Bigger is NOT Better: The Disruption of the Consolidated Hospital Industry

Bigger is NOT Better: The Disruption of the Consolidated Hospital Industry

Are physicians who are employed by hospital systems set up for failure?     

Physicians are moving away from the traditional independent practice and seeking refuge in employment models endorsed by resource-rich conglomerates such as hospital systems.  This plausible trend is a result of ongoing threats to physician reimbursement, operating costs heading disproportionately higher and more administrative and compliance burdens with Obama Care. But what if the healthcare industry today is on the verge of disruption?  Have doctors made the right decision to merge with hospital systems or did they sell their souls early?  There is no better way to analyze these questions properly than by reviewing the power of Harvard Professor Clay Christensen’s theory of disruptive innovation.  

Regarding this theory, the large consolidated hospital model that believes that a strategy of “bigger is better” and “we will do everything for everybody” follows the same flawed pattern replicated time and time again across all industries.  Unfortunately for hospitals, this model will eventually succumb to the disruptive forces and instead of continued consolidation, disintegration will ensue.      

“Were it not for today’s tangled web of subsidies, administered prices, and regulations that constrain competition, today’s general hospitals would not be economically or competitively viable.”  The Innovators Prescription, pg 76

Christensen’s concern about the unsustainability of the current hospital delivery system without subsidies can be best exemplified by the expansion of the 340B, a pharmacy program that started in 1992 but will see considerable expansion under The Affordable Care Act.  Under 340B, certain hospitals can be eligible to buy drugs at a forced discount, sometime up to 50%, while charging the full cost to the consumer contributing to a hefty margin.  The well intentioned plan has now expanded to include up to a 1/3 of all hospitals in 2011 compared to just an estimated 90 hospitals in 1992.   This program alone amounted to approximately 40% of Duke University Health System’s operating income in 2011.   With only 5% of the Duke’s 340B qualified patients categorized as uninsured, it seems the program is now serving mostly a financial agenda versus its original intent.    

According to Christensen, history has demonstrated that the pattern of growing into a large, vertically integrated entity to gain adequate competitive advantage has failed with companies like IBM, AT&T, Merck, Pfizer and other industry leaders. Following this course impacted those industries in ways that forced disintegration or de-consolidation. For example (this example in book), IBM was forced to outsource many of its original functions in order to focus on their core business of assembling computers.  This outsourcing of software and hardware components spawned new companies such as Microsoft and Intel.  The Healthcare industry is destined to experience the same effect.  The consolidation of hospitals with physician practices as a means of “getting bigger and being all things to all patients” is not a sustainable model for the future, but one set up for disruption.  In fact, it has already begun.

Before we can explore why disruption in the healthcare market is inevitable, we need to first determine why vertical integration is the key strategic initiative of large delivery systems.  This initiative has led to a doubling of hospital employed primary care physicians and quadrupling of specialty physicians since 2000. These trends are creating a new practice paradigm where independent practices led mostly by physicians are becoming extinct while an accelerated shift in the direction of hospital-physician employment model is on the rise.  The reason is obvious:  more money.  Conglomerate healthcare entities are able to negotiate higher fees for patient services due to their scalability, therefore using their power to get more dollars per transaction.  For example, Mr. David Hubbard, a patient from Reno highlighted in a recent WSJ article, saw a four time increase in cost for an echocardiogram study from just 4 months prior.  Why such a difference in cost?  The independent cardiology practice was recently bought by local hospital system.  Since the cardiology practice is now unified with the local health system, the fees charged to the patients can now be charged at the systems’ rates which are almost always much higher.  With no substantial change in service or equipment, it is safe to conclude there is no real added benefit to the patient.  In fact, it seems that a price tag that went from $373 to $1605 per study has significant financial ramifications straining our 2.5 trillion dollar healthcare industry further.  Furthermore, even the 340B pharmacy program discussed previously can play a role in price inflation.  According to an article written in the WSJ by Scott Gottlieb:

“Acquiring a single oncologist and moving the doctor's drug prescriptions under a hospital's 340B program can generate an additional profit of more than $1 million for a hospital. In the process, treatment of the doctor's patients is moved from an office setting to a hospital outpatient department.”

