprise modeled on specialization and smallness is the concept of limitation. Critics of specialty hospitals are especially vocal on the issues of patient selection and lack of emergency department provision. But the focus on single specialties may well mean that the patients with co-morbidities will be best treated in the full-service hospital where there is easy access to other specialists they may need, and smallness of size can preclude attaining the volume of emergency services required to achieve economies of scale. Any judicious policy approach to the specialty hospital debate will be cognizant of these economic realities. This means that general community hospitals need to recognize that their greater share of sicker patients is not necessarily ‘unfair’, and that specialty hospital owners acknowledge that their full-service competitors need to be financially compensated for the financial burden of providing for those patients.

A continuum of specialty facilities

The debate over specialty hospitals has focused on cardiac, orthopedic, and surgical hospitals, the three specialties subject to the moratorium, and most policy recommendations proposed to date target these three categories as a group. But there are a number of key differences among the specialty hospital types (Leavitt, Reference Leavitt2005). Cardiac hospitals, which when measured by number of beds are larger than approximately 30% of US acute care hospitals, are much larger than orthopedic/surgical hospitals; the former average 56 beds and the latter 14 beds (AHA, 2004; MedPAC, 2006). Specialty hospitals also differ substantially on payer mix. About two-thirds of cardiac specialty hospital patients are reimbursed by Medicare with the remaining one-third by private payers. For orthopedic and surgical hospitals, the Medicare-private payer mix is approximately the reverse. Specialty hospitals as a group are much less likely to have emergency departments than community hospitals (nearly all of which offer emergency services) but of the specialty hospitals visited by MedPAC, eight of the 12 cardiac facilities had emergency rooms, but only one of 11 surgical hospitals.

For policymaking, it would be extremely useful to envision physician-owned specialty hospitals along a continuum of limited service facilities. In many respects, cardiac hospitals have more in common with full-service hospitals than do orthopedic and surgical hospitals. The latter are more similar to ambulatory surgery centers (ASCs), a rapidly growing group of over 4,000 medical facilities that specialize in elective same-day or outpatient surgical procedures (FASA, 2006). For the most part, ASCs are owned by the surgeons who practice in them, and like specialty hospitals, ASCs have been exempt from the Stark physician self-referral laws. They generally do not have emergency departments and approximately half are single specialty.

More importantly, policy makers should be aware that the economic strengths as well as the problems associated with specialty hospitals do not apply equally across the continuum of limited service facilities. Early evidence suggests that cardiac hospitals may be more successful in lowering average costs than orthopedic/surgical hospitals. For its updated report on specialty hospitals, MedPAC found that in comparison to competitor hospitals, orthopedic and surgical hospitals had significantly higher inpatient costs per discharge, but cardiac hospitals had similar inpatient costs (MedPAC, 2006). This finding was attributed to lack of inpatient economies of scale and low occupancy in orthopedic/surgical hospitals. And a study of the effects of cardiac specialty hospitals on the costs and quality of care found that markets with entry of cardiac specialty hospitals have lower spending for cardiac care without significantly worse outcomes (Barro et al., Reference Barro, Huckman and Kessler2006). The most powerful argument in support of SSHs is that they induce community hospitals to improve their quality of service and to perform more efficiently. While early evidence suggests that cardiac hospitals may have an advantage over orthopedic/surgical hospitals in this domain, more research in this area is very much needed.

Policies aimed at addressing potential physician inducement of services and/or patient selection problems also generally do not consider that these problems may not apply equally to all limited service facilities. For instance, there is now general agreement that specialty hospitals treat lower severity patients (Cram et al., Reference Cram, Rosenthal and Vaughan-Sarrazin2005; Moore and Coddington, Reference Moore and Coddington2005; Barro et al., Reference Barro, Huckman and Kessler2006; Greenwald et al., Reference Greenwald2006; Guterman, Reference Guterman2006; Mitchell, Reference Mitchell2006), but there is also evidence that patterns of such patient selection differ by type of specialty hospital. MedPAC found that cardiac hospitals treated both more profitable diagnosis-related groups (DRGs) and less severe patients within DRGs, that favorable selection by surgical hospitals was limited to within-DRG severity, and that orthopedic hospitals showed evidence of neither form of selection (MedPAC, 2005). Thus, from a policy standpoint, the merits of re-weighting the Medicare DRG reimbursement schedule to improve payment equity are very different for cardiac hospitals than for orthopedic or surgical hospitals.

Evidence for potential demand inducement, while limited, also points to differences across types of specialty hospitals. Research shows just 6% higher utilization of cardiac surgeries nationally across markets with and without physician-owned cardiac specialty hospitals (MedPAC, 2006). However, research on physician-owned orthopedic hospitals shows very dramatic increases in market area volume and utilization rates for spinal and other surgeries in Oklahoma as a result of specialty hospital entry. For example, the market area utilization of highly profitable spinal fusion surgery increased 100% in Oklahoma City and roughly 1700% in Tulsa following the recent entry of three physician-owned orthopedic and spine hospitals serving those markets (Mitchell, Reference Mitchell2006). These results of research on potential demand inducement mirror the relative incentives among hospital types as measured by the share of physician ownership. The percentage of ownership by all physicians combined varies from 35% in cardiac hospitals, to 67 and 73% in orthopedic and surgical hospitals, respectively (MedPAC, 2005).

