Michael Nugent

The secret to achieving an effective pricing strategy is to consider how to accelerate the development of your organization's pricing core competency while avoiding common potholes.


At a Glance 

There are at least four things your organization can do to accelerate progress toward more defensible, margin-enhancing prices and rates: 

  • Choose the right starting point 
  • Adopt a pricing formula 
  • Create a pricing toolkit 
  • Align pricing roles and responsibilities 

Until recently, hospitals have not had to manage prices as other industries have. Insured patients have generally been shielded from healthcare prices and rates. Price-based competition has been quite limited. And the notion of a community attacking its hometown hospital's pricing practices has been implausible to most hospital executives.

Consequently, few hospitals have considered broader strategic issues such as patient price sensitivity, competitor response, or public perception when setting prices and rates. Rather, hospitals could generally count on wholesale commercial price increases to offset expense increases, public payer underpayments, and no-pays. And raise prices they have, as exhibited by long-term trends in private payer payment-to-cost ratios.

But hospitals' ability to buoy margins and investment levels through annual price and rate increases is under siege. Increased competition, new substitutes, and payer consolidation are already reducing providers' pricing power, particularly for commodity services. Add higher patient cost sharing and price transparency to the mix, and a hospital's ability to automatically shift costs to patients will diminish further. If hospitals are to sustain margins, the focus of pricing and contracting will need to ultimately expand from shifting costs to reflecting, if not creating, differentiated value for the price. Organizations that fail to create and demonstrate value for the price will be more likely to experience margin and share declines as price becomes a more important variable in how patients and providers relate to one another.

Historical Pricing Approaches: Diminishing Returns, Increasing Risk

Unfortunately, hospitals' traditional approaches to pricing and contracting are ill-equipped for a more transparent, value-oriented marketplace. In fact, current approaches not only fall short, but also subject hospitals to undue risks-if not missed opportunities.

Take, for example, "strategic pricing" or "price optimization." In this approach, hospitals concentrate their price increases on high-volume services within their percentage-of-charge commercial contracts. As a result, what looks like a 5 percent across-the-board increase to some payers may actually be 7 percent or 8 percent because of the way the price increases are distributed.

See Exhibit 1 

/uploadedImages/exhibit-1-Picking Up the Pace.jpg 

Although many hospitals have reaped immediate revenue improvements from this approach, payers have begun to push back. Furthermore, years of this approach have generated unjustifiable price-to-cost markups for services patients are most likely to receive (including the infamous $100 aspirin). Worse yet, these high prices have attracted niche competitors, many of whom have been able to enter the market at relatively high price levels but low volume and productivity levels.

What once may have seemed like a rational pricing decision has exacerbated hospitals' market share losses over time, particularly in high-margin ambulatory services. In response, some hospitals have hastily lowered their prices hoping to gain back lost share, rather than differentiating services on outcomes, access, or service. Lower-cost competitors have subsequently matched hospitals' price reductions, resulting in price wars and leaving hospitals at a loss for how the situation arose in the first place.

The systemic problem is that pricing and contracting strategy has overemphasized market leverage to shift costs, rather than reflecting (or enhancing) value for the price. And when price transparency, which accelerates downward price pressure, is added to the mix, three go-forward pricing and contracting imperatives emerge:

  • Prices/rates must be defensible.
  • Prices/rates must reflect (if not create) differentiated value for the price.
  • Prices/rates should support service line and business unit margin targets.

This is not to say that size and leverage will no longer matter when it comes time to negotiate rates. Rather, a singular emphasis on size and leverage (to the detriment of the three imperatives) leaves an organization more susceptible than ever to patient backlash, price wars, market share losses, and decreased margins. How senior financial leaders pursue these new pricing and contracting imperatives will therefore have a major impact on their organizations' long-term financial health and competitive position.

How Hospitals Are Responding

The very question of "how" to implement a pricing strategy has no easy answer. Although generalized pricing approaches exist (Nugent, M., "The Price is Right?" hfm, December 2004), their applicability is limited to helping an organization envision the ideal process, with minimal attention to the organization's readiness to implement. Furthermore, a "one size fits all" approach tends to overlook the fact that pricing and contracting represent a core, competitive competency that is as much about people, systems, and strategy as it is process. Thus, the real secret to achieving defensible, sustainable, and value-oriented prices is to consider how to accelerate the development of your organization's pricing core competency while avoiding common mistakes.

Accelerator 1: Choose the Right Starting Point.

"Where do we start?" is the most common question we encounter across the country. In practice, we observe that providers tend to pick one of three starting points.

Wait and see. Despite the risks associated with current pricing and contracting practices, some healthcare organizations still opt for a "wait and see" approach. Until their prices or rates come under public scrutiny, these hospitals will stick to traditional techniques, including benchmarking prices to Medicare, selectively increasing chargemaster prices, and avoiding outrageous markups on inexpensive drugs and supplies.

