Waking up to a pathology rent nightmare

16 minute read

Why is Medicare running a quiet test case that could unleash a lot more income grief for practice owners?

The three major  general practice income streams in order of importance are generally “rent” (irony to come) from “tenant doctors” (if you run a services business model as most practices do), PIP (a surprisingly large and increasing component) and, wait for it, pathology rents.

It’s not a well known statistic but more than 6000 practices earn good income from renting space to a pathology provider on the premises where they also “rent” rooms to doctors.

Over the years to the idea that pathology rents have been excessive has been a varyingly attractive assumption for both Medicare and pathology providers.

Medicare worries that in some cases rent may might not have been established on an “arm’s-length” commercial basis and therefore could constitute a back-door inducement by a pathology provider for that practice to be channelling exclusive business to it (as is specifically not allowed by the Health Insurance Act 1973), and channelling more than it needs to (i.e. overservicing). It’s a valid thing to worry about.

Pathology providers, of course, would simply love their rents to be a lot less.

You can imagine that if you amortise significant reductions in rent across hundreds and maybe even thousands of locations, you are a going to get a pretty neat bump to your bottom line. Like a hundreds of millions of dollars bump. Hence the constant interest in this topic from the major providers.

What is commercial rent?

But what is a commercial rent for a pathology provider parking their services inside a medical practice?

Medicare and some pathology providers seem to be having a lot of trouble working that out over the years. But they keep trying.

Ostensibly, in law, a commercial rent is what a tenant is prepared to pay for the value they get in paying that rent (there’s a few riders which we’ll get to but this is basically it).

You don’t have to have a good imagination to believe that having your pathology service in the building where the pathology referrals are made is a massive advantage for a provider. It has two great effects for the incumbent pathology tenant:

  • Virtually no patient would bother exercising their right to go any pathology outfit they want (as they can), if they are walking past a service on the way out their doctor’s door. Apart from most punter patients having no clue that they don’t have to go to the provider of the brand that their referral form has plastered all over it, the inconvenience of walking past the service and seeking it out somewhere else is just way too big for a patient to do it.
  • If there is no pathology service located within a practice, the drop-off rate of patients actually exercising their referral is huge. Once they leave the practice and get back into every day life, depending on what the test is for, a lot of patients simply don’t bother going the next step and the business is lost to the provider.

So there is massive value attached to a pathology provider being onsite in terms of business turnover.

Usually the question of how to value a commercial rent comes down to: if a practice were to put this opportunity out to tender among the various pathology providers, who would pay top dollar, and what would that amount be?

It’s not a case of getting a local small business valuer to take an average of the butcher shop and hairdresser next door.

A tender process should be cleanly commercial and if you have gone through a tender process, kept things reasonably transparent between the parties, and you have your records straight, you should usually be OK with Medicare in terms of the issue of inducement, according to specialist medical advisory principle, David Dahm.

Of course, Medicare could turn around and ask if one tenderer offered a crazy amount more than any other tenderer.

Does that constitute an “inducement” not in line with the HIA 1973?

Given the money at stake, you can see why sometimes people get suspicious and this issue keeps raising its ugly head.

We say ugly here because, although the third-highest income source for many practices, pathology rents usually make up enough of an overall income stream to be very meaningful in terms of a practice profit profile.

It has been estimated that pathology rents can make up between 10 and 25% of overall practice income, depending on a few important variables – like number of doctors servicing the practice, the practice location, and its demographic profile of patients.

A test case

OK, what do you think would happen if Medicare came along, or indeed a major national pathology provider came along, and suggested that a particular pathology rent was up to 400% over market value?

That would suggest something very fishy, if proven, right?

Certainly if it were proved to be true then Medicare would likely have the basis of starting a case that might end up in a fine for inducement, which can top $1m, for both the practice, and the pathology company. 

Not great.

But wait a minute.

If a practice copped such a fine, it’s highly likely it would not survive. Even a big practice with good turnover would struggle to overcome such a huge one-off fine. And after that, something like 3-8% of its overall ongoing turnover would be destroyed, and that is within the spectrum of profit range for a lot of practices.

So if the fine didn’t kill the practice, the ongoing revenue drop might.

And if neither of these did, the fact that directors can face jail if found in breach of this Medicare requirement would certainly seal the fate of most practices.

But what about the pathology provider?

