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Open Letter to the American CEO: Five Need-to-Know Facts About Health Care

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Dear CEO of Any Company:

Want in on a little secret? Here's what health care's brightest business people think about reform: whatever lawmakers accomplish this fall, it won't alter how the system works or move the needle on costs.

Now—more than ever—you need to understand health care's fundamental underpinnings. As the corporate leader, you aren't just managing health care costs. Even if your business is in a non-health care industry, you are likely seeing new revenue opportunities emerge in health care as it expands across the economy.

Whether cost control or revenue growth, knowing how the system works is a crucial first step towards margin expansion.

Consider these five must-know facts.

1. Supply and demand do not transact with each other. At a recent Lyceum roundtable on health care reform, one entrepreneur noted: "Are we going to change a system where consumers don't pay and payers don't consume? I don't think so, unless Washington suddenly starts advocating market-based solutions."
It's ironic, and perhaps telling, that a section of the economy as large as health care doesn't perform as a normal industry. At ground level, physicians provide services, but payment is received not from customers but from commercial health plans and government. Because supply does not actually transact with demand—unlike any other industry—there can be no market-determined price or consistent measure of quality and value.

What's more, physician service reimbursement occurs under a volume-based framework, called fee-for-service, where doctors submit claims based on specific inputs, not total care.

Medicare, for example, applies a complex reimbursement formula called the resource-based relative value scale ("RBRVS") to non-hospital rendered physician services—about 25% of total health care expenses. A 29-member committee, determines exactly how much Medicare will pay for these individualized services. Critically, it also serves, de facto, as the basis for commercial health plan reimbursement. This single committee, therefore, controls nearly $600 billion dollars in industry pricing.

Transparency is non-existent. And the medical value chain is left with cost control as its only profit lever.

2. Market forces also don't shape the drug supply chain.
While in-patient and out-patient services exist outside standard economic practices, the other 20% of health care—the drug supply chain—does not follow the same framework, except for products that providers directly administer, such as infused and injected biologics. Commercial health plans and pharmacy benefit managers, instead, apply formularies to steer beneficiaries to more effective medication usage.

At least that's the intent. In reality, drug benefit managers also operate in their own opaque system, just not one controlled by a single committee. To optimize business margins, they negotiate directly with drugmakers on behalf of employers, their clients. Volume-driven rebates, pharmacy network spreads and mail service margins all affect formulary placement. Large margins, in particular, characterize generic drugs.

Drug manufacturers, meanwhile, have targeted physicians, directly and indirectly through consumer-directed advertising for branded products. Doctors, however, don't pay for the products. And those eagerly-courted erectile-dysfunctional consumers, happily forking out $30 co-pays, have no conception of actual prices.

Still, Caterpillar's recent effort with Walmart (and now Walgreens) attempts to alter this system by introducing a new competitive force: the retail channel. And unlike the medical side, the entire drug supply chain is publicly-traded, exposing it to shareholder demands and expectations.

The net effect of all this is that prescriptions are prescribed, purchased and paid for outside of anything resembling a normal supply/demand market framework.

3. Information is the most important commodity.
In a system as complex as health care, knowing what someone else doesn't know can make all the difference in the world.

Here, there's an important parallel with the financial service industry. Broker-dealers, Wall Street's middlemen, have traditionally operated at the confluence of market data streams. Whether it's corporate news flow or clients orders, no other entity processes as much information. While so-called Chinese walls presumably deter misuse of this information, neither corporations nor institutions possess even a fraction of this information wedge.

In the late 1990s, things changed, as broadband Internet democratized information access. Suddenly, new tools allowed counterparties to know as much—or more than—the broker-dealer. At the same time, electronic share trading networks emerged, allowing institutions to transact directly with each other.

As a result, margins in traditional advisory services shrank, and broker-dealers began turning to high-margin proprietary trading and investment services.

Health records are still 90% paper-based. On the medical side, information is so fragmented that no one entity has a distinct advantage over another. Claims processing, for example, often takes weeks or months to adjudicate, as provider and payer bicker over codes, procedures and contract pricing.

On the pharmacy side, the pharmacy benefit manager functions similarly to the broker-dealer. No other entity controls as much information about manufacturers, payers, providers and consumers.

Just as the Internet revolution recast the financial services landscape, it could likewise upend the traditional flow of information in health care. For medical benefits, it could create new power centers as information is digitized. For the pharmacy side, it threatens to disintermediate existing channels.

4. New revenue opportunities exist across industries.
So what if health care is 17% or 30% of GDP? If it's efficient, then it's creating jobs and contributing to economic growth.

Many different opportunities exist for non-health care companies to take advantage of the industry's growth. Take the affordability problem, for example. Why shouldn't bankers explore new lending channels to help consumers reduce the monthly premium burden? And what about information technology? Washington has already passed legislation that will provide incentives for electronic health record adoption. Like Sarbanes-Oxley, myriad rules will apply, a complex intertwining which creates opportunities for sophisticated software and service vendors.

Health care is first and foremost a service industry. Because supply is finite, economic rules apply as in any other industry. The problem with health care is an inability to define value on a consistent basis. If a company is smart in how it navigates the industry's nuances, then plenty of revenue opportunities will exist.

Retail-centered strategies such as convenient care clinics are challenging traditional delivery of care. Emergent, cash-based business models in the primary care profession are challenging traditional reimbursement practices.

As much as regulatory constraints may burden the system, there's no shortage of innovative strategies. It's just a question of matching resolve with the appropriate resources.

5. The CEO needs to be in control. The health care dollar begins with the employer. It just doesn't necessarily end there. Health benefits is a cost center, and typically reports up through the human resource department to the CFO. In most cases, CEOs never engage in this business unit other than to monitor trend growth. And while the direct cost exposure could be 5% or more of the cost base, the indirect opportunity cost in employee efficiency is much greater.

The problem, though, is that concepts such as presenteeism and workforce productivity are difficult to quantity, and particularly difficult to justify committing big dollars to when shareholders are assessing quarterly performance.

But how much are changes in market conditions now affecting expectations placed on CEOs? We may be emerging from recession, but few people expect economic growth to sustain an accelerated pace. With trend growth lower than in the previous economic cycle—corresponding to reduced revenue expectations—CEOs have little choice but to re-examine cost structures to preserve margins.

Just as health care may present new revenue opportunities, it also creates opportunities for chief executives to drive internal efficiency, simply because only a handful of companies have taken advantage of this, and so much low-hanging fruit exists.

The CEO needs to drive this process. Whether Caterpillar, General Mills, Pitney Bowes, Safeway or Whole Foods, examples exist of CEOs forcing efficiency. But these are just a handful of companies against the thousands out there that could be doing likewise.

Health care may be complex, but knowing its basic workings puts the corporate leader at an immediate advantage. Whether cost control or revenue growth, this is no time for herd mentality.
Be proactive. How smartly you manage health care's various risks and opportunities will determine your company's success.

Disclosure: No Positions