BB&T Contributing Editor

IRVINE, California – The market for healthcare products and services, including the medical device and diagnostics segment, has exhibited attractive growth recently, driven by increasing demand for healthcare worldwide. Growth in the medical device and diagnostics sector, for example, has averaged between 8% and 9% over the past four years, and is projected at 7.2% per year over the next four years, with the global market expected to exceed $225 billion in 2006.

While challenges are now emerging that could represent barriers to growth in the future, there also are opportunities, particularly in certain segments of the market. The opportunities and challenges facing the U.S. healthcare system were the topic of this year’s Health Care Forecast Conference, organized here by the Center for Health Care Management and Policy of the Paul Merage School of Business at the University of California Irvine (UCI).

Healthcare information technology (IT) is one area of opportunity, based on applying technology to increase the productivity and efficiency of the healthcare system, creating market growth for IT suppliers while helping to resolve profitability issues for providers. Major challenges exist, however, in creating an environment that provides the proper incentives for adoption and in implementing IT that produces true improvements in productivity and efficiency. Additional challenges exist in restructuring healthcare systems worldwide to cope with the conundrum of rising demand for and cost of healthcare services in the face of limited financial resources.

Key topics covered at the UCI conference included trends in healthcare insurance, economic trends, recent initiatives by the federal government to rein in healthcare cost increases, and challenges faced by healthcare providers, including hospitals and practitioners. The impact of the political climate on trends in the healthcare system also was discussed in depth at the conference, with a consensus that the likelihood of any major new initiatives emerging from the federal government is low, given that 2006 is an election year in Congress. There are also a number of issues related to political scandals that are likely to preoccupy legislators, along with an unusually short legislative schedule.

The lack of action by legislators, however, does not mean that healthcare suppliers and providers will be unaffected by changes in healthcare policy. In particular, cutbacks in Medicare and Medicaid spending already are scheduled for implementation in 2006 that could have a significant impact on both providers and suppliers. Those cutbacks are being implemented in spite of questions about the legal validity of the legislation on which they are based.

Changes in the structure of healthcare insurance, most importantly in the area of consumer-driven health plans, also are moving forward since they have already been cleared by legislators, but their impact is controversial. Some presenters at the UCI conference also indicated that healthcare providers may be contemplating changes in the structure of their care delivery programs, particularly in the area of disease management.

IT to transform healthcare?

Healthcare IT has often been cited as a tool that has the potential to provide major improvements in efficiency and productivity for healthcare providers. Some experts believe that the widespread implementation of healthcare IT, in the form of electronic medical records (EMRs) and connectivity extending throughout the U.S. healthcare system, could provide a significant reduction in overall cost.

Roger Taylor, MD, of the RAND Corp. (Mississauga, Ontario, Canada), presented the results of a study of the costs and benefits of electronic medical record systems that shows benefits are large relative to costs, but that major barriers exist that limit the realization of the potential benefits. Taylor has quantified the productivity improvements achieved in other industries, such as in retail and telecom, and modeled the impact on healthcare spending that would result if similar improvements were realized in healthcare. For example, the retail industry has realized a 1.5% annual improvement in productivity from implementing IT, and the telecom industry has realized an annual improvement of 8%.

If the healthcare industry realizes a 1.5% productivity improvement, Taylor projects that total healthcare spending in 2016 would drop from $4.2 trillion to about $3.3 trillion, potentially reducing national healthcare spending from 20% of GDP to about 16%. If a 4% productivity improvement were achieved (one-half that achieved by the telecom industry), total spending would drop to about $2.3 trillion, reducing spending as a percentage of GDP to 11%, significantly improving the outlook for dealing with the burden of affordability of healthcare in the U.S. economy.

The RAND study analyzed the potential benefits of implementation of EMRs and EMR systems (EMR-S) throughout the U.S. healthcare system, and barriers to implementing EMR-S. The EMR, which replaces the paper medical record, forms the basis of an EMR system, but the EMR-S adds a number of higher-level functions such as clinical decision support, patient tracking and reminders, personal health records, computerized physician order entry, interface with knowledge banks, care guidelines, and interface with other providers, patients, and regional networks.

