In a recent study published in JAMA, the authors concluded that hospitals might have financial disincentives for reducing surgical complications. The study confirms some well-known healthcare financial management realities: Some procedures are more profitable than others, and sometimes complications generate positive returns for hospitals. But the study was flawed.
The widely publicized study, published in April 2013, examined the relationship between surgical complications and hospital finances in a 12-hospital not-for-profit system in the southern United States.a Perhaps not surprisingly, when compared with the 32,436 patients who did not experience complications, the 1,820 patients who did had much longer lengths of stay and generated much higher costs to insurers—or, from another perspective, higher revenues to the hospitals. The new study findings were similar to those of an earlier study of hospitals in Michigan.b
Analysis of the data in the JAMA article can provide additional insight. Using these data, it is possible to calculate the mean revenue, contribution margin (defined as revenue minus variable cost), and total profit margin per patient for those who did and those who did not experience complications for the procedures examined, as shown in the exhibit below. Total revenue generated for each procedure, the proportion of revenue generated by patients who had complications, and complication rates also can be computed.
Analysis discloses that those measures varied considerably, both by procedure and by payer.
In the 12 hospitals included in the JAMA study, spine surgery was a high-volume, highly reimbursed procedure with a low complication rate—and a high profit margin. Intracranial procedures were low volume and had very high complication rates—but were also profitable. Both procedures remained profitable when patients had complications. In contrast, hospitals in the study incurred substantial losses when complications arose in patients who underwent low-cost, low-margin, and relatively high-volume procedures such as hip replacement, cholecystectomy, or appendectomy.
For every type of procedure in the study, contribution margins and total profit margins dropped, sometimes precipitously, when complications occurred. This effect varied by payer type: Postsurgical complications resulted in higher contribution margins for Medicare and private insurance patients but lower margins for Medicaid and self-pay patients.
The study confirms some healthcare financial management realities that are well known: Some procedures are more profitable than others, and sometimes complications generate positive returns for hospitals.
But the study described in the JAMA article was flawed in two ways. First, the authors’ categorization of nursing labor costs as variable costs (i.e., costs that vary with changes in patient volume) as opposed to fixed costs (which do not change) made interpretation of their findings challenging. Second, and more important for managerial purposes, the authors’ conclusions are based on average, not marginal, analysis.
Mischaracterizing Labor Costs
Labor costs in health care are largely fixed and do not change with volume at the margin, particularly in the short run.c A good analogy, which is frequently cited in discussions about healthcare safety, is provided by the airline industry.
I recently took a relatively empty flight to Amsterdam. On this flight, which costs are fixed and which are variable? Clearly, the airplane itself is a fixed cost; the price of the payment to finance the airplane does not change with the number of seats that are filled, although, as in health care, the long-term prospects of the service purveyor very much do. The fuel costs are largely fixed. Although it may cost a bit more to fly a fully loaded flight to Amsterdam, the costs associated with flying a partially full flight are not much different; favorability of tail winds is likely to have a bigger impact.
What about labor costs? Despite the flight’s ample unused capacity, it could not fly without a captain or the two first officers. Similarly, according to James, a helpful flight attendant on my trip who had a lot of time on his hands, a minimum of seven flight attendants are required to provide a degree of opulence for first-class passengers and safe travel across the Atlantic for all. These are fixed costs that are required whether the plane is virtually empty or filled to capacity. To be sure, the airlines took advantage of the unused capacity to minimize their labor costs: Three fewer flight attendants were used than would have been used on a full flight.
The airline’s greatest variable cost reduction was likely in food service, through lower consumption of items and the potential to designate unused items for use on future flights (to a degree; even airline food has a shelf life) on future flights. Offsetting these lower costs, duty-free sales revenue doubtless suffered on this flight because of the paucity of customers. Similarly, in health care, large fixed capital outlays are required to run the business, and there are few variable costs, labor not really being among them.
Underestimating Contribution Margins
Returning to the JAMA article, why does it matter whether labor costs are considered fixed or variable? It’s all about the contribution margin, which is a main focus of the JAMA article. By defining labor costs as variable, the authors overestimated variable costs and, therefore, underestimated contribution margins. Although the total margin would have remained the same, the higher contribution margins better explain hospitals’ tremendous incentive to keep beds full.
Further, higher contribution margins underscore the challenge that hospital administrators face in trying to control costs in a world with accountable care organizations: An organization’s survival depends much less on reducing complications than on gaining market share so that lower anticipated procedure rates will be applied to a larger base and high fixed costs can be covered. The consolidation that continues to occur in the airline industry foreshadows what is coming in health care.
The Limitations of the Airline Analogy
Health care might learn something about labor management as well as safety from the airline industry. But here, too, airlines have a distinct advantage in being better able to anticipate and regulate volumes. People schedule airline travel—emergency surgery, not so much. Price promotions may influence travel volumes, but healthcare services are provided as population needs arise.
This observation raises the second concern about the authors’ analysis. The inherent assumption is that healthcare resources are fungible, liquid, and nonperishable—but they are none of those. Just like suddenly freed marginal nursing labor, a freed hospital bed must be used immediately to generate revenue and, in turn, generate marginal cost benefits to the hospital—it cannot be saved for a rainy day any more than it can be transferred to another clinical service (for example, avoidance of a complication in a cardiac intensive care unit does not allow a patient to be admitted to the neurosurgical intensive care unit).
Health care’s ability to manage freed capacity generated from more efficient and effective use of care will require a larger population base, fewer but better-managed labor and capital resources, and a much-improved capacity to accurately anticipate population healthcare needs. Until that happens, health care will be burdened with unnecessary spending on labor and capital as it strives to achieve minimum staffing requirements and succeed in an industry in which safety is paramount and expected. Health care does not yet deliver on the safety promise to the degree that the airline industry does, but this much can be said: The food quality is similar.
William B. Weeks, MD, is a professor, The Geisel School of Medicine, Hanover, N.H., and a member of HFMA’s New Hampshire-Vermont Chapter.
a. Eappen, S., Lane, B.H., Rosenberg, B., et al., “Relationship Between Occurrence of Surgical Complications and Hospital Finances,” JAMA, April 17, 2013.
b. Dimick, J.B., Weeks, W.B., Karia, R.J., et al., “Who Pays for Poor Surgical Quality? Building a Business Case for Quality Improvement,” Journal of the American College of Surgeons,June 2006.
c. Rauh, S.S., Wadsworth, E.B., and Weeks, W.B., “The Fixed Cost Dilemma: What Counts When Counting Cost Reduction Efforts?” hfm, March 2010; and Rauh, S.S., Wadsworth, E.B., Weeks, W.B., ;et al., “The Savings Illusion: Why Clinical Quality Improvement Fails to Deliver Bottom-Line Results,” The New England Journal of Medicine, Dec. 14, 2011.