Standardized costs per discharge in
physician-owned orthopedic/surgical hospitals
are higher than those of other hospitals

Average costs compared with national, 2004

Number of

Hospital group hospitals Case weighted Simple mean
All IPPS hospitals 3,386 100% 101%
All operating in 2004

Physician-owned orthopedic/surgical 55 120 131*

Peer 15 109 118

Competitor community 300 101 100

All other 3,016 100 100
Operating in 2002 and 2004

Physician-owned orthopedic/surgical 33 114 17"
Entered market after 2002

Physician-owned orthopedic/surgical 22 135 152**

Note: Excludes hospitals open for less than one year and those with missing or erroneous cost data. Costs are standardized for differences in case-mix
severity, prevalence of shortstay kransfers, prevalence of high-cost outliers, local input prices, the effects of training residents, share of lowincome
patients, and differences in interest expenses per discharge. Percent of national valves are based on national amounts for all U.S. nonspecialty
hospitals paid under the inpatient prospective payment system. Peer hospitals are specialized, but are not physician owned. Compelitor communily
hospitals are in the same market as specially hospitals and provide similar services. The all other hospital groups include all hospitals except the
particular specialty, peer, and competitor community hospitals.

*Standardized cost per discharge is significantly higher compared with both competitors and all other hospitals, but not peer, in a Tukey mean
separation test with a criterion value of 0.05

**Standardized cost per discharge is significantly higher compared with peers, competitors and all other hospitals in a Tukey mean separation
test, with a criterion value of 0.05.

Source: MedPAC analysis of Medicare hospital cost data and 11 million inpatient claims for fiscal year 2004 from CMS.

orthopedic/surgical hospitals had significantly higher costs than their competitors. Shorter stays
should lead to lower costs, but we found equal or higher inpatient costs at specialty hospitals.

The cost differences we see may reflect a variety of factors, including high depreciation and lease
expenses, different staffing levels or employee compensation, and greater supply costs because
of specialty hospitals’ focus on surgeries as opposed to medical care. In the case of some cardiac
hospitals, high capital costs may reflect their decision to build only single occupancy rooms that
are equipped for intensive care. In the case of orthopedic/surgical hospitals, their high capital
costs could partly reflect their small scale and low occupancy. Differences in interest expenses
should not affect our findings because we adjusted for them.

MECpAC Physician-owned specially hospitals revisited | August 2006 11


that do not provide angioplasty or bypass services

Regression coefficients

Model 2:
Model 1: Community Model 3:
Community hospitals’ hospitals’ total Community
Medicare inpatient revenue per hospitals’ total
Explanatory variables revenue per 1997 bed* 1997 bed margin
Physician-owned specialty hospitals
Physician-owned heart hospitals’ market -140,241** -321,480 10.9
share in the HRR® (37,983) {196,960} (23.0)
Physicianowned orthopedic or surgical 2,096 =10,872 0.6
hospitals’ market share in the HSA® (26,834) (105,620) (20.3)
Demographic characteristics
Percent change in population in the HSA, 107,083 ** 474,305** 14.4**
relative to the nation’s growth (13,687) (91,519) (4.4)
Percent change in per capita income in the 432,479** -7.3
HSA, relative to the nation’s growth N/A (181,579) (4.2)
Year (relative to 1997):
1998 -4,127** 16,031** -1.6**
1999 -4,978** 30,563 ** -2.4**
2000 -6,003** 43,737 ** -2.3**
2001 -2,678** 65,636** -2.3**
2002 -126 89,289 ** -2.7**
2003 -128 106,697 ** -2.6**
2004 1,549 121,981 ** -2.9%**
Number of hospitals in the data set 942 942 942

Note: HRR (hospital referral region], HSA (hospital service area}, N/A (no! applicable). Data are for community hospitals. Regression coefficients
reflect the effect of a 1 percent increase in physician-owned specialty hospitals’ market share on community hospitals’ Medicare revenue, total
revenue, and total margins. Standard errors are in parentheses. The model was computed using @ generalized least squares fixed effects model
with robust standard errors.

* P05

** P01

» Revenues per bed are adjusted to correct for differences in input prices across regions using the CMS wage index. Revenves are deflated

to 1997 dollars using the CMS hospital market basket. Beds are fixed at their 1997 level to prevent hospitals that build new capacity from
‘oppearing to have lower demand for inpatient services per bed.

© The HRR refers to the Dartmouth Alas cardiac surgery referral regions. The HSA refers to market areas for general surgery. Market share is
the specialty hospitals’ aggregate revenue for that specific year divided by the market's revenue in 2004. The denominator in the ratio (2004
revenue} is held constant across all years to prevent changes in community hospitals’ performance from affecting market share (the independent
variable}

Source: MedPAC analysis.

32 > Physician-owned specialty hospitals revisited | August 2006 MECpac




M E Cc Medicare ow nd 601 New Jersey Avenue, NW « Suite 9000 » Washington, DC 20001
A Payment Advisory (202) 220-3700 * Fax: (202) 220-3759 » www.medpac.gov


Medicare services as determined by Makuc and colleagues (1991). We use two different market
areas because patients often travel farther for a cardiovascular surgery than for general surgery,
which is available in more hospitals.

Characteristics of specialty, peer, and competitor
community hospitals P P

The specialty hospitals that formed during 2002 through 2004 have very similar characteristics

to older specialty hospitals. In general, heart hospitals are focused on serving Medicare patients
and generate most of their revenue from inpatient services (Table 2). In contrast, the orthopedic/
surgical hospitals gain most of their revenue from private payers and tend to focus on outpatient

Median characteristics of heart hospitals

Heart specialization

Physician-owned Peer community combonty
Characteristics hospitals hospitals hospitals
Number of hospitals 20 25 148
Number of beds 56 322 216
Annual admissions 3,638 17,503 12,020
Occupancy 66% 72% 65%
Inpatient charges as a percent of total charges 79% 75% 65%
Medicare share of discharges 63% 45% 37%
Medicaid share of discharges 3% 7% 13%
Building and equipment book value* (millions) $33 $109 $81
Total revenue (millions) $59 $262 $175
Median total margin 7% 5% 5%
Return on invested capital** 13% 5% 5%
Number of physician investors 36 N/A N/A
Ownership share per physician 1% N/A N/A
Hospital income per physician investor $40,000 N/A N/A

Note: N/A (not applicable). Peer hospitals have ai similar concentration to specialty hospitals, but are not physician-owned. Compatitors include all
hospitals in the hospital referral region offering similar (cardiac) services
* Book value is the purchase price less accumulated depreciation
**Rotum on invested capital is income plus interest expense divided by total assets and measures average return on the equily and debt invested
in a hospital.

Source: MedPAC analysis of survey and 2004 cost report data for hospitals open for a full year in 2004.

MECpAC Physician-owned specially hospitals revisited | August 2006


Methodology

This section focuses on the association between physician ownership of heart hospitals and the
rate of cardiac surgery per capita. Specifically, we tested whether physician investments in heart
hospitals are followed by either (1) an increase in the overall number of cardiac surgeries per
capita among Medicare beneficiaries living in that market, (2) an increase in certain types of
surgery such as CABG, or (3) a shift toward operating on healthier (more profitable) Medicare
patients in the market. During the time frame of our study (1996 to 2004), there was a large
increase in most types of cardiac surgeries across the nation. We controlled for overall industry
trends by comparing utilization changes in markets with physician-owned heart hospitals to
utilization changes in markets without such hospitals. We did not evaluate whether increased
utilization equates to better care or better outcomes.

An above-average increase in the overall rate of cardiac surgeries per Medicare beneficiary could
indicate that heart hospitals are meeting a previously unmet community need or that physician
investors are inducing additional demand for surgeries due to the economic incentives associated
with hospital ownership. Such inducement could be direct (e.g., a cardiac surgeon—investor

who recommends and performs surgery) or indirect (e.g., a cardiologist-owner recommends
surgery by a surgeon who operates in the cardiologist’s hospital). While we can not determine
the degree to which aggregate increases in cardiac surgeries were due to financial incentives, we
can examine whether shifts in the types of surgeries performed are consistent with the investors’
financial incentives. If we see an increase in the ratio of highly profitable surgeries to less
profitable surgeries, it would indicate that financial incentives may have influenced at least some
physicians’ behavior. We test whether the presence of physician-owned hospitals is associated
with a market-level increase in this ratio.

Profitable types of patients

In addition to testing for the overall growth in cardiac surgery following the entrance of a
physician-owned heart hospital, we examine three specific types of surgery. First, we examined
CABG surgery. This is a relatively high marginal profit surgery. A review of cost report data, the
literature, and discussions with owners of cardiac hospitals confirmed that between $6,000 and
$12,000 of the $24,000 payment for CABG surgery represents marginal profit on an average
patient. Our example of a moderate profit surgery is angioplasty. According to the literature and
hospital financial officers, the marginal profit from angioplasty is significant, but lower than that
of CABG. Our example of a historically low-profit procedure is defibrillator implantation. There
was a perception in the hospital field that the cost of purchasing a defibrillator made up most of
the payment for this service. While defibrillator implantation was relatively unprofitable through
2002, profitability may have improved by 2004.°

In addition to dividing surgical procedures by type of surgery, we divided cases by level of
patient severity. Physician-owned hospitals tend to treat lower severity patients who cost less

and are thus more profitable (Cram 2005, MedPAC 2005, CMS 2005). In contrast, the sickest
patients require more resources and are less profitable. We tested whether physician ownership of
heart hospitals is associated with a market-wide shift in surgical volumes toward lower severity

MECpAC Physician-owned specially hospitals revisited | August 2006

15


More about MedPAC





References

Berenson, R., T. Bodenheimer, and H. Pham. 2006. Specialty-service lines: Salvos in the new
medical arms race. Health Affairs 25: 337-343.

