Capitation makes a return — but this time for implant prices

The move could help reduce hospital/surgeon disputes over implant choices. Watch for more hospitals to move from sole or dual sourcing to capitated pricing.

As a follow-up to our survey of orthopedic surgeons (recapped in Orthopedics Today, January 2006; pg. 74) we recently spoke individually with hospital purchasing managers, focusing on their cost-containment strategies for orthopedic implants. We came away with many insights, but far and away the most notable: Most hospitals we spoke with are either pursuing or considering a capitated pricing model. This is a change in strategy, as hospitals have historically pursued sole-source agreements in order to extract price concessions from suppliers.

We think this trend is significant because a cap pricing approach tends to favor more innovative companies and “niche” providers of differentiated products. We expect this trend to drive an increase in product innovation by orthopedic manufacturers, with a focus on clinical evidence of improved patient outcomes. We think this bodes well for the long-term prospects of the orthopedic industry and patient care.

What’s Driving the Trend?

The optimal strategy for cost containment — and the approach used in most other device markets — is sole or dual sourcing, which can potentially extract the greatest pricing benefits from manufacturers. However, this approach has not proven particularly successful for orthopedic implants, primarily because of the historical strength of the surgeon-rep relationship, the high degree of service provided by the rep, and the reluctance on the part of surgeons to switch among different manufacturers’ implants and instruments.

While hospitals continue to use a variety of cost-containment strategies, we were quite surprised to find that most hospitals we spoke with were looking into a capitated pricing model. In our surgeon survey, 43% indicated their hospitals were considering a cap pricing model. And our recent conversations with hospital purchasing managers suggest this percentage could be on the rise.

A move to cap pricing would have implications for the market, emphasizing the need for differentiated products for which orthopedic manufacturers can justify premium pricing. The fixed-price categories inherent in this model also “level the playing field” with respect to pricing of similar implants. We think this also addresses a common concern of hospitals — ie, in some cases they pay a wide range of prices for implants that are for the most part therapeutically equivalent.

Capitated Pricing Primer

In the price capitation model, hospitals simplify their approach to pricing and contracting with implant manufacturers by creating a fixed number of categories for hips and knees. For example, they may have several pricing categories for knees, such as “high-performance knees,” which might include the extra features found in most manufacturers’ premium knee implants (eg, high-flexion, cross-linked poly). For each category, the hospital will pay a fixed price, regardless of the manufacturers’ individual prices. This eliminates the need for the hospital to track multiple prices for the various SKUs from each manufacturer.

Benefits of Cap Pricing

One of the key benefits of the cap-pricing model: It can help avoid the disputes that sometimes arise between hospitals and surgeons when a hospital tries to move to a limited number of manufacturers. With cap pricing, all manufacturers are included provided they adhere to the hospital’s established guidelines. This is particularly important for hospital groups that may include several different surgical teams, each potentially having different manufacturer preferences.

Challenges of Cap Pricing

Despite its advantages, cap pricing is not without its challenges. A hospital’s purchasing system must be fairly flexible in how it tracks implant costs, since the hospital must typically pay a flat price for the collection of multiple components that make up an implant (eg, hip stem, femoral head, acetabular shell and liner). In addition, the contract manager and materials management team must be able to coordinate with the operating room nurses who put through the purchase orders to make sure the implants are paid for at the correct cap level.

Differentiation Is Key

The aspect of cap pricing that bears the most significance for manufacturers is the way unique and premium products are handled. Under their individual agreements with manufacturers, hospitals accommodate exceptions to the cap categories for products that are:

unique and provided only by a single manufacturer (ie, cannot be categorized);
able to show sufficient clinical data supporting improved patient outcomes associated with the device; and
approved by a hospital clinical review committee.

Who Wins?

It is in this area that manufacturers can defend pricing for their products that are truly unique and/or deliver significantly improved patient outcomes. In the near term, we believe this favors companies already focused on innovative, “niche” products. Over the longer term, we expect that all manufacturers will increase their emphasis on innovating and supporting their products with clinical evidence of improved patient outcomes. We view this as a potentially positive development for the long-run health of the orthopedic industry.

(Important disclosures relating to this article are available at morganstanley.com/institutional/research/ot02102006.pdf)

Glenn Reicin and Matt Miksic are equity analysts covering the medical-device industry at Morgan Stanley. Their insights into the orthopedic industry led the editors of Orthopedics Today to ask them to contribute articles from time to time. They have agreed to contribute (without compensation) in hope of eliciting feedback from the orthopedic community. You may contact them through Mr. Reicin at glenn.reicin@morganstanley.com.