Specialty Hospitals and Community Hospitals - 57908

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The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 included an 18-month moratorium on payments to specialty hospitals (cardiac, orthopedic, and surgical) that were not operating or under development by November 2003 and in which physicians had an ownership or investment interest. This moratorium expired in June 2005. The CMS effectively extended the moratorium by continuing to review its criteria for approving or starting to pay new specialty hospitals.

Specialty hospitals have been around for a long time—children’s hospitals, rehabilitation hospitals, psychiatric hospitals, eye and ear hospitals, and cancer hospitals. The Omnibus Budget Reconciliation Act of 1989 included a provision against payment for physician referrals to facilities in which they had an economic interest, but specifically exempted ambulatory surgery centers and “whole” hospitals. Thus far, specialty hospitals have qualified as whole hospitals.

A specialty hospital is defined as an inpatient hospital in which at least two thirds of the claims are in one or two major diagnostic categories or diagnosis-related groups (DRGs). In February 2003, 110 hospitals met these criteria. Of those, 92 were cardiac, orthopedic, surgical, or women’s hospitals. They had tripled in number between 1990 and 2003 and were concentrated in states without certificate of need (CON) legislation. Seventy-four percent were for-profit hospitals and on average were 50 percent physician-owned. Seventy percent had some physician ownership. Their growth and that of the ambulatory surgery centers were in part attributed to the substitution of DRG-based reimbursement for fee-for-service payment in the late 1980s. DRGs are not finely calibrated to reflect the actual costs of different kinds of cases that would fall within the same grouping.

Has there been a difference between the older group of specialty hospitals and the new ones? The older ones tended to operate as nonprofits that supplemented the existing facilities in the community. The newer ones tend to be for-profit, physician owned and to duplicate the facilities and services already supplied by community hospitals. It can be argued that when community hospitals perform the kinds of profitable procedures that are attractive to for-profit specialty hospitals, they use the profits to cross-subsidize other community services (Altman et al., 2006). Vladeck (2006) suggested that they subsidize the following:

•           Health professions education

•           Losses in special departments (burn centers, trauma centers, neonatal intensive care units, and AIDS clinics)

•           Standby (emergency and surge capacity) costs

•           Uncompensated care

•           Other community services.

These services accounted for 16% to 18% of a community hospital’s budget. Some states compensate hospitals for some of these services. For example, New York compensates 8.95% for health professions education.

Specialty hospitals can be very attractive to physicians. They are drawn to these focused factories by the following:

•           Their control over scheduling, staffing, admission, discharge, and so forth

•           Added profits from ancillary services and technical component revenues

•           Profits from case mix within DRGs

•           Selection of the patients and their payer mix

•           Reduced “on-call” responsibilities

•           Avoiding participation in hospital governance and other mandated activities.

They do have to pay for additional capital facilities and equipment that would normally be supplied by the community hospital; however, the variety and scale of these investments are considerably reduced by the narrow range of services provided.

Community hospital advocates point to the fact that physicians may select only those patients with adequate insurance, can “cherry pick” the healthier patients, avoid emergency department duties, and avoid surveillance under some quality improvement and utilization review programs.

Community hospitals have responded by (Greenwald et al., 2006):

•           Prohibiting physicians with a competing ownership interest from participating in governance

•           Buying up the potentially referring primary care practices

•           Signing exclusive service contracts with insurers

•           Providing other resources, such as office space, to their competitors

•           Offering inpatient specialist “management” subcontracts to offset ownership

•           Advertising their own “centers of excellence”

•           Making economic credentialing decisions that penalize competing physicians.

The legal status of these measures under federal and state anticompetitive statutes is likely to be in litigation for quite some time.

Results of Studies

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 required the Medicare Payment Advisory Commission (MedPAC) and the U.S. Department of Health and Human Services to study a number of related issues during the moratorium period. The MedPAC’s report (Guterman, 2006; Stensland & Winter, 2006) concluded that physicians were responding to incentives built into the DRG payment rates. These incentives resulted from the wide variation in the relative costliness of cases. Cardiac hospitals seemed to treat more of the profitable cases than community hospitals. Orthopedic hospitals seemed to treat more complex cases, but in healthier patients than community hospitals. No conclusions were reached about the surgical hospitals. Patient satisfaction also seemed higher in the specialty settings.