Centers for Medicare & Medicaid Services, Department of Health and Human Services. 2005.
Study of physician-owned specialty hospitals required in Section 507(c)(2) of the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003. Baltimore: CMS.

Cram, P., G. Rosenthal, and M. Vaughtan-Sarrazin. 2005. Cardiac revascularization in specialty
and general hospitals. New England Journal of Medicine 352, no. 14: 1454-1462.

Government Accountability Office. 2003. Specialty hospitals: Information on national market
share, physician ownership, and patients served. GAO—04—167. Washington, DC: GAO.

Government Accountability Office. 2006. General hospitals: Operational and clinical changes
largely unaffected by presence of competing specialty hospitals. GAO-06-520. Washington, DC:
GAO.

Hannan, E., M. Racz, G. Walford, et al. 2005. Long-term outcomes of coronary-artery bypass
grafting versus stent implantation. New England Journal of Medicine 352: 2174-2183.

Makuc, D., B. Haglund, D. Ingram, et al. 1991, Health service areas for the United States.
National Center for Health Statistics Vital and Health Statistics, 2, no. 112.

Medicare Payment Advisory Commission. 2005. Report to the Congress: Physician-owned
specialty hospitals. Washington, DC: MedPAC.

Skinner, J., D. Staiger, and E. Fisher. 2006. Is technological change in Medicine always worth
it? The case of myocardial infarction. Health Affairs Web Exclusives (February 7). http://www.
healthaffairs.org.

Stensland, J., and A. Winter. 2006. Do physician-owned cardiac hospitals increase utilization?
Health Affairs 25, no. 1: 119-129.

Tarakji, K., R. Brunken, P. M. McCarthy, et al. 2006. Myocardial viability testing and the effect
of early intervention in patients with advanced left ventricular systolic dysfunction. Circulation
113: 230-237.

Wennberg, D., F. L. Lucas, A. E. Siewers, et al. 2004. Outcomes of percutaneous coronary
interventions performed at centers without and with onsite coronary artery bypass graft surgery.
Journal of the American Medical Association 292, no. 16: 1961-1968.

Wennberg, J., and M. Cooper, eds. 1999. The Dartmouth atlas of health care. Chicago: American
Hospital Association.

26 = Physician-owned specially hospitals revisited | August 2006 MECpac


12

Length of stay in physician-owned heart
hospitals is shorter than that of other hospitals

Length of stay .
Number of Lin a ys) Ratio of actu

Hospital group hospitals Actual Expected length of stay
All IPPS hospitals 3,386 5.5 5.5 1.00
All operating in 2004

Physician-owned heart 19 3.5 46 76*

Peer 25 5.9 5.7 1.03

Competitor community 147 5.5 5.4 1.01

All other 3,195 5.5 5.5 1.00
Operating in 2002 and 2004

Physician-owned heart 11 3.6 46 79*
Entered market after 2002

Physician-owned heart 8 3.4 47 72*

Note: Excludes hospitals open for less than one year and those with missing or erroneous cost data. Expected length of slay is the weighted average of
the regional ayerage lengths of stay for all inpatient prospective payment system hospitals in each all patient refined diagnosis related group and
severity class, weighted by the specialty hospitals’ mix of cases among the same categories. Peer hospitals are specialized, but are not physician
‘owned. Competitor community hospitals are in the same market as specialty hospitals and provide some similar services. The “all other” hospital
groups include all hospitals except the particular specially, peer, and competitor community hospitals
“The ratio of actual to expected length of stay is significantly lower {actual lengths of stay are shorter than expected) than for peer, competitor
community, and cll other hospitals in a Tukey mean separation test with a criterion value of 0.05

Source: MedPAC analysis of 11 million Medicare hospital claims for fiscal year 2004 from CMS.

Low volume and unused capacity

Heart specialty hospitals often have over 3,000 admissions per year and often have about

the same levels of unused inpatient capacity as their peers and competitors. Their costs are
comparable to competitor community hospitals. Orthopedic/surgical hospitals, however, are
typically much smaller (a median of 14 beds) and operate with a large percentage of unused
inpatient capacity (28 percent occupancy). These facilities are primarily focused on outpatient
procedures, as indicated by the low share of their total charges that comes from inpatient
services (median value of 32 percent). Together, the low inpatient volume and unused capacity of

Physician-owned specialty hospitals revisited | August 2006 MECpac


18

Per capita growth in low-severity versus high-severity surgeries

Rate per 1,000 beneficiaries Change

Type of discharge 1996 2002 2004 1996-2002 2002-2004
Low-severity surgeries
Markets with physician-owned heart hospitals:

Open by FY 2002 18.3 21.8 22.3 3.5 0.5

That opened in FY 2003 17.9 23.0 25.9 5.1 2.9
Other markets 17.5 20.8 21.1 3.3 0.3
High-severity surgeries
Markets with physician-owned heart hospitals:

Open by FY 2002 9.2 10.1 11.3 0.9 11

That opened in FY 2003 10.4 11.0 12.4 0.6 14
Other markets 97 10.5 11.2 0.8 0.7

Note: FY fiscal year). Low severity refers to all patient refined diagnosis related group severity level one or two; high severity, three or four

Source: MedPAC analysis of Medicare discharge data.

bypass surgery (Wennberg et al. 2005). However, the rate of decline was slower in markets with
physician-owned heart hospitals.

We also tested whether markets with physician-owned heart hospitals had faster growth in low-
severity (higher profit) patients relative to their growth in high-severity (lower profit) patients,
compared to other markets. Markets with physician-owned hospitals had above average growth in
both low-severity and high-severity surgeries (Table 9).

Multivariate results

It is important to avoid placing too much emphasis on the descriptive statistics due to the large
differences in the market shares that heart hospitals had in 2004. For example, a heart hospital
with 3,000 admissions may have a larger impact on market-wide utilization than a heart hospital
with 300 admissions. To account for the size of the specialty hospital, we used the specialty
hospitals’ market share as the key independent variable in the fixed effects regression. The
regression models test whether the share of the market held by specialty hospitals is associated
with either an increase in the volume of Medicare cardiac surgeries or a shift toward operating

on healthier Medicare patients. We used fixed market effects to control for differences in the
characteristics of patients and practice patterns across markets. To control for nationwide changes

Physician-owned specialty hospitals revisited | August 2006 MECpac


Low-volume specialty hospitals have higher than average costs

$20,000 73

18,000

16,000

14,000

12,000

10,000
A
8,000 ig A A
La‘ i]
6,000 +4 rv A £ ——

4,000

Standardized costs per discharge
>
oh

2,000

(0) 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

Discharges

— National average A Orthopedic and surgical hospitals D Heart hospitals

Note: Costs are standardized for differences in case-mix severity, local input prices, the effects of training residents and serving a disproportionate
share of poor patients, and differences in interest expenses per discharge. The national average refers to the average for all inpatient prospective
payment system hospitals.

Source: MedPAC analysis of Medicare cost report data,

Physician-owned hospitals and rates of cardiac surgery

In our March 2005 specialty hospital report, we noted that markets with physician-owned heart
hospitals had 4 percent more cardiac surgeries per capita in 2002 than otherwise would have
been expected. This 4 percent difference was not statistically significant. The only statistically
significant finding was that the rate of coronary artery bypass graft (CABG) surgeries was higher
than expected in markets with physician-owned hospitals. In this follow-up study we examined
data through 2004 and found that openings of physician-owned hospitals are associated with a
higher rate of growth in overall cardiac surgeries through 2004 and higher than expected rates of
CABG surgery through 2004, but no shift in the ratio of low-profit to high-profit surgeries.

14 Physician-owned specialty hospitals revisited | August 2006 MECpac


Endnotes

1 A hospital is deemed to be physician-owned if one or more physicians have partial or full
ownership of the hospital. Joint ventures between community hospitals and physicians are
still considered physician-owned hospitals.

2. In our March 2005 study, we included two women’s hospitals in the surgical category. We
decided to exclude those two hospitals in this study to make the surgical hospitals a more
homogeneous category.

3. Orthopedic and general surgery markets refer to health service areas that are used for
routine hospital services by Medicare beneficiaries. These markets were described and
delineated by Makuc et al (1991).

4 It is possible that orthopedic/surgical hospitals are less costly providers of outpatient
surgeries. However, we are not able to test this hypothesis due to the need to develop a
severity of illness adjuster for outpatient surgeries.

