The physician compensation conundrum
Experienced healthcare professionals have seen a steady wave of physician practice acquisitions by health systems over recent years. While the activity level has ebbed and flowed, most health systems have maintained an interest in expanding their medical groups, either through outright acquisition with employment or through other affiliation strategies, such as professional service arrangements (PSAs). But, regardless of the particular structure, a key consideration in these transactions is the level of compensation paid to physicians.
Health system executives must balance their desire to present an attractive offer to physicians with various healthcare compliance considerations, including IRS private inurement, the anti-kickback statute, and Stark laws. Although each area of compliance has unique attributes, they all have similar requirements for transactions involving health systems and physicians. For instance, they all stipulate the purchase price paid to physician owners and the post-deal physician compensation arrangements must be supportable under the fair market value (FMV) standard of value and, under certain circumstances, the transaction must also meet the commercial reasonableness (CR) standard.
A common method used to support the FMV/CR of compensation arrangements involves physician compensation surveys. The survey method includes a comparison of the proposed compensation arrangement to data from the surveys. If the proposed level of compensation falls within the range indicated by the surveys, health systems have generally felt comfortable the compensation terms were supportable under the FMV/CR standards. Many professional service firms have also followed this approach when issuing independent opinions of FMV/CR.
But certain healthcare compensation pundits have expressed caution with this method, since the surveys typically do not represent a random sample and often only represent a small percentage of practicing physicians. Further, surveys often combine data provided by survey respondents from large geographic areas, including both urban and rural settings that may have unique payer and reimbursement dynamics. Despite these limitations, though, the surveys have been heavily utilized over the years and continue to be referenced by many health system executives.
Those opposed to sole reliance on the survey method recommend an alternative – the cash flow method – that involves an analysis of the compensation level that could be funded by the target practice. The cash flow method includes analysis of historical and projected financial performance of the target practice and estimation of the compensation pool that could be funded from ongoing practice operations. Various operating expenses may be adjusted as part of the analysis if they would not be expected to continue following a transaction. For example, expenses related to a physician’s automobile lease may be eliminated, and those dollars would be available to fund additional compensation. But the cash flow method can pose challenges, since it can yield materially different conclusions than the survey method.
Let's look at an example that highlights the potential challenges to both methods. An established primary care practice with ten physicians is approached by a local health system interested in acquiring the practice and employing the physicians. The average compensation of the physicians in the practice’s latest fiscal year was $175,000, after adjusting expenses as described above.
The physicians have told the health system they require the median level of compensation for family practice physicians reported in the 2016 MGMA Provider Compensation and Production Report. The physicians also communicate to the health system that they're aware of employed primary care physicians at a competing health system earning that level of compensation.
The MGMA Report median figure of $230,000 is $55,000 higher than the level of physician compensation that could be funded by the target practice. If the practice maintained similar financial results following the transaction and the median level of compensation was paid, the health system would have to fund a $550,000 annual operating loss. To further complicate the situation, the health system indicated that it's currently paying from $200,000 to $220,000 to recruit new primary care physicians to its medical group.
How does a health system deal with the conundrum? The following four considerations can help bridge the gap between the survey and cash flow methods:
- Expense savings and operational synergies
- Taking a deeper dive into the target practice’s financial performance may identify additional operating expense savings to offset the potential loss. Staffing costs are typically the largest expense for practices, and many buyers – including health systems, private equity groups and other physician practices – may be able to reduce staffing levels in the future by consolidating operations.
- Enhanced reimbursement and collection opportunities
- Enhanced reimbursement opportunities may be available following the transaction, although any upside that would not be attainable by private physicians, such as a shift to provider-based reimbursement, could be subject to compliance challenges. Improved billing processes and collection activities may result in improved cash flow.
- Physician productivity
- Although many private practice physicians may be earning compensation below the median levels reported in various surveys, the physicians’ productivity – expressed as either work RVUs or collections – often exceed survey medians reported for those metrics. Identifying highly productive physicians can help support compensation increases.
- Multiple sources of market data
- Taking additional compensation surveys into account can help validate figures reported in the MGMA Report. In addition to surveys, other sources of market data include compensation figures provided by physician recruiters in the area or compensation levels offered for other physicians in the market (if available).
Rarely is there a bright line to guide health system executives and their advisors in these situations. While it's hard to ignore local market conditions, it's also important to keep in mind national survey data may be weighted toward markets with different reimbursement and recruiting dynamics.
Rarely is there a bright line to guide health system executives and their advisors in these situations.
When health system executives anticipate a significant increase in physician compensation, they and their advisors need to develop a thorough analysis that considers all market data, including national surveys and available local and regional information, as well as the target practice’s adjusted financial results and physician productivity.