Brian S. Channon
Ellen G. Riley
Jason H. Sussman

Hospitals and health systems must make the needed strategic changes to transform their cost structures in response to new-era requirements, or risk being marginalized in their markets.

At a Glance

Means for hospitals and health systems to achieve necessary, sustainable cost transformation include:

  • Using a structured approach with rigorous analysis  
  • Understanding the organization's capital position and quantifing the shortfall  
  • Identifing potential savings sources  
  • Using internal and external benchmarks  
  • Ensuring integration of cost-reduction targets with organizational plans and budget  

The need for rigorous cost management is clear. Accelerated by unsustainable growth in national healthcare costs, the emerging value-based business model and healthcare reform will push hospitals and health systems to improve quality, access, and outcomes, while reducing expenses. Simply bending the curve of cost increases will be inadequate, however; an entirely new, lower curve needs to be created and sustained.

To meet community healthcare needs in the new delivery and payment environment, hospitals and health systems will be required to address quality and efficiency across clinical and nonoperating dimensions and refine their business structure, pursuing both cost management and structural initiatives.

Cost management initiatives focus on cost reduction and efficiency improvement in current operations, assuming no changes to the organization's portfolio of service offerings. Cost structure initiatives, by contrast, reshape the distribution of services across the organization's geographic market or markets and rethink service offerings to focus solely on those that are core to the mission. The nine strategic recommendations presented here relate to initiatives of both types that can help hospitals and health systems sustainably transform their costs.

Use a Structured Approach

Many healthcare organizations have been working hard to reduce costs and improve operational efficiency. What they require to further identify and implement improvement opportunities is a structured approach with rigorous analysis.

Such an approach should begin with an objective assessment of the organization's current competence with cost management, which is critical for developing the capabilities needed to deliver high-quality services at the lowest possible cost. The assessment should include both quantitative and qualitative analyses. The first analysis should ascertain whether the organization has systems, practices, and controls in place to manage costs and, if such elements are present, how effective they are and/or how well they are being used.

Consider, for example, the experience of Central Washington Hospital (CWH), a regional 198-bed medical center in Wenatchee, Wash., that has achieved considerable success in managing costs. CWH is using a structured approach to strengthen its balance sheet and build capital capacity to meet the healthcare needs of residents in its service area, while preparing for potential payment reductions.

"Given trends in the healthcare environment, we need to be making care more affordable and efficient while sustaining uncompromised quality of care in our facilities," says Steven Jacobs, vice president of financial services and CFO for CWH. Providing care to patients regardless of their ability to pay is a continued priority. "We already reduced $5 million in expenses in 2010 and didn't want to go through a 'slash-and-burn' process to further reduce costs," says Jacobs. "Rather, we wanted to use a data-driven approach that identifies and supports logical reductions."

Understand the Organization's Capital Position and Quantify the Shortfall

Another important early analysis focuses on the organization's capital position. To identify its capital capacity and shortfall, CWH thoroughly updated its strategic-financial-capital plan to incorporate projections related to the impact of the new business model, weak economy, reduced payments, lower volumes, and the completion of a new bed tower in May 2011. The plan showed a budget gap of $6 million to $7 million. Senior leadership, with involvement of physician leaders, department directors, and the board, set $7 million as the cost-reduction target in 2012 based on an operating budget of $200 million. Based on this target, CWH leaders then evaluated the feasibility of closing this gap and developing a plan for doing so.

Other data analyses can help identify the overall level of savings opportunities and validate cost-reduction estimates as realistic and achievable. Three analyses "triangulated" CWH's needed savings and supported the appropriateness of a cost-reduction target that would enhance operating performance, improve the balance sheet, and better position the organization to meet future capital investment needs. The exhibit at below shows results of these analyses, including:

  • The operating performance improvement that would be required to support current strategic capital needs (the budget gap)
  • Expense growth as a percentage of revenue (a critical indicator)
  • Industry cost benchmarks (for example, median ratios for healthcare bond ratings, among others)

Exhibit 1


The "triangulation" indicated that the $7 million cost-reduction goal was appropriate.

Identify Potential Savings Sources

Types of cost-reduction opportunities and their drivers vary by organization, but many are common to hospitals and health systems nationwide, independent of size. Staffing and productivity drivers should be a key focus, as labor costs often constitute more than half of an organization's operating expenses, as is the case at CWH. Understanding key drivers of inefficiencies in these arenas enables executives to focus on high-impact cost-reduction initiatives.

To identify savings sources, CWH formed an executive steering committee, which included C-suite leaders and, at numerous points throughout the process, physician representatives and the directors of human resources, quality care management, and finance. The committee developed preliminary targets for each division of the hospital. Then, executives in charge of divisions developed cost center plans, working with their teams to identify savings opportunities that would meet the target and documenting their improvement plans.

