. 8
( 21)


It would be useful for MMC™s managers to know what premium would be Breakeven
required to obtain the original forecasted pro¬t of $1,662,312 (see Tables Analysis
7.1 and 7.3), assuming a capitated plan enrollment of 35,000. Here, we
are conducting a breakeven analysis but not, as previously illustrated, on
volume. By using a spreadsheet model, MMC™s managers found that a PMPM
premium of about $37.69 would produce a projected pro¬t of $1,662,312.
Therefore, MMC could lower the premium to that amount, if necessary, to
obtain 35,000 enrollees, without reducing its pro¬t below the initial forecast.

Average Variable Total
Number of Revenue per Revenue Cost per Variable Contribution
Medical Center:
Payer Admissions Admission by Payer Admission Costs Margin
Payer Worksheet: Analysis
Capitated 3,161 $5,315 $ 16,800,000 $1,903 $ 6,015,512 $10,784,488
Medicare 4,268 7,327 31,271,636 2,529 10,793,772 20,477,864
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 $40
Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 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 $ 111,273,163 $ 36,893,591 $ 74,379,573
Weighted average $6,197 $2,055

P&L Statement:
Total revenues $ 111,273,163
Variable costs 36,893,591
Contribution margin $ 74,379,573
Fixed costs 71,746,561
Pro¬t $ 2,633,012

Note: Some rounding differences occur in the table.
200 Healthcare Finance

Furthermore, MMC could set the premium as low as $33.73 and still reach
accounting breakeven (i.e., zero pro¬t), assuming 35,000 enrollees.

The Value of Finally, consider the value inherent in utilization and cost reduction efforts.
Utilization and Suppose that MMC actually obtained 25,000 enrollees at a premium of
Cost Reduction $47.04. The expected net income in this scenario is $1,662,312 (see Table
7.3). However, assume that MMC instituted a utilization review process that
lowered the annual utilization rate for capitated enrollees from the current
0.0903 admissions per enrollee to 0.08 admissions per enrollee, for a reduc-
tion of about 11 percent. Furthermore, assume that MMC conducted a review
of its clinical guidelines for capitated patients, resulting in a variable cost per
admission reduction from $1,903 per admission to $1,800 per admission, or
by about 5 percent. The results of such utilization and cost control efforts are
shown in Table 7.6.
Again, the changes from Table 7.3 occur on the ¬rst line of the payer
worksheet, along with aggregate and average values. The overall result is
that variable costs, both for capitated patients and in total, are lowered by
$35,174,873 ’ $34,478,079 = $696,794, so projected pro¬t increases to
$1,662,312 + $696,794 = $2,359,106. A reduction in utilization alone
produces a cost savings of $490,616, and a reduction in variable cost per
admission alone produces a cost savings of $232,754. Each effort, therefore,
contributes to the projected increase in MMC™s pro¬tability.3 The bene¬ts of

Average Variable Total
Montana Number of Revenue per Revenue Cost per Variable Contribution
Payer Admissions Admission by Payer Admission Costs Margin
Medical Center:
Payer Worksheet:
Capitated 2,000 $7,055 $ 14,110,583 $1,800 $ 3,600,000 $10,510,583
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 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
Plus Utilization Commercial 845 11,770 9,943,296 2,969 2,508,211 7,435,085
and Cost- 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 16,796 $ 108,583,746 $34,478,079 $ 74,105,667
Weighted average $6,465 $2,053

P&L Statement:
Total revenues $ 108,583,746
Variable costs 34,478,079
Contribution margin $ 74,105,667
Fixed costs 71,746,561
Pro¬t $ 2,359,106

Note: Some rounding differences occur in the table.
Chapter 7: Pricing and Service Decisions

cost containment would be even greater if the program could be applied to
all payer groups rather than only to the capitated patients.
Note, though, that MMC would have to incur costs to establish and
run the utilization and cost containment programs, so the real question is
not what is the bene¬t of such programs, but what is the net bene¬t. The
programs should be undertaken only if the estimated annual costs are less than
the projected $696,794 annual bene¬t. Of course, the greater the number
of patients that are brought under these programs, the greater the gross
annual bene¬t and the greater the costs could be and still make the programs
¬nancially worthwhile.

1. Brie¬‚y explain why the base case analysis required the calculation to
move up the pro¬t and loss statement rather than down (the normal
2. How are capitated revenue requirements typically expressed?
3. What is scenario analysis, and why is it so critical to good pricing
4. What is the most uncertain variable in MMC™s capitated plan pricing

Setting Managed Care Plan Premium Rates
A primary ¬nance task within managed care plans is the development of
premium rates. In this section, we illustrate several methods that an HMO
(or an integrated health system) can use to estimate the payments it must
make to its providers to cover a de¬ned population. These payments are then
aggregated and combined with the HMO™s own costs to set the premium
rate. Rates typically are developed as if all providers in the system were
capitated because the ¬nal premium rate will be quoted on a PMPM
basis. However, actual reimbursement to the providers in the plan (or
system) could be by capitation, discounted fee-for-service, or any other
method. Typically, different classes of providers would be reimbursed using
different methods.
Assume that BetterCare, Inc., an aggressively managed HMO, must
develop a premium bid to submit to Big Business, a major employer in Bet-
terCare™s service area. To keep the illustration manageable, assume that most
of the medically necessary in-area services can be provided by a single hospital
that offers both inpatient and outpatient services (including emergency room
services) a single nursing home, a panel of primary care physicians, and a panel
of specialist physicians. In addition, BetterCare must budget for covered care
to be delivered out of area when its members are traveling and for a small
amount of specialty services that will be provided outside of the physician
202 Healthcare Finance

panel. Thus, to develop its bid, BetterCare has to estimate the amount of
payments to this set of providers for the covered population, plus allow for
administrative expenses and pro¬ts.

Institutional Rates
The fee-for-service approach is often used to set the within-system hospital
inpatient capitation rate. This method is based on expected utilization and fee-
for-service charges rather than underlying costs, although there clearly should
be a link between charges and costs. To illustrate, assume that BetterCare
targets 350 inpatient days for each 1,000 members, or 0.350 inpatient days per
member. Furthermore, BetterCare believes that a fair fee-for-service charge in
a competitive environment would be $938 per inpatient day. The number of
inpatient days re¬‚ects a highly managed working-age population, and the fee-
for-service charge is designed to cover all hospital costs, including pro¬ts, in
an ef¬ciently run hospital that operates in a highly competitive environment.
The inpatient cost PMPM is found this way:

Per member utilization rate — Fee-for-service rate
Inpatient cost PMPM =
0.350 — $938
= = $27.35 PMPM.
Thus, using the fee-for-service method, BetterCare estimates that inpatient
costs for Big Business™s HMO enrollees is $27.35 PMPM. Actual payment to
the hospital would likely be on a per diem basis.
The rate for out-of-area hospital usage, hospital outpatient visits, and
skilled nursing home stays was developed using the fee-for-service method
also. Here is a summary of BetterCare™s estimates for these services:

Annual Usage Fee-for-Service Capitation
Service per Member Rate Rate PMPM

Out-of-area inpatient days 0.025 $1,495 $3.11
Outpatient surgeries 0.050 1,082 4.51
Emergency room visits 0.125 138 1.44
Skilled nursing home days 0.005 150 0.06

Here, each PMPM capitation rate was calculated by multiplying annual usage
times the fee-for-service rate and then dividing the product by 12 to get the
PMPM rate. The end result is a capitation estimate of $9.12 PMPM for the
services listed. Actual payments to these providers typically would be made on
a fee-for-service basis.

