William J. Ward, Jr.
Lynn Spragens
Ken Smithson
Hospital performance improvement projects that focus on reducing costs risk undermining clinical quality, while failing to achieve any real financial benefit. A better approach is to focus on improving cost efficiencies.
At a Glance
Following are key findings of VHA Inc.’s Transformation of the ICU collaborative:
- Instead of improving patient outcomes, focusing too much on reducing costs as a performance improvement strategy only lays the groundwork for increased quality problems and higher costs.
- Improving quality can improve the bottom line, as long as there is patient demand.
- As a type, hospitals are organizations that characteristically have high fixed costs. The more customers such organizations can serve with the same investment, the greater their profits.
Are your hospital’s performance improvement efforts reaching the organization’s bottom line? That’s a question that is gaining importance for many hospital CFOs. Consider the following scenario:
Your hospital’s fully loaded costs for an ICU bed-day average $2,500. The critical care performance improvement team has implemented the “Surviving Sepsis” guidelines promoted by the Society of Critical Care Medicine and, through improved outcomes, shortened overall length of stay for sepsis and severe sepsis patients by 100 days per year. Using the data from the cost accounting system, the team estimates it has saved the hospital $250,000 a year and a celebration ensues.
As CFO, you are invited as an honored guest to share in the success of the team. When you arrive at the party, however, you take note that despite the reduced LOS, there were no reductions in staff, and that aggressive therapy actually increased the costs of supplies and medications. You give the team your elevator speech on why allocated expense reduction does not equate to operating income. The party gets very quiet. You then explain that, because many of the ICU days eliminated by the project had been paid per diem or by discounted charges, the project resulted in reduced revenue of over $100,000. Rather than put an even bigger damper on the party, you hold off the announcement of the meeting to reevaluate ICU staffing until another time.
How is it that improved clinical quality can be at such odds with the financial well-being of healthcare organizations? That’s a question that CFOs need to address more than ever today, as the nation’s increasing focus on pay-for-performance reinforces the mission-critical need for clinical performance improvement measures while the costs of those measures soar.
A Financial Shortfall
Not long ago, hospitals considered performance improvement activities to be a price of doing business. And because the costs of these activities tended to be modest, hospital senior financial leaders seldom gave them a second thought.
No longer. Hospitals are now being asked to expend millions of dollars for projects such as computerized provider order entry and electronic intensive care unit systems, all designed to improve the quality of care. Finance executives need to take a hard look at such projects to make sure they make good financial sense, and they must be on the same page as clinical improvement experts regarding the expectations for these projects. A thorough benefit-cost analysis is required, as befits any major investment. But as a recent article in Health Affairs points out, efforts to examine the business case often lead to frustration when projected cost savings fail to reach the bottom line (Leatherman, S., et al., “The Business Case for Quality: Case Studies and an Analysis,” Health Affairs, March-April 2003).
Why do so many performance improvement activities fail to pay off? Results of a national performance improvement project in critical care led by Irving, Texas-based VHA Inc.—a provider alliance comprising more than 2,400 member organizations—suggest that problems arise when the business case is based on the wrong expectations. Too often, the focus of the project is on reducing costs, and the business case is made without a clear understanding of a hospital’s fixed and variable costs.
Hospital cost structure lies at the root of the problem of evaluating the financial benefits of performance improvement. Hospitals represent huge investments in plants, people, skills, and equipment. A study published in JAMA estimated that hospital fixed costs are on the order of 85 percent to 90 percent (Roberts, R.R., et al., “Distribution of Fixed vs. Variable Costs of Hospital Care,” JAMA, Feb. 17, 1999). That puts hospitals more in a league with transportation or heavy manufacturing than with most other service industries. When performance improvement teams have only 10 percent to 15 percent variable costs to work with, opportunities for significant short-term cost reductions are minimal. Results of a study by an Australian researcher, Nicholas Graves, indicate that, given hospitals’ high fixed costs, it is difficult, if not impossible, for clinical improvement programs to reduce expenses enough to cover costs (“Economics and Preventing Hospital-Acquired Infection,” Emerging Infectious Disease [serial online], April 2004, www.cdc.gov/ncidod/EID/vol10no4/02-0754.htm). What’s more, by focusing on cost reduction, larger opportunities are missed.
