Advisory Opinion to Cumming (07-17-96)

July 17, 1996

George A. Cumming, Jr., Esquire
Brobeck Phleger & Harrison, L.L.P.
Spear Street Tower
One Market
San Francisco, California 94105

Dear Mr. Cumming:

This letter responds to your request for an advisory opinion on behalf of Mayo Medical Laboratories (“Mayo”), an affiliate of The Mayo Clinic in Rochester, Minnesota. Mayo is a national reference laboratory whose primary business is the provision of “esoteric” testing services to referring hospitals, physicians and other health care providers. Mayo intends to establish networks of hospital laboratories in various parts of the United States to compete for contracts with managed care plans and other payers on a statewide or regional basis to provide laboratory services for outpatients .(1)

This opinion is based on our understanding of the facts as explained in your letter and during a meeting between Mayo representatives and Health Care Division staff. We have not conducted an independent investigation, and our assessment could change if the facts change significantly.

Background

According to your letter, laboratory services may be provided by hospitals, physician offices, and independent commercial laboratories.(2) The range of testing services provided by these firms varies. The letter describes three categories of testing services, based on the relative sophistication involved, that hospital laboratories participating in the networks may provide.(3)

A number of large national laboratory firms, through owned or affiliated local laboratories, are able to offer a full range of laboratory services, from routine tests to esoteric referral laboratory services. Commercial laboratories have made significant gains in market share in recent years,(4) largely by contracting with managed care companies. The three largest commercial laboratories, Corning, LabCorp and SmithKline Beecham, earned 44 percent of all commercial laboratory revenues in 1995.

The market share of hospital laboratories has fallen significantly in recent years, particularly for outpatient tests. Much of this decline is due to the growing preference of HMOs and other payers for regional, statewide, or nationwide laboratory service contracts. Mayo has found that many payers believe it is more efficient to contract with large commercial laboratories than to create their own networks, and are not willing to incur the additional costs of contracting with individual providers. Payers obtain at least three benefits from broad-area contracts with large laboratory companies. First, larger contracts cover a sufficiently large pool of patients to permit the laboratories to assume risk for the volume of services provided to those patients. Second, payers benefit from the administrative efficiencies of having fewer contracts. Third, large commercial laboratories can provide payers with the standardized utilization and quality review reports that payers desire. In order to compete for this business, smaller laboratory firms are forming networks.

The Proposed Networks

Mayo proposes to form regional or statewide laboratory networks with local hospitals. Hospitals will provide basic and second level tests, depending on their capabilities. Mayo will perform esoteric tests that cannot be performed by a local network hospital. Mayo will contract with smaller independent laboratories where necessary to provide the geographic coverage that managed care payers desire.

Mayo believes that its networks will help hospitals increase their outpatient laboratory testing volume. Hospitals need to maintain laboratory capacity for inpatient services, and many have significant excess capacity. Some hospitals have discontinued operation of full service in-house laboratories and outsourced all tests to commercial laboratories. Mayo hopes to take advantage of the economies of scale that can result from using the excess capacity in hospitals to secure managed care contracts.(5) Individual hospital laboratories are unable to get this business now because they lack the breadth of geographic coverage and services demanded by payers.

Mayo intends to develop networks in a number of areas, and it has provided more information about two proposed geographic sites: a statewide network in Michigan and a regional network in the San Francisco Bay Area. Mayo believes that these two are typical of the networks it proposes to organize. As Mayo recognizes, this opinion letter applies directly only to the specific examples discussed here.

Mayo has signed letters of understanding with 34 of 206, or about 17 percent, of the hospitals in Michigan, as well as with four community-based laboratories in that state. Mayo has similar letters with 9 of 81, or about 11 percent, of the hospital laboratories in what it defines as the San Francisco Bay area. Commercial laboratories have a significant presence in both areas.(6) Mayo has been unable to obtain revenue or volume information on outpatient testing in these markets due to the fragmented nature of the laboratory services industry.

Mayo anticipates that the great majority of network business will be provided on a financial risk-sharing basis through the use of capitation arrangements or significant financial withholds from the fees paid to the networks. Many payers will only consider capitation contracts, and the three major commercial laboratory companies already are willing to take such contracts. Other contracts may provide for risk withholds of 15 to 20 percent that will be paid to the laboratories based on their meeting predetermined total laboratory utilization targets. For risk-based contracts, the networks will present a jointly-determined offer to payers, although individual laboratories are not bound by network contracts until they ratify them.

