David Friend is a Managing Director and CTO at BDO Center for Healthcare Excellence & Innovation. He has more than 35 years of global healthcare experience and provides advice on mergers and acquisitions, strategy, clinical integration, physician engagement, and enhancing shareholder value. He received his BA from Brandeis University, his MBA from The Wharton School of The University of Pennsylvania and his PhD from The University of Connecticut.
Steve Monroe
I’m lucky to have here with us David Friend. He’s a managing director and chief transformational officer for BDO. David, we all know, and you’re obviously on top of all this, that the skilled nursing facilities have been going after the Medicare rehab business, but there’s been some new rules posted as to the discharge requirements for skilled nursing facilities for hip and knee replacements. Can you tell me, what’s going on and how does this relate to the controversial five-star rating system?
David Friend
Sure. I’ll try. What’s happening is that Medicare has begun to do a lot of data analytics, and one of their conclusions is that there is a tremendous amount of variance in the way patients are treated for the identical problems in the nursing homes. By and large, Medicare has been able to eliminate that variation in the hospitals, but significantly it has found that virtually all of the variation now in patient care going forward is in nursing homes.
So, what Medicare has decided to do on in essence a trial basis, although it’s going to be quite a large trial—from New York to Los Angeles there are about 70 markets involved, but they’re big so it encompasses at least half, if not more than half, of the patients—is they’re doing several things simultaneously.
First for basically a DRG470, which is the joint replacement, they’re saying that we are now going to allow the hospitals to create a bundle, meaning that they’re going to give the hospital a chunk of money and the hospital is going to be responsible for managing not only the care inside the hospital but outside the hospital, including skilled nursing, home care. Now, as an inducement to give the hospital some more flexibility, what they’ve said is this: if you, a hospital, want to discharge your patient early, you can do so.
So, currently, for example, there is a three-day rule in the hospitals, and what this means for the nursing home is that the nursing home would only have Medicare pay for the service if the patient were in the hospital for at least three days. So, if the patient was really healthy enough after two days to leave the hospital, if we sent that patient to the nursing home, there would be no Medicare coverage.
As you can imagine, patients and their families have really resisted that and have really wanted the nursing home stay to be covered by Medicare, so they’ve really put a lot of pressure on the hospitals to keep the patients in for three days.
Steve Monroe
And that’s been going on for decades.
David Friend
Correct. But here’s the difference. If I’m a physician in the hospital and I’ve been under this pressure—and more and more now the hospital is saying, Dr. Friend, if that patient is ready to go home in two days, you’ve got to send them home because if you keep them here a third day, we, the hospital, are potentially filing a false claim. We, the hospital, are potentially defrauding Medicare, and we don’t want that hassle, Dr. Friend.
So, Dr. Friend has been stuck between a rock and a hard place. The rock is my chief medical officer at the hospital saying, if that patient doesn’t belong here, you’ve got to discharge them because we’re going to have a problem. But at the same time, if I, Dr. Friend, say, well, I’ve got to send your mother home, Steve, you’re saying, Dr. Friend, she’s not going to be covered.
Do you see that issue? Does that make sense?
Steve Monroe
That issue’s been going on for years, yeah.
David Friend
So, now, there’s a change. There’s a fundamental change. This is a big deal, and you’ll see this. CMS has said, okay, Dr. Friend, we’re going to make it easy for you. If you send Steve’s mother to a nursing home that has a three-star rating or better, we waive the three-day rule. So, think about that. Now I no longer have to deal with the pressure of my chief medical officer and my hospital staff because if the patient really should go home after two days, I’m good, I can discharge them. And I can say, Steve, you don’t have to worry because as long as I send your mom to a three-star facility or better, it’s going to be covered.
That’s never been the case before, as you know.
Steve Monroe
Right.
David Friend
So, this is the first time we’ve now linked explicitly the star rating to payment. And the advantages are so tremendous for the hospital. In essence, it’s a safe harbor. It doesn’t have to worry about false claims. It doesn’t have to worry about compliance. It doesn’t have to worry about CMS coming down our throats.
