R E P O R T T O T H E C O N G R E S S

Physician-Owned

Specialty Hospitals

R E P O R T T O T H E C O N G R E S S

Physician-Owned

Specialty Hospitals

601 New Jersey Ave., NW • Suite 9000 • Washington, D

(202) 220-3700 • Fax: (202) 220-3759 • www. m e d p a c . g o 

The Commission also benefited from the many individuals—in government, industry, and the resea

community—who generously offered their time and knowledge. Our thanks to the following: Richa

Allen, Dr. Thomas Ashcom, Dr. Ely Bartal, David Bloom, John Brindley, Victor Campbell, Dr. Lawr

Casalino, Scott Chapman, James Cosgrove, Doug Crabtree, Frank Creedon, Kathleen Dalton, David D

Al Dobson, Laura Dummit, Nancy Farber, Cheryl Fahlman, Randy Fenninger, Jon Foster, Jon Gabe

Zachary Gaumer, Paul Ginsburg, Dr. Norbert Goldfield, James Harris, Charles Hart, Randy Haught

Samuel N. Hazen, Richard Herrington, David A. Hyman, Doug Johnson, Chip Kahn, Bruce Kelly, C

Lesser, Michael Lipomi, Sarah M. Mathias, Joel May, Kevin McAnaney, Jim Murguia, Becky Nelso

Thomas Nester, David Nevill, John Oviatt, Robin Pederson, Dr. Hoangmai Pham, Dr. Allen Pierrot,

Ellen Pryga, John Rex-Wa l l e r, Barbara Rothenberg, Patricia Schultheiss, Fred Slunecka, Jon Soderho

Dr. Benny Soffer, Steve Speil, Caroline Steinberg, Bruce Steinwald, Mike Stuhr, John Thomas, Roy

Vinson, Larry Vitts, Jim Watson, and Diane Zamora.

We also thank the staff members of the Centers for Medicare & Medicaid Services who, despite a

heavy workload, gave us their help: Tom Gustafson, Jim Hart, Fred Thomas, Jackie Proctor, Paul

Olenick, and Liz Richter.

Once again, the programmers at Social and Scientific Systems proved highly capable in assisting th

Commission staff. In particular, we appreciate the exceptional work of Valerie Aschenbach. In addit

Valeriy Bakaushin, Daksha Damera, Deborah Johnson, John May, Anthony Pridgen, Charles Thoms

and Arlene Turner provided invaluable assistance. We also thank Kelley Albert, Mimi Cantwell, and

Kimberly Ferraro for their editing and producion help.

Finally, the Commission wishes to extend a special acknowledgment to Cynthia Pratt for managing 

the production of this report.

Executive summary

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P h ys ic i an - Ow n e d S p e c i al t y H o sp i ta l s | M a r c h 

services that are less profitable. 

The Congress, in the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MM

imposed an 18-month moratorium that effectively halted the development of new physician-owned 

specialty hospitals. That act also directed MedPAC and the Secretary of the Department of Health a

Human Services to report to the Congress on certain issues concerning physician-owned heart, orthop

and surgical specialty hospitals. 

In answer to the Congress’s questions, we analyzed hospitals’ Medicare cost reports and inpatient cl

from 2002 (the most recent available) and found that: 

• Physician-owned specialty hospitals, thus far, do not have lower costs for Medicare patients than 

community hospitals, although their patients have shorter lengths of stay.

• They treat patients who are generally less severe cases (and hence expected to be relatively more 

profitable than the average) and concentrate on particular diagnosis-related groups (DRGs), some 

which are relatively more profitable. 

• They tend to have lower shares of Medicaid patients than community hospitals. 

• The financial impact on community hospitals in the markets in which physician-owned specialt

hospitals are located has been limited, thus far. Those community hospitals competing with speci

hospitals have demonstrated financial performance comparable to other community hospitals. 

• Many of the differences in profitability across and within DRGs that create financial incentives 

patient selection can be reduced by improving Medicare’s inpatient prospective payment system 

acute care hospitals.

These findings are based on the small number of physician-owned specialty hospitals that have bee

operation long enough to generate Medicare data. The industry is in its early stage, so some of thes

findings could change as the industry develops. Although we did not evaluate the comparative qual

of care in specialty hospitals, the Secretary is mandated to do so in a forthcoming report.

We found that physicians may establish physician-owned specialty hospitals to gain greater control 

over how the hospital is run, to increase their productivity, and to provide greater satisfaction for th

and their patients. They may also be motivated by the financial rewards, some of which derive from

inaccuracies in the Medicare payment system. Our recommendations concentrate on remedying tho

inaccuracies, which result in the system paying too much for some DRGs relative to others and too
v i i i Ex ec ut i v e S u m m a r y 

• refining the current DRGs to more fully capture differences in severity of illness among patients, 

• basing the DRG relative weights on the estimated cost of providing care rather than on charges, an

• basing the weights on the national average of hospitals’ relative values in each DRG.

R E C O M M E N D AT I ON 2

The Congress should amend the law to give the Secre t a ry authority to adjust the DRG 

relative weights to account for diff e rences in the prevalence of high-cost outlier cases.

Taken together, these recommendations will change the potential to profit from patient and DRG selec

and result in payments that more closely reflect the cost of care while still retaining the incentives f

efficiency in the hospital inpatient prospective payment system (IPPS). For example, we found that

physician-owned specialty heart hospitals now benefit from both the selection of DRGs and the selec

of patients they treat within those DRGs. Under current policy, heart hospitals’expected relative 

profitability from their combination of DRGs and patients is substantially above the national averag

profitability for all DRGs and patients. Following our recommendations, that ratio would be about 

equal to the national average. Selection benefits in orthopedic and surgical physician-owned special

hospitals would also be reduced.

These payment system refinements would affect all hospitals—both specialty hospitals and commu

hospitals—and many would see significant changes in payments. A transitional period would mitiga

those effects and allow hospitals to adjust to the refined payment system. 

R E C O M M E N D AT ION 3

The Congress and the Secre t a ry should implement the case-mix measurement and out

policies over a transitional period.

Making these payment system improvements and designing the transition will not be simple tasks. 

We recognize that the Centers for Medicare & Medicaid Services (CMS) has many priorities and lim

resources, and that the refinements will raise some difficult technical issues. These include the poten

large number of payment groups created, possible increases in spending from improvements in cod

rewarding avoidable complications, and the burden and time lag associated with using costs rather t

charges. Nevertheless, certain approaches that we discuss in this report, such as re-estimating cost-b

weights every several years instead of annually, could make these issues less onerous.
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

utilization, and efficiency, but it is based on a small sample of hospitals, early in the development o

industry. We do not know yet if physician-owned hospitals will increase their efficiency and improv

quality. We also do not know if, in the longer term, they will damage community hospitals or increa

use of services beyond the norm. Information from the Secretary’s forthcoming report on quality an

further information on physician-owned specialty hospitals’ performance is needed before actions a

taken that would, in effect, entirely shut them out of the Medicare and Medicaid market. The Congr

will need time during the upcoming legislative cycle to consider our recommendations and craft leg

tion, and the Secretary will need time to change the payment system. Continuing the moratorium wi

allow time for such eff o r t s and time to gather more information.

Aligning financial incentives for physicians and hospitals could lead to efficiencies. Physician owner

fully aligns incentives; it makes the hospital owner and the physician one in the same, but raises conce

about self-referral. Efficiencies might be achieved by allowing the physician to share in savings t h a 

would accrue to the hospital from re-engineering clinical care. Such arrangements have been stymied,

however, by provisions of law that prevent hospitals from sharing savings with physicians because 

concerns about possible stinting on care and quality. Structured properly, gainsharing arrangements c

garner the benefits of aligning incentives while allaying legitimate concerns.

R E C O M M E N D ATION 5 

The Congress should grant the Secre t a ry the authority to allow gainsharing arr a n g e m e 

between physicians and hospitals and to regulate those arrangements to protect the

quality of care and minimize financial incentives that could affect physician re f e rrals. 

Gainsharing could capture some of the incentives that are animating the move to physician-owned 

specialty hospitals while minimizing some of the concerns that direct physician ownership raises.

Permitting gainsharing opportunities and lessening the current inaccuracies in the Medicare paymen

system will provide an alternative to starting physician-owned specialty hospitals. At the same time

these actions should maintain incentives for improved hospital performance.

Physician-owned specialty hospitals

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1 The Secretary should improve payment accuracy in the hospital inpatient prospective

payment system by: 

• refining the current DRGs to more fully capture differences in severity of illness 

among patients,

• basing the DRG relative weights on the estimated cost of providing care rather 

than on charges, and 

• basing the weights on the national average of hospitals’ relative values in each DRG.

COMMISSIONER VOTES: YES 16 • NO 0 • NOT VOTING 0 • ABSENT 1

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2 The Congress should amend the law to give the Secretary authority to adjust the DRG

relative weights to account for differences in the prevalence of high-cost outlier cases.

COMMISSIONER VOTES: YES 14 • NO 1 • NOT VOTING 0 • ABSENT 2

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3 The Congress and the Secretary should implement the case-mix measurement and

outlier policies over a transitional period.

COMMISSIONER VOTES: YES 15 • NO 0 • NOT VOTING 0 • ABSENT 2

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4 The Congress should extend the current moratorium on specialty hospitals until

January 1, 2007.

COMMISSIONER VOTES: YES 16 • NO 0 • NOT VOTING 0 • ABSENT 1

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5 The Congress should grant the Secretary the authority to allow gainsharing arrangements between physicians and hospitals and to regulate those arrangements to protect

the quality of care and minimize financial incentives that could affect physician referrals.

COMMISSIONER VOTES: YES 15 • NO 0 • NOT VOTING 0 • ABSENT 2
P h ys ic i an - Ow n e d S p e c i al t y H o sp i ta l s | M a r c h 

more control over the care process, they assert such hospitals can produce care more efficiently and

with higher-quality outcomes. Proponents also contend that specialty hospitals’ smaller scale and fo

on patient-centered care not only improve clinical outcomes but also satisfaction among their patien

and physicians. Specialty hospital advocates state that they spur system-wide innovations because—

through competition—they pressure community hospitals to make comparable improvements.1

Community hospital representatives state that specialty hospitals skim off the most profitable patien

by the types of services they provide and by treating the least complex (and, therefore, least expens

patients. This selection, they contend, undermines community hospitals’ ability to subsidize the less

profitable services they furnish to their communities. Critics of physician-owned specialty hospitals 

also contend that specialty hospitals do not contribute enough to community needs, such as providin

emergency services and care for the poor and uninsured. 

The Congress was sufficiently concerned about the development of specialty hospitals—and the poss

consequences for existing community hospitals, Medicare beneficiaries, and Medicare payment—to

include a moratorium on their further development in the Medicare Prescription Drug, Improvemen

and Modernization Act of 2003 (MMA). Specifically, the law imposed an 18-month moratorium du

which physician-investors in new specialty hospitals may not refer Medicare or Medicaid patients t

those hospitals, thereby effectively halting the development of new specialty hospitals.2 The morato

expires on June 8, 2005. 

The law also requires both MedPAC and the Secretary of Health and Human Services to examine 

physician-owned specialty hospitals.3 For purposes of the moratorium and our report, the law define

specialty hospitals as hospitals that are physician owned and “primarily or exclusively engaged” in 

the care and treatment of patients with a cardiac or orthopedic condition, patients receiving a surgic

procedure, or any other specialized category of services designated by the Secretary.

4

The Secretary is charged with analyzing the referral patterns of physician-owners, the quality of car

furnished in physician-owned specialty hospitals, and the extent to which specialty hospitals furnish

uncompensated care. MedPAC is to consider: 

• the cost of care at physician-owned specialty and full-service community hospitals, 

• the financial impact of physician-owned specialty hospitals on local full-service community hospi

• d i fferences in the payer mix between specialty and full-service community hospitals,
4 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

What are specialty hospitals and where are they located? 

We found 48 hospitals that met our criteria for physician-owned specialty hospitals: 12 heart hospit

25 orthopedic hospitals, and 11 surgical hospitals. Our criteria are that the hospitals must:

• Be physician owned.

• Specialize in certain services—at least 45 percent of their Medicare cases must be in cardiac, 

orthopedic, or surgical services or at least 66 percent must be in two major diagnostic categories

(MDCs), with the primary one being cardiac, orthopedic, or surgical cases.5

• Have a minimum volume of at least 25 total Medicare cases during 2002 (to ensure a minimum vo

of Medicare cases for analysis).

• Have submitted Medicare cost reports and claims for 2002.

Throughout this report, “specialty hospitals” will refer to the 48 physician-owned hospitals meeting t

criteria. Altogether, there are now about 100 specialty hospitals, but some could not provide sufficie

data for our analysis because they either opened after 2002 or are still under construction.6

According to our survey of hospitals (see Appendix C for a description of the survey), specialty hospi

vary in the total share that is owned by physicians (Table 1). On average, physicians own 60 percent:

Physicians at heart hospitals own the smallest average share (35 percent), while those at surgical hosp

own the largest average share (73 percent). About one-third of orthopedic and surgical hospitals were

owned almost entirely by their physicians (not shown), while no heart hospital was. At half of all physi

owned specialty hospitals, the largest physician shareholder owned at least a 4 percent interest in the 

hospital. The largest share owned by any individual physician varies considerably across the specialty 

hospitals. In about one-third of specialty hospitals, the largest share owned by a single physician is 2 per

or less. Yet in about one-fifth of the hospitals, one physician owned at least 15 percent of the facility. 

Specialty hospitals differ from most hospitals 

Specialty hospitals are small: The average orthopedic specialty hospital has 16 beds and the average

surgical specialty hospital has 14. Heart hospitals are larger, averaging 52 beds. Specialty hospitals 

much less likely to be teaching hospitals than other hospitals. Only one orthopedic specialty hospital 

a teaching hospital, and it did not meet the criteria for a major teaching hospital.7In our data, specia

hospitals are also much less likely to treat low-income patients, as measured by the share of hospita

receiving disproportionate share hospital (DSH) payments under the Medicare IPPS.8
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Note: Note: Share owned by individual physicians varies. For the median specialty hospital, the largest share owned by a single physician is 4 percent. 

At about one-third of specialty hospitals, the largest share is 2 percent or less. At one-fifth of specialty hospitals, the largest share owned by a sing

physician is at least 15 percent. 

Source: MedPAC National Survey of Specialty Hospitals, 2004.

Almost all community hospitals (93 percent) have emergency departments (EDs) (MedPAC 2005).

Specialty hospitals on average are about half as likely to have EDs, but 8 of the 12 heart hospitals w

examined have EDs, compared with only 1 of the 11 surgical hospitals. The use of the emergency

department may influence how much control the hospital has over its schedule and patient mix. The

heart hospitals we visited that had EDs (see text box) were included in their area’s emergency medi

systems’ routing of patients who required the services they could provide. In contrast, even when 

surgical and orthopedic specialty hospitals have EDs, they may not treat many emergencies. On one 

our site visits, the lights of one surgical hospital’s emergency room had to be turned on to show us 

appeared to be a rarely used room, and ambulances were not routed to it.

Specialty hospitals also vary considerably in physician staffing of EDs. All of the heart hospitals with 

have physicians in the EDs around the clock, compared with only one orthopedic and no surgical hosp

All of the physician-owned specialty hospitals are for profit, compared with under 20 percent of all I

hospitals. In some cases, community hospitals have ownership interests in the specialty hospitals. In

others, the specialty hospital is owned in part by a national chain. Eight of the twelve heart hospital

owned in part by the MedCath Corporation.

MedPAC staff conducted site visits to three specialty hospital markets: Austin, Texas; Wichita an

Manhattan, Kansas; and Sioux Falls, South Dakota. In total, we interviewed representatives from

eight specialty hospitals and nine community hospitals during our site visits. The site visits provid

additional market information and input from stakeholders about the issues surrounding specialty

hospitals. We also spoke with directors of ambulance services and private insurers. These sites wer

selected based on their geographic diversity, the number and types of specialty hospitals located

there, the age of the specialty hospitals, and the mix of specialty hospital-community hospital

arrangements. In addition to the site visits, we spoke with representatives from an additional 7

community hospitals and 14 specialty hospitals. ■

Site visits
Specialty hospitals are geographically concentrated

FIGURE

1

Reported specialty hospital in 

construction or opened after 2002 (63)

States with Certificate of Need

Specialty hospitals in MedPAC Study

Heart (12)

Orthopedic (25)

Surgical (11)

6 P h ysician-Owned Specialty Hospitals 

Specialty hospitals are concentrated geographically

Specialty hospitals are not evenly distributed across the country (Figure 1). Almost 60 percent of the

specialty hospitals we studied are located in four states: South Dakota, Kansas, Oklahoma, and Texas.

This concentration results in some states such as South Dakota having a high share of the specialty

hospitals (16 percent) even though its share of IPPS hospitals is small (less than 1 percent). Many of the

specialty hospitals that are under construction or have opened since 2002 are located in the same states

and markets as the specialty hospitals we studied. As the map shows, specialty hospitals are concentrated

in states without certificate-of-need (CON) programs. (This is somewhat less true for surgical specialty

hospitals, although still more than 80 percent are located in non-CON states.)

State hospital licensing laws may be another key factor in determining which states have specialty

hospitals. States vary in their requirements for hospitals to have emergency departments. For example,

specialty hospitals in Arizona, California, and Kansas are not required to have EDs. Some states (such

as South Dakota, Arizona, and Kansas) have different classes of hospital licenses that make it easier to
P h ys ic i an - Ow n e d S p e c i al t y H o sp i ta l s | M a r c h 

markets with surgical specialty hospitals, several of which are rural areas, did not have larger popula

or population growth. The markets of orthopedic and surgical specialty hospitals had lower managed 

penetration than markets without them, while the rates were higher for heart hospital markets. 

The populations of specialty hospital markets were younger and had poverty rates similar to those o

other markets. Within their markets, specialty hospitals did not appear to systematically locate in hi

income areas. Although the census tracts where they were located had median household income le

2 percent higher than the average for the county, the difference was not statistically significant. Mar

with specialty hospitals had fewer hospital beds and surgical specialists per 1,000 population compa

with markets without them, but similar per capita service use.

Motivations for developing physician-owned 

specialty hospitals, and critics’ concerns

Physicians are motivated to develop specialty hospitals for two main reasons: to directly control hosp

operations regarding patient care and to augment their incomes. The physician-owners we spoke wi

varied in the importance they placed on each of these factors. Critics of specialty hospitals emphasiz

financial rewards of specialty hospitals to their owners and the threat physician-owned specialty hosp

pose to community hospitals.

Physicians see control as essential 

During our site visits, the physician-owners we spoke with said the primary issue for them was grea

control of hospital operations. Some physicians involved in the formation of specialty hospitals stat

that they had tried unsuccessfully to change their community hospitals. Some community hospital

administrators acknowledge they were slow to react to their physicians’ demands for changes. Physi

seeking control of hospital operations is not new. Paul Starr cites a 1902 Journal of the American Med

Association (JAMA) article in which one physician asks “Is it not time the professional mind began 

to dominate in the control of these institutions?” (Starr 1982). The current wave of specialty hospita

formation may just be the latest manifestation of the desire for physician control.

In the physician-owned specialty hospitals we studied, the cardiologists and surgeons want to admit t

patients, perform their procedures, and have their patients recover with minimal disruption. Physici

control, they believe, makes this possible in ways community hospitals cannot match. Control allows 

to increase their own productivity for the following reasons:
8 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Physician-owners argue that the smaller scale of specialty hospitals helps to create a hospital environm

that is more satisfying for their patients and their patients’ families. In addition, some specialty hosp

are designed to minimize moving patients during their stay (for example, by equipping patient room

function as recovery or step-down areas), making it easier for visitors (and physicians) to locate patie

By not moving patients as they change levels of care, hospitals can increase the continuity of nursin

care. Some specialty hospitals are also increasing the ratio of nurses to patients. More nursing atten

for each patient is thought to contribute to shorter lengths of stay and improve patient outcomes.

