Vertical Integration in Healthcare: Why It has Failed and What to Do Instead

Vertical Integration in Healthcare:  Why It has Failed and What to Do Instead

By Jeff Goldsmith

While it has been with us for decades,  the concept of vertical integration has recently revived in healthcare both as a solution to maturing demand for healthcare organizations’ traditional products and as a vehicle for ambitious outsiders to “disrupt” care delivery.  Unfortunately, vertical integration is being misunderstood by many healthcare CEOs, investors and analysts. Pursuing it may end up wasting billions of dollars as well as damaging organizations and health professionals alike. 

Below we will:

Explore the Industrial Origins of Vertical Integration

Explain How this Idea Became Central to Healthcare Strategy

Trace the Health Policy Community’s Fifty Year Obsession with Integration 

Explain Why the Idea has Fizzled

Discuss the History of Kaiser, US Healthcare’s Largest Vertical Enterprise

Outline What Healthcare Enterprises Need to Do to Simplify their Businesses

Industrial History

The strategy of vertical integration was a creature of the US industrial Revolution. The concept was elucidated by the late Alfred DuPont Chandler, Jr. who was a Professor of Business History at the Harvard Business School.  Chandler produced two remarkable studies of  business strategy during the US industrial revolution in the late 19^th and early 20^th centuries:   Strategy and Structure: Chapters in the History of the US Industrial Enterprise  (1962) and the Visible Hand: The Managerial Revolution in American Business (1977), which won a Pulitzer Prize.  

Chandler found a common pattern of growth and adaptation of 70 large US industrial firms. He looked in detail at four firms that came to dominate markedly different sectors of the US economy:  DuPont, General Motors, Sears Roebuck and Standard Oil of New Jersey.   They all followed the same four-step pattern:    

1)     growth by acquisition-first horizontally, absorbing competing firms making the same product, then vertically, firms that controlled either precursors to that product or distribution of the finished product. The goal of vertical integration was to lower procurement costs and squeeze out middlemen’s profits, not to be a “loss leader” in service of volume growth.   

The most clearcut physical embodiment of vertical integration was the famed 1200 acre River Rouge complex at Ford in Detroit, where literally iron ore to make steel, copper to make wiring and  sand to make windshields went in one end of the plant and finished automobiles rolled out the other end.  Only the tires, made in nearby Akron Ohio, were manufactured elsewhere. Ford owned 700 thousand acres of forest, iron and limestone mines in the Mesabi range, and built a fleet of ore boats to bring the ore and other raw materials down to Detroit to be made into cars.  By the late 1990’s, it had become a SuperFund site, though a part of it has today been repurposed is the site of the Ford F-150 Lightning electric truck.    

All this growth and growing complexity created problems of co-ordination as well as a declining return on investment, requiring

2)     rationalization by management control- centralized structures of accounting, purchasing, marketing etc. were created to enable owners to improve efficiency and profitability.

Those that succeeded in this effort then pursued:

3)     diversification into manufacture and distribution of related products  (eg. refining gas and diesel fuel from crude oil, nylon from gun cotton) as well as into new geographic markets (e.g. overseas).

After all the additional complexity required to manage all these diverse activities dragged down earnings, firms re-organized into a:

4)     multi-divisional structure  which decentralized basic corporate functions into semi-autonomous divisions to manage products targeted at specific markets.  General Motors’ multiple divisions- Chevrolet, Pontiac,  GMC, Oldsmobile, Buick, Cadillac and AC Delco -were the classic example.

This evolving pattern- growth, rationalization, more growth, further rationalization- was driven by the continuing need to improve efficiency and generate cash flow.  Firms that did not follow this pattern either failed or were acquired. However, Chandler also showed the advantages of each stage were fleeting.  Specifically, whatever benefits vertical integration conferred on these firms did not last.

By the late 1960’s, the sun was setting on the successful firms Chandler wrote about.  Chandler’s writing coincided with an historic transition in the US economy from a manufacturing dominated industrial economy to a post-industrial economy dominated by technology and services.   Supply chains re-oriented around relocating and coordinating the value-added process to where it could be most efficient.  Owning the entire value chain no longer made economic sense.

