Michael E. Nugent

More and more provider-payer contract negotiations are turning into an adversarial "pay me more/pay you less" exchange. To excel in an emerging value-based purchasing environment, providers need to partner with their top payers.

At a Glance

To move beyond the "pay me more"/"pay you less" black hole, providers and payers need to work with their internal constituencies and each other to:

  • Inspire their organizations to develop a disciplined "pay me right" strategy
  • Understand patients' price sensitivities and purchasing behavior
  • Redesign what and how they are paid   
  • Hold each other mutually accountable to a multiyear implementation plan that shares risks and rewards

Providers everywhere are feeling the pain. The current economic downturn has increased pressure on both payers' and providers' bottom lines, as investment income, volumes, and collections have languished.

For providers, it's a good time for a reality check:

  • What might the Obama administration's proposed payment reforms do to your organization's financial position?
  • Do you have the market clout to achieve 6 percent to 12 percent annual increases in an ever- consolidating managed care environment?
  • Even if you do, will a tax-exempt community board approve increases of this magnitude when every other economic indicator is down?
  • Will your typical hospitalized patient be able to spend 20 percent or more of his or her income on healthcare expenses by 2016? Or is today's price increase tomorrow's bad debt?

These questions underscore the significant problems that providers face today, and they expose the fatal flaws with provider's historical "pay me more" contracting strategy. But if there is a silver lining in the downturn, it is that these fatal flaws with the current payment system are motivating providers, as well as payers, to seriously reevaluate the details of what and how they pay or are paid. In fact, an increasing number of payers and providers are working together to jointly develop their "pay me right" road map.

The "Pay Me Right" Road Map

Many managed care, revenue cycle, and clinical leaders have witnessed first-hand payer's growing resistance to their historical "pay me more" strategy. All three parties are also familiar with the costs incurred when billing, collections, contracting, and clinical management fail to coordinate. That is exactly why these parties need to collaboratively take the lead on formulating their "pay me right" strategy.

Without such a coordinated effort, the current payment system will continue to foster mistrust among payers, providers, and patients. Providers also risk concentrating price and rate increases on services whose volumes are declining, or overinvesting in physicians, services, and other areas that do not yield incremental value for the price the market is willing to pay. The result will be even higher levels of cost shifting, cross subsidization, and accounting maneuvers that will blow up, much like the financial "innovations" that have wreaked havoc on the broader economy.

In practice, we observe four basic steps are required to produce meaningful change.

Step 1: Inspire the Organization to Develop a "Pay Me Right" Strategy

Before anything else can happen, clinical, revenue cycle, and managed care leaders need to openly acknowledge their roles in the de facto "pay me more" strategy. They must collectively embrace concepts including premium payment for premium performance and shared accountabilities to reduce costs.

Clinical managers can take the lead in this process by benchmarking the organization's managed care rates as compared with cost, access, and quality to quantify risks inherent during the transition to more "at risk" payment.  In particular, providers should look for premium-priced services for which performance (e.g., access, outcomes, service, and uniqueness in the market) is undifferentiated from that of competitors, or even subpar. In instances where price and value are misaligned, providers need to consider whether they will either decommoditize the product (e.g., expand service level), "skim price" (meaning keep price high even though volume is likely to decline), or employ some other tactic. Clinical managers often play an important role in informing such decisions.

Managed care staff can get involved by sharing what payers are saying about the health system. This communication includes educating colleagues about those areas where payers believe they should be paying less. Managed care staff should also keep their colleagues informed of the risks of federal payment reform, local payer consolidation activities, and potential negotiation sticking points.

For revenue cycle staff, the first step might be quantifying the administrative costs and denials by contract, due to nonstandard claim forms, bundling, and carve-out logic, documentation, and coding rules. Too often, though, revenue cycle staff are stuck in a purely operational/back office role, rather than actively participating in the "pay me right" process.

Together, these three parties should seek ways to educate and inspire their broader organization to formulate their "pay me right" strategy.  The entire organization should be made to understand that aligning price and value will require modifying product offerings, capacity, prices, and contract/risk sharing arrangements to substantially reduce costs, deliver high-quality care, and get paid for it. In practice, we observe that four key messages will need to be shared throughout the organization.

