Modern Health Care has reported that hospitals often lose approximately $176,000 a year per each employed physician.

While this initially seems like a surprising statistic, it is understandable that hospitals lose money when they employ physicians. Physicians in private practice often pay their staff less than comparable hospital employees. When a hospital buys a physician’s practice, the benefit costs typically increase if the staff receives the hospital’s fringe benefit package. Moreover, hospital overhead is typically higher than a private physician practice with regard to HR costs and other support services.

Many systems claim that the only way to manage the health of a given population (which is what ACO and other similar payment structures are requiring) is to be fully integrated with employed physicians, so covering the losses incurred by employing physicians is the necessary cost of preparing for the new paradigm. The ugly, and legally problematic, truth is that most health systems look beyond the income generated by physicians for treating patients but also at income from physician ancillary referrals to justify the economic losses caused by acquiring physician practices. This raises concerns under the Stark law.

The Stark law prohibits a physician from referring any Medicare or Medicaid patient for one of eleven designated health services when the services are furnished by an entity with which the physician (or immediately family member) has a financial relationship, unless there is an exception that allows the financial relationship.

The Stark law does provide an exception for “bona fide employee relationships.” There are two key components of what is considered to be a bona fide employment relationship: first the compensation paid to the physician needs to be consistent with the fair market value and secondly, the payments may not be determined in a manner that takes into account, directly or indirectly, the volume or value of any referrals, although the compensation may be in the form of productivity bonuses based on services performed by the physician. Stark also contemplates under 42 CFR §411.354(d)(4) that certain referrals are permitted.

In fact, an employment agreement with a physician can require the physician to make referrals to the hospital employer until : (1) the patient expresses a preference for a different provider; (2) the patient’s insurer determines the provider; (3) the referral is not in the best interest of the patient’s medical interest in the physician’s judgment; or (4) the required referral is beyond the scope of the employment (i.e. the physician is employed part-time by the hospital and is still required to refer all of the physician’s private patients unrelated to the part-time employment by the hospital).

In regards to the fair market requirement, when hospitals buy physician practices and bring physicians into the hospital’s health care delivery system, the hospitals typically retain appraisal companies to value the practice assuring that only fair market value is paid for the physician practice. Additionally, hospitals often obtain compensation studies confirming the compensation package offered to new physicians is at fair market value.

Unfortunately, the courts have begun to challenge (1) the motivation of hospitals as they purchase physician practices, (2) the documentation of fair market value, and (3) the structure of the compensation paid to the physician employees.

For example, in 2004, Tennant Healthcare Corporation agreed to pay $22.5 million to resolve allegations that Northridge Medical Center in Fort Lauderdale, Florida paid its physicians more than what they previously had earned in private practice and the resulting losses were being offset by laboratory referrals. The losses otherwise could not be justified.

In addition in 2009, Covenant Medical Center in Waterloo, Iowa, was accused by the Justice Department of violating the Stark law by paying commercially unreasonable compensation to five employed physicians. These physicians were supposedly not just the highest paid employed physicians in Iowa but in the entire United States. Reportedly, two of the five physicians were paid more than $2 million per year. The inference in this case was the oddly high salaries could only be justified if the hospital was receiving referrals.

In 2011, the court in U.S. vs. Campbell concluded that Joseph Campbell, a cardiologist, who had entered into a part-time employment agreement with University of Medicine and Dentistry of New Jersey was not in a bona fide relationship because, although he personally performed cardiac procedures for the hospital, he did not actually perform all the duties set forth in his employment. The government argued that the compensation he received could not be at fair market value for those unperformed services and, therefore, must serve some other purpose such as payment for referrals. This was a structural problem in the compensation in that not all contractual duties were performed by the physician.

In 2014, Halifax Hospital Medical Center of Volusia County, Florida entered into an $85 million settlement over payments to six employed medical oncologists. The problem in Halifax was a structural one concerning the calculation of the bonus for the six oncologists. The bonuses were based upon a bonus pool equal to 15 percent of the operating margin of the hospital’s oncology program. Apparently, the contracts did not define operating margin but, during discovery, there was evidence that the term meant the revenue from the overall program which would include designated health services such as prescription drugs and outpatient services not personally performed by the oncologists. The government argued that this bonus arrangement, since it took into effect volume or value of patient referrals (i.e. the drug referrals), caused the exception for a bona fide employment to fail, and tainted over 75,000 Medicare claims generated by the six oncologists. The government also ignored the hospital’s law firm’s opinion that argued that the arrangement complied with the Stark law. Therefore, documentation from a third party that there is compliance is not enough if the government believes the motivation is based upon illegal referrals.

Another compensation structural problem was pointed out in the Tuomey Healthcare System litigation. Tuomey Healthcare System (“Tuomey”) was a 242 bed hospital located in Sumter, South Carolina. In October 2015, the Department of Justice resolved the $275 million judgment against Tuomey by entering into a settlement where it received $72.4 million and Tuomey was forced to sell to Palmeto Health, a multi-hospital healthcare system.

The physicians in Tuomey received a base salary, productivity bonuses based upon their collections and an incentive bonus for receiving certain quality goals, a familiar arrangement. However, the amount paid to the physicians significantly exceeded the amount collected for their services. For each procedure that a physician personally performed there was also a referral to Tuomey for the technical component or facility fee associated with the procedure. Each physician’s compensation, because it was based upon a percentage of collections by the hospital, caused the physician’s compensation to increase based upon the hospital’s technical component portion of the fees. Therefore, the government argued that the physician’s compensation varied with the volume or value of the physician referrals associated with the hospital’s technical facility charges. The government estimated that Tuomey was losing $1 to $2 million per year based upon the amount it was paying the physicians in excess of the revenue generated from their personal services. The government argued that no hospital would enter into such an arrangement unless it was to secure the revenue stream based on referrals. Simply because a hospital was incurring losses by employing physicians, there was an inference of a Stark violation, and the government looked for a structural problem in how compensation was calculated.

Even more recent, Memorial University Medical Center in Savanah, Georgia paid a settlement amount of $9.9 million. The government argued that Memorial was losing money with its group practices and paying above market compensation to its physicians. The government argued that this combination of losses caused by high compensation showed that the hospital was paying physicians for the volume and value of referrals. In the Memorial Health case, it was actually the President and CEO who, while investigating the operating losses at Memorial Health, caused at least partially by the physician practices losses, blew the whistle against Memorial after he was fired for recommending hiring outside counsel to analyze whether the arrangements needed to be reported to the government.

The above cases show the pitfalls of purchasing physician’s practices which inevitably cause losses for the hospital and the structural problems in compensation that can occur when physicians are paid based upon the volume and value of their referrals. All hospitals that lose money on their employed physicians need to make sure that their compensation arrangements only pay for physician services and not for referrals by those same physicians. These recent cases show that the government will be very quick to claim a Stark violation if they believe the only reason for the hospital employing the physicians is to capture the referral revenue stream. Given the push for more integration of physicians into hospital systems to allow population management, hospitals will have to continue to purchase physician practices and employ these physicians, while being mindful that these transactions may be scrutinized by the government.