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The California Public Employees' Retirement System happily ended 2010 with insurance rates $15 million lower than they might have been, thanks to aggressive efforts by hospitals and doctors to curb medical expenses.

Catholic Healthcare West, now Dignity Health, which helped deliver those savings, ended that year with millions of dollars less in revenue.

The San Francisco-based hospital system was among the early adopters of accountable care, a new method to pay for healthcare that has won sizable support across the industry despite one awkward fact: Hospital executives trying to control spending face the costly prospect of actively trying to keep patients out of the hospital.

“The bottom line is that this is a tough transition time for these hospitals,” says Kristen Miranda, vice president of provider network management at Blue Shield of California. The insurer joined Dignity Health and Hill Physicians in the accountable care organization that slashed spending for CalPERS.

Fewer admissions and shorter stays at Dignity hospitals accounted for the bulk of first-year savings, Miranda says.

“That is just the reality,” she says.

Insurers are beginning to test payments such as accountable care that offer incentives, both carrot and stick, to slow growth in medical expenses. Hospitals—with their high utilization of pricey technology and teams of highly skilled professionals working around the clock—are a prime target to curb costs. Of all the places to care for patients, hospitals account for the greatest share of the nation's healthcare dollar.

So policymakers and healthcare executives have begun to focus on patients who might be able to avoid a hospital visit with the right assistance to manage their medications or illness.

But hospital officials say doing so requires some financial support. Some are negotiating slightly higher payments from insurers to coordinate patients' care. Accountable-care contracts offer providers a cut of the savings they achieve.

Others are seeking to become the sole hospital or system within an insurer's network in an effort to gain market share.

Indeed, many executives say strategies to lower costs will allow them to compete more aggressively and beat out rivals for more of the market.

Hospitals may no longer see every patient who might have once been admitted, but will make up some volume with market gains, executives say.

“We think this is the only way to remain competitive and have a margin in the future,” says Howard Gold, senior vice president of revenue and business development for North Shore-Long Island Jewish Health System, based in Great Neck, N.Y.

Financial concerns aren't the only reason to keep patients out of the hospital. Hospitals are unsettling and potentially risky environments for patients. Hospitals look uncomfortably sterile but are not; patients risk infection from germs that evolved in the hospital's sickly ecosystem.

Still, hospitals increasingly face financial incentives to reduce admissions. Medicare, hospitals' largest customer, will begin to cut payments to hospitals with high numbers of repeat patients starting in October. Research suggests that many of those repeat hospital visits could be prevented.

Meanwhile, new ways to pay for healthcare such as bundled payments and shared savings, which include financial penalties for care that drives healthcare spending upward, have added urgency to the efforts.

Hospitals began to cut costs with the economic downturn but have continued to do so to prepare for new payment models.

Fairview Health Services, based in Minneapolis, entered into its first contract to tie payment to quality and cost controls about three years ago, says Terry Carroll, the system's senior vice president for transformation and chief information officer. Contracts with private insurers have grown more sophisticated ahead of federal payment reform efforts, such as Medicare ACOs and bundled payments. Fairview is among the first to test Medicare accountable care, a group known within the industry as “Pioneer” Medicare ACOs.

The system's efforts to improve quality and efficiency began before that but are now expanding, as is the case with efforts to prevent hospital admissions for patients with congestive heart failure. The University of Minnesota Physicians Heart at Fairview launched a heart-failure clinic about eight years ago that is dedicated to helping patients manage the chronic ailment while at home. Since then, repeat hospital visits for heart failure have dropped 67% for patients enrolled in the clinic.

Fewer readmissions mean lower costs but also lower revenue.

“There's no question that if we reduce avoidable readmissions, there's a loss of revenue that goes along with that,” Carroll says.

As a result, efforts to manage Fairview's capacity have grown more critical, he says.

“By improving access to care in our clinics, we have the opportunity to grow clinically appropriate patient volumes and referrals to our hospitals.”

System officials have focused efforts on reducing fixed costs, addressing excess capacity and lowering the total cost of care, he says.

“We need to develop a new operating model that allows us to be rewarded for clinical and operational efficiency.”

As the system seeks that new model, the heart-failure program is expanding across the Twin Cities' system and its efforts continue to evolve.

The heart-failure program staff recently worked to modify menus at a transitional facility for patients who leave the hospital but who are not yet strong enough to return home, says Dr. David Laxson, a cardiologist with the University of Minnesota Physicians Heart at Fairview and a manager of the heart-failure program.

Heart-failure patients needed low-sodium diets and, without them, were returning to the hospital more frequently.

