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The Trials and Tribulations of Buying a Hospital

Alan M. Preston, Sc.D.
Professor, Texas Health and Science University, Austin, Texas

So you wake up one day and an opportunity comes your way to purchase a hospital. You think to yourself, why not? Well, I will tell you some reasons as to why you might want to consider it and why you may want to avoid the idea completely.

The first question you need to ask yourself is: who are the previous owners and why are they interested in selling? The most prevalent answer to that question as to why they are selling is probably due to poor financial performance. In my case, the hospital was owned by a group of physicians. And, unfortunately, in today’s environment, this administration is opposed to physicians owning hospitals and imposes Stark restrictions upon them. Intuitively, it makes some sense to have doctors be invested in the hospital world since the patient often originates with seeking care of such physicians. And yes, it is true; they can also make money, or lose money, when they are the owners. And as a self-confessed capitalist, I am ok if they make money!

It may appear that hospitals owned by physicians seem to be a natural fit. About four percent of hospitals operating in the United States (U.S.) are physician owned. Many have demonstrated excellent patient outcomes. Some of those who are critical of physician-owned hospitals claim the excellent outcomes are due to physicians "cherry picking" the patients and not admitting the poor or patients with complicated cases. Regardless, many physicians would like to be in more control of the hospitals where they admit their patients. Unfortunately, the federal government does not share that perspective and there are many laws that prohibit physicians owning a hospital if the hospital is interesting in taking federal dollars like Medicare, Medicaid or TRICARE, which is the healthcare program for military beneficiaries who are registered in the Defense Enrollment Eligibility Reporting System.1  The Patient Protection and Affordable Care Act (PPACA)2 strictly prohibits physician ownership of hospitals to the extent they are interested in taking federal payers.

The federal government’s required exclusion of federal payers is a conundrum for many physician-owned hospitals. The simple reason is that age is an independent risk factor in the acquisition of diseases of all types. Simply put, the older we get, the more we need medical care. Some of the care needed are procedures which are performed at a hospital on an outpatient basis and, at times, maybe even require an overnight stay at the hospital. Most hospitals’ patients are 65 years or older. In fact, about 60 percent of a hospital’s patients are eligible for Medicare. Thus, if the hospital is barred from taking Medicare or other government payers as a result of physician ownership, that is a HUGE market to forgo when trying to fill the empty beds, the operating rooms and the procedure rooms.

Of course, one could simply buy out the physician ownership and then be in a position to take on federal payers. Did I just use the word "simply" in the previous sentence? Most physicians I know like being in control. So trying to remove the physicians from ownership and thus a departure from some level of control, is anything but simple. It is achievable, but not simple. In my opinion, it is important to make sure that physicians have a voice in how their patients are being managed. That is the easy part. The hard part is how much voice physicians shall have in the management of the operations of the hospital?

Imagine for a minute inviting a group of physicians to a fabulous dinner some hours away from the hospital. You are inviting five of them, thus you decide to rent a stretch limousine. The doctors observe the stretch limousine and all of them want to drive it. They all want to drive it all at once. Why is this? Simple, they want to be in control. My opinion is that control is somewhat overrated. I could simply tell the one driver where I want to go and have him communicate back to me if there are any problems challenging the driver getting to the destination in a safe and timely manner. Of course, we have the ability to look outside to assure he is going in the right direction and heading there in a safe manner. That is, of course, just considered feedback. And good management needs to keep their stakeholders informed of the hospital’s direction (financially and operationally), hospital safety concerns, production issues and a number of attributes concerning the overall health of a hospital. Not everyone needs to be in the driver’s seat holding on to the steering wheel.

The true customers to all hospitals are physicians. That claim surprises a lot of people; however, the patients only receive the benefit of the hospital services. Patients are then the beneficiaries of the services of the hospital and are also customers, just not in the typical sense of the definition. However, it is the physician that primarily decides at which hospital a patient may have a procedure or be admitted. Those decisions are often based on admissions privileges and physician preferences called practice patterns. Of course, the decision is often done with the secondary customer, the entity that pays the bulk of the bill: the insurance carrier. If the insurance carrier is not contracted with a hospital where a physician wants to admit the patient, the referral will not be authorized and the hospital may not allow the admission to occur.

Many are under the impression that federal law requires hospitals to take anyone who shows up to the hospital. They often reference the Emergency Medical Transportation and Active Labor Act (EMTALA) Title 42 USC 1395dd.3 When a hospital has an emergency department, any individual (whether or not eligible for benefits) comes to the emergency department and a request is made on the individual’s behalf for examination or treatment for a medical condition, the hospital must provide for an appropriate medical screening examination within the capability of the hospital’s emergency department, including ancillary services routinely available to the emergency department, to determine whether or not an emergency medical condition exists. If any individual (whether or not eligible for benefits) comes to a hospital and the hospital determines that the individual has an emergency medical condition, the hospital must provide either: (A) within the staff and facilities available at the hospital, for such further medical examination and such treatment as may be required to stabilize the medical condition, or (B) transfer of the individual to another medical facility as appropriate. Obviously, this rule occurs for emergent care and not routine care that is scheduled in advance with the patient’s physician team.