Another motivation for specialty hospital formation applies to physicians converting ambulatory surg 

centers (ASCs) to hospitals. Medicare does not pay facility fees for procedures in ASCs that require

overnight stays. Some physicians want to expand the range of cases seen in ASCs to include patient

who might require more monitoring and an overnight stay. Doing so requires conversion of the ASC 

a hospital. 

Physician ownership of hospitals is not the only way for physicians to have influence over hospitals

operations. Physicians can influence hospitals’ operations by serving on hospital boards, participatin

in hospital committees, serving as hospital chief medical officer or chief executive officer (CEO), a

through their roles on hospitals’ medical staffs. At some hospitals, physicians may have enough 

influence to change hospital management when they feel that the hospital is not being run in their 

interest. Another alternative is for physicians to form a nonprofit entity in which they have more 

influence over the hospital operating environment. An example of the latter model is the Mayo Clin

a nonprofit entity that owns hospitals and physician practices. Mayo physicians represent approxim

20 percent of the board members of each Mayo hospital, and a physician is often CEO. (However, 

in a nonprofit hospital directed by physicians, physicians in different specialties would still have to

compete with one another for limited hospital resources.) Theoretically, this nonprofit model provid

high level of physician influence without creating strong financial incentives for physicians to steer

profitable patients or increase service use. 

Physicians have economic incentives to form specialty hospitals 

The other motivation to form specialty hospitals is economic. In addition to increased productivity

resulting in more professional fees, physician-investors also could augment their income by retainin

a portion of the facility profits for their own and others’ work. Although some specialty hospitals ha

not made distributions, the annual distributions at others frequently have exceeded 20 percent of the

physicians’ initial investment. Physician-owners of ASCs converting to hospitals might also benefit

from higher outpatient rates versus ASC rates, fewer restrictions on allowable procedures, and the ab
P h ys ic i an - Ow n e d S p e c i al t y H o sp i ta l s | M a r c h 

hospitals. On our site visits, we were told that banks usually require evidence of physician investme

before they grant loans for the hospital as a way to ensure sufficient physician commitment. Some

maintain that ownership is central to keeping physicians involved in decisions about how to organiz

patient care. Others believe that ownership is not essential, but having physicians direct the way car

is organized is key. Some community hospital administrators assert that even after meeting physicia

demands, their physicians still formed a specialty hospital, reinforcing suspicions that financial incen

were the key motivation. Whatever the initial motivation, certain aspects of physician ownership contri

to specialty hospitals’ financial performance, as we discuss below.

Securing a core group of referring physicians is critical to specialty hospitals’ viability. Making physi

investors in the project can help ensure referrals. Some facility administrators also reported they req

or encourage their physician-investors to sell their interests when they retire or if they fail to bring i

minimum number of cases. Many specialty hospitals establish large referral networks that expand in

rural areas to secure admissions. 

Specialty hospitals aggressively work with their medical staffs to standardize their use of medical supp

(such as sutures) and devices (such as implants, stents, and pacemakers). By streamlining the numb

of suppliers and increasing the volume ordered from each, hospital administrators assert the hospita

can gain leverage over the suppliers used, thereby securing deeper discounts. Ownership and involvem

in establishing hospital policies make many physicians willing to accept limits on their use of suppl

and devices, which, community hospitals report, they were unwilling to accept when practicing at 

community hospitals.

Specialty hospitals have greater control over admissions compared with full-service community hospi

First, many specialty hospitals reported that physicians have admitting privileges at a nearby commu

hospital, which allows the specialty hospital physicians to send certain cases to one hospital and oth

types of cases to the other. Second, hospitals that do not have EDs have more control over the types 

of cases admitted, including the payer mix. Patients are generally first seen in physicians’ offices or 

outreach clinics, giving physician-owners time to consider the case and where to treat it. In addition

narrower range of services offered at specialty hospitals will help shape their mix of payers and pat

regardless of physician ownership. 
1 0 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Community hospitals also contend that the specialty hospitals’ limited service mix contributes to th

uneven playing field they face in competing with specialty hospitals. The lack of certain services at 

specialty hospitals may increase the likelihood that patients with relatively complex care needs or th

who lack insurance will go elsewhere for their care. 

Some specialty hospitals acknowledge that they treat the relatively uncomplicated patients within th

clinical categories they serve, but they believe that this patient selection reflects responsible medici

They state that because they lack readily available consulting specialists or specialized equipment t

handle patients with complicating conditions, they should not expose such patients to unnecessary r

by admitting them for care. Other specialty hospitals deny that they select patients who are easier to 

and those with emergency rooms note that they cannot control their admissions, as their opponents con

Community hospitals point to declines in volumes and margins, and hold specialty hospitals respon

for any deterioration. In rural areas, community hospitals’ limited ability to attract replacement physic

to generate hospital referrals may make their recovery more precarious. 

H o w e v e r, some proponents of specialty hospitals argue that competition with specialty hospitals impro

community hospital operations. Some community hospital administrators admit that competition wi

specialty hospitals has had some positive effects on community hospitals’ operations. One commun

hospital administrator told us that the specialty hospitals were akin to a wake-up call—getting them 

pay more attention to hospital operations and physician relations. We heard several examples of con

structive improvements sparked by the entrance of a specialty hospital into a market, including exten

service hours, improving operating room scheduling, standardizing the supplies in the operating roo

and upgrading equipment.

In reaction to the entry of specialty hospitals, some community hospitals sought exclusive contracts w

private payers and Medicaid managed care plans, with varying success. In some markets, specialty 

hospitals have been locked out of contracts, undermining their ability to generate volume. In other 

markets, the community hospitals told us that the specialty hospitals had diluted some of the levera

the community hospitals might have otherwise had with payers. Some specialty hospitals told us th

are lower-cost providers than community hospitals and that payers have been eager to contract with th

reportedly paying some specialty hospitals lower rates. One private plan representative told us that 

pay lower rates to surgical and orthopedic specialty hospitals because the surgical hospitals’ cases a
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

exacerbated by physician ownership of specialty hospitals and the physicians’ ability to select and 

refer patients.

Patient selection 

Much of the financial success of specialty hospitals may revolve around selection of patients. Physic

influence where their patients receive care, and physician ownership gives physician-investors a fina

incentive to refer profitable patients to their hospital. If the payment system does not adequately dif

entiate among patients with different expected costs, and the factors determining cost, such as sever

of illness, can be observed in advance, then the physician has an incentive to direct patients accordi

At the extreme, some community hospitals reported that physicians sometimes transferred patients o

of the community hospitals to specialty hospitals that the physicians owned. Referrals of healthier

(more profitable) patients to limited-service specialty hospitals may not harm less complex patients.

N o n e t h e l e s s , critics argue that referral decisions should not be influenced by financial incentives, an

therefore, they object to physician ownership of specialty hospitals. In addition, studies have found 

physicians with ownership interests in other types of facilities order additional services for their

patients, and thus induced demand may also be an issue.10

Legal prohibitions on self-referral 

Restrictions on physician self-referral have a long history in the Medicare program. The two laws b

and their implementing regulations set out the basic limitations on self-referral and create exceptions. 

primary concern was that self-referral would create financial incentives that could influence physici

professional judgment and lead to higher use of services. In addition, self-referral could lead to unf

competition if one hospital is owned by the referring physician and competing hospitals are not.11

The two key laws are the:

Anti-kickback statute—This criminal statute, initially passed in 1972, broadly prohibits the purposef

o ff e r, payment, or receipt of anything of value to induce the referral of patients for services reimburs

by a federal health care program. The Department of Justice is the primary enforcement agency (as 

for all federal criminal statutes), although the Office of Inspector General (OIG) of the Department 

Health and Human Services participates through its regulatory and advisory opinion process. Becaus

enforcement requires prosecutors to prove beyond a reasonable doubt that parties involved intended 

to violate the law, few cases were successfully litigated, and the statute’s application to ancillary joi

ventures is disputed. In any event, physician ownership of health care ancillary facilities, such as laborato

was not deterred.
1 2 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

called Stark II, supplanted the anti-kickback statute as the primary law regulating physician investm

in ancillary joint ventures. 

The law does not apply to surgical services provided by ambulatory surgical centers.12 It also allows

physicians to provide ancillary services, such as laboratory tests or X-rays, in their offices. Addition

the law creates a broad exception for physician ownership of hospitals to which they refer Medicare 

Medicaid patients. However, the law restricts compensation arrangements (such as consultancies) betw

physicians and hospitals, as with other providers of designated health services. 

The hospital exception requires that the investment of a referring physician be in the whole hospita

rather than a subdivision or part of the hospital, and that the physician be authorized to perform ser

at the hospital. This exception—known as the “whole-hospital exception”—permits physician invest

in whole hospitals because hospitals generally provide a wide array of services. Thus, referrals by a

individual physician-investor would theoretically have a limited effect on overall hospital profits. O

the other hand, physicians have a greater ability to influence the profits of a single hospital departm

which is why investment in hospital departments was prohibited. 

At the time of Stark II’s enactment (1993), there were probably far fewer single specialty hospitals 

t o d a y. According to the GAO, the number of specialty hospitals increased from 29 in 1990 to 92 in 2

most of these hospitals have physician-investors (GAO 2003b). At least until the MMA imposed a

moratorium on new physician-owned specialty hospitals, the legal restrictions on physician self-refe

did not inhibit the growth of such hospitals. Physician-investors have a greater opportunity to influe

profits at single-specialty hospitals—which generally provide a limited range of services—than at f

service hospitals. Thus, the development of physician-owned specialty hospitals raises questions ab

whether they should be considered more similar to a hospital department than to a “whole hospital.

(For a more complete discussion of these laws and their histories, see Appendix B.)

Do specialty hospitals have lower costs? 

As part of the mandate to examine physician-owned specialty hospitals, the Congress asked MedPA

to determine if differences exist between the costs of health care services furnished to patients by th

hospitals and the costs of such services furnished by local full-service community hospitals within 

specific diagnosis-related groups (DRGs). Evidence showing that specialty hospitals have lower co

would lend support to the “focused-factory” argument that specialization makes specialty hospitals
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

Competitor hospitals are a subset of community hospitals that are:

• located in the same market as specialty hospitals, and

• provide at least some of the same services provided by specialty hospitals in that market.14

Peer hospitals are:

• specialized, 

• not physician owned, and

• not necessarily located in the same market as specialty hospitals.15

The number of competitor and community hospitals far outweighs the number of specialty hospital

(Table 2). Community hospitals represent the largest comparison group. Competitor hospitals, on th

other hand, are the group that specialty hospitals most directly compete with because they provide s

of the same services in the same market. Peer hospitals are the smallest group; in fact, in the orthop

hospital category, physician-owned hospitals outnumber peer hospitals. Peer hospitals provide anoth

dimension for comparing specialty hospitals with other hospitals. By being specialized but not physi

owned, this group allows us to look for the effects of physician ownership.

Type of specialty hospital Specialty Peer Competitor Communi

H e a rt 1 2 3 6 7 9 3 0 3

O rt h o p e d i c 2 5 1 7 3 0 5 4 5 3

S u rgical 1 1 2 5 2 3 7 2 7 6

Note: All hospitals in this table had at least 25 Medicare discharges in fiscal year 2002. Specialty hospitals are specialized and physician owned. Peer 

a re specialized but are not physician owned. Competitor hospitals are in the same markets as specialty hospitals and provide some similar service

Community hospitals are all hospitals in the same market as specialty hospitals.

S o u rce: M e d PAC analysis of 2002 MedPAR data from CMS. 

Number of specialty, peer, competitor, and community hosp

TABLE 

2
1 4 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Defining three comparison groups enables us to compare hospitals in a variety of ways. For exampl

we analyzed the degree of specialization in heart cases (Table 3). In specialty heart hospitals, 80 pe

of the discharges were heart cases and 66 percent of those heart cases were surgical. The specialty 

hospitals concentrated more on heart cases than any other comparison group including peer hospita

which were selected for comparison because of their specialization. Within heart cases, their concentra

on surg e r y, coronary artery bypass grafts (CABGs), and angioplasty was roughly similar to peer hospi

Among the two comparison groups in the same market—community hospitals and competitor hospita

competitor hospitals had the greater focus on surgery. This is not surprising because that group was

defined as providing some of the same services as specialty hospitals in the same market. (Orthoped

hospitals also showed a predominance of surgical cases, as, of course, did surgical hospitals.)

Cost differences between specialty hospitals and community hospitals 

Do specialty hospitals have lower costs than full-service community hospitals? To answer this, we

examined Medicare inpatient costs per discharge reported in hospitals’ Medicare cost reports for fis

year 2002. Differences in length of stay (LOS) might be one potentially controllable factor contribu

to differences in costs per discharge. Therefore, we also compared average lengths of stay for Medi

patients treated by specialty and comparison hospitals in fiscal year 2002. 

Inpatient costs per discharge 

Average Medicare inpatient costs per discharge may differ among hospitals for a number of reasons

For example, we would expect costs to reflect differences in local input prices and in the mix of pati

treated and the services provided to care for them. Other differences in hospitals’ products also may

affect inpatient costs per discharge. For example, inpatient costs per discharge tend to be measurabl

higher in hospitals that operate residency programs for training physicians or serve a disproportiona

share of low-income patients (although the latter effect is small). 

After controlling for these potential sources of variation, including patient severity, we found that b

the aggregate mean and median values for costs at physician-owned specialty hospitals are higher th

the corresponding values for peer, competitor, and community hospitals. However, these differences

were not statistically significant (Table 4). Even though the absolute differences in cost sometimes

Note: IPPS (inpatient prospective payment system). Specialty hospitals are specialized and physician owned. Peer hospitals are specialized but are not ph

owned. Competitor hospitals are in the same markets as specialty hospitals and provide some similar services. Community hospitals are all hospital

same market as specialty hospitals.

S o u rce: M e d PAC analysis of 2002 MedPAR data from CMS. 
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

appear large, we observed large variances in costs per discharge across a small number of hospitals

For that reason, the results are not statistically significant. For example, surgical hospitals may have

very few inpatient stays because they have few inpatient beds and most of their business is focused 

outpatient procedures.16 These factors can lead to substantial variation in reported inpatient costs am

surgical hospitals.

Length of stay 

In comparing length of stay, we controlled for differences in the mix of patients treated among hosp

using the severity classes of the all-patient refined DRGs (APR–DRGs). We compared each hospita

actual LOS with an expected LOS, based on its mix of cases and regional average. We used the reg

average as the standard because specialty hospitals and their peers are not spread uniformly across a

geographic regions, and we know that LOS patterns differ across regions. Our analysis shows that 

specialty hospitals appear to keep patients for shorter-than-expected stays (Table 5, p.16). 

Actual lengths of stay were 17 percent to 31 percent lower than regional averages, depending on th

type of specialty hospital. Moreover, specialty hospitals’ lengths of stay were often significantly sho

relative to the expected average, than those for peer hospitals. 

y 

O rthopedic hospitals

Specialty 2 4 1 1 7 1 1 7

P e e r 1 5 1 1 0 1 1 6

C o m p e t i t o r 2 7 9 1 0 2 1 0 1

C o m m u n i t y 4 0 5 1 0 1 1 0 0

S u rgical hospitals

Specialty 1 0 1 3 3 1 3 0

P e e r 2 1 1 1 4 1 0 3

C o m p e t i t o r 2 1 8 9 9 1 0 0

C o m m u n i t y 2 3 9 9 9 9 9

Note: IPPS (inpatient prospective payment system). None of the percentages is significantly diff e rent from 100 percent using a Tukey mean separation test 

p<.05 criterion. Costs are adjusted for diff e rences in case mix, severity, local input prices, and the effects of training residents and serving poor pa

The mean is the discharge-weighted average of all hospitals in the group. The median is the value at which 50 percent of hospitals in the group ha

higher value and 50 percent have a lower one. Some hospitals are not included because of missing data elements. Specialty hospitals are specializ

physician owned. Peer hospitals are specialized but are not physician owned. Competitor hospitals are in the same markets as specialty hospitals a

p rovide some similar services. Community hospitals are all hospitals in the same market as specialty hospitals. 

S o u rce: M e d PAC calculations based on data re p o rted in hospitals’ fiscal year 2002 Medicare cost re p o rts from CMS.
1 6 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Heart specialty hospitals have significantly lower ratios of actual-to-expected LOS (0.83) compared

with peer heart hospitals, which are above the average (1.03). Although the ratio for physician-own

heart hospitals is also lower than that for all community hospitals (1.0), the difference was not signi

cant. Orthopedic specialty hospitals had lengths of stay that were 22 percent shorter than expected a

significantly lower than those in either peer orthopedic or community hospitals. Surgical hospitals h

stays that are 31 percent lower than expected, given their case mix. Although their ratio of actual-to

expected LOS is lower than those for peer and community hospitals, the difference is significant on

when compared with community hospitals.

Lengths of stay in specialty hospitals were shorter, in some cases significantly so, than those in compar

hospitals. Although standardized costs per discharge were higher in specialty hospitals than in the 

comparison hospitals, those differences were not statistically significant. Other things being equal, sho

stays should lead to lower costs. The apparent inconsistency of these results raises questions about w

other factors might be offsetting the effects of shorter stays. Such factors might include staffing lev

Community 3 1 5 5 . 2 5 . 2 9 9

O rthopedic hospitals

S p e c i a l t y 2 5 3 . 0 3 . 9 7 8a , b

Peer 1 7 5 . 1 4 . 9 1 0 5

C o m p e t i t o r 3 0 5 5 . 6 5 . 4 1 0 3

C o m m u n i t y 4 7 7 5 . 5 5 . 4 1 0 2

S u rgical hospitals

S p e c i a l t y 1 1 2 . 3 3 . 3 6 9b

P e e r 2 5 4 . 5 4 . 6 9 8

C o m p e t i t o r 2 3 7 5 . 0 5 . 2 9 6

C o m m u n i t y 2 8 9 5 . 0 5 . 2 9 6

Note: IPPS (inpatient prospective payment system). Actual average length of stay (LOS) is based on total Medicare days per discharge, where discharges 

adjusted to reflect cases transferred to another acute care hospital or certain post-acute care settings. Expected LOS values are based on regional a

LOS values for severity classes within each all-patient refined diagnosis-related group (APR–DRG) and hospitals’ mixes of Medicare discharges amo

APR–DRG severity classes. Regions are defined by the nine Census divisions. Specialty hospitals are specialized and physician owned. Peer hospita

specialized but are not physician owned. Competitor hospitals are in the same markets as specialty hospitals and provide some similar services. 

Community hospitals are all hospitals in the same market as specialty hospitals. 

a Significantly diff e rent from the actual-to-expected ratio for peer hospitals using Tukey mean separation test and p<.05 criterion.

b Significantly diff e rent from the actual-to-expected ratio for nonpeer community hospitals using the Tukey mean separation test and a p<.05 criteri

S o u rce: M e d PAC analysis of data from the MedPAR file for fiscal year 2002.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

hospitals on community hospitals. 