"The focus was and is on reductions that will not affect patient care," says Jacobs. With approximately 1,200 FTEs, CWH's goal is to reduce staffing by 70 to 75 FTEs to assist in achieving the savings. "We wanted to use attrition and other savings strategies to help reduce the number of layoffs that would be required. We strengthened the vacancy review process for approval of replacement staffing and offered an early retirement incentive program for employees at the age of 60 and over." By year-end 2011, 39 employees had elected to participate.

CWH also looked at other sources for savings:

  • Working with physicians to reduce costs related to inpatient pharmaceuticals, lab tests, supplies, and other costs, using specific benchmark and internal data comparing utilization per DRG by chargemaster
  • Initiating a clinical documentation improvement project to ensure that physicians and other providers are accurately documenting patient information in the medical record, thereby ensuring proper coding
  • Identifying cost-reduction opportunities related to supply chain management and vendor contracting

All plans were presented to CWH's physician-driven clinical performance committee for input. "If, for example, we proposed a change in the way lab results were delivered or case management was being handled, the committee provided input regarding the impact of those changes, and we shaped plans accordingly," says Jacobs. "Physician involvement is critical throughout the process."

Each department formally presented its plan to the executive steering committee. "By year-end 2011, departmental plans for achieving the $7 million savings were identified, in place,and incorporated in the 2012 budget," comments Jacobs.

Exhibit 2


Use Internal and External Benchmarks

Much information can be gained about sources and amount of possible savings through review of historical trends, application of global and departmental benchmarks, peer department comparisons, and supplementary "drill down" data analyses.

For example, poor alignment of staffing with patient volume, combined with poor execution of existing staffing plans, is among the more common contributors to high labor costs. Although many organizations believe that their current staffing methods are highly effective in matching staffing and volume, they should test such assumptions rigorously. They are likely to find that many opportunities still exist to strengthen the relationship between staffing and patient demand. Often, staff schedules are not aligned with patient arrivals in the operating room or emergency department. Assumed or planned-for staff "flexing"- that is, adjustment upward or downward with changes in volume-may not be occurring, as expected. A close review of census-based staffing grids for inpatient nursing units often discloses a less-than-ideal correlation between staffing and volume.

Given operating characteristics that may be unique to the departments at any specific organization, the applicability of industry benchmarking may be limited, and sensitivity to such comparisons may exist. However, use of appropriate historically derived "internal" benchmarks, coupled with external benchmarks, can build organizational support for the level of cost reduction that may be available.

CWH pulled historical staffing data by pay period for a three-year interval and carefully considered which nursing units could be compared. "Getting data that were good matches for benchmarking was critical to ensure process integrity and the buy-in of departments," notes Jacobs. "Getting a good match for individual nursing departments was challenging. For example, one medical unit might be better compared with a medical/oncology unit than another medical unit, so we decided to use a more global statistics for nursing in general." For diagnostic imaging staffing, CWH combined all the diagnostic imaging departments for benchmarking purposes. For support, general, and administrative departments, CWH used adjusted discharges as the key statistic, and for all benchmarking data, the organization ensured that the data included productive hours or total hours to allow for a valid comparison.

Integrate Cost-Reduction Targets with Organizational Plans and Budget

To achieve real cost reductions, the savings opportunities identified through the structured analyses should be included in the organization's strategic-financial plan, annual budget, and operating plans.

Productivity reporting systems and targeted metrics also should integrate appropriately with the organization's budget. Further, staffing schedules should align with staffing plans that are reflected in the budget. If "disconnects" occur and these elements are not closely linked in the budget, cost efficiencies and reductions will be difficult to achieve and expenses will be higher than expected or warranted. Maintaining a strong strategic cost management project infrastructure is critically important throughout the cost-reduction development and implementation process.

Plan for the Right Timeline and Keep on Track

"Buy-in and participation of department directors are critical, as is continuous communication with staff, physicians, and the community to help alleviate some of their fears regarding cost reductions," says Jacobs. "All of this can't be accomplished in two months; organizations need six to eight months to do a proper job of organizing and analyzing the right data and building the needed consensus around benchmark comparability and cost-reduction targets." Activities such as compiling the data and verifying their accuracy often require significant time.

The tracking of results must be detailed and timely to ensure that targets are achieved. A timeline tool defines key steps and guides progress. "Organizations need to be empowered with the structure, tools, and processes to achieve sustainable cost savings, while preserving their community resource for the provision of high-quality health care," says Jacobs. "The approach we are using builds and draws on leadership capabilities at all levels to achieve the necessary cost-savings target." With a June 2011 start date, by December 2011, CWH had implemented many of the department cost savings plans and progress will continue to be made throughout 2012.