Sears was in decline long before the Internet gutted its business.  Today, Sears is bankrupt and largely liquidated.  General Motors has endured several near death experiences, notably declaring bankruptcy after the 2008 financial crisis, and is now is the sixth largest auto manufacturer in the world. DuPont has struggled to survive in global chemical market and is now the 25^th largest global chemical company.  Standard Oil  of New Jersey became Exxon, and merged with Mobil in 1998 and is now the fourth largest global energy firm.  

Vertical Integration in Healthcare

This author  met Alfred Chandler in 1976 when he was being recruited to the Harvard Business School faculty. As a result of this meeting and reading Chandler’s writing, I wrote about the relevance to healthcare of Chandler’s framework in the Harvard Business Review in 1980 and then in a 1981 book Can Hospitals Survive: The New Competitive Healthcare Market, which was, to my knowledge, the first discussion of vertical integration in health services.

 Can Hospitals Survive correctly predicted a significant decline in inpatient hospital use (inpatient days fell 20% in the next decade!).  It also argued that Chandler’s pattern of market evolution would prevail in hospital care.  However, some of the strategic advice in this book did not age well, because it focused on defending the hospital’s inpatient franchise rather than evolving toward a more agile business model.  It advocated controlling care pathways pre- and post-hospitalization, and depriving other hospitals of their inpatient volumes through competition in order to prop up the hospital’s inpatient mission.  Ambulatory services, which are today almost half of hospital revenues, were viewed as precursors to hospitalization rather than the emerging care model. 

Kaiser Transfixes Healthcare Policymakers

This focus on vertically integrated healthcare models was timely, because,  at that time, policymaker’s attention was fixated on Kaiser Permanente, the largest vertically integrated actor in healthcare (then and now).   Dr Paul Ellwood, a health reform advocate, persuaded the Nixon Administration to sponsor the HMO Act of 1973, designed to foster health plans modelled on Kaiser as an alternative to a government run national health insurance plan. 

Kaiser was the creation of Kaiser industries founder Henry J Kaiser and Dr. Sidney Garfield, a visionary physician . Garfield created two small hospitals for Kaiser Industries during the 1930s to care for workers building the Los Angeles Municipal Water Conduit in the Mojave Desert and subsequently the Grand Coulee Dam in the wilds of Eastern Washington.  The Grand Coulee Dam project employed 6500 workers and was the largest pre-WWII  private construction project. 

Garfield’s plan enabled workers to be cared for in his hospitals for 5c a day for industrial accidents and an additional 5c a day for general medical coverage.  Vertical integration-combining hospital, physician care and subscription model health insurance in a single enterprise- was unavoidable given the geographic isolation of these remote construction projects. 

These small hospital projects were so successful that Kaiser asked Garfield to replicate his vertically integrated model during World War II for shipyard workers in Richmond, California near San Francisco and in Portland,  Oregon.   After the War ended, Garfield and Kaiser collaborated to open enrollment in Kaiser’s prepaid medical plan to folks in both communities, with an enrollment base in unionized heavy industry and public services.   Major unions-the Longshoremen and Retail Clerks, persuaded Garfield to open  a branch in Los Angeles, Kaiser’s third major market, during the early 1950’s.  Kaiser franchises in Sacramento, San Diego and Hawaii shortly followed.  Kaiser became a dominant early  presence in the large West Coast health insurance markets by the mid-1950’s and grew as those markets did. 

Nixon’s 1973 HMO Act provided federal grants to foster HMOs as a vehicle for containing soaring health spending through market mechanisms. As a result of these federal investments, HMOs covered 31% of the privately insured population by 1990.   Many hospitals viewed HMOs as a new channel for patients to reach their facilities and physicians.    Many multi-hospital systems-Intermountain in Utah, Henry Ford in Detroit, Sentara in Virginia,  Geisinger in Pennsylvania, Humana, Lutheran Hospital Society of Southern California, Michael Reese and Rush Presbyterian Hospitals in Chicago-created their own HMOs during the 1970’s and early 80’s

However, Kaiser-style health plans, which either employed their physicians directly (staff models) or contracted, as Kaiser did,  exclusively with closed physician groups  (group models) did not prosper in communities with strong traditions of independent (e.g. solo and partnership) medical practice.  As a result, the industry became dominated by HMOs contracting with private physicians individually or through physician sponsored Independent Practice Associations (IPAs).  Many IPAs were medical society-sponsored responses to the growth of Kaiser.    IPAs enabled physicians to participate in HMOs without being employed by them or by hospitals, and to earn extra income through shared profits. 

