Today’s Lab Test Model Won’t Survive Reforms

Doing more testing to drive down unit costs doesn’t work when payers cut lab test prices

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CEO SUMMARY: For more than three decades, independent lab companies have waxed fat by increasing their respective market share of lab test referrals from office-based physicians. This era is poised to end as growing numbers of office-based physicians begin to practice medicine within an accountable care organization (ACO) or similar new integrated care delivery model, while, at the same time, both government and private payers aggressively push down reimbursement for lab tests.

HOW DOES ANY INDUSTRY RESPOND when its most profitable customers undergo a fundamental and radical change to their business model? The clinical laboratory industry will soon need to answer that question for itself.

That’s because, starting in 2012, an extraordinary mix of government and market forces will begin to push the American healthcare system toward very different models of care delivery and reimbursement. The speed with which these changes will take root will catch most clinical labs and anatomic pathology group practices unprepared.

As a consequence, many lab testing organizations will find themselves losing significant amounts of money. They will also lack the management acumen and access to capital required to keep pace with the demands of government health programs, private payers, and providers to perform greater volumes of clinical lab testing at ever-lower prices for this testing.

Unfortunately for independent laboratory testing companies, the one health- care sector that will transform at the fastest pace is that of the office-based physician. Why will this trigger a financial crisis for independent lab companies?

The answer lies in the one great truth about the market for lab testing services in the United States. Since the early 1980s, the major source of profit for independent lab companies has been the lab test specimens originating in physicians’ offices.

Moreover, test referrals from office-based physicians is, itself, a huge market segment. According to Wikipedia.com, there are approximately 230,000 office-based physician practices and groups. Almost 90% of the nation’s 680,000 physicians see patients in an office setting.

Based on its study of the range of trends and reform initiatives unfolding today within the American health system, THE DARK REPORT predicts that, within the next 36 months, there will be significant erosion in the level of reimbursement paid on lab tests referred by office-based physicians. This will disrupt the reliable profit engine that has fueled the growth and financial success of independent laboratory organizations for more than three decades—reaching back to 1980.

Of course, reductions to reimburse- ment on the lab tests originating from office-based physicians will not be uniform across all medical specialties and all types of laboratory tests. Some medical specialty testing areas will continue to generate ample reimbursement.

Revenue-Per-Requisition

But what will become evident, over the next 60 months, is that the overall level of reimbursement will decline by a noteworthy amount. This will be true when prices across the full menu of clinical laboratory and molecular assays are aggregated. It means that most of the larger independent labs doing routine testing will see average revenue-per-test and average revenue-per-requisition flatten and begin to decline.

THE DARK REPORT is not alone in its analysis of the financial challenges that lie ahead for independent clinical laboratories and pathology groups. Twice in the last six months, our editor has seen presentations by keen strategic thinkers who conclude that the current business model of laboratory testing in the United States and several other developed nations is unsustainable.

It is essential that pathologists, lab administrators, and industry executives understand the changes now unfolding in the American healthcare system and why they will change—in fundamental ways— how the system utilizes lab testing and reimburses labs for these services. To that end, a special session on this topic will take place on May 1-2, 2012 at the upcoming Executive War College on Lab and Pathology Management in New Orleans, Louisiana.

Speakers from two of the world’s most respected business strategy consulting firms will discuss the changes that are coming to healthcare and how they will disrupt today’s status quo in the lab testing marketplace.

Threat to Business Model

First, from Boston Consulting Group, James Tucker will describe the twin vice jaws that threaten the existing business model for independent clinical lab companies. One jaw of the vice is the substantial increase in lab test utilization that is projected due to demographics of an aging population and the increased incidence of chronic disease.

The other jaw of the vice is the expected continual decline in the reimbursement paid by government and private payers for lab test services. As the opposing jaws of this vice come together, many independent labs will have limited options to protect their financial viability.

That is because, under the current business model for independent lab companies, it is higher volumes of testing that generate increased profits due to the economies of scale that contribute to lowering the lab’s average cost-per-test.

Statistical Analysis

Tucker will provide the statistical analysis that shows why this business model for lab testing becomes unsustainable when government health plans and private insurers repeatedly cut the price they pay per test.

For those lab companies organized on the fundamental premise that higher volumes generate higher profits (because of greater economies of scale), the financial squeeze is obvious. A rapid decline in prices paid for tests at the same time that the lab is hit by greater volumes of these same tests, portends financial disaster.

This will be particularly true for those laboratories that have used deeply-discounted lab test prices as a way to access pull-through business. These labs organized themselves around this business strategy: “more volume = lower costs = greater profit from fee-for-service prices.”

McKinsey’s Strategic View

The speaker that follows Tucker will describe the macro trends now reshaping the nation’s healthcare system. It is Paul Mango from McKinsey & Company.

Mango will explain how integration of clinical care and health informatics will take the nation’s health system in unexpected directions. He expects that Medicare ACOs are not to be prime players in this story.

Attendees at the Executive War College will learn about a host of health reform initiatives led by employers, by private health insurers, and by provider groups, that will unfold at a faster pace than similar Medicare and Medicaid initiatives.

