Wednesday, January 26, 2011

Business Risk and the Physician Reimbursement Model

Picture this. You're a lawyer or financial adviser. You operate independently and take enormous pride in the service you perform. At the same time, you understand that your service is a business, and that no matter how much pride or skill you possess, your business won't float if you don't cover costs.

Now imagine that an obscure regulatory body determines exactly what your clients pay you. Oh, and the people who pay you aren't the ones who actually consume your services.

Talk about out-of-control business risk. On the one hand, straightforward market supply and demand dictate the price levels of your expenses. On the other hand, an anonymous group of people big enough to fill the corner coffee shop presets the price levels of your revenues.

In the normal world, if your costs rise you adjust prices accordingly. If you're a skilled business person and understand your market and customers, you'll set prices that match your specific demand.

In this alternative world, because you have no control over prices, you're reduced to vendor pleading. Any negotiating position—call it pricing power—you might otherwise have had simply does not exist.

That world, of course, is health care.

In health care, the 240,000-member American Medical Association convenes a 29-person committee that 'recommends' physician reimbursement rates to the Centers for Medicare and Medicaid Services ("CMS"). Since CMS accepts and implements the committee's recommendations 90 percent of the time, the committee has become the de facto market price-setter.

Once a year, the Relative Value Scale Update Committee (or "RUC") makes its recommendations. Every five years, it submits broad reviews.  RUC has "no official government standing", according to the Wall Street Journal. "Members are mostly selected by medical-specialty trade groups. Anyone who attends its meetings must sign a confidentiality agreement."

"In sessions that can stretch 12 hours or longer each day," the Journal notes, "the committee walks through dozens of services. The discussions can be mind-numbing—a subcommittee once debated whether to factor tissues into the payment for a psychoanalysis session."

But as obscure as RUC is, the formula that CMS uses to determine its fee schedule and implement the committee's recommendations might as well exist a hundred miles underground. Writing in the New York Times, noted health economist Uwe Reinhardt explains the Resourced-Based Relative Value Scale ("RBRVS") as follows:

In a nutshell, for a particular service (e.g., a routine office revisit or an appendectomy or a heart transplant) that we shall call Z, Medicare pays a fee calculated with this formula:

FeeZ is the dollar amount of the fee paid for the service, Work RVUZ denotes the relative value units for the physicians’ work going into the production of service Z, PEZ denotes the relative value units of the physician’s practice expenses allocated to service Z and PLIZ denotes the relative value units for the professional liability insurance premium allocated to service Z.

Each of these three relative cost factors is adjusted for its own geographic price index, GPCI in the equation. Thus, there is one GPCI for the physician’s work, one for practice expenses and a one for malpractice premiums.

The sum of these three RVU components, adjusted by their GPCIs, is multiplied by CV, the conversion factor. This is the dollar amount that Medicare pays for one overall RVU.


Maybe to a Princeton economist—or a PhD in mathematics or, for that matter, a Wall Street quant—it makes perfect sense. For most physicians, RBRVS is just the way the world works.

In fact, because the average doc contributes no input anyway, the formula could be any number of tangled algorithms. The consequences would be no different.

And let's not forget that CMS is the dominant payer. Commercial health plans, rather than undertaking an entirely different approach, simply base their rates on what it—the government—pays. (So much for moving to a single payer system.)

Perhaps one of the least noted risks to health care is a sudden and sustained change in vendor pricing levels.

The United States hasn't experienced double digit inflation for 30 years—10 years prior to Congress legislating the RBRVS standard. Nevertheless, price volatility ebbs and flows.

As the chart below shows, current volatility is the highest since the 1960s. (We calculate volatility as the annualized ratio of standard deviation in the Personal Consumption Expenditures index to its mean—the coefficient of variation.)

More than the absolute price level, what's important to business owners is the extent of variation. High variation increases business risk especially for folks with little or no pricing power, and vice versa.

Several experts warn that overly aggressive fiscal and monetary policy could resurrect 1970s-style inflation. Consumers need only visit the local gas station to experience one commodity already rapidly rising in price.

Volatility, of course, would persist (likely elevate) as the economy jumps to this higher level.

What if rents, utility bills and other business costs remain unstable? How does RUC, which only makes its recommendations once a year, compensate for this?

