Philadelphia Reflections

Cost to Charge Ratio (2)

of the community when all is said and done, this system is designed to keep indirect costs within reasonable boundaries. If that aggregate is spoken of as a single product, its costs can be grouped together as company-wide costs. In the case of Apple, the main costs outside direct production costs are research and development, marketing and administration. In the case of hospitals, in addition to direct production costs, there is usually less marketing cost than a manufacturer would experience and considerably more charity. By calculating the variation of prices to costs among different products, it is possible to see which particular product is carrying the burden, and which product is being subsidized. In the case of hospitals, this analysis would permit an outside opinion to form about the fairness of such cross-subsidy, which is most commonly motivated by local competition. The neighbor hospital has some expensive gizmo and we don't; we buy a gizmo to keep up with them and subsidize its cost by overcharging for everything else. Decades ago there was a rage for establishing planning commissions to determine how many gizmos a community needs, but it was largely dropped because of bickering about what is normal business flexibility in every industry. It is now generally agreed that hospitals should have the business latitude to make these choices themselves, and suffer the consequences if unrelated prices get pushed out of line by cross-subsidies of excessive expansion.

Indirect costs are a much harder matter to judge. Some administrators are paid too much, some renovations are excessive, some charity is really poor debt collection; but if these things are passed off to insurance companies, who pass them off to the public, they can unduly escalate. Direct costs are whatever they are, but indirect costs are more a matter of opinion. Some insight can be gained by measuring the ratios of direct to indirect costs, and then making a national comparison of those ratios with peer institutions, a process that is hampered by the traditional regulation by states instead of nationally. Since the cost of health care has long been rising faster than the cost of living, the suspicion is fostered that insurance companies put up less price resistance than a marketplace without them would. Since the cost of major illness is often beyond the means of its victims, insurance does seem to be called for, and the higher the cost the more that is true. For more than seventy-five years, health insurance has been in the middle, between the party who wants lower prices, and the party who wants higher ones. That may well have been a bad decision, requiring some experimentation with a return toward "indemnity insurance" and away from "service benefits". That is, the insurance pays money to the patient, and the patient then pays the bill. An indemnity system protects the insurance company from cost overruns, and this at least removes the pressure for the insurance company and the hospital to collude against the patients' financial interest. Once a suspicion arises that there could be some degree of collusion between the two, it is possible to see that using insurers to police a hospital's indirect costs may be something to discourage. Alternatively, it might be possible to apply patient copayment to the indirect, but not the direct, hospital costs. At the moment, copayments have little or no effect on patient utilization, but the selective application of them might be worth at least a pilot study, to see if they could dampen prices better than they affect service volume. A copayment of 20% of the indirect cost component of a patient's bill would certainly draw attention. Even a 1% copayment would dramatize the point.

Hospital prices have been inflated far too much, and far too irregularly, to serve as cost signals. In order to minimize the true cost of charity care, the services more heavily used by the indigent have had their indirect costs minimized by cost-shifting them away to better-reimbursed departments; it is a perfectly natural thing to do. Poorly utilized departments are subsidized by better-reimbursed ones; so what else is new? To assign a fixed ratio of charges to costs would greatly hamper the flexibility needed to keep the institution from failing. But without some understood relationship between the posted, stated price and its true cost, the hospital doctors are quite unable to design a cost-effective treatment strategy. Knowing very well the lack of relationship between prices and costs, the doctors freely admit they disregard the prices entirely. While allegiance to what is scientifically best is not completely bad, it is not necessary to be so blind to the economics of the various alternatives. In time, it will lead to the design of model treatment strategies by committees. That is not itself a bad thing, except for the way it undermines individual thinking by the professional who is closest to the specifics of a case. That is a debilitating thing; a bad thing if you wish. It certainly lessens the potential for minimizing the cost of care, which is the flag it is flying. Some way must be found to improve the usefulness of prices as a guide to costs, an imperative which is otherwise certain to lead to the use of some degree of force to achieve it. And that would be a really bad thing.

from the for the Hospitals tend to be either for-profit corporations like Apple or nonprofit corporations with a different accounting system. It may help a little to know that for-profit corporations are measured by their profitability, while nonprofits are measured by the increase (or decrease) in their assets compared with last year. Items enclosed on a balance sheet with parentheses have always gone in an (unfavorable) direction. Increases (or decreases) in assets are intended to include gifts and variations in stock market prices. However, increases (or decreases) in assets like fine art don't count at all. Sometimes that can be highly misleading, as when the Barnes Art Collection increased in value by billions of dollars. Other assets, like buildings and equipment, are measured by depreciation, which is not always parallel to market prices. There is a movement favoring "mark-to-market", but investment firms are particularly opposed to marking to market, because temporary drops in market price are sometimes unrealistic, only requiring a little time to recover, a phenomenon sometimes seen in endowment funds, as well. Conventional measures of success, like the profit margin and the increase in net assets for nonprofits, are generally useful. But they can also conceal many traps. The most prominent one is to introduce these concepts when someone questions why everything costs so much as if to imply that it is unlikely that a hospital could be overcharging when it is only generating a 2% profit.

The ten dollar aspirin tablet is usually introduced at this point in the discussion, balanced by descriptions of accident room patients who try to pay nothing at all. The discussion is now one of cost-shifting. It must be obvious that the cost to charge ratio is well over a thousand percent for the aspirin, whereas Apple probably is less than a hundred percent for everything they sell you. Perhaps not, perhaps it is over a thousand percent for a number of retail items. In any event, the problem for the hospital customer is he has no way of telling what is being given free to bring the overall cost to charges down to 5%. That is, he is given no role in choosing the charity he is supporting, but he knows it varies widely between hospitals. He has to have some trust that the institution is behaving in a responsible way, which is difficult when he sees new and glistening hospital interiors or reads of seven-figure executives. Perhaps it is a little unfair to blame the trustees for avoiding embarrassing questions with no particular justification, but it does not seem unfair to ask that the hospital cost accountant prepare meaningful reports to both the management and the trustees. To the management first, to allow them time to look into oddities in the reports before having to answer for them. But no matter how it is handled, the cost accountant should be made more central than he usually is.

Every item ought to be assigned a cost to charge ratio, both inclusive and exclusive of overhead costs. It is usual to include overhead by a so-called step-down process since overhead must be paid and it generates no charges at all, only costs. But to include it in the net cost to charge ratio is potentially to bury one of the things you are trying to discover: is the overhead excessive? Having determined that point, it may be legitimate to re-include overhead in the "net" calculation of the cost to charges. Hence the suggestion of reporting it both ways. No one doubts the books balance; the items of expenditure include most of the costs. The essential issue is whether this is all pretty expedient, whether too much frivolous expenditure is being permitted by shifting its cost to certain profit centers. When this cost to charge system is compared among other hospitals or other years in the same hospital, it is possible to recognize the unusual items or departments quickly. However, the beginning trustee or utilization reviewer may need to have the costs and charges stripped out and aggregated, to highlight the highly deviant figures for ready appraisal. Consequently, it may be necessary for the insurance company to require reports of certain items, structured in that way. Other such reports may be needed to identify overpaid employees, or overstaffed departments, usually as patients and dollars per employee, compared with other institutions. Ultimately, it may even be necessary to establish norms, but that begins to resemble micromanaged cost control, when peer pressure may be all that is required.

Originally published: Wednesday, July 17, 2013; most-recently modified: Wednesday, May 15, 2019