Vital signs: taking the pulse of your managed care contract performance

Healthcare Financial Management, July, 2005 by Pamela M. Waymack, William J. Ward, Jr.

AT A GLANCE

Three essential baseline measures of managed care performance that should be reported on a regular basis are:

* Overall profitability of the organization's managed care portfolio

* Payer mix and profitability

* Performance of major managed care contracts

Many of us are familiar with the adage, "You cannot manage what you cannot measure." For many providers, managed care contracts have become the only profitable payer segment--thus the health and size of this segment are critical to the health of the enterprise. Sharing key managed care indicators with the organization's senior financial managers ensures an understanding of actual contract performance, and can also serve to raise questions that will help improve the organization's overall performance under managed care. Without periodic monitoring of managed care vital signs, misconceptions and inconsistent beliefs can impair the organization's ability to respond strategically and operationally.

Measuring Profitability

A key metric in contract performance is profitability. Defining profitability sounds simple, but the level of variation in the measures used between organizations is tremendous. Some providers define contract profitability as the percentage of charges collected. Although simple to compute, this measure is inadequate because it fails to address whether costs are covered.

Other organizations compare expected payment with Medicare expected payment to determine the profitability of a contract. Unfortunately, this measure is not related to the cost of service delivery for the patient population of that contract. In addition, it ignores the fact that Medicare payment is a government-established rate that varies year to year based on the political climate.

A traditional business profitability measure is based on the difference between payments and costs. Therefore, the first challenge in creating a meaningful profitability indicator is defining the measures to be used for payment and cost in the calculation.

Profitability requires some measure of payments. Charges are not as relevant as they once were. Expected income based on modeled contract terms and actual service utilization is a reasonable measure of payment due to the organization.

Ultimately, however, organizations may want to refine this measure further and look at actual realized revenue (expected income less denials, underpayments, and overrecoveries) on a retrospective basis. Generally, realized revenue is less than expected income, thus lowering the revenue basis for profitability calculations. The difference in yield between realized revenue and expected income varies among payers and may change over time.

To compute profitability requires a cost estimate. Where a cost accounting system exists, using actual costs as the source for cost information is best. Alternatively, a ratio of costs to charges can be used where there are no reliable cost data.

Given the dominance of managed care, full costs, including both fixed and variable, should be included in any cost measure used. Basing profitability solely on coverage of variable costs fails to recognize that managed care contracts must cover their full costs in the long run.

Using payments with costs allows an organization to measure managed care profitability. Some organizations prefer to compute profit margin, also referred to as net revenue margin, as a measure of profitability:

Expected Revenue--Full Costs/Expected Revenue x 100

Example:

$1,040,000-1,000,000/1,040,000 x 100 = 3.846%

An alternative measure of profitability is expected payment as a percentage of full costs:

Expected Revenue/Full Costs x 100

Example:

$1,040,000/$1,000,000 x 100 = 104%

Whichever profitability measure is used, this metric can consistently measure profitability across contracts and over time.

Three Baseline Measures to Report to the Executive Team

Although countless measures of managed care contract performance can be developed, there are three essential performance measures that should be provided to the executive team. They provide a view of overall performance of the managed care book of business as well as that of major contracts.

Overall managed care profitability. Profitability of the managed care payer segment is critical to the health of the organization. The first measure, therefore, should track profitability of the overall managed care book of business. A five-year profitability trend line allows management to see where this business has been and anticipate where it is going. This measure can be contrasted with total organization profitability to better understand correlations between the two.

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For the provider illustrated, the sharp drop in managed care profitability in 2002 contributes to the declining profitability of total operations. It illustrates the close tie that exists today for many providers between managed care profitability and overall margin. Although historic profitability is a lagging indicator, using a trend line of historic performance provides a hint of where profitability may be going. In this example, proactive contracting had not been occurring and was overdue. Had the executive team members been monitoring overall managed care profitability, they would have been able to address the problem when less adjustment to overall rates was needed.