The effort for CalPERS shaved $20 million off medical costs, of which $15 million was passed along to CalPERS. Dignity, Hill Physicians and Blue Shield of California shared the remaining $5 million, which helped offset some lost revenue, Blue Shield's Miranda says.

CalPERS reported that hospital readmissions dropped 15% during the first year of the effort, and patients who were admitted did not stay as long. The average patient visit fell by half of a day. Fewer patients had lengthy hospital stays; the number of patients who remained in the hospital for at least 20 days was reduced by half, according to CalPERS.

To mitigate the loss to hospitals, the accountable-care partners sought to refer or transfer patients whenever appropriate to Dignity hospitals from non-network hospitals, Miranda says.

Patients included in the accountable-care network who previously were referred elsewhere were directed to Dignity hospitals; those ACO patients admitted outside the accountable-care network were transferred when possible, she says.

Miranda says the accountable-care network also gained some patients because its coverage was priced more competitively. That's because Dignity, Hill Physicians and Blue Shield agreed to absorb losses if CalPERS healthcare costs increased rather than dropped, which allowed the insurer to more aggressively price benefits.

Blue Shield of California has since reached five more deals for ACOs with two more under development. That hospitals will see the largest change to revenue “has been a point of considerable conversation,” Miranda says.

She says hospitals that move early to adopt new payment models should be applauded.

“The next three to four years are going to be toughest on hospitals that survived on straightforward fee-for-service,” Miranda says.

Policymakers have sought to edge hospitals away from fee-for-service, a payment model that pays for the volume of services or hospital admissions. Fee-for-service has been widely criticized for giving hospitals and doctors an incentive to perform more procedures or increase visits.

The Patient Protection and Affordable Care Act calls for alternatives to fee-for-service, including accountable care and bundled payments. Some health systems and medical groups selected to be the first to test accountable care will switch from fee-for-service to capitation, or a lump sum to cover all medical costs, starting in 2014.

Private-market efforts to revamp health payments and curb health spending have also emerged, such as the Blue Shield of California contracts.

North Shore-LIJ operates with roughly 5% of its business under commercial contracts that put the system at financial risk to manage healthcare costs.

That percentage is expected to grow, Gold says. North Shore will move employees into similar contracts starting next year. The system, which owns 11 hospitals, will also seek to test Medicare bundled payments.

Gold says the system is working to adopt necessary analytical tools to support cost-control efforts, which will target patients in need of frequent or complex care.

“You go where the spend is,” he says. “You go where the use is.”

Lower costs would create a profit on operations at more competitive rates to lure patients away from rivals, he says. “We expect if we do this right … we'll have more money to spend,” Gold says.

Perhaps not immediately. Gold acknowledges the system's early effort to manage costs for a small group of patients leaves North Shore-LIJ without the scale and financial cushion of larger efforts.

That could leave the system vulnerable to losses as it learns from its first attempts, but Gold says the education is worth potential hits for future gains.

“We're willing to take that risk,” Gold says.

For Intermountain Healthcare, population growth has helped offset lost revenue as a growing list of wellness and quality efforts have kept patients out of the hospital or lessened the need for highly complex treatment, says Greg Poulsen, senior vice president for the system.

But with fewer less-complex patients treated in the hospital, beds have filled with those more acutely ill.

“To a greater and greater degree, our hospitals are becoming big ICUs,” he says. That puts greater demands on doctors and nurses; some require additional training to care for the more acutely ill patients.

Nonetheless, system officials have scaled back projected capital needs for inpatient services and instead will invest in outpatient care and physician offices, he says.

“If we can get people to be treated in a more effective way, probably earlier, and avoid unnecessary hospitalization, we think that's good across the board, except for the hospitals, per se,” he says.

Hospitals should have time to adapt to changing volume and demands, he says. “Certainly our expectation will be less construction of inpatient facilities than in the past,” Poulsen says.

Of course, not all hospitals operate in growing markets. Executives say they expect cost-cutting efforts to win over patients with lower costs.

“We think if we do the right thing” by slowing healthcare spending “people will take notice,” says George Wheeler, vice president of managed care for Bon Secours Health System in Virginia. Wheeler says the system will seek to gain market share.

But as hospitals invest to prevent hospital admissions, insurers must somehow pay for services that were not previously covered to offset some lost revenue, says Dr. Marlon Priest, executive vice president and chief medical officer for Bon Secours.

As hospitals compete to claim a bigger share of their markets, the strategy could produce new alliances as well as winners and losers. One hospital's market share gain is another's loss.

As Leo Brideau, president and CEO of the Ascension Health Care Network in St. Louis, told a conference in New York: “Not everybody's going to make it up on market share.”