William O. Cleverley
James O. Cleverley
Is your strategic pricing strategy based on fact or myth?
At a Glance
- Transparency and defensibility of pricing are key issues, but some myths about strategic pricing exist.
- Sensitivity to the complexity of strategic pricing is imperative.
- Implementing a realistic pricing strategy will help hospitals achieve positive outcomes.
The state of the U.S. economy is making everyone more cost-conscious than usual. The healthcare industry is no exception. Always a sensitive issue, hospital pricing seems to be on the minds of many in the healthcare industry today. Survey results of nearly 2,000 healthcare finance executives, presented in HFMA’s Healthcare Finance Outlook 2008-2013, found that one of the most prominent issues they face today is “adopting transparent and justifiable pricing.” Transparent and defensible pricing—under the heading of strategic pricing—continue to gain significant attention in healthcare circles across the country. Yet the continued momentum of this issue has generated a number of ideas about strategic pricing that are false and need to be addressed.
Myth No. 1
Pricing makes a small difference in overall profitability.
Given the increased focus on hospital pricing practices and limited number of payers using billed charge terms for payment, many in the healthcare industry have questioned the purpose of conducting strategic pricing exercises at all. However, abandoning strategic pricing altogether poses significant issues.
As stated, strategic pricing involves the planning and implementation of justifying—or defending—current and proposed pricing. Eliminating a regular review of this important area is sure to cause problems in the hospital and in the community.
Beyond defensibility, however, lies a more intriguing point that is often missed in this myth—that pricing does, in fact, positively affect profitability. In a study of 61 hospitals completing strategic pricing initiatives in the first part of 2007, we found an average 18 percent difference between recovery percentages for traditional across-the-board (ATB) pricing increases versus strategic pricing increases with the same overall facility rate increase (i.e., a 6 percent overall rate increase at the hospital). Recovery rates are defined as the financial return a hospital can expect, on average, for every dollar of rate increase. In our study, the average ATB recovery rate was 13.5 percent compared with the strategic pricing average recovery rate of 15.5 percent.
The key factors in driving the magnitude of potential profit from pricing are contracts, to be sure, but small percentages of billed charge payers can have a profound effect. In addition to increased profitability, the hospitals in our study were also able to include defensibility parameters by relating price to underlying cost and competitors. Pricing, while restricted for some payer groups, is still a critical issue to examine for financial sustainability.
Myth No. 2
Prices do not affect volume because health care is price inelastic.
Although price inelasticity may be true for a number of healthcare services from a relative industry perspective, the degree of price elasticity in the healthcare industry has increased dramatically in the past decade. The rapid rise in the number of health plans with high-deductible provisions has made consumers much more sensitive to hospital prices, especially in outpatient services. Patients are often demanding estimates of prices for common elective procedures such as endoscopies and imaging procedures.
In addition, managed care firms are vitally interested in hospital prices, especially in areas where their payment is related to price. A common negotiation ploy is to identify a provider as “high charge” relative to other providers in the market. This often serves as the basis for a deeper discount to presumably create payer equity. In some situations where negotiations reached an impasse, the payer may deselect the provider from its network. The bottom line is that in most cases the managed care plan is the ultimate purchaser and is very sensitive to prices.
Myth No. 3
Comparative pricing data are becoming more available and meaningful.
This myth is only partly false. Over the past several years, comparative pricing data have become much more available to consumers, especially in electronic form via the Internet. According to the National Conference of State Legislatures, as of September 2007, 38 states had either passed or proposed transparency legislation to make hospital pricing more available to the public.
The real myth behind this statement is that comparative pricing data have become more meaningful. The increased number of sources for hospital price information has only generated more confusion. This confusion is due to inconsistency of reporting as most hospital price data sources provide comparison at either the encounter or procedure level. The lack of uniformity in reporting consistently across all sources confuses even healthcare professionals. To illustrate, consider an example using 2006 Medicare outpatient claims. The exhibit below compares Hospital A and B average charges at the encounter level (per visit) and by procedure (CPT®).
View Exhibit 1
Exhibit 1 Caption. Hospital A bundles additional item codes more often than Hospital B does, leading to price differences at the encounter level and the procedure level.
Although Hospital A has overall encounter charges that are below those of Hospital B, the comparison is reversed at the procedure level. The explanation can be found in the bottom row that highlights the level of bundling at both facilities. Hospital B bundles additional item codes (often for supplies and drugs) far less often than Hospital A, creating the differences in comparison at both levels. Comparison at the encounter level is much more meaningful and appropriate, but organizing the data in this way can be more challenging.