Critics of specialty hospitals contend that physicians have financial incentives to steer profitable pati

to specialty hospitals in which they have an ownership interest. These physicians may also have an

incentive to avoid Medicaid, uninsured, and unusually costly Medicare patients. Critics further argu

that if physician-owned hospitals take away a large share of community hospitals’ profitable patient

community hospitals would not have sufficient revenues to provide all members of the community

access to a full array of services. Supporters counter that the specialty hospitals are engaging in hea

competition with community hospitals and that they are meeting unmet demand for services. They

acknowledge that community hospital volumes may decline when they enter a market, but claim th

community hospitals can find alternative sources of revenue and remain profitable even in the face 

competition from physician-owned specialty hospitals.

We present evidence that supports the following findings:

• Physician-owned heart, orthopedic, and some surgical hospitals tended to treat fewer Medicaid pati

than peer hospitals and community hospitals in the same market. Heart hospitals treated primarily

Medicare patients, while orthopedic and surgical hospitals treated primarily privately insured patie

• The increases in cardiac surgery rates associated with the opening of physician-owned heart hospi

were small enough to be statistically insignificant for most types of cardiac surg e r y. So it appears 

specialty hospitals obtained most of their patients by capturing market share from community hosp

• Though the opening of heart hospitals was associated with slower growth in Medicare inpatient rev

at community hospitals, most community hospitals competing with physician-owned heart hospital

not experience unusual declines in their all-payer profit marg i n .

Note that most specialty hospitals are relatively new and the number of hospitals in our analysis is sm

The impact on utilization and community hospitals could change over time, especially if a large num

of additional specialty hospitals are formed. 

Payer mix 

A specialty hospital may have a different mix of payers—private insurers, Medicare, Medicaid, and

self-pay—than competing community hospitals. Such differences may stem from the hospital’s loca

the presence and staffing of an ED, the mix of services offered, selective contracting with insurers, 
1 8 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

physicians’ efforts to steer patients (Figure 2). For example, hospitals that do not offer obstetric serv

may have fewer Medicaid patients, and hospitals without emergency rooms may treat fewer s e l f - p a 

patients. Further, as discussed, physician-owners with admitting privileges at both the community h o s 

and their own specialty hospital have a financial incentive to fill their hospital with better-paying

patients and steer unprofitable patients to the community hospital. 

Referral networks may also affect payer mix. For example, the specialty hospital may take all prospec

patients, but they may cultivate relationships with family practitioners and internists who do not. On 

site visits, one specialty hospital told us that its referral base included practices with very few indig

and Medicaid patients. Thus, specialists who own the specialty hospital may not need to actively select

p a t i e n t s based on their insurance status—it may already have been done for them. 

pppy

insurance contracts

Share of hospital discharges

Type of hospital Number of hospitals Medicare Medicaid All oth

All nonspecialty IPPS hospitals 4 , 2 4 7 3 6 % 1 5 % 5 0 %

H e a rt hospitals

S p e c i a l t y 1 2 6 2 4 3 4

P e e r 3 6 4 0 1 2 4 8

C o m m u n i t y 3 0 3 3 1 1 5 5 4

O rthopedic hospitals

S p e c i a l t y 2 5 3 3 1 6 5

P e e r 1 7 3 5 5 5 9

C o m m u n i t y 4 5 3 3 5 1 6 4 9

Note: IPPS (inpatient prospective payment system). Specialty hospitals are specialized and physician owned. Peer hospitals are specialized but are not ph

owned. Competitor hospitals are in the same markets as specialty hospitals and provide some similar services. Community hospitals are all hospital

same market as specialty hospitals. Totals may not sum to 100% due to ro u n d i n g .

S o u rce: M e d PAC analysis of 2002 Medicare cost re p o rt s .

Specialty hospitals have lower shares of Medicaid dischar

TABLE 

6
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

is lower than the median (7 percent) for peer hospitals. The largest Medicaid share among orthoped

hospitals was 11 percent of discharges, indicating that at least one physician-owned specialty hospit

has a Medicaid share above the average for peer orthopedic hospitals. Our findings are similar to th

of the GAO, which indicated that specialized hospitals tend to have lower shares of Medicaid patien

The share of self-pay revenue and charges 

Because the cost report data we used do not distinguish between privately insured and self-pay pati

we gathered data on revenues (net of discounts and allowances) using a telephone survey of special

and peer hospitals to examine payer mix in more detail (see Appendix C for a discussion of the surv

methodology). Although specialty heart hospitals with EDs tended to have higher shares of revenue

from self-pay patients than specialty hospitals without EDs, the differences are not statistically signif

(Table 7). 

Heart hospitals derive most of their revenue from Medicare patients (almost 60 percent). Orthopedi

and surgical specialty hospitals tended to derive their revenue from patients with private insurance (

percent). The survey also confirmed that orthopedic and surgical hospitals have lower shares of Med

revenue than peer hospitals (5 percent versus 9 percent). 

Share of hospital revenues

Type of hospital Number of hospitals Medicare Medicaid Private insurance Self-

H e a rt hospitals

Specialty without ED 4 5 8 % 2 % 3 8 % 2 

Specialty with ED 8 5 7 3 3 5 5

P e e r 8 5 0 8 3 7 5

O rthopedic and surgical hospitals

S p e c i a l t y 2 9 2 5 5 6 4 5

P e e r 1 3 3 3 9 5 4 5

Note: ED refers to an emergency department staffed by on-site physicians, as opposed to an ED staffed by on-call physicians. Of the 29 physician-owne

o rthopedic and surgical hospitals, only 1 had an ED staffed by on-site physicians, and its payer mix was similar to that of other orthopedic and su

hospitals. Surgical hospitals specializing in women’s care (whose Medicaid shares could be quite diff e rent from other surgical hospitals) are exclud

Specialty hospitals are specialized and physician owned. Peer hospitals are specialized but are not physician owned. Totals may not sum to 100% 

to ro u n d i n g .

S o u rce: M e d PAC National Survey of Specialty Hospitals, 2004. 

Specialty hospitals have lower shares of Medicaid reven

TABLE 

7
2 0 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

examination of discharge data, revenue data, and GAO’s findings. 

Financial incentives to admit patients differ by patient characteristics 

Opponents of physician-owned hospitals stress that physicians who invest in hospitals have a financ

incentive to admit profitable patients to the hospital they own. In response, specialty hospital advoc

counter that each physician owner’s share of the hospital’s profit is insignificant, since most investi

physicians only have between a 1 and 5 percent ownership in the hospital. They argue that professio

fees may be large enough to induce some physicians to increase utilization, but hospital ownership 

not create enough of an additional financial incentive to induce higher utilization. 

Although the incremental income from ownership may not be large relative to each physician’s annua

income, the incentive for a group of physician-investors to increase admissions can be substantially la

than specialty hospital advocates suggest. Specialty hospital advocates omit two key factors when discussing the profits associated with increasing admissions. First, a large share of hospital costs are fixed 

the short run—that is, they do not increase when an additional patient is admitted to a hospital with ex

capacity (Ennis et al. 2000). By filling an empty bed with a patient, the hospital’s additional expense w

be limited to the costs that vary with the admission, such as supplies, devices, and additional nursing h

to care for the patient. When payments exceed these variable costs, the remaining marginal profit accru

the hospital and its owners. These marginal profits represent the incentive to admit specific types of patie

Second, physicians together own at least a 30 percent interest in most physician-owned specialty hosp

By being part of a group of physicians that admit most of their patients to the specialty hospital, eac

physician receives not only the profits from his own patients but also a share of the profits from the

other physicians’ patients. For example, if 10 cardiologists each have a 3 percent interest in a hospi

(30 percent in total), they will receive 3 percent of the marginal profits from all 10 cardiologist-inves

patients. Receiving 3 percent of the profits from 10 cardiologists’ patients is equivalent to a single c

diologist receiving 30 percent of the marginal profits from his own patients (assuming the cardiolog

admit equally profitable patients with equal frequency). (See text box opposite.)

Do heart hospitals increase utilization of profitable heart surgeries? 

Investors in heart hospitals have a stronger incentive to increase utilization of surgeries with a high

marginal profit and a weaker incentive to increase utilization of services with low marginal profits. 

If the entry of a heart hospital into a market is followed by an increase in the volume of profitable

admissions in that market, but not unprofitable admissions, that increase would suggest that some

physicians are following their financial incentives. 
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

We examine utilization at the market level rather than at the hospital level to control for shifting of 

market shares from community hospitals to the specialty hospital. Markets are defined as the 306 hosp

referral regions (HRRs) in the Dartmouth Atlas of Healthcare (Wennberg et al. 1999). We identified 

10 markets that gained a physician-owned heart hospital between 1997 and 2001. In these 10 marke

the physician-owned specialty hospitals captured between 20 and 45 percent of the market for cardi

surgeries in 2002.

We examined growth rates of several types of cardiac surgeries. Specifically, we examined whether

markets with physician-owned heart hospitals had above-average increases in per capita use rates fo

Medicare beneficiaries of: 

• All cardiac surg e r i e s

• CABG surgeries (a higher marginal profit surg e r y )

• Angioplasty (a moderate marginal profit surg e r y )

• Defibrillator implantation (a lower marginal profit surg e r y )

suggests that variable costs equal approximately 60 percent of the DRG payment, roughly $14,400.

Hence the m a rg i n a l profit—payments minus variable cost—would be $9,600 per patient ($24,000–

$14,400). If 10 cardiologists owned a 3 percent interest each and they all induced one additional

s u rgery per year, each cardiologist’s income would increase by $2,880 ($9,600 x 3% x 10). T h e

degree to which physicians will alter their behavior when faced with financial incentives of this

magnitude is not clear.

Note that variable costs consist of only costs that vary with patient volume and do not include fixed

costs (such as depreciation and interest costs). Hospitals will use the marginal profits on their first

patients to cover the hospital’s fixed costs, which prevents the owners from having to absorb hospital

losses. After the hospital’s fixed costs are covered, the remaining marginal profits of $9,600 per

CABG patient would accrue to the owners of the facility. ■
2 2 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

hospitals to markets without physician-owned heart hospitals, we can control for national changes i

technology and practice patterns.

Taken together, our findings suggest that physician-owned specialty hospitals may affect practice 

patterns, but their effect is smaller than nationwide trends, such as growth in angioplasty and defibril

implantation. 

Between 1996 and 2002, heart surgeries for Medicare beneficiaries grew by 5.5 surgeries per 1,000

beneficiaries in markets with physician-owned hospitals and 4.4 surgeries per 1,000 beneficiaries in

Rate per 1,000 beneficiaries

Type of discharge by market 1996 2002 Difference

H e a rt surg e ry

Markets with heart hospitals 2 6 . 4 3 1 . 8 5 . 5

Other markets 2 7 . 1 3 1 . 5 4 . 4

Medical cardiac 

Markets with heart hospitals 6 0 . 2 6 1 . 5 1 . 4

Other markets 6 9 . 7 7 0 . 8 1 . 1

C o ro n a ry art e ry bypass graft

Markets with heart hospitals 5 . 3 4 . 8 – 0.5*

Other markets 5 . 6 4 . 6 – 0.9*

Angioplasty 

Markets with heart hospitals 7 . 6 1 1 . 5 3 . 9

Other markets 7 . 3 1 0 . 8 3 . 5

Defibrillator implantation

Markets with heart hospitals 0 . 4 1 . 0 0 . 6

Other markets 0 . 4 1 . 2 0 . 8

Note: 10 markets with heart hospitals, 295 other markets. The sum may not equal the total of components due to ro u n d i n g .

* Growth rates in markets with heart hospitals were significantly diff e rent from other markets using a t-test with a p<.05 criterion.

S o u rce: M e d PAC analysis of 1996 and 2002 MedPAR data from CMS. 

Growth in rates of Medicare cardiac admission

markets with and without heart hosp

TABLE 

8
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

• CABG surgeries declined everywhere due to the substitution of angioplasties for this procedure

( We n n b e rg et al. 2004). However, the rate of CABG surgeries per 1,000 beneficiaries declined mo

slowly in heart hospital markets than in other markets. The difference is statistically significant. 

• The rate of angioplasties, a service with modest profit potential, rose rapidly in both types of mark

Although the growth rate was slightly higher in heart hospital markets, the difference in growth ra

was not statistically significant. 

• The rate of defibrillator implantation, the service that may have been unprofitable in 2002, also gr

r a p i d l y, but not as rapidly in markets with heart hospitals. The difference is not statistically signifi

The small changes in utilization are always in the direction that would be predicted by looking at 

financial incentives. 

The markets with physician-owned heart hospitals only had 4 percent more surgeries than otherwise

would be expected, even though physician-owned hospitals captured between 20 and 45 percent of 

cardiovascular surgeries in their markets. Thus, physician-owned heart hospitals have obtained mos

their patients by taking market share away from community hospitals.21 The shift in market share ra

the question of how the loss of cardiac patients affects community hospitals’ profitability.

Little impact on community-hospital profitability through 2002 

Community hospitals in markets with physician-owned specialty hospitals complain of declining pr

i t a b i l i t y. To assess the impact of physician-owned hospitals on community hospitals’ financial p e r f o r m a 

we examined whether the profit margins of community hospitals in markets with physician-owned 

specialty hospitals declined compared with those of community hospitals in markets without physic

owned specialty hospitals.

We identified 8 heart hospitals and 14 orthopedic and surgical hospitals that were formed between 1

and 2001. Thirty-five community hospitals compete with the eight heart hospitals for open-heart surg 

and angioplasty cases. Fifty community hospitals compete with the 14 orthopedic and surgical hosp

( Table 9, p. 24). For these 85 competitor hospitals, we examined changes in community hospital prof

m a rg i n s from 1997 (before physician-owned hospitals opened) to 2002 (after physician-owned hospi

o p e n e d ). We compared the changes in these competitor hospitals’ profits with changes in profitabili

2,132 community hospitals in markets without physician-owned specialty hospitals. Full-service hosp
2 4 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

that compete with specialty hospitals had changes in all-payer margins that were similar to changes 

other community hospitals, suggesting that they were able to “make up” lost revenue from other sou

or reduce their costs.

In addition to the descriptive statistics shown in Table 9, we ran multivariate models that controlled 

other market influences (such as changes in population). The multivariate model of Medicare reven

indicated that Medicare inpatient revenue in community hospitals grew more slowly when they had 

compete with a physician-owned heart hospital. (The effect for hospitals competing with orthopedic 

surgical hospitals was not statistically significant, possibly because of the small size of those hospit

In addition, the multivariate model of total profit margins indicated that community hospitals did not h

an unusual decline in their total margins, which supports the descriptive statistics in Table 9. 

If heart hospitals are taking patients from community hospitals, how did community hospitals avoid

unusually large declines in total profit margins? From our site visits, we learned that community hosp

used various strategies to compensate for the loss of cardiac revenue. Some hospitals lowered their

expenses by cutting staff; others instituted aggressive pricing strategies to raise revenue from privat

payers. Many noted their expansions into areas they view as profitable, such as imaging, rehabilitat

pain management, and neurosurg e r y. Through such efforts, these hospitals were often able to compen

for the revenue lost to physician-owned specialty hospitals. 

If physician-owned specialty hospitals continue to grow rapidly, however, community hospitals may 

it more difficult to compensate for the loss of patients. Rural community hospitals that already have 

volumes of surgical cases may find it particularly difficult to compensate for the lost patient revenu

Our findings reflect a small number of hospitals in an early stage of development. The magnitude o

findings could change as more data become available.

py p

All IPPS hospitals with over 65 beds 2 , 1 3 2 6 . 4 2 . 7 – 3.7

Note: IPPS (inpatient prospective payment system). The competitors to orthopedic and surgical hospitals do not include hospitals that compete with heart ho

We present medians rather than means to limit the influence of outliers. We only look at hospitals with 65 or more beds to make community hospita

markets without specialty hospitals comparable to competitor hospitals. Competitor hospitals are in the same markets as specialty hospitals and prov

some similar serv i c e s .

S o u rce: M e d PAC analysis of 1997 and 2002 Medicare cost re p o rts from CMS. 
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

Our analysis supports the following findings:

• Under Medicare’s IPPS, DRGs that were common in specialty heart hospitals—primarily surg i c a l

DRGs—were relatively more profitable than the national average DRG (see text box on page 26 f

the definition of relative profitability). Medical cardiovascular DRGs, which were found less freque

in specialty heart hospitals, tended to be less relatively profitable than the average DRG. The mos

common orthopedic surgery DRGs tended to be relatively less profitable than the average DRG, b

relatively more profitable than medical orthopedic DRGs. The most common surgical DRGs foun

specialty surgical hospitals were about as profitable as the average DRG. 

• Within DRGs, the least severely ill Medicare patients generally were relatively more profitable tha

the average Medicare patient. More severely ill patients generally were relatively less profitable th

average, reflecting their higher costs but identical payments. Specialty hospitals had lower severity

patient mixes than peer, competitor, or community hospitals. 

• Taking both the mix of DRGs and of patients within DRGs into account, specialty hospitals would 

expected to be relatively more profitable than peer, competitor, or community hospitals. 

Medicare’s inpatient prospective payment system 

encourages selection across and within DRGs 

Discrepancies between Medicare’s payment rates and hospitals’ average costs per discharge across D

result in differences in profitability. These profitability differences create financial incentives—for a

hospitals, specialty and nonspecialty alike—to specialize in treating relatively profitable DRGs. Simila

differences in profitability across patients of varying illness severity would give hospitals financial

incentives to select the less severely ill (and less costly) patients within DRGs. Because the coexisti

medical conditions that affect severity (and cost) are known and somewhat predictable, hospitals co

obtain a favorable mix that was likely to be relatively profitable if physicians had a choice of hospi

to which they could admit patients and incentives to do so.

Under Medicare’s IPPS, hospitals generally are paid a predetermined amount per discharge. The pay

rate for each case is intended to reflect the expected cost of treating the specific type of patient, tak

into account the hospital’s market circumstances and certain other factors (see text box, p. 28). In th

system, substantial differences in profitability across and within DRGs may arise primarily from prob

with the DRG definitions, the DRG relative weights, and the outlier policy.
2 6 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

When DRGs are defined too broadly they fail to isolate differences in severity of illness that substan

affect the cost of hospital inpatient care. The resulting differences in profitability within DRGs crea

financial incentives for hospitals to select relatively low-cost patients, such as those who have the s

diagnosis but are less severely ill. 

The DRG relative weights, which are based on the national average of hospitals’ c h a rges billed to Med

for patients in each DRG, might over- or understate the expected cost differences across DRGs.23 We 

based on hospitals’ charges might not accurately reflect the relative cost of treatment for several reas

Hospitals may raise their charges at different rates for different services. The results from MedPAC

survey of hospitals’ charging practices suggest that hospitals use diverse strategies for setting servic

charges and raising them over time (Worzala and Ashby 2004). Data from hospitals’ Medicare cost

reports indicate that markups tend to be systematically higher for ancillary services (for example, 

operating room time, imaging services, and supplies) than for routine services (for example, room, b

and routine nursing care). Consequently, over time, the weights for DRGs in which patients typicall

use a lot of ancillary services might have become too high compared with the actual relative cost of 

Weights for DRGs in which patients use primarily routine and special care services (intensive care) m

have become too low.

p, pyg

1.10 (payments were 10 percent above costs), then the relative profitability of DRG 107 would b

1.10/1.04, or 1.06 times the national average. The relative payment-to-cost ratio for each A P R – D R 

severity class combination is computed using the same method.

Expected relative profitability. An expected relative profitability ratio refers to the average relativ

profitability we would expect a hospital (or hospital group) to have based on the mix of patients 

treats and the national average relative profitability of each patient category. For example, if a 

hospital treated two patients and one was in a DRG with an average relative profitability ratio of

1.00 and the other was in a DRG with an average profitability ratio of 1.10, then the hospital’s

expected relative profitability would be equal to 1.05. These ratios are used to compare the financ

desirability of the mixes of patients treated—whether the mix of patients is favorable or unfavorable

for hospitals of average efficiency and costs. Because the measure uses national average relative

profitability ratios, the variation in the measure reflects differences in the mix of patients; it does

not measure differences in hospitals’ actual relative profitability. ■
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

a difference of 8 percentage points in relative profitability between these DRGs. 

