Strategic alternatives abound for health system outreach laboratories

Various industry pressures have accelerated an evolution in laboratory businesses in recent years, with particular impacts on labs owned by health systems. As a result, many health systems are considering alternatives for their labs, with an emphasis on outreach labs.

A health system’s outreach lab business includes tests ordered for patients primarily in non-acute settings such as physician practices or skilled nursing facilities. The tests are not tied to an inpatient or outpatient encounter and are therefore charged on a per test, rather than bundled, basis.

The role of large, national laboratory operators (e.g., LabCorp, Quest Diagnostics, Sonic) in the outreach lab business has continued to grow. As these operators have built scale, they have also been able to reduce their fixed costs and establish efficiencies that allow for highly competitive pricing. Labs owned by health systems typically are reimbursed at a rate often multiple times higher than are national lab operators, which makes their position more vulnerable in a market with a growing emphasis on consumerism and price transparency. Payers are well aware of these rate differentials and have begun carving out narrow networks that exclude hospital outreach labs.

Health systems face other challenges in the outreach lab business, including the following:

• An already high fixed-cost structure is being further pressured by rising salary, benefit  and supply costs, compressing the margin on outreach lab services.
• Future Medicare payment cuts under the Protecting Access to Medicare Act (PAMA) will put additional pressure on margins.
• A focus on population health management and analytics favors the national lab operators, which have large, diverse patient bases that enable more advanced predictive analytics and sophisticated statistical analyses, and which also have user-friendly reporting capabilities that allow them to utilize information across specific modalities of care or specific populations.

A need for partnerships

These factors are driving more health systems to seek partnerships that help them accomplish some combination of the following:

• Lower the cost structure of the lab and out-of-pocket costs for their patients
• Tap into a greater degree of capabilities with their lab data
• Increase performance for provider-sponsored health plans
• Streamline their ambulatory lab network
• Monetize outreach programs that have shrinking margins but are currently selling at historically high multiples

The industry is seeing a notable uptick in lab transactions, which commonly involve outreach platforms but also may include options for inpatient/outpatient lab tests, as further described below.

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Between 2013 and 2021,  among U.S. health systems, an average of two outreach lab transactions were announced per year. Data tracked by Kaufman Hall show that, in 2022, activity increased significantly, with seven transactions announced, including several with larger scale regional or national health systems. And in 2023, an additional two transactions were already announced in just the first quarter of the year.

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An outreach lab transaction involves the sale or joint venture of an organization’s outreach test business to a national laboratory operator. The business includes the associated outreach volume and the space and equipment needed to collect the outreach tests. Neither the laboratory itself nor inpatient and outpatient volumes are included in the transaction.

Health systems are pursuing outreach lab transactions today for several reasons:

• There has been a recent “race to scale” among the national lab operators, and competition for health systems’ outreach lab businesses has led to very competitive terms in recent transactions.
• Valuation multiples have accelerated significantly and have generally increased by 150% to 200% over the past few years.
• Operational and financial headwinds have made cash even more critical for health systems, and the proceeds from outreach lab transactions allow them to shift resources to core endeavors.

Alternatives for health systems

There is no one-size-fits-all transaction model for outreach labs. Health systems that do not wish to transition their entire outreach platform can choose from a wide range of collaborative arrangements — including joint ventures and other mutually beneficial partnerships.

Other alternatives are available that also relate to a health system’s broader inpatient-outpatient lab volumes, either as stand-alone options or as parts of outreach transaction packages. These alternatives include the following.

A management services agreement (MSA). MSAs are best for a health system that needs assistance with the full management of day-to-day operations of its laboratory business. Under an MSA, a national laboratory operator takes over certain testing and management functions for a certain time (e.g., three to five years), transferring the risk of inflating costs and locking in a per-test cost for the term of the agreement. The laboratory operator then leverages its scale, global contracts, operating expertise and offsite testing capacity, often achieving 10% to 20% savings of addressable costs for the health system. The MSA does not necessarily require management of the entire lab; à la carte options are available to manage certain aspects of the lab.

A reference agreement. This is a vendor agreement between a health system and a national laboratory operator in which the health system agrees to send most of its higher specialty “send-out” tests to the operator as a “preferred provider” in return for a per-test savings below the existing fee schedule. These agreements are most beneficial for health systems that are sending tests to a wide array of national laboratory operators and that could benefit from streamlining their referral process. Reference expense savings of 10% to 20% are typical, and the health system also benefits from easier user interfaces.

A reverse reference agreement. These agreements are used in situations where a national laboratory operator lacks local core laboratory capacity for certain test volumes and agrees to transfer certain tests from the community to a hospital-owned lab that has capacity. These agreements are geography-specific, and they allow the hospital to collaborate on laboratory strategy with a national operator. The types of tests included in a reverse reference agreement typically depend on the hospital-owned lab’s specialized capabilities and the needs of the national operator.

Health systems that are interested in pursuing these opportunities should begin by considering the key questions outlined below.

Questions for health systems considering alternative outreach lab strategies

When assessing the relative benefits of strategic outreach lab alternatives, health system leaders should consider the following questions:

• Is our health system currently receiving outsized laboratory reimbursement? Are outreach volumes at risk of significant reimbursement declines or reduced volumes due to exclusion from narrow networks?
• Is our outreach lab business truly differentiated? Even if we have superior turn-around times, does that insulate our business enough from other headwinds?
• Are physician groups or other outside service partners steering laboratory volumes away from our lab due to payer contracting and costs?
• Are we getting the most out of our laboratory population data today? Would partnering with a national lab allow for access to enhanced data and population health capabilities?
• What is the envisioned future of the laboratory? Are there plans to expand our laboratory network?
• What are near-term capital needs for the laboratory to keep up with specialized capabilities? Would potential proceeds from an outreach lab partnership allow us to better service other capital needs within the health system?
• Does our lab have the capacity to service additional volumes? Would partnering with a large operator accelerate our ability to grow our regional lab presence through a joint venture or reverse reference agreement?

A window of opportunity

Even though health systems face significant headwinds in the outreach laboratory business, there are a range of potentially beneficial options available in the market today to restructure, grow or monetize that business. Careful assessment of both the challenges and opportunities in the evolving lab landscape can help a health system identify the best path forward.