In the past decade, as the baby boom physicians who had dominated our health system edged toward retirement, hospitals filled the gap in care by employing a sizable number of new medical graduates. According to the American Hospital Association, in 2014, hospitals employed almost 123,000 physicians (not counting interns and residents but including dentists), a 76 percent increase since 2003. How hospitals maximize the value of their substantial physician franchise has become a major strategic challenge.

The immediate result of the physician employment surge was escalating financial losses. With hospitals’ top-line revenues and volumes mostly flat, physician compensation (including call pay and directorships) became many hospitals’ fastest-growing expense. A recent report by Moody’s Investors Service found that physician employment was damaging hospital operating margins and, thus, their creditworthiness.

Operational improvement

Perhaps 10 percent of a typical community hospital budget involves physician subsidies of various kinds, though for hospitals in economically troubled rural areas, the percentage may be much higher. In 2012, losses in excess of $200,000 per hospital-employed physician were not unusual, according to the Medical Group Management Association, Englewood, Colo.

Hospitals, however, have markedly improved medical group operations in the past four years. According to the MGMA, median losses on hospital-owned multispecialty practices (measured by net operating costs before subsidies) have narrowed to $128,000 per physician, from $183,000 in 2012 ("MGMA Cost Survey: 2013 Report Based on 2012 Data" and "MGMA Cost Survey: 2016 Report Based on 2015 Data"). Median physician revenue after operating costs among hospital-owned groups is only 57 percent of that in physician-sponsored groups, due in part to a much higher percentage of younger physicians whose practices are building volume, higher Medicaid patient volumes, and accounting treatment of ancillary use.

Practice-support expenses, though, are 40 percent lower in hospital-sponsored multispecialty groups because of the substantial leveraging of the hospital’s administrative infrastructure. Drug and supply costs are also much lower in hospital-sponsored groups. The differential in practice expenses between hospital- and physician-owned practices has grown because of meaningful use requirements for information technology. Hospital-sponsored groups were able to use the hospital’s information technology support to hold operating expenses nearly constant from 2011 to 2015. Physician-owned group practice expenses rose by 25 percent from 2011 to 2015.

Hospitals have succeeded in standardizing administrative support activities across different practice sites as well as revenue-cycle functions like coding, documentation and collections. Reducing variation in these essential functions may be disruptive for established or recently acquired practices in the short term but is essential to conserve scarce clinical-support dollars.

Moreover, how effectively physicians use their electronic records to document their clinical activity will be essential not only to comply with forthcoming Merit-based Incentive Payment System documentation requirements (from the Medicare Access and CHIP Reauthorization Act of 2015) but also to be paid fairly for their services. This standardization will markedly reduce practice losses and improve physician productivity in the longer term.

The bundling challenge

The next frontier in standardization will be to reduce needless variation among employed physicians in clinical-resource use. There is well-documented wide variation among individual physicians in use of clinical resources (tests, supplies, operating room time, average length of stay and so forth) to treat the same conditions. Under present Medicare payment models such as diagnosis-related groups, failure to manage this variation and reduce low-value clinical use costs hospitals billions of dollars in operating losses.

These losses will increase if, as seems likely, Medicare pays for more clinical services through all-inclusive bundled payments. Practice sponsors’ net income also can be hurt in capitated or two-sided risk contracts with both public and private payers. Curing this problem is complex, pick-and-shovel work involving creative use of data on practice patterns and counseling of outlier physicians. Most physicians are empiricists. When presented with blinded results about how length of stay and granular resource consumption varies among their colleagues for treating the same conditions, most physicians voluntarily alter their practice patterns and practice more resource-sensitive care.

As bundling becomes more established under Medicare, however, health systems will need to strengthen clinical practice and service standards through protocols and service guarantees, such as those developed at Geisinger Health System in its ProvenCare program. The key to sustainable productivity enhancement and higher patient satisfaction is to work with clinicians to develop clinical service protocols that define best clinical practice. Patients don’t just want effective clinical encounters; they want someone to take ownership of the complete solution to their clinical problem.

A systems approach

Ultimately, hospital and health system management will need to take a more holistic view of the role of their physician practices to fully realize their value. It only makes sense to operate physician practices if they generate a quantifiable overall contribution margin for the health system.

Employed physicians do generate incremental downstream inpatient and outpatient revenues (given higher loyalty rates than community physicians), which can be calculated by analyzing patient-level data. Employed physicians also generate referrals to consulting physicians, generating additional revenue.

In addition, employed physicians perform administrative responsibilities, offsetting the cost of hiring other administrators. They also conduct research and demonstration activities to bring in additional funding. And they promote the health system’s brand, often leading to incremental donations to the health system’s foundation.

Thus, narrowing operating losses is only one piece of the management challenge. As value-based incentive payments grow as a percentage of total hospital payment and as the opportunity to reduce episode costs becomes more important, health systems will have to be much more systematic about improving both clinical practice norms and the patient experience. The encouraging progress in reducing physician practice losses is only the first step in a journey toward higher-functioning medical groups that truly add value for patients and the community. — Jeff Goldsmith is national adviser to Navigant Healthcare and associate professor of public health sciences at the University of Virginia, Charlottesville. He is a regular contributor to H&HN Daily and a member of Speakers Express. Jimmy Burnett and Ross Nelson, M.D., are managing directors at Navigant Consulting Inc. •