5 In 2002, there was a broad consensus that defibrillator implantation was relatively less
profitable than other cardiac surgeries. However, in October 2003, CMS created two new
defibrillator DRGs for defibrillator implantation with cardiac catheterization. DRG 535 is
for patients with an acute myocardial infarction (AMD), heart failure, or shock—this DRG
weight increased from 6.3376 in FY 2003 to 8.1560 in FY 2004. DRG 536 is for patients
with cardiac catheterization but without AMI, heart failure or shock. On average, payments
for defibrillator implantation increased by roughly 10 percent from FY 2003 to FY 2004.
Due to the increases in payment rates from FY 2002 to FY 2004, decreases in patients’
lengths of stay, and uncertainty regarding changes in device prices, the relative profitability
of defibrillator implantation is less clear in FY 2004 than in FY 2002.

6 Five of the 306 Dartmouth Atlas HRRs were eliminated from our analysis due to having
either a physician-owned hospital open mid-way through 2004, the sale of a physician-
owned hospital to a nonprofit entity, or an unusual volatility of cardiac surgery volumes.

7 We divide the specialty hospitals’ aggregate revenue in each year (e.g., 2003) by the
market’s total hospital revenue in 2004. We always divide by the same year’s total revenue
to prevent changes in the dependent variable (changes in community hospital revenue) from
affecting the independent variable (specialty hospital revenue/all hospitals’ revenue).

8  Wealso tested for the impact of physician-owned heart and orthopedic hospitals on
hospitals’ operating margins and found no significant effect.

9 The GAO (2006) found that community hospitals in markets without specialty hospitals
engage in many of the same strategies to enhance revenue including expansion of
bariatric services, imaging centers, and cardiology services. The GAO study had limited
information on how pricing policies change when specialty hospitals enter a market.

MECpAC Physician-owned specially hospitals revisited | August 2006

27


We standardized hospitals’ reported inpatient costs to remove the effects of factors that could
confound our evaluation of cost per discharge at physician-owned specialty hospitals and their
comparison groups (peer hospitals and competitor community hospitals). These factors include
local input price levels, case-mix severity, prevalence of short-stay transfers, prevalence of high-
cost outliers, extent of teaching activity, and share of low-income patients (although this effect
is very small). We also equalized interest expenses per discharge across all hospitals to remove
differences in reported capital costs that reflect hospitals’ financing choices rather than real
differences in resource use. We did not make this adjustment in our earlier comparison of 2002
costs per discharge. To further ensure comparability, we excluded 6 of the 25 heart specialty
hospitals, 8 of the 63 orthopedic/surgical hospitals, and a few peer and competitor community
hospitals from the analysis because they were open for less than a full year in 2004 or their
estimated inpatient cost per discharge or outlier prevalence was obviously implausible.

Heart specialty hospitals, peers, and competitors have similar
Inpatient costs

After controlling for the cost factors outlined above, heart specialty hospitals had moderately
higher mean costs per discharge (108 percent) than peer hospitals and local competitors (Table 4,
p. 10). The differences in mean costs, however, were primarily due to high costs at a few low-
volume providers, and were not statistically significant. When we weighted hospitals’ costs by
their case volumes, the heart hospitals did not have any higher costs than competitor community
hospitals. Consequently, we conclude that heart specialty hospitals have costs that are similar to
those in competitor community hospitals. We also examined differences between older and newer
heart hospitals. We found little difference in costs per discharge between those that opened after
2002 and those that have been open for a longer period.

Orthopedic/surgical specialty hospitals have significantly higher
Inpatient costs

After adjusting for the same cost factors, orthopedic/surgical specialty hospitals appear to have
inpatient costs that are 20 percent to 30 percent higher than costs at competitor community
hospitals (Table 5, p. 11). It is possible that orthopedic/surgical hospitals do become more
efficient over time. However, even among hospitals that were open at least two full years,
adjusted inpatient costs per discharge were 117 percent of the national average.

Length of stay

As we did in our analysis of 2002 LOS data, we controlled for differences in the mix of cases
treated among hospitals using the severity of illness classes of the all patient refined diagnosis
related groups (APR—DRGs). Because average length of stay varies by region, we compared each
specialty hospital’s LOS to the LOS pattern within that hospital’s region.

MECpAC Physician-owned specially hospitals revisited | August 2006


Physician-owned
specialty hospitals revisited



24

While heart hospitals capture an average of 23 percent of the Medicare cardiac surgery revenue
in their HRRs, they receive only 4 percent of total hospital revenue (for all services) in the HRR
on average (Table 11). Orthopedic/surgical hospitals receive only 3 percent of total hospital
revenue in the surgical health service area. Because specialty hospitals still captured a relatively
small share of 2004 total revenues in their markets, it may not be surprising that their financial
impact on community hospitals is limited. In 2004, there were only 12 HSAs where the sum of
heart hospitals’ market share and orthopedic/surgical hospitals’ market share of total hospital
revenues was over 10 percent. Even in these markets with a substantial specialty hospital
presence, the 18 competitor community hospitals had a median 2004 total margin of 4.2 percent,
which is not significantly different from the national median of 3.6 percent. The higher margin
in markets with physician-owned hospitals may reflect the faster population growth in these
markets.

Multivariate results

In the multivariate analysis, we are able to estimate the combined impact of physician-owned
cardiac and physician-owned orthopedic/surgical hospitals on competitor community hospitals.
The full regression results are shown in Appendix A. Physician-owned heart hospitals reduced
competitor community hospitals’ Medicare revenues. However, they did not have a statistically
significant effect on competitor hospitals’ total profit margins.’ Physician-owned orthopedic/
surgical hospitals did not have any statistically significant financial effects on competitor
community hospitals. This is consistent with the small market share of orthopedic/surgical
hospitals.

Effect of physician-owned cardiac hospitals. Heart hospitals generate 75 percent of their
revenue from inpatient services and Medicare patients represent roughly 60 percent of their
admissions. For the average heart hospital, Medicare admissions generated roughly $25 million
of the $60 million in total hospital revenue. Because heart hospitals are taking Medicare patients
from competitor community hospitals, the loss of patients should cause a significant decrease

or at least slow down the rate of growth in competitor community hospitals’ Medicare inpatient
revenues.

Model | of our regression model suggests that the entrance of a typical heart hospital (capturing
4 percent of total revenues in the market) will result in roughly a 5 percent decline in the
Medicare inpatient revenues of competitor community hospitals (.04 x 183,265/160,000) (Table
A-1, p. 33). The declines for competitor community hospitals not offering cardiac surgery are
somewhat less, but are still statistically significant. This suggests that heart hospitals do capture
patients from the competitor community hospitals. These results may also suggest an indirect

or cascade effect in which heart specialty hospitals take patients from competitors that offer
cardiac surgery, and these competitors then fill their beds by taking other types of patients from
community hospitals that do not offer cardiac surgery.

However, despite competitor community hospitals’ loss of Medicare revenue, cardiac hospitals
did not have a statistically significant effect on the total revenue or total margins of competitor
community hospitals in their markets. This suggests that competitor community hospitals are

Physician-owned specialty hospitals revisited | August 2006 MECpac


Whether the increase in surgeries stems from increased capacity, from the financial incentives

for physicians to self-refer patients to facilities they own, or a combination of these factors,
increased surgeries can lead to increased Medicare spending. Some observers have suggested
that physician-owned specialty hospitals are just one aspect of a broader trend toward expansion
of relatively well paid service lines resulting in additional strain on the sustainability of the
Medicare system (Berenson et al. 2006). A complete discussion of the literature on physician self
referral and the magnitude of the incentives to increase cardiac surgery admissions is available
elsewhere, and is beyond the scope of this paper (Stensland and Winter 2006).

Does the 6 percent increase in cardiac surgery rates (and associated increases in spending)
improve the health or extend the lives of Medicare beneficiaries? We do not attempt to evaluate
the costs and benefits of the marginal increase in cardiac surgeries. However, some have
suggested that the movement of patients from medical treatment to angioplasty and even from
angioplasty to CABG may improve outcomes (Hannan et al. 2005, Tarakji et al. 2006). Others
suggest that geographic areas that spend more on cardiac care have not experienced more rapid
improvements in outcomes (Skinner et al. 2006). Therefore, while the increased rate of cardiac
surgery may increase Medicare expenditures, we can not say whether the benefits of those
surgeries outweigh the increased costs.

What is the finan: impact of physician-owned hospitals on competitor
community hospitals?

The preceding section documented that physician-owned heart hospitals obtain most of their
patients by capturing market share from competitor community hospitals. In this section we
evaluate how that loss of patients affects community hospitals. We find that physician-owned
hospitals are associated with slower Medicare revenue growth at competitor community

hospitals, but do not have a statistically significant effect on competitor hospitals’ total revenues
or total profit margins.

Methodology

To determine whether the entry of physician-owned specialty hospitals has an appreciable effect
on the profitability of local community hospitals, we compared financial results for hospitals that
compete with physician-owned specialty hospitals to the results for similar hospitals located in
markets without physician-owned specialty hospitals. We used three multivariate models to test
the effect of physician-owned specialty hospitals on Medicare revenues, total revenues, and total
margins.

Competitor community hospitals. In this analysis we limited the set of competitor community
hospitals to those that competed with a physician-owned hospital that was open for the full year
in 2004 and did not own an interest in a physician-owned heart hospital. In addition, if a hospital
competed with both a physician-owned heart hospital and a physician-owned surgical hospital,
we categorized it as a heart competitor.

MECpAC Physician-owned specially hospitals revisited | August 2006

21


vi

share, impact on competitor community hospitals, and whether market entry of physician-owned
heart hospitals is associated with an increase in cardiac surgeries.

