Health Care Finance

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Copyright 2013 by FACHE 6/15/12

Case 2

University Hospital

(Marginal Cost Pricing)

University Hospital is a regional leader in the very intense and medically

sophisticated area of organ transplants. Mark Lewis, the director of the

Transplant Center, has been with the Hospital for ten years. When Mark joined

the Hospital he was put in charge of a kidney and heart transplant program

that was averaged 50 transplants per year. Today, the Transplant Center

performs over 200 transplants annually, including transplants from the newly

initiated liver, lung, and pancreas programs.

The liver transplant program is the most successful of all organ programs in

terms of volume and revenues. Last year, volume totaled 100 transplants, and

this year Mark is optimistic that the liver program can do even better.

However, he knows that increased volume is largely dependent on the number of

organ donors and his success in negotiating a new contract with the

Transplant Management Corporation (TMC), the largest transplant-benefits

company in the nation.

Because transplants are relatively rare in comparison with other, more

conventional medical treatments, only the largest health insurers have the

expertise to manage transplant services. However, the costs to insurers for

transplant services are typically very large—usually in the six-to-seven-

figure range. To ensure the best and most cost-effective management of

transplant services, most health insurers outsource transplant management to

companies, such as TMC, that specialize in these services.

Contracting for transplant services is unique and complex because of the

sophistication of the medical procedures involved. Transplant services

consist of five phases: (1) patient evaluation, (2) patient care while

awaiting surgery, (3) organ procurement, (4) surgery and the attendant

inpatient stay, and (5) one year of follow-up visits. The costs involved in

Phase 1 are relatively simple to estimate, but the remaining phases can be

extremely variable in terms of resource utilization, and hence costs, because

of differences in patient acuity and surgical outcomes.

Historically, reimbursement for transplant services has been handled in a

number of different ways. Initially, many providers bundled all five phases

together and offered insurers a single, global rate. Although this method

simplified the contracting process, the rate set was often chosen more on the

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basis of building market share than on covering costs. Indeed, many providers

could not even estimate with any confidence the true costs of providing

transplant services.

Somewhat ironically, success in gaining market share usually increases the

financial risk of the transplant program because higher volumes increase the

likelihood of higher acuity patients. Although the total costs associated

with all phases of a liver transplant average about $400,000, the amount can

more than quadruple if the patient requires a re-transplant or if other

complications occur. Because of this extreme variability in costs, outlier

protection is a critical aspect of contract negotiations if the reimbursement

methodology is a fixed prospective rate.

Thus far, several elements of the proposed contract with TMC have been

finalized. Specifically, Phases 1, 2, and 5 will be reimbursed at a set

discount from charges. Furthermore, to reduce the amount of financial risk

borne by University Hospital, Phase 3 (organ procurement) will be reimbursed

on a cost basis. This makes sense because the cost of Phase 3 is almost

completely uncontrollable by the Center. In general, Phase 4 costs are

divided into two categories: hospital costs and physician costs. Physician

costs have already been agreed on, so what needs to be hammered out (and the

make-or-break part of the contract) is the hospital reimbursement amount for

Phase 4.

The key to a sound negotiation with TMC is to identify relevant costs. Mark

plans to be aggressive in pricing these services, because he wants the

contract. He feels that the additional volume will lower per transplant cost

and hence increase the Center’s profitability. Still, he wants to set a price

that does not degrade the current profitability of the Center, which is good

but not spectacular.

To help with the decision, Mark compiled the Phase 4 hospital costs of 12

recent liver transplant patients. In reviewing these data, shown in Table 1,

Mark noted that a total average cost of $119,805 for 19 days average length

of stay translates to a staggering per diem (per day) average cost of over

$6,000.

Mark is convinced that a price close to $120,000, which would cover total

costs, would not be acceptable to TMC. So, he examined the possibility of

lowering costs by reducing the average length of stay (LOS). However, the

costs associated with Phase 4 are not a linear function of LOS. The first day

of Phase 4 is usually the most costly while the last day is usually the least

costly. Indeed, over half of Phase 4 costs occur in the first 24 hours of

hospitalization.

