William O. Cleverley
James O. Cleverley 

At a Glance

Healthcare finance leaders can use a methodology and metrics to compare managed care payments against those of their local and regional peers. Depending on payment levels, they should adopt one of the following negotiation stances with payers:

  • If payment levels are both equitable and adequate, they should view a continuation of the present structure as desirable.
  • If payment levels are adequate but not equitable (e.g., payments are lower than payments peers are receiving for similar services), they should seek increases in payment to level the payment structure among providers.
  • If payment levels are neither adequate nor equitable, they should demand correction in the near future to avoid the need to cease operations.
  • If payment levels are equitable but not adequate, however, they should question the viability of the delivery system.

Hospital finance leaders can use this framework for assessing managed care payments in negotiations with commercial payers.

Josh Marshall, CFO of the hypothetical Lydia Memorial Hospital (LMH), has been meeting with his CEO Riley Dean to discuss a negotiation strategy for commercial contracts. Riley is upset with the hospital's current payment terms for several of its large commercial contracts and believes that the hospital's low operating margins demonstrate poor payment terms relative to other hospitals in the region, especially compared with LMH's major local competitor, which is reporting higher levels of profitability. Riley has directed Josh to prepare some background information on the hospital's payer contract strategy for the next board meeting.

The above scenario is being played out in many hospitals as they begin to address strategies for dealing with expected reductions in government payments. Fingers often are pointed at large managed care firms for not providing adequate levels of payment. This perception of hospitals raises an important question: What are adequate and equitable managed care payment levels?

Defining Adequate and Equitable

Adequacy of payment is defined as a level of payment necessary to ensure the financial viability of the healthcare provider. Quite simply, total payments must exceed total costs by some amount to ensure financial survival. Profit is not a luxury; it is a necessity.

Equity of payment is defined as similar payments for identical services by a payer across multiple providers. The Medicare program might be used as an example. Medicare provides for identical payments to providers for the same services subject to a few adjustments for specific factors. The issue of payment equity enrages many hospital and health system executives, who believe that another provider is being treated or paid better than their organizations. Sometimes this may be true; in other cases, it is not.

Assessing Payment Differences Across Hospitals

The best way to assess payment differences across hospitals is to compare actual payments made for like services across all payers. For example, assume that there is only one patient encounter type-a simple pneumonia case. The exhibit below provides a hypothetical illustration of a two-hospital payer comparison.

In this example, both hospitals have received an average payment of $5,000 per case. But Hospital A has received $14,000 per private payer case, while Hospital B has received $5,111 ($46,000 / 9). Both hospitals receive $4,000 per case from the government, which requires Hospital A to negotiate a much larger private payer payment because 90 percent of its business is governmental compared with Hospital B's 10 percent.

This pattern of payment illustrates so-called "cost shifting" in the healthcare marketplace. Hospitals and other providers with high levels of government patients, especially Medicaid, and medically indigent patients must receive larger payments from commercial payers to remain solvent. Commercial health plans may argue that they should not be held responsible for a poor payer mix, but the reality is that someone must provide higher payments to providers that receive inadequate payments from the government and indigent patients-or these providers will become insolvent.

This example does not assess payment adequacy for either hospital. We do not know whether the levels of payment are sufficient to meet underlying operating expenses. We do know that there is payment equity when all payers are combined; each hospital receives $5,000 per case. However, there is not payment equity across private payers. One hospital receives $14,000 per case, while the other receives $5,111 per case from private payers.

Exhibit 1


Assessing Payment Inequity

Let's return to our earlier case scenario of CFO Josh Marshall at LMH. To help Josh develop a negotiation strategy for LMH's commercial contracts, we will evaluate comparative data on a number of key metrics (see exhibit 2).

