How hospitals can tackle the profitability crisis

The following article comes from Tony Colarossi, partner at Plante Moran’s acute healthcare consulting services: 

The profitability of U.S. hospitals is at its lowest level since the 2008 financial crisis, increasing the urgency for health systems to undertake significant efforts to tackle their high fixed costs.

The challenge facing hospitals was recently underscored in a report by Moody's Investors Service that revealed that median operating cash-flow margins, a key measure of profitability for both not-for-profit and public hospitals, declined to 8.1% in 2017 from 9.5% a year earlier. At the same time, the growth of expenses was faster than revenue growth.

Hospitals are getting squeezed.

On the one hand, they are faced with high labor costs amid a red-hot employment market and declining reimbursement. On the other hand, hospitals are in the middle of a shift where they are being paid not for the volume of patients treated and instead being reimbursed based on outcomes.

The central challenge is that hospitals are a high fixed-cost business. Whereas a typical commercial enterprise has fixed costs of about 40%, a hospital has enormous fixed costs to just open the door for a single patient, amounting to about two thirds of revenues, or even more.

So, for example, if a health system improves primary care to such an extent that fewer patients need to be treated at their hospitals, revenues at the hospital would decline while fixed costs remain unchanged. As a consequence of that, most U.S. hospitals are not profitable.

At the average hospital 30% of spending is waste, and incremental improvement toward reduction in operations costs can be reached by applying the principles of lean management — looking for small, continuous improvements in efficiency and quality. Most regional health systems have dedicated teams to address lean initiatives; however, they may be limited in the number of issues they may be able to conquer each year.

Effective cost management most often falls into two broad areas: supply chain and labor costs. On the supply chain side, savings can be realized on such things as optimizing utilization and reducing the amount of supplies that are opened and not used. On the labor side, implementing best practice productivity standards and maximizing patient flow through services are paramount. The idea is not just to make sure that staffing levels are correct, but that the right staff are working in the right areas at the right times.

Nevertheless, hospitals can work to improve their margins more aggressively by focusing on three areas in particular:

Reduce overhead: Hospital executives should aggressively address costs related to everything that is not part of the core service and mission of providing clinical care to patients. This includes everything from the amount of facility space, to billing, to information technology and finance. With 25% of health system cost represented by administrative and corporate overhead, a 20% reduction in overhead expense can approach a 5% improvement in operating margin. Where possible, hospitals should consider outsourcing these functions to reduce their fixed costs.

Regional collaboration on low margin operations: Having contained supply chain and labor costs, administrators should audit every clinical service offered by the health system to identify which ones are least likely to ever be profitable due to low volume or restrictive public policy on reimbursement.

For these unprofitable services, ranging from such things as behavioral health to obstetrics -- and in the near future, laboratory services -- hospitals should seek out collaborations or joint ventures to offer shared services over a wider geographic area. That effort will remove the loss leaders from the health system’s books, reducing capital cost, centralizing scarce resources and minimizing losses.

Modernize pricing: Health systems have typically taken an approach to pricing that would make any professional business analyst blush -- tallying costs and their desired margin in order to produce their price for any given service. Transparency and consumerism have never been a requisite component of the business model.

Future forward, health systems should consider adopting a manufacturing model of pricing: Identify a product (knee replacement surgery, for example) determine what price the market can sustain with competitive differentiation, and then re-engineer, using the previously described lean process, the clinical delivery of that product in order to turn a reasonable profit at the prevailing market price.

While profits are falling today at hospitals, the situation is likely to only get worse in any kind of economic slowdown. Even though health insurance prices have risen significantly in recent years, employers have largely soaked up those increases without passing them on to employees because the labor market has been so tight. If the economy slows, that will almost certainly change, raising out-of-pocket health costs for the average American and increasing the imperative for hospitals to operate more efficiently.

Transformative health executives will get started on this important work now.

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