Purchase of DME Supplier - Earn-Out Provisions

Home Blog Purchase of DME Supplier - Earn-Out Provisions

AMARILLO, TX - Assume that John Smith owns 100% of the stock of (i) ABC Pharmacy, Inc. ("ABC Pharmacy") and (ii) ABC Medical Equipment, Inc. ("ABC Equipment"). Assume that XYZ Medical Equipment, Inc. ("XYZ") purchases all of ABC Equipment's stock, resulting in (i) Smith continuing to own ABC Pharmacy and (ii) ABC Equipment becoming a wholly owned subsidiary of XYZ. Now let's make the following additional assumptions:

• After closing, ABC Pharmacy will have the right (but not the obligation) to refer patients to ABC Equipment, now owned by XYZ. ABC Pharmacy, in fact, refers patients (covered by a government health care program) to ABC Equipment.
• The purchase price paid by XYZ for ABC Equipment's stock will be (i) $1 million plus (ii) over the next three years, 5% of ABC Equipment's gross annual revenue in excess of $1.5 million.

The foregoing scenario runs the risk of violating the Medicare anti-kickback statute ("AKS") which states that an entity/person cannot give "anything of value" to another entity/person in exchange for referring (or arranging for the referral of) patients covered by a government health care program … or for recommending the purchase of items or services covered by a government health care program.

In our scenario, there is a "referral" - that is - ABC Pharmacy is referring government health care program patients to ABC Equipment. And XYZ, the owner of ABC Equipment, is paying remuneration to Smith (the owner of ABC Pharmacy) in the form of 5% of ABC Equipment's gross annual revenue in excess of $1.5 million. ABC Pharmacy is incentivized to refer as many customers as possible to ABC Equipment because of the potential of Smith receiving percentage revenue in return.

If scrutinized by the Office of Inspector General ("OIG"), the OIG may conclude that the arrangement violates the AKS. The OIG has previously discussed problematic "earn out" provisions associated with sales. The OIG's discussion is focused on acquisitions of physician practices; however, the discussion applies to scenarios like the one outlined above. Specifically, in 1992, D. McCarty Thornton, Associate General Counsel with the OIG, sent a letter ("Thornton Letter") to the IRS that states, in part:

Typically, in the case of the acquisition of a physician practice by a hospital or other entity, there is a large, up front payment to the physician … This sum is asserted to be payment for the purchase of the assets of the practice. There are also payments made to the physician subsequent to the sale of the practice where the physician becomes employed by the hospital or entity or otherwise enters into a contract to provide services to patients. These payments are asserted to be compensation for services rendered to patients by the physician … We have significant concerns under the [AKS] about [this] type of physician practice [acquisition] … Frequently, hospitals seek to purchase physician practices as a means to retain existing referrals to or to attract new referrals of patients to the hospital. Such purchases implicate the [AKS] because the remuneration paid for the practice can constitute illegal remuneration to induce the referral of business reimbursed by the Medicare or Medicaid programs …

In particular, we are concerned that the remuneration paid in connection with or as a result of the acquisition of a physician's practice could serve to interfere with the physician's subsequent judgment of what is the most appropriate care for a patient. The remuneration could result in the delivery of inappropriate care to Medicare or Medicaid beneficiaries by inducing the physician to utilize the affiliated hospital rather than another hospital or less costly facility which may provide better or more appropriate care. It could also have the effect of inflating costs to the Medicare or Medicaid programs by causing physicians to overuse inappropriately the services of a particular hospital (or other affiliated provider) … Finally, these arrangements could significantly interfere with a beneficiary's freedom of choice of providers. All these considerations are the very abuses that the [AKS] was designed to prevent.

The concerns set out in the Thornton Letter apply to the arrangement outlined at the beginning of this article. In our arrangement, the safest course of action is for the purchase price paid by XYZ to be fixed at closing (i.e., no subsequent "earn out" payments). A less safe course of action is for the earn out payments to remain in place, but for ABC Pharmacy and Smith to agree not to directly or indirectly refer patients (covered by a government health care program) to ABC Equipment. However, this is a "slippery slope." There is risk that such referrals will occur.

Now let us change the facts and discuss a scenario in which a variation of an earn-out is proper. Assume that Smith only owns ABC Equipment (i.e., Smith does not also own ABC Pharmacy). Assume that ABC Equipment sells its assets to XYZ. XYZ pays exactly $1 million to ABC Equipment for the assets. At closing, ABC Equipment closes its doors and relinquishes its PTAN. Assume that at closing, Smith becomes a full-time bona fide employee of XYZ. And assume that Smith's compensation is a fixed salary plus bonuses based on the success of XYZ's DME business. Because Smith is a bona fide employee of XYZ, the arrangement complies with the Employee Safe Harbor and employee exception to the AKS.

The take-away is that if a purchaser buys a DME operation, if part of the price for the operation is based on future production, and if the owner of the selling DME operation is in the position to directly or indirectly refer patients to the purchaser, then the parties need to be careful not to violate the AKS.



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