Robert A. Guy, Jr.
J. Reginald Hill

Hospitals should be wary of common myths that can cause them to make missteps in developing clinical service outsourcing arrangements.


At a Glance

  • Outsourcing clinical services is a strategy that many hospitals are using today to expand into new practice areas, save costs, and reduce administrative hassles.  
  • Hospitals too often enter such arrangements with outsourcing companies without being fully aware of the details that need to be addressed to minimize the hospital's risk.
  • By too readily accepting common myths regarding how the arrangements should be structured, hospitals often are deterred from negotiating important contract provisions that would serve their best interests.

Consider this cautionary tale: Persuaded by the promise of both financial and clinical benefits, Community Hospital contracts with an outsourcing company to provide physician staffing for its emergency department. Everything starts well enough, until Community Hospital's outsourcing partner falls into financial difficulties. The outsourcing company files for bankruptcy, and although it continues in business, it is unable to pay its physicians on time.

When the physicians threaten to walk out, Community Hospital's only option is to pay them directly-and then try to terminate the staffing contract.  Unfortunately for Community Hospital, though, the bankruptcy court will not allow termination of the contract. Why? Because the staffing contract does not require that the physicians be paid on time-it requires only that they show up to staff the ED, which they are still doing. Terminating the contract is not possible, says the court, until the staffing company breaches the contract and the physicians actually walk out. For Community Hospital, providing critical services in a rural community, allowing its ED to shut down is unthinkable. As a result, Community Hospital is left at the mercies of a bankrupt staffing company, and has to backstop the payments to the physicians to prevent a walkout.

This is a true story. And why would it happen? There exists in the healthcare industry a myth that many hospitals too readily accept regarding outsourcing agreements with clinical service providers: that such agreements need not be carefully evaluated because they involve only short-term  commitments and little risk.

Outsourcing clinical services can be an excellent strategy for hospitals. It can enable them to expand into new practice areas, save costs, and reduce administrative hassles. But as our opening cautionary tale shows, this strategy also involves significant risks, which can be exacerbated if hospital leaders do not take sufficient time to examine their assumptions about such arrangements. Community Hospital's story is just one example of what can happen when hospital leaders harbor misconceptions about how best to structure an outsourcing arrangement.

Such misconceptions form the basis of the outsourcing myths that many hospital leaders too willingly accept today.  This discussion focuses on 10 of the most commonly accepted myths. By recognizing the fallacies in each of these myths, hospital leaders can take advantage of important opportunities to fortify their outsourcing arrangement against risk.

Myth # 1: The most important factor in selecting an outsourcing provider is cost-efficiency-get the lowest price for the broadest scope of services possible. Obviously, price and scope of services are important. But intangibles such as reputation, quality of service, and depth of experience are also critical. The two most important risks that a hospital faces when it enters an outsourcing relationship are profitability risk and liability risk, and these can dramatically affect the ultimate cost.

Profitability risk includes the financial losses a hospital could suffer as a result of a bad outsourcing relationship. Such losses could derive from delayed and lost collections, tarnished reputation, lost referrals, damaged morale, and personnel turnover. A hospital can lose significant income when outsourcing turns sour, and recovering the financial losses later can be difficult, if not impossible.

Liability risk includes the potential liabilities a hospital can suffer as a result of the actions of its outsourcing provider. In particular, such risk can be of a regulatory nature. Because most healthcare regulation is aimed at the facility level, many outsourcing companies are unregulated, and an outsourcing company's noncompliant activities could become a regulatory problem for the facility.  Further, in many situations hospitals can have vicarious liability for the actions of outsourcing providers.

Suggestion: When deciding how to outsource a service, remember that intangibles are key. Take time when considering the contract price to also identify the potential profitability and liability risks.

Myth # 2: The best way to select an outsourcing provider is to have the hospital administrator make the decision. The administrator may well be the appropriate person to lead the process, but the issues raised by an outsourcing relationship cross multiple departments. A hospital's risk manager, for example, may end up dealing with the results of the outsourcing relationship long after the relationship has ended. Also, morale issues can develop quickly if physicians are surprised with a significant new outsourcing relationship or are required, without being consulted, to use an outsourcing provider that delivers inconsistent service or that they perceive has a poor reputation.

Suggestions: Use a selection process that includes representatives from the administrative, financial, legal, risk management, and compliance departments. Consider soliciting input from the physician staff, or in the very least, lay the groundwork to ensure that the physician staff remains informed of the process.

Myth # 3: Outsourcing contracts are usually plain vanilla and are not subject to healthcare regulatory requirements. Few contracts in the healthcare arena are free from regulatory scrutiny and risk. Outsourcing relationships, like most healthcare contracting, can raise a number of significant regulatory issues including questions of compliance with anti-kickback, self-referral, licensure, and antitrust laws, to name a few. If the outsourcing relationship is not structured appropriately from the start, the hospital can suffer bad outcomes ranging from financial losses due to payment problems and unenforceability of the contract to regulatory interventions or fines and even criminal imprisonment of responsible individuals.

