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The PAMA Effect: Consolidation of Clinical Labs Expected as Legislation Set to Take Effect

NEW YORK (360Dx) – Eric Liston worries a lot these days. In fact, the assistant vice president of laboratory services at Intermountain Health System said something's been weighing heavily on his mind for some time.   

"I've aged a whole bunch in the last year," he said.

At the beginning of next year, federal legislation called the Protecting Access to Medicare Act, or PAMA, will take effect, resulting in cuts in reimbursements to clinical laboratories on a scale that the industry has rarely, if ever, seen. When it does, labs like Intermountain will see a reduction in reimbursements for some test procedures of up to 10 percent for each of the first three years after implementation, followed by reductions of up to 15 percent for each of the next three years.

All clinical labs in the US — from the largest reference labs to hospital labs to physician-practice labs — will be touched by the changes to varying degrees, and as the clock continues ticking, anxiety about its implications is widespread throughout the industry.

Even for the largest labs, like Quest Diagnostics and Laboratory Corporation of America, which may see some benefits from PAMA, the legislation is not without its concerns. But because of their size, they will be able to better absorb cuts in reimbursements. On the other hand, PAMA could result in cuts deep enough to smaller labs that they may struggle to stay in business.

When the dust settles, what results may be a market with fewer independently operated small and regional labs, as well as fewer outreach labs that are owned by hospitals. Instead, such operations could become part of Quest's and LabCorp's networks. Together, the two already have about a 27 percent share of the $50 billion clinical lab market, measured by revenues, according to Barclays analyst Jack Meehan. By volume, they own an even bigger slice of the pie, 45 percent.

In a research report in January, he wrote, "Ultimately, we believe smaller labs with outsized Medicare exposure will be consolidated over time (either organically or inorganically), benefitting LabCorp and Quest as the industry leaders."

A spate of deals this year has already borne out Meehan's prediction, and comments from executives at Quest and LabCorp suggest more deals may come before the year is over — even before PAMA takes effect on Jan. 1, 2018.

PAMA pains

Enacted in April 2014, PAMA's immediate effect was to delay a scheduled 24 percent cut in Medicare reimbursements to physicians at the time. Longer term, it provided a vehicle to reform the clinical laboratory fee schedule — a mechanism for determining reimbursement rates for laboratories conducting diagnostic tests — by creating a market-based reimbursement system.

Under PAMA, reimbursements for diagnostic tests will be based on a volume-weighted median rate for all lab submissions. To date, Medicare has generally reimbursed for diagnostic tests at a higher rate than commercial payors, but PAMA could change that. In particular, the legislation is expected to reduce reimbursements for routine testing such as immunochemical testing and clinical chemistry-based testing.

Molecular tests, on the other hand, are anticipated to be reimbursed at a higher rate than they are currently.

Because of their high volume, heterogeneous patient mix, diverse payor mix, and wide set of available tests, Quest and LabCorp are partially shielded from anticipated cuts, most experts said. According to Meehan, Medicare comprises about 12 percent of Quest's revenues and 9 percent of LabCorp's revenues. By volume, the program represents even less of their businesses.

For smaller labs, the picture may be wildly different, with some smaller labs dependent on Medicare for up to half of their volumes, he wrote.

As a result, PAMA could tilt the market in such a way that it accelerates M&A deals. In recent comments, executives from Quest and LabCorp have suggested M&A in the lab space remains a strong strategic focus. Quest CEO Steve Rusckowski essentially guaranteed that the company will continue on its strategy of buying smaller labs, including hospital labs, saying that Quest remains confident that it will maintain the 1 to 2 percent growth through acquisitions that it has achieved in recent years — but this time driven by purchases in the clinical lab space.

At the Barclays Global Healthcare Conference in mid-March, he said that Quest's pipeline for potential hospital lab deals — both partnerships and acquisitions — remains "very strong, so we're optimistic about that."

With the implementation of PAMA just months away, "we think hospitals are going to reevaluate whether they're in or out of 'the laboratory business," he added.

"[W]hen you think about value-based healthcare — which is no longer a system that's based upon doing activity, but doing the right activity at the right time, to deliver the best quality of care at the lowest possible cost — the systems that we work with on their lab strategy are thinking about going to the lowest cost per service to the provider," he said. "And if you're the largest, and most efficient, and the best at what you do, which is what we believe we're continuing to drive Quest to be, we will be very successful long term," Rusckowski said.

Quest has already done a handful of lab deals in 2017. In January, it announced a diagnostic laboratory service partnership to provide New York's Montefiore Health System with some low-complexity testing. A month later, Quest said it was acquiring PeaceHealth's outreach lab services, and would manage PeaceHealth's 11 labs. The deal was completed in May.

The same month, Quest and Hartford Healthcare said they signed a letter of intent for Quest to buy the outreach labs of two Hartford hospitals.

In an April research note, Canaccord Genuity analyst Mark Massaro said that "given its successful traction partnering with hospitals … or acquiring hospital outreach, we believe Quest is in the early days of its hospital strategy."

