Determining physician compensation -- Part I. (Nuts and Bolts of Business).

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While the initial focus of this column centered on understanding cost and profitability, one of the most frequent questions posed by readers is, "How can you use business principles to determine physician compensation?"

First, you must decide on the compensation model you want to use. The three most common models are:

1. Straight salary

2. Salary with incentive pay

3. Productivity-based compensation

Straight salary

A base pay or straight salary compensation model is the simplest to understand and administer.

Salaries are derived by using market comparisons or data based on academic titles. These base salaries may or may not incorporate merit in the calculation. Merit increases may relate to length of time in the practice or academic title.

The major advantage of this compensation model is that you know up front what your total compensation will be. In addition, most consider base salary compensation models to be democratic and non-competitive.

The major disadvantage of this model is that it doesn't encourage or award extra effort or productivity. It doesn't provide flexibility for extra compensation.

Salary and incentive pay

The second compensation model is a base salary combined with incentive pay in the form of bonuses.

The advantages include the ability to reward individuals or groups for clinical productivity, as well as provide incentives for non-clinical activities, such as research, teaching or administrative duties.

The first step in using this model is to determine the source of funds for the bonus pool. Groups may decide to hold back a portion of salaries to create the incentive pool, budget a separate pool of funds or depend solely on profits generated by the practice.

The more difficult component of this model is to determine how to distribute the bonus pool. The group must decide if distribution will be based purely on clinical productivity or other factors, as well.

For academic practices, factors such as teaching, research and administrative responsibilities may come into play when determining the distribution.

If you base incentive compensation solely on clinical productivity, then you must standardize your productivity measure to allow comparison between full-time and part-time clinicians.

In other words, to reward individuals with bonus dollars for clinical productivity, you must make sure that you are comparing apples to apples. Common productivity measures include:

* Billed charges

* Ambulatory encounters

* Work relative value units

To standardize productivity, you should multiply your productivity measure by 100 and then divide this product by the percent of time the individual is involved in billable clinical activity.

For example, look at three individuals, "A," "B,", and "C," who billed $800,000, $600,000, and $400,000 and who work 100 percent, 80 percent and 60 percent clinically, respectively.

If you base a bonus on productivity using billable charges, without standardizing the productivity measure, then "A" receives 45 percent of the bonus pool ($800,000/$1,800,000), "B" receives 33 percent ($600,000/$1,800,000) and "C" receives 22 percent ($400,000/$1,800,000).

However, if you standardize the productivity measure to account for actual clinical activity, the bonus pool distribution changes. Standardizing for clinical activity, and taking a weighted average of the results, "A" receives 36 percent, "B" receives 34 percent and "C" receives 30 percent of the bonus pool.

The main disadvantage of this model is it requires the practice to either hold back pay or create a separate pool of funds for the incentives. As a result, the guaranteed portion of the salary may be reduced.

If the practice is not profitable, the incentives may not be available, despite an individual or group's extra efforts. In addition, it may be difficult to place a dollar value on publications, teaching or administrative duties. We'll look at techniques to place a value on these criteria in my next column.

Productivity-based compensation

The final compensation model is based purely on productivity. In this model, a formula is derived based on productivity factors such as work relative value units, net collected charges or net operating income.

The major advantage is it rewards individuals for increased productivity. The harder you work, the more money you make. There is no subsidization of less productive partners, so it is very responsive to market conditions.

In order for this model to work, all partners in the group must agree, up front, that their individual overhead allocations are fair. This is why it is important to avoid common overhead mistakes such as failing to trace costs directly, use of inappropriate allocation bases and separating out common costs to properly determine individual contribution margins.

Having properly assigned overhead and determined individual contribution margins, you may then use a weighted average of the individual contribution margins to distribute funds.

For example, if three physicians, "D," "E," and "F" have individual contribution margins of $75,000, $50,000 and $25,000, they will be eligible for 50 percent, 33 percent and 17 percent of the profits.

Likewise, you may use a modification of the concept of "return on investment" (ROI) to distribute the funds. Return on investment is calculated by multiplying margin and turnover. Individual ROI may be determined by multiplying individual contribution margin by billings, then dividing this product by the average accounts receivable balance (turnover) of the individual. You may then take a weighted average of the ROI to distribute profits.

If, in our example above, "D" billed $800,000 over the year and maintained an average accounts receivable balance of $250,000, then "D's" ROI is $75,000 x $800,000/$250,000 or $240,000.

If "E" and "F" achieved ROI's of $175,000 and $150,000 respectively, then the pool would be distributed as 42 percent for "D,", 31 percent for "E," and 27 percent for "F."

When using a productivity model for employed physicians, I recommend setting a hurdle rate above a predetermined target of collections to be achieved, before a productivity bonus is received.

A common measure used to set the hurdle rate is the weighted average cost of capital (WACC) of the practice. This is determined by adding the products of the percent of debt times the cost of debt and the percent of equity times the cost of equity (your accountant can assist in determining your WACC and I will discuss the methodology in a future column on practice valuation).

For example, if the cost of debt is 6 percent and it comprises 30 percent of the capital structure, while the cost of equity is 15 percent and it comprises 70 percent of the capital structure, then the WACC = (6% x 30%) + (15% x 70%) = 12.3%.

So an employed physician would have to achieve a level greater than 12 percent of a predetermined collection target to be eligible for incentive funds.

The major disadvantage of this model is that it may create intense competition among partners for the better-insured patient population within a practice. As a result, the administration of this model is more difficult since payer mix, as well as proper overhead allocation, must be taken into account.

Salary is usually based on the previous year's productivity, with withholds built in to prevent overpayment for decreases in productivity. Therefore, it is more difficult to plan what actual compensation will be from year to year.

No matter what model you choose, all parties involved must understand and accept the methodology. By using sound business principles in the day-to-day operations of a practice, fair and equitable compensation models can be developed.

David P.Tarantino, MD, MBA, is the executive medical director of Shock Trauma Associates, P.A., a 50+ physician, multispecialty practice associated with the University of Maryland School of Medicine. In addition, he is the chief executive officer of The MD Consulting Group, LLC, a health care management consulting firm in Baltimore, Md. Tarantino can he reached by phone at 410/328-3198 or by e-mail at [e-mail].