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CHAPTER 10
Managing Costs and Revenues
Matthew Dyer
With acknowledgement to Suzanne Discenza and Kevin D. Zeiler for their contributions to this
chapter in previous editions of this textbook.
LEARNING OBJECTIVES
By the end of this chapter, the student will be able to:
■ Evaluate the importance, purpose, and major objectives of financial management in
health care organizations;
■ Compare and contrast tax status implications of for-profit versus not-for-profit health care
entities;
■ Assess the primary methods of reimbursement to providers;
■ Apply methods for classifying and controlling costs;
■ Explain the value of cost allocation and determining cost drivers;
■ Evaluate determinants and initial processes considered by health care managers in
setting charges/prices for products and services;
■ Appraise the purposes, primary sources, and major problems associated with managing
working capital;
■ Analyze some of the important issues and major processes involved in managing
accounts receivable in health care organizations;
■ Examine the importance, basic tenets, and commonly accepted methods for managing
materials and inventory;
■ Analyze the major characteristics and types of budgets utilized by health care managers;
■ Critique the basic tenets of health care billing and coding principles; and,
■ Discuss special research issues related to managing costs and revenues.
In T
troduction
he purpose of this chapter is to give a general overview of the various components of
financial management within health care organizations, providing examples and applications.
Students in health care management and administration frequently become apprehensive about
dealing with the financial management aspects of the field. No matter how anxious these
materials make you, it cannot be emphasized enough that a solid understanding of finance is
critical to any student who desires to better understand the business function—and to get ahead
in the field. The entry-level management position will, at the very least, require an understanding
and grasp of the basic concepts of accounting and finance principles, budgets, billing and coding,
and forecasting goals and techniques. Each section of this chapter will provide an overview that
will help with future studies and lay the groundwork for continued research and application. We
will all consume health care many times during our lifetimes; therefore a general understanding of
health care finance is also invaluable to one’s personal life.
What Is Financial Management and Why Is it Important?
Health care financial management is the process of providing oversight for the health care
organization’s day-to-day financial operations as well as planning the organization’s long-range
financial direction. Put simply, financial management is used to inform strategic decision making
which involves working to increase the revenues and decrease the costs of the organization. This
involves making organizational forecasts, while taking into consideration numerous external
environmental variables such as the economy, insurance company policy changes, legislative
rules and regulations, and so on. These can have profound impacts on the financial forecast.
Ultimately, it is the goal of the finance department to put the organization in the best position
possible.
Finally, post Affordable Care Act (ACA), all students, health providers, and financial personnel
must understand that financial management will be an ever-changing field that will continually be
affected by outside influences. The ongoing uncertainty surrounding the repeal, replacement, or
retention of the ACA has caused many health care providers concern because it makes strategic
planning for the future challenging. This statement does not mean the uncertainty surrounding the
ACA is going to ruin the health care industry; instead, it means that the savvy financial manager
will need to stay on top of industry changes in order to maintain the financial health of the
organization.
Most health care organizations attempt to meet their economic goals by charging their finance
departments with both accounting and finance tasks. These functions help to establish the
groundwork for reaching the aforementioned goals.
Accounting consists of two types:
1. Managerial accounting, in which financial data are oriented towards operational
reports and are provided concurrently or prospectively to internal users (managers,
executives, and the organization’s governing board); and,
2. Financial accounting, in which data are oriented towards financial statements and are
provided retrospectively to external users (stockholders, lenders, insurers, government,
and suppliers).
Finance generally includes:
1. Borrowing and investing funds; and,
2. Analyzing accounting information to evaluate past decisions and make sound decisions
that will affect the future of the organization.
The primary purpose of financial management is to assist organizational decision makers with
accurate and timely accounting information to support strategic decision making to advance an
organization’s business interests. This includes reviewing prior budgeted accounting data to
compare to actual accounting data to determine why any variances occurred. Understanding why
variances occurred is key to informing the next round of financial planning for an organization’s
future.
The latter implies the importance of involving managers at all levels of the organization in financial
analysis and decision making. For example, the manager in the radiology unit of a hospital should
be directly involved in looking at both the revenues, i.e., the amount of money generated by
procedures (X-rays, ultrasound procedures, CT scans, etc.) performed in the department and the
expenses incurred (i.e., money that is spent) in running the department, in addition to being
involved in hiring personnel, managing appropriate staffing ratios, making decisions involving the
replacement or purchase of equipment, and so on.
Tax Status of Health Care Organizations
In order to fully comprehend the financial needs and constraints of any given health care
organization, it is important to first determine the tax status of that organization. A health care
organization’s tax status typically has either of two classifications: for-profit or not-for-profit. We
can further break down the not-for-profit into two categories: public or government-owned. For the
student’s clearer understanding, they have been arranged somewhat differently below, and
additional comments have been included:
■ For-profit, investor-owned health care organizations: These organizations are owned by
investors or others who have an interest in making a profit from the services that are provided.
These are normally viewed as the for-profit organizations that are required to pay taxes as a
cost of doing business. Traditionally, this has included most physician practices and skilled
nursing facilities.
■ Not-for-profit health care organizations: Historically, these organizations have taken care of
the poor, needy, and indigent residents of communities and have been granted tax-exempt
status. They include the following groups:
1. Business-oriented (private) organizations, which are characterized as private
enterprises with no ownership interests, that are self-sustaining from fees charged for
goods and services, are exempt from income taxes and may receive tax-deductible
contributions from those who support their mission and must provide a certain amount
of charity care or community service. Based on their relationships with religiously
affiliated organizations, it is not surprising that this group has included an overwhelming
majority of hospitals.
