The Medicare Prescription Drug Bill Amendments to the Stark Act: Strategic Options

This article describes certain strategic options that specialty hospitals can evaluate in light of the Drug Bill.

The Drug Bill includes amendments to the Ethics in Patient Referrals Act, 42 U.S.C. §1395nn, as amended (the “Stark Act”), and the regulations promulgated thereunder, 42 C.F.R. §411.350 et seq. (the “Stark Rules”). The effect of these amendments would be to impact negatively physician investment in specialty hospitals, and further to eliminate the existing exception to the Stark Act for physician-owned hospitals in rural areas. The amendments are applicable under the Bill’s moratorium until May of 2005. I. Regulatory Overview

The Stark Act prohibits physicians from referring Medicare or Medicaid patients to an entity for the provision of designated health services if the referring physician (or his or her immediately family member) has a financial relationship with or ownership interest in the entity, unless an exception to the prohibition applies. Any referral of Medicare or Medicaid patients to a specialty hospital by a physician owner of the hospital would implicate the Stark Act because the referral of patients to the hospital will be for inpatient and outpatient hospital services, which are considered designated health services.

Physicians have relied on the Stark exception, commonly referred to as the “whole hospital exception,” in structuring their ownership of specialty hospitals in order to avoid Stark liability concerns. The “whole hospital exception” provides that a physician’s ownership in a hospital will not create a financial relationship with that hospital for purposes of the Stark Act if (A) the referring physician is authorized to perform services at the hospital, and (B) the ownership or investment interest is in the hospital itself (and not merely in a subdivision of the hospital). This exception allows a physician to refer patients to a hospital in which he or she has an ownership interest if the physician owns an interest in the entire entity as opposed to just owning an interest in a discrete hospital department or joint venture. The effect of this exception has been to permit physician ownership in specialty and whole hospitals if the ownership interest is in the entire entity and the physician is on staff at the hospital. This exception, however, has been severely limited by the Drug Bill.

II. Legislative Initiatives

The Drug Bill revises the whole hospital exception to the Stark Act to exclude from the exception a physician’s ownership interest in a hospital that is primarily or exclusively devoted to cardiac or orthopedic patients, surgical procedures, even if the hospital were located in a rural area. The Drug Bill grandfathers certain existing specialty hospitals and certain specialty hospitals that are in the development phase, as defined in the Bill by DHHS.

III. Potential Alternatives if Legislative or Regulatory Initiatives Are Successful

In light of the legislative initiatives described above, or any variations of such initiatives. A specialty hospital may attempt to examine changes to their structure and their operations in one or more of the following manners in order to attempt to avoid a violation of the Stark Act. Any such modification may materially and substantially affect an investment in the hospital. Further, if all alternatives ultimately proved to be not viable, an investor in the hospital could lose his or her investment.

Broaden Service Range to Avoid Definition of a “Specialty Hospital”. A specialty hospital may consider expanding its operations to avoid being defined as a “specialty hospital”. It is unclear as of this date how a specialty hospital will be defined. For example, the United States General Accounting Office (“GAO”) has deemed an entity a specialty or surgical hospital if more than two-thirds of its services or surgical procedures fall within the same major diagnostic category. Under the Bill, however, an entity is deemed a specialty hospital if it is exclusively or “primarily” devoted to cardiac, orthopedic, surgical or other specialties designated by the DHHS. “Primarily” can mean fifty percent or fifty-one percent or sixty-six percent (as the GAO used). It is also unclear whether the proposed rules will be based on revenues, or based on the number of patients seen or procedures performed at the hospital. Depending on the interpretation of the definition of specialty hospital that is ultimately adopted, this option may or may not be a viable solution for some specialty hospitals.

Divide the Project into an ASC and Spin Out an Imaging Facility. The proposed legislative initiatives do not affect the ability of physicians to own an ambulatory surgery center (“ASC”). Further, they also do not affect the ability of a group practice or a hospital to own an imaging facility. Thus, a specialty hospital could be scaled back and be operated as an ASC, as opposed to a specialty hospital. The imaging portion of the project could be purchased by a single group practice or a hospital. The group practice would be able to own the imaging portion of the project pursuant to the group practice exception to the Stark Act (as discussed below).

Cease Performing Cases on Medicare and Medicaid Patients. The Stark Act’s restriction on referrals applies to patients who are covered by a federal health care program. Thus, if a specialty hospital does not furnish services to patients who are insured by Medicare or Medicaid, then the restrictions imposed by the Stark Act would not apply. Such a modification in a specialty hospital’s operations may not be economically feasible. Furthermore, state regulation may impose restrictions on physician ownership of hospitals that could apply to referrals of all patients and not just patients insured by a federal health care program. In addition, certain state laws may conflict with this approach by requiring that a hospital provide a certain percentage of its business to Medicare, Medicaid or indigent patients.

Sell the Specialty Hospital to a Third Party. A specialty hospital may also consider selling its business to a non-physician third party. The physician owners of the specialty hospital may still be able to retain ownership in the real estate on which the hospital is constructed and act as a landlord or serve in other aspects of the business.

Merge or Combine with Other Specialty Hospitals or ASCs to Create Publicly Traded Company. One exception to the Stark Act permits a physician to refer patients for designated health services to a publicly-traded company in which he or she has an ownership interest. A specialty hospital may consider combining with other hospitals in order to fit within this exception. The resulting entity would need to have more than $75 million in total assets or stockholder equity (on average over the preceding three (3) fiscal years) and be publicly-traded. This would be a complex and expensive process. Certain combined lab and radiology businesses have used this approach in the past in response to earlier Stark Act regulations.

Rural Exception. A specialty hospital located in a rural area (as defined under the Stark Act) that provides “substantially all” of its services to individuals residing in such a rural area may qualify for the rural exception under the Stark Act. However, as discussed above, the Drug Bill eliminates this exception for specialty hospitals. The Bill does not impact the ability of physicians to own imaging facilities in rural areas.

Create a Not-for-Profit Holding Company for the Specialty Hospital. Physician owners could likely avoid a prohibited financial relationship with a specialty hospital if the hospital were owned entirely by a not-for-profit holding company. Under this structure, however, the specialty hospital would not be able to pay shareholders any profits of the Company. Under this approach, the not-for-profit entity could be governed by a board made up of the current physician owners of the hospital. However, any remuneration that a physician or a physician’s family member would receive from the not-for-profit corporation, such as a salary or lease payments, would be considered compensation for purposes of the Stark Act and would need to meet a separate exception under the Stark Act.

Engage in Lobbying Effort. Specialty hospitals should heavily engage in political and legislative efforts aimed at defeating a continuation of the Bill’s amendments after such amendments expire in 18 months.

Group Practice. The Stark Act contains an exception that allows a group practice to wholly own an ancillary services entity. Thus, physician owners of a specialty hospital may consider combining their practices. The combined practice could own the hospital in a manner that complies with the office ancillary services exception to the Stark Act. This exception to the Stark Act, however, may not survive or work for this purpose.

Dissolve the Entity. It is possible that the owners of a specialty hospital may decide to dissolve the entity and return to the business of operating an ASC.

All of the approaches described above present various challenges, and may ultimately prove to not be viable. The continuation of any legislative or regulatory initiatives which would have the effect of harming the viability of physician-owned specialty hospitals could materially and negatively impact investment in such hospitals.

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