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allocation rate is different for the two support departments because they have
different cost pools (total costs).
The ¬nal step in the allocation process is to calculate the actual dollar
allocation to each of the patient services departments, which is shown in Ta-
ble 6.6. The support departments are listed in the ¬rst column, along with
the applicable allocation rate, while the patient services departments are listed
across the top. To illustrate the calculations, consider Routine Care. It pro-
duces $16,000,000 in patient services revenue, and the overhead allocation
rate for Financial Services is $0.05556 per dollar of patient services revenue,
so the allocation for such support is 0.05556 — $16,000,000 = $888,960.
Furthermore, Routine Care has 199,800 square feet of space; with a Facilities
rate of $12.64 per square foot, its allocation for Facilities support is $12.64
— 199,800 = $2,525,472.
The allocations to Routine Care for Housekeeping, Administration,
and Personnel services support shown in Table 6.6 were calculated similarly.
The end result is that $8,644,050 out of a total of $13,850,000 of the
indirect (overhead) costs of Kensington Hospital are allocated to Routine
Care. Routine Care also has direct costs of $5,500,000, so the total costs of the

TABLE 6.5
Cost Pool Total Allocation
Kensington
Department (Total Costs) Cost Driver Utilization Rate
Hospital:
Overhead
Financial Services $1,500,000 Patient revenue $27,000,000 $0.05556
Allocation Rates
Facilities 3,800,000 Square feet 300,600 12.64
Housekeeping 1,600,000 Labor hours 91,000 17.58
Administration 4,400,000 Salary dollars $10,183,000 0.432
Personnel 2,550,000 Salary dollars $10,183,000 0.250
170
Healthcare Finance
TABLE 6.6
Kensington Hospital: Final Allocations

Patient Services Department

Support Department Routine Care Laboratory Radiology

— $16,000,000 = — $5,000,000 = — $6,000,000 =
Financial Services ($0.05556) $ 888,960 $ 277,800 $ 333,360
— 199,800 = — 39,600 = — 61,200 =
Facilities ($12.64) 2,525,472 500,544 773,568
— 76,000 = — 6,000 = — 9,000 =
Housekeeping ($17.58) 1,336,080 105,480 158,220
— 5,709,000 = — 2,035,000 = — 2,439,000 =
Administration ($0.432) 2,466,288 879,120 1,053,648
— 5,709,000 = — 2,035,000 = — 2,439,000 =
Personnel ($0.250) 1,427,250 508,750 609,750
Total indirect costs $ 8,644,050 $ 2,271,694 $ 2,928,546
Direct costs $ 5,500,000 $ 3,300,000 $ 2,800,000

Total costs $ 14,144,050 $ 5,571,694 $ 5,728,546

Total indirect costs = $8,644,050 + $2,271,694 + $2,928,546 = $13,844,290.
Total costs = $14,144,050 + $5,571,694 + $5,728,546 = $25,444,290.

Note: Because of rounding in the allocation process, the totals here differ slightly from the values contained in Table 6.2.
171
Chapter 6: Cost Allocation



department, including both direct and indirect, are $8,644,050 + $5,500,000
= $14,144,050. The cost allocations and total cost calculations for Laboratory
and Radiology shown in Table 6.6 were done in a similar manner.
For general management purposes, understanding the mechanics of the
allocation is less important than recognizing the value of choosing good cost
drivers. The cost driver for Housekeeping (i.e., the number of service hours
provided) is good in the sense that it re¬‚ects the true level of effort expended
by this department in support of the patient services departments. The patient
services department heads are being fairly charged for Housekeeping services
and, more importantly, patient services managers can take actions to lower the
allocated amounts by reducing the amount of these services utilized.
In closing this illustration, note how Table 6.6, after the allocation pro-
cess, reconciles with Table 6.2, before the allocation process. First, as shown
in Table 6.2, total support services (overhead) costs are $13,850,000. This is
the same amount (except for a rounding difference) shown in Table 6.6 as the
total overhead allocated to the patient services departments: $8,644,050 (to
Routine Care) + $2,271,694 (to Laboratory) + $2,928,546 (to Radiology) =
$13,844,290. The total after-allocation costs of $25,444,290 shown in Table
6.6 also equals the original forecast for total costs in Table 6.2 of $25,450,00
(again, except for a rounding difference).


Self-Test
1. Brie¬‚y outline the allocation procedures used by Kensington Hospital.
Questions
2. What underlying characteristic creates a good cost driver?
3. What is the most important organizational bene¬t derived from the
selection of a good cost driver?


The Impact of Changing Cost Drivers
The Kensington Hospital illustration in the previous section presents an ap-
plication of the direct method of cost allocation. This illustration builds upon
the previous section and continues using the direct method, but focuses on
the bene¬ts of moving from one cost driver to a better one.
The hospital historically has allocated the $1,500,000 in Financial Ser-
vices costs on the basis of the dollar volume of patient services provided. How-
ever, it was widely recognized by the managers involved that this driver is not
highly correlated with the actual resources expended by Financial Services, and
hence it was not perceived as being fair. More importantly, it did not create
the incentive for overhead cost reduction, because patient services department
heads would not reduce the amount of services provided (and hence reduce
revenues) just to lower their overhead allocations.
A through analysis of the work done by Financial Services indicated that
its primary task in support of the patient services departments is generating
third-party payer billings and collecting on those bills. Thus, the conclusion
172 Healthcare Finance



was drawn that the cost of providing ¬nancial services is more highly corre-
lated with the number of bills generated than with patient services revenues,
so number of bills was chosen as the new cost driver.
Table 6.7 contains the new cost allocations for Financial Services as
well as a comparison with the allocations under the old (patient services
revenue) driver. Note that the allocations have changed substantially. Because
the average amount of a Routine Care bill is much higher than the average
amounts of Laboratory or Radiology bills, Routine Care has signi¬cantly fewer
bills than the other patient services departments in spite of its signi¬cantly
higher revenues. Thus, the new Financial Services allocation is very much
lower for Routine Care than the amount under the old driver, but much higher
for Laboratory and Radiology.
The move to a different cost driver represents more than just change
for the sake of change. It represents an attempt by Kensington™s managers to
base the allocation on the actual work performed by Financial Services, and
thus to create an allocation that has economic meaning, that is perceived to
be fair, and that will encourage patient services department heads to reduce
their utilization of Financial Services.
In spite of the improvement that results from the change, the new cost
driver is not perfect. Other changes could be made to improve the allocation
even more. For example, the Financial Services department performs tasks
other than billing, such as generating numerous reports the organization, in-
cluding both ¬nancial statements and managerial accounting reports. Indeed,

TABLE 6.7
Utilization of Financial Services
Kensington
Patient Services Department Number of Bills required
Hospital: New
Financial Routine Care 3,200
Laboratory 60,300
Services
Radiology 36,500
Allocations
Total 100,000


Allocation Rate
$1,500,000 / 100,000 = $15.00 per bill.