Physician Rates
The cost approach will be used to estimate physicians™ costs for Big Business™s
enrollees. This method, which is the most common for setting physicians™
Chapter 7: Pricing and Service Decisions

payments, is based on utilization and underlying costs as opposed to charges.
Again, the starting point is expected patient utilization, but now it is for pri-
mary care and specialty physicians™ services. This demand is then translated
into the number of full-time equivalent (FTE) physicians required to treat
the covered population, which depends on physician productivity. Next, the
cost for physician services is estimated by multiplying physician staf¬ng re-
quirements by the average cost per FTE, including base compensation, fringe
bene¬ts, and malpractice premiums. Finally, an amount is added for clinical
and administrative support for physicians”usually some dollar amount per
1,000 members.
In developing its rate for primary care physicians, BetterCare made the
following assumptions:

• On average, each enrollee makes 3.0 visits to a primary care
physician per year.
• Each primary care physician can handle 4,000 patient visits per year.
• Total compensation per primary care physician is $175,000 per year.

Given these assumptions, one way to calculate primary physician™s costs is to
recognize that each enrollee will require 3 / 4,000 = 0.00075 physicians,
for an annual cost of 0.00075 — $175,000 = $131.25 per enrollee. Thus,
the cost PMPM = $131.25/12 = $10.94 and the rate that BetterCare will
propose to Big Business will include a payment of $10.94 PMPM for primary
care physician compensation.
The rate for specialists™ care is developed in a similar way. The end result
is an annual cost per member of $170.40, giving a PMPM of $170.40 / 12 =
$14.20. The rate that BetterCare will propose to Big Business will therefore
include a payment of $14.20 PMPM for specialist physician compensation.
Thus far, the capitation rate for physicians™ compensation has been es-
timated, but BetterCare™s analysis has not accounted for the other costs as-
sociated with physicians™ practices. First, on average, physicians require 1.7
FTEs for clinical and administrative support, and each supporting staff mem-
ber receives an average of $35,000 per year in total compensation. Because
the physician requirement to support one member is 0.00075 primary care
plus 0.00060 specialists, for a total of 0.00135 physicians, each member will
require 0.00135 — 1.7 — $35,000 = $80 of physician™s support, or $80 / 12
= $6.67 PMPM.
Next, expenditures on supplies, including administrative, medical, and
diagnostic, at physicians™ practices average $10 per visit, and members are ex-
pected to make 4.2 visits per year to both primary and specialty care physicians.
Thus, the annual cost per member is $42, and the cost PMPM is estimated to
be $42 / 12 = $3.50 PMPM. Finally, overhead expenses, including depreci-
ation, rent, utilities, and so on, are estimated at $6 PMPM.
BetterCare has estimated numerous categories of costs attributable
204 Healthcare Finance

solely to physicians. For ease, assume that BetterCare plans to contract with a
single medical group practice to provide all physicians™ services and to pay the
group a capitated rate. The total capitation rate for the medical group would
be as follows:
Primary care $10.94 PMPM
Specialist care 14.20
Support staff 6.67
Supplies 3.50
Overhead 6.00
Subtotal $41.31 PMPM
Pro¬t (10%) 4.13
In-area total $45.44 PMPM
Outside referrals 3.40
Total $48.84 PMPM

The $48.84 PMPM total capitation rate for the medical group is the aggregate
of the rates previously developed for physicians™ services, plus two additional
elements. First, BetterCare believes that a fair pro¬t markup on medical ser-
vices is 10 percent, so $4.13 PMPM is allowed for pro¬t on the in-area physi-
cian subtotal of $41.31 PMPM. Second, $3.40 PMPM is allocated to cover
referrals outside the group practice when needed either because a particular
specialty is not available within the group or the covered member is outside
the service area. Finally, note that the medical group may not capitate all its
physicians even though it receives a capitated rate from BetterCare.
In general, capitation rates paid to individual physicians include ad-
justments for the types of patients assigned. Thus, an alternative method for
calculating provider costs uses utilization data broken down by age and sex.
This demographic approach focuses on the characteristics of the population
being served, which is then coupled with cost or fee-for-service data to esti-
mate the capitation rate. Table 7.7 illustrates the demographic approach by
applying it to the population that would be served if BetterCare wins the
contract to provide an HMO plan for Big Business. The male/female costs
were calculated by multiplying the population percentages for each sex by the
applicable costs PMPM. The total cost for each service is the sum of the male
and female costs.
The total cost for physicians, $16.17 + $29.27 = $45.44 PMPM, is
the same as BetterCare estimated using the cost approach. If the data are
consistent, both methods should lead to the same capitation rate. Also, the
hospital/other institutional capitation rate of $36.47 PMPM is the same as the
rate obtained using the fee-for-service approach: $27.35 + $9.12 = $36.47.
Clearly, the data were fudged so the results would be consistent. In most
cases, capitation rates that are developed using different methodologies will
be different, and hence a great deal of judgment must be applied in the rate
setting process.
Chapter 7: Pricing and Service Decisions

Cost per Member per Month
Demographics Primary Care Specialist/Referral Hospital/Other
Based Rates
Age Band Male Female Male Female Male Female Male Female

0“1 1.9% 1.9% $47.00 $47.00 $31.42 $31.42 $ 29.93 $29.93
2“4 2.8 2.8 20.25 20.25 11.19 11.19 16.29 16.29
5“19 12.4 12.4 11.04 11.04 11.19 11.19 15.35 15.35
20“29 11.4 15.4 10.53 15.92 18.44 49.30 11.58 55.65
30“39 9.6 10.0 13.04 17.56 23.26 44.51 24.95 58.97
40“49 5.3 5.7 16.40 19.56 32.64 41.05 53.74 52.31
50“59 3.6 3.6 20.74 22.74 47.13 47.74 80.60 66.91
60+ 0.7 0.5 24.93 25.60 73.43 58.91 121.54 87.60
Total 47.7% 52.3%

Male/female cost $ 7.07 $ 9.10 $10.58 $18.69 $ 13.24 $23.23
Total service cost $16.17 $29.27 $36.47

Setting the Final Rate
The goal in this illustration is to set a premium rate that BetterCare can use
to make a bid to cover Big Business™s employees. Thus far, the capitation
rates required to pay all the providers needed to serve the population have
been estimated for both in-area and out-of-area services. The assumption
is that pharmacy and durable medical equipment (DME) bene¬ts will be
handled separately, or carved out, and that the cost of these bene¬ts would
be $7 PMPM. After all costs have been considered, BetterCare™s managers
conclude that they should submit a bid of $108.21 PMPM. Included in the
overall bid amount is $13.85 PMPM for contract administration and $2.05 to
build reserves and earn a pro¬t. Thus, of the $108.21 PMPM premium that
BetterCare would receive from Big Business, $15.90 would be retained by
the HMO and $92.31 PMPM would be paid out to providers, if expectations
are met.

