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    A Novel Type of Health Care Corporation

    The Palo Alto Medical Clinic was originally incorporated as a for-profit partnership of physicians who were the sole stockholders in a real estate corporation that owned the group's land, buildings and equipment. New physicians would buy equity in the partnership, and the Clinic would in turn cash out the shares of retiring partners. The doctors were thus in complete control of the Clinic's assets, governance and strategic direction.

    For nearly 50 years, this model worked. But by the 1970s, changes in the health care marketplace were starting to threaten its sustainability. Two problems in particular stood out. First, factors such as rising real estate values had pushed up buy-in prices for partners to near $200,000, threatening the Clinic's ability to recruit new doctors. Second, the creation of Medicare and other developments in health insurance had begun to drive down patient fees, decreasing the doctors' revenue.

    Looking out across the coming years, then-Executive Director Dr. Robert Jamplis began to doubt that the Clinic would be able to cover new technologies or buildings out of its own pocket, and to fear that this precarious financial situation would leave it vulnerable to takeover by a profit-driven organization. "It was not what I wanted or what I thought Russ Lee had founded the Clinic for. I wanted an institution that would be a public trust and would live in perpetuity," he said.

      Dr. Robert Jamplis
    Dr. Jamplis could see the Clinic needed other sources of funding to continue successful operations. "The only way I knew to get the money," he said, "was through philanthropy and low-cost financing" such as tax-exempt bonds. But as a for-profit organization, the Clinic was legally unable to access either. Looking to the experience of other medical groups such as the Mayo and Cleveland Clinics, Dr. Jamplis proposed a radical solution: convert the organization to a not-for-profit, tax-exempt, charitable foundation that would be unhindered by such financial constraints.

    The foundation would collect all revenues, manage business functions, employ non-physician staff members and make strategic decisions regarding patient care. It would provide medical care to its patients through an exclusive contract with the physician partnership, which in turn would continue to exist as a separate for-profit corporation (still called the Palo Alto Medical Clinic) under the foundation umbrella.

    The idea passed muster with the Internal Revenue Service and the state Franchise Tax Board. But it conflicted with a section of California law prohibiting the "corporate practice of medicine" – or the provision of outpatient health care by any organization other than a licensed health care clinic – because while the Clinic's physicians would be licensed, the foundation would not. Never one to be easily swayed from an idea he thought had merit, Dr. Jamplis joined forces with the Santa Barbara Clinic and the Scripps Clinic in San Diego, which were facing similar financial difficulties.

    The groups successfully lobbied the state Legislature to pass a new law allowing for the legal creation of "a clinic operated by a nonprofit corporation ... which conducts medical research and education and provides health care to its patients through a group of 40 or more physicians and surgeons, who are independent contractors representing not less than 10 board-certified specialties, and not less than two-thirds of whom practice on a full-time basis at the clinic." The provision was tacked onto another bill and passed the Senate and Assembly without a single dissenting vote.

    The Clinic partnership also had to approve the change, and if the Legislature was relatively easy to convince, the doctors most certainly were not. Although they would continue to own their assets, the change meant giving up control over business decisions and strategic planning to a separate organization – one that would be governed by a lay board of directors and managed primarily by lay administrators. The doctors would also be asked to make short-term financial sacrifices to generate initial start-up capital for the Foundation.

    The Executive Board members divided up the 130 partners between them and embarked upon a political campaign to convince each one that the idea had merit. "We had to explain to these guys that, while they were giving control to a lay board, these laymen were their patients, their friends," said Dr. Jamplis. After months of dinner meetings and difficult conversations, the proposal came to a vote and passed resoundingly.

    As the base for their new organization, Clinic leaders used the Palo Alto Medical Research Foundation, which was already a separate not-for-profit entity. The Research Foundation's mission – to conduct biomedical research and education – was expanded to add the words "health care." The Clinic became the Health Care Division of the new corporation; the Research Foundation changed its name to the Research Institute and became the Research Division; and a new Education Division, providing health information and other support resources to patients, was created.

    On January 1, 1981, the Palo Alto Medical Foundation for Health Care, Research and Education (PAMF) came into official existence. Dr. Jamplis became its first CEO, while Dr. R. Hewlett Lee took over as Clinic executive director. Leading community members were recruited to act as trustees. A few Clinic physicians also sat on the board or took management roles within the new Foundation, creating even tighter links between the two organizations.

    Buying Out the Doctors

    While the Foundation got up and running, the physician partnership continued to own all of the land, buildings and equipment used in patient care, with the Foundation paying "rent" for those assets. By 1987, PAMF trustees felt it would be best to transfer ownership of the properties to the larger Foundation by buying out the physician partners. The change would eliminate the continued problem of high buy-in costs for new doctors, strengthen the Foundation's financial position and allow the Clinic partners to focus on what they did best: providing patient care.

    Again, the doctors had to be convinced. This time, they worried less about loss of control; after seeing PAMF's leaders raise $30 million in their first six years without compromising patient care, most physicians had become "convinced these laymen were so wonderful they couldn't do without them," Dr. Jamplis said. But with each doctor personally invested in the real estate corporation as a stockholder, some had financial concerns.

