Many community hospitals and health systems are facing an existential crisis. They have long maintained high levels of care at lower profit margins than other health systems. Yet health care reform — which we estimate will lead to reimbursement reductions of 12 to 28 percent over the next five to seven years — now threaten their viability as stand-alone entities.

Market forces are tipping in favor of larger hospitals and health systems, which have the resources to fund new clinical programs and technology and to participate in such innovative models as accountable care organizations and bundled payments.

The issue is difficult for many hospital boards and management teams to address. If managers and board members disagree on how to proceed, a stalemate will ensue, and financial performance will deteriorate. It's crucial for leaders to get ahead of the problem while the organization is still in a position of relative strength.

The move away from independence and toward partnership entails three distinct steps: First, the organization must be proactive in determining whether it can continue operating as a stand-alone entity. Second, if the answer is no — and we believe it will be for many community hospitals — managers must evaluate the best partnership model. Third, it must choose the partner that has a complementary market strategy and internal capabilities.

Be Proactive

Management teams need to make a clear-eyed examination of where the business stands and whether remaining independent is viable. This requires a baseline forecast of financial performance in a "steady state," taking into account the implications of health care reform, changing patient trends and the need for cash to reinvest in the organization.

The forecast will help managers estimate the gaps — both in finances and in clinical delivery — that threaten survival, as well as the means available to improve performance. Options include day-to-day operational efficiency improvement and overall cost-reduction; portfolio rationalization that sheds underperforming service lines, excess capacity and noncore assets; and the pursuit of new growth opportunities, such as contracting directly with local employers and launching new service lines.

In some cases, management teams may come away from this analysis with a clear road map for remaining independent. In many other cases, they will realize that they cannot fully close the financial and performance gaps, and that a strategic partnership is the only viable solution. In either situation, being proactive early will ensure that management teams and the board have agreed on the best path forward. This will enable managers to act from a position of strength rather than being forced to accept a deal in a distressed situation later.

Evaluate Partnership Models

When the analysis reveals that the hospital or health system cannot survive alone, the organization should evaluate the type of partnership model it wants to pursue. In this evaluation, managers should consider the organization's capabilities, which we define as the ability to reliably and consistently deliver a specified outcome, through the right combination of processes, tools, knowledge, skills and organization.

Our analysis of health care merger and acquisition activity has shown that partnerships that bring together complementary capabilities tend to outperform deals driven by the traditional merger logic of increasing scale and market power. Among 30 large deals between health systems from 1998 to 2010, those that enhanced the partners' capabilities outperformed others by 27 percent, and our experience suggests that these gains translate to nonprofit hospital systems as well.

There are capabilities-based partnership models through which community hospitals and health systems can create new value together. For example, in a geographic cluster model, the community hospital helps the acquiring partner to increase its presence in a market. The community hospital benefits from increased market power and lower costs. It also can pursue risk-based delivery models because of reduced "patient leakage" out of the system and, hence, better control over patients' health.

By comparison, in the hub-and-spoke model, the community hospital can help the partner to expand its footprint and increase patient volume at a tertiary or quaternary hub. This model also allows the community hospital to focus on quality care while benefiting from a larger organization's advantages, such as a more integrated information technology platform.

A third example is the location-based model, in which the community hospital provides a means for the acquiring partner to capture demand from a captive local population, along with more cost-effective ways to satisfy it. This is the most likely model for many community hospitals — particularly in rural areas — but it is also the most susceptible to cost pressure, owing to the looming changes in reimbursements.

An honest assessment of the hospital or health system's capabilities will help managers to identify the best partnership model to pursue.

Choose the Right Partner

Once hospital management teams identify the best partnership model, they need to develop a short list of partners who can help to execute it and identify those who will offer the best fit. Managers can create a compelling argument for partnership by determining their organization's "ask" — what it needs — and its "give" — what it can bring to the table.

For example, in deciding whether a potential partner is suitable, the management team at a community hospital likely will look at financial and competitive strength. Their "ask" could be for a partner with a sound financial position, including the means to fund investments in the hospital. They may also want aggregate purchasing across facilities (to achieve volume-based discounts) and strong negotiation capabilities to exert pricing pressure from their suppliers. At the same time, the community hospital's "give" could be a location that is sufficiently protected from moves by competitors, along with a willingness to reorganize its internal operations on the basis of financial necessity.

Also, community hospitals likely would consider the values and culture of any potential merger and acquisition partners to determine whether they are in alignment. The hospital may want an acquirer that respects the organization's community and service mission and that can continue to provide support for elements like teaching. The hospital, in turn, can provide a clear articulation of its values and culture, along with management support required to win over physicians and staff, who may be skeptical about the acquirer's intentions. Similar considerations apply for factors like service lines, where the hospital may be able to offer strong primary and secondary care in specific lines in exchange for know-how in other areas, where it has higher costs.

If these capabilities match — through an analysis of the organization's "ask" and "give" — the community hospital or health system can present a compelling argument for partnership, positioning itself as uniquely qualified to help an acquirer, and thus commanding a higher value. More important, such a deal is far more likely to create value for both partners.

Chart a Course

As financial conditions in the health care industry become more challenging, leaders who take action now could ensure the survival of their community hospitals and health systems, sustaining their commitment to the communities they support. Standing alone may not be possible for everyone, but identifying this fact early could make the difference between a hospital or health system that charts its own course and one that is facing a distressed sale.

Thomas DeMinico is a senior executive adviser in the health practice at Booz & Co. He is based in Chicago. Senior associates Sachin Jain and Sara Richlin contributed to this article.