A. Wayne Ferch, FACHE
President and Chief Executive Officer
Adventist Health California Medical Foundation
Deer Park, California

Brief Summary of the Problem
As the medical foundation was formed, it became necessary to implement a physician compensation methodology that would achieve the organization’s financial goals, comply with all applicable laws and regulations, and be acceptable to the physicians. Management sought to address these goals through experimentation with a number of physician compensation formulas with varied results.

Description of the Problem
To understand the physician compensation challenge in this medical foundation, it is important to understand the background of the foundation and its physicians. The medical foundation was formed by the purchase of small one-physician and two-physician practices scattered over a large geographic area. Prior to purchase, the physicians paid themselves based on cash flow in the practice. At the end of each year, and in some cases monthly, any excess cash was paid out and no reserves were retained. The physicians paid themselves the difference between cash receipts and the total of all office expenses and physician benefit costs. This resulted in large swings in compensation month to month. The physicians had a significant incentive to control costs and increase revenues.

Once the practices were purchased, the physicians did not want to be offered incentives based on the actions or inactions of the foundation. Additionally, because of the geographic distance between physicians, they did not know many of the other physicians in the group, which made it virtually impossible to convince them to share risk with other physicians. Most of the physicians who joined the foundation preferred to be on a productivity formula and were resistant to any salary proposals. Working through these issues to develop a workable compensation formula was my job as the president and CEO of the foundation. I had significant interaction with key physician leaders and other administrative staff. The foundation used a couple of consulting groups and sought advice from other similar organizations.

The foundation experienced several issues and problems while attempting to establish a compensation formula:

1. The foundation operated on an accrual-based accounting system instead of a cash-based accounting system, making it more difficult to project actual revenues with accuracy satisfactory to the physicians. Physicians did not trust accountants, and therefore did not trust calculations for write-offs. The physicians strongly preferred to use cash-based accounting. The foundation could not use this method of calculating revenue, as it would create extra accounting work and cost. Additionally, if any drop in cash receipts occurred, the physicians would blame the billing department even if they had not caused the problem. A decision was made that revenues would be measured using accrued revenue versus cash receipts.
2. Prior to joining the foundation the physicians had unwritten compensation formulas. The foundation had to reduce the new formulas to contractual terms and comply with various laws and regulations surrounding physician compensation. Significant legal assistance was required to ensure compliance with all the various laws and regulations.
3. Although the physicians did not desire to be offered incentives as a group, the foundation wanted to create a group culture. The foundation sought to create a common compensation formula that would promote a group culture and protect it against charges of discrimination.
4. The foundation needed to minimize expenses in administering the physician compensation program. At the same time, it needed flexibility to address the unique issues of each practice site. Therefore, the compensation formula’s were kept as simple as possible.

Administrative Decisions
After significant discussion and analysis by various individuals and through consultations with experts in the field, the following compensation decisions were made:

1. The compensation formula needed to motivate physicians to perform actions or behaviors that they could control but still provide indirect incentives in areas where the physicians could influence. The foundation wanted the physicians to allow the foundation to operate their practices according to its policies but also wanted the physicians to have incentives to see enough patients to achieve the financial goals.
2. The foundation decided that it must be able to defend the methodology as being consistent. One long-term goal was to have a formula that could be openly shared among all members of the group. But because of the differences in how each office was organized and had historically operated, the foundation needed some flexibility in the implementation of the formula. The consistent element of the compensation formula(s) was designated to be that the individual practice site had to achieve a defined level of profitability.
3. Because of the complexities of California law surrounding physician-hospital organizations and legal counsel’s interpretation of these laws, physician compensation had to be in the form of individual employment agreements and could not be changed more often than once per year. This restriction created many challenges, particularly when the compensation formula had to be modified more often than annually.
4. The foundation determined that except in cases of income guarantees used in the recruitment of new physicians salaried compensation formulas would not be used.
5. The foundation wanted to have a formula flexible enough that if a physician felt it desirable to have extra staff or make other changes that affected expenses the formula could be changed to reflect those decisions so that the medical office would still achieve its financial goals.
6. The foundation decided to have a formula that was easy to administer and would minimize potential legal challenges or disputes at a later date. This required keeping the formula simple and well defined.

Based on these decisions, the foundation initially determined that it would pay physicians based on a percentage of adjusted gross billings. Adjusted gross billings were defined as the gross charges attributable to that particular physician less calculated or estimated write-offs and contractual adjustments. The estimated adjustment rate would be based on actual write-off percentage over the prior year and updated quarterly.

The compensation percentage would be adjusted at least annually or as often as needed to maintain the profitability targets for the practice site. Therefore, each location would have different percentages based on the expenses of the site and the level of adjusted gross billings produced by the physicians.

This formula was believed to meet the criteria decided upon by the foundation. Few obstacles were encountered in implementation of this formula, but initially some physicians complained that their percentage was too low when compared to colleagues or compared to industry norms. The formula required physicians to have a basic understanding of the financial results of their practice. In some cases, the physicians who received a lower percentage accused the foundation of increasing the cost of operating their particular office.

