Activity Based Costing & Activity Based Management in Hospitals

The following article was written by a colleague, John P. Ortiz.
John is a partner in Tatum’s Healthcare Services practice.
I want to express my gratitude for John's contribution to Arnie's CFO Spot, as this is an important and timely topic for the industry.

Healthcare Looks to Other Industries for Cost Management


Historically, the healthcare industry has not been faced with overwhelming pressure to know, understand and manage costs. Some services have been and are still reimbursed based on cost actually incurred. Cost-plus revenue arrangements have historically left little incentive for managing those costs.

Times have changed. Today, more pressure exists to manage healthcare costs: Medicare at-risk, Medicaid at-risk, Pay-for-Performance, Accountable Healthcare Organizations, managed care and the rising cost of caring for the indigent. Effective operational management has never been more crucial to the success of a healthcare organization. Just as global competition has driven manufacturers to better understand and manage costs, today’s pressures are providing the same impetus in healthcare. Savvy healthcare managers are beginning to take notice of the powerful tool used in other industries, cost management through activity-based information techniques. Activity-based information techniques have the potential to be the business weapon of this century and beyond for healthcare.

Tools for Different Needs

Activity-based information techniques include two powerful components: activity based costing (ABC) an accounting tool and activity based management (ABM) a management tool. Activity-based costing looks at cost from a strategic point of view to answer the question, how much does a service or procedure cost?” It’s a way to maintain and process financial and operating data on resources, activities, the things that drive cost, cost objects (e.g. the organization’s patients, service lines, payers, physicians and network facilities), and activity performance measures. It also assigns cost to activities and cost objects.

Activity-based management takes an operational point of view to answer the question, “What makes costs occur?” It studies the things that drive costs and the activities that go into processes, and helps measure performance. ABM relies heavily on ABC information.

Not your Father’s Cost Vehicle

Organizations that calculate profitability by service line or patient usually rely on traditional cost allocation accounting. For example, a material burden charge might be allocated to the surgical services department. This method helps executives understand cost according to the revenue that’s generated.

Cost allocation is a straightforward idea for healthcare executives, but it has inherent problems for operations managers. An administrative overhead charge doesn’t reflect the diversity of the real work that goes on in the various overhead departments and it doesn’t give management the tools to manage costs. So to answer the question, “What do things cost?” healthcare financial officers have started to look at techniques used in other industries including ABC.

Traditional Cost Cutting Failures

When an organization uses traditional methods of cost accounting and want to trim expenses, cuts may be made in the wrong places. For example, executives may call for across-the-board cuts. The tactics commonly used include hiring or wage freezes, or eliminating entire portions of a budget which may improve expenses in the short term but be harmful in the long run. The organization might try benchmarking, though most benchmarking projects don’t shed light on the processes that lead to excellent results. The organization might focus on trimming the highest cost areas. But resource costs don’t provide information on activities or their value to the organization. For example, knowing someone’s salary doesn’t shed light on that person’s activities or the value they add. If managing costs in a business were as easy as saying just cut 10% across the board, then why not cut 20%. What about 50%? What the heck, cut 100% of the cost. That will really trim expenses. The obvious reason executives in healthcare have historically not specified large cuts is because they know they have no idea what effect an across the board reduction will have on their organization. So the smaller the reduction, the less likely it is for major problems to crop up.
ABM can bridge the gaps. Using activity cost as the starting point, ABM helps managers find out if those activities add value. To determine this, it provides a platform for analyzing, ‘What causes costs to occur?” In taking this approach, ABM focuses on “cost drivers” and performance measures. A Cost driver is any factor which causes a change in the cost to be incurred. There are multiple cost drivers for any activity. Understanding the significance of cost drivers, both individually and in combination with each other, is the key to both understanding what causes costs to occur and how to reduce costs.
Performance measures are used to measure the output of activities. They include not only measures, but also non financial measures such as quality, cycle time, and customer satisfaction. Understanding the impact that activities have on key performance measures is critical to achieving the optimal answer, not just the lowest cost. If the lowest cost is the only objective, simply eliminate the activity. Eliminating an activity yields no cost, however, it also eliminates any benefit the activity was providing which may have included reducing costs in other areas such as preventative maintenance.