The Financial Executive’s Perspective
Another reason hospitals’ performance improvement efforts have not achieved clear financial benefits may be that, in the past, such efforts have not enjoyed the full support and involvement of senior executives. Results of a survey by VHA disclosed that although virtually all American hospitals are actively involved in clinical improvement—and have been for more than a decade—only one-third of the hospital executives surveyed could estimate the financial return on their hospitals’ investment in performance improvement. Of the executives who could estimate an ROI, two-thirds did so based on anecdotal information rather than solid financial data.
It should be no surprise that few senior executives see performance improvement as a critical element in their organization’s financial strategy. Depending on local payer mix and payment methodology, longer LOS, complications, and medical errors may actually benefit the hospital financially at the same time teams are working hard to improve them. In some instances, performance improvement teams’ hard work may result in savings that accrue to health plans or the government rather than the hospital.
For example, most CMS quality measures, such as pneumonia and influenza vaccines, smoking cessation counseling, beta-blockers, and aspirin therapy, improve patients’ outcomes after discharge from the hospital. Medicare and health plans realize the financial savings from patients’ improved long-term health status, but it is the hospitals that bear the expense of implementing the programs. Even when the programs are directed toward quality problems in the hospital, it is difficult to translate clinical improvement into a positive bottom line.
Nonetheless, performance improvement remains imperative for today’s U.S. hospitals, and given the increasing costs of such projects, support
and involvement of senior financial executives are likewise imperative. And without a doubt, hospital financial leaders should require a strong business case before embarking on a multimillion-dollar performance improvement program. But building such a case requires a new perspective on the results that should be expected from performance improvement programs and an analytical method that both financial and performance improvement staff understand and endorse.
Developing such a method became a goal of VHA’s national performance improvement initiative focusing on hospital intensive care units, called the Transformation of the ICU project.
About the TICU Project
Beginning in 2000, the TICU project was a nationwide collaborative in which groups of VHA member hospitals worked with nationally known experts to identify and implement effective and financially viable improvements to clinical care processes. Many clinical achievements of the TICU teams have become national standards, including those for preventing ventilator assisted pneumonias and eliminating catheter-related infections. The TICU project also featured some of the nation’s first rapid response teams and medication reconciliation programs.
Nonetheless, many of the improvement teams were unable to translate clinical achievements into identifiable financial outcomes. Some organizations touted millions of dollars in savings, while others’ financial analyses indicated millions of dollars of losses despite similar clinical results. It soon became clear that each organization was using a financial system built on assumptions unique to the institution, many of which had little relevance to the financial potential of performance improvement projects.
It also became clear that the two executive groups involved in valuing the projects—financial and performance improvement executives—viewed clinical projects from different perspectives.
The finance staff’s role is to maintain the economic well-being of the hospital, but most have limited experience regarding clinical issues or interventions. The performance improvement staff’s primary goals are saving lives and eliminating complications and medical errors, but most have little understanding of the financial consequences of their actions. In the TICU initiative, the two groups’ differing viewpoints hampered collaboration and often resulted in conflict. The differences also explained some of the reported discrepancies in savings and losses.
A Meeting of Minds
The discrepancies in reported results led to an inquiry that produced the key finding that hospital performance improvement initiatives should focus on improving cash flow, not reducing costs. This finding points to a real financial opportunity for hospitals. But converting the opportunity into financial advantage requires that finance and performance improvement leaders develop a common understanding and strategies to sustain improvements and improve cash flow.
The inquiry found that what was missing—in the TICU organizations, and in health care in general—was a standard model for calculating the economic returns from clinical improvements. Finance leaders need reliable pro formas to determine whether performance improvement initiatives will be a financial boon or drain on their organization. Performance improvement leaders need to validate their project’s impact on finances as well as on improving patient care and saving lives. The TICU staff and team leaders set out to find a way to fill those needs while persuading both finance and performance improvement areas to adopt a cash-flow mindset.
Barrier to a New Perspective
For most institutions, moving to a cash-flow mindset requires a major shift. Cost reduction has been the primary focus of performance improvement strategies since the first major voluntary efforts in the 1970s, and changing this focus requires educating staff about the limitations of this approach.
The cost reduction approach was reinforced by the reporting requirements of auditors and state and federal agencies. To meet those requirements, hospitals must identify all their costs and then make assumptions as to where they should be allocated against revenue. Such assumptions vary widely and were never designed to support clinical improvement.
Based on average cost data derived from the cost accounting system, clinical units are charged with the direct costs of their departments: labor, supplies, and occasionally medications. The costs of services from related, nonrevenue-producing units such as transportation, dietary, and security are collected by the cost accounting system and allocated to them. There also are cost considerations for corporate overhead for administration, debt service, plant management, and similar accounts. Regardless of whether they use direct or fully loaded costs, performance improvement leaders are invited into the trap of believing that they are dealing with hard dollars, as the scenario at the opening of this article shows.
