The Merger of UCSF Medical Center and Stanford Health Services

In May 1995, Dr. Joseph Martin, Chancellor of the University of California, San Francisco (UCSF), and Gerhard Casper, President of Stanford University, first discussed the idea of merging their two prestigious medical centers during a casual "walk in the woods" at an academic conference. More than a year later, on November 15, 1996, Stanford's Board of

Trustees and the University of California (UC) Board of Regents voted to merge the two medical centers. Another year passed during which there were innumerable meetings, reports, analyses, hearings by the state legislature, and protests by unionized UCSF employees. Finally, on November 1, 1997, the merger became official, and the assets of the public UCSF hospitals and the private Stanford Health Services were transferred to a new private corporation, UCSF Stanford Health Care (USHC). The new non-profit corporation consisted of four hospitals: UCSF's Moffitt/Long Hospital and UCSF/Mount Zion Hospital in San Francisco, and Stanford University Hospital and Lucile Packard Children's Hospital 40 miles away in Palo Alto. The medical schools and research facilities of the two universities remained separate.

Dr. Martin, interviewed after the UC regents voted in favor of the merger in 1996, proclaimed, "I am very excited. I have a feeling something great has happened today...I believe this will be seen, when we look back in five or ten years, as one of the most important things that happened in American academic medicine in the 1990s." Stanford President Casper agreed: "I see in this a long-term potential for joint projects between the two best medical schools in the country. We clearly share identical missions, to provide teaching, learning, research and the most advanced health care this country can give." Peter Van Etten, Stanford Medical Center President, said the merger would create "one of the nation's premier academic health centers.

However, less that two years later, in October 1999, the merger came to an abrupt end amid staggering financial losses, accusations of mismanagement, lack of support from faculty members, layoffs and other cost-cutting measures, and a loss of confidence from key individuals at both universities and at the state level.

Was the merger of the two academic medical centers, one private and one public, located 40 miles apart in the San Francisco metropolitan area, an ill-conceived "snakebit venture" as described in one headline at the time, or was it a reasonable response to the environmental and economic pressures of the time that fell apart in its execution? Was it a bold vision that had the potential to provide stability to two medical centers under siege from drastic reimbursement cuts, or "an arranged marriage between rival kingdoms...forced upon unwilling participants by decree" and "perhaps...doomed at the start"?

Background

The UCSF Medical Center was one of five academic medical centers operated by the University of California, and was considered by many to be the crown jewel of the system. It consisted of three hospitals in San Francisco: Moffitt/Long Hospital (560 beds), UCSF/Mt. Zion (365 beds), and Langley Porter Psychiatric Hospital (not included in the merger). In addition, UCSF Medical Center operated ambulatory care centers at the Moffitt/Long and Mt. Zion sites, as well as several satellite clinics. At the time of the merger, the two acute care hospitals were staffed by about 950 physicians and provided approximately 160,000 days of care.

Stanford Health Services, located in Palo Alto, 40 miles south of San Francisco, was a university- owned non-profit corporation that included Stanford University Hospital (611 beds), the Stanford University Clinics consisting of approximately 100 outpatient clinics, and the Lucile Salter Packard Children's Hospital (214 beds). In 1997, Stanford Health Services had a medical staff of 1,800 physicians, and provided approximately 164,000 days of care.

By the mid-1990s, both the Stanford and UCSF medical centers were facing an increasingly competitive environment. The Bay Area had come to be dominated by managed care plans, large physician groups, and powerful employer purchasing groups which had successfully reduced both reimbursement rates and hospital utilization. Medi-Cal, the California Medicaid program, had cut payments to hospitals, and was encouraging recipients to enroll in managed care plans. The federal Balanced Budget Act of 1997 would reduce Medicare payments, including medical education payments to teaching hospitals, even further in the near future.