Allocations
New Old Difference
Routine Care $15.00 — 3,200 = $ 48,000 $ 888,960 ’$840,960
Laboratory 15.00 — 60,300 = 904,500 277,800 +626,700
Radiology 15.00 — 36,500 = 547,500 333,360 +214,140

Total $1,500,000 $ 0
≈$1,500,000
173
Chapter 6: Cost Allocation



the department has one analyst whose full-time job is creating and helping
to interpret managerial accounting reports. (Managerial accounting reports
are discussed in Chapter 8.) A better allocation of Financial Services costs,
therefore, may be based on multiple cost drivers. If this were done, some pro-
portion of the department™s total costs of $1,500,000 would be assigned to
report preparation, and a separate cost driver would be identi¬ed to allocate
these costs to the other departments.
Even though an even better cost driver may be developed, the change
that has taken place is still meaningful. Cost accounting studies generally have
shown that the relationship between overhead cost usage and volume, either
measured by revenues or units of service, is not very strong. Indeed, use of vol-
ume as the cost driver often results in systematic, as opposed to random, errors
in cost allocation. Volume based allocation schemes create a bias against larger
revenue-producing departments or services by overallocating their costs, while
the overhead costs of smaller revenue-producing departments or services are
under allocated. This bias occurs largely because a volume based cost driver
fails to recognize the economies of scale inherent in larger departments and
services in the utilization of overhead services. For example, it probably costs
no more to bill a third-party payer for $5,000 than it does to bill for $500 in
terms of the resources required to produce and transmit the bill and to mon-
itor payment. Yet, a revenue based allocation scheme would tend to allocate
more ¬nancial services costs to a patient services department with relatively
high charges than to a department with relatively low charges that had exactly
the same patient load and hence the same number of bills.
Although the allocation change appears to be a zero-sum game (i.e.,
one patient services department gains while another loses), the decision to
make the change was not really dif¬cult for Kensington™s senior managers.
With a better cost driver, the hospital has moved to a more equitable allocation
of Financial Services costs even though it may not seem that way to the
department heads who saw their allocated amounts increase. However, those
departments with allocation increases for Financial Services (Laboratory and
Radiology) are now being allocated their fair shares of the overhead expenses.
They were formerly being subsidized by the Routine Care department whose
allocation was too high.
In additon, revenue-producing department heads can reap the bene¬ts
of their efforts to make the billing process more ef¬cient. If the head of Lab-
oratory does not like the new higher allocation, he or she can do something
about it”generate fewer bills. The task must be done without lowering the
total billing amount, which may not be easy. In fact, the effort will probably
have to be done jointly with Financial Services, and perhaps with third-party
payers.
The critical point is that patient services department heads are now
motivated to participate in making the billing process more ef¬cient. If Lab-
oratory can cut the number of bills in half, it can cut its allocation in half. If
174 Healthcare Finance



enough patient services departments do this, Kensington will eventually dis-
cover that it can get along with fewer resources devoted to Financial Services
and thus reduce total overhead costs. A reduction in overhead costs is the ulti-
mate bene¬t of moving to a better cost driver. A well-chosen cost driver makes
department heads accountable for the use of support department resources,
which is the starting point in gaining control of overhead costs within any
organization.


Self-Test 1. What are the advantages of changing from a poor cost driver to a better
Questions one?
2. What are the costs involved in the change?
3. Why is good cost allocation critical to good decision making?


Step-Down Method Illustration
We close our cost allocation illustrations with a simple example of the step-
down method. Fargo Medical Associates, which has two support departments
(Financial Services and Administration) and two patient services departments
(Home Care and Diagnostic Services), will be used. In the previous illustra-
tion, support department costs were allocated directly to the patient services
departments with no recognition of intrasupport department services. Now
we will recognize, at least partially, that support departments provide services
to each other.
The allocation is summarized in Table 6.8. The ¬rst decision that must
be made under the step-down method is which of the two support depart-
ments is the most primary (i.e., which support department provides the most
services to the other). In this illustration, we assume that Administration pro-
vides more support to Financial Services than Financial Services provides to
Administration. Thus, in the step-down process, the ¬rst support department
to be allocated is Administration.3
In the step-down method, the $312,425 in Administration direct costs
are allocated not only to the revenue-producing departments but also to
Financial Services, the other support department. Thus, the initial allocation
in the top section of Table 6.8 shows that Administration costs are allocated
to Financial Services, Home Care, and Diagnostic Services.
The allocation of Administration costs is made using payroll costs of
the receiving departments as the cost driver. The total payroll for Fargo, less
the Administration department, is $4,307,281, so the $312,425 in Adminis-
tration costs are allocated at a rate of $312,425 / $4,307,281 = $0.072534
per dollar of payroll. For example, the allocation of Administration costs to
Financial Services is 0.072534 — $505,321 = $36,653, while the allocation
to Home Care is 0.072534 — $3,376,845 = $244,937. The key point is that
under the step-down method, overhead costs are allocated both to support
175
Chapter 6: Cost Allocation


TABLE 6.8
Initial Allocation of Administration Department Costs: Fargo Medical
Associates:
Administration costs = $312,425.
Allocation rate = $312,425/$4,307,281 = $0.072534 per dollar of payroll. Step-Down
Allocation of
Financial Diagnostic
Administration
Services Home Care Services Total
and Financial
Payroll costs $ 505,321 $3,376,845 $ 425,115 $ 4,307,281
Services Costs
Percent of total 11.7% 78.4% 9.9% 100.0%
Allocation $ 36,653 $ 244,937 $ 30,835 $ 312,425

Subsequent Allocation of Financial Services Department Costs:
Financial Services costs = $665,031 + $36,653 = $701,684.
Allocation rate = $701,684/14,456 = $48.539 per bill.
Number of bills 10,508 3,948 14,456
Percent of total 72.7% 27.3% 100.0%
Allocation $ 0 $ 510,051 $ 191,633 $ 701,684




departments and to patient services departments. Table 6.8 places Financial
Services in the allocation scheme, while similar tables under the direct method
listed only patient services departments.
Now that Administration costs have been allocated across support and
patient services departments, the role of Administration in the allocation pro-
cess is terminated. The next step is to allocate Financial Services costs, which
now include both direct costs plus the indirect costs from the allocation for
Administration overhead. This allocation is shown in the bottom section of
Table 6.8. Although Financial Services has only $665,031 in direct costs, the
total amount to be allocated is $701,684, because it includes $36,653 of allo-
cated Administration overhead. Because some of the costs of Administration
now ¬‚ow through Financial Services, the allocation of Financial Services costs
to the patient services departments is somewhat greater than it would be using
the direct method. However, the allocation of Administration costs to the pa-
tient services departments is less under the step-down method than under the
direct method because some costs that had been allocated directly to patient
services departments are now allocated to another support department.
The step-down method of allocation is somewhat more complicated
than the direct method. However, a good managerial accounting system can
accomplish either allocation method quite easily. The real disadvantage of the
step-down method is that it is more dif¬cult for department heads to un-
derstand, especially in large, complex organizations. Still, for the reasons dis-
cussed previously (equity and cost control), managers want the best possible
allocation system. In addition, CMS requires that the step-down method be
176 Healthcare Finance



used in reporting Medicare costs. Thus, in practice, the step-down method
dominates the others in terms of usage.



Self-Test 1. What is the primary difference between the direct and step-down
Questions methods of cost allocation?
2. Why might organizations adopt a more complicated allocation system?



Activity Based Costing
Our discussion thus far has focused on traditional cost allocation methods.
In essence, the traditional methods begin with aggregate costs, typically at
the department level. Overhead costs are then allocated downstream to the
patient services departments. Thus, traditional methods can be thought of as
a top-down allocation. Although traditional costing works well for estimating
costs at the department level, its usefulness for estimating the costs of activities
within or across departments, such as individual tests, services, or diagnoses,
is limited.
Activity based costing (ABC) is a relatively new allocation system that
is gaining popularity in the health services industry. ABC uses an upstream
approach to cost allocation. Its premise is that the foundation of all costs
within an organization stems from activities, hence its name. In fact, the
term cost driver, which has been used throughout the chapter, originated with
ABC”a cost driver is the basic activity that causes costs to be incurred in the
¬rst place. In ABC, because activities are the focus of the cost accounting
system, costs can be more easily assigned to individual patients, individual
physicians, particular diagnoses, a reimbursement contract, a managed care
population, and so on.
The key to cost allocation under ABC is to identify the activities that
are performed to provide a particular service and then aggregate the costs of
the activities. The steps required to implement ABC are as follows:

• Identify the relevant activities.
• Determine the cost of each activity, including both direct and
indirect.
• Determine the cost drivers for the activity.
• Collect activity data for each service.
• Calculate the total cost of the service by aggregating activity costs.

