The disclosure of pumped-up Medicare revenue at Tenet Healthcare Corp., the nation's second-largest publicly traded hospital company, has exposed a flaw in the Medicare system: By raising rates sharply, Tenet hospitals triggered an obscure mechanism that automatically boosted their payments.

At issue is Tenet's outsize revenue from supplemental fees for the most expensive patients, called "outliers" in Medicare terminology. Those fees, according to Medicare data, are making up nearly a quarter of the company's projected revenue this fiscal year from the federal medical-insurance system for senior citizens -- and brought in $412 million more in 2002 than just two years earlier. Medicare's top administrator said in an interview this weekend that the mechanism "invited gaming" and has to be changed.

Tenet is in mounting crisis amid a federal audit into the payments. At the same time, two heart doctors that work in a Tenet hospital -- two of the top Medicare billers in their specialties in Northern California -- have drawn a fact-finding raid by FBI agents looking into whether they performed unnecessary surgeries and other procedures. Tenet's stock price has dropped by 72% since Oct. 28 and Standard & Poor's and Fitch have cut its debt rating.

Chief Executive Jeffrey C. Barbakow last week responded by cleaning house, bringing in a new second in command and crowding out chief operating officer Thomas B. Mackey, who developed the company's aggressive pricing strategy, and chief financial officer David L. Dennis, Mr. Barbakow's longtime friend.

FULL COVERAGE   Listen to a Tenet conference call1 on Medicare payments.   For more health coverage, visit the Online Journal's Health Industry Edition at wsj.com/health2 and receive daily health e-mails3.

The company is not accused of any wrongdoing. Tenet officials say they didn't encourage doctors to perform expensive operations, or change the company's pricing structure to deliberately gouge Medicare. They say the increased payments were a side effect of the company's growing size and clout in California and other markets that allowed it to raise rates it charged health insurers.

Tom Scully, administrator of the Centers for Medicare & Medicaid Services in Washington, said the Medicare mechanism that Tenet profited from had to be fixed. "I can guarantee you in the next couple of weeks, we'll have a new proposal" he said. "It's now No. 1 on my list of things to do." Mr. Scully declined to comment specifically on the Tenet case.

But auditors will look at whether Tenet went too far. Among the nation's big hospital chains, Tenet gets by far the highest percentage of its Medicare income from supplemental payments for the most expensive patients, called "outliers." HCA-The Healthcare Co., the largest hospital company, is projected to get only 5% of its Medicare revenue from outlier payments in fiscal 2003, compared with 23.5% for Tenet, according to Medicare data.

Tenet's aggressive strategy helped transform the company into a Wall Street darling in the last three years, as it posted a string of stellar earnings reports. Its stock price soared, allowing executives at the Santa Barbara-based firm to reap tens of millions of dollars selling shares and exercising options. It represented an impressive turnaround for Mr. Barbakow, who was brought in to clean up Tenet nine years ago after its predecessor company, National Medical Enterprises Inc., was nearly destroyed by criminal fraud charges against its psychiatric hospitals, which it later sold.

One of those profiting from the soaring stock was Mr. Mackey, the chief operating officer. On Oct. 4, Mr. Mackey sold 277,500 shares of Tenet stock at $51.50 a share, garnering $14.3 million. That was a day after a 52-week high and a few weeks before an Oct. 28 analyst's report about Tenet's reliance on outlier payments sent the stock falling. The company says Mr. Mackey exercised option grants. Mr. Mackey didn't respond to several messages left for him.

Mr. Barbakow sparred with investors in a conference call last week that stretched nearly three hours.He said in an interview this weekend that he hasn't "found any evidence as of this point" that Tenet was doing anything wrong. But he says the pricing strategy's effect on Medicare payments "puts the company in a position I don't feel comfortable with."

The market's reaction to the events has been swift and severe. Instead of reassuring investors, Mr. Barbakow's actions -- and statements that he wasn't aware of the details of the pricing strategy -- have made them worried that Tenet's situation could turnworse. U.S. Rep. Pete Stark, a California Democrat, compares Tenet's actions with those of HCA, which two years ago paid a record $840 million in criminal fines, civil penalties and damages to end a government probe of its Medicare billing practices.

The company's defenders argue that the Medicare system itself is largely to blame for a reimbursement formula that resulted in outsize payments to Tenet. Health-industry executives frequently criticize the system for being so convoluted and full of gray areas that it invites abuse. The Medicare handbook for hospitals and physicians is more than 100,000 pages long and "represents more than 35 years of regulations, changes, adjustments and readjustments," said Ken Weakley, an analyst at UBS Warburg., author of the Oct. 28 report on Tenet's outlier payments.

A question for auditors is whether the enlarged payments to Tenet hospitals were proper or whether the company deliberately set up its pricing structure to manipulate the reimbursement system for greater gains.

The trail begins in 1999, after Tenet consolidated two big acquisitions that brought it a slew of new hospitals in California, its largest market and home state. The competitive landscape there was shifting. A consumer revolt against managed care had weakened the state's powerful health-maintenance organizations, giving hospitals more clout in negotiating deals to treat the HMOs' patients.

Mr. Mackey, who had overseen the Western region, took over the nuts and bolts of Tenet's hospital operations nationwide. Mr. Mackey, a National Medical veteran who had joined the company in 1985, faced a grim situation. A cutback in hospital Medicare payments had flattened Tenet's revenue growth, depressed its stock and forced a wrenching 30% cut in corporate overhead spending.