Hospital inpatient $ 27.35 PMPM
Other institutional 9.12
Pharmacy and DME bene¬ts 7.00
Physician care 48.84
Total medical care costs $ 92.31 PMPM
HMO costs:
Administration $ 13.85 PMPM
Contribution to reserves/pro¬ts 2.05
Total HMO costs $ 15.90 PMPM

Total premium $108.21 PMPM
206 Healthcare Finance

Note that the monthly revenue to providers would be about 5 percent higher
than the embedded capitated rates because enrollees will be required to make
copayments for selected services.
BetterCare™s bid most likely will be subject to market forces”that is,
there will be multiple bidders for Big Business™s health contract. If Better-
Care™s bid is to be accepted, it must offer the right combination of price and
quality. If BetterCare™s costs and therefore bid is too high, or its quality is
too low, it will not get the contract. In that case, it must reassess its cost and
quality structure to ensure that it is competitive on future bids.

Self-Test 1. Brie¬‚y describe the following three methods for developing premium
Questions rates:
• Fee-for-service approach
• Cost approach
• Demographic approach
2. Of the three approaches, which one would be the most accurate? Which
approach is the easiest to apply in practice?
3. It is common to express premium rates as PMPM. Does this mean that
all providers will be capitated?

Using Relative Value Units (RVUs) to Set Prices
A relative value unit (RVU) measures the amount of resources consumed to
provide a particular service. Its use in healthcare pricing and reimbursement
was in¬‚uenced primarily by the RBRVS (Resource Based Relative Value Sys-
tem), which uses RVUs to determine Medicare payments for physician ser-
vices. Here, we use the RVU concept to price services for a hospital™s clinical
laboratory. Note that there is a great deal of similarity between the RVU pric-
ing method and activity based costing (ABC).
To keep the illustration manageable, assume that the clinical laboratory
performs only four tests. Furthermore, an in-depth study by the department
head and ¬nancial staff identi¬ed the number of RVUs required to perform
each test. To begin, they de¬ned one RVU as equal to ¬ve minutes of tech-
nicians™ time, $10 worth of laboratory equipment use, and $5 worth of lab-
oratory supplies. Then, each of the four tests conducted in the laboratory
was examined in detail to determine the time, test equipment, and supplies
required to perform one test. The result was the RVU estimates given in the
second column of Table 7.8. The RVUs for each test were then multiplied by
the number of tests performed annually, and the products summed to obtain
the total RVUs for the laboratory”165,000.
Now, assume that the annual costs of the laboratory, including over-
head, total $250,000. The laboratory volume and cost estimates could be
historical, or they could be budgeted values for the coming year. With these
Chapter 7: Pricing and Service Decisions

Number of Tests
Test Number of RVUs Performed Annually Total RVUs
Laboratory RVU
Urinalysis 5 5,000 25,000
Blood typing 10 4,000 40,000
Blood cell count 50 1,000 50,000
Tissue analysis 200 250 50,000

Test Number of RVUs Price per RVU Test Price
Laboratory Price
Urinalysis 5 $1.90 $ 9.50
19.00 List
Blood typing 10 1.90
Blood cell count 50 1.90 95.00
Tissue analysis 200 1.90 380.00

estimates, it is now possible to estimate the cost per RVU by dividing total
costs by total RVUs:

$250,000/165,000 = $1.52 per RVU.
Finally, the cost associated with each test is merely the number of RVUs
assigned to the test multiplied by the $1.52 per RVU cost.
To obtain a price list for the laboratory, assume that the hospital wants
to make a 20 percent pro¬t margin on its laboratory services, so each test™s
price must be 25 percent higher than its cost. The pro¬t-adjusted charge
(price) per RVU then becomes $1.52 — 1.25 = $1.90.4 Table 7.9 lists the
price for each test. For example, a very simple urinalysis would be priced at
$9.50, while a very complex tissue analysis would be priced at $380.
The goal of RVU pricing is to create prices that re¬‚ect the cost of
the resources used to provide the service. Of course, the key to the fairness
of RVU pricing is how well the number of RVUs assigned to each service
actually matches the cost of the resources consumed. Because of the dif¬culties
involved in initially assigning RVU values to services, this method is used most
often when RVU values have already been estimated, such as for procedures
performed by physicians.

1. What is a relative value unit (RVU)?
2. Explain how RVUs can be used to estimate costs and set prices on
individual services?
208 Healthcare Finance

Making the Service Decision (Contract Analysis)
The primary focus of the previous illustrations was price setting. This illustra-
tion moves to a related decision”the service decision.

Base Case Analysis
County Health Plan (CHP), an HMO with 40,000 members, has proposed
a new contract that would capitate Baptist Memorial Hospital for all inpa-
tient services provided to CHP™s commercial enrollees whose primary care
physicians are af¬liated with the hospital. The proposal calls for a capitation
payment of $35 PMPM for the ¬rst year of the contract. Baptist™s managers
must make the decision whether or not to accept the proposal.
To begin the analysis, Baptist™s managed care analysts developed the
inpatient actuarial data contained in Table 7.10. The data are presented under
two levels of utilization management. The data in the top section are based
on a loosely managed delivery system in Baptist™s service area. These data
represent a bare minimum of utilization management effort and hence re¬‚ect
relatively poor utilization management practices. The bottom section contains
data that represent the best-observed practices throughout the United States.
These data are based on hospitals located in service areas that have extremely
high managed care penetration. The differences between the two data sets
illustrate the potential for improved ¬nancial performance that comes with
more sophisticated utilization management systems. Both sets of data re¬‚ect
populations with characteristics similar to CHP™s commercial enrollees.
To illustrate the calculations, consider the top line in the top sec-
tion (General). Under loosely managed utilization, the covered population
is expected to utilize 157 days of general medical services for each 1,000 en-
rollees. Furthermore, the costs associated with one day of such services total
$1,500. Thus, the general services costs for each 1,000 enrollees are expected
to be 157 — $1,500 = $235,500, or $19.62 PMPM. Calculations for other
inpatient services were performed similarly and added to obtain total medical
costs of $50.39 PMPM.
There are two additional categories of costs beside medical costs. Each
section of the table has lines for administrative costs and risk (pro¬t) margin.
Administrative costs include costs incurred in managing the contract such
as those associated with patient veri¬cation, utilization management, quality
assurance, and member services. The second category of nonmedical costs is
the risk (pro¬t ) margin. Because Baptist would be bearing inpatient utilization
risk for the covered population, it builds in a margin both to provide a pro¬t on
the contract commensurate with the risk assumed and to create a reserve that
could be tapped if utilization, and hence costs, exceeds the amount estimated.
It is Baptist™s practice to allow 10 percent of the total premium for these two
nonmedical costs, so medical costs represent 90 percent of the total premium.
For example, in the upper section of Table 7.10, 0.9 — Total Premium =
$50.39, so Total Premium = $50.39 / 0.9 = $55.99. Furthermore, it is
Chapter 7: Pricing and Service Decisions

TABLE 7.10
Loosely Managed (Sub-optimal) Utilization:
Average Cost
per Member Memorial
Inpatient Days Average Cost
Service Category per 1,000 Enrollees per Day per Month* Hospital:
General 157 $1,500 $19.62 Analysis Under
Surgical 132 1,800 19.80 Two Utilization
Psychiatric 71 700 4.14 Management
Alcohol/Drug abuse 38 500 1.58
Maternity 42 1,500 5.25
Total medical costs 440 $1,374 $50.39
Administrative costs 2.80
Risk (pro¬t) margin 2.80
Total PMPM $55.99

Tightly Managed (Optimal) Utilization:
Average Cost
Inpatient Days Average Cost per Member
Service Category per 1,000 Enrollees per Day per Month*

General 79 $1,600 $10.53
Surgical 58 1,900 9.18
Psychiatric 13 800 0.87
Alcohol/Drug abuse 4 600 0.20
Maternity 26 1,600 3.47
Total medical costs 180 $1,617 $24.25
Administrative costs 1.35
Risk (pro¬t) margin 1.35
Total PMPM $26.95

*Based on 40,000 members (enrollees).
Note: Some rounding differences occur in the table.