In general, our findings are similar to our earlier work; however, the statistical significance of
some findings has increased due to having a larger number of specialty hospitals to examine.
Specifically we find:

. The number of physician-owned specialty hospitals roughly doubled from 2002 to 2004.
Specialty hospitals continue to locate in areas that lack certificate-of-need laws and have
above average population growth.

. The median heart hospital has 56 beds and a strong focus on Medicare inpatient services.

+ The median orthopedic/surgical hospital has 14 beds, focuses on outpatient services, and
receives a majority of its revenue from private payers.

. Both types of physician-owned hospitals tend to have lower shares of Medicaid patients
than local competitors and nonlocal peer hospitals that specialize in cardiac or orthopedic
care.

* Medicaid patients represented 3 percent of discharges at the median physician-owned
heart hospital and 2 percent at the median physician-owned orthopedic and surgical
hospital. The median competitor community hospitals in those markets had a 13
percent Medicaid share. Competitor community hospitals may attract a larger share
of Medicaid patients primarily because they offer a different set of services including
obstetrics.

. In an effort to control for service mix, we also compared physician-owned specialty
hospitals to peer hospitals (hospitals with similar levels of specialization that are not
physician owned). The median peer heart hospitals had a 7 percent Medicaid share,
and the median peer orthopedic/surgical hospital had a 3 percent Medicaid share. The
Government Accountability Office (GAO) found similar differences in their analysis
of Medicaid shares.

. Specialty hospitals’ inpatient services are not less costly than community hospitals’
services, as might be expected from a “focused factory” hypothesis. But they do have some
competitive advantages, such as shorter lengths of stay.

. Heart hospitals have inpatient costs per discharge that are comparable to those of
competitor community hospitals.

+ Orthopedic/surgical hospitals tend to have inpatient costs per discharge that are about
20 percent higher than those of competitor community hospitals. The difference in
costs is statistically significant.

Physician-owned specialty hospitals revisited | August 2006 MECpac


Executive summary

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) required
that MedPAC investigate several aspects of physician-owned specialty hospitals. We fulfilled this
mandate with our March 2005 specialty hospital report. In that report we found that:

+ Physician-owned specialty hospitals (specialty hospitals) did not have lower costs per
severity-adjusted discharge than competitor community hospitals in their markets, although
their patients had shorter lengths of stay.

. Specialty hospitals generally admitted less severe cases (which are expected to be more
profitable) and concentrated on particular diagnosis-related groups (some of which were
expected to be relatively more profitable than the average).

. Specialty hospitals tended to have lower shares of Medicaid patients than competitor
community hospitals.

. Specialty hospitals drew patients from community hospitals, resulting in a small reduction
in Medicare revenue growth. However, the financial impact on competitor community
hospitals was limited because these hospitals took steps to compensate for lost revenue
growth. Competitor community hospitals have had profit margins that are comparable
to those of community hospitals located in markets without physician-owned specialty
hospitals.

. From 1996 to 2002, cardiac surgeries per capita grew 4 percent faster in markets that
gained a physician-owned heart hospital than in other markets. However, the 4 percentage
point difference in growth rates was not statistically significant. The heart hospital markets
also had a higher than expected rate of coronary artery bypass graft (CABG) surgery. The
association between physician-owned cardiac hospitals and changes in the rate of CABG
surgery per capita through 2002 was statistically significant.

However, the report also stressed that our findings could change as specialty hospitals evolve
and capture a larger share of the market for hospital services. The 2005 report was based on
the limited set of specialty hospitals that were operating for all of 2002. Our 2005 report and
this report do not evaluate the quality of care in physician-owned specialty hospitals. Congress
mandated that the Centers for Medicare & Medicaid Services (CMS) address that issue (CMS
2005).

After we presented the results from our March 2005 report, members of the congressional
committees with jurisdiction over Medicare asked us to do some follow-up work when more data
were available. The purpose of this paper is to update our analysis of physician-owned hospitals
using two additional years of data (2003 and 2004) from an expanded set of specialty hospitals.
We use the expanded data set to reexamine specialty hospitals’ cost of inpatient care, Medicaid

MECpAC Physician-owned specially hospitals revisited | August 2006


10

Table 4

Standardized costs per discharge in physician-owned
heart hospitals are similar to those of other hospitals

Average costs compared with national, 2004

Number of

Hospital group hospitals Case weighted Simple mean
AIl IPPS hospitals 3,386 100% 101%
All operating in 2004

Physician-owned heart 19 100 108

Peer 25 100 99

Competitor community 147 102 100

All other 3,195 100 101
Operating in 2002 and 2004

Physician-owned heart i 99 107
Entered market after 2002

Physician-owned heart 8 102 108

Note: IPPS [inpatient prospective payment system). Excludes hospitals open for less than one year and those with missing or erroneous cos! data. None
of the differences in standardized cost per discharge among heart specially, peer, competitor community, or other hospitals are statistically
significant in a Tukey mean separation test with a criterion value of 0.05. Costs are standardized for differences in case-mix severity, prevalence
of shortstay transfers, prevalence of high-cost outliers, local input prices, the effects of training residents, share of low-income patients, and
differences in interes! expenses per discharge. Percent of national values are based on national amounts for all U.S. nonspecially hospitals paid
under the inpatient prospective payment system. Competitor hospitals are specialized, but are not physician owned. Competitor community
hospitals are in the same market as specialty hospitals and provide similar services. The all other hospital groups include all hospitals except the
particular specialty, peer, and competitor community hospitals.

Source: MedPAC analysis of Medicare hospital cost data and 11 million inpatient claims for fiscal year 2004 from CMS.

Our 2004 data set yields findings that mirror our 2002 findings. Controlling for the type of
patient admitted, specialty hospitals keep patients for significantly shorter stays than peer,
competitor community, and all other hospitals (Table 6, p. 12, and Table 7, p. 13). Average
lengths of stay were 24 percent to 28 percent shorter than expected in heart specialty hospitals
and 20 percent to 23 percent shorter than expected in specialty orthopedic/surgical hospitals. This
holds for new and older specialty hospitals.

Why are specialty hospitals’ costs not lower?

Specialty hospitals’ lengths of stay were significantly shorter than those in peer and competitor
community hospitals. Yet heart specialty hospitals had roughly average costs and specialty

Physician-owned specialty hospitals revisited | August 2006 MECpac


While the specialty hospitals took profitable surgical patients from the competitor
community hospitals (slowing Medicare revenue growth at some hospitals), most
competitor community hospitals appeared to compensate for this lost revenue. From our
site visits in 2004, we learned that in some cases competitor community hospitals cut
expenses by cutting staff; in some cases they instituted “aggressive pricing strategies” to
raise revenue from private payers; and in many cases they expanded profitable business
lines such as imaging, rehabilitation, pain management, cardiology, and neurosurgery.
These responses to the specialty hospital challenge coupled with population growth in
many of the markets where specialty hospitals operate combined to allow competitor
community hospitals to maintain profit margins that are in line with national averages.

As physician-owned entities capture more profitable service lines, the effect on community
hospitals may increase. However, we found that community hospitals’ profit margins
appeared stable through 2004, even in markets where physician-owned hospitals captured
more than 10 percent of all admissions.

Physician-owned specialty hospitals revisited | August 2006 MECpac



16

Cardiac surgery growth rates

Rate per 1,000 beneficiaries Change
Type of admission
and type of market 1996 2002 2004 1996-2002 2002-2004
All heart surgeries
Markets with physician-owned heart hospitals:
Open by FY 2002 (n=10) 27.5 32.0 33.6 4S 1.6
That opened in FY 2003 (n=8} 28.3 34.0 38.3 5.7 43
Other markets (n=283) 27.2 31.3 32.3 4d 1.0
Coronary artery bypass graft
Markets with physician-owned heart hospitals:
Open by FY 2002 5.6 5.0 43 -0.6 -0.7
That opened in FY 2003 61 5.5 48 -0.6 -0.7
Other markets 5.6 46 3.8 -1.0 -0.8
Angioplasty
Markets with physician-owned heart hospitals:
Open by FY 2002 8.0 117 12.3 3.7 0.6
That opened in FY 2003 8.5 12.4 15.0 3.9 2.6
Other markets 7.3 10.8 12.0 3.5 1.2
Defibrillator implantation
Markets with physician-owned heart hospitals:
Open by FY 2002 04 1.0 1g 0.6 0.9
That opened in FY 2003 04 1.3 2.5 0.9 1.2
Other markets 0.4 1.2 go 0.8 0.7

Note: FY (fiscal year). Ten markets had at leas! one physician-owned heart hospital for all of 2002; eight markets gained a heart hospital in late 2002
or 2003

Source: MedPAC analysis of 1996, 2002, and 2004 MedPAR data from CMS.

(and higher profit) patients. The alternative hypothesis is that the overall ratio of low-severity to
high-severity patients in the market stays the same. We are not suggesting that cardiac surgeons
operate on perfectly healthy patients. The question is subtler. For the marginal case, are some
physicians who invest in cardiac hospitals more likely to recommend surgery on less severely ill
patients when their hospital profits most from the healthier patients?

