Financial Management

Industry Overview

Most industries in the United States are subject to traditional free-market competition. However, this principle does not fully apply to health care because relatively few people who use health care pay directly for it. Most people are beneficiaries of some form of health insurance. This, in combination with the number of uninsured and underinsured, has led to a system that provides services even when no one pays adequately for them. Most medical claims are paid by a third party, such as the government (Medicare, Medicaid) or a private insurance company. Thus someone other than the patient usually pays the provider of health care.

The health care industry is one of the largest industries in the United States and continues to be a growing sector of the gross domestic product, having increased from 5.1% ($27 billion) in 1960 to 17.9% ($3.5 trillion or $10,739 per person) in 2017 (Centers for Medicare & Medicaid Services [ ). Hospitals continue to be a driving force behind escalating health care costs. Most U.S. hospitals are tax exempt, not-for-profit entities. Though “not-for-profit” suggests that no profit is made, it actually means that profits are not distributed to owners or shareholders; instead, profits are reinvested in the organization. Historically, not-for-profit status led hospital administrators to be less profit conscious than counterparts in other businesses. However, today’s hospitals are having a difficult time just covering operating costs given dwindling reimbursement and increasing supply and labor costs. With scarce money left for capital reinvestment in equipment, buildings, facilities, and technology, hospitals are aggressively seeking new ways to produce a profit to invest for the future.

Defining and Identifying Costs

A cost (expense) is the supply, labor, and overhead money spent on a product or service ( ). It is important to understand costs to accurately price tests and other services, to determine when and how to offer new tests, and to determine whether to acquire new outreach client business or a managed care contract. Costs can be classified in different ways ( Table 13.1 ).

TABLE 13.1

Cost Classification

Direct costs are expenses that can easily be traced directly to an end product. In the laboratory setting, the end product is a billable test. Examples are reagents, consumables, and hands-on technologist time. In contrast, indirect costs are not directly related to a billable test but are necessary for its production. Indirect costs are often referred to as overhead. Examples are proficiency testing and utility expenses.

Variable costs change proportionately with the volume of tests. As test volume grows, so do reagent costs. If the reagent cost per test is $1.00, when 1000 tests are performed, the reagent cost is $1000; when 20,000 tests are performed, the reagent cost is $20,000. Fixed costs do not change with the volume of tests performed. If a laboratory pays $5000 per month to rent its space, this expense remains the same if the laboratory produces 1000 or 20,000 tests per month ( Fig. 13.1 ).

Because fixed costs do not vary with activity, the goal is to produce as much as possible from fixed costs to achieve economies of scale. The more that is produced, the lower the fixed cost per activity . In the preceding scenario, if the laboratory produced 1000 tests, the fixed cost per test is $5.00; with 20,000 tests, the fixed cost per test falls to $0.25. Note that even some fixed costs have a variable component. For example, if an instrument’s capacity is 20,000 tests per month and the volume increases beyond that, another instrument will have to be purchased, increasing the fixed costs per test. Fixed costs that change with increments of volume are called step costs .

Salary costs need to be looked at differently from nonsalary costs because salary costs have fringe benefits associated with them. Salary expenses account for approximately 50% to 70% of the laboratory budget. Because salary expenses are generally fixed, it is important to strive for economies of scale. The hourly pay or salaried wage of an employee is not the entire cost of employment. Fringe benefits such as Social Security, health insurance, tuition reimbursement, pension plans, and life insurance can represent an additional 16% to 28% expense above the base salary. Costs are also associated with the recruitment, interview, and selection process. Once an employee is hired, orientation, training, and ongoing growth and development costs are incurred.

Operating costs are the expenses incurred to produce a product or service. Many items have only a one-time use and, once used, the item has no further value. Examples of one-time operating costs include reagents, electricity, disposable pipettes, and the salary expense in the production of a test. Other items, such as analytic equipment, computers, and the physical plant, have a useful life greater than one production cycle. These items are capital items. To qualify as a capital item, it must meet three criteria: time, price, and purpose. To meet the time criterion, the item must have a useful life of longer than 1 year. The institution must designate a minimum dollar amount, usually $1000 to $5000, that qualifies an item as capital. The purpose of acquiring capital items is usually to replace older equipment with safer and more efficient models or to add new equipment to support new products or services. With time, capital equipment loses its value. The annual loss of a capital item’s value is called depreciation and is an annual expense that is deducted from the revenue of a business. Depreciation is not a cash expense (i.e., you do not “pay it” each year), but it is a real expense in that it recognizes the “wearing out” of an asset that was acquired with cash and eventually will have to be replaced. If an analyzer has not yet been fully depreciated, it still has “book value.” Note that operating and capital costs are budgeted separately (see later discussion).

