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References Keegan, A. J. (1994). Hospitals become cost centers in managed care scenario. Healthcare

Financial Management: Journal Of The Healthcare Financial Management Association, 48(8), 36–39. Retrieved from http://library.ashford.edu/EzProxy.aspx? url=http://search.ebscohost.com.proxy-library.ashford.edu/login.aspx? direct=true&AuthType=ip,cpid&custid=s8856897&db=cmedm&AN=10146043&site=ehost- live

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HOSPITALS BECOME COST CENTERS IN MANAGED CARE SCENARIO MANAGED CARE In a risk-bearing managed care enterprise, acute-care facilities will change from being profit centers to being cost centers, and this transformation will require a focus on controlling costs rather than increasing admissions. This article details the elements of change that healthcare financial managers should consider, from the increased difficulty of matching revenue to expense, to the expanded role of clinical engineers.

The concept of profits in hospitals is rapidly going the way of tailfins on Cadillacs. A new breed of American health-care managers are setting out to transform their organizations

from gas-guzzling, unwieldy, acute-care providers into sleek, fuel-efficient, risk-bearing managed care companies. Successful transformation from hospital organizations to integrated delivery systems will erase the marketing paradigm that has governed the management of acute-care organizations since the end of World War II.

The word "hospital" will survive this transition, but the role that hospitals play in the modern community will change. They will no longer be independent entities with their own agendas. They will reemerge as parts of a greater whole. Of course there will be acute-care centers of excellence and rural hospitals that will be able to remain independent. But hospitals existing outside of a managed care organization will be the exception, not the rule.

In a risk-bearing managed care enterprise the acute-care organization is not the main engine of profits. In fact, acute care is not even a profit center; it is a cost center. Acute care is just one of a suite of options for the managed care company's physicians to use in providing care to enrollees--the most expensive option. The change from profit center to cost center will require a reordering of the hospital's operational goals, management paradigm, and mission.

This transformation is more far-reaching and ambiguous than the transformation wrought by the switch from cost-based reimbursement to DRGs. The switch to DRGs changed many of the hospital's service departments from profit centers to cost centers, but left the entire hospital as a profit center. This new transformation makes the hospital just a service arm of a larger, more encompassing profit-making entity, the managed care enterprise. As a result of this change, the hospital's relationship to the organization changes from a producer to a consumer of revenues. This change will force senior administrative staff and board members to focus on controlling the acute-care cost center rather than expanding the hospital profit center.

Less is more The traditional accounting model for a healthcare organization highlights the importance of a marketing culture in a profit-making enterprise. The classic profit center model, the cost volume profit model, is illustrated in Exhibit 1. The underlying assumption in this model is that the enterprise can always increase profitability by increasing the volume of output. Increasing market share while maintaining price sustains the success of the enterprise. In fact, one can use the accounting model to define a profit center. A profit center is an organization where the volume indicator driving profits is the same as the volume indicator driving cost.

In a managed care organization the factor driving profit is the number of covered lives.

Profit varies up and down with the number of people covered by the health insurance plan. The more lives covered, the greater the probability the organization will cross its break-even point into the domain of profitability.

But covered lives in and of themselves do not imply more business for an acute-care subsidiary of the managed care organization. For acute care, the factor driving cost is the number of admissions or encounters. Admissions may not vary proportionately with covered lives. In the managed care organization real economic incentives exist to keep the growth rate in admissions below the growth rate in covered lives. It is easy to show how too much acute care for a given number of lives means lower profits (see Exhibit 2). The managed care organization will allocate a certain percentage of revenue for acute care. Increasing demand for acute care beyond the amount allocated will force a shortfall somewhere else in the organization. If acute care demand increases too much, the organization will begin to lose money.

The incentive for managed care organizations to slight the mix of acute care is well documented in the exhaustive writings of Arnold Relman, M.D. In fact, if the acute care team successfully markets its services to its physician panel, it may simply overheat the managed care engine and bring the whole machine to a grinding halt.

There is a story from the early days of DRGs that illustrates paridigmatic shifts in management. The director of the laboratory at a medical center was very successful in marketing laboratory tests to the medical staff. The laboratory director would persuade physicians to order several tests when one would do. He would convince doctors to enhance their care with exotic and expensive testing and retesting for fairly simple maladies. The laboratory director is a case study of the marketing management paradigm.

In the days of cost-based reimbursements, this laboratory director's flair and marketing skill were highly valued by the medical center and he was coveted by local competitors. When DRGs came along, the laboratory director could not believe that encouraging physicians to use more of his services harmed the organization. In his eyes, Medicare could not possibly refuse to pay for "necessary" lab tests.

Needless to say, this laboratory director eventually was a victim of change rather than an agent of change. Much of the acute-care industry apparently faces the same kind of transformation--only on a grander scale. Successful acute-care leaders are finding their worlds turned upside down. And like the aforementioned lab director, many will not accept the new paradigm simply because it does not favor their skill set.

Institutional leadership: Can anybody play this game? Successful leadership of a cost center, even a large complex one, differs greatly from the leadership of a profit center. Profit center leadership favors a marketing and entrepreneurial style while cost center leadership favors an operational and engineering style. As hospitals change from profit centers to acute-care cost centers, the skills needed to lead them will also change.

Internal customers replace external customers. A profit center leader must market to his customers. In a profit-making hospital the customers are varied. Admitting physicians are customers, referring physicians are customers, managed care companies are customers, employers are customers, and walk-in patients are customers. The profit center mentality hinges on expanding the volume of customers and market share in each of these markets. The internal needs of the organization take a back seat to customer needs.