Exhibit 3


For Needed Structural Change, Focus on Mission

Forward-thinking organizations-whether freestanding hospitals, multihospital systems, or other provider entities-are evaluating all aspects of their business in light of changing market conditions and requirements for future success under the new business model. The costs involved in building competencies-including tight physician integration, a care management infrastructure, a sophisticated health IT platform, and partnerships across the care continuum-will be considerable for all organizations.

Leaders of all organizations should be asking three important questions:

  • What businesses and services are core to our mission and vision going forward?
  • Where can we most effectively invest our limited capital and human resources to meet continuing healthcare needs in our communities?
  • What services should we offer in each location (and to what scope and scale) with consideration of the population's care needs and of access, cost, and quality objectives?

(For a related discussion, see Grube, M.E., and Morrissey, W.W., "Finding the Best Strategy for Service Distribution," hfm, November 2011.)

Executives should evaluate each business unit and service line to identify "core" elements, using criteria such as current market attractiveness, competitive landscape, fit with strategic mission and vision in communities served, current financial performance, and projected financial performance under new delivery and payment models.

For small community hospitals, it probably will not be possible to continue being "all things to all people." Rather, they may need to arrange for community access to certain services through referral or partnership arrangements.

Executives should understand clearly where their hospitals stand in their markets. Market definitions are changing with today's increasing regionalization by health systems, involving the acquisition of hospitals in contiguous geographies, even across state lines.

Evaluate the Strategic Options and Businesses/Services

An organization's ability to reach the position that's "right" and sustainable depends more than ever on its leaders' ability to identify and assess strategic options under varied organizational, service line, and business unit scenarios. Integrated strategic financial planning related to these options is essential.

Evolving incentives will force inefficiencies out of the broader healthcare system. Organizations run the risk of being marginalized in their markets if they do not explore options for the organization as a whole and for its business units and make the necessary strategic changes.

Using a structured approach, the management team should closely evaluate the efficiency and effectiveness of each business and service that the team and board deem to be core through the evaluation process described in the previous section. This assessment should verify the organization's ability to sustain the relevance of each business or service in a changing market. The assessment has six key steps:

  • Evaluate the geographic market
  • Assess each business/service within that market
  • Identify how services could be better distributed across the delivery system
  • Formulate a strategy for achieving more optimal distribution 
  • Prepare and evaluate volume and financial projections for individual businesses and services and the hospital or health system as a whole
  • Make and implement decisions for a desired future delivery system

Use of an analysis framework like the one shown in the exhibit below, can be helpful.

Exhibit 4


Make the Tough Decisions

Ultimately, discussions related to an organization's businesses and services should directly address the overall value of each business or service to ascertain whether it represents the best use of scarce resources available to meet community needs. A business/service line evaluation matrix can provide an "at-a-glance" illustration of strategic-financial value. Hospital and health system boards and executives will need to make and implement tough decisions to "reset" the cost curve.

Consider the case of UMass Memorial Health Care (UMMHC), the largest healthcare system in Central and Western Massachusetts, with five hospitals, more than 1,100 beds, and more than 12,000 employees. Given the significant capital investment requirements of the new business model, UMMHC revisited its strategic-financial plan to include new market and financial projections and the impact of care delivery and payment changes under healthcare reform.

To evaluate its options in the changing landscape, UMMHC completed modeling under different strategic assumptions related to what would be considered "core" services in the communities it serves. Full evaluations started with the development of a financially oriented business plan for each service line and business unit currently owned and operated by UMMHC.

Each business plan was supported by fact-based assumptions about volume, revenue, expense, and associated capital costs going forward. Sensitivity and scenario analyses were completed for the key drivers to understand the range of probability of outcomes. Each plan was integrated into the organization's long-term strategic-financial plan to delineate the businesses' impact on the organization's strategic and financial success going forward.

UMMHC owned a home care business and a laboratory business, among other entities.

Exhibit 5


Home health business. UMMHC needed to ensure that its patients would receive high-quality post-acute care following discharge and to minimize readmissions, but the economics of its home health business were difficult. "Competition is intense in this market," notes Todd Keating, vice president and CFO for UMMHC. "The business is not profitable and its losses are expected to increase. We also are concerned about our ability to sustain the business in the long run and provide the necessary capital resources for ongoing high-quality services."

UMMHC decided to divest the home health business to one of the major players in the market, with the understanding that the player would continue to provide high-quality services effectively and efficiently in the community. "The divestiture would mitigate UMMHC's losses and enable us to redirect capital to initiatives in the organization's core competency/mission-driven areas," says Keating.