To illustrate the ABC concept, suppose that the seven activities per-
formed at a family practice clinic are identi¬ed as: (1) patient check-in, includ-
ing insurance veri¬cation; (2) preliminary assessment; (3) diagnosis; (4) treat-
ment; (5) prescription writing; (6) patient check-out; and (7) third-party-
177
Chapter 6: Cost Allocation



payer billing. Furthermore, assume that the clinic has 10,000 visits annually
split evenly between two services: A and B. Before we go further, note that
this example is highly simpli¬ed. Its purpose is merely to give you a ¬‚avor for
how ABC works.
Table 6.9 contains the initial data and allocation rate calculations. For
example, the annual costs of patient check-in, consisting of clerical labor and
supplies (direct costs) plus space and other overhead (indirect costs), are
$50,000 to support 10,000 total visits, giving an allocation rate of $5.00 per
visit. Also, the total (direct labor by a nurse and overhead) costs required
to conduct the initial assessment is $75,000, spread over (5,000 visits — 5
minutes for A) + (5,000 visits — 10 minutes for B) = 25,000 + 50,000 =
75,000 minutes annually, giving an allocation rate of $1 per minute.
As shown in Table 6.10, the ¬nal step is to aggregate the activity costs
for each service. Note that this is done on a per visit basis. For example,
for Service A, the cost of check-in is 1 visit — $5.00 = $5.00, the cost of
assessment is 5 minutes per visit — $1.00 = $5.00, and the cost of diagnosis
is 10 minutes per visit — $2.00 = $20.00. Other activity costs for Service A,
and for Service B, were calculated in a similar manner.
The end result of summing the individual activity costs associated with
each service is a total cost of $75.10 for Service A and $130.40 for service
B. The ability of the family practice to estimate the costs of its individual
services allows the services to be priced properly (on the basis of costs). In
addition, cost control is made easier because the activities, and hence resource
expenditures, associated with each service have been clearly identi¬ed.
Note that the total annual costs of providing Service A are 5,000 visits
— $75.10 = $375,500, while the total costs for B are 5,000 visits — $130.40
= $652,000. Because there are only two services in this simple example, the
total costs of the practice are $375,500 + $652,000 = $1,027,500, which
equals the total cost amount identi¬ed in Table 6.9.
Clearly, ABC holds great promise for healthcare providers. The ability
to assess the costs of individual services provides managers with much better
information regarding the true costs of providing services. However, the infor-
mation and resource requirements to establish an ABC system far exceed those
required for a traditional cost allocation system. For this reason, traditional
cost allocation still dominates the scene, but ABC is becoming more preva-
lent as the need for better cost data becomes more important and providers
invest in newer and more powerful managerial accounting systems.



Self-Test
1. What are the key differences between traditional and activity based
Questions
costing?
2. Why does ABC hold so much promise for healthcare providers?
178
Healthcare Finance
TABLE 6.9
ABC Illustration: Initial Data and Allocation Rate Calculation
Activity Data
Allocation
Activity Annual Costs Cost Driver Service A Service B Total Rate


Check-in $ 50,000 Number of visits 5,000 5,000 10,000 $ 5.00
Assessment 75,000 Number of minutes per visit 5 10 75,000 1.00
Diagnosis 250,000 Number of minutes per visit 10 15 125,000 2.00
Treatment 450,000 Number of minutes per visit 10 20 150,000 3.00
Prescription 2,500 Drugs prescribed per visit 0.5 2.0 12,500 0.20
Check-out 50,000 Number of visits 5,000 5,000 10,000 5.00
Billing 150,000 Number of bills per visit 1.0 2.0 15,000 10.00

Total costs $1,027,500
TABLE 6.10
ABC Illustration: Final Aggregation of Activity Costs per Visit

Service A Service B

Activity Cost Driver Rate Consumption Cost Consumption Cost


Check-in Number of visits $ 5.00 1 $ 5.00 1 $ 5.00
Assessment Number of minutes 1.00 5 5.00 10 10.00
Diagnosis Number of minutes 2.00 10 20.00 15 30.00
Treatment Number of minutes 3.00 10 30.00 20 60.00
Prescription Number of drugs 0.20 0.5 0.10 2.0 0.40




Chapter 6: Cost Allocation
Check-out Number of visits 5.00 1 5.00 1 5.00
Billing Number of bills 10.00 1.0 10.00 2.0 20.00

Total cost per service $75.10 $130.40




179
180 Healthcare Finance



Final Thoughts on Cost Allocation
This chapter has been more mechanical than conceptual, but readers should
not lose sight of the basic principles of cost allocation. The primary goal of
cost allocation is to allocate as many costs as possible to those activities that
create the need for the costs. In addition, to be an effective allocation system,
the cost drivers used must meet two tests. First, a good cost allocation system
must be fair; managers must believe that the overhead allocations to their
departments truly re¬‚ect the amount of overhead services consumed. Second,
the allocation process should foster cost reduction within the organization.
To ensure fairness and cost control incentives, cost drivers must re¬‚ect those
factors that truly in¬‚uence the amount of overhead services consumed.
For any organization, the better its cost allocation process meets these
two tests, the better the managerial decisions. After all, costs play a major
role in provider decisions such as what prices to charge, what services to
offer, and how much should clinical managers be paid. If the cost allocation
system is faulty, those decisions may be ¬‚awed, and the ¬nancial condition of
the business and employee morale will be degraded. Although the allocation
process may seem rather mundane, the more con¬dence that all managers
have in its validity, the better the organization will function.


Self-Test 1. What is the goal of cost allocation?
Questions 2. What are the two primary tests that good cost allocation processes pass?
3. Why is the cost allocation process important to health services managers?


Key Concepts
This chapter focused on cost allocation. The key concepts of this chapter are:
• Direct costs are the unique and exclusive resources utilized only by one
unit of an organization, such as a department, and therefore are fairly easy
to measure.
• Indirect costs, in contrast, are inherently dif¬cult to measure because these
costs constitute a shared resource of the organization as a whole, such as
administrative costs.
• The goal of cost allocation is to assign as many costs of an organization as
possible directly to the activities that cause them to be incurred.
• Cost allocation is a critical part of the costing process because it addresses
the issue how to assign the costs of support activities to the
revenue-producing (patient services) departments.
• The motivation to improve cost allocation systems comes largely from the
increasing pressure to optimize economic performance within health
services organizations and the resultant managerial incentive systems that
focus on ¬nancial parameters.
181
Chapter 6: Cost Allocation



• The identi¬cation of meaningful cost drivers is an important step in
developing a sound cost allocation system.
• The best cost drivers have a strong positive correlation with the amount of
overhead services utilized.
• A good cost driver will be perceived by department heads as being fair,
and will promote cost control measures within the organization.
• There are three primary methods for cost allocation: direct, reciprocal, and
step down.
• The direct method recognizes no intrasupport department services. Thus,
support department costs are allocated exclusively to patient services
departments.
• The reciprocal method recognizes all intrasupport department services.
Unfortunately, the reciprocal method is dif¬cult to implement because it
requires the simultaneous solution of a series of equations.
• The step-down method represents a compromise that recognizes some of
the intrasupport department services.
• Regardless of the allocation method, all costs eventually end up in the
patient services departments.
• Activity based costing (ABC) allocates costs on the basis of activities and
hence aggregates costs from the basic components that create costs in the
¬rst place.
• ABC can provide a much more meaningful allocation of costs because
costs can be assigned to individual patients, diagnoses, patient
populations, and so on.
• However, ABC requires a very sophisticated and costly managerial
accounting information system.