In our March 2005 specialty hospital report, we found that physician-owned heart hospitals
tend to treat less severely ill patients. However, through 2002, physician-owned hospitals appear

Physician-owned specialty hospitals revisited | August 2006 MECpac


AUGUST 2006

REPORT TO THE CONGRESS

Physician-Owned

Specialty Hospitals
Revisited

‘Commission

MEO PAC Seer


The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) required
that MedPAC investigate several aspects of physician-owned specialty hospitals. We fulfilled this
mandate with our March 2005 specialty hospital report. However, that initial report was limited to
examining hospitals that were operating by 2002, and we stressed that our findings could change
as specialty hospitals evolve and capture a larger share of the market for hospital services.

After we presented the results from our March 2005 report, members of the congressional
committees with jurisdiction over Medicare asked us to do some follow-up work when more data
were available. The purpose of this paper is to update our analysis of physician-owned hospitals
using two additional years of data (2003 and 2004) from an expanded set of specialty hospitals.
We use the expanded data set to reexamine specialty hospitals’ cost of inpatient care, Medicaid
share, and impact on competitor community hospitals. We also look at whether market entry of
physician-owned heart hospitals is associated with an increase in cardiac surgeries.

Characteristics of physician-owned specialty hospitals
The number of physician-owned hospitals almost doubled from 2002 to 2004. Heart hospitals
have a strong focus on inpatient services for Medicare patients, and orthopedic/surgical hospitals

tend to focus on outpatient care for private payers. Both types of physician-owned hospitals tend
to have slightly lower Medicaid shares than specialized hospitals that are not physician owned.

Methodology

We identified hospitals’ specializations by examining Medicare discharge data for fiscal year
2004. Hospitals were deemed specialized if at least 45 percent of their discharges were in one
area of specialization or 66 percent were in two areas of specialization. We also limited our
population to hospitals with at least 25 Medicare discharges. Physician ownership was identified
through telephone surveys conducted during 2004 and 2005.' Our specialty hospitals are divided
into the following three categories:

+ Heart hospitals: Cardiac discharges represent 45 percent or more of Medicare discharges in
either 2002 or 2004. In addition, the hospital performs angioplasty and bypass surgery.

. Orthopedic hospitals: Orthopedic discharges represent 45 percent or more of Medicare
discharges or represent 66 percent of Medicare cases when combined with other surgeries
or cardiac cases in either 2002 or 2004.

. Surgical hospitals: Surgical cases (other than orthopedic and cardiac surgeries) represent
over 45 percent of all Medicare discharges or 66 percent of the cases when combined with
orthopedic or cardiac cases in either 2002 or 2004. The surgical category excludes hospitals
focusing on obstetrics.

MECpAC Physician-owned specially hospitals revisited | August 2006




Commission members

Glenn M. Hackbarth, J.D., chairman

Bend, OR

Robert D. Reischaver, Ph.D., vice chairman

The Urban Institute
Washington, DC

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, LLC
Oakland, CA,

Arnold Milstein, M.D.,
M.P.H.

Pacific Business Group on Health
San Francisco, CA

Ralph W. Muller
University of Pennsylvania
Health System
Philadelphia, PA

William J. Scanlon, Ph.D.
Health policy consultant
Oak Hill, VA

Nancy-Ann DeParle, J.D.
JPMorgan Partners
Washington, DC

David F. Durenberger, J.D.
National Institute of Health Policy
University of St. Thomas
Minneapolis, MN

Jennie Chin Hansen, R.N.,
M.S.N., F.A.A.N.

AARP

San Francisco, CA

Nancy M. Kane, D.B.A.
Harvard School of Public Health
Boston, MA

Nicholas J. Wolter, M.D.
Billings Clinic
Billings, MT

Term expires April 2009

Mitra Behroozi, J.D.
1199SEIU Benefit and
Pension Funds

New York, NY

Karen R. Borman, M.D.
University of Mississippi
Medical Center

Jackson, MS

Ronald D. Castellanos, M.D.
Southwest Florida Urologic
Associates

Ft. Myers, FL.

Glenn M. Hackbarth, J.D.

Douglas Holtz-Eakin, Ph.D.
Maurice R, Greenberg Center for
Geoeconomic Studies

Council on Foreign Relations
Washington, DC

Robert D. Reischaver, Ph.D.

Physician-owned specialty hospitals revisited | August 2006

35


Characteristics of competitor community hospitals and their markets

Markets with Markets without
physician-owned hospitals physician-owned hospitals
Community Community Comparison Comparison
hospitals hospitals community — community
competing competing with hospitals hospitals
with cardiac only orthopedic/ with cardiac with general
hospitals surgical hospitals surgery surgery
Mean hospital characteristics
Number of hospitals 101 107 776 901
Beds in 2004 301 225 332 147
Medicare revenue in 2004
divided by beds in 1997* 160,000 130,000 160,000 100,000
Total admissions in 2004
divided by beds in 1997* 64 57 57 46
Total revenue in 2004 (in millions) $260 $173 $301 $92
Total profit margin in 2004 5.5% 2.5% 4A% 2.3%
Mean characteristics of the
hospitals’ markets
Population growth in the market
1997-2004 9% 12% 7% 6%
Personal income growth in the market
1997-2004 9 31% 35% 28%
35%
Heart hospitals’ share of all cardiac
surgery revenues 23% N/A N/A N/A

Heart hospitals’ share of all 2004
hospital revenue in the cardiac
market (HRR) 4% N/A N/A N/A

Orthopedic/surgical hospitals’ share
of all 2004 hospital revenues in the

surgical market (HSA} 1% 3% N/A N/A

Note: N/A {not applicable), HRR (hospital referral region), HSA (hospital service area). Markets are divided into those with cardiac hospitals (which
can also have orthopedic/surgical hospitals), markets with only orthopedic/surgical hospitals (no cardiac hospitals}, and comparison markets.
*We divide revenue and discharges by the number of beds the hospital had in 1997 to prevent an increase in hospital beds during 1997 to
2004 from appearing to affect admissions or revenues. Mean valves are shown.

Source: Medicare cost reports, Area Resource File, MedPAC survey, and Medicare discharge data.

Physician-owned specialty hospitals revisited | August 2006

23


22

Using this set of competitors, we obtained financial data (Medicare cost reports) from 101
competitor community hospitals that competed with physician-owned heart hospitals for cardiac
surgery and an additional 102 hospitals that competed with physician-owned orthopedic/surgical
hospitals (and did not compete with heart hospitals) during 2004.

Comparison hospitals. The competitor community hospitals were compared to a group of
community hospitals in markets without physician-owned specialty hospitals. To be a comparison
hospital to the cardiac competitors for a specific year, the hospital must have had at least 70

beds, 1,200 discharges, and at least 10 angioplasties or bypass operations in 2004. Orthopedic/
surgical comparison hospitals also had to meet the same size criteria. We chose 70 beds and
1,200 discharges as cutoff points for the comparison groups because all competitor community
hospitals had at least this number of beds and discharges. This allows us to compare competitors
with hospitals that are at least as large as the smallest competitor community hospital.

Using these criteria, we identified 766 comparison hospitals that offer cardiac surgery and did
not compete with physician-owned heart hospitals. We also identified 901 hospitals that offer
orthopedic or surgical services and did not compete with physician-owned orthopedic/surgical
hospitals.

Multivariate model. \n 2004, the number and size of physician-owned specialty hospitals varied
from market to market. Therefore, we want our key independent variable to be the specialty
hospitals’ market share rather than simply a dichotomous variable indicating the existence of a
specialty hospital. To compute heart hospitals’ market share, we divided heart hospitals’ revenue
in the HRR by the HRR’s total hospital revenue in 2004. We computed orthopedic/surgical
hospitals’ market share as their revenue in the HSA divided by the HSA’s total hospital revenue
in 2004.’ This creates an approximate market share for each type of specialty hospital that can be
used in the multivariate model.

Some market characteristics, such as area population and personal income, change over time.
To account for these factors, the model includes variables for population growth, changes in
personal income, and time trends. To control for hospital-specific characteristics that do not
change over time, such as location and mission, we used a fixed-effects regression model. After
controlling for demographics, time trends, and hospital specific factors, the fixed-effects model
asks: Do competitor community hospitals have better or worse financial performance than we
would expect given their performance prior to the opening of the physician-owned hospital,
national trends, and the region’s income and population growth?

Descriptive statistics

Table 11 compares hospitals that compete with physician-owned hospitals to our two sets of
comparison hospitals. By design, the comparison hospitals offering cardiac surgery are similar

to the community hospitals that compete with physician-owned heart hospitals. The primary
difference is that physicians tend to build heart hospitals in markets with above average population
growth. Likewise, the comparison hospitals offering orthopedic/surgical services are similar to the
community hospitals that compete with physician-owned orthopedic/surgical hospitals.

Physician-owned specialty hospitals revisited | August 2006 MECpac


Both groups of specialty hospitals have 20 percent to 25 percent shorter lengths
of stay than competitor community hospitals, and the difference is statistically
significant.

However, the potential savings from shorter stays are not sufficient to offset the effects
of other factors on orthopedic/surgical hospitals’ costs.

. Some of the higher costs per discharge at physician-owned orthopedic/surgical
hospitals are due to low inpatient volume and higher unused capacity (medians
of 14 beds and 28 percent occupancy).

