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

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

Determining the basis for a flexible budget. An IDS most likely would use days or DRGs as the basis for a flexible hospital budget, whereas it would tend to use visits or encounters for the flexible budget of a physician group practice or home health entity, or tests for a freestanding laboratory. However, not all inpatient days or DRGs require the same resources, nor do all visits, encounters, or tests. Thus, a flexible budget requires both volume and mix factors - meaning, the IDS will need to develop appropriate financial measurement and reporting systems. Simply modifying a cost-accounting system that worked well for cost-based reimbursement, or even for DRGs, will not do.

Administrative time and effort. Given the above complications, a two-part transfer pricing approach initially would be more time-consuming and costly to administer than a per-diem or per-discharge payment system. Over time, however, the administrative costs probably would decline as the IDS developed and refined its various systems and procedures.

Determining Payment Amounts

To define and pay reasonable costs and develop a realistic budget for its hospitals, an IDS's senior management must address two related issues. First, management must recognize that both case mix and volume lie largely outside a hospital's control. Instead, they are determined primarily by the morbidity patterns of the HMO's enrollees and by the decisions of primary care physicians to hospitalize patients or treat them in outpatient settings. Second, financial controls should focus on a combination of the hospital's fixed costs and the variable costs associated with three cost drivers: resources per case, efficiency of resource delivery, and factor prices.(d)

Once a patient with a given diagnosis is hospitalized, the hospital's (thus, the IDS's) incremental costs are determined by these three cost drivers - all of which are controlled largely from within the hospital, albeit by different occupational groups. By focusing on fixed and variable costs for the three cost drivers, an IDS can structure its HMO's payments to its owned provider entities using two-part transfer prices. In effect, a flexible budget and a two-part transfer price use the same methodology.

Step 1: Separate operating costs. Each provider entity must separate its operating costs into fixed and variable components. This task can be complicated, due to the presence of step-function costs in many hospital departments. When the separation is part of a transfer-pricing methodology, however, the provider entity and IDS senior management must agree on the approach, including volume corridors for each step.

At a minimum, fixed costs include depreciation and general administrative costs. Depreciation can be a function of existing assets, including buildings and equipment. Moreover, because the owned HMO would pay for its share of the depreciation component of fixed assets, the IDS's hospital(s) should expect to obtain prior approval from the HMO before acquiring new capital or technology. The HMO, in turn, would commit to partial payment for the new investment. For the IDS, this is a major governance issue that has important financial management consequences.