Healthcare Advisor: Hospitals and Physician Practice Losses – Do Not Accept it at Face Value

February 2, 2017 by Ken Conner, CPA,  David Cranford, CPA,  Ira Bedenbaugh

In the early 2000s we began to see the first wave of physicians unwinding themselves from hospitals and regaining their independence. Since that time, hospitals have now begun the next round of integration of physician practices through employment, acquisition or other means. Hopefully, everyone is a little wiser and now enters the arrangement with eyes wide open. No longer do we see the purchase prices that existed with Phycor, MedPartners and other roll-up companies– and the competitive hospital pricing that ensued. We now see productivity and quality based models that create greater accountability with the idea of protecting against losses. While hospital physician integration will be judged by access, quality and value, it is still important that the health system be fiscally responsible.

Before an employment or acquisition, practices generally operate at a breakeven with all of the year-end cash distributed to the physician owners. However, hospitals still face losses from owned practices. So what happens once they are acquired? How can a hospital better prepare to avoid or minimize losses before the transaction or employment closes?

As we have all learned from past experience, physician operations are not without financial and operational challenges. Two very different cultures must blend together. The independent spirit of one group must figure out how to work in the corporate structure of the other and vice versa. But with hospitals ‘controlling’ the finances and physicians held to productivity, why do some struggle and others thrive? Our experience has shown us that the success or failure can be summarized in a few words: expectations, process and accountability.

Past experience should also tell us to begin identification of financial issues or changes impacting financial performance, as early as possible, preferably before closing the employment or acquisition.

The financial struggles of hospital-owned practices may arise from a variety of issues. When losses occur, many immediately point to compensation, while others point to the inability of a hospital to manage physician practices. Much has already been written on the regulatory emphasis of FMV compensation, and for the sake of this article, we assume that, at the time of the transaction, the compensation was fair market value. This article focuses on experiences associated with integrating practices. Each practice is different and, no matter how many physician transactions the hospital has done, it will be the first and only for the physician practice. Furthermore, how the hospital adapts its own policies and procedures to fit a physician practice will impact the success or failure.

We divide the issues based on common traits from which they arise. These can be positive, negative or both, depending on how they are managed. One common thread is knowing from where you started, or having a good benchmark. The six primary areas that challenge the financial success of physician hospital integration are:

  • Functional – This includes physicians with minimum staffing levels that, based on volume, may require subsidy – Hospitalist, Emergency room, Anesthesiology may require financial subsidy to compensate for the treatment of charity, Medicaid or indigent patients. It may also include on-call payments to a variety of specialists.
  • Organizational – These are policy changes to the operations or finances of the practice based on the hospital’s corporate structure, including benefit cost and overhead allocation. Some of these issues, such as hospital cost structure, may be avoided by maintaining a separate physician organization.
  • Operational – How well does the hospital-physician organization perform versus the previous physician practice?
    • Is there a billing system conversion?
    • Who is in charge? Does the practice management team have enough authority to deal with both the hospital and the physician? Is the physician undermining authority or resisting needed changes?
    • What is the cost of upgrades to the practice? (Including recruitment of new physicians and physician extenders.)
    • Poor management performance – how much is this mistaken for one or more of the items listed above?
  • Structural – The biggest of these is whether or not ancillaries and mid-level providers remain part of the practice, but may also include the structure of physician compensation, payer mix, and the use of physician extenders, as well as, office expansion or location.
    • Changing incentives from new compensation models – If they go to Production-only, then they are no longer responsible for expense control.
    • Transfer of ancillary revenue and profitability to the hospital books.
  • Cultural – Everyone should expect a change in any transaction and the potential for conflict. The key is to work to minimize issues arising from the change in culture and structure by preparing in advance and being responsive as issues arise.
    • Physician becomes disengaged from practice operation – They can either agree to pass on the responsibility of operational control and participate or the hospital takes total control without buy-in.
    • Cultural shifts or conflicts in operation – Human Resource policies, purchasing practices, resistance by physician to the new work environment
  • Errors or mistakes that may misstate the true performance – These arise from matching of revenues and posting of expenses or compensation calculations.

Analyzing the Profitability of a Practice

Attached is a table of 16 challenges where we begin to explore some of the issues in more detail. There is an underlying theme of examining what the practice looked like before the transition to the hospital ownership or management. Understanding how the practice performed in the period leading up to the effective date is critical to evaluating any of the problems above. What was working? What was not? What changed? Did it have to change?

Highlighted below are a couple of excerpts from the table.

