Managing Financial Operations in Healthcare

CHAPTER 7
Managing Financial Operations
Revenue cycle (billing and collections)
Receivables management
Cash and marketable securities management
Inventory (supply chain) management
Operational monitoring and control
Copyright 2009 Health Administration Press
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Financial Operations
Financial operations involves the day-to-day oversight of such
tasks as billing and collections (revenue cycle), cash
management, and inventory management.
The specifics are highly dependent on the type of provider (e.g.,
hospital versus medical practice versus nursing home).
Thus, the focus here is on fundamental concepts as opposed to
details.
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The Revenue Cycle
The revenue cycle is defined as all activities associated with
billing and collecting for services.

In general, revenue cycle management should ensure that
patients are properly categorized by payer,
correct and timely billing takes place, and
correct and timely payment is received.
The revenue cycle includes the activities listed on the next
slide.
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The Revenue Cycle (cont.)
Before-service activities:
Insurance verification
Certification of managed-care patients
Patient financial counseling
At-service activities:
Insurance status verification
Service documentation/claims production
After-service activities:
Claims submission
Third-party follow-up (if needed)
Denials management
Payment receipt and posting
Monitoring and reporting:
Monitoring
Review and improvement
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The Revenue Cycle (cont.)
In revenue cycle management, each of the identified activities is
closely monitored to ensure that

the correct amount of reimbursement is collected on each
patient,
reimbursements are collected as quickly as possible, and
the costs associated with the revenue cycle are minimized
consistently with rapid and correct collections.
Two important keys to good revenue cycle management are
information technology and electronic claims processing.
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Receivables Management
If a service is provided for cash, the revenue is immediately
received.
If the service is provided on credit, the revenue is not received
until the receivable is collected.
Receivables management, which falls under the general
umbrella of the revenue cycle, is extremely important to
healthcare providers.
Why?
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Accumulation of Receivables
Suppose Valley Clinic contracts with an insurer whose patients
use $2,000 in services daily and who pays in 40 days.
The clinic will accumulate receivables at a rate of $2,000 per
day.
However, after 40 days, the receivables balance will stabilize at
$80,000:
Receivables = Daily sales × Average collection period
= $2,000
× 40

= $80,000
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Cost of Carrying Receivables
Valley Clinic must pay its expenses (i.e., labor and supplies)
before it receives its payment.
Suppose Valley Clinic uses bank financing that has an interest
rate of 10 percent to pay its costs (finance its receivables).
The annual cost of carrying the receivables is $8,000:
$80,000 × 0.10 = $8,000.
What two factors influence the dollar cost of carrying
receivables?
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Monitoring Receivables
It is important that healthcare managers continuously monitor
the firm’s receivables to ensure that
payment is received promptly, and
the quality of receivables does not deteriorate.
Monitoring methods include
average collection period (ACP), often called days in patient
accounts receivable, and
aging schedules.
Receivables are monitored both in the aggregate and by specific
payer.
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Cash Management
The goal of cash management is to hold the minimum amount
necessary to meet liquidity requirements. Why?
The primary cash management technique is float management:
Acceleration of receipts
Disbursement control
The cost of cash management initiatives must be balanced by
corresponding benefits.
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Float Management
Float is the difference between the cash amount on the bank’s
books and the amount on the firm’s checkbook.
Suppose Family Healthcare writes $2,000 in checks daily. It
takes six days for them to be received and clear the banking
system, so the bankbook is $12,000 more than the checkbook.
Family Healthcare receives $3,000 in checks daily. They are
cleared in three days, so the checkbook is $9,000 more than the
bankbook.
Thus, the float is $12,000 − $9,000 = $3,000.
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Acceleration of Receipts
Float is maximized by accelerating receipts and slowing
disbursements.
Some techniques used to accelerate receipts:
Daily receipt of deposit checks
Lockboxes
Concentration banking

Automated clearinghouses
Federal Reserve wire system
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Disbursement Control
Disbursement control is the “flip side” of receipt acceleration.
Some techniques used to control disbursement:
Payables centralization
Master and zero-balance accounts
Controlled (remote) disbursement
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Short-Term Securities Management
Businesses hold short-term (marketable) securities for two
primary reasons:
As an interest earning substitute for cash
As a temporary repository for cash being accumulated to meet a
specific need
In reality, cash and short-term securities are managed
simultaneously.
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Short-Term Securities (cont.)
In general, short-term securities are chosen on the basis of
safety.
Protection of principal is primary.
Amount of return is secondary.

Securities used depend on
the expected holding period, and
the size of the business.
Some examples:
Short-term Treasury securities
Money market funds
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What marketable securities might be held by a business that:
(1) keeps $50,000 in reserve to meet
unexpected cash outlays?
(2) is accumulating $100,000 to make the
next quarterly income tax payment?
(3) is accumulating $1 million that, along
with new debt financing, will be used to
purchase an MRI system?
Discussion Items
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Inventory Management
Inventory management, also called supply chain management or
materials management, is important to providers because
medical supplies are critical to patient services.
Inventories consist of base stocks plus safety stocks.
The goal of inventory management is to meet operational needs
at the lowest cost.
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Inventory Management (cont.)
Some inventory management techniques now being used by
providers include
just-in-time systems,
stockless systems, and
consigned inventory systems.
In addition, some providers have contracts with suppliers that
are priced on the basis of the amount of medical services
provided or even capitated.
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Monitoring Operations
Healthcare managers must monitor operations to ensure that the
business operates efficiently and meets performance goals.
For the most part, monitoring involves a set of metrics that
measure aspects of financial and operational performance.
Here we will introduce just a few commonly used hospital
metrics that focus on managing operations.
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Outpatient Revenue Percentage
Net outpatient revenue
Outpatient revenue percentage = ×
100.
Total revenue
Measures the percentage of total (net) revenue realized from
outpatient services. A high or low value is not necessarily bad;

it just measures the reliance on outpatient services (as opposed
to inpatient services and other patient sources) as a source of
revenue. If outpatient services are more profitable than inpatient
services, a higher value would mean greater overall
profitability. Note that the ratio is multiplied by 100 to convert
the decimal form to a percentage.
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Medicare Percentage (Inpatient)
Medicare discharges
Medicare percentage = × 100.
Total discharges
Measures the percentage of discharges realized from Medicare
patients—in other words, the hospital’s reliance on Medicare
patients. Because government payers generally are considered
to be less generous than other payers, and because Medicare
patients on average have longer stays than younger patients (and
hence higher costs), a high Medicare percentage is considered a
negative indicator. Also, high reliance on Medicare and other
government-insured patients means that the hospital will be
affected to a greater degree by political rather than economic
decisions.
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Occupancy Rate

Average daily census
Occupancy rate = × 100 .
Number of beds
Measures inpatient volume as a percentage of the number of
beds. The higher the occupancy rate, the better, unless it is so
high that the hospital does not have the capacity to deal with
emergency situations. To raise the occupancy rate, hospitals can
(1) increase admissions, (2) increase length of stay (which
makes no sense under many reimbursement schemes), or (3)
decrease the number of beds. Note that number of beds can be
measured either as licensed beds or staffed beds. Also note that
this measure is sometimes called occupancy.
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Length of Stay (LOS)
Total annual patient days
Length of stay = .
Total discharges
Measures the average number of days an inpatient stays in the
hospital. Because most reimbursement is independent of length
of stay (LOS), the shorter the LOS, the lower the cost of
treatment and hence the greater the profitability of inpatient
services. Note that this measure is often called average length
of stay (ALOS).
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Price per Discharge
Net inpatient revenue
Net price per discharge = .
Total discharges
Measures the amount of net revenue per discharge. Because
allowances have been deducted, net price per discharge
measures the actual amount of revenue (reimbursement) per
discharge. This indicator is a measure of the market’s
assessment of the value of the inpatient services as opposed to
the hospital’s assessment.
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Cost per Discharge
Total inpatient operating expense
Cost per discharge =
.
Total discharges
Measures the average cost of each inpatient stay. Regardless of
the reimbursement methodology, lower service costs lead to
higher profitability, all else the same. Note that this ratio can be
adjusted for wage and case mix differentials by multiplying the
denominator by the wage and all-patient case mix indexes.
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Profit per Discharge
operating expenses
Profit per discharge =
.
Total discharges
Measures the amount of profit earned on each inpatient
discharge. Low values (including negative values) can be traced
to high inpatient costs, low inpatient reimbursement, or both.
Obviously, a lack of inpatient profitability can spell financial
trouble for hospitals. However, lack of inpatient profitability
can be offset (in whole or partially) by outpatient care profits
and/or non–patient care revenues, such as contributions and
grants.
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FTEs per Occupied Bed
Inpatient FTEs
FTEs per occupied bed = .
Average daily census
Measures the productivity of labor devoted to inpatient services
as a function of the number of patients. Because the provision
of inpatient services is labor intensive, labor productivity has a
large influence on inpatient costs. Of course, in addition to the
number of patients, the intensity of services provided also
affects the requirement for labor resources. Thus, this ratio

often is adjusted for case mix differentials by multiplying the
denominator by the all-patient case mix index.
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A raw metric number, such as an occupancy rate of 58.0%, is
difficult to interpret.
Managers use
comparative analysis, such as comparing to the hospital industry
average of 62.3%; and
trend analysis, such as noting that the last five years’ occupancy
(oldest first) was 61.1%, 60.7%, 59.7%, 58.8%, and 58.0%.
Interpreting the Metrics (Ratios)
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Key Performance Indicators
and Dashboards
Key performance indicators (KPIs) are a limited number of
operational (and financial) metrics that measure performance
critical to the success of an organization.
Dashboards are a way of presenting an organization’s KPIs
(often as gauges) that allows managers to quickly interpret the
indicators.
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Dashboard Example