    Retired partners, who were still receiving payments from the Clinic corporation for the shares they had previously held, were particularly irate, because the deal was structured so that they would not receive 100 percent of the payout provided to younger doctors. "A sliding scale was built so that every year after age 65, a smaller percentage was given to the doctor," said Dr. Maurice Fox, who was on the Clinic Executive Board at the time. "But one of the doctors who was off the end of that bell curve – someone so old that he got no share – threatened to kill Hewey Lee. The ones in the middle of the curve weren't happy either, but they just wanted to beat him up."

    Fortunately, the deal was approved by the doctors without violence. To pay for the transaction, the Foundation floated $26.4 million in tax-exempt bonds, becoming the first medical group in California to use this type of financing. The physicians also made a tax-deductible gift of about $9 million, a significant measure of support for the Foundation. With PAMF now in a position of financial strength, it began to concentrate again on growth and development, launching capital campaigns to fund new buildings and directing resources toward new services such as health education.

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    The Sutter Affiliation

    Just five years after selling their assets, Palo Alto Medical Clinic doctors confronted yet another major development: the Foundation's decision to affiliate with Sutter Health, a not-for-profit network of
    hospitals and medical groups across Northern California. Affiliation might have seemed like a strange choice for this historically free-thinking group. But PAMF leaders again saw the structural change as critical for their continued survival and success.

    By the late 1980s, it was clear that managed care was becoming the dominant type of health insurance in California. At the time, about 35 percent of PAMF's patients were capitated, meaning that the group received payment in advance for their care. But projections showed this figure could soon grow to 70 or 80 percent. At a series of retreats, leaders decided it was time to become a "managed care organization," meaning not that it would accept only capitated patients, but that it would treat all of its patients as if they were capitated.

    In practice, this meant that the Clinic would add primary care physicians, who then represented only a third of the group, to coordinate care for both managed care and fee-for-service patients. The Foundation would also seek ways to reduce overhead costs, since managed care payments were often lower than fee-for-service rates. Partnering with a larger organization would give PAMF better negotiating leverage with insurance and medical supply companies, assistance with increasingly complex business management and information-technology functions, and capital to bring in more physicians.

    At the same time, PAMF had come up against physical constraints to its growth. With its Palo Alto operations spread out over several blocks in aging facilities, it envisioned a modern campus that would integrate all of its services and allow it to incorporate state-of-the-art technology, such as an electronic health record, to improve the quality and efficiency of care. While the Foundation had successfully used tax-exempt financing in the past and benefited significantly from the generosity of donors, it needed a partner with deeper pockets for a project of this magnitude.

      PAMF and Sutter Health officials
    Large "integrated delivery systems," which brought together hospitals and clinics into single networks, were proliferating as managed care penetration increased and individual providers realized there was strength in numbers. PAMF initially explored the option of partnering with nearby Stanford University, then decided an outside partner would be preferable. With a reputation for excellence, PAMF quickly had two serious suitors: a national for-profit physician practice management company called Caremark, and Sutter Health, a not-for-profit, Sacramento-based hospital system that was just beginning to expand in Northern California.

    As they had in 1981, PAMF's leaders again felt it important to view PAMF as a public trust and were concerned that affiliation with the for-profit Caremark might alter its mission of meeting community need. Unanimously, the board chose to partner instead with Sutter Health, whose management style and philosophy seemed a better fit.

    As structured, the affiliation agreement protected much of PAMF's ability to govern itself locally. Although Sutter representatives gained seats on the PAMF Board of Trustees, the majority of trustees continued to be community members and physicians. Sutter also was given the power to approve the board's selection of new local trustees, to jointly choose the Foundation's next CEO and to approve all PAMF budgets. But in more than a decade of affiliation, Sutter has never overturned the board's trustee selection; nor has the fiscally responsible Foundation been much impacted by budgetary oversight.

    As for CEO selection, the affiliation agreement also required that the choice be approved by a majority of the Palo Alto Medical Clinic's physician Executive Board. "In effect, what that means is that the Foundation CEO is always going to be a physician," said David Druker, M.D., Foundation president and CEO from 1999 to 2010, at that time. Meanwhile, PAMF received access to Sutter capital – including an initial $50 million payment for building construction and expansion – and services such as contracting, information technology and purchasing assistance.

    The Sutter affiliation had little impact on the individual Clinic physician. Although the agreement did not have to be approved by the doctors, it was nonetheless put before them for a vote and passed with little opposition. "I think I can confidently say that if you talk to most doctors, they would know little about our relationship with Sutter, because it hasn't made much difference in their practice," said David Druker, M.D., Foundation president and CEO from 1999 to 2010. For the Foundation, he added, the relationship has been "like a marriage: not always perfect, but good on the whole. Sutter is an ethical, well-run system, and we and our patients certainly benefit from our involvement in many of their technology and quality initiatives."

    Managed care companies never captured as much of PAMF's patient population as had been projected. At the highest, about 65 percent of the group's patients were capitated, and today the percentage has shrunk back to where it was 10 years ago – about 35 percent to 40 percent – thanks to widening consumer dissatisfaction with health maintenance organizations. But Dr. Druker still felt the 1990s decision to concentrate on managed care was the right one. "It re-emphasized primary care and focused us more on disease prevention and education, which are the only ways to improve health status while lowering costs," he said.

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