2. Public not-for-profit organizations are publicly funded but are not directly managed by
the government. These types of organizations are exempt from paying taxes and can
issue debt (borrow money) directly to investors which in turn typically receive the
benefit of tax-exempt interest payment revenue. An example of a public not-for-profit
organization is a public health clinic which generally provides health care to the
medically indigent.
3. Government-owned organizations are influenced by political interests and are exempt
from paying taxes. An example of a government-owned health care organization is a
government-owned hospital. These types of hospitals can also issue debt directly to
investors which can receive tax exempt interest payment revenue.
In addition, there are significant differences in financial management goals based on tax status,
which can be summarized as follows:
■ Financial goals in for-profit organizations: The primary financial goal of a for-profit health care
organization is to maximize profits and financial benefits for the owners and/or shareholders.
Simply put, to make money. This does not always lead to quality patient care because the
primary incentive is to maximize profits.
■ Financial goals in not-for-profit organizations: Not-for-profit organizations still attempt to
optimize their financial gain but attempt to do this while providing a community benefit. This
usually does not lead to optimal financial gain but leads to providing vital services to the
community, many of whom would otherwise not receive those services.
TABLE 10-1 delineates the primary differences between for-profit and not-for-profit health care
organizations.
TABLE 10-1 Comparison of For-Profit and Not-for-Profit Organizations
| For-Profit | Not-for-Profit |
| Serve private interests | Serve public or community interests |
| Pay federal and state income taxes on profits, state and local sales taxes, and property taxes |
Are exempt from taxes; health care organizations receive 501(c)(3) designation if they meet federal IRS criteria |
| Must file an annual for-profit tax return | Must file the IRS 990 annual corporate tax return, including a community services benefits report |
| Are motivated by profit, with income benefitting individuals |
Revenues cannot benefit individuals, beyond payment of reasonable salaries |
| Must pay business fees | Are exempt from paying most business fees and licenses |
| Must adhere to taxable bond yields | Can access tax-exempt bond markets to raise capital |
| May participate in political campaigns and influence legislation |
Typically, may not participate in political campaigns or influence legislation |
| Able to issue stock to raise capital and offer stock options to recruit and retain staff |
May not issue stock or offer stock options to staff |
| Have limited obligation to provide indigent care | Must provide designated amounts of community benefit, including indigent care |
Financial Governance and Responsibility Structure
The organizational structures of these health care organizations may also be affected by their tax
status, although the largest differences are probably seen in the structures of their governing
bodies, or boards of directors or trustees. While similar types of professionals (or “volunteers,” in
the case of not-for-profit boards) are specifically charged with financial accountability and
stewardship, in smaller organizations one individual may perform several of the separate
functions. Knowing the organizational structure of the financial components of the organization
will allow all managers to access the appropriate individual(s) in order to make judicious financial
decisions for their departments or divisions. In order of responsibility:
■ The Governing Body, the Board of Directors or Board of Trustees: These bodies’ primary
responsibilities include: establishing organizational direction, planning, financial oversight,
supervision of the CEO or Executive Director, and serving on committees. All these
responsibilities are meant to ensure the proper use of organizational resources. This is often
referred to as providing a “fiduciary” role, where the board is expected to act in good faith in
managing the finances of the organization. In for-profit organizations, the Board of Directors
may be paid, but a Board of Trustees serve strictly as volunteers in most not-for-profit
organizations.
■ The chief executive officer (CEO) is hired and delegated authority by the board and serves
as chief administrator of the operations of the entire organization. The CEO’s fiscal
performance is monitored through the board’s Finance Committee.
■ The chief operating officer (COO), often the senior vice president, is responsible for the dayto-day operations of the organization.
■ The chief financial officer (CFO), who may also serve as a vice president, is responsible for
the entire financial management function of the organization. The CFO oversees two primary
financial branches, involving (1) the accounting function and (2) management of financial
assets. The CFO directly supervises the controller and treasurer (and occasionally one other)
directly in charge of these functions. In some organizations, the COO and the CFO may be the
same person.
■ The controller (also called the comptroller) is the chief accounting officer responsible for
the accounting and reporting functions, including financial record keeping. They oversee such
departments and activities as patient accounts, accounts payable, accounts receivable, cost
analysis, budgets, tax status, the generation of financial reports, and sometimes internal
auditing.
■ The treasurer is charged with the stewardship of the organization’s financial assets, including
cash management, commercial bank relations, investment portfolios, management of
pensions or endowment funds, capital expenditures, management of working capital, and
long-term debt obligations.
■ The internal auditor is often a separate staff position from the CFO in large health care
organizations and is responsible for ensuring that the accounting, bookkeeping, and reporting
processes are performed in accordance with generally accepted accounting principles
(GAAP), the nationally accepted rules that determine how financial information is recorded
and reported. GAAP includes, among other things, the overarching ideas of conservatism,
consistency, and matching of revenues and costs. The internal auditor protects the
organization’s assets from fraud, error, and loss.
■ The chief information officer (CIO), present in many large health care organizations, is the
corporate officer responsible for all health information systems, including medical records,
computer systems, health informatics, and other applications. The CIO reports either to the
CFO or directly to the CEO.
■ The independent auditor, generally a large accounting firm, is retained by the health care
organization to ensure that all financial reports sent to external entities are accurate as to
format, content, and scope in presenting the organization’s true financial position.
All managers in a health care organization are financial managers to the extent that they consider
asset selection, charges, financing, reimbursement, and/or department budgets. This shared
responsibility at all levels of the organization serves to maximize efficiency and accountability.
Managing Reimbursements from Third-Party Payers
One of the major objectives of financial management involves facilitating and managing thirdparty reimbursements, which is vital to generating revenues for the daily operations, growth, and
competitiveness of the health care organization. The process of managing reimbursements from
patients and third-party payers is often referred to as Revenue Cycle Management. This section
will discuss both the methods of payment to providers by managed care organizations (MCOs)
and other private insurers and reimbursements to providers from public entities such as Medicare
and Medicaid.