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This concludes our discussion of Chapter 7 (Managing Financial
Operations).
Although not all concepts were discussed, you are responsible
for all of the material in the text.
Do you have any questions? If so, please feel free to post it on
the discussion board under Chapter 7.
Conclusion
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HCA 445 Mid-Term Questions
1. List the eight finance activities.
2. List the four c’s
3. True or False
The primary role of finance in healthcare organizations, as in all
businesses, is to plan for,
acquire, and use resources to minimize the efficiency and value
of the enterprise.
4. Fill-in-the-Blank
The finance department in large provider organizations

generally consists of a chief financial
officer (CFO), comptroller, and ______________.
5. Fill –in-the-Blank
_______________ is a critical part of the costing process
because it addresses the issue of how
to assign the costs of support activities to the revenue-
producing departments.
6. Before-tax (BT) income can be converted to after-tax (AT)
income using what equation:
7. Please show the formula for calculating average cost.
8. Please show the formula for calculating total variable costs.
9. Before-tax (B) income can be converted to after-tax (AT)
income by using this equation:
10. True or False
Direct costs are the unique (exclusive resources used only by
one unit of an organization, such
as a department, and therefore are fairly easy to measure.
11. Assume that Provident Health System, a for-profit hospital,
has $1 million in taxable income for
2008, and its tax rate is 30%.
a) Given this information, what is the firm’s net income? (Net

income is what remains
after taxes have been paid.)
b) Suppose the hospital pays out $300,000 in dividends. A
stockholder, Carl Johnson
receives $10,000. If Carl’s tax rate on dividends is 15%, what
is his after-tax dividend?
12. Kim Davis is in the 40% personal tax bracket. She is
considering investing in HCA (taxable) bonds
that carry a 12% interest rate.
a) What is her after-tax yield (interest rate) on the bonds?
b) Suppose Twin Cities Memorial Hospital has issued tax-
exempt bonds that have an
interest rate of 6%. With all else the same, should Kim buy the
HCA or the Twin Cities
bonds?
c) With all else the same, what interest rate on the tax-exempt
Twin Cities bonds would
make Kim indifferent between these bonds and the HCA bonds?
13. Assume that a radiology group practice has the following
cost structure:
Fixed cost $500,000 Variable cost per procedure $50
Furthermore, assume that the group expects to perform 10,000
procedures in the coming year.

a) What is the group’s underlying cost structure?
b) What are the group’s expected total costs?
c) What are the group’s estimated total costs at 5,000
procedures? At 12,500 procedures?
d) What is the average cost per procedure at 5,000; 10,000; and
12,500 procedures?
14. Assume that the managers of Fort Winston Hospital are
setting the price on a new out-patient
service. Here are the relevant data estimates:
Variable cost per visit $10.00
Annual direct fixed costs $350,000
Annual overhead allocation $75,000
Expected annual utilization 12,500 visits
a) What per visit price must be set for the service to break
even? To earn an annual profit
of $150,000?
b) Repeat Part a, but assume that the variable cost per visit is
$15.
c) Return to the data given in the problem. Again repeat Part a,
but assume that direct
fixed costs are $850,000
d) Repeat Part a, assuming both a $15 variable cost and
$1,000,000 in direct fixed costs.
15. Consider the data in the following table for three
independent healthcare organizations:

Total Fixed Total
Revenues Variable Costs Costs Costs Profit
a. $2,000 $ 1,400 ? $ 2,000 ?
b. ? 1,000 ? $ 1,600 $ 2,400
c. 4,000 ? $ 600 ? 400
Fill in the missing data indicated by a question mark.
The operating plan, is often called ____________, contains
more detailed information than does
the strategic plan.
17. Short answer
A variance is the difference between:
______________ entails the entire process of constructing and
using budgets, which are
detailed plans for obtaining and using resources during a
specified period of time.
19. Consider the following 2012 data for Newark General
Hospital (in millions of dollars):

Simple Flexible Actual
Budget Budget Results
Revenues $ 4,700,000 $ 4,800,000 $ 4,500,000
Costs $ 4,100,000 $ 4,100,000 $ 4,200,000
Profit $ 600,000 $ 700,000 $ 300,000
a) Calculate and interpret the two profit variances.
b) Calculate and interpret the two revenue variances.
c) Calculate and interpret the two cost variances.
d) How are the variances related?
20. Northeast Medical Group, a family practice, has the
following financial data and operational
metrics:
Number of physicians 5
Total revenue $2,748,360
Total operating costs $1,557,615
Total procedures per physician 12,353
Patients per physician 1,941
Visits per physician 5,333
a) What is the group’s revenue per physician?
b) What is the group’s operating cost per physician?
c) What is the group’s total operating profit?
d) What is the group’s profit per physician?
e) What is the group’s profit per patient?
f) What is the group’s profit per visit?
g) What is the group’s profit per procedure?

Big sky’s revenue sources
Big Sky Dermatology Specialists is a small group practice in
Jackson, Wyoming. The city is located in the scenic Jackson
Hole Valley and is a major gateway to the Grand Teton and
Yellowstone National Parks. In addition, it is home to the
world’s largest ball of barbed wire. (It’s amazing what you
learn when studying healthcare finance!)
Jen Latimer, a recent graduate of Idaho State University’s
healthcare administration program, was just hired to be Big
Sky’s practice manager. One of her first tasks was to review the
group’s payer mix. (Payer mix is a listing of the individuals and
organizations that pay for a provider’s services, along with each
payer’s percentage of revenues.) After all, revenues are the first
step (of many) needed to ensure the financial success of any
business.
To better understand Big Sky’s revenues, Jen focused on two
questions. First, who are the payers? In other words, where does
Big Sky’s revenue come from? Second, what methods do the
payers use to determine the payment amount? By gaining an
appreciation of the group’s
revenues, Jen believed she could accurately judge the financial
riskiness of the practice. Furthermore, she would be able to
identify possible steps toward increasing the practice’s revenues
and reduce the riskiness associated with those revenues.
By the end of the chapter, you will have a better understanding
of healthcare provider revenue sources and how the specific
payment method influences provider behavior. Specifically,
you, like Jen, will know more about how these issues affect Big
Sky.
3.1 introduction
In most industries, the consumer of the product or service (1)
has a choice among many suppliers, (2) can distinguish the

quality of competing goods or services, (3) makes a
(presumably) rational decision regarding the purchase on the
basis of quality and price, and (4) pays for the full cost of the
purchase.
The provision of healthcare services does not follow this
general model, as healthcare is delivered under unique
circumstances. First, often only a few individuals or
organizations provide a particular service. Second, judging the
quality of competing providers is difficult, if not impossible.
Third, the decision (or at least recommendation) on which
provider to use for a particular service typically is not made by
the consumer but rather by a physician or some other clinician.
Fourth, the bulk of the payment to the provider is not normally
made by the user (the patient) but by an insurer. Finally, for
most individuals, the purchase of health insurance is paid for
(or heavily subsidized) by employers or government agencies,
so patients are insulated from the true cost of healthcare
services.
This highly unusual marketplace significantly influences the
supply of and demand for healthcare services. To gain a better
understanding of the unique payment mechanisms involved, we
must examine the healthcare reimbursement system.
3.2 basic insurance concepts Because insurance is the
cornerstone of healthcare reimbursement, an appreciation of
basic
insurance concepts will help you better understand the
marketplace for healthcare services.
A Simple illustration
Assume that no health insurance exists and that you face only
two medical outcomes in the coming year:
Outcome Probability Outcome Probability
Stay healthy 0.99 Stay healthy 0.99
Get sick 0.01 Get sick 0.01
1.00 1.00

Cost Cost
$ 0 $ 0
50,000 50,000
What is your expected healthcare cost (in the statistical sense)
for the coming year? To find the answer—$500—multiply the
cost of each outcome by its probability of occurrence and then
sum the products:
Expected cost = (Probability of outcome 1 × Cost of outcome 1)
Expected cost = (Probability of outcome 1 × Cost of outcome 1)
+ (Probability of outcome 2 × Cost of outcome 2) + (Probability
of outcome 2 × Cost of outcome 2)
= (0.99 × $0) + (0.01 × $50,000) = (0.99 × $0) + (0.01 ×
$50,000)
= $0 + $500 = $500. = $0 + $500 = $5
Now, assume that everyone else faces the same medical
outcomes and hence faces the same odds and costs associated
with healthcare. Further- more, assume that you, and everyone
else, make $60,000 a year. With this salary, you can easily
afford the $500 expected healthcare cost. The problem,
however, is that no one’s actual cost will be $500. If you stay
healthy, your cost will be zero; if you get sick, your cost will be
$50,000, and this amount could force you, and most people who
get sick, into personal bankruptcy, which is a ruinous event.
(Don’t forget, you have to pay all of your living expenses out of
your $60,000 annual income in addition to any healthcare
costs.)
Now, suppose an insurance policy that pays all of your
healthcare costs for the coming year is available for
$600.Would you take the policy, even though it costs $100 more
than your “expected” healthcare costs?
Most people would, and do. Because individuals are risk averse,
they are willing to pay a $100 premium over their expected
benefit to eliminate the risk of financial ruin. In effect,

policyholders are passing the costs associated with the risk of
getting sick to the insurer who, as you will see, is spreading
those costs over a large number of subscribers.
Would an insurer be willing to offer the policy for $600? If the
insurer could sell enough policies, it would know its revenues
and costs with some precision. For example, if the insurer sold
1 million policies, it would collect 1,000,000 × $600 = $600
million in health insurance premiums; pay out roughly
1,000,000 × $500 = $500 million in claims, and hence have
about $100 million to cover administrative costs; provide a
reserve in case claims are greater than predicted; and make a
profit. By writing a large number of policies, the financial risk
inherent in medical costs can be spread over a large number of
people, reducing the risk for the insurance company (and for
each individual).
Critical Concept
Risk aversion is the tendency of individuals and businesses to
dislike financial risk. Risk-averse individuals and businesses
are motivated to use insurance and other techniques to protect
against risk. For example, a favorite tool to control risk is di-
versification, which in the context of revenues means lowering
risk by having different sources of income. By not depending on
one source—say, Medicare patients—a provider can reduce the
uncertainty (riskiness) of its revenue stream. Insurance is
another way to limit risk. Individuals buy insurance on the
houses they own to limit the consequences of calamitous events,
such as fires or hurricanes.
basic characteristics of insurance
The simple example above illustrates why individuals seek
health insurance and why insurance companies are formed to
provide such insurance. But let’s dig a little deeper into
insurance basics.
Insurance typically has four distinct characteristics:
1. Pooling of losses. The pooling (sharing) of losses is the heart
of insurance. Pooling means that losses are spread over a large