Similarly, distortions in the relative weights may arise if average treatment costs change at different

rates across DRGs but hospitals do not adjust their charges accordingly. For example, costs per disch

in two DRGs might change at different rates if a new technology decreased length of stay in only o

while their charges grew at the same rate. As a result, patients in one DRG would become relatively

more profitable, on average, while patients in the other category would become relatively less profita

Relative weights also may become distorted if markups or costs differ substantially among hospital

Relative weights for some DRGs would be inflated if their patients were more likely to be treated in

hospitals with high markups or high costs. Likewise, relative weights would be deflated for DRGs i

which patients were more often treated in hospitals that have low markups or low costs.

1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0 2 0 0 5

Illustration of divergence in DRG relative weights w

ancillary charges rise faster than routine char

F I G U R E

3

Note: DRG (diagnosis-related group). Assumes the following: Ancillary charges rise by 5 percent per year, routine charges rise by 4 percent per year, all 

rise by 4 percent per year, and total Medicare inpatient payments rise by 4 percent per year. 

I I I I I 

1 . 1 0

1 . 0 6

1 . 0 2

0 . 9 8

0 . 9 4

DRG A where 70% of total charges 

a re for ancillary serv i c e s

DRG B where 30% of total charges 

a re for ancillary serv i c e s
2 8 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

l i e r s , and those relative weights apply to all cases in the DRG, nonoutlier cases and outlier cases ali

Medicare determines the payment rates in its inpatient prospective payment system (IPPS) for acu

care hospitals in several steps: 

CMS defines more than 500 diagnosis-related groups (DRGs) based on the clinical condition

(principal and other diagnoses) and procedures performed. 

CMS assigns a relative weight to each DRG that is intended to reflect the relative costliness of

typical patients in that group compared with the cost of treating the average Medicare patient. 

CMS sets a national base payment amount per discharge, which represents what Medicare will 

pay for a case with a relative weight of 1.0.

The national base payment amount is adjusted (primarily by a wage index) to account for diff e r e n c 

in the levels of input prices that hospitals have to pay in local markets.

The DRG payment rate for any case is obtained by multiplying the adjusted national base 

payment amount per discharge for the hospital’s market area (calculated in the previous step) by

the relative weight for the DRG. 

Payment rates for teaching hospitals and those that serve disproportionate shares of low-income

patients are increased to reflect hospital-specific percentage add-ons—indirect medical education

(IME) and disproportionate share hospital (DSH) payments—intended to support those activities

Certain rural hospitals that historically had high levels of costs receive add-on payments that are

intended to preserve access to care for local beneficiaries.

Under certain circumstances, the payment rates are altered for individual cases. When a patient 

is transferred early to another IPPS hospital or to certain post-acute care settings, a daily paymen

is made. When a patient turns out to be extraordinarily costly, the hospital receives additional socalled outlier payments. ■

Determining payment rates in the Medicare hospital inpatient 

prospective payment system
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

Cardiovascular conditions 

Across selected cardiovascular conditions, we found that relative profitability varied considerably b

DRG (Table 10).26 For example, cases in DRG 122 had a relative profitability ratio of 0.89, meaning

that the payment-to-cost ratio for the average Medicare case in this category was 11 percent less than 

average for all Medicare cases. The relative payment-to-cost ratio for DRG 517 was almost 16 perc

above the average. As shown earlier in Table 3, surgical DRGs account for 66 percent of cardiac di

charges at specialty heart hospitals and 60 percent of cardiac discharges at peer heart hospitals. Wit

one exception (DRG 116), all of the surgical DRGs had high relative profitability ratios. In contrast

relative profitability ratios for the medical cardiovascular categories were all below 1.00, meaning t

patients in these categories have less-than-average relative profitability.

DRG DRG title Relative profitability r

S u rgical DRGs

1 0 4 C a rdiac valve and other major cardiothoracic pro c e d u re with cardiac catheterization 1 . 1 2

1 0 5 C a rdiac valve and other major cardiothoracic pro c e d u re without cardiac catheterization 1 . 0 6

1 0 7 C o ro n a ry bypass with cardiac catheterization 1 . 0 9

1 0 9 C o ro n a ry bypass without PTCA or cardiac catheterization 1 . 0 4

5 1 6 P e rcutaneous cardiovascular pro c e d u re with AMI 1 . 1 0

5 1 7 P e rcutaneous cardiovascular pro c e d u re with coro n a ry art e ry stent without AMI 1 . 1 6

5 1 8 P e rcutaneous cardiovascular pro c e d u re without coro n a ry art e ry stent or AMI 1 . 1 2

1 1 6 Other permanent cardiac pacemaker implantation 0 . 9 7

Medical DRGs

1 2 1 C i rc u l a t o ry disorders with AMI and major complication, discharged alive 0 . 9 2

1 2 2 C i rc u l a t o ry disorders with AMI without major complication, discharged alive 0 . 8 9

1 2 7 H e a rt failure and shock 0 . 9 4

1 3 8 C a rdiac arrhythmia and conduction disorders with complications or comorbidities 0 . 9 1

Note: DRG (diagnosis-related group), PTCA (percutaneous transluminal coro n a ry angioplasty), AMI (acute myocardial infarction). Relative profitability com

the national average inpatient Medicare profitability of one patient category (DRG) with the national average inpatient profitability of all Medicare 

d i s c h a rges. The relative profitability measure is an average for each DRG category, based on cost accounting data. Thus, small diff e rences (for exa

1 percent or 2 percent) in relative profitability among DRGs may not be meaningful. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Estimated relative profitability for selected cardiovascular D

TABLE 

1 0
3 0 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

APR–DRG DRG DRG title 1 2 3 4

S u rgical DRGs

8 1 0 4 C a rdiac valve and other major cardiothoracic pro c e d u re 1 . 6 1 1 . 4 6 1 . 1 7 0 

with cardiac catheterization

1 6 3 1 0 5 C a rdiac valve and other major cardiothoracic pro c e d u re 1 . 4 4 1 . 2 8 1 . 0 4 0 

without cardiac catheterization

1 6 5 1 0 7 C o ro n a ry bypass with cardiac catheterization 1 . 4 7 1 . 2 7 1 . 0 4 0 

1 6 6 1 0 9 C o ro n a ry bypass without PTCA or cardiac catheterization 1 . 3 4 1 . 1 8 0 . 9 5 0 

1 7 4 5 1 6 P e rcutaneous cardiovascular pro c e d u re with AMI 1 . 3 9 1 . 2 3 0 . 9 3 0 

5 1 7 P e rcutaneous cardiovascular pro c e d u re 

1 7 5 with coro n a ry art e ry stent without AMI 1 . 4 1 1 . 1 9 0 . 8 7 0 

5 1 8 P e rcutaneous cardiovascular pro c e d u re 

without coro n a ry art e ry stent or AMI

1 7 1 1 1 6 Other permanent cardiac pacemaker implantation 1 . 2 0 1 . 0 2 0 . 8 0 0 

Medical DRGs

1 2 1 C i rc u l a t o ry disorders with AMI and major complication, 

1 9 0 d i s c h a rged alive 1 . 2 1 1 . 0 9 0 . 9 5 0 

1 2 2 C i rc u l a t o ry disorders with AMI without major complication, 

d i s c h a rged alive

1 9 4 1 2 7 H e a rt failure and shock 1 . 5 0 1 . 1 3 0 . 7 5 0 

2 0 1 1 3 8 C a rdiac arrhythmia and conduction disorders 

with complications or comorbidities 1 . 0 8 1 . 0 3 0 . 7 4 0 

Note: APR–DRG (all-patient refined diagnosis-related group), DRG (diagnosis-related group), PTCA (percutaneous transluminal coro n a ry angioplasty), AM

(acute myocardial infarction). Relative profitability compares the national average inpatient Medicare profitability of one patient category (APR–DR

the national average inpatient profitability of all Medicare discharges. The relative profitability measure is an average for each DRG category, base

cost accounting data. Thus, small diff e rences (for example, 1 percent or 2 percent) in relative profitability among DRGs may not be meaningful. The 

shown for the APR–DRG and severity classes associated with any DRG may re p resent fewer cases than the original DRG if some cases were assign

other APR–DRGs, or more cases if additional cases were assigned to this APR–DRG from other DRGs. Severity level 1 is least severely ill.

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Relative profitability ratio b

APR–DRG severity class
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

APR–DRG DRG DRG title 1 2 3 

S u rgical DRGs

3 0 1 2 0 9 Major joint and limb reattachment pro c e d u res 1 . 1 4 1 . 0 2 0 . 8 1 

3 0 2 of lower extre m i t y 0 . 9 1 0 . 9 7 0 . 9 2 0 . 7 4 

Bilateral or multiple major joint pro c e d u res 

3 0 0 4 7 1 of lower extre m i t y 0 . 9 5 1 . 0 5 0 . 9 8 0 . 7 9 

Hip and femur pro c e d u res except 

3 0 8 2 1 0 major joint age >17 with CC 0 . 8 2 0 . 9 4 0 . 9 1 0 . 7 7 

3 0 4 4 9 7 Spinal fusion except cervical with CC 0 . 9 9 1 . 0 0 1 . 0 5 0 . 8 3 

4 9 8 Spinal fusion except cervical without CC 0 . 9 1

3 1 0

4 9 9 Back and neck pro c e d u res except 1 . 0 4

spinal fusion with CC 1 . 1 1 1 . 0 8 0 . 7 8 

5 0 0 Back and neck pro c e d u res except 

spinal fusion without CC 1 . 0 0

Medical DRGs

3 4 0 2 3 6 F r a c t u res of hip and pelvis 0 . 8 0 1 . 2 2 0 . 9 8 0 . 6 7 

3 4 1 1 . 1 5 0 . 9 1 0 . 6 5 

3 4 7 2 4 3 Medical back pro b l e m s 0 . 8 5 1 . 1 3 0 . 8 7 0 . 6 0 

Notes: APR–DRG (all-patient refined diagnosis-related group), DRG (diagnosis-related group), CC (complications or comorbidities). Relative profitability c

the national average inpatient Medicare profitability of one patient category (DRG or APR–DRG) with the national average inpatient profitability o

M e d i c a re discharges. The relative profitability measure is an average for each DRG category, based on cost accounting data. Thus, small diff e renc

example, 1 percent or 2 percent) in relative profitability among DRGs may not be meaningful. The values shown for the APR–DRG and severity cla

associated with any DRG may re p resent fewer cases than the original DRG if some cases were assigned to other APR–DRGs, or more cases if add

cases were assigned to this APR–DRG from other DRGs. Severity level 1 is least severely ill. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Estimated relative profitability ratios for sele

DRGs and APR–DRG severity classes: orthop

TABLE 

1 2

Relative profitability ratio by 

Entire DRG APR–DRG severity cla
3 2 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Patient selection in specialty hospitals 

We found that specialty hospitals treat a mix of patients that, on average, should result in higher-tha

average relative profitability. Heart hospitals benefit financially from both the mix of DRGs and the

severity of patients within them. In contrast, orthopedic and especially surgical hospitals benefit fro

treating less sick patients and not from the mix of DRGs. 

APR–DRG DRG DRG title Entire DRG 1 2 3 

5 1 3 3 5 9 Uterine and adnexa pro c e d u re for non-malignancy w/out CC 0 . 9 5 1 . 0 2 1 . 0 4 0 . 6 9 

3 5 8 Uterine and adnexa pro c e d u re for non-malignancy with CC 0 . 9 8

4 8 2 3 3 7 Tr a n s u rethral prostatectomy without CC 0 . 9 5 1 . 0 4 1 . 0 8 0 . 6 5 

3 0 1 2 0 9 Major joint and limb reattachment pro c e d u res of 0 . 9 1 1 . 1 4 1 . 0 2 0 . 8 1 

3 0 2 lower extre m i t y 0 . 9 7 0 . 9 2 0 . 7 4 

2 2 1 1 4 8 Major small and large bowel pro c e d u res with CC 1 . 0 8 1 . 3 6 1 . 4 3 1 . 0 0 

1 4 9 Major small and large bowel pro c e d u res without CC 0 . 9 2

4 8 0 3 3 5 Major male pelvic pro c e d u res without CC 0 . 9 9 1 . 0 4 1 . 0 4 0 . 7 2 

2 2 7 1 6 0 H e rnia pro c e d u res except inguinal and 

femoral age >17 without CC 0 . 9 0 0 . 9 8 1 . 1 3 0 . 7 5 

4 0 4 2 9 0 T h y roid pro c e d u re s 1 . 0 3 1 . 3 3 1 . 0 1 0 . 5 2 

Note: APR–DRG (all-patient refined diagnosis-related group), DRG (diagnosis-related group), CC (complications and comorbidities). Relative profitability 

c o m p a res the national average inpatient Medicare profitability of one patient category (DRG or APR–DRG) with the national average inpatient pro 

of all Medicare discharges. The relative profitability measure is an average for each DRG category, based on cost accounting data. Thus, small diff 

(for example, 1 percent or 2 percent) in relative profitability among DRGs may not be meaningful. The values shown for the APR–DRG and severity 

associated with any DRG may re p resent fewer cases than the original DRG if some cases were assigned to other APR–DRGs, or more cases if addi

cases were assigned to this APR–DRG from other DRGs. Severity level 1 is least severely ill. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Estimated relative profitability for sele

DRGs and APR–DRG severity classes: surg

TABLE 

1 3

Relative profitability ratio by 

APR–DRG severity class
Both specialty heart and peer heart hospitals have a favorable selection of patients compared with 

competitor hospitals and community hospitals in the specialty heart hospitals’ markets, as well as w

all IPPS hospitals. 

P h y s i ci a n - O w ne d S pe c i al t y H o sp i ta l s | M a r ch 

Expected relative profitability due to selecti

Number of Patient DRGs and 

Type of hospital hospitals DRGs severity patient sever

All nonspecialty IPPS hospitals 4 , 3 7 5 1 . 0 0 1 . 0 0 1 . 0 0

H e a rt hospitals

Specialty 1 2 1 . 0 6 1 . 0 3 1 . 0 9a , b

Peer 3 6 1 . 0 4 0 . 9 9 1 . 0 3b

Competitor 7 9 1 . 0 1 1 . 0 0 1 . 0 0

Community 3 1 5 0 . 9 9 1 . 0 1 1 . 0 1

O rthopedic hospitals

Specialty 2 5 0 . 9 5 1 . 0 7 1 . 0 2a , b

Peer 1 7 0 . 9 5 1 . 0 1 0 . 9 6

Competitor 3 0 5 1 . 0 0 1 . 0 0 1 . 0 0

Community 4 7 7 1 . 0 0 1 . 0 1 1 . 0 1

S u rgical hospitals

Specialty 1 1 0 . 9 9 1 . 1 6 1 . 1 5a , b

Peer 2 5 1 . 0 0 1 . 0 6 1 . 0 6b

Competitor 2 3 7 0 . 9 9 1 . 0 1 1 . 0 1

Community 2 8 9 0 . 9 9 1 . 0 1 1 . 0 1

Note: IPPS (inpatient prospective payment system), APR–DRG (all-patient refined diagnosis-related group), DRG (diagnosis-related group). Expected r

profitability measures the financial attractiveness of the hospital’s mix of Medicare cases, given the national average relative profitability of eac

patient category (DRG or APR–DRG severity class). The relative profitability measure is an average for each DRG category, based on cost acco

data. Thus, small differences (for example, 1 or 2 percent) in relative profitability may not be meaningful. Specialty hospitals are specialized a

physician owned. Peer hospitals are specialized but are not physician owned. Competitor hospitals are in the same markets as specialty hospit

provide some similar services. Community hospitals are all hospitals in the same market as specialty hospitals. 

a Significantly diff e rent from peer hospitals using a Tukey mean separation test and a p<.05 criterion.

b Significantly diff e rent from nonpeer community hospitals using a Tukey mean separation test and a p<.05 criterion.

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Specialty hospitals have high expected relative profitabilit

inpatient care under Medicare because of the mix of cases they t

TABLE 

1 4
3 4 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

community hospitals where they receive their other medical care. 

Favorable patient selection in orthopedic specialty hospitals 

In contrast to the heart hospitals, neither orthopedic specialty hospitals nor their peers seem to have 

favorable DRG selection. They both have a mix of DRGs with expected relative payment-to-cost ra

of 0.95 (Table 14). However, by treating a high proportion of low-severity patients within their mix 

DRGs, specialty orthopedic hospitals show an overall favorable selection (1.02). Peer orthopedic 

hospitals experience only a small effect from favorable selection across severity classes, leaving the

slightly advantaged by their severity mix but with less-than-average expected relative profitability f

Medicare patients. 

Favorable patient selection in surgical specialty hospitals 

Like orthopedic hospitals, surgical specialty hospitals and their peers do not appear to have a favora

mix of DRGs, but show a favorable selection of patients overall (1.15) because they treat relatively

low-severity patients within the DRGs (Table 14). Note, however, that surgical hospitals are a diver

set of often small facilities that treat few Medicare patients in a wide range of DRGs. The 11 surgic

specialty hospitals that we identified treated only 1,117 Medicare patients in fiscal year 2002. Due t

the small numbers of cases, these results should be viewed with greater caution than results for hear

and orthopedic hospitals. Nevertheless, these results are consistent with frank statements attesting to

favorable selection made by some surgical hospital physicians whom we talked with on our site vis

Peer surgical hospitals also experience favorable selection across severity classes and favorable selec

overall. Both specialty and peer surgical hospitals have expected relative profitability that is significa

higher than that of community hospitals. 

On our site visits, some physicians practicing at orthopedic and surgical specialty hospitals spoke op

about patient selection, though sometimes the selection was described in terms of what services we

available at the specialty hospital. We were told that patients with comorbidities (for example, patie

with chronic obstructive pulmonary disease or a history of heart problems) or who might need more

sophisticated or backup services were admitted to the community hospital. Often these decisions we

expressed as practicing responsible medicine. Some specialty hospitals’ admission policies are clear a

patients who will not be admitted; these include, for example, those who require critical care nursin

invasive monitoring, or mechanical ventilation. 
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

cases. The numbers of cases transferred were small, however. The typical specialty heart hospital 

transferred out 27 cardiac cases and 18 noncardiac cases out of about 2,000 cases per year. On our 

visits, we were told that patients who were transferred out included those who required neurosurger

transplants, gastrointestinal surgery, or the use of equipment that the specialty hospital did not have

But specialty heart hospitals are also a transfer destination for patients from other hospitals. More th

one-quarter of their heart patients are transferred in from other hospitals, compared with less than 5 per

of cases for their competitors and under 20 percent for peer hospitals. At the typical heart hospital, 

transfer-in rate meant that more than 500 cases a year came from other acute care hospitals (often s

rural hospitals). Though the shares of noncardiac cases transferred in were considerably smaller for

each hospital group, they were still substantial. 

Policy options and recommendations

The Congress asked the Commission to recommend changes to the IPPS to better reflect the cost of

delivering care. As shown in the previous section, changes are needed to improve the accuracy of th

payment system and thus reduce opportunities for hospitals to benefit from selection. We present sev

policy options and recommendations to improve the IPPS. 