Mayo also anticipates that some payers will request bids for contracts on a fee-for-service basis, without risk-sharing features. For these customers, Mayo, in conjunction with its accounting firm, plans to survey network members about their current pricing, combine that information with whatever additional information about payer contracts Mayo and its accounting firm can obtain, and then form a schedule of prices to be given to a payer as an initial offer. Offers from interested payers would then be referred individually to each network member for unilateral acceptance or rejection. Network members will not share among themselves current or future price information. Mayo chose this structure to enable the networks to respond promptly when payers submit requests for proposals simultaneously to the networks and competing commercial laboratory organizations, while eliminating direct discussion of price among network members.

In addition to permitting hospitals to make better use of existing laboratory capacity and increasing competition for wide-area contracts through the creation of additional competitors, Mayo believes that the networks will offer a number of benefits to payers. First, Mayo asserts that doing most tests at local hospitals will reduce turnaround time, facilitate follow-up consultation between the ordering physician and laboratory personnel, and eliminate the need for duplicate testing in cases where the patient is admitted for follow-up care to the hospital where initial tests ordered by the attending physician were performed. Beyond that, Mayo intends to work with payers and their physician panels to eliminate duplicate or unnecessary testing, and to make better use of tests that are ordered, thus reducing laboratory costs and improving clinical care. Within a fully integrated laboratory delivery system, local laboratory personnel (such as pathologists, medical technologists, and administrators) will consult with local clinicians and will work with local physicians to develop new testing algorithms designed to eliminate unnecessary follow-up tests and physician office visits, and to identify unnecessary testing and inappropriate profiles that may trigger unnecessary additional work-ups. These systems will be developed both to manage the risk assumed by the networks under risk contracts and to add value to make the networks more attractive to potential buyers. In addition, Mayo will provide consultation to network professionals, assist the laboratories in minimizing turnaround times, and assist network members in linking their computer systems so they can generate the utilization and quality review reports that are often required by payers. These various mechanisms will be employed by the networks for all their business, including services furnished under fee-for-service contracts as well as risk-sharing arrangements.

The networks will not establish a separate corporation; their members will be linked by contract only. Each network will be governed by a Steering Committee consisting of a representative of Mayo and of each network member laboratory. The Steering Committee will develop information technology to assist network members in producing the utilization and quality review reports.

Mayo states that the networks will be non-exclusive. Network members will be free to join other networks and to contract individually with payers. Mayo and network laboratories are free to accept test referrals from non-network hospital and commercial laboratories. However, during the ninety days following a Steering Committee decision to proceed with a network payer proposal, Mayo will be the member’s exclusive negotiating agent with such payer, unless the member decides in advance not to participate in the proposal. In addition, members may not actively participate in an effort by another network to market its services in competition with a Mayo network.

Analysis

The general antitrust analysis applicable to the proposed networks is described in the Department of Justice/Federal Trade Commission Statements of Analytical Principles Relating to Multiprovider Networks.(7) As discussed in that statement, antitrust law prohibits naked agreements among competitors that fix prices. Such agreements will be evaluated under the rule of reason, however, when they are reasonably necessary to achieve the procompetitive benefits of a joint venture involving significant economic integration among competitors. Among the ways in which such economic integration can be evidenced is substantial financial risk-sharing among participants in the joint venture. Agreements to provide specified services to members of a health plan at a capitated or fixed per member rate, or to provide services on a fee-for-service basis that is subject to a substantial risk withhold or other arrangement that creates significant financial incentives for members of the group to achieve specified cost-containment goals, are examples of situations in which members of a network may share substantial financial risk.

The proposed networks expect the great majority of their business to be subject to risk-sharing contracts, under which the networks either will receive a capitation amount per member, or will be paid on a fee-for-service basis subject to a significant risk withhold. The networks’ risk-sharing business will involve a direct agreement among the participating hospitals concerning the prices to be charged under capitated and fee withhold contracts.