group of individuals so that each individual realizes the
average loss of the pool rather than the actual loss incurred. In
addition, pooling involves the grouping of a large number of
homogeneous exposure units (people or things having the same
risk characteristics). Thus, pooling implies (a) the sharing of
losses by the entire group and (b) the prediction of future losses
with some accuracy based on the law of large numbers. (The
law of large numbers implies that predicting outcomes is easier
when many identical trails are involved. For example, if a coin
is flipped only once, you do not know whether the results will
be a head or a tail. But if the coin is flipped 1,000 times, the
result will be very close to 500 heads and 500 tails. In other
words, you cannot predict the results of a single toss with any
confidence, but you can predict the aggregate results if you
have a large pool of tosses.)
2. Payment only for random losses. A random loss is
unforeseen, is unexpected, and occurs as a result of chance.
Insurance is based on the premise that payments are made only
for losses that are random. We discuss the moral hazard
problem, in which losses are not random, in a later section.
3. Risk transfer. An insurance plan almost always involves risk
transfer. The sole exception to the element of risk transfer is
self-insurance, whereby an individual or a business does not
buy insurance. (Self-insurance is discussed in a later section.)
Risk transfer means that the risk is shifted from the insured to
the insurer, which typically is in a better financial position to
pay the loss than is the insured because of the premiums
collected. Also, because of the law of large numbers, the
insurance company is better able to predict its losses.
4. Indemnification. Indemnification is the reimbursement of the
insured if a loss occurs. Within the context of health insurance,
indemnification occurs when the insurer pays, in whole or in
part, the insured or the provider for the expenses related to an
insured’s illness or injury.

In summary, we applied these four characteristics to our
insurance example: (1) The losses are pooled across 1 million
individuals, (2) the losses on each individual are random
(unpredictable), (3) the risk of loss is passed to the insurance
company, and (4) the insurance company pays for any losses.
Pooling
The spreading of losses over a large group of individuals (or
organizations).
Random loss
An unpredictable loss, such as one that results from a fire or
hurricane.
Risk transfer
The passing of risk from one individual or business to another
(usually an insurer).
Indemnification
The agreement to pay for losses incurred by another party.
real-world problems
Insurance works fine when the four basic characteristics are
present. However, if any of these characteristics is violated,
problems arise. The two most common problems are adverse
selection and moral hazard.
Adverse Selection
One of the major problems for insurers is adverse selection.
Adverse selection occurs because those individuals and
businesses likely to incur losses are more inclined to purchase
insurance than are those less likely to incur losses. For example,
an otherwise healthy individual without insurance who needs a
costly surgical procedure is more apt to get health insurance if
he or she can afford it, whereas an identical individual without
the threat of surgery is less likely to purchase insurance.

Similarly, consider the health insurance purchase likelihood of a
20-year-old versus that of a 65-year-old. All else the same, the
older individual, with much greater health risk because of age,
will probably obtain insurance. (Individuals aged 65 or older
consume more than three times the dollar amount of healthcare
services as younger individuals do.)
If the tendency toward adverse selection goes unchecked, a
disproportionate number of sick people, or those most likely to
become sick, will seek health insurance, causing the insurer to
experience higher-than-expected claims. This increase in claims
will trigger a premium increase, which worsens the problem,
because healthier members of the plan will either pursue
cheaper rates from another company (if available) or forgo
insurance.
One way health insurers attempt to control adverse selection is
by instituting under- writing provisions. Thus, smokers may be
charged a higher premium than nonsmokers. An- other way is
by including preexisting condition clauses in contracts. (A
preexisting condition is a physical or mental condition of the
insured individual that existed before the issuance of for
insurance. the policy.) A typical clause might state that
preexisting conditions are not covered until the policy has been
in force for some period of time—say, one or two years.
Preexisting conditions present a true problem for the health
insurance industry because an important characteristic of
insurance is randomness. If an individual has a preexisting
condition, the insurer no longer bears random risk but rather
assumes the role of payer for the treatment of a known
condition.
Because insurers tend to avoid paying large predictable claims,
the US Congress passed the Health Insurance Portability and
Accountability Act (HIPAA) in 1996. Among other actions,
HIPAA sets national standards, which can be modified within
limits by the states, regarding what provisions can be included
in health insurance policies. For example, under a group health
policy—say, one that covers employees of a furniture

manufacturer—coverage to individuals cannot be denied or
limited, and employees cannot be required to pay more in
premiums if they suffer from poor health.
Although preexisting condition clauses in policies for adults are
not currently banned, insurers are limited as to what conditions
they can count as preexisting and how long they can delay
before beginning coverage. Also, time credit for preexisting
conditions under one plan can be credited toward a second plan
should the employee change jobs, provided no break in coverage
occurs. (Preexisting condition clauses for children are banned
under the Patient Protection and Affordable Care Act [ACA]
and, if not changed, will be banned for adults in 2014. See
section 3.8 for a discussion of the ACA.)
Critical Concept:
Adverse selection, in its simplest form, means that individuals
most likely to need healthcare services are most likely to buy
health insurance. This tendency creates a problem for insurers
because it drives the costs of healthcare for a defined
population to higher-than-anticipated levels.
Finally, health insurance cannot be canceled if the policyholder
becomes sick, and if a policyholder leaves the company, he or
she has the right to purchase insurance (for a limited time) from
the insurer that provided the company’s group policy. All in all,
the provisions of HIPAA protect individuals against arbitrary
actions by insurers when their health status changes for the
worse or when they leave the employer.
For Your Consideration
When the cost of health insurance is relatively low, such as in
an employer-subsidized plan, most people to whom it is made
available will opt in (take the insurance). But when the cost of
health insurance is relatively high, the choice is not as easy to

make. Often, those who opt in will be more likely to have
immediate healthcare needs and hence be more expensive to
insure than the population as a whole. Thus, as Kay Lazar wrote
in a June 30, 2010, Boston Globe article titled “Short-Term
Insurance Buyers Drive up Cost in Mass.,” adverse selection is
a factor in increased health insurance costs, and the higher the
costs, the higher the premiums, which means even more
individuals will forgo coverage.
The traditional techniques used by insurers to mitigate adverse
selection risk have included denying coverage to or charging
higher premiums for individuals with preexisting health
conditions or excluding those conditions from the individual’s
policy. Although necessary for the current healthcare insurance
system to remain viable, these techniques are one reason health
insurance is viewed in a negative light by many consumers.
Now, however, healthcare reform (discussed in section 3.8)
eliminates or limits most of the traditional adverse selection
risk management techniques. Instead, the legislation’s aim is to
maximize the number of healthy people who obtain coverage by
offering subsidies to lower-income Americans and mandating
penalties for those who refuse to take coverage. This
“individual mandate” approach is intended to put almost
everyone into the insurance pool, thereby eliminating adverse
selection.
What do you think? Will the individual mandate eliminate
adverse selection? What specific provisions (sticks and carrots)
are necessary for the mandate to work? Note that more than two
dozen states, interest groups, and individuals have sued the
federal government, arguing that the individual mandate is
unconstitutional. By the time you read this For Your
Consideration box, the issue will have been settled by the US
Supreme Court.
Moral Hazard
The fact that insurance is based on the premise! that payments

are made only for random (unforeseen) losses creates the
moral hazard problem. The most common illustration of moral
hazard is the owner who deliberately sets a failing business on
fire to collect the insurance.
Moral hazard is also present in health insurance, but its form
typically is not so dramatic—not too many people are willing to
voluntarily sustain injury or illness for the purpose of collecting
health insurance benefits. How- ever, undoubtedly some people
do purposely use healthcare services that are not medically
required. For example, some people who live alone might visit a
physician or a walk-in clinic for the social value of human
companionship rather than to address a medical necessity.
More consequential is the fact that someone other than the
patient is usually paying for the healthcare he or she receives,
leading to greater consumption of services than would occur if
patients bore the full costs. When the full cost or most of the
cost of healthcare services is covered by insurance, individuals
are more inclined to agree to undergo a $1,000 MRI (magnetic
resonance imaging) scan or other high-cost procedure even
when its need is questionable. If the same test required total
out-of-pocket payment, an individual would probably think
carefully before agreeing to such an expensive procedure,
unless it is a true medical necessity.
An even more insidious aspect of moral hazard is the impact of
insurance on individual behavior. Individuals are less likely to
take preventive health actions when the costs of not taking
those actions will be borne by insurers. Why worry about
getting a flu shot if the monetary costs associated with the
treatment are borne by the healthcare services
insurer? Why stop smoking if others will pay for the likely
adverse health consequences?
The fact that insurance exists causes some individuals to forgo
preventive actions and embrace unhealthy behaviors, both of
which might be approached differently in the absence of
insurance.
Insurers attempt to protect themselves from moral hazard claims

by paying less than the full amount of healthcare costs. Forcing
insured individuals to bear some of the cost lessens their
tendency to consume unneeded services or engage in unhealthy
behaviors. One way to make patients pay out of pocket is to
require a deductible. Medical policies usually stipulate a dollar
amount that must be satisfied before benefits are paid.
Although deductibles help offset the moral hazard problem,
their primary purpose is to eliminate the need for an insurer to
pay a small claim, if that is the only healthcare expense for the
year. In such cases, the administrative cost of processing the
claim may be larger than the amount of the claim itself. To
illustrate, a policy may state that the first $500 (or more) of
medical expenses incurred each year will be paid by the
individual. Once the deductible is met, the insurer will pay all
eligible medical expenses (less any copayments and
coinsurance) for the remainder of the year.
The primary weapons that insurers have against the moral
hazard problem are copayments and coinsurance. Copayment (or
copay) is a fixed amount paid by the patient each time a service
is rendered, such as $20 per office visit or $75 for each
emergency department visit. Coinsurance is the sharing of costs
between the patient and insurer, typically on a percentage basis.
For example, the patient bears 20 percent of the costs of a
hospital stay.
Copays and coinsurance serve two primary purposes. First,
these payments discourage overutilization of healthcare services
and hence reduce insurance benefits. By extension, by being
forced to pay some of the costs, insured individuals will
presumably seek fewer and more cost-effective treatments and
embrace a healthier lifestyle than they would otherwise.
Second, because insured individuals pay part of the cost,
premiums can be reduced. Health insurance premiums (the cost
of the policy to the subscriber) have risen rapidly in the past ten
years and now exceed $15,000 annually for family coverage.