Another minor obstacle encountered was the desire by some physicians to reward higher levels of adjusted gross billings with a higher compensation percentage. The foundation experimented with this variation but found it difficult to accurately predict where the appropriate thresholds or cutoff points should be for higher percentages resulting from higher productivity. Compounding this, most physicians have large variations in revenues from month to month because of the seasonality of patient load, vacation schedules, and so forth. Attempts to have stair-stepped percentages based on differing levels of revenue were abandoned.

Results
This solution was implemented from the beginning of the foundation in 1993 and largely continues today as the primary methodology for physician compensation. However, within a year or two after the implementation of this formula, certain problems arose that required attention and modification.

1. The foundation experienced high variability in the actual financial results primarily because of fluctuations in gross charges. For example, a percentage of 45 percent might have been calculated based on projected adjusted gross billings for a particular physician of $275,000. However, the physicians and administrators were overly optimistic and the actual results were significantly less, resulting in a net loss to the practice. Rare circumstances also occurred in which physician productivity far exceeded the projections, resulting in a very large and arguably unfair return to the foundation. In these cases the physicians asked for midcontract year increases in compensation.
2. The formula also had shortcomings in that when staffing or other administrative changes to the practice were made that either increased or decreased the cost structure, modification of the compensation formulas for each of these changes was cumbersome. Changing the formula required protracted negotiations with the physicians. In fact, in small offices adjustments in the operations occurred frequently, which often resulted in practice losses because of the foundation’s inability to quickly adjust the compensation formula.
3. The formula was perceived as unfair to physicians who were located in nicer offices with higher overhead. Such physician’s incomes would be lower than colleagues producing similar revenue in offices that were less desirable but had lower overhead.
4. Significant challenges were encountered in calculating an appropriate write-off rate to be applied against the gross charges to determine the adjusted gross billings. Physicians resisted agreeing to write-off or send accounts to collection agencies because they knew it would negatively affect their compensation. Partially as a result of this problem, the foundation experienced a rising level of accounts receivable. An even larger challenge occurred once the foundation determined this was happening and began writing off these accounts. This practice accelerated increases in the write-off rates and increased dissatisfaction by the physicians in the billing services.
5. When physicians earned significant amounts of outside revenues such as medical directorship fees, hospital stipends, and call fees, the formula treated these like all other fees. Physicians perceived this as unfair because in their opinion such earnings had no overhead costs and therefore the physicians felt they should receive 100 percent of these payments instead of the percentage negotiated for the practice.

On the positive side, the administrative staff felt that the formula was easy to calculate and the majority of physicians expressed general satisfaction with the formula because it was predictable and easy to understand.

Because of these weaknesses with the formula, the foundation decided to experiment with some variations on the compensation formula, and a new formula has been implemented that shows great promise. This new formula is described by the foundation as a “margin formula.”

The margin formula involves negotiating a “net margin” or “net income” target for the particular site. This margin would be the return to the foundation for that particular site. The physician would then be compensated by subtracting direct practice expenses, physician benefits costs, and the margin from the adjusted gross billings. The remainder would be paid to the physician as compensation. The results of this new formula are favorable in some respects and unfavorable in others.

Favorable:

1. The foundation achieved a predictable net income as that was written into the agreement as the “margin.”
2. The physicians are very motivated to control expenses and increase revenues because changes in both had an immediate and direct effect on compensation.
3. The foundation experiences less concern when physicians propose increasing staff or making changes that might increase expenses, as any increased costs without increased revenues to offset them would result in lower physician compensation.

1. The calculation of the compensation is highly complex and requires significant accounting resources.
2. The formula is confusing to some physicians, particularly those who have never been in private practice.
3. Some physicians had the impression that because of how the margin formula is structured, any equipment purchased and expensed through the practice was, in fact, their own personal property because “they paid for it.” This was not true but created conflicts with some physicians.
4. Physicians became concerned over the foundation’s management decisions that result in increases to their costs, such as pay-scale adjustments, contracts for certain support services, and managed care agreements. Some physicians want to micromanage the practice as a result.
5. The new formula creates stress for the administrative staff because some physicians are not willing to let the administrative staff do whatever it felt necessary to operate the practice in an efficient manner.
6. The formula created animosity between some physicians because some physicians did not want to coordinate or share services or equipment between offices because of the effect on their cost and compensation formula.

Summary
The foundation has determined that the adjusted gross billing methodology is a viable method to be considered for a nonprofit medical foundation in compensating physicians. The foundation continues to experiment with the margin formula and is exploring other potential formulas, but believes with certain modifications the percentage of adjusted gross billing methodology can be effective and useful because of its simplicity, ease of administration, and motivational effect on the physicians. The primary improvement to the model needed would be the ability to adjust the formula on a frequent basis for individual practice variations. Modifications will continue to be made as circumstances change, but the basic principles will remain constant.

A. “Wayne” Ferch, FACHE, is president & CEO of Adventist Health California Medical Foundation in Deer Park, California. Prior to that he was president and CEO of a rural hospital located in central Oregon, and has also held positions as a hospital CFO, director of managed care for a multihospital system, and a medical group administrator. Mr. Ferch is a Fellow in the American College of Health Care Executives and a member of Medical Group Management Association and other professional societies. This case study represents part of his Fellow project and was voted one of the best case studies in 1999.