Although this chapter contains a great deal of detail, the most important point
to remember is that a sound cost allocation system is required in making
good pricing and service decisions, which is the topic of discussion in the
next chapter.


Questions
6.1 What are the primary differences between direct and indirect costs?
6.2 What is the goal of cost allocation?
6.3 a. What are the three primary methods of cost allocation?
b. What are the differences among them?
6.4 a. What is a cost pool?
b. What is a cost driver?
c. How is the cost allocation rate determined?
6.5 Effective cost drivers, and hence the resulting allocation system, must
have what two important attributes?
182 Healthcare Finance



6.6 Brie¬‚y describe (illustrate) the cost allocation process. (To keep things
simple, use the direct method for your illustration.)
6.7 Which is the better cost driver for the costs of a hospital™s Financial
Services department: patient services department revenues or number of
bills generated? Explain your rationale.
6.8 How does activity based costing (ABC) differ from traditional costing
approaches?


Problems
6.1 The Housekeeping Services department of Ruger Clinic, a multispecialty
practice in Toledo, Ohio, had $100,000 in direct costs during 2004.
These costs must be allocated to Ruger™s three revenue-producing
patient services departments using the direct method. Two cost
drivers are under consideration: patient services revenue and hours
of housekeeping services utilized. The patient services departments
generated $5 million in total revenues during 2004, and to support
these clinical activities, used 5,000 hours of housekeeping services.
a. What is the value of the cost pool?
b. What is the allocation rate if:
• patient services revenue is used as the cost driver?
• hours of housekeeping services is used as the cost driver?
6.2 Refer to Problem 6.1. Assume that the three patient services departments
are Adult Services, Pediatric Services, and Other Services. The patient
services revenue and hours of housekeeping services for each department
are:
Department Revenue Housekeeping Hours
Adult Services $3,000,000 1,500
Pediatric Services 1,500,000 3,000
Other Services 500,000 500
Total $5,000,000 5,000

a. What is the dollar allocation to each patient services department if
patient services revenue is used as the cost driver?
b. What is the dollar allocation to each patient services department if
hours of housekeeping support is used as the cost driver?
c. What is the difference in the allocation to each department between
the two drivers?
d. Which of the two drivers is better? Why?
The following data pertain to the Problems 6.3 through 6.6:
St. Benedict™s Hospital has three support departments and four
patient services departments. The direct costs to each of the support
departments are:
183
Chapter 6: Cost Allocation



General Administration $2,000,000
Facilities 5,000,000
Financial Services 3,000,000
Selected data for the three support and four patient services departments
are:
Patient Space
Services (Square Housekeeping Salary
Department Revenue Feet) Labor Hours Dollars
Support:
General 10,000 2,000 $1,500,000
Administration
Facilities 20,000 5,000 3,000,000
Financial Services 15,000 3,000 2,000,000
Total 45,000 10,000 $6,500,000

Patient Services:
Routine Care $30,000,000 400,000 150,000 $12,000,000
Intensive Care 4,000,000 40,000 30,000 5,000,000
Diagnostic Services 6,000,000 60,000 15,000 6,000,000
Other Services 10,000,000 100,000 25,000 7,000,000

Total $50,000,000 600,000 220,000 $30,000,000

Grand total $50,000,000 645,000 230,000 $36,500,000

6.3 Assume that the hospital uses the direct method for cost allocation.
Furthermore, the cost driver for General Administration and Financial
Services is patient services revenue, while the cost driver for Facilities is
space utilization.
a. What are the appropriate allocation rates?
b. Use an allocation table similar to Table 6.6 to allocate the hospital™s
overhead costs to the patient services departments.
6.4 Assume that the hospital uses salary dollars as the cost driver for General
Administration, housekeeping labor hours as the cost driver for Facilities,
and patient services revenue as the cost driver for Financial Services.
(The majority of the costs of the Facilities department are devoted to
housekeeping services.)
a. What are the appropriate allocation rates?
b. Use an allocation table similar to the one used for Problem 6.3
to allocate the hospital™s overhead costs to the patient services
departments.
c. Compare the dollar allocations with those obtained in Problem 6.3.
Explain the differences.
184 Healthcare Finance



d. Which of the two cost driver schemes is better? Explain your answer.
6.5 Now, assume that the hospital uses the step-down method for
cost allocation, with salary dollars as the cost driver for General
Administration, housekeeping labor hours as the cost driver for Facilities,
and patient services revenue as the cost driver for Financial Services.
Assume also that General Administration provides the most services
to other support departments, followed closely by Facilities. Financial
Services provides the least services to the other support departments.
a. Use an allocation table to allocate the hospital™s overhead costs to the
patient services departments.
b. Compare the dollar allocations with those obtained in Problem 6.4.
Explain the differences.
c. Is the direct method or the step-down method better for cost
allocation within St. Benedict™s? Explain your answer.
6.6 Return to the direct method of cost allocation and use the same cost
drivers as speci¬ed in Problem 6.4 for General Administration and
Facilities. However, assume that $2,000,000 of Financial Services costs
are related to billing and managerial reporting and $1,000,000 are
related to payroll and personnel management activities.
a. Devise and implement a cost allocation scheme that recognizes that
Financial Services has two widely different functions.
b. Is there any additional information that would be useful in completing
Part a?
c. What are the costs and bene¬ts to St. Benedict™s of creating two cost
pools for Financial Services?
6.7 Consider the following data for a clinical laboratory:
Activity Data

Activity Annual Costs Cost Driver Test A Test B Test C Test D
Receive specimen $ 10,000 Number of tests 2,000 1,500 1,000 500
Equipment set up 25,000 Number of minutes per test 5 5 10 10
Run test 100,000 Number of minutes per test 1 5 10 20
Record results 10,000 Number of minutes per test 2 2 2 4
Transmit results 5,000 Number of minutes per test 3 3 3 3

Total costs $150,000


a. Using ABC techniques, determine the allocation rate for each activity.
b. Now, using this allocation rate, estimate the total cost of performing
each test.
c. Verify that the total annual costs aggregated from individual test costs
equal the total annual costs of the laboratory given in the table above.

Notes
1. Cost allocation takes place both for historical purposes, in which realized costs
over the past year are allocated, and for planning purposes, in which estimated
185
Chapter 6: Cost Allocation



future costs are allocated to aid in pricing and other decisions. The examples in
this chapter generally assume that the purpose of the allocation is for pricing,
and so the data presented is estimated for the coming year”2005.
2. In reality, Kensington™s managers must make another decision”identifying the
appropriate cost pools. Typically, a cost pool consists of the all of the direct
costs of one support department. However, if the services of a single support
department differ substantially (in the sense that the patient services departments
use different relative amounts), it may be bene¬cial to separate the costs of that
support department into multiple pools. For example, suppose Kensington™s
Financial Services department provides two signi¬cantly different services:
patient billing and budgeting. Furthermore, assume that Routine Care uses
more patient billing services than does Laboratory, but Laboratory uses more
budgeting services than does Routine Care. In this situation, it would be best
to create two cost pools for one support department. To do this, the total costs
of Financial Services must be divided into a billing pool and a budgeting pool.
Then cost drivers must be chosen for each pool and the costs allocated to the
other departments as previously described.
3. If the two support departments were Human Resources and Housekeeping, the
decision to which department to allocate ¬rst may be more dif¬cult because
each of these departments provides signi¬cant support to the other. In such
a situation, the best allocation method may be the reciprocal method (see
Figure 6.1).