Mr. Mackey developed a policy to raise so-called chargemaster prices, a kind of health-care equivalent of the sticker price at car lots. Insurers and the government don't actually pay chargemaster rates. But they are used in complex pricing formulas that determine how much Medicare pays in supplemental fees for outliers, expensive cases that exceed normal fixed rates.

As Tenet raised its prices aggressively, the ratio used to calculate Medicare payments for such cases was thrown badly out of whack. It triggered a decades-old mechanism that substitutes a ratio of statewide average costs and charges. The mechanism was designed to determine payments when data from individual hospitals appeared wildly inaccurate.It boosted the payments to Tenet. In essence, Tenet reaped rewards by triggering a hidden jackpot in the Medicare system. None of HCA's hospitals are receiving any payments from the substitute ratio, Mr. Weakley reported.

Tenet's price increases became more aggressive in 2000 after Mr. Dennis, a veteran investment banker, became Tenet's chief financial officer. He stepped up pressure to keep Tenet's revenue growing swiftly and instituted high performance targets at the corporate level, people close to the situation say. That set up a race between Mr. Mackey and Mr. Dennis to achieve ever-better financial results, those people say. They add that tensions developed inside Tenet's headquarters as some managers started to feel uncomfortable with the hard-charging style of Mr. Barbakow's two top lieutenants. Mr. Barbakow says, "I'm not arguing with that, but I didn't see that." Mr. Dennis did not return calls for comment.

The impact of the stepped-up outlier payments on Tenet was enormous. Those payments increased to $763 million in fiscal 2002, up from $351 million two years earlier. Almost two-thirds of the 2002 number -- $481 million -- came from Tenet hospitals that benefited from the statewide average multiplier. That also represented 46 cents of the company's $2.17 per share earnings from operations. Tenet believes that in the current fiscal year, it will collect even more, $515 million, from these statewide average payments. That would be 50 cents of the company's projected per-share earnings for 2003 of $2.93, based on a 25% increase in adjusted earnings from 2002.

Mr. Barbakow says that he had never focused on the financial impact of the outlier payments until sometime in the week of Oct. 14 when Mr. Weakley, the UBS Warburg analyst, called to ask questions of a Tenet investor-relations executive, who in turn talked to Mr. Barbakow.

Two days after Mr. Weakley's report hit the market, FBI agents raided Redding Medical Center and the offices of two physicians, Dr. Chae Hyun Moon and Dr. Fidel Realyvasquez Jr. A public affidavit prepared by an FBI agent and filed with the federal court in Sacramento accused the two doctors of performing unnecessary procedures including open-heart surgeries and angioplasties.

It is unclear what connection, if any, there could be between the increased outlier payments and the FBI's interest in the two doctors. One question it could raise is whether Tenet hospital administrators may have pressured doctors in ways that encouraged them to do unnecessary high-priced operations and procedures. "Flatly no," Mr. Barbakow says. "That hasn't been our strategy."

Neither the two doctors nor Tenet was charged with any crime, but investors were spooked. Tenet has been stressing to investors its success in attracting patients to its cardiology, neurology and orthopedic departments, which are among the highest billers in any hospital. Kevin Wenck, president of Polynous Capital Management Inc., an investment firm in San Francisco that has a Tenet stake, says people are wondering whether Tenet managers "prefer revenue to quality of care."

According to the affidavit, Dr. Realyvasquez and Dr. Moon were the Nos. 1 and 2 billers to the Medicare program in their respective medical specialities in the Northern California region. Redding also is one of Medicare's biggest beneficiaries of outlier payments in the country. Upon news of the raid, Tenet's stock fell another 26%

Dr. Moon, the head of Redding's cardiology program, and Dr. Realyvasquez, a cardio-thoracic surgeon there, have denied any wrongdoing. The two doctors and Redding Medical Center have since been hit by at least four malpractice suits. Tenet announced that it had hired an outside medical auditor to review the work of the two Redding doctors. It also announced it will review treatments at other company hospitals that generated high levels of outlier payments.

Last week, Mr. Barbakow separately confronted Mr. Dennis, 53, and Mr. Mackey, 54 , telling them he had lost confidence in them. "I expect people to flag the headaches and things I should be getting involved in. I guess I didn't hammer away enough on these individuals," he said. Last Thursday, Tenet announced Mr. Mackey's retirement and said Mr. Dennis had voluntarily left the company. Mr. Barbakow brought back Trevor Fetter, 42, a trusted lieutenant who had moved over to a Tenet hospital services affiliate in 2000, and named him president.

The reshuffle, which was accompanied by a more full disclosure by Tenet of the role outlier payments played in its performance, backfired. Tenet shares again fell, leaving its stock price last Friday at $14.90, down from a high of $52.50 on Oct. 3. Mr. Barbakow "obviously fumbled the ball to some degree by not asking the right questions," said David Woodyatt, a buy-side investment analyst at Harris Bank, a unit of Bank of Montreal. "You get into a situation where either he knew and didn't tell us, so you can't trust him, or he didn't know something he should have known."

Write to Rhonda L. Rundle at rhonda.rundle@wsj.com⁴ and Anna Wilde Mathews at anna.mathews@wsj.com⁵

Updated November 11, 2002 12:30 p.m. EST