Three things could happen to the path provider and both should feel pretty problematic as far as GPs are concerned:

  • The pathology company, if a national supplier, with an annual bottom line in the billions, wouldn’t be overly perturbed by a $1m fine. It wouldn’t even be much disturbed by lots of $1m fines. Because in the long term, if their rents drop 50-75% across all their locations, the ongoing savings are going to pay back those fines really quickly, and their share prices will go up significantly immediately.
  • The pathology company, depending on the circumstances, might not be targeted at all by Medicare in some of these cases. In some cases they could end up not being blamed for having to fork out what Medicare considers non-commercial rents as inducements. After all, although technically they are offering the inducement, it’s the practice getting the material benefit from such an arrangement.
  • The structure of our major pathology provider and its size would mean the chance of any directors going to jail would be microscopically small, compared with the chances of jail for a director of a small to medium-sized medical practice. Can you remember any white-collar director from a billion-dollar-plus company going to jail for anything in the last few years? (OK, for the pernickety, there is one, and ironically, he came from what is now For Health, which then became Healius, but started as Primary Health Care – but this individual was pinged for something that happened in a previous corporate life with a major global construction group).

Lose-lose for GPs, win-win for pathology

Overall, if you step back from the above scenario, it’s pretty much lose-lose for a medical practice and its owners/directors, and if not win-win for a large pathology provider, well, it’s at least lose a bit to start, then a giant ongoing win. After all, if a big pathology provider manages to get a rental drop across all its centres on a national basis, based on the above 75% scenario, what is that going to do their ongoing bottom line and share price (if they’re public)? Answer: make both skyrocket.

Unfortunately, the above the scenario is based on an actual case that is running right now, between Medicare, and, somewhat strangely, a pathology provider (strange because the practice involved is not a party to the proceedings). TMR reported the case and the potential implications yesterday.

More alarming is the article that one of the law firms representing Medicare wrote on its website earlier this year, in which it stated:

QUOTE “The case has the potential to clarify how ‘market rent’ will be defined for the purposes of the relevant sections of the Health Insurance Act 1973 (Cth) and as a result, may prompt widespread rental reviews in the sector.”

Is that the intention of the law firm, Medicare or the pathology providers, we wonder?

Whatever it is, it feels pretty leading saying your case is likely going to set a precedent which will set off a whole lot of savings for the pathology providers in the country.

I can imagine what you might be thinking at this point.

Not another story of unfolding doom to go along with all those payroll tax horror show stories?

No thanks.

Don’t panic yet and read on a bit

It feels like this horror show may not even make it to the screen, all things being equal, so this hopefully is a good news story in the end.

First the basics of the case – Chief Executive Medicare On Behalf of the Commonwealth of Australia vs Specialist Diagnostic Services – so far.

The Chief Executive Medicare commenced proceedings in the Federal Court of Australia against Specialist Diagnostic Services (SDS) Pty Ltd (aka Healius Pathology) in February this year.

Medicare is alleging that SDS contravened the Health Insurance Act 1973 by agreeing to pay rent that “substantially” exceeds the market rate for similar co-located pathology centres. It is alleged that by doing this SDS has provided benefits to the medical practice which are not “permitted benefits” under in the Act.

The Commonwealth via Medicare is seeking declarations, pecuniary penalties and costs.

What a lot of practice owners should be asking straight up here is: why is Medicare participating in a case that its lawyers are even declaring is a likely precedent case that could crash pathology rents for GPs all over the country?

Does Medicare really think:

  • That GPs are taking inducements and are in breach of the Health Insurance Act 1973 all over the country, as the precedent comment from the law firm suggests?
  • That given the federal government has frozen GP MBS rebates for years, and that state revenue offices are now weaponising medical practice payroll tax, is now the right time to try to crater the third biggest income source for general practice, and send the profits of already hugely profitable (thanks to covid) pathology companies through the roof?
  • That after nearly decades of trying to catch out medical practices for charging excessive pathology rents and largely failing, now they will succeed somehow?

If you’re scratching your head on this one, you’re not the only person doing that.

It’s simply weird given the context of where the federal government – if you believe Health Minister Mark Butler and his intentions around the Strengthening Medicare Taskforce – says it is going.

If you were a conspiracy theorist (we aren’t but we obviously talk to a few), you’d think that there’s some backroom deal going on here between the pathology providers and Medicare.

As much as this is a pretty bizarre thing to be thinking out loud, try to explain why Medicare is taking this case and only joining a major pathology provider in the action, and not the practice, plus, is OK with its lawyers saying the case may set a pathology rent-crashing precedent.

Back to the case details for minute.

This chart published by the law firm in its article is pretty helpful in outlining just how out of whack Medicare believes the rent is in this case. It outlines what Medicare thinks is commercial value versus what is being charged in this instance.

There’s a lot more detail but to short circuit what is going on here, the whole case rests on Medicare proving the “alleged market rate”.

Fingers crossed, this whole case may end up going off the rails.