References
Baker, J. J. 1995. “Activity-Based Costing for Integrated Delivery Systems.” Journal
of Health Care Finance (Winter): 57“61.
Baker, J. J., and G. F. Boyd. 1997. “Activity-Based Costing in the Operating Room
at Valley View Hospital.” Journal of Health Care Finance (Fall): 1“9.
Greene, J. K., and A. Metwalli. 2001. “The Impact of Activity Based Cost Accounting
on Health Care Capital Investment Decisions.” Journal of Healthcare Finance
(Winter): 50“64.
Hill, N. T., and E. L. Johns. 1994. “Adoption of Costing Systems by U.S. Hospitals.”
Hospital & Health Services Administration (Winter): 521“537.
Hoyt, R. E., and C. M. Lay. 1995. “Linking Cost Control Measures to Health Care
Services by Using Activity-Based Information.” Health Services Management
Research (November): 221“233.
Meeting, D. T., and R. O. Harvey. 1998. “Strategic Cost Accounting Helps Create a
Competitive Edge.” Healthcare Financial Management (December): 43“51.
Pedan, A., and Baker, J. J. 2002. “Allocating Physicians™ Overhead Cost to Services:
An Econometric Accounting-Activity Based-Approach.” Journal of Healthcare
Finance (Fall): 57“75.
Ramsey, R. H., IV. 1994. “Activity-Based Costing for Hospitals.” Hospital & Health
Services Administration (Fall): 385“396.
Ridderstolpe, L., et al. 2002. “Clinical Process Analysis and Activity-Based Costing at
a Heart Center.” Journal of Medical Systems (August): 309“322.
186 Healthcare Finance



Sides, R. W. 2000. “Cost Analysis Helps Evaluate Contract Pro¬tability.” Healthcare
Financial Management (February): 63“66.
Stiles, R. A., and S. S. Mick. 1997. “What is the Cost of Controlling Quality.” Hospital
& Health Services Administration (Summer): 193“204.
Upda, S. 1996. “Activity-Based Costing for Hospitals.” Health Care Management
Review (Summer): 83“96.
. 2001. “Activity Cost Analysis: A Tool to Cost Medical Services and Improve
Quality of Care.” Managed Care Quarterly (Summer): 34“41.
West, D. A., T. D. West, and P. J. Malone. 1998. “Managing Capital and Adminis-
trative (Indirect) Costs To Achieve Strategic Objectives: The Dialysis Clinic
Versus the Outpatient Clinic.” Journal of Health Care Finance (Winter): 20“
34.
Zeller, T. L., G. Siegel, G. Kaciuba, and A. H. Lau. 1999. “Using Activity-Based
Costing to Track Resource Use in Group Practices.” Healthcare Financial
Management (September): 46“50.
CHAP TER



7
PRICING AND
SERVICE DECISIONS

Learning Objectives
After studying this chapter, readers will be able to:

• Describe the difference between providers as price setters and
providers as price takers, and how this difference affects pricing and
service decisions.
• Explain the difference between full and marginal pricing.
• Describe how target costing is used.
• Explain how accounting and actuarial information are used to make
pricing and service decisions.
• Conduct basic analyses to set prices and determine service offerings
under both fee-for-service and capitation.


Introduction
One of the most important uses of managerial accounting data involves either
establishing a price for a particular service or, given a price, determining
whether or not the service will be pro¬table. For example, in a charge-based
environment, managers of healthcare providers must set prices on the services
that their organizations offer. Managers also must determine whether or not
to offer volume discounts to valued payer groups, such as managed care plans
or business coalitions, and how large these discounts should be. Such decisions
are called pricing decisions.
In many situations, insurers, especially governmental and managed care
plans, dictate the reimbursement amount. Therefore, health services managers
are not setting prices but must decide whether or not the payment is suf¬cient
to assume the risks associated with providing services to the covered popu-
lations. These decisions are called service decisions. Because service decision
analyses are similar to pricing decision analyses, the two types of analyses are
discussed jointly.
Pricing and service decisions affect a business™s revenues and costs and
hence its ¬nancial condition, which ultimately determines the business™s long-
term viability. The importance of such decisions is easy to understand. In
essence, pricing and service decisions determine both the strategic direction of
187
the business and the ability of the organization to survive and prosper. In this
188 Healthcare Finance



chapter, the focus is on the analyses behind such decisions, including doing
so in a capitated environment.


Healthcare Providers and the Power to Set Prices
Two extremes exist regarding the power of healthcare providers to set prices.
At one extreme, providers have no power whatsoever and must accept the
reimbursement levels set by the marketplace. At the other extreme, providers
can set any prices (within reason) desired and payers must accept those prices.
Clearly, few real-world markets for healthcare services support such extreme
positions across all payers. Nevertheless, thinking in such terms can help health
services managers better understand the pricing and service decisions that
they face.

Providers as Price Takers
As discussed throughout the book, healthcare services are provided in an in-
creasingly competitive marketplace. As providers respond to market competi-
tion, managers must assess the ability of their organizations to in¬‚uence the
prices paid for the services offered. If the organization is one of a large number
of providers in a service area with a large number of commercial fee-for-service
purchasers (payers), and if little distinguishes the services offered by different
providers, economic theory suggests that prices will be set by local supply-
and-demand conditions. Thus, the actions of a single participant, whether a
provider or payer, cannot in¬‚uence the prices set in the marketplace. In such
a perfectly competitive market, healthcare providers are said to be price takers
because they are constrained by the prices set in the marketplace.
Although very few markets for healthcare services are perfectly compet-
itive, some payers, notably government payers and managed care plans with
market power, can set reimbursement levels on a “take-it-or-leave-it” basis. In
this situation, as in competitive markets, providers also are price takers in the
sense that they cannot in¬‚uence reimbursement rates. Because many markets
either are somewhat competitive or are dominated by large payer groups, and
because governmental payers cover a signi¬cant proportion of the population,
most providers probably qualify as price takers for a large percentage of their
revenue.
As a general rule, providers that are price takers must take price as a
given and concentrate managerial efforts on cost structure and utilization to
ensure that their services are pro¬table. From a purely ¬nancial perspective,
a price-taking provider should offer all services with costs that are less than
the given price, even if that price has fallen because of discounting or other
market actions.
Although the pure ¬nancial approach to service decisions is obviously
simplistic, it does raise an important managerial accounting issue: What costs
are relevant to the decision at hand? To ensure long-term sustainability, prices
189
Chapter 7: Pricing and Service Decisions



must cover full costs. However, prices that do not cover full costs may be
acceptable for short periods, and it might be in the provider™s long-run best
interests to do so. This matter is discussed in the next major section.

Providers as Price Setters
In contrast to the previous discussion, healthcare providers with market dom-
inance enjoy large market shares and hence exercise some pricing power.
Within limits, such providers can decide what prices to set on the services
offered. Furthermore, if a provider™s services can be differentiated from others
on the basis of quality, convenience, or some other characteristic, the provider
also has the ability, again within limits, to set prices on the differentiated
services. Healthcare providers that have such pricing power are called price
setters.
The situation would be much easier for managers if a provider™s status
as a price taker or price setter were ¬xed for all payers for all services for
long periods of time. Unfortunately, the market for healthcare services is ever
changing, and hence providers can quickly move from one status to the other.
For example, the merger of two healthcare providers may create suf¬cient
market power to change two price takers, as separate entities, into one price
setter, as a combined entity. Furthermore, providers can be price takers for
some services and price setters for others, or price takers for some payers
and price setters for others. To make matters even more complicated, a large
provider that serves separate market areas may be a price taker for a particular
service in one geographical market yet be a price setter in another geographical
market.


Self-Test
1. What is the difference between a price taker and a price setter?
Questions
2. Are healthcare providers generally either price takers or price setters
exclusively? Explain your answer.


Price Setting Strategies
When providers are price setters, alternative strategies can be used to price
healthcare services. Unfortunately, no single strategy is most appropriate in all
situations. In this section, we discuss two of the price setting strategies most
frequently used by health services organizations.