Myth No. 4
Defensibility of prices is not totally related to competitor price comparisons.
Consider a local newspaper calling a hospital financial executive to inquire about the differences between charges for a particular service at the hospital and its local competitor. The hospital charges 20 percent more than the competitor, and the reporter would like to know why. The scenario is commonly presented across hospitals throughout the country. What is the response?
The key in communicating pricing information is to address charges not only for individual services—an important element, for sure—but also at the facility level. Hospitals can and often will have different prices, but the prices may be defensible. The key creator of differences is payer and contract terms. For example, the exhibit below presents data for a sample hospital.
View Exhibit 2
Exhibit 2 caption. Payment terms drive prices for U.S. hospitals. Also, as the number of patients who pay less than the cost of their services grows, the required price for services at the hospital will increase.
The example assumes that the hospital has 100 patients and offers one service to those patients at a cost of $100. The payment rates for each payer group highlight governmental programs and uninsured patients paying less than cost while managed care, as a group, pays more than cost for the service. The required mark-up of price to cost for this hospital would be $270 price to $100 cost. Interestingly, the U.S. median mark-up ratio for acute care hospitals in 2006 was 2.5—very similar to our example hospital’s 2.7 value. The lesson is clear: Payment terms drive price for U.S. hospitals. In addition, as the number of patients who pay less than cost increases, so too will the required price for services at the hospital.
Myth No. 5
Pricing has no effect on net revenues when all payers pay on a prospective basis.
Although this argument seems true on the surface, most contracts include specific provisions that can make price a critical factor in the final determination of net revenues. For example, even Medicare pays for selected procedures on a less-than-price-or-fee schedule basis. Many commercial contracts have similar language for payment of less-than-fee schedule or charges for many ancillary procedures, especially lab and radiology. In a recent pricing study, we found more than $23 million of lost revenue because internal prices were below fee schedule.
A large number of commercial contracts also have claim level less than provisions. If claim charges are below the case payment schedule, the payer will pay charges. Perhaps the most widely cited area is inpatient stop loss provisions. When charges exceed a specified threshold, the hospital is paid on a percentage of billed charge basis. At many large U.S. tertiary care facilities, the stop loss impact can account for 50 percent or more of the total change in net revenues from pricing changes.
Myth No. 6
Negotiating contracts is not a part of pricing.
Often, people believe that strategic pricing is limited to establishing rates for individual line items in the chargemaster. However, more broadly, pricing is determining rates of payment for products and services. Subsequently, part of this process would logically involve contract negotiation, as well.
The contract negotiation process includes two critical phases.
First, a hospital must understand what its costs are to ensure adequate rates of payment. This can be accomplished by examining internal cost accounting data or, in the absence of an internal cost accounting system, by applying department-specific ratios of cost to charge to prices for individual charge codes. In addition to covering costs, the hospital should also consider a reasonable rate of return to provide for capital investment. This cost of business is sometimes missed and can have serious financial implications.
Second, a hospital must understand its relative payment position compared with similar providers. Although benchmarking data are sensitive in this area, it is possible to examine group averages from noncompeting markets without risk of violating antitrust regulations. Gaining an understanding of payment comparison is important to payers and providers alike. It is necessary for both parties to establish reasonable and appropriate levels of payment to ensure the viability of the provider and efficient healthcare delivery offered to payers and their members.
Myth No. 7
Determining the impact of price changes can be accurately tested with a revenue and usage summary.
Evaluating the impact of pricing decisions for budgetary purposes is a critical process hospitals undertake at least annually. When pricing at the line-item level, the hospital clearly needs data with line-item detail. This requirement leaves two sources: a revenue and usage summary and actual line-item claims data. The revenue and usage file is smaller in total size but does not address the impact of claim-level provisions such as outliers or procedure carve-outs. The impact of these claim-level provisions can be significant.
Consider a payer that pays for inpatient care on a per diem basis with an outlier provision of 85 percent of billed charges at a $50,000 threshold. Claims reaching that threshold would still receive no weight using a revenue and usage summary. However, evaluating the impact of those claims using the claims themselves would clearly produce an accurate pricing recovery. Further, consider a payer that pays a percentage of billed charges for outpatient services but has a maximum payment of $1,700. All outpatient activity for this payer would be estimated on a billed charge basis using the revenue and usage summary. The end result would be an overestimation of pricing impact for that payer. Again, using the detailed claims data would produce an accurate estimation.
There are two clear benefits of using detailed claims data in the pricing evaluation process. First, the hospital is able to gain the most accurate revenue projections for the budgetary process. Second, the hospital is able to determine and communicate the impact of the pricing changes to payers. This payer-specific analysis allows hospitals to evaluate the fairness of pricing changes and to work with payers to achieve appropriate payment levels.
