Hospital Cost Accounting: Million Dollar Decisions Should Not Be Based on “Guesstimates”

All well-run businesses use data to drive their decisions. The higher the stakes, the more accuracy they demand from their data. Hospitals are businesses, even not-for-profit ones, and should conduct their operations like any other business.

The area where hospitals lag far behind other businesses is in cost accounting. Most hospitals simply don’t know for sure how much the cost of care is for a patient encounter (i.e., visit), or an entire service line. They have an idea, but that’s not nearly good enough for the purposes of expanding (or shrinking) a service line or setting prices.

This article makes the case that hospitals can switch to a more accurate cost accounting methodology, and it does not have to cost a lot of money.

Healthcare, in general, is an extremely complex environment with many variables. Providing care to patients is not like running a manufacturing or service business. It is often unpredictable. Two patients with the same symptoms may have two different underlying conditions. Similarly, two patients with the same condition, may respond differently to the same treatment. This results in situations where two patients sharing the same room may cost the hospital different amounts because of their unique resource utilization.

Hospitals do have good cost data, at the aggregate level. Like other businesses, they know exactly what hits their general ledger (GL). It is the process of assigning the costs from the GL to the patient encounters that can be challenging.

Most hospitals adopt a method called ratio of cost-to-charge (RCC) cost accounting. They have the aggregate costs in the GL and charges from their billing system, so they calculate a ratio that they subsequently apply to estimate costs for sub-populations.

The description of RCC above is oversimplified, but it is essentially a top down approach which assumes (often wrongly) that markups are uniform. From the proverbial 30,000 ft view, the cost estimates look good, but as you drop to a few hundred feet view, the costs may look “out of whack”.

A far better cost accounting methodology is the activity-based costing (ABC) method. ABC relies on relative value units (RVUs) to allocate cost center GL expenses to the individual charge codes within that cost center. A patient’s encounter is then costed by adding the costs of the various charges (i.e., activity) incurred by that patient.

Although activity-based cost accounting is more accurate in allocating expenses to encounters and service lines, in 2016, only 29% of hospitals (source: hfma), used that method. What explains that? There are many reasons, including:

1. It is time consuming. All charge codes would need to be assigned RVUs, and all GL accounts and position codes would need to be assigned cost types.
2. The decision support systems that do all the data crunching can be prohibitively expensive, often in the $100,000s of dollars.
3. Many executive decision makers are unaware that there are more accurate cost accounting methodologies. Historically, their cost data may not have been an issue.

Perhaps those executives had been right, at least in the past. After all, no one would want to spend $100,000s of dollars and numerous staff hours to “refine” their calculations when things were working “just fine”. Moving forward, however, they can no longer afford to ignore the potential discrepancies between their calculated costs, and reality.

Healthcare consumers (i.e., patients) are savvier that ever. As insurance companies shift more of their expenses to patients (in the form of deductibles and coinsurance), patients start to shop around for the best prices. A hospital could price itself out of a market simply because it relied on inaccurate cost estimates.

So, what can hospitals do to switch from RCC to ABC accounting? Large hospitals that can afford to purchase a decision support system with ABC accounting functionality should do so. Having the resources to get the most accurate cost data but not acting upon it would be unfortunate, especially since market forces may divert its business elsewhere.

Smaller hospitals, on the other hand, may be able to do the calculations outside of their DSS system. The math is relatively easy, and the calculations can be performed in MS Office products. Data extracts can be pulled into Access and/or Excel to calculate the costs, which can either remain in their database, or be pulled back into the DSS, if the system permits that.

There is no reason for smaller hospitals to continue using rough guesstimates. Today’s desktop computers are very powerful and can easily crunch the numbers. It just takes a little bit of outside the box thinking.

In addition to improved cost accuracy, ABC cost accounting allows hospitals to do flex budgeting, which is the subject of my next article.

For brevity purposes, the article has not addressed the differences between direct and indirect costs, but, in a nutshell, the ABC method can be applied to both. Most hospitals rely mainly on contribution margin analysis (net revenue minus direct costs) when evaluating a service line, because indirect cost allocation is subjective.

Sahel Shwayhat, MBA, FACHE, Principal at ELY Analytics, is a Management Consultant with over 30 years of experience in Healthcare Operations and Data Analytics. A Lean Six Sigma Black Belt, Mr. Shwayhat has dual degrees in Electrical and Biomedical Engineering. He is also is fellow in the American College of Healthcare Executives. Mr. Shwayhat's career spans multiple roles, where he gained significant experience analyzing large data sets to uncover inefficiencies, identify outliers, and compare staff and equipment outputs. He is adept at performing location analytics to identify potential clients, focus resources, and capture a greater share of the market.

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