Outsourcing arrangements that involve joint ventures can be particularly problematic from a regulatory standpoint. For not-for-profit hospitals, for instance, an ill-considered joint venture could jeopardize the organization's tax-exempt status.

Suggestions: Take great care to structure outsourcing contracts to satisfy all applicable regulations. If the outsourcing arrangement is structured as a joint venture, for-profit hospitals should consider whether it is possible to consolidate the revenues of the joint venture for accounting purposes, and not-for-profit hospitals should be careful to structure the joint venture to ensure that it does not compromise the organization's tax exemption.

Myth # 4: Once an outsourcing contract is signed, the hospital can turn the process over to the provider and expect a seamless transition. Poor integration is one of the most common complaints in outsourcing relationships. Hospitals often are surprised to find that the outsourcing company is not adept at managing the transition to the new arrangement. Horror stories abound: Consider the hospital system that outsourced its billing office and found itself with almost no collections for several months. The hospital system never recovered financially and ultimately closed its doors.

One of the quickest roads to patient dissatisfaction, and to financial distress, is a lack of integration in insurance plans among the hospital, its physicians, and the outsourcing company's professionals. Similarly, incompatibility in information systems can present unexpected obstacles to an effective transition. Other potential shortcomings of outsourcing providers include poor communication, poor patient service, scheduling mishaps, failure to comply with the hospital's internal procedures, and lack of understanding of the hospital's capabilities.

Suggestions: No matter how experienced the outsourcing provider may seem to be, appoint someone to manage the transition process internally. Also, before moving ahead with the agreement, openly investigate compatibility issues with the outsourcing company, taking note of potential integration problems and informing the company of all procedural considerations that it would be expected to abide by, and of any special capabilities of the hospital that should be accounted for in the arrangement.

Myth # 5: Because outsourcing providers are usually independent contractors, specific performance standards in outsourcing contracts are inappropriate. Many outsourcing contracts set minimal performance standards, and hospitals often accept form contracts provided by outsourcing companies. Without detailed standards, however, hospitals can have difficulty realizing their expectations and maintaining their standards for quality of patient services.  Indeed, the scenario involving Community Hospital at the beginning of this article underscores the importance of detailed performance standards.

Suggestions: When negotiating contract terms, make sure that the contract includes performance standards that reflect the hospital's expectations.

Myth # 6: As long as the contract requires the outsourcing company to buy insurance and indemnify the hospital against claims, the hospital is safe. Recent changes in the insurance industry have greatly increased the cost of liability insurance. As a result, many companies, including outsourcing providers, are moving to alternative insurance vehicles. These alternatives are not always as safe as they appear. One popular policy is the matching deductible policy, which is basically self-insurance. If the outsourcing company does not have the assets to self-insure, then it is essentially without coverage. Overseas captives also are popular, but they can be difficult to reach in litigation. These types of coverage choices by the outsourcing company can be problematic for the hospital: If claims develop, the hospital may find little or no coverage available from the outsourcing partner.

Problems also could arise if obligations are limited to a local affiliate of a national outsourcing chain. If business were to turn bad, the local affiliate could simply close its doors, leaving the hospital in a serious predicament if the contract included no provision to force the parent company to make up any losses the hospital might suffer.

Suggestions: At a minimum, require certificates of coverage, establish insurance requirements in the contract, demand that the hospital be listed as an additional insured, and have clear rights of indemnity against the outsourcing provider. Also, negotiate for the right to have notice prior to any cancellation or modification of the insurance policy (including modification of the aggregate or the payment schedule), and investigate the aggregate amount of the insurance coverage to verify that it is sufficient to cover all the liability at all the points where the outsourcing partner may be doing business. To the extent possible, negotiate for additional protections.

Recognize that indemnity is only as good as the entity standing behind it, so when choosing an outsourcing provider, make sure the provider has the financial wherewithal to meet its obligations (including future anticipated capital contributions in the case of a joint-venture). If you are negotiating with a local affiliate of a national outsourcing chain, see if you can get the parent company to guaranty the affiliate's obligations.

Myth # 7: If an outsourcing provider performs poorly, terminating the provider is usually a simple process.Hospitals need a clear right to exit from the relationship should it go sour. And that right should extend not only to circumstances where the hospital has "cause" to terminate the contract, but also to circumstances where the hospital may wish to terminate "without cause." A contract that requires a hospital to prove "cause" before it can exit is often inadequate because "cause" is open to interpretation and has frequently been the source of protracted legal battles between the parties.

Nonetheless, while "without cause" provisions are desirable, it is also important that the contract include some "cause" provisions for termination. To avoid a legal dispute over whether "cause" exists for the termination, the termination provisions should be detailed and specific, directed to the performance standards that reflect the expectations of the hospital.

Poor performance by the outsourcing provider calls for quick intervention. Unfortunately, most hospitals wait until problems reach a crisis level. As with personnel issues, diligent documentation of problems can go a long way to avoiding litigation if termination becomes necessary.

