Hospitals' supply costs rising faster than volume

For the third year in a row, patients seeking treatment at Froedtert Health, a Milwaukee-based system, have been sicker than they were in years past. And the specialty drugs it purchases for conditions such as hepatitis C are getting more expensive.

As a result, Froedtert saw its supply costs shoot up 14.5% in its fiscal 2014, which ended June 30. Salary and fringe benefit costs also increased a combined 14.4%, in part because of higher-acuity patients but also because of its strategy of buying physician practices.

The overall rise in expenses narrowed its operating margin for fiscal 2014. Despite a 10.4% year-over-year increase in revenue, it finished the year with a 5% operating margin compared with 5.6% the previous fiscal year.

After a quiet 2013, many health systems such as Froedtert are beginning to see volume pick up, particularly in states that have expanded Medicaid under the Patient Protection and Affordable Care Act to adults earning up to 138% of the federal poverty level. Demographic trends, such as the aging baby boomers, also are moving in hospitals' favor.

But as more care is delivered in an outpatient setting, the patients who wind up in the hospital tend to have more complex medical needs than they did in the past. These higher-acuity patients require more equipment and more sophisticated technology, driving up supply and labor costs at a time when systems also are facing public and private payment squeezes.

As a result, for many systems across the country, the expense side of the balance sheet is growing almost as fast as the revenue side, prompting providers to look for new ways to cut costs.

A Modern Healthcare analysis of fiscal 2014 financial results for 59 not-for-profit health systems found that operating expenses increased an average of 6.2% while revenue increased 6.7%. More than half of the systems in the analysis reported a year-over-year decline in their operating surplus.

While higher patient volume is generally a good thing for hospitals, providers are also seeing more patients who previously were uninsured or underinsured, said Lori Pilla, vice president of supply chain optimization at Amerinet, a group purchasing organization. At the point where these patients arrive for care, they often require a higher level of service.

At HCA, the largest hospital chain by revenue, the acuity of patients covered by health plans purchased through Obamacare insurance exchanges is running about 8% to 10% higher than among its nonexchange, managed-care patients, executives said during a third-quarter earnings call. The Nashville-based company attributed the difference to fewer obstetrics patients in the exchange group. HCA said it expects its patient acuity to continue to increase as care for less serious conditions moves to the outpatient setting.

Providers such as HCA and Tenet Healthcare Corp. also said they're concentrating on expanding their specialty service lines as a way to recruit physicians and attract new patients. But investing in cardiac catheterization labs and emergency departments requires costly equipment that can quickly run up expenses, particularly for smaller hospitals that might not get the same volume boost, Pilla said.

Amerinet looks at a hospital's payer mix and most common billing codes and compares those factors to the hospital's purchasing habits. A small rural facility, for instance, would be advised against investing in a robotic surgery system if it doesn't have the volume to support the cost, especially for indications where it won't see additional reimbursement, Pilla said.

Earlier this year, Sentara Healthcare asked its employees for ideas on boosting quality while also cutting costs. The 12-hospital system based in Norfolk, Va., saw a 10.7% increase in costs associated with medical supplies, purchased and contracted services, and taxes and licenses during the first nine months of 2014.

Its performance-improvement initiative is designed to take a hard look at all of its nonsalary operating costs. About 300 suggestions poured in, including simple solutions such as using in-house dietary departments instead of outside vendors to cater meetings and events. Savings just from that one change could reach $745,000 through the end of next year.

“There's a tendency at organizations for expense creep,” said Michael Gentry, corporate vice president at Sentara, who credited the initiative with helping to hold down overall costs.

Sentara's focus is on standardizing practices across its growing portfolio of hospitals. Sentara's same-hospital admissions have been flat, but the system did see additional volume from two new takeovers. In July 2013, it merged with Halifax Regional Health System in South Boston, Va., and last February it finalized a long-term lease agreement to operate Albemarle Health in Elizabeth City, N.C.

One example of standardization was eliminating continuous passive motion as a standard of care in orthopedics. Continuous passive motion machines were designed to flex the knee joint after surgery but have shown no benefit in recent studies. Sentara expects to save more than $224,000 in 2015 from the move.

Similarly, it projects it will cut its imaging costs by more than $28,600 by performing CT scans without using contrast, which doesn't enhance the images from its 64-slice CT scanners. “The more variation we can push out, the better the clinical outcomes,” Gentry said. “And most of the time—not always, but most of the time—we can also save money.”

Sentara also is part of an alliance with Medstar Health, based in Columbia, Md., and Novant Health, based in Winston-Salem, N.C., to coordinate purchases for physician preference items.

Many systems have banded together to form regional alliances that still allow them to retain their independence, but offer the purchasing power of a much larger organization. The more that systems can coordinate their purchases—not only across their hospitals but also their physician practices—the more money they can potentially save, Pilla said.

Trinity Health, a not-for-profit system formed in 2013 from the merger of Trinity Health with Catholic Health East, has been leveraging its size to better manage its purchases, said Chief Financial Officer Benjamin Carter. Its three-year plan sets a goal to achieve $300 million in cost savings; the system says it has cut $50 million in its first fiscal year as a combined organization. Most of those savings came from the corporate office, in areas such as risk management, human resources and information technology. “We never take our eye off those synergies,” Carter said.

To tackle compensation costs, Trinity froze its pension plan for legacy employees of the pre-merger Trinity Health and moved all staff members to a defined-contribution plan. Vested employees had the option to take a lump-sum payout. It also cut the number of full-time equivalent employees by 1% this year, which will reduce its labor costs in fiscal 2015.

While systems are focusing on creative ways to cut costs, one area where they've run into difficulty is pharmaceutical supplies. New drugs for cancer and hepatitis C carry price tags in the upper five figures—or higher. “Pharmacy is the area where we're most challenged,” said Sentara's Gentry, who added that even prices for generic drugs have been rising.

“A lot of companies are very aggressive with drug prices,” said Don Ellis, a pharmaceutical analyst at Avondale Partners.

Hospital systems that also operate health plans particularly have felt the pinch of higher drug costs. Partners HealthCare, Boston, said its health plan incurred $10 million in costs associated with Sovaldi, the $84,000 hepatitis C drug that was approved last December. The Massachusetts Medicaid program has not yet determined whether it will pay Medicaid managed-care plans for the cost of the product, the system said in an earnings report.

Drugs costs are increasing much faster than the costs of other supplies. “If there's a cost anomaly, it's really in specialty drugs,” said Scott Hawig, Froedtert's CFO.

Although Froedtert doesn't have much control over drug prices, it can scrutinize the value they offer, such as whether they reduce hospitalizations. The system also is looking to its newly acquired health plan, Network Health, to help answer the question of how to drive down the cost of care. To that end, Froedtert has been opening additional ambulatory surgery and other outpatient centers to move lower-acuity patients to a lower-cost care setting.

Wisconsin implemented a modified expansion of Medicaid, opting to lower the income eligibility threshold to 100% of the federal poverty level while opening eligibility to single, childless adults. In the first quarter of 2015, Froedtert began to see the impact of that policy change when revenue from Medicaid patients grew to represent 14.3% of total revenue, compared with 11.8% during the same period last year.

Its overall patient volume increased 6.5% while its supply costs spiked 9.4%. But with its cost-control efforts, supplies now represent 18.8% of revenue compared with 19.5% during the first quarter of last fiscal year.

Froedtert has projected that its operating margin for fiscal 2015 will be in line with the previous year, Hawig said. And so far, after four months, it's beating that budget.

Follow Beth Kutscher on Twitter: @MHbkutscher