Full Cost Pricing
Full cost pricing recognizes that to remain viable in the long run, health
services organizations must set prices that recover all costs associated with
operating the business. Thus, the full cost of a service, whether a patient day
in a hospital, a visit to a clinic, a laboratory test, or the treatment of a particular
diagnosis must include the following: (1) the direct variable costs of providing
190 Healthcare Finance



the service, (2) the direct ¬xed costs, and (3) the appropriate share of the
overhead expenses of the organization.
Because of the dif¬culties inherent in allocating overhead costs dis-
cussed in Chapter 6, the full costs of an individual service are dif¬cult to
measure with precision and hence have to be viewed with some skepticism.
Nevertheless, in the aggregate, revenues must cover both direct and overhead
costs, and hence prices in total must cover all costs of an organization. Further-
more, all businesses need pro¬ts to survive in the long run. In not-for-pro¬t
businesses, prices must be set high enough to provide the pro¬ts needed to
support asset replacement and to meet growth targets. In addition, for-pro¬t
providers must provide equity investors with an explicit ¬nancial return on
their investment.

Marginal Cost Pricing
In economics, the marginal cost of an item is the cost of providing one ad-
ditional unit of output, whether that output is a product or service. For ex-
ample, suppose that a hospital currently provides 40,000 patient days of care.
Its marginal cost, based on inpatient day as the unit of output, is the cost of
providing the 40,001th day of care. In this situation, it is likely that ¬xed costs,
both direct and overhead, have already been covered by reimbursements asso-
ciated with the existing patient base (the 40,000 patient days), so the marginal
cost that must be covered consists solely of the variable costs associated with
an additional one-day stay. In most situations, no additional labor costs would
be involved; additional personnel would not be hired nor overtime required.
The marginal cost, therefore, consists of expenses such as laundry, food and
expendable supplies, and any additional utility services consumed during that
day. Obviously, the marginal cost associated with one additional patient day is
far less than the full cost, which must include all direct ¬xed and overhead costs
plus a pro¬t component.
Many proponents of government programs such as Medicare and Med-
icaid argue that payments to providers should be made on the basis of marginal
rather than full costs. The argument here is that some price above marginal
cost is all that is required for the provider to “make money” on government-
sponsored patients. By implication, nongovernmental payers would cover all
base costs. However, what would happen if all payers for a particular provider
set reimbursement rates based on marginal costs? If such a situation occurred,
the organization would not recover its ¬xed costs, including both direct and
overhead, and hence would ultimately fail.
Should any prices be set on the basis of marginal costs? In theory,
the answer is no. For prices to be equitable, all payers should pay their fair
shares in covering providers™ total costs. Furthermore, if marginal cost pricing
should be adopted, which payer(s) should receive its bene¬ts by being charged
lower prices? Should it be the government because it is taxpayer funded, or
should it be the last payer to contract with the provider? There are no good
191
Chapter 7: Pricing and Service Decisions



answers to these questions, so the easy way out, at least conceptually, is to
require all payers to pay full costs and hence equitably share the burden of the
organization™s total costs.
However, as a practical matter, it may make sense for healthcare provid-
ers to occasionally use marginal cost pricing to attract a new patient clientele
or to retain an existing clientele (i.e., gain or retain market share). To survive
in the long run, however, businesses must earn revenues that cover their
full costs. Thus, marginal cost pricing either must be a temporary measure
or the organization must employ cross-subsidization (price shifting ). In such
situations, some patients or covered populations are overcharged for services,
as compared to full costs, while others are undercharged.
Historically, price shifting was used by providers to support services,
such as emergency care, teaching and research, and indigent care, that were
not self-supporting. Without such price shifting strategies, many providers
would not have been able to offer a full range of services. Payers were willing to
accept price shifting because the additional burden was not excessive. Today,
however, overall healthcare costs have risen to the point where the major
purchasers of healthcare services are not willing to support the costs associated
with providing services to others, and hence purchasers are demanding prices
that cover only true costs, without cross-subsidies. Payers perhaps rightly
believe that they do not have the moral responsibility to fund healthcare
services for those outside of their covered populations.


Self-Test
1. Describe two common pricing strategies used by price setters and their
Questions
implications for ¬nancial survivability.
2. What is cross subsidization (price shifting)?
3. Is cross subsidization used by providers as frequently today as it was in
the past? If not, why?


Target Costing
Target costing is a management strategy that helps providers deal with situa-
tions in which they are price takers. Target costing assumes the price for a
service is a given, and then subtracts the desired pro¬t on that service to obtain
the target cost level. If possible, management then will reduce the full cost of
the service to the target level, with a goal of continuous cost reduction that
will eventually push costs below the target. Essentially, target costing backs
into the cost at which a healthcare service must be provided in the long run
to attain a given pro¬tability target.
Perhaps the greatest value of target costing lies in the fact that it forces
managers to take very seriously the prices set by external forces; that is, it rec-
ognizes that the purchasers of healthcare services do not really care whether or
not prices are based on the underlying costs of the services provided. Thus, to
192 Healthcare Finance



ensure ¬nancial survival, providers must attain cost structures compatible with
the revenue stream. Providers that cannot lower costs to the level required to
make a pro¬t will ultimately fail.


Self-Test 1. What is target costing?
Questions 2. What is its greatest value?


Setting Prices on Individual Services
The best way to understand the mechanics of pricing and service decisions is
to work through several illustrations. The ¬rst illustration examines how prices
can be set on individual services.
Assume that the managers of Windsor Community Hospital, a not-for-
pro¬t provider, are planning to offer a new outpatient service. The hospital™s
managerial accountants have estimated the following cost data for the service:

Variable cost per visit $10
Annual direct ¬xed costs $100,000
Annual overhead allocation $25,000
Furthermore, the hospital™s marketing staff believes that demand for the new
service will be 5,000 visits during its ¬rst year of operation.
To begin, Windsor™s managers want to know what price must be set
on each visit for the service to break even during the ¬rst year. For accounting
breakeven, the expected pro¬t of the service must be zero, so revenues less
costs must equal zero. One way to calculate the breakeven price is to express
the relationship between revenues, costs, and pro¬t in equation form:

Total revenues ’ Total costs = $0
Total revenues ’ Total variable costs ’ Direct ¬xed costs ’ Overhead = $0
(5,000 — Price) ’ (5,000 — $10) ’ $100,000 ’ $25,000 = $0
(5,000 — Price) ’ $175,000 = $0
5,000 — Price = $175,000
Price = $175,000 / 5,000 = $35.

Thus, under the utilization and cost assumptions developed by Windsor™s
managers, a price of $35 per visit must be set on the new service to break
even in the accounting sense.
Of course, Windsor™s managers want the service to earn a pro¬t, and
hence achieve economic breakeven. Suppose the goal is to make a pro¬t of
$100,000 on the new service. Examining the calculations above show that
193
Chapter 7: Pricing and Service Decisions



costs at 5,000 visits are expected to total $175,000. Thus, to make a pro¬t of
$100,000, service revenues must total $175,000 + $100,000 = $275,000.
With 5,000 visits, the price must be set at $275,000 / 5,000 = $55 per visit.
To this point, the analysis has focused on full cost pricing. Suppose that
Windsor™s managers wanted to price the service aggressively to quickly build
market share. What price would be set under marginal cost pricing? Now, the
service must only cover the variable (marginal) cost of $10 per visit, so a price
of $10 is all that is required. This price, which is well below the accounting
breakeven of $35, would result in a loss of $125,000 ($100,000 in direct ¬xed
costs and $25,000 in overhead) during the ¬rst year the service is offered,
assuming that the aggressive pricing does not affect the 5,000-visit utilization
estimate.
What price should Windsor™s managers actually set on the new service?
It should be obvious to readers that a great deal of judgment is required to
make this decision. One important consideration is the relationship between
price and utilization, which the analysis has ignored by assuming that the
service would produce 5,000 visits regardless of price. A more complete
analysis would examine the effect of different prices and utilization levels on
pro¬ts. Another consideration is how easy it would be to increase the price
that is initially set. If price increases are expected to be met with a great deal
of resistance, then pricing low to gain market share today might not be a good
long-run strategy.


