1995 saw a huge leap in the number of hospital mergers and alliances in the United States, primarily in response to the expansion of managed care systems that have forced down hospital prices and utilization rates. That year, there were 138 separate deals involving 269 hospitals, a 48 percent increase over the 1994 activity level.¹ The assumption underlying these mergers is that multi-hospital systems (MHS) will not only enjoy economies of scale, but be able to bargain more effectively with health maintenance organizations (HMOs), medical equipment suppliers and physicians because of high market share and consequently greater market power. The net result should be improved performance. However, evidence to date indicates MHS do not necessarily outperform independent hospitals.

Are MHS more profitable than independent hospitals?

When performance is measured broadly across many markets as return on sales (ROS), MHS fail to outperform stand-alone hospitals (Exhibit 1). However, these numbers could mask differences in hospital performance caused by different levels of managed care penetration in different markets, and the number and relative size of the hospital players in each market. The degree of HMO penetration in a given market, for example, has a strong, statistically significant effect on hospital return on sales (Exhibit 2). Both factors therefore have to be taken into account.

Given that the merger wave in hospitals has been prompted by the belief that higher market share will increase negotiating leverage and improve hospital performance, one would expect a correlation between market share and profitability. However, at the regional level this does not appear to exist. Exhibit 3 shows that even among hospitals with as much as 60 percent of market share there is no statistically significant relationship between market share and profitability.

A more complex measure of local market power would take into account the share positions of multiple players to develop a view of the overall level of hospital power in a given market. The Herfindahl index is a measure of overall market power commonly used in academic and regulatory studies.² Here the results do suggest that markets with greater hospital concentration—higher Herfindahl indexes—generate higher overall hospital returns (Exhibit 4).

However, the importance of market-level concentration diminishes significantly when HMO penetration is included in the analysis (Exhibit 5). In 1994, HMO penetration was the more powerful driver of hospital returns in these markets, which indicates that the performance of MHS has less to do with size or market share, than by factors not directly under their control. Though MHS formation tends to be greatest in highly competitive markets comprised of large numbers of hospitals and strong managed care payors, the evidence suggests that in already strong managed care markets, forming large MHS does little to improve hospital profitability. In these mature markets it may simply be too late to reverse the effects of managed care penetration. The likelihood is that large share positions, in excess of 50 percent, would be required to extract any meaningful price or volume concessions from payors. In most markets, building such a position would be prohibitively expensive and difficult to pass through the regulatory process. The question whether the presence of large hospital systems could deter the growth of managed care organizations remains unanswered The testing ground could be mid-sized cities such as Modesto or Charlotte, where a few hospital systems have built large share positions and HMOs have not yet penetrated the market to any great degree.

Are MHS more efficient?

Just as the evidence on share position fails to support the notion that forming MHS improves hospital profitability in every market, so the evidence on cost performance suggests that MHS are not more efficient than their stand-alone counterparts (Exhibit 6). Even when adjusted for differences in case mix and local wage rates, there are no statistically significant differences in cost performance. This conclusion is, of course, not surprising given the profitability results. It is hard to imagine how an advantage in cost performance would not translate into a profitability advantage.

Why MHS have not delivered

So why is it that MHS formation has not generated the hoped-for performance gains in the form of improved ROS and increased efficiency? It may be that MHS still need greater market share, or that many are still young and have not had time to digest recent acquisitions and develop new strategies. A more fundamental explanation, however, may involve structural factors that limit the ability of the hospital industry to compete with other healthcare players, such as HMOs and physician groups. These structural factors might include:

• High relative fixed-cost structures. Industries with high fixed costs as a proportion of total costs tend to exhibit highly competitive pricing. There is a strong incentive for players to price below average cost to generate marginal income. The hospital business is like the airline business in this regard: the marginal cost of filling one more bed is quite low compared with the total cost of operating a hospital.
• Homogeneous products for many hospitals. For many hospital procedures, the product purchased by consumers or payors is undifferentiated—most hospitals look the same to the average consumer. In fact, the factors most frequently cited by managed care purchasers and consumers determining choice is simple convenience, hospital location, for example, and the relationship between patient and doctor. Neither have anything to do with whether or not the hospital is part of an MHS. However, recent attempts by large MHS to build brand image through direct advertising to consumers may create some product distinction.
• Falling demand and excess capacity. The growth of managed care has forced down the number of patient admissions and the length of stay per admission, resulting in significant excess hospital capacity. It is possible that declining demand for hospital services has outpaced the accumulation of market power by local MHS. Put another way, the value of market power falls in a shrinking market.
• Large not-for-profit competitive fringe. Numerous studies have shown that the ability of oligopolies to drive extra profits is reduced by the presence of numerous smaller competitors, the "competitive fringe." This means that even in relatively concentrated markets, say where the top three hospital systems control 80 percent of the market, the power of the large systems will be substantially reduced if a large number of hospitals make up the remaining 20 percent. In the 29 markets analyzed, the average number of players outside of the three largest ranged from 2 to 102, with an average of 23. In the hospital business, this problem is exacerbated by the fact that the fringe is predominantly composed of not-for-profit players who are slower to exit unprofitable markets. In some markets, the fringe also contains large academic institutions with strong branded positions.
• Limited ability to capture economies of scale. Hospitals have been unable to generate substantial economies of scale through consolidation for several reasons. First, the largest scale economies come from system-wide, multi-hospital rationalization of clinical functions and related capital spending. However, this kind of rationalization requires the support of physicians at several hospitals. In general, hospitals have been reluctant to share the benefits of rationalization with physicians, with the predictable outcome that physicians have been unwilling to support rationalization that would disrupt their established practice patterns. Moreover, hospital administrators have been reluctant to anger key specialist physicians who provide a disproportionate share of revenues and income and who frequently control the clinical functions offering the largest rationalization opportunities such as cardiac care units. Second, other economies, such as purchasing, are available to stand-alone hospitals from buying groups and other cost pooling organizations. This leaves administrative overheads as the only easy target for MHS cost cutters. And though administrative costs have declined, they are too small relative to clinical and purchasing costs to give MHS much advantage. Whether or not the new systems will develop the products and skills necessary to leverage their size is an open question.

Hospitals should recognize that integrated systems do not of themselves provide valuable services to either consumers or payors. Consumers care about convenience and reputation; payors are looking for value for money. Neither cares whether or not a hospital is part of a bigger system.

To create value, any hospital must develop the right skills and services. In advanced managed care markets, this includes efficient and high-quality services that help payors control costs. In less mature markets, hospitals need to invest in new services, build physician loyalty and seek to build share position ahead of managed care growth. Building MHS may indeed be part of a successful strategy. But creating large systems that do no more than boost the supply of undifferentiated beds simply raises the chance of a losing hand.