Wage and Benefit Structure for Employees

Issues 5 and 6 in the table address changes in wage and benefit structure. A hospital should develop a budget for the new practice considering changes in staffing (including positions or services, such as general accounting or transfers from the practice to a more centralized physician practice revenue cycle operations); wage adjustments, if any required, for internal equity; increases or decreases in the benefit cost due to plan design, employee participation, employee cost sharing, holiday and time off policies, etc.; changes in direct overhead cost, including office relocations with new rent structures; elimination of site specific costs borne by a central office; and the list goes on. These changes are likely to produce a combination of savings or additional costs. The expected impact of the transaction should be monitored comparing the actual results to the assumptions. For example, suppose a practice required the employee to pay $800 per month for family health insurance but the hospital requires only $400 per month for a slightly richer plan but roughly the same total cost. Immediately, the hospital would see an increase in benefit cost of $4,800 for each employee covered by a family plan and, likely, additional cost of some who may have not elected coverage under the physician practice.

Ancillary Revenue

Issue 14 addresses ancillary profit and the transfer of some or all ancillary services to the hospital. The elimination of ancillary revenue from a practice can be a major factor in post transaction practice losses and warrants additional attention. Ancillary revenue is, in many specialties, a key component of income for the practice and thereby part of compensation. The consistent treatment of ancillary profits in the transaction and in the determination of FMV compensation is critical, and the two must be considered both individually and together as part of one transaction. It is important to understand what is happening to ancillary revenue and to monitor revenue and expense for items in the practice over the long term as well.

When considering FMV compensation, it is important to recognize that physician compensation reported in various surveys will include compensation derived from in-office ancillaries, leverage from physician extenders and overall profitability of the practice. But not all physicians in the survey will have meaningful in-office profits, and many large groups are distributing profits equally. The distribution of ancillary profits varies with the size of the group and the means of allocating in a Stark compliant manner.

It is preferable to recognize ancillary profits separately if they are removed from the practice post-transaction. However, as a minimum, if there is not upfront payment from ancillaries, amounts ‘built’ into compensation can be effectively recognized as an ‘installment’ sale of the ancillary cash flow. Such cash flow should be identified on the front end and consistent with the FMV of such profits at the time of the transaction.

Profit in the Operation of the Practice

Issues 4, 11 and 12 address the hospital operation of the practice and related expense.

We must remember that the success of the pre-hospital financials was based on the encounters and procedures (wRVUs), profitability of ancillary services and the control of practice expenses. A successful practice with high volumes and efficient systems will produce a profit from additional volume once the fixed cost has been covered. A physician, as any small business owner, doesn’t make any money until there is enough money to cover all expenses. But because many of the expenses are fixed (ex. rent, certain salaries and insurance), the more services that are provided, the more likely a profit is available from sources other than wRVUs. So a physician may collect $40 per wRVU based on the average of all payers. But a physician may earn $55 dollars per wRVU because the practice operates efficiently enough to ‘profit’ from the RVUs associated with practice expense RVUs and ancillary services. Can the hospital operate the practice in a manner that will produce a profits from practice expense RVUs?

While physician practices should cover their share of direct overhead from all sources, the practices can be judged for only what they consume and control. Measuring the practices’ Contribution Margin is more meaningful than measuring performance with indirect overhead. Hospitals must be honest about what direct overhead is and what indirect overhead is; anything that can be directly attributed to the physician practice should be. If an item cannot be directly allocated or assigned, is there a proxy or market value to use? Be careful not to be arbitrary in the allocation of cost. For example, it will typically cost less to contract the cleaning of office space than to have it cleaned by hospital staff and allocate all that goes with a 24-hour-a-day hospital environment.


While significant losses by a hospital from its physician practice might be a red flag to regulators or would-be whistleblowers, there may be many reasons for the reported losses. The hospital is responsible for identifying and mitigating, as much as possible, the factors generating the loss or reducing profits. A hospital must understand the losses, document the relationship of the losses to the hospital’s overall mission, work to improve the profitability of the practices and monitor compensation over the long term for appropriateness.

Regardless of the regulatory issues, hospitals have a fiduciary responsibility to the organization to operate a physician practice in the most efficient manner for the physician, the patient and the organization as a whole, not unlike other areas of hospital operation.

Key Takeaways:

  1. Benchmark the pre-transaction performance. Document any immediate changes to the practice’s expense or revenue.
  2. Give the practice management group authority and talent to run the practices in collaboration with the physicians. How high in the hospital organization does practice management report?
  3. Understand that the compensation methodology is a key factor in the practice profitability and correctly administering compensation. Compensation Compliance doesn’t stop at the FMV opinion. It is an ongoing process that includes monitoring the proper periodic calculation, coding and physician performance.
  4. Invest in physician assimilation into the new organization. Integrate a physician and their staff into billing, scheduling, medical records and human resources as soon as possible so that addressing transition issues and obtaining standard use of systems quickly lead to a more efficient practice.
  5. Manage the Contribution Margin considering all direct cost at the practice and consolidated level. Consider using a separate organization to operate the practices allowing for different benefit plans, personnel policies and accounting staff (when appropriate and financially feasible).

Interested in learning more about our support to physician practice and hospital integration or how to improve the financial results of physician practices, contact us.

Printable Version and Table of 16 Challenges