Seeing the handwriting on the wall, publicly traded Humana actually divested its 77 hospitals in 1993 and became a health insurer exclusively.  Humana leadership concluded that owing a business that reduced hospital utilization and rates, and that squeezed their specialists’ incomes,  did not make sense if hospitals were their core businesses.  They chose to shed their hospital business to focus on their health plan business.  Humana is today a leading Medicare Advantage plan with over five million members.

Clinton, then Obama, Revived Vertical Integration

The abortive Clinton health reforms during 1993-1995 provided a further push toward vertical integration.   The almost inexplicably complex Clinton plan would have required the entire care system to be re-organized into competing Kaiser-like regional health enterprises that would receive a global payment for caring for all citizens in its region.  The Clinton reforms foundered over concerns about restricting consumer choice of physicians and hospitals (and because no-one could understand exactly what they were trying to do).  Even though never implemented, the Clinton plan catalyzed a wave of physician practice acquisitions by hospitals and by private equity backed companies like MedPartners and PhyCor. 

Shortly thereafter,  HMOs endured an angry consumer and employer backlash (fanned by organized medicine and hospitals).   Commercial insurers including Blue Cross plans, United Healthcare, Aetna, Humana and CIGNA displaced group and staff model HMOs in the commercial market through broad network Preferred Provider Organizations (PPOs) that contracted with networks of hospitals and doctors through, mainly, discounted fee-for-service payment.   Today, HMOs represent only about 12% of private insurance enrollment, of which Kaiser’s members represent well more than half.   

The Obama Administration’s 2010 health reforms attempted to revive enthusiasm for vertically integrated healthcare by fostering “value based care”, a fluffy term intended to describe a raft new payment models that shifted risk onto provider organizations-hospitals,  physician groups and others.  The policy intent was that “value based care” would serve as  a bridge to full risk/delegated risk capitation.  The end goal was similar to Clinton’s: foster global budgeting based on population-based payment in order to control cost.    

ObamaCare included a complex new “shadow” capitation model for the regular (e.g. non-Medicare Advantage) part of Medicare- the Accountable Care Organization (ACO).  ACOs paid providers on a fee-for-service basis, but then retroactively compared their actual spending for populations attributed statistically to the ACO  vs cost targets to determine potential bonuses.   

The ObamaCare experiments in ACOs as well as a raft of alternative payment approaches have been a big disappointment.  A recent head of the federal CMS Innovation Center, which is responsible for them, said in a recent NEJM paper, “the vast majority of the Center’s models have not saved money, with several on pace to lose billions of dollars. Similarly, the majority of models do not show significant improvements in quality.”

The Eclipse of Private Medical Practice

However, the prospect of major payment changes catalyzed yet another wave of anticipatory mergers and physician practice acquisitions by hospitals and others. By 2020, nearly half of what were formerly independent physicians had moved into salaried employment-in vast conglomerates like United Healthcare’s Optum subsidiary, private equity roll-ups like Envision and Team Health and, most importantly,  hospitals, who now employ  more than a third of all practicing physicians.

Hospitals enjoyed a special non-market related advantage in this consolidation:  Medicare’s generous provider-based Part B (so-called “site of service”) payments, which helped offset the six-figure per physician losses hospitals were experiencing due to the gap between physician billings and actual collections plus practice overhead.  Medicare’s Part B payment policy effectively made physician time more valuable if they were hospital employees than if they were in private practice. These subsidies were cut during the Trump administration and are under renewed attack as of this writing.
 

This federal subsidy flow  papered over a fundamental problem hospitals were having with vertical integration into physician care:  the negligible economies of scale or co-ordination in large scale physician enterprises.  