As the only two academic medical centers in the San Francisco area, Stanford and UCSF faced additional challenges. They, like most teaching hospitals, had traditionally had higher costs than other hospitals both because of their complex mix of tertiary and quaternary care patients, and because of the additional costs of supporting medical education, training, and research programs. Both Stanford and UCSF were operating in the black in 1996, but in an article in the Los Angeles Times in May 1996, UCSF Medical Center Director William Kerr reported that UCSF had earned just $1 million on a budget of nearly $500 million that year. He was reported as telling the UC Regents that UCSF could not survive "without dramatic change." Dr. Haile Debas, Dean of the UCSF Medical School, was also quoted in the same article, saying that UCSF faced "a bleak future" unless dramatic steps were taken to forge partnerships with private health care providers. Two other teaching hospitals in the UC system, Irvine and San Diego, were in financial trouble in 1996, and were beginning to explore the possibility of partnerships or mergers with private health care providers.

Reductions in hospital utilization were not only threatening the hospital's finances, but were also eroding the patient base needed for medical school education and training programs. Both Stanford and UCSF were having difficulty providing clinical rotations for their third- and fourth-year students in several disciplines, and some residency programs, such as neurosurgery and dermatology at UCSF, had shrunk to critically small sizes.

The Growth of Managed Care and Its Impact

The San Francisco Bay Area experienced dramatic growth in the managed care industry during the 1990s, and by 1997 had one of the highest HMO penetration rates in the country. In most of the urban areas (such as Oakland, San Francisco, Santa Rosa, and Vallejo) over 50% of the population were members of HMOs, compared with 21% nationwide. Those who were not in HMOs were covered primarily by Medicare or Medi-Cal, and 16% of the nonelderly population was uninsured. Indemnity insurance played an almost non-existent role in the area. For example, at Stanford, patients covered by indemnity insurance dropped from 15% in 1990 to 1.5% in 1998. Stanford Health Services "calculated that each 1 percent drop in the indemnity patient population stripped $4 million from the annual bottom line."

In order to gain market share, HMOs in the area competed with one another by keeping insurance premiums low. This was accomplished by tightly controlling the use of physician and hospital services, reducing payments to providers, and consolidating with one another to cut costs. The HMO market was dominated by Kaiser Foundation Health Plans, Inc., which as of July 1996 served almost half of the HMO enrollees in San Francisco, and well over 50% in Oakland and San Jose. Two other plans played major roles in the area: HealthNet/Foundation with slightly more than a 10% market share in the Oakland and San Francisco areas; and Lifeguard with a 13.5% share in the San Jose area.

The HMOs themselves were subjected to pressures to control premium costs by large employer purchasing groups. Two of these, the California Public Employees Retirement System (CalPERS) and Pacific Business Group on Health (PBGH), represented millions of employees, and were very successful at negotiating lower premiums and demanding that plans monitor and improve the quality of care being provided.

Because HMOs already held such a large market share, they were not expected to grow dramatically. However, in the mid-1990s, HMOs in the Bay Area were beginning to compete aggressively for the Medicare population. In addition, cost-containment efforts by the state were focused on moving Medi-Cal recipients into managed care plans. HMOs were expected to experience incremental growth as these populations were added to managed care plans.

The impact of the growth of managed care was far-ranging throughout the rest of the health care industry in the area. As managed care plans put downward pressure on reimbursement rates, physicians and hospitals reacted by consolidating to improve their bargaining power. Most physicians in the Bay Area joined group practices, and smaller physician groups continued to merge with one another or to join large existing medical groups in order to improve their ability to obtain managed care contracts. In the mid-1990s, most of these groups were paid under

capitated payment systems, many of them in risk contracts. "In the Oakland, San Francisco, and San Jose areas more that 70% of total HMO physician reimbursement is capitated rather than traditional fee-for-service."1 These groups had been very successful at reducing member hospitalization rates.

The pressure on utilization resulted in low hospital occupancy rates and an oversupply of beds in the region. As of 1997, this surplus was estimated to be approximately 2,400 beds, or 11 average-sized hospitals, assuming a 70% occupancy level.