An August 2012 article in the WSJ illustrates this phenomenon further:

“Major health insurers say a growing number of rate increases are tied to physician-practice acquisitions.  The elevated prices also affect employers, many of which pay for their workers’ coverage.  A federal watchdog agency said doctor tie-ups (Note:  Physician practices/hospital consolidations) more likely resulting in higher Medicare spending as well, because the program pays more for some services performed in a hospital facility.”

Because of these tactics and inherent structural flaws in our healthcare system, it is often a wise decision for the independent practices to merge with the consolidators.  Can you blame them?  With very few adjustments to patient services, the physicians can often benefit from higher salaries and employment benefits, and the new employer will can benefit from higher quantity of studies at the inflated fees.  The employer will also benefit from an improvement in the referral tributaries as they seek to widen their catchment opportunity, an enormous benefit under the current payment incentives.  This “structure” yields even more opportunistic dollars as physicians will typically refer within the system to which they are now employed.  However, how will vertical integration in healthcare fair as the disruptive forces begin challenging the status quo?  Have physicians that chose to unite with the “big-is-beautiful” camp, a phrase coined by author Regina Herzlinger, made the right decision?  Long term, it is clear, at least to me, that it may be the wrong decision for a majority of physicians, in spite of the fact that today’s economic forces, administered prices and regulations clearly support a case for large vertically integrated systems.       

The inevitable shift that will disrupt the consolidation model of today is best defined by Harvard professor Clay Christensen who coined the term: Disruptive Innovation. This disruption must have three (3) effects to occur:  a technological enabler, a business model innovation, and a new value network.  Technological enablers change once complex problems that once required expert analysis shift to a more simplified rules-based system that involves less human skill, thereby reducing costs significantly. 

“Those technologies that enable precise diagnosis and, subsequently, predictably effective therapy are those that have the potential to transform health care through disruption.  Scientific progress usually advances to the point of commoditizing their expertise, thereby enabling many more scientists and technicians to continue building on their initial work.” 

Business model innovation involves 4 points:  value proposition, resources, processes and profit formula.  Value proposition is a must for any business and is intended to “help customers do more effectively, conveniently, and affordably a job they’ve been trying to do”.  The success of any value propositions must be aligned with existing resources, processes, and profit formula. 

The third type of business model, facilitated networks, comprises institutions that facilitate systems where customers can buy, sell, deliver and receive things from other participants according to Christensen.  For example, in the book, The Innovator’s Prescription, consumer banking and multiplayer internet gaming would qualify as network businesses.

Miraculous technologies such as computer-aided tomography (CT), positron emission tomography (PET), magnetic resonance imaging (MRI), technologies that weren’t even available 40 years ago, have disrupted the surgical practice by dramatically decreasing the amount of exploratory surgeries required to “see what’s inside” a patient’s body.  The disruptive forces will move through each piece of the value chain starting with the least profitable and move steadily upward spreading throughout the system says Christensen.  Healthcare industry disruption is here today. 

“Historically, it is almost always new companies or totally independent business units of existing firms that succeed in disrupting an industry.”

As technology enablers replace the traditional ways of providing healthcare services, disruption will continue.  For example, nurse practitioners and physician assistants will disrupt primary care physicians and CRNA’s will disrupt anesthesiologists, as rule-based disease can be handled by lower cost professionals.   Primary care physicians will disrupt specialists as up to date medical information and decision making tools become more readily available and accessible. Telemedicine will also play a large part in disruption.  As technology enables us to precisely diagnose cause, then therapy can be targeted effectively for each patient and become standardized.  This will create new networks and business models just as Microsoft and Intel spawned from the disruptive forces that ultimately changed IBM.  Mr. Christensen calls this the path to precision medicine.  As more of our disease processes are better understood, more of how we “practice” medicine will become more efficient and cost effective. 