What Are the Primary Methods of Payment Used by Private Health Plans
for Reimbursing Providers?
Private health care plans use a variety of methods for reimbursing the providers servicing the
plan’s enrollees. Some are utilized more frequently than others for payments to different provider
groups. They are classified according to the amount of financial risk assumed by health care
organizations and whether reimbursements are determined after or before health care services
are delivered.
Retrospective Reimbursement
Under retrospective reimbursement, the amount of reimbursement is determined after the
delivery of services, providing little financial risk to providers in most cases. It can involve the
following methods:
■ Charges: Health care providers are paid close to or at 100% of their submitted prices or rates
for care provided. Because there is virtually no financial risk to providers, these are no longer
common. Where full charges persist, they are with self-pay patients and uninsured individuals,
who do not have insurance companies to negotiate discounted rates on their behalf.
■ Charges minus a discount or percentage of charges: Health care organizations offer
discounted charges to third parties in return for large numbers of patients. This is the second
most common form of reimbursement to hospitals.
■ Cost plus a percentage for growth: Health care institutions receive the cost for care
provided, plus a small percentage to develop new services and products.
■ Cost: The organization is reimbursed for the projected cost, expressed as a percentage of
charges. While this method provides the smallest amount of reimbursement to providers, there
is little risk unless full costs (direct costs of providing care plus indirect costs or overhead
for running the organization) are not recognized.
■ Reimbursement modified on the basis of performance: The provider is reimbursed based
on quality measures, patient satisfaction measures, and so on. Obviously, this method poses
more risk for providers.
Prospective Reimbursement
This method of reimbursement to providers is established before the services are provided to
patients. These are the primary methods utilized by managed care organizations (MCOs):
■ Per diem, in which a defined dollar amount per day for care is provided. This is the most
common method of reimbursement to hospitals. It presents risks and incentives. It tends to be
bad for acute-only patients, for whom greater costs are incurred earlier in care without the
opportunity to make up differences later, when less intense services may be needed.
■ Per diagnosis, in which a defined dollar amount is paid per diagnosis. It provides risks and
incentives. Most common are those similar to the rates utilized by the Centers for Medicare &
Medicaid Services (CMS) for Medicare reimbursements, including Diagnosis-Related
Groups (DRGs) for hospitals, Resource Utilization Groups (RUGs) for nursing homes, and
Home Health Resource Groups (HHRGs) for home health care. Additional rates have more
recently been determined for outpatient and inpatient rehabilitation hospital services. In
virtually all cases, fewer patient treatments or visits, and/or shorter hospital stays, are now
being provided for any given diagnosis.
■ Accountable Care Organizations (ACOs): The model of the ACO is based on the idea that
groups of providers come together and take responsibility for delivering care to a defined
patient population (Colla, Lewis, Shortell, & Fisher, 2014). This approach uses a primary
care physician (PCP) to orchestrate the care delivered. The ACO is encouraged to deliver
efficient and appropriate care and to keep patients healthy. The approach relies heavily on
information technology, so that providers have access to medical records, particularly test
results, which is intended to prevent duplication. If those goals are achieved and costs are
reduced, the ACO is eligible to share in the savings with Medicare. ACOs differ from HMOs in
that the PCP doesn’t act as a gatekeeper and patients have the choice of going out of network
to receive care (Gold, 2014).
■ Bundled Payments: This model is based on the idea of providing a single payment for a
specific episode of care or a specific procedure. Instead of paying multiple providers to
perform their specific tasks in, for example, a surgery such as a knee replacement, a single
payment is made. Under this model, “a group of providers receives a fixed payment that
covers the average cost of a bundle of services” (Ridgely, de Vries, Bozic, & Hussey, 2014,
p. 1345). CMS has developed four models of payment under its Bundled Payments for Care
Improvement Initiative, which is being used to test different methods of reimbursement
(retrospective and prospective), as well as different types of bundling (CMS, 2013). The
models are being phased in at different times “to assess whether the models being tested
result in improved patient care and lower costs to Medicare” (CMS, 2014, para. 4). The
Advisory Board Company (2014) reported that many provider groups have signed up to
participate in this program as of summer 2014, but a report on an early demonstration in
California indicated that problems existed with the program and that few contracts were signed
to continue after the initial phase of the demonstration; specific concerns were with “a number
of barriers, such as administrative burden, state regulatory uncertainty, and disagreements
about bundle definition and assumption of risk” (Ridgely et al., 2014, p. 1345).
■ Fee-for-Service (FFS), which is the most common method for reimbursement of specialty
physicians. Health care providers are paid the lesser of a negotiated contractual rate or
amount of charges billed for services rendered based on the Current Procedural
Terminology (CPT) code. Generally, no organization would bill under their contracted rate,
but this does happen due to the lack of proper financial oversight and understanding of
reimbursement. In general, the more complex and time-consuming the procedure, the higher
the rate of reimbursement.
■ Capitation is an agreement under which a health care provider is paid a fixed amount per
enrollee “member” per month by a health plan in exchange for a contractually specified set of
medical services in the future. Negotiated capitated payments are based on perceptions of
expenses for a population. Thus, capitation shifts the risk of coverage from the insurer to the
provider of care, providing the most financial risk but also the most opportunity for financial
gain. It is the most common reimbursement method for primary care physicians in MCOs,
providing penalties and withholdings for too much care and bonuses as an incentive for
ordering lower levels of care.
■ Medical Home: This model also focuses on connecting patients to primary care, linking them
to all types of services, and developing a system that encourages and assures quality of care.