1. High prices do not necessarily produce the highest margins. Providers and payers have long used price (rate) as a blunt instrument to drive top-line revenue. But traditional "across-the-board" fee-for-service price/rate increases can actually have an adverse effect on margins when high prices mask cost problems or steer customers to competitors.

Consider a recent case in which a community hospital's lab set high prices on cytology. On the surface, the services appeared to be generating a positive contribution margin. Indeed, the lab service line director's initial position was that the tests were "generating a considerable financial margin that the hospital couldn't afford to lose if finance were to decrease price (rate)." However, upon further investigation, the director's "maximize unit reimbursement to maximize margin" strategy was sabotaged by a number of hidden operational and competitive issues. First, the underlying productivity of the lab equipment was very low. Furthermore, the hospital had very costly technology that ordinarily would be found only in large academic medical centers. In addition, the lease terms were quite poor, and market data showed the hospital was losing share to a lower priced competitor.

Upon further discussion with the lab director and pathologists, the team agreed it needed to regain market share that had been lost over the past two years due in part to the hospital's high prices/rates. The hospital communicated price/rate reductions to referring physicians and renegotiated its equipment lease terms. Ultimately, market share and net margin actually rebounded-even as price and patient out-of-pocket amounts decreased, proving that high prices/rates do not automatically optimize margins.

By analyzing the lab prices/rates data relative to cost and market and rebalancing their product portfolio, the COO and CFO resolved five issues: productivity, logical/defensible prices, market share losses, margin leakage, and referring physician dissatisfaction. To make its "pay me right" strategy more relevant to clinical managers, the two executives also added charge, rate, cost, and utilization variance reporting into existing department reports to get a balanced view of revenue and costs.

The lesson? A pricing analysis can serve as an objective lens through which product, cost, and capacity issues can be quickly discovered and resolved to optimize margins and market share.

2. Specific contracts entail substantial administrative costs. Depending on individual payer requirements, a provider could well be spending as much as $60 to document, code, bill, and collect a single claim, which translates to $10 million in administrative costs for a typical community hospital that submits 200,000 claims each year to 100 or more payers, each with different rules about when/what to pay.a And based on the reasonable assumption that 7 percent to 8 percent of the typical community hospital's commercial claims are reimbursed less than $60 each, that hospital could be losing money on up to 7 percent to 8 percent of its patient encounters before the patient even receives care.

Until payers and providers make administrative cost reduction a priority, administrative layers will continue to multiply as new ICD-10 and ANSI standards come on line and payer-specific pay-for-performance contract terms are added to a dizzying array of DRG, MS-DRG, APC, APG, percentage-of-charge, stop-loss, and carve-out-based terms. If the sheer number of administrative activities is allowed to swell unchecked, your colleagues need to understand that simply hiring-let alone retaining-experienced staff will become a full-time job for many contracting and revenue cycle professionals. To reduce administrative costs then, payers and providers need to consider a variety of improvements as part of a "pay me right" strategy, including:

  • Adopt CMS documentation and coding standards
  • Standardize precertification and medical necessity denial policies
  • Adopt an industrywide contract and chargemaster template
  • Standardize rate structure (e.g., bundling logic, groupers, and carve outs)
  • Terminate problematic contracts

3. Doing nothing invites public scrutiny and lawsuits. After a few years of relative quiet, the number of provider pricing-related lawsuits and front-page stories is once again on the rise as the economy slows and patient out-of-pocket expenses increase.b The focus of the lawsuits and media coverage is shifting from unfair billing practices (which many hospitals have addressed through updated charity care policies) to the next layer of what some call pricing "abuse"-including high variability in market rates, higher-than-expected outlier revenue, 50+ percent discounts, and 500+ percent markups over costs that simply do not compare well in the court of public opinion with markups in other industries.

