Specialty hospitals have become a subject of debate among health care policymakers. One issue concerns physician ownership of specialty hospitals and whether such ownership might inappropriately affect physicians’ clinical decision-making and referral behavior. A related issue concerns the potential for specialty hospitals to benefit financially by treating patients who are less severely ill, and therefore less costly, while leaving general hospitals responsible for a mix of patients who need more care and are more expensive to treat. Our April 2003 report provided information on both issues: the extent of physician ownership at specialty hospitals and the relative severity of patients’ illnesses at specialty and general hospitals. Much of the concern about specialty hospitals centers on physician ownership issues. Federal law generally prohibits physicians from referring Medicare patients for specific health care services to facilities in which they (or their immediate family members) have financial interests.This prohibition, a key component of the Medicare self-referral or Stark law (named after its chief sponsor in the House of Representatives, Representative Pete Stark) was enacted after several studies found that physicians with ownership interests in separate clinical laboratories, diagnostic imaging centers, or physical therapy providers tended to make more referrals to them and order substantially more services at higher costs. The Stark law contains an exception that is relevant in the case of referrals to specialty hospitals. The law includes an exception that permits physicians who have an ownership interest in an entire hospital and who also are authorized to perform services there to refer patients to that hospital. The premise is that any referral or decision made by a physician who has a stake in an entire hospital would produce little personal economic gain because hospitals tend to provide a diverse and large group of services. However, the Stark law does prohibit physicians who have ownership interest only in a hospital subdivision from referring patients to that subdivision. With respect to specialty hospitals, the concern exists that, as these hospitals are usually much smaller in size and scope than general hospitals and closer in size to hospital departments, the exception to Stark could allow physician owners to influence their hospitals’—and therefore their own—financial gain through practice patterns and referrals. The question of favorable patient selection—the contention that specialty hospitals treat a more financially favorable selection of patients as compared to general hospitals—has added to the debate about the advantages and drawbacks of specialty hospitals. This issue is linked to the way hospitals are paid. The fixed-rate, lump-sum payments that Medicare and many other health care payers typically make to hospitals for inpatient care for patients with a given diagnosis, regardless of the costs of serving particular patients, are designed to promote efficiency by discouraging hospitals from providing unnecessary services as a way to boost revenues. However, these lump-sum payments foster undesirable incentives, as hospitals may gain financially by serving a disproportionate share of lower-cost patients with the same diagnoses. Medicare’s hospital payment system rules illustrate this principle. Under its system of prospective payments, Medicare pays a predetermined rate for each hospital discharge, based on the patient’s diagnosis and whether the patient received surgery. In other words, the payments reflect an average bundle of services that the beneficiary is expected to receive as an inpatient for a particular diagnosis. Discharges are classified according to a list of DRGs. DRG payment rates are based on the expected cost of the diagnosis group’s typical case compared with the cost for all Medicare inpatient cases. The DRG payment is not adjusted for within-DRG differences in severity of illness. Therefore, hospitals have a financial incentive to treat as many patients as possible whose costs are low relative to the costs of the average patient in each DRG. Our April 2003 study found that 21 out of 25 specialty hospitals treated a lower percentage of patients who were severely ill compared with patients in the same diagnosis categories treated at general hospitals in the same urban areas. For example, in an urban area in Texas, 3 percent of an orthopedic hospital’s patients with that hospital’s most common diagnoses were classified as severely ill, as compared with 8 percent of patients with the same diagnoses treated by the area’s more than four dozen general hospitals. In an urban area in Arizona, about 17 percent of a cardiac hospital’s patients with that hospital’s most common diagnoses were classified as severely ill, as compared to 22 percent of patients with the same diagnoses treated by the area’s more than two dozen general hospitals. Not all specialty hospitals treated patients who were, by comparison, less sick. Two of the 25 specialty hospitals treated a higher percentage of severely ill patients and two others treated about the same percentage as area general hospitals. In examining the illness severity differences between specialty and general hospitals, we did not determine the clinical or economic importance of these differences. For-profit status is a salient characteristic of specialty hospitals we identified. More than 90 percent of the specialty hospitals that have opened since 1990 were for-profit. Overall, 74 percent of specialty hospitals are for-profit, as compared to about 20 percent of all general hospitals. (See table 