Size should matter

Executive summary

Over the past two decades, U.S. hospitals have undergone a continuous wave of consolidation, seeking to become more profitable through mergers, partnerships, and other strategic alliances. The implicit logic of these arrangements is that by getting larger, hospitals and healthcare systems will generate scale and reduce operating costs while still delivering the same level of care — or better. Yet, based on our experience, most transactions have failed to deliver the promised benefits of scale.

To better understand the issue, we analyzed data from the Centers for Medicare & Medicaid Services (CMS) regarding patient encounters for more than 5,600 individual facilities and 526 healthcare systems nationwide, including for-profit and nonprofit organizations, and both teaching and non-teaching hospitals (see “Methodology”).

We tested the data to see if larger facilities and systems benefited from scale effects. The results show that for individual facilities, larger hospitals (across all categories) have a lower cost per encounter than smaller hospitals. Yet for healthcare systems comprising multiple facilities, the data indicates no relationship between size and cost. Bigger companies are not yet able to convert their size into operating efficiencies.

The data also shows that there is no correlation between quality and cost per encounter. Spending more money does not necessarily lead to better outcomes. Similarly, the data demonstrates no relationship between facility size and quality.

The primary explanation for the absence of scale economies is that healthcare systems are often run as de facto holding companies — i.e., a collection of highly autonomous hospitals — rather than as integrated organizations that have standardized procedures and systematically reduced costs.

We believe that healthcare systems can improve this performance and realize scale benefits that will help them reduce costs by 15 to 30 percent. To do so, however, they will need to standardize procedures — administrative as well as clinical. They will also need to revamp their operating model to emphasize overall system performance, establish appropriate decision rights, measure their progress, and accommodate separate, dissimilar cultures in any consolidation.

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Consolidation in healthcare, but little scale

The U.S. healthcare industry is experiencing a tsunami of change. As reimbursement rates decline for both public and private payors, hospitals and healthcare systems face declining revenue, pressuring them to reduce costs by 20 to 25 percent in the short term.

In this environment, mergers, partnerships, and strategic alliances are becoming more popular as healthcare systems realign themselves to establish the right set of clinical specialties, referral networks, and geographic coverage. Institutions that cannot compete become attractive M&A candidates. And many faith-based healthcare systems are seeking new corporate arrangements to become more viable healthcare system partners. By Strategy& estimates, roughly 1,000 hospitals — or one in five across the U.S. market — will be realigned during the next decade.¹

The core logic of this realignment is that larger healthcare systems will be able to achieve economies of scale, and thus reduce both administrative and clinical costs. Yet in many cases, scale economies seem perennially just out of reach. Our industry research suggests that scale is possible in healthcare mergers — with the potential to reduce costs by 15 to 30 percent — yet many healthcare systems fail to capture this advantage, leaving them burdened with unnecessarily high cost structures. Moreover, we have found that there is little or no correlation between a healthcare system’s cost structure and the quality of its care.

¹ Philip Betbeze, “M&A Forecast: 1 in 5 hospitals to realign over next decade,” HealthLeaders Media, Jan. 25, 2013. Gerald Adolph, Gary D. Ahlquist, Anu Sharma, and Brett Spencer, “The coming surge in health provider M&A: How historical forces and healthcare reform will combine to drive activity,” Strategy&, 2012.

Conclusion

In sum, our evidence shows that despite a wave of consolidation, most healthcare systems have not yet realized the potential scale efficiencies from these mergers. Scale efficiencies are possible, yet capturing those efficiencies requires a change in management philosophy, an emphasis on standardization and integrated operations, and an investment in cultural transformation. Collectively, such elements could lead to cost reductions as high as 15 to 30 percent. This is an ambitious effort, and it will require much hard work on the part of executive teams. Yet it is certainly worth the effort if the ultimate prize is more satisfied patients and higher-quality care at lower costs.

Survey

Do you believe that your organization is operating at peak effectiveness and efficiency? We have developed a survey to validate your opinion. The survey analyzes publicly available data from the Centers for Medicare & Medicaid Services to compare your responses to those of peer groups. We invite you to take our proprietary Fit for Growth* survey and identify potential opportunities to improve your organization’s costs and efficiency.

* Fit for Growth is a registered service mark of PwC Strategy& LLC in the United States.

Metholology

We used 2013 cost data from the Centers for Medicare & Medicaid Services (which is adjusted to accommodate the variety of cases and the geographic disparity in wages). The normalized hospital data set included variables such as expense per admission, number of beds, average length of stay, full-time employees (FTEs) per bed, discharge per bed, total facility FTEs, SG&A costs, operating margin, and number of admissions. We analyzed the data to identify any correlation of multiple variables against expense per admission for stand-alone facilities and aggregated healthcare systems. For quality, we used CMS quality scores.