A variety of payment models allow hospitals and health systems to chart a course to value-based care by shaping contracts to their specific needs and capabilities.

At a Glance

Numerous factors contribute to an organization’s “risk tolerance” under performance-based risk arrangements, including its size, patient population, and the strength of its financial position. There are three types of risk inherent in value-based contracting:

  • Financial risk
  • Actuarial risk
  • Strategic risk

Value-based contracting is beginning to take root in markets around the country as the nation shifts to a healthcare system in which payments are based on the value of care, rather than the quantity of services. Under this emerging business model, hospitals and other healthcare organizations are providing evidence-based care for specific populations under payment methodologies that include incentives for achieving quality goals and disincentives for poor quality performance. This transition poses new challenges for providers, with significant upside and downside strategic, operational, and financial implications.

The extent to which hospitals and health systems are currently involved in value-based contracting varies based on market dynamics such as provider readiness as well as payer willingness to delegate risk. Progressive healthcare leaders are moving their organizations forward either by negotiating performance-based risk arrangements with payers or by preparing for such contracts to enter their market. Leaders reluctant to accept performance-based risk soon may find that they have no other choice but to participate, especially if their organizations want to preserve clinical and financial integrity and be an essential provider in their communities.

Even so, organizations should move toward incentive-based contracts at an appropriate pace—and avoid taking on more risk than they are prepared to accept.

Evaluating Value-Based Payment Arrangements

A variety of value-based payment arrangements, such as global capitation, shared savings, or bundled payments, are available to hospitals and health systems (see the exhibit below). Selecting the best contract involves assessing an organization’s long-term needs, resources, and capabilities and comparing them with the operational and financial contract provisions offered by payers. Risk-sharing arrangements are not yet available everywhere, but organizations seeking to shift toward value-based business models may be able to opt for pay-for-performance or other incentive-enhanced arrangements offered under the current fee-for-service system.

Exhibit 1

Pizzo_Exhibit 1

Whether considering a contract proposed by a payer or another provider or developing contractual elements to propose to a payer or employer, understanding the requirements and evaluating the advantages and disadvantages are essential.

By definition, risk-based arrangements increase the potential for financial losses or gains depending on how well providers meet quality care metrics and control costs by decreasing utilization or other measures. Such contracts can help organizations foster effective care coordination and closer relationships with physicians and other provider partners. There are several issues hospitals and health systems should consider in evaluating value-based arrangements.

Assessing Risk Tolerance

Under value-based contracts, healthcare providers take on some or all of the financial insurance risk associated with the provision of care, based on the idea that they can better control utilization. Such contracts typically include quality provisions to ensure patients’ needs are being met. The scope of these contracts, and the related risks, can vary. For example, the contracts may cover only primary care services, all professional services, all organizational services, or—in the case of global or full-risk contracts—both professional and organizational services.

Value-based contracts may offer healthcare providers upside financial incentives for improving population health measures, meeting or exceeding quality thresholds, and lowering the costs of care to or below predetermined expenditure benchmarks. Such contracts also can carry downside risk in the form of reduced payments for providers that do not meet specified health measures or quality thresholds, or that cannot lower the costs of providing care below defined target levels.

Hospitals, health systems, and other providers have varying capacity to carry risk without endangering their strategic, operational, or financial performance. Numerous factors contribute to an organization’s “risk tolerance,” including its size and patient population and the strength of its financial position. The three types of risk inherent in value-based contracting are financial, actuarial, and strategic.

Financial risk. This type of risk is inherent in any value-based contract. Hospitals and health systems cannot develop their care-management infrastructure, including the necessary physician networks and technology, without significant investments. Value-based contracts require organizations to direct capital resources to population health management, resulting in fewer resources for traditional care areas.

Providers also take on considerable market and operating risks when they enter into value-based contracts, affording them less flexibility to tolerate risks associated with making capital structure changes that could lower the cost of capital and enhance earnings. This shifting of resources may impact an organization’s credit rating or outlook long term.

