How Much Market Power Do Hospital Systems Have?

Sometimes big game hunters find frustration when their prey moves by the time they’ve lined up to blast it. That certainly appears to be the case with the health policy target de jour: whether providers, hospital systems in particular, exert too much market power. A recent cluster of papers in Health Affairs and policy conferences this spring have targeted the question of whether hospital mergers have contributed to inflation in health costs, and what to do about them.

Hospitals’ market power appears to be one of those frustrating moving targets. The past eighteen months have seen a spate of hospital industry layoffs by market-leading institutions, and also a string of terrible earnings releases from some of the most powerful hospital systems and “integrated delivery networks” in the country. These mediocre operating results raise questions about how much market power big hospital systems and IDNs do, in fact, exert.

The two systems everyone points to as poster children for excessive market power-California-based Sutter Health and Boston’s Partners Healthcare, both released abysmal operating results in April. Mighty Partners reported a paltry $3 million in operating income on $2.7 billion in revenues in their second (winter) quarter of FY14. Partners cited a 4.5 percent reduction in admissions and a 1.6 percent decline in outpatient visits as main drivers. Captive health insurance losses dragged down Partners’ patient care results. Sutter did even worse, losing $22 million on operations in FY13 (ended in December), – compared to a gain of $697 million in FY11 – on more than $9.6 billion in revenues.  A 3 percent decline in admissions led to FY13 revenue growth of 0.9 percent (that is, nine-tenths of one percent), against 7.3 percent in expense growth.

These results were not atypical. After Sutter, the second most powerful health system in the West, Seattle-based Providence Health and Services, had $37.7 million in operating earnings in FY13 – compared to $239 million in 2011 – on $11 billion in revenues and essentially flat admissions. While some of these results were clearly affected by Providence’s take-over of the failing Swedish Health System in Seattle, there were broad declines in revenue growth across the system. Henry Ford Health System in Detroit, one of the nation’s first hospital-based integrated delivery networks, lost $12 million on operations in FY13 (before some one-time accounting changes), on $4.6 billion in revenues, and had only $75,000 in total system revenue growth. Expense increases of 2.6 percent effectively wiped out earnings.

Catholic giant Ascension Health reported net patient services revenue up 1 percent year over year in its Spring 2014 operations report (9mo), with a same-store 3 percent admissions decline and outpatient visits essentially flat. It was able to generate roughly a 4 percent increase in net patient services revenue per adjusted admissions (inpatient admissions adjusted for outpatient activity). Several Ascension hospitals, notably St. Vincent in Indianapolis and St. John in Detroit, had major layoffs in 2013, but the overall system generated 4 percent operating margins, down only 10 percent vs. the prior year thanks to vigorous cost cutting.

What Do These Earnings Reports Mean?

What I think they mean is that these large systems have been unable to offset declines in utilization and Medicare funding reductions by cost shifting to private insurers. According to the Bureau of Labor Statistics, overall hospital pricing growth has gradually declined for a decade into the low single digits. One is dying to know the dispersion around this declining mean, and how this chart looks in highly concentrated markets like Boston and San Francisco. If hospital industry consolidation, which accelerated after 2008, is “helping” hospital pricing, it isn’t obvious from this chart.

Producer Price Index, Hospital Component

Source: BLS

I think the soft rate controls contained in the ACA, including the de facto 10 percent cap on health insurance rate increases imposed by CMS, and the threatened exclusion of plans that raise their rates by more than the cap from the ACA’s Exchanges, may have toughened the rate negotiating posture of health plans with their hospital networks. A number of large national health plans missed their earnings targets in the 4^th Quarter of 2013, according to CitiGroup’s health insurance analyst, Carl McDonald. These earnings misses will undoubtedly result in continued pressure on rate negotiations between hospitals and insurers. If the cost surge some analysts saw early in 2014 continues, the rate negotiations this summer and fall for next year will be bloody.

Effects of Consolidation and Market Power

If one looked at FY11 operating results for the health systems above, one would have drawn a completely different conclusion about the effects of industry consolidation, as many large health systems generated record operating earnings in that year. Did their leverage completely disappear in the succeeding two years?  Probably not. Higher contracted price increases to the large regional hospital systems may have been “financed” by minimal or non-existent increases to the marginal hospital players, rather than being passed on to the ultimate employer customer, explaining the overall pricing trend in the above chart.  But it does appear that double-digit rate increases for big hospital systems have taken a holiday.

Conspiracy-minded observers might theorize that the political pressure on the big systems has encouraged them to “lie low” for a couple of years to let the pressure for regulatory solutions subside. Generally, I don’t believe in conspiracies; they are too much trouble to pull off.  Rather, I believe that the negotiating climate between systems and health plans has actually materially toughened. A more plausible explanation for some big systems’ mediocre operating results is that a few really good years led to laxity on the cost control side, requiring health system managers to refocus on efficiency and quality, as indeed Ascension did.  The only way to know for sure is to be patient and let the market reveal itself to us.

The policy challenges created by disinflation are different than those required by hyperinflation. Multiple years of aggressive rate increases by large systems has likely left behind very significant pricing gaps between large and small players in many markets – a source of great vulnerability for these systems in an era of rising cost sharing, etc.

This means that reference pricing strategies that reward consumers for selecting high value providers for certain procedures (imaging, arthroscopy, cardiac care, etc.) – which were discussed in Paul Ginsburg and Gregory Pawlson’s recent paper and advocated by the large self-funded employer collaborative Catalyst for Payment Reform – could have a major effect of shifting volume to more efficient, or less aggressively priced, smaller players, including physician sponsored surgical and imaging providers.

Bruce Vladek expressed doubts about consumers’ ability to exert, or interest in exerting, purchasing power. He’s at least partially right. Consumers of health care are not always price-motivated shoppers and are not capable of exerting influence on the non-elective care hospitals provide. But consumers don’t have to pressure prices across the entire spectrum of hospital services to profoundly affect hospitals’ earnings; moving volume for the highly profitable elective services like imaging and surgery (inpatient and outpatient) will have an outsized impact. Reference pricing should concentrate on this type of elective care that multiple providers, including physician groups and networks, might offer.

The current disinflationary pricing environment for hospitals raises a lot of questions about the need for hospital rate controls or other permanent regulatory remedies amenable to capture by powerful hospital interests. It is possible that a resurgence of cost inflation will lead yet again to outsized rate increases for the most powerful players in local hospital markets. But permanent and rigid solutions to cyclical problems probably aren’t good policy.

Health insurers and employers will certainly need to keep the pressure on their provider networks. But it is clear that the most reliable source of future earnings for these powerful health systems will be in squeezing waste out of their staffing and care processes, and actually finding the elusive “economies of scale” the consultants and bankers have talked about for the past thirty years. Ultimately, as I’ve suggested elsewhere, creating measurable value for the ultimate customer of health care, patients, and their families, is the most reliable and defensible source of future earnings growth.

Originally published on Health Affairs.