William O. Cleverley

The balance between generating a reasonable ROI and setting reasonable prices is not always easy for hospitals to maintain.


At a Glance: 

Resolving the conflict between generating a profit and keeping prices reasonable is critical to the financial welfare of the hospital industry. Four steps may make this resolution easier: (1) determine the level of profit required, (2) assess the reasonableness of current costs, (3) assess the reasonableness of current prices, and (4) negotiate more equitable payment arrangements. 


When setting prices, most hospitals have two major conflicting management goals. On one hand, hospitals need to generate a reasonable return on their investment to remain financially viable. On the other, hospital executives are concerned with public reaction to prices that might be viewed as too high or unreasonable.

The balance between those two conflicting goals is not easy to maintain, but resolving the conflict is critical to the financial welfare of the hospital industry. The following four steps may make this resolution easier:

  1. Determine the level of profit required.
  2. Assess the reasonableness of current costs.
  3. Assess the reasonableness of current prices.
  4. Negotiate more fair payment arrangements.

Determine the Level of Profit Required

Rhetoric is rampant in the hospital industry, sometimes at the cost of facts. In the May 20 issue of The Wall Street Journal, Sid Abrams, chair of CalPERS Health Benefits Committee, is quoted as saying, "We need to send hospitals in this state the message that Californians will not be held hostage by those who are motivated by greed." The statement makes exciting press copy but is incorrect. It is apparent from the exhibit at the top of page 51 showing relative rates of industry profitability that U.S. acute care hospitals are not, and have never come close to being, greedy.

How much profit should a not-for-profit hospital target? Although there is no single answer that fits all hospital situations, there is an acceptable methodology based on the principle of sustainable growth. Sustainable growth says that any business must generate growth rate in equity equal to its projected long-term growth rate in assets. The median five-year growth rate in hospital investment is approximately 6 percent per year. This would imply a need for equity growth or return on equity (ROE) of 6 percent per year. Hospitals in growth areas would need larger rates, and hospitals with highly leveraged capital structures or low cash reserves would also require larger ROE values. Also, changes in expected rates of economic inflation would affect required earning rates.

Defining the required ROE sets a target for total net income but does not define the amount of profit required from a pricing change. The amount required from pricing changes is simply the difference between fixed-fee payments and costs subtracted from required net income:

Revenue from nonfixed-fee patients = Required net income + Costs - Fixed-fee schedule payments 

The larger the deficit from fixed-fee payment plans-which include Medicare, Medicaid, and many large managed care plans-the more profit will be required from patients who pay on a billed-charge basis.

Assess the Reasonableness of Current Costs

A common reaction by many board members, managed care plans, and the press is that high prices are the result of high levels of cost. They may agree that a hospital's level of profitability is acceptable, but that its costs reflect countless inefficiencies. In short, the argument goes, hospitals are being paid too much not because of greed but because of inefficiencies.

This is a legitimate argument and should not be dismissed too quickly. If costs are excessive, they should be reduced to more reasonable levels. But what represents a reasonable level? Although facilitywide measures such as cost per adjusted patient day or cost per adjusted discharge historically have been used with possible adjustments for case mix and/or cost of living, such a methodology is fundamentally flawed.

A better measure of costs is the "hospital cost index" (HCI). (See "The Hospital Cost Index," hfm, June 2002, for a full explanation of how this measure is used.) This measure is constructed by weighting two other cost measures:

  • Medicare cost per discharge (MCPD): Case-mix-index- and wage-index-adjusted
  • Medicare cost per outpatient claim (MCPC): Relative-weight- and wage-index-adjusted

The HCI is then constructed as follows:

HCI = (% inpatient revenue x MCPD/U.S. average) + (% outpatient revenue x MCPC/U.S. average)

Both facilitywide measures are based on public-use file data and can, therefore, be reported for virtually all U.S. hospitals. Comparisons of HCI values and their two supporting measures-Medicare cost per discharge (case-mix-index- and wage-index-adjusted) and Medicare cost per outpatient claim (relative-weight- and wage-index-adjusted)-with local market hospitals or relevant peer groups should be useful in assessing the reasonableness of current costs. A number of healthcare information vendors can supply these numbers. Also, individuals can compute the values directly if they have access to the public use files required, which would include Medicare cost reports, Medicare Provider Analysis and Review (MEDPAR), and the Hospital Outpatient Prospective Payment System.

Often both payers and hospitals will assess the reasonableness of their prices based on comparisons with similar or local hospitals. A number of states and local communities have reporting mechanisms for hospitals to report charges for either specific procedures or some aggregate measure of facility output such as discharges. Most recently, some states, including California, have made portions of hospital charge description masters (CDMs) publicly available. One of the difficulties with comparing hospital charges is that they may vary significantly across hospitals, not because of operating cost differences so much as payer differences. Hospitals with heavy percentages of Medicare, Medicaid, and indigent patients tend to have higher prices to realize minimal levels of profitability.

Maryland is apparently the only state that mandates uniform discounts from billed charges. Under this type of regulatory control, hospital markups (the relationship of charges to cost) are much lower than in other states, and there is much less variation in price across hospitals in Maryland.

Comparing hospital prices is difficult for a variety of reasons. However, one of the first issues to address is unit of service. That is, are we comparing prices for individual procedures (e.g., CDM-level prices), or is the basis of comparison an encounter (e.g., an admission or outpatient visit)? The level of variation is great at both the CDM level and the admission or visit level, but the comparison of units should be more comparable at the CDM level. For example, a two-view chest X-ray should be more comparable across hospitals than a DRG 127 (heart failure and shock).