The cost of producing a test can be derived in different ways. Microcosting determines the total direct labor and supply costs of producing a test, and it is the starting point for determining the fully loaded cost and ultimately the price for a test. Most testing in the clinical laboratory is performed in batches or continuous “runs” of many samples during one or more shifts. A run can be a group of tests that are performed once or many times during a shift or an entire 24-hour period. A run includes all quality control and calibration costs needed to produce patient results. When microcosting a test, it is important to consider how a test is performed because labor and supply costs vary according to workflow and laboratory policy for quality control and repeats. The cost per reportable result (CPRR) distributes the total direct costs of a run over the patient “reportable” results for that run. Testing efficiency is defined as the total reportable patient results/total test results. Thus the more repeats and controls performed, the lower the efficiency and the higher the CPRR. As testing efficiency increases, the CPRR decreases. The incremental cost is the cost of producing one additional test that, typically, does not require additional salary or capital. For example, the incremental cost of running a chemistry test is usually the cost of dispensing reagent for one additional test assuming that there are no sample collection costs. Other associated costs, such as technologist time, equipment, or quality control, are fixed costs that are incurred irrespective of the additional test. The incremental cost is usually the lowest possible cost incurred to produce a result. It is best used to assess how much it costs to produce small increments in test volume. As volume grows, a laboratory may need additional staff and equipment; these costs would have to be included in the incremental costing analysis. Incremental costing is especially useful when one is trying to determine whether additional outreach work is profitable or not. The fully loaded cost for a test is the sum of direct and indirect costs. The allocation of indirect costs is usually done using a formula. The goal of allocating indirect costs is to apply the costs based on the strongest correlation between the indirect cost and to what it is being applied. For example, utilities could be based on departmental square footage, while human resources costs could be based on the number of employees in the department. Make-versus-buy decisions should be based on the fully loaded cost to produce the test compared with the price offered by a commercial or reference laboratory. If it costs more to produce a test than to buy it from another supplier, the test should be considered for outsourcing. However, when make-versus-buy decisions are made, cost is only one factor to consider. Medically necessary turnaround time, methods, and reliability of the potential alternative supplier should also be considered. The price charged for a test needs to be marked up (increased) from the fully loaded cost to realize a profit. However, a profit may also be realized on additional business priced lower than the fully loaded cost, as long as the incremental revenue from the work exceeds the incremental cost of doing the work. One must also take into consideration the expected collection rate, relative to charge. The contribution margin is the balance remaining after the fully loaded costs are deducted from the price charged for a test. Table 13.2 demonstrates various ways to determine the cost of a test and how to establish its charge.

The total cost of ownership (TCO) for a laboratory is the life cycle cost of its capital assets. It focuses attention on the sum of all costs of owning and maintaining all assets for a specific service or product as opposed to the initial capital or operating costs. In the laboratory, TCO includes acquisition, setup (construction, training), support (ordering supplies, dealing with backorders), ongoing maintenance (scheduled and unscheduled downtime), service, and operating expenses (reagents, controls, repeat testing, inventory control, proficiency testing, testing personnel, supervisory personnel) of a specific workbench and its associated testing instrumentation. TCO is useful in considering make-versus-buy decisions, but determining an accurate TCO can be very difficult.

Revenue

Revenue is the total price of services rendered or products sold ( ). It is the money a business is entitled to receive for the services and products it produces. In health care, revenue should not be confused with reimbursement or cash collected. Gross patient revenue consists of the total charges at a facility’s full-established rates (list price) for provision of inpatient and outpatient care before deductions from revenue are applied. Net patient revenue is the gross inpatient and outpatient revenue minus all related deductions. Deductions from revenue include contractual adjustments, provision for bad debts, charity care, and other adjustments and allowances that reduce gross patient revenue. Contractual adjustments account for the difference between billings at full-established rates and amounts received or receivable from third-party payers under formal contract agreements. For example, if the list price of a test is $10 but the contracted payment from the insurance company is $6, the adjustment is $4. If all deductions and contractual allowances are correct, net patient revenue should equal cash collected, or $6 in this example.

