CEO Summary: In a groundbreaking study just released, consulting firm Alvarez & Marsal determined that as many as half of the nation’s hospitals are failing to generate enough patient revenue to sustain expenses! With a median occupancy rate of 43%, these hospitals are likely to experience a wave of bankruptcies, financial restructurings, and forced mergers. This is the second major report in 24 months to describe how and why many hospitals are failing to compete effectively against physician-owned facilities and why consumers are voting with their feet.
ABOUT HALF OF THE ACUTE-CARE HOSPITALS in the United States are insolvent and teetering on the edge of bankruptcy, according to a recent study conducted by Alvarez & Marsal, LLC, a restructuring and consulting firm in New York. Of the 3,900 acute care hospitals studied, at least 2,000 were not making a profit on patient care.
These findings should catch the attention of pathologists and laboratory directors working in hospitals and health system laboratory organizations. THE DARK REPORT believes the findings in the Alvarez & Marsal (A&M) study, titled “Hospital Insolvency: The Looming Crises,” presage a coming overhaul of the hospital industry in the United States. Should that scenario occur on the scale A&M’s findings indicate, then these events could directly affect—and dramatically change—the clinical laboratory and anatomic pathology professions.
Alvarez & Marsal, LLC, prepared the report after studying the financial operations of 3,861 of the 4,900 acute-care hospitals operating in the United States. Out of the total 3,861 hospitals studied, Alvarez & Marsal said 2,044 don’t make a profit on patient care. (See study methodology in sidebar on page 14.)
The bad news doesn’t stop there. Alvarez & Marsal determined that 744 hospitals in the study earn so little that they cannot fund day-to-day operations, make needed repairs, or support basic capital expenditures. These findings led the study’s authors to estimate that capital expenses in U.S. hospitals are underfunded by as much as $20 billion.
A&M identified two characteristics about the most financially troubled hospitals, saying, “737 hospitals, or 19% of the sample, had both negative care profitability and EBITDA margins below 4%. Hospitals with 100 to 300 beds represented 44% of the universe, but 46% of potentially insolvent hospitals.”
Access to sufficient numbers of patients is a major reason so many hospitals are failing to generate adequate revenue to fund daily operations, make necessary repairs, and provide the capital needed for major facility improvements. A&M observed that, “Potentially insolvent hospitals had a median occupancy rate of 43%, compared to 53% for the remainder of the universe.”
For many hospital-based laboratory managers and pathologists, A&M’s conclusions are not good news. “Similar to competitive markets in other industries, second-tier and third-tier competitors (small and mid-size urban hospitals) are rapidly losing ground to the dominant medical centers and integrated delivery systems in their service areas,” wrote A&M. “A ‘flight to (perceived) quality’ is occurring by both physicians and patients—creating a bigger gap between the fiscally strong and fiscally weak hospitals in a given market.
Losing Patient Admissions
“Lower-tier hospitals cannot offer the competitive equipment and amenities available from their larger, better-capitalized rivals,” continued the study’s authors. “Physicians cannot justify admitting to second-tier and third-tier facilities when the market leading hospitals have beds available.”
In a surprising finding, A&M determined that urban hospitals are under greater economic pressure than are rural hospitals. “Contrary to conventional wisdom, urban hospitals have a greater chance of being insolvent than rural hospitals,” declared A&M. “While rural hospitals enjoy quasi-monopolistic markets, the 100- to 300-bed urban hospitals must face the brutal competition offered by well capitalized academic medical centers and integrated delivery systems located in population centers. It is this group of hospitals where decisive and immediate strategic decisions must be made to ensure survival.”
The unbroken 30-year trend of double digit growth in outpatient procedures is also a major factor in the failing finances of many hospitals. A&M stated that, “In an effort to preserve income levels, physicians are banding together and stripping profitable services out of hospitals and establishing alternate settings [outpatient services]. Services such as MRI and day surgery, once big money-makers for hospitals, are now cash cows for physicians.”
