by MATTHEW HOLT

So to celebrate 20 years, we’ll be publishing a few classics for the next week or so. This is one of my faves from the early days of THCB, back in 2006. It’s interesting to compare it with Jeff Goldsmith’s NEW piece from yesterday on vertical integration because at the time a pair of Harvard professors, Michael Porter and Elizabeth Teisberg were telling hospitals to change their operations in a way that seemed to me were going to destroy their business–cut down to one or two service lines they were best at and stop with the rest. McKinsey picked up on this and I went to town on why they were all wrong. In fact in the next decade and a half, despite all the fuss and consulting fees generated, almost no hospital system did anything other than merge horizontally with local competitors, stick up its prices, and buy feeder systems of primary care doctors or ally with/bribe specialists to keep their procedural referrals up. The result is the huge regional oligopolies that we have now. Despite all the ignoring of their advice, I don’t think Porter/Teisberg or McKinsey went broke in that same period.–Matthew Holt

McKinsey, an organization that prides itself on increasing the amount of consulting dollars it gets paid by improving the strategic direction of American business is making another foray into health care.

You may recall their last study on CDHPs was roundly criticized (see Tom Hillard for a good example including a hilarious and brutal smackdown of their research methodology in the last couple of paras), and this time they cleverly aren’t bothering with data—in fact they’re basically copying Porter and Teisberg. The piece, by Kurt Grote, Edward Levine and Paul Mango, is about hospitals and how they need to get into the 21st century.

And of course the idea is that hospitals need to change their business approach.  Well, given that I hadn’t noticed a rash of hospital closings and the the industry as a whole has been growing its revenues pretty successfully over the years, what exactly are the problems?

The rise of employer-sponsored insurance in the 1930s and 1940s, and the emergence of government-sponsored insurance in the 1960s all insulated hospitals from the need to compete for patients. Today hospitals are “price takers” for nearly 50 percent of their revenues, which is subject to the political whims of the federal and state governments. Hospitals are also required to see, evaluate, and treat virtually any patient who shows up, solvent or not. Furthermore, physicians were productive because hospitals put a great deal of capital at their disposal. Yet these hospitals didn’t enforce standardized and efficient approaches to the delivery of care. At many hospitals today, doctors still bear only limited economic
responsibility for the care decisions they make. Little wonder that it is often they who introduce expensive—and sometimes excessive—nonreimbursable technologies or that hospitals not only suffer from declining margins but are also performing less well than other players in the health care value chain 

The piece then has a pretty incomprehensible chart that compares the EBITDA (profit) of hospitals compared to drug companies and insurers. Surprisingly enough they make a whole lot less EBITDA than those businesses–although long time THCB readers will know we’ve been well down that path. And apparently their margins got worse and then better (from 25% in 1990 to 15% in 1995 to 10% in 2000 but back up to 15% in 2004).

McKinsey’s answer, basically filched from Porter/Teisberg, is for hospitals to specialize in particular service lines, stop being generalists and start trying to please the consumer who’ll be choosing among them. As a general mantra, this might be good for consultants to stick up on Powerpoint, but to be nice it’s massively oversimplified, and to be nasty it’s just plain wrong for most hospitals for the current and foreseeable medium-term future.

Their analysis ignores the fact that there are (at least) three broad categories of hospitals–inner city and rural  safety-net providers, big academic medical centers, and suburban community hospitals. Each of these has a completely different audience, completely different set of incentives, and more to McKinsey’s point, different profit margins.

Right up front they talk about the 50% of revenue that comes from the government–but for the first two categories, it’s more than that! And for everyone, as public programs grow, it’s going to be increasing.

Those hospitals relying on Medicare make most of their money but playing very careful attention to the DRG mix. The ones who play that game well and make most profit on Medicare outliers (like the for-profits McKinsey features in its metrics) don’t really want to change that by stopping their patients becoming those outliers, because if they get better at treating patients, they make less money. Brent James’ famous Intermountain story tells the truth, and until Medicare really changes the way it pays, you don’t want to be ahead of that curve. Intermountain may have spent more than 10 years leaving money on the table, but those rich Mormons can afford it.

Meanwhile, for the mainstream community hospitals, as more and more services and patients leave the building, the imperative is not to change their business model, it’s to get their hands on that revenue that’s leaving with them. That’s why most big hospitals are now-co-investing with physicians in specialty hospitals et al. But while that’s a defensive battle to build better “hotels” for the star surgeons, it’s still about building better “hotels”–not junking the model of being the nicest possible host to the big time admitting surgeons.