Suggestions: Bargain for the right to terminate "without cause" upon notice (90 days or less if possible). Negotiate the right to terminate immediately with "cause" in the event of a material adverse event, such as a threat to patient safety or the cancellation of the outsourcing company's insurance, or on very short notice in the event of other specified breaches by the outsourcing provider. Track the company's performance and document instances where it falls short of performance expectations.

Myth # 8: When a contract with an outsourcing provider must be terminated, the hospital can easily provide the services itself or retain another outsourcing provider. It is not always a simple matter for a hospital to line up physician staff to immediately replace those that had been provided by a terminated outsourcing company. In some instances, physicians or staff may have noncompete obligations that run in favor of the outsourcing company. Thus, the hospital would have to pay the outsourcing provider for the right to hire the individuals after termination.

Also, without clearly defined termination rights and specific performance standards, a hospital  could run into a double-obligation dilemma. Such a dilemma arises when a hospital is in a fight with the current outsourcing company about whether "cause" exists to terminate the company for a breach, and the hospital retains a new provider before the dispute is resolved. If the hospital loses the dispute with the current provider, it will have contracts with two different providers for the same services.

Suggestions: If necessary, negotiate at the outset of the contract for the right to hire physicians and staff from the outsourcing company at specific prices despite the noncompetes, rather than allowing this matter to wait until after termination of the contract, when you might be desperate for staffing. If an individual worked for your hospital before the outsourcing company entered the picture, make sure you do not have to pay a fee to hire the person back later. Also, despite your best efforts, you may find yourself in a legal dispute over your right to terminate the contract with "cause." Have a contingency plan in place for such circumstances to provide the services on a temporary basis until the dispute has been resolved.

Myth # 9: After an outsourcing provider has been terminated, it is no longer important to track the company's financial condition and its insurance policies. Malpractice or other claims based on the outsourcing provider's work may trickle in for years following the termination of the contract. Indemnity and insurance obligations should survive termination of the contract, and a hospital needs to continue tracking the provider to make sure these obligations are fulfilled.

Suggestions: If the outsourcing provider is required to continue to purchase malpractice insurance for the hospital's benefit, continue, in the very least, to demand coverage certificates regularly.

Myth # 10: If an outsourcing company goes out of business, the hospital has few options to recover for the obligations that the contractor owes. If a hospital's outsourcing partner goes out of business, there are a number of things the hospital can and should do. But these actions should be pursued quickly. The hospital typically will have a short amount of time, for example, to act on outstanding or potential medical malpractice claims. The more claims that make it to the outsourcing company's insurer before the policy is cancelled or reduced, the better.  The hospital may also be able to negotiate directly with the outsourcing company's insurer for continued insurance coverage before the policy is cancelled or coverage reduced; buying additional coverage this way may be cheaper than obtaining a separate policy elsewhere.

Further, the hospital may have some recourse against other parties. Even without a guaranty, the hospital may be able to reach the parent company of the outsourcing provider. If the provider made any distributions in the last several years to the parent company, these distributions may be subject to recapture as unlawful dividends or "fraudulent transfers," and this recovery can be used to pay the hospital's damages.

In addition, a failed company will sometimes move valuable assets (like accounts receivable, physician contracts, or equipment) to a new corporate shell to start doing business again. This is a form of "fraudulent transfer" and can justify claims against the new company and the individuals involved. Other potential claims may also be available against the related entities and individuals, and it is important for the hospital to realize that the shutdown of the outsourcing company might be more a visual deterrent than a real barrier to collection.

Suggestions: Should your outsourcing partner go out of business, tender every medical malpractice claim and potential claim to the outsourcing company's insurer as soon as possible. Also, consider negotiating directly with the outsourcing provider's insurance company to purchase a tail policy or buy some level of continuation coverage.

Further, always consider all of your alternatives before giving up the chase. See if you can recover any obligations from the parent company, and investigate the situation to determine whether there may be claims against third-parties or successor companies that can be pursued.

A Final Suggestion

The presence of risk is no reason for hospitals to reject outsourcing of clinical services as a strategy. Outsourcing always will pose some risk, but the extent of that risk-and how it compares with the potential benefits-will be determined to a significant degree by the hospital leaders charged with negotiating the contract. Consider how different the outcome for Community Hospital would have been if its contract had defined "breach" to include failure of the staffing company to pay its own physicians. Success for a hospital can hinge on small details like this one.

Among the myths discussed here, many share one common theme: They reflect a measure of complacency that can lead to disaster. The final suggestion? If you are pursuing an outsourcing arrangement, make vigilance be your mantra.


Robert A. Guy, Jr., JD, is a partner, Waller Lansden Dortch & Davis, LLP, Nashville, Tenn. (bobby.guy@wallerlaw.com).

J. Reginald Hill, JD, is a partner, Waller Lansden Dortch & Davis, LLP, Nashville, Tenn. (reggie.hill@wallerlaw.com).

The information contained in this article is provided for general information purposes and should not be construed as legal advice.


Outsourcing Observed

This article was inspired, in part, by results of a survey conducted  by Waller Lansden Dortch & Davis, LLP in 2006, which examined the current popularity of outsourcing and addressed multiple structures for outsourcing relationships.

Publication Date: Friday, June 01, 2007

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