Frederick Stodolak 

Point-of-service estimates won't mean much if they are based on irrational and indefensible line item prices.

At a Glance

  • The integrity of patient estimates at the point of service can be compromised if the line item prices supporting them are irrational and indefensible.
  • Hospital financial managers who previously had optimized their chargemaster prices or inherited irrational chargemasters should consider a hospital zero-base pricinginitiative.

How did hospital prices become irrational? Healthcare organizations have experienced years of inadequate inflationary update factors and other adjustments under the federal inpatient and outpatient prospective payment systems. As a result, operating margins, once attained through tight operating budget controls and across-the-board price increases to payers, have suffered. With many hospitals experiencing reimbursement shortfalls, some optimized their chargemaster prices to subsidize such losses and to help maintain their financial viability. Unfortunately, those techniques have caused individual chargemaster line item prices to become irrational and indefensible.

Exhibit 1 illustrates how hospitals were able to subsidize reimbursement shortfalls without increasing overall gross charges or prices.

See Exhibit 1

exhibit-1-Hospital Zero-Base Pricing Can Make a Difference

Laboratory line items with a higher-than-average charge payer contribution factor, such as complete blood count (CBC) and urinalysis, were increased 20 percent, and those with lower-than-average contribution factors, such as potassium and magnesium, were decreased by 20 percent. The result? No overall increase in gross revenue, yet a favorable increase in net revenue of 8.4 percent.

Exhibit 2 illustrates that, for hospitals using these optimization techniques, prices that were once reasonable based on cost could easily have risen above market norms.

See Exhibit 2

exhibit-2-Hospital Zero-Base Pricing Can Make a Difference

And to the extent that some prices were decreased dramatically, prices could have fallen below allowable fee schedule (or ambulatory payment classification [APC]) rates.

Can You Defend Your Prices? Market Alignment Is Not Enough

To defend prices and reduce the chances that patient estimates will be
compromised by irrational line item prices, it is important to first assess and restructure the chargemaster prices, as necessary, to become more rational. But what is rational? To determine the rationality of prices within your chargemaster, ask yourself if you can explain to a consumer how an individual price was derived. And can you demonstrate to that same consumer how that price makes sense in relation to other items in the chargemaster? If your answer to those questions is no, then it is likely that restructuring your chargemaster pricing is in order.

How does a healthcare organization go about restructuring its prices to become more rational? Because many hospitals have deployed price optimization techniques in the past, wide variations exist in prices among competing hospitals for similar chargemaster items. Therefore, simply realigning prices within market norms may help you defend prices based on your competitors' average prices. However, this can also leave you with line item prices that don't make sense based on consumer perception of value, in relation either to other charges reflected on their bill or to the prices at competitor hospitals.

Presented with a proposed chargemaster restructuring that was based on market prices for nearby and similar hospitals, Jim Nolan, CFO, AtlantiCare Health System, Atlantic City, N.J., noticed a significant amount of deviation at the chargemaster line item level among AtlantiCare's market area hospitals-perhaps the result of years of price cross-subsidization. Nolan asked his support team, "Does it really make sense to realign our prices with competitor prices that clearly appear irrational?"

The Solution? Zero-Base Pricing

Like zero-base budgeting, hospital zero-base pricing does not use the current or prior year's chargemaster prices to establish the new gross revenue and net revenue budget. Thus hospital financial managers cannot simply apply an across-the-board increase to current prices for inclusion in the upcoming gross revenue budgets.

Instead, the hospital zero-base pricing approach may begin with the identification of missing or outdated chargemaster line items, but ultimately it focuses on re-establishing chargemaster line item unit prices. The most defensible prices for a given hospital would be those rooted in the actual unit cost to perform the service. To be sure, higher-cost hospitals might still have to defend their prices, but defending prices from the standpoint of the organization's operating efficiency is easier than trying to defend prices that bear no resemblance to reasonable cost and reflect legal but questionable optimization tactics.

Those with cost accounting systems can develop a price rooted in unit costs with consideration for overhead, uncompensated care, and reasonable profit margin. But rushing to implement such newly established prices based solely on these factors could be financially devastating.

Newly or preliminarily established cost-based prices require consideration of the following:

  • The net revenue impact
  • Public relations ramifications related to traditional loss leaders such as clinic and ambulance charges
  • The relative standing of the prices compared with fee schedule floors, freestanding facility prices, and competitor hospital prices for high-volume line items such as chest X-rays and mammograms

As Rosemary Nuzzo, director of finance at AtlantiCare Regional Medical Center, said at HFMA's 2007 Annual National Institute, "We probably ran over 85 models and simulations before we achieved a rational pricing structure."

Those without cost accounting systems can easily leverage the knowledge and experience of their department heads to develop direct unit cost estimates for each line item within their area of responsibility. Although some vendors supply relatively inexpensive software designed for this purpose, the objective is for department heads to select the best range of estimated time spent or expense incurred for those positions and line item expenses most often used within their department (for example, the 80/20 rule).

Once the department head has chosen the best range for each line item and each major position or expense item, the midpoint for each range selected can be multiplied by the usage statistics or frequency for the respective chargemaster line items to derive a weighted basis for allocating the expense associated with that position or expense item. When the expenses for all positions and nonsalary expense items have been allocated to all chargemaster line items, the individual line item amounts can be grossed up to account for nominal positions or expense items ignored in the earlier 80/20 steps. Finally, the grossed-up amounts for each chargemaster line item can be divided by the frequency statistics to derive the estimated direct unit costs for each chargemaster line item.

To account for overhead, financial managers can choose to gross up these direct unit cost amounts, whether derived from this approach or a cost accounting system, using a uniform markup factor or department-specific markup factor based on a Medicare cost report step-down or similar methodology. In this step it may be useful to establish an overhead markup factor that, after its application to the direct unit costs and multiplied by the usage statistics, reconciles with the operating expenses for the period.

Preliminary prices for initial modeling purposes can be based on the fully allocated expenses at the unit cost level marked up for uncompensated care costs, other allowances, and a necessary operating margin provision, as shown in Exhibit 3.

See Exhibit 3

exhibit-3-Hospital Zero-Base Pricing Can Make a Difference

In this exhibit, the zero-base price is considered preliminary because there is still more to do before these cost-based prices can be safely implemented.

Favorable Outcomes

As illustrated in Exhibit 4, the final hospital zero-base pricing model favorably realigns prices based on cost (as adjusted for overhead, uncompensated care, and profit margin consideration) but with consideration given to market prices, fee schedule floors, gross and net revenue objectives, and more.

See Exhibit 4

exhibit-4-Hospital Zero-Base Pricing Can Make a Difference

This is in sharp contrast to the situation depicted in Exhibit 2, in which prices bear no resemblance to the cost of providing the service, make no sense in relation to each other or their competitors, and are in some instances actually below contractually agreed-upon amounts from payers.

For many financial managers and administrators, the most favorable benefit of hospital zero-base pricing is that it permits them to understand, explain, defend, and document how each chargemaster line item price was derived and why it makes sense. And for those implementing a system to provide patient estimates, it's a natural complementary step.


Frederick Stodolak is chairman and CEO, Panacea Healthcare Solutions, LLC, Tampa, Fla., and a member of HFMA's New Jersey Chapter.

Important steps to consider for your hospital zero-base pricing initiative (click to enlarge):

exhibit-5-HospitalZero

Publication Date: Monday, September 01, 2008

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