Tier contracts and their effects on a provider’s finances

Under the current healthcare environment with declining reimbursements and increasing focus on "pay-for-performance," effectively managing costs is critical to the success of healthcare organizations.

Tier pricing provides one such cost-saving opportunity. Tier pricing is offered by individual vendors that support their corporate sales and market share strategies. When healthcare providers are dealing with multiple vendors, managing these different strategies is complex because every strategy is a combination of tier conditions such as volume, market share, spend and pricing.

In addition, healthcare providers need to make purchasing decisions based on total cost of ownership, and this requires them to monitor tier prices continuously or on a quarterly basis at minimum. The leading practices related to strategic sourcing, category management and contract management will facilitate effectively utilizing tier pricing. If tier pricing is managed appropriately, healthcare providers will realize significant savings annually.

Tier pricing for healthcare clinical products is a contracting strategy applied by vendors and Group Purchasing Organizations (GPOs) to incentivize larger volume purchasing commitments from healthcare providers. Tier pricing can offer cost benefits to providers if managed appropriately. However, the benefits often are not realized due to onerous agreement implementation requirements, poor internal compliance especially for physician preference items (PPIs) and decentralized purchasing structure of the healthcare organization leading to rogue buying outside of the pre-agreed-upon products and vendors.

What is tier pricing?
Select vendors may offer healthcare providers multiple pricing tier options for healthcare clinical products and PPIs based on historical purchasing volume, market share or other factors specific to the individual healthcare provider organization.

Tier pricing is structured by the vendors or Group Purchasing Organizations to drive additional sales and gain market share. This results in different tier conditions across multiple vendors offering similar products.

Some examples of tiers can include:
• Different pricing options: front-end price reduction, rebates and additional discounts off already negotiated contracts
• Volume thresholds: product group volumes, specific stock keeping unit volumes and category volumes
• Spend thresholds: product group spend, specific SKU spend, category spend and aggregate vendor spend
• Market share: market share commitments incentivize vendors to provide attractive pricing options to member integrated delivery networks or individual healthcare organizations based on bed size and/or clinical product demands
• Some healthcare providers also negotiate independent tier pricing agreements directly with vendors based on bed size and/or product purchasing history.

How does a health care provider gain access to tier pricing?
Tier pricing negotiations typically are based on 12 months of the vendor's historical product volume and/or spend data. Contracts are generally structured to allow the vendor to evaluate the commitment compliance during the contract period. Vendors often offer other strategies, such as combining product volumes across individual facilities owned and/or operated under the parent healthcare organization to leverage incentivized pricing tiers.
When a new tier contract is implemented, multiple vendors and providers need to update their systems to confirm accurate purchasing to invoicing. To start, a letter of commitment of purchasing a set of products must be established and signed. Upon signature, the GPO typically notifies the manufacturer of the updated contract. The manufacturer updates its system and notifies the distributor to update its system. Then the distributor updates its system and notifies the customer.

Finally, the customer validates the distributor price list and updates its ordering systems.

This process enables the synchronization of all the systems and is critical to capturing tier pricing value. The systems often are out of sync resulting in lower savings for providers and process inefficiencies across the value chain. Unfortunately, the reality is that while this process may enable the synchronization of the systems, it does not necessarily enable the systems to effectively track or validate tier spending or tier pricing maximization. Additional system capabilities may be required to either be purchased or configured to help with managing tiers (outside of what their GPO's may offer).

Why should health care executives care about tier pricing?
In our experience working with clients, healthcare provider clinical product expenses typically make up 20%-30% of the total hospital spend, making it a high focus area for supply chain cost-reduction initiatives.
Tier pricing is generally found in the high-dollar and high-value clinical product expenses of healthcare providers. We've found that PPIs can account for between 30% and 40% of the total clinical product spend, which translates into millions of dollars in associated costs.

What are the challenges of tier pricing structures?
Tier pricing structures and qualifying groups vary across a range of clinical product categories and vendors: there are no standards.

Tier pricing structures are defined independently by individual vendors and healthcare organizations, resulting in healthcare providers needing to carefully manage a complex catalog of tier pricing contracts. For example:
• Structures are developed to drive total revenue and impose quarterly and annual vendor sales targets that include all categories of spend with individual vendors
• Structures are developed to drive market share, which may extend to other categories of spend with individual vendors
• Market share calculations across vendors are further complicated because many vendors segment their product lines with specific categories.