Actuarial risk. This risk centers on a provider’s ability to accurately estimate costs and patient utilization and to mitigate losses from inaccurate projections. Few organizations have the internal expertise and resources to manage this type of risk; most will need to seek the help of advisers.

Strategic risk. An organization’s ability to manage strategic risk is a reflection of its ability to execute a value-based contracting plan over the long term. A hospital or health system that wants to provide a full continuum of services across all service lines and levels of acuity needs deep financial resources and a comprehensive risk-management infrastructure. A sustained negative impact over time could weaken a hospital’s or health system’s ability to serve its patients, underscoring the importance of balancing risks across an organization.

When evaluating a specific contract, hospital leaders should possess a comprehensive understanding of the patient population to be served, including its size, historical growth patterns, demographics, and utilization trends. The leaders should assess the potential costs and revenue associated with covering the defined population. They also should carefully evaluate the infrastructure needs required to care for a specific population and how those needs could be met by the organization. The sidebar below covers initial questions to ask in examining a potential population health management initiative.

The Importance of Clearly Defined Responsibilities

When hospitals or health systems enter into value-based contracts, they agree to set payment arrangements in exchange for managing defined services for target populations. Payment provisions can range from fee for service (FFS) to capitation, and operational and infrastructural requirements will vary based on these provisions. For example, under a shared-savings payment model, the savings are paid to the hospital, health system, or other contracted entity. That entity, in turn, is responsible for distributing payments to physicians and other direct patient care providers in accordance with separate contracts with those providers. These downstream contracts should clearly delineate responsibilities and payment provisions of any funds received.

In considering a contract, organizations should ensure that all parties involved–including payers and partner providers—are speaking the same language and have a common understanding of definitions and the expected responsibilities. Transparency throughout the negotiation process is critical. The contract terms should clearly state the responsibilities of the payer and provider, including how distribution of payments will be handled, how quality and utilization will be measured, who will provide what services, and who will carry the risk for each service provided. Details about the provision of care also should be negotiated prior to signing an agreement, such as how to handle out-of-area care and high-cost, high-risk items such as transplants. 

An operational infrastructure that provides meaningful, actionable patient data is a prerequisite for hospitals and health systems preparing to take on performance risk-based payment arrangements. Such infrastructure should include ready access to timely data from all caregivers and payers, including inpatient and outpatient claims, medical records, prescriptions, and lab and test results, to help providers measure and track performance and frame clinical programs and protocols. 

It is important that contracts be designed to distribute risk equitably and transparently. The Division of Financial Responsibility (DOFR) framework is one example of a template for defining the parties that are financially responsible for specific services. A coded version of the framework was developed by the California-based Integrated Healthcare Association, which represents health plans. It offers a starting point to aid providers and payers in negotiating contracts. Once an agreement is in place, the DOFR also supports contract administration and claims payment.

In some markets, payers prefer to contract directly with physicians or independent physician associations (IPAs), which then contract with hospitals or health systems. Hospitals and health systems participating in these contracts should ensure that there is a clear understanding up front regarding how savings generated by the plan will be distributed. 

Regardless of which entity is the primary contractor, there should be thorough financial analysis to support the downstream provider payment model. Maintaining some balance in the distribution of risk is critical. For example, an organization receiving capitated payments under a full-risk contract would likely want to avoid paying all of its partner providers on a FFS basis. Likewise, a hospital contracting under an IPA should receive a portion of the plan “savings” to offset decreases in inpatient utilization that are expected to be the key drivers of those savings.

Projecting the Financial Implications of a Contract

Determining the bottom-line impact of a specific value-based contract requires an in-depth, iterative evaluation. Healthcare finance leaders should calculate the percentage of their inpatient and outpatient revenues associated with proposed contracts by individual service line. The calculation of projected revenues varies according to the type of contract. 

