The Cost Reduction Imperative

U.S. hospitals and health systems are on the brink of a fiscal crisis. The impact of healthcare reform, coupled with demographic shifts, may devastate these organizations unless they begin reducing costs immediately. Reimbursement reductions and shifts in demand are likely to lead to 15 to 25 percent declines in hospital revenue yields in the next decade, according to Booz & Company modeling. To counter this, many hospitals and health systems will need to reduce their cost structures by 10 percent or more in order to maintain margins and survive.

Creating a sustainable cost structure will require an innovative, forward-looking approach that systematically establishes a much lower cost base as the "new normal." To do this, hospitals and health systems must overcome the seemingly insurmountable cultural obstacles such change entails, as opposed to employing traditional cost-cutting approaches that incrementally reduce costs from one budget cycle to the next. As hospitals and health systems are looking to take costs out, they must also simultaneously build new capabilities to compete in the changing healthcare landscape. Consequently, savings goals must well exceed 10 percent in order to invest the necessary resources in the new strategies.

Don't rely on the past

The tactical cost levers that hospitals usually pull — supply chain savings initiatives, capital spending freezes and benchmark-driven headcount reductions — are neither sustainable nor significant enough to achieve the savings they need to survive and thrive. Health system executives already recognize this: Less than 23 percent of them believe these actions deliver substantial results, according to a recent survey by the Healthcare Financial Management Association.

To achieve double-digit cost savings, hospitals must drive out costs by redesigning care delivery and administrative processes; unleash the capacity, service and clinical quality gains needed to compete in the post-reform marketplace; and support a cost management system that locks in improvements and prevents costs from creeping back. Other industries — automotive, aviation and financial services among them — have used similar approaches to achieve stepwise cost reduction. However, significant barriers of complexity and fear have deterred most hospitals and health systems from taking on the challenge.

Illuminate complexity, eliminate fear

A transformative cost reduction approach first needs a technical component to address complexity — a strategic framework and toolkit that helps managers determine where to invest their efforts and how to improve performance while extracting cost. It then needs a cultural component to overcome the inevitable emotional resistance to change, empowering managers to energize the organization and get results.

Unlike budget clipping, a transformational cost reduction starts at the strategic level with explicit decisions about how to allocate resources. These decisions should be filtered through a health system's capabilities — a small set of internal, interlocking strengths that differentiate the health system in the marketplace. Through this filter, executives must decide what capabilities they need to keep, and where they need to invest to meet the quickly changing needs of patients, employers and payors and ensure future growth. The choices they make will vary based on their strategy, but virtually any "way to play" in the market will require investments in information technology, new clinical programs, additional facilities and other assets along the care continuum. This is the key to cutting costs and growing stronger.

Fortunately, many of these investments, if made wisely, will also boost efficiency. For example, new payment models can lower administrative costs, and improved clinical quality reduces the cost of caring for patients. Once management knows where to focus its cost reduction efforts, it can take actions that promise the greatest potential for savings. These include the following:

•    Redesign care delivery processes to remove waste by eliminating redundant and non-value-added work, automating manual processes, consolidating or decommissioning underutilized operations, and ensuring that everyone is working "top of license." To optimize the redesign, it should be applied holistically across the enterprise and not applied piecemeal to individual departments or facilities; that’s because the process redesign might, for instance, involve adding costs in one area in order to substantially lower costs elsewhere. Process redesign can also lower supply costs by reducing open-but-not-used supplies, tidying up physician preference cards and identifying substitutes for expensive diagnostic testing, implants, surgical supplies and other high-cost items.

•    Standardize care processes to reduce unnecessary care and costs by creating protocols or implementing new programs to ensure that patients are placed in the most appropriate inpatient setting, avoiding unnecessary or redundant diagnostic tests and therapies and reducing unnecessary lengths of stay. Care process improvement and standardization should also focus on avoiding penalties from programs like value-based purchasing. This may require building capabilities, such as the use of transitionalists, that incur some costs but reap far greater savings by avoiding readmissions.

•    Tighten the management of labor costs by better matching staff levels to true demand for services. Legacy staffing models based on simple heuristics such as inpatient nursing ratios are too crude to capture the wide variation in workloads. Create new algorithms to set staff levels on the basis of a detailed, bottom-up understanding of the actual care that each patient will receive. Build a more flexible workforce through cross-training, broader use of float pools, centralized management of shift staffing and more part-time/flex-time staff.