At present, an EMR in some form has been implemented in only 20% to 25% of hospitals and 10% to 15% of physicians’ offices nationwide. Connectivity of EMRs and higher-level functionality has not yet been implemented to a significant degree outside of certain integrated provider organizations.

The RAND researchers identified three key elements that must be in place in order to realize maximum benefit from EMR system adoption. Those elements formed the base assumptions for the model evaluated in the study. First, widespread adoption (90%) of EMR systems is needed. Second, effective connectivity across providers and with patients is required. Third, improvements in the healthcare system that can be enabled by EMR systems must be implemented, such as team care for chronic disease management, prevention and wellness education and reminders, a focus on improving quality and efficiency, and restructured processes and workflows.

A key factor for widespread adoption of an EMR, as discussed by Vijay Gurbaxani, PhD, associate dean and professor of information systems at the Paul Merage School of Business, UC Irvine, is establishing standards for the EMR and for connectivity of the EMR system. Standards are particularly important in a fragmented industry such as healthcare. Gurbaxani noted that Kaiser Permanente (Oakland, California) has achieved a high level of adoption of healthcare IT because it has set standards that are followed throughout the organization.

The results of the RAND study show that, while there is a substantial cost to implement a nationwide EMR system, the benefits should more than justify the investment. As shown in Table 1 below, the study estimates the efficiency savings from widespread EMR system adoption at more than $600 billion over 15 years, vs. a cost for implementation of about $120 billion, resulting in a five-fold return on investment.

The majority of savings (75%), as well as investment, are attributable to the hospital sector, although the return on investment is higher for physician offices. In addition, a number of safety and health benefits are likely to accrue from EMR system adoption, including fewer errors from illegible handwriting, reduced adverse drug events, better delivery of preventive care and self-care, and better management of chronic diseases.

The value of the health and safety benefits in terms of cost savings for the U.S. healthcare system are estimated at $162 billion per year, more than doubling the savings from efficiency improvement alone. Improved preventive care, one of the benefits that could result from nationwide EMR adoption, offers an example of the health benefits that could be realized. As shown in Table 2, a large percentage of the population is currently not compliant with disease screening and vaccination programs, resulting in later detection of diseases such as breast and colorectal cancer and more costly treatment as well as a higher death rate. Lack of compliance with vaccination programs also results in more deaths and needs for acute care, leading to higher healthcare costs.

There are, however, a number of barriers to widespread EMR system adoption. These include a disconnect between who pays for healthcare IT and who benefits from its adoption, a lack of standard-based EMR systems, lack of connectivity between providers and with patients, lack of market pressure or infrastructure to support performance-based improvements and competition, and a disincentive for sharing of clinical information between unaffiliated organizations since most healthcare provider groups view patients as key competitive assets that must be protected.

Taylor recommends initiatives by government and payors to provide incentives for standards-based EMR adoption, potentially including targeted subsidies to develop regional health information exchange networks, initiatives to reduce the risk of adoption and networking, and a monitoring system to assess adoption patterns and needs. One proposal is a per-encounter payment to physicians who adopt EMRs. He estimates that a $1.60 incentive per encounter provided over a three-year period would cost $2.2 billion but show a benefit/cost ratio of 8.5:1. Similarly, a targeted 80% hospital subsidy for EMR system implementation would cost $15 billion but show a benefit/cost ratio of 5:1.

Another factor impeding the adoption of EMR systems is the rather poor track record of past investments in healthcare IT. In reality, most IT investments in healthcare have not paid off, at least for those who have made the investment, due largely to the disconnect between who pays and who benefits. Also, as discussed by Andrew Wiesenthal, MD, associate executive director of the Permanente Federation for Clinical Information Support (Oakland, California), 60% of all large healthcare IT projects fail, creating a high-risk setting for healthcare providers or government organizations that are considering such investments. The recent announcement by President George Bush to commit funding of $61.7 million for the Office of National Coordinator of Health Information Technology and his call to establish a national interoperable electronic health record within 10 years are indicators that government is beginning to play a role in moving healthcare IT forward.