. Higher levels of depreciation and lease expenses per discharge may explain a
small share of the higher costs at orthopedic/surgical hospitals.

. Physician-owned heart hospitals were associated with a statistically significant increase in
the rate of cardiac surgeries in the market area.

For a typical market, we estimate that entrance of a physician-owned cardiac hospital
was associated with a 6 percent increase in the number of cardiac surgeries per 1,000
Medicare beneficiaries (confidence interval | percent to 11 percent).

The typical heart hospital had 26 percent of the cardiac surgery market in 2004
and obtained most of its market share (roughly 20 of the 26 percentage points) by
diverting patients from competitor community hospitals.

As was the case with our analysis of 2002 data, heart hospital markets had more
CABG surgeries per 1,000 Medicare beneficiaries than would have been expected
given the market’s historical experience and national trends. Our model estimates
that the entrance of a physician-owned hospital into a market is associated with a 9
percent increase in the number of CABG surgeries (confidence interval 1 percent to
18 percent) over the rate per 1,000 beneficiaries that would have been expected in the
absence of the heart hospital.

We also categorized cardiac surgery patients into relatively high- and low-profit cases.
Physician-owned hospitals did not have a significantly larger effect on the volume of
relatively high-profit surgeries (low-severity patients) than they had on historically
less profitable surgeries (high-severity patients) in the market.

Taken together these findings—an increase in overall surgeries, but no material shift
in the ratio of high-severity to low-severity surgeries—are consistent with more than
one hypothesis. One hypothesis is that physicians have a financial incentive to invest
in cardiac hospitals, and these new specialty hospitals result in more surgical capacity
and hence more surgeries per capita. Alternatively, individual physicians’ clinical
decision making is directly affected by financial incentives, but the change is a broad
shift toward more surgeries rather than a precise shift toward the most profitable
surgeries.

Physician-owned specialty hospitals revisited | August 2006

vii


Table 7

Length of stay in phy: in-owned orthopedic/surgical
hospitals is shorter than that of other hospitals

Length of stay .
Number of mn days) ss Ratio of actu

Hospital group hospitals Actual Expected length of stay
All IPPS hospitals 3,386 5.5 5.5 1.00
All operating in 2004

Physician-owned orthopedic/surgical 55 29 37 79*

Peer 15 49 48 1.02

Competitor community 300 5.4 5.4 1.00

All other 3,016 5.5 5.5 1.00
Operating in 2002 and 2004

Physician-owned orthopedic/surgical 33 3.0 37 .80*
Entered market after 2002

Physician-owned orthopedic/surgical 22 27 3.5 77*

Note: Expected length of stay is the weighted average of the regional average lengths of stay for all inpatient prospective payment system hospilals in
each all patient refined diagnosis related group and severity class, weighted by the specialty hospitals’ mix of cases among the same categories.
Peer hospitals are specialized, but are not physician owned. Competitor community hospitals are in the same market as specially hospitals and
provide some similar services. The all other hospital groups include all hospitals excep! the particular specially, peer, and competitor communily
hospitals.
“The ratio of actual to expected length of stay is significantly lower {actual lengths of stay are shorter than expected) than for peer, competitor
community, and all other hospitals in a Tukey mean separation test with a criterion value of 0.05

Source: MedPAC analysis of 11 million Medicare hospital claims for fiscal year 2004 from CMS.

orthopedic/surgical specialty hospitals appear to account for a substantial portion—though not
all—of their higher costs per discharge (Figure 2, p. 14).

Figure 2 demonstrates plainly the strong relationship between volume and costs per discharge.
Orthopedic/surgical specialty hospitals operating at low volume are unable to capture the
benefits of economies of scale for inpatient services, and have relatively high costs. Larger heart
hospitals—those with 3,000 or more discharges—had costs that are comparable to competitor
community hospital costs.

Physician-owned specialty hospitals revisited | August 2006

13




Table A-1

Impact of phy: in-owned heart hospitals on other
hospitals that furnish angioplasty and bypass services

Regression coefficients

Model 2:
Model 1: Community Model 3:
Community hospitals’ hospitals’ total Community
Medicare inpatient revenue per hospitals’ total
Explanatory variables revenue per 1997 bed* 1997 bed margin
Physician-owned specialty hospitals
Physician-owned heart hospitals’ market -183,265* -A402,219 -8.1
share in the HRR® (72,300) (336,273) (24.3)
Physicianowned orthopedic or surgical 64,533 -63,900 18.0
hospitals’ market share in the HSA® (36,873) (184,462) (12.1)
Demographic characteristics
Percent change in population in the HSA, 91,245** 480,491 ** 22.8**
relative to the nation’s growth (23,151) (107,376) (3.9)
Percent change in per capita income in the 307,809** 3.2
HSA, relative to the nation’s growth N/A (91,920) (4.0)
Year (relative to 1997):
1998 -3,562** 17,202** -1.4**
1999 -4,212** 37,882** -2.4**
2000 -3,182** 57,567 ** -2.4**
2001 4,286** 90,342** -2.4**
2002 10,403 ** 128,817** -2.7**
2003 11,267** 160,678 ** -1.9**
2004 15,826** 185,838 ** -2.2**
Number of hospitals in the data set 930 930 930

Note: HRR (hospital referral region], HSA (hospital service area). Data are for community hospitals. Regression coefficients reflect the effect of a |
percent increase in physician-owned specialty hospitals’ market share on community hospitals’ Medicare revenue, total revenue, and total
margins. Standard errors are in parentheses. The model was computed using a generalized least squares fixed effects model with robust
standard errors.

* Pe.05

** P01

» Revenues per bed are adjusted to correct for differences in input prices across regions using the CMS wage index. Revenves are deflated

to 1997 dollars using the CMS hospital market basket. Beds are fixed at their 1997 level to prevent hospitals that build new capacity from
‘oppearing to have lower demand for inpatient services per bed.

© The HRR refers to the Dartmouth Alas cardiac surgery referral regions. The HSA refers to market areas for general surgery. Market share is
the specialty hospitals’ aggregate revenue for that specific year divided by the market's revenue in 2004. The denominator in the ratio (2004
revenue} is held constant across all years to prevent changes in community hospitals’ performance from affecting market share (the independent
variable}

Source: MedPAC analysis.

Physician-owned specialty hospitals revisited | August 2006


Five multivariate regression models indicate heart hospitals
are associated with increased utilization for some services, 1996 to 2004

Changes in the volume of surgeries per
1,000 Medicare beneficiaries: regression coefficients

Model 5:
Model 4: Ratio of low-
Model 1: Model 2: Model 3: All cardiac severity to high-
Explanatory variables CABG Angioplasty _ Defibrillator surgeries severity patients
Physician-owned heart 0.014* 0.02 0.005 0.07* 0.002
hospitals’ market share (0.006) {0.02) (0.004) {0.03} {0.002)
of cardiac surgeries in
percentage points
Year:
2002 -0.97** 3.47** 0.80** 4.17** 0.17**
{0.05} (0.16) (0.04) (0.25) (0.02)
2004 -1.74** 47\** 1,50** 5.21** 0.06**
(0.05) (0.16) (0.04) (0.26) (0.02)

Note: CABG (coronary artery bypass grat). Regression coefficients indicate the number of additional surgeries per 1,000 Medicare beneficiaries
associated with a 1 percent increase in physician-owned specially hospitals’ market share. The year variables reflect the nationwide change in
the rate of surgeries since 1996. Low severity refers to all patient refined diagnosis related group severity levels | or 2; high severity refers to
levels 3 or 4. Variables that are significantly different from zero are noted by: * p<.05 ** p<.01. Standard errors are shown in parentheses

Source: MedPAC analysis of Medicare claims dala, using a panel data set with market specific effects.

in cardiac surgery practice patterns, we included variables that account for nationwide changes in
cardiac surgery practice patterns from 1996 to 2002 and 2004.

From 1996 to 2004, angioplasty, defibrillator implantation, and overall cardiac surgeries
increased and the rate of CABG surgeries per 1,000 beneficiaries declined (Table 10). These
nationwide trends held in markets with and without physician-owned specialty hospitals, as is
shown by the large impact of the 2002 and 2004 year effects. However, the table also suggests
that the entrance of physician-owned heart hospitals is associated with a statistically significant
change in the rate of CABG surgeries and overall cardiac surgeries per capita.

The level of overall cardiac surgeries per 1,000 beneficiaries was estimated to increase by .07
surgeries for every | percent market share held by a specialty hospital. In a typical market
where a heart hospital has a 26 percent market share, the model suggests that the formation of
the physician-owned hospital was associated with roughly 1.82 (.07 x 26) additional cardiac
surgeries per 1,000 Medicare beneficiaries. This is equivalent to a 6 percent increase in cardiac
surgeries. The 6 percent figure should not be viewed as a precise estimate, as the 95 percent
confidence interval ranges from a | percent to an 11 percent increase in surgeries. We can

MECpAC Physician-owned specially hospitals revisited | August 2006

19


Executive summary



Commission staff

Mark E. Miller, Ph.D.
Executive director

Sarah Thomas, M.S.
Deputy director

Jack Ashby, M.H.A.
Cristina Boccuti, M.PP.
Niall Brennan, M.P-P.
Sharon Bee Cheng, M.S,
David V. Glass, M.S.
Timothy F. Greene, M.B.A.
Scott Harrison, Ph.D,
Kevin J. Hayes, Ph.D.
Sally Kaplan, Ph.D.
Kathryn Linehan, M.P.H.
Craig K. Lisk, MLS.