1.) For-profit status varied somewhat by specialty type, ranging from 78 percent of orthopedic hospitals to 65 percent of women’s hospitals. In our April 2003 report, we found that 70 percent of the more than 100 specialty hospitals in existence or under development had some degree of physician ownership. Among specialty hospitals with any degree of physician ownership, physicians’ combined ownership shares averaged slightly more than 50 percent of the hospital. Physicians’ combined ownership tended to be somewhat smaller at cardiac hospitals (31 percent) and larger at surgical hospitals (70 percent). The degree of individual physician ownership varied by hospital, but was generally low. At approximately half of all specialty hospitals with physician ownership, the average share owned by an individual physician was less than 2 percent. The share of a specialty hospital owned in the aggregate by the physicians in a revenue-sharing group practice could be much higher. At more than half of the specialty hospitals with physician owners, physicians in a single group practice owned more than 25 percent of the hospital. The majority of physicians who worked in specialty hospitals had no ownership interest in the facilities. Overall, approximately 73 percent of physicians with admitting privileges to specialty hospitals were not investors in their hospitals. (See fig. 1.) The percentage of admitting physicians who were investors varied by specialty hospital type, ranging from about 7 percent at women’s hospitals to about 44 percent at surgical hospitals. We identified three basic business structures for specialty hospitals. Our survey results indicated that about one-third of specialty hospitals were independent. Most of these hospitals were orthopedic or surgical and 76 percent had some degree of physician ownership. Approximately one-third of specialty hospitals were owned in part by a specialty hospital chain. Among this group, most hospitals were cardiac or orthopedic and 76 percent had some degree of physician ownership. The remaining one-third of specialty hospitals were owned or operated in part by local general hospitals. Almost half (48 percent) of the hospitals in this last group, which varied in specialty type, had some degree of physician ownership. In 2001, specialty hospitals accounted for approximately $871 million, or 1 percent, of Medicare’s spending on hospital inpatient services. Nearly two- thirds of this amount went to cardiac hospitals. (See table 2.) Although 28 states had at least one existing specialty hospital, about two- thirds of the 100 specialty hospitals we identified were located in 7 states. The specialty hospitals that are planned to open over the next few months or years will reinforce this pattern of concentration. Specialty hospital location was associated with regulatory and demographic conditions that may facilitate or encourage hospital development. Specialty hospitals are concentrated in seven states: Arizona, California, Kansas, Louisiana, Oklahoma, South Dakota, and Texas. Texas, with 20 specialty hospitals, had almost twice as many specialty hospitals as the state with the second highest number of specialty hospitals, California, with 11. States such as Oklahoma (9), Kansas (8), and South Dakota (7), although smaller in area and population than California, had nearly as many specialty hospitals. The remaining 21 states with specialty hospitals had between 1 and 4 specialty hospitals each. (See fig. 2.) The specialty hospitals that are planned to open over the next few months or years will tend to reinforce the existing pattern of geographic concentration. In June 2003, at least 26 specialty hospitals were under development in 10 states. (See fig. 3.) Nine of the 10 states that had one or more specialty hospitals under development already had at least 1 existing specialty hospital. About 60 percent of specialty hospitals under development were located in three states: Texas had 7; California, 5; and Louisiana, 4. Seven other states had 1 or 2 specialty hospitals that were under development as of June 2003. Based on the specialty hospitals known to be under development, the number of surgical hospitals will increase by 65 percent and the number of cardiac hospitals will increase by approximately 40 percent in the next few months or years. Seven cardiac hospitals, 2 orthopedic hospitals, and 17 surgical hospitals are under development. The location of specialty hospitals is strongly correlated to whether states allow hospitals to add beds or build new facilities without first obtaining state approval for such health care capacity increases. All of the specialty hospitals that are under development and 96 percent of the specialty hospitals that opened from 1990 to June 2003 are located in such states. (See table 3.) State requirements for prior approval to increase health care capacity are commonly referred to as certificate of need (CON) laws or requirements. Federal legislation enacted in 1975 to promote comprehensive planning and development of hospitals and other health care resources conditioned funding to states on their establishment of CON requirements. At that time, many policymakers contended that CON requirements could prevent the construction of unnecessary capacity and help control health care costs. CON opponents argued that such requirements could stifle competition and lead to higher health care costs. Whether CON requirements achieved their objectives was inconclusive,and in 1986 the federal legislation was repealed. Subsequently, several states dropped their CON requirements. In 2002, 37 states maintained CON requirements to varying degrees.