Baptist™s policy to split the $55.99 ’ $50.39 = $5.60 in nonmedical costs
evenly between the two categories, so administrative costs and risk (pro¬t)
margin are allocated $2.80 each.5
Table 7.10 sends a strong message to Baptist™s managers regarding the
acceptability of CHP™s $35 PMPM contract offer. If Baptist were to accept the
offer, and then loosely manage the enrollee population, it would lose $55.99
’ $35 = $20.99 PMPM on the contract. The costs in Table 7.10 represent
full costs as opposed to only variable (marginal) costs. Baptist may therefore
be able to carry the contract in the short-run, but it would not be able to
sustain the contract over time. On the other hand, if Baptist could manage
the enrollee population in accordance with “best observed practices,” it would
make a pro¬t of $35 ’ $26.95 = $8.05 PMPM on the contract.
210 Healthcare Finance

The contract also can be analyzed in accounting, rather than actuarial,
terms. This format, along with the required worksheets, is shown in Table
7.11. Again, focus on the loosely managed section. In Table 7.11, instead of
showing inpatient days per 1,000 enrollees as in Table 7.10, inpatient days
are expressed in terms of the total number of enrollees, which is expected
to be 40,000 for this contract. Thus, using utilization data from Table 7.10,
the total number of patient days of general medical services is 157 — 40,000
= 6,280. With an estimated cost of $1,500 per day, total costs for general
medical services amount to 6,280 — $1,500 = $9,420,000. The costs for
all service categories were calculated in the same way and, for all service
categories, total $24,192,000. Each nonmedical service cost was calculated
as 40,000 — $2.80 — 12 = $1,344,000, resulting in total costs under loosely
managed utilization of $26,880,000.
Regardless of the level of utilization management, revenues from the
contract are expected to total 40,000 — $35 — 12 = $16,800,000. Thus, the
projected P&L statements in simpli¬ed form consist of this revenue amount
minus total costs under each utilization scenario. The end result is an expected
net loss of $10,080,000 under loosely managed utilization and a pro¬t of
$3,864,000 under tightly managed utilization.
What should Baptist™s managers do regarding the contract? For now,
the decision appears simplistic: accept the contract if the hospital can tightly
manage utilization, or reject the contract if it can not. Unfortunately, the base
case contract analysis, like many ¬nancial analyses, raises more questions that
it answers. This demonstrates that analyses conducted to help with pricing
and service decisions tend more to raise managers™ awareness of potential
consequences than offer simple solutions.
What else would Baptist™s managers want to know prior to making
the decision? One key element of information is the cost structure (¬xed
versus variable) associated with the contract. Even though the analyses in-
dicate that the contract is unpro¬table under loosely managed utilization,
the analysis has been on a full cost basis. If the costs associated with the
contract consist of 50 percent ¬xed costs and 50 percent variable costs, the
variable cost PMPM in the worst case (loosely managed utilization) would
be 0.50 — $55.99 = $28.00. At a premium of $35, the marginal PMPM
contribution margin is $35 ’ $28 = $7. Thus, even under loose manage-
ment, the premium would at least cover the contract™s variable costs. If Bap-
tist cannot afford to lose the market share associated with CHP™s mem-
bers, its managers may deem the contract acceptable in the short run. As-
suming that the hospital can improve its utilization management over time,
it will be able to eventually cover the total costs associated with the
Cost structure is not the only variable that can change over time. Per-
haps Baptist can demonstrate superior quality and negotiate a higher premium
Chapter 7: Pricing and Service Decisions

TABLE 7.11
Loosely Managed (Sub-optimal) Utilization:
Inpatient Days Average Cost Total
Service Category per 40,000 Enrollees per Day Annual Costs Hospital:
Projected Cost
General 6,280 $1,500 $ 9,420,000 Worksheets and
Surgical 5,280 1,800 9,504,000 P&L Statements
Psychiatric 2,840 700 1,988,000
Alcohol/Drug abuse 1,520 500 760,000
Maternity 1,680 1,500 2,520,000
Total medical costs 17,600 $1,374 $ 24,192,000
Administrative costs 1,344,000
Risk (pro¬t) margin 1,344,000
Total annual costs $ 26,880,000

Tightly Managed (Optimal) Utilization:
Inpatient Days Average Cost Total
Service Category per 40,000 Enrollees per Day Annual Costs

General 3,160 $1,600 $ 5,056,000
Surgical 2,320 1,900 4,408,000
Psychiatric 520 800 416,000
Alcohol/Drug abuse 160 600 96,000
Maternity 1,040 1,600 1,664,000
Total medical costs 7,200 $1,617 $ 11,640,000
Administrative costs 648,000
Risk (pro¬t) margin 648,000
Total annual costs $ 12,936,000

Loosely Managed (Sub-optimal) Utilization:
Total revenues $16,800,000
Total costs 26,880,000
Pro¬t (Loss) ($10,080,000)

Tightly Managed (Optimal) Utilization:
Total revenues $16,800,000
Total costs 12,936,000
Pro¬t (Loss) $ 3,864,000

Note: Some rounding differences occur in the table.

over time. On the down side, perhaps CHP will gain additional market power
over time and attempt to push the premium lower. These are just a few of
the imponderables that Baptist™s managers must consider when making the
service decision.
212 Healthcare Finance

Self-Test 1. Why does utilization management play such an important role in pricing
Questions and service decisions under capitation?
2. Why are nonmedical costs included in the analysis?
3. What would you do regarding the contract if you were the CEO of
Baptist Memorial Hospital?
4. What other factors should Baptist™s managers consider when making the
capitation contract decision?

Key Concepts
Managers rely on managerial accounting and actuarial information to help
make pricing and service decisions. Pricing decisions involve setting prices
on services for which the provider is a price setter, while service decisions
involve whether or not to offer a service when the price is set by the payer
(the provider is a price taker). The key concepts of this chapter are:
• Pricing and service strategies are linked to an organization™s ¬nancial
statements and the need for revenues to (1) cover the full cost of doing
business and (2) provide the pro¬ts necessary to acquire new technologies
and offer new services.
• Price takers are healthcare providers that have to accept, more or less, the
prices set in the marketplace for their services, including the prices set by
governmental insurers.
• Price setters are healthcare providers whose services can be differentiated
from others, either by market share or by quality or other differences, such
that they have the ability to set the prices on some or all of their services.
• Full cost pricing permits businesses to recover all costs, including both
¬xed and variable and direct and indirect, while marginal cost pricing
recovers only variable costs.
• Purchasers of healthcare services are now exercising considerable market
power, thereby restricting the ability of providers to cross-subsidize (price
• Target costing is a concept that takes the prices paid for healthcare services
as a given and then determines the cost structure necessary for ¬nancial
survival given the prices set.
• Three primary techniques are used to develop capitation rates: the
fee-for-service approach, the cost approach, and the demographic approach.
• Pricing and service decisions are supported by a variety of analyses that use
both actuarial and accounting data. Typically, such analyses include a base
case, which uses the most likely estimates for all input values, plus a
scenario analysis that considers the effects of alternative assumptions.
Chapter 7: Pricing and Service Decisions

• One common method to set prices, especially for medical practices, is to
use relative value units (RVUs) to measure the amount of resources
consumed by individual services.

