William O. Cleverley

Issues and Actions

Pricing is an effective strategy for increasing hospital revenue.

  • Usually between 10 and 25 percent of a hospital's business is charge-related.
  • Hospital executives should consider price-driven payment, such as that affected by carve-out arrangements.
  • Critical pricing issues must be thoroughly understood to perform an effective pricing study.

Hospitals struggling to offset financial losses resulting from caring for Medicare and managed care patients need a systematic pricing strategy.

To many hospital financial executives, pricing strategy may seem unimportant, given the current preponderance of fixed-fee payment. The Medicare and Medicaid programs usually pay for both inpatient and outpatient care on a prospective basis. Most managed care programs pay for inpatient care on a DRG or per diem basis, with outpatient care payment provisions based on fee schedules or discounted charges. Recovery rates for self-pay patients, who do pay on a charge basis, may even be low because of high bad-debt or charity care write-offs.

Pricing thus would seem to have a minimal effect on profitability. But our pricing studies indicate that the actual percentage of a hospital's total business that is charge-related usually runs between 10 and 25 percent.

Hospital executives often overlook other types of price-driven payment, including payment from the following sources:

  • Self-pay patients
  • Indemnity payers
  • Managed care plans with outpatient percentage of charge payment provisions
  • Specific drug and prosthesis carve-out arrangements
  • Stop-loss thresholds
  • Medicare outliers

Several of these areas are not often identified as price-related. For example, some contracts specify percentage-of-charge payment for high-cost drugs and/or prostheses. Payment for these item codes would be related to their prices. Stop-loss thresholds are becoming increasingly important as charges rise above thresholds. In many contracts, payment for cases above the threshold is a percentage-of-charge arrangement. Charges can have an impact on Medicare payment. Much has been made of the pricing impact upon inpatient outliers, but Medicare outpatient outliers, whether on a claim or line-item basis, also are related to charges through the methodology of ratio of cost to charges (RCC). Higher charges will increase payments for Medicare device pass-throughs.

Finally, Medicare outpatient transitional corridor payments are based upon differences between payment and cost, where cost is the result of departmental RCCs multiplied by charges.

When all of these areas are added, most acute care hospitals will have charge recovery percentages equal to at least 10 percent, and many will be above this level. 

Determining Price Levels

Many factors can affect pricing decisions, especially in competitive markets. The key underlying economic principle is "price elasticity." Simply stated, will demand drop if prices are increased, and if so, by how much? Because hospital customers have varying degrees of price sensitivity, price elasticity is hard to evaluate. Many healthcare executives believe that outpatient procedures are more price-elastic than are inpatient procedures, because patients pay either all of the charge or a greater proportion of it. High prices also can drive managed care plans with payment provisions based upon charges to other providers, although the reaction is not so quick as that experienced with self-pay patients.

Price-elasticity issues are important in pricing, but in many cases, hospitals have a great deal of pricing latitude. Raising prices may not materially affect short-term demand. If hospitals, both tax-exempt and taxable, were seeking optimal profit, hospital prices would be at much higher levels. Hospitals must, however, set rates at levels sufficient to maintain their financial viability. But what is that level? Prices should be set to cover average reasonable costs, losses from payers that pay less than cost, and reasonable return on investment (ROI).

Hospitals that lose money on Medicare and managed care contracts must raise rates sharply to a limited charge-related payer base. Large write-offs or discounts to the charge-related payer base often escalate prices to levels that bear little relationship to costs. This price escalation reflects the economic environment facing hospitals today. Hospitals should not be embarrassed by high prices as long as their costs are reasonable and their ROI or level of profit is not excessive.

The key factor in the above two conditions is ROI. A defensible return on equity for most hospitals is at least 8.0 percent. This level will permit reasonable growth and acquisition of new technology and working capital expansion. Higher levels would be needed for hospitals with above-average financial leverage. 

Setting Price Increases

Hospitals that initiate price changes usually adopt one of two strategies in an attempt to realize reasonable revenue goals. The first approach is the "across-the-board" increase. In this method, all item codes in the charge description master (CDM) are increased at a constant percentage. The second approach is selective price increases or decreases for each item code to achieve a stated overall charge increase. The latter approach usually attempts to place price increases in areas where recovery opportunities are greatest. For example, item codes with little or no charge-related payer volume would be poor candidates for price increases. Pricing studies suggest that selective price increase strategies are more effective than an overall increase, often generating 20 to 50 percent more revenue.

Understanding and managing critical issues relating to effective pricing will enhance the effectiveness of any pricing study, whether it is done internally or with outside assistance. Before starting a pricing study, three data sets must be available: 

  • Current CDM
  • Three to nine months of claims with line-item detail
  • Payer contract information

CDM review. Say, for example, the CDM of a hypothetical hospital contained 10,641 item codes. A review of three months of claims finds that 3,410 line items, or 32 percent, were actually used. This finding is not unusual; it is common for the average percentage of used item codes to be about 34 percent, with a range from 20 to 60 percent.

The primary issue that hospitals must face is why so many item codes in their CDMs are used so infrequently. The inclusion of infrequently used or unused codes increases CDM complexity and makes CDM management more difficult. Hospital executives should review item code utilization and consider eliminating codes that are not used or used fewer than five times per year.

