My parking lot is full; What happened to my bottom line?

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From 2015 to 2017, in the wake of a historic expansion in insurance coverage from the Affordable Care Act (ACA), health systems experienced a 39% drop in their operating earnings, the steepest decline in over 40 years.

Two-thirds of health systems in this Navigant study saw significant drops in earnings, including many who had dominated their regional markets for decades. This completely unexpected downdraft was the product of a sharp deceleration in patient care revenue growth that was unmatched by expense reductions.

As health system CFOs conducted an autopsy on these troubling two years, they discovered fundamental flaws in their budget assumptions about the revenue side of their business. In the wake of the ACA, many systems signed complex new “value-based” insurance contracts with health insurers they did not fully comprehend. Some systems gave up steep front-end rate discounts to avoid being excluded from the ACA’s health exchanges, expecting value-based bonuses and increased commercial volumes to make up the difference.

When the smoke cleared, they discovered several things. One key thing was that the expected volume of new customers from the new value-based contracts failed to materialize. This was because the health exchanges enrolled only about half the customers expected by the Congressional Budget Office and most independent analysts. Very few systems recovered those steep front-end discounts through a surge of new exchange customers.

Health systems also failed to generate the performance bonuses they expected from many of these contracts or incurred penalties for underperformance, despite numerous new expenses related to organizing their physicians and acquiring the performance information the contracts required. The net effect: the new value-based contracts have proven to be a drag on earnings.

In addition to the revenue challenges created by lower rates, lack of volume, and higher self-pay receivables, hospitals experienced an unexpected increase in claims denials. Insurers dramatically tightened their criteria for evaluating and paying claims, one reason why health insurer profits have remained so robust. The new contracts contained increasingly restrictive payment rules on what services are covered, where they must be performed, and how they must be pre-authorized before services are delivered.

Not only did one well-managed health system have to write off $15 million in unexpected denials from just three of their dozens of clinical services, but it cost them almost $1 million of administrative expense to correct coding problems to avoid further denials. When this health system recalibrated its forecasted revenues based on fresh data on cash yield, they discovered a $70 million problem, which, if expenses were not reduced correspondingly, would have resulted in a large operating loss! And this was just from their commercial insurers, which represented about 30% of their business.

Finally, management has not fully appreciated the cumulative revenue effects of changes in their payer mix (e.g., more government-funded patients), site of service (more outpatient) and service mix (e.g., less surgery, more medicine). In one relatively small system with $1.5 billion in annual revenues, the cumulative impact of all these changes was $500 million less revenue over just five years!

In particular, pressures from losses from Medicare, a hospital’s largest payer, have accelerated as baby boomers transition from private insurance to Medicare. Failure to understand and budget for all these revenue impacts and failure to actively manage complex payer contractual relationships is an open invitation to further unpleasant surprises.

What should health system executives and Boards take away from these experiences?

1) Health system leaders must actively manage the revenue side of their business. They must treat their contracts with private insurers, Medicare Advantage, Medicaid managed care plans, and the major government payers like Medicare itself, as a portfolio of relationships, and actively manage that portfolio from month-to-month. Merely to forecast revenues from this profusion of contracts 18 months to two years ahead of time and budget on that basis is dangerous,an open invitation to further surprises.

2) This must lead to real-time management of expenses. Health system leaders need to be prepared to make mid-year expense reductions if negative trends materialize from this active monitoring process. Waiting until the middle of the budget year is too late because expense reductions have a lagged effect, and do not generate actual cash savings quickly enough to avoid losses.

3) The revenue portfolio must be “rebalanced” based upon actual yield. Some value-based contracts and payment policy terms are so one-sided in the favor of insurers that they pose an active threat to the system and should be terminated, or else dramatically renegotiated. Systems often do not need to wait for two or three years until contracts expire to do this. Equally essential is tracking detailed monthly data by clinical service showing revenues, costs, denials and write-offs to enable clinicians to take corrective actions in how they actually manage patient care.

4) Active engagement with physicians is essential. Physicians need to understand and buy in to changes in practice that reduce cost and, therefore, losses. They also need to document what they do properly and in a timely fashion. Eliminating care variation that does not improve quality or that adds needless expenses (e.g., for duplicative or inappropriate lab or imaging studies), cannot be done without active physician collaboration. In some cases, physicians might have to shift the site of care (e.g., from inpatient to outpatient) or help consolidate overlapping or duplicative programs that produce substandard results. This is what we meant in our 2019 Harvard Business Journal piece about having affirmative control over the delivered cost of care.

The 2015-2017 health systems earnings debacle should have been a wake-up call to health system management. The proliferation of value-based contracts and the growth of Medicare Advantage and other non-traditional revenue streams requires health system leaders to rethink how they manage their business. The era of managing based on passive annual revenue estimates is over. There is too much fluidity in revenue flows to rely on two-year-old revenue forecasts..

There is no alternative for responsible health system executive teams to actively managing their revenue portfolios and to rebalancing the revenues that flow from that portfolio to actual expenses. This active management is the key to assuring profitable operations in an era of heightened enterprise risk.

Payers have doubled down on micromanagement of their network contracts with hospital systems to maximize their profits. It is time for health systems to step up to the challenge with their own robust portfolio approach to respond aggressively to this challenge.

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