Last August, representatives of six of the Washington area's most prestigious hospitals were ushered into the board room of Blue Cross and Blue Shield in southwest Washington to hear a special warning.

At the time, the hospitals were involved in a high-stakes feud over which would start the area's first heart transplant program. Three separate groups were vying for the right to carry out one of medicine's most complicated procedures, raising the threat of unnecessary and costly duplication of a service that was sure to attract beneficial publicity.

The message that day from Blue Cross and Blue Shield executives was stark: They would pay health insurance benefits for only one of the proposed heart transplant programs. "We said either you get your act together," recalled Joseph Gamble, president of the health insurer, "or we're going to pick one of you and the other two are going to be left out in the cold."

Within a matter of days, Blue Cross and Blue Shield officials say, the hospitals had engaged in discussions that later resulted in the unprecedented creation of a consortium to jointly administer a single heart program.

Although hospital officials say they were beginning to cooperate anyway, the timing was one more example of the kind of clout that Blue Cross and Blue Shield exert daily -- though usually more subtly -- throughout the Washington medical community. A decision by the Blues not to pay for a costly, controversial or unproven medical procedure can mean the virtual elimination of that service. When the Blues decide to crack down on physician fees, most doctors can ill-afford not to accept the order.

Today, however, the dominance of Blue Cross and Blue Shield is being tested like never before by revolutionary forces overtaking the health insurance industry. For the first time, Blue Cross and Blue Shield have discovered competition.

New forms of financing medical care, such as health maintenance organizations, have risen to rival the Blues -- the companies that for years were virtually synonymous with health insurance -- for a share of the health insurance business. Employers have demanded greater attention to cost-containment measures and more complex financing arrangements to help them restrain their escalating health care expenses. Cost-conscious consumers have started questioning health plans more closely.

A bit belatedly, officials admit, Washington's Blue Cross and Blue Shield have begun to fight back. They have forged into a host of new areas, setting up a health maintenance organization of their own, overhauling the claims-paying system, even looking to new markets abroad.

As other Blue Cross and Blue Shield plans around the country have found, however, the advent of competition has raised perplexing questions for a plan that has long prided itself on its devotion to social ideals:

How do the Blues respond to the desire for cost-containment measures without alienating the doctors and hospitals with whom they have traditionally enjoyed close relations? How can the Blues keep their costs down while at the same time opening their doors to high-risk people and groups who could not get health insurance elsewhere? Can the Blues continue to justify their tax-favored status as social welfare organizations?

"I can foresee increasing strains," said Thomas Chapman, president of the Greater Southeast Community Hospital, who says his hospital has worked well with the Blues in the past. "As the dollars become more restricted and the pressures on the hospital revenues increase ... . eventually we're going to become adversaries. I don't know exactly when that is going to happen."

Steven Sieverts, vice president for health care finance at the Washington plan, aptly describes his organization's dilemma: "We now have to behave in an almost schizoid way, on the one hand competing in a highly competitive market, on the other hand meeting our role of community service."

Blue Cross and Blue Shield executives say they are continuing that community role, whether it means seeking to restrain high-cost procedures like heart transplants or offering insurance to sicker individuals the commercial carriers wouldn't cover.

Others have their doubts. Last year Congress stripped the Blues' general exemption from federal taxes, arguing that the nonprofit plans have come to behave no differently than commercial companies.

"We're at a crossroads in our history in trying to hang on to our traditional values," said Bernard Tresnowski, president of the national Blue Cross and Blue Shield Association. Tresnowski suggested that it is in the Blues' own commercial self-interest to retain those values: "Any competitor likes to differentiate themselves from the competition in the marketplace. Companies like our coverage because they like our orientation."

For many veterans of Blue Cross and Blue Shield, the transformation to a competitive marketplace has been a wrenching one, largely because it comes as such a stark contrast to the more relaxed environment in which they grew up.

The first Blue Cross plans -- Washington's among them -- got their start during the Depression. There was no other health insurance to speak of, and hospitals and business leaders around the country seized on the idea of offering a set amount of hospital care in return for a regular monthly payment. By the 1940s, medical societies began offering similar arrangements to pay for doctors' bills through Blue Shield plans.

From these beginnings emerged a network of 78 independent organizations that today cover 77 million Americans. Each plan is responsible for a geographic area; the local plan covers subscribers in Washington,Maryland and Virginia.

In Washington, as in most of the rest of the country, the Blues long dominated the health insurance market, even after the commercial companies began to enter the business following World War II. It was a simple business in those days: when Joe Gamble joined Blue Cross as assistant controller in 1957, shortly after his family sold its meat business, there were 230 employes and only a few different health plan options. All subscribers paid the same "community rate," ensuring that even the sickest patients could find coverage at affordable prices.

"For a long time it seemed like the product just sold itself," said Benjamin Giuliani, now the plan's executive vice president, not a small bit wistfully. "Those days just went away."

They went away at least in part because the Blues were a tempting target for new players in the game, much like another former monopoly -- AT&T.

Profit-making commercial insurers were able to steal accounts by offering employers "experience-rated" contracts that based rates only on the costs of their own employes, not the higher costs that reflected serving the entire community. As health care costs continued to balloon in the 1970s and '80s, new competitors, principally HMOs, emerged that offered lower-cost care. It didn't help that Blue Cross and Blue Shield's had a reputation among many employers as a big and inefficient bureaucracy.

