New care delivery models and healthcare reimbursement trends are heating up the market for hospital employment of physicians yet again, but does a productivity-based compensation model still work in this environment? Hospitals have competing goals in setting compensation, and as long as they observe the three “Hows,” compensation can reflect those various objectives. This holds true even if the hospital is incurring losses on an employed physician.

Hospital employment of physicians is increasingly popular. According to one recent survey, the number of hospital-employed primary care physicians increased from 10% to 20% from 2012 to 2014. But with the growth of physician employment also comes increased regulatory risks surrounding the financial arrangements between the hospital and its employed physicians. In particular, in the current environment, how can a hospital create compliant compensation incentives based on factors other than productivity, such as the reduction in healthcare costs and increases in quality?

Such interests also raise questions regarding the import of financial losses incurred by many hospitals on their employed physicians. One recent survey found that local hospitals incurred greater losses on employed physicians in 2014 than in 2013 and that 58% of the respondents reported losses exceeding $100,000 per employed physician in 2014. These sustained losses raise several important questions, such as is it commercially reasonable for hospitals to lose money on their employed physicians? By considering the three “Hows” of physician compensation, hospitals can comply with the Stark Law’s employment exception and minimize regulatory risks.

How Much?

The first “How” of physician compensation is how much is a physician being paid for services furnished to a hospital, and is the compensation within the range of fair market value (FMV)? Under the Stark Law, FMV means the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties who are not otherwise able to generate business for the other party. On this point, it’s helpful to obtain an FMV analysis to support a physician’s compensation, but not essential in every instance. It is wise to create a policy or process to determine when a hospital obtains an outside valuation for a physician employment arrangement and when a hospital can rely on internal resources. For example, if a physician’s compensation will exceed some established threshold (e.g., the 90th percentile of a recognized compensation survey), then the hospital will obtain a valuation from a recognized valuation expert. Note, however, that the Centers for Medicare & Medicaid Services (CMS) cautions that reliance on a proper valuation may be relevant to a party’s intent, but it does not establish the ultimate issue of the accuracy of the valuation figure itself.

How Calculated?

The second “How” of physician compensation addresses the issue of how compensation is calculated and what is taken into account when calculating a physician’s compensation. In addition to being consistent with FMV, an employed physician’s compensation may not be determined in a manner that varies with or takes into account the volume or value of any “designated health service” referrals that the physician may generate. The compensation paid to employed physicians may not take into account or vary directly or indirectly with the volume or value of the physician’s designate health service (DHS) referrals, and any bonus paid to the physician must be based on the physician’s personally performed services. In other words, a physician may not receive any portion of the revenues attributed to the DHS services that he or she orders but are performed by ancillary personnel supervised by the physician. By contrast, a physician who works in a group practice that relies on the in-office ancillary services exception may receive a portion of the DHS revenues generated by the physician, as long as the payments are not based “directly” on the volume or value of the physician’s DHS referrals. The failure to consider how physician compensation is calculated can and has resulted in significant penalties being assessed against hospitals, including False Claims Act liability and the imposition of Office of Inspector General corporate integrity agreements.

How Come?

The third “How” of physician compensation asks why or what the purpose of the employment arrangement is. The Stark Law requires that compensation be commercially reasonable, even if no referrals were made to an employer. There is no statutory or regulatory definition of “commercial reasonableness.” Instead, CMS informally describes “commercial reasonableness” to mean an arrangement that appears to be a sensible, prudent business agreement from the perspective of the particular parties involved, even in the absence of any potential referrals. To support the assertion that physician employment arrangements are commercially reasonable, employers should document the goals of the employment arrangement (e.g., to promote clinical integration to support participation in value-based payment programs) and avoid the suggestion that the purpose of a physician employment strategy is to drive more volume to the hospital. In addition, employers should follow the first two “Hows” of physician compensation (i.e., ensuring that a physician’s compensation falls within the range of FMV and is calculated in a manner that does not take into account the volume or value of patient referrals).

Correctly navigating the three “Hows” of physician compensation will help minimize regulatory risks of hospital-employed physicians, even in those instances where a hospital is losing money with respect to an individual physician employee.