For hospitals with limited competition, this approach may be appropriate. But for hospitals with impending competition and a historical overreliance on annual price increases, the "we'll get to pricing in our spare time" approach ignores the inevitability of more price-based competition.

Rational pricing. Currently, many health systems are considering a rational pricing and contracting initiative to both defend their current prices and opportunistically enhance their market position. These organizations recognize the shortcomings of historical "strategic pricing" or "price optimization" approaches-and seek a more robust set of pricing and contracting principles, tools, and tactics to justify price and rate changes.

As with any "new" approach to pricing, the major risks relate to following the masses or reverting to the path of least resistance. Some common mistakes or traps include:

  • Simply posting chargemaster prices without other data to demonstrate the overall value (in terms of outcomes, service, and access) for the price
  • Ignoring contracted rates and patient out-of-pockets (and focusing on publishing only chargemaster prices)
  • Overlooking the importance of senior management buy-in to the process
  • Pursuing price decreases on more commoditized ambulatory services without a clear sense of cost structure, patient price sensitivity, or breakeven volume required to maintain net margin
  • Allocating insufficient resources and overlooking the fact that an internally rational, transparent process is a prerequisite for externally rational, transparent prices
  • Blaming the government for hospitals' having to charge such high prices (which rarely quells the ire of the influential board member, employer, or local public action group

Value pricing. Providers are increasingly using pricing as an internal discipline to align customer needs with how the organization creates value for the price. Rather than simply repricing current offerings, these organizations start by strategically assessing their price-versus-value relationship as part of a broader price transparency or retail pricing and contracting strategy. Common questions include:

  • How and where should we compete on value (rather than risk competing only on price)?
  • Which product/service features (e.g., access, personalization, outcomes, timeliness) warrant a premium price given the value? To whom?
  • What sorts of price innovations (e.g., package pricing, special financing, money-back guarantee, loyalty programs, peak pricing) would create value for which patient segments?
  • Which cost improvements (ergo value enhancements) are required to offer services at differentiated price points?
  • How will we demonstrate value to payers and improve reimbursement on our more proprietary, differentiated services?

These questions force a more deliberate discussion of how volume, service mix, cost management, capital investments, and prices will achieve annual budget targets such as net operating income. These discussions can even uncover new ways to use price to enhance margins, including peak pricing.

See Exhibit 2 

/uploadedImages/exhibit-2-Picking Up the Pace.jpg 

See Exhibit 3 

/uploadedImages/exhibit-3-Picking Up the Pace.jpg 

Accelerator 2: Establish a Common Pricing Formula

A second accelerator to managing defensible, margin-enhancing prices is a simple pricing formula. The primary advantage of a formula is to improve internal transparency around key pricing decisions that would otherwise go unrecognized.

One of the most basic pricing formulas is:

Price =  Base Rate  X  Markup Factor 

The benefit of a base rate is that it creates one common organizationwide starting point for setting all prices. We recommend that hospitals consider following three steps to set base rates.

  1. Carefully define the services you'll price, reflecting on costs. Consumers naturally relate to costs when thinking about whether any price is fair or not. Therefore, actual costs should be the default for base rate when possible. Furthermore, investments in good cost information can shed insights into how providers can reduce costs, transfer risk, and create more value for the same or even a higher price.
  2. Where cost data are murky, consider a cost proxy such as an ambulatory payment classification or relative value unit. These cost proxies are commonly used to set base rates for ancillary services, but also can be used to level-set other prices.
  3. Compare prices with the market. When cost and cost proxy data are not available-and as a final filter to justify prices-market comparisons to publicly available MedPAR and AHRQ Healthcare Cost and Utilization Project data should be used to justify the base rate.

The purpose of the markup is to justify why prices should be higher or lower than those of competitors, and how much higher or lower. Thus the markup factor is broken into two separate decisions.

Markup strategy. The markup strategy decision depends on the particular service's competitive position, its overall strategic objectives, and cost position in the market. By separating out markup strategy from markup magnitude, two important questions are raised:

  • Under what circumstances should we premium-price versus lower our price versus ignore a competitor's price change?
  • Under what circumstances should pricing be used to attract specific customer segments?

Markup magnitude. The markup magnitude depends on the relationship between price and volume, and thus addresses the following key issues:

  • What differential value does our offering provide relative to competitors?
  • Given our costs, how much would volumes have to increase to benefit from a price reduction?
  • How much could volumes decline before a price increase becomes detrimental to the organization?
  • Is the markup magnitude defensible in light of the relative value we deliver?
  • How will competitors respond?

In summary, a pricing formula creates a level of internal transparency, which is a prerequisite to external transparency. In doing so, it forces more enlightened pricing and contracting conversations than most organizations have pursued historically.