Looking back over the past 30 years, it is more than likely the cost-reduction imperative contributed to reduced healthcare quality while costs continued to rise. Despite the best efforts of the industry, the healthcare share of the GDP is twice what it was in the 1970s.
An article in The New England Journal of Medicine observed that, because much of the work was directed toward reducing labor costs, a series of yo-yo-like manipulations of the labor force, particularly nursing, led to understaffing and a lower quality of care, in the form of more complications, more medical errors, longer LOS, and lower satisfaction of patients, families,
physicians, and employees (Needleman, J., et al., “Nurse-Staffing Levels and the Quality of Care in Hospitals,” The New England Journal of Medicine, May 30, 2002). Instead of improving patient outcomes, cost-reduction thinking laid the groundwork for bigger quality problems and higher costs. Exacerbating the problem is loss of job security experienced by nurses, which has contributed to the nursing workforce crisis.
Cost Efficiency Strategy
To explain how hospitals can best implement a performance improvement strategy based on cash flow, it is helpful to review examples of strategies used by companies in other industries with high fixed-cost environments. Companies such as Toyota and Southwest Airlines give much less attention to cost reduction (although it is never ignored), and focus on asset and capacity management, in particular by improving throughput to optimize investment in fixed costs.
Having invested billions in plants and equipment, Toyota continuously seeks ways to increase the number of cars produced by a given plant, and as productivity increases, the cost per car automatically decreases. Airplanes don’t generate revenue while on the ground, so Southwest Airlines boards passengers in groups without assigning seats and is able to turn around its planes in 20 minutes, almost twice as fast as competitors. If turnaround times were 10 minutes longer, it is estimated Southwest would need 40 new aircraft at a cost of hundreds of millions of dollars to handle the same passenger load, according to a recent article by Christina Lewis and Ron Lieber in The Wall Street Journal (“Testing the Latest Boarding Procedures,” Nov. 2, 2005).
The more customers that organizations with high fixed costs can serve with the same investment, the greater their profits. Poor quality slows the line, and dissatisfied customers go elsewhere, reducing demand. The same conditions exist in health care.
The silver lining of high fixed costs is high marginal profits. If true marginal costs are low, small increases in case volume will result in high marginal cash flow. Thus, improving quality can have a substantial positive effect on the bottom line, assuming there is patient demand. And of course the best way to ensure patient demand is to ensure higher quality outcomes. To realize this potential means hospitals must educate staff to think differently and use data in a new way.
Improving clinical outcomes, reducing medical errors, and eliminating complications have the potential to significantly improve cash flow. However, estimating this economic benefit using average cost data doesn’t work. For this purpose, performance improvement and finance planners need to shift to marginal cost data and logic. Consider the following scenario:
A hospital performs 500 hip replacements a year and is paid at an average rate of $10,000 for each case. However, the average direct costs are $11,500, including marginal costs of $4,500 for the implantable devices and other supplies (the true variable costs associated with each hip procedure). The performance improvement team identifies process improvements that would reduce the average LOS and result in enough capacity to do another 50 cases a year. Should the project be approved?
If the hospital’s financial managers had employed average cost logic, the pro forma would have predicted a $75,000 loss ($575,000 in additional costs minus $500,000 in additional revenue) for the hospital—and the project would not have been approved. However, they chose to analyze the project using marginal cost logic, and as a result, they found that the additional cases would cost $225,000 (true variable costs), but the revenue would be $500,000, for a positive cash flow of $275,000. The project sailed through.
Same numbers, same clinical outcome, but a vastly different, and more accurate, ROI. In this example and most of the others tested in the TICU project, the greatest potential for increased cash flow stems from shortened LOS and the potential to accommodate additional patient volume. Knowing the marginal cost for a service or product is essential for understanding the implications of that incremental volume, evaluating program initiatives, negotiating contracts and prices, and making sound business decisions. Unfortunately, most performance improvement leaders lack access to the data and methods they need to make these decisions.
Bridging the Gap
Once finance and performance improvement are in agreement as to how to proceed, finance staff can facilitate the performance improvement staff’s access to the requisite data. To this end, the faculty of the TICU program created a spreadsheet tool that performance improvement staff can use to design and analyze their projects.