In the collapsing municipal bond market, we see not just the dire finances of state and local governments, but extreme regional economic conditions—unimaginably complex for a 29-person body to manage.

Simply put, committee-based pricing encourages consolidation. It handicaps practitioners who want independence. And it contorts basic economics, favoring obscurity over transparency and inflexibility over resilience.

On Wall Street, bankers—the conventional ones advising corporate bosses on deals and financing, and who generate revenues based on negotiated fees—are ascendant again, replacing enigmatic quants and their bullet-proof trading models. In health care, the foundation stones remain an obscure decision-making process and an indeterminate formula.

To be sure, the same certainty that existed on Wall Street where a limited group of really smart people could protect a business model continues to apply to the care delivery system.

For a lawyer, financial adviser or just about anyone else outside of the health industry, the ability to price a service is an essential business tool.

For a physician that inability is fast-becoming a sacrifice in independence.

Thursday, January 20, 2011

A New Yardstick for PDUFA Reauthorization

For better of worse, PDUFA reauthorization will likely be the only FDA-specific legislation that the 112th Congress considers, notes Steven Grossman in Perspectives. You can bet, therefore, that the 2012 bill will become a lightning rod for device and drug industry issues.

User fees constitute 20% of the FDA's budget, plugging a near $500 million gap that federal appropriations (the agency's other revenue source) leave open.  In the prescription drug program, the split is 50:50.

The nation's economic backdrop and emphasis on deleveraging will also weigh on the legislative debate. And depending on how health reform plays out and the extent to which it bites into device- and drug-maker profits, industry could strongly resist efforts to shift more responsibility for the agency's budget onto its shoulders, i.e. paying even higher fees.

The tax payer, meanwhile, will certainly take note of the more-than $2 billion in annual appropriations that the bill will lift from his pocket.

The FDA's scope is endless. At least six to 10 times each day we interact with products it regulates—equal to roughly 25% of consumer expenditures in the United States. Its oversight encompasses 80% of the food supply and nearly every radiation-emitting device.

As with any regulatory body, it fights a constant battle of keeping pace with innovation. It features staffers much less well-paid than their industry counterparts, and substantially inferior technology and organizational structure than fast-evolving private enterprises.

Any massive budget surge would likely produce only a fleeting advantage, if one at all.

It should be no surprise, then, when the debate over user fee reauthorization begins later this year that many will scrutinize the agency in a different way. Rather than size, the yardstick will likely be return on investment. (If the new Congress accomplishes anything, it will be the introduction of more business-centric language to debates on the Hill.)

Industry will question the limited extent to which increasing user fees have yielded new product approvals, and whether the Patient Protection and Affordable Care Act and other legislative burdens allow for even higher fees. Taxpayers will question the responsiveness and adaptability of an even larger agency.

At this early point in time, the odds favor a future bill resembling previous reauthorizations—an inflation-adjusted continuation of the same model.

In the coming months, those odds could change substantially.

Wednesday, January 12, 2011

The Upside-Down World of CEO Pay

Perspectives latest article targets the upside-down world of CEO compensation at the nation's biggest publicly traded companies. Upside-down because risk and return, in contrast to the way it should happen, correlate inversely.

"Short-term perspectives", it begins, "increasingly dominate how we think and perform."

Too often, boards of directors dismiss the long-term interests of their companies and their shareholders, as a result.

Even in this tenuous post-financial-crisis world, legislators and regulators still won't acknowledge a dangerous, persistent market distortion. What happened before will likely happen again to the detriment of shareholders:

Did Robert Nardelli's contract terms serve Home Depot's shareholders well when the board offered him $82 million ($20 million due in cash within the first 30 days) if it dismissed him?

Did Carly Fiorina's $21.4 million pre-nup serve her shareholders well?

What about Stanley O'Neal and Merrill Lynch? He steered his shareholders into subprime mortgages in the mid 2000s, and was fired “for cause” in October 2007. Still, he pocketed $94 million.

Did legislators and regulators hold directors responsible in any of these cases? Of course they didn’t.

The solution isn't a government mandate or compensation czar, but rather a shift in incentives that allows "old-fashioned entrepreneurship to root itself beyond privately-held enterprises".

And the best way to alter incentives is to alter the tax code.

Read "Turning Fat Cat CEOs into Long Term Lions" here.