However, only a few hospitals had closed in the area during the first half of the decade. Instead, most had merged or affiliated with one another in order to improve their competitive position, and by 1997, few independent hospitals remained. The three major hospital systems in the area were Sutter/CHS (California Healthcare System), Catholic Healthcare West, and Kaiser, all non- profit entities. In the first half of the decade, these three systems sought to further strengthen their market position by developing vertically integrated delivery systems through affiliations or mergers with other health care providers such as long-term care facilities, physician groups, home care agencies, and outpatient clinics. But by the mid-1990s, vertical integration through ownership was beginning to decline in California. Some of the HMOs like Kaiser were beginning to spin off their hospitals and medical groups, and others were turning to long-term contracting with providers.

Competition and Market Share As of the end of 1996, there were 38 acute care hospitals operating within UCSF's and Stanford's primary service areaSan Francisco, San Mateo, and Santa Clara counties. Exhibit 1 provides the 1996 utilization statistics for the hospitals identified as the primary competitors at the time of the merger. Figures 1-3 provide information on how UCSF and Stanford stacked up against the competition in terms of expenses per discharge, LOS, and volume. Population Growth The population in the three-county Bay Area was projected to grow by about 9% over the next ten years. The increase was expected to be unevenly distributed, with most growth shifting outward from the urban centers. For example, San Francisco County was expected to grow by only 2.4% from 1997 to 2010, while Santa Clara and San Mateo counties were projected to increase by 10% during the same period. In San Francisco county, the elderly population was expected to grow by only 14.3% compared with a 28.8% increase in San Mateo County and 48.1% increase in Santa Clara County. The Decision to Merge In the years prior to the merger, Stanford and UCSF explored a number of approaches to dealing with the worsening conditions of the market. At UCSF, management focused on improving efficiency and reducing costs. Both medical centers experimented with vertical integration by acquiring or affiliating with physician groups, and strengthening referral relationships. They also considered affiliating with community hospitals. But at both Stanford and UCSF, management concluded that, given the unique structure of the health care market in the Bay Area, integration strategies would not improve their financial situation. According to Peter Van Etten, President of Stanford Health Services, "Capitation rates in northern California are among the lowest in the nation, making profitability difficult or impossible for most primary-care based practices. It is neither the core mission nor the core capability of an AMC to run an extensive system of capitated community-based primary care...Lastly, at least in the northern California market, AMCs risk jeopardizing their existing referral sources by becoming a competitor."2 Historically, the two medical centers had competed not with each other but with large community hospitals. Stanford and UCSF hoped that by merging they could build larger market share, build their niche as "leaders in the treatment of complex illnesses," and be able to negotiate better rates with the area's HMOs and other insurers. In Van Etten's analysis, "The benefits of doing so [i.e., increasing their market share of complex care] are significant, since a 2 percent increase in market share would bring the enterprise an additional $100 million of revenue. A note-worthy benefit of the merger is to enable Stanford and UCSF to more effectively differentiate themselves from their community competitors by emphasizing unique characteristics that appeal to the general public." As described in a California State Auditor's Report,3 the leadership at UCSF and Stanford hoped that the merger would "enhance its academic mission, strengthen its regional referral role, and build a more cost-effective teaching hospital." This in turn would help the two universities maintain financial support for their academic missions while also being able to fund the programs and capital needs of their hospitals. By combining their hospitals, they would be able to offer a broader patient base for both their undergraduate and graduate medical programs, and "create opportunities for clinical research and collaborations between the two faculties and medical staff." UCSF and Stanford predicated the success of the merger primarily on their ability to "capitalize upon the combined and enhanced reputation of the two entities to increase its volume of highly specialized cases drawn from the Bay Area and beyond." They also hoped to achieve economies of scale by consolidating purchases using fewer vendors, and negotiating larger quantity discounts; eliminate competition between the partners who shared about 11% of the tertiary and quaternary care market; decrease administrative costs by consolidating departments and spreading fixed costs; and achieve clinical cost savings and care improvement through coordination and adoption of best practice procedures. Other teaching hospitals, facing similar problems, adopted different approaches. These included: selling a majority interest in the teaching