Two-part transfer pricing improves IDS financial control - integrated delivery systems

Healthcare Financial Management, August, 1998 by David W. Young

To help coordinate patient care services across its various provider entities, an integrated delivery system (IDS) must address two financial control matters: design of responsibility centers and selection of an appropriate transfer pricing methodology. Although designating an HMO as a profit center is appropriate, such a designation is inappropriate for an IDS's provider entities. Instead, these entities are more appropriately designated as standard expense centers. Further, an HMO owned and operated by an IDS should purchase patient care from the delivery entities by means of two-part transfer prices, that is, having fixed costs paid for in a lump sum and variable costs paid for on the basis of the actual volume and mix of services provided. The IDS's management must recognize, however, that both case mix and volume lie largely outside a hospital's control and that financial controls should focus on a combination of the hospital's fixed costs and variable costs associated with resources per case, efficiency of resource delivery, and factor prices.

One of the goals of integrated delivery systems (IDSs) is the achievement of a high degree of clinical integration of patient care services across the system's various functions, activities, and operating units. a Clinical integration gives an IDS the potential to reduce overall healthcare costs while simultaneously improving quality of care and patient satisfaction.

To achieve clinical integration, an IDS confronts a variety of management challenges, including financial controls. In particular, senior management must design a financial control system that promotes goal congruence between the individual provider entities and the IDS. Without goal congruence, provider entities' decisions may conflict with the IDS's strategy, thereby impeding clinical integration and compromising the organization's financial performance. Central to an IDS's success in promoting goal congruence are the design of financial responsibility centers and the selection of an appropriate transfer pricing methodology.

Background

A true IDS consists of an HMO and a variety of owned or exclusively contracted provider entities at multiple levels of care. Many healthcare organizations that identify themselves as or aspire to become IDSs do not own an HMO and thus are not part of a fully vertically integrated IDS.

The formation of true IDSs, however, appears to be on the rise. During the 1990s, delivery systems were formed in many regions of the country, including rural areas, and some have since become vertically integrated. According to The Singer Report on Managed Care Systems and Technology, the number of IDSs grew by 78 percent from 77 to 137 between 1993 and 1995.(b) The newsletter predicts that within the next five years, there will be more than 300 IDSs nationwide. The Manasquan, New Jersey-based Managed Care Information Center estimates the current number of IDSs in the U.S. at 527.

The financial control model presented below is designed primarily for fully vertically integrated IDSs with exclusive buyer-seller relationships between their owned provider entities and HMOs. Clearly, some true IDSs are not organized with an HMO at the top, and most lack exclusive buyer-seller relationships. Nevertheless, the IDS still must manage the financial relationships between the HMO and the system's provider entities. Moreover, an integrating (as opposed to fully integrated) system can learn much from the financial controls used by a true IDS, particularly if the former expects to start or acquire an HMO or is being acquired by one. Indeed, because many systems are moving in the direction of true IDS status, the sooner senior management begins to develop an appropriate financial control system, the better. Waiting for optimal strategic and organizational conditions may delay the design effort until it is too late to remain competitive with other providers in the market.

The financial control issues facing senior management-responsibility center design and the selection of an appropriate transfer pricing methodology - cover a wide variety of matters. They include capital and operational budgeting, accounting for the distinction between fixed and variable costs, identifying cost drivers, aligning responsibility with control, improving clinical and administrative efficiency, and providing appropriate incentives to the managers of the IDS's provider entities. Some of these issues no doubt are familiar to senior management, but all require a change in mindset for systems moving toward true IDS status.

Responsibility Center Design

In a true IDS, the HMO de facto drives the activity of the entire organization, whether or not the health plan is organizationally at the top. Because the plan is responsible for the care of a defined population, it does not exist to serve the needs of the IDS's hospitals - rather, the hospitals serve the plan and its membership (as well as other patients) and, thereby, the IDS. Consequently, the HMO is the only or principal revenue generator and quite appropriately is designated as a profit center. One of senior management's tasks is to determine whether the organization's owned provider entities - hospitals, physician group practices, IPAs, PHOs, home health agencies, nursing homes, and so forth - also should be designated as profit centers.