Key suppliers of healthcare IT products include Cerner (Kansas City, Missouri), Misys Healthcare Systems (Raleigh, North Carolina), McKesson (San Francisco), Meditech (Westwood, Massachusetts), EPIC (Verona, Wisconsin), GE Healthcare (Waukesha, Wisconsin) and Siemens Medical Solutions (Malvern, Pennsylvania). As discussed by Chris Brandt of Deloitte Consulting (Los Angeles) at the UCI conference, there has been a considerable amount of consolidation within the healthcare IT vendor segment recently, as exemplified by GE’s acquisitions of IDX Systems (Burlington, Vermont) and a number of smaller vendors of healthcare software products. GE has evolved its product line to add clinical information systems to its portfolio, expanding beyond the financial focus characterizing most healthcare IT products originally.

Suppliers who did not add clinical IT lost share in the market as customers increasingly have demanded such capabilities. An issue for transitioning to an integrated nationwide EMR system is that different hospitals and provider groups use different IT vendors, creating difficulties for physicians who need to interface electronically with multiple hospitals, and pointing to the need for industry standards that will help resolve connectivity issues. Some progress is being made, as evidenced by Siemens’ announcement in late January of the implementation of a regional electronic health information network linking Northwest Physicians Network (Tacoma, Washington) and St. Luke’s Health System (Boise, Idaho), allowing the exchange of clinical health data between different provider groups across significant distances. An indication of the future direction of healthcare IT described by Wiesenthal at the UCI conference is Kaiser Permanente’s network, which already has been implemented in most of the Kaiser facilities in the U.S. and will be completed in 2007.

Because of the integrated nature of Kaiser itself, standardization of IT was more readily accomplished than in the entire U.S. healthcare system. As a result, a member in any of the nine states included in the Kaiser organization will by 2007 be able to go online to make appointments, order medications, access lab results, talk with a doctor and access his or her own medical record. The Kaiser system also provides decision support tools and online reminders.

Information can be shared nationwide within the Kaiser network, which includes 8.4 million members and logs 40 million ambulatory patient visits annually. Kaiser initially attempted to develop its own IT network internally, but eventually switched to an external vendor, EPIC, that now is supplying Kaiser’s systems nationwide.

The most difficult segment of the healthcare system in which to implement EMRs is the physician’s office, due to the large number of independent practices, lack of capital to invest in EMR systems, and lack of time and IT expertise to devote to the task of implementation. As discussed by David Kibbe, MD, director of the Center for Health Information Technology at the American Academy of Family Physicians (AAFP; Washington), there are about 150,000 small medical practices in the U.S., vs. about 5,000 non-federal hospitals.

Based on AAFP statistics, 70% of physicians practice in groups of five or less. The number of patient encounters, and the related need for health information, is about 1 billion per year in the physician’s office, at an average patient charge of $200, vs. about 8 million hospital visits annually at an average charge of $50,000 per visit. Hospitals spent about 5% of revenues or $24 billion total in the U.S. in 2004 on IT, while less than 1% or under $2 billion was spent in the physician office.

Clearly, the current level of IT investment is highly imbalanced compared to the relative amount of healthcare spending in each segment. The situation is beginning to change, however. Kibbe’s data on the 95,000 physician members of the AAFP show that the use of electronic health records increased from 10% of practices in 2002 to 30% in 2005. Physicians also perceive IT to be less risky now than in 2003.

The main factors limiting adoption of EHRs in the physician’s office include cost and concerns about a decrease in productivity. The average cost for a fully integrated EHR for a physician’s office is $7,232 per physician, according to data presented by Kibbe, although costs vary widely, and can range as high as $134,750. One possible approach to resolving the cost issue, he said, is for hospitals and insurers to serve as sources for EHR implementation in the physician office, since both would also derive benefit. Regardless of the funding source, there is obviously a large, mostly untapped market for EHR systems in the physician’s office.

Another driver of growth in the healthcare IT market, which may become increasingly important in the future as trends such as pay for performance become more prevalent in the healthcare system, is investment in EHRs and clinical information systems as a means to quality improvement.

Continued growth in healthcare market

Continued expansion of the market for healthcare IT products, and of the healthcare market overall, is virtually assured by the aging of the U.S. population, growth in the use of technology in healthcare, and patient demands for best available treatment. Total spending on healthcare in the U.S. is projected to increase at 7.2% annually on average from $2 trillion in 2005, or 16.2% of GDP, to $4 trillion by 2015, or 20% of GDP, based on current assumptions of spending and economic growth.