To illustrate the power of activity-based information techniques consider the following scenario: Hospital management has dictated a 10% reduction in costs. Which expense statement below would be the most helpful in achieving the goal?

Medical/Surgical Unit                                         Medical/Surgical Unit
Labor                               $525,000                  Deliver Care                        $225,000
Benefits/Payroll Taxes          90,000                  Document Care                      115,000
Supplies                              60,000                   Process Patient Orders           110,000
Depreciation                       60,000                   Transport patients                   75,000
Other Costs                         40,000                   Obtain Test Results                 70,000
  Total                             $775,000                 Admit Patients                        50,000
                                                                        Process Transfers/Discharges 30,000 
                                                                        Develop Care Plan                25,000
                                                                        Perform General Admin.        75,000
                                                                          Total                              $775,000 
Obviously focusing on Processing Patient Orders and Documentation of Care would be a good starting point that traditional cost measures would not have surfaced as a problem.
Understanding activity-based techniques can dramatically improve healthcare management’s ability to make wise cost reduction decisions that are based in fact, sustainable over the long haul, and not at the expense of quality.

ABM is becoming widely recognized as an effective tool to manage costs in healthcare. The Healthcare Financial Management Association in conjunction with Tatum, one of the leaders in ABM, has teamed up recently to develop courses to train healthcare executives on ABM. Courses are being scheduled for the fall of 2010 and the spring of 2011.
For further information on ABM, contact John Ortiz at Tatum, at 678-637-4823.

Once again, my thanks to John. What is your facility doing with respect to managing cost?

Satisfy Your Customer To Improve Your Margins

It seems like a no-brainer, but as hospitals strive to implement programs and processes to improve their bottom line, they don't always focus on this most important element. Like most of you, I've been in the role of patient on occasion and have at times been gob-smacked by the poor customer service attitude of the employees (both clinical and support personnel) I interacted with. For example, how often have you experienced a perceived lack of compassion by clinical staff, a cumbersome or non-friendly registration process, or bad meals?

In the June 2010 edition of HFM Magazine, a brief article on data trends, prepared by the American Hospital Directory, delineates the correlation of positive patient questionnaire responses to operating margins. The data was collected by the Centers for Medicare & Medicaid Services (CMS) based on the Hospital Consumer Assessment of Healthcare Providers and Systems survey instrument.

Hospitals were ranked into quartiles, based on high to low overall ratings, and the median operating margin was calculated for each quartile. The following table tells the story:

          Quartile       Margin
               1             (1.65418)
               2             (1.46375)
               3             (0.44875)
               4              0.409934

Quality, as perceived by patients, is not solely measured by clinical indicators. Everyone having contact with the patient/customer must exhibit a passion to satisfy or exceed their expectations. This can only be accomplished through cultural training and by measuring customer friendliness as a component of employee's periodic evaluations.

Needless to say, it all starts with senior management's dedication to achieving cultural change, and the CFO is an integral player in that regard. Be a role model for your staff and the rest of the organization. The numbers indicate it can only help your bottom line.

EHR Meaningful Use Final Rules - What's The Verdict?

So, doctors and hospitals will be rewarded for the "meaningful use" of electronic medical records. The final rules (all 864 pages), issued last Tuesday lighten up on the proposed requirements that the healthcare industry deemed unrealistic. A brief overview in the July 14th edition of the New York Times indicated the industry could receive as much as $27 billion over the next 10 years to buy equipment to computerize patients’ medical records. A doctor can receive up to $44,000 under Medicare and $63,750 under Medicaid, while a hospital can receive millions of dollars, depending on its size.


