Cost accounting—hospitals' nickel-and-dime path to profitability

Hospitals have long operated under an arbitrary fee-for-service model that pays for volume, not outcomes. As normal economic actors, it's not surprising that hospitals too often provide unnecessary and overpriced treatments when Medicare and other health insurers pay them for doing so. Revenue rules.

Unfortunately, hospitals' intense focus on optimizing revenue has atrophied their ability to understand and manage operating costs. Today, this operating deficiency poses a serious challenge for hospitals as the market moves toward value-based purchasing.

To adapt, hospitals must develop sophisticated cost accounting capabilities that align quality improvement with cost reduction. This becomes more imperative as customers move into high-deductible plans and face the sticker-shock of paying first-dollar costs.

As consumers and employers shop for medical services, hospitals are experiencing increasing demands for price transparency and lower prices. Pricing pressure can be particularly intense for routine procedures (and most procedures are routine).

There's no turning back. Castlight's entire business model (and its $1.1 billion market value) is predicated on delivering price and quality transparency to U.S. healthcare.

It's not getting easier. A recent Standard and Poor's report found declining hospital profitability last year for the first year since 2008. Expenses grew by 7% while revenue increased by only 5%.

Worse yet, revenue increases came less from core operations (increased patient volumes), and more from consolidation and governmental incentive payments. The future is now. Hospitals receive lower payments for routine care and risk penalties for inferior care provision.

When profitability flattens, hospitals instinctively deploy sophisticated revenue-cycle strategies to improve earnings. This approach is inadequate in a post-reform world.

The cost, quality and price of every healthcare procedure must align. Better collection systems won't get the job done.

As companies in other consumer industries have learned, it is impossible to offer competitive pricing and remain profitable without advanced cost accounting systems to determine per-unit costs, optimize productivity and improve quality.

Most hospitals, however, lack effective cost accounting systems, have a limited understanding of per-unit costs and aren't well-positioned for productivity improvement and competitive price-setting. Moreover, few hospitals have the organizational culture necessary to improve quality and efficiency while reducing costs.

Hospitals that fail to develop these capabilities may not be sustainable. In other industries, customers make purchasing decisions based on price, product quality and customer experience. Profits come when per-unit revenue exceeds per-unit costs.

Cost accounting rules. As more healthcare revenue links to performance, hospitals must learn how to do the same: Correlate per-unit revenue, quality and costs.

Growing volume will no longer automatically translate into greater profitability. Supported by effective cost accounting, earning more nickels and dimes through the higher productivity will differentiate winning and losing hospitals.

David Johnson spent 28 years as an investment banker at Merrill Lynch, Citigroup and BMO Capital Markets before launching 4sight Health, a healthcare consulting firm.