So what does this all mean?  The healthcare incumbents are acting exactly how all threatened incumbents typically act, using the “rear view mirror” to pave the path for the future and ultimately succumbing to the disruptive competitors. As in every other industry that reacts to the threats of disruption, we see consolidation and vertical integration first as a reactionary impulse and necessity.  A great example of this can be seen in the billion-dollar drug industry.  According to Christensen, Pharmaceutical companies like Merck had to integrate in order to keep up with the steep scale required to play in the industry.  They had to take on research and development, distribution, and marketing which, at first, was required in order to sustain a competitive advantage.  Healthcare conglomerates are stuck in this strategy.  However, much like other industry companies like U.S. Steel and GM who went through a similar course, disruption is inevitable.  For example, in the pharmaceutical industry much of the disintegration is resulting in more outsourcing to firms who focus on drug discovery.  The products that have been discovered through outsourcing now represent 30% of pharmaceutical sales today according to Christensen.  As the story unfolds, the vertically integrated monolithic entities of today must go through the disruptive era all but ensuring de-consolidation and a breakdown of the current “bigger is better” trend.   

As fast as industries consolidate, de-consolidation will work to balance the shift.  Outsourcing and de-consolidation is the first step toward disruption.  Christensen explains that disruption occurs by implementing business models that adequately support the specific needs of the people.  Christensen uses Norwegian School of Management Professor Fjeldstad’s three general types of job-focused business models to make his point.  Those three models are solution shops, value-adding process (VAP) businesses, and facilitated networks.  Historically, de-consolidation will translate into leaner more efficient specialty clinics that will utilize two of the three job-focused models:  solution shops and VAP businesses (Christensen’s analysis).  This is where physician-centric healthcare entities will bring value.  Those areas of medicine that are largely dependent on intuitive medicine will continue to be paid through a fee for service type of arrangement, much like legal services of today.  This model is called solution shops, where most of medicine is parked today.  Those other areas of medicine where precision medicine is well defined, the model will follow the VAP model where payment is tied to an outcome.  This model is usually embedded in processes and equipment versus expert consulting.  An example of a VAP business would be a Lasix specialty clinic or MinuteClinic which deliver care at prices up to half of physicians’ practices and hospitals.  Even more complex areas of medicine are now moving toward VAP models such as transplant services where payment is now moving in the direction of bundle payments according to Christensen.

Disruption occurs when the existing business model is not sustainable.  Hospitals today are largely solution shops with VAP models intermixed.  The problem with this according to Christensen is the following:

“As technological and scientific progress enabled standardized processes and treatments for precisely diagnosed disorders, hospitals commingled value-adding process and solution shop activities within the same institution-resulting in some of the most managerially intractable institutions in the annals of capitalism.”

In other words, the conglomerate entities that are “all things to all people” will inherently fail not because they are bad people.  They are some of the best leaders in the industry and are only playing by the rules of today.  The issue is that the current business model encompasses two separate models under one roof.  By definition this setup is a failed approach that cannot possibly be managed effectively according to Christensen.  

The opportunity for physicians to regain the value proposition and autonomy required to truly deliver the right care individualized for the patient will come full circle, however, under much different business models.  Those businesses that are “hired to” diagnose will behave mostly as solution shops.  Those businesses that are created to “fix” the issue after a diagnosis will be largely under a VAP model.  According to Christensen, “These activities are not unlike those that occur in… a manufacturing plant, or the kitchen of a restaurant… workers pick up a set of tools, follow a series of relatively proven value-adding steps, and then ship a more complete product out the other door”. 

As Mr. Christensen goes on to point out, there are three key lessons that we can garner from history.  First, the technological enablers almost always emerge from laboratories of leading institutions.  Business model innovations do not!  Regulators and incumbents will seek to impede the oncoming disruption but they always fail in the end.  An excellent example of this was articulated in Regina Herzlinger’s book, Who Killed Health Care, when a local hospital system successfully bankrupted the specialty hospital, Heart Hospital of Milwaukee. The local hospital refused to sign contracts with insurers that also had the specialty hospital in their networks and pressured referring physicians affiliated with them to not refer patients to the specialty hospital.   Dr. Bruce Wilson, a physician-partner, commented:

While hospitals claim that it is a conflict for doctors to own hospitals, nobody seems to be saying that it is a conflict for hospitals to own doctors.  As in virtually all cities with heart hospitals, Milwaukee’s general   hospitals told their “owned” physicians whom they could and could not use as heart specialist… They removed my partners from ER on-call lists.  How does it feel to know that the person who manages the general hospital is choosing your specialist for you and denying you access to focused programs?”