The Commission recognizes that physician-owned specialty hospitals are a relatively new phenome

and we do not want to unnecessarily inhibit the development of organizational arrangements that m

bring innovations to care delivery. However, our early evidence, limited as it is, does not show lower 

in specialty hospitals and does show that specialty hospitals are benefiting from selection opportuni

among and within DRGs that are rewarded by the current IPPS. We await the Secretary’s report for 

evidence on whether they improve quality. Recognizing those uncertainties and the ongoing concern

about physician conflict of interest stemming from self-referral, we recommend extending the curre

moratorium on new physician-owned specialty hospitals, without going so far as to prohibit their deve

m e n t altogether at this time. We also consider what other measures might better align physician and

hospital financial incentives while limiting the undesirable incentives related to physician investmen

in hospitals. 

Options to revise the IPPS 

Earlier, we presented information showing that Medicare’s IPPS payment rates result in substantial 

differences in national average relative profitability across and within DRGs. 
3 6 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

These differences in relative profitability give hospitals financial incentives to specialize in treating

patients in relatively profitable DRGs and to prefer low-cost patients within DRGs. In this section, 

present policy options designed to mitigate these financial incentives. 

To address the limitations described above, we examined four potential refinements to Medicare’s pol

and methods. 

1) Using hospital-specific relative values to calculate relative weights. In contrast to the current rela

weights, which are based on the national average charges in each DRG, weights based on the

national average of hospital-specific relative values would not be affected by differences among

hospitals in the overall level of charges or costs.27 

2) Using refined DRGs. Refined DRGs would account more completely for differences in severity 

of illness (and associated costs) among patients. To illustrate the potential gains that might be

obtained from refining the DRGs, we used the severity class definitions from the APR–DRG 

patient classification system. 

3) Substituting weights based on the estimated costs of furnishing care for weights based on hospi

billed charges. Weights based on estimated costs would have fewer distortions that result from 

hospitals using different markups for services furnished in different hospital departments. 

4) Accounting for differences in frequency of outliers across patient categories. Weights that are

adjusted for outlier prevalence would more accurately reflect the costs of the typical cases in ea

DRG or refined DRG. (Other aspects of current outlier policy would remain unchanged. For exam

the inclusion of all payments including DSH and IME when calculating the loss and the fixed lo

threshold would remain—as would any anomalies they present.)28 

We focused our assessment of the policy options on two outcomes: their effect on the accuracy of paym

across and within patient categories and their effect on IPPS payments to hospitals. To evaluate paym

accuracy, we examined changes in the national average relative profitability of DRGs and APR–DR

severity classes. To the extent that the relative profitability ratio for a DRG or a severity class differ

from 1.00, it represents a potential opportunity for hospitals to benefit (or be disadvantaged) by selec

across and within DRGs. As payments become more accurate, the spread in average relative profitab

should decrease and cluster around 1.00—that is, patient categories should be neither relatively more 

n o r less profitable than the average. To measure the impact of the policy options on hospitals’ IPPS 

payments, we estimated the percentage change in payments for each option relative to the payments

under current policy.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

Option 4. Change the outlier policy to account for outlier prevalence across APRDRGs, use co

APR–DRGs, and HRV w e i g h t s .

Policy changes would make payments more accurate 

The four policy changes taken together have the best potential to make payments more accurate, ther

limiting the advantage a hospital could gain by selecting DRGs and patients. For instance, the relati

profitability ratio in DRG 105 would drop from 1.09 to 1.04 if we were to use relative weights that w

based on the national average of hospital-specific relative values; it would fall further if we were to a

more refined patient-severity categories. If we also adopted cost-based relative weights, the ratio w

be close to 1.00. The same convergence of the relative profitability ratios toward 1.00 can be seen for o

DRGs (see Appendix D for estimates of relative profitability under each policy option for selected DR

Together, the policy changes substantially reduce the share of IPPS payments that would fall in DR

that have profitability ratios that are more than 5 percent above or below the average (Figure 4). As 

C u rrent policy H o s p i t a l - s p e c i f i c

relative weights

Plus APR–DRG Plus cost-based

w e i g h t s

Plus adjuste

o u t l i e r

Improvement in payment accuracy from policy chan

F I G U R E

4

Note: DRG (diagnosis-related group), APR–DRG (all-patient refined diagnosis-related gro u p ) .

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

I I I I I 

1 0 0

9 0

8 0

7 0

6 0

5 0

4 0

3 0

2 0

1 0

0

Below 0.95

Between 0.95 and 1.05

Above 1.05

DRGs with relative payment-to-cost ratios:

3 0

3 5 3 5

2 5

4 9

2 6 2 7

5 3

2 0

1 2

7 3

1 5

5

8 6

9
3 8 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

values (but still charge based) and APR–DRGs would reduce the potential advantage to 1.04. Adop

cost-based relative weights would bring the ratio down to 0.99. In other words, the favorable selection n

observed at specialty heart hospitals would be substantially reduced. Similarly, the potential advanta

now enjoyed by specialty orthopedic and surgical hospitals would be reduced under these policy chan

H o w e v e r, opportunities for selection never fully disappear for two reasons. First, our profitability mea

is an average for each severity-adjusted DRG category, based on Medicare cost report data that may d

from a hospital’s own cost accounting data. Second, physicians always know more than CMS about

i n d i v idual patients’ expected costs. At the group level, most other hospitals do not benefit from favor

selection now, and the groups would neither gain nor lose under these policy changes. 

H o w e v e r, taken together, the policy changes would change payments to some individual specialty hosp

by a significant amount. If all of the policy changes were implemented, almost 90 percent of physic

owned heart hospitals would see their Medicare IPPS payments fall by more than 5 percent. About 

percent of physician-owned orthopedic hospitals would see their payments decline by 5 percent or m

(Table 16). 

Current Hospital–specific Plus Plus cost– Plus adju

Hospital type policy relative weights APR–DRG based weights outlie

Specialty 

H e a rt 1 . 1 3 1 . 0 8 1 . 0 4 0 . 9 9 0 . 9 9

O rt h o p e d i c 1 . 0 6 1 . 0 7 0 . 9 8 0 . 9 5 0 . 9 9

S u rgical 1 . 1 4 1 . 1 6 0 . 9 9 0 . 9 6 1 . 0 0

All other IPPS 

Urban 1 . 0 1 1 . 0 0 1 . 0 1 1 . 0 0 1 . 0 0

Rural 0 . 9 9 1 . 0 1 0 . 9 8 0 . 9 9 1 . 0 1

High IME/DSH 1 . 0 2 1 . 0 0 1 . 0 2 1 . 0 1 1 . 0 0

Note: APR–DRG (all-patient refined diagnosis-related group), IPPS (inpatient prospective payment system), IME/DSH (indirect medical education/dispro p o r

s h a re). IME payments go to teaching hospitals, and DSH payments go to hospitals that treat a dispro p o rtionate share of Medicaid and poor Medic

patients. The relative profitability measure is an average for each DRG category, based on cost accounting data. Thus, small diff e rences (for examp

or 2 percent) in relative profitability may not be meaningful. Payments include all IPPS payments. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Hospitals’ expected relative profitability ratios appro

one when all policy options are taken toge

TABLE 

1 5
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

Some community hospitals also could see large changes in their payments. For example, 7 percent 

urban community hospitals would see their payments decline by more than 5 percent, while 22 perc

would have increases greater than 5 percent. In general, these estimates suggest that some kind of tr

sition policy would be helpful in cushioning the fairly large changes that some hospitals could exper

if all four policy changes were adopted. 

Payment recommendations 

In view of our findings, we recommend that the Secretary of Health and Human Services (HHS) an

the Congress adopt specific refinements in the DRG patient classification system and in the method

and data used to set the DRG relative weights.

R E C O M M E N D A T I O N 1

The Secre t a ry should improve payment accuracy in the hospital inpatient prospective 

payment system by:

• refining the current DRGs to more fully capture diff e rences in severity of illness 

among patients, 

• basing the DRG relative weights on the estimated cost of providing care rather than 

on charges, and

• basing the weights on the national average of hospitals’ relative values in each DR

All other IPPS

Urban 2 , 4 8 5 7 2 2 1 6 3 3 2 

Rural 1 , 6 3 1 8 2 5 1 7 3 3 1 

High IME/DSH 5 5 4 8 2 8 1 4 2 5 2 

Note: IPPS (inpatient prospective payment system), IME/DSH (indirect medical education/dispro p o rtionate share). IME payments go to teaching hospitals

DSH payments go to hospitals that treat a dispro p o rtionate share of Medicaid and poor Medicare patients. Only hospitals with both usable claims 

cost re p o rt data are included. Only two surgical hospitals had complete data available for analysis, and because of the small number of claims re p re 

a group distribution is not re p o rted. Totals may not sum to 100% due to ro u n d i n g .

S o u rce: M e d PAC analysis of Medicare claims and hospital cost re p o rt s .
4 0 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

see discussion of coding creep, page 42.) 

B e n e f i c i a ry 

This recommendation is not expected to change beneficiary access to care. 

P ro v i d e r

Payments will increase for some providers and decrease for others depending on their selection 

DRGs and patients.

R E C O M M E N D A T I O N 2

The Congress should amend the law to give the Secre t a ry authority to adjust the DRG 

relative weights to account for diff e rences in the prevalence of high-cost outlier cases.

R a t i o n a l e

The variation in the prevalence of high-cost outlier cases contributes to current disparities in relativ

profitability across and within DRGs. These disparities could give hospitals an incentive to serve lo

severity patients in DRGs that have a high prevalence of outliers. 

Once the Congress provides the Secretary with statutory authority to adjust the weights, CMS shou

adopt this change to increase payment accuracy. Typical (that is, nonoutlier) cases in DRGs that hav

a disproportionate prevalence of outlier cases would no longer benefit from relative weights that are 

overstated. In addition, cases in DRGs that have a low prevalence of outliers would be paid more

appropriately because their payments would rise with the removal of the current national uniform o

I m p l i c a t i o n s

S p e n d i n g

This recommendation would not affect federal program spending relative to current law.

B e n e f i c i a ry 

This recommendation is not expected to change beneficiary access to care. 

P ro v i d e r

Payments will increase for some providers and decrease for others depending on their mix of D

and nonoutlier and outlier cases. 
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

I m p l i c a t i o n s

S p e n d i n g

This recommendation would not affect federal program spending relative to current law.

B e n e f i c i a ry 

This recommendation is not expected to change beneficiary access to care. 

P ro v i d e r

Providers with large anticipated changes in payments would experience smaller changes than 

otherwise would occur during the transition period. 

Implementation issues 

Making these payment system improvements and designing the transition will not be simple tasks. 

We recognize that CMS has many priorities and limited resources and that the refinements will rais

some difficult issues. These include the potentially large number of payment groups created, potent

increases in payments from improvements in coding, and the burden on CMS and time lag associat

with using costs rather than charges. As we discuss these issues below, we outline approaches that c

make implementation less onerous.

Implementation issues regarding a refined DRG system 

The larger number of DRGs might mean that CMS would be faced with establishing weights in ma

categories that have few cases and thus potentially creating unstable estimates. To avoid creating refi

DRGs with unstable relative weights, the Secretary should be selective in adopting fine clinical distinct

similar to those reflected in the APR–DRGs. Refining the DRGs will require carefully weighing the ben

of more accurate clinical and economic distinctions against the potential for instability in relative we

based on small numbers of cases. Many of these judgments could be relatively straightforward. The A 

DRGs were designed to classify patients of all ages and include many categories that generally have 

or no patients in the Medicare population. In addition, estimated differences in average costs among

severity classes may be small enough in many instances to suggest that these distinctions are not nee
4 2 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

offsetting adjustment to the national average base payment amounts.

We recognize that projecting the appropriate adjustment to offset reporting changes in response to D

refinements is a difficult task. One way to assess the amount of actual case-mix change (as opposed 

to coding changes) would be for CMS to use the information gathered from its quality assurance 

contractors as they review and reabstract claims. These data would indicate the extent to which hosp

reporting actually changed; the data could then be used to make offsetting adjustments and minimiz

any forecast errors.

Implementation issues regarding cost-based weights 

Using claim-level costs instead of billed charges raises several issues. The process of estimating cas

level costs is difficult and expensive. Additionally, CMS gets access to cost report data more slowly

than claims, thus lengthening the lag in the data for updating the relative weights. One way to addre

these problems would be to continue annually calculating weights based on the most recent availab

charge data, but adjust those weights based on the relationship between cost-based weights and cha

based weights. For example, one approach would be to calculate the ratio of the cost weight to the

charge weight for each DRG using data for a given year. Then the same ratio would be used to adju

the charge weights until the next major revision of the cost estimate. 

Recommendations on revising laws governing 

financial relationships between physicians and hospitals 

We have explored whether to modify the laws that govern financial relationships between physician

and hospitals. Although ownership of hospitals gives physicians control over hospital operations, it 

creates financial incentives that may improperly influence physicians’ professional judgment and cr

unfair competition among hospitals. Hospitals with physician-investors have a competitive advantag

over other hospitals because physicians influence where patients receive care. Competition among hosp

should be based on quality and cost of care, rather than on the financial gains that physicians who r

patients may receive. 

The options we considered include financial disclosure requirements for physician-investors, curtail

development of physician-owned specialty hospitals, and allowing gainsharing between physicians 

hospitals. 
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

realize that their physicians’ ownership interests could affect their referral decisions. Even if they ar

aware of this, many patients trust their physician to recommend care that is in the patient’s best inte

They may be unwilling to question their physician’s professional judgment, especially when they ar

sick. Patients may also lack other sources of information to verify that the treatment recommended 

their physician is appropriate and the physician-owned hospital is the best facility for their conditio

Curtail development of physician-owned specialty hospitals 

The current IPPS creates unfair competitive advantages for physician-owned specialty hospitals by

rewarding the selection of certain cases and patients. Moreover, our early evidence does not show l

costs in specialty hospitals for Medicare patients. Evidence is not yet in on whether specialty hospit

provide higher quality patient care. (The Secretary’s report on specialty hospitals, including their qu

of care, is due out in March 2005.) If the IPPS changes discussed above are made, competitive advan

based on selection should be substantially reduced. Nonetheless, the Commission has some remaini

concerns about whether there is an inherent conflict of interest in physician-ownership. 

The Commission considered one option to deal with these concerns: repealing the “whole hospital”

exception in Stark II. This would effectively end the development of physician-owned hospitals ser

Medicaid and Medicare patients. However, specialty hospitals may be an important competitive for

that promotes innovation and may be an appropriate response to physician frustration with commun

hospitals’ lack of responsiveness and physicians’ desire for control. Therefore, the Commission doe

want to preclude their development before gaining a fuller understanding of their quality and efficie

As more information and further data on service use and community impact become available, the

Commission may reconsider the advisability of repealing or otherwise modifying the whole hospita

exception. One modification that could be considered in the future would be to create provisions to

limit the types of hospitals physicians might own (for example, requiring that all physician-owned 

hospitals have emergency departments or serve a minimum share of Medicaid patients). 

At this point, the Commission recommends that the Congress should extend the MMA’s moratorium

prohibiting physicians who invest in new specialty hospitals from referring Medicare and Medicaid

patients to those hospitals until January 1, 2007. This would provide more time to gather informatio

specialty hospitals’ efficiency and quality, and their effects on community hospitals and use of servi

It would also give the Congress and the Secretary time to consider our recommended changes to th

IPPS. (If the Secretary completes the DRG revisions called for and the Congress provides the Secre
4 4 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Medicares IPPS, as currently structured, provides incentives to hospitals to select more profitable c

and patients, and evidence shows they are benefiting from favorable selection. Because physician-ow

hospitals are uniquely situated to take advantage of these incentives, they have an unfair competitiv

advantage over other hospitals. Physicians also have an incentive to increase the use of high-profit serv

at hospitals in which they invest. 

I m p l i c a t i o n s

S p e n d i n g

This recommendation would not affect federal program spending relative to current law.

B e n e f i c i a ry and pro v i d e r

This recommendation is not expected to change beneficiary access to care. 

Allow gainsharing arrangements between physicians and hospitals

Gainsharing arrangements offer an opportunity to better align physician and hospital financial incent

while limiting the undesirable incentives related to physician investment in hospitals. In a gainshari

arrangement, hospitals and physicians agree to share savings from re-engineering clinical care in th

hospital. Such efforts could include single sourcing of medical devices, more efficient scheduling o

operating rooms, and compliance with clinical protocols that improve efficiency and quality. If qual

bonuses were available, they could also be shared. Gainsharing has the potential to encourage physic

and hospitals to cooperate in developing more efficient ways to deliver care, thus countering the som

times conflicting payment incentives caused by separate payment systems for physicians and hospit

under fee-for-service Medicare. 

The Commission believes that gainsharing arrangements have the potential to improve patient care 

reduce hospital costs as long as safeguards are in place to minimize the undesirable incentives. For exam

physicians who participate in gainsharing should not be rewarded for increasing referrals or stinting 

care or reducing quality.

E fforts to promote gainsharing arrangements in the late 1990s were largely halted in response to a sp

advisory bulletin issued by the OIG in 1999. The OIG advised that gainsharing arrangements were 

prohibited by a civil monetary penalty (CMP) provision in the Social Security Act that prohibits hosp

from offering physicians financial incentives to reduce or limit services to Medicare beneficiaries (O

1999b). However, the statute permits the Secretary to regulate physician incentive arrangements wit
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

In a later advisory opinion, the OIG approved a narrow gainsharing arrangement because the plan h

several features that protected the quality of care and minimized incentives that might affect physic

referral patterns (see text box below).

Key features: 

• The plan clearly identified specific actions that would produce savings, such as curbing the

inappropriate use of supplies. For example, the agreement encouraged surgeons to forgo the

use of a preoperative medication unless indicated by clinical standards. 

• The plan was transparent and disclosed to patients, which promoted physician accountability

and deterred abusive behavior.

• Periodic reviews of quality of care by an independent agent would take place.

• The agreement set thresholds of appropriate use of supplies based on clinical standards and

historic patterns. Surgeons could not receive a share of savings if use fell below this baselin

• The plan was of limited scope and duration (only one year). 

The advisory opinion also found that several of the plan’s features made it unlikely to be used 

to financially reward physicians for referring patients to the hospital, a potential violation of the

anti-kickback statute:

• Participation in the arrangement was limited to surgeons already on the medical staff, thus

minimizing its potential to attract new surgeons.

• The potential savings would be capped based on the number of prior year admissions by the

surgeons; thus, little incentive would exist to increase the number of admissions.

• To minimize the incentive to steer less costly patients to the hospital, the severity, age, and

insurance coverage of patients admitted by physicians to the hospital would be monitored.

Example of gainsharing agreement
4 6 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

• include periodic reviews of quality of care by an independent org a n i z a t i o n ;

• limit the amount of time during which physicians can share cost savings, to prevent hospitals from

using these agreements as a mechanism to induce physician referrals;

• avoid rewarding physicians for increasing referrals to the hospital, such as capping potential savin

based on the number of prior year admissions; and

• monitor changes in the severity, age, and insurance coverage of patients affected by the arrangeme

In developing the rules, the Secretary should consult with physicians, hospitals, and beneficiaries. I

addition, the Secretary may want to develop model arrangements, or safe harbors, that incorporate 

several of the features noted earlier. Agreements that meet the safe harbor standards would be prote

from prosecution under the CMP provision and the anti-kickback statute. 

