How one hospital is thriving in the age of Obamacare

November 18, 2013: 1:25 PM ET

To avoid getting squeezed by the Affordable Care Act, the Children's Hospital of Philadelphia is marketing itself globally and has begun doubling as a venture capital firm.

In addition to its main facility, CHOP operates a regional network which generates a large volume of medical procedures.

In addition to its main facility, CHOP operates a regional network which generates a large volume of medical procedures.

FORTUNE -- It's well known that America's hospitals are hurting. And that's before the Affordable Care Act starts clamping tight limits on their fees. But hospitals can still thrive if they can apply classic practices from the private sector—everything from offering high-margin, specialized services that attract customers from around the globe to creating full-blown new ventures from the seeds of their own research.

And there's no better model of how a venerable institution can operate as a highly successful business in the era of Obamacare than The Children's Hospital of Philadelphia, known (infelicitously) as CHOP.

Founded in 1855, CHOP is one of the world's leading facilities specializing in care for children. It combines a top-flight research branch with a broad patient-care network. CHOP serves as the pediatric teaching hospital for the Perelman School of Medicine at the University of Pennsylvania. And its research unit manages a $300 million a year budget and employs 2,000 people, including 1,000 physicians and researchers. The main hospital in Philadelphia admits 29,000 patients a year, and its outpatient network hosts 1.2 million visits a year from children.

Though it's a non-profit, CHOP posts numbers that would be the envy of many a private provider. It generates annual revenues of around $2 billion, about 85% from patients and another 8% or so from federal funds for research. From that $2 billion, it's able to cover not only all of its salaries, rents, and materials costs, but $74 million in uncompensated care, and a $55 million contribution to the research budget. Amazingly, it typically books a surplus of around $150 million that it divides between boosting its investment portfolio and building new facilities.

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CHOP maintains its robust health by pursuing three strategies. While other hospitals may not be able to replicate these strategies exactly, the thinking behind them provides a useful model for how hospital companies can adapt.

The first strategy is that CHOP has expanded well beyond its main facility and operates a regional network which generate large volumes of tests and procedures. CHOP's branches are chiefly in the suburbs of Philadelphia, both in Pennsylvania and central New Jersey. It operates 30 satellite offices for primary care, and another 9 specialty care centers that perform same-day procedures and surgery. (The most common is installing special tubes for ear infections.)

"Having a broad network diversifies our base of payers," says CHOP's CEO, Dr. Steven Altschuler. He explains that for most children's hospitals, at least 50%, and as many as 80%, of the kids are covered by Medicaid. For CHOP, the figure is just 40%. That's because the suburbs, in general, are more affluent than the cities where most children's hospitals concentrate.

Since the payments flow largely from private plans, CHOP collects more per procedure than hospitals that rely heavily on Medicaid. Altschuler also finds that productivity is far higher in suburban specialty care centers than for the same routine procedures in a teaching hospital. "We find a surgeon can do 20 procedures a day in a care center versus around 10 in our main complex, which is run as a teaching facility," he says. Even parking is easier.

All told, the same procedure costs 30% less in the outlying centers, reflecting lower rents and staffing expense. "The reimbursements are about the same," says Altschuler, "so we get better margins in those facilities."

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A second core strategy is that CHOP doesn't perform routine deliveries of newborns at its main hospital. Rather, it specializes in highly sophisticated procedures where its physicians and equipment rank among the best in the world. Altschuler calls them "luminary programs."

CHOP has developed a new cell therapy that reengineers the immune system to fight cancer. Its surgeons have performed 1,000 fetal interventions for children who've contracted spina bifida and other congenital conditions. Spina bifida is a condition contracted during pregnancy where the structures that protect the spinal cord fail to fuse and the fetus is left with a hole in the spine that can cause paralysis and other complications in a newborn. The surgeon makes an incision in the uterus and removes the fetus, then performs on the operation, with the placenta still attached. The operation completed, then the surgeon places the fetus back in the uterus. The pregnancy then follows its normal course. Many of the children are born without any deformity as a result of the procedure. Such complex cases cost tens of thousands of dollars for the surgery alone, then the babies require weeks of neonatal intensive care.

Thanks to its array of specialties, CHOP benefits handsomely from medical tourism. About 15% of its revenue now comes from U.S. patients outside its home market, and another 5% from patients from abroad, around 80% of whom arrive from the Middle East. The foreign revenues are growing fast. And though CHOP also treats poor children from abroad, most of its non-U.S. patients are treated at a modest discount from the full fees. Still, on average, the children visiting from abroad pay about twice as much as the reimbursements from local kids, many of whom are on Medicaid or whose families lack insurance.

CHOP wants to become the world's biggest center for DNA testing. It recently formed a partnership with BGI, formerly the Beijing Genomics Institute of China, to create a library of two million DNA samples accessed by robot and stored at minus 30 degrees Celsius in a facility at its main campus. BGI supplies the computing power; CHOP provides the samples and the clinical expertise. The idea is to use DNA sequencing to discover the underpinnings of pediatric diseases, from cancer to diabetes. "It will be a data center that other hospitals will use in the future," says Altschuler. "We're creating a new genomics service, and a new business."

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The third strategy is that CHOP is exploiting its own innovations by doubling as a venture capitalist. In 2008, it sold the royalty stream from its rotavirus vaccine, which combats a condition that's potentially deadly for children, to investors for $180 million. The next stop is the startup. It recently transformed its gene therapy research unit into an independent company, funded with $10 million, and fully owned, by CHOP.

The new venture, Sparks Therapeutics, has two drugs in clinical trials, one for blindness and the other for hemophilia. The blindness treatment is the only gene therapy ever to win FDA approval through Phase 1 and Phase 2 clinical trials in the U.S., and is now in Phase 3 trials. "Most hospitals license drugs to pharmaceutical companies in exchange for an upfront payment and a royalty," says CFO Tom Todorow. "We literally had a core competency in manufacturing and regulation, and a pipeline, worthy of an independent company. So we did a spinoff as opposed to licensing."

For Todorow and Altschuler, it's all part of getting ready for a future of Obamacare. "We need to diversify our revenue sources," says Todorow. "With the Affordable Care Act, revenues may decrease. So we took a fantastic opportunity to spin off a company, and at the end of the day to maximize our future return."  That's the kind of creative thinking that may point the way to satisfying America's greatest need: better, cheaper healthcare.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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