A new organizational paradigm

A decade ago, conflict between competition and regulation in the US hospital industry centered on a storm over nonprofit conversions to for-profit status. In the public interest, that issue raised questions around responsibilities that hospitals have to their communities, and concerns over access to health care by vulnerable populations. Since then, the growing percentage of community hospitals that are for-profit has leveled off, and research increasingly suggests that full-service nonprofit hospitals and for-profit hospitals are becoming more alike, and can be expected to become even more alike in the future as competition increases (Sloan, Reference Sloan, Culyer and Newhouse2000). They have converged in size as measured by number of beds (David, Reference David2005), and are not very different in the share of patient operating expenditures devoted to uncompensated care. While the average Medicaid payer mix and amount of charity care provided by nonprofit hospitals is somewhat higher than for-profit general hospitals, this difference is driven by a small percentage of nonprofits. Most nonprofit hospitals are similar to for-profits in providing care to under-insured and charity cases, with the bulk of the burden borne by public hospitals. Nonprofits claim to provide additional contributions to their communities, however efforts at monitoring these community benefits have reportedly been largely unsuccessful (GAO, 2005b).

More relevant is the fact that both for-profit and nonprofit full-service hospitals have financial strategies for cross-subsidizing services with different levels of profitability. Through cross-subsidization, hospitals maintain support of services such as emergency, trauma, and burn care, which are more costly and which also are more heavily utilized by uninsured and underinsured patients. Smoothing profitability levels within the Medicare administered pricing system can reduce within hospital cross-subsidization of services and possibly eliminate an unfair advantage currently benefiting physician-owners of specialty hospitals. At the same time, this policy approach may impair the ability of full-service hospitals to provide access to underserved populations.

The growth of limited service facilities is creating a new organizational paradigm that is more complicated than the old dichotomy between nonprofit and for-profit ownership of hospitals. This industry-wide evolution encompasses not only specialty hospitals, but ambulatory surgery centers, physicians’ offices where procedures that were formerly done only in hospitals are now increasingly performed, and a rapidly growing number of cutting-edge diagnostic centers, all of which threaten to siphon insured patients who require services that generate profit away from general hospitals.

One distinction that appears to be emerging from the early stages of research is that on average, full-service hospitals treat more complex and more costly patients. Proponents of limited service facilities argue that nonprofit hospitals are already compensated for these additional costs through a variety of tax advantages, namely exemptions from most federal, state and local taxes, opportunities for low interest rate bond financing, and the ability to collect tax-deductible donations. This argument is not sufficiently sensitive to the context of the new competitive environment created by specialty hospitals. While it is true that nonprofits receive favorable tax treatment that arguably has helped level the playing field between nonprofit and for-profit hospitals over the years, the recent growth in physician-owned hospitals has disturbed that balance because entry has been in the most profitable specializations for treatment of relatively profitable patients.

Leveling the playing field

In October 2006, CMS took the first step toward refining the inpatient reimbursement system by adopting a cost- (as opposed to charge-) based system for calculating DRG payment weights. Further adjustments in relative reimbursement rates are currently under evaluation (Hayes et al., Reference Hayes, Pettengill and Stensland2007). Improvement in payment accuracy is an appropriate and important policy measure that will go far in creating an equitable environment for competition. Yet the Medicare payment system is not the outcome of a competitive process. Eliminating distortions in the weights is warranted and possible, but DRG payments are still administered prices, and overdue updates cannot make them entirely reflective of differences in cost, which will remain largely obscured to observers and continually in flux. Moreover, attempts by MedPAC to make payments more equitable, could have unintended consequences given that hospitals rely on the stability of DRG payment weights to set particular reimbursement strategies. Therefore, the process must be undertaken with great care.

Revising the Medicare payment system could be a giant step toward leveling the playing field in the hospital industry if done effectively. Yet even if successful, it will be inadequate to restore complete balance, and it will not have the same effects on orthopedic/surgical as on cardiac hospitals, since payer mix varies so much. Full-service community hospitals may continue to bear the weight of more complex patients and, particularly in the case of public hospitals, the burden of the uninsured. But in the new competitive environment marked by the entry of physician-owned single specialty hospitals, the tax exemption advantages of the past will not be sufficient to compensate community hospitals for their distinct social mission.

The role of commercial non-Medicare insurance in the development of limited service facilities is still unfolding. In theory, private payers stand to benefit from increasing competition among hospitals, which can enhance payers’ market power in rate negotiations with hospitals. Yet to date, many payers appear to be reluctant to include specialty hospitals in their networks out of concern over jeopardizing their relationships will full-service hospitals (Chollet, 2007). Others have refused outright to reimburse physician-owners for expensive ancillary services, which they believe are prescribed increasingly by physicians when there is an ownership interest (Berenson et al., Reference Berenson, Bodenheimer and Pham2006).

New policy approaches to restoring balance in the hospital industry are needed, but they are not unprecedented. ASCs receive different payments from Medicare for the same services performed in outpatient units in full-service hospitals. Medicare reimbursement for inpatient services in psychiatric and rehab specialty hospitals have been different from general medical and surgical hospitals from the beginning of the Prospective Payment System (PPS), as regulators recognized early on that the criteria for diagnosis and treatment in these specialties were less well-defined. The Medicare disproportionate share adjustment was also instituted early in the PPS era when it became clear that larger payments were called for in hospitals serving large portions of indigent patients. And more recently, as part of the Balanced Budget Amendment of 1997, Congress established the Critical Access Program which permits financially vulnerable rural hospitals to receive cost-based reimbursement under Medicare.