What especially damaged the local plan was its loss of federal workers, who a decade ago made up more than 50 percent of its business but who have increasingly turned away from the high-cost Blue Cross option to HMOs and government union-sponsored plans. Between 1979 and 1985, more than 300,000 Washington-area federal workers dropped out of Blue Cross and Blue Shield, although officials believe they have finally stopped the erosion by rearranging the benefits package of their lower-cost option.

Nonetheless, this hemorrhaging of federal workers contributed to a dramatic loss of market share for the Washington Blue Cross and Blue Shield. While the plan remains by far the largest private insurer in the area, between 1976 and 1986 the number of Blue Cross and Blue Shield subscribers here dropped from 1.6 million, or 45 percent of the metropolitan market, to a little more than 1 million, or a 33 percent market share.

Enrollment figures suggest that health maintenance organizations like Kaiser Permanante and Group Health Association have been the primary beneficiary of the Blues' woes: in the last five years alone, area HMO enrollment more than doubled, to more than 500,000.

Blue Cross and Blue Shield executives contend that the market share figures don't reflect the robust financial health of their program. The plan reported revenues exceeding $914 million in 1986, up from $810 million in 1985; If it were a stockholder-owned public company, it would be the 12th largest in the Washington area. Though it lost $42 million last year, officials say the plan is in the middle of a typical cycle that will see it return to profitability by 1989.

Yet as even executives acknowledge, the market share decline was alarming to an organization that depends on its large subscriber base to negotiate lower prices with doctors and hospitals. "What I saw happening was other forces coming into being that were beginning to drain our customers away," said Gamble, who became the plan's chief executive in 1982. "Our problem is, how do we prevent that from happening? Or, if it is going to happen, how do we deal with it?"

Gamble's answer has been an ambitious diversification program aimed at improving service and broadening the choices offered businesses and consumers:

In 1985, Blue Cross and Blue Shield formally merged into a single organization. Though the two plans -- Blue Cross for hospital insurance and Blue Shield for doctors insurance -- have long been marketed jointly, they both had separate boards and staffs, making for a clumsy claims and administrative process, executives say.

The plan spent $40 million to overhaul its antiquated computer system and integrate many functions that had previously been on separate systems. As part of the restructuring, Blue Cross and Blue Shield moved to streamline its internal organization, establishing special staff units with responsibility for all administrative matters on a given account, ranging from processing claims to answering questions.

After several years of sitting on the sidelines, Blue Cross and Blue Shield has jumped with a vengeance into alternative forms of health insurance. The plan has established at great cost its own health maintenance organization, called CapitalCare, and has been recently pushing to set up an offshoot of this called a preferred provider organization. The plan also set up a new subsidiary designed to help employers adopt cost-containment techniques, as well as a "third part administration" firm that manages health benefits programs for employers without taking on the risk of insurance.

In perhaps its most innovative gambit, Blue Cross and Blue Shield has launched a huge international marketing effort. World Access, a joint venture with the New York plan, was started in 1983 to provide medical assistance to Americans abroad through a network of participating hospitals around the world.

Separately, the plan has begun to target customers in other lands: the plan recently landed a contract to cover workers for the government of the U.S. Virgin Islands. While only a small fraction of its overall business today, Gamble projects that the international market could amount to more than 20 percent of Blue Cross and Blue Shield's total business by the 1990s.

The cumulative effect of these ventures, executives say, has been a midcourse change in the direction of Blue Cross and Blue Shield, from an organization that passively paid claims to a much more market-driven company. The effect has not been lost on physicians who long saw the plan as more of an ally than an adversary.

"Blue Shield has become more of another insurance company," said Dr. Carlos Silva, a surgeon who heads the D.C. Medical Society. "The so-called doctors' plan is no longer a doctors' plan."

One sign of the changing times is the decreased representation of physicians on the Blue Cross and Blue Shield board. Doctors also grumbled two years ago when the plan tightened the rules governing contracts with physicians, and a small group even decided to junk the agreements. Similar complaints surfaced last winter when the plan asked doctors to accept slightly lower fees as part of the new lower-priced "preferred provider" option Blue Cross and Blue Shield has begun offering employer groups.

Ronald Huling, a Washington consultant who advises companies on their health benefit programs, said that if it is to regain popularity with some employers, Blue Cross and Blue Shield needs to shed the perception of being too cozy with area doctors and hospitals. He suggested that the plan is already moving in this direction, citing as an example the aggressive stance it has taken on heart transplants and other planning issues.

"Ten years ago, my sense is that they would never have done that," Huling said.

But Blue Cross and Blue Shield must walk an extremely fine line in distancing itself from providers. Unlike commercial insurers that still by and large pay bills as they come in, Blue Cross and Blue Shield's traditional advantage has been its ability to sign contracts with doctors and hospital that require them to accept the insurer's reimbursement as payment in full and tie them to standards of practice developed with the plan. The advanatge may be even more important in coming years, as such contractual arrangements become even more popular in the industry moving to what industry experts call "managed care" programs.

Some doctors said that while they are displeased with the increasing commercialization of the Blues, a sense of working together still endures, albeit tenuously. They say can still get a fair hearing on reversing claims denials or on how to implement cost-containment measures. "Blue Cross and Blue Shield is still closest to understanding what health care is all about," said Dr. Massimo Righini, another area surgeon. "It's not strictly economic."