Self-Test
1. Brie¬‚y explain the process for pricing individual services.
Questions
2. What do you think the price should be on Windsor™s new service?
Justify your answer.


Setting Prices Under Capitation
The second illustration focuses on how one hospital priced a new capitated
product.

Base Case Analysis
Table 7.1 contains relevant 2005 forcasted revenue and cost data for Montana
Medical Center (MMC), a 350-bed, not-for-pro¬t hospital. According to its
managers™ best estimates, MMC is expecting to earn a pro¬t (net income) of
$1,662,312 in 2005. The data consist ¬rst of a worksheet, which breaks down
the cost data by payer. Here, the assumption is that all payers use fee-for-
service reimbursement, including discounted fee-for-service. The Table 7.1
cost data also include the hospital™s cost structure, broken down by variable
costs; ¬xed costs, including both direct and overhead (the $71,746,561 given
in the P&L statement); and contribution margin.
To illustrate the data, consider MMC™s Medicare patients. Medicare is
194 Healthcare Finance


TABLE 7.1
Average Variable Total
Montana Number of Revenue per Revenue Cost per Variable Contribution
Medical Center: Payer Admissions Admission by Payer Admission Costs Margin
Projected Payer
Payer Worksheet:
Worksheet and
Medicare 4,268 $7,327 $ 31,271,636 $2,529 $10,793,772 $20,477,864
P&L Statement Medicaid 5,895 5,448 32,115,960 1,575 9,284,625 22,831,335
for 2005 Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544
Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540
Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140
Commercial 1,408 11,770 16,572,160 2,969 4,180,352 12,391,808
Self-Pay 1,289 2,053 2,646,317 1,489 1,919,321 726,996
Other 1,149 11,539 13,258,311 3,085 3,544,665 9,713,646
Total 17,054 $108,583,746 $35,174,873 $73,408,873
Weighted average $6,367 $2,063
P&L Statement:
Total revenues $ 108,583,746
Variable costs 35,174,873
Contribution margin $ 73,408,873
Fixed costs 71,746,561
Pro¬t $ 1,662,312




expected to provide the hospital with 4,268 admissions at an average rev-
enue of $7,327 per admission, for total revenues of 4,268 — $7,327 =
$31,271,636. Expected variable cost per admission for a Medicare patient
is $2,529, which results in expected total variable costs of 4,268 — $2,529
= $10,793,772. The difference between expected total revenues and the ex-
pected total variable costs produces a forecasted total contribution margin
of $31,271,636 ’ $10,793,772 = $20,477,864 for the Medicare patient
group. This total contribution margin is combined with the total contribu-
tion margins of the other payer groups to produce an expected aggregate
total contribution margin for the hospital of $73,408,873. As shown in the
P&L statement portion of Table 7.1, the total contribution margin both cov-
ers MMC™s forecasted ¬xed costs of $71,746,561 and produces an expected
pro¬t of $1,662,312.
MMC™s managers are considering taking a bold strategic action”offer-
ing a capitated plan for inpatient services. One of the ¬rst tasks that must
be performed is setting the price for the new plan. Table 7.2 contains the
key assumptions inherent in the pricing decision. The hospital™s managers
believe that about 13 percent of the current patient base would be converted
to the capitated plan. To be conservative, the assumption was made that no
additional patients would be generated. Thus, at least initially, patients in
the capitated plan would come from MMC™s current patient base. In effect,
MMC would have to cannibalize from its own business with the expectation
of protecting current market share and using the capitated plan as a marketing
tool to expand market share in the future.
195
Chapter 7: Pricing and Service Decisions



Assumptions also have been made regarding where the cannibalization
would occur and the number of admissions under the capitated plan. These
data are provided in Points 2 and 3 of Table 7.2. The patient mix assumptions
will be important when costs are estimated for the new plan.
MMC™s managers believe, at least initially, that hospital utilization will
be unaffected by the conversion of some patients from fee-for-service con-
tracts to capitation. Another expectation is that variable costs for the new plan
would be the same as experienced in the past with each payer group. These
are two very important assumptions. MMC™s managers are assuming that the
utilization and delivery of healthcare services for the capitated population will
be exactly the same as for the fee-for-service population. This is probably a rea-
sonable starting assumption given that the capitated population will represent
only a small portion of MMC™s overall business. However, if increased man-
aged care penetration in MMC™s service area leads to a greater proportion of
capitated patients, both utilization patterns and the underlying cost structure
are likely to change as the hospital responds to the incentives created.
Finally, and perhaps most importantly in terms of pricing strategy, the
capitated price that MMC plans to offer to the market must result in the
same pro¬t ($1,662,312) as expected if the hospital were to remain totally
fee-for-service. The underlying logic here is that MMC™s managers want to
experiment with capitation, but they are unwilling to do so at the expense
of the bottom line. This pricing goal, and the expected cost structure of
serving the capitated population, therefore, will drive the monthly premium
established for the capitated product. If the goal of preserving the bottom line
while adding the new product proves to be unattainable, MMC™s managers
would have to reevaluate their initial pricing strategy.


TABLE 7.2
1. The capitated plan will initially enroll the following percentages of the
Montana
hospital™s current patients:
a. Medicaid: 20 percent Medical Center:
b. Commercial: 40 percent Initial
c. Self-pay: 40 percent Assumptions for
2. Assuming that utilization rates are not affected by the change to a capitated
a Capitated Plan
plan, admissions from the capitated group are expected to total (0.20 —
5,895) + (0.40 — 1,408) + (0.40 — 1,289) = 2,258.
3. Based on current coverage information, the patient population under
capitation (number of enrollees) would be 25,000.
4. Variable costs for capitated patients will remain the same as currently
estimated for each payer group.
5. Total ¬xed costs will remain the same.
6. All other assumptions inherent in the Table 7.1 forecast hold for the capitated
plan.
7. The goal for the price set for capitated enrollees will be to generate,
at a minimum, the pro¬t forecasted in Table 7.1 under fee-for-service
reimbursement.
196 Healthcare Finance