hospital to a for-profit chain; enhancing revenues by building a network of physician practices, community hospitals, and managed care plans; merging with an existing integrated delivery system; reducing costs by improving efficiency and developing best practices; and merging medical schools. On November 15, 1996, the University of California Regents and Stanford Trustees voted to provide a new private, non-profit corporationUCSF Stanford Health Care (USHC)to unite the two medical centers. Before this vote, a number of reports and analyses had studied the feasibility of the merger. All of these reports concluded that the merger was a good idea and would result in substantial savings to the institutions, although the estimates of the potential savings varied dramatically. In May 1996, Ernst & Young, LLP, estimated that the net financial benefits of the merger would be approximately $236 million over a four-year period from 1997 to 2000. The E&Y study identified two major advantages stemming from the merger which they claimed would not be possible if the hospitals continued to operate independently. These were: "(1) reductions in operating expenses and avoided capital expenditures [equaling $152 million] and (2) increased operating income associated with projected volume enhancements made possible by price reductions and enhanced outcomes expected to result from combined operations [equaling $84 million]." In early fall 1996, a second analysis, performed by Warren Helman and Bain & Company, also concluded that the merger was a sound business decision. They felt that the savings expected from reductions in operating costs were reasonable, but felt that the increased income projected due to volume enhancements was too aggressive given the stagnant market for hospital services, and should be cut to approximately $50 million. The California State Auditor's office then completed its own analysis in September 1997, which reduced the estimate of income from volume enhancements even further. The state felt that the market plan which projected an increase of 12.8% over the first four years of the merger in the number of tertiary and quaternary patients treated (from 16,669 to 18,152) was too aggressive. They also felt it was unlikely that the merged entity would be able to achieve all of the cost savings goals. But, they, like the other two reports, concluded that the merger was a good idea. In the state auditor's report, merger costs were estimated to be approximately $68 million over the first four years of the merger, consisting primarily of pension costs and severance pay. No other discussion of potential costs of the merger were presented in the auditor's report. Union Opposition and Other Problems The votes to approve the merger by Stanford's Trustees and the UC Regents were greeted with enthusiasm by Stanford's President Casper and UCSF Chancellor Dr. Martin. In contrast, they sparked "a small riot by union leaders" as reported in an article in the San Francisco Chronicle at the time. From the beginning, the unions representing most of the employees at the UCSF hospitals had opposed the merger, fearing massive layoffs and loss of pensions, salaries, and other union benefits. As quoted in the newspaper, one union representative complained, "To date, we have been given virtually no information...Under the circumstances, we can only oppose the merger." Libby Sayre, statewide executive vice president of the University Professional and Technical Employees, a union that represented staff researchers and technicians, reacted to the vote, saying, "This is a dark day for public education in California. The Regents have absolutely betrayed the public trust on this. There is no reason for taxpayers to support the University of California if they think their support is going to be handed over to private interests down the line." As the UC Regents and Stanford Trustees worked to formalize the merger during the year from November 1996 to November 1997, they faced many obstacles. The unions continued to try to block the deal. In addition, the courts ruled on a series of legal issues, including whether the Regents had the right to transfer UCSF's hospitals to a private corporation. At one point late in that year, President Casper threatened to walk away from the deal over the issue of how much of the private financial information of the Stanford system would have to be made publicly available. And, in a major setback to the merger effort, just days before the Regents voted on the merger in November 1996, Dr. Joseph Martin, one of the primary architects and supporters of the merger, announced that he would be resigning his post as UCSF Chancellor on July 1, 1997, to become head of the Harvard Medical School. "This came a year too soon," he was quoted in an interview. "But the opportunity to be Dean of Harvard Medical School doesn't come up very often." Martin also said his decision did not reflect any problems with the merger, but presented him with a chance to "return to the heart of what I like to do." Some critics of the merger immediately called for a reassessment of the situation. One Regent reacted to Dr. Martin's announcement by saying, "I frankly believe it is time to push the pause button. No one can step into his place and continue the work he was doing." However, Dr. Haile Debas, Dean of the UCSF Medical School, agreed to take on the position of Chancellor for one year, and work on the merger continued.

