Economic and health policy experts seem to agree that healthcare delivery is a “market failure.” The U.S. spends much more on healthcare than countries with similar economies—16 percent of the gross domestic product. This puts U.S. businesses at a competitive disadvantage in the global marketplace and acts as a drag on the economy.

Despite spending twice as much as most major industrialized countries on healthcare, the outcomes associated with these expenditures are mixed. We trail other countries in most measures of health quality (e.g., infant mortality, life expectancy, and disease prevention). This is not new; many of the same issues and concerns have been discussed over the past twenty years. Healthcare executives and leaders have been calling for the creation of larger hospital “systems” for at least a decade.

This white paper seeks to develop a framework in which to consider the likely impact of the Patient Protection and Affordable Care Act and the Healthcare and Education Reconciliation Act of 2010 (collectively referred to herein as healthcare reform) on hospital consolidation and, specifically, how this might occur and what hurdles are likely to be encountered. (For the purposes of this white paper, consolidation refers to horizontal combinations of ownership and control between hospitals, rather than the creation of vertically arranged businesses through combinations.) We do not attempt to review the need for scale and larger companies; this topic has been well covered by others. Rather, we take this as a given and attempt to develop a framework for recommendations as to how management teams and boards might best prepare for responding to healthcare reform. In order to do this, we explore the sources of the hospital industry’s historical resistance to change, review the current structure and development of the industry, and develop a view regarding those industry participants who are best positioned to lead this change.

Despite some consolidation in the past two decades, the hospital industry remains fragmented and populated by many relatively small companies. Healthcare reform has the potential to dramatically alter the hospital business and accelerate consolidation.

Healthcare reform is expected to profoundly affect consolidation between hospitals. Not only is it expected to increase the number and size of mergers, but the underlying motivations are also expected to change. Until the present, microeconomic factors have driven hospitals to consider business combinations. We believe that this will likely change so that the formation of larger companies will become a “top-down” macroeconomic requirement. This is because healthcare reform will impose lower prices and enforce reimbursement models that create powerful incentives for hospitals to form large systems of care, including bundled payments, payments for quality, and accountable care organizations.

The hospital industry is highly regulated, capital and labor intensive, technologically and commercially complex. And yet, the overall structure of the industry appears to be a mixture of cottage industry with a heavy dose of altruism, rather than the large sophisticated industry it needs to be. One could argue that reform, effectively, results in the federal government telling the health delivery industry: “the cost of healthcare delivery is unsustainable. We are going to fix this by driving down prices; you, the providers, figure-out how to make this work.”

Despite the significant level of discussion regarding business combinations occurring at the present time, significant hospital consolidation and creation of large companies seem far-off. Why is this? What is it about the hospital industry that causes it to have an incredibly fragmented structure and to be so resistant to change? While there are some obvious and understandable reasons for this structural anomaly, this white paper attempts to explore the reasons behind the now-antiquated structure of the hospital industry, and considers how it can evolve in the immediate future.

In preparing this white paper, we sought input regarding the factors influencing the rate of consolidation from independent and multi-hospital systems, located in both urban and nonurban areas. We then gathered available data illustrating the consolidation trends that have occurred over the past two decades. To this, we added our own experience in advising non-profit boards on business combination transactions. We hope that this will provide readers with greater awareness and insight into this complex topic as they prepare to respond to healthcare reform.

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