The concept of the medical home, which is also referred to as the patient-centered medical
home (PCMH), is not new, as it was initially devised in 1967 to provide care to children with
special needs (Health Resources and Services Administration [HRSA], n.d.). What is new is
that it has been adapted for coordinating the care of adults and other children. The Affordable
Care Act “contains various provisions that support implementation of the medical home model
including new payment policies, Medicaid demonstrations, and the creation of Accountable
Care Organizations—which are similar to medical homes, on a larger scale” (National
Conference of State Legislatures, 2012, para. 7).
The medical home model is based on the following seven principles as adopted by the American
Academy of Family Physicians, the American College of Physicians, and the American
Osteopathic Association:
1. Personal physician: patients are linked to a primary care physician (PCP).
2. Physician-directed medical practice: a team of care givers works with the PCP to
provide and be responsible for care; this includes nurses, social workers, nutritionists,
etc.
3. Whole person orientation: the PCP and the team take a holistic approach to the patient
and assume responsibility for all types of care across the person’s entire life, including
primary care, behavioral health, chronic care, etc.
4. Care is coordinated and/or integrated: all types of providers within the health care
system and community can become involved in the provision of care in order to assure
that appropriate care is provided.
5. Quality and safety are hallmarks of the medical home: providers and patients work
collaboratively to assure quality and good outcomes.
6. Enhanced access to care: practices make access more accessible through offering
expanded hours and improved communication with patients.
7. Payment: payment includes coverage of the management of care, specific provider
visits, inpatient procedures and stays, as well as the sharing of any savings derived
from the management of care (HRSA, n.d.; National Conference of State
Legislatures, 2012).
A recent survey of 172 patient-centered medical home initiatives found extensive expansion in the
number between 2009 and 2013. The study also found that private insurers, Medicaid, and
Medicare participated; used different types of payment reform incentives, such as FFS, pay for
performance bonuses, per member per month (PMPM) payments, and various combinations of
these; covered almost 21 million people; and concluded that the “model is likely to continue to
both become more common and to play an important role in delivery system reform” (Edwards,
Bitton, Hong, & Landon, 2014, p. 1823).
The third-party reimbursement system in the health care arena has become so complex, many
health care providers (including hospitals and large physician practices) have been forced to hire
employees specializing in different contract types within their insurance/finance departments to
negotiate the labyrinth of rules and regulations. Accuracy is critical in today’s health care industry,
where improper coding or billing or untimely filing can lead to missed opportunity—or charges of
fraud. Thus, reimbursement is a form of risk for the organization. The risk associated with
reimbursement isn’t only the risk on profits and losses but also the compliance risk. Billing is
tightly regulated and if billing is done incorrectly, organizations can face serious fines and those
involved could even face jail time. Remember, finance is forecasting, so you can see how a
complex reimbursement system can and will affect an organization financially if billing is not done
correctly.
What Are the Primary Methods of Payment Used for Reimbursing
Providers by Medicare and Medicaid?
The largest government-sponsored health care programs in the U.S. are Medicare and Medicaid,
as discussed in Chapter 9. Different methods are used to provide reimbursement to various
providers of care by these programs, as discussed further below. The current regulations
regarding reimbursement to providers in these programs are, however, reflective of various costcontainment efforts. It is also worth mentioning that health reform has also affected Medicare and
Medicaid by creating the Center for Medicare and Medicaid Innovation (CMI), which was
established to test innovative payment and service delivery models (Shafrin, 2010). As you enter
the field or continue to study health care finance, keep in mind that reimbursement will continue to
change and adapt to the numerous factors listed earlier in this chapter. Cost-containment issues
will continue to arise and will continue to force financial managers to adapt and change to this
volatile environment.
Reimbursement to Hospitals and Contractual Allowances
Due to rapidly rising health care expenditures based on an initial retrospective, charge-based
reimbursement system to providers, Congress passed the Tax Equity and Fiscal Responsibility
Act (TEFRA) in 1982, with particular emphasis on Medicare cost controls. Included among its
provisions was a mandate to hospitals for a prospective payment system (PPS) with
reimbursement rates established up-front for certain conditions, the option of providing managed
care plans to Medicare beneficiaries, and the requirement that Medicare become the secondary
payer when a beneficiary has other insurance.
Like most third-party payers for hospital services, CMS substantially reduces reimbursement to
hospitals (from original hospital charges to beneficiaries) based on a system of contractual
allowances. Contractual allowance is the maximum dollar amount an insurance carrier will
reimburse a provider for services rendered based on the CPT code. The contractual amounts are
typically negotiated with third-party payors and are set by the CMS for Medicare and Medicaid
covered patients.
In the case of Medicare-eligible patients, CMS reimburses a fixed amount per admission and per
diagnosis, based on the patient’s Diagnosis-Related Group, or DRG. For example, patients being
admitted for heart bypass surgery would receive a higher reimbursement rate than patients
admitted for observation after a fall in which they suffered a fractured humerus (arm bone).
Because hospitals risked losing significant revenue based off the DRG reimbursement
methodology, the Omnibus Budget Reconciliation Act of 1990 included capital expenses into the
reimbursement calculations.
On the other hand, the Medicaid reimbursement rate to hospitals for any given service varies from
state to state, but in all cases includes a substantial contractual allowance. Individual states
implement cost controls for Medicaid payments, using either DRGs (like Medicare) or case mix to
set reimbursement rates. Case mix, also referred to as patient mix, is usually related to the mix
of patients served by an organization based on the severity of illnesses. An example of
differences in this type of reimbursement would be a nursing unit primarily serving patients on
ventilators that would be reimbursed at a substantially higher rate than a nursing unit serving
patients with orthopedic problems, due to the greater expenses incurred by the former. In all
cases, providers must accept reimbursement as payment in full and follow designated efficiency
and quality standards.