Why Vertical Integration Hasn’t Worked in Healthcare

We now have had five full decades of broad experimentation with vertical integration strategies in healthcare.  Kaiser, the exemplar, is nearly eighty years old, but its growth has not kept pace with population growth except in the West.     With the benefit of hindsight, Chandler’s four-step evolution has not worked well in this field.  There has been a lot of “consolidation” but not a lot of efficiency gains.  Costs have soared.  Something about healthcare has fiercely resisted “industrialization”

The main problem in healthcare:   professional judgment and the personalized care guided by it does not scale very well.  People, not raw materials, transportation or energy, are the vast majority of health costs. Healthcare’s value chain is fundamentally different and more complex than that in manufacturing or retailing.  There is also greater variability and uncertainty at the point of service, as well as greater personal risk to the “consumer” than just about anywhere else in the economy.  Chandler’s four-step pattern has also not held for the other professional services that dominate the American economy:  education, law, accounting, consulting, etc.

Healthcare mergers-horizontal or vertical- have not only not reduced cost, but may actually have added cost through high transaction costs and new and expensive layers of supervision.  Vertical integration of physician practice into hospitals has increased costs, not reduced them.  And “integrated delivery systems” that combined hospital, physicians and health plans in a single organization are neither cheaper nor of demonstrably higher quality than less integrated competitors in the same markets.  

The vertical exemplar, Kaiser, has prospered, growing to $95 billion in revenues in 2022.  However, it has remained largely a creature of the markets in which it originated (e.g the Pacific Coast) where over 80% of its members live.  It has taken nearly eighty years to grow to 12.7 million members (and about 2% of total US health spending).  Only 1.2 million of those members are Medicaid beneficiaries even though more than one quarter of the US population are enrolled in Medicaid.   Kaiser suffered several years of major financial losses by attempting to become a “national brand” in the late 1990’s.  Kaiser’s success was likely attributable to the market conditions in their original marketsrather than the vertical strategy for which it has become famous. 

Where Does the Physician Fit into the Vertical Paradigm?

It is far from clear how best to incorporate physicians into the healthcare enterprise, whether the core is hospitals, health plans or other actors like pharmacies or retailers.    Physicians are less than a million of the nearly 17 million people who work in healthcare.  Yet despite the growing use of advanced practice nurses like NPs and CRNAs, physicians remain the pivotal actors in the $4.5 trillion US healthcare enterprise.

Private medical practice in solo practice or small groups has withered, In major part, because of  federal policy which has held Medicare physician payments under Part B far below the rate of inflation for two decades.    Commercial rates for physician care have also not kept pace with inflation, further encouraging consolidation.  Many hospitals discovered that they could not recruit young physicians burdened with debt, or retain older physicians whose practices were stagnating without taking them on as full time employees.   And as mentioned earlier, federal policy actively encouraged consolidation in physician markets by subsidizing hospital-based physician practice. 

Hospitals have always rested on the base of the physician communities they serve.  But while hospital employment of physicians has helped stabilize, particularly, small and rural facilities, it has been at best a mixed blessing for larger enterprises, many of which are now homes to thousand+ person medical practices that struggle to meet physicians’ practice needs.   Those vast practices are not organizations, but rather collections of independent docs with rebadged offices, all too often lacking the shared values,  strategic vision, leadership and sense of common purpose of real groups. 

As a consequence, many hospital systems have had to rely on outside publicly traded management services organizations (MSOs)  like Agilon, Privia and Evolent to organize their physician “groups”  to assume population risk through contracts with insurers. These organizations have billion dollar valuations.   So add together the losses on physicians’ employment contracts, the  hospital’s administrative overhead for managing them, the operational costs of participating in ACOs and other value based care models, consulting services and the fees and margins of the MSOs, employing physicians  has simultaneously increased cost to the community and damaged hospital financial performance.

Mass retailers like Amazon, CVS, Walgreens, WalMart and Dollar General are entering the physician business, though in some cases, the model seems more like “nurse in the broom closet” than a physician-centric approach.   Where they are going to find scarce clinicians in a rapidly tightening clinical marketplace is anyone’s guess.  While cloaked in hazy mentions of “value based care”,  mass retailers’ strategies seem like thinly disguised efforts to prop up stagnant core businesses- to increase “sales per square foot” of grossly underutilized store space, or, in Amazon’s case,  sell additional services to passive subscribers.