•    Streamline overhead functions such as finance, human resources, legal, risk and insurance, and real estate management. Process redesign, standardization and workflow automation can yield significant labor savings, especially in finance and HR. Demand management reduces consumption of overhead services through unit-based pricing and pay-as-you-go models. Meanwhile, shared services and outsourcing unlock economies of scale and economies of scope.

•    Pursue care delivery model innovation such as medical homes, "productized" care for specific episodes and new reimbursement mechanisms to encourage the right behaviors. For instance, product bundles integrate care delivery and financing for a specific condition for a single price. This bundling prompts the redesign and standardization of care delivery processes and the elimination of extraneous administrative activities (such as claims processing or utilization management) to improve value and reduce variation in cost, quality and the patient experience. This bundling may require creating clinically integrated organizations, where physicians, outpatient centers, home care agencies and hospitals can more efficiently and cost-effectively deliver care.

To achieve and sustain the savings associated with these actions, senior hospital executives must lead a transparent change management process that assuages fear and engages employees on the front lines. This work must be done by employees, not forced upon them. Senior managers should enlist middle managers to identify and drive operational improvements that hit savings targets. And it’s critical that employee transition programs exist to reduce the pain and anxiety of workforce reductions.

When the leaders of hospitals and health systems adopt this approach to cost reduction, institutional fear and inertia are overcome. As inefficiencies are revealed and savings opportunities come into sharp focus, the “lightbulbs” switch on across the enterprise, making true transformative change possible. This is the right way to capture stepwise savings and deliver the higher levels of patient care and service quality necessary for a healthy and prosperous future.

CEO primer: critical success factors for cost reduction

Transformational cost reduction begins at the top of an organization — the CEO's leadership and commitment to it is imperative. Hospital and health system CEOs should use this primer as their guide through any cost reduction program.

•    Don't underestimate the scope. Resizing the cost base and reallocating resources is akin to gutting your home, changing the floor plan and redesigning the plumbing. It's not an agenda item. It requires a distinct program.

•    Commit the necessary time and attention. This effort will take 24 to 36 months. It will require your ongoing attention and must be a top priority. Your leadership must be highly visible and unwavering.

•    Set aggressive targets, and stick to them. Do not rely on benchmarks to set targets. These merely compare your current cost structure to underperforming peers in a rapidly changing industry. Instead, set the target needed to achieve strong financial results and fund new capabilities in a fundamentally more austere reimbursement environment.

•    Set an example by thinking boldly. Change of this magnitude will be uncomfortable for many. The natural tendency is to avoid difficult decisions, but don't allow the organization to shy away from disrupting the status quo.

•    Engage physicians from the start. Physicians have the clinical expertise necessary to redesign how care gets delivered. Their behavior is hugely influential and can determine the success or failure of a cost reduction program.

•    Create a program office. This dedicated office can coordinate the effort. Create teams to tackle different elements of the cost structure. Assign your best and brightest.

•    Think ahead. Launch the cost reduction effort before margin compression hits. Reactive cost reduction tends to be indiscriminate and even destructive. Proactive cost reduction reinforces the organization's priorities and strategy.

•    Eliminate positions carefully. Create a human capital plan that integrates all hiring and terminations. Create transparency so employees whose positions are being eliminated can apply for other positions within the organization. Use attrition, and avoid reductions if possible.

•    Change performance objectives. Make sure the incentives for senior leadership align with the goals of the program.

•    Communicate. Nothing hurts morale, diverts attention and undermines success more than a rumor mill, especially when big change is afoot and jobs are on the line.

•    Execute relentlessly. Keep a laser-like focus on objectives, and hold the correct people consistently accountable for meeting those objectives.

Curt Bailey ( is a partner with Booz & Company based in San Francisco. He co-leads the firm's hospital and health systems practice in North America and serves leading healthcare delivery and services organizations.

More Articles on Hospital Cost Reduction Strategies:

Moody's Lisa Goldstein: 5 Major Trends for Non-Profit Hospitals

8 Strategies for Hospitals to Approach Cost Management

Hospital CFO Panel: How Are You Approaching Your Fiscal Strategy Right Now?

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