In the next chapter, our coverage of managerial accounting continues with a
discussion of planning and budgeting.

7.1 a. Using a healthcare provider (e.g., a hospital) to illustrate your answer,
explain the difference between a price setter and a price taker.
b. Can most providers be classi¬ed strictly as a price setter or a price
7.2 Explain the essential differences between full cost and marginal cost
pricing strategies.
7.3 What would happen ¬nancially to a health services organization over
time if its prices were set at:
a. Full costs
b. Marginal costs
7.4 a. What is cross-subsidization (price shifting)?
b. Is it as prevalent today as it has been in the past?
7.5 a. What is target costing?
b. Suppose a hospital was offered a capitation rate for a covered
population of $40 per member per month (PMPM). Brie¬‚y explain
how target costing would be applied in this situation.
7.6 What is the role of information systems in pricing decisions?
7.7 Compare and contrast the following three methods for developing
capitation rates: fee-for-service approach, cost approach, and
demographic approach.
7.8 a. What is scenario analysis as applied to pricing and service decisions?
b. Why is it such an important part of the process?
7.9 a. De¬ne a relative value unit (RVU)
b. Explain how RVUs can be used to set prices on individual services.

7.1 Assume that the managers of Fort Winston Hospital are setting the price
on a new outpatient service. Here are relevant data estimates:
Variable cost per visit $5.00
Annual direct ¬xed costs $500,000
Annual overhead allocation $50,000
Expected annual utilization 10,000 visits
214 Healthcare Finance

a. What per visit price must be set for the service to break even? To earn
an annual pro¬t of $100,000?
b. Repeat Part a, but assume that the variable cost per visit is $10.
c. Return to the data given in the problem. Again repeat Part a, but
assume that direct ¬xed costs are $1,000,000.
d. Repeat Part a assuming both a $10 variable cost and $1,000,000 in
direct ¬xed costs.
7.2 The Audiology department at Randall Clinic offers many services to
the clinic™s patients. The three most common, along with cost and
utilization data, are:
Variable Cost Annual Direct Annual Number
Service per Service Fixed Costs of Visits
Basic examination $5 $50,000 3,000
Advanced examination 7 30,000 1,500
Therapy session 10 40,000 500
a. What is the fee schedule for these services, assuming that the goal is
to cover only variable and direct ¬xed costs?
b. Assume that the Audiology department is allocated $100,000 in total
overhead by the clinic, and the department director has allocated
$50,000 of this amount to the three services listed above. What is
the fee schedule assuming that these overhead costs must be covered?
(To answer this question, assume that the allocation of overhead costs
to each service is made on the basis of number of visits.)
c. Assume that these services must make a combined pro¬t of $25,000.
Now, what is the fee schedule? (To answer this question, assume that
the pro¬t requirement is allocated in the same way as overhead costs.)
7.3 Allied Laboratories is combining some of its most common tests into
one-price packages. One such package will contain three tests that have
the following variable costs:
Test A Test B Test C
Disposable syringe $3.00 $3.00 $3.00
Blood vial 0.50 0.50 0.50
Forms 0.15 0.15 0.15
Reagents 0.80 0.60 1.20
Sterile bandage 0.10 0.10 0.10
Breakage/losses 0.05 0.05 0.05
When the tests are combined, only one syringe, form, and sterile
bandage will be used. Furthermore, only one charge for breakage/losses
will apply. Two blood vials are required and reagent costs will remain
the same (reagents from all three tests are required).
a. As a starting point, what is the price of the combined test assuming
marginal cost pricing?
Chapter 7: Pricing and Service Decisions

b. Assume that Allied wants a contribution margin of $10 per test. What
price must be set to achieve this goal?
c. Allied estimates that 2,000 of the combined tests will be conducted
during the ¬rst year. The annual allocation of direct ¬xed and
overhead costs total $40,000. What price must be set to cover full
costs? What price must be set to produce a pro¬t of $20,000 on the
combined test?
7.4 Assume that Valley Forge Hospital has only the following three payer
Number of Average Revenue Variable Cost
Payer Admissions per Admission per Admission
PennCare 1,000 $5,000 $3,000
Medicare 4,000 4,500 4,000
Commercial 8,000 7,000 2,500

The hospital™s ¬xed costs are $38 million.
a. What is the hospital™s net income?
b. Assume that half of the 100,000 covered lives in the commercial
payer group will be moved into a capitated plan. All utilization and
cost data remain the same. What PMPM rate will the hospital have to
charge to retain their Part a net income?
c. What overall net income would be produced if the admission rate of
the capitated group were reduced from the commercial level by 10
d. Assuming that the utilization reduction also occurs, what overall net
income would be produced if the variable cost per admission for the
capitated group were lowered to $2,200?
7.5 Bay Pines Medical Center estimates that a capitated population of
50,000 would have the following base case utilization and total cost
Inpatient Days Average Cost
Service Category per 1,000 Enrollees per Day
General 150 $1,500
Surgical 125 1,800
Psychiatric 70 700
Alcohol/Drug abuse 38 500
Maternity 42 1,500
Total 440 $1,374

In addition to medical costs, Bay Pines allocates 10 percent of the total
premium for administration/reserves.
a. What is the PMPM rate that Bay Pines must set to cover medical costs
plus administrative expenses?
216 Healthcare Finance

b. What would be the rate if a utilization management program would
reduce utilization within each patient service category by 10 percent?
By 20 percent?
c. Return to the initial base case utilization assumption. What rate would
be set if the average cost on each service were reduced by 10 percent?
d. Assume that both utilization and cost reductions were made. What
would the premium be?
7.6 Assume that a primary care physician practice performs only physical
examinations. However, there are three levels of examination”I, II, and
III”that vary in depth and complexity. A RVU analysis indicates that a
Level I examination requires 10 RVUs, a Level II exam 20 RVUs, and a
Level III exam 30 RVUs. The total costs to run the practice amount to
$500,000 annually, including a diagnostic laboratory, and the number
of examinations administered annually are 2,400 Level I, 800 Level II,
and 400 Level III.
a. Using RVU methodology, what is the estimated cost per type of
b. If the goal of the practice is to earn a 20 percent pro¬t margin on
each examination, how should the examinations be priced?