So, if you think about it—and at the same time, it’s very friendly to the patients. So, think about this. Once this rule is in effect, why would I ever send a patient to a one- or two-star facility again? And once this happens for DRG and CMS starts seeing the improvements, I think, I predict, that this will occur very rapidly throughout the entire system. And given of the about 15,000 nursing homes in this country—they’re roughly distributed, about 3,000 one-star, 3,000 two-star, 3,000 three-star—I think you’re going to see a sea change not only in the valuation of the one- and two-stars, but since this is a zero-sum game, you could improve and other people could go down, if a two-star gets good enough to become a three-star, that means a three-star might get knocked down to two. I would argue of the 15,000 nursing homes in the United States, 9,000 of them are going to be impacted dramatically because if they can’t improve their quality, they’re going to find their business is going to start to go away.
And I think once Medicare pulls this off, it will be a short time before Medicaid sees this. So, I think this is really the spark that’s going to change the way we look at patient care, and for the first time we’re really going to explicitly link quality to price. I’ll stop there. I’ve given you a mouthful.
Steve Monroe
So, if it’s a fifth, a fifth, a fifth, that would be 6,000 nursing homes in theory have a one or two rating.
David Friend
Correct.
Steve Monroe
So, they’re out of it if they’re in a market where they bundle payments. So, how quickly can I change my one or two star rating? Do I have to just wait until the annual survey, or can I petition to get one in earlier?
David Friend
No, no, you can do things immediately to begin the process. Remember, the star rating is made of several components, one of which is your staffing, one of which is the state visits that you get, state inspections. And this is a continual process. Remember, this is now continuing. You are going to continually be rated. So, it’s not enough just to say, well, we’re going to temporarily go from here to here. You now have to make this a way of life.
The other problem is because it’s a zero-sum game, Steve, if you’re the two-star and I’m the three-star, if you become the three, I get knocked down to the two. Because remember, as some people move up, other people get pushed down because this is a mandatory ranking right now, right? It’s a mandatory ranking. So, everyone’s going to have to do better because if I’m a three-star and I just stay where I am, but you, my competitor, improve and I do nothing, I can get pushed down.
So, if you think about what CMS wants to do, and it makes perfect sense, they want to start driving a race to the top. They want people to start saying, we have to improve. But every time someone goes up, someone else is going to come down. So, this is now a big deal.
Steve Monroe
That’s going to be a little unfair. The whole point is to have the quality across the board go up. So, you’re saying that legally it’s an impossibility for all 15,000 nursing facilities to be four- and five-star rated.
David Friend
That is correct.
Steve Monroe
No matter what they do.
David Friend
It’s a forced ranking. Just like remember Jack Welch at General Electric said, we force rank our employees and we would get rid of the bottom. Many organizations force rank. If you go on many valuations sites. If you go to schools, A, B, C, that’s a forced ranking. They don’t give As to everybody.
And the bottom line is their feeling is, well, why should patients have to endure poor care anymore? We don’t want to pay for poor care anymore. What’s unfair is that we’ve been paying the same price for a five-star as a one-star.
Steve Monroe
So, what do you think a lender’s going to do when they look at their portfolio and they’ve got a few one- and two-star rated nursing facilities as collateral?
David Friend
I think this is a profound problem because right now, if assets are roughly priced equally, whether you’re a one- to five-star, then we have clearly mispriced all the assets because it tells us the one- and two-star probably are worth less than we think and the four- and five- stars, which are going to pick up a lot of patient volume, are potentially worth more than we think.
So, I think the impact here is profound across the entire continuum.
Steve Monroe
But some people argue that the five-star system is kind of rigged because people can game the system to get a three-, four-, five-star rating.
David Friend
Well, that may be true, but everyone’s going to be playing by the same rules, so the reality will be that if you’re my competitor and I think you’re rigging the game, I’ll be hurt financially but I might have a real incentive then to report you if I really think that you’re rigging the game. Because this is going to be the way it is.
And so, the reality is if you’re an investor, you’re not going to want to deal with a one- or two-star facility, so what you’re going to say to these guys is, look, either you’ve got to improve or you’re worth less. You’re not going to get the cream of the Medicare patients, and the risk you run is slowly over time you’re going to get fewer and fewer patients. It’s just the way it is.
Steve Monroe
And are hospitals today really monitoring the ratings of the skilled nursing facilities in their markets?
