BBI Contributing Editor

"Know your customers" is a fundamental tenet of successful sales in any industry. So sales executives, reimbursement experts and regulatory staff of medical device companies have been trying to follow the dizzying ups and downs of their customers – especially hospitals – during the last several years. Changes in reimbursement methods, changes in Medicare budget allocations and changes in the fundamental structure of the hospital industry have challenged medical technology companies' abilities to keep abreast of and properly interpret their customers' needs. One thing is certain, however: These changes have taken a substantial toll on hospitals' financial strength.

Hospital statistics covering the last couple of years show an industry struggling to maintain or achieve profitability. In a report issued earlier this year, Solucient (formerly HCIA Sachs; Evanston Illinois) indicated that hospital operating profit margins were flat at an annualized average of 3.69% in 2000, an "unsustainable" margin, particularly in light of spiraling pharmaceutical costs and pressure from continuing hospital labor shortages. "Average operating margin percent" measures the percentage of revenue generated from patient care services after all related expenses have been accounted for. The disappointing margin gains in 2000 capped several years of declining profitability for the nation's hospitals.

In fact, margin pressures extended to hospitals of all sizes, according to the Solucient report, from hospitals with fewer than 150 beds to hospitals with more than 300 beds showing only slight operating margin increases over those reported in 1999. This is particularly worrisome because many hospital analysts had predicted that by December 1999 hospitals would have begun to recover from the dramatic reductions in Medicare reimbursement contained in the Balanced Budget Amendment (BBA) implemented in 1997.

For-profit and not-for-profit hospitals are both struggling. A report published in Modern Healthcare in June indicated that not-for-profit hospitals in 2000 lagged significantly behind for-profits with respect to operating margins. Not-for-profits managed a slim 0.6% operating margin in 2000, compared to a 9.4% margin for for-profit hospitals. Despite the better showing by for-profit hospitals, industry experts view the 9.4% margin as a major disappointment. According to the Modern Healthcare report, a healthy operating margin for for-profit hospitals is in the 13% to 17% range and 2% to 4.5% for not-for-profit hospitals.

Impact of reimbursement changes

The biggest recent impact on hospital margins occurred in 1997, when Congress passed the BBA. Under this reform, Medicare enacted a number of changes that effectively rolled back reimbursement to hospitals. These included reductions in Diagnosis Related Group (DRG) inflation payments, graduate medical education program payments, disproportionate share payments, bad-debt expense reimbursement and a number of other Medicare-financed programs.

Perhaps more importantly, however, the BBA mandated the implementation of new reimbursement programs for hospital outpatient services, skilled nursing services and home health services – all service lines that hospitals had invested heavily in during the late 1980s and early 1990s as part of the shift to managed health care. Medicare reimbursements for all of these services have shifted from a fee-per-procedure program to a prospective payment system where hospitals are paid in advance for these services.

In particular, the hospital outpatient prospective payment system, known as OPPS, has fundamentally changed the way hospitals are reimbursed for services provided in outpatient clinics and surgical areas. The new system – initially implemented in July of last year and modified since then – relies on a system of Ambulatory Patient Classifications (APC) that provides a fixed rate of reimbursement for categories of outpatient services. Under the OPPS, outpatient procedures and some medical visits are grouped into several hundred APCs, each with associated reimbursement based on historical costs. In addition to the APC payments, for a limited time hospitals also will be eligible to bill Medicare directly for some medical technologies meeting specific Center for Medicare Services (CMS; formerly Health Care Financing Administration; Baltimore, Maryland) criteria under a program known as "transitional pass-through" payments. These payments are limited to new medical technologies that were not included in the APC reimbursement calculation. These transitional payments can last for a maximum of two to three years, at which time the APC payment is supposed to be accurately recalculated to account for the cost and use of the new technology.

Although the ultimate financial impact of the outpatient prospective payment system is not yet clear, early estimates suggest that the program may increase the pressure on margins that hospitals as a group already are experiencing.