Anne Mutti, M.PA
Jennifer Podulka, M.P.Aff.
Nancy Ray, M.S.

Rachel Schmidt, Ph.D.
Joan Sokolovsky, Ph.D.
Jeffrey Stensland, Ph.D.
Ariel Winter, M.P-P.
Daniel Zabinski, Ph.D.

Megan Moore

36 Physician-owned specially hospitals revisited | August 2006

Special assistant to the
tive director

Annissa McDonald

A

Reda H. Broadnax, B.S.,
Executive officer

Wylene Carlyle

Diane E. Ellison
Timothy Gulley

Tina Jennings, MTESL.
Plinie (Ann) Johnson
Jason McMahon
Cynthia Wilson.

Staff consultants
Carol Carter, Ph.D.
Dana K. Kelley, M.P.A.

Julian Pettengill



6

Median characteristics of orthopedic/surgical hospitals

Orthopedic or surgical specialization

Physician-owned Peer community SSmnpenty
Characteristics hospitals hospitals hospitals
Number of hospitals 58 16 298
Number of beds 14 84 173
Annual admissions 649 3,150 8,758
Occupancy 28% 36% 60%
Inpatient charges as a percent of total charges 32% 58% 62%
Medicare share of discharges 33% 36% 36%
Medicaid share of discharges 2% 3% 13%
Building and equipment book value* (millions) $5 $38 $53
Total revenue (millions) $17 $67 $108
Median total margin 12% 9% 4%
Return on invested capital** 34% 8% 5%
Number of physician investors 25 N/A N/A
Ownership share per physician 3% N/A N/A
Hospital income per physician investor $50,000 N/A N/A

Note: N/A (not applicable). Peer hospitals have ai similar concentration to specialty hospitals, but are not physician-owned. Competitor community
hospitals include 298 of the 300 hospitals in the health service areas offering orthopedic/surgical services. We are missing data on two
competitor community hospitals.

* Book value is the purchase price less accumulated depreciation
**Return on invested capital is income plus interest expense divided by total assets and measures average return on the equity and debt invested
in a hospital.

Source: MedPAC survey of hospitals and analysis of 2004 cost report data for hospitals open for a full year in 2004.

services (Table 3). Both types of specialty hospitals tend to have above average total profit
margins and yield higher returns on invested capital than competitor community hospitals.
While some specialty hospitals are unprofitable, the unprofitable hospitals are often either newer
facilities or facilities with relatively low patient volumes.

Interviews with physician investors during our earlier site visits suggest that physicians will
continue to be interested in investing in hospitals to (1) increase operating room capacity in their
market to provide them with more desirable operating room scheduling, (2) gain more control
over their workplace, and (3) obtain the attractive returns on capital—especially from orthopedic/
surgical hospitals—which often require modest investments in fixed assets.

Physician-owned specialty hospitals revisited | August 2006 MECpac


six states, Medicaid discharges represented 3 percent of the cardiac discharges at heart hospitals
and 6 percent of the cardiac discharges at community hospitals in those markets (GAO 2003).
The GAO findings and our findings both suggest that specialization does not fully account

for physician-owned hospitals’ low Medicaid shares. Other specialty hospital decisions such

as location, mission, emergency room capability, and physician financial incentives to avoid
Medicaid patients may have contributed to the lower Medicaid shares at physician-owned
hospitals.

be physician-owned hose ccceueseeseseceesesseesesensnunnsnnnisssssusssimnietscseeteseetsretessssnnsinisisvesseses

In the Commission’s earlier study of 2002 data, we found that heart and orthopedic/surgical
specialty hospitals had higher inpatient costs per discharge than the corresponding values for
competitor community hospitals. The cost differences, however, were not statistically significant.
We noted that this finding was based on data for a small number of specialty hospitals that had
not been operating for long, and their relative costs could change as they matured and expanded
their patient volume.

In this updated analysis, we again find that orthopedic/surgical hospitals have higher inpatient
costs than competitor community hospitals. In this larger sample of orthopedic/surgical hospitals
the difference is statistically significant. The higher costs are associated with a lack of inpatient
economies of scale and low occupancy at orthopedic/surgical hospitals. Heart hospitals have
inpatient costs similar to those of their local competitors. Taken together, our inpatient cost
findings are inconsistent with the hypothesis that hospitals specializing in a narrow range of
clinical practice—focused factories—are less costly than traditional full-service community
hospitals.‘

Updated methodology

To revisit this issue, we examined Medicare inpatient costs per discharge reported in hospitals’
Medicare cost reports for fiscal year 2004. As we did in our earlier analysis of 2002 data, we also
compared hospitals’ lengths of stay (LOS) for Medicare claims reported in the fiscal year 2004
Medicare Provider Analysis and Review (MedPAR) file, controlling for differences in case-mix
severity and regional LOS patterns.

In the 2004 data, we now have two groups of specialty hospitals. Some opened prior to 2002

and have been operating for three or more years, while others opened after the start of 2002 and
thus have been operating for only one or two full years. We took the opportunity to examine
whether hospitals that have been open for one to two years have a different experience than those
that have been open longer. However, we excluded hospitals that were open for less than a full
year because they generally had very high costs due to low occupancy in their startup phase of
operation.

Physician-owned specialty hospitals revisited | August 2006 MECpac




APPENDIX

Regression results



to have a less severely ill patient mix primarily due to diverting less severely ill patients from
community hospitals. If specialty hospitals are inducing a market-wide shift in the ratio of low-
severity to high-severity patients, the magnitude of that shift is too small to be detected with our
tests of statistical significance.

Data

We identified cardiac surgery and CABG discharges using diagnosis related groups (DRGs).
Defibrillator implantation and angioplasty were identified using procedure codes from claims
data because they did not have their own DRGs in 1996 (the first year of this study). We
categorized patients into two severity categories using APR—DRGs (3M version 15). Patients
tanked 1 or 2 on the APR—DRG severity scale were deemed less severely ill, and patients ranked
a 3 or 4 on the APR-DRG severity scale were deemed more severely ill. Based on the earlier
work done for our specialty hospital report, we assume that less severely ill patients are more
profitable, while more severely ill patients are less profitable (MedPAC 2005).

Markets. We compare changes in the volume of surgeries per 1,000 fee-for-service Medicare
beneficiaries in the 18 markets with physician-owned heart hospitals to changes in the volume of
surgeries in 283 markets without physician-owned cardiac hospitals through 2004.°

In the 18 markets with physician-owned heart hospitals in 2004, the median heart hospital
discharged 26 percent of the cardiac surgeries in its market. However, the share of cardiac
surgeries varied widely from 3 percent in one market to 41 percent in another. Because the
market penetration of heart hospitals varied widely in 2004, it is important to control for the
market share of the heart hospital when evaluating the impact of the heart hospital on utilization
in the market. Our tests of statistical significance are conducted using a multivariate fixed effects
regression model. The essence of this model is to evaluate whether marketwide changes in the
rate of cardiac surgery are related to the heart hospitals’ market share.

Descriptive statistics

We divided our heart hospital markets into those where the heart hospital opened prior to the
start of 2002 and those where the heart hospital’s first full year of operation was 2003. The
purpose is to see if the differences in surgery growth rates are more pronounced after the heart
hospital opens and then return to more average levels. In general, the rate of cardiac surgeries
grew faster in markets with physician-owned heart hospitals (Table 8). From 2002 to 2004, the
number of surgeries grew by 1.6 per 1,000 beneficiaries in markets where the heart hospital was
open prior to 2002, 4.3 per 1,000 beneficiaries in markets where the heart hospital opened in
2003, and by 1.0 per 1,000 beneficiaries in markets without physician-owned heart hospitals.
Interestingly, heart surgeries were growing rapidly prior to 2003 in markets where the heart
hospital’s first full year of operation was 2003. With a couple of exceptions, angioplasty and
defibrillator implantation all tended to grow faster in markets with heart hospitals than in markets
without them. Bypass surgeries declined in most markets due to substitution of angioplasty for

MECpAC Physician-owned specially hospitals revisited | August 2006

17


AUGUST 2006

REPORT TO THE CONGRESS

Physician-Owned

Specialty Hospitals
Revisited

“Commission

MECDAC i=

601 New Jersey Avenue, NW * Suite 9000 * Washington, DC 20001
(202) 220-3700 * Fax: (202) 220-3759 * www.medpac.gov


largely able to adjust to the loss of revenue from Medicare cardiac cases by obtaining additional
revenues from other sources. There is no statistically significant effect on hospitals’ total revenue
or margins.

Effect of physician-owned orthopedic/surgical hospitals. Orthopedic/surgical hospitals tend

to be much smaller ($20 million in total revenues) than heart hospitals and generate most (65
percent) of their revenue from outpatient services on average. Therefore, it is not surprising that
they do not have a statistically significant effect on Medicare inpatient revenues or total revenues.
In addition, they do not have a statistically significant effect on hospitals’ total margins.

