US hospitals are under fire: recent reports have highlighted medical-safety issues, the uneven quality of emergency rooms, high costs, and lengthening wait times. Simultaneously, these institutions face increasingly severe economic pressure as their competitiveness against more focused alternatives declines and health care consumers become more value conscious. To overcome such difficulties, the industry must make some big moves. Many hospitals will have to reorganize around a narrower range of clinical activity, differentiate themselves on quality and service, think more like the retailers they are fast becoming, and overhaul their relationships with physicians.

How did US hospitals—a triumph of 20th-century technology and organization—reach the point where such dramatic changes are needed? Like the vertically integrated businesses that emerged contemporaneously early in the last century, hospitals once exploited economies of scale and scope by combining and managing a specific set of assets, such as pharmacies and imaging departments, clinical laboratories, and emergency rooms. Thanks to the professional nursing and aseptic procedures of hospitals, they were just about the only places that offered high-quality medical treatment. For physicians, practicing in hospitals was far more productive than traveling door to door. In addition, the standard of excellence hospitals are known to adhere to, as well as their inspirational mission made them frequent beneficiaries of philanthropy, which in turn helped them acquire expensive cutting-edge technologies that further enhanced the care they offered.

Little noticed were the seeds of future problems. Hospitals never really had to depend upon their most direct customers—patients—for revenue. The generosity of philanthropists and volunteers, the rise of employer-sponsored insurance in the 1930s and 1940s, and the emergence of government-sponsored insurance in the 1960s all insulated hospitals from the need to compete for patients. Today hospitals are "price takers" for nearly 50 percent of their revenues, which is subject to the political whims of the federal and state governments. Hospitals are also required to see, evaluate, and treat virtually any patient who shows up, solvent or not.

Furthermore, physicians were productive because hospitals put a great deal of capital at their disposal. Yet these hospitals didn't enforce standardized and efficient approaches to the delivery of care. At many hospitals today, doctors still bear only limited economic responsibility for the care decisions they make. Little wonder that it is often they who introduce expensive—and sometimes excessive—nonreimbursable technologies or that hospitals not only suffer from declining margins but are also performing less well than other players in the health care value chain (exhibit).

These structural weaknesses have created openings for more focused providers that increasingly offer superior value: lower prices, higher quality, and better service. Stand-alone ambulatory service centers, diagnostic-imaging centers, endoscopy suites, and specialty hospitals have become powerful competitors. More are surely on the way as the equity markets (both public and private) and physicians themselves pour capital into the sector. At the same time, payers and consumers are becoming much better at recognizing and acting on price and value differences. Patients have much more at stake with the advent of high-deductible health plans, whose growth has accelerated as a result of the introduction of health savings accounts (HSAs).¹ Enrollment in US consumer-directed health plans (CDHPs) of all types seems likely to exceed seven million people by the end of 2006. And a growing number of "infomediaries"—from payers to independent Web-based services to state governments—now help consumers make more informed decisions by providing information in areas such as hospital prices, quality, and service. Knowledgeable, value-conscious patients are beginning to view some hospitals as less effective places to seek care compared with many of their alternatives, including physicians' offices.

Hospitals can't respond to this shifting competitive and consumer landscape without tackling the underlying structural issues. A vital first step is to compete on the basis of strengths in specific clinical service lines rather than relying on the power of full integration. In areas such as cardiology, neurosciences, and oncology, it's impossible to sustain excellence with just a few patients a day, so all but the largest hospitals will need to rationalize their activities and become more focused: only with a critical mass of patients for individual service lines will they achieve competitive quality at reasonable cost. Several large payers are already nudging hospitals in this direction by adopting a "center of excellence" approach, which allows these payers to inform patients about (and reward them for using) preferred institutions. Hospitals that resist organizing around a narrower set of clinical services will probably enter a downward performance spiral as they experience greater difficulty recruiting top physicians, paying for the best specialty-service and equipment providers, exploiting economies of scale, and implementing best practices consistently. But hospitals that do these things well will also capture direct financial value from the quality improvements.

When hospitals become more focused and their patients more value conscious, they will start to resemble companies in other competitive service industries. Like cutting-edge retailers, they must identify the characteristics of the patients they can best serve and attract those people by creating specific value propositions. Indeed, since different patients want different types of improved services (such as private rooms, catered meals, and more attentive nursing), hospitals must understand what customers want and how they want it.² Along with players in many other competitive service industries, hospitals are likely to find that a key source of differentiation is the consistent execution of frontline tasks, such as adhering to clinical protocols, maintaining efficient patient flows, administering drugs safely, and coordinating disparate activities effectively.

The importance of execution will extend beyond clinical activities. Hospitals that can't or won't quote prices before delivering service will drive away selective, value-conscious consumers. Hospitals with weak skills and systems for extending credit or making collections at the point of service may have higher bad debts. Better execution will require drastic behavioral changes from physicians, nurses, administrative personnel—and senior executives, whose jobs are becoming more complex. Better training, performance metrics, and compensation structures will all be needed to help hospitals change.³

Given the central role of physicians in operational and resource allocation decisions, it will be difficult to effect change without building a much stronger cultural and economic alignment between physicians and hospitals. For many physicians—particularly clinical specialists in the service lines where hospitals hope to differentiate themselves—the traditional arm's-length and more recent competitive relationship must give way to some sort of formal employment or to gain-sharing schemes such as joint ownership of equipment or even whole facilities. Furthermore, performance criteria for physicians must shift. In a world in which transparent quality, service, and prices help patients choose places to seek treatment, metrics such as admissions volumes will become less relevant. The more important considerations will include a physician's adherence to well-established standards of medical practice, willingness to embrace teamwork, and bedside manner, as well as a selection of services and equipment that strikes the right balance between cost and performance.

Changes of this magnitude may seem a tall order, but they are not impossible. US hospitals still represent the medical world's greatest accumulations of technological, human, and financial resources. If hospitals improve their focus, execution, responsiveness to consumers, and internal alignment, they can better their economic performance and make an even bigger contribution to health care in the 21st century than they did in the 20th.