William Kerr, director of the two UCSF hospitals, was named CEO of UCSF Stanford Health Care. To balance his appointment, Isaac Stein, a member of Stanford's Board of Trustees, was named Chair of the newly formed USHC Board. Unfortunately, in another unexpected twist, Kerr changed his mind the day after he had accepted the job, and turned it down. The position was then offered to Peter Van Etten, President and CEO of Stanford Health Services, who in turn, asked Kerr to act as COO, a position Kerr accepted. The loss of Dr. Martin dealt a serious blow to the fragile coalition being built between Stanford and UCSF. Not only did the merger lose one of its major proponents, but Gerhard Casper lost a trusted colleague. Dr. Martin was the one person he knew well, trusted, and felt comfortable working with at UCSF. In addition, many on the faculty at UCSF felt angry and betrayed. There was a sense that Dr. Martin had initiated the merger only to leave at a crucial point, leaving the rest of the faculty holding the bag. The unexpected turnaround by William Kerr, whom everyone had expected to become the CEO of USHC, and the subsequent appointment of Peter Van Etten from Stanford, coupled with the appointment of Isaac Stein from Stanford to head the Board, left UCSF feeling at a disadvantage in the merger from the outset. Despite Van Etten's attempt to defuse this situation by asking Kerr to be his COO, the die was cast. The two institutions came into the merger feeling wary of each other, sensitive to the threat of having changes imposed on it by the other, and preoccupied with issues of parity. The Structure of the Merger As of November 1, 1997, UCSF and Stanford transferred equipment, personal property, and other assets to the new corporation, UCSF Stanford Health Care (USHC), at no cost, but retained separate title to all land, buildings, and improvements in their respective medical centers. Under the terms of the merger agreement, either UCSF or Stanford could call for an involuntary dissolution of the merger should either one "determine that USHC fails to carry out the purposes for which it was organized."4 The two medical centers were essentially equal partners in the merger, although each brought particular strengths to the deal. Stanford contributed $483 million in equity (56%), and UCSF $386 million (44%) to the total of $869 million. Stanford had $167 million in long-term debt, and UCSF $44 million. UCSF contributed liquid assets (cash, stock, and bonds) of approximately three times the amount of its long-term debt, while Stanford contributed liquid assets equal to two times its debt. Between 1992 and 1996, UCSF's net income totaled $251 million, while Stanford's was $215 million. UCSF's earnings from operations over the five-year period equaled $186 million, compared with Stanford's of $150 million. Over the five-year period (1992-1996), both medical centers were profitable as measured by net income and operating income prior to the distribution of earnings to the medical schools. UCSF's income had been relatively stable, while Stanford's was more volatile. Approximately 30% of Stanford's net income was from investment earnings, while 26% of UCSF's net income resulted from investment earnings and an appropriation from the State of California for clinical teaching support. USHC, the new entity formed by the merger, was a private non-profit organization operating four hospitals. It employed approximately 12,000 staff and provided facilities and support for over 1,700 faculty, 3,900 community physicians, and 2,900 registered nurses. The merged entity, with 1,268 beds, accounted for approximately 54,000 inpatient admissions and 980,000 outpatient visits, and had an operating budget of $1.5 billion. Control of the assets and operation of UCSF Medical Center and Stanford Health Services was transferred to a 17-member Board of Directors. The Board consisted of three UC Regents, three representatives from the Stanford Board of Trustees, three independent directors chosen by a selection committee, the UCSF Chancellor and Stanford President, the Deans and a faculty member from each of the two medical schools, and the CEO and Chief Medical Officer of USHC.

