Contributed by Jamie Cleverley
Several months ago, I was in San Diego for a presentation on hospital pricing. One of the primary discussions involved California’s higher relative charges for hospital services and the defensibility of those charges in light of heightened public attention.
The topic is increasingly discussed as healthcare professionals try to evaluate and communicate the reasonableness of their pricing structure. What is the answer?
Certainly, benchmarking data to compare hospital pricing at the encounter level is important and will continue to be provided to consumers for comparison. However, how do these measures relate to profitability and address headlines that report hospital profits and increased charges? Defending prices and profitability at the facility level requires something more than discharge and visit price comparisons.
To address the issue, hospital executives can draw on a helpful and easy-to-understand model – one that is used by public utilities that want to justify rate increases to regulatory boards. The model is based on return on investment and its comprising elements.
Consider a basic formula for ROI, such as [volume times (price minus cost)] divided by investment. The price component can be removed, and the remaining three – ROI, cost and investment – can be tested. If it can be proved that ROI, cost and investment are not excessive, then the formula demonstrates that price is also reasonable.
To put it more plainly, if an organization does not have excessive levels of profitability, does not have high costs and is not overly invested in fixed assets, then its pricing structure would have to be reasonable. It would not be using high prices for high profits or covering up for cost and investment inefficiencies.
In exploring the model with the health professionals in California, the following tests were performed.
Is ROI excessive? Reviewing data from The State of the Hospital Industry 2007 Edition, which uses 2005 data, California hospitals’ median return on equity was 9.5 percent, only slightly higher than the U.S. median of 8.5 percent. Clearly, the state median is very close to that of the rest of the U.S. hospital industry.
Then, the level of profitability was compared with that of other industries. Reutor’s ProVestor Reports, dated February 8, 2007, identifies the five-year average return on equity for the U.S. pharmaceutical industry at 24.5 percent, the U.S. healthcare insurance industry at 11 percent and the Standard & Poor’s 500 at 20 percent, putting them all above the ROE of the hospital industry. The data show that the profitability levels of U.S. hospitals, and California facilities in particular, are less than those of other healthcare and non-healthcare industries.
Is investment excessive? Organizations may charge more for services to make up for excessive investment in facilities and equipment. This can be examined by looking at plant age and plant efficiency.
California’s median plant age, as measured by its accumulated depreciation percentage, was at 53 percent in 2005, very close to the U.S. median value of 52 percent. In addition, the ratio of revenue to net fixed assets, the measure for fixed asset efficiency, was at 3.2 in 2005, better than the U.S. median of 2.5. From this data, California hospitals have plant age approximate to the U.S. and better-than-average plant efficiency.
Is cost excessive? Finally, median costs are examined to determine if a hospital is charging more simply because of a higher underlying cost structure. To evaluate this, the Hospital Cost Index of Cleverley and Associates is used. The index compares Medicare inpatient and outpatient costs at a hospital to the U.S. median to create an indexed facility-wide comparison. The California median was 102.7 in 2005, compared with the U.S. median of 101.3, so costs in California are not significantly higher than costs throughout the U.S.
As a result, median performance for California passed all three price tests, showing that state hospitals were reasonable in profitability, investment and cost. Subsequently, it logically follows that pricing in California, as a whole, is reasonable.
Why then, are median hospital charges for California approximately 50 percent higher than that for the nation? The answer primarily stems from a less favorable operating environment, where a higher percentage of low-income patients – California has the third-highest disproportionate share percentage in the nation – and inadequate payer terms have necessitated higher prices. It is clear from this model, however, that these higher prices have not led to higher profits or resulted from cost and investment inefficiencies.
Communicating a price strategy to a concerned community is a daunting task for hospitals. With all of the complexity surrounding price-setting, it may be useful to isolate other elements to share.
By illustrating an organization’s success in passing profit and efficiency tests, its executives can remove pricing from the central point of discussion. The tests help community members see the organization as a responsible business and service partner, as well as an organization that operates in a very difficult environment overall for the hospital industry.