A profound change is occurring in the health care industry, one accelerated by the damage inflicted by the capital and credit market crises and by the basic principles of reform. The change is the emergence of a new business model that is surfacing independently of legislation in the health care or financial arenas.

Since Medicare was introduced in 1966, the hospital industry has operated under a model driven by the fee-for-service payment system. Fee for service has generally rewarded health care providers for growth in both total services provided and market share.

The twin impacts of the financial crisis, which significantly diminished the financial position of many hospitals and health systems, and the enduring tenets of health care reform, which include improved value of delivered services and increased provider accountability for outcomes, are now eroding the current business model. We believe that the hospital industry may now, in fact, be experiencing the process that Austrian-born economist Joseph Schumpeter described in 1942 as "creative destruction."

Then teaching at Harvard University, Schumpeter used this term to explain how change occurs in a capitalistic economy through a process of destroying old models and creating new ones. According to Schumpeter, the genius of capitalism is that it incentivizes people in the business world to identify what's old and not working well and to replace it with something new that works better. Continuous replacement of models that have become stale gives capitalism its ongoing vibrancy, he noted.

Examples of this process in business are both plentiful and increasingly significant. Bill Gates' invention of the PC operating system substantially impacted the mainframe computer business. Apple's iPod both destroyed the CD business and permanently damaged the revenue model in the music business. Google's recent addition of free GPS software to cell phones is creating an unexpected competitive threat to the GPS device industry.

In health care, a similar change is under way with ever-louder calls for hospitals to work with physicians, patients and other constituents in a very different way.

Tomorrow's Definition of Success

Within the new business model, strategic and financial success for hospitals and health systems will not be achieved through the volume of services provided. Rather, success will come from positive patient outcomes at acceptable "value," defined with quality and cost dimensions, with care processes integrated across the continuum of care. To achieve the goal of highest value for lowest cost, patients will need to receive services in the right place. As has been highlighted during the reform discussions, this would push hospitals and physicians to coordinate patient care along the provider continuum in more cost-effective and appropriate ways.

The Obama administration has been citing certain organizations as models of the health care delivery system under this new business model. What these organizations have in common are strong physician traditions and culture with continued visible and effective physician leadership, and the employment of most, if not all, of the physicians who practice in the organization.

During their many decades of operations, for example, Geisinger Health System, Kaiser Permanente and Mayo Clinic have aligned organizational and physician interests both clinically and financially. The assumption is that such alignment has given these organizations greater control of patient care costs, quality and outcomes.

Many of the model organizations also have extensive care and disease management capabilities, achieved through the use of evidence-based protocols. They also have effective IT platforms, which help to ensure maximum levels of clinical and operational effectiveness and efficiency and include electronic medical record systems that have been in place for many years.

There's much talk about the "replicability" of the systems and cultures embedded at these organizations, but it is clear that the new business model would require hospitals to gain closer economic alignment with physicians and tighter control of both services provided and related costs.

This trend is likely to alter thinking about who needs care in hospitals, what procedures physicians are allowed to perform in them, and how they define their markets. Hospitals likely to be most successful in delivering services with this new operating method are those with highly integrated arrangements with physicians, efficient use of capital, the ability to direct patients to the lowest cost setting consistent with quality and outcomes targets, and the capacity to direct the care delivery process from start to finish.

Although there appears to be broad agreement with this direction, the mechanisms to get there have yet to be fully defined and proven. Both the Centers for Medicare & Medicaid Services and commercial payers have been testing various payment and care delivery methods based on this business model. These include:

  • Bundled payment, which provides a single payment for an array of services by multiple providers to care for a patient diagnosed with a specific condition across a defined episode of care; and
  • Various value-based payment systems that link payment more directly to the quality of care provided.

Health Care as a Social Good

For hospitals, physicians and other providers, the fee-for-service environment offered a more predictable volume-based revenue stream. As such, it changed health care from a social good to an economic good. Business or economic goods respond to supply and demand curves; social goods do not. The move away from fee-for-service reimbursement mechanisms in the new hospital model could change health care back to a social good.

From a payment system perspective, the fee-for-service model appears unsustainable. Since 1970, total health care spending has grown at an average annual rate of 9.6 percent, or about 2.4 percentage points faster than nominal GDP, according to a 2009 Henry J. Kaiser Family Foundation report. Articles about how fee for service incentivizes utilization of services while doing little to emphasize quality, value and outcomes proliferate in the popular and professional press. A May 2009 White House fact sheet noted that the administration's goal is to reduce the rate of increase of total health care spending by 1.5 percentage points.

Eye on Utilization

To reduce utilization and costs, payment mechanisms in the new business model will need to create incentives to provide necessary and appropriate care. There are only two ways to reduce total health care costs or slow the rate of cost increase: reducing price or reducing the number of units of care provided.

In this regard, it is important for health care executives to carefully consider how utilization will change. There are two ways to view the situation: First, utilization may dramatically increase, driven by two critical factors—baby boomers coming into the Medicare program and by what many experts point to as the now rapidly increasing provision of chronic care. Second, the increase in utilization may slow because the changing business model will require providers to aggressively manage costs to keep pace with changing reimbursement assumptions.

Obviously, resource allocation decisions for both physical and intellectual capital will require a point of view on the direction of utilization. Pay close attention to local and national trends around utilization and make sure your scenario planning is robust and taking all options into account.