Employers, on average, pay about 75 percent of the premium
costs. Because of this alarming trend in health premium costs,
employers are seeking ways to reduce them; one way is to pass
more of the costs on to employees through copays and
coinsurance.
Some health insurance policies contain out-of-pocket
maximums, whereby the insurer pays all covered costs,
including coinsurance, after the insured individual pays a
certain amount of costs—say, $2,000. Finally, prior to 2010,
most insurance policies had policy limits, for example, $1
million in total lifetime coverage, $1,500 per year for mental
health benefits, or $100 for eyeglasses. These limits were
designed to control excessive use of certain services and protect
the insurer against catastrophic losses. The ACA, as it currently
stands, has banned lifetime limits and is phasing out annual
limits on most health plans.
Before we move on, we should briefly mention a newer type of
health insurance that is gaining popularity: high-deductible
health plans (HDHPs). An HDHP has a higher annual deductible
(more than $2,000 for family coverage) than traditional plans
do. But it allows individuals to set up savings accounts for the
sole purpose of paying healthcare costs. Furthermore,
contributions to such accounts are tax deductible (up to a set
limit) and can roll over from year to year. HDHPs are becoming
popular with executives and other highly paid workers because
of the tax shelter benefit, but they have not been as widely
accepted by blue-collar workers because of the high deductible
amount.
Copayment
A fixed cost to the patient each time a service is rendered (e.g.,
$20 per outpatient visit).
Coinsurance

A sharing of costs between the patient and the insurer (e.g., the
patient pays 20 percent of the costs of hospitalization).
High-deductible health plan (HDHP)
A type of health insurance that requires high deductibles but
allows insured individuals to set up tax-advantaged savings
accounts to pay those deductibles.
3.3 Third-party payers
As mentioned earlier, a large proportion of provider revenues
does not come directly from patients (the users of healthcare
services) but from insurers, known collectively as third-party
payers. Because a healthcare organization’s revenues are key to
its financial viability, we first discuss the sources of most
revenues in the healthcare industry. In the next section, we
examine the types of reimbursement methods employed by these
payers.
Health insurance originated in Europe in the early 1800s when
mutual benefit societies were formed to reduce the financial
burden associated with illness or injury. Today, health insurers
fall into two broad categories: private insurers and public
programs.
private insurers
In the United States, the concept of public, or government,
health insurance is relatively new, while private health
insurance has been in existence since the early twentieth
century. In this section, we discuss the major private insurers.
Blue Cross and Blue Shield
Blue Cross and Blue Shield organizations trace their roots to the
Great Depression, when both hospitals and physicians were
concerned about their patients’ abilities to pay healthcare
bills.

Blue Cross originated as a number of separate insurance
programs offered by individual hospitals. At that time, many
patients were unable to pay their hospital bills, but most people,
except the poorest, could afford to pay small monthly premiums
to purchase some type of hospitalization insurance. Thus, the
programs were initially designed to benefit both patients and
hospitals.
The programs were all similar in structure: Hospitals agreed to
provide a certain number of services to program members who
made periodic payments to the hospitals whether services were
used or not. In a short time, these programs were expanded from
single-hospital programs to community-wide, multihospital
plans that were called hospital service plans. The American
Hospital Association (AHA) recognized the benefits of such
plans to hospitals, so a close relationship was formed between
the AHA and the organizations that offered hospital service
plans.
In the early years, several states ruled that the sale of hospital
services by prepayment did not constitute insurance, so the
plans were exempt from regulations governing insurance
companies. However, the legal status of hospital service plans
clearly would be subject to future scrutiny unless their status
was formalized. Thus, the states, one by one, passed legislation
that provided for the founding of not-for-profit hospital service
corporations that were exempt both from taxes and from the
capital requirements (reserves) mandated for other insurers.
However, state insurance departments had (and continue to
have) oversight over most aspects of the plans’ operations. The
Blue Cross name was officially adopted by most of these plans
in 1939.
Blue Shield plans developed in a manner similar to that of the
Blue Cross plans, except that the providers were physicians
instead of hospitals and the professional organization involved
was the American Medical Association instead of the AHA.
Today, 38 Blue Cross/Blue Shield (the Blues) organizations

exist, some of which offer only one of the two plans (most offer
both). The Blues are organized as independent corporations, but
all belong to a single national association that sets the standards
required for using the Blue Cross/Blue Shield name.
Collectively, the Blues provide healthcare coverage for about
100 million people in all 50 states, the District of Columbia,
and Puerto Rico.
Historically, the Blues have been not-for-profit corporations
that enjoyed the full benefits accorded to that status, including
freedom from taxes. But in 1986, Congress eliminated the
Blues’ tax exemption on the grounds that they engaged in
commercial-type insurance activities. However, the plans were
given special deductions, which resulted in taxes that are
generally less than those paid by commercial insurers.
In spite of the 1986 change in tax status, the national
association continued to require all Blues organizations to
operate entirely as not-for-profit corporations, although they
were allowed to establish for-profit subsidiaries. In 1994, the
national association lifted its traditional ban on member plans
becoming investor-owned companies, and several Blues have
since converted to for-profit status.
Commercial Insurers
Commercial health insurance traditionally was issued by life
insurance and casualty insurance (home and auto) companies.
Today, however, most health insurance is provided by
companies that exclusively write health insurance. Examples of
commercial insurers include Aetna, Humana, and UnitedHealth
Group. Most commercial insurance companies are stockholder
owned, and all are taxable entities.
Commercial insurers moved strongly into health insurance
following World War II. At that time, the United Auto Workers
negotiated the first contract with employers in which fringe
benefits were a major part of the contract. Like the Blues, the
majority of individuals with commercial health insurance are

covered under group policies with employee groups,
professional and other associations, and labor unions.
Self-Insurers
An argument can be made that all individuals who do not have
some form of health insurance are self-insurers, but this
statement is not accurate. Self-insurers make a conscious
decision to bear the risks associated with healthcare costs and
then set aside (or have available) funds to pay for costs they
may incur in the future. Individuals, except the very wealthy,
are not good candidates for self-insurance because, as discussed
earlier, individuals who do not pool risks face much uncertainty
in future healthcare costs.
On the other hand, large organizations, especially employers,
are good candidates for self-insurance. In fact, most large
companies, and many midsized companies, are self- insured.
The advantages of self-insurance include the potential to reduce
costs (cut out the middleman) and the opportunity to offer plans
tailored to meet the unique characteristics of the organization’s
employees. Organizations that self-insure typically pay an
insurance company to administer the plan. For example,
employees of the State of Florida are covered by health
insurance, the costs of which are paid directly by the state, but
the plan is administered by Blue Cross/Blue Shield of Florida.
public insurers
Government is both a major insurer and a direct provider of
healthcare services. For example, the government provides
healthcare services directly to qualifying individuals through
Department of Veterans Affairs, Department of Defense, and
Public Health Service medical facilities. In addition, it either
provides or mandates a variety of insurance programs, such as
workers’ compensation and TRICARE (health insurance for
military members, their families, and uniformed services
retirees). In this section, however, we focus on the two major
government insurance programs—Medicare and Medicaid—that

fund roughly one-third of all healthcare services provided in the
United States.
Medicare
Medicare was established by Congress in 1965 primarily to
provide medical benefits to individuals aged 65 or older. About
50 million people have Medicare coverage, which pays for
about 20 percent of all US healthcare expenditures.
Over the decades, Medicare has evolved to include four major
types of coverage:
1. Part A provides hospital and some skilled nursing home
coverage.
2. Part B covers physician services, ambulatory surgical
services, outpatient services, and other miscellaneous services.
3. Part C is managed care coverage offered by private insurance
companies. It can be selected in lieu of Parts A and B.
4. Part D covers prescription drugs.
In addition, Medicare covers healthcare costs associated with
selected disabilities and illnesses (such as kidney failure)
regardless of age.
Part A coverage is free to all individuals eligible for Social
Security benefits. Individuals who are not eligible for Social
Security benefits can obtain Part A medical benefits by paying
monthly premiums. Part B is optional to all individuals who
have Part A coverage, and it requires a monthly premium from
enrollees that varies with income level. About 97 percent of
Part A participants purchase Part B coverage, while about 20
percent of Medicare enrollees elect to participate in Part C, also
called Medicare Advantage plans, rather than Parts A and B.
Part D offers prescription drug coverage through plans offered
by private companies. Each Part D plan offers somewhat
different coverage, so the cost of Part D coverage varies widely.
Because Parts A and B do not cover all costs of care and the

