Specialty Hospitals: Focused Factories or Cream Skimmers?

Originally published as Issue Brief No. 62 by the Center for Studying Health System Change (HSC), April 2003. Authors: Kelly Devers, Linda R. Brewster, Paul B. Ginsburg. HSC was a nonpartisan policy research organization funded principally by the Robert Wood Johnson Foundation.

Hospitals dedicated exclusively to cardiovascular and orthopedic procedures were spreading rapidly across the country in the early 2000s, forcing communities and policymakers to grapple with difficult questions about the future of hospital care. Supporters of these facilities argued they could deliver better outcomes at lower cost. Critics countered that specialty hospitals might actually degrade quality, push costs higher, and erode access to basic community services. Findings from the Center for Studying Health System Change (HSC) site visits pointed to two primary motivations behind the specialty hospital building wave: the high profit margins attached to select surgical procedures, and specialists' desire to gain more control over their working environment while boosting their income. Policymakers were weighing how to let these facilities compete and innovate without creating problems for quality, cost, or access.

The Growth of Specialty Hospitals

While the United States had long maintained certain kinds of specialty hospitals -- children's facilities, rehabilitation centers, and eye-and-ear hospitals among them -- the new generation of cardiovascular and orthopedic hospitals was a different phenomenon. These facilities were multiplying fast. HSC's site visits and local reporting documented the emergence of 11 specialty hospitals across the 12 communities that HSC tracked between 1997 and 2002. Press accounts showed similar activity in many other markets. Though comprehensive national figures were unavailable, one estimate put the number of such hospitals already operating at 50 or more, with additional facilities under construction. The trend extended a broader pattern of providers placing increasing emphasis on inpatient and outpatient specialty services and of physicians taking ownership stakes in outpatient surgical centers.

Three factors drove specialty hospital development nationally. First, reimbursement rates for certain procedures -- particularly cardiac and orthopedic surgeries -- were substantially higher than for general medical admissions, creating attractive profit margins. Hospital executives had reported since HSC's earliest site visits in 1996-97 that surgical admissions generated far more revenue than medical ones, and that cardiovascular and orthopedic procedures ranked among the most lucrative. It was unlikely payers had deliberately created these payment distortions. Second, specialty hospitals gave physicians greater say in hiring, staffing, scheduling, and equipment purchasing decisions. Third, physician-owners could boost their earnings through higher productivity and a share of facility profits.

Indianapolis: A Case Study in Heart Hospital Competition

Indianapolis offered a particularly vivid illustration of the forces at work. Beginning in late 2000, a metropolitan area of just 1.6 million residents saw four heart hospitals and one orthopedic hospital either open, begin construction, or enter the planning stages. Four major hospital systems competed for high-tech specialty business, and several large single-specialty physician groups practiced across multiple systems.

The chain of events began when cardiology groups tied to Community Health Network (CHN) started talking with MedCath, a national for-profit cardiovascular company, about jointly building a heart hospital. These cardiologists had previously asked CHN to let them take an ownership stake in a new cardiac facility, but the system had declined. Faced with the prospect of losing its cardiologists to a MedCath partnership, CHN reversed course and built a freestanding heart hospital offering physicians up to 30 percent ownership through a joint venture. CHN consolidated its cardiovascular programs into the new facility, located it in an affluent suburb historically served by competitor St. Vincent, added roughly 29 new beds for future growth, and placed the hospital within two miles of its own community hospital to allow easy patient transfers.

St. Vincent faced similar pressure. CareGroup, a physician organization with about 90 cardiologists and 55 internists serving roughly 30 percent of St. Vincent's patients, threatened to sign with MedCath. St. Vincent agreed to build a freestanding heart hospital one mile from its main campus, giving the physicians a 50 percent ownership share. Unlike CHN, St. Vincent did not consolidate its existing cardiovascular programs, meaning the new facility's 122 beds represented entirely new capacity. The two remaining major Indianapolis systems -- Clarian Health and St. Francis Hospital -- responded with their own heart hospitals, though without physician ownership arrangements. Even orthopedic surgeons announced plans for a dedicated 40-to-60-bed orthopedic facility, though financing had not yet been secured.