Reimbursement to Physicians
A Resource-Based Relative Value System (RBRVS) was implemented in 1992 for
reimbursement for physician office services rendered to Medicare beneficiaries. This system pays
a prospective flat fee for physician visits and is based on the Healthcare Common Procedure
Coding System (HCPCS) codes used by outpatient health care providers and medical suppliers
to code their professional services and supplies. The CPT codes are the generally accepted
coding methodology utilized. An example of this system is the higher reimbursement rate afforded
to a physician for an extended initial patient visit to fully assess a patient’s medical condition,
versus the lower reimbursement provided for a brief follow-up visit to assess how well a
prescribed medication was working.
However, legislation (April 2015) passed through both houses set up a new way to pay
physicians. The current plan allows physicians to see pay increases over the next five years until
a new, merit-based program is approved (Carey, 2015). Therefore, the reimbursement formula
from the 1990s mentioned above, will become a thing of the past.
Because Medicare serves over 54 million Americans, it was important to pass such legislation so
the program can continue into the future (Cornwell & Humer, 2015). Furthermore, the new
system will be focused on, “quality, value and accountability” (Carey, 2015, para. 3). Similarly,
state Medicaid programs have implemented cost controls for reimbursement to physicians,
initially through fee schedules, but with many states more recently requiring beneficiaries to enroll
in capitated managed care plans.
Medicare Reimbursements to Other Providers
Despite reductions in reimbursements for hospital admissions and physician visits, Medicare
expenditures continued to soar throughout the 1990s. Congress passed the Balanced Budget Act
of 1997 in an attempt to control costs for other health care services. Prospective payment
systems were implemented in other settings beginning in 1998, as follows:
■ Skilled nursing facilities (SNFs), in 1998, with RUGs (Resource Utilization Groups);
■ Home health agencies (HHAs), in 2000, with HHRGs (Home Health Resource Groups); and
■ Outpatient hospitals and clinics, in 2002, with OPPS (Outpatient Prospective Payment
System).
How Are Providers Reimbursed by Self-Pay Patients?
As discussed above, those individuals who are not covered by any type of health plan, whether
private or public, are often billed for full charges (generally well above costs) by the health care
organization delivering the care. This is largely due to the inability of the individuals to negotiate
discounted rates for their care that are usually afforded patients covered by group health plans.
This phenomenon has had the consequence of substantially increasing the number of personal
bankruptcies related to medical bills. A study found that in 2013, “1.7M Americans live in
households that will declare bankruptcy due to their inability to pay their medical bills”
(LaMontagne, 2015, para. 3). As a direct result, there have been increases in the amount of
uncompensated, or unreimbursed, care.
Not-covered or uncompensated care is a measure of total hospital care provided without
payment from the patient or an insurer. This accounted for between 5.8% and 6.1% of hospital
total expenses between 2007 and 2013 (American Hospital Association, 2015). The two major
types include:
■ Bad debt, in which the health care organization bills for services but receives no payment.
These operating expenses are based on charges, not costs, and are written off by the
organization. This term is usually used with for-profit organizations.
■ Charity care, in which the not-for-profit organization provides care to a patient who it knows
will be unable to pay. The level of charity care (based on either costs or charges) must be
documented in footnotes to the financial statements; otherwise, the organization’s tax status
can be questioned.
Although uncompensated care may be written off as bad debt or charity care by the health care
organization, and although it is even required to a certain extent with a not-for-profit organization
to maintain its 501(c)(3) status, it is important for managers to recognize that providing too much
of this type of care could serve to financially cripple the organization, both in terms of difficulty in
maintaining current operations and inability to maximize investment opportunities. Some for-profit
organizations question the tax status of not-for-profit organizations and their ability to write off
debt as “charity care.” They also decry the use of the term “bad debt,” because it implies that the
manager who extended the credit used poor judgment. This is a controversial topic and one that
bears watching.
Coding in Health Care
After a patient receives any type of health care service, a bill is generated. Typically, after an
encounter with a physician, ambulatory surgery center, or other provider, diagnosis and procedure
codes are assigned to the bill. Codes also represent symptoms and medications in order to
process a claim properly. The bill is then submitted to the payer, often a health insurance
company, in order to receive payment for services rendered. This interaction is known as the
billing cycle or revenue cycle and can take several days to several months to complete.
The diagnosis codes and procedure codes assist the insurance company in determining the
medical necessity of the services and whether the services are covered and should be paid.
Usually, a medical coder abstracts information from documentation in the patient’s medical
record, assigns the appropriate codes, and creates the claim to be paid by the commercial
insurance company or government agency such as the CMS (American Association of
Professional Coders, 2015).
Since the late 1800s, an international system of classification for diseases and other health
problems has been used to record vital records such as death certificates by the World Health
Organization (WHO, 2015). Since 1948, WHO has assumed responsibility for managing and
publishing this International Classification of Diseases (ICD) (WHO, 2015). This is the
standard tool for categorizing diseases and health problems for clinical and epidemiological
purposes such as mortality statistics as well as for reimbursement decisions around the world. It
is updated every ten years. ICD-10 is the 10th revision of the classification system and increases
the number of codes from more than 17,000 to 69,000 different codes (Centers for Disease
Control and Prevention, 2015). The compliance date for ICD-10 was October 1, 2015
(American Medical Association [AMA], 2015b). The CMS has continued to make several
changes since the ICD-10 implementation to prevent Medicare claims denials and other
penalties, thus making the changeover less disruptive for physician practices (Dustman, 2016,
para. 4).
In 1966, the AMA created the Common Procedural Terminology (CPT) set, which is updated
every year (AMA, 2015a). CPTs describe medical procedures and other services. In the 1970s,
the federal government released the Healthcare Common Procedure Coding System (HCPCS),
pronounced as “hick picks,” which is based on the AMA’s CPT codes for Medicare payment. This
coding is necessary for Medicare, Medicaid, and other health insurance programs (AMA, 2015a).
