AAOS Bulletin - December, 2005

Income distribution in a group practice

Decreasing reimbursements and increasing costs underscore need for compensation formulas

By Michael J. McCaslin, CPA

Orthopaedic group practices often have three compensation formulas: The one they currently have, the one they used to have, and the one they are thinking about changing to. Compensation formulas are often the most discussed subject within any orthopaedic group and an ongoing issue of concern.

During discussion on “the one you are thinking about changing to,” there are two things that orthopaedic groups need to remember:

• Whatever behavior your income distribution methodology rewards, your practice members will do.

• Orthopaedic surgeons are extremely intelligent and will figure out how to make the plan work for them.

Compensation philosophy

Before a group practice considers any specific pay formula or plan, it should review its compensation philosophy. The group should carefully analyze what the goals and objectives of their compensation formula should be. While goals may differ from group to group, some goals to consider might include: Aligning compensation with work effort; promoting a group culture; providing health care services to the underinsured or uninsured; ensuring cost-effective quality care; ensuring a methodology that will attract and retain quality physicians; improving service to referring physicians; permitting a balanced lifestyle for those who desire it; valuing business leadership and physician administrative services; and promoting teaching, education and research.

When considering design principles for the income distribution methodology, groups are wise to seek formulas that are well-defined and understood, thus leaving little to interpretation and the resulting potential for mistrust. The methodology also should employ measures that are simple to understand and calculate, within the physician’s control and clearly related to the group’s goals.

Although it is unlikely that a formula can perfectly meet all of the wants and needs of the group, the group’s goal should ultimately be to develop an income distribution methodology with the most livable downsides.

Cost accounting

A group practice must review its cost accounting to ensure that operating expenses are being handled properly before it can address revenue, ancillary services net income and expense allocations as they relate to income distribution methodologies. A major issue is cost allocation for ancillary services.

Has the practice properly allocated indirect costs to the ancillary services profit centers? Often, both fixed and variable overhead costs are allocated to physicians, but only direct expenses associated with an ancillary service are allocated to it, even though the ancillary uses management time, billing and collection services, check-in and check-out services and legal and accounting services.

Unless these costs are allocated to the ancillary service appropriately, the net income from the ancillary services will be overstated and the net income from professional services will be understated.

Revenue allocation

Several models exist for allocating revenues. These include productivity models, revenue-sharing models, relative value unit models and a separate allocation of ancillary service revenues.

The most popular income distribution model among orthopaedic group practices is some version of direct professional services revenue allocation or productivity models. In the historic productivity model, each physician is credited for the collections that his or her professional services generated.

Today, however, differing demographics within a practice’s locations and different levels of reimbursement for subspecialty services make this historic model less useful. If the group’s goals include being a full-service orthopaedic provider, serving a diverse population and serving multiple locations, a direct professional services collection allocation model may not be the best choice.

To address this problem, many orthopaedic groups have incorporated elements of a revenue-sharing model into their income distribution formula. Usually, a small percentage (no more than 10 percent) of total practice revenue is pooled for equal allocation among the practice members. This equal share pool helps offset the lower productivity income generated by those who serve a more diverse population or provide less lucrative orthopaedic services.

In today’s environment, production benchmarks are commonly incorporated into the plan formula that physicians must meet to participate fully in the revenue sharing plan. This leads to the construction of tiers or corridors of production. Depending on his or her production, a practice member may receive 100 percent of a full share of the revenue pool, 75 percent of a full share, or 50 percent of a full share. This results in a revenue-sharing model that has a built in productivity element.

An alternative to production corridors is the use of the relative value unit (RVU) to determine compensation. Under this concept, groups will pool a percentage of the total professional services revenue and allocate it based upon the total RVU work units of production. This formula gives each unit of service the same dollar value. Those who produce more units of service still make more money, but the RVU approach mitigates the distortion that would otherwise be experienced by those physicians who serve a predominantly Medicare or indigent population or have poorer-paying contracts.

It can be argued that the RVU system does not provide an equitable arrangement because it does not properly value the services. Indeed, this debate is ongoing and unlikely to produce a meaningful outcome. The group members must accept that everyone will feel some sense of inequity with some element of the group’s formula.