Myth No. 8
The real objective of pricing is always to get a targeted bottom line.
There is no disagreement with the need for a targeted bottom line, but individual payer impact is critical to understand. To follow the preceding section, payer-specific analysis is vital to long-term sustainability for both payer and provider alike. For example, assume that one larger payer renegotiates a contract that results in $3 million lower payment for the hospital. To recover this loss, prices are increased—a decision that shifts most of the increased revenue burden to several smaller payers with high payment of billed charges. Long-term, this process will negatively impact the ability for these smaller payers to compete in the market—creating higher costs for the insurer and subsequently, higher costs for the insured. This situation will also negatively impact the hospital as the larger payer will gain more negotiating power and continue the demand for decreased payment. Clearly, determining appropriate payment for all parties is essential for mutual benefit and equity.
In addition to payer equity issues, focusing solely on net income optimization can erode price defensibility. Certainly, rate increase decisions without market pricing data can negatively affect the hospital’s relative charge position. A sensible pricing approach is one that is mindful of payer equity, price defensibility, and appropriate net income targets that achieve sustainable growth.
Myth No. 9
Billed charge arrangements are always more desirable than a prospective plan.
Most hospital financial executives express a strong desire for discount from billed charge payment arrangements. In most instances, this direction is desirable because it greatly simplifies claim administration. We have seen trends moving in both directions. Some organizations have succeeded in moving contract payment to billed charges, while others have been forced to convert some payment areas to fee schedule. It is important to accurately assess the financial impact of any proposed contract change. Fee schedules can actually provide greater payment in some situations than an existing billed charge payment methodology.
One area that hospital executives often overlook is the impact that a price increase limit clause can have upon future payment. As a general rule, the price increase limit should be greater than the medical services consumer price index (CPI) increase. The medical services CPI is based upon changes in net payment in the country, not charges. Charges must increase at greater rates to reflect the deficiencies in payment from government programs and the uninsured. It is also preferable to have a rate increase limit stated as an offset to an annual adjustment. For example, the contract may specify annual increases in payments of 8 percent. If a hospital put in a rate increase below 8 percent, its current payment percentage would actually increase.
Myth No. 10
Prices should be set at a constant mark-up for all services.
The price defensibility discussion has prompted some hospital administrators to consider a constant mark-up for all services. Ideally, many believe, all prices should reflect cost in the same way; however, no major industries establish pricing in this manner. While there are benefits to pursuing this strategy in terms of communicating pricing methodology to the community, there are also concerns. Chief among the concerns is the financial impact that can result from restating pricing in this way.
Using data from our internal study of 61 hospitals, we find that the average recovery rate for a cost-based price adjustment would be -2.7 percent. This means that for every dollar of rate increase, the hospital can expect to lose almost 3 cents. This compares with a nearly 16-cent recovery for a strategic approach that addresses both defensibility and profitability concerns. Beyond the negative net impact at the organization, price fluctuations are often extreme with a move to cost-based pricing. It is not uncommon to see individual rates decrease by 75 percent and increase by the same percentage with a switch to cost-based pricing. Of course, a constant mark-up can be beneficial for defensibility; however, a move to this pricing strategy should be conducted over time with sensitivity to the bottom line. As seen, initiation of this strategy in one year can prove detrimental to a hospital’s finances and line-item pricing differentials.
It is also important to recognize that pricing decisions in almost every industry are market-based and relate to the firm’s strategic goals. In this regard, the hospital industry is facing significant competitive pressure from freestanding outpatient centers providing a range of services from imaging to surgery. Growth is also more rapid in these areas than in traditional inpatient acute care services. Given greater market share in inpatient services and slower growth, economics would suggest setting higher prices in inpatient service sectors while discounting prices in fast-growing outpatient arenas to capture market share. The primary concern is pricing at levels that exceed marginal or variable cost to garner increased volume.
Positive Outcomes
Strategic pricing is certain to continue receiving heightened interest among hospital executives, payers, and community members. Sensitivity to the complexity of the issue is imperative. Creating and implementing pricing strategy based on reality will permit positive outcomes for all involved.
About the authors
William O. Cleverley, PhD, is president, Cleverley and Associates, Worthington, Ohio, and a member of HFMA’s Central Ohio Chapter (bcleverley@cleverleyassociates.com).
James O. Cleverley is principal, Cleverley and Associates, Worthington, Ohio, and a member of HFMA’s Central Ohio Chapter (jcleverley@cleverleyassociates.com).