As their core businesses have faltered, expensive corporate strategy advisers and investment analysts have told these retail giants that they “have to be in healthcare”, which is 17+% of the economy. While anyone can conceivably lose $30-40 a visit to generate more prescriptions or sell more shampoo or Doritos, it is not clear where the return on their capital in recent costly acquisitions like One Medical and Oak Street Health is going to come from.  CVS paid over $18 million per physician for its recent acquisition of Oak Street’s nearly 600 physicians.

The largest employer of physicians in the US today is no longer Kaiser or the Veterans Health Administration, but rather the vast Optum Health subsidiary of $360 billion health insurance giant UnitedHealth Group.    Optum Health claims 70 thousand physicians, but the number includes “affiliated” independent physician members of IPAs related to the employed groups they have acquired. 

Optum Health also owns urgent care centers, surgicenters and home health agencies,  Optum Health is more than fifteen years old, but has grown explosively by acquisition since its $4.9 billion purchase of HealthCare Partners from DaVita in 2019.  It has almost tripled in size  in the past five years, from

$24.1 billion in 2018 to $71.2 billion in 2022.  But to characterize Optum Health’s growth as “vertical integration” is increasingly inaccurate.  

Unlike Kaiser, Optum is not a closed panel care system devoted exclusively to caring for United’s health insurance subscribers.  Optum Health has actually grown less vertical in the past five years as Optum’s income from sources outside United’s health plan have grown from 36% to 41% of total revenues.  Simultaneously,  Optum Health’s  operating earnings have fallen from 10% in 2018 to 6.4% in the most recent fiscal quarter.  A study conducted in 2018, just before the DaVita acquisition,  found a significant geographical mismatch between where United has its Medicare Advantage enrollment (the most lucrative United insurance product)  and where Optum Health care system assets is located. The geographic mismatch between United’s health insurance enrollment and its care system assets has likely grown, not shrunk, since 2018. 

As large as it is,  United lacks the market power to move its Optum Health patients from competing health plans to United’s health plan offerings or move it United’s health insurance subscribers from independent docs to Optum’s care system.   Doing so would likely gut Optum Health’s profitability.  UnitedHealth Group is, as its name suggests,  a conglomerate, and Optum, a conglomerate inside a conglomerate.  It has relied on conservatively priced accretive acquisitions, not vertical integration, to achieve its remarkable size and prosperity.

An ominous development for the vertical strategy was the recent failure of Geisinger, a 110 year old exceptionally high quality multi-specialty physician group-based health system with a significant health plan and ten hospitals in central Pennsylvania.  Geisinger lost $842 million in 2022, and was losing $20 million a month on operations when it announced a complex, non-merger style affiliation with Kaiser through a new enterprise unpromisingly named Risant.  At almost $7 billion revenues, it is difficult to argue that Geisinger had insufficient scale to prosper.   Rather, Geisinger’s demise as a freestanding enterprise raises serious questions about the viability of the vertically integrated model.

What to Do (and Not to Do)

Vertical integration  is being touted as the strategy most likely to “disrupt” both hospital and health insurance markets.  However, our view is that vertical integration is a relic of the industrial age.  It neither guarantees market dominance nor profitability in healthcare.  

 Keep What You Do Well or Which Would Be Missed If you Did Not Do It.  Lose the Rest.

Health care enterprises’ earnings and financial resources have been damaged by the pandemic, and restoring a positive return on the organization’s assets and people is essential.  

It is time to ask Peter Drucker’s famous question:  If we were starting fresh today, would we own all these assets and programs?     Do we do a good job of running them (e.g. generate both happy customers and black ink), and would anyone miss them if someone else did?   Eliminating duplicative services both within your enterprise and in your community will directly address continuing concerns about excessive healthcare costs. 

 Don’t just guess what you do best. Rely on empirical sources if available, whether  federal HCAHPS patient survey results or Medicare STAR ratings, Leapfrog ratings, independently gathered Net Promoter Scores or  internal surveys of clinicians and managers working in each service area, as well as a searching and fearless analysis of where positive cash flow is being generated. The surveys of your clinical and administrative staffs are important considerations given the recent stresses on healthcare enterprises of the COVID pandemic and widespread evidence of burnout and disillusionment both among clinicians and their partners in management.

Community needs are an important consideration.  If your community would suffer if you stopped doing something vertical, you can count the losses you incur by continuing to do it as part of your community benefit.   An important exception might be for teaching institutions, for whom the breadth of clinical experience required to train new physicians might dictate a breadth of service that does not make sense otherwise.  Those losses are in part covered by Medicare’s direct and indirect medical education supplemental payments.