Population growth dominates other factors. Both sets of regressions indicate that the region’s
population growth and nationwide trends in profitability have had a larger effect on competitor
community hospital profit margins than specialty hospitals. Higher population growth
significantly increases hospitals’ revenue, discharges, and margins. We also see a nationwide
decline in Medicare revenue and hospital margins following enactment of the Balanced Budget
Act of 1997. However, Medicare revenues (inflation adjusted) recovered by 2001, following the
enactment of the Balanced Budget Refinement Act of 1999 and the Medicare, Medicaid, and
SCHIP Benefits Improvement and Protection Act of 2000. Due to high cost growth, total margins
tended to be lower in 2004 than in 1997.

Discussion of community impact

The entrance of heart hospitals into markets slowed the competitors’ Medicare revenue growth.
While the specialty hospitals took profitable surgical patients from the competitor community
hospitals, most competitor community hospitals appeared to compensate for this lost revenue.
From our site visits in 2004, we learned that in some cases competitor community hospitals cut
expenses by cutting staff; in some cases they instituted “aggressive pricing strategies” to raise
revenue from private payers; and in many cases they expanded profitable business lines such as
imaging, rehabilitation, pain management, cardiology, and neurosurgery.’ These responses to

the specialty hospital challenge coupled with population growth in many of the markets where
specialty hospitals operate combined to allow competitor community hospitals to maintain profit
margins that are in line with national averages.

As physician-owned entities capture more profitable service lines, the effect on community
hospitals may increase. However, we found community hospitals’ profit margins appeared stable
through 2004, even in markets where physician-owned hospitals captured more than 10 percent
of all admissions.

While the community hospitals can maintain their profit margins, there still may be a price to pay
in the form of higher overall healthcare costs. Physicians, specialty hospitals, and community
hospitals have all been expanding their profitable service lines and are providing a larger number
of services per Medicare beneficiary (GAO 2006, Berenson 2006). Increasing the volume of
services per beneficiary is a serious threat to the sustainability of the Medicare system. And
without clear evidence that the marginal increase in utilization improves outcomes, we can not
say whether the benefits of increased utilization justify the costs. Ill

MECpAC Physician-owned specially hospitals revisited | August 2006

25




20

conclude that there is some increase in utilization, but most of the heart hospitals’ 26 percent
market share of cases represents cases diverted from local community hospitals, not an increase
in market-level utilization.

Physician-owned hospitals opened in markets that tended to have equal or above average
numbers of CABG surgeries per capita in 1996 (Table 8, p. 16). By 2004, the difference between
these markets and the national average expanded. The coefficient in the regression model is .014
with a 95 percent confidence interval of .002 to .026 (Table 10, p. 19). Hence for the median
market where the heart hospital has a 26 percent share of the cardiac surgery market, the model
estimates that the total number of Medicare CABG surgeries was increased by roughly 0.4
surgeries per 1,000 beneficiaries (i.¢., .014 x 26). This is a 9 percent increase in the number

of CABG surgeries above what otherwise would have been expected. The growth rates of
angioplasties and defibrillator implantation when measured separately are not significantly higher
in markets with physician-owned cardiac hospitals. The ratio of low-severity cases to high-
severity cases did not grow significantly faster in markets with physician-owned hospitals.

Discussion of utilization issues

We found that the typical physician-owned cardiac hospital is associated with a roughly 6 percent
market-wide increase in the rate of cardiac surgeries per 1,000 Medicare beneficiaries. Therefore,
from 1996 to 2004, we would expect cardiac surgeries to grow by roughly 25 percent in a typical
market with a cardiac hospital compared with the 19 percent growth rate observed in markets
without physician-owned hospitals. We also found that the ratio of high-profit surgeries to low-
profit surgeries was not significantly affected by the presence of physician-owned hospitals.

Taken together, our findings of an increase in surgeries—but no material shift in the ratio of
high-severity to low-severity surgeries—are consistent with more than one hypothesis regarding
physician behavior. The first hypothesis is that financial incentives only indirectly affect

surgical volumes through the effect on surgical capacity. Under this hypothesis, physicians

have a financial incentive to invest in cardiac hospitals, and as these hospitals are built, surgical
capacity increases. More hospital capacity could lead to more surgeries. More capacity

may allow for more procedures by existing surgeons and invasive cardiologists. In addition,
community hospitals may try to compensate for lost cardiac-surgery market share by recruiting
new cardiologists and cardiac surgeons to compete with the physician-owned facility. More
surgeons and more hospital beds could lead to more surgeries even if individual surgeons’
clinical decision making does not change. The second hypothesis is that some physicians’ clinical
recommendations are directly affected by financial incentives, but the financial incentives cause
a broad shift toward more surgeries and not a precise shift toward focusing only on the most
profitable cardiac surgery cases. For example, some cardiologist-investors may react directly

to the financial incentives by slightly increasing recommendations for invasive procedures for
all types of patients, but do not make a conscious decision to focus on only the most profitable
patients. Either one of these factors could produce the 6 percent increase in surgeries that we see
in markets with physician-owned hospitals.

Physician-owned specialty hospitals revisited | August 2006 MECpac


4

Number of physician-owned specialty hospitals nearly doubles

Type of physician-owned In 2002 Added to 2004

specialty hospital data set data set Total in 2004
Cardiac 12 13 25
Orthopedic 27 26 53
Surgical 7 4 i
Total 46 43 89

Note: The set does not represent all physicianowned specialty hospitals. Some orthopedic or surgical hospitals may have fewer than 25 Medicare
cases. The set also excludes hospitals focusing on obstetrics

Source: MedPAC survey of specially hospitals.

Using the above criteria, our population of physician-owned specialty hospitals consists of 46
hospitals from our prior study that met our criteria in 2002, and 43 additional hospitals that met
our criteria in 2004 (Table 1). Most of the 43 hospitals that qualified in 2004 first entered the
market in 2003 or 2004. Due to the similarity of orthopedic and surgical hospitals, we combined
them into one category (with 64 hospitals in total) for all of our analyses.

Categories of hospitals

As in our earlier study, we compared our physician-owned hospitals to two types of hospitals.
The first category is “peer” hospitals, defined as hospitals that met the specialization criteria
(heart or orthopedic/surgical), but were not physician-owned. They usually operate in markets
without physician-owned hospitals. We identified 25 peer heart hospitals and 16 peer orthopedic/
surgical hospitals with complete cost report information. The peer group is compared to
physician-owned hospitals so we can better distinguish the effect of specialization from the effect
of physician ownership.

The second category is “competitor community” hospitals. We used this category of hospitals to
compare physician-owned hospitals to community hospitals in the same markets and to see how
physician-owned hospitals affect the financial condition of their local competitors. A hospital is
deemed to be a “heart competitor” if it had at least 10 Medicare bypass or angioplasty surgeries
in 2004 and is located in the same cardiac surgery market as a physician-owned heart hospital. A
hospital is deemed to be an “orthopedic/surgical competitor” if it is in the same general surgery
market and had at least 5 Medicare surgical cases in 2004. We identified 148 “heart competitors”
and 300 “orthopedic/surgical competitors.”

The markets for cardiac surgery are defined using the 306 Dartmouth Atlas of Healthcare
hospital referral regions (HRRs) (Wennberg 1999). The HRRs were developed by looking
at travel patterns of Medicare beneficiaries who received cardiac surgery. The markets for
orthopedic/surgical hospitals are defined using the 803 hospital service areas (HSAs) for routine

Physician-owned specialty hospitals revisited | August 2006 MECpac


Physician-owned hospitals tend to have low Medicaid shares

As we discussed in our March 2005 report, many factors can influence a hospital’s Medicaid
share including location, type of services offered, mission, Medicaid managed care contracts, and
type of referral relationships with primary care physicians. For example, hospitals with obstetrics
departments tend to serve more Medicaid patients. This could partially explain why Medicaid
patients represent 13 percent of competitor community hospital patients, 3 percent of heart
hospital patients, and 2 percent of orthopedic/surgical hospital patients (Figure 1).

To control for differences in service offerings, we compared physician-owned hospitals to

peers that are focused on a similar set of services. We found that peer heart hospitals had a 7
percent inpatient Medicaid share (compared to 3 percent at physician-owned heart hospitals).
Peer orthopedic and surgical hospitals had a 3 percent inpatient Medicaid share (compared to

2 percent at physician-owned orthopedic/surgical hospitals). It should be noted that Medicaid
shares vary widely among orthopedic peer hospitals. For example, some orthopedic/surgical peer
hospitals had an inpatient mix that was less than 1 percent Medicaid, while two larger orthopedic/
surgical peers had an inpatient mix that was over 10 percent Medicaid.

The Government Accountability Office (GAO) had similar findings, although their approach
was different. They examined specific types of discharges (e.g., cardiac) at physician-owned
hospitals and competitor community hospitals in their markets. Among cardiac discharges in

Physician-owned hospitals have a lower median Medicaid share

15%
13% 13%
e 12
o
<=
a
z
3 9
3 7%
=
ce 6
&
3
3% % %
7 _ =
0
Heart Orthopedic and surgical
Hl Physicianowned specialty hospitals D Peer community hospitals [1 Competitor community hospitals

Note: For all 3,342 community hospitals in our data set, the median Medicaid share was 13 percent,

Source: Medicare cost reports and survey data for hospitals open one full year in FY 2004.

MECpAC Physician-owned specially hospitals revisited | August 2006 7