Shared savings contracts, for example, can entail only upside risk or both upside and downside risk. Upside-only shared savings contracts give providers incentives to offer more efficient care by reducing utilization and achieving quality benchmarks over time. In calculating the projected revenues, finance leaders should multiply the number of service units provided by the agreed-upon price, and then add the incentive payment their organizations would receive for quality and/or efficiency goals. To achieve a net gain, a provider would have to lower variable expenses and service units, and the share of savings generated would need to offset lower revenues from decreased utilization.

Exhibit 2


Introducing risk through shared savings contracts with upside and downside arrangements alters the formula slightly. Providers still have the incentives of additional payments for reducing utilization and meeting quality benchmarks. However, they also are subject to reduced payments if those goals are not met. In calculating revenues under upside and downside arrangements, organizations must factor in both potential savings payments for efficiencies, and deductions.

Capitation contracts require multiplying the agreed-upon fixed per-member-per-month (PMPM) payments by the health system’s attributed or assigned patient population. Under such contracts, PMPM payments are intended to cover the full cost (minus any carve outs) of providing care, so the costs would be subtracted from the total payments.a Whether the organization experiences a net gain depends largely on patient utilization, with higher utilization resulting in lower profits and higher losses.

Scenario modeling provides an invaluable tool for organizations in projecting the potential financial impacts of a proposed contract and—to the extent possible—reducing the uncertainties that are inherent with such contracts. With scenario modeling, hospitals and health systems calculate the financial implications of contracts under various operating assumptions or risk levels. These calculations allow organizations to compare the financial results of their current contract conditions with projected results of proposed shared savings or other value-based contracts.

Scenario modeling also can help a hospital’s or health system’s leaders assess how a contract might affect their organization’s credit rating by providing a detailed look at operating margins, balance sheet ratios, and cash-on-hand and cash-to-debt ratios. Healthcare finance professionals can assist in evaluating the budget implications of various contract arrangements, including the different payment models, length of the contract, and how benchmarks or targets might factor into payments. Stop-loss insurance, risk limits, and “risk corridors” also may be needed to limit losses and protect the organization’s financial position.b

Scenario Modeling: Taking a Closer Look

A 350-bed hospital with approximate net patient revenue of $450 million evaluated switching from a FFS contract with a major payer to a full-risk capitated contract, in which it would accept financial risk for inpatient and outpatient professional and institutional services for a select portion of the commercially insured population. 

Hospital leaders sought to determine how much risk the organization could accept based on the size of its regional presence, the population to be covered, its capabilities, the services to be offered through its network, and the capitated rate to be negotiated. The leaders’ goal was to understand the potential impact on profitability of various scenarios, which included different assumptions for populations and services that might be incorporated into a contract. Finding an appropriate balance between covering too few or too many lives was essential.

Scenario modeling was conducted to project the impact of four potential options:

  • Assuming full risk for 30,000 patients with a capitated rate of $210 per patient
  • Assuming full risk for 15,000 patients with a capitated rate of $222.60 per patient
  • Assuming full risk for 5,000 patients with a capitated rate of $209.24 per patient
  • Assuming full risk for 2,500 patients with a capitated rate of $194.60 per patient

As with any value-based arrangement, it was possible for the hospital to accept too much risk by taking on too large a capitated population, given that the farther patients live from the primary hospital, the more likely they are to use out-of-network providers, making it more difficult for the hospital to control costs. Conversely, accepting risk for too small a patient population also could weaken financial performance, because the associated costs of bearing that risk would be higher than the revenue generated.

Prior to evaluating the individual scenarios, the hospital obtained an analysis of its overall risk capacity. The maximum risk profile covered several factors, including the recommended number of capitated lives, contract length, and services and providers to be included. The assessment was performed based on variables such as the hospital’s current revenue/financial position, operational capacity, provider network, market, and historical experiences managing risk. 