See Exhibit 2 for a list of board members and their affiliations. Detailed financial data can be found in Appendix A. The Merger's First Year Financially, the merger seemed to be on track during its first year, ending fiscal year 1998 (August 31, 1998) with a $20 million surplus. Peter Van Etten attributed $20 million worth of savings to the merger that year: $12 million from reduced prices paid to vendors, and $8 million from reduced administrative costs. Ongoing capital savings were beginning to be realized as well, by avoiding duplication in purchasing expensive new technology. For example, UCSF bought a $4.5 million gamma knife for use in treating brain cancer, and Stanford invested in cardiac magnetic resonance technology. These tools were available for use by both medical centers, and for joint educational and research activities. It was also hoped that by having the latest technology, USHC would further define itself as a leader in high-tech medical care. Exhibit 3 shows the trends in total and complex discharges at USHC since the merger. In November 1998, in order to support further cost cutting initiatives, USHC brought in the Hunter Group, a consulting group known for developing and implementing hospital financial recovery plans. The consultants' plan focused on reducing costs, including $170 million of cuts in personnel, supplies, and overhead over a three-year period. They also proposed plans for improving profitability, including increasing payment rates and patient volume, reducing medical school support, and closing or changing the services offered at Mt. Zion Hospital. Despite apparent success in the financial arena, other facets of the merger were not proceeding smoothly. The debacle caused by William Kerr's appointment as CEO and subsequent resignation heightened the anxiety levels of the faculties at each university and fueled an intense preoccupation with parity in all merger-related activities. This led to a number of decisions the purpose of which was to allay those fears, but which instead ended up pleasing no one. As described by Van Etten, "since the deal was a merger of equals, one institution could not simply impose its own structure and systems....we tried to compromise and ended up with mush."5 An example of such an ill-fated compromise was the siting of the corporate headquarters for USHC in $150,000-a-month offices in a "faceless office park" located halfway between UCSF and Stanford. This separate and inconvenient location fed a perception that top management did not understand or even know what was going on at the two medical centers. As tensions mounted, a "bunker mentality" seemed to develop within corporate headquarters. In another attempt to provide parity, the Chief Medical Officer (CMO) position was offered to Dr. Bruce Wintroub, Executive Vice Dean of UCSF's School of Medicine. He came to the job with strong credentials, but as a dermatologist, he was not considered to have the background or experience in inpatient hospital issues required in a CMO, and he received little or no support from the faculty on either campus.