See sample spreadsheet
Exhibit Caption
Faculty of the VHA-led Transformation of the ICU collaborative created a spreadsheet tool—including this sample spreadsheet—for use by finance and performance improvement in designing and analyzing performance improvement projects. The tool is available at www.vha.com.
The entire tool can be downloaded free from www.vha.com.
To make effective use of the tool, performance teams should work with finance staff to identify a maximum of 15 data elements. Although some cost data (acquisition costs when available) are required, the most important elements involve revenue and cash flow. By inserting the data elements into the spreadsheet, decision makers can conduct “what-if” analyses in the design process, follow the economic impact during the project, and document the financial benefits once the programs are in place.
Using cash flow as the driving force for performance improvement unifies the hospital’s clinical and financial agendas. Reducing complications and medical errors and shortening LOS can create the potential for increased revenues. Improving the satisfaction of patients, nurses, and physicians drives the increased demand.
Leveraging Cost Efficiencies
In addition to the immediate cash flow benefits, optimizing efficiency has other important benefits. Hospitals operating at full capacity can increase their capacity by improving throughput, obviating the immediate need for potentially costly capital expansion.
Improved efficiency also can remove cash flow bottlenecks and reduce personnel turnover. For example, lack of ICU availability can limit emergency department visits because ambulance patients may need to be diverted to other hospitals, and it can cause elective surgeries to be cancelled, forcing physicians to use other hospitals. Inside the overworked ICU, sinking nurse morale can lead to staff resignations, bringing added costs for agency staff, recruitment, and training. Eliminating this ICU bottleneck opens the door to a significant cash flow benefit because the productivity of the ICU-reliant units can increase dramatically.
Sustaining Improvements
Sustaining positive cash flow from performance improvement activities ultimately depends on an organization’s ability to look beyond the walls of individual units. As illustrated above, ICU throughput improvements can boost unit productivity and efficiencies that create cash flow opportunities in the ED and elective surgery while avoiding unnecessary personnel costs. But to take advantage of the additional ICU capacity, coordination must exist between the ICU and those upstream units. In the same way, regular Med/Surg units that receive transfers from the ICU must be involved, or downstream constraints will likely eliminate the economic benefits of the performance improvements in critical care.
Operationalizing the improvements into normal workflow thus is a critical step to sustaining them. Once the performance improvement team signs off, the hospital must rely on unit managers to integrate new processes and policies into daily operations. Unit managers, particularly those managing increased throughput, must revise performance metrics and work management.
For example, most nursing work occurs on the first and last patient day in the hospital. If the LOS is shortened, then the work per patient-day for nursing increases accordingly. Yet to ensure long-term success, it’s important that the productivity focus shift not to increased staff time per patient, but to improved throughput, which will drive higher cash flow. Staffing, management reporting, and financial incentives should reflect this change. If this change is managed correctly, the organization can align performance improvement gains with the organization’s financial objectives.
Because most unit managers have little access to operational financial information, finance staff need to play an integral role in the planning, implementation, and ongoing operation of this new type of performance improvement initiatives. The TICU tool is one way to facilitate finance’s involvement. But given that each U.S. hospital presents a unique cultural and financial environment, this tool is only a starting point, not a panacea.
In the end, it is up to finance staff to facilitate a meaningful dialogue with performance improvement staff, with an understanding that performance improvement activities should no longer be considered a price of doing business. And they should do so with an understanding that performance improvement activities focused on cash flow—far from being just a price of doing business—can improve both patient outcomes and the bottom line.
About the authors
William J. Ward, Jr., is associate professor, Johns Hopkins Bloomberg School of Public Health, Baltimore, and a member of HFMA’s Maryland Chapter.
Lynn Spragens is president, Spragens & Associates, LLC, Durham, N.C., and a member of HFMA’s North Carolina Chapter.
Ken Smithson, MD, is vice president of research, VHA Inc., Irving, Texas (ksmithso@vha.com).
TICU Project Resources
The VHA-led TICU project created two tools to promote a standard approach uniting finance and performance improvement teams toward a common goal. First, a cash flow model with a spreadsheet was created to perform calculations of revenue, payer mix, supply, and medication costs and facilitate the calculation of financial return. Second, a monograph was produced to explain how best to bridge the knowledge gap between performance improvement and finance executives. The tools may be downloaded for free at www.vha.com. Click on “Clinical Improvement” on the menu at left, and then scroll down to “Building a Financial Case for Clinical Improvement” under “Articles and Reports.”