Financial Sustainability

How healthcare providers can avoid being at a disadvantage when negotiating risk contracts

March 16, 2020 3:28 pm


Risk stratification is an effective short-term strategy for providers seeking to negotiate risk contracts from a position of strength.

To gain leverage in risk-based contracting, healthcare finance leaders require a means to identify the true cost of care at the patient level based on actual care services and supplies delivered. But most organizations are years away from possessing such a capability, so their finance leaders require an interim solution to help them gain an advantage in their contract negotiations with payers.

Why payers have an advantage today

Healthcare payers are increasingly using the contracting process to hold providers accountable for outcomes — not just patient outcomes, but also cost outcomes. However, the current framework for contract negotiations strongly favors the payers.

Most risk-based contract discussions today begin with a focus on claims data. This focus gives payers a significant advantage because claims data represents the payer’s cost of entering a proposed contract, while saying very little about the provider’s cost to sign the same agreement. The underlying issue is how each party defines cost. Payers define cost based on service utilization aggregated from claims data. Providers define cost as direct and allocated expense from clinical services provided to patients.

The problem is that, although all healthcare CFOs understand their costs at the aggregate level, few can accurately identify their organization’s cost of delivering care at the patient level. Most hospital finance leaders also lack information on costs incurred outside their organization, including post-acute care and admissions to other hospitals. When it comes to risk-based contracting for a specific population, the end-result is problematic. The payer can cap its costs, while the health system is forced to enter an agreement that may or may not yield a margin.

To overcome this advantage of payers, providers should pursue a long-term strategy developing the ability to fully account for their actual costs of care.

Long-term goal: robust cost accounting

The key is to develop true cost accounting capabilities. Currently, finance departments start with aggregate costs and allocate them across the health system. These allocation methodologies range from basic to more sophisticated, with some models being able to allocate costs to the unit level. Ultimately, however, every allocation methodology is a series of educated guesses due to the lack of direct cost allocation capabilities in patient accounting systems.

In contrast, a genuine cost accounting strategy starts with expenses. The first step is to implement a system for capturing direct and indirect expenses in granular detail. One challenge, of course, is creating a way to tie granular expenses to individual patients. Another is devising a way to capture expense information from outside providers. Although building such a system takes years, doing so is imperative because only with this level of detail can an organization quantify the actual cost of delivering care, whether to an individual patient or a specific patient population.

Understanding the cost of care is critical to assuming contractual risk for cost performance. Within a bundled payment contract, a robust cost accounting system allows finance leaders to accurately predict the cost of providing a defined service across the care continuum. Within a larger member-based care contract, it enables finance leaders to predict the total cost of caring for a defined population.

Short-term strategy: risk stratification

Because risk-based contracting is happening now, however, CFOs also need tools they can use right away to better manage costs.

A first step is to stratify the patient population by risk as a means of understanding cost drivers. Finance leaders can start by incorporating patient risk factors into their current cost allocation methodology. For example, an enhanced allocation model might assign additional costs to patients with certain chronic diseases. A risk stratification approach also could use a tool like the LACE Index to allocate more costs to patients with higher clinical complexity and an increased risk for readmission.[1]

Eventually, finance leaders could work with primary care providers to begin capturing CMS Hierarchical Condition Categories for all patients, thereby allowing organizations to allocate costs based on patient complexity. Although such an approach will not measure the true cost of care, it will allow CFOs to develop cost models based on population risk cohorts. This will provide a much more accurate understanding of likely future costs used at the negotiation table.

2 benefits to a risk-stratification approach

A risk-stratification-based approach to cost identification offers two benefits.

1. Lays the groundwork for a powerful financial management system that aligns clinical service delivery with patients’ clinical complexity. Again, the long-term goal is a robust cost accounting system, but the addition of patient risk factors will only enhance an organization’s total risk management infrastructure.

2. Helps CFOs understand how costs are distributed throughout the continuum of care. Finance leaders then can identify opportunities to shift costs within the care continuum and across different care settings to maximize outcomes while minimizing expenses.

Stratifying patients by risk helps finance leaders understand the cost implication differentials of shifts in utilization, immediately giving their organizations a more solid footing in risk-based contract negotiations.


[1] The LACE index was developed in 2010 by researchers published in CMAJ, the journal of the Canadian Medical Association. The index measures the impact on outcomes from length of stay, acuity of admission, co-morbidities and emergency department visits within the past six months. See van Walraven, C., et al., “Derivation and validation of an index to predict early death or unplanned readmission after discharge from hospital to the community,” CMAJ, April 6, 2010.


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