Michael Nugent

For optimal price setting, you'll need a strategic focus that adjusts for recent industry trends.

At a Glance 

Given recent industry trends such as capital shortfalls, increased public scrutiny, and increased patient cost sharing, providers are well advised to revisit their pricing strategy and processes. Actions likely will include: 

  • Defining the organization's pricing intent 
  • Defining customer segments 
  • Segmenting services 
  • Establishing a competitive fact base 
  • Understanding pricing alternatives 
  • Calculating a range of prices 
  • Conducting sensitivity and scenario analyses across contractual portfolios the price is right? 

At most healthcare systems, commercial pricing approaches tend to follow three common themes: Most systems will price at the margin, meaning they consider pricing new business to cover variable costs and margin if capacity exists. If no excess capacity exists, then they consider overhead costs as well. Or they may cross-subsidize, supporting money-losing procedures and contracts with profitable ones. Or they may simply test what the market will bear by instituting across-the-board increases to the charge description master.

These days, however, such tried-and-true strategies may no longer cut it.

What's Changing?

Three emerging market dynamics suggest hospitals should reassess their pricing practices:

  • Capital shortfalls
  • Increased patient cost sharing
  • Greater public scrutiny of hospital pricing practices

Capital shortfalls. Today's restrictive capital funding environment poses a profound and multifaceted challenge to healthcare leaders as they strive to access capital that will accommodate increasing patient demand and technological innovation. Aging facilities, staffing shortages, governmental deficits, and marginal industry operating performance do nothing but exacerbate the impending capital gap that many hospitals face.

As hospitals explore strategies to improve their financial outlook, strategic pricing becomes of greater significance. Assuming stable volumes, a 4 percent margin, and an 80/20 fixed-to-variable cost structure, a 1 percent across-the-board price increase would generate a 25 percent increase in a typical hospital's operating profits. Such a gain would be equivalent to a 5 percent fall in variable costs and be greater than the impact of a 1 percent increase in volume. (Note: Pricing can have a downside as well. For example, nearly a 7 percent increase in volume would be required to offset a 5 percent decrease in price-a situation that could conceivably occur if the hospital inadvertently initiated a price war with a competitor.)

Putting aside the power of pricing for a moment, the issue that naturally comes to mind is which prices hospitals can influence. Experience indicates that hospitals traditionally have had particular latitude on commercially insured outpatient services, stop-loss arrangements, and carve-out pricing for devices and drugs-which in sum can represent 10 percent of a hospital's total business. In theory, a hospital that increases its price 10 percent on 10 percent of its business could achieve a 25 percent increase in margin (from 4 to 5 percent). This figure is significant given the capital gap that many hospitals face.

Increased patient cost sharing. Employer-sponsored health care represents $450 billion in health spending and 30 to 40 percent of a typical hospital's payer mix, according to CMS. Assuming premium increases of 10 to 15 percent per year, the average family's healthcare insurance premiums will double from $6,500 to $13,000 per employee in as few as five years. Consequently, most experts predict patient cost sharing will continue to outpace premium increases as employers seek to control costs through new health insurance products, decreased coverage, and pay-for-performance arrangements.

Employee spending accounts may have the most potential to increase price transparency and impact patient behavior. In theory, the employee will become more accountable for healthcare decisions under these arrangements where the employer funds a discretionary spending account alongside a high deductible health plan. In an ideal world, employees would forgo duplicative services and research providers more carefully. On the flip side, if the plan design is not carefully managed, spending accounts could cause some individuals to save for nonmedically necessary services (e.g., cosmetic surgery) instead of receiving medically necessary ones. Furthermore, unless proper incentives are adopted, high-deductible spending account plan designs have the potential to disrupt the insurance pool by attracting a disproportionate share of the young and healthy.

Assuming this cost-sharing trend results in more informed patients with strong incentives to manage their healthcare spending, hospitals will need to consider setting prices not only based on leverage with insurers, but also based on what patients will pay. This need will be most pronounced in more retail-oriented elective services where substitutes exist. Increased price transparency will also force providers to rethink how they cross-subsidize particular services (such as subsidizing inpatient trauma, psychiatry, general medicine, and pediatrics with highly competitive outpatient surgery and imaging services).

Increased price transparency also may lead to some reconfiguration of service lines and physical assets to achieve economies of scale/scope and competitive differentiation in the minds of patients. Ultimately, these changing economics will result in hospitals needing to reexamine pricing in the context of their overall competitive strategy.

Increased public scrutiny. The days of setting charges artificially high to maximize payment are numbered. Increased public scrutiny of hospital pricing, exemplified in recent news reports and congressional hearings, should be expected as the number of uninsured and cost sharing continue to increase.

What Should You Do?

Keeping in mind these changing trends is important when examining pricing. Most organizations are knowledgeable of the mechanics of pricing, but they frequently do not address the strategic context in which pricing decisions should be made.

The following seven steps can translate an organization's competitive strategy into a more informed and justifiable set of prices given the context of today's changing times.