Services that do not sustainably return your capital or generate a positive work experience for clinicians should be flagged for divestiture, unless you need to continue doing them for teaching purposes or meeting a significant and demonstrable unmet community need.  It makes no sense to own the tenth home care agency or the sixth chain of convenience clinics just to “feed” your clinicians referrals or to field a complete continuum of care.

Health Plans in Hospital Systems:  A Bridge to Nowhere?

The future of population level risk in healthcare delivery enterprises is cloudy.  It is true that some health systems saw windfall profits in their captive health plans from declining healthcare use during COVID provide a significant offset to their care delivery losses.   But this was a once-in-a-century health emergency, not a “use case” for continuing to invest scarce capital (in a capital intensive business) in a business most care enterprises have struggled with.

Being a “payvider” is not vertical integration, nor is it an efficient vehicle for growing healthcare volumes; it is unrelated and risky diversification with probable negative investment returns.   Health insurance and healthcare delivery are different businesses, with dramatically different critical success factors. Unlike inside Kaiser, where the sole access point is enrollment in their health plan, there is “dysergy”, not synergy, between these businesses in most care systems. Success in the health plan business requires reducing  both unit cost and utilization in care systems. 

It is unlikely that the current experiments with “value based care” will lead to a Kaiser-style, full risk contracting framework for Medicare or Medicaid. This author’s experience has been that failure rate for health plans started by health care delivery enterprises approached 80%.  And success in the Accountable Care Organization business had more to do with high pre-existing Medicare cost benchmarks than organizational strategy or execution.  Health systems will need to take a hard look at their investments in payor strategies, and cut their losses.  

Having said this, health plan revenues in some large health systems (UPMC, Sentara, Spectrum/CoreWell, InterMountain, e.g. ) are such a significant piece of overall revenues and have such a significant market presence that the plans are integral to the future of the overall enterprise.  How many of these large systems prop up their health plans’ profitability with “below market” payment rates and that pay their physician groups on an RVU basis that incents them to do “more” rather than “less” are interesting research questions.   But for organizations with a smaller footprint in health insurance or sponsored “risk models”, it is time for an agonizing re-appraisal of these investments. Sharing risk via delegated risk models (where market conditions permit) will make much more sense for many than “owning the premium dollar” via direct sponsorship of health plans.

Stop Relying on Market Anomalies to Justify Physician Employment

Physicians are complex professionals, not pawns on a three dimensional chess board.

Non-compete clauses in their employment contracts and Medicare subsidies have papered over a fundamental problem:  aggrandizing the market for physician care is not a cost-effective means of leveraging other healthcare businesses. It is also ruining clinical medicine by creating substandard working conditions for busy professionals and conveying the impression that physicians’ services are a means to an end, not a valuable end in itself.  It also fosters the illusion that those physicians’ patients belong somehow to the “owner”, not the clinicians who are responsible for them.     The push by major retailers like Amazon, CVS and WalMart into the physician business is likely to end in tears, both for the companies and the professionals they employ.   

Hospitals will likely lose the Medicare subsidies for employed physicians as federal budgetary conditions worsen.  It is also likely the FTC will also outlaw non-compete clauses in physicians’ contracts (though non-profit hospitals and systems may or may not be exempt).   Relying on coercive measures like non-competes clauses to compel physicians to remain employed in your community (and laying claim to their patients as if they were your property) is a sad confession of a bankrupt corporate culture.  Outlawing non-competes as FTC intends will probably damage the big retail “disrupters”, the contract physician providers like Envision and Team Health and the vast enterprise that is Optum Health more than it will damage hospitals and systems.   

Conclusion

Healthcare providers of all stripes must leave the industrial world behind. If you look and feel like Sears or General Motors, you may well end up like them.   Virtual care, the advent of AI in healthcare and consumer demand will require a flexible, 24/7 and care anywhere business model.  Those who build the best modern clinical mousetrap will end up with a committed clinical staff and loyal patients.   Healthcare isn’t about the building, or the brand, or scale.   Surviving and thriving in the future will require engaged clinicians who foster trust on the part of their patients and the community.