Business Fundamentals

While Medicare accounts for transplant costs in a very specific way, hospitals often use other methods to examine transplant programs' fiscal health. One common way is a responsibility-based accounting system that looks at fixed and variable costs as well as direct and indirect costs. In this system, fixed costs are business-unit related costs that are not related to volume. These include hospital allocation of costs for nonrevenue functions like clinic costs and indirect costs, finance costs such as interest expenses, and administration and compliance. Because fixed costs are unrelated to transplant volume, they remain the same whether a center performs one transplant a year or 100.

On the other hand, variable costs are those directly related to each patient, and they can be either direct or indirect. Direct costs here would include professional fees for transplant surgeons and other physicians; acquisition costs for the patient; ancillary services such as lab, radiology and esoteric; and supplies and prescription medications. Indirect costs in this model are business-unit related costs that are indirect to the patient. These include malpractice costs, teaching/research labs, marketing and business development, and business unit administration.

One other element that comes into play during reimbursement is uncollectible costs, or the costs that Medicare does not cover. Transplant centers accrue these costs as part of delivering service to Medicare patients, and they are becoming increasingly higher as Medicare shifts its burden to providers.

As a transplant program matures, the relationship between its fixed and variable costs evolves. In the earliest stages of growth, when a program still is doing a low volume of transplants and trying to add patients to its list, fixed costs constitute the bulk of total program costs. As a program grows and the volume of transplants becomes more moderate (100 to 250 people on program waiting lists), fixed and variable costs become more evenly split. And once a program matures and begins providing a high volume of transplants, variable costs begin to outweigh fixed costs. At this stage, variable costs also start rising disproportionately to volume, and it becomes increasingly important for physicians to take part in monitoring them.

Understanding what drives costs in each area of reimbursement is critical to maximizing efficiency and margins. The biggest drivers on the DRG side are large critical care pathway deviations and longer patient stays in the hospital. On the physician side, salary, practice expense, and liability insurance make up 90% of cost. And on the OACC side, the cost a program pays to the OPO for the organ is notable, but this area also contains the most critical cost driver by far: waiting lists.

As suggested in the organ acquisition cost section above, long waiting lists can drive up variable costs more than any other factor. Long lists can be a double-edged sword for transplant programs: On one hand, a high volume of patients provides more income to the physician group. On the other, a program with excessively long lists of patients to evaluate and maintain suffers from a cumulative effect of waiting list time and cost compounded with price increases and inflation.

In a mature, high-volume transplant program, waiting list costs are akin to inventory costs, so the longer patients spend on the waiting list, the higher costs go up per patient. For example, if a program's waiting list today has 100 patients with an acquisition cost of $40,000 per patient, the program currently has a $4 million inventory cost. Assuming monthly monitoring for patients, annual reevaluations, and cost increases of 7% annually each year over a 60-month waiting list period for a cadaveric transplant, if that waiting list grows by 15% each year, that waiting list will have 200 patients by the end of five years with an acquisition cost of $58,000—or an inventory cost of $11.6 million.

Because excessively long waiting lists trap capital, the most effective way to manage costs is to manage the ratio between the number of people on the waiting list and the number of transplants. In some cases, living donors can be extremely helpful in reducing inventory. In many cases, though, there is little physicians can do to manage the waiting lists themselves, as they cannot very well remove patients from the list because inventory is too high. However, physicians and surgeons at least need to recognize the fiscal effects of long waiting lists and long wait times, as payors also look closely at the relationship between list and transplant growth.

To calculate acquisition costs and responsibility accounting thoroughly, a hospital must look at the rate of inventory turnover, or the number of people on the transplant waiting list, divided by the number of annual transplants. Financial executives also use this ratio to compare their programs against others in the marketplace. Because facilities with longer waiting lists are technically higher cost ones than those that turn their inventory over sooner, the average waiting list in terms of years is a key variable that should be factored into pricing strategies.

Pricing Strategies

The vast majority of hospitals use cost-based pricing for transplant services, meaning they use their own transplant and acquisition costs to determine how much to bill payors. Such cost-based pricing models are focused internally on the institution, as hospital administrators review hospital costs and set price targets based on the cost of delivering the service and running the hospital, plus a minimal acceptable return on capital. The target price in this case usually is 102% to 105% of costs for all business units and products—regardless of how they compare to similar services in the marketplace—and this target price is used as a guide for achieving overall institutional profitability. This model also is consistent with financial reporting and Medicare accounting practices.

Some transplant programs may use an externally focused, market-based pricing strategy. In this case, the program provides a discounted or premium price compared to the market average based on brand strength, quality difference, product maturity or payor buying power. However, a market-based pricing strategy is a much more sophisticated and somewhat riskier model requiring solid market intelligence on factors such as competitors' services, competitors' pricing strategies, payor buying power, and market maturity.

Many third-party payors pay a global fee for the transplant episode that also is intended to cover organ acquisition costs. Since most institutions use a cost-based pricing approach, an effective pricing strategy should focus on vendors and stratify customers based on volume of business. Using this model, preferred vendors, or those that historically have provided the greatest share of cases (10% or more), would be billed 102% to 107% of costs. The next tier down would be vendors that provide a large amount of business (but still less than 10%) and who eventually could become preferred vendors. These vendors would be charged 105% to 120% of costs. Finally, small independent groups that contract for one or two transplants at a time would be charged 120% of costs, as these are fairly labor intensive, and efficiency on return is fairly low.