Given the variety and complexity of potential gainsharing arrangements, we recognize that it will b

difficult to craft rules that prevent the use of gainsharing to reward physician referrals or stinting on

care for patients. At the same time, improving or achieving quality measures could be part of the ga

sharing arrangement. Such arrangements might be encouraged if hospitals and physicians start getti

paid for quality performance, as recommended in our March 2005 R e p o rt to the Congre s s ( M e d PAC 20

Although we do not estimate that this recommendation will reduce Medicare spending, it will allow

CMS to resume demonstration programs that involve gainsharing arrangements in which Medicare 

hospitals and physicians a global payment for Part A and Part B services. In 2004, a federal district

court stopped CMS from implementing an eight-hospital demonstration of gainsharing based on the

CMP provision (Robert Wood Johnson University Hospital v. Thompson 2004). Such programs cou

eventually lead to savings for Medicare. 
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

I m p l i c a t i o n s

S p e n d i n g

This recommendation would not affect federal program spending relative to current law.

B e n e f i c i a ry and pro v i d e r

This recommendation is not expected to change beneficiary access to care. 
4 8 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

Government Accountability Office. 2003a. Specialty hospitals: Geographic location, services pro v i d e 

and financial performance. GAO-04-167. Washington, DC: GAO. October 22.

Government Accountability Office. 2003b. Specialty hospitals: Information on national market share ,

physician ownership, and patients serv e d . GAO-03-683. Washington, DC: GAO. April 18. 

Government Accountability Office. 1994. M e d i c a re: Referrals to physician-owned imaging facilities 

w a rrant HCFA’s scru t i n y. GAO-95-2. Washington, DC: GAO. October.

Medicare Payment Advisory Commission. 2005. R e p o rt to the Congress: Medicare payment policy.

Washington, DC: MedPA C .

O ffice of Inspector General, Department of Health and Human Services. 1999a. Medicare and state he

programs: Fraud and abuse; clarification of the initial OIG safe harbor provisions and establishment o

additional safe harbor provisions under the anti-kickback statute. Final rule. Federal Register 64, no. 2

(November 19): 63517–63557. 

O ffice of Inspector General, Department of Health and Human Services. 1999b. Special advisory bull

Gainsharing arrangements and CMPs for hospital payments to physicians to reduce or limit services 

b e n e f i c i a r i e s . Washington, DC: OIG. July.

S t a r r, P. 1982. The social transformation of American medicine. New York: Basic Books.

United States District Court, District of New Jersey. 2004. R o b e rt Wood Johnson University Hospital 

T h o m p s o n . Civil Action No. 2:04-CV-00142 (JWB), April 15.

We n n b e rg, D. E., F. L. Lucas, A. E. Siewers, et al. 2004. Outcomes of percutaneous coronary interven

performed at centers without and with onsite coronary artery bypass graft surg e r y. Journal of the A m e r i 

Medical Association 292, no. 16: 1961–1968. 

We n n b e rg J. E., M. M. Cooper, J. D. Birkmeyer, et al. 1999. The Dartmouth atlas of health care in the

United States. H a n o v e r, NH: Dartmouth Medical School.

Worzala, C. and J. A s h b y. 2004. Survey of hospital charge-setting practices. Presentation to Medicare

Payment Advisory Commission meeting, September 10, Washington, DC. http://www. m e d p a c . g o v.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

5 Three of the surgical hospitals are women’s hospitals; we include them because they meet the surg

prevalence criteria, not because we are including women’s hospitals as a specialty group.

6 According to GAO, the number of specialty hospitals more than tripled from 29 in 1990 to 92 in 2

Using similar criteria, GAO identified 17 cardiac, 36 orthopedic, 22 surgical, and 17 women’s hosp

that specialize in certain types of care. Their higher counts are due to their inclusion of hospitals th

are not physician owned and women’s hospitals (GAO 2003b). 

7 A m a j o r teaching hospital is defined as having a resident-to-bed ratio of 0.25 or higher. O t h e r teac

hospitals have a ratio between 0 and 0.25. 

8 Hospitals qualify for additional Medicare payments if they treat a disproportionate share of Medic

patients and Medicare patients on supplemental security income. 

9 Small and midsized urban areas are defined as metropolitan areas with populations under 1 millio

l a rge urban areas are metropolitan statistical areas (MSA)s with populations of at least 1 million. 

1 0 For example, the GAO found that physicians who were investors in diagnostic imaging centers 

referred their patients more frequently for tests than nonowners (GAO 1994).

11 T h e o r e t i c a l l y, hospital ownership of physician practices might also create unfair competition when 

hospitals compel their employed physicians to refer patients to the hospital-employer. The current 

rules allow hospitals to require that employed physicians refer patients to the hospital employer, a

long as such referrals do not conflict with the patient’s preferences and insurance coverage and the 

p h y s i c i a n ’s professional judgment. In addition, the physician’s compensation must be fair market 

value for services performed and must not take into account the volume or value of referrals to the 

hospital (see Appendix B). 

1 2 In 1999, the OIG established “safe harbors” that protect physician investments in ASCs from 

prosecution under the anti-kickback statute (OIG 1999a). The safe harbors are limited to physician

who routinely use the facilities and to facilities that do not provide ancillary services other than th

included in the bundled ASC facility fee.

1 3 We defined markets using the Dartmouth hospital referral regions (HRRs), which are based on the 

referral patterns for coronary artery bypass grafts (We n n b e rg et al. 1999).
5 0 P h y si c i a n- O w n e d Sp e c i a l t y H os pi t a l s 

1 6 This analysis focused on inpatient care and did not evaluate the cost of outpatient services. It is pos

that surgical hospitals perform better than average financially on outpatient cases.

1 7 Table 6 does not include surgical hospitals. We classified hospitals as surgical hospitals if 45 perce

of the hospital’s Medicare discharges were surgical patients. Some of these surgical hospitals are 

w o m e n ’s hospitals with high rates of Medicaid patients. Other surgical hospitals are general surge

hospitals with almost no Medicaid patients. Due to the variance of Medicaid rates within this grou

presenting a summary Medicaid share for the group is not meaningful. 

1 8 The GAO examined specialty hospitals’ of Medicaid discharges in six states. Their definition of 

specialty hospitals included specialty hospitals that were not physician owned. The GAO found th

Medicaid patients constituted 3 percent of the cardiac patients treated at heart hospitals compared 

6 percent of the cardiac patients at area general hospitals (GAO 2003a).

1 9 We categorize admissions as surgical or medical based on the DRG system. Hence, we define 

angioplasties as a surgical procedure. The profit margin on angioplasties may be close to that of 

CABG surg e r y, but the dollar value of marginal profits is expected to be higher for CABG surg e r y

2 0 On our site visits, financial officers of specialty hospitals stated that the cost of a defibrillator can 

equal or exceed the payment that is received from Medicare. Note that CMS responded to compla

that hospitals were losing money on defibrillator implantation and substantially increased Medicar

payment starting in October 2003, when it created two new defibrillator DRGs. However, industry 

representatives claim that these services are still unprofitable.

2 1 We found that that community hospitals’ Medicare inpatient revenue per bed grew 2.4 percent slo

from 1997 to 2002 in markets with physician-owned heart hospitals. This difference is consistent 

the finding that heart hospitals are capturing market share from community hospitals. 

2 2 Of the 25 specialty hospitals examined, 21 had a relatively favorable selection of cases—fewer in 

h i g h -severity classes and more in low-severity classes—compared with area general community 

hospitals (GAO 2003b). 

2 3 C h a rges are standardized to remove the effects of differences in local prices for inputs (input price 

adjustment), and the extent to which hospitals operate resident training programs (the IME adjustm

or serve a disproportionate share of low-income patients (the DSH adjustment).

2 4 A small number of claims are excluded because they are s t a t i s t i c a l outliers. But these exclusion 

thresholds are very conservative and affect only a few claims. 
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

2 8 So that the relative weights are not distorted by the costs of outlier cases, the Secretary could appl

DRG-specific offsets that would reduce the relative weight by the proportion that expected outlier 

payments represent of DRG payments plus outlier payments. These offsets would be set to expend 

the current outlier pool, which is equal to 5.1 percent of the sum of operating DRG payments and 

outlier payments. At the same time, the 5.1 percent national uniform offset, currently applied to th

base payment amounts to finance outlier payments, would be removed. Under current law, the 

Secretary is required to finance outlier payments by a uniform offset to the national base operating 

payment amounts.

2 9 This estimate differs from that in Table 14 because the relative weights used here for DRGs and 

APR–DRGs are simulated for the process of analyzing policy options and are based on more rece

data (see Appendixes C and D).

Mandate for re p o rt

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P h y s i ci a n - O w ne d S pe c i al t y H o sp it a l s | M a r ch 

(A) and inserting a semicolon; and

(ii) by redesignating subparagraph (B) as subparagraph (C) and inserting after subparag

(A) the following new subparagraph:

‘‘(B) effective for the 18-month period beginning on the date of the enactment of the Med

Prescription Drug, Improvement, and Modernization Act of 2003, the hospital is not a spec

hospital (as defined in subsection (h)(7)); and’’.

(B) DEFINITION.—Section 1877(h) (42 U.S.C. 1395nn(h)) is amended by adding at the 

the following:

‘‘(7) SPECIALTY HOSPITAL.—

‘‘(A) IN GENERAL.—For purposes of this section, except as provided in subparagraph 

the term ‘specialty hospital’means a subsection (d) hospital (as defined in section 1886(d)(1)

that is primarily or exclusively engaged in the care and treatment of one of the following 

categories:

‘‘(i) Patients with a cardiac condition.

‘‘(ii) Patients with an orthopedic condition.

‘‘(iii) Patients receiving a surgical procedure.

‘‘(iv) Any other specialized category of services that the Secretary designates as inconsi

with the purpose of permitting physician ownership and investment interests in a hosp

under this section.

‘‘(B) EXCEPTION.—For purposes of this section, the term ‘specialty hospital’ does not inc

any hospital—

‘‘(i) determined by the Secretary—

‘‘(I) to be in operation before November 18, 2003; or

‘‘(II) under development as of such date;

‘‘(ii) for which the number of physician investors at any time on or after such date is 

greater than the number of such investors as of such date;

‘‘(iii) for which the type of categories described in subparagraph (A) at any time on o

after such date is no different than the type of such categories as of such date;
5 6 M a n da t e f o r R e po r t 

‘‘(A) substantially all of the designated health services furnished by the entity are furnishe

individuals residing in such a rural area; and

‘‘(B) effective for the 18-month period beginning on the date of the enactment of the Med

Prescription Drug, Improvement, and Modernization Act of 2003, the entity is not a spec

hospital (as defined in subsection (h)(7)).’’.

(b) APPLICATION OF EXCEPTION FOR HOSPITALS UNDER DEVELOPMENT.—

For purposes of section 1877(h)(7)(B)(i)(II) of the Social Security Act, as added by subsection (a)(1

in determining whether a hospital is under development as of November 18, 2003, the Secretary 

shall consider—

(1) whether architectural plans have been completed, funding has been received, zoning requ

ments have been met, and necessary approvals from appropriate State agencies have been 

received; and

(2) any other evidence the Secretary determines would indicate whether a hospital is under 

development as of such date.

(c) STUDIES.—

(1) MEDPAC STUDY.—The Medicare Payment Advisory Commission, in consultation with 

Comptroller General of the United States, shall conduct a study to determine—

(A) any differences in the costs of health care services furnished to patients by physician

owned specialty hospitals and the costs of such services furnished by local full-service 

community hospitals within specific diagnosis related groups;

(B) the extent to which specialty hospitals, relative to local full-service community hospi

treat patients in certain diagnosis-related groups within a category, such as cardiology, an

analysis of the selection;

(C) the financial impact of physician-owned specialty hospitals on local full-service comm

hospitals;

(D) how the current diagnosis-related group system should be updated to better reflect th

cost of delivering care in a hospital setting; and

(E) the proportions of payments received, by type of payer, between the specialty hospita

and local full-service community hospitals.
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

(D) to assess the differences in uncompensated care, as defined by the Secretary, between 

specialty hospital and local full-service community hospitals, and the relative value of any 

exemption available to such hospitals.

(3) REPORTS.—Not later than 15 months after the date of the enactment of this Act, the 

Commission and the Secretary, respectively, shall each submit to Congress a report on the stu

conducted under paragraphs (1) and (2), respectively, and shall include any recommendation

legislation or administrative changes.

Laws governing financial 

arrangements between physicians 

and health care providers

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

The legal restrictions 

The Congress has enacted two laws to deter inappropriate physician referrals to health care facilitie

the federal anti-kickback statute, originally passed in 1972, and the Ethics in Patient Referrals Act 

(also known as the Stark law after California Rep. Fortney Pete Stark, its principal sponsor), origina

enacted in 1989 (Stark I) and expanded in 1993 (Stark II). These laws reflect two general concerns

about physicians referring patients to facilities in which they have ownership. 

• Physician ownership creates a financial incentive to order additional services. 

• Rather than considering quality and convenience, physician-investors might refer patients to the fac

they own, which undercuts fair competition among providers.

Anti-kickback statute 

The anti-kickback law is a criminal statute that broadly prohibits the purposeful offer, payment, or

receipt of anything of value to induce the referral of patients for services reimbursable by a federal h

care program. Like all federal criminal statutes, the Department of Justice is the primary enforceme

agency, although the Office of Inspector General (OIG) of the Department of Health and Human

Services participates through its regulatory and advisory opinion process. To enforce this law, prosecu

must prove beyond a reasonable doubt that the parties involved intended to violate it, which has resu

in few cases being successfully litigated and little discouragement of physician ownership of health 

ancillary facilities. 

In the 1980s, syndicators of a wide range of ancillary service entities (such as clinical laboratories a

imaging centers) began offering equity interests in the ventures to physicians who were in a positio

refer large numbers of patients to the facilities. The trend toward physician investment in ancillary vent

was sharply criticized in some quarters. Dr. Arnold Relman, the then editor of the New England Jour

of Medicine, vocally criticized the ethics of these physician self-referral arrangements. The America

College of Physicians adopted a provision in its code of ethics stating that “physicians should avoid 

business arrangement that might, because of personal gain, influence their decisions in patient care.

1986 the Institute of Medicine also criticized physician self-referral practices and recommended leg

tion to address the issue. 

In 1989 the government began to scrutinize physician investments in ancillary facilities. Federal off i 

issued an unprecedented “Special Fraud Alert,” warning the health care industry that abusive joint vent

with referral sources would be prosecuted under the anti-kickback statute. The OIG also sought to exc

a major syndicator of physician clinical laboratory ventures, the Hanlester Network, from the Medi
6 2 L a w s g o v e rn in g f in an c i a l a r r a n ge m e n ts b e t we en p hy si c ia ns a n d he a l t h c a re pr o v i de r s 

certain financial relationships regardless of any intention to encourage referrals. 

Over the next several years a number of studies showed that physician investment in ancillary facil

increased the use of ancillary services and their costs to Medicare and Medicaid. At the same time, 

shortcomings of relying on case-by-case enforcement using the anti-kickback statute to regulate physi

ownership of ancillary joint ventures were becoming more apparent. OIG only had the resources to

investigate and prosecute a few cases, and even those took years because of inevitable appeals. In it

1995 decision of U.S. v. Hanlester Laboratories, a federal appeals court rejected the government’s

position that the selective offering of investment shares in a clinical laboratory to physicians who co

profit indirectly from their referrals to the laboratory violated the anti-kickback statute. At a minimu

the court indicated, some other culpable conduct was necessary, such as rewarding physicians who 

many patients or punishing physicians who refer few patients.

By the time of the Hanlester decision, the Congress amended Stark I to apply its prohibitions to a b

array of health care services. Stark II took effect on January 1, 1995, and replaced the anti-kickback

statute as the primary law regulating physician investment in ancillary joint ventures. As expanded, 

law applies to the following “designated health services”: clinical laboratory, physical and occupati

therapy, radiology, radiation, home health care, hospital, outpatient prescription drugs, and many ty

of equipment and supplies. 2

Stark II permits physicians to refer Medicare or Medicaid patients to several types of physician-own

facilities, including: 

• ASCs for surgical services only, and

• hospitals, as long as the physician’s investment interest is in the whole hospital and not a subdivis

or part of the hospital, and the physician is authorized to perform services at the hospital.3

The law permits physician investment in whole hospitals because hospitals generally provide a wide a

of services. Thus, referrals by an individual physician-investor would theoretically have a limited effe

overall hospital profits. The law also allows physicians to provide ancillary services in their offices, 

as laboratory tests or X-rays. The exception reflected a judgment that there often is a clear need for q

turnaround time on crucial tests (Congressional Record 1989).4
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

provided by the hospital (such as radiology and laboratory) whether or not the physicians perform t

In 1999, OIG applied these rationales to establish “safe harbors” that protect physician investments 

ASCs from prosecution under the anti-kickback statute (OIG 1999a).5 The ASC safe harbors are lim

to physicians who routinely use the facilities and to facilities that do not provide ancillary services 

than those included in Medicare’s bundled ASC facility fee. These two conditions curtail the incent

to overuse services and to profit from services physicians do not personally perform. 

In January 2001, CMS issued the first installment of the final Stark II regulation, clarifying the exact

boundaries of the Stark prohibitions and exceptions. For example, the rule permitted physician owne

of entities that provide services and equipment to providers of designated health services, so long as 

ownership interest is not in the actual entity submitting the claim to Medicare or Medicaid. Physicians w

own an entity providing services or equipment to a health care provider have a financial incentive to r

patients to that provider, similar to the incentive created by direct ownership of a provider (MedPAC 20

Specialty hospital moratorium 

Although the whole-hospital exception was originally intended to apply to full-service hospitals, m

physician-owned single-specialty hospitals now take advantage of it. Because specialty hospitals de

their revenues from a limited range of services, the opportunity for an individual physician-investor 

influence hospital profits is greater than with full-service hospitals, which creates a larger financial

incentive to refer patients to the hospitals. Legislation introduced in 2003 would have amended the

Stark law to prohibit physicians from investing on preferential terms in specialty hospitals to which

they refer Medicare or Medicaid patients. This led to a provision in the MMA that imposes an 18-m

moratorium during which physician-investors in new single-specialty hospitals may not refer Medic

or Medicaid patients to those hospitals. 

Hospital strategies to influence physician referrals 

The anti-kickback statute prohibits hospitals from offering anything of value to physicians to influe

their referrals. Because the courts have interpreted the law to prohibit any payment where one purp

is to encourage patient referrals, even payments at fair market value could violate the statute. OIG ha

interpreted other statutes to prohibit hospitals from engaging in gainsharing arrangements in which 

hospitals share cost savings with physicians who cooperate in reengineering clinical care in the hos

to reduce costs (see below). Despite these restrictions, hospitals have used several strategies to culti

medical staff loyalty, including office practice support, acquisition of practices, partnering, and restrict

on medical staff privileges (economic credentialing). 
6 4 L a w s g o v e rn in g f in an c i a l a r r a n ge m e n ts b e t we en p hy si c ia ns a n d he a l t h c a re pr o v i de r s 

physician practices. The acquisition of physician practices was thought to have three principal advanta

for hospitals: The practice provided hospitals with a source of patients; the combination of physicia

and hospitals was expected to give them greater bargaining power with managed care payers; and 

this arrangement protected hospitals’ patient bases from being purchased by competitors. Many of t

expected efficiencies and cost savings did not materialize, however, as managing physicians turned 

out to be much more difficult than expected. Many practices acquired by hospitals lost considerable

amounts of money. As a result, several hospitals have since returned the practices to the physicians 

substantial loss. 

The Stark law protects hospital payments to employed physicians as long as the compensation is fa

market value for services performed by the physicians and does not take into account the volume or

value of their referrals to the hospital. The Stark rules allow hospitals to require that employed physi

refer patients to the hospital-employer; however, this right is subject to the patient’s preferences and

insurance coverage and the physician’s professional judgment. Several substantial legal settlements h

alleged that hospitals violated the Stark and anti-kickback laws by first overpaying for the physician

practices and then overcompensating the employed physicians.