Intense, New Competition
Hospitals face intense, new competition for patients by better-managed hospitals and physicians. At one time, of course, all patients stayed in hospitals for a number of days and many hospitals, particularly those in small towns, had little if any competition. But the relentless focus on cost control over the past two decades drove down length of stay and made hospitals compete for patients. At the same time, physicians and entrepreneurs have taken patients away from hospitals by developing alternative facilities such as ambulatory surgery centers and outpatient clinics.
A&M predicts an epic struggle lies ahead between hospitals and the physicians that refer patients. “With dwindling reimbursement, a Darwinian drama may play out as physicians will be more inclined to satisfy their own income demands, regardless of the consequences to the hospital,” stated A&M. “For the over-leveraged group of potentially insolvent hospitals (debt to assets of 71%, compared with 43% for all other hospitals), it will be difficult-to-impossible to find the investment dollars needed to improve amenities and re-attract physicians. Hospitals must explore alternate organizational structures that create an alignment of physician and hospital incentives with institutional mission.”
The need for hospitals to align themselves with physicians is exactly what Paul Mango, Consultant at McKinsey & Company, predicted. THE DARK REPORT was first to introduce the laboratory profession to McKinsey’s strategic predictions for the hospital industry. (See TDR, September 5, 2006.)
In a 2006 report titled, “U.S. Hospitals in the 21st Century,” Mango and his colleagues laid out radical strategic transformations that will occur to the nation’s hospital industry. In the report, McKinsey stated, “ many hospitals will have to reorganize around a narrower range of clinical activity,  differentiate themselves on quality and service,  think more like the retailers they are fast-becoming, and  overhaul their relationships with physicians.”
McKinsey further explained the problems created by competition from physicians and the effect of consumer choice. On physician competition, McKinsey wrote that “these structural weaknesses [of hospitals] have created openings for more focused providers that increasingly offer superior value: lower prices, higher quality, and better service. Stand-alone ambulatory service centers (ASCs), diagnostic imaging centers, endoscopy suites, and specialty hospitals have become powerful competitors. More are surely on the way as equity markets (both public and private) and physicians themselves pour capital into that sector.”
In explaining why consumers increasingly prefer other treatment settings over hospitals, Mango and his colleagues wrote, “Knowledgeable, value-conscious patients are beginning to view some hospitals as less effective places to seek care compared with many of their alternatives, including physicians’ offices.”
Reinforcing this new consumer attitude is the change in health benefits plans, which the McKinsey report described, stating, “at the same time, payers and consumers are becoming much better at recognizing and acting on price and value differences. Patients have much more at stake with the advent of high-deductible health plans [HDHPs].”
In many ways, the A&M report validates McKinsey’s strategic assessments by documenting how: 1) the same trends McKinsey described (and A&M corroborated) have already eroded the financial stability of half of the nation’s community hospitals, leaving them at dangerous levels; and, 2) what effect inadequate capital has on the ability of financially weak hospitals to attract patients.
“Physical plants at many community hospitals have deteriorated since capital spending has been necessarily curtailed due to lack of funds,” A&M reported. “We estimate that capital expenses in the hospital industry are $10 billion to $20 billion underfunded. Like it or not, the practice of medicine is a consumer-facing business. (Italics by TDR.) The lack of attractive—or even acceptable—physical facilities is a contributing factor to the decline of many hospitals.”
This next A&M prediction should catch the attention of laboratory directors and pathologists working in any financially-struggling hospital. “There are scores of hospitals that are slowly asphyxiating and slipping into insolvency as they divert capital dollars to fund operations,” wrote the study’s authors. “For most of these hospitals, it is only a matter of time before they hit a ‘sudden’ liquidity crisis and cannot make payroll without entering insolvency and being forced into restructuring their finances and operations.”
Decades Of Underinvestment
In a written statement, George D. Pillari said, “The findings of this study underscore the sobering reality that decades of incremental change have not ensured the long-term viability of our nation’s hospital system.” Pillari is Managing Director in Alvarez & Marsal’s Healthcare Industry Group. “With a government safety net becoming less and less reliable and non-patient sources of funding becoming fragile, it has become critical for hospital management and boards to deal with these troubling issues head on and take urgent steps—such as restructurings, mergers or recapitalizations—to improve their finances and allow hospitals to execute on their missions. In the absence of such action, hospital insolvencies will increase and community after community could be forced to grapple with a steady decline in access to care,” he wrote.
