Blog | Cost Reduction

A New World Order for Hospital Margins

Blog | Cost Reduction

A New World Order for Hospital Margins

As expenses grow faster than revenues, hospitals are looking for ways to maintain margins.

Experienced health system executives have become quite adept at flexing their “margin muscles” when necessary. In recent years, revenue typically has grown at a higher rate than expenses, with only occasional periods of slower revenue growth. 

During those times, system leaders have actively turned their attention to cutting costs proportionally to stabilize margins. However, for two consecutive years now, expenses have risen faster than revenues, and all signs are pointing to a future of persistently slower revenue growth.  

Converging Pressures Squeeze Margins

Medicare rate increases are marginal, and more dollars are moving into risk-based payment. Commercial rates have slowed dramatically, shrinking what has been an important subsidy to offset Medicare and Medicaid losses. Moreover, the shift away from hospital-based care and the corresponding move from inpatient to ambulatory fee schedules are likely to have an even greater effect than that of smaller rate increases. The ongoing impact of all these changes means that system executives must be able to exercise their margin muscles in a new way that they can sustain over the long term. 

A recent Advisory Board survey of 146 health system C-level executives found that cost control has replaced growth as the most urgent strategic priority. “Preparing the enterprise for sustainable cost control" was far and away the top-ranked topic. The second highest topic was “Innovative approaches to expense reduction.” The responses suggest a recognition of a structural margin challenge—and the need for different-in-kind, sustainable solutions.

Just how different is the margin challenge confronting health systems today? And how can health systems adapt their cost cutting approach to this new world order? 

Hospitals, which remain the financial epicenter of the health system, face an especially critical challenge. Despite the movement toward value based care since the passage of the Affordable Care Act in 2010, health systems today still rely heavily on hospital margins to drive overall bottom-line performance. The recent Moody’s report noted that median operating cash flow for not-for-profit health systems declined 15 percent in 2017, a reflection of the impact lower hospital margins have on overall system cash flow. 

Three Capabilities for Sustainable Cost Reduction

Financial sustainability for hospitals—and the health systems they help support—requires a discipline of aggressive cost cutting and ongoing cost avoidance. Three emerging foundations are enabling health systems to tackle this challenge in an organized fashion, laying the groundwork for success:

A comprehensive financial forecast. In order to guide strategic decision making, a reliable financial forecast should combine the change in payer terms with changing usage and volume patterns, competitive activity, and market disruptors to predict annual net revenue on a rolling 3-5 year basis. Operating expenses and strategic and routine capital requirements will predict margin and—more importantly—cash flow. This information must become the new starting point of health system planning and operational priorities.

A strategic margin plan. A comprehensive approach is needed to identify both short- and long-term initiatives that will reduce cash outlay and lower the overall cost of care. Traditional margin drivers such as productivity, supply chain, and revenue cycle still apply, but new margin terrains including care delivery efficiency and service line rationalization should be a significant focus because of the impact on strategic and financial results.

A robust oversight system. Financial goals will be met only by deploying multiple initiatives across the organization. Each initiative team will need a tactical action plan, an empowered leader, and project management resources. Ensuring the teams meet their objectives and the required financial results are actually realized requires discipline and focus. An effective oversight system ensures all activities are coordinated and also empowers, equips, and holds teams accountable for results. 

Many health systems already have begun to experience the financial downturn caused by the changes taking place in the industry, while others are still meeting their financial targets. Regardless of where an organization is today, it is time to start laying the foundation for long-term financial sustainability.


John Johnston, CPA, MHA is senior vice president at Optum Advisory Services, Washington, D.C. 

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