View Exhibit 1


Several hospitals have made initial, defensible pricing investments to eliminate the most egregious perceived offenses-e.g., the $100 aspirin-item from their chargemasters. However, few hospitals have designed or adopted a charge-code-by-charge-code pricing methodology that is auditable, logical, and defensible. Thus, we still see $750 basic metabolic panels, $3,500 MRIs, and 1,000 percent chargemaster gross charge markups on high-cost drug items that feed misperceptions of provider greed.

4. Doing nothing promotes payer consolidation. As if public scrutiny and suboptimal margins were not enough to spur action, the provider "pay me more" strategy continues to fuel commercial payer consolidation nationwide. Smaller payers that drive a disproportionately high percentage of provider margins continue to be consolidated out of many markets-leaving providers at a greater disadvantage at the negotiation table.

And payers are not stopping at consolidation. Payers are amassing detailed claims data, Medicare data, and publicly available quality and satisfaction data on hospitals and physicians to support their "pay you less" strategy. Yet most providers have limited, if any, budget/staff to efficiently gather and present comparative data on essential considerations such as rates and quality. The predictable result is that providers are failing to coordinate across service lines and managed care and revenue cycle functions to address employers' and patients' top concerns, including growing medical and administrative cost trends.

But payers are not stopping at amassing their analytic arsenal, either. Payers are also redoubling their efforts to infuse more price competition into the market through new health benefit product designs. Examples include recent benefit designs that charge no copayment for the use of retail clinics and higher copayments for physician office visits and an increased willingness of employers to cover airfare for employees to seek advanced, prescheduled care at institutions recognized for their low costs and high quality, such as the Mayo Clinic.c These payer moves put provider margin at even more risk, particularly if the provider is making the majority of its margins on these services (e.g., imaging, procedures) that payers are commoditizing most aggressively.

In summary, now is the time for managed care, service line, and revenue cycle leadership to educate their constituents on the unsustainability of the "pay me more" strategy. This requires all three parties to coordinate across their functional silos to reassess their overall product portfolio, capacity, pricing, and contracting terms to substantially reduce administrative and medical cost trends and defend their net revenue.

Step 2: Understand Patients' Price Sensitivities and Purchasing Behaviors

As one would expect, the economic downturn and higher patient out-of-pocket spending have changed customers' price sensitivities and purchasing behaviors, just as Americans have changed their general spending habits over the past 12 months. For example, employers are more price sensitive than ever when purchasing health insurance. Patients, too, have been more selective, as demonstrated by recent declines in utilization.d

These changing purchasing behaviors are creating big problems for both payers and providers.  Problems arise when  payers and providers attempt to develop benefit designs, service offerings, and reimbursement arrangements that steer patients to the right place at the right price. Unfortunately, most payers and providers are too poorly organized to quantify these dynamics. But this too creates a new opportunity for payers and providers to mutually focus on understanding patient priorities, price sensitivities, and purchasing behaviors-particularly if they are going to simultaneously manage risk and grow together.

So where are payers and providers vulnerable?  And how can your organization quantify how vulnerable it is to major shifts in patient (or employer) purchasing behavior?

One common way to quantify vulnerability for most existing clinical services or health plan products is classical breakeven analysis, with a twist. This technique uses provider revenue and expense data to plot a contribution margin "indifference curve" representing all the price/quantity points that yield the same contribution margin.  Then using classical conjoint analysis techniques, it is possible to plot an industry demand curve, and model the impact of a price increase on volume. If there is not enough of a volume bounce, then the price decrease should be avoided. (For additional detail on how to conduct such an analysis, go to www.hfma.org/hfm.)

Pricing brand-new services calls for a different set of tools-including cost-effectiveness analysis. Historically, many providers have evaluated new, highly specialized services primarily on market need, employing a "build it and they will come" mindset. But the economic downturn increases the risks with this approach. And if the feds have their choice, payers and providers will need to justify the clinical effectiveness versus marginal cost of new products and services relative to the next best (and typically less costly) alternative.