Partnering 

Many hospitals have increasingly sought to partner with physicians on their medical staffs. By doin

so, they can enlist staff in creating more efficient hospital operations and in cooperating in ventures 

which they might otherwise compete with physicians. The former initiative is best represented by g

sharing arrangements and the latter by hospital-physician ventures, such as ambulatory surgical cen

cardiac catheterization facilities, and imaging centers. The anti-kickback statute and the Stark law h

historically imposed significant obstacles to some joint-venture arrangements. 

Gainsharing 

In the late 1990s, consultants began to promote gainsharing arrangements.6 Those efforts were large

halted in response to a special advisory bulletin that OIG issued in 1999 stating that gainsharing

arrangements were prohibited by a civil monetary penalty (CMP) provision in the Social Security A

that prohibits hospitals from offering physicians financial incentives to reduce or limit services to

Medicare beneficiaries (OIG 1999b).7 Since OIG’s advisory bulletin, there has been little reported act

i n v o l v i n g gainsharing with respect to Medicare and Medicaid patients. 
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

cost-saving measures in which the surgeons participated. OIG concluded that the plan technically 

violated the CMP provision, but it did not impose sanctions because the agreement had several feat

that protected the quality of patient care. For example, the plan clearly identified specific actions th

would produce savings, such as curbing the inappropriate use of supplies. OIG also stated that the

agreement would not likely be used to financially reward physicians for referring patients to the hospi

a potential violation of the anti-kickback statute. 

In 2003, CMS approved an eight-hospital demonstration of gainsharing, but was stopped from impl

menting it by a federal district court ruling in 2004. The ruling concluded that, without an advisory

opinion from OIG, CMS had no authority to approve the demonstration due to the CMP provision

(United States District Court 2004).

Restrictions on medical staff privileges 

As physicians expand into activities where they compete directly with local hospitals, hospitals are

exploring whether and under what circumstances they can restrict the privileges of physicians who 

are competing with them. One type of restriction prohibits medical staff members from having certa

enumerated financial conflicts of interest, such as investments in competing hospitals or ambulatory 

surgical centers. A second type of restriction imposes a loyalty test on medical staff members, requi

the staff to admit a certain percentage of their patients who require hospitalization to the hospital. In 2

OIG solicited comments on the legality of such practices under the anti-kickback statute. At issue is

whether hospital privileges might constitute remuneration under the statute. 
6 6 L a w s g o v e rn in g f in an c i a l a r r a n ge m e n ts b e t we en p hy si c ia ns a n d he a l t h c a re pr o v i de r s 

Medicare Payment Advisory Commission. 2005. R e p o rt to the Congress: Medicare Payment Policy.

Washington, DC: MedPA C .

O ffice of Inspector General, Department of Health and Human Services. 2001. OIG advisory opinion 

0 1 - 1. Washington, DC: OIG. January 11. 

O ffice of Inspector General, Department of Health and Human Services. 1999a. Medicare and state he

programs: Fraud and abuse; clarification of the initial OIG safe harbor provisions and establishment o

additional safe harbor provisions under the anti-kickback statute. Final rule. Federal Register 64, no. 2

(November 19): 63517–63557. 

O ffice of Inspector General, Department of Health and Human Services. 1999b. Special advisory bull

Gainsharing arrangements and CMPs for hospital payments to physicians to reduce or limit services 

b e n e f i c i a r i e s . Washington, DC: OIG. July.

O ffice of Inspector General, Department of Health and Human Services. 1998. OIG advisory opinion 

9 8 – 1 2 . Washington, DC: OIG. September 16.

United States District Court, District of New Jersey. 2004. R o b e rt Wood Johnson University Hospital 

T h o m p s o n . Civil Action No. 2:04-CV-00142 (JWB), April 15.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

and had expanded rapidly using a strategy of offering referring physicians equity investments in 

hospitals. 

4 The in-office ancillary exception did not permit physicians to provide most durable medical 

equipment and parenteral and enteral nutrition services in their offices because there was no cle

justification for permitting referring physicians to provide these services.

5 Safe harbors protect investments in ASCs made by surgeons, certain nonsurgical specialists, 

and hospitals.

6 Consultants may have been encouraged by the success of a CMS demonstration of a global pay

for coronary artery bypass graft (CABG) surgery. This demonstration reimbursed hospitals and

physicians with a single global payment for CABG that was less than the aggregate of the Part A

hospital and Part B physician services payments, but permitted the hospitals and physicians to

divide it. By reducing the hospitals’ costs, both hospitals and physicians could earn more. 

See http://www.cms.hhs.gov/researchers/reports/1998/oregon2.pdf.

7 The CMP was enacted in response to reports that hospitals were giving incentives to physicians 

discharge patients “sicker and quicker” under the Medicare inpatient prospective payment syste

The statute permits the Secretary to regulate physician incentive arrangements with managed ca

plans that enroll Medicare beneficiaries, but not physician arrangements with hospitals.

Data and methods used in this report

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

a national survey we conducted to identify physicianowned and other specialized hospitals and

determine their mixes of payers;

• Medicare inpatient claims that were selected to match hospitals’ most recent Medicare cost repo

available at the end of 2003;

• fiscal year 2002 Medicare cost reports and IPPS Impact file;

• Medicare cost reports for fiscal year 1996 for community hospitals located in markets that have 

specialty heart hospital; and 

• Medicare hospital inpatient claims from fiscal year 1996 and 2002 MedPAR files.

Most of these data sources need little description because they are available to the public from the Cen

for Medicare and Medicaid Services (CMS). These include the hospital inpatient claims files—stan

analytic files (SAF) and MedPAR files—the Medicare cost reports, and the IPPS Impact file. The o

unique data source we used is the national survey of specialized hospitals, which is described below

Our survey involved a two-step process. First we identified the population of relatively specialized hosp

that met two criteria. They:

• specialized in certain services during fiscal year 2002—at least 45 percent of their Medicare cas

were in cardiac, orthopedic, or surgical services or at least 66 percent were in two major diagnosti

categories (MDCs), with the primary one being cardiac, orthopedic, or surgical cases.

• had a minimum volume of at least 25 total Medicare cases during 2002 (to ensure a minimum vol

of Medicare cases for analysis).

Second, we surveyed executives from the 134 specialized hospitals that met our criteria to determin

whether physicians fully or partially owned the hospital in 2002. We also inquired about the hospita

payer mix. We received 110 responses, an 82 percent response rate. In most instances, the responde

was either the CFO or the CEO of the organization. The remaining respondents held other leadershi

positions in the hospital, such as chief medical officer.

For the 24 nonrespondents, we used secondary data sources to examine the hospital’s nonprofit stat

If a hospital was a nonprofit or government entity, we assumed it was not physician owned. In the c

of for-profit hospitals, we made a second attempt to contact hospital officers to determine ownershi
7 2 Da ta a n d me th o d s u s e d i n t hi s r e p o r t 

• the effect of physician-owned hospitals on the financial performance of local community hospit

• differences in relative profitability among types of cases under Medicare’s IPPS; 

• the extent to which physician-owned specialty and other hospitals may benefit from patient 

selection; and

• the effects of options for refining Medicare’s IPPS payment policies.

Comparing relative costs per discharge and lengths of stay 

As discussed in the report, we compared relative costs and lengths of stay in physician-owned spec

and full-service community hospitals. Relative costs were based on Medicare inpatient costs per dis

charge reported in hospitals’ fiscal year 2002 cost reports as of August 2004. We used data from the

IPPS Impact file for fiscal year 2002 and our own estimated case-mix index based on all-patient ref

diagnosis-related groups (APR–DRGs) to standardize hospitals’ reported costs to remove the effect

differences in severity-adjusted case mix, market input price levels, and the extent to which they tra

residents and serve poor patients.1 To test differences in standardized costs for statistical significanc

we used the Tukey mean separation test, with a p<.05 criterion.

The comparisons of lengths of stay (LOS) between physician-owned specialty and community hosp

were based on data from the fiscal year 2002 MedPAR claims file. We compared hospitals’ actual a

age LOS with their expected averages. The expected average LOS was based on the hospital’s (or h

pital group’s) mix of cases among severity classes within APR–DRGs and the regional average LO

for each severity class in the hospital’s geographic location. We used the regional average as the stan

b e c a u s e physician-owned specialty and peer specialty hospitals are not spread uniformly across all 

geographic regions, and we know that LOS patterns differ strongly across regions. Regions are defi

by the nine Census divisions. The resulting expected LOS tells us what each hospital’s LOS would 

given its mix of cases, if it had the regional average LOS for each severity class within each APR–D

We used the expected average LOS to calculate the ratio of the actual average LOS for a hospital o

group to its expected LOS. These ratios tell us whether a hospital or a group has a pattern of relativ

longer or shorter LOS (controlling for differences in case-mix severity) than other hospitals in the s

region. We used the Tukey mean separation test to evaluate the statistical significance of difference

the ratios among hospital groups.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

physician-owned heart hospitals. At the starting point in 1996, none of the 11 physician-owned faciliti

had opened; by 2002 all of them had been open for more than one full year.

We tested growth rates of surgical cardiac discharges, medical cardiac discharges, CABG, angiopla

and defibrillator implantation. We identified CABG discharges using DRGs. Defibrillator implantat

and angioplasty were identified using procedure codes from claims data. To test for significant diff e r e 

in growth rates, we used a standard T test. 

Measuring financial impact on community hospitals 

We also examined the effect of market entry by physician-owned hospitals on full-service commun

hospitals’ financial performance. We first identified competing full-service community hospitals tha

might be affected if a physician-owned hospital opened in the same market. A community hospital i

considered to compete with a physician-owned heart hospital in the same cardiac surgery market if 

performed at least 10 bypass or angioplasty surgeries on Medicare beneficiaries in fiscal year 2002. 

A community hospital is deemed to compete with a physician-owned orthopedic or surgical hospita

the same general surgery market if it had at least five Medicare surgical cases in fiscal year 2002. 

We used the 306 HRRs to define markets for cardiac surgery. The markets for orthopedic and gener

surgery were defined by the 803 hospital service areas (HSAs) for routine Medicare services as dete

mined by Makuc et al. (1991). We used different market definitions because patients often travel fa

for cardiovascular surgery than for general surgery, which is available in more hospitals. 

Among the 48 physician-owned specialty hospitals that we identified, 22 opened between 1998 and

2001. The remaining 26 were opened either before 1998 or in 2002. We excluded hospitals that ope

before 1998 because we did not have readily available pre-opening financial data for community hosp

operating in the same market. Similarly, we excluded hospitals that opened in 2002 because we did 

have a full year of post-opening financial data for community hospitals operating in the same mark

The 8 heart hospitals and 14 orthopedic and surgical hospitals that opened between 1998 and 2001 

located in 17 markets. In those 17 markets, there are 35 hospitals competing with physician-owned

heart hospitals for open-heart surgery and angioplasty cases and 50 hospitals competing with orthop

and surgical hospitals for surgical cases. 
7 4 Da ta a n d me th o d s u s e d i n t hi s r e p o r t 

on the 35 hospitals that are competing with physician-owned heart hospitals. 

Estimating relative profitability among case types 

To assess hospitals’ opportunities to benefit from the selection of patients they treat, we needed met

for evaluating whether certain Medicare patients are relatively more profitable than other patients. I

profitability differences exist, we also needed a method for evaluating whether physician-owned speci

hospitals or other hospitals treat a favorable or unfavorable selection of patients. Hospitals could ha

favorable selection of patients if they specialized in certain relatively profitable groups of patients, 

they could treat relatively profitable (low-cost) patients within any broad patient category.

We sorted Medicare patients into categories using two patient classification systems: (1) diagnosisrelated groups (DRGs) used in the IPPS for fiscal year 2002 (DRG grouper version 18) and (2) all-pat

refined diagnosis-related groups (APR–DRGs) and severity classes—“refined” DRGS—(APR–DRG

version 15). APR–DRGs make greater use of secondary diagnoses than DRGs to sort patients with 

given condition and treatment strategy (an APR–DRG) into four levels of illness severity (classes 1

For each APR–DRG, class 1 patients tend to be relatively healthier and uncomplicated, while class 

patients usually have multiple coexisting conditions, major complications, or both. 

We measured the relative profitability of different DRGs and of severity classes within APR–DRGs

under Medicare’s IPPS in fiscal year 2002. We focused on relative profitability because the concern

underlying this analysis is that the current DRG payment weights may cause differences in profitab

across categories. Absolute levels of costs, payments, and profitability may change over time, but we 

primarily interested in the relative attractiveness of different types of patients. The relative profitabi

of a specific DRG is defined as the payment-to-cost ratio for that DRG divided by the overall avera

payment-to-cost ratio. For example, if the payment-to-cost ratio for DRG 107 averaged 1.10 (paym

were 110 percent of costs) and the overall average payment-to-cost ratio was 1.04, then we would s

that the relative profitability of DRG 107 was 1.10/1.04, or 1.06 times the average. We computed 

relative payment-to-cost ratios for APR–DRG severity class combinations using the same method.

Relative payment-to-cost ratios were based on estimated costs and payments for 10.3 million Medic

hospital inpatient claims selected to match hospitals’ latest available Medicare cost reports as of

December 31, 2003. Estimated costs were based on claim charges adjusted by the hospital’s cost-to

c h a rge ratio for the appropriate department. This method helps to reduce distortions in the cost estim

that result from differences in hospitals’ markups across departments. Because the claims span a pe

of about 30 months ending on September 30, 2002, we inflated the cost estimates to reflect the midp

of fiscal year 2002. 
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

Measuring patient selection at specialty hospitals 

We had two selection questions: 

1. Are specialty hospitals focusing on DRGs that tend to be relatively more profitable than averag

This question asks whether the hospital is specializing in profitable types of services (DRGs). 

2. Are specialty hospitals treating patients within APR–DRGs that are in severity classes that are 

relatively more profitable than average? This asks whether the hospital is obtaining patients wh

are expected to be relatively more profitable because their conditions are straightforward and

uncomplicated.

To answer the first question, we developed an index of each hospital’s expected relative profitability

The index has two components: the hospital’s mix of patients across DRGs in the 2002 MedPAR fi

and the national average relative profitability ratio for each DRG. We weighted hospitals’ shares of

cases among DRGs by the national average cost per case in each DRG, reflecting the different shar

of hospital expenditures associated with different DRGs. Thus, the index is equal to the expenditure

weighted relative profitability of the DRGs treated in the hospital. For example, assume a hospital t

two patients. The first is in a DRG with a relative payment-to-cost ratio (profitability) that is 1.2 tim

the national average and national average cost per discharge equals $20,000. The second patient is i

DRG with a relative payment-to-cost ratio that is 0.8 times the national average and the national aver

cost per discharge is $5,000. Given these assumptions, the weighted expected relative profitability f

the hospital would be:

(1.2 x 20,000 + 0.8 x 5,000) / (20,000+5,000) = 1.12

The hypothetical hospital would have an expected Medicare payment-to-cost ratio that is 1.12 times 

national average. The overall expected profitability is above 1.0 because a higher weight is given to 

DRG with higher costs and higher payments. This measure tells us about the relative profitability o

h o s p i t a l ’s case mix if the hospital had average performance in each DRG. It does not measure the hospi

actual profitability. When this method is applied to the national average case mix for all community

hospitals in 2002, the expected relative profitability ratio equals 1.0.

To answer the second question, we developed an index of each hospital’s expected relative profitab

using the hospital’s mix of cases across APR–DRG severity classes and the corresponding national

average relative profitability ratios for those categories.3 Once again, the weighted average is compu
7 6 Da ta a n d me th o d s u s e d i n t hi s r e p o r t 

ppgg

• Change the data used to calculate the relative weights, substituting estimated costs for standardi

charges.

• Adjust the relative cost weights to account for differences in the expected proportion of outlier 

payments among refined DRGs.

To illustrate the potential benefits that might be obtained from refining the DRGs, we used (but do 

endorse) the severity classes of APR–DRGs. We also evaluated an alternative method of calculating

DRG relative weights that would make them more accurate. In this method, the charges (or estimat

costs) for each hospital’s cases are converted to hospital-specific relative values by dividing them b

the hospital’s average charge (cost) per case and then adjusting the relative values for the hospital’s 

m i x .4 Then the national relative weight in each DRG is calculated as the national average of the adju

relative values across all cases in the DRG. 

Although this hospital relative-value method removes the effects of hospital-wide differences in cha

markups or costs, it does not remove the effects of differences in markups across hospital service

departments or among services within departments. For example, if most hospitals were to mark up

operating room use by 400 percent and routine room and board services by 20 percent, then the rela

weights still would be overstated for DRGs in which operating room services were important. Simila

the weights would be understated for DRGs in which patients use a lot of routine services. 

To address this problem, we evaluated changing the basis of the weights from standardized charges 

to costs. Using costs instead of charges removes the effects of differences in markups across hospita

departments, which are often substantial. When combined with the hospital relative-value method, t

approach has the potential to remove from the weights many—though not all—of the distortions th

result from differences in hospitals’ charging practices.

We also evaluated a method of reducing the distortion caused by including the charges for most out

cases in the calculation of the relative weights. This method would reduce each relative weight to o

anticipated outlier payments for cases included in the patient category. As a result, the relative weig

would account for differences in the prevalence of outlier cases and payments across categories and

approximate more accurately the relative costliness of typical cases in each category.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

ratio for all Medicare discharges. 

We estimated payments for five policy options including current (2002) policy and the four combin

tions of payment refinements described in the report. All payment estimates, including current polic

payments, reflect DRG (or APR–DRG) relative weights calculated by the appropriate methods usin

10.3 million claims for which we had both charges and estimated costs. That is, for these compariso

we recomputed “current policy” DRG relative weights similar to those actually used in fiscal year 2

but based on the same data we used in computing relative weights for the other policy options. This

approach ensures that estimated differences in relative profitability between current policy and any 

the policy options reflect only differences in policies, not differences in the underlying data.5

We also wanted to measure the extent to which the various policy options might alter the potential 

benefits of favorable patient selection for hospitals. For this purpose, we calculated measures of expe

relative profitability for hospitals and hospital groups, again using the methods described earlier. Th

is, we measured hospitals’ expected relative profitability based on their mix of Medicare cases amo

DRGs or APR–DRG severity classes and the national average relative profitability in each category

under each policy option. The expected relative profitability measures tell us what the hospital’s rel

profitability would look like, given its mix of cases, if it had the national average relative profitabil

in each DRG or APR–DRG severity class under each policy option.

To measure the impact of the policy options on hospitals’ IPPS payments, we estimated the percent

change in payments for each option relative to the payments under current policy. We applied a sma

budget-neutrality factor to the payment estimates under each option to ensure that aggregate payme

would remain the same as under current policies. This is consistent with current law, which requires 

Secretary to ensure that projected payments resulting from changes in the DRG definitions and wei

remain budget neutral. 
7 8 Da ta a n d me th o d s u s e d i n t hi s r e p o r t 

4 The adjustment for case mix is necessary to scale the relative values consistently across hospitals,

because a hospital’s overall average charge (or cost), and the level of its relative values, reflect its 

of cases. 

5 The actual DRG relative weights for fiscal year 2002 were computed using charges on claims 

included in the fiscal year 2000 MedPAR file. The claims used here are primarily from fiscal years 2

and 2002.
Effect of policy options

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

policy change. Relative profitability ratios would become increasingly uniform, moving toward 1.0

national average relative profitability ratio. This pattern holds across both DRGs (the top half of the ta

and severity classes of APR–DRGs (the bottom half). These changes are measured in this table by t

shares of estimated IPPS payments that would fall into patient categories that have relative profitab

ratios within plus or minus 5 percent of the national average relative profitability ratio. The estimat

the top half of the table were used in creating Figure 4 of the report.

