Managing the stages of hospital cost accounting

Healthcare Financial Management, April, 1993 by David W. Young, Leslie K. Pearlman

Hospital A, feeling intense financial pressure due to Medicare's fixed-price payment for patients in each diagnosis-related group (DRG), wishes to determine its DRG "winners and losers." If it is to think strategically about its preferred mix of patients, Hospital A must have accurate, full cost information for patients in each DRG category. Unfortunately, the hospital's cost-accounting system optimizes revenue under a cost-based form of reimbursement. The hospital therefore needs to revise its cost-accounting system to determine the costs incurred by individual patients and patient groups.

Hospital B has received a request from a local health maintenance organization (HMO) to bid a price for performing uncomplicated hysterectomies for HMO patients. Hospital B's cost-accounting system does identify DRG winners and losers; however, the cost information provided by the system will be of little use in preparing the bid for the HMO. Because the system provides only full cost information, it does not distinguish between fixed and variable costs. The hospital therefore cannot base its bid on the variable cost of each hysterectomy, and it certainly will lose business to another hospital that can bid a price slightly higher than the variable cost for the procedure. Hospital B could determine variable costs by analyzing the cost behavior in a number of departments. This process will take several months, though. By that time, it will be too late for the hospital to submit a bid.

Hospital C has discovered that it has almost no DRG winners; in most instances, the full cost for care of a patient in a specific DRG exceeds the fixed Medicare reimbursement. If Hospital C is to avoid large operating losses, it must control its costs. Because Hospital C's cost-accounting system assigns costs only by cost center, it does not identify the managers or other individuals in the hospital who actually control costs. Hospital C's cost-accounting system must be altered to measure the performance of its managers, physicians, and other professionals who make the decisions that influence costs.

Hospital D has asked its managers, physicians, and other professionals to reduce their operating costs. But, these individuals insist they cannot squeeze any more slack out of their budgets without seriously compromising the quality of patient care. Indeed, in many instances, individuals in different departments have been working at cross purposes. For example, surgeons who wish to reduce their patients' lengths of stay are ordering stat laboratory tests. This practice has increased the staffing pattern in the laboratory and raised departmental costs far over budget. Senior management realizes that it must restructure the hospital's operating system to assure the institution's financial survival and redesign the cost-accounting system to fit with the new operating system.

Four stages of cost-accounting

These four hypothetical situations represent four stages in the development of new hospital cost-accounting systems. In Stage 1, hospitals improve their overall cost-accounting systems. In Stage 2, they assess cost behavior in their departments. In Stage 3, they control overall costs, and in Stage 4, they design new cost-conscious administrative systems. The stages are summarized in Exhibit 1.

Many hospitals have not reached Stage 1. These hospitals continue to operate with cost-accounting systems that worked well when the goal of senior management was to maximize revenue under cost-based reimbursement; however, these systems are inappropriate for the demands of fixed-price reimbursement under Medicare. Moreover, as other third-party payers, such as Blue Cross, move toward the adoption of DRGs, hospitals with cost-based accounting systems will find themselves even further behind. Without accurate, full cost information for each DRG, a hospital cannot identify its preferred mix of diagnoses. It therefore cannot determine the kinds of facilities, programs, equipment, and medical specialties it needs to develop strategically. Without accurate full-cost information by diagnosis, a hospital stands little chance of surviving.

Many hospitals have not progressed beyond Stage 1 to Stage 2. They have built their cost-accounting systems in a fairly traditional way to distinguish between direct and indirect costs and use relatively sophisticated allocation mechanisms. Unfortunately, these hospitals cannot use such cost-accounting systems when they bid competitively or determine the financial feasibility of subcontracting for some services, such as laundry, housekeeping, or laboratory testing. For these sorts of decisions, managers need information on cost behavior, which requires variable costs to be distinguished from fixed costs. The distinction between variable and fixed costs does not parallel the distinction between direct and indirect costs. Thus, the direct and indirect costs in a hospital's full cost system are of little use for a wide variety of decisions that managers must make.