Hospitals At Financial Risk
In addition, Pillari had another, more frank prediction: “Today there is a large—and growing—number of hospitals at risk for insolvency if their sources of nonpatient funding falter. While such subsidies have been easily accessible and almost guaranteed during the boom times of the past two decades, strains on government coffers and broader economic forces will put an end to the trend. Management and boards of hospitals must take action quickly to ensure long-term solvency. The alternative as experienced in New York State—is that the government will take steps independently to deal with over-leverage, underutilization and excess capacity.”
This is the second time in 24 months that THE DARK REPORT has alerted lab directors and pathologists to the looming financial crisis in the nation’s hospital industry. It is important to note that, in every sizeable community, tertiary care and academic hospitals are generally doing quite well. However, most of the American public does not recognize that as many as half of the second-tier and third-tier hospitals in the same community are operating on a razor-thin financial margin.
Labs Should Be Watchful
This situation offers both an opportunity and a challenge for hospital lab administrators and pathologists. An effective laboratory outreach program can make important contributions to the hospital’s cash flow and cost structure. But the parent hospital may not have the capital necessary for the outreach program to build the infrastructure needed to support and grow the business.
Lackluster Executive Leadership in Hospitals Is A Significant Factor in Poor Financial Performance
IN EXPLAINING WHY SO MANY HOSPITALS are teetering on the edge of insolvency, the authors of the Alvarez & Marsal study were extremely critical of the performance of hospital and health system administrators.
“As a result of the predominantly non-profit nature of the hospital industry (and the corresponding lack of equity-based compensation), the industry has not attracted the best and the brightest management talent,” wrote the A&M study’s authors. “Without true economic stakeholders, [hospital] management and boards across the industry have been accountable typically only to themselves and more vaguely, their ‘community missions.’ This has created a situation where distressed hospitals limp along on life support at 43% occupancy. In most industries, a plant running at 43% capacity would be closed or consolidated.
“Not so in healthcare,” they continued. “The tangle of religious, governmental and community missions allows the industry to tolerate excess capacity that would be unheard of in rational economic markets.
“The hospital industry, for the most part, has tolerated decades of incremental performance change, with few institutions showing the willingness to embark on more significant change- driven measures,” said the study’s authors, “such as restructurings, mergers or recapitalizations, that occur regularly in other industries to turnaround troubled organizations and improve financial and operational performance. Soon they may no longer have a choice—unless the choice is to simply shut down.”
Alvarez & Marshall Started With 4,510 Hospitals in Study
TO conduct its study of hospital finances, Alvarez & Marsal (A&M) gathered data on 4,510 hospitals. These data included operating expenses and net revenue for fiscal years ending in 2005 and 2006 for each short-term acute care hospital in the U.S. with more than 25 beds. If data for a hospital were unavailable, A&M eliminated that hospital from its study.
This reduced the final sample from 4,510 to 3,861. To ensure the sample was representative and unbiased, A&M then compared this sample to the universe, as published in the American Hospital Association’s directory, Hospital Statistics.
Alvarez & Marshal used two key measures to analyze hospital performance. First was patient care margin, calculated as (net patient revenue less operating expenses)/ net patient revenue. The second was EBITDA margin, calculated as (net income + depreciation + amortization + interest + taxes) /operating revenue, where operating revenue is net patient revenue + all other revenue. Also defined in the A&M study was how certain financial ratios would limit the strategic options of hospitals, as follows:
Patient Care Margin less than 0.0%— If a hospital cannot earn a profit on its patient care services, it must rely on non-patient care sources of funding to remain viable. Hospitals not earning a profit on patient care will become insolvent when they can no longer sell or borrow against assets, or receive emergency governmental aid to fund losses.
EBITDA Margin less than 4.0%—A minimum level of profit and cash flow is required for a hospital to fund daily expenses and re-invest in necessary, nondiscretionary capital expenditures. Capital investment needed to remain competitive is estimated at 6.0% to 8.0% of annual operating revenues. This analysis identified a level of 4.0% as the minimum level of profitability for a hospital under pressure to fund day-to-day activities, as well as a “survival” level of capital expenditures.