The McKinsey/Porter/Teisberg theory is of course that if you get good at one service line, you’ll be attractive to consumers, and that they’ll choose you. There is more truth to this notion now than there was five years ago, but not much more. Doctors choose hospitals for their patients. That’s always been the case, other for those that get admitted via the ED, and that’s a function of location. That’s why hospitals suck up to surgeons. But even when consumers make choices, they’re not very active consumers beyond the deductible, and basically all hospital spending is beyond the deductible, and even in the cash non-hospital business (the stuff like genetic testing) most consumers take their doctor’s advice.

Which leads of course to who the other real consumer for the hospital is, and that’s the third party payer. First rule of dealing with payers is to figure out how to play the Medicare system well enough that you make it very profitable, but not too “well” that you get busted, a la Columbia/HCA, Tenet & St Barnabas.

Second rule is that you need to get bargaining strength against the health plans. No one can pretend that health plans really care in a global sense about having their providers cut costs and improve care delivery. They may say they care about it, but health plans add a chunk on the top of what they pay providers and stick that to their clients (usually employers) — who basically take it in a mealy mouthed way.

There is, though, a fight in any local market about where to draw the line on hospital pricing. But this fight is not about having providers from outside (or even within) the region swooping in to capture all a payer’s business with better pricing on certain service lines, and payers moving patients to these disease-specific treatment centers.  Well, it is about that in the McKinsey/Porter/Teisberg fantasy land, but in reality the fight is about setting global pricing for all the services a payer needs for its members in that region.

Look at the big fights going on now. In Denver there’s a dust-up between United HealthGroup and HealthOne and a similar one between United (again) and HCA in Florida. HealthOne is using a rather amusing tactic that–it says United should increase what it’s paying because it gave HealthOne a good report card. But let’s be real, this is about who can create enough market power so that the other side has to hand over a bigger slice of the pie if it wants services or patients delivered. Sutter showed this well when it beat up Blue Cross in California, and that lesson has been understood by provider systems across the nation as they lined up to form oligopolies.

If hospitals decide that they are going to improve care processes, and stop offering certain services, but offer the ones they are good at at a lower rate, insurers will say two things. First, thanks for the lower price, we’ll happily pay you less, and two, can you please organize coverage for the service lines you’re dropping as our patients in that metro area need it and don’t yet want to fly to Mumbai–they don’t even want to drive across town:

Aventura resident Jean Glick, who received a letter on Aug. 4, said she was furious. ‘If they claim to be a community hospital, this not serving your community,” she said. For Aventura residents insured by UnitedHealthcare, the next closest hospitals that accept their insurance are Parkway Regional in North Miami Beach and Mount Sinai in Miami Beach. <snip> Glick said she fears that not having a nearby hospital that accepts her health insurance could be expensive and even life threatening. ”I can’t afford to pay out of network,” she said.

The interviewed resident may not exactly understand the dynamics, but she doesn’t exactly sound ready for the brave new world. And let’s not underestimate the extent of the change McKinsey’s calling for. Here’s what they say about physicians:

For many physicians—particularly clinical specialists in the service lines where hospitals hope to differentiate themselves—the traditional arm’s-length and more recent competitive relationship must give way to some sort of formal employment or to gain-sharing schemes such as joint ownership of equipment or even whole facilities. Furthermore, performance criteria for physicians must shift. In a world in which transparent quality, service, and prices help patients choose places to seek treatment, metrics such as admissions volumes will become less relevant.

That looks like a license to drop a whole bunch of money hiring doctors and dealing with all the headaches that brings–not to mention dealing with the Stark laws. And all that just after the huge successes of hiring physicians in the 1990s! It would indeed be a brave CEO who stopped caring about the admission rates of his star surgeon. I can imagine the board meeting where he says that his hospital will have a smaller but more efficient service line that one day will grow to replace the others they’re dropping, and the gruff board member asks where the money to cross-subsidize the money-losing ED will come from.

It may be the case that in some far distant future patients can really be served (and moved around) on a national or international scale, and that the local monopoly/oligopoly model gets broken. But these things change very slowly. Delta airlines tried it about a decade back (flying employees around to centers of excellence)–have you noticed the huge impact on the system? Me neither.

Furthermore, almost none of the safety net hospitals, and few AMCs, can realistically take this course, as it destroys their mission of being all things to all comers. That matters not just because of their mission but because most of their money follows their mission. (For the safety-net via local taxes/Medicaid, and for the AMCs via Federal money for training residents and research).

I’m not saying that this is a good thing one way or the other. I’m in fact all in favor of changing incentives so that more efficient and better patient care is delivered, but I am saying that with the current and near-future market realities jumping on the McKinsey bandwagon is not a great idea for the vast majority of hospitals. But don’t worry—have McKinsey come in and change your strategy, and then in a few years they can come change it back!

CODA: It’s only fair to say that  a while back (in 2001)  one of the McKinsey authors Paul Mango wrote a prefectly sensible article about how hospitals could become more profitable by doing what they do now more efficiently, and understanding capacity optimization. And that five years later is pretty much still true.