Battles over funds flows within the new merged corporation were also extensive and destabilizing. According to Van Etten, "it is one of the enduring myths of the merger that Stanford's physician organization was top down while UCSF's was bottom up." The primary sources of funds for faculty supportphysician billing, hospital and medical school (institutional) supportat both medical centers was summarized by Mr. Van Etten: Stanford had a Faculty Practice Plan, which on paper was part of Stanford Health Services, which had been formed in 1994 to bring together the hospital and practice plan. While it therefore would appear that physician billing was centralized, in fact the practice plan was operated in a manner whereby each department controlled the revenue they were responsible for generating. There was some sharing of revenues from rich to poor departments through differential overhead rates. The issue of how to distribute revenue and expenses was the subject of very extensive debate for years prior to the merger. Stanford also had a complex and vast maze of programs whereby the hospital revenues supported physician programs. As for institutional support, the Dean provided funds, often with the hospital, for departments that were in deficit. With the hospital, the medical school provided support for recruiting and space. At UCSF, there was no physician practice plan. This had been the subject of extensive debate prior to the merger. The situation at UCSF was similar to the actual practice at Stanford except that Stanford had more deficit departments than UCSF, perhaps because there was greater institutional support at UCSF. (This was the source of the myth that Stanford's departments were weaker and that Stanford was top down rather than department based.) The hospital payments to the departments were not as extensive as at Stanford, but significant nonetheless. Institutional support was much more extensive than at Stanford. The state paid core salary support to a significant number of faculty, and because of the UC over-funded pension program, none of the departments had to make retirement payments (typically 12% of salary). Many hours were spent analyzing the financial relationships at each medical center after which management concluded that the total payments made from each school and hospital to its faculty were about equal. This conclusion was hotly contested by many faculty members, but was corroborated by an independent study. However, vast differences did exist in the way that payments were made, and which departments benefited from those payments. Once the relationships became understood more clearly, department chiefs who felt that they were receiving less than their counterparts at the other school demanded that the funds flow be equalized. Despite management efforts to rationalize the payment systems, suspicions and animosity among faculty members grew. The push to develop "product lines"one of the goals of the mergeralso sparked tensions. The integration of the faculties and the development of product lines was seen as the basis for the merger's success, and would presumably lead to an increase in the number of patients, improvements in clinical outcomes, and reduction of costs by promoting best practices. However, because the two medical schools remained separate, the faculties were faced with major conflicts of interest in these deliberations, since decisions to consolidate programs onto one campus would leave the medical school at the other campus lacking specific training opportunities. Lack of direction and support for these efforts from upper management also hampered progress. In addition, historically little or no relationship had existed between the two faculties so there was little precedent for working together. However, despite these obstacles, cross-campus work did proceed in pediatrics, adult cardiac care, and standardizing cancer drugs and protocols. The Merger Enters Its Second Year In January 1999, the financial picture changed drastically as USHC announced a $10.7 million loss for the first quarter of its fiscal year which ended November 30, 1998. This was a shock for management which had expected a $10 million profit for that time period. By early summer of 1999, estimates of losses for the fiscal year had grown to $60 million. As the losses were mounting, USHC was in the midst of upgrading the information systems at UCSF, and merging five separate accounting systems into one. During this time, operating and financial reports were typically not available until two to three months after the close of a period, limiting management's ability to measure its performance and identify problems in a timely manner. Although admissions were actually up during this period, the impact of drastic cuts in Medicare reimbursement from the BBA of 1997 were beginning to be felt. In addition, many private insurers had substantially cut their rates. Drug costs had increased 20% and expenses for operating room supplies were up by 5-10%. These increases were outstripping the increases in patient volume. Other problems were also contributing to the financial downturn. The business plan for the merger had anticipated a reduction of 120 management and non-management employees over a five-year period, as well as an increase of between 100 and 200 employees to deal with the increased volume of specialized cases. Instead, USHC added nearly 1,000 employees in the first year of the merger. Approximately one third of these were hired because of volume increases, while the rest were the result of merger-related activities in finance, administration, and information technology, all of which turned out to be much more complex than anticipated. Specifically, UCSF underestimated the amount of support it received from the UC system, and the number of employees it had to hire to replace those lost services. In addition, USHC had expected costs of $25 million to unify the computer systems at Stanford and UCSF. By March 1998, those costs had risen to $126 million. Two-thirds of that was spent on unanticipated replacement