How General Hospitals Responded

The specialty hospital wave alarmed general hospitals, which depended heavily on the revenue generated by these very procedures. Cardiology services alone could account for 25 percent of all hospital stays and more than 35 percent of total revenue at community hospitals. These services were especially profitable, partly because payer reimbursement formulas had not kept pace with productivity gains in these specialties.

General hospitals adopted several strategies in response. Some built their own specialty facilities to hold onto revenue and retain physicians who might otherwise leave to start competing hospitals. Others formed joint ventures with local physicians, accepting a partial ownership stake rather than losing the business entirely. As one hospital CEO put it: 'Ideally, I'd like to have a whole loaf of bread. But if I can't have that, I'd rather have a half a loaf than none.' A third tactic involved 'economic credentialing' -- denying admitting privileges to physicians with ownership interests in competing facilities. Some courts had upheld this practice, though cases were still pending. When none of these approaches worked, general hospitals faced losing patients and revenue, potentially forcing them to cut unprofitable services or negotiate higher prices for other lines of business.

Quality, Cost, and Volume Concerns

Research had established a link between higher surgical volume and better patient outcomes, and specialty hospital proponents drew on the 'focused factory' concept to argue that concentrating on a narrow range of procedures would increase volume, build team expertise, and drive innovation. Opponents countered that specialty hospitals could not achieve sufficient volume without pulling patients away from community hospitals. If multiple hospitals competed for the same pool of cases, each might end up with too few to maintain quality, and per-case costs could rise due to excess capacity. There were also concerns about overutilization: studies of physician-owned ambulatory surgery centers had shown that physician ownership can distort referral patterns, and specialty hospitals with physician investors might face similar issues.

Both types of hospitals could maintain adequate volume only if demand for specialty services continued growing. Several factors supported rising demand -- population growth, aging, higher expectations for functioning and quality of life, and poor health stemming from smoking and obesity. But other developments could work in the opposite direction. Drug-eluting stents, for example, promised to reduce the need for coronary bypass surgery by allowing more patients to be treated with less invasive procedures or to live longer before surgery became necessary.

Emergency care raised additional quality questions. While some specialty hospitals maintained full-service emergency departments as required by state licensure, others handled only emergencies related to their specialty services. Facilities with limited emergency capacity might lack timely transfer arrangements with general hospitals or staff capable of treating conditions outside their specialty focus.

Access and Patient Selection Issues

Beyond quality and cost, specialty hospitals posed risks to community access. By drawing away the most profitable patients and services, these facilities threatened general hospitals' capacity to cross-subsidize money-losing functions like emergency departments, burn units, psychiatric services, and community outreach programs. Physician ownership created further opportunities for patient selection, since research showed that physicians with stakes in ambulatory surgery centers referred differently than their peers without such interests.

Policy Implications

Policymakers faced the challenge of preserving the potential benefits of specialty hospitals -- innovation, focused expertise, competitive pressure -- while guarding against cream-skimming and harm to community services. Options under discussion included strengthening disclosure requirements for physician ownership, adjusting payment formulas to reduce the profit distortions that fueled specialty hospital growth, monitoring quality outcomes more closely at all types of hospitals, and ensuring that specialty facilities participated in emergency care networks. Congress had imposed a temporary moratorium on physician self-referral to new specialty hospitals while these issues were studied further, and the Medicare Payment Advisory Commission (MedPAC) and others were examining the evidence to inform future policy decisions.

Sources and Further Reading

This Issue Brief was based on HSC site visit findings from 12 communities tracked between 1996 and 2003, with particular focus on Indianapolis as a case study in specialty hospital development. The research was conducted by Kelly Devers, Linda R. Brewster, and Paul B. Ginsburg of the Center for Studying Health System Change. Related work on the focused factory concept, physician self-referral patterns, and the volume-outcome relationship in surgical care provided additional context for the analysis.