Editor's note: This is the fifth installment in "From the Trenches," a new monthly series that continues through October.


My 32 years of experience working in the health care industry has led me to conclude that two laws of physics apply to physician-hospital transactions: Newton's Third Law of Motion, which states that "for every action there is an equal and opposite reaction," and Aristotle's observation that "nature abhors a vacuum." Let me explain.

Physicians are in the business of practicing medicine. Like any good businesspeople, physicians are constantly in search of ways to mitigate threats to their incomes. Thus, when they see Medicare cutting their fee schedule, the physicians' highly rational "reaction" is to search for ways to enhance their incomes. Over the years they have pursued joint ventures, taken on ownership of ancillary services, demanded call pay, accepted employment by hospitals and so forth. Thus the application of Newton's Third Law of Motion clearly applies.

Many of these income enhancement strategies explore the untested boundaries of the regulatory envelope and in many cases redirect revenues from traditional providers, usually hospitals. But hospitals, given their conservative nature and desire to preserve revenues, have been slow to respond to the physician demands for many of these new engagements.

More often than not, opportunistic entrepreneurs enter the market to satisfy this demand for physician income enhancement, which affirms Aristotle's observation about the inevitable filling of vacuums. The demand has spurred a broad array of "engagement strategies" and industries, including ambulatory surgery center management companies, physician practice management companies, under arrangement joint ventures, physician-owned hospitals, and lawyers and consultants (of which I am one) specializing in structuring and valuing these transactions. While some of these engagement strategies have passed the test of time, many have fizzled after their initial fanfare due to business or regulatory factors.

The Numbers Don't Always Add Up

Co-management has emerged as the physician engagement strategy du jour. Co-management is a formal arrangement between a health system and a group of physicians in which the physicians receive both base and incentive compensation for their efforts to improve the quality and value of care for a particular service line. Over the past year, I have been contacted by several health systems whose physicians are requesting (or in some cases, demanding) the formation of a co-management relationship after hearing a "too good to be true" presentation at their specialty society meeting. A typical request to explore co-management includes the following, which was recently presented to one of my health system clients:

"A co-management agreement would formalize the physicians' commitment, improve communication and yield much better results for quality, efficiency and financial improvements.

"The arrangement typically has two levels of payment. The base fee is an annual fee that is consistent with fair market value [FMV] for time and efforts of the physicians and physician management team. The second level is a bonus fee and is a series of pre-determined payments that are contingent on the achievement of mutually agreed upon targets. The payments must be commercially reasonable and at FMV. As a percentage of the service line net revenues, we have been advised that the total fee payable to the physicians should range from 2.5 percent to 6.5 percent. Note: The base fee typically is 50 to 70 percent of the total fee."

With $40 million in revenue, the proposed orthopedic co-management transaction described above could cost the health system $1 million to $2.6 million in co-management fees. Based on the information provided, I attempted to calculate the specifications for the co-management agreement based on the parameters presented in their proposal: First, I applied the very aggressive assumptions that (1) the base fee hourly rate should be set at the 75th percentile of the Medical Group Management Association (MGMA) 2011 compensation survey for orthopedic surgeons, i.e., $350 per hour, and (2) the bonus should equal an additional $350 per hour. From this I calculated the number of hours that the orthopedic group would have to devote to achieve a co-management fee at the low end of the proposed range.

My conclusion was that in order to achieve the co-management fee of $1 million, the orthopedic surgery group would have to devote 1,428 hours per year to their co-management efforts (almost six hours per weekday!), and they would have to achieve 100 percent of their quality bonus. When I presented this fact to the administrator of the orthopedic group, he responded:

"The physicians are very disappointed and expressed their great concern over the value the consultant [me] chooses to place on the work they have and could do for the overall service line of orthopedics within the health system."

Rather than jump to conclusions I reviewed the industry literature and surveyed prominent health care law firms and valuation companies to determine the reasonableness of this proposed transaction. There is agreement that (1) the bonus should be based on nationally recognized quality metrics but not based on reductions in length of stay, and (2) that payments should be commercially reasonable and at fair market value. But this is where the industry consensus ends and the vehement disagreement begins:

  • There is no consensus regarding the requirement for the base compensation to be 50 percent of the total fee.
  • There is significant disagreement among valuation firms regarding the use of "percentage of revenue" as a measure of commercial reasonableness and FMV. Some valuation firms will automatically consider 2 percent to 4 percent of revenue as FMV for a co-management relationship while others believe that a percentage of revenue calculation does not provide a valid basis for valuation. One prominent health care attorney who represents physicians told me that the percent of product line revenue approach clearly "isn't consistent with the regulatory notion of FMV."
  • There is significant disagreement whether the quality incentives should be paid contingent on measurable improvement in metrics or if the co-management bonus can be based on maintaining specific levels of performance.
  • Valuation experts disagree on whether the total calculated hourly rate paid (base rate plus incentive divided by the hours the physicians devote to co-management) can exceed the MGMA 90th percentile or even that this calculation of payment per hour is a valid indicator of commercial reasonableness and fair market value.

Crunch the Numbers before Entering an Agreement

What is apparent from my research is that different valuation and law firms can analyze the same information and arrive at significantly different conclusions. Just as nature abhors a vacuum, if you look long and hard enough you can find a valuation firm that will produce a report supporting the 2.5 percent to 6.5 percent value for a co-management transaction. As the old saying goes: If you torture data long enough, it will confess to anything. But the differences in methodologies and values being used for co-management transactions are so great that someone has got to be wrong.

The regulations have made it clear that it is the "end user" of a valuation who is accountable for the lack of compliance with the standards of fair market value and commercial reasonableness regardless of whether they have obtained a third-party valuation. And the magnitude of penalties for payments deemed above fair market value, not commercially reasonable, or both, can be catastrophic to a provider organization. As the "end user," health system executives should err on the side of caution until the regulators (or case law) provide more clarity:

  • The total payments to physicians under co-management, when calculated as an hourly rate, should not exceed the 90th percentile of MGMA.
  • Bonuses should be based on achievement of marked improvements in nationally recognized quality metrics.
  • Before retaining a valuation firm, especially one recommended by your physicians and/or their representative, make sure you understand and agree with the valuation methodology by asking for a blinded copy of a recent similar valuation. Avoid firms that primarily use percent of revenue as justification of fair market value.
  • Finally, if you are uncomfortable with legal advice or the valuation methodology, get a second opinion.

I am a major proponent of physician engagement as essential in improving a health system's service value. And that physicians deserve fair remuneration for their efforts. However, given the ambiguities of the regulatory environment, discretion is the better part of valor.

Nathan Kaufman is the managing director of Kaufman Strategic Advisors LLC in San Diego. He is also a member of Speakers Express.