and upgrade costs for the antiquated UCSF system which needed to be completed before January 1, 2000. Reactions to the Losses USHC administrators and hospital industry experts attributed the losses to pressures being felt by all California hospitals being squeezed between HMOs and decreased government reimbursements. Daniel Berman, spokesman for USHC, said that "during the quarter, the hospitals admitted as many patients as they had expected, but received less money than budgeted because of declining reimbursements for Medicare and Medi-Cal, which make up half of all revenues." He said that USHC "did experience a slight increase in payments from private health insurers, who contribute the other half of revenues, but the increase 'kicked in later than expected.'" Mr. Van Etten insisted that the system's recent loss was not caused by the merger. He noted that other giant health systems such as Kaiser Foundation Health Plan were also running in the red because of higher drug costs, cuts in Medicare reimbursement, and labor shortages that boosted payroll expenses. "We're operating in an environment where the costs are escalating and the reimbursements are capped."6 The majority of the losses occurred in the San Francisco hospitals, which had 3% more Medicare patients and 4% more Medi-Cal patients than Stanford. Private insurance covered 58% of patients at Stanford and at higher rates, compared with 47% at UCSF. As described by Dean Debas of UCSF, "...the health care market on the Peninsula is different and more lucrative than in San Francisco." In fact, during the first six months of fiscal year 1999, Mt. Zion Hospital accounted for $24 million in losses, or 80% of the total $31 million in operating losses run up by USHC. However, losing money was not a new phenomenon at Mt. Zion. The hospital, which served a largely poor and indigent population, had lost money every year since it had joined the UCSF system, but had been supported by the more profitable UCSF Medical Center. When Mt. Zion merged with UCSF in the early 1990s, its finances were consolidated with those of the UCSF Medical Center so that most of the faculty at UCSF were unaware of its financial situation. The true state of Mt. Zion's finances were also never brought to light during all the studies and analyses that were done prior to the merger. Now the UCSF Medical Center was also losing money and was no longer able to subsidize Mt. Zion, making its losses very visible. The announcement of the financial problems at USHC sparked renewed controversy over the merger and calls for its dissolution. UCSF professors were upset that their once profitable hospitals were now losing money, and that they might lose Mt. Zion Hospital. Stanford faculty felt that their financial well-being was being threatened by "a money pit in San Francisco." The unions felt that their worst fears were being realized. Rose Ann Demoro, executive director of the California Nurses Association, said, "We've always maintained that this merger was not in the public's interest. Mergers mean consolidate, downsize, and rid yourself of cost items. In the case of Mount Zion, that means abandoning poor populations." Several state senators were highly critical of USHC management and called for an investigation. "There are totally dysfunctional elements to this merger," claimed one senator. "There has not been consolidation of departments, even when there were opportunities along the way because department chiefs left or retired." Amid the growing controversy, CEO Peter Van Etten and COO William Kerr resigned in August 1999, and the day-to-day operations of USHC were taken over by the Hunter Group. The Merger Dissolves Support for the merger eroded quickly. Dean Debas of UCSF, on sabbatical in England, recommended that USHC be "restructured in a fashion that would allow the San Francisco hospitals to operate once again as public entities, eligible for state financial aid. He indicated that state funds were the only way to save financially troubled Mt. Zion Medical Center."7 He also disclosed that the financial operations of the UCSF hospitals had been separated from those of the Stanford hospitals in a kind of trial separation. According to Dean Debas, the leadership of USHC felt that "Mt. Zion is a UCSF problem, and UCSF should decide what to do with Mt. Zion." By early October 1999, the Stanford trustees were calling for separate accounting and management of the hospitals, and a bylaw change that would limit the financial losses that one half of the partnership would have to absorb if they are caused by the other half. A poll taken among the faculty at UCSF indicated that only 23% continued to support the merger. At the end of the month, President Casper of Stanford called for an end to the merger. "We took on too much," Casper was reported as saying in a Chronicle interview. In the article, he indicated that it would have been better for UCSF and Stanford "to have collaborated in a less ambitious fashion, in ways that could have evolved toward closer ties."8 Casper concluded that the problems facing USHC were insoluble because the faculties at neither UCSF and Stanford were committed to the merger. "We clearly have not achieved a new culture where people identified with UCSF Stanford rather than with UCSF or Stanford respectively." In contrast, Peter Van Etten maintained that the merger was blamed for many of the ills that would have befallen Stanford and UCSF anyway, stating, "The entire hospital industry is getting killed by these [reimbursement] cuts." David Hunter of the Hunter Group agreed, saying, "It's a shame. People aren't taking into account that the environment has gotten much more nasty. It makes these mergers look worse because they're underperforming.

Questions

1. What environmental and market forces were UCSF and Stanford Health dealing with in the early 1990s? Compare the positioning of these hospitals in their local markets.
2. What were the strategic rationales for this merger?
3. How would you expect this merger to create value?
4. Evaluate the implementation of the merger?