remaining out-of- pocket costs can be significant, many
Medicare participants purchase additional coverage from private
insurers to help cover the “gaps” in Medicare coverage. Such
coverage is called Medigap insurance.
The Medicare program falls under the purview of the federal
Department of Health and Human Services (HHS), which
creates the specific rules of the program on the basis of
enabling legislation. Medicare is administered by an agency in
HHS called the Centers
for Medicare & Medicaid Services (CMS). CMS’s eight regional
offices oversee the Medicare (and Medicaid) program and
ensure that regulations are followed. Medicare payments to
providers are not made directly by CMS but by contractors for
15 Medicare Administrative Contractor jurisdictions.
Medicaid
Medicaid began in 1965 as a modest program jointly funded and
operated by the individual states and the federal government.
The idea was to provide a medical safety net for low-income
mothers and children and for elderly, blind, and disabled
individuals.
Congress mandated that state programs, at a minimum, cover
hospital and physician care but encouraged states to provide
additional benefits either by increasing the range of benefits or
extending the program to cover more people. States with large
tax bases were quick to expand coverage to many groups, while
states with limited revenues were forced to establish more
restrictive programs. In addition to state expansions, a
mandatory nursing home benefit was added in 1972. As a
consequence, Medicaid is now the largest payer of long-term
care benefits and the largest single budget item for many states.
In total, Medicaid covers roughly 70 million individuals and
pays for about 15 percent of all healthcare expenditures in the
United States.
Over the years, Medicare and Medicaid have provided access to

healthcare services for many low-income individuals who
otherwise would have no health insurance coverage.
Furthermore, these programs have become an important source
of revenue for healthcare providers, especially for nursing
homes and other providers that treat large numbers of low-
income patients. However, Medicare and Medicaid expenditures
have been growing at an alarming rate, forcing federal and state
policymakers to search for more cost-effective ways to provide
healthcare services.
Critical Concept
Medicaid is a joint federal–state health insurance program that
primarily covers low-income individuals and families. The
federal government funds about half of the costs of the program,
while the states fund the remainder. Although general guide-
lines are established by CMS, the program is administered by
the individual states. Thus, each state, as long as it follows
basic federal guidelines, can set its own rules regarding
eligibility, benefits, and provider payment
3.4 managed care Organizations
Managed care organizations (MCOs) strive to combine the
provision of healthcare services and the insurance function into
a single entity. Typi- cally, MCOs are created by insurers that
either directly own a provider network or create one through
contractual arrangements with independent providers.
Occasionally, however, MCOs are created by integrated
delivery systems that establish their own insurance companies.
Historically, the most common type of MCO was the health
maintenance organization (HMO). HMOs were developed to
thwart the per- verse incentives created by traditional insurer–
provider relationships whereby providers were rewarded for
treating patients’ illnesses but given little incentive to provide
prevention and rehabilitation services. By combining the
financing and delivery of healthcare services into a single

system, HMOs theoretically have as strong an incentive to
prevent as to treat illnesses. However, because their
organizational structures, ownership, and financial incentives
differ from plan to plan, HMOs can vary widely in cost and
quality.
HMOs use a variety of methods to control costs. These include
limiting patients to particular providers, called the provider
panel, and using primary care physicians as gatekeepers who
authorize all specialized and referral services. In general,
services are not covered if beneficiaries bypass their gatekeeper
physician or use providers that are not part of the HMO panel.
The federal Health Maintenance Act of 1973 encouraged the
development of HMOs by providing federal funds for HMO
operating grants and loans. In addition, the act required larger
employers that offer healthcare benefits to their employees to
include an HMO as one alternative, if one was available in the
area, in addition to traditional insurance plans.
Although the number and sizes of HMOs grew rapidly during
the 1980s and 1990s, since that time they have lost some of
their luster because healthcare consumers have been unwilling
to accept access limitations, even though such limitations might
reduce costs. To address consumer concerns and falling
enrollments, another type of MCO—the preferred provider
organization (PPO)—was developed. These organizations do not
wield as much control as HMOs but combine some of the cost-
savings strategies of HMOs with features of traditional health
insurance plans.
PPOs do not mandate that beneficiaries use specific providers.
They do, however, offer financial incentives to encourage
members to use providers that participate in the plan. That panel
of providers typically negotiates discounted price contracts with
the PPO. Furthermore, PPOs do not require plan members to use
preselected gatekeeper physicians. Finally, PPOs are less likely
than HMOs to provide preventive services, and they do not
assume any responsibility for quality assurance because
enrollees are not constrained to use only the PPO panel of

providers.
In an effort to achieve the potential cost savings of MCOs,
health insurers are now applying managed care strategies, such
as preadmission certification, utilization review, and second
surgical opinions, to their conventional plans. Thus, the term
“managed care” now describes a continuum of plans, which can
vary significantly in their approaches to providing combined
insurance and healthcare services. The common feature in
MCOs is that the insurer has a mechanism to control, or at least
influence, patients’ utilization of healthcare services. Today,
most employer-sponsored health coverage is provided by some
type of MCO.
Provider panel
The group of providers—say, doctors and hospitals—designated
as preferred by a managed care plan. Services delivered by
providers outside of the panel may be only partially covered, or
not covered at all, by the plan.
Gatekeeper
A primary care physician who controls specialist and ancillary
service referrals. Some managed care plans only pay for referral
services approved by the gatekeeper.
3.5 alternative
reimbursement methods
Regardless of payer, only a limited number of payment methods
are used to reimburse providers for healthcare services.
Payment methods fall into two broad classifications: fee-for-
service and capitation. In this section, we discuss the most
frequently used reimbursement methods.
Fee-for-Service
In fee-for-service payment methods, of which many variations
exist, the more services provided, the higher the
reimbursement. The three primary fee-for-service methods of

reimbursement are cost based, charge based, and prospective
payment.
Cost-Based Reimbursement
Under cost-based reimbursement, the payer agrees to reimburse
the provider for the costs incurred in providing services to the
insured population. Cost-based reimbursement is retrospective
in the sense that reimbursement is based on what has happened
in the past. This type of reimbursement is limited to allowable
costs, usually defined as costs directly related to the provision
of healthcare services. For all practical purposes, cost-based
reimbursement guarantees that a provider’s costs will be
covered by revenues generated from the delivery of those
services.
Charge-Based Reimbursement
Under a charge-based reimbursement system, when payers pay
billed charges, they pay ac- cording to a rate schedule, called a
chargemaster, established by the provider. To a certain extent,
this reimbursement system places payers at the mercy of
providers, especially in markets where competition is limited.
In the very early days of health insurance, all payers reimbursed
providers on the basis of charges. Now, the trend is shifting
toward other, less generous reimbursement methods, and the
only payers expected to pay the full amount of charges are self-
pay (private-pay) patients. Even among those consumers, low-
income uninsured patients often are given discounts from
charges or not required to pay at all.
Most insurers that still base reimbursement on charges now pay
negotiated, or discounted, charges. Insurers that offer managed
care plans, as well as conventional insurers, often hold
bargaining power because they have the capacity to bring a
large number of patients to a provider, which allows them to
negotiate discounts that generally range from 20 percent to 50
percent (or more) of charges. The effect of these discounts is to
create a system similar to hotel or airline pricing, whereby few

people pay the listed rates (rack rates or full fares,
respectively). Many people argue that chargemaster prices have
become meaningless, and hence the entire concept should be
abandoned. But old habits die hard, and chargemaster prices
still play a role in some reimbursement methods, so we expect
they will be in use for some time.
Prospective Payment Reimbursement
In a prospective payment system, the rates paid by payers are
determined by the payer before the services are provided.
Furthermore, payments are not directly related to either costs or
charges. Here are the common units of payment used in
prospective payment systems:
◆ Per procedure. Under per procedure reimbursement, a
separate payment is made for each procedure performed on a
patient. Because of the high administrative costs associated
with this method when applied to complex diagnoses, per
procedure reimbursement is primarily used in outpatient
settings.
◆ Per diagnosis. In the per diagnosis reimbursement method,
the provider is paid a rate that depends on the patient’s
diagnosis. Diagnoses that require higher resource utilization,
and hence are more costly to treat, have higher reimbursement
rates. Medicare pioneered this basis of payment in its diagno-
sis-related group (DRG) system, which it first used for hospital
inpatient reimbursement in 1983. (See the Industry Practice
box on page 72 for examples of per procedure and per diagnosis
reimbursement.)
◆ Per diem (per day). Some insurers reimburse institutional
providers, such as hospitals and nursing homes, on a per diem
(per day) basis. In this approach, the provider is paid a fixed
amount for each day that service is provided. Often, per diem
rates are stratified, which means that different rates are applied
to different services. For example, a hospital may be paid one
rate for a medical/surgical day, a higher rate for a critical care

unit day, and yet a different rate for an obstetric day. Stratified
per diems recognize that providers incur widely varied daily
costs for providing different types of inpatient
care.
◆ Bundled (global) reimbursement. Under bundled
reimbursement, payers reimburse providers a single prospective
payment that covers all services delivered in a single episode,
whether the services are rendered by a single provider or by
multiple providers. For example, a bundled price may be set
for all obstetric services associated with a pregnancy provided
by a single physician, including all prenatal and postnatal visits
and the delivery. For another example, a bundled price may be
paid for all physician and hospital services associated with a
cardiac bypass operation. Note that at the extreme, a bundled
price could be set for all services provided to a single patient,
which, in effect, is capitation reimbursement, as described in
the next section.
capitation
Capitation is an entirely different approach to reimbursement
from fee-for-service. Under capitated reimbursement, the
provider is paid a fixed amount per covered life per period
(usually a month), regardless of the amount of services
provided. For example, a primary
care physician might be paid $15 per member per month to
serve 100 members of a managed care plan. Capitation
payment, which is used mostly by managed care organizations
to reimburse primary care physicians, dramatically changes the
financial environment of healthcare providers. Its implications
are addressed in section 3.6 and as needed throughout the
remainder of this book. (For additional information about
capitation, see Chapter 17, which is available online at
ache.org/books/FinanceFundamentals2.)