In health care, it is important to distinguish between inpatient and outpatient care because they are reimbursed differently. Inpatient laboratory testing charges usually are not reimbursed separately; they are considered to be part of a per diem rate (i.e., general hospital daily room reimbursement rate) or diagnosis-related group (DRG) rate (i.e., set rate for the entire hospital stay, regardless of actual length of stay). Thus inpatient laboratory testing is considered a “cost center.” The hospital is paid the same rate regardless of how many tests are provided. In contrast, outpatient laboratory testing has historically been a revenue center because each test is separately reimbursed, usually by a third party ( Table 13.3 ). Thus there has been a financial disincentive to perform inpatient tests and an incentive to perform outpatient tests. However, because new reimbursement models focus on accountable care, shared risk, and bundled payments, incentives to perform outpatient testing are likely to change.

Payers and Reimbursement

Hospitals in early America served a different purpose from those of today. A visiting physician usually provided health care in the patient’s home, and care was administered by family members, midwives, and servants. Early hospitals were founded to shelter older adults, the dying, orphans, those with mental illness, and vagrants, and to protect the citizens of a community from contagious diseases and the dangerously insane. Many of today’s county, municipal, or religious order hospitals were originally a combination of these almshouses and isolation hospitals ( ).

The transformation of hospitals from charitable institutions to complex technical organizations came about with the passage of the Hill-Burton Hospital Construction Act of 1946 and the growth of private hospital insurance. The Hill-Burton Act provided federal money to the states to plan and construct new facilities. The first private health insurance policy was formed by a group of teachers and Baylor Hospital in Dallas to provide coverage for certain hospital expenses. This arrangement created the model for the development of what was to become Blue Cross Insurance. The development of health insurance to provide reimbursement for routine medical care carried gigantic implications. The original concept of any insurance was to guard against the low risk of a rare occurrence such as premature death or accident. Today’s health insurance provides for coverage of routine, predictable services and unforeseen illnesses and injuries ( ).

Reimbursement Coding Systems

To be paid, a medical claim must document the patient’s medical condition (or diagnosis) and must list the services (or tests) provided. This information is conveyed via a standardized coding system, recognized by all government and private payers: Healthcare Common Procedure Coding System (HCPCS) codes describe the test or service ( ), and International Classification of Diseases, Tenth Revision, Clinical Modification ( ICD-10-CM ) codes describe the patient’s condition or diagnosis ( ). These coding standards allow data to be accurately communicated among physicians, patients, and third-party payers.

The HCPCS was developed in 1983 and consists of two levels of codes. Level I is the Current Procedural Terminology (CPT) coding system, used to identify nearly all clinical laboratory tests and most medical services ( ). CPT codes are assigned by the American Medical Association (AMA) and are reviewed and updated annually to keep current with changes in technology and medical practice. Each CPT code consists of five digits and a description of the test or service. For example, the CPT code for a total prostate-specific antigen (PSA) test is 84153.

Level II HCPCS codes are assigned by the CMS. CPT does not contain all the codes needed to report services or to describe special circumstances that may apply to Medicare. The CMS developed this second level of codes to fill the gap. HCPCS Level II codes begin with a single letter (A through V), followed by four digits. These codes are updated annually by the CMS. An example of Level II coding is PSA for cancer screening, G0103. Note that the CMS treats this test differently than the PSA CPT code described earlier, even though the tests are identical to those of the laboratory. This allows the CMS to assign different criteria for reimbursement based on why a test is ordered.

The ICD was originally developed by the World Health Organization (WHO) as a classification system for reporting of mortality and morbidity statistics by physicians throughout the world. The ICD-10-CM is a U.S. clinically modified revision of the WHO ICD-10 . This modification is maintained and updated by the National Center for Health Statistics. These modifications assist health care providers to index patient records, retrieve case data for clinical studies, and submit claims for health care services. In contrast to ICD-9 , ICD-10 (implemented in 2015) provides much greater detail, precisely defines location (including laterality), and provides changes in terminology and expanded concepts for injuries and other related factors. As a result, ICD-10 is composed of about 68,000 codes (three to seven characters long), in contrast to ICD-9 ’s approximately 13,000 codes (three to five characters long) ( ).