Currently, HCPCS has two levels of coding: Level 1 is the CPT code and Level 2 is alphanumeric
and includes non-physician services like ambulances, devices, and supplies.
Until the 1980s, claims were submitted using paper forms when electronic submission of bills
began. Now, Medicare bills must be sent electronically, and payment is transmitted to providers
electronically, as well. Over the years, coding has become more sophisticated, covering more
services and specialties such as dental care and skilled nursing facilities. Because of this
complexity, medical billing and coding specialists must pass examinations to become certified and
may even specialize in areas such as outpatient coding or interventional radiology coding
(American Association of Professional Coders, 2015). Auditing and compliance are essential
aspects of the billing and coding process to ensure quick and accurate claims submission, faster
reimbursement, fewer denials, and better-managed practices. Here are some examples.
Question: What is the ICD-10 code for acute appendicitis?
Answer: K35.2 is a billable ICD-10-CM code that can be used.
Question: What is the ICD-10 code for leprosy?
Answer: A30.9 is the billable ICD-10 code.
Question: What is the HCPCS code for 15 minutes of medical nutrition therapy initial
assessment and intervention?
Answer: The CPT code is 97802. This code can only be used once a year.
Question: What is the CPT code for hepatitis A vaccination?
Answer: The CPT code is 90632 for monovalent hepatitis A vaccine for adults
(ICD10data.com, 2015).
Any manager in health care needs to understand the importance of billing and coding
classification systems in receiving payment based on accurate and prompt claim submissions.
Meticulous processing of records related to office visits, planned surgery, or outpatient procedures
will ensure compliance with insurance requirements and federal regulations.
In summary, almost every medical condition, procedure, service, and supply can be identified by a
numeric code, primarily because Medicare and other third-party payers require numeric coding on
claim forms. Accurate coding is the key to prompt reimbursement for services. Knowing the
difference between a diagnosis code of 280 (iron deficiency anemia) and 820 (a fracture of the
neck of the femur) will help protect a practice from fraud and abuse investigations, as well as help
ensure getting paid appropriately and in a timely manner.
Controlling Costs and Cost Accounting
Historically, health care organizations, especially hospitals, have been provided strong financial
incentives to maximize reimbursements rather than control costs. However, as can be seen in the
preceding discussion, there has been a major movement during much of the past two decades to
decrease the levels of reimbursement to providers in almost all sectors of the industry. It has thus
become increasingly important for health care organizations to understand how to estimate and
manage their costs. This changing environment has also resulted in separation of “cost
accounting systems from financial accounting systems” and movement “from traditional
allocation-based cost systems to activity-based cost systems” (Zelman, McCue, Millikan, &
Glick, 2003, p. 15).
While Nowicki (2004) describes its purpose as providing managers with cost information for such
reasons as “setting charges and profitability analysis” (p. 145), it is important to note that cost
accounting ultimately leads to decision making. This might include enhancing departments that
are making money, eliminating services that are losing money, and carefully managing loss
leaders (i.e., procedures provided cheaply or below cost to attract customers to the organization).
Cost accounting also provides methods for classifying and allocating costs, as well as more
precisely determining product costs, all of which will be described briefly in this section.
Classifying Costs
Although there are a number of ways in which costs may be classified, the purpose of TABLE 10-
2 is to illustrate a sampling of the most frequently utilized methods. The importance of such
systems is merely to provide a point of departure for controlling costs.
TABLE 10-2 Frequently Utilized Methods of Classifying Costs
| Method | Classification | Example |
| By behavior | Fixed costs—stay the same in relation to changes in volume of services Variable costs—change directly in relation to changes in volume Semivariable costs—partially fixed and partially variable |
Buildings, utilities (water & electricity), depreciation, salaries of full-time employees, supplies (sutures & gauze), hourly employee pay, & medications Salaried employees are fixed costs until the increase in the number of patients warrants a new employee. |
| By traceability | Direct costs—can be traced to a particular patient, product, or service |
Gauze pads used in dressing a wound and provider salaries Electricity, the accounting and human resource department costs |
| Indirect costs (overhead)— cannot be traced to a particular patient or service Full costs—both direct costs and indirect costs |
Provider salaries and accounting department costs | |
| By decision making capability |
Controllable costs—under the manager’s influence Uncontrollable costs—cannot be controlled by the manager Sunk costs—already incurred and cannot be influenced further Opportunity costs—proceeds lost by rejecting alternatives |
Wages of certified nursing assistants (CNAs) per shift and hourly employee costs. Cost of insurance paid and rent expense. Consulting costs which were paid regardless if the project moves forward or not. Lost revenue from use of a new X-ray machine if a new ultrasound machine was purchased instead. |
While many authors provide a concise summary of the major methods of classifying costs, such
as those shown in Table 10-2 (Nowicki, 2004; Zelman et al., 2003), they do not show how these
classifications are often combined by managerial accountants to demonstrate the complexity of
cost analysis within health care organizations. For example, concerning salaries and wages in
hospitals, the salaries of radiology department managers are both direct and fixed, the wages of
on-call nurses are direct but variable, and the salaries of the CEO and CFO are fixed but indirect.
Allocating Costs
Cost allocation involves the determination of the total cost of producing a specified health care
service through assigning costs into revenue-producing departments and then further allocating
the costs down to the unit-of-service or procedure level based either on departmental revenue or
volume. The purpose of this methodology is:
■ To allocate costs, thereby ensuring the expenses associated with a particular department and
service are being allocated (assigned) to that department and action. It doesn’t make sense to
allocate a surgeon’s salary or the entire cost of the accounting department to the primary care
department when there are other departments consuming these resources, this would lead to
bad financial data.