1. Define the organization's pricing intent. Defining pricing intent typically involves increasing revenue, reducing risk, and aligning prices with the organization's overall competitive strategy and goals. Pricing decisions need to consider the following issues:

  • Distinguishing products and services from competitors on factors including, but not limited to, price
  • Increasing revenue as a function of price, volume, capacity, and collections
  • Creating a gateway for more profitable services
  • Rewarding customer loyalty
  • Improving customer perception

2. Define customer segments. Customer segmentation is a common technique used across industries to match product and price to customer. Hospitals rarely segment customers beyond the payer (Medicare, Medicaid, or commercial). However, as consumer purchasing power increases, market segmentation will become a useful tool to allow providers to tailor information,products, and incentives to the unique needs of a particular consumer segment.

Several methods of segmentation exist, including defining consumers by various demographic characteristics, such as gender, insurer, location, or age; clinical characteristics, such as treatment or condition; or psychographic characteristics, such as willingness to pay or lifestyle. The challenge for health systems is to harness customer perception and utilization data to perform an actionable segmentation analysis. Those that do are bound to find ample opportunities to better serve their market and optimize available pricing opportunities.

3. Segment services. Not surprisingly, researchers have determined that patient price sensitivity and utilization differs not only by customer segment, but also by type of service. One common theme is that patients' price sensitivity and utilization depends on whether a service is elective or emergency. (See "Price Sensitivity by Type of Service" chart on page 60.)

In general, patients are more sensitive to pricing for elective services than acute services. Price sensitivity also depends on the number of substitutes available. The greater the number of substitutes, the more sensitive consumers will be to price.

Historically, employee cost-sharing incentives have not been aligned with these service characteristics. For example, low dollar copayments for brand-name drugs where generic substitutes exist run counter to the fact that many patients would pay more for brand name drugs. Flat physician copayments, regardless of specialty or expertise, represent another example where patients are willing to pay a premium.

Payers have begun to recognize and test the limits of patients' price sensitivity through various cost-sharing arrangements. As these trends continue, hospitals should keep tabs on how consumers react and adjust their pricing models accordingly.

Notable examples of changing incentives include the following:

  • Increasing incentives for patients to receive preventive care, such as annual checkups and immunizations, given that research shows that many patients would forgo these services as cost sharing increases
  • Increasing generic vs. brand-name prescription drug copayment differentials to further incentivize patients to elect generics where substitutes are available
  • Targeting and creating incentives for patients with specific chronic diseases to join a separate disease management program and comply with the protocols, given research that shows patient price sensitivity and compliance problems with sustaining chronic care regimens
  • Increasing cost sharing for elective/discretionary care-whether it be through an extra premium or higher copayments/coinsurance
  • Increasing cost sharing for emergency cases (Although controversial, the rationale is that there are few substitutes for true emergency care, so the price charged should reflect the value derived.)

Hospitals need to pay particular attention to services where payers are drastically reducing coverage and then adjust their rates in accordance with what patients are actually willing to pay.

4. Establish a competitive fact base. Hospitals are more often comparing themselves with competitors when pricing a service. However, few hospitals conduct the competitive pricing and utilization analysis at the payer, episode, procedure, and customer segment levels. Strategic pricing requires a detailed analysis at these levels to uncover opportunities to adjust prices for particular services and customers based on patient price sensitivity and competitive dynamics.

5. Understand the pricing alternatives. Health care in general has been slow to adopt other industries' pricing approaches. A variety of pricing alternatives from other industries can modify patients' price sensitivities. Several of these pricing alternatives can be achieved through traditional mechanisms, such as discount-off charges, rebates, per diems, and capitation (where regulations allow).

6. Calculate a range of prices. The traditional approach to pricing typically considers margin requirements, cost structure, and prior contractual discounts. However, when strategically reassessing pricing, the net present value of the benefits accrued to the patient and employer should be considered to establish a maximum price point. These benefits may include everything from disability days saved to improved morbidity. Then a separate bottom-up costing method can be used to estimate the minimum price. If the two estimates overlap, the provider may find it doesn't make sense to deliver the service unless the market allows the premium price.

7. Conduct sensitivity and scenario analyses across contractual portfolios. The price points from the previous step should be combined with projected volumes and modeled under different market scenarios to determine the optimal portfolios of prices. Finally, sensitivity analysis should consider the following types of issues:

  • How will pricing affect the cash, debt, and margin requirements associated with the current or desired bond rating?
  • How will competitors react?
  • What additional administrative requirements are necessary to execute the contract?

Pricing for Competitive Advantage

As prices increase and employers reduce benefits, competition among healthcare providers will continue to intensify-particularly for less differentiated elective services. Increased competition will require hospitals to better understand customers' needs, price sensitivities, product and service substitutes, and means for competitive advantage. Hospitals that revisit pricing strategies and processes now will be best positioned to capture first mover advantages and shape their competitive landscape.

 Michael Nugent, CHFP, is a manager, Tiber Group LLC, Chicago, and a member of HFMA's First Illinois Chapter.

Publication Date: Wednesday, December 01, 2004

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