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Vertical versus virtual integration

By David M. Zimba

Managed care and capitated insurance plans continue to force market strategies upon health care providers. Many organizations have embraced the concept of vertical integration, where hospitals, physician groups and health plans are owned and operated by a single entity. The belief is that the integrated delivery system will be able to reduce costs, improve quality and increase market share by owning and coordinating components of the health care system.

While certain benefits may be realized through vertical integration, this asset-based method of organizing health care delivery has some drawbacks. First, purchasing the organizations that make up the system is very costly. Hospitals, medical groups and HMOs will have to spend, on average, the following amounts to purchase components that make up integrated delivery systems: independent practice associations/managed care networks—$ 1.2 million, physician-hospital organizations—$2.2 million, staff-model physician organizations—$7.8 million, management services organizations—$9.6 million, freestanding medical groups—$19.7 million, foundation-model medical groups—$20.0 million.

The result is that many vertically integrated organizations have undertaken sizable debt and have negatively affected their competitive position. Owning everything, particularly those components that are dissimilar to your core competency, could place a significant burden on your financial position.

A second drawback to this model of vertical integration is that the creation of one large entity may make it less responsive to the needs of the market. Several integrated staff model HMOs offer a poignant example. Many wholly owned staff and group model HMOs were unable to respond to the changing market conditions that managed care produced during the first half of the 1990s. Increased competition led buyers to demand broader choices and more convenience for their enrollees, but several of these organizations’ structures and systems of internal controls did not allow the flexibility to meet these needs. After losing ground to the competition in the early 1990s, staff model HMOs have now begun offering other forms of provider plans. Had these organizations not been so capital-intensive and rigid in their organizational structure, they probably would have been able to respond much more rapidly to the changing demands of the market. Third, physician groups that are becoming components of a larger system often lose the incentive to produce that comes with autonomy and a small business environment. As managed care evolves, we may find that the vertically integrated organizations do not offer the optimal solution to providing efficient, cost-effective care. Hospitals are under a false sense of security when they believe that owning physician practices will guarantee their future.

Finally, when an integrated system creates or purchases its own HMO or other similar health plan, it may lose business from current customers. Competing insurers may see the integrated system’s actions as a threat and pull existing contracts for delivery of patient services.

What’s the Best Structure for Health Care?

Vertically integrated delivery systems offer opportunities to reduce costs and improve health care delivery, but the negative aspects of asset-based integration can reduce or eliminate the value of these benefits. Is there an organizational system that will allow the health care industry to lessen some of these potentially negative outcomes of integration? Virtual integration may be one alternative solution.

Virtual integration is similar to vertical integration in the sense that it attempts to link the components of an integrated system to operate as a single entity. The means with which this objective is reached, however, are quite different. Virtual integration emphasizes coordination through patient management agreements, provider incentives and information systems, rather than investment in large numbers of facilities and people. The virtually integrated system seeks to link the core competencies of individual organizations through cost-sharing and risk-sharing agreements so that these organizations can act as a larger, single entity.

The virtually integrated organization utilizes the concepts found in standard contractual agreements and alliances, but it takes the organizational responsibilities one step further. First, there is an operating system of agreements and protocols for managing patient care. The partners in the system agree on how the organization will be run and the most appropriate methods of patient care. Second, a framework of incentives governs how physicians and hospitals are paid. Third, information systems are linked to provide a seamless delivery of patient and administrative information. These differences allow the components of the virtual organization to share information, avoid duplication of services, and ultimately share risk.

The biggest attraction of virtual integration is that organizations can integrate care without investing huge amounts of capital or completely altering their structures. These savings should allow the linked organizations to invest in the technology and training needed to improve the cost structure and quality of care of these organizations. Virtual integration also allows for the linked organizations to continue to operate as separate entities, giving them opportunities to pursue business in other areas.

One example of virtual integration is The Northwest Physician Alliance, comprised of Blue Cross/Blue Shield of Oregon, Legacy Health Systems and three large physician practices that have grouped together to act as a single integrated delivery system, yet remaining self-owned organizations. They have created a governing board that will steer the direction of the joint venture and have begun creating the information systems infrastructure that will allow rapid access to patient care records and managed care data. The risks and rewards of this venture are divided among the member organizations. BC/BS will be able to reduce expenditures on claims processing and utilization review, since the clinicians and hospitals have a vested interest in reducing costs, and the physicians and hospitals in the Alliance now have more control over patient care because they are financially linked with the payor. Eventually, the Alliance will be fully capitated, with the physician groups, hospitals and BC/BS jointly setting capitation rates for the system. Each member of the Alliance is allowed to pursue other opportunities as well, which means that clinics and hospitals may continue serving other insurance plans and BC/BS may continue to offer other forms of insurance.

The Northwest Physician Alliance should reap the rewards of successful virtual integration. The key to its success and to that of others attempting this type of alliance rests on the ability of management to make the concept work. Management must build relationships with other companies, negotiate “win-win” deals for all parties involved, find the right partners with compatible goals and values and provide the alliance with the correct balance of freedom and control. If management can do this, the benefits from virtual integration should abound.

Virtual integration has the opportunity to revolutionize the health care industry because it is able to draw on the positive aspects of vertical integration (reduced costs, a focus on the care continuum and increased market share) without creating sizable debt for the parent organization. If management can create the proper environment, companies participating in virtual integration agreements will be able to use their core competencies to create a stronger umbrella entity that is more responsive to the needs of the patient. As market conditions evolve, the independence maintained by these contractually linked organizations should allow them to be more responsive to changes in the health care industry.

David M. Zimba is a manager in the Healthcare Consulting Practice of Arthur Andersen LLP in Pittsburgh.


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