By GEORGE PILLARI

While the effects of persistently high unemployment have surfaced in the shape of reduced consumer spending, shrunken tax rolls and a host of social problems, there is yet another harsh reality lurking in the shadows. Hospitals, already in precarious financial positions, are seeing their most profitable source of revenue fade away. Should the situation continue, even darker days for hospitals will surely be in store.

More than 150 million people in the U.S. rely on employer-sponsored health insurance to pay for the bulk of their medical costs. One of the more credible criticisms of health reform is the potential backlash against the employer pay-or-play provisions in the legislation, which could throw millions of today’s insured off their employer plans and into the streets with the chronically uninsured. Even if this did not occur, or at least not to a market-moving degree, it would be small recompense, literally, for hospitals relative to the boogeyman that no political party can legislate or filibuster in or out of existence at will: unemployment. Hospitals in our country rely on the privately insured and better-paying patients for approximately 35 percent of net revenue. Given the already compressed profit margins in the hospital industry, any deterioration in the supply of its best customers could seriously threaten the financial solvency and operational viability of many hospitals across the country. Health reform will not prevent this from happening. Reform targets the un- and under-insured and provides only a base level of coverage (Medicaid), coverage that traditionally add nothing to hospital margins and in many cases erode them.

While many factors can contribute to the demise of a business, one factor is usually the most difficult from which to recover: a shrinking market for its products or services. Hospitals are happy, or in most cases, lucky, to break even on Medicare and Medicaid patient loads, which generally represent about half of a hospital’s cash collections. The battle ground for hospitals is the patient who carries commercial insurance that is subsidized by the patient’s employer. Such patients pay higher rates than governmental payors, are younger and healthier than most other patients, and often are interested in receiving the most advanced and sophisticated care available, as long as such care is covered by their employer-based health insurance.

According to the American Hospital Association, over the last 20 years U.S. hospitals have generated an average total profit margin of 4.8 percent annually. Many in the industry believe that the hospital payor mix derived from commercial payors accounts for at least 100 percent of the profit figure. So, while any shrinkage in patient supply is detrimental to a hospital’s solvency profile, a decline in private-pay patients is much more serious than the loss of other types of patients. The ultimate conversion of these patients to Medicaid levels of coverage, through the mechanisms of health reform, may provide some backstop; these money-losing patients do help cover a hospital’s fixed costs, which is why – contrary to regulators’ arguments for more EMTALA-like mandates – hospitals take Medicaid and Medicare patients in the first place. But sooner or later, margins under five percent will prove disastrously inadequate, and the typical hospital will be financially unable to weather the conversion of private pay patients to publicly funded patients.

During the same 20 years that hospitals were steadily producing profits, the U.S. economy moved along with the unemployment rate averaging a mere 5.4 percent. This figure grew so familiar for so long, it helped anchor the roughly four percent figure that economists for years referred as “the natural rate of unemployment.” Then something strange happened, the country entered the New Economy, again. While the first New Economy was characterized by the Internet boom of the late 1990s, and an unemployment rate in some regions actually dropping below the “natural rate,” this version of the New Economy is marked by a boom of its own: an unemployment rate jumping to 10 percent.

The sharp increase in unemployment is only the start of the bad news for hospitals. Almost all of the job losses are from the private sector, which supplies the critical flow of willing and financially able patients hospitals desperately need to make cost-shifting and cross-subsidizing strategies work. Additionally, nobody is forecasting a return to “normal” unemployment rates for at least three-to-five years. As a result, we could be entering one of the most challenging periods ever faced by modern hospitals.

While federal government intervention in the form of COBRA subsidies to individuals has softened the blow so far, these subsidies are expiring. For the millions of people relying on COBRA subsidies as means of affording health insurance, a difficult decision will have to be made once the subsidy ends. As long as unemployment remains high, few of these subsidy-dependent families will be able to find new employment and thus, new commercial health insurance. As unemployment rates persist at current levels, the lack of private-pay patients will exert significant financial pressure on U.S. hospitals. Such declining volumes will be a motivating factor driving horizontal mergers of hospitals, as well as vertical integration of hospitals with physician practices and other providers. If these strategic reactions sound like déjà vu, they are: the last time many hospitals even countenanced vertical and horizontal consolidations was the mid-1990s, and the threat then was the targeting by managed care, on behalf of employers, of high prices and lengthy stays for commercially insured patients.

Aggressive consolidation around core competencies, openness to in-market alliances with competitors and the selective use of capital markets (when available) to leverage and strengthen balance sheets are only a few of the measures necessary for survival after the recent worldwide economic meltdown. For hospitals that fail to plan for the nuclear winter ahead, closures and bankruptcies will follow swiftly. Hospitals and their boards cannot put their heads in the sand and pretend the future will be all right. It will be a different future and one that needs to be planned for today.

George Pillari is a Managing Director with Alvarez Marsal Healthcare Industry Group in San Francisco. Prior to joining AMH, Mr. Pillari was the CEO of CBCA Inc., a health benefits outsourcing company that managed more than $1 billion of medical costs annually on behalf of corporate customers. Prior to CBCA, Mr. Pillari was co-founder and CEO of Solucient, a leading provider of healthcare information and comparative metrics.