Certain segments of the market, however, will exhibit higher growth than others. For example, as discussed by Paul Ginsburg, PhD, president of the Center for Studying Health System Change (Washington), a recently conducted nationwide survey of the healthcare provider market shows that hospitals are focusing on expansion of profitable specialty services such as cardiovascular therapy, orthopedics, neurosurgery and oncology. Hospitals also are expanding their emergency departments to capture more inpatient volume and focusing their expansion in rapidly growing affluent areas.

At the same time, physician groups are expanding ancillary services that can be provided on an outpatient basis such as ambulatory surgery, endoscopy, imaging and diagnostic testing. Mergers of physician practices also are occurring due to the need to build scale for equipment investment, a trend that is aided by technology advances that permit smaller scale facilities requiring less capital to be built.

Another trend noted by Ginsburg is the expanded use of hospitalists who assume responsibility for patient management once they are admitted. That trend tends to cause primary care physicians to lose their connection with the hospital, further fueling the competition between hospitals and physicians.

The broadened competition between hospitals and physicians might be expected to control cost increases, but Ginsburg believes that ways in which the two segments are competing may actually drive up spending and threaten access to care for the less affluent. For example, many service expansions are focused on growing affluent areas, where patients have the ability to pay, while inner-city hospitals are faced with obsolete facilities and limited ability to raise capital for upgrades. There also is a decline in the alignment of specialists with hospitals, creating difficulties for hospitals in maintaining, let alone expanding, services.

Another key trend in the healthcare market is the growing utilization of consumer-driven health plans (CDHPs), a factor that is driving growth in the managed care sector. A number of experts presenting at the UCI conference expressed pessimism regarding the positive impact of CDHPs, and in particular effectiveness of the primary tools of such plans, including Health Savings Accounts (HSAs) and Health Reimbursement Arrangements (HRAs) in limiting growth in healthcare costs. HSAs and HRAs are designed to make patients better consumers of healthcare by providing an incentive to shop for providers who offer the best value, primarily for non-catastrophic illness.

According to Jon Gabel, vice president of the Center for Studying Health System Change, 4% of firms in the U.S. now offer an HRA or HSA, and 26% are likely or very likely to offer a high-deductible plan with an HRA or HSA within the next two years. The plans are more popular with employers and insurers than with employees, as indicated by statistics showing that only 7% of employees choose an HSA if offered both a conventional insurance plan and an HSA plan. A recent survey by America’s Health Insurance Plans (Washington) found that 1 million HSA policies had been sold as of March 2005, and more recent data suggests that enrollment could be as high as 3 million, although that figure may include high-deductible health plans without an HSA.

As discussed by Pat Bousliman, a member of the Senate Finance Committee, the experience to date with HSAs is not highly favorable, with only about 1.2% of all covered workers in HSA-qualified high-deductible health plans. A key issue is the difficulty of shopping for healthcare due to limited access to comparative cost and quality data. The ability of consumers to make well-informed choices about the cost of competing healthcare options is a key requirement that is needed in order for CDHPs to work as intended.

Another negative factor is that health insurance plans with an HSA option tend to attract healthier and higher-income workers, and not necessarily the sicker patients with chronic diseases who account for the majority of national health expenditures. On a positive note, proponents claim that 33% to 40% of enrollees in HSA plans were previously uninsured, so the plans may be more affordable than conventional insurance for lower-income workers. Nevertheless, the experience with HSAs so far does not indicate that they are the solution to the problem of affordability of healthcare.

Budget cuts to impact market growth

One of the most important factors expected to affect the healthcare market over the next few years is the Deficit Reduction Act (DRA) enacted in late 2005. The act is designed to produce $40 billion in net savings for the federal government over five years (FY 2006-2010), and $99 billion in savings over 10 years. One-third of the five-year savings are generated from reductions in Medicare and Medicaid spending, including a $6.4 billion reduction in Medicare spending and a $6.9 billion reduction in Medicaid spending over five years. In addition, the act links payment to performance by requiring hospitals and home health agencies to submit data on quality measures in FY07 or receive a payment reduction of market basket minus 2%. Baseline performance measures are to be adopted beginning in October.