In the acute-care cost center the key customers are the marketing and medical arms of the larger managed care organization. The acute-care organization does not capture resources by expanding its market share. It captures resources by competing with other internal groups and proving that it is the most cost-effective user of the organization's limited resources. It must continually make and remake the case that its treatments are most cost-effective and its efforts make the greatest contribution to expanding the organization's share of covered lives. An internally competitive market requires different skills than the external or free market. Analytical strength and business plan presentation skills will replace strength in politicking with the medical staff.

Growth is not always good. In a profit center, growth usually pushes the organization to the break-even point and beyond. Any strategy that leads to increased utilization of a profit center means higher profits and more financial security for the entire organization. Growth of cost centers is often considered unhealthy unless the cost center provides those services most highly valued by the consumer. Growth in a cost center is derived from growth somewhere else and is not sought as an end in itself.

Leaders who followed a strategy of growth for growth's sake will not make the transition from hospital to acute-care cost center easily. The marketing style that characterized the successful leadership team of the last 25 years will not serve the acute-care cost center of the future.

Matching revenue to expense will increase in difficulty. The fundamental techniques used for planning and control within the acute-care organization will change as its status changes. Flexible budgeting and cost accounting are much more difficult in a cost center

environment than in a profit center because managed care customers will not be buying hospital services directly. Therefore any matching of revenue to acute-care expense will be artificial and potentially misleading. It will be harder for internal accounting systems to perform the important requirement of properly matching revenues and expenses.

Also, acute-care organizations will no longer have meaningful prices. Prices provide a very effective discipline on costs. The price is a lid for unit costs. This discipline will have to be replaced with transfer price and cost standard lids in the new paradigm.

Acute-care cost centers are at risk of becoming large unwieldy organizations with no real revenue accounts. At best, transfer prices will substitute as surrogates for true revenue. Traditionally, control of large cost centers has focused on the use of standard costing systems. The problems in using standard costing systems for management control are legion. Critics of the standard costing approach include Edward Deming, Tom Peters, and hundreds of others.

Revenue as a measurement of performance will no longer apply. Even if standard costing systems are imperfect, the need for a new indicator will be imperative. The organizations designing the best surrogate indicators for revenue will have the best chances for survival.

CFOs are out; controllers are in. The finance function embodied in the chief financial officer is a link to the capital structure of the organization. The best security for debt or equity capital is the healthy, long-term revenue stream of the organization. The finance function will leave the hospital and follow the revenue stream to the managed care portion of the organization.

The acute-care cost center will not have a capital stream independent of the entire organization. The skills needed to raise low-cost capital in the bond and equity markets will be of little or no value to the acute-care cost center. The key issues will become short-range cash flow forecasting, budgeting, and cash management. Long-term investment and financing decisions will move out of the acute-care cost center never to return.

Bye, bye bills. Prices carry important information in society. They signal changes in the marketplace. In the stock market, daily price signals determine who is able to raise inexpensive capital versus expensive capital. Ask any ex-manager of IBM how important these price signals can be.

Acute-care cost centers will have no meaningful prices. As billing becomes vestigial,

there will be less pressure to produce an accurate bill. Today, the hospital bill is the most important source of information on the resources consumed by individuals and groups of patients. Organizations will have to decide between keeping the bill, burdening the medical record with resource consumption information, or inventing a some other way to record and track resources that will be at least as accurate as the old bill was.

Also, the disappearance of billing means radical reductions in the size of patient accounting offices and patient admitting functions. Complex billing and admitting will be necessary only for the few patients that are outside the managed care plan. Billing will follow revenue to the managed care arm of the organization.

The salesperson leaves, the engineer arrives. As the marketeers leave hospital management or migrate to the managed care group, a new type of acute-care leader will arise. The new leaders' skills will be more analytical and less visionary. He or she will be attentive to detail and spend time on reengineering the clinical care process and right- sizing the acute care organization rather than expanding its domain.

These new leaders will understand the clinical care process better than they understand the market place. Motivating the workforce will be more important than pleasing the medical staff. Doing things right will be more important than doing what is new. These new leaders may well emerge as a generation of clinical engineers with strong operational experience behind them.

New departments of clinical engineering and clinical process control will spring up from either nursing or medical records. These specialists will redesign and monitor how acute care is produced and delivered.

Conclusion As the provision of acute care shifts to the role of being one more cost center in the care-managed integrated delivery enterprise, much of what is accepted as good acute- care management will fall by the wayside. Pursuit of lower costs will replace the current goal of greater market share. Internal markets will replace external markets. Costs will replace prices as signals to produce more or less. The organization charts of hospitals will undergo a revolution, shedding some departments and adding new ones. The biggest change will be in the types of people and skills necessary to lead the change from hospital to acute-care cost center.

GRAPH: Exhibit 1: Traditional cost-volume profit model

As volume (V) increases, revenue (R) and total cost (TC) increase, while fixed costs

(FC) remain unchanged. The profit center moves from teh domain of loss (L) to the domain of profit (P).

GRAPH: Exhibit 2: Cost-volume profit model for an acute-care cost center

As volume of cases (V) increase, revenue (R) and fixed cost (FC) remain unchanged, while total costs (TC) rise. With increased volume, the organization moves from the domain of profits (P) to the domain of loss (L). This illustrates the important paradigm shift from acute-care enterprise to acute-care organization.

Exhibit 3: Directions of shifts in the acute-care paradigm

From To

External customers TENDS TO Internal customers More is more TENDS TO Less is more Revenues TENDS TO Cost standards CFOs TENDS TO Controllers Accurate bills TENDS TO Accurate charts Market-focused leaders TENDS TO Care-focused leaders

PHOTO (BLACK & WHITE): KEEGAN

~~~~~~~~ By Arthur J. Keegan, MBA

Arthur J. Keegan, MBA, is vice president for strategic planning, HBO & Company, Atlanta, Georgia, and a member of HFMA's Georgia Chapter.

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