He further added that the approximately $17 billion hospital outreach market "is large enough for both labs to participate in," alluding to LabCorp.

Indeed, LabCorp has also been active on the lab M&A front this year and has acquired Pathology Associates Medical Laboratories (PAML) and the assets of Mount Sinai Clinical Outreach Laboratories.

During LabCorp's conference call in April to discuss its financial results, LabCorp Chairman and CEO Dave King said that the firm's M&A pipeline remains "robust," though he attributed that to "the general change in the healthcare environment," rather than specifically to PAMA-based factors.

"We're seeing a big push to being able to procure services, the highest quality services at the most effective cost. And as hospitals and smaller laboratories are recognizing that trend, I think a lot of them are relooking at, do we belong in this business?," King said. "Is it a core competency? Are we bringing value to the patient?"

At the Barclays conference, he described LabCorp's M&A approach as a carefully crafted strategy that targets "anchor systems that are large, that are growing, that are multistate, and that are preeminent players in their markets. And we want to grow with them.

"We're not just managing their labs. It's reference business, it's outreach business, it's pathology, it's supporting them with couriers and [patient service centers]."

The deal with Mount Sinai, for example, further established LabCorp's presence in the New York City market, and provided it with a potential partner on projects, such as those involving next-generation genomics and molecular diagnostics, King said recently.

It's not just the very largest labs that are looking to capitalize on the shifting landscape, either. In February, Sonic Healthcare USA, a subsidiary of Australian firm Sonic Healthcare, announced laboratory partnerships with Western Connecticut Health Network to form a joint venture covering lab services for patients and providers throughout Connecticut.

That same month, it partnered with Memphis, Tennessee-based Baptist Memorial Health Care to create a bacteriology lab serving Baptist's 17 hospitals in Tennessee, Mississippi, and Arkansas, as well as Sonic's existing referrers in the mid-south US.

Push toward consolidation

For smaller, and even mid-sized labs, however, PAMA is a cause for handwringing, though many are reluctant to discuss it publicly. More than a dozen labs contacted either declined to comment or did not respond to requests for interviews.

But a survey of labs published last September may provide a glimpse into what could happen in the near- to mid-term in the lab space. According to the survey conducted by Chi Solutions, 34 percent of responding labs said that they had been approached by a national or regional competitor interested in buying their lab outreach program.

Of that 34 percent, 71 percent said they were not interested in selling their outreach business, while 29 percent said that a sale "was somewhat likely," suggesting that, overall, 10 percent of the respondents believe a sale of their hospital outreach program is likely if the offer is right.

It is unclear what effect, if any, PAMA had on the survey results, but Piper Jaffray analyst William Quirk said that he believes the pace of deals between Quest and LabCorp, and hospital/hospital systems has ticked up and will continue to do so.

"We have also heard that because of PAMA, hospital and hospital systems are more willing to entertain these sorts of deals," he said.

He explained that for the past decade, hospitals sought to expand their outreach programs, driven by acquisitions of physician practices and further accelerated by the Affordable Care Act. But faced with the possibility of sharp reimbursement cuts from PAMA, the strategy is now to look at large players like Quest and LabCorp to partner with or to sell to.

Intermountain Health has no plans for a merger, Liston said, but the challenges it faces illustrate the pressures confronting clinical labs. Liston said that about 40 percent of Intermountain's total payor mix is Medicare-based. When PAMA is implemented, its Medicare payment rates will be slashed by about 50 percent over the first five years, the Salt Lake City-based health system estimated.

Commercial payors are also anticipated to follow Medicare's lead and cut their reimbursement rates for similar tests. "Maybe not in 2018, but I'm sure in 2019, we'll see similar cuts … and then the dollars become really big," Liston said.

Overall, Intermountain's payment rates from Medicare and commercial payors combined could be slashed by around 40 percent in the first five years after the new PAMA rates take effect, he said.

Labs have known for several years about PAMA, and Intermountain has been "in a multiyear plan of finding reductions," to make up for the expected reimbursement decline. They include going to Intermountain's suppliers "and pushing on [them] and vendors in relationships, both from a reagent, from a capital standpoint, even from a reference standpoint," Liston said.

The company has also in-sourced more work, when appropriate; examined its staffing situation; and rooted out waste.

There is also a concerted effort to increase volume, and "double down in the physician market," where it feels it can complete with Quest and LabCorp, in order to pick up some of the physician outreach work, he said.

"We are a big enough player in the outreach market that we do feel like we can still grow appropriate volume in the outreach market [and] that would help also offset some of those reductions," Liston noted, adding Intermountain is also taking steps to prevent "leakage out of our own internal system that maybe is going somewhere else."

"[W]e feel like we're a good enough sized lab that we can weather the storm," Liston said. "I think we feel like we're in the spot where we don't need to … be merged or get acquired or start some new or different partnership."