Accelerator 3: Create a Pricing Toolkit

The intent of a pricing toolkit is to inform day-to-day pricing and contracting decisions. In its most primitive form, the toolkit should identify short-term pricing vulnerabilities, including instances in which prices are less than costs or well out of range of competitors. In its more advanced form, the toolkit should evaluate the tradeoffs between volume, service mix, cost reductions, capital, pricing, and contracting decisions in hitting specific budget targets such as net operating income and return on assets. To do so, organizations are beginning to integrate volume forecasts, market reimbursement, cost and capacity trends, and even patient price-sensitivity information to make pricing and contracting decisions more strategically.

See Exhibit 4 

/uploadedImages/exhibit-4-Picking Up the Pace.jpg 

Accelerator 4: Align Pricing Roles and Responsibilities

Pricing functions are typically widely distributed throughout most hospitals. Numerous individuals other than finance are involved, including department managers, supply chain directors, strategic planning, and even the board. This fragmentation contributes to unclear ownership and opaque processes, which create barriers for defensible, value-oriented prices and rates.

Thus a key accelerator becomes how to align a team beyond the finance department to execute a pricing and contracting strategy. Although no "one size fits all" approach exists, some patterns are emerging from organizations moving most rapidly toward rational, value-based pricing:

  • CFO role. Sponsors the rational or value-based pricing initiative; takes leadership role in articulating pricing intent and process changes to key constituents
  • VP, revenue management role. Designs how pricing strategy is integrated with existing billing, coding, collections, scheduling, and eligibility functions
  • VP, contracting role. Translates pricing strategy into long-term contracting strategy, including prioritization of contract renegotiations and package pricing opportunities
  • VP, strategy, marketing, and business development role. Provides critical input to customer segmentation, price sensitivity analysis, pricing scenario analysis, and markup decisions; educates community on price versus value relationship; partners with physicians to price for growth; plans new products and services such as peak pricing and premium offerings
  • COO role. Defines the role of department and service line directors in managing prices and rates
  • Decision support. Provides dedicated time to support pricing initiatives (rather than the more typical "do it in your spare time" approach)
  • Project management office. Provides implementation project management and resources for specific initiatives such as toolkit development and posting and quoting prices

Picking Up the Pace

Price transparency promises to accelerate the pace at which hospitals will expand their pricing and contracting focus from cost shifting to demonstrating, if not creating, value. In doing so, historical price-setting tactics such as across-the-board markups and strategic pricing will give way to more consumer-oriented price management competencies employed in other industries. Ultimately, finance leadership will play a key role in defining the right starting point, adopting pricing formulas, developing the tools, and crafting new roles and responsibilities to best position the organization for a more transparent, consumer-oriented environment.


Michael Nugent, CHFP, is director, provider practice, Navigant Consulting, Inc., Chicago, and a member of HFMA's First Illinois Chapter (mnugent@navigantconsulting.com).


Why Invest in a Pricing and Contracting Core Competency?

Short-term benefits/deliverables 

  • More informed senior management team and board as to key pricing risks and opportunities
  • Elimination of specific pricing vulnerabilities
  • Preparation for mandated price and/or rate disclosure
  • Defensible pricing formula/methodology
  • Robust, standardized analytic toolkit
  • Simplified and internally transparent price setting and management process
  • Uniform list of chargeable items across facilities
  • Improved cost accounting policies/procedures across facilities
  • Updated billing and collection policies (including charity care)
  • Ability to selectively post/quote prices and rates
  • Tactics to align contracts, pricing, and overall market strategy
  • Net revenue improvement

Longer-term benefits/deliverables 

  • Alignment of prices/rates with other organizationwide strategic imperatives (e.g., quality)
  • New insights into how to grow/defend market position
  • New consumer-oriented products and services
  • Ability to leverage pricing discipline along with portfolio and cost management techniques to make market exit/entry decisions more strategically

CFOs' Top 10 Questions

"How to" pricing questions that CFOs frequently ask include:

  • Where do we start?
  • What's the destination?
  • What are the common mistakes?
  • What is contracting's role relative to prices? Do they need to be involved?
  • Is there a magic pricing formula we can use?
  • Under what circumstances should we raise versus lower versus maintain prices?
  • When and how do we post/quote prices?
  • How do we avert a price war?
  • How do we determine when to change course?
  • What systems and people requirements exist?

Rational Pricing Checklist

  • Conduct board and senior management education sessions on state of pricing.
  • Conduct community education on pricing and billing.
  • Update billing and collections policies (including charity care).
  • Develop ongoing approach to benchmark charges/rates.
  • Standardize chargemaster with key price and compliance vulnerabilities resolved.
  • Develop uniform list of chargeable items.
  • Update cost accounting policies/procedures.
  • Establish standard defensible pricing formula/methodology.
  • Develop approach to post/quote prices and rates.
  • Create pricing strategies to grow/defend share.
  • Set higher margins for services with demonstrable, value-added features.
  • Set contract renegotiation timelines consistent with overall pricing strategy.

Publication Date: Thursday, October 01, 2009

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