David Friend
Absolutely. Hospitals are already narrowing their networks. Look at Partners in Boston. They had roughly 80 nursing homes; they now roughly have 20 to 25. This is going on all throughout the system, and I would argue most people in senior care do not understand this because very few people in senior care ever work in a hospital. I’m a physician. I was on the board of the University of Connecticut School of Medicine. I ran a teaching hospital. And I was the executive vice-president at Golden Living. I’m one of the few individuals that understands this world. Most senior care people do not understand that they are truly now the partner with their hospital, and if they are not keeping that hospital happy, they are going to find their admissions are going to fall fairly dramatically.
Steve Monroe
And are hospitals expecting to make up the lost revenue from going from three days, let’s say, to two days, that one day lost revenue, are they anticipating at least making that up with the bundled payment cost savings that they’re going to share in?
David Friend
Sure. Think about it from the hospital perspective. If it gets the same payment whether the patient is in for three days or two days, the hospital would rather have you for a shorter period of time. Remember, the hospital is not paid like the nursing home. The nursing home is paid per day. The hospital has been paid per case. So, if I can actually reduce my length of stay in the hospital, I’m incredibly happy. I make more money. So, if I can tell doctors—go ahead.
Steve Monroe
Aren’t they now sharing that with the skilled nursing provider and the home health provider?
David Friend
Let’s go slowly. First of all, the hospital can make a lot more money if you can go after two days as opposed to three because it’s getting the same payment. Now, the share is a negotiation between the hospital and the nursing home. It doesn’t necessarily have to give the nursing home its full share. It depends on the market power of that nursing home. This is another thing that senior care investors need to understand and, we have found, very few have understood, which is what’s the competitive environment of other nursing homes? If you’re the only nursing home in town, if you’re the only nursing home that’s accessible, you are in a command position. If you have competitors across the street and you’re starving for patients, the hospital may tell you, you know what, we’re not going to give you much at all, but if you don’t take this deal, we’re going to take all the patients across the street.
So, some of the nursing homes are in good bargaining positions; some of them are in very poor positions.
Let me give you another thing that I don’t think most people in senior care understand. Once we have a bundle, the hospital might actually do something that you might find counterintuitive. Rather than keeping them in for let’s say the three days, they’ll say, Dr. Friend, keep them in for five days, and then they’ll be healthy enough that we can bypass the nursing home entirely and take them to home care.
The net result is that we’ll make more money to the hospital. We’ll completely bypass the nursing home, and we’ll take them right to home care. That’s also going on right now in the hospital industry, and this trend is also going to accelerate.
So, another thing you’ve got to think about if you own a nursing home or are investing, are you competitive quality wise, are you competitive cost wise? Because the hospitals are going to now compare you directly to home care.
And what the CMS data seems to suggest for many, many illnesses is that the patient being sent directly from the hospital to home is getting equal to or better care and we’re spending considerably less.
So, this is another thing that folks that are investing in senior care need to comprehend. The economics of the field—and we’ve been in this a long time. As you said, you’ve heard quality ratings for a long, long time. This is the first time ever in my opinion that you’ve seen this kind of sea change and linkage between quality and cost and the flexibility now for the hospitals to direct patients in ways they never had before.
Steve Monroe
Right. Yes, that’s going to be interesting. And it’s probably going to get the pencil-pushers doing the math to figure out, okay, do we keep them longer and hope they can do better with home health, or do we keep them shorter and let them go to skilled nursing. I think that’s going to be a little bit risky because you never know who you’re going to get on the home health side and who’s going to be doing the rehab there. It’s a little bit more stable, I would imagine, in the skilled nursing facility.
David Friend
You know what? I actually think that’s not true. It’s no riskier. In fact, I would argue it’s a lot safer. The riskiest system we have is the system we have today. So, no, I think the improvements in quality and reduction of cost are going to be stunning. And it’s this variance that CMS has found problematic. In other words, in senior care, you’ll find one patient in rehab for ten days with the exact same illness, another patient in rehab for 30 days. There’s no discernible difference in outcome.
So, everyone says, well, why are we paying three times as much for nothing better? Let me give you an analogy to see if this makes sense to you. Let’s say there were two gas stations across the street. We’ll call one the red, and we’ll call one the blue. The red charges $4 a gallon for gas, for regular gas, and the blue station charges $2 a gallon for regular gas. You’d go to the blue every time. You’d never go to the red, would you?
Steve Monroe
Right.