Our healthcare system is regulated through a very complicated patchwork of laws, rules and regulations at the federal and state level and, to a smaller degree, the local county and city. Healthcare is one of the most regulated industries of all industries and it is, indeed, an enormous industry. Every year, we spend about 2.4 trillion dollars on healthcare services and nearly one trillion is spent for hospital care. At 2.4 trillion dollars, if our healthcare industry were a country, the amount the U.S. spends on that one industry would rival the sixth largest economy in the world based on gross domestic product: Russia. And that number is only going to increase over time with the passage of the PPACA, universally known as Obamacare, and the expansion of Medicaid to 400 percent of federal poverty guideline for those states that expanded Medicaid. And since the baby boomers are aging, that group will have more people demanding more and more services. Technology improvements are great, however costly, particularly when duplicated throughout the U.S. And the supply of physicians will not be able to keep up with the demand, which is likely to drive up the cost of healthcare. What does all of this mean? Healthcare cost will continue to increase as a result of the issues mentioned previously, as well as many more issues not mentioned. So when a political candidate like Bernie Sanders makes claims that he can save consumers over $5 million dollars a year in premiums; I can assure that will NOT happen. President Obama made similar claims about saving everyone $2.5 million and that hasn’t happened.

One person’s cost is another’s revenue. For the nearly 6,000 hospitals operating in the U.S., that means the occupancy rates will likely increase in the near future. Because hospitals are institutions with very high fixed costs, it is important to fill up the beds and bring in the revenue the beds represent. The other source of revenue for a hospital is in the procedures they perform. The hospital will receive a facility or technical fee associated with such. Now depending upon the insurance carrier, the hospital can be reimbursed in a variety of ways. They can receive a fee-for-service though rare these days. They can receive a diagnostic related grouping, which is a prospective payment methodology where the hospital receives an up-front fixed amount depending upon the diagnoses of the patient. The hospital may receive a per diem that is fixed or variable. The hospital can also receive a capitation payment for a defined level of services by a managed care company for a population of patients. Understanding how to get paid is critical to the success of a hospital and it is surprising how many hospital administrators lack the sophistication regarding their revenue sources. In fact, the insurance industry that pays most of the bill is often viewed as the bad guy because they do not pay the charges a hospital submits. Retail medical charges are often artificially created and thus fail to represent any meaningful cost based accounting system or a market value for a particular service. Biting the hand that feeds you is never a good strategy in achieving profitability.

Gross revenue is always reduced by expenses. Hospitals are very expensive places to operate. The largest cost is almost always the building and surrounding campus. Those cost are fixed, thus if you have one patient or fill the hospital to 90 percent of capacity, the cost of the building and equipment are largely the same. Employees represent the next largest cost of a hospital because a hospital is open 24 hours a day, seven days a week with three shifts of employees needed. At various capacity levels, the hospital can have a fixed number of employees and contract for others until such capacity grows to predictable levels in order to make appropriate adjustment with staff as the census goes up and down in a given day. Variable costs involve all the supplies used for procedures, operations and for the day-to-day care of a patient. If the institution is well managed, they can make a decent profit. Hospitals over the last ten years have ranged in margin from four percent to eight percent net profit according to the American Hospital Association. About 25 percent of the 6,000 hospitals have a negative financial margin. Even if they are well managed, the location, competition, number of insurance carriers in the market, the overall health of a community and other factors can have a negative financial impact on a hospital.

One of the greatest predictors for success is the strategy the operators of the hospital implement. Let me walk you all through a couple of strategies and the attributes and detriments of each. Let’s assume that a group of doctors want to purchase a hospital. They hire a team of business and legal professionals to guide them through the process. The doctors are presented two options (strategies):

  1. Own the hospital where the doctors will get to have a tremendous amount of input as to management decision and direction of the hospital. The trade-off is that the doctors will not be able to take Medicare, Medicaid or TRICARE as they are banned from doing so by Obamacare. They decide not to contract with too many insurance companies which will make the hospital an out-of-network provider; thereby giving the ability of the hospital to charge a significant higher price than would be allowed under Medicare.
  2. Doctors do not own the hospital and the hospital can take Medicare, Medicaid and TRICARE and a sizable number of insurance companies. The reimbursement is less than full charges. The doctors do not have the level of "control" they would have under the first option.