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Because it would be difficult to lower Phase 4 hospital costs by reducing

LOS, Mark decided to pursue a different strategy. His experience at the

Transplant Center has convinced him that there are economies of scale present

in liver transplants, and hence the marginal cost of each transplant is lower

than the average cost. Thus, Mark believes that he can base the contract

price on marginal costs rather than total (full) costs. Such a rate would

(hopefully) be attractive to TMC yet, at the same time, preserve the Center’s

profitability.

Assume that you have been hired as a consultant to recommend a fixed price

(the base rate) that should be proposed in the contract negotiations for

Phase 4 hospital services. To help in the analysis, Mark has indicated that

approximately 60 percent of nursing, ancillary, operating room, and

laboratory costs are fixed. The remaining costs--radiology, drug, and other

services--are predominantly variable.

TABLE 1

University Transplant Center

Phase 4 Hospital Costs

Total Nursing Ancillary OR Lab Radiology Drug Other

Patient Age LOS Costs Cost Cost Cost Cost Cost Cost Costs

A 61 25 $141,092 $10,261 $65,416 $6,770 $13,712 $1,483 $20,992 $22,458

B 56 15 139,306 11,969 63,668 8,501 7,409 2,261 24,504 20,994

C 42 12 74,259 6,939 33,661 3,128 5,279 668 6,964 17,620

D 52 13 115,349 7,221 54,063 5,779 6,112 903 7,638 33,633

E 12 26 172,613 28,205 72,204 6,847 10,550 1,766 23,061 29,980

F 59 22 83,807 16,858 33,474 4,654 6,211 1,397 9,698 11,515

G 41 25 136,060 9,645 63,208 6,489 13,091 1,382 20,127 22,118

H 35 17 139,308 11,969 63,669 8,501 7,409 2,261 24,505 20,994

I 52 12 74,259 6,939 33,660 3,128 5,280 668 6,964 17,620

J 38 13 115,348 7,221 54,063 5,778 6,111 903 7,639 33,633

K 59 25 166,224 26,909 69,657 6,765 10,061 1,677 22,007 29,148

L 60 21 80,034 15,629 32,202 4,531 5,937 1,293 9,122 11,320

Average 47 19 $119,805 $13,314 $53,245 $5,906 $8,097 $1,389 $15,268 $22,586

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QUESTIONS

1. What is the estimate of the marginal cost of the Phase 4 hospital services

assuming, as given in the case, that 60 percent of the designated costs

are fixed and the remaining costs are variable?

2. Assume that the agreed-upon price is $90,000. What is the expected profit

on the contract assuming that it brings in 20 new patients? (Assume for

now that no new fixed costs would be required.)

3. Now assume that the additional patients will add $200,000 in total to the

Center’s fixed costs. Now what is the expected profit on 20 new patients?

On 40 new patients? (No new fixed costs are required to support the second

group of 20 patients.)

4. What role do the following factors play in the decision as to whether or

not to use marginal cost pricing on the new contract?

a. Reimbursement amounts paid by current transplant third-party payers.

b. The amount of excess capacity in the transplant unit.

c. The potential reaction by current payers to a new, lower price

contract.

5. What is your final recommendation regarding the base rate for Phase 4

hospital services that should be built into the contract?

6. Should you worry only about the contract’s first year pricing, or should

you develop a long-term pricing strategy for TMC? What are some possible

features of a long-term pricing strategy?

7. Briefly describe how outlier payments might be handled to ensure that the

Center does not suffer large losses on outliers (patients with unusually

high costs). (Hint: Cost outliers are identified by having costs that

exceed a specified threshold. Then, in addition to the standard payment,

the provider is reimbursement for some percentage of the costs above the

threshold. For this question, you must choose a cost threshold and outlier

payment percentage.)