1. The values in Tables 7.1 and 7.3 were obtained from a spreadsheet analysis,
which does not round to the nearest dollar. Thus, there are some minor rounding
differences when the calculations are made by hand.
2. This type of analysis is also called sensitivity analysis because its purpose is to
determine how sensitive the results are to changes in the underlying assumptions.
However, in Chapter 16, we will use the term “sensitivity analysis” to describe a
very particular type of analysis, so we will call the analysis here scenario analysis.
3. The two cost savings amounts total $490,616 + $232,754 = $723,370, which is
$26,576 greater than the $696,794 savings actually realized if both efforts were
undertaken. This apparent anomaly occurs because a reduction in admissions
lowers the value of the reduction in variable costs by 258 — $103 = $26,574,
which, except for a rounding difference, equals $723,370 ’ $696,794 =
4. To make a 20 percent pro¬t margin, Pro¬t / Price = (Price ’ Cost) / Price =
0.20. Solving for price as a function of cost gives Price = Cost / 0.80 = 1.25 —
Cost. In the example, each RVU has a pro¬t component of $1.90 ’ $1.52 =
$0.38, which gives a pro¬t margin of $0.38 / $1.90 = 0.20 = 20%.
5. Baptist™s managers use the same 10 percent nonmedical cost allocation for both
the loosely and tightly managed utilization scenarios. One could argue that the
greater the utilization management effort, the higher the administrative costs.
Thus, it might be better to allocate a greater percentage for administrative
costs in the tightly managed scenario than in the loosely managed scenario. In
fact, administrative costs could require a higher dollar allocation under tightly
managed utilization, even though the overall premium amount is lower.
Chapter 7: Pricing and Service Decisions

Anderson, G. F., et al. 1990. “Setting Payment Rates for Capitated Systems: A Com-
parison of Various Alternatives.” Inquiry (Fall): 225“233.
Baker, J. J., P. Chiverton, and V. Hines. 1998. “Identifying Costs for Capitation
in Psychiatric Case Management.” Journal of Health Care Finance (Spring):
Benz, P. D., and R. V. Nagelhout. 1986. “Evaluating Pricing for Health Care Service
Contracts.” Journal of Health Care Finance (Winter): 59“78.
Berlin, M. F., et al. 1997. “RVU Costing Applications.” Healthcare Financial Man-
agement (Nov): 73“74.
Cleverley, W. O. 2003. “What Price is Right.” Healthcare Financial Management
(April): 64“70.
Heshmat, S. 1997. “Managed Care and the Relevant Costs for Pricing.” Health Care
Management Review (Winter): 82“85.
HFMA. 2004. “Strategic Price Setting: Ensuring Your Financial Viability Through
Price Modeling.” Healthcare Financial Management (July): 97“98.
Horowitz, J. L., and M. A. Kleinman. 1994. “Advanced Pricing Strategies for Hos-
pitals in Contracting with Managed Care Organizations.” Journal of Health
Care Finance (Fall): 90“100.
Jacobs, P., and C. R. Franz. 1985. “Developing Pricing Policies by Diagnostic Group.”
Healthcare Financial Management (January): 50“52.
Keough, C. L., and A. Ruskin. 2004. “Medicare Implications of Discounts to the
Uninsured.” Healthcare Financial Management (July): 40“43.
Pickard, J. G., R. A. Friedman, and T. J. Johnson. 1991. “Repricing Plan Yields
Realistic Revenue Enhancement.” Healthcare Financial Management (May):
Rosko, M. D., and C. E. Carpenter. 1994. “Hospital Markups: Responses to Environ-
mental Pressures in Pennsylvania.” Hospital & Health Services Administration
(Spring): 3“16.
West, T. D., E. A. Balas, and D. A. West. 1996. “Contrasting RCC, RVU, and ABC for
Managed Care Decisions.” Healthcare Financial Management (Aug): 54“61.
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Learning Objectives
After studying this chapter, readers will be able to:

• Describe the overall planning process and the key components of
the ¬nancial plan.
• Discuss brie¬‚y the format and use of several types of budgets.
• Explain the difference between a static budget and a ¬‚exible budget.
• Create a simple operating budget.
• Use variance analysis to assess ¬nancial performance and identify
operational areas of concern.
• Explain the construction and use of a cash budget.

Planning and budgeting play a critical role in the ¬nance function of all health
services organizations. In fact, one could argue (and usually win) that planning
and budgeting are the most important of all ¬nance related tasks.
Planning encompasses the overall process of preparing for the future.
Because of its importance to organizational success, most health services man-
agers, especially at large organizations, spend a great deal of time on activities
related to planning. Budgeting is an offshoot of the planning process. A set of
budgets is the basic managerial accounting tool used to tie together planning
and control functions. In general, organizational plans focus on the long-term
big picture, whereas budgets address the details of both planning for the im-
mediate future and, through the control mechanism, ensuring that current
performance is consistent with organizational plans and goals.
This chapter ¬rst introduces the planning process and then discusses
how budgets are used within health services organizations. In particular, the
chapter focuses on how managers can use ¬‚exible budgets and variance anal-
ysis to help exercise control over current operations. Unfortunately, in an
introductory book, only the surface of these very important topics can be

220 Healthcare Finance

The Planning Process
The strategic plan is the foundation of any organization™s planning process.
It begins with the organization™s mission statement, scope, and objectives. It
then outlines the broad strategies to be followed to achieve the organization™s
stated objectives. Although the strategic plan is the lynchpin of the planning
and budgeting process, it does not provide managers with detailed operational
guidance. The “how to” or perhaps “how we expect to” portion of the
planning process is contained in the operating plan.
Operating plans can be developed for any time horizon, but most
organizations plan ¬ve years into the future. Thus, the term ¬ve-year plan
is often used in place of operating plan. In a ¬ve-year plan, the plans are
most detailed for the ¬rst year, with each succeeding year™s plan becoming
less speci¬c. Unlike the strategic plan, which is short on speci¬cs, the ¬ve-
year plan contains considerable detail concerning who is responsible for what
particular function and when speci¬c tasks are to be accomplished.
Table 8.1 outlines the key elements of Bayside Memorial Hospital™s
¬ve-year plan, with an expanded section for the ¬nancial plan. A full outline
would require several pages, but Table 8.1 provides some insights into the
format and contents of a ¬ve-year plan. Note that the ¬rst two chapters of the
operating plan are drawn from the organization™s strategic plan.
Table 8.2 contains the hospital™s annual ¬nancial planning schedule.
This schedule illustrates the fact that for most organizations the ¬nancial
planning process is essentially continuous. For Bayside, much of the ¬nancial
planning function takes place at the department level, with technical assis-
tance from the marketing, planning, and ¬nancial staffs. Larger businesses,
with divisions, would focus the planning process at the divisional level. Each
division would have its own mission and goals, as well as objectives and bud-
gets designed to support its goals, and these plans, when consolidated, would
constitute the overall corporate plan.
The ¬rst part of the ¬nancial plan (Chapter 7.C of the ¬ve-year plan)
focuses on ¬nancial condition, investments, and ¬nancing at the organiza-
tional level. Its ¬rst component is a review of the business™s current ¬nancial
condition, which provides the basis, or starting point, for the remainder of the
¬nancial plan. (Insights into how this is accomplished are presented in Chapter
17.) Next, the capital budget, which outlines future capital investment (i.e.,
long-term asset purchases), is presented. (Capital budgeting procedures are
discussed in Chapters 14 and 15.) This information feeds into the forecasted
¬nancial statements, which are projected for the next ¬ve years.2 Finally, the
organization™s external ¬nancing requirements are listed, along with a plan for
obtaining these funds. (Financing decisions will be covered in Chapters 11,
12, and 13.) As can be seen from its content, Section 1 of the ¬nancial plan
provides an overview of the ¬nancial future of the organization.
Chapter 8: Planning and Budgeting

Chapter 1 Corporate mission and goals
Chapter 2 Corporate objectives
Chapter 3 Projected business environment
Chapter 4 Corporate strategies Hospital:
Chapter 5 Summary of projected business results Five-Year Plan
Chapter 6 Service line plans Outline
Chapter 7 Functional area plans
A. Marketing
B. Operations
C. Finance
1. Financial condition, investments, and ¬nancing
a. Financial condition analysis
b. Capital budget
c. Forecasted ¬nancial statements
d. External ¬nancing requirements
2. Working capital management
a. Overall working capital policy
b. Cash budget
c. Cash and marketable securities management
d. Inventory management
e. Credit policy and receivables management
f. Short-term ¬nancing
3. Managerial accounting (¬rst year only)
a. Statistics budget
b. Revenue budget
c. Expense budget
d. Operating budget
e. Control procedures
D. Administration and human resources
E. Facilities