In addition, Mayo expects that some payers, who now contract with commercial laboratories on a discounted fee-for-service basis without risk-sharing features, will issue requests for proposals on that basis, to which the networks will respond. Bids for contracts of this nature would not involve a fee schedule agreed to in advance by the hospitals. Instead, Mayo and an independent agent will develop a suggested list of prices or range of prices that will be presented to the payer. Mayo would then expect to receive an offer from the payer, which would be referred individually to each network member for acceptance or rejection.

The use of an independent agent by the networks avoids direct discussion among network members about pricing as well as sharing of pricing information, and thus provides some protection against possible anticompetitive spillover effects on pricing by network members concerning services delivered independently outside the network. It does not, however, eliminate the existence of an agreement among network members as to prices to be charged under the non-risk contracts. For purposes of this opinion, we treat network members as competitors of one another,(8) and assume that all contract prices will be the product of a horizontal agreement among those members.

In the circumstances described here, however, we conclude that the proposed networks would involve substantial integration among their members that creates the likelihood of producing significant efficiencies, and the price agreements are reasonably necessary for the network to achieve those efficiencies and provide effective competition to other sellers for statewide and regional contracts. Consequently, we evaluate the price agreements under the rule of reason.

Joint pricing by network members on contracts involving risk-sharing clearly is ancillary to the members’ integration required to offer those arrangements, and thus subject to rule of reason analysis. In the circumstances described in the request letter, the non-risk contracts also involve substantial integration among the networks’ members that appears capable of producing significant efficiencies that could benefit purchasers of the networks’ services. As discussed above, the networks intend to offer integrated laboratory services that may reduce costs not only of laboratory services but of overall clinical care as well, and to provide uniform utilization and quality review reports to payers. The networks intend to apply the types of coordination and integration among the laboratories that are necessary to permit the networks to manage costs under the risk contracts to the services rendered under non-risk contracts as well. The pricing mechanism that the networks propose will permit them to compete for non-risk contracts, including those that are offered through requests for proposals.

Your request letter does not provide enough information to permit us to conclude with certainty what are the relevant product or geographic markets in which the networks will operate, or to calculate the approximate share of network members in those markets. As discussed above, you assert that the necessary information is not available. Thus, we cannot offer a definite opinion that the ventures would be found to be permissible after a full rule of reason analysis. The information that is available, however, suggests that the two networks described in the request letter do not pose a significant risk to competition in any market.

Neither network will involve a large proportion of the hospitals operating in the area to be served by the network. While the numbers of hospitals involved in a network tell us little about those hospitals’ market share or capacity in outpatient testing services, it does not appear likely that the members of either network will possess in any laboratory testing market levels of market power that could endanger competition. (9) The networks will face significant competition from commercial laboratory firms, some of which offer a full range of services and operate on a national basis, as well as from networks of other commercial laboratories and networks of other hospitals that may be organized.(10)

Nor is operation of the network likely to restrain competition significantly in local hospital service markets. According to the request letter, most of the hospitals that will be involved in the networks are not significant competitors of one another in any aspect of their operations. The networks will compete only for business that the member hospitals cannot practicably compete for as individuals, and the venture is structured in a way that makes anticompetitive spillover effects unlikely. There do not appear to be any agreements relating to the prices of services rendered outside the networks.(11)

For the reasons discussed above, operation of the networks as described in this letter does not appear likely to pose a risk of anticompetitive effects in any market. On the contrary, the proposed ventures may have procompetitive effects by permitting the participating hospitals to compete for business they could not get on an individual basis, thereby providing additional purchasing options to payers.

Conclusion

For the reasons discussed above, Commission staff has no current intention to recommend a challenge to Mayo’s proposed establishment and operation of the laboratory networks described above. This letter sets out the views of the staff of the Bureau of Competition, as authorized by the Commission's Rules of Practice. Under Commission Rule § 1.3(c), 16 C.F.R. § 1.3(c), the Commission is not bound by this staff opinion and reserves the right to rescind it at a later time. In addition, this office retains the right to reconsider the questions involved and, with notice to the requesting party, to rescind or revoke the opinion if implementation of the proposed program results in substantial anticompetitive effects, if the program is used for improper purposes, if facts change significantly, or if it would be in the public interest to do so.

Sincerely yours,

Robert F. Leibenluft
Assistant Director

(1) As used in this letter, the term "outpatients" refers primarily to patients treated in physicians’ offices, clinics, nursing homes, and other non-hospital settings.

