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

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

If both direct and allocated costs are included, it is likely that the transfer price will exceed the price at which the patient care department could purchase the item from an outside supplier. This fact, in turn, impedes the ability of the hospital's profit centers to achieve their financial goals. Similarly, an IDS does not want charges billed to it by its own providers to exceed the cost of those services if obtained from outside providers. Therefore, regardless of whether its provider entities are designated as profit centers or standard expense centers, an IDS can have its HMO purchase services from the system's own providers via transfer prices.

Because the transfer pricing methodology creates a set of incentives for the managers of its provider entities, the way an IDS establishes its transfer prices can influence the effectiveness of its financial controls. The nature of the incentives depends to a great extent upon the chosen payment unit.

In a hospital or nursing home, for example, a per-diem payment creates an incentive for long inpatient stays, for two reasons - the per diem must cover both fixed and variable costs, and most hospitals and nursing homes have a sizable base of fixed costs. Similarly, a per-discharge payment, whether diagnosis adjusted or not, encourages providers to increase the number of admissions, shorten inpatient stays, and/or seek a case mix with a high contribution margin (low variable costs relative to the payment rate). Cost-effectiveness - reducing admissions or accepting low-margin patients - actually is penalized because some of the provider's fixed costs will not be reimbursed. Integrated systems now face the same potential problems with their own provider organizations.

Single versus Two-Part Transfer Prices

The problem of per-unit transfer pricing is not unique to health care. In a commercial system, the incentive to sell a large number of units is considered acceptable; indeed, it is a fundamental characteristic of capitalism.

When the transaction is something other than arm's length, however, the incentives in a commercial system generally are considered dysfunctional. Therefore, many multidivisional corporations set two-part transfer prices in direct recognition of the presence of fixed and variable costs in selling divisions "whose primary purpose is to make intermediate products for other divisions."(c)

A two-part transfer price is based on the idea that fixed costs are time based and variable costs are volume based. Each buying division pays its share of a selling division's fixed costs on the basis of time, usually a flat amount per month, and pays for the selling division's variable costs on the basis of the number and mix of purchased units. As a result, a two-part transfer price blunts the selling division's incentive to either charge higher-than-necessary prices to buying divisions or produce unneeded volume. When there are multiple buying divisions, each division's share of the selling division's fixed costs usually is based on anticipated demand, which generally is considered the major driver of capacity and, hence, fixed costs.