A few weeks ago, a group of gentlemen met around a table and had a meeting that nobody wanted to have. The CEO of a community hospital, let's call it St. Peter's, asked representatives from four pacemaker companies -- Medtronic (NYSE:MDT), Guidant, owned by BostonScientific (NYSE:BSX), Saint Jude Medical (NYSE:STJ), and Biotronik (privately owned) -- to join him and a cardiologist, who I will call Dr. Paul. He was upset at the companies, but, first, a little background information is in order.

St. Peter's is a medium-sized community hospital serving over 100,000 people in a growing part of the U.S. About three years ago, Dr. Paul asked the hospital CEO about starting an electrophysiology (EP) program. The program would allow residents to have regular pacemakers, heart failure pacemakers, and defibrillators, placed locally. There was no question that many in the community needed these services, as patients were routinely traveling down the local interstate to a large heart hospital. After some due diligence, the CEO signed off on starting the program.

Everyone was enthused and excited. New sophisticated EP equipment was purchased, and St. Peter's' cardiology staff was sent out of state for extensive training. Dr. Paul was thrilled to bring high-tech services to his community. The pacemaker companies were eager to develop another center for implants.

Pacemaker companies have a marketing problem that drug companies do not share. Since any physician can prescribe virtually any drug, drug manufacturers can advertise to hundreds of thousands of doctors. Few doctors implant pacemakers, and there are even fewer EP doctors to place the more sophisticated and expensive devices. For example, at a large hospital with a medical staff of a thousand doctors, there might be a few dozen cardiologists, but only a handful of EP doctors. Most community hospitals do not provide EP service, so pacemaker companies were understandably enthused about St. Peter's' program.

Like computer companies, pacemaker companies grow their revenues by selling newer devices that have additional features. The initial implanted devices were used to treat patients with very slow heart rates and are known as "brady" devices. Pacemakers initially utilized one lead, then two leads. Next came "tachy" devices, known as defibrillators, that shock life-threateningly fast heart rates back into normal rhythms automatically. Big bulky devices that required heart surgeons to implant in operating rooms gave rise to smaller devices that cardiologists could implant in catheterization labs. Devices with three leads that can be used to improve the strength of a weak heart, as well as shocking the heart back into rhythm, were next. The newest models have sensors that can track pressures within the heart and sophisticated telemetry monitoring. Currently, uses of pacemakers outside the heart are being explored.

The meeting occurred after a consultant was hired. The consultant discovered that the prices that St. Peter's was paying for the pacemakers were so expensive, that reimbursement received by the hospital did not cover all of the hospital costs. Every time a patient had a device placed, St. Peter lost thousands of dollars. Effectively, Dr. Paul's program was robbing St. Peter's, with the pacemaker companies making the money. How did this happen?

First of all, during the time between the program's green light and its start, Medicare changed its rules. Medicare used to allow for a routine diagnostic EP study to be charged and paid for before placement of "tachy" devices, and that was curtailed. So the amount of money received by hospitals went down. Second, St. Peter's had negotiated prices, but those prices were still higher than other hospitals were paying. Third, like many other products, "brady" and "tachy" devices come with different prices for good, better, and best models; the difference in the prices is substantial. If you're in your 50s and are very active, you need a top-of-the-line model, but if you're wheelchair-bound in a nursing home, then a good model should work just fine. One might expect some variation in the sophistication and expense among the models placed commensurate with the variation in patient population.

But almost always, the most expensive device was implanted. When a pacemaker is implanted, a pacemaker representative is called to bring a device to sell to the hospital for the procedure. The representatives earn part of their compensation based upon sales of their devices, so they're understandably handing out lots of the super-deluxe models. The consultant found that only one representative had ever volunteered a "good" or "better" model; the others always provided their "best" model.

So a less-than-thrilled CEO told four pacemaker companies and Dr. Paul that St. Peter's could only afford to pay a certain amount for its devices or the EP program would have to stop. As additional hospitals review how much they pay for pacemakers, pricing pressures could affect pacemaker companies' margins. Additionally, in early 2006, Medicare announced that it was going to cut reimbursement of defibrillators by over 20% for 2007. It subsequently reduced the cut to around 3%. However, with Medicare spending increasing much more rapidly than inflation, it's likely that the future will bring more discussion about additional reductions.

In summary, pacemaker companies will likely have more downward pricing pressures of their devices than in the past. Medicare may continue reducing reimbursement for the devices. The meeting at St. Peter's didn't have a happy ending for all. Only one company met the price the CEO wanted to pay for its pacemakers, and it became the sole vendor of pacemakers at that hospital.

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Fool contributor Dr. Cecil is a cardiologist and the author of Drugs for Less. To discuss the article, feel free to email him.Dr. Cecil does not own any of the stocks mentioned in the article. The Fool has adisclosure policy.