Can compensation paid to a hospital-employed physician be Fair Market Value (FMV) when the hospital loses money on the professional practice?
Recent government interest in the topic, as well as ongoing debates on the applicability of the Income Approach when valuing physician compensation, have highlighted the need to address this question. This article will explore the complexity of the issue, including some of the reasons why practice losses occur and focus specifically on the impact that operating in a quasi-regulated industry has on the determination of FMV.
Market Dynamics Impacting Physician Practices
Understanding the market dynamics impacting physician practices is an integral part of identifying why practice losses occur and how FMV is implicated when a hospital is subsidizing physician compensation. Below are four important market factors that affect the finances of a physician practice.
Advances in healthcare have led to an increased life expectancy for Americans, and we now face an aging population. With an aging population comes an increased demand for healthcare services. While increasing life expectancies is positive; it does put a strain on healthcare resources.
Supply and Demand of Physicians
Over past decades, the supply of physicians has not been able to keep up with demand. Now, the Affordable Care Act (ACA) has increased the number of insured patients, further increasing demand for healthcare services. One recent study reported a shortage of 46,100 to 90,400 physicians by 2025. The market is responding with non-physician practitioners, such as nurse practitioners and physician assistants; however, the demand for physicians will continue to exceed the supply.
Hospital Employment Physician Practices
Over the past decade, there has been a substantial swing from private practice groups to hospital employment. Many financial changes occur when a hospital operates a physician practice. While these changes often have a positive financial impact, such as improved insurance contracts or bargain purchasing power for certain supplies, other changes often increase the expenses of the practice, such as increased salaries and benefits and overhead allocations from hospital departments. In addition, a hospital may choose to move certain services previously offered by the practice to another department of the hospital, whereas private practices take advantage of the in-office ancillary exception and often realize a profit from those ancillaries. Private practices must “break even” to stay in business; however, hospital-owned practices are merely a department or subsidiary of a larger operation and do not necessarily have the same economic restrictions.
Medicare is the most significant payer for many physician practices. It is the rare physician practice that can survive without participating in the Medicare program. But, Medicare reimbursement rates are not negotiated like other payers; they are regulated by Congress. Sequestration and other government imposed sanctions increase the pressure on available dollars to fund Medicare. Recently, a budget deal was struck to keep the federal government functioning and depends largely on Medicare cuts. Additionally, government payers, such as Medicare and Medicaid, are typically the lowest payers in a market. Changes in Medicare do not only impact government payers in the long run; Medicare largely sets the reimbursement for much of the healthcare market. Commercial insurances often index their fee schedule to the Medicare fee schedule, so when Medicare cuts rates, the commercial insurances presumably will follow.
Each of the above dynamics can contribute to physician practice losses. Valuators have an obligation to gain an understanding of a client’s business and industry, including the dynamics listed above. As such, each of the above market factors can significantly impact a FMV analysis. Below, we will discuss the resulting implications for FMV.
Impact on FMV
The aging population, coupled with the supply and demand for physicians, creates a significant amount of pressure on the physician practice model. Traditional market theory of supply and demand does not hold true in physician practices, due primarily to a regulated reimbursement model. As previously discussed, demand for physician services is exceeding supply. The increase in demand is reflected in market data traditionally used to value physician compensation, but is not reflected to the same extent in the government reimbursement. Further, the aging patient base that is creating much of the demand is increasingly covered by Medicare. Unfavorable payer markets and the requirement for hospitals to treat patients regardless of their ability to pay further increase the volume of Medicare, Medicaid, and uninsured patients. This will generally lead to lower reimbursement, leaving less money available for physician compensation, and potentially leading to losses at the practice level.
The question remains: can physician services be supported as FMV even when practice losses are incurred? In attempting to answer this question, we must consider how FMV is determined. Valuators are required to consider all three primary valuation approaches: the Market, Income, and Cost Approaches, and then use professional judgment to determine the applicability of each.
As healthcare valuators, we have historically been somewhat limited to the Market Approach for physician compensation valuations. With the inapplicability of the Cost Approach, along with the issue of physician practice losses, ultimate reliance on the Market Approach is commonplace. However, ultimate reliance on the Market Approach does not diminish the importance, or responsibility, of considering the Income Approach.
The application of the Market Approach alone results in compensation driven by market data without consideration for the economic impact on the hospital or practice. This creates risk, as inappropriate application of the market data causes self-perpetuating increases in physician compensation without regard for the impact on the hospital.
Conversely, in situations where a hospital is incurring a loss on a physician practice, sole reliance on the Income Approach would not be adequate to support competitive or FMV physician compensation. However, many valuators feel singular reliance on the Income Approach in such a situation would not result in an appropriate indication of FMV, due to the market factors and restrictions discussed above. Assuming the employing hospital has sufficiently documented the community need for the physician’s professional services, and physician compensation can be supported as FMV under the Market Approach, it may be appropriate to place little to no reliance on the Income Approach in a final conclusion of value.
Valuators, attorneys and the government have all considered the implication of practice losses on FMV, and the theoretical debate is sure to continue. The facts and circumstances of each market and each individual transaction between a hospital and physician should be carefully considered in conjunction with practice losses and the Income Approach to value. Proper documentation of factors such as community need, physician supply and demand, and the history and ability to recruit in a particular market are just a few of the factors that should be analyzed when determining the FMV of physician compensation and the appropriate consideration of the Market or Income Approaches.