Which strategy would you select? Many doctors like the concept of the first option for two main reasons: control and higher reimbursement. The problem with the first option is that healthcare is so substantially regulated that the concept of "control" is an elusive concept as it has to be operated in the context of the regulatory framework. Furthermore,getting 100 random people to agree as to what the color the scrubs should be will cause a tremendous amount of conflict and disharmony when everyone feels they are owners and thus should assert their opinion about a plethora of issues. Also, excluding 60 percent or more of the marketplace from accessing services is seldom a good strategy given the high fixed cost of a hospital. Additionally, asking a customer to pay the full rack rate 4and receiving the full rack rate are two very important, distinct issues. I have seen hospitals fail because they could not collect millions in receivables.

Thus, employing the wrong strategy can result in catastrophic results for any business and the healthcare industry is a very complex industry that adds to the difficulty of implementing any strategy that will be effective 100 percent of the time. All strategies have some degree of trade-off and depending upon the objective, the financial results will and should reflect such. If the objective is to care for patients who do not have insurance, then a strategy to make a lot of money will be hard to achieve. A strategy has to embrace the objective of the institution; not the other way around.

If you are going to purchase a hospital, what exactly are you purchasing? The legal framework is important to understand. We often think in monolithic terms that owning a hospital is a single entity and thus a single company. More often than not, the purchase of a hospital is broken down into a number of components and companies. Let’s first start off with the real estate. Many hospitals that you see today lease the buildings that prominently display the name of the hospital. Like so many other businesses, the tenant running the business seldom owns the building. There are advantages and disadvantages to both ownership of the building vs. leasing the building.

If you lease the building, then as the operator, how much of the hospital do you want to operate? Many hospitals lease out certain functions such as radiology, anesthesiology, pathology and emergency room care. Also, it is not uncommon for the operators of the hospital to "outsource" billing, accounts payable, accounts receivable, information technology and other "management" services. As a result, there may be other "companies" that comprise functional components of the hospital, but the ownership of such services are separate and distinct; nevertheless, important to the overall functions of a hospital. Thus, when one says they are purchasing a hospital, what exactly are they purchasing? Are they purchasing the real-estate, the operating company, the management company or some other portion of the hospital operations? The pathway is not simple nor is it straightforward and the complexity increases as the size of the institution increases.

I was asked whether or not a hospital we are looking to purchase should be a specialty hospital. The answer of course is: that depends. It depends as to whether it is a going concern already branded in some particular specialty or not. If it is a new start up, my answer is very different. Because of the high fixed costs of a hospital, it becomes important to perform a lot of outpatient cases while simultaneously filing as many beds on the inpatient side. Specializing, by its very nature, is a strategy that restricts some aspect of the market. Restricting the market to patients with an esoteric healthcare need seems counterintuitive to filling beds.

Over time, a hospital may attract some specialties more than others. The famous iconic architect, Frank Lloyd Wright, was once commissioned to design a college. He worked on it and finally gave a presentation to the owners of the college. They loved the open spaces and overall design of the buildings. One careful observer noted there were no sidewalks on the plan designs. Mr. Wright was asked about the sidewalks and why he forgot to put them into the plans. Mr. Wright told the group he didn’t forget at all; he noted that until the natural patterns of the students revealed themselves to Mr. Wright, he was not going to assume in advance how the crowd was going to move. He wanted to see how the crowd naturally moved from one place to another and once he understood such, he would then put the sidewalks in place. Likewise, if a specialty or two reveals itself to a hospital as a dominant customer, the hospital may over time move in that direction; however, in the beginning, allowing as many physicians to practice is a practical option.

Of the nearly 6,000 operating hospitals, 60 percent of those operate under a non-profit status.5 Does that suggest they don’t care about profit? Of course not. What it does mean is that the hospital has received a tax exempt status as a 501(c)3 status from the Internal Revenue Service (IRS). The implications are that the hospital is exempt from paying taxes and the quid pro quo is that some benefit is inured to the community as a result of not paying taxes. What is the amount of taxes that are avoided by non-exempt hospitals? In the aggregate, it is in the billions. There has been enormous criticism regarding non-profit hospitals for not paying taxes because it has been estimated that the "free or uncompensated care" provided to the community by non-profits have not come close to the amount of money that is avoided in the payment of taxes. Non-profits do not pay income tax, sales tax, property tax, ad valorem tax or any other tax levied against similar hospitals that are not tax exempt. The sales and property tax alone is enormous. Critics have also noted that all too often the non-profit hospitals bill the full charges to patients who do not have insurance and end up at one of the non-profit hospitals via an emergency. Most non-profit hospitals have no intention or expectation of collecting 100 percent of their billed charges and they can demonstrate to the IRS the amount of bad debt based on charges as opposed to their actual cost of such services or even opportunity cost as a percentage of Medicaid. Additionally, some non-profits have lost or come close to losing their tax exempt status when certain physicians involved in the hospital benefited above and beyond and the IRS considered that a private inurement to one group which is a violation of the 501(c)3 status.

