What price is right? Hospitals struggling to offset financial losses resulting from caring for Medicare and managed care patients need a systematic pricing strategy - Feature Story

Healthcare Financial Management, April, 2003 by William O. Cleverley

To many hospital financial executives, pricing strategy may seem unimportant, given the current preponderance of fixed-fee payment. The Medicare and Medicaid programs usually pay for both inpatient and outpatient care on a prospective basis. Most managed care programs pay for inpatient care on a DRG or per diem basis, with outpatient care payment provisions based on fee schedules or discounted charges. Recovery rates for self-pay patients, who do pay on a charge basis, may even be low because of high bad-debt or charity care write-offs.

Pricing thus would seem to have a minimal effect on profitability. But our pricing studies indicate that the actual percentage of a hospital's total business that is charge-related usually runs between 10 and 25 percent.

Hospital executives often overlook other types of price-driven payment, including payment from the following sources:

* Self-pay patients

* Indemnity payers

* Managed care plans with outpatient percentage of charge payment provisions

* Specific drug and prosthesis carve-out arrangements

* Stop-loss thresholds

* Medicare outliers

Several of these areas are not often identified as price-related. For example, some contracts specify percentage-of-charge payment for high-cost drugs and/or prostheses. Payment for these item codes would be related to their prices. Stop-loss thresholds are becoming increasingly important as charges rise above thresholds. In many contracts, payment for cases above the threshold is a percentage-of-charge arrangement. Charges can have an impact on Medicare payment. Much has been made of the pricing impact upon inpatient outliers, but Medicare outpatient outliers, whether on a claim or line-item basis, also are related to charges through the methodology of ratio of cost to charges (RCC). Higher charges will increase payments for Medicare device pass-throughs.

Finally, Medicare outpatient transitional corridor payments are based upon differences between payment and cost, where cost is the result of departmental RCCs multiplied by charges. When all of these areas are added, most acute care hospitals will have charge recovery percentages equal to at least 10 percent, and many will be above this level.

Determining Price Levels

Many factors can affect pricing decisions, especially in competitive markets. The key underlying economic principle is "price elasticity." Simply stated, will demand drop if prices are increased, and if so, by how much? Because hospital customers have varying degrees of price sensitivity, price elasticity is hard to evaluate. Many healthcare executives believe that outpatient procedures are more price-elastic than are inpatient procedures, because patients pay either all of the charge or a greater proportion of it. High prices also can drive managed care plans with payment provisions based upon charges to other providers, although the reaction is not so quick as that experienced with self-pay patients.

Price-elasticity issues are important in pricing, but in many cases, hospitals have a great deal of pricing latitude. Raising prices may not materially affect short-term demand. If hospitals, both tax-exempt and taxable, were seeking optimal profit, hospital prices would be at much higher levels. Hospitals must, however, set rates at levels sufficient to maintain their financial viability. But what is that level? Prices should be set to cover average reasonable costs, losses from payers that pay less than cost, and reasonable return on investment (ROI).

Hospitals that lose money on Medicare and managed care contracts must raise rates sharply to a limited charge-related payer base. Large write-offs or discounts to the charge-related payer base often escalate prices to levels that bear little relationship to costs. This price escalation reflects the economic environment facing hospitals today. Hospitals should not be embarrassed by high prices as long as their costs are reasonable and their ROI or level of profit is not excessive.

The key factor in the above two conditions is ROI A defensible return on equity for most hospitals is at least 8.0 percent. This level will permit reasonable growth and acquisition of new technology and working capital expansion. Higher levels would be needed for hospitals with above-average financial leverage.

Setting Price Increases

Hospitals that initiate price changes usually adopt one of two strategies in an attempt to realize reasonable revenue goals. The first approach is the "across-the-board" increase. In this method, all item codes in the charge description master (CDM) are increased at a constant percentage. The second approach is selective price increases or decreases for each item code to achieve a stated overall charge increase. The latter approach usually attempts to place price increases in areas where recovery opportunities are greatest. For example, item codes with little or no charge-related payer volume would be poor candidates for price increases. Pricing studies suggest that selective price increase strategies are more effective than an overall increase, often generating 20 to 50 percent more revenue.