Operational Pressures

As a result of the economic crisis, hospitals and other providers are facing challenges that could make it difficult to absorb the financial impact of a transition to a different business model. The crisis led to the worst stock market crash in 80 years, followed by the worst recession since the Great Depression. These events have had a direct, powerful impact on the financial stability and equilibrium of many nonprofit institutions.

The list of miseries creating pressures on hospital operations, credit quality and capital is a long one, and includes softening volumes, deteriorating payer mix, increasing bad debt, falling operating and EBIDA (earnings before interest, depreciation and amortization) margins, reduced liquidity associated with considerable investment losses, reduced access to capital, more expensive capital when it is available, and accelerating capital needs related to physicians, facilities and information technology.

Movement toward achieving the goals of reform will place additional pressures on the existing hospital business model. A high degree of change will be required of hospitals to provide care to 32 million newly insured patients by 2019 while reducing costs, improving value and increasing provider accountability for outcomes. The population of uninsured or underinsured patients up through and beyond 2019 will present a continuing challenge as well. Shrinking payment updates and penalties will accelerate the financial impact on hospitals. For example, Medicare payment update reductions start this year; penalties for "excess" readmissions begin in 2013. At some point, Medicare may simply stop paying providers for hospital readmissions within 30 to 60 days of discharge. According to a White House fact sheet on the 2010 budget, 18 percent of hospitalized Medicare patients are readmitted for care related to their original admission. No reimbursement for those readmissions would have a significant financial impact on hospitals. All of the concepts mentioned earlier represent fundamental, not incremental, change to the hospital payment system.

Where Do We Go From Here?

The combined challenge of the economic crisis and health care reform is leading to tremendous consolidation pressures in the health care industry, especially among not-for-profit hospitals. At this point in history, there appear to be three distinct types of hospitals and health systems on the consolidator-consolidated spectrum.

The first type is organizations that have been doing well during the last 10 to 15 years and may have the opportunity to do even better under the new business model. They have a high degree of readiness in the area of hospital-physician integration and financial strength to move aggressively within their markets.

The second type is organizations that have been struggling under the old model and are likely to struggle more under the new model. They have a low degree of hospital-physician integration and little financial strength to invest in strategies required by the new business model.

The third type is organizations that have newly challenged financial and market positions and, given new models and standards, have complex strategic decisions immediately ahead of them. Continued independence as a stand-alone hospital or small hospital system may no longer be viable. The moves these organizations make toward partnerships with stronger health systems may largely determine how fast and how radically different markets react to consolidation.

Hospital boards and management teams should analyze their organizations' current strategic-financial condition and how they might be positioned competitively under a new business model. Asking and answering the following five questions can help to clarify their status.

  1. Does our governance structure support the strategic decision-making that may be needed imminently for dramatic service delivery changes? Discussions around board committee structure, size, composition, meeting frequency, functioning and culture would be appropriate. Will these characteristics and practices work to the organization's advantage in a rapidly changing care management and payment environment?
  2. Does our management and administrative structure and skill set support the rapid changes that may be required for the new business model? A 1960s hospital administration structure and style are probably not going to be appropriate; the new model would require hospital executives with significantly different skill sets. Because hospitals will be employing physicians, physician management capabilities—including the ability to integrate, organize and retain physician groups—would be critical. Care management capabilities and a thorough understanding of quality, performance and outcome evaluation would also be required, as would expertise in the development of sophisticated IT and hospital communication systems.
  3. Is our existing portfolio of hospitals and other lines of business the right portfolio for changing competitive conditions? Businesses accumulated by hospitals and health systems during the past decades, such as long-term care facilities, home health agencies, managed care plans or joint-venture ambulatory surgery centers may no longer be affordable or essential to the organization. The portfolio of services should be carefully examined and businesses that are not core to the mission should be considered for divestiture.
  4. Without assuming a level of risk that is unacceptable to the board and management team, can our financial plan be managed to create the capital capacity and working capital needed to grow and change our business model? The board must understand the total level of enterprise risk assumed as the organization changes its strategic direction under the new business model. It's likely that the organization will have to take on more risk. Financial leaders should ensure thorough and timely financial forecasting and scenario analysis to determine where the organization stands with each opportunity and how quickly opportunities can be pursued. In some situations, it may be appropriate for the organization to move more quickly; in other situations, it will need to slow down.
  5. What is the proper level of scale for our organization, given a certain market? All hospitals are currently asking questions related to size and scale. How big is big enough and how small is too small in these rapidly changing conditions? Marketplace competitive pressures going forward under a new business model would challenge hospital boards and management teams to a much greater extent than in the past. Market share would be determined not by the number of procedures or services performed, but by the number of patients under care and the quality of outcomes across the entire continuum.

Because the task of reorganizing care delivery is so substantial, hospitals will likely play a unique role. No other provider group has the ability to organize resources and execute strategies on such a broad geographic and comprehensive level.

Act Now

A new business model for the nation's hospitals will fundamentally alter the overall landscape for health services delivery and how hospitals survive and thrive in that landscape. Successful hospitals and health systems will be those that moved forward early to align with physicians, acquire care and disease management capabilities, implement integrated IT and communication systems, and gain sufficient size and scale to direct the care delivery process in their markets. First movers will be rewarded.

Kenneth Kaufman (kkaufman@kaufmanhall.com) is managing partner at Kaufman, Hall & Associates Inc. in Skokie, Ill.