benchmarks. These reimbursement systems, which are really
modified fee-for-service or capitation systems, are called pay-
for-performance (P4P) systems.
In most P4P reimbursement schemes, insurers pay providers an
“extra” amount if
certain standards, usually related to quality of care, are met. For
example, a primary care
practice may receive additional reimbursement if it meets
specified goals, such as administering mammograms to 85
percent of female patients older than 50 or placing 90 percent of
diabetic patients on appropriate medication and administering
quarterly blood tests. A hospital may receive additional
reimbursement if it falls in the lower 10 percent of hospitals
experiencing medical errors and hospital-acquired infections.
The idea behind P4P is to create financial incentives for
providing high-quality care, which may incur higher costs for
insurers in the short run but will lead to lower overall medical
costs in the long run. In some P4P plans, insurers reduce
payments to poor performers and use the savings to increase
payments to high performers, forcing some providers to bear the
cost of the plan.
3.6 The impact of reimbursement on Financial incentives and
risks
Different methods of reimbursement create different incentives
and risks for providers. In this section, we briefly discuss these
issues.
provider incentives
Providers, like individuals or other businesses, react to the
incentives created by the financial environment. For example,
individuals can deduct mortgage interest from income for tax

purposes, but they cannot deduct interest payments on personal
loans. Loan companies responded to this tax code regulation by
offering home equity loans to homeowners that function as a
type of second mortgage for tax purposes. The intent is not for
such loans to be used to finance home ownership, as the tax
laws assumed, but for other expenditures, including paying for
vacations and purchasing cars or appliances. In this instance,
tax laws created incentives for consumers to carry mortgage
debt rather than personal debt, and the mortgage loan industry
responded accordingly to accommodate the consumers.
In the same vein, alternative reimbursement methods have an
impact on provider behavior. Under cost-based reimbursement,
providers are essentially issued a “blank check” to acquire
facilities and equipment and incur operating costs. If payers
reimburse providers
for all service-related costs, the incentive is to incur such costs.
Facilities will be lavish and conveniently located, and staff will
be available to ensure that patients are given red-carpet
treatment. Furthermore, services that are not required will be
provided because more services lead to higher costs, which
lead to higher revenues.
Under charge-based reimbursement, providers have the
incentive to set high prices and offer more services. However,
in competitive markets, prices will be constrained. Still, to the
extent that insurers, rather than patients, are footing the bill,
considerable leeway exists. Also, because reimbursement paid
on the basis of charges is a fee-for-service type of
reimbursement, a strong incentive exists to provide the highest
possible amount of services. In essence, providers can increase
utilization, and hence revenues, by creating more visits,
ordering more tests, extending inpatient stays, and so on.
Although charge-based reimbursement does encourage providers
to contain costs, the incentive is weak because charges can more
easily be increased than costs can be decreased. In recent years,
the ability of providers to increase revenues by raising charges
has been greatly offset by insurers through negotiated discounts

or constrained reimbursement increases, which place additional
pressure on profitability and hence sweeten the incentive for
providers to reduce costs.
Under prospective payment reimbursement, provider incentives
are altered. First, under per procedure reimbursement, the
profitability of individual procedures varies depending on the
relationship between the actual costs incurred and the payment
for that procedure. In other words, because of inconsistencies in
reimbursement, some procedures are more profitable than
others. Providers, typically physicians, have the incentive to
perform procedures that have the highest profit potential.
Furthermore, the more procedures performed, the better,
because each procedure typically generates additional profit.
The incentives under per diagnosis reimbursement are similar.
Providers, usually hospitals, seek patients with diagnoses that
have the greatest profit potential and discourage (or even
discontinue) services that have the least potential. (Why, in
recent years, have so many hospitals created cardiac care
centers?)
In all prospective payment methods, providers have the
incentive to reduce costs because the amount of reimbursement
is fixed and independent of the costs actually incurred. For
example, when hospitals are paid under per diagnosis
reimbursement, they have the incentive to reduce length of stay,
which reduces overall costs. However, when per diem
reimbursement is used, hospitals have an incentive to increase
length of stay. Because the early days of a hospitalization
typically are more costly than the later days, the later days are
more profitable. However, as mentioned previously, hospitals
have the incentive to reduce costs during each day of a patient
stay regardless of the prospective payment method.
Under bundled reimbursement, providers do not have the
opportunity to be reimbursed for a series of separate services.
For example, a physician’s treatment of a fracture could be
bundled and billed as one episode, or it could be unbundled,
with separate bills submitted for making the diagnosis, taking

the X-rays, setting the fracture, removing the
cast, and so on. The rationale for unbundling is usually to
provide more detailed records of treatments rendered, but often
the result is higher total charges for the parts than would be
charged for the entire package under bundled payment.
Also, bundled reimbursement, when applied to multiple
providers for a single episode of care, forces those providers
(usually physicians and hospitals) to jointly offer the most cost-
effective treatment. A joint view of cost containment may be
more effective than each provider separately attempting to
minimize its treatment costs because the actions of one provider
to lower costs could increase the costs of the other provider.
Finally, capitation reimbursement totally changes the playing
field by reversing the actions that providers must take to ensure
financial success. Under all fee-for-service methods, the key to
provider success is to work harder, increase the amount of
services provided (utilization), and hence maximize profits.
Under capitation, the key to profitability is to work smarter and
decrease utilization.
As with prospective payment, capitated providers have the
incentive to lower the cost of the services provided, but now
they also have the incentive to reduce the amount of services
provided. Thus, only those procedures that are truly medically
necessary should be performed, and treatment should take place
in the lowest cost setting that can provide the appropriate
quality of care. Furthermore, providers have the incentive to
promote health, rather than just treat illness and injury, because
a healthier population consumes fewer healthcare services.
provider risks
One key issue providers contend with is the impact of various
reimbursement methods on financial risk. Think of financial
risk in terms of the effect that the reimbursement methods have
on profit uncertainty—the greater the uncertainty in
profitability (and hence the greater the chance of losing money),
the higher the risk.

Cost- and charge-based reimbursements are the least risky
methods for providers because payers more or less ensure that
provider costs are covered, and hence profits will be earned. In
cost-based systems, costs are automatically covered. In charge-
based systems, providers typically can set charges high enough
to ensure that costs are covered, although discounts introduce
some uncertainty into the reimbursement process.
In all reimbursement methods, except cost-based payment,
providers bear the cost- of-service risk in the sense that costs
can exceed revenues. However, a primary difference among the
reimbursement types is the ability of the provider to influence
the revenue–cost relationship. If providers set charge rates for
each type of service provided, they can most easily ensure that
revenues exceed costs. Furthermore, if providers have the power
to set rates above those that would exist in a truly competitive
market, charge-based reimbursement could result in higher
profits than cost-based reimbursement can realize.
Prospective payment creates additional risk for providers. In
essence, payers are setting reimbursement rates on the basis of
what they believe to be sufficient. If
the payments are set too low, providers cannot make money on
their services without sacrificing quality. Today, many hospitals
and physicians believe that Medicare and Medicaid
reimbursement rates are too low to compensate them adequately
for providing healthcare services to those populations. Thus, the
only way for these providers to survive is to recoup these losses
from privately insured patients or stop treating government-
insured patients, which for many providers would take away
more than half of their revenues. Whether or not government
reimbursement is too low is open to debate. Still, prospective
payment can place significant financial risk on providers’
operations.
Under capitation, providers assume utilization risk along with
the risks assumed under the other reimbursement methods. The
assumption of utilization risk has traditionally been an
insurance, rather than a provider, function. In the traditional

fee-for-service system, the financial risk of providing
healthcare services is shared between providers and insurers: If
costs are too high, providers suffer; if too many services are
consumed, insurers suffer. Capitation, however, places both cost
and utilization risk on providers.
When provider risk under different reimbursement methods is
discussed in this descriptive fashion, an easy conclusion to
make is that capitation is by far the riskiest reimbursement
method to providers, while cost- and charge-based
reimbursement are by far the least risky. Although this
conclusion is not a bad starting point for analysis, financial risk
is a complex subject, and we have just scratched its surface. For
now, keep in mind that payers use different reimbursement
methods. Thus, providers can face conflicting incentives and
differing risk, depending on the predominant method of
reimbursement.
In closing, note that all prospective payment methods create
financial risk for providers. This assumption of risk does not
mean that providers should avoid such reimbursement methods;
indeed, refusing to accept contracts with prospective payment
provisions would be organizational suicide for most providers.
However, providers must understand the risks involved in
prospective payment arrangements, especially the impact on
profitability, and make every effort to negotiate a level of
payment that is consistent with the risk incurred.
3.7 medical coding: The foundation of Fee-For- Service
reimbursement
Medical coding, or medical classification, is the process of
transforming descriptions of medical diagnoses and procedures
into numerical codes that can be universally recognized and
interpreted. The diagnoses and procedures are usually taken
from a variety of sources within the medical record, such as
doctors’ notes, laboratory results, and radiological tests. In
practice, the basis for most fee-for-service reimbursement is the

patient’s diagnosis (in the case of hospitals) or the procedures
performed on the patient (in the case of outpatient settings).
Thus, a brief background on medical coding will enhance your
understanding of the reimbursement process.
Diagnosis codes
The International Classification of Diseases (commonly known
by the abbreviation ICD) is the standard resource for
designating diseases and a wide variety of signs, symptoms, and
external causes of injury. Published by the World Health
Organization (WHO), ICD codes are used inter- nationally to
record many types of health events, including hospital inpatient
stays and deaths. (ICD codes were first used in 1893 to report
death statistics.)
WHO periodically revises the diagnostic codes in ICD, which is
now in the tenth revision (ICD-10). However, US hospitals still
use a clinical modification of the ninth revision (ICD- 9-CM).
Conversion to ICD-10 codes in the United States was slated to
occur in 2013; however, in April 2012 HHS proposed a one-
year delay of the ICD-10 compliance date, to October
1, 2014. (The conversion is expected to be time consuming and
costly because ICD-10 contains more than five times as many
individual codes as does ICD-9. Of course, the information
provided by the new code set will be more detailed and
complete.)
The ICD-9 codes consist of three, four, or five digits. The first
three digits denote the disease category, and the fourth and fifth
digits provide additional information. For example, code 410
describes an acute myocardial infarction (heart attack), while
code 410.1 is an attack involving the anterior wall of the heart.
In practice, the application of ICD codes to diagnoses is
complicated and technical. Hospital coders must thoroughly
understand the coding system as well as the medical
terminology and abbreviations used by clinicians. The medical
coding function is highly complex, and proper reimbursement
from third-party payers depends on accurate coding; therefore,