Comparing CDM prices is the level most often referenced in articles on hospital pricing. Many people have read or heard of the infamous $58 Tylenol and reacted with disgust at the unfair pricing policies of hospitals. Buried in this price comparison, however, is the significant labor cost involved in packaging, distributing, and recording the usage. This is not to affirm a $58 charge for Tylenol; rather, it suggests that hospitals incur significant expenses in the delivery of care that may or may not be reflected in a particular facility's price for various items.

Comparing the cost of procedures such as a CT scan or a two-view chest X-ray is not quite so easily done because most consumers know very little about the cost of equipment and labor involved in those procedures. The exhibit on page 52 shows the 2003 distribution of prices for a two-view chest X-ray (CPT code 71020) compared with prices for DRG 127 (heart failure and shock). As expected, there is more variation at the encounter (DRG) level than at the procedure level.

Variation in pricing at the encounter level is shown in the exhibit on page 54. To develop the figure, four quartiles were created based on the 2003 Medicare charge per discharge (case-mix- and wage-index-adjusted). The exhibit shows the variation between the lowest charge quartile and the other three quartiles. For instance, the highest charge quartile had a median charge per discharge of $20,978, which was about 165 percent above that of the lowest charge quartile.

Although significant variation exists in median charges among the four quartile groups, higher costs do not appear to be the primary driving factor for higher charges. In that regard, Medicare cost per discharge for the highest charge quartile, at $6,560, is only 35 percent above the lowest charge quartile group. Clearly, there is some relationship between higher cost and higher charge; however, the variation is more affected by payer-mix variables. Perhaps more important is the variation among the deduction ratio values. The lowest charge quartile had a deduction ratio of 36.25 percent compared with the highest charge quartile value of 68.94 percent, which is about 90 percent higher. Although the high-charge group may have significantly higher charges, they are clearly writing off a much larger percentage of their gross charges compared with the lowest charge quartile. Some of this larger write-off is related to government payment, especially Medicaid. For example, the lowest quartile of charge hospitals derives only 8.1 percent of its inpatient days from Medicaid, while the highest charge quartile derives 11.3 percent. Finally, the EBIDA-to-assets variance shows that the highest charge quartile group is not using higher charges to realize more significant levels of profit; very little difference is seen between the values.

Negotiate More Equitable Payment Arrangements

Some hospitals find that their profits are not excessive and their costs are reasonable, but their prices are higher than those of similar hospitals. The causes for this can always be broken down into one of two scenarios.

First, the hospital may have high percentages of Medicaid and self-pay patients. Although the public uproar over working families being forced into bankruptcy because of medical bills that are two or three times the rates managed care firms would pay is understandable, the reality of actual payment does not fit with the few situations reported in the press. Most hospitals struggle to collect 10 percent of billed charges on self-pay patients. This figure does not include deductibles or coinsurance that insured patients may pay on their own.

Second, the payer mix may be acceptable, but the payment terms are inadequate. Many large managed care plans negotiate hospital payment down to levels that do not pay hospitals for the reasonable costs of treatment.

Perhaps hospitals are willing to accept payment below cost from major payers because they believe loss of the contract would create larger losses. In other instances, hospital management may not know what costs really are, or they believe they will make money on parts of the contract, such as stop loss and cardiology.

The solution is clear: Payers must provide payment that covers reasonable cost, including charity care and capital replacement. Without that level of reasonable payment, hospitals will be forced to price services to those patients and their payers who pay billed charges or discounted billed charges in a manner that will ensure their financial viability. There is simply no other solution. The problem is not pricing, but rather inadequate payment. But how might such payment be structured?

A Reasonable Solution

For the most part, hospital prices are not unreasonable and are a direct result of the hospital's payer mix and payer contractual terms. It is true that prices for services to the medically uninsured are significantly higher than average payments received from most third-party payers. However, very few medically uninsured patients actually pay at a level approaching average payment levels of most third-party payers because the vast majority of the bill is written off either as charity care or bad-debt expense. Although large write-offs on self-pay patients are a reality for every U.S. hospital, many hospitals have defined charity care policies that relate charity care discounts to family income and other factors.

Also, any policy change that either restricts hospital pricing or limits charges to medically uninsured patients would have an adverse impact on already thin hospital profits. Forcing hospitals to limit pricing in any way would require comparable increases in payments from other third-party payers such as Medicare, Medicaid, and other commercial carriers. Given the current economic environment, this does not appear to be a likely outcome.

In addition, hospitals that fail to set prices to recover their true financial requirements, including a profit factor to permit replacement of capital assets and to finance working capital, will erode their financial position and shift the financial burden to the next generation of patients. This strategy does not appear to be economically sound or equitable.

It is clear that all payers should pay hospitals for reasonable costs of patient services. A percentage-of-billed-charge arrangement with upper limits on payment makes the most sense because it would be both equitable and easier to administer. Stating this fact seems obvious, but such as arrangement is difficult to achieve. It is possible that hospitals could insist on equitable payment arrangements in their negotiations, but pressures to retain contracts in competitive markets will in many cases force hospitals to accept less equitable payment plans. Ultimately, in free markets, prices should be set to recover costs plus a required return on capital, but this outcome is made more difficult when major public payers such as Medicare and Medicaid fail to provide payment commensurate with costs. Perhaps the only workable solution would be to have prices set in a regulatory manner similar to Maryland, where all payers pay a uniform but regulated percentage of billed charges.


William O. Cleverley, PhD, is president, Cleverley & Associates, Columbus, Ohio, and a member of HFMA's Central Ohio Chapter.

Questions and comments about this article may be sent to the author at wcleverley@cleverleyassociates.com.

Publication Date: Friday, October 01, 2004

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