Laboratory business. By contrast, UMMHC's laboratory business was quite profitable, having been significantly capitalized over the years. The lab business, however, did not meet leadership's criteria for "core services."

Two large laboratory companies, which already provided services in the community, proposed to purchase the UMMHC's lab business to increase their companies' market penetration. UMMHC decided to divest its lab business and use the proceeds to build its balance sheet to support core strategic initiatives.

A Call to Action for Healthcare Executives

Senior healthcare finance and other leaders face an extremely demanding environment in which to position their organizations for success. To deliver high-quality care with better outcomes at lowest possible costs, their organizations require transformational change. Executives can best help their organizations accomplish this change through cost management and cost structure efforts, using the strategies described here.

In addition, ensuring that costs do not creep back into the system is critically important. Finance leaders therefore should work with other senior leaders to take appropriate steps to ensure that inefficient business and clinical structures and processes are truly transformed and to build within the organization the knowledge, capabilities, and self-sufficiency required for vigilant monitoring, tough decision making, and seamless execution. For all hospitals and health systems, aggressive action is required and recommended.

Brian S. Channon is senior vice president, Kaufman, Hall & Associates, Inc., Skokie, Ill., and a member of HFMA's First Illinois Chapter (

Ellen G. Riley is senior vice president, Kaufman, Hall & Associates, Inc., Los Angeles, and a member of HFMA's Southern California Chapter (

Jason H. Sussman is managing director, Kaufman, Hall & Associates, Inc., Skokie, Ill., and a member of HFMA's First Illinois Chapter (

Sidebar 1

Components of Cost Management Competency  

  • Cost management scope-the breadth and depth of how major cost drivers are identified and defined and how corresponding improvement initiatives are planned and implemented
  • Target-setting and tracking-the systems and processes used to set targets and monitor performance
  • Systems thinking-the prevalent organization and culture of how costs are considered and decisions made, whether on a departmental/entity/silo basis or systemwide, as an integrated whole
  • Alignment-the processes and methods used to ensure alignment and integration of plans, targets, and financial performance
  • Accountability and execution-the systems and processes in place that hold management and staff accountable for delivering targeted results, executing plans, and generating success
  • Management controls-the breadth and depth of management controls in place to hardwire success in meeting cost-management targets
  • Operational planning-the processes used to plan and drive improvements
  • Overhead management-the mechanisms in place to right-size overhead expenditures organizationwide

Source: Kaufman, Hall & Associates, Inc.

Sidebar 2

CWH's Strategic-Financial Circumstances  

Key statistics reflecting the strategic and financial circumstances of Central Washington Hospital (CWH) are as follows:

  • The organization serves a population of 250,000 in an area constituting approximately one-fifth of the state.
  • Seventy percent of its hospital and clinic patients are covered through the Medicare and Medicaid programs.
  • State budget cuts for 2011 to 2013 have been projected to result in a $5 million reduction in Medicaid payment to the hospital.
  • The organization provided $13.5 million in uncompensated care (charity care and bad debts) and $8 million in unreimbursed Medicaid costs in 2011, with expected increases in 2012.
  • Uncompensated care grew more than 30 percent between 2008 and 2010.
  • Previously enacted state safety net funds were designated for non-healthcare uses, which affected CWH by $2.1 million.
  • Costs incurred in 2010 and 2011, including implementation of an electronic medical record system and construction of a new bed tower, reduced capital capacity.

Sources: Central Washington Hospital and Kaufman, Hall & Associates, Inc.

Sidebar 3

Key Drivers of Staffing and Productivity Inefficiencies  

  • Inadequate staffing plans/alignment
  • Poor execution of staffing plans
  • Inappropriate/unclear staffing roles, target workloads, and assignments
  • FTEs that "fly below the radar" 
  • Service and functional redundancy/excess capacity 
  • Insufficient management controls 
  • Use of overtime/premium labor

Source: Kaufman, Hall & Associates, Inc.

Sidebar 4

Elements of CWH's Strategic Cost Management Structure  

  • Identification of cost center targets/savings, rolled up to responsible department executives for adjustment across their area
  • Hardwired schedules and staffing grids to meet new targets and rigorous monitoring of adherence to staffing grids
  • A process for review and approval of new and replacement staffing
  • A productivity monitoring system, with regular updates
  • Specific plans for implementing the improvements and execution of such plans
  • A thoughtful communication plan for the dissemination of proposed cost savings and ongoing communication to department heads, physicians, and the community
  • Regular progress reporting to an executive steering committee

Sources: Central Washington Hospital and Kaufman, Hall & Associates, Inc.


Publication Date: Thursday, March 01, 2012

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