Section 2 of the ¬nancial plan concerns current asset and current lia-
bility management, which often is called working capital management. Here,
the plan provides overall guidance regarding day-to-day, short-term ¬nancial
operations. (The cash budget is discussed later in the chapter. The remainder
of working capital management is covered in Chapter 16.) In essence, Section
2 of the ¬nancial plan provides short-term operating benchmarks for all levels
of management.
The managerial accounting portion (Section 3) provides ¬nancial goals
at the micro level”for example, by division, contract, or diagnosis”and is
used to control operations through frequent comparisons with actual results.
In essence, this portion contains the budgets that provide the benchmarks
that managers should be striving to attain throughout the year.
If ¬nancial planning were compared to planning a cross-country road
trip, Section 1 of the ¬nancial plan could be thought of as a roadmap of the
222 Healthcare Finance

Months Action
April“May Marketing department analyzes national and local economic
Hospital: factors likely to in¬‚uence Bayside™s patient volume and
Annual reimbursement rates. At this time, a preliminary volume
forecast is prepared for each service line.
June“July Operating departments prepare new project (long-term
Schedule asset) requirements as well as operating cost estimates
based on the preliminary volume forecast.
August“September Financial analysts evaluate proposed capital expenditures
and department operating plans. Preliminary forecasted
¬nancial statements are prepared with emphasis on
Bayside™s overall sources and uses of funds and forecasted
¬nancial condition.
October“November All previous input is reviewed and the hospital™s ¬ve-year
plan is drafted by the planning, ¬nancial, and departmental
staffs. At this stage, the operating and cash budgets
are ¬nalized. Any changes that have occurred since the
beginning of the planning process are incorporated into the
December The ¬ve-year plan, including all budgets for the coming year,
is approved by the hospital™s executive committee and then
submitted to the board of directors for ¬nal approval.

United States, which provides the overview, while Sections 2 and 3 could be
thought of as the state maps, which provide the details.

Self-Test 1. What is the primary difference between strategic and operating plans?
Questions 2. What is the most common time horizon for operating plans?
3. Brie¬‚y describe the contents of a typical ¬nancial plan.
4. What is the primary difference between Sections 1 and 3 of the ¬nancial

Introduction to Budgeting
Budgeting involves detailed plans, expressed quantitatively in dollar terms,
which specify how resources will be obtained and used during a speci¬ed
period of time. In general, budgets rely heavily on revenue and cost estimates,
so the budgeting process applies many of the managerial accounting concepts
presented in Chapters 5, 6, and 7.
To be of most use, managers must think of budgets not as accounting
tools but as managerial tools. Budgets are more important to managers than
Chapter 8: Planning and Budgeting

to accountants because budgets provide the means to plan and communicate
operational expectations within an organization. Every manager within an
organization must be aware of the plans made by other managers and by the
organization as a whole, and budgets provide the means of communication.
In addition, the budgeting process and the resultant ¬nal budget provide the
means for senior managers to allocate ¬nancial resources among competing
demands within an organization.
Although planning, communication, and allocation are important pur-
poses of the budgeting process, perhaps the greatest value of budgeting is
that it establishes ¬nancial benchmarks for control. When compared to actual
results, budgets provide managers with feedback about the relative ¬nancial
performance of the entity”whether it is a department, diagnosis, contract,
or the organization as a whole. Such comparisons help managers evaluate the
performance of individuals, departments, product lines, reimbursement con-
tracts, and so on.
Finally, budgets provide managers with information about what needs
to be done to improve performance. When actual results are not as good as
those speci¬ed in the budget, managers use variance analysis to identify the
areas that caused the sub-par performance. In this way, managerial resources
can be brought to bear on those areas of operations that offer the most
promise for ¬nancial improvement. In addition, the information developed
by comparing actual results with planned results (i.e., the control process) is
useful in improving the overall accuracy of the planning process. Managers
want to meet budget targets, and hence most managers will think long and
hard when those targets are being developed.

1. What is budgeting?
2. What are its primary purposes and bene¬ts?

Budget Types
Although an organization™s immediate ¬nancial expectations are expressed in
a document called the budget (or master budget ), in most organizations “the
budget” is actually composed of several different budgets. Unlike a business™s
¬nancial statements, budget formats are not in¬‚uenced by external require-
ments, so the speci¬c organization and contents of the budget are dictated by
the business™s mission and structure and by managerial preferences. That said,
several types of budgets are used either formally or informally at virtually all
health services organizations.

Statistics Budget
The statistics budget is the cornerstone of the budgeting process in that it spec-
i¬es the volume and resource assumptions used in other budgets. Because the
224 Healthcare Finance

statistics budget feeds into all other budgets, accuracy is particularly impor-
tant. Note that the statistics budget does not provide detailed information on
required resources such as staf¬ng or short-term operating asset requirements,
but it provides general guidance.
Some organizations, especially smaller ones, may not have a separate
statistics budget, but instead may incorporate its data directly into the revenue
and expense budgets or perhaps into a single operating budget. The advantage
of having a separate statistics budget is that it forces all other budgets within
the organization to use the same set of volume and resource assumptions.
Unfortunately, volume estimates, which are the heart of the statistics budget
and which drive all other forecasts, are among the most dif¬cult to make.
To illustrate the complexities of volume forecasting, consider the vol-
ume forecast procedures followed by Bayside Memorial Hospital. To begin,
the demand for services is divided into four major groups: inpatient, outpa-
tient, ancillary, and other services. Volume trends in each of these areas over
the past ¬ve years are plotted, and a ¬rst approximation forecast is made, as-
suming a continuation of past trends. Next, the level of population growth
and disease trends are forecasted. For example, what will be the growth in
the over-65 population in the hospital™s service area? These forecasts are used
to develop volume by major diagnoses and to differentiate between normal
services and critical care services.
Bayside™s managers then analyze the competitive environment. Con-
sideration is given to such factors as the hospital™s inpatient and outpatient
capacities, its competitors™ capacities, and new services or service improve-
ments that either Bayside or its competitors might institute. Next, Bayside™s
managers consider the effect of the hospital™s planned pricing actions on vol-
ume. For example, does the hospital have plans to raise outpatient charges
to boost pro¬t margins or to lower charges to gain market share and utilize
excess capacity? If such actions are expected to affect volume forecasts, these
forecasts must be revised to re¬‚ect the expected impact. Marketing campaigns
and changes in managed care plan contracts also affect volume, so probable
developments in these areas must be considered.
If the hospital™s volume forecast is off the mark, the consequences can
be serious. First, if the market for any particular service expands more than
Bayside has expected and planned for, the hospital will not be able to meet
its patients™ needs. Potential patients will end up going to competitors, and
Bayside will lose market share and perhaps miss a major opportunity. However,
if its projections are overly optimistic, Bayside could end up with too much
capacity, which means higher than necessary costs because of excess facilities
and staff.

