Cartwright Financial Management1 Managerial Accounting: Pricing and Service Decisions

Cartwright Financial Management2 Managers must set prices and/or determine services Price takers –no market power –take it or leave it offers from MCO and Government –concentrate on cost structure Price setters –market power and size. –Differentiated service

Cartwright Financial Management3 Full-cost pricing In the long run must set a price to cover all costs in the firm. Direct variable costs of service Direct fixed costs Appropriate share of overhead

Cartwright Financial Management4 Marginal-Cost Pricing The cost of providing one more additional unit of output Medicare and Medicaid argue that providers should be payed marginal cost, not full costs. How will they cover fixed and overhead? and Who will pay? Actually this is more like an incremental cost calculation, rather than the economic concept of marginal cost.

Cartwright Financial Management5 Cost Classification Review Direct – inputs into service Indirect (overhead) – shared inputs of organization. (insurance, director salary) Variable – activity, utilization, volume impact on costs. (supplies) Fixed – Pre-determined, no variation with activity, utilization, and volume. (short-run staffing level)

Cartwright Financial Management6 Marginal-Cost Pricing Cross subsidization or price shifting is used to cover additional costs imposed for service units that are not full cost priced. Payers no longer are accepting price shifting. Affecting emergency care, teaching and research and indigent care.

Cartwright Financial Management7 Direct Cost Pricing Prices are set to cover the direct costs of providing services These are both variable and fixed costs. Indirect or overhead costs not covered. Usually higher price than marginal cost

Cartwright Financial Management8 Competitive Pricing Cost structure is not relevant to pricing A high cost structure as compared to to the revenues under competitive pricing results in low or negative profits or net earnings High costs may result in going out of business

Cartwright Financial Management9 Economics Price = Marginal cost Costs –Short run rising marginal cost –Long run u shaped average cost curve In equilibrium, Price = average cost –Sufficient profit to stay. –Lowest point of average cost curve.

Cartwright Financial Management10 Target Costing Take the price given for a service Subtract the desired profit on that service Now have target cost level Reduce the full cost to the target level and continue to push costs down

Cartwright Financial Management11 Setting Prices on Individual Services Use the revenue, cost, profit equation Solving for price given a profit ( economic breakeven) and pricing assumption

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Cartwright Financial Management16 Hospital Price Setting Under Capitation Offer a capitated plan for inpatient services What is the new price for the plan? 13% conversion of patient base Number of admissions under plan stay the same as selected groups. Capitated price must provide same net income.

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Cartwright Financial Management18 Capitation Assumptions Enrollment: Medicaid (20%), Commercial (40%), Self Pay (40%) Adjust admissions accordingly Enrollees in new plan will be 25,000 Total Fixed Costs Stay Same

Cartwright Financial Management19 Net Income hold harmless Capitated plan must bring in $108,583,746 - $94,473,163 = $14,110,583

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Cartwright Financial Management22 Sensitivity Analysis As managers, you need to assess the impact of changes in the key variables from the base case scenario Scenario 1 – only 15,000 enrollees, not 25,000 Scenario 2 – Additional 10,000 enrollees added to plan. (35,000) Scenario 3 – Lower premium to $40

Cartwright Financial Management23 Capitation with 15,000 enrollees at PMPM 60% shortfall in enrollees –For Medicaid, 0.60 X 20% = 12% Need distribution of the type of enrollees in the shortfall. Smaller numbers coming out of other plans. Medicaid (12%, ): (1-.12) x 5895 = 5188 Commercial (24%): (1-.24) x 1,408 = 1070 and Self-Pay (12%): (1-.24) x 1,289 = 980

Cartwright Financial Management24 Capitation with 15,000 enrollees at $47.04 premium Note premium has been fixed and therefore the sensitivity analysis is looking at the net income generated. Net income is the same, since the reduction in the capitated plan enrollment means that admissions remained in the other plans.

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Cartwright Financial Management26 What if 10,000 additional enrollees in the capitated plan Increase enrollment to $47.04 PMPM Utilization rate of 903 per 10,000 constant Variable cost per admission constant Additional enrollees are brand new and do not cannibalize other plans Each additional enrollee brings in $47.04 PMPM in additional revenue. Where would MMC get these additions?

Cartwright Financial Management27 What if 10,000 additional enrollees in the capitated plan? Marginal (incremental) revenue – 114,227,979 –108,583,746 =5,664,233 Marginal (incremental) cost – 36,893,591 – 35,174,873 = 1,718,718 Total contribution margin 3,925,515 – added to the bottom line.

