It's not only the times that are changing. The changes are changing, too. Unprecedented circumstances in the medical marketplace are compelling hospitals and health systems to explore partnerships that were unthinkable only a few years ago.

Providers realize their long-term survival depends on becoming part of a larger organization, either by joining an existing network or creating a new one, because their suppliers and payers are becoming bigger and stronger. Freestanding organizations simply do not have enough knowledge, resources and market power to survive entirely on their own.

Nearly all the larger entities created over the past few years have been created through horizontal integration — formal affiliation with other economic units producing the same goods and services. Horizontal networks of hospitals and medical groups can, theoretically, lower costs through economies of scale, but they do not necessarily respond to the growing number of noneconomic threats: scientific and technological advances; purchasers' growing demands for value; and consumers' needs for affordability, convenience and informed choice.

Solving all these problems requires bringing together parties on the supply and demand sides of the marketplace — that is, vertical integration of all key stakeholders.

The Problems with Horizontal Integration

Horizontal affiliation of firms making the same products is supported by economic theory and practice, especially in technology-driven industries with high capital requirements that put smaller production units at a competitive disadvantage for cost and quality. Health care would seem to meet these conditions, but there's not yet any evidence that horizontal mergers of health systems have reduced price or improved quality. We've all seen impressive progress toward these important economic goals on a case-by-case basis, but I believe the successes are most often due to better leadership and management, not horizontal integration per se.

Indeed, recent actions by the Federal Trade Commission and the Department of Justice suggest that horizontal mergers of providers are inherently problematic in the medical marketplace. Several high-profile mergers and acquisitions have been undone by government agencies that determined the new provider entities would raise prices or generate other anticompetitive outcomes, putting a damper on consolidation planning by similar organizations. It's become a no-win situation for more and more providers.

Pursuing a horizontal merger takes lots of time and money and may not succeed, but failing to consolidate can lead to failure in the long run. Vertical integration is an idea whose time has come for hospitals and health networks — as long as it produces win-win outcomes for all parties.

Vertical Integration in Health Care

Vertically integrated networks have an advantage because they include the stakeholders likely to be harmed by a horizontal organization, which can raise prices, reduce quality, withhold services or otherwise control markets. To prevent noncompetitive outcomes of horizontal affiliations, providers forming vertical networks should encompass the following stakeholders and empower them in a transparent and accountable partnership specifically organized to build an efficient and effective health system:

Health plans. Adversarial relationships with third-party payers are arguably the No. 1 threat to providers' survival, so it's hard to imagine improving the medical marketplace until hospitals and health plans work together to build an efficient and effective delivery system. (For detailed analysis, see Bauer, J.C. Paradox and Imperatives in Health Care: Redirecting Reform for Efficiency and Effectiveness, CRC Press, 2015.) The potential benefits of provider-payer collaboration surely will come sooner if both parties contribute their unique and complementary expertise according to the economic law of comparative advantage.

With very few exceptions, hospitals don't have the resources or skills to start their own insurance companies, nor are insurance companies generally competent to provide health services. They need each other to succeed in the new marketplace, but other partners must also be at the table to prevent harmful collusion.

Medical groups. Physician relations are surely a close No. 2 on the list of threats to providers' viability. Hospitals can't exist without a medical staff, but many physicians can be successful without a hospital. However, hospitals have much better access to capital and can create the technological infrastructure needed to support 21st-century health care. In return, physician leaders need to help steer hospitals away from their focus on inpatient care. Physician-hospital integration should be structured to build a better health system, not to preserve the 20th-century hospital because medical science and technology are rapidly reducing the need for big brick buildings with beds.

Employers. Employment-based insurance is declining because employers do not believe they are getting value for the money they spend on health benefits. Involving employers as active participants in vertical affiliations could help reverse this disturbing trend because business groups have a lot of useful knowledge about what does and does not work in getting the best return on medical spending.

Consumers. Because they are becoming major payers with "skin in the game," consumers need to be included in the planning and operating activities of vertically integrated networks. They are essential partners for defining why and how providers must create convenience, accountability, transparency and choice in both patient-centered and consumer-driven care.

Critical Success Factors for Vertical Integration

To improve the medical marketplace while preventing anticompetitive outcomes, vertically integrated networks must formalize their relationship and operating principles. In particular, they must agree to work together for a minimum of five years because implementing change in a tradition-bound sector like health care takes a long time. Partners will need to make investments and organizational changes that require at least this long to yield desired results. (For example, renegotiating employee health benefits every year prevents providers from making necessary operational changes that take longer than a year to pay off.)

The vertical partners must also agree that success requires shifting from volume-based (fee-for-service) payment to capitation and other value-based mechanisms that impose efficient and effective operations via fixed operating budgets and pervasive performance improvement (e.g., Lean, Six Sigma).

Finally, the partners must share a commitment to fixing the way care is delivered. True to the basic principles of cost-effective strategic planning, they will agree to pursue input substitution (e.g., use of qualified nonphysician practitioners, expansion of telemedicine) and expect to create a health system that looks very different from the one with which they started.

Establishing an enterprise that accomplishes all these goals through vertical integration does not require mergers or acquisitions. Nor does it preclude them if time allows. However, the rate and magnitude of change in today's medical marketplace effectively compels taking the path of least resistance in the community's best interests — involving all the stakeholders.    

Jeffrey C. Bauer, Ph.D., an independent health futurist and medical economist, has 45 years' experience as a medical school professor, health policy adviser and industry consultant. He is a member of Speakers Express.