Some reimbursement relief

While some Medicare reimbursements continue to decline, hospitals have managed to win some reimbursement relief from non-Medicare commercial insurance carriers and from the inpatient Medicare program. In rules issued early last month and scheduled to be implemented in October 2002, the CMS is planning to pay hospitals supplemental amounts for new technologies whose costs are not yet accounted for in DRG payments. These supplemental payments would go into effect when the use of a new technology raises a hospital's per-case cost a certain amount above the average DRG. Medicare will compensate the hospital 50% of the excess cost. The hospital and medical device industries were disappointed both at the narrowness and perceived miserliness of this ruling. Nonetheless, this is an important development for both hospitals and medical technology companies because new technology has a dramatic and immediate negative impact on hospital profitability if it must be absorbed within static DRG payments.

To their relief, many hospitals have been successful in wringing additional reimbursements from commercial insurance carriers and HMOs during the past year. In fiscal year 2000, hospitals were able to offset stagnant government increases in reimbursement with heftier payments from other insurers, contributing to the slight uptick in operating revenues for the year compared to 1999. However, when commercial payments rise, so typically does the number of uninsured, which tends to increase hospitals' bad debts. Commercial insurance carriers raise premiums to employers in order to fund reimbursement increases to hospitals and physicians. As premiums rise, more employers, especially small employers, terminate insurance programs, cut back benefits or drastically increase employee contributions, sometimes causing employees to voluntarily withdraw from insurance coverage. After nearly a decade of low single-digit increases in health insurance costs, premiums rose an average of 8.3% in 2000 and 11% in 2001. The premium increases for 2001 represented the largest jump in costs since 1992. (Health Affairs, September/October 2001)

Procedure-related margins

As reimbursement for medical procedures and technologies continues to be volatile, medical costs continue to increase. Pharmaceutical costs are cited as the primary culprit underlying recent medical cost increases, but industry data indicate that increasing retail pricing of physician and hospital services, combined with the rising costs and use of medical technology, are important components as well. When hospital revenue (based on reimbursements from Medicare and insurance companies) remains flat while costs increase, hospital margins suffer. Hospitals are acutely aware of the procedures that make money and their willingness to purchase and adopt new technologies is in part tied to the current state of profitability of the clinical areas the technologies support.

In an effort to deal with declining reimbursements and rising costs, hospitals began a furious consolidation binge some eight years ago. The idea was that large systems of hospitals could generate efficiencies in buying power and insurance company contracting over and above that possible as a single independent unit. As hospitals consolidated, excess space and facilities were closed, reducing the total number of beds available in U.S. hospitals from 1,035 in 1997 to 1,013 in 1998 to 994 beds in 1999 (Hospital Statistics, 2001; American Hospital Association). At the same time, the number of inpatient admissions to hospitals has risen, reflecting our aging population. Consequently, occupancy rates for hospitals have been rising steadily during the last three years as smaller, leaner hospitals experience rising hospital admissions and pressure on the very low length-of-stays the industry was experiencing just a few years ago. The National Hospital Indicators Survey, published by CMS, illustrates the change in hospital admission and inpatient day patterns. In 1998, there were 25,953 admissions and 135,084 inpatient days in U.S. hospitals. By 2000, those figures had risen to 27,436 admissions and 141,849 inpatient days. Some industry experts are calling this awkward situation "profitless growth."

Profitless growth refers to hospitals that are at or near capacity in terms of bed occupancy – usually a good thing – but still experiencing stagnant or declining per-patient and per-bed profitability. In this situation, hospitals have no choice but to focus on reducing procedure-related costs. It is in this arena that innovations in technology can have a real impact. If technologies can be shown to reduce the costs associated with a given procedure while meeting or exceeding current clinical outcomes, then technologies can contribute substantially to hospital profitability. For technology companies seeking to develop targeted sales programs, an appreciation of hospitals' occupancy rates, their procedure-related operating margins and their costs can go along way toward designing pricing, packaging, reimbursement and sales programs that truly meet their customers' needs.

(Next month: How some hospitals make decisions about capital equipment purchases, medical device purchases and new service offerings.)