At the Margins

Why my post on health care costs made one member very angry

Health care costs are a hot-button issue. But I have to admit I was still surprised at the furious email I got recently from one Advisory Board member who read my blog post on the difference between ‘cost’ and ‘cost.’

What did I do wrong?

Too imprecise about accounting terms

It wasn’t a disagreement about politics, or a dust-up over who’s responsible for bending the health care curve. My sin was imprecision. The member, a financial analyst at a community hospital, took me to task for not clearly delineating the difference between fixed and variable costs, on one hand, and direct and indirect costs on the other.

What I originally wrote was:

    First of all, there are "hospital input costs," by which I mean, "the costs that a hospital incurs to provide care." This includes the "variable costs" of everything it takes to treat an individual patient: the salaries of nurses and techs, as well as costs of supplies and drugs. It also includes the "fixed costs" of keeping the hospital in operation, such as electricity, major pieces of equipment, and even the land and buildings.

    CMS and other insurers sometimes track "direct" and "indirect" hospital input costs, which are almost, but not exactly, the same as fixed and variable costs.

As my correspondent pointed out, direct costs and variable costs are not the same thing in the world of cost accounting; in fact, a cost can be direct but not be variable. The classic health care example of this is the salary of a hospital nursing supervisor, whose work is directly attributable to patient care, and therefore “direct,” but does not vary directly based on the number of patients in the hospital—and thus is “fixed.”

Getting more specific about direct vs. variable costs

So I tried to clarify the original post as much as I could, adding a sentence that says:

    "Direct costs" are those costs directly associated with patient care, while "indirect costs" are other costs.

(Inelegant, perhaps, but I didn’t want to further confuse what was already a complicated post about five different other types of costs.)

But this whole episode got me thinking: why do these accounting distinctions really matter? Especially for people in health care who may not know (or care) about the difference between a balance sheet and an income statement?

The more I thought about it, though, the more I wondered whether cost accounting could be one of the keys to population health management success.

Why? Because effective population health management will inevitably result in the elimination of certain health care services consumed today: better prevention will obviate the need for health care, better management will result in the substitution of less intensive procedures, and better practice will result in more compliance with clinical guidelines and therefore, in many cases, fewer diagnostics or procedures.

(If you want evidence, just check out the sometimes amazing levels of variation our Crimson research teams found when they mined inpatient imaging utilization data from across the cohort of participating hospitals.)

Why accounting matters to care transformation

From the perspective of the insurer (or the accountable care organization) the financial impact of eliminating ten $1,000 MRI scans is equivalent to eliminating one $10,000 knee replacement: $10,000 in costs not incurred.

But from the perspective of the health care provider, the impact is not at all the same.

The MRI story: The real variable cost associated with providing an MRI procedure is the cost of the radiology technician’s time, the cost of the contrast agent (if any), and the cost of the radiologist’s time for reading and interpreting the MRI exam. In sum, those costs might total $200 per exam, a small fraction of the price. This is because the lion’s share of the cost associated with MRI exams is fixed: health providers need to defray the million-dollar cost of an MRI scanner, so they spread the scanners’ cost over many thousands of exams.

Still, because most of the MRI costs are fixed, eliminating one hypothetical MRI exam would result in $1,000 less revenue for the provider, but reduce only $200 of the provider’s costs. The net impact for the provider would be $800 less per exam, or $8,000 for ten exams.

The knee replacement story: For MRIs, technology accounts for a great deal of the procedure cost, but in the case of knee replacement it is the cost of the implant—say, $5,000 of the $10,000 total. That implant cost is a variable cost; the hospital only incurs it if the patient actually has the knee replacement procedure. And the other costs associated with the procedure—nursing care, drugs, supplies, and so forth—are largely variable as well.

What that means is that variable costs might account for as much as $8,000 of our hypothetical $10,000 knee replacement procedure. And so if one of those procedures is averted, the negative impact on the health care provider is only the $2,000 difference, which would have otherwise gone to pay for fixed costs and profit on the procedure.

In other words, eliminating the MRI scans would have a much bigger negative impact on health care provider finances than eliminating the knee replacement procedure.

But you would only know that if you were careful about tracking the different types of costs associated with each procedure. And that’s a discipline that not every health care provider has—let alone the ability to pull up and analyze the data correctly in their information systems.

The moral? For success in the value-based health care market, maybe all of us (and our information systems too) need to take a refresher course in cost accounting.

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The Episodic Cost Profiler outlines average Medicare spending by condition and site of service 30, 60, and 90 days after admission—so you gain visibility into the distribution of costs within and beyond hospital walls.


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Gain Visibility into Costs Across the Care Continuum

The Episodic Cost Profiler outlines average Medicare spending by condition and site of service 30, 60, and 90 days after admission. Use the tool »


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Meet the Author

Michael Koppenheffer
Executive Director