Fortunately, payers and providers can borrow techniques traditionally used by the pharmaceutical industry  to evaluate marginal cost with clinical effectiveness. Consider the process to get a new drug "on formulary" which includes considerable analysis of patient needs, patient price sensitivity, and the product's costs and clinical effectiveness.e Given that hospital and physician spending dwarfs pharmacy spending, one would expect that hospitals, physicians, and payers would be just as rigorous at evaluating supply-demand microeconomics. Yet that has not been the case, and the situation must change, starting with payers and providers being much more transparent with sharing their data, so they can more rigorously evaluate the marginal costs of new procedures relative to predictors of clinical effectiveness.

Step 3: Redesign What and How You Are Paid

Once the groundwork is laid, the next step is to reconsider both reimbursement levels and reimbursement methodologies. Fortunately, payers and providers do not have to start from scratch when it comes to these items. Payers and providers should review HFMA's 2007 Reconstructing Hospital Pricing Systems, as well as with HFMA's 2008 report Healthcare Payment Reform: From Principles to Action.f In these reports, HFMA proposes several payment principles to guide systemwide payment reform, including:

  • Meaningful, timely, and relevant information
  • Simplicity
  • Comparability of price and quality
  • Ease and equity of administration
  • Equity for providers
  • Defensibility
  • Protection of community benefit
  • Fairness to consumers

We recommend that payers and providers abide by these principles as they solve for the optimal contract using the following three-step process.

1. Set preliminary financial targets. Most contracting initiatives begin with financial targets from the long-term financial plan. For providers, these targets typically run from 5 percent to 10 percent to sustain current functional capacity and mission.  For payers, the targets normally equate to the  budgeted annual cost trend limit (e.g., 4 percent to 6 percent). The differences must be made up by considering potential cost savings, growth, and risk/reward sharing options.

2. Identify potential cost savings, growth, and risk/reward sharing options in specific clinical areas. Executives need to engage key operators from supply chain staff to ED nurses to identify the full array of avoidable days/admits, throughput improvements, program expansion opportunities, and other opportunities that over time can fund a risk pool that is shared among participating physicians and/or hospitals.

3. Use mathematical optimization theory to solve for the reimbursement levels and methodologies that fulfill margin and trend targets under projected volume, payer mix, and cost scenarios. This more sophisticated, holistic modeling approach is starting to replace the historical approach of modeling incremental contract changes, and increasing chargemaster prices on percentage-of-charge contracts with limited if any attention to defensible markups.

This three-step model allows each party to transparently and in real time evaluate-as they have never done in the past-the advantages and disadvantages of different reimbursement levels, methodologies, and cost-reduction initiatives. The approach also allows you to answer several "what if" scenarios, including:

  • What competencies must be developed to excel in an increasingly "shared risk" environment?
  • What sorts of direct investments should be collaboratively pursued with our top payers, to improve efficiency and quality?
  • What services should remain fee for service and/or percentage of charge?

Consider the goodwill that could be created between payer and provider if the two parties were to use this approach to collaboratively benchmark and model product, capacity, and cost-reduction initiatives to achieve more sustainable and predictable cost increases, as well as a sufficiently sized risk pool, distributed commensurately with initial investment of each party and overall implementation risk (see exhibit).

View Exhibit 2


Over time, the approach can also be expanded to optimize the risk-reward payoff that each party faces across its entire contractual portfolio-creating an opportunity for each organization to manage its contract portfolio as rigorously as its investment portfolio.
Step 4: Hold Each Other Mutually Accountable to a Multiyear Implementation Plan that Shares Risks and Rewards

Anyone who has been involved with major strategic or process change knows the devil is in the details. Product offerings, prices, capacity, and contract structures cannot be changed overnight. To succeed with such an effort, payers and providers must hold each other accountable to a multiyear implementation plan to adjust capacity and phase in new products, prices, and contract terms that limit cost increases. As we know from earlier attempts at payment reform, simply educating stakeholders on the problems with the current system, piloting a few undersized shared risk arrangements, and doing the "math" are not enough to create or align incentives to reduce waste (see exhibit).