In January 2007, the act makes imaging services provided in physicians’ offices (X-ray, ultrasound, nuclear medicine, MRI, computed tomography and fluoroscopy, but not diagnostic and screening mammography) subject to payment caps, and could have a significant negative impact on the market for diagnostic imaging equipment. Questions have surfaced regarding the validity (and legality) of the DRA because different versions of the bill may have been signed by the House, the Senate and the president, which violates legislative rules and makes the bill illegal.

In spite of the questions surrounding the DRA, the Centers for Medicare & Medicaid Services (CMS; Baltimore) is moving ahead to implement the changes called for in the bill. Cuts in Medicare spending are also proposed in the President’s FY 2007 budget that if implemented could have significant impacts on certain segments of the medical device market. Table 3 lists a summary of the proposed Medicare savings in the president’s budget. Major cuts are proposed for hospital inpatient spending, phasing out of bad debt payments, knee/hip replacement post-acute care, home healthcare, skilled nursing facilities, and oxygen rental. The cutbacks in knee/hip replacement, home healthcare and oxygen rental, which total $12.5 billion over five years, could have a significant adverse impact on suppliers in those segments.

Government payors are not likely to be alone in targeting cutbacks in reimbursement for healthcare products and services. Private insurers have been much less aggressive in increasing insurance premiums over the past two years, as discussed by Gabel. While increases in health insurance premiums remain well above the overall rate of inflation and the increase in workers’ earnings, the rate of increase has dropped by almost one-half, from over 14% in 2003 to 9.2% in 2005, and a further drop in the rate is anticipated in 2006 to the 7% to 7.5% range, according to Gabel. The declining trend is expected to continue, creating pressure on insurers to cut increases in reimbursement to providers. In part, the rate of increase in insurance premiums has been dropping, however, because insured members have been switching to plans with higher deductibles, and paying more costs out of pocket.

Another issue for payors is that one strategy they have been banking on to control increases in healthcare costs, namely disease management programs, is not proving as effective as hoped. As discussed by James Baumgardner, deputy assistant director for health policy in the Congressional Budget Office, new studies about to be released show that disease management is not paying for itself. While disease management may produce better patient outcomes, it may cost more to get that benefit. CMS also has been targeting disease management as a tool to control costs, and has been conducting demonstration programs in disease management, but one major participant in those programs recently dropped out due to cost issues. Trends in the insurance industry are not positive, indicating that insurers may begin pressing for reductions in healthcare costs more aggressively. One leading insurer, UnitedHealth (Minneapolis), may report an $800 million cash loss for 1Q06, according to Sheryl Skolnick, PhD, of CRT Capital Group (Stamford, Connecticut).

One positive factor is that the current economic expansion is expected to continue at least through 2007, providing a basis for growth of the healthcare market and a comparatively stable environment for investment. According to projections by Jim Glassman, PhD, of JP Morgan Chase (New York), the U.S. economy will grow 4.3% in real terms in 2006, and growth in 2007 will be about 3.8%. Concerns about the negative impact of the U.S. budget deficit on the economy appear overblown, since the federal budget deficit for 2005 and the projected 2006 deficit are both at 2.6%, very near the midpoint of actual deficits over the past 40 years. The deficit in percentage terms is less than in Japan and Europe, according to Glassman, so there is not significant pressure to implement drastic measures to reduce it. Furthermore, as shown in Table 4 below, the deficit is forecast to decline over the next few years (based on current assumptions) and return to a surplus in 2012. The projected deficit for 2005 was slightly higher than the actual deficit, lending some confidence to the latest projections.

Long-term, growth in entitlement programs including Medicare, Medicaid and Social Security is a major concern, leading to the proposed cuts. Consequently, the goal of legislators is to find a means of reducing the excess cost growth of the Medicare and Medicaid programs, i.e., the growth in program spending in excess of GDP growth. Over the 1990-2004 interval, excess growth in Medicare was 1.9% per year, and for Medicaid the excess growth was 1.4%. Elimination of excess growth would result in spending as a percentage of GDP increasing by only about 2%, whereas excess growth of 2.5% could drive spending for Medicare and Medicaid alone from about 5% of GDP at present to well above 20% of GDP by 2050, an untenable level. Clearly, continued budget-cutting initiatives by CMS and by legislators are in store for the future as government attempts to prevent healthcare from bankrupting the federal government.