Top 4 things the CFO needs to know about purchased services

In today's ever-evolving healthcare environment, hospital CFOs face a number of challenges.

These include changing reimbursement levels, the transition to ICD-10 and the trend toward hospital consolidation, in addition to their ongoing effort to drive cost savings and drive value creation for their hospital. According to a report by Standard & Poor's, healthcare systems in the U.S. saw expenses outpace revenue growth for the first time since 2008.

So, how do hospitals stay ahead of the curve? By focusing on purchased services.

This is an area of spend that has risen to the top of the cost containment strategy for CFOs nationwide. Purchased services have a clear effect on the cost structure of an organization, often accounting for up to 25-30 percent of a hospital's nonlabor costs. Industry research shows hospitals have the potential to reduce their purchased services costs by 10-30 percent. However, purchased services largely escape the same level of scrutiny applied to capital, consumable and physician preference items.

As the purchased service space continues to evolve and change, there are four key points hospital CFOs should keep in mind.

1. Purchased services affect a hospital's revenue and cost structure.
2. Driving purchased services improvement often requires leadership engagement.
3. The purchased services supplier market continues to mature and gain complexity.
4. Managing purchased service contracts is challenging but worth the effort.

With these four key points, CFOs can precisely focus their efforts in the purchased services space and drive value for their organizations.

Purchased services affect a hospital's revenue and cost structure.

Purchased services clearly affect both the revenue and costs for a hospital. A portion of CMS reimbursement is tied directly to a hospital's Total Performance score, which is composed of the following:

- Clinical process of care (12 measures).

- Patient experience of care (HCAHPS - 8 measures).

- Outcomes (mortality, safety, HAI - 5 measures).

- Efficiency (Medicare spending per beneficiary - 1 measure).

A CFO's current portfolio of existing purchased service providers may affect these measurements. For example, if an organization has a third-party dialysis service providing treatment within its facility, the performance could affect the clinical process of care measurements, patient experience of care and outcomes and safety. If an organization has outsourced its Emergency Department staff or leveraged a third-party perfusion provider, these clinical elements may be more pronounced. A less obvious example is related to leveraging a purchased service provider to clean a facility. The performance could directly affect the question of "During this hospital stay, how often were your room and bathroom kept clean?" in the HCAHPS survey questionnaire.

The result of underperformance of purchased service providers in these areas could result in a reduction in reimbursement. For this reason, any clinical outsourced services that affect patient care should be undergoing a ruthless bottom-line evaluation, as well. These clinical services, such as labs and diagnostic imaging, should be evaluated under the same cost spotlight as nonclinical services in any hospital's portfolio.

In the past, hospitals traditionally drove the adoption of purchased services for three primary reasons:

- Improving the performance of service.

- A desire to transform a fixed cost to a variable cost.

- Reducing overall cost to serve.

These three primary drivers continue to resonate with our hospital members with an ever-increasing focus on reducing the overall cost to serve. From a cost structure perspective, we have observed the percentage of nonlabor expenses driven by purchased services increasing from 5-10 percent in the 1990s to almost 35 percent in some cases today. Many hospitals leverage a third-party provider in the largest purchased services spend categories, including biomedical engineering, food services, revenue cycle management and reference laboratory. We have also seen the market evolve with hospitals leveraging purchased services providers in less traditional noncore categories, such as property management, IT cloud services and patient surveys.

Key CFO Questions:

1. Do I have line of sight into the purchased services that might affect my reimbursement?
2. Does my organization have the appropriate cost structure between purchased services and in-house service providers?

Driving purchased services improvement often requires leadership engagement.

Purchased services touch all parts of the organization. These categories often fall under the responsibility of many different internal stakeholders. Common examples of internal stakeholders and the purchased service categories they own can be seen in the image below. When seeking to transform a purchased service, hospitals may encounter issues when these internal stakeholders are not aligned on the overall strategic vision.

In addition to having individual categories with specific owners within the organization, many categories have a cross-functional effect. As an example, if an organization leverages radiology as a purchased service, that service touches multiple stakeholders within the organization. This includes nursing (scheduling/transport), physician staff, quality and risk management (oversight for services provided), finance (cost and reimbursement considerations), IT (potential EHR integration), facilities (potential space considerations), compliance (vendors) and supply chain (procurement activities).

Given the cross-functional nature of purchased services and that many of these stakeholders report to different executives within the hospital, we have found CFOs' engagement is necessary to do the following:

- Ensure the objective of the effort is clearly understood.

