Orthopedics Probe's Deep Roots

There was a time when Lee Memorial Health System actually made money replacing the worn-out joints of senior citizens.

But these days, the Florida hospital must spend half of its Medicare reimbursement on orthopedic implants -- devices made by the likes of Stryker (SYK Quote) and Zimmer (ZMH Quote) -- so it never has enough left over to cover the rest of the surgeries' costs.

Every year, Lee Memorial -- which caters to the huge senior population in southwest Florida -- ranks as one of the busiest hip-replacement centers in the country. It also rates among the best. But it pays for that success.

"We actually lose money on what is a massive growth business for us," Lee Memorial CEO Jim Nathan said. "It's a significant issue."

Indeed, Nathan compared the situation to the California energy crisis. In both instances, he said, the government established fixed prices that eventually failed to cover the actual costs of the services provided.

Nathan offered a chart, based on industry data, to bolster his own case. Between 1991 and 2004, the chart shows, Medicare increased payments for joint-replacements by only 16%. During that same period, however, implant makers hiked their own prices by 132%.

Moreover, Nathan said, Lee Memorial faced higher implant prices than most, despite its voluminous joint-replacement business.

"In any normal business, you would expect the highest volumes to bring the lowest costs," he said. "But we have virtually no leverage with the implant companies."

Instead, industry sources say, orthopedic surgeons -- hit by drastic Medicare cutbacks -- tend to call the shots. They select expensive devices manufactured by companies that, sometimes, pay them for other services. And then the hospitals pick up the tab.

"As physician reimbursement declined, the implant makers pushed prices up and entered into financial contracts with physicians as a means of additional compensation to physicians and market share," explained Peter Young, a business consultant at HealthCare Strategic Issues.

At one point, Nathan asked the federal government -- with its huge buying power -- to step in and negotiate better prices. But the government has chosen to intervene in other ways instead. For starters, it has begun approving "gain-sharing" agreements that allow hospitals to split certain cost savings with physicians. The new arrangements reward both hospitals and physicians for bringing health care costs under control.

More recently, the government has gone a step further by investigating the deals that may have driven implant prices so high in the first place. Last week, the feds subpoenaed three implant makers -- Biomet (BMET Quote), Stryker and the Depuy unit of Johnson & Johnson (JNJ Quote) -- seeking information about their financial arrangements with physicians. The probe could engulf all the major orthopedic implant makers in the end.

Warning Shot

Morgan Stanley analyst Glenn Reicin has been warning about trouble for months. Indeed, he caused something of a stir when he questioned the industry's selling practices -- and, more specifically, its cozy ties to physicians -- during an early November presentation at Harvard.

Aching Joints Hospital payments lag behind surging orthopedic implant prices*

Source: Lee Memorial Health System *Manufacturer price increases as reported in January Orthopedic Network News, 1992-2004. Hospital payment changes are based on Medicare payments in October 1991 vs. October 2003.

Working Knowledge, published by the Harvard Business School, shared his words of caution.