Not only was local competition stifled in the above example, the U.S. congress has time and again proven to be a great friend to the big-is-beautiful camp by promoting laws that impede competition.  When transparency was the focal point, U.S. Congress often helped promote opacity- a goal of the big conglomerates.  In Who Killed Healthcare, Herzlinger asserts:

“It was up to the U.S. congress to force these guys to come clean.  But the hospitals and insurers testified at this meeting that transparency would confuse us.  They might be willing to post a range of their prices- say, a number between $200 and $3,000- but an exact number? No, too confusing… I had heard these self serving arguments against transparency many times, but I had never heard them used against the poor uninsured before.”  Who Killed Healthcare, pg 3.

It is also of note that the most important stakeholders, the physician and patient, were excluded in the congressional hearings.  This has become a reoccurring theme that has become a standard in healthcare debate.   

To support her case further, Herzlinger emphasizes monopolistic trends and its negative impact on affordability by four observations in her book Who Killed Healthcare.  First, hospitals have decreased more than 20% between 1970 and 2005 suggesting high merger activity.  Second, mergers are not the only means of stifling competition but also come in the form of affiliations.  She states that there are roughly 2,700 hospital “affiliations” that assist in the creating mega systems.  Third, in 2003 alone, consolidation via mergers and affiliations led to 700,000 more individuals unable to afford healthcare or 5.5 million between 1990 and 2003.  Lastly, many hospital markets have doubled their HHI, Herfindahl-Hirschman Index (a measure of undue concentrations in a market), from 1990 to 2003. 

Others have questioned the massive power and consolidation of the conglomerates as monopolistic.  As recently as September of 2012, California’s attorney general weighed in, also in the WSJ:

“California’s attorney general has launched a broad investigation into whether growing consolidation among hospitals and doctor groups is pushing up the price of medical care, reflecting increasing scrutiny by antitrust regulators of medical-provider deals.”

Disruption rarely comes about piece by piece according to Christensen.  Entire new value networks arise, disrupting the old.  In the end, EVERY industry leader embarks on the same pattern of failed strategy by continuing to promote and improve their best products by focusing on the most profitable customers.  This is exactly how the healthcare industry is behaving today.  Those with the most power, e.g. hospital systems, have to consolidate in order to perform in today’s production model much like the pharmaceutical industry has done in the past.  The scale required for success dictates this behavior as does the profit formula. 

An analogy of today’s healthcare model can be compared to the mainframe computing industry, a comparative example used by Christensen.  Much like the mainframe computing industry, healthcare is made up of mostly large centralized centers that perform all things for all people at a hefty cost with extreme inconvenience.  This is exactly how ALL industries start out: large, vertically integrated with mostly expert, expensive consulting as the only option.  Just as the mainframe computing industry was disrupted by the mini and personal computer, the large healthcare conglomerates will also be disrupted by expert, focused centers with synergistic business models created to meet the demands of the patients.  As disruption works its way toward disintegration, there will be a place for the hospital industry, although the scale will be less grand and the service more focused.  As we have learned from every other industry from steel to computing, the large expensive hospital systems will be forced to move toward disintegration and will serve only those patients that will require the most complex disease management and intensive care.  The rest will fall into diversified solution shops and VAP models because it will be cheaper, more convenient, with higher quality and service.  This set up is exactly what patients are looking “to hire to get a job done”. 

So, it is clear why the acquisition of physician practices by hospitals is enticing to BOTH parties and it is very predictable behavior by both stakeholders.  In other words, the hospitals and physicians are responding in ways that are very typical of an industry that is on the verge of being disrupted.

I look forward to the future of healthcare and agree with Mr. Christensen that its course is no different from other industries.  The disruptive forces are at work today and will continue to shape the future of healthcare.  My question to my fellow colleagues:  Are your actions today aligned with the changes that disruptive forces will manifest or will you continue down the path of least resistance until it will be forced upon you?

 

Article written by:
Robert Moghim, M.D.
CEO, Onyx M.D.

Disclaimer: The views expressed in this article are the personal views of Robert Moghim, M.D. and do not necessarily represent and are not intended to represent the views of the company or its employees.




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