Revenue Budget
Detailed information from the statistics budget feeds into the revenue budget,
which combines volume data with reimbursement data to develop revenue
Chapter 8: Planning and Budgeting

forecasts. Bayside™s planners consider the hospital™s pricing strategy for man-
aged care plans, conventional fee-for-service contracts, and private pay patients
as well as trends in in¬‚ation and third-party payer reimbursement, all of which
affect operating revenues.
The end result is a compilation of operating revenue forecasts by ser-
vice, both in the aggregate”for example, inpatient revenue”and on an in-
dividual diagnosis basis. The individual diagnosis forecasts are summed and
then compared with the aggregate service group forecasts. Differences are
reconciled, and the result is an operating revenue forecast for the hospital as a
whole but with breakdowns by service categories and by individual diagnoses.
In addition to operating revenues, other revenues, such as interest
income on investments and lease payments on medical of¬ce buildings, must
be forecasted. Note that in all revenue forecasts both the amount and the
timing are important. Thus, the revenue budget must forecast not only the
amount of revenue expected, but also when it is likely to be received, typically
by month.

Expense Budget
Like the revenue budget, the expense budget is derived from data in the statis-
tics budget. The focus here is on the costs of providing services rather than the
resulting revenues. The expense budget typically is divided into labor (salaries,
wages, and fringe bene¬ts) and nonlabor components. The nonlabor compo-
nents include expenses associated with such items as depreciation, leases, util-
ities, administrative and medical supplies, and medical training and education.
Expenses normally will be broken down into ¬xed and variable components.
(As discussed later in this chapter, cost structure information is required if an
organization uses ¬‚exible budgeting techniques.)

Operating Budget
For larger organizations, the operating budget is a combination of the rev-
enue and expense budgets. For smaller businesses, the statistics, revenue, and
expense budgets often are combined into a single operating budget. Because
the operating budget (and, by de¬nition, the revenue and expense budgets) is
prepared using accrual accounting methods, it can be roughly thought of as a
forecasted income statement. However, unlike the income statement, which is
typically prepared at the organizational level, operating budgets are prepared
at the sub-unit level”say, a department or product line. Because of its over-
all importance to the budgeting process, most of this chapter focuses on the
operating budget.

Cash Budget
Finally, the cash budget focuses on the organization™s cash position. Because
the operating budget and its component budgets use accrual accounting, they
do not provide cash ¬‚ow information. Like the statement of cash ¬‚ows, which
226 Healthcare Finance

recasts the income statement to focus on cash, the cash budget recasts the
operating budget to focus on the actual ¬‚ow of cash into and out of a business.
Thus, the cash budget tells managers whether the business is projected to
generate excess cash, which will have to be invested, or to experience a cash
shortfall, which will have to be covered in some way.
The primary difference between a cash budget and a forecasted state-
ment of cash ¬‚ows is time period. The projected statement of cash ¬‚ows gen-
erally is prepared on an annual (and perhaps quarterly) basis and is used for
long-term planning. Conversely, the cash budget is prepared on a monthly,
weekly, or daily basis and is used for short-term cash management. Cash bud-
geting will be discussed later in this chapter, while its implications for cash
management will be discussed in Chapter 16.

Self-Test 1. What are some of the budget types used within health services organiza-
Questions tions?
2. Brie¬‚y describe the purpose and use of each.
3. How are the statistics budget, revenue and expense budgets, and
operating budget related?
4. How does the cash budget differ from the operating budget? From the
statement of cash ¬‚ows?

Budget Decisions
In addition to the types of budgets used within an organization, managers
must make several other decisions regarding the budget process.

Virtually all health services organizations have annual budgets, which set
the standards for the coming year. However, it would take too long for
managers to detect adverse trends if budget feedback were solely on an annual
basis, so most organizations also have quarterly budgets, while some have
monthly, weekly, or even daily budgets. Not all budget types or sub-units
within an organization have to use the same timing pattern. Additionally,
many organizations prepare budgets for one or more out years, or years beyond
the next budget year, which are more closely aligned with ¬nancial planning
than with operational control.

Conventional Versus Zero-Based Budgets
Traditionally, health services organizations have used the incremental/decre-
mental, or conventional, approach to budgeting. In this approach, the previous
budget is used as the starting point for creating the new budget. Each line
on the old budget is examined, and then adjustments are made to re¬‚ect
changes in circumstances. In this approach, it is common for many budget
Chapter 8: Planning and Budgeting

changes to be applied more or less equally across departments and programs.
For example, labor costs might be assumed to increase at the same in¬‚ation
rate for all departments and programs within an organization. In essence,
the traditional approach to budgeting assumes that prior budgets are based
on operational rationality, so the main issue is determining what changes
(typically minor) must be made to the previous budget to account for changes
in the operating environment.
As its name implies, zero-based budgeting starts with a clean slate.3 For
example, departments begin with a budget of zero. Department heads then
must fully justify every line item in their budgets. In effect, departments
and programs must justify their contribution (positive or negative) to the
organization™s ¬nancial condition each budget period. In some situations,
department and program heads must create budgets that show the impact of
alternative funding levels. Senior management, then, can use this information
to make rational decisions about where cuts could be made in the event of
¬nancial constraints.
Conceptually, zero-based budgeting is superior to conventional bud-
geting. Indeed, when zero-based budgeting was ¬rst introduced in the 1970s,
it was widely embraced. However, the managerial resources required for zero-
based budgeting far exceed those required for conventional budgeting. There-
fore, many organizations that initially adopted zero-based budgeting soon
concluded that its bene¬ts were not as great as its costs. There is evidence,
however, that zero-based budgeting is making a comeback among health ser-
vices organizations, primarily because market forces are requiring providers to
implement cost-control efforts on a more or less continuous basis.
As a compromise, some health services organizations use conventional
budgeting annually but then use a zero-based budget on a less frequent
basis”say, every ¬ve years. An alternative is to use the conventional approach
on 80 percent of the budget each year and the zero-based approach on 20
percent. Then, over every ¬ve-year period, the entire budget will be subjected
to zero-based budgeting. This approach takes advantage of the bene¬ts of
zero-based budgeting without creating a budgeting process in any year that
is too time consuming for managers.

Top-Down Versus Bottom-Up Budgets
The budget affects virtually everyone in the organization, and individuals™
reactions to the budgeting process can have considerable in¬‚uence on an
organization™s overall effectiveness. Thus, one of the most important decisions
regarding budget preparation is whether the budget should be created top-
down or bottom-up.
In the bottom-up, or participatory, approach, budgets are developed
¬rst by department or program managers. Presumably, such individuals are
most knowledgeable regarding their departments™ or programs™ ¬nancial
needs. The department budgets are submitted to the ¬nance department for
228 Healthcare Finance

review and compilation into the organizational budget, which then must be
approved by top management. Unfortunately, the aggregation of department
or program budgets often results in an organizational budget that is not ¬-
nancially feasible. In such cases, the component budgets must be sent back to
the original preparers for revision, which starts a negotiation process aimed
at creating a budget acceptable to all parties or at least to as many parties
as possible.
A more authoritarian approach to budgeting is the top-down approach,
in which little negotiation takes place between junior and senior managers.
This approach has the advantages of being relatively expeditious and re¬‚ect-
ing top management™s perspective from the start. However, by limiting in-
volvement and communication, the top-down approach often results in less
commitment among junior managers and employees than does the bottom-
up approach. Most people will perform better and make greater attempts to
achieve budgetary goals if they have played a prominent role in setting those


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