Mango is uniquely qualified to explain how these health reform trends will change the lab testing industry. He was the architect of the Reference Laboratory Alliance in Pittsburgh (RLA). This was a regional laboratory network of 40 hospitals that competed successfully for physicians’ office business in the mid-1990s, until the creation of competing health systems in Pittsburgh brought an end to the network. (See TDR, September 25, 1995.)

Negotiating Lab Contracts

Following Tucker and Mango at this session will be Professor Leslie Burnett, Consultant Pathologist at Pacific Laboratory Medicine Services (PaLMS) in Sydney, Australia. Over the past decade, Burnett has been involved at the highest levels in negotiating the national clinical lab/pathology testing contract between the federal government and the lab medicine establishment.

What Australia has that the United States doesn’t is accurate data on national utilization of laboratory testing. This data stretches back into the early 1980s. Burnett will show the year-over-year growth in utilization of lab testing that the federal government now considers to be financially unsustainable in coming years.

Next, Burnett will address laboratory workforce challenges in his country. Medical schools and laboratory science training programs in Australia are already failing to deliver the number of pathologists, clinical chemists, and laboratory scientists required to meet the steady increase in lab testing.

This special session at the Executive War College is designed to give lab administrators and pathologists the full range of information they need to understand how reforms unfolding in the American healthcare system will change utilization and reimbursement for laboratory tests.

Strategic Thinking

It will be the first public forum that presents the strategic thinking and insights about the clinical lab testing industry that has been shared privately with a number of billion dollar lab companies and in vitro diagnostics (IVD) manufacturers.

A key theme here is that the pre-eminence of office-based physicians as the primary source of revenue growth and ample profits for clinical lab organizations over the past three decades is about to end.

It is timely for lab administrators and pathology practice administrators to understand the dynamics of healthcare reform, then prepare an effective strategy to help their lab organizations add value with lab testing services in a financially sustainable manner.

Why Growth Is Slowing at Quest and LabCorp: Analyst Highlights Role of Discounted Prices

MANY PATHOLOGISTS AND LAB ADMINISTRATORS will be interested to learn that some financial analysts on Wall Street are catching on to the negative consequences when lab companies use marginal cost pricing to win new lab test business.

One example is a February 16 web post on SeekingAlpha.com, by hedge fund manager Paul Nouri, titled “Investors Should Wait Out Quest and LabCorp.” He is one of the first to publicly point out that, after paying some $5 billion to purchase large lab organizations since 2006, neither of the two blood brothers “has shown extraordinary growth” during this time, particularly in revenue and specimen volume.

Nouri further stated that this lack of extraordinary growth “can be attributed to a weak pricing environment and meager organic growth. Since LabCorp undersold Quest on the UnitedHealth contract [in 2007], both companies have seen operating margin erosion.”

He discussed the strong growth rates of the clinical laboratory testing divisions at Enzo Life Sciences, Inc., and MedTox Scientific, Inc. Among other factors, Nouri attributed their rapid increases in market share to “physician discontent in dealing with large firms such as Quest and LabCorp.”

“The large labs are comfortable with their position in the market and have significant contracts negotiated with providers [and payers],” noted Nouri. “In any industry, this can lend itself to a sense of complacency.”

Debt from Stock Buybacks

He went on to point out that both companies “are saddled with nearly $4 billion in debt after spending over $2 billion to buy back 36.5 million shares over the past three years and making over $1 billion in acquisitions.”

In Nouri’s view, the two companies face an uphill fight. “Looking at Quest and LabCorp, it’s difficult to see how either company will excel in the current environment…” he wrote. Further “…the lab space is an easier space for Medicare to cut [lab test prices] than the aforementioned sectors. First, Quest and LabCorp control more than two-thirds of the non-hospital clinical lab market [read: office-based physicians market]. Lawmakers could feel more comfortable making cuts to what is perceived to be a couple of large players…”

It is a fact of life in the marketplace that when companies use “cheapest price” to win customers, they can generally only hold on to those customers so long as they continually underbid the price of competitors. Once another firm offers price-sensitive customers an even lower price, that customer will rapidly switch loyalties to gain access to those lower prices.

‘Meager Organic Growth’

Nouri’s observation that the “lack of extraordinary growth” at Quest and LabCorp “can be attributed to a weak pricing environment and meager organic growth” is based on recognition of this business principle. A significant portion of the core routine testing business at both of the two Blood Brothers is highly sensitive to price.

This is true of the managed care contracts with major health insurers that have been negotiated at prices reported to be at 40% or even less than Medicare. It is also true of client-bill accounts in states that allow physicians to mark up lab testing services. In these regional markets, Quest Diagnostics and LabCorp have been aggressive at using deeply-discounted prices to win the specimen referrals from these office-based physicians.

Today, both lab firms must deal with the consequence of their “lowest price” strategy. They know that, if they raise prices on these customers, that business will move to a lower-priced competitor. Meanwhile, as Nouri points out, smaller competing labs that “focus on service” are able to “gain and maintain their client bases”—frequently by taking customers away from Quest Diagnostics and LabCorp.

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