The exhibit below illustrates the recommended risk limits for each of the key capitated contract terms as analyzed for this hospital. For example, for services included in a risk-based arrangement, the maximum recommended risk included both inpatient and outpatient services (see the third row of the exhibit). However, the target risk identified favored outpatient services because inpatient services historically had proven not very profitable for the organization. 

Exhibit 3


To test the maximum risk profile assumptions, the hospital obtained a risk scenario analysis to evaluate each of the proposed options. This analysis incorporated the projected capitation revenue and the related expenses for all inpatient and outpatient facility and professional services, including physician fees, laboratory and imaging costs, and more. Expenses associated with disease management were itemized, because improving the management of care for chronically ill patients was a high priority for the organization as a requirement for effective population health management. Also included were third-party administrator fees and stop-loss reinsurance, which would provide protection against large losses under each option.

Determining the best scenario centered on a medical loss ratio (MLR) target of 85 percent, meaning that the organization would spend about 85 percent of its revenue on expenses on direct patient care services. These scenarios were prepared to allow management to understand the potential impact of each scenario based on various assumptions and help in negotiations with the payer.

The analysis found the hospital would have accepted risk for too large a patient population under Scenario A, and too small a population under Scenarios C and D (see the exhibit below).

Exhibit 4


Scenario B, covering 15,000 members with a MLR of about $34 million, or 84.71 percent, was identified as the best option because it would allow the hospital to make its profitability targets both in terms of dollars as well as the desired percentage of revenue to expenses. 

The Importance of Being Proactive and Fiscally Vigilant

Healthcare executives and board members face crucial decisions in terms of when, with whom, and how to begin managing population health. Payers seeking to enter into value-based contracts with providers may use a “take it or leave it” approach. Healthcare leaders should keep in mind that most things are negotiable, and they should take advantage of the variety of payment models available to shape the contract terms to their organization’s specific capabilities, goals, and needs.

Once a hospital or health system is prepared to move forward with an agreement, there must be top-down management of risk—with executive buy-in and commitment at all levels—and a comprehensive partnership between payers, hospitals, and physicians. The pace at which providers adopt value-based care will differ. Although it is important to be proactive, healthcare leaders should carefully assess the full implications of entering into each new contract. In most cases, the best approach is a measured one. Incremental assumption of risk over time allows providers to build the expertise and infrastructure needed to realize the long-term benefits of value-based care for their patients and their communities.

James J. Pizzo is a managing director, Kaufman, Hall & Associates, Inc., Skokie, Ill.

Carlos Bohorquez is a vice president, Kaufman, Hall & Associates, Inc., Los Angeles, and a member of HFMA’s Southern California Chapter.

Andrew Cohen is a vice president, Kaufman, Hall & Associates, Inc., New York.

Debra Ryan is a vice president, Kaufman, Hall & Associates, Inc., Skokie, Ill.


a. A carve out names an exception in a contract. For example, a payment contract may cover all inpatient and outpatient services, but "carve out" high-risk, high-cost items such as transplant services.

b. Stop-loss insurance, risk limits, and risk corridors provide protection for healthcare organizations entering into value-based contracts by placing controls ont he amount of risk those organizations are subject to.


Understanding Patient Population Needs: Key Questions to Ask

What population will be covered by this contract?

  • If an existing contract covers this population, what level of profit is it achieving?
  • What infrastructure elements are required for successful management of this population— such as primary care and specialty providers, allied health professionals, facilities, staff, and technology support? Answers to the following questions can help in this evaluation:

– What are this population’s inpatient and outpatient utilization patterns?
– What employers cover a portion of the enrolled population, and what are the corresponding benefit designs that need to be considered?
– What has been the population’s historical growth pattern?
– What other demographic factors should be considered?

  • What is the projected utilization for this population going forward under our management?
  • What expenses do we project for this population going forward under our management?
  • Will accepting this contract interfere with the organization’s ability to work with other providers, payers, and employers in the market?
  • Will the terms and conditions of this contract contradict our charitable cause?

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