The first metric is "net patient revenue per equivalent discharge," which we developed. The formula for net patient revenue per equivalent discharge is:

Net Patient Revenue / Equivalent Discharges®  

Where Equivalent Discharges® =

Gross Inpatient Revenue / Average Charge per Discharge CMI Adjusted  

Plus (Gross Outpatient Revenue/Average Charge per Visit APC Weight Adjusted x 0.012)  

We believe this metric is an accurate assessment of the revenues actually received by a hospital for equivalent units of service. Values for this metric would not be affected by payer mix, as was seen in the previous example. (The metric is described in detail in our article, "A New Workforce Productivity Metric," Strategic Financial Planning, Summer 2011.)

As shown in exhibit 2, LMH's revenues for equivalent patient care services are not equal to those of its peers. The local peer hospital is receiving 7.5 percent more revenue than LMH ($8,367 compared with $7,888). Other peer hospitals in the region are receiving 12 percent more than LMH ($8,819 compared with $7,888).

Exhibit 2


There are two possible reasons for lower net patient revenue per equivalent discharge values at LMH. One is poor payer mix: LMH could have higher levels of Medicaid, Medicare, and indigent patients, which produce low levels of payment that cannot be cost shifted to commercial payers. We would describe this as "all-payer inequity" because payment, in total, would be lower than that received by the peer hospital.

The second possible reason is lower payment per patient encounter: LMH could be receiving lower levels of payment from its commercial payers than other hospitals. We describe this as "specific payer inequity."

Which reason is driving the difference at LMH? The comparative data show that LMH has a significantly lower level of Medicaid gross patient revenue than its local peer or its regional market, suggesting that LMH's lower values for net patient revenue per equivalent discharge are not the result of a less favorable payer mix. However, given that Medicare payment is roughly equal for these facilities, the difference is a reflection of lower payments from managed care contracts. Note that the local peer hospital has a less desirable payer mix than LMH, but its net revenue per equivalent discharge is higher, suggesting that payment terms from local health plans are more favorable at the local peer than at LMH. Assuming the validity of this observation, a situation of payment inequity would exist.

Assessing Payment Adequacy

We have determined that payment levels from commercial payers to LMH are most likely lower than those received at other similar hospitals. However, lower levels of payment imply only an inequity in payment from commercial health plans. Lower payment levels do not necessarily imply an inadequacy of payment.

The issue of payment adequacy is ultimately linked to financial viability. Some healthcare organizations may be able to attain financial viability with lower levels of payment than other organizations. Although some may object to the existence of payment inequity, a not-for-profit provider may find it difficult to argue for greater payments if it is not financially disadvantaged. For example, a hospital that receives lower payments than its local peers receive from its commercial payers, but maintains high profit margins because of large sources of philanthropy, may not be able to argue convincingly for higher payment levels.

Profitability. The comparative data (see exhibit 2) depict a situation of lower profitability at LMH for both operating margins and total margins. Most likely, the lower operating margins are a direct result of lower levels of payment from commercial payers (i.e., the payer inequity that was established earlier). LMH also appears to have less nonoperating income, such as investment income, than its peer hospital, which saw a sizable increase in its total margin (5.4 percent) from its operating margin (3.1 percent).

Cost position. If costs were high at LMH, the low levels of profitability could be improved through better cost management, which might obviate the need for increased payments. A lower cost structure could improve LMH's operating margins and make the hospital's level of profitability adequate to sustain it moving forward. This would mean that payment adequacy would be present, and commercial payers might argue against rate increases because of unreasonable costs at LMH.

However, according to the comparative data, LMH enjoys a 6 percent cost advantage relative to its peers, but this cost advantage is not being rewarded in higher operating profitability. LMH's local peer has 6 percent higher costs, but its higher cost is offset with 7.5 percent higher net revenues.

Financial requirements. Although LMH has low net revenues, low costs, and low profitability, there may not be a need for additional profit. In general, if a hospital has an enormous cash stockpile, a payer or the community may argue that that hospital should use some of that surplus before expecting any payment increases. Remember, higher commercial payments will require higher premiums from local businesses, and many of those local business executives may be on the hospital's board. In short, even though LMH's profits are lower than those of its peers, LMH may not need higher profits.