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Cartwright Financial Management29 Capitation Assuming 35,000, but $40 PMPM Expansion requires a concession on price to be attractive in the market place Loss of revenue is – 35,000 x 7.04 x 12 = $2,956,800 Adjust Revenues by Payor – 19,754,816 – 2,956,800 = 16,798,016 –Which is rounded to $16,800,000 in Table 7.6

Cartwright Financial Management30 Capitation Assuming 35,000, but $40 PMPM Net income is $2,633,012 which falls $2,954,815 from $5,587,827 No offsetting reduction in cost Therefore, entire $7.04 PMPM decrease falls on net income. Premium can fall to $37.69 to achieve original net income without capitation of $1,662,312

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Cartwright Financial Management32 Utilization and Cost Reduction Effects on Net Income Assume 25,000 and $47.04 PMPM Utilization rate falls from 903 per 10,000 to 800 per 10,000 Revision of clinical guidelines result in a variable cost per admission reduction from $1903 to $1800

Cartwright Financial Management33 Utilization and Cost Reduction Effects on Net Income 25,000 x.08 = 2000 admissions 103/1903 = 5.4% reduction in costs Insert changes in Capitated row. Variable costs fall by $696,794 Net income increases by same 1,662, ,794 = $2,359,106 Should these be applied to all groups?

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Cartwright Financial Management35 Developing a Premium Rate for Managed Care Plan Institutional rates - fee-for-service equivalent method (set charge) Budgetary or Cost rates – usage and costs –Demand,FTE,average cost per FTE, support Demographic base rates –Utilization by age and sex, costs PMPM

Cartwright Financial Management36 Institutional Rates Inpatient cost PMPM Per member utilization rate x Fee-for-service rate inpatient days for 1,000 members =.350 days per member $938 per day charge (.350 * $938)/12 = $27.35 PMPM

Cartwright Financial Management37 Institutional Rates Out of Area Use

Cartwright Financial Management38 Budgetary or Cost Approach Based on usage or underlying costs Expected patient demand FTE physicians Physician cost: base compensation, fringe benefits, malpractice premiums Costs for staffing x FTEs

Cartwright Financial Management39 Example for BetterCare Each enrollee makes 3.0 visits to primary care physician per year (3 per 1,000 rate) FTE handles 4,000 patient per year Total Compensation is $175,000 per year

Cartwright Financial Management40 BetterCare PMPM for Primary Physician Compensation Each enrollee requires 3/4,000 Physicians or physicians Annual Cost = x $175,000 = $ per year Cost PMPM = /12 =$10.94

Cartwright Financial Management41 BetterCare Physician Specialist Care 1.2 visits to specialist per enrollee 1000 enrollees have 1,200 visits Each Specialist sees 2,000 patients per year Total compensation is $284,000 per year 1,000 enrollees require $1,200/$2000 x FTE Cost is 0.60 x $284,000 = $170,400 per 1,000 Cost PMPM is $170.40/12 = $14.20

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Cartwright Financial Management43 Demographic Approach Age/sex distribution of enrollees is specified and specific cost data is applied to estimate the capitation rate. Total service cost (PMPM) is a weighted average of age and sex.

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Cartwright Financial Management45 Getting to Final Cost Need a capitation rate to pay all providers in –area or outside-of-area services Some services will be carved out like pharmacy and durable medical equipment Carve-out of behavioral health benefit Carve-outs may be in the offer and costs or out.

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Cartwright Financial Management47 Management Decisions What is the market like? Does this bid look too low given current prices? Does this bid look to high? What is the competition? Is the right quality in the bid?

Cartwright Financial Management48 Using Relative Value Units (RVUs) to set prices Resources consumed to provide service Establish RVUs for each of type of lab test Multiply number of tests x RVUs to get total RVUs Divide Total costs/total RVUs to get dollar per RVU $250,000/165,000=$1.52 Adding markup of 25% 1.25 x $1.52 = $1.90

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Cartwright Financial Management50 Service Decision Accept or reject a new proposal or contract Is the offered PMPM sufficient to do business? Should I make a counter offer? Maybe we are not too far apart. Any contingencies to negotiate

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Cartwright Financial Management56 What is the decision? Accept if the hospital can tightly manage the contract Reject the contract if it cannot tightly manage the contract Conduct more sensitivity analyses

Cartwright Financial Management57 What if? Utilization management may improve over time Five year or six year horizon –May be profitable in sixth year Can the hospital afford to loose market share? Can variable costs be covered? Can Baptist capture more market share and raise prices (or lower costs with economies of scale)? Is the market stable or is there great turmoil?