- Identify and overcome individual concerns or biases.

- Ensure that a fact-based approach is leveraged to make a decision, such as make vs. buy or when switching vendors.

Our experience indicates that the "size of the prize" alone often merits CFO engagement. In comparison to consumable savings opportunities, which can range from 5-15 percent, individual purchased service categories savings opportunities range from 10-30 percent. Given that most hospitals are operating between -5 percent and 4 percent margins, savings in this range could materially affect the cost structure for a hospital.

Key CFO Questions:

1. Does my organization have a clear process to make decisions around purchased service vendors?

2. Are there specific categories in which executive engagement will remove obstacles and drive alignment?

The purchased services supplier market continues to mature and gain complexity.

The purchased services market continues to mature and gain complexity, and many vendors are expanding the depth and breadth of services they offer. As an example, Crothall Healthcare, long known for providing laundry and linen services, has expanded its portfolio to provide environmental services, patient transportation, facilities management and healthcare technology, such as management and oversight of a hospital's medical devices and clinical technology. In a similar fashion, Aramark has expanded from its base in food services to include energy use and consulting. Like Crothall, Aramark is a large player in the biomedical and diagnostic imaging service sector.

These expansions and changes require the attention of the CFO, who should be aware of key vendor moves Crothall and Aramark have engaged in. CFOs should provide oversight to ensure that vendors with broad portfolios are delivering the appropriate value across all services offered and not disaggregating their spend with hospitals to their advantage.

In a similar fashion to the expansion we are seeing in the depth and breadth of services, vendors continue to consolidate market share in select categories. The dialysis market is a good example of how two leading companies, DaVita and Fresenius, command over 70 percent of the market, according to the Fresenius 2013 annual report. Complexity is further magnified by segmentation within individual categories. This happens at both a geographic level where local and regional vendors have emerged and at a subcategory level.

The final indicator of market complexity is the vendor's approach to pricing. Vendors are developing complex pricing models. We have seen clinical contracts that are structured with various pricing schemes based on a combination of consecutive procedures, standby only, owned vs. leased equipment, etc. Revenue Cycle Management is a key example of a purchased services category that requires extensive price modeling. Financial structures, such as annual adjustments and mandatory service level agreements and performance arrangements for provided data, could adjust the ROI dramatically for purchased services.

Key CFO Questions:

1. Do I know who my strategic purchased service suppliers are?

2. Are my category teams aware of the dynamics in the supplier market?

3. Do I have the right resources modeling complex pricing schemes?

Managing purchased service contracts is challenging but worth the effort.

We have found that many hospitals do a tremendous job establishing value in the contract with a vendor but lack the ability to manage the performance of the contract going forward. With limited resources and infrastructure, service line leads and procurement are often limited in their ability to provide oversight. We have seen "value leakage," often the product of the complexity of purchased services, of up to 10 percent. Leakage may result from incorrect pricing, poor demand management or lack of value received by the hospital (e.g., the vendor does not meet contractual turnaround time performance expectations). We have also seen value leakage when market pricing moves more rapidly than contract pricing. We have seen this happen with transcription, where market pricing decreased on an almost monthly basis, yet hospitals were locked into three-year fixed pricing agreements.

Often we see organizations leveraging a suite of approaches to address "value leakage" challenges, including contract management systems, invoice to contract reconciliation, A/P spend analysis to identify off-contract spend, periodic benchmark reviews and quarterly vendor performance reviews.

Key CFO Questions:

1. How does my organization know if vendors are delivering the value for which we contracted?

2. Are my contracts in line with the market in year one, year two, year three, etc.?

Conclusion

What healthcare CFOs ultimately need to know are the right questions to ask, which will be different across each of the outsourced services that are contracted across the organization. They must also evolve along with the purchased service landscape, which continues to grow and change. CFOs who understand the dynamics of the market and the four elements described above are positioned to drive the greatest value from purchased services for their organizations (revenue, improved cost structures or improved service).

Mr. Peter Stelling joined MD Buyline in 2015 with over 20 years of leadership and management experience. Mr. Stelling was a consultant with A.T. Kearney and Ernst & Young with a focus on Hospital Supply Chain operations, system implementation and strategic sourcing. Mr. Stelling served a combined 15 years in the U.S. Army and U.S. Army Reserve in combat and logistics leadership roles. Mr. Stelling has a Bachelor of Science from the United States Military Academy in West Point, New York and a Masters in Business Administration from the Cox School of Business at Southern Methodist University in Dallas.

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