■ To ensure that patients are paying a fair proportion of the cost it takes to deliver their specific
care. For example, in general, if a patient is seeing their primary care physician, they shouldn’t
be paying a proportion of the surgeon’s salary.
■ To help managers and decision makers with:
Identifying cost drivers for services in the hope of reducing those expenses.
Identifying which costs are being misallocated and where they should go.
Identifying financial performance broken down by department and service.
Although a number of methods have been identified for cost-allocation purposes, in each case the
process ends when all the organization’s costs (including those generated in non-revenueproducing departments, such as housekeeping and medical records) are allocated to the cost
centers of revenue-producing departments (radiology, pediatrics, and so forth). These methods
have been widely used for pricing and reimbursement purposes in the past but are beginning to
be replaced by more accurate methods of determining product costs.
Understanding the costs of delivering a service and the associated departmental costs of
providing that service are key elements of financial management. For instance, if a health care
organization doesn’t understand the cost of a service, it wouldn’t know what to charge for that
service. Often one element of management performance is based on financial performance; if the
wrong costs were being allocated to a service or department, the manager could have negative
financial results and be viewed as not managing those services properly. The opposite could
occur; a manager may achieve positive financial results not due to good management of services
but because costs are being allocated to a different service and department. The allocation of
these costs is determined by cost drivers (e.g., number of patient visits, number of labs drawn,
square-feet being used, providers tied to a service, direct expenses, revenue generated, and
many more). A cost driver can be thought of as each unit of activity occurs, there is a measurable
growth in an expense. By understanding this relationship between activities and costs, managers
can better control the associated costs and attempt to gain better efficiencies leading to increased
revenue. Indirect expenses are much more difficult to allocate than direct expenses. This is
because unlike direct expenses, indirect expenses, such as electricity, rent, and administration,
don’t always increase as the delivery of services increase. This is where the finance department
uses the available information to determine the best possible cost drive. For instance, for
administration, the cost driver could be the number of employees who directly provide a service or
the total number of employees in a department. Once all expenses are properly allocated,
managers can then determine the cost of services. TABLE 10-3 provides an example of how
indirect costs can be allocated to revenue-producing departments. As mentioned above, indirect
costs are allocated based on cost drivers which are best associated with each indirect expense.
In the example, the medical center allocates indirect costs based on revenue generated by each
department, routine care and orthopedics. Last fiscal year the routine care department generated
$2,050,000 in revenue and the orthopedics department generated $1,301,000 in revenue. Table
10-3 shows that direct expenses for both departments total $2,760,000 and the associated
allocation amount for each department. The total indirect costs associated with routine care and
the orthopedic department are $502,500. There are two main expenses which make up the
indirect expenses, facilities expense and general overhead. General overhead are the expenses
associated with accounting, human resources, and technology support. Total facilities expenses
equal $335,000 and total general overhead is $167,500. TABLE 10-4 shows the allocated direct
and indirect expenses along with net income for each department. This information is needed to
calculate the allocation rate for indirect expenses. Currently the cost driver used for both facilities
expense and general overhead is total revenue. To calculate each allocation rate, indirect
expense is divided by total revenue.
TABLE 10-3 Statement of Revenue and Expenditures for the Entire Company
| Allocation Rate | |
| We Care Medical Center | |
| Statement of Revenue and Expenditures (Company) | |
| Revenues | |
| Routine care | $2,050,000 |
| Orthopedics | $1,301,000 |
| Total revenue | $3,351,000 |
Direct Expense
| Salaries and benefits | $2,250,000 |
| Supplies | $510,000 |
| Total direct expenses | $2,760,000 |
Indirect Expenses
| Facilities expense | $335,100 | $0.10 $0.05 |
| General overhead * |
$167,550 | |
| Total indirect expenses | $502,650 | |
| Net income | $88,350 |
accounting, human resources & technology support.
TABLE 10-4 Statement of Revenue and Expenditures for the Entire Company
*
The calculation would look like this: Facilities Expense allocation rate = $335,100 / $3,351,000 =
$0.10 & General Overhead = $167,550 / $3,351,000 = $0.05. These rates were applied to create
the indirect expense allocation amount to each department in Table 10-4. The allocation rate is
then multiplied for each of the department’s individual revenue to get the associated department’s
indirect expense allocation amount.
For Routine Care the calculations for Facilities Expense is $2,050,000 × $0.10 = $205,000; and
for General Overhead is $2,050,000 × $0.05 = $102,500. The calculations for the Orthopedic
department for Facilities Expense is $1,301,000 × $0.10 = $130,100; and for General Overhead is
$1,301,000 × $0.05 = $65,050. When these amounts are added together, it equals the total
indirect expenses amount of $502,650. This shows the allocation was done correctly. Now we can
see what the net income is for each department based on using revenue as the cost driver for
indirect expenses. The calculation for net income is Revenue – Expenses = Net Income.
Break-Even Analysis
The ultimate goal of managing costs is minimally to break even and not run a deficit. Break-even
analysis is the method of determining at what level of volume the production of a good or service
will equal the revenues created. It is used by health care managers for the purpose of determining
profit or loss. The break-even point is the volume of production in units and sale of goods or
services where total costs equal total revenue. Once the break-even point is achieved, each
additional unit of service delivered contributes to the organization’s profit, meaning fixed costs
have now fully been covered, and the only costs left to cover are variable costs. Variable costs
always exist and after the break-even point is hit, profit per unit of service can be calculated using
this formula:
Revenue per unit of service – variable cost per unit of service = profit.