The study also concluded that the specialty hospitals delivered less uncompensated care, but that this was offset by the payment of property and corporate income taxes and by not receiving disproportion share hospital payments. The U.S. Department of Health and Human Services study (Greenwald et al., 2006) reached similar conclusions and observed that physicians did refer to hospitals they owned, but often continued to take emergency department calls to maintain their referral base. The studies did not identify much differential impact on either quality or utilization. Their recommendation was to modify the DRG prices to reflect costs more closely and to remove the incentives they provided.

CMS Decisions

CMS ended the moratorium in August 2006 and proposed to follow the MedPAC’s recommendations to revise the DRG payments so that they would be closer to hospital costs than hospital charges. It also proposed a rule that specialty hospitals would have to accept patient transfers under the Emergency Medical Treatment and Labor Act. At oversight hearings before the Senate Finance Committee, this decision was questioned sharply by ranking Senators Chuck Grassley (R-Iowa) and Max Baucus (D-Montana), who noted the negative impact on community hospitals and the apparent conflict with the intent of existing self-referral prohibitions.

The Various Points of View

The prologue to a series of articles on these issues in the January-February 2006 issue of Health Affairs (25:94) noted that:

In the larger context, though, the issues are not so simple. A decade ago, “market-driven reform” meant competition between integrated delivery organizations whose incentives for quality and efficiency derived from the capitated payments they received. Specialty competition and price transparency are fee-for-service strategies that exacerbate the distress of multi-specialty groups that thrived under capitation and were the darlings of the policy community a decade ago.

The proponents of three economic system views have sought support in press releases, testimony, lobbying, and the published literature. All three sides used parts of the U.S. Department of Health and Human Services and MedPAC studies to support their positions.

Oligopolistic Competition

On May 30, 2006, the American Hospital Association supported the senators for continuing “to stand up for the needs of patients and the community hospitals that take care of them.” Berenson et al. (2006) suggested that the specialty hospital movement and parallel physician efforts to control service lines within community hospitals may signal the restoration of the types of hospital–physician relationships that preceded managed care.

Administered System

Choudhry et al. (2005) wrote about the role of law in this situation and recommended that the issue be controlled by CON determinations to avoid duplication of resources and increased utilization. Altman et al. (2006) seemed to support the administered approach by asking, “Could U.S. Hospitals Go the Way of U.S. Airlines?” They argue that specialized competition, coupled with price transparency and consumer price sensitivity, would result in community hospital downsizing, reduced community services, reduced staffing levels, and reduced salaries.

Free-Market Competition

The American Association of Orthopedic Surgeons’ December 2005 “Position Statement on Specialty Hospitals” urged the repeal of all CON laws to foster “healthy competition.” Their statement also attributed that position to the Federal Trade Commission and the Department of Justice. Havighurst’s (2005) commentary on Choudhry et al. (2005) took a strong position that CON inappropriately supported the oligopoly position of the community hospitals. In January 2006, the American Medical Association president-elect issued a statement continuing its strong support of specialty hospitals (Champlin, 2006). Porter and Teisberg (2006) also argued against the CON approach because it supported local monopolies, but acknowledged the risks associated with physician ownership and self-referral.


1.   What has happened with this debate since mid 2006?

2.   How might one try to come to an objective conclusion?

3.   Senator Grassley noted during the Senate Finance Committee hearings that “it appears that 40 new specialty hospitals have opened” during the moratorium and the investigation. Do some research to find out whether this is true and how it might have happened.

4.   If you were a legislative decision maker, what solutions would you propose after the MedPAC proposals to reduce selected DRG payments substantially and redefine a number of groupings for orthopedic and cardiac procedures that were headed off by a campaign by lobbyists for medical device makers, hospitals, and specialist physicians?

 McLaughlin, Curtis P. Health Policy Analysis: An Interdisciplinary Approach. Jones & Bartlett Learning, 2007-09-05. VitalBook file.


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