Table 7.3 contains an analysis similar to the one shown in Table 7.1,
except that Table 7.3 includes the proposed capitated plan. Changes from
the Table 7.1 values are shown in boldface. For example, the entire ¬rst line
of the worksheet, labeled “Capitated,” is in boldface because this is MMC™s
new product line, which does not appear in Table 7.1. Also in boldface are
selected values on the Medicaid, commercial, and self-pay lines because these
values will change because of the shift of some of these payer groups™ patients
to the capitated plan.
Notice that the Table 7.3 volume levels re¬‚ect the expected patient
shifts from fee-for-service to capitation. For example, the Medicaid group
re¬‚ects the 20 percent decrease resulting from patients shifting to the capitated
plan: 0.80 — 5,895 = 4,716. The commercial and self-pay payer groups also
re¬‚ect their 40 percent losses in admissions to the new plan. In total, the
capitated plan is expected to siphon off 0.20 — 5,895 = 1,179 Medicaid
admissions, 0.40 — 1,408 = 563 commercial admissions, and 0.40 — 1,289
= 516 self-pay admissions, for a total of 2,258 admissions.
For now, pass by the revenue columns in Table 7.3 and focus on the
variable cost columns for the capitated patients. Because each capitated patient
is expected to have the same variable cost as under the previous plans, variable
costs for the capitated plan are expected to total (1,179 — $1,575) + (563
— $2,969) + (516 — $1,489) = $4,296,794.1 With an expected number
of admissions of 2,258, the average variable cost per capitated admission is
$4,296,794 / 2,258 = $1,903.
Now, consider the revenue columns. To keep the projected pro¬t the
same as in Table 7.1, revenues must total $108,583,746. Furthermore, ex-
pected total revenues from all payer groups except the new plan amount to
$94,473,163. Thus, the capitated plan must bring in revenue of $108,583,746
’ $94,473,163 = $14,110,583 to achieve MMC™s target pro¬t. This calcu-
lation can be thought of as working backward on (or up) the projected P&L
statement shown on the bottom of Table 7.3.
With expected admissions at 2,258, the average revenue per admission
can be calculated as $14,110,583 / 2,258 = $6,250. However, this implied
average revenue per admission has no real meaning in a capitated plan because
MMC will not be charging these patients on a per admission basis. The
calculated per admission revenue value of $6,250 is a fee-for-service equivalent
revenue, and every worker at MMC must recognize that the hospital will not
actually receive $6,250 per admission under the new plan. As MMC™s patients
move from fee-for-service to capitation, revenue will be based on enrollment
rather than admissions.
With all this information at hand, MMC™s managers now can price the
new plan. Total revenues of $14,110,583 are required from 25,000 enrollees,
so the annual revenue per enrollee is $14,110,583 / 25,000 = $564.42.
Because premiums are normally expressed on a per member per month (PMPM)
basis, the annual revenue requirement must be divided by 12 to obtain $47.04
197
Chapter 7: Pricing and Service Decisions


TABLE 7.3
Average Variable Total
Montana
Number of Revenue per Revenue Cost per Variable Contribution
Medical Center:
Payer Admissions Admission by Payer Admission Costs Margin
Projected
Payer Worksheet: Analysis
Capitated 2,258 $ 6,250 $ 14,110,583 $1,903 $ 4,296,794 $ 9,813,789
Assuming
Medicare 4,268 7,327 31,271,636 2,529 10,793,772 20,477,864
25,000
Medicaid 4,716 5,448 25,692,768 1,575 7,427,700 18,265,068
Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544 Enrollees and
Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 Constant Net
Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140
Income
Commercial 845 11,770 9,943,296 2,969 2,508,211 7,435,085
Self-Pay 773 2,053 1,587,790 1,489 1,151,593 436,198
Other 1,149 11,539 13,258,331 3,085 3,544,665 9,713,646
Total 17,054 $108,583,746 $35,174,873 $73,408,873
Weighted average $ 6,367 $2,063

Annual capitated revenue requirements = $14,110,583/25,000 = $564.42 per member.
Monthly capitated revenue requirements = $564.42/12 = $47.04 per member per month (PMPM).

P&L Statement:
Total revenues $ 108,583,746
Variable costs 35,174,873
Contribution margin $ 73,408,873
Fixed costs 71,746,561
Pro¬t $ 1,662,312

Note: Some rounding differences occur in the table.



PMPM. This PMPM charge is what MMC™s managers would set as the initial
price when marketing the new plan.

Scenario Analysis
The previous section illustrated how MMC™s managers could establish a price
for a new capitated plan. However, a good pricing analysis goes well beyond
the base case analysis (or base case scenario), which uses the most likely es-
timates for all input variables”number of enrollees, variable costs, and so
on. The second part of a complete pricing analysis involves scenario analysis,
whereby MMC™s managers assess the impact of assumptional changes in key
variable values from their base case values by creating alternative scenarios.2

Table 7.4 repeats the analysis, but now the assumption is that 10,000 new Additional
enrollees are added to the capitated plan. Coupled with the base case estimate Enrollees
of 25,000 enrollees from MMC™s other payer groups, total enrollment in the
capitated plan is increased to 35,000. The assumptions are that the new en-
rollees would utilize hospital services at the same rate as current plan members,
and the variable cost per admission would be the same for the new enrollees
as for the existing 25,000 enrollees. Furthermore, no additional ¬xed costs
would be required to handle the increased volume.
198 Healthcare Finance


TABLE 7.4
Average Variable Total
Montana Number of Revenue per Revenue Cost per Variable Contribution
Medical Center: Payer Admissions Admission by Payer Admission Costs Margin
Projected
Payer Worksheet:
Analysis
Capitated 3,161 $6,250 $ 19,754,816 $1,903 $ 6,015,512 $ 13,739,304
Assuming Medicare 4,268 7,327 31,271,636 2,529 10,793,772 20,477,864
35,000 Medicaid 4,716 5,448 25,692,768 1,575 7,427,700 18,265,068
Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544
Enrollees at
Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540
$47.04 PMPM
Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140
Commercial 845 11,770 9,943,296 2,969 2,508,211 7,435,085
Self-Pay 773 2,053 1,587,790 1,489 1,151,593 436,198
Other 1,149 11,539 13,258,331 3,085 3,544,665 9,713,646
Total 17,957 $ 114,227,979 $36,893,591 $77,334,388
Weighted average $6,361 $2,055

P&L Statement:
Total revenues $ 114,227,979
Variable costs 36,893,591
Contribution margin $ 77,334,388
Fixed costs 71,746,561
Pro¬t $ 5,587,827

Note: Some rounding differences occur in the table.



Those entries that differ from Table 7.3 are boldfaced. The addition
of new capitated enrollees does not affect any of the other payer groups,
so the changes in Table 7.4 are limited to the ¬rst line of the payer work-
sheet, the totals and averages, and the P&L statement. Adding 10,000 en-
rollees increases MMC™s total revenues by $114,227,979 ’ $108,583,746
= $5,644,233 but only increases total variable costs by $36,893,591 ’
$35,174,873 = $1,718,718, thus resulting in a total contribution margin
gain of $5,644,233 ’ $1,718,718 = $3,925,515. Assuming that ¬xed costs
remain at $71,746,561, the entire amount of the contribution margin increase
will ¬‚ow to the bottom line, so projected pro¬t increases by a like amount.
An alternative way to consider the effect of additional enrollees on the
bottom line is to examine the contribution margin on capitated patients. Each
additional enrollee brings in $47.04 — 12 = $564.48 per year, but what about
the cost side? The 35,000 enrollees are expected to have 3,161 admissions,
for an average rate of 3,161 / 35,000 = 0.0903 admissions per enrollee, so
the expected variable cost per enrollee is 0.0903 — $1,903 = $171.84. Thus,
the contribution margin per enrollee is $564.48 ’ $171.84 = $392.64, and
10,000 new enrollees would add $3,926,400 to the bottom line, which is the
same as calculated previously (except for a rounding difference).
This analysis con¬rms the bene¬t that would accrue to MMC if the cap-
itated plan does indeed result in increasing the hospital™s market share. Note,
however, that the increased market share analysis has several key assumptions
199
Chapter 7: Pricing and Service Decisions



”notably, that the premium remains at $47.04 PMPM, that utilization and
costs associated with new enrollees are the same as for the initial cannibalized
enrollees, and that no additional ¬xed costs are required.

What would happen if the initial premium of $47.04 PMPM has to be low- Reduced
ered to $40 to be attractive in the marketplace? To examine the effects of a Premium
lower premium, consider the analysis presented in Table 7.5. In this case, the
assumption is that a premium of $40 results in the same 35,000 enrollees as
analyzed in the last scenario. The only changes from Table 7.4 stem from the
reduced revenues associated with lowering the premium from $47.04 PMPM
to $40 PMPM, or by $7.04 PMPM. The loss of annual revenue of 35,000 —
$7.04 — 12 = $2,956,800, with no offsetting reduction in costs, ¬‚ows directly
to the bottom line. The end result is a corresponding reduction in projected
pro¬t (except for a rounding difference).

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