Profit Margins vs. Contribution Margins

Regardless of the pricing strategy, net reimbursement for a transplant equals billed charges less uncollectible costs. Profit margin equals net reimbursement less the fixed, variable, and capital costs; and contribution margin equals any reimbursement above fixed costs. In other words—how much the program's net reimbursement revenues offset the cost of having that program in that space in the hospital. Targets for profit margins and contribution margins are examined annually and set by the culture of the organization.

According to the Healthcare Financial Management Association, profit margins are about 3% for academic hospitals nationwide. This is derived almost entirely from DRG reimbursement for growth and development and is meant to subsidize nonrecoverable costs. In the Medicare reimbursement model for transplant services, DRGs are the only place where the hospital can make a profit mar-gin—and it can only do that if the physicians are efficient and provide services totaling less than the preset DRG payment. (OACC are reimbursed on a full cost basis without opportunity for profit margins.)

On the physician reimbursement side, physicians have little incremental ability to affect variable cost because charges are a reflection of Association of American Medical Colleges (AAMC) charges across the country rather than physicians' and surgeons' true costs, which are very difficult to calculate. Also, physicians' practices constitute a fixed cost structure because the number of surgeons and physicians required to perform the services required for the operation of the transplant center is fixed and, therefore, the cost is fixed (unless a new physician or surgeon is hired). In other words, there is no mechanism to recognize variable cost with each service or procedure.

While hospitals look most closely at profit margins when examining their business units, contribution margins can better define the significance of transplant programs to their institutions. In order to understand their program's fiscal health and the significance of the transplant program to the hospital, physicians and surgeons must be aware of their program's contribution margin in both dollars and as a percentage relative to the institution's fixed costs.

Because Medicare reimburses organ acquisition cost centers on a full cost basis (including direct costs) and not on a charge basis, there is no profit margin ever possible on OACCs. However, the contribution margin provided by the OACC constitutes a significant proportion of the total contribution margin of the transplant program. This impacts positively both the hospital and physicians because if OACCs provide a strong contribution margin, the transplant center is much more likely to apply resources to transplant programs.

Contracting Strategies

The importance of well-structured contracts cannot be overemphasized when it comes to maximizing reimbursement. Contracts with payors are usually episode oriented, defining billing around four key events for the patient:

• Pretransplant evaluation,

• Acquisition, or the period between being listed and before the transplant (includes the start of acquisition services and other associated requirements),

• A very defined transplant admission, and

• Post-transplant care.

Under a global contract, a commercial payor generally provides one lump sum to the hospital, which then divides payment between itself and transplant physicians and surgeons based on prearranged terms. Alternatively, a discount contract reimburses all transplant charges at a discount. Medicare, on the other hand, usually regards each stage of the transplant experience as a discrete episode (defined by DRG), reimburses acquisition costs on an annual "pass-through" to the hospital based on the Medicare cost report, and pays on a fee schedule for the professional fees.

Because regulated payors such as Medicare have very specific rules that cover reimbursement, contract negotiations are extremely limited in this area except insofar as transplant centers can manage the number of cases that come in through these channels. Commercial payors technically contract with hospitals on either a global or discount basis, and hospitals, in turn, vary in how they distribute payments to their physicians and surgeons. The hospital-physician arrangement may take the form of an employment relationship, where the physician is an employee of the transplant center, or a contractual arrangement where payment can be based on fee-for-service, an hourly rate, some type of global rate based on a percentage, or any other financial arrangement.

Unfortunately, payor compensation usually benefits either the hospital or physicians at the expense of the other. Hospitals historically have benefited from Medicare reimbursement, but physicians have not: Reimbursement versus recovery of the fixed and variable costs (charges) usually leaves physicians significantly below their actual cost to deliver services. Meanwhile, physicians tend to fare better under global contracts while hospitals do not. Some centers rely on internal transfers of funds to help physicians offset shortfalls from Medicare by shifting the physician component up in the global package, transferring an increased portion of the package to physicians and surgeons. Only one reimbursement formula, the discount from billed charges, aligns financial incentives for both hospitals and physicians and can benefit both equally. Under this structure, the transplant center and physicians recover total costs plus profit margin at a predetermined percent of charges.

One critical aspect of contracting strategies is that physicians and hospitals can mix and match these modalities. If a transplant center is in a global rate agreement with a payor, the entire transplant experience does not have to be on a global arrangement. Certain portions of a transplant patient's care can be provided on a percent discount from charges, and other portions can be provided as a global case rate. A typical arrangement may have the transplant experience from admission to discharge negotiated on a global case rate, while evaluation and post-op care are negotiated on a per diem or percent discount from charges.

In most cases, patients also have two insurers, further underscoring the need for thorough contract agreements with payors. For example, a patient may have a commercial payor as the primary insurance and Medicare as the secondary. In the case of kidney transplantation, an entitlement to those undergoing transplantation is that Medicare is the secondary payor. Therefore, there exists an opportunity for coordination of benefits (COB) that allows the hospital to obtain full reimbursement from Medicare for costs not covered by the primary payor in full. The system is full of examples of such opportunities, which eventually could reflect badly on the fiscal health of a transplant program that in fact is being undermined by an ineffective contract or accounting system.

Managing the Bottom Line

Complex transplant centers cannot remain fiscally sound without rigorous participation from physicians and surgeons. The focus should be on managing costs through efficiency, quality, and forward fiscal thinking.

On the DRG side, physicians play a very important role in managing the bottom line because they control the cost (cost drivers) of the services provided. Since payment is fixed for each DRG, more efficient care leads to a higher DRG profit. However, managing the bottom line requires a thorough knowledge and understanding of all components of cost and reimbursement. This effort requires a high level of collaboration between the medical directors of each transplant program and the hospital administrators responsible for the transplant program.

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