Usually, profitability is required for three major financial requirements:

  • Replacement of aging physical facilities
  • Retirement of outstanding debt
  • Improvements in cash reserves

Normal expenses, such as salaries, are not included because these items are subtracted from revenues to determine profit.

Replacement of physical facilities. LMH's physical facilities, using the average age of plant metric, are much older than any of the comparative groups. Most likely, sizable capital expenditures will soon be required to maintain care standards, which implies that LMH must have significant levels of existing cash reserves or the ability to borrow large amounts of capital.

The comparative data clearly show that LMH is heavily leveraged relative to other hospital comparative groups. We have already determined that LMH will be required to make sizable capital expenditures because of its older physical facilities. We believe that LMH will find it very difficult to raise additional capital given current low levels of profitability and its high levels of existing debt. This further strengthens the argument for LMH to realize higher levels of operating profitability.

Cash reserves. A final critical question is the definition of surplus or excess cash reserves. The availability of cash reserves would seem to be the best option for financing future capital expenditures. Implicit in our assessment is the maintenance of 25 days of cash to meet working capital needs. We also estimate that not-for-profit hospitals need to reserve a portion of their accumulated depreciation to meet eventual replacement needs on those depreciated assets. We believe that hospitals, especially not-for-profit hospitals, need to carry balances of cash that will enable them to meet working capital needs and to provide for eventual replacement of their physical facilities. In the exhibit below, we have assumed that 25 days is a reasonable standard for working capital needs.

Exhibit 3


The exhibit shows that LMH has 11.5 percent of its inflation-adjusted capital needs available as of June 30, 2011. This level is extremely low in light of the 15-year average age of plant and the high levels of current debt. LMH needs to add cash reserves in significant amounts-and very soon. The major source for this cash would be increases in revenues from commercial payers.

Coming to a Conclusion

The preceding analysis of LMH financial information results in the following conclusions.

First, current levels of payment from commercial health plans to LMH appear to be inequitable. They are below the local peer hospital and other similar hospitals across LMH's market.

Second, current levels of payment at LMH are also inadequate. LMH has low levels of income even while maintaining a low cost structure. Operating income needs to be increased because:

  • LMH has a much older physical plant that will require significant future capital expenditures
  • LMH is not in a position to borrow because it is already highly leveraged
  • LMH has minimal levels of cash reserves

Finally, LMH needs significant improvement in payment from commercial health plans because current payment levels are inadequate to meet the hospital's financial needs and because these payment levels also appear to be inequitable.

Identifying the Best Negotiation Strategy

It is possible to have commercial payments that are adequate but not equitable, and it is also possible to have payments that are equitable but not adequate. Four possible case scenarios result with various implications for negotiations:

  • If payment levels are both equitable and adequate, a continuation of the present structure is desirable.
  • If payment levels are adequate but not equitable (e.g., the provider is receiving lower payments for similar services than its peers), the provider should seek increases in payment to level the payment structure between providers. Without that leveling, providers with more favorable contract terms will grow at the expense of those with inequitable payment levels.
  • If payment levels are neither adequate nor equitable, correction is required in the near future-or the provider will cease operations.
  • If payment levels are equitable but not adequate, the entire viability of the delivery system is called into question. This, for example, could be the direct outcome of nationalized health care: Payment levels would be equitable across providers but not sufficient to meet legitimate costs of operation.

The framework outlined in this article separates issues of payment adequacy from payment equity. Hospital finance leaders can use this framework for assessing managed care payments that can be used in negotiations with commercial payers.

William O. Cleverley, PhD, is president, Cleverley & Associates, Inc., Worthington, Ohio, and a member of HFMA's Central Ohio Chapter (bcleverley@cleverleyaassociates.com).

James O. Cleverley is a principal, Cleverley & Associates, Inc., Worthington, Ohio, and a member of HFMA's Central Ohio Chapter (jcleverley@cleverleyassociates.com).

Publication Date: Thursday, November 01, 2012

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