View Exhibit 3



Conclusions and Next Steps

Today's deep economic downturn has increased the urgency for providers and payers to look beyond their respective "pay me more" and "pay you less" strategies. The future viability of our nation's healthcare system depends on the willingness of these traditionally adversarial parties to join forces to put the patient first, reduce cost, measure results, and share risks and rewards. In anticipation of future payment reforms, those that take the lead in developing their "pay me right" strategy will likely be best positioned to receive more of the dwindling reimbursement dollar. Maintaining the status quo will only accelerate cost increases, shift destinies to others' hands, and steer both parties away from their common objective: improving patient health at a sustainable price.

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


a. Estimate is based on Navigant Consulting, Inc., experience.

b. See, for example, Carreyrou, J., "Nonprofit Hospitals Flex Pricing Power," Wall Street Journal, Aug. 28, 2008; and Allen, S., and Bombardieri, M., "A Handshake that Made Healthcare History," Boston Globe, Dec. 28, 2008.

c. See, for example, "Blue Cross and Blue Shield of Minnesota Offers No Co-Pay for Use of Retail Clinics," Blue Cross and Blue Shield press release, July 29, 2008; "Peabody Pays Mayo Clinic Prices to Save on Health-Care Costs," Bloomberg Sept. 26, 2008; and "WellPoint Soon Will Offer Some Medical Travel Benefits," Minneapolis Star Tribune, Nov. 14, 2008.

d. See, for example, Cunningham, P. J., and Felland, L.E., Falling Behind: American's Access to Medical Care Deteriorates, 2003-2007, Tracking Report No. 10, Center For Studying Health System Change, June 2008.

e. See, for example, Nugent, M., "Rethinking Formulary Strategy: Management and Measurement Considerations," American Journal of Managed Care, September 1999.

f. Access Reconstructing Hospital Pricing Systems and Healthcare Payment Reform: From Principles to Action.

The Need for Change

Many of the significant challenges facing the nation's hospitals and health systems have been exacerbated by the economic downturn. The following are just a few examples of why it has become critical for providers and payers to change the way they do business with each other.

Managed care payments have become more important than ever. Recent data from the American Hospital Association support a finding that managed care margins account for 200 percent to 400 percent of the typical hospital's net margin. Yet few providers have a plan to sustain (let alone grow) margins and market share with their top payers as administrative costs and bad debt increase dramatically.

High-priced, high-margin managed care volumes are decreasing. More than 30 percent of hospitals responding to a recent survey (with results from 736 U.S. hospitals) have experienced a moderate to severe decrease in high-margin, elective services through late 2008, according to an American Hospital Association news release issued Nov. 19, 2008. Indeed, the demand for some healthcare services is elastic, declining as the price to consumers increases. Yet few providers are equipped to adjust their product offerings, capacity, prices, or contract and risk sharing arrangements to soften these demand shifts.

Administrative costs are eroding margins. By some reliable industry estimates, providers spend between $30 and $60 to document, code, bill, and collect a single claim.a This translates to $10 million in administrative costs for a typical community hospital that submits 200,000 claims each year to 100 or more payers. Yet payer-provider negotiations devote minimal attention to reducing administrative costs.

Payers can no longer afford provider's historical "pay me more" strategy. Many providers are still budgeting 6 percent to 12 percent annual managed care increases to fund billions in new facilities, programs, and physicians. These increases are not economically sustainable.

a. Estimate is based on Navigant Consulting, Inc., experience.

Considering Defensibility: Can You Defend Your Health System's Prices?

There is no Medicare regulation that dictates "defensible charges." Rather, defensible is a relative term.

At a line item level, hospitals define defensibility as standardized charge-to-cost and charge-to-fee-schedule markups by service or department that are comparable with the markups by other hospitals in their market-accounting for major differences in payer mix and managed care discount rates between hospitals.

Logical price relationships between charge codes also warrant attention. In aggregate, hospitals define defensible charge levels as ones that allow them to make a reasonable return in line with similar hospitals. But to have truly defensible pricing, a hospital should have a documented code-by-code pricing methodology that is auditable and logical and that supports the hospital's payment strategy. The hospital also should conduct a chargemaster price review to encourage service line, revenue cycle, and managed care leadership to focus their thinking on right pricing.

Publication Date: Monday, June 01, 2009

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