I don't think there's any argument EMR meaningful use will lead to “better, smoother care, more reliable care”, as Don Berwick, the new administrator of the Centers for Medicare and Medicaid Services, has stated. The question is, will doctors and hospitals be able to achieve meaningful use in the time frame required by CMS. The clock for progressive attainment of meaningful use runs from 2011 through 2016. There won't be any incentive payments after that, and if a provider doesn't achieve the measure of progress in a given year the incentive payment for that year cannot be recovered. Meanwhile, at this point only 20 percent of doctors and 10 percent of hospitals use even basic electronic health records, according to Kathleen Sebelius, secretary of Health and Human Services.
 

Under  the incentive program, eligible providers must utilize “certified EHR technology” if they are to be considered eligible for the incentive payments. Whether "meaningful use" can be achieved in the time frame allotted remains to be seen, but this is only one of a number of issues raised. For example, as reported in Crain's Health Pulse, several of New York's hospitals are protesting a CMS decision to award the promised $27 billion in funding based on Medicare provider identification numbers. In New York's hospital systems, many smaller hospitals use their flagship hospital's Medicare I.D. number. One major tertiary system, which has 1,500 beds on three campuses, will be treated like it has only 500 beds,” says it's Chief Executive Officer. In his system's case, that means a loss of $25 million in potential government funding.

At the Greater New York Hospital Association, a spokesman says so many of the region's hospitals are in the same situation that the association's lobbyists are pressuring Congress to change the eligibility rules. “We're deeply disappointed,” he says of CMS' decisions, noting the restriction will prevent scores of hospitals from getting the federal money. “We do not believe this was Congress' intent.”

As always, the devil is in the details. It remains to be seen how this will all shake out. I sincerely hope truly meaningful use of EMRs will be a reality in the not-too-distant future, but it can't happen without the realization of the significant dollars associated with the Medicare and Medicaid Programs Electronic Health Record Incentive Program.

Some Financial Distress Is Self-Inflicted

Sure, there are many sophisticated and technical processes that can be applied to deal with cost management. Toyota's Lean or Six Sigma can be utilized to reduce variances in processes. Benchmarking the right indicators can identify areas of opportunity. Technology can be simply tweaked, or major EMR initiatives pursued. Clinical protocols can be established. I could go on, but you get the idea. And these steps will need to be taken to overcome the fiscal crisis faced by many hospitals (and, I would add, other industries). A good discussion of these and other techniques can be found in an article entitled Taking On the Cost Drivers, on the Health leaders media website.

But I maintain, as financial distress mounts, organizations can become so absorbed in mounting such initiatives, or perhaps are so beaten down, they fail to see opportunities that can be easily addressed by looking carefully for simple, even silly, problems. Here are two examples from my own experience, where I was involved with turnaround situations.

Let's start with a silly example. In the first week I was engaged as a CFO at a large urban hospital with a 40% Medicaid payor population, I happened to be standing near the reception desk when a FedEx courier arrived with a package. I saw the courier speaking with the receptionist for a few minutes, whereupon he turned on his heels and left with the package. I asked the receptionist what happened. Turned out the hospital had not paid it's outstanding FedEx bill, so the package was delivered COD. The receptionist had no money, so the package was not handed over. When I researched the matter, I found FedEx was owed about $125. What was in the package? A Medicaid check for $1.8 million! If someone was paying attention, the FedEx bill would have been timely paid, and the hospital, which was suffering severe cash flow problems would have received it's Medicaid funds on time.

This one is not silly, but shows how some creativity can be applied to a situation. A hospital system, again with a severe cash shortfall, could not pay it's Workers Compensation insurance premiums. As a result, the State had declined to renew several large grants, as one of the eligibility requirements was to carry Workers Compensation insurance. I spoke to the State, and indicated if they would renew the grants, we could utilize a portion of the funds to participate in a State-sponsored self-insurance fund. They agreed. The hospital obtained its insurance and obtained the grants.

This is not rocket science. Sometimes, when you're under the gun, its easy to miss the obvious. Don't let the pressures of a distressed situation keep you from scrutinizing the basics and looking for the low-hanging fruit.

I would be interested in any similar anecdotes that support this thesis.