Nonetheless, he acknowledged that no matter how much Intermountain may prepare, the firm has its limitations.

"Even when we look in other areas of [healthcare], this type of cut, 10 to 15 percent a year on different codes that can last over five years, that's huge," he said. "It's a huge cut."

The waiting game

The consensus is that labs that are especially reliant on Medicare revenues will most likely see the deepest cuts from PAMA: Much, if not most, testing done with the Medicare population is routine, or non-molecular.

"There are some tests within PAMA that are expected to increase in reimbursement, although, I think it is safe to say — and certainly our own proprietary survey work does suggest that — a lot of the routine testing, things like chemistry, immunochemistry, hematology, that sort of thing, are likely to see more pressure than some of the newer, more specialized tests," said Quirk.

And even for labs like ARUP Laboratories, which works only on a limited basis with physician offices, and, instead, works mostly with hospital labs and other local labs, the reduction in Medicare reimbursements could spell problems.

"A major part of our clients is the hospital laboratories, and if they have a significant portion of outreach, and within this … they have a significant portion of Medicare Part B patients, it will then affect us one way or the other," ARUP President and CEO Edgar Braendle said.

While fears around PAMA may already be accelerating M&A activity in the lab space, ultimately, the implications of the legislation on the laboratory M&A landscape won't be fully known until the new rates are set. Labs have until today to submit their private payor data, which will serve as the basis for those rates.

The deadline was pushed back two months past the original submission date, after the lab industry complained that the original March deadline was unrealistic. But the delay has not quelled other rumblings within industry about data collection and which labs have to submit their private payor information.

At issue is the definition of "applicable labs" — those labs that are required to report its private payor rates to CMS for setting the new PAMA rates.

Whether a lab is deemed an applicable lab is based on two criteria: its percent of Medicare revenue, and a dollar amount threshold of revenues from the clinical lab fee schedule. If a lab meets both criteria, it would be required to report its payor data. If it doesn't meet either, it cannot submit its data.

A lab would meet the first requirement if more than half of its Medicare revenues derive from the clinical lab free schedule or the physician fee schedule. Then, if the lab also received more than $12,500 in Medicare revenues from lab services in the first six months of 2016, it would be defined as an applicable lab.

But according to Paul Radensky, a principal at law firm McDermott Will & Emery, most hospitals derive their revenues outside of the clinical lab fee schedule and the physician fee schedule, and so they would be excluded from reporting their private payor data to CMS for the purpose of PAMA.

Also, many physician office labs don't do large-volume testing, and so would fall short of the $12,500 clinical lab fee schedule threshold, and would be excluded from reporting their private payor data.

"The concern is that the data may not be representative," of what the commercial market is paying for tests, which, in turn, could drive down PAMA reimbursement rates, Radensky said.

Braendle added, "I think the major concern at this point in time is that the collected data is not complete … because some of the hospital labs are not really reflected in the current assessment … and, therefore, there is some concern how this market price by this current methodology [will be] established."

During their April earnings conference calls, both Quest and LabCorp also reiterated their views that CMS's private payor data collection method is flawed.

Quest's Rusckowski said that the current definition of an applicable lab would represent only 69 percent of Medicare payments for lab tests performed in 2015. "While we support reform of [the] Medicare payment system, we believe any modification should be market-based and appropriately include all applicable independent and hospital outreach laboratories," he said on the call.  

During LabCorp's April earnings conference call, CEO King labeled the current definition of an applicable lab "incorrect" and added that it would exempt 95 percent of hospital labs from having to report their payor data, "which means their commercial pricing, which is multiples above ours, is not going to be considered part of the 'market.'"

There is also a push by industry to delay implementation of PAMA to January 2019, though there is no indication that CMS will do so. In an email, a CMS spokesperson said, "Any changes to this implementation date would require proposed and final rule-making."

PAMA was originally set to go into effect this past January, but because CMS was late in getting the rules out, the implementation was delayed one year.

At this point, the timeline is roughly for "preliminary rates" to be published in September. Then stakeholders will have a chance to review them and report to CMS any wildly inconsistent rates. However, Radensky said that except for sole-source laboratory tests, "it's going to be very difficult … to know for sure if the numbers accurately reflect private payor rates."

The final rates are expected to be released around November this year.

When they are, the winners and losers, post-PAMA, will become clearer. For example, said Quirk, a hospital outreach lab located on the Florida Gulf Coast — where there may be large numbers of retirees who use Medicare as their primary health insurance — could stand to be one of the losers. In contrast, a hospital outreach lab based in San Francisco, which may have a higher population of patients with private insurance, could emerge from PAMA relatively unscathed.

As for Intermountain Health, Liston said that it will survive PAMA, but that doesn't mean there won't be PAMA-inflicted wounds.

"I think we're vulnerable on the fact that that's a lot of cuts from a big payor," he said. "We're vulnerable on the fact that we've got to change our operating model, and we've got to continue to drive costs out. So, I'd be a liar if [I said that] we weren't nervous and anxious about this."