Practice acquisition: the next generation

By William H. Maruca, Esq.

It wasn’t so long ago that health systems engaged in bidding wars against each other as well as against managed care companies and Wall Street startups to purchase medical practices in hopes of locking in physicians’ patient bases and lucrative referrals. We all know how that turned out. Guaranteed salaries rose through the roof, bonus target formulas proved to be unachievable, layers of inefficient management pumped up overhead, hospital-based billing offices bungled collections, incentives were misaligned, and many of the start-up practice management companies (and a few health systems) landed in Bankruptcy Court. Many physicians whose practices were purchased for six and seven figures were quietly returned to private practice at a fraction of the initial price, and some were even paid to take their practices back before the contracts expired. Having been burned, many health systems got out of the physician practice ownership business altogether, except for isolated strategic acquisitions.

In the intervening years, the regulatory environment has continued to tighten and the ability of hospitals to subsidize physicians in exchange for loyalty has been restricted by the ongoing series of Stark rules (including the last batch of proposed changes in the proposed Medicare fee schedule published on July 1, 2008), tax exemption considerations, the Anti-Kickback law, and enforcement pressure from the qui tam whistleblower bar. Hospital employment, often overestimated as a cure-all, still provides significant flexibility that other arrangements cannot match.

Hospitals still need physicians and their patients to survive, and many physicians are looking for ways to legally preserve or increase their income in an era of shrinking reimbursement and increasing costs. New forms of affiliations between hospitals and physicians are emerging that bear little resemblance to the 1990s style practice purchases. Here are two of the latest models we are seeing.

Some health systems have adopted this term to describe arrangements that attempt to retain much of the autonomy and incentives that characterize traditional private practice while establishing an employment relationship that permits levels of support otherwise prohibited for independent physicians. In a typical deal, the physician sells his or her hard assets to the health system for fair market value determined by an appraiser, and enters into an employment contract that includes features atypical to the 90s style employment contracts: there are generally few if any salary guarantees. Instead, the base compensation is based on a productivity model, sometimes referred to as “eat what you kill,” often supplemented by additional stipends for administrative/management duties, meeting quality standards, teaching, etc.

Many elements of overhead remain under the control of the physician, such as staffing levels, office leases, etc., with the health system retaining veto authority over big-ticket items. The physicians are given wide latitude on hiring office staff subject to the oversight of the health system’s HR department. The physicians may have the right to select their own billing agency or have billing performed by their existing staff (now employed by a health system affiliate), or alternatively “purchase” billing services from a hospital-owned MSO. The hospital may also be able to subsidize certain expenses such as electronic medical records or malpractice premiums for employed physicians.

Under this model, there are few top-down requirements or restrictions for office hours, call coverage or vacation since those physicians who choose to take more time off, work fewer hours or see fewer patients automatically see a reduction in their compensation package. There is typically no payment for goodwill or charts, and consequently there is often a pre-arranged disengagement mechanism under which the physician can opt to return to private practice after a stated period, reclaim the charts with no fee, and repurchase the hard assets at their market value. Instead of a broad geographic noncompete, the agreements contain a “soft covenant” prohibiting the physician from re-selling his practice to a competing health system for a time period, or alternatively, granting the health system a right of first refusal.

What’s the advantage for the health system? First of all, it’s much more affordable than the 90s style contract with large goodwill payments and guarantees. Secondly, the incentives for the physician are aligned with the hospital’s incentives – work harder, see more patients, hold expenses down, take home more money. Most importantly, under the Stark regulations, the existence of a bona fide employment relationship allows an employer to require its employed physicians to refer within the health system’s network for services such as hospital care and ancillary tests with three exceptions: the physician may not be required to make referrals to a particular provider, practitioner or supplier if the patient expresses a preference for a different provider, practitioner or supplier; the patient’s insurer determines the provider, practitioner or supplier; or the referral is not in the patient’s best medical interests in the physician’s judgment.

What’s the attraction for the physicians? First, retention of autonomy – nobody telling them how to run their practice, how many employees to hire or when they can take time off. Next, control over the billing and collection process, which was poorly handled by most hospital-based billing operations in the past. Freedom to break off the relationship with few obstacles and resume private practice is another key selling point, although in such cases the health system generally keeps the receivables in the pipeline and the doctor has to begin again with an empty cash register. Then there are the financial incentives, which can be thorny: most doctors want a way to share in ancillaries they generate, which is exactly what the entire body of Stark law and regulation is designed to prevent. Ancillaries performed in a practice’s office under the doctor’s personal supervision may be credited as income to the doctor, but there are many technicalities to be met before this can be done safely. It may be possible to create bonus pools that can be shared on a referral-neutral basis by the participating physicians, but the size of those pools cannot be themselves determined with regard to the collective referrals of those physicians. On the positive side, the hospital can also fund costly EMR systems that solo physicians could not otherwise afford, and the hospital can also typically cover the costs of malpractice insurance and provide coverage at lower costs than independent physicians could obtain on their own.

This is a variation on the virtual private practice model under which the physician’s old practice entity (professional corporation or LLC) continues to exist under the physician’s ownership, but becomes a management services organization (MSO) that sells services to the newly-created hospital subsidiary (Physician Enterprise) that employs the physician to provide clinical care. (The idea was presented by Peter A. Pavarini, Esq. and Michael F. Schaff, Esq. at the June 2008 American Health Lawyers Association Annual Meeting in “How Community-Minded Hospitals And Entrepreneurial Doctors Are Working Together: The Physician Enterprise and Other Emerging Models.”) The hospital does not buy the practice’s hard assets, which are retained by the old practice entity/new MSO. Staff remains employed by the same entity with pay and benefits controlled solely by the physician owner(s). The MSO enters into a comprehensive management agreement with the Physician Enterprise to supply staff, equipment, space and administrative services subject to a safe-harbor compensation formula that meets the Stark exception for service agreements.

As in the virtual private practice model, the physicians and hospital share an incentive to hold down costs and maximize income. In fact, the physicians may be paid (through their old corporation/MSO) reasonable fees for management services they may be doing already without pay. Also, as employees of the Physician Enterprise, the physicians may be required to refer in-system subject to the three Stark exceptions. They may also share in appropriately-designed bonus pools, carefully avoiding links to referral volume. Finally, the old entity remains in existence ready to be converted back to a medical practice if the physician decides to leave hospital employment.

Both these new models share a potential drawback in that they tend to preserve separate, “balkanized” management and administrative systems for each practice that do not achieve economies of scale. Those of us who lived through the last round of acquisitions may snicker at that term, since few of the promised economies of scale of larger, integrated hospital-owned practices ever materialized. These models may prove more viable since they align key incentives and give physicians and hospitals tangible reasons to think and act like they are on the same side. Time will only tell if these models will be successful enough to survive, or if they will appear naEFve in retrospect in a future article on yet another generation of hospital-physician affiliation methods.

William H. Maruca, Esq., is a partner with the Pittsburgh office of Fox Rothschild LLP who concentrates his practice in the area of health care.