The idea that pathology rents are too high isn’t new. It’s something pathology companies have been lobbying behind the scenes for years to prove. But they never really have in a substantive manner.

So how are they going to do it now?

When we say “they” here by the way, we actually mean Medicare, because quite bizarrely Medicare is going to try to do what the pathology companies would love to do have done themselves, and prove the rent is too damn high.

Even though SDS will cop the fines and bad press, the precedent will be what counts for the pathology providers.

They can take that and go forth to their 5999 other leases across the country, trigger break clauses – which unfortunately exist in many of the leases – and plead that if the practices don’t substantively reduce the rent, they will get into trouble with Medicare, as demonstrated by this case. As long as they lose this case, they win everywhere else.

The long game for the pathology companies is pretty overt.

Initial fines, even in the millions, will be water off some very sleek ducks’ backs.

But the pathology companies and Medicare possibly have a very big problem still.

And it’s the same problem they’ve always had.

What is the actual commercial value of these leases?

Obviously it’s a hell of a lot more than the butcher shop next door. That’s already clear, although in the early days, that’s what some companies tried on.

This case is going to come down to how an “expert” valuer assesses the situation.

By the way, another smelly thing about the case is that for some reason back in July, the sitting judge accepted an application to gag the proceedings.

In other words, if there is an expert, and they provide a methodology for arriving at a value, and the judge accepts that, then the public don’t get to see what that methodology was. At least while the case is running.

How is this a sensible thing?

Surely the most important aspects of public interest here are how the court arrives at and accepts a valuation of the rent in this case.

What if Medicare wins?

If the court finds in favour of Medicare, and against SDS, do you think SDS is going to appeal?

If a medical practice was joined in this action by Medicare, which would have seemed like the logical thing to do, do you think it would appeal?

Answer: it’s not in SDS’s long term interests to appeal. They have way too much to gain in lower rents across the country to try to fight it. But if a medical practice were joined in the case, they’d be appealing their hearts out.

But of course there is no medical practice joined in the case.

Feels a tad planned, doesn’t it?

What’s the good news here, then?

According to speciality medical practice accountancy firm principal David Dahm, there are a few points about how this case is unfolding which should provide some comfort to GPs that a mass crash in average pathology rentals won’t actually happen.

Firstly, he pointed out in his comments to TMR yesterday the circumstances of each location are always different, and one case, therefore should not mean there is a precedent to lower rents necessarily in a widespread manner.

“If the court determines rent is $1/sqm at this specific practice it does not mean it cannot be $1 million/sqm in another practice,” he said.

“The only condition would be that you find an independent and experienced valuer that can justify such a valuation. An independent valuation can make an unsubstantiated excessive pathology rent allegation legally valid”.

The most important part of what Dahm is saying is the bit about “independent valuation”.

He doesn’t say it, so we will: how independent is a valuation provided to the court by a so-called “expert” on behalf of Medicare? And what does it say that the case is gagged, so the public can’t question that valuation in any way?

Dahm won’t go into the detail because he says each case is different and it can be misleading to generalise, but he will say that he’s had a few clients who have been called to task by Medicare for potentially excessive rent, and every one so far has successfully defended their position.


Again, Dahm won’t be drawn on the detail of the question for reasons of devil and detail (perhaps for reasons of IP too?), but he will say that he thinks the fundamental principle behind establishing rental value of “who is actually prepared to pay the highest” isn’t the only factor in play necessarily.

“Put it this way, very few if any commercial agents who do rent valuations have any idea about the dynamics in play here, including, but not limited too, how the business model of medical practice works. Without that understanding you can’t really establish value. With it, you can. And we have for all our clients.”

Dahm is confident that most practice owners, with the right legal, expert valuation and accounting advice, will be able to make the case that their rents are commercial.

One hint Dahm does seem to give away is “look at the commercial model of practices”.

If you do that (and referring to the brackets early on in this article re “rent” and “tenant”) that model for most practices under the spotlight of payroll tax audits these days is “tenant/landlord”.

In the payroll tax cases, a clean defence is that a doctor working at your premises is simply a “tenant” paying a service provider “rent”.

Hmmmm … what does that tenant pay in rent I wonder?

And if they pay $X per square metre, wouldn’t that form some basis for rental value of another type of tenant, a pathology company, for example?

Dahm counsels that should the case be won by Medicare, GP owners should be very careful not to accept the precedent without checking their own situation properly first, and that they should smell a rat immediately if they are contacted by their pathology tenant in reference to the case and the finding to question the current lease.

Feels like this old chesnut of pathology rents isn’t entirely cracked yet by the pathology providers.

Let’s hope so, anyway.

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