Ancillary services

Currently, there are three ways to deal with a group practices’ ancillary services net income. The first is to equally allocate the income and to fully account for costs associated with the ancillary services. Although Stark II does not require an equal allocation of ancillary services or designated health services net income, many groups have used this model as another element of team building.

The second trend is to create benchmarks of productivity for physicians to continue to share equally in the ancillary services net income. As ancillary net income has grown, it has become a substantial portion of the total physician earnings in some groups. As a result, some physicians may reduce their productivity, thinking that the earnings from ancillary services net income will offset the lost income. This has led many groups to establish productivity thresholds that must be met for physicians to participate fully in the equal allocation of the ancillary services net income. A physician who does not meet the established threshold receives a reduced allocation or may be removed from the ancillary services net income pool.

The third trend is to adopt productivity allocation methods allowable under Stark II. This could include the use of office visits, total professional productivity excluding Medicare-designated health services, RVUs or other productivity measures. Many groups have adopted a blended methodology in which some portion of the ancillary services net income is allocated equally and the remainder is allocated on a productivity measure. Again, the group’s goals should drive the choice of allocation method.

Overhead allocation methodologies

Group practices generally have three overhead pools: fixed or equally allocated to the physicians and ancillary departments; variable and allocated in proportion to some form of utilization or productivity; and direct expenses, which are allocated directly to the physician or ancillary department that benefits or incurs the expense. The reference to fixed and variable expenses in discussing physician compensation formulas should not be confused with fixed and variable expenses when discussing cost accounting. The two are entirely different concepts.

High-producing physicians frequently challenge the allocation of fixed and variable expenses. These physicians clearly benefit if expenses are classified as fixed (equally allocated) rather than variable (productivity allocated). They do not believe that they actually consume more practice resources than lower-producing physicians and feel that they are being penalized because they have higher fee ticket cases.

To reach a satisfactory agreement, the practice can change how fixed and variable expenses are allocated. The process can take one of three forms:

1. A line item analysis of each expense item

2. A change in the allocation percentage being used for fixed and variable expenses (such as moving from a 30/70 split to a 40/60, or 50/50 split)

3. A change in the productivity measure for which variable expenses are being allocated

Recently, the most significant change has been in the productivity measures, as practices focus on office visits as a measure of resource consumption rather than gross charges, net charges, or net collections. The medical office and its staff constitute the largest overhead item. Allocating this category based on a revenue measure can penalize physicians who generate high revenues but don’t actually use the office very much, such as those who spend most of their time in surgery. The counter-argument is that, even though a physician is in surgery, billing, collection, and scheduling still take place in the office.

Physicians who bill and collect more will, in the end, provide a degree of subsidized overhead for others in the group. Because it is difficult to make a drastic change in an allocation method, groups may blend approaches and base 50 percent of the variable allocation on net collections and 50 percent on patient visits.

Change management process

When it comes to compensation plans, the change management process is very difficult. No matter how much philosophical discussion takes place, the end point of every process is to compare the new formula to the old formula using current or prior year’s data. This results in a zero-sum situation because the total amount distributed does not change. As a result, some physicians in the group will get more money, some will get less money, and the rest will get approximately the same money.

This look-back process ignores the impact of behavioral changes that are likely to occur under the new formula and thus is not a fair measure of the proposed formula. In managing the change process, it is very important to provide a significant amount of both internal and comparable data, including the following information, on a per physician basis:

• Raw dollar change in compensation from the old formula to the new formula

• Percentage change in compensation from the old formula to the new formula

• Percentage of overhead to allocated revenue in the old formula

• Percentage of overhead to allocated revenue in the new formula

• Raw dollars of overhead with the old formula

• Raw dollars of overhead with the new formula


The two areas where compensation formulas are evolving are in the use of productivity thresholds to receive ancillary income, and changes in the productivity measure for allocating variable expenses. There is no perfect formula; the formula that works for one group may not work for any other group.

It is essential to have the strategic goals and objectives of the group clearly articulated and agreed upon, and to use this as the starting point of any process to modify or completely change the group’s compensation plan. When evaluating any changes to your income distribution methodology, proceed with caution and care.

Michael J. McCaslin, CPA, is a principal in Somerset CPAs, PC, an Indianapolis-based certified public accounting and consulting firm, and a faculty member for AAOS practice management courses. He can be reached at: mmccaslin@somersetcpas.com

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