How activity-based costing can boost hospital finances

The COVID-19 pandemic has strained hospital and pharmacy wholesalers’ revenue because of reduced patient volumes and expenses related to the virus. To improve their financial picture, organizations must make cost-reduction decisions based on credible patient-level cost and quality data using the most accurate cost management method. 

Some cost management methods are obsolete, but activity-based costing can accurately measure and assess clinical costs by providing insights into how resources are used, and by whom, Rob DeMichiei, retired executive vice president and CFO of Pittsburgh-based UPMC, said during a Jan. 20 session at the Becker’s Healthcare CEO + CFO virtual forum, sponsored by Health Catalyst.

Five takeaways from the session:

1. Various forces are driving unpredictable fragmentation of provider revenues, according to Mr. DeMichiei. One of those is COVID-19, which has led to reduced revenue-generating elective procedures and reduced use of the emergency department. The pandemic has also increased telehealth use and is another consideration when assessing future operations and operating margins. Mr. DeMichiei said the question in the long term is: “What will be the actual strategic integration of telehealth into the everyday operations of a hospital, and basically, what will that do to the footprint that you have of your healthcare system from the utilization of telehealth?” Other driving forces include the economy, as Americans have lost their jobs and employer-based health insurance, as well as insurers, some of which have seen greater profits amid the pandemic as the use of healthcare services on the provider side fell.  

2. Amid the fragmentation of provider revenues — and the continued move from fee-for-service to value-based care — healthcare organizations face greater pressure to know their costs. To take on financial risks under value-based care, healthcare organizations need to understand their costs — and understand them in an accurate way, according to Mr. DeMichiei. This means they must have a methodology that accurately measures activities, resources and patients. Hospitals can then identify revenues and expenses at a patient level and gain full insight into their clinical and service line costs. 

3. Healthcare organizations must have a usable and accurate cost accounting system to improve operations and operating margins. But Mr. DeMichiei argued against cost management methods such as relative value units, which are used to determine the value of a service or procedure, or ratio of cost to charges, the ratio between a hospital’s expenses and charges. “The EMR has a wealth of information that can be utilized to understand consumption, and consumption actually is what drives costs in healthcare,” he explained. “These old systems, that may be used by your system today, are based on an outdated model. They did not have the benefit of an EMR, and so they’re not really relevant to be utilized in modern healthcare and modern finance.”

4. Information about an organization’s costs is best provided through activity-based costing, because it accurately measures and assesses 100 percent of clinical costs and allows users to see where and how resources are being consumed, according to Mr. DeMichiei. He defined activity-based, supported by advanced extrapolation technologies, as a methodology that “connects the actions and decisions of clinicians to the actual cost of each action and decision.” The goal is for physicians, who are making clinical decisions, to be able to connect their actions and decisions to the actual costs of those actions and decisions. That way there is good stewardship of resources. “When we’re using CORUS, the Health Catalyst tool, and we’re using [for] activity-based costing, we want them to understand how their actions impact the entire [healthcare] Triple Aim,” said Mr. DeMichiei. “It’s not only the health that they’re creating and maintaining, it’s not only the patient experience, but it’s also the cost of their actions as well.”

5. Activity-based costing includes three steps. Mr. DeMichiei said the first one is assigning direct costs to each patient using the EMR and financial data from the organization’s general ledger. These are things like drug and supply costs. Then those direct patient costs are removed from the general ledger, and indirect clinical costs are left.

These indirect clinical costs are significant (approximately 70 percent of total clinical costs) and are usually allocated or considered “overhead” by traditional costing methods; understanding the actual consumption of indirect clinical costs is critical to accurately measuring the financial performance of a service line, an individual procedure, or the performance of a specific physician.]

Lastly, activity/consumption drivers are used to understand the consumption of indirect clinical costs, such as the number of minutes spent in the operating room or length of stay. “That helps to define the actual consumption of the resources related to those activities,” said Mr. DeMichiei, adding that defining that consumption can enable some cost reduction opportunities and essentially improve the organization’s financial picture. 

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