Physician-owned hospitals represent a small but rapidly growing sector of the healthcare industry. Proponents argue that physician-owned hospitals take advantage of financial incentives created by physician ownership to generate more efficient operations and higher quality outcomes than traditional hospitals. Detractors argue, however, that these hospitals compete unfairly with traditional hospitals because the physician owners may refer their own patients to the hospital, and because the hospitals tend to focus on the healthiest and best-insured patients. The Medicare Payment Advisory Commission reported to Congress in March 2005 that physician-owned specialty hospitals did not have lower Medicare costs than traditional hospitals, and that physician-owned specialty hospitals had no negative impact on competing community hospitals financially. However, the report found that physician-owned specialty hospitals treated generally less severe cases, and tended to focus on certain diagnosis related groups that were relatively more profitable. A recent advisory opinion released by CMS on June 16, 2008 appears to encourage the establishment of physician-owned rural health care facilities. In Advisory Opinion No. CMS-AO-2008-02, certain physician owners of rural health care provider (“the Physicians”) offering a variety of services, including physician consultation, as well as clinical laboratory and diagnostic radiology services (“the Diagnostic Center”), sought an opinion from CMS that the Physicians’ ownership of the Diagnostic Center would comply with the physician self-referral statute, section 1877 of the Social Security Act (the “Stark Law’). Under the Stark Law, a physician may not refer a Medicare patient for designated health services (“DHS”) to an entity with which the physician has a financial relationship, unless an exception applies. One such exception is the rural provider exception, which applies in the case of DHS furnished in a rural area by an entity, if substantially all of the DHS furnished by such entity are furnished to individuals residing in a rural area. CMS has interpreted “substantially all” to mean not less than 75% of the DHS that an entity furnishes are furnished to residents of a rural area. A rural area is defined as a non-urban area. An urban area, in turn, is defined by the Office of Management and Budget (“OMB”) as a Metropolitan Statistical Area (“MSA”) or a New England County Metropolitan Area. The rural provider exception applies only to ownership or investment interests in a DHS entity. In order for the Physicians’ ownership of the Diagnostic Center to meet the rural provider exception, the Diagnostic Center had to pass a two-part test. First, the DHS furnished by the Diagnostic Center had to be furnished in a rural area. The Physicians certified that all of the DHS furnished at the Diagnostic Center was, and would continue to be, furnished outside of an MSA. Based on that certification, CMS concluded that the Physicians’ ownership of the Diagnostic Center satisfied the first requirement of the rural provider exception to the Stark Law. The second requirement of the rural provider exception to the Stark Law is that at least 75% of the DHS furnished by an entity must be furnished to individuals residing in a rural area. The Physicians certified to CMS that at least 75% of the services furnished by the Diagnostic Center on an annual basis were furnished to patients residing in a rural area. Based on that certification, CMS found that the Diagnostic Center satisfied the second requirement of the rural provider exception to the Stark Law. However, CMS cautioned that the 75% requirement is an ongoing requirement. Thus, if the area where the Diagnostic Center is located is later classified as a MSA, or if less than 75% of services furnished at the Center are furnished to patients residing in rural areas, then the rural provider exception will no longer shield the Physicians from the penalties of the Stark Law. The rural provider exception to the Stark Law represents a policy decision by CMS to encourage the establishment of healthcare providers in rural areas, and the recent advisory opinion buttresses that exception. While protection from violation of the Stark Law may provide some encouragement for physicians to establish hospitals and other health care facilities in rural areas, many factors still discourage the establishment of physician-owned facilities, including the difficulty of receiving a Certificate of Need and certification to open a facility, the financial risk associated with such a venture, and the diminishing returns currently associated with health care facilities. Greater government incentives are required in order to encourage the expansion of physician-owned hospitals and other healthcare facilities into rural areas. CMS Advisory Opinion 2008-02 is available at: http://www.cms.hhs.gov/PhysicianSelfReferral/Downloads/CMS-AO-2008-02.pdf. Robin Franco is an Associate in the Health Care Law practice group at Balch and Bingham, LLP. July 2008