ICD coders require a great deal of training and experience.
procedure codes
While ICD codes are used to specify diseases, Current
Procedural Terminology (CPT) codes are used to specify
medical procedures (treatments). CPT codes were developed and
are copyrighted by the American Medical Association.
The purpose of CPT is to create a uniform set of descriptive
terms and codes that are used by clinicians
accurately describe medical, surgical, and diagnostic
procedures. CPT codes are revised periodically to reflect
current trends in clinical treatments. To increase standardization
and the use of electronic medical records, federal law requires
that physicians and other clinical providers, including
laboratory and diagnostic services, use CPT to code and transfer
healthcare information. (The same law also requires that ICD-9-
CM [soon, ICD-10-CM/ PCS] codes be used to document
hospital inpatient services.)
The CPT code set includes ten codes for physician office visits:
Five codes apply to new patients and five apply to established
patients on repeat visits. The differences among the five codes
in each category are based on the complexity of the visit, as
indicated by three components: extent of patient history review,
extent of examination,
and difficulty of medical decision making. For repeat patients,
the least complex (typically shortest) office visit is coded
99211, while the most complex (typically longest) is coded
99215.
Because government payers (Medicare and Medicaid) and other
insurers require additional information from providers beyond
that contained in CPT codes, the Centers for Medicare &
Medicaid Services (CMS) developed an enhanced code set,
called the Healthcare Common Procedure Coding System
(HCPCS) (commonly pronounced “hick picks”). This system
expands the set of CPT codes to include no physician services,
such as ambulance services, and durable medical equipment,

such as prosthetic devices.
Although CPT and HCPCS codes are not as complex as the ICD
codes, coders still must have a high level of training and
experience to use them correctly. As in ICD coding, correct
CPT coding ensures correct reimbursement. Medical coding is
so important that many businesses offer services, such as books,
software, education, and consulting, to hospitals and medical
practices to improve coding efficiency.
3.8 HEALTHCARE REFORM
Healthcare reform is a generic term used to describe the actions
taken by Congress in 2009 and 2010 to “reform” the healthcare
system. The messy legislative process was completed in early
2010, when President Barack Obama signed the Patient
Protection and Affordable Care Act (ACA).
Healthcare reform includes a large number of provisions that
are expected to take effect over the next several years with the
primary goal of helping an additional 32 million Americans
obtain health insurance. The provisions include expanding
Medicaid eligibility, subsidizing insurance premiums, providing
incentives for businesses to provide healthcare benefits,
prohibiting denial of coverage on the basis of preexisting
conditions, establishing health insurance exchanges, and
providing financial support for medical research. For the most
part, reform focuses on the insurance side of the healthcare
sector as opposed to the provider side. Thus, many people
believe that the legislation should be called “insurance reform”
rather than “healthcare reform.”
In addition to those affecting the insurance segment of
healthcare, some provisions are designed to offset the costs of
reform by instituting a variety of taxes, fees, and cost-saving
measures. Examples include new Medicare taxes for high-
income earners, taxes on indoor tanning services, cuts to the
Medicare Advantage (Part C) program, fees on medical devices
and pharmaceutical companies, and tax penalties on citizens

who do not obtain health insurance.
Finally, other provisions fund pilot programs to test various
changes to provider systems and reimbursement methodologies
(primarily Medicare) designed to increase quality and decrease
costs. Provisions likely to have the greatest impact on providers
and how they are reimbursed include the establishment of pilot
programs to explore the feasibility of accountable care
organizations (ACOs) (discussed below), the effectiveness of
payment bundling, and the potential quality gains from the
medical home model (also discussed later).
The reform law contains some provisions that went into effect
immediately, but most provisions are to be phased in over time
until 2018. Detailed guidance will be provided by the
government departments responsible for implementing the
legislation, so we will not know many of the details until the
implementing regulations are promulgated (and, as you know,
the devil is in the details).
Finally, legislative changes may occur before some provisions
of the law are imple- mented that could significantly alter some
of the program’s features. All of these conditions create
uncertainty for insurers and providers, but the good news is that
the finance principles and concepts contained in this book
remain valid regardless of the ultimate outcome of healthcare
reform.
accountable care Organizations
Accountable care organizations, one of the cornerstone concepts
of healthcare reform,
integrate local physicians with other members of the healthcare
community and reward
them for controlling costs and improving quality. While ACOs
are not radically different from other attempts to improve the
delivery of healthcare services, their uniqueness lies in the

flexibility of their structures and payment methodologies and
their ability to assume risk. Similar to some MCOs and
integrated healthcare systems such as the Mayo Clinic, ACOs
are responsible for the health outcomes of the population served
and are tasked with collaboratively improving care to reach cost
and clinical quality targets set by Medicare.
To help achieve cost control and quality goals, ACOs can
distribute bonuses when targets are met and impose penalties
when targets are missed. To be effective, an ACO should
include, at a minimum, primary care physicians, specialists, and
a hospital, although some ACOs are being established solely
by physician groups. In addition, it should have the managerial
systems in place to administer payments, set benchmarks,
measure performance, and distribute shared savings. A variety
of federal, regional, state, and academic hospital initiatives are
investigating how to implement ACOs. Although the concept
shows potential, many legal and managerial hurdles must be
overcome for ACOs to live up to their initial promise.
One feature of healthcare reform is a shared savings program in
which Medicare pays a fixed (global) payment to ACOs that
covers the full cost of care of an entire
population. In this program, cost targets are established and
then any cost savings (costs that are below target) are shared
between Medicare and the ACO.
medical home model
A medical home (patient-centered medical home) is a team-
based model of care led by a personal physician who works
collaboratively with the team’s other healthcare professionals to
provide continuous, coordinated, and integrated care throughout
a patient’s lifetime to maximize health outcomes. This
responsibility includes the provision of preventive services,
treatment of acute and chronic illnesses, and assistance with
end-of-life issues.
The medical home model is independent of the ACO concept,
but observers anticipate that ACOs will provide an

organizational setting that facilitates implementation of the
model. Supporters of the model claim that it will allow better
access to healthcare, increase patient satisfaction, and improve
health. Although the development and implementation of the
medical home model are in their infancy, the model’s key
characteristics are shaping up as follows:
◆ Personal physician. Each patient will have an ongoing
relationship with a personal physician trained to provide first
contact and continuous and comprehensive care.
◆ Whole-person orientation. The personal physician is
responsible for providing for all of a patient’s healthcare needs
or for appropriately arranging care with other qualified
professionals. In effect, the personal physician will lead a team
of clinicians who collectively take responsibility for patient
care.
◆ Coordination and integration. The personal physician will
coordinate care across specialists, hospitals, home health
agencies, nursing homes, and hospices.
◆ Quality and safety. Quality and patient safety are ensured
by a care planning process, evidence-based medicine, clinical
decision-support tools, performance measurement, active
participation of patients in decision making, use of information
technology, and quality improvement activities.
◆ Enhanced access. Medical care and information are
available at all times through open scheduling, expanded hours
of service, and new and innovative communication
technologies.
◆ Payment methodologies. It is essential that payment
methodologies recognize the added value provided to patients.
Payments should reflect the value of work that falls outside of
face-to-face visits, should support adoption and use of health
information technology for quality improvement, and should
recognize differences in the patient populations treated within
the practice.

Several ongoing pilot projects are assessing the effectiveness of
the medical home and ACO models, and a great deal of
information is available online by searching “accountable care
organizations” online.
CHAPTER 6
Planning and Budgeting
The planning process
Budget decisions
Budget types
Operating budget example
Flexible budgeting and variance analysis
6 - ‹#›
The Planning Process
The strategic plan is the foundation of the planning process. It
contains
a mission statement,
a values statement,
a vision statement,
goals, and
objectives.
The operating, or five-year, plan is the portion of the planning
process that outlines how the organization expects to meet its
objectives.
The planning process takes place more or less continuously
throughout the year.

6 - ‹#›
Operating (Five-Year) Plan Format
Chapter 1: Mission, values, vision, and goals
Chapter 2: Corporate objectives
Chapter 7: Functional area plans
A. Marketing
B. Operations
C. Finance
D. Administration and human resources
E. Facilities
Note that the plan is most detailed for the first year.
6 - ‹#›
Financial Plan Format
C. Finance
1. Current financial condition analysis
2. Capital investments and financing
a. Capital budget
b. Financing plan
3. Financial operations
a. Overall policy

b. Cash budget
c. Cash and marketable securities management
d. Inventory management
e. Revenue cycle management
f. Short-term financing
6 - ‹#›
Financial Plan Format (cont.)
4. Budgeting and control (first year only)
a. Revenue budget
b. Expense budget
c. Operating budget
d. Control procedures
5. Future financial condition analysis
What are the keys to an effective planning process?
6 - ‹#›
Budgeting Basics
Budgets are detailed plans, expressed in dollar terms, that
specify how resources will be used over some period.
Budgets may be developed and applied to any level of an
organization:
Aggregate
By department
By service line
By contract
By the nature of the expenditure
6 - ‹#›

Budgeting Basics (cont.)
To be effective, budgets must not be thought of as financial
staff tools, but rather as managerial tools.
Budgets are used for
planning,
communication, and
control.
Three decisions must be made regarding a business’s budgeting
process. (See the next three slides.)
6 - ‹#›
Conventional vs. Zero-Based Budgets
Traditionally, health providers have used the conventional
approach to budgeting.
The old budget is the starting point.
Typically, only minor changes are made.
Changes often are applied equally.
In zero-based budgeting, each new budget is started from
scratch.
What are the advantages and disadvantages of each approach?
6 - ‹#›
Budget Timing
All organizations use annual budgets to set standards for the
coming year.
Most also use quarterly (or more frequent) budgets to ensure
timely feedback and control.
Not all budget types have to follow the same timing pattern.