(2) According to one source, the total revenue for laboratory tests in 1995 was approximately $40 billion, of which $15.5 billion was for outpatient tests. Hospital laboratories accounted for $1.4 billion (9 percent), physician office laboratories accounted for $5.4 billion (35 percent), and commercial laboratories accounted for $8.65 billion (56 percent) of total outpatient laboratory revenues. Smith Barney, "The Current Laboratory Industry," p. 5 (Dec. 20, 1995) (attached to Mayo’s request letter).

(3) Basic tests include tests that all hospital laboratories perform on a routine basis. Second-level tests are more sophisticated and less routine, and are performed by some, but not all, hospital laboratories. Hospitals that provide specialized inpatient care are likely to have broader test capabilities in areas relevant to their specialties. “Esoteric” testing includes the highly sophisticated testing performed by national reference laboratories like Mayo. In a recent business review letter involving a proposed network of independent commercial laboratories, the Department of Justice defined three similar distinct markets for laboratory tests: stat, routine, and esoteric. Stat testing requires rapid turnaround times to support immediate treatment decisions. Routine services generally are uncomplicated and widely-used but not particularly time-sensitive. Esoteric services are more infrequently requested, require more time and diagnostic skill, and often are referred to specialized laboratories. United States Department of Justice Business Review Letter, No. 95-20, from Anne Bingaman, Assistant Attorney General, to W. Bradley Tully, Esq., on behalf of Preferred Laboratory Access Network (December 7, 1995) (“DOJ Letter”).

(4) Commercial laboratories increased their aggregate market share of total laboratory testing revenues from 20% in 1985 to 39% in 1995.

(5) Unless the ordering physician or the hospital’s contract with a payer directs otherwise, network laboratories will be required to refer to another network member all second-level tests that they cannot perform, and to refer all esoteric tests to Mayo, whether the request was initiated inside or outside of the network. Pricing and other terms for non-network-initiated referrals will be set by one-on-one dealings between the two parties to the transaction.

(6) Corning, LabCorp, SmithKline Beecham, Universal Standard Medical, Biotech Clinical Laboratories and Citation Clinical Laboratories are present in Michigan; SmithKline Beecham, LabCorp, Spectra Laboratories, Meris Laboratories, Physicians Clinical Lab, PathLab, UniLab and Shaffer Laboratories perform tests in the San Francisco Bay region.

(7) United States Department of Justice and Federal Trade Commission, Statements of Antitrust Enforcement Policy and Analytical Principles Relating to Health Care and Antitrust at 89 (September 27, 1994), reprinted in 4 Trade Reg. Rep. (CCH) ¶ 13,150 (1994) ("Health Care Statements").

(8) At least some of the hospitals are competitors in their hospital service markets, and thus may compete with each other in providing some laboratory services. While the hospitals apparently have made little effort to attract the type of outpatient laboratory business that the networks are attempting to obtain and do not now appear to be significant competitors for that business, and they cannot individually compete for the national and regional contracts to be sought by the networks, they are at least potential competitors for network contracts.

(9) The request letter’s assertion that the laboratory business in California is competitive is consistent with a business review letter recently issued to a proposed commercial laboratory network in California that states that payers regard the clinical laboratory business in California as extremely competitive, that almost all payers reimburse laboratories by capitation, and that entry into particular geographic markets by laboratories operating in adjoining geographic areas is not difficult. There are approximately 500 independent clinical laboratories in California. The three largest all have revenues of $100 million or more, and they account for 44.5% of independent laboratory sales in the state. DOJ Letter, supra note 3. According to Mayo’s request letter, a number of significant commercial laboratories also operate in Michigan.

(10) While the request letter states that network hospitals are not precluded from dealing with payers outside the networks or from participating in other laboratory networks, there are some restrictions on the ability of laboratories to compete with the Mayo-organized networks. While these contract terms may promote legitimate business objectives of the networks, they also limit member laboratories’ ability to do business outside the network. Since, however, there are many other sources of laboratory services available to buyers, these restrictions do not appear likely to have any significant anticompetitive effect.

(11) Network hospitals are required to refer tests that they cannot perform, even for non-network business, to another network member or to Mayo, unless the ordering physician or the hospital’s contract with a payer directs otherwise. However, the agreement does not set the prices for such referrals.