US hospitals are under fire: recent reports have highlighted medical-safety issues, the uneven quality of emergency rooms, high costs, and lengthening wait times. Simultaneously, these institutions face increasingly severe economic pressure as their competitiveness against more focused alternatives declines and health care consumers become more value conscious. To overcome such difficulties, the industry must make some big moves. Many hospitals will have to reorganize around a narrower range of clinical activity, differentiate themselves on quality and service, think more like the retailers they are fast becoming, and overhaul their relationships with physicians.

How did US hospitals—a triumph of 20th-century technology and organization—reach the point where such dramatic changes are needed? Like the vertically integrated businesses that emerged contemporaneously early in the last century, hospitals once exploited economies of scale and scope by combining and managing a specific set of assets, such as pharmacies and imaging departments, clinical laboratories, and emergency rooms. Thanks to the professional nursing and aseptic procedures of hospitals, they were just about the only places that offered high-quality medical treatment. For physicians, practicing in hospitals was far more productive than traveling door to door. In addition, the standard of excellence hospitals are known to adhere to, as...