The remaining tables in this appendix show estimated relative profitability ratios for DRGs and sev

classes of the corresponding APR–DRGs under current policy and each of the policy changes we 

recommended. The patient categories in each table were selected because they represent groups of pat

frequently seen in specialty heart hospitals or their competitors (Table D-2), specialty orthopedic an

surgical hospitals or their competitors (Table D-3), or nonsurgical patients generally seen in commu

hospitals but less frequently encountered in specialty hospitals (Table D-4).

In examining these estimates, note that the relative profitability ratios for current policy differ somew

from those shown in Tables 10–13 in the report. These differences reflect intentional differences in 

study objectives and the methods we used in the two analyses. 

The estimates in Tables 10–13 show differences in relative profitability across and within DRGs un

2002 (“current”) policies as hospitals saw them in fiscal year 2002. Thus, we used the actual 2002 D

weights in estimating IPPS payments for the cases in our claims file. The 2002 DRG relative weigh

reflect hospitals’ charges for claims in the fiscal year 2000 MedPAR file, which were the latest claim

available at the time. 

To analyze policy options for refining IPPS payments, we recalculated the DRG relative weights to esti

IPPS payments under current policy. This was necessary because all of the policy options under consi

t i o n entail changing the relative weights. To ensure comparability between payments under current p

and under each policy option, the relative weights in all instances must be based on the same set of c

Otherwise, comparisons between current policy and the policy options would reflect both the policy

changes under study and differences in the data underlying the relative weights. 

Thus, we calculated and then recalibrated a new set of DRG relative weights using essentially the s

methods CMS uses to recalibrate the weights and the cases in our claims file. These weights differ 

the official 2002 weights primarily because they are based on later claims, from 2001 and 2002, rat

than from 2000. The estimates in all of the tables in this appendix reflect the recalibrated weights.
8 2 E ffe ct o f p o l i cy op ti o n s 

P e rcent of payments in APR–DRG 

severity categories with PCR:

Below 0.95 3 0 . 7 3 0 . 9 2 7 . 1 5 . 8 0 . 1

Between 0.95 and 1.05 1 8 . 6 1 6 . 2 4 7 . 3 7 5 . 7 9 9 . 2

Above 1.05 5 0 . 7 5 2 . 9 2 5 . 5 1 8 . 5 0 . 7

Note: DRG (diagnosis-related group), APR–DRG (all-patient refined diagnosis-related group), PCR (national relative payment-to-cost ratio). 

The “Percent of payments in DRGs with PCR” rows were shown as Figure 4 in the re p o rt. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.
P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

DRG 107 Coro n a ry bypass with cardiac cath (S) 1 . 1 0 1 . 0 4 1 . 0 5 0 . 9 9 1 . 0 0

APR–DRG 165 level 1 1 . 4 7 1 . 4 0 1 . 0 2 0 . 9 4 0 . 9 9

APR–DRG 165 level 2 1 . 2 7 1 . 2 1 1 . 0 2 0 . 9 5 0 . 9 9

APR–DRG 165 level 3 1 . 0 4 0 . 9 9 1 . 0 4 0 . 9 9 0 . 9 9

APR–DRG 165 level 4 0 . 8 0 0 . 7 7 1 . 1 0 1 . 0 4 0 . 9 8

DRG 109 Coro n a ry bypass 

without PTCA or cardiac cath (S) 1 . 0 5 1 . 0 2 1 . 0 3 0 . 9 9 1 . 0 0

APR–DRG 166 level 1 1 . 3 5 1 . 3 1 1 . 0 0 0 . 9 4 0 . 9 9

APR–DRG 166 level 2 1 . 1 9 1 . 1 6 1 . 0 0 0 . 9 5 0 . 9 9

APR–DRG 166 level 3 0 . 9 6 0 . 9 3 1 . 0 2 0 . 9 8 0 . 9 9

APR–DRG 166 level 4 0 . 7 2 0 . 7 1 1 . 1 0 1 . 0 5 0 . 9 8

DRG 116 Other permanent cardiac 

pacemaker implantation (S) 1 . 0 0 0 . 9 8 0 . 9 9 0 . 9 7 0 . 9 9

APR–DRG 171 level 1 1 . 2 4 1 . 2 1 0 . 9 9 0 . 9 6 0 . 9 9

APR–DRG 171 level 2 1 . 0 5 1 . 0 3 0 . 9 8 0 . 9 6 0 . 9 9

APR–DRG 171 level 3 0 . 8 3 0 . 8 2 0 . 9 9 0 . 9 8 0 . 9 9

APR–DRG 171 level 4 0 . 6 3 0 . 6 2 1 . 0 3 1 . 0 3 1 . 0 0

DRG 516 Percutaneous cardiovascular 

p ro c e d u re with acute myocardial infarction (S) 1 . 1 4 1 . 0 9 1 . 0 9 0 . 9 7 0 . 9 8

APR–DRG 174 level 1 1 . 4 5 1 . 3 8 1 . 1 1 0 . 9 5 0 . 9 9

APR–DRG 174 level 2 1 . 2 7 1 . 2 1 1 . 1 0 0 . 9 6 0 . 9 9

APR–DRG 174 level 3 0 . 9 7 0 . 9 2 1 . 0 7 0 . 9 8 0 . 9 9

APR–DRG 174 level 4 0 . 8 3 0 . 8 0 1 . 1 2 1 . 0 3 0 . 9 8

DRG 127 Heart failure and shock (M) 0 . 9 0 0 . 9 3 0 . 9 3 0 . 9 9 1 . 0 1

APR–DRG 194 level 1 1 . 4 3 1 . 4 9 0 . 9 1 0 . 9 7 1 . 0 2

APR–DRG 194 level 2 1 . 0 8 1 . 1 3 0 . 9 1 0 . 9 7 1 . 0 2

APR–DRG 194 level 3 0 . 7 2 0 . 7 5 0 . 9 3 0 . 9 9 1 . 0 1

APR–DRG 194 level 4 0 . 4 8 0 . 4 9 1 . 0 4 1 . 0 5 1 . 0 0

DRG 138 Cardiac arrhythmia and conduction 

d i s o rders with complications or comorbidities (M) 0 . 8 8 0 . 9 3 0 . 9 1 0 . 9 5 0 . 9 8

APR–DRG 201 level 1 1 . 0 7 1 . 1 2 0 . 9 2 0 . 9 5 1 . 0 0

APR–DRG 201 level 2 1 . 0 0 1 . 0 6 0 . 9 2 0 . 9 6 1 . 0 1

APR–DRG 201 level 3 0 . 7 2 0 . 7 6 0 . 9 3 0 . 9 8 1 . 0 1

APR–DRG 201 level 4 0 . 4 6 0 . 4 7 1 . 0 3 1 . 0 4 1 . 0 0

Note: DRG (diagnosis-related group), APR–DRG (all-patient refined diagnosis-related group), S (surgical DRG), M (medical DRG), cath (catheterization), 

( p e rcutaneous transluminal coro n a ry angioplasty). Relative profitability compares the national average inpatient Medicare profitability of one patient ca

(DRG or APR–DRG) with the national average inpatient profitability of all Medicare discharges. The relative profitability measure is an average for 

severity-adjusted DRG category, based on cost accounting data. Thus, small diff e rences (for example, 1 percent or 2 percent) in relative profitability 

DRGs may not be meaningful. The values shown for the APR–DRG and severity classes associated with any DRG may re p resent fewer cases than the o

DRG if some cases were assigned to other APR–DRGs, or more cases if additional cases were assigned to this APR–DRG from other DRGs. Severity 

is least severely ill. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.
8 4 E ffe ct o f p o l i cy op ti o n s 

APR–DRG 227 level 4 0 . 5 1 0 . 5 1 1 . 1 0 1 . 0 6 1 . 0 1

DRG 210 Hip and femur pro c e d u re 0 . 9 7 0 . 9 7 0 . 9 6 0 . 9 6 0 . 9 9

APR–DRG 308 level 1 1 . 0 4 1 . 0 6 0 . 9 4 0 . 9 5 1 . 0 0

APR–DRG 308 level 2 1 . 0 7 1 . 0 8 0 . 9 4 0 . 9 6 1 . 0 0

APR–DRG 308 level 3 0 . 9 2 0 . 9 2 0 . 9 7 0 . 9 7 1 . 0 0

APR–DRG 308 level 4 0 . 6 4 0 . 6 3 1 . 0 3 1 . 0 2 0 . 9 9

DRG 290 Thyroid pro c e d u re 1 . 0 2 1 . 0 4 1 . 0 1 0 . 9 6 0 . 9 9

APR–DRG 404 level 1 1 . 3 0 1 . 3 3 1 . 0 4 0 . 9 6 1 . 0 1

APR–DRG 404 level 2 0 . 9 8 1 . 0 0 1 . 0 2 0 . 9 7 1 . 0 1

APR–DRG 404 level 3 0 . 5 1 0 . 5 2 1 . 0 3 1 . 0 2 1 . 0 0

APR–DRG 404 level 4 0 . 4 8 0 . 4 8 1 . 1 1 1 . 1 0 1 . 0 2

DRG 334 Major male pelvic 

p ro c e d u res with CC 0 . 9 9 1 . 0 1 0 . 9 5 0 . 9 1 0 . 9 3

DRG 335 Major male pelvic 

p ro c e d u res without CC 1 . 0 0 1 . 0 0 1 . 0 6 1 . 0 1 1 . 0 6

APR–DRG 480 level 1 1 . 0 3 1 . 0 4 0 . 9 9 0 . 9 4 0 . 9 9

APR–DRG 480 level 2 1 . 0 1 1 . 0 3 1 . 0 0 0 . 9 6 0 . 9 9

APR–DRG 480 level 3 0 . 6 9 0 . 7 1 1 . 0 3 0 . 9 9 1 . 0 0

APR–DRG 480 level 4 0 . 5 2 0 . 5 2 1 . 1 2 1 . 0 8 1 . 0 1

DRG 336 Tr a n s u rethral 

p rostatectomy with CC 0 . 9 3 0 . 9 8 0 . 9 7 0 . 9 6 1 . 0 0

DRG 337 Tr a n s u rethral 

p rostatectomy without CC 0 . 9 7 0 . 9 9 1 . 0 4 1 . 0 2 1 . 0 7

APR–DRG 482 level 1 1 . 0 4 1 . 0 7 0 . 9 8 0 . 9 6 1 . 0 1

APR–DRG 482 level 2 1 . 0 3 1 . 0 8 0 . 9 7 0 . 9 6 1 . 0 1

APR–DRG 482 level 3 0 . 6 2 0 . 6 5 0 . 9 7 0 . 9 8 1 . 0 0

APR–DRG 482 level 4 0 . 4 2 0 . 4 3 1 . 0 9 1 . 0 7 1 . 0 3

Note: DRG (diagnosis-related group), APR–DRG (all-patient refined diagnosis-related group), CC (complications or comorbidities). Relative profitability com

the national average inpatient Medicare profitability of one patient category (DRG or APR–DRG) with the national average inpatient profitability o

M e d i c a re discharges. The relative profitability measure is an average for each severity-adjusted DRG category, based on cost accounting data. Th

small diff e rences (for example, 1 percent or 2 percent) in relative profitability among DRGs may not be meaningful. The values shown for the APR

and severity classes associated with any DRG may re p resent fewer cases than the original DRG if some cases were assigned to other APR–DRGs, 

cases if additional cases were assigned to this APR–DRG from other DRGs. Severity level 1 is least ill. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.
P h y s i c ia n - O w ne d S pe ci a lt y H o sp i ta l s | M a r ch 

DRG 89 Pneumonia with 

complications and comorbidities 0 . 8 8 0 . 9 4 0 . 9 4 0 . 9 8 1 . 0 1

APR–DRG 139 level 1 1 . 0 3 1 . 1 4 0 . 9 0 0 . 9 6 1 . 0 1

APR–DRG 139 level 2 1 . 0 5 1 . 1 3 0 . 9 2 0 . 9 6 1 . 0 1

APR–DRG 139 level 3 0 . 7 8 0 . 8 4 0 . 9 4 0 . 9 8 1 . 0 1

APR–DRG 139 level 4 0 . 8 4 0 . 8 4 1 . 0 2 1 . 0 3 1 . 0 2

DRG 243 Medical back problems 0 . 8 5 0 . 8 8 0 . 8 8 0 . 9 6 1 . 0 0

APR–DRG 347 level 1 1 . 1 1 1 . 1 6 0 . 8 5 0 . 9 5 1 . 0 0

APR–DRG 347 level 2 0 . 8 6 0 . 9 0 0 . 8 7 0 . 9 5 1 . 0 0

APR–DRG 347 level 3 0 . 5 9 0 . 6 2 0 . 9 0 0 . 9 7 0 . 9 9

APR–DRG 347 level 4 0 . 4 1 0 . 4 1 1 . 0 2 1 . 0 3 0 . 9 7

DRG 296 Nutritional and metabolic 0 . 8 8 0 . 9 2 0 . 9 1 0 . 9 7 1 . 0 0

APR–DRG 422 level 1 1 . 0 9 1 . 1 5 0 . 8 7 0 . 9 6 1 . 0 1

APR–DRG 422 level 2 1 . 1 0 1 . 1 5 0 . 8 9 0 . 9 7 1 . 0 1

APR–DRG 422 level 3 0 . 8 3 0 . 8 6 0 . 9 1 0 . 9 8 1 . 0 1

APR–DRG 422 level 4 0 . 5 3 0 . 5 4 1 . 0 0 1 . 0 4 1 . 0 1

DRG 316 Renal failure 0 . 9 6 0 . 9 7 0 . 9 8 1 . 0 2 1 . 0 1

APR–DRG 460 level 1 2 . 2 0 2 . 2 4 0 . 9 2 0 . 9 9 1 . 0 4

APR–DRG 460 level 2 1 . 4 4 1 . 4 6 0 . 9 2 0 . 9 9 1 . 0 3

APR–DRG 460 level 3 0 . 9 3 0 . 9 4 0 . 9 6 1 . 0 1 1 . 0 2

APR–DRG 460 level 4 0 . 5 9 0 . 5 9 1 . 0 6 1 . 0 7 1 . 0 0

Note: DRG (diagnosis-related group), APR–DRG (all-patient refined diagnosis-related group). Relative profitability compares the national average inpatie

M e d i c a re profitability of one patient category (DRG or APR–DRG) with the national average inpatient profitability of all Medicare discharges. The 

p rofitability measure is an average for each severity-adjusted DRG category, based on cost accounting data. Thus, small diff e rences (for example, 

cent or 2 percent) in relative profitability among DRGs may not be meaningful. The values shown for the APR–DRG and severity classes associated 

any DRG may re p resent fewer cases than the original DRG if some cases were assigned to other APR–DRGs, or more cases if additional cases we

assigned to this APR–DRG from other DRGs. Severity level 1 is least severely ill. 

S o u rce: M e d PAC analysis of Medicare hospital inpatient claims and cost re p o rts from CMS, fiscal year 2000–2002.

Commissioners’ voting 

on recommendations

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

weights on the national average of hospitals’ relative values in each DRG.

Ye s : B e rtko, Burke, Crosson, DeBusk, DeParle, Dure n b e rg e r, Hackbarth, Milstein, Muller, 

Nelson, Raphael, Reischauer, Scanlon, Smith, Stowers, Wolter 

Absent: Wa k e f i e l d

Recommendation 2

The Congress should amend the law to give the Secretary authority to adjust the DRG relative weig

to account for differences in the prevalence of high-cost outlier cases.

Ye s : B e rtko, Burke, Crosson, DeBusk, DeParle, Dure n b e rg e r, Hackbarth, Nelson, Raphael, 

R e i s c h a u e r, Scanlon, Smith, Stowers, Wolter 

N o : M u l l e r

Absent: Milstein, Wa k e f i e l d

Recommendation 3

The Congress and the Secretary should implement the case-mix measurement and outlier policies o

transitional period.

Ye s : B e rtko, Burke, Crosson, DeBusk, DeParle, Dure n b e rg e r, Hackbarth, Muller, Nelson, 

Raphael, Reischauer, Scanlon, Smith, Stowers, Wolter 

Absent: Milstein, Wa k e f i e l d

Recommendation 4

The Congress should extend the current moratorium on specialty hospitals until January 1, 2007.

Ye s : B e rtko, Burke, Crosson, DeBusk, DeParle, Dure n b e rg e r, Hackbarth, Milstein, Muller, 

Nelson, Raphael, Reischauer, Scanlon, Smith, Stowers, Wolter 

Absent: Wa k e f i e l d

Recommendation 5

The Congress should grant the Secretary the authority to allow gainsharing arrangements between 

physicians and hospitals and to regulate those arrangements to protect the quality of care and minim

financial incentives that could affect physician referrals.

Ye s : B e rtko, Burke, Crosson, DeBusk, DeParle, Dure n b e rg e r, Hackbarth, Muller, Nelson, 

Raphael, Reischauer, Scanlon, Smith, Stowers, Wolter 

Absent: Milstein, Wa k e f i e l d

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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P h y s i c i an - O w ne d S pe ci a lt y H o sp i ta l s | M a r c h 

Term expires April 2005

Nancy-Ann DeParle, J.D.

JPMorgan Partners

Washington, DC

David F. Dure n b e rg e r, J.D.

National Institute of Health Policy

University of St. Thomas

Minneapolis, MN

C a rol Raphael

Visiting Nurse Service of New York

New York, NY

M a ry K. Wakefield, Ph.D.

R.N., F. A . A . N .

Center for Rural Health

University of North Dakota

Grand Forks, ND

Nicholas J. Wo l t e r, M.D.

Deaconess Billings Clinic

Billings, MT

Term expires April 2006

A u t ry O.V. “Pete” DeBusk

DeRoyal

Powell, TN

Glenn M. Hackbarth, J.D.

Alan R. Nelson, M.D.

American College of Physicians

Washington, DC

R o b e rt D. Reischauer, Ph.D.

David A. Smith

Demos

New York, NY

Ray E. Stowers, D.O.

Oklahoma State University 

College of Osteopathic Medicine

Tulsa, OK

Term expires April 2007

John M. Bertko, F. S . A . ,

M . A . A . A .

Humana, Inc.

Louisville, KY

Sheila P. Burke, M.P. A . ,

R.N., F. A . A . N .

Smithsonian Institution

Washington, DC

Francis J. Crosson, M.D.

The Permanente Federation, LL

Oakland, CA

A rnold Milstein, M.D., M.P

Pacific Business Group on Hea

San Francisco, CA

Ralph W. Muller

University of Pennsylvania 

Health System

Philadelphia, PA

William J. Scanlon, Ph.D.

Health Policy Consultant

Oak Hill, VA
9 4 M o r e ab o u t M ed PA C 

Nancy Ray, M.S.

A n a l y s t s

Cristina Boccuti, M.P.P.

Sharon Bee Cheng, M.S.

David V. Glass, M.S.

Timothy F. Greene, M.B.A.

Kathryn Linehan, M.P.H.

Craig K. Lisk, M.S.

Rachel Schmidt, Ph.D.

Joan Sokolovsky, Ph.D.

Jeffrey Stensland, Ph.D.

Ariel Winter, M.P.P.

Chantal Worzala, Ph.D.

Daniel Zabinski, Ph.D.

R e s e a rch assistants

Chad Ellimoottil

M a rgo Harrison

Sarah Kwon

ff

Wylene Carlyle

Mathew Chase

Diane E. Ellison

Donna M. Fletcher

Plinie (Ann) Johnson

Cynthia Wilson

601 New Jersey Avenue, NW • Suite 9000 • Washington

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