For-profit hospitals represent 19 percent of the hospital market and have to pay taxes and they also provide uncompensated care; which they do at nearly the same level as non-profits. Some are publicly traded, while others are privately owned. Hospital Corporation of America, as an example, has been privately held and then went public and now is back to operating as privately held. Tenet Healthcare is probably one of the largest publically held for profit hospital chains in the U.S.

Community or government-owned hospitals account for the remainder and they consist of 21 percent of the hospital market. They include county owned hospitals, state owned hospitals like Hawaii and Louisiana and federally owned hospitals like the Veterans Affairs hospital system. Again, there are advantages and disadvantages to having the government own hospitals. Critics point out that if the services provided at a government-owned hospital were provided at private institutions, that the care would be better and the waiting lines to receive care would be shorter. As a devout capitalist, I concur with such an opinion. In a free market system, the government, whether federal, state or county, should not compete with the private free market system. Governments should regulate and nurture the activities of private enterprise; not compete with it. A voucher or third party payment system could be established for any private enterprise to provide the necessary services demanded by those currently seeking benefits at the government institutions. Competition almost always creates a more effective and efficient process and better outcomes as opposed to government run institutions.

Buying a hospital is a complicated transaction and there is not a clear or straightforward answer as to the correct way to purchase a hospital. The first step is always the objective. What is the objective in acquiring a hospital? A purchaser should start there and then develop strategies that support the objective and be realistic and understand the regulatory framework that you have to comply with before you ever begin. Be realistic as to the revenue projections in terms of actual collections and the timing of such collections. Be realistic as to the projected costs. Be realistic as to the changes of practice patterns needed to get the medical community to support your endeavor. Without the support of the medical community, the best reimbursements, the lowest cost of supplies, the cheapest rent will not matter if you do not have the support of the medical community. Clearly, any strategy must include the willingness of the many stakeholders involved. Of course, this article is just food for thought and is by no means a comprehensive list of everything one needs to consider when purchasing a hospital. Nevertheless, if you want to purchase a hospital, get ready to write out a really big check and have a lot left over to pave the way until profitability occurs.

1The Tricare (styled TRICARE), formerly known as the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS), http://www.tricare.mil/, https://en.wikipedia.org/wiki/Tricare
The Patient Protection and Affordable Care Act, http://www.dol.gov/ebsa/healthreform/
Certification and Compliance For The Emergency Medical Treatment and Labor Act EMTALA), CMS.gov, https://www.cms.gov/medicare/provider-enrollment-and-certification/certificationandcomplianc/downloads/emtala.pdf
Rack rates are defined as the full amounts medical facilities charge for procedures outside of negotiated discounts. http://health.usnews.com/health-news/patient-advice/articles/2014/09/04/the-thorny-problem-with-prices
Nonprofit status may make an organization eligible for certain benefits, such as state sales, property and income tax exemptions. https://www.irs.gov/Charities-&-Non-Profits/Applying-for-Exemption-Difference-Between-Nonprofit-and-Tax-Exempt-Status
501(c)(3), whereby a nonprofit organization is exempt from federal income tax if its activities have the following purposes: charitable, religious, educational, scientific, literary, testing for public safety, https://www.irs.gov/Charities-&-Non-Profits/Charitable-Organizations/Exemption-Requirements-Section-501(c)(3)-Organizations

Alan M. Preston, Sc.D., is a professor in the Healthcare Management MBA program at Texas Health and Science University. He has served as Chief Executive Officer for Oncologics, a company of eight radiation and oncology clinics, and GMG Management Group who operates primary care clinics, outpatient surgery center, physical therapy, occupational medicine, radiology and urgent care. He was CEO and Founder of Synergist Research, where he serviced co-owned research centers as well as contract research functions to various start-up pharmaceutical companies. From 2010 to 2012, Dr. Preston served as Vice President for Academics, Research and Assessment at Texas Health and Science University. He has served as Professor at University of the Incarnate Word in San Antonio and is currently Professor at Texas A&M University where he teaches graduate-level business and management students and conducts research in the areas of epidemiology, statistics, healthcare policy, health insurance systems and healthcare management. Dr. Preston has Sc.D. in Health Services Research and a MHA in Health Management from Tulane University, New Orleans, LA, and a BBA in Business Administration, from the University of Louisiana, Lafayette, LA. He resides in San Antonio, Texas. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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