David Friend
Okay. Now, let’s change it a bit. Imagine the red station sells regular gas for $2, and the blue station sells premium gas at the same price. So, you can go to the red station and get the regular, or you can go to the blue station and get the premium and pay the same price. Where would you go?
Steve Monroe
The blue station.
David Friend
Premium, right? Okay. Now, imagine the worst of all worlds. The red gas station charges you $4 for regular; the blue station charges you $2 for premium. Where would you go?
Steve Monroe
Gee, let me think about that one.
David Friend
Blue, right? So, now, we’ve got 5,000 red skilled nursing facilities in the United States. You tell me, how viable is that business going forward if they don’t change? And the difference has been people did not have access to the data. They couldn’t see the quality. They couldn’t see the price. And the government, which was the biggest payer, said, it doesn’t matter.
All of a sudden, the government is saying, you know what—
Steve Monroe
It does matter.
David Friend
Maybe we shouldn’t go to the red gas station so much. So, I think this is profound, and to the extent that you’re an investor, let me give you a couple of ideas. First of all, if you’re paying the same for a one- or two-star and a three or four, you don’t understand the business. Second of all, you should be thinking about if you have a one- or two-star, how can you improve it, how can you get up to be a three-star or better? If you’re a three-star, you can’t rest on your laurels because the competition’s coming at you. If you are really, really good, you should think about buying a red and doing a turnaround to the blue. That’s possible. There are people who do turnarounds.
But you’re going to have to factor this into your investing equation, whether you’re a lender, whether you’re an equity owner. And this I really believe is a very big deal. And again, as you know, our business we spend about half our time helping people improve their operations and about half our time helping people analyze these things differently. And it’s the data, it’s the algorithms, to be able to understand what’s going on. And this really I think is a big change.
We’ve both been in this business a long time. This is a big change in the way you think about those asset classes.
Steve Monroe
It’s going to be interesting to watch, especially from the investor side, how they’re going to view this. I think they’re going to get it and understand it. It’s a question of whether they’ll believe it or whether they think they can—
David Friend
Well, they’re going to see their patient volumes dropping already. It’s not even a question of belief. When I have clients that tell me about belief, I ask them, do you guys believe in gravity? Because we have to start there. If you don’t, we’ve got to move on. But assuming you do believe in gravity—this isn’t a matter of belief. This is actually already occurring. We’ve already bundled in the dialysis business.
Let me give you an example. This rule came out around the 20th of November. About a week later, the ACOs—you’ve heard of these ACOs? The ACOs have now said, oh, we’re going to now mimic that same thing. We’re going to waive the three-day rule for three-stars. So, you already now have a second part of the system saying that it’s also going to do the same thing.
So, it is not hard to imagine that this will occur. And as you know, in the nursing home industry generally, if your Medicare is below 20 percent, you have an issue. Usually successful nursing home operators have at least 20 percent Medicare of their patients. Assume a building of 100 patients, so roughly 20 will give you a decent operating margin. If you only lose a handful of patients, if you lose five, six or seven patients to your competition—let’s say there’s a five- or six-patient shift—that can actually throw your margins negative. That’s how sensitive a lot of these industries are run. They run on very tight margins and they’re very dependent really on a small population for all their profits because the rest of the patients help them break even.
So, that’s why I think this is even more levered and frankly the diversion of patients is even more profound. And it’s the high-quality lucrative patients that are going to be taken away first. The hips, the knees, the full-rate folks. These have been the most valuable patients in the nursing homes. These are the people that you’re going to lose first if you don’t improve your quality.
Steve Monroe
Well, David, thank you. I think we’re going to have to check in with you late in 2016 and see how this is impacting things in the acquisition market and values and census and all that and see who—
David Friend
Yeah, please do. The rules go into effect April 1, and hospitals, we’re working with them right now as we’re speaking. They’re figuring out who’s going to be in and who’s going to be out. So, we would really encourage everyone who’s investing in this space to learn more because we think the valuations are already changing, and so if you’re a smart investor, you can arbitrage the knowledge you’re going to get from this article against a lot of people who don’t understand what’s really coming at them.
Steve Monroe
Right. I’m going to close with: investors and lenders, beware. All right, great catching up with you. Thanks for your insight, as always, and we hope late in 2016 we may do a repeat and see how everything is panning out.
David Friend
I think you’ll do it even earlier. I wish you a happy holiday, and we’ll talk sooner.
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