Out-year budgets are more for planning than for control
purposes.
6 - ‹#›
Top-Down vs. Bottom-Up Budgets
Bottom-up budgets
begin at subunit (departmental) level,
are reviewed and compiled by the finance department, and
are approved by senior management.
Top-down budgets
begin at the finance department with senior management
guidance, and
are sent to the departments for review.
What are the advantages and disadvantages of each?
6 - ‹#›
Revenue Budget
Most businesses have
a revenue budget,
an expense budget, and
an operating budget.
The revenue budget uses volume and payment data to forecast
revenues.
The end result is a revenue forecast
in the aggregate,
by department,
by service, and
by diagnosis (or other clinical basis).

6 - ‹#›
Expense Budget
The expense budget combines volume data with detailed
resource utilization data to forecast expenses.
To be most useful, expenses must be broken down into fixed
and variable components.
Like revenues, expenses must be forecasted at multiple levels.
6 - ‹#›
Operating Budget
For larger organizations, the operating budget, which focuses on
projected profitability, combines information from the revenue
and expense budgets.
Smaller organizations may use a single operating budget in
place of multiple budget types.
6 - ‹#›
Operating Budget Illustration
Consider the 2008 operating budget of Carroll Clinic, shown on
the following four slides. This budget was created at the end of
2007.
The budget is divided into four parts:
Volume assumptions
Revenue assumptions
Cost assumptions
Pro forma P&L statement

6 - ‹#›
2008 Operating Budget (Parts I and II)
I. Volume (Number of Visits)
A. Payer A 9,000
B. Payer B 12,000
C. Total 21,000
II. Reimbursement (Average Payment Per Visit)
A. Payer A $100
B. Payer B $ 90
6 - ‹#›
2008 Operating Budget (Part III)
III. Costs
A. Variable Costs:
Supplies $ 315,000
B. Fixed Costs:
Labor $1,035,000
Overhead 500,000
Total $1,535,000
6 - ‹#›

2008 Operating Budget (Part IV)
IV. Pro Forma P&L Statement
Revenues:
Payer A $ 900,000
Payer B 1,080,000
Total revenues $1,980,000
Variable costs $ 315,000
Fixed costs 1,535,000
Total costs $1,850,000
Projected profit $ 130,000
6 - ‹#›
Variance Analysis
Variance is the difference between the actual results and the
budgeted (standard) value.
Variance analysis is a technique applied to budget data to
identify problem areas, and
enhance control.
Why is variance analysis so useful to health services managers?
6 - ‹#›
Simple Variance Analysis Example
To illustrate variance analysis, we will use Carroll Clinic’s
forecasted 2008 budget presented in slides 15-17 as the simple
(original) budget.
Assume it is now January 2009, and the operating results for

2008 have been compiled. These actual (realized) results are
shown on the next slide along with a simple variance analysis.
6 - ‹#›
2008 Results (Parts I, II, and III)
6 - ‹#›
2008 Results (Part IV)
6 - ‹#›
Simple Variance Analysis Interpretation
Profitability was $22,500 (17.3 percent) below standard.
Revenues were $47,500 (2.4 percent) greater than expected.
However, costs were $70,000 (3.8 percent) greater than
expected.
Higher revenues were attributed to Payer A, which had higher
than expected volume and reimbursement.
Costs were higher across the board.
6 - ‹#›
Flexible Variance Analysis
The variance analysis just performed is a simple analysis in that

it compares actual results with initial (beginning of year)
assumptions.
We can glean additional information by constructing a flexible
budget, which is based on the initial budget but is adjusted
(flexed) to reflect actual (realized) volume.
Now, the variances will reflect financial performance
differences other than those that stem from volume forecast
errors.
6 - ‹#›
2008 Results (Parts I, II, and III)
6 - ‹#›
2008 Results (Part IV)
6 - ‹#›
Flexible Variance Analysis Interpretation
Profitability was $70,000 (39.4 percent) below standard.
Revenues were $7,500 (0.4 percent) less than expected.
However, costs were $62,500 (3.4 percent) greater than
expected.
When volume is considered, both revenues and costs were less
than expected.
Management needs to work on
increasing reimbursement rates (especially with Payer B), and

controlling costs.
6 - ‹#›
Variance Analysis Example Recap
In practice, variance analysis typically is much more detailed
than that presented in this illustration.
Also, variance analysis is applied to operating data, such as
census, labor hours, number of outpatient visits, and so on,
often on a weekly (or even daily) basis.
Is all this work worth it?
6 - ‹#›
This concludes our discussion of Chapter 6 (Planning and
Budgeting).
Although not all concepts were discussed, you are responsible
for all of the material in the text.
Do you have any questions?
Conclusion
6 - ‹#›
Simple
Actual
Variance

a
Budget
Results
Dollar
(Visit)
Percentage
I. Volume (Number of Visits
)
A.
Payer A

9,000 10,000
1,000
11.1
%
B.
Payer B
12,000
1
1
,
5
00
(500
)
(4.2)
C.

Total
21,000
21
,500
500
2.4
II. Reimbursement (Per Visit)
A.
Payer A
$100 $105
$5
5.

0
%
B.
Payer B
$ 90 $ 85
($5)
(5.6)
III. Costs
A. Variable Costs:
Suppl
ies
$
315,000 $
320,000

($
5,000)
(1.6%)
B. Fixed Costs:
Labor
$1,035,000 $1,050,000
($15,000)
(1.4)
Overhead
500,000
550,000

(
50
,000
)
(10.0)
Total
$1,535,000
$1,600,000
(
$65,0
00
)
(4.2)
IV.
Forecasted
P&L Statement
Simple

Actual
Variance
a
Budget
Results
Dollar
(Visit)
Percentage
Revenues:
Payer A

$ 900,000 $1,050,000
$ 150,000
16.7%
Payer B
1,080,000
977,500
(102,500
)
(9.5)
Total
revenues
$1,980,000
$2,027,500
$
47,500

2.4
Variable costs
$ 315,000 $ 320,000
($
5,000)
(1.6)
Fixed costs
1,535,000
1,600,000
(65,000
)
(4.2)
Total
costs

$1,850,000
$1,920,000
(
$
70,000
)
(3.8)
Profit
$ 130,000
$ 107,500
(
$
22,500
)
(17.3)
Flexible
Actual

Variance
a
Budget
Results
Dollar
(Visit)
Percentage
I. Volume (Nu
mber of Visits)
A.
Payer A
10,000 10,000

B.
Payer B
11
,
5
00
11
,
5
00
C.
Total
21,5
00
21,500
II. Reimbursement (Per Visit)
A.

Payer A
$100 $105
$5
5.
0
%
B.
Payer B
$ 90 $ 85
($5)
(5.6)
III. Costs
A. Variable Costs:
Supplies
$ 322,500 $ 320,000

$ 2,500
0.8%
B. Fixed Costs:
Labor
$1,035,000 $1,050,000
($15,000)
(1.4)
Overhead
500,000
550,000
(
5
0,000
)

(10.0)
Total
$1,535,000
$1,600,000
(
$65,000
)
(4.2)
IV.
Forecasted
P&L Statement
Flexible
Actual
Variance

a
Budget
Results
Dollar
(Visit)
Percentage
Revenues:
Payer A
$1,000,000 $1,050,000
$ 50,000
5.0%

Payer B
1,0
35
,000
977,500
(57,500
)
(5.6)
Total
revenues
$2
,0
35
,000
$2,027,500
(
$ 7,500
)

(0
.4
)
Variable costs
$ 322,500 $ 320,000
$
2
,
5
00
0.8
Fixed costs
1,535,000
1,600,000
(65,000
)
(4.2)

Total
costs
$1
,85
7
,
5
00
$1,920,000
(
$
62
,
5
00
)
(3.
4
)
Profit
$ 177
,
5
00

$ 107,500
(
$
70
,
0
00
)
(
39
.
4
)
CHAPTER 5
Pricing Decisions and Profit Analysis
Pricing
Decisions
Strategies
Profit analysis
Fee for service (FFS)
Capitation
Impact of cost structure on risk
5 - ‹#›

Introduction
Some uses of managerial accounting information in health
services organizations:
Set the prices (and discounts) on services offered under charge-
based reimbursement
Determine the financial impact of services offered when prices
are dictated
Identify the lowest feasible price when prices are negotiated
In addition, cost and price information can be combined to
conduct profit analyses.
5 - ‹#›
Price Setters Versus Takers
When a provider has market dominance, and, hence, can set its
own prices (within reason), it is said to be a price setter.
In other situations, providers are price takers:
Perfectly competitive markets
Payer dominance
Government programs
However, in many situations, providers are neither pure price
takers nor price setters, and room for negotiation exists.
5 - ‹#›

Price-Setting Strategies
When a provider is a price setter (or when negotiation is
possible), there are several theoretical bases on which prices
can be set.
The two most common are
full cost pricing, and
marginal cost pricing.
5 - ‹#›
Price-Setting Strategies (cont.)
Under full cost pricing, prices for a service are set to cover all
costs:
Direct costs (fixed and variable)
Overhead (indirect) costs
Economic costs (profit)
Under marginal cost pricing, prices for a service are set to cover
incremental, or marginal, costs. Generally, this means
recovering only direct variable costs.
5 - ‹#›
Discussion Items

Can a provider survive if all services are priced at marginal
cost?
What is cross-subsidization, or price shifting?
Should marginal cost pricing ever be used?
5 - ‹#›
Target Costing
Target costing is a management strategy used by price takers.
Under target costing,
revenues are projected, assuming prices as given in the
marketplace;
required profits are subtracted from revenues; and
the remainder is the target cost level.
What is the primary benefit of target costing?
5 - ‹#›
7
Profit (CVP) Analysis
Profit analysis, also called cost-volume-profit (CVP) analysis,

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