Ideally, pricing studies follow CDM reviews, but even if a CDM review has just been completed, a limited desk review of the CDM and claims should be conducted to review the following areas: 

  • Deleted or invalid CPT/HCPCS codes
  • Duplicated line items
  • Medicare noncovered items
  • Item codes requiring CPT code for Medicare payment
  • Incorrect revenue codes
  • Pass-through codes

Line-item claims. The line-item claims provide the basis for determining recovery rates by item code. A recovery rate is simply the percentage of any charge increase that will be recovered as increased profit. Recovery rates may range from 0 percent (no payers pay charges) to 100 percent (all payers pay 100 percent of charges).

Some pricing analysts will choose to use revenue and use reports in lieu of line-item claims. These data may be relatively easy to obtain, but significant limitations are associated with their use in a pricing study. Most of the problems revolve around defining actual payment provisions. For example, stop-loss thresholds could not be modeled from revenue and use data. A variety of complex outpatient payment provisions also could be lost, which would affect the accuracy of estimated recovery rates.

Recovery rates are defined by relating payer frequencies by item code to payer payment terms. An item code that had only Medicare patient utilization would have a zero recovery. The major issue in claims sampling is the period of time to review. Claims should be sampled for a minimum of three months and a maximum of nine to 12 months. Sample periods less than three months can lead to a bias in estimating payer frequencies by item code. A larger sample over a longer time period should be used when seasonality could be a significant factor in utilization. For example, hospitals in Florida with high Medicare utilization in the winter may require a sample period of nine months to a year.

When CDM changes have taken place in the claims period, the claims data may need to be remapped to reflect the current CDM.

Payer contract information. A review of all of the claims data will identify the relevant payers represented in the claims sample. Each of the payer categories must be reviewed to appropriately define payment terms. This review is perhaps the most critical part of any pricing study. If payment terms are not accurately modeled, the study's conclusions will be flawed. Key areas that should be examined are: 

  • Presence of stop-loss provisions
  • Presence of carve-outs for drugs or devices
  • Nongrouped outpatient surgical categories
  • Expected recovery on self-pay portions
  • Presence of fee schedules for selected outpatient areas, such as laboratory and radiology

Although many payers may not have a hospital contract, these payers may account for a relatively small dollar volume. Hospitals should validate specific recovery rates for these payers and not apply a universal factor that may not be accurate. Dollar volumes for these payers, although small, may represent a substantial percentage of the total recovery rate for many item codes. 

Model Constraints

Most pricing studies deal with three major model constraints: 

  • Absolute total charge increase
  • Corridors for individual item codes
  • Competitive price limits

In the hypothetical hospital, a 10 percent total charge increase would yield $17,641,600 on an annualized basis. The larger this number is, the greater the potential for increased profit. Hospitals with either low current prices or strong market positions usually are more comfortable with larger rate increases. Oftentimes, pharmacy and medical supplies items may be excluded from the pricing study because these prices may be formula-driven. If these items are excluded, the rate base is reduced by about 15 to 25 percent, depending upon the hospital's service profile.

Rate corridors limit individual item code price changes. A rule of thumb in pricing studies is to limit the corridors to no more than twice the absolute rate increase. For example, a 10 percent overall rate increase would limit rate corridors to +20 percent and -20 percent. Larger corridors permit hospitals to load more of the total rate increase into areas with higher recovery rates, thus achieving optimal rate-increase revenue.

There are, however, two major disadvantages to high rate corridors. First, large corridors may destroy present pricing relativity. For example, consider polycillin (250 mg) and polycillin (500 mg) priced at $25 and $27, respectively. With 20 percent rate corridors, it is possible that the polycillin 250 mg dosage could be repriced to $30 and the 500 mg dosage repriced to $21.60, which is not logical or defensible. Careful review of relative price differentials must be undertaken in any pricing study, but large rate corridors greatly increase the probability of undesired results. Second, large rate corridors can also kill the goose that laid the golden egg: By increasing prices to payers that pay charges, the hospital may hurt the payer's competitive position to the extent that it eventually may be forced to exit the market, leaving the hospital with low payments from fixed-fee payers.

The inclusion of competitive price restraints in the pricing study can help reduce the negative effects of large rate corridors by ensuring that the hospital's prices are close to those of market competitors. Competitor prices are usually taken from large public-use file databases, specifically MedPAR and the Standard Analytical Outpatient File. Both databases are derived from Medicare claims and provide comparative prices for both room rates and procedures with a CPT or HCPCS code. The major areas that are excluded from the pricing study are pharmacy and medical supplies. Because these prices are often formula driven, the comparisons may not be so important.

Competitive price constraints can dampen profit significantly because this presumably is a high-price hospital, but that constraint also would likely help create more defensible pricing in its market. Competitive price constraints will reduce revenue potential in most cases, and management must decide whether they want short-term gains or long-term competitive market positions.

Selective price increases combined with detailed competitive price constraints may be the most effective strategy for increasing hospital net revenue. It is critical, however, to raise prices in a manner that is defensible to the hospital's board of directors and the community. Raising prices when profits are already more than adequate or when costs are high is not a sound strategy. Not raising prices when profits are low and costs are reasonable is also not a sound strategy and only pushes the costs of care on to a future generation.

William O. Cleverley, PhD, is president, Cleverley & Associates, Columbus, Ohio, and professor emeritus, The Ohio State University, Columbus.

Questions or comments regarding this article may be sent to the author at wcleverley@cleverleyassociates.com.

Publication Date: Tuesday, April 01, 2003

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