What are the impacts to health care organization operations and the financial statements?
Operations are impacted with additional costs incurred in the management of tier pricing. For example, to determine appropriate tier assignment as well as price validity, provider facility operations have additional staff focused on significant monitoring costs who:

• Analyze and assign tiers based on historical behavior as well as new promotions and incentives from the vendors.
• Monitor each vendor/category/tier combination on a quarterly basis to confirm that tier requirements are achieved and rebates and incentives are applied and recognized.

In addition to the operations, the financial statements are impacted. Purchasing clinical products to achieve a tier target may not yield the lowest total cost of ownership. Total cost of ownership can include the cost of the item plus the administration, transaction and inventory costs of purchasing these items. Some total cost of ownership examples and how they can impact financial statements include:

• Pricing inconsistencies can occur due to multiple entities involved in the process: providers, GPO, vendors and distributors resulting in overpayments and recoveries.
• Excess inventory, product demand increases, obsolesce of materials held in inventory and write downs on the income statement.
• Executing higher order quantities at the end of the rebate period to achieve tier targets can result in additional cost outlays of cash flow.
• Delayed rebates due to vendor review and audits lead to higher cash outflows.

Recommendation/ perspective

What can health care providers do to manage the complexity of tiers?

The first principle a healthcare provider should remember is that they control what and how purchases of clinical products and services are executed.

Potential tier incentives provided by a vendor may not be the best outcome for a provider if the level of internal investment to effectively manage the tier program exceeds the incentive value.

Tier pricing structures and rebates should be minimalized and controlled as best as possible to simplify the total cost of running a provider network.

Early and frequent provider leadership and physician involvement is paramount for the success in decision making about supply chain contracts and tiers.

Provider executives should prioritize tier incentive opportunities and develop a holistic approach to drive tier pricing management and optimization via technology enablement and robust process design.

Implementing an exhaustive tier pricing management program for a healthcare provider may require a higher than acceptable level of investment and However, significant short-term return on investment can still be captured by taking a strategic prioritized approach to high value opportunities.

Strategic sourcing: develop competitive market actions for pricing improvement for clinical products

Negotiate favorable tier (or no tier) pricing structures in each contract to align strategically with the healthcare organization's operations and needs (e.g., gross volumes, market shares and product families).
Leverage strategic market actions to capture top tiers (e.g., unpublished tiers and strategic sourcing tiers) for each vendor and targeted product categories.

Capture non-contract spend by targeting niche product classes and groups to be incorporated into broader tier pricing arrangements.

Category management: manage a health care provider's internal purchasing processes and organizations to control clinical product spend. Some examples include:

Identify the healthcare organization services that have the highest use of tiers and develop working councils of administration, clinical and supply chain analysts to formulate strategies for clinical product purchases. The working councils will manage communications throughout the organization about the changes required to meet new compliance tiers.

• Strategically manage tier opportunities with individual provider facilities and systems to communicate and align potential tier market opportunities with hospital demand.
• Identify noncompliance activities outside of directed contract tier opportunities within the healthcare organization and implement policies and procedures to mitigate the risk of future noncompliance
• Consult current industry benchmarks to determine an appropriate range for clinical product pricing; keeping in mind number of vendors, market share, case volumes and ability to effectively leverage volumes.
• Facilitate an open-door policy to receive hospital supply chain leadership, material manager feedback, department clinicians and structures to contribute to overall category strategy and prospective tier market actions.

Contract management: Purchase or develop additional contract management tools to manage tier contracts and the GPO functions to report and audit purchases. Some examples include:

• Develop and implement a designated contract management function for tier pricing opportunity identification and compliance reporting. Target tier pricing remediation areas and potential tier improvement areas.
• Manage master archive of tier pricing contracts, group arrangements, commitments, etc.
• Generate regular reporting workflows and utilize automated tools to assist in tracking demand management and category management activities as well as potential tier strategic sourcing opportunities.

Bob Doyle, Americas Health Supply Chain Leader, EY
Paul Fanella, Americas Supply Chain Procurement, EY
Nancy Bateman, Health Supply Chain, Clinical Category, EY
Matthew White, Health Supply Chain, Category Management and Sourcing, EY
Tom Behrens, Health Supply Chain, Category Management and Sourcing, EY

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