Wednesday, June 1, 2016

The New Medicare Gold Rush

(A version of this column was published by Forbes.)

Over the next few years, Medicare will significantly change how it pays hospitals, physicians, and other providers. This is sparking a gold rush among investors. BDO, a leading management consulting firm, released a report last month describing significantly increased private equity investment in long-term care facilities, rehabilitation facilities and home health agencies. BDO reported 79 deals in 2015, in which private equity sponsors invested $5.92 billion, up from just $1.67 billion in 2014. The previous high-water mark was $3.58 billion in 2011.


A key driver of these deals is innovation in the way Medicare pays for certain procedures. Until now, doctors have been paid using a technique that would make a Soviet bureaucrat blush. William Hsiao, the economist who designed it, determined Medicare’s fees as follows:

He put together a large team that interviewed and surveyed thousands of physicians from almost two dozen specialties. They analyzed what was involved in everything from 45 minutes of psychotherapy for a patient with panic attacks to a hysterectomy for a woman with cervical cancer. They determined that the hysterectomy takes about twice as much time as the session of psychotherapy, 3.8 times as much mental effort, 4.47 times as much technical skill and physical effort, and 4.24 times as much risk. The total calculation: 4.99 times as much work. Eventually, Hsiao and his team arrived at a relative value for every single thing doctors do.
(Rick Mayes and Robert A. Berenson, Medicare Prospective Payment and the Shaping of U.S. Health Care, Baltimore: Johns Hopkins University Press, 2006, p. 86.)
Hospitals were originally paid in a similar “cost plus” way. Later, Medicare introduced Diagnostic Related Groups (DRGs) made up of identifiable episodes. An important example is MS-DRG 470, which comprises “major joint replacement or reattachment of lower extremity without major complications or comorbidities.”

DRGs were an improvement, because they approximated how a customer would pay for a procedure in a normal market. (For example, if you rent a hotel room, you do not pay separate charges for renting the furniture in the room, housekeeping, utilities, depreciation of the building, et cetera.)
Nevertheless, the government still decided what goods and services were in each DRG, and what the payment would be. Because the boundaries of each DRG were usually restricted to procedures performed inside hospitals, this introduced a perverse incentive: If a discharged patient is re-admitted for complications resulting from the initial procedure, the hospital makes more money!

This makes it very difficult for hospitals to compete on either cost or quality. The Affordable Care Act of 2010, which gave us Obamacare, set out to improve this by introducing a new agency, the Center for Medicare & Medicaid Innovation (CMMI). CMMI has courted controversy by making some of its innovations mandatory for the time being, although only for selected providers. Other providers are prevented from adopting the innovation immediately. This allows CMMI to observe the results as in a randomized clinical trial of a new drug, and then propose whether it should be more broadly adopted.

Hopefully, this will result in faster and better innovation than Medicare has experienced until now. While Medicare has sponsored countless voluntary pilot studies, they attract providers which already know they can succeed in the pilot study. This means the results are not scalable.

One new mandatory “experiment” is Comprehensive Care for Joint Replacement, launched in 67 Metropolitan Statistical Areas last April. The model combines the physician and hospital components of hip or knee replacement (including MS-DRG 470) into one payment. More importantly, it lengthens the scope of the payment to include 90 days of costs after discharge. Hospitals will suffer financially if a discharged patient is re-admitted because the joint replacement was not done right the first time.

This is what is driving private equity investment in post-acute care facilities and services. The site of discharge is a significant factor determining whether a patient discharged from hospital will bounce back. Sending a patient straight back home without follow up will often result in his early return to hospital.

Post-acute care providers now have opportunities to enter deals with hospitals and doctors that will result in shared savings within the 90-day period, if the post-acute care providers can reduce the likelihood of hospital re-admission.

There are a lot of moving parts to these deals, and the risks are not yet fully known. Nevertheless, the current crop of "experiments" is just the beginning. Medicare has gained confidence in its campaign for innovative payments, especially as a result of an April 2015 law that gave Medicare even more power to experiment with new payment models. This law passed with huge bipartisan majorities in Congress, imparting momentum to payment reform without the stigma of Obamacare.

More reforms will come quickly, continuing to present opportunities to investors.

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