This formula is called the Contribution Margin; how much profit is obtained after variable cost
per unit of service is removed from revenue obtained from each unit of service. Another way to
look at the contribution margin is how much revenue is contributed to paying for fixed costs before
the break-even point is achieved.
In for-profit health care organizations, most services should be able to obtain the break-even point
and beyond creating profit, but there are some instances where services may not reach the
break-even point. In this instance these services should be evaluated to determine if they provide
a different benefit such as contributing to fixed costs, acting as a support service or referring
patients to a profitable service. Due to the nature of fixed costs not generally increasing if more
services are provided, if a service contributes to paying for fixed costs (meaning that service has
a positive contribution margin), keeping that service may be warranted.
Not-for-profit health care organizations often keep services which lose money, not only from not
being able to cover fixed costs but also when they have a negative contribution margin. These
organizations usually receive other funding to help support those services which provide a
community benefit. The funding could be in the form of donations, grants, and/or government
subsidies. This is one of the key differences between for-profit and not-for-profit organizations.
Not-for-profit health care organizations will keep services which lose large amounts of money for
the good of the community, whereas most for-profit health care organizations often terminate
those services to minimize losses. One notable example of this difference between not-for-profit
and for-profit health care organizations is the fact that in 2006 almost 100% of not-for-profit
hospitals had Emergency Departments (EDs) versus 65% of for-profit hospitals (Jessamy, 2006).
Since that time, the ACA has been enacted prompting some researchers to suggest that EDs can
become profit centers (Wilson & Cutler, 2014). In addition, the proliferation of for-profit, freestanding urgent and emergency care centers has taken many insured patients away from the notfor-profit hospitals—leading to higher Medicare costs (Patidar et al., 2017). As you can see from
just these few examples, the market is dynamic, and the health care manager must stay on top of
these trends to keep their organization viable.
Setting Charges
Only after costs have been determined can health care organizations go about the business of
setting rates or charges for their services and products. While the earlier section on “Managing
Reimbursements from Third-Party Payers” describes a number of methods used by third-party
payers and health care organizations to negotiate payments for services, a more complete picture
of what is involved when setting charges should be taken into consideration by any provider.
A first step in this discussion might be to differentiate the meanings of charges versus actual
prices set by the organization. The Robert Wood Johnson Foundation defines charges as the
“amount of money a provider would charge absent discounts” (Painter, Chernew, & Dunn, 2012,
p. 9). In other words, charges do not reflect costs and are often published simply for reporting
purposes. A list of these services and their charges is often referred to as the Chargemaster or
the Charge Description Master (CDM). They do not reflect what the consumer will pay or the true
value of the services. Charges are typically set abnormally high to ensure when billing third-party
payors all contracted rates are billed. For instance, if Blue Cross paid $100 for an office visit,
Cigna paid $90, and Humana paid $120, the minimum charge would be set at $120, and it would
be quite common for the charge to even be set at $150 or higher, so as to not have to worry about
missing any revenue or to capture future changes in the contracted rate. This can unfairly burden
self-pay patients, although many organizations provide a self-pay discount, which is not typically
offered upfront. In fact, it may not be offered until the patient calls stating a hardship paying their
medical bill.
As of January 1, 2019, hospitals are required to post their charges online in an effort increase
price transparency, thereby informing consumers of what they can expect to be charged for
various services and providing information to allow them to compare across providers (Bresnick,
2018). These rules, promulgated by CMS in August 2018, relate to the prospective payment rates
for acute care and long-term care hospitals (CMS, 2018).
Prices in health care, on the other hand, involve opportunity costs, what consumers or third-party
payers give up in order to acquire medical goods or services, including:
■ Money actually spent.
■ The perceived value of:
These goods or services;
Time sacrificed in acquiring these services; and,
Other opportunities forgone (purchases, activities).
In other words, charges posted by the organization do not necessarily translate into actual prices
paid for services.
Other Determinants of Setting Charges and Prices
Although not claiming to be all-inclusive, the following factors are provided to make sure that the
health care manager gives due consideration to each when involved in setting prices for services
or products.
■ State and federal laws and regulations;
■ The Joint Commission and other accrediting body regulations;
■ Antitrust and other fair-pricing laws; and,
■ Profit-oriented pricing, including profit maximization, satisfactory profits, or break-even
strategies.
Setting charges or rates remains a highly complex activity within any health care organization due
to the need to consider a huge number of variables, both internal and external to the organization.
While individual health care managers may be involved in providing substantial input into this
process, larger organizations employ experts dedicated to this task in order to sustain revenue
maximization and competitiveness in the health care market.
Managing Working Capital
“Working capital refers both to current assets,” that is, inventory, cash on hand, accounts
receivable, and other such items that can be converted to cash in less than one year, “and to
current liabilities,” meaning “those liabilities that will be paid within the current accounting
period” (McLean, 2003, p. 288). Virtually all experts, however, define net working capital as
“current assets minus current liabilities,” a concept that seems to remind us that health care
organizations are never without accumulation of debt.
What Are the Purposes of Working Capital Management?
There are two sets of purposes in managing working capital. The end result of the first set of
purposes is to increase revenues and reduce expenses in order to:
■ Serve as the “catalyst” to make capital assets (buildings and equipment) productive by wisely
managing such current assets as labor and inventory.
■ Control the volume of resources committed to current assets. McLean (2003) states that
“financing working capital by the least costly means available can allow one’s organization to
deliver the same amount of care at lower cost or can allow an organization with a limited
budget to deliver a greater amount of care” (p. 288).
■ Conserve cash by cutting the organization’s financing costs in order to take advantage of
short-term investments.
■ Manage cash flow, that is, the amount of inflows and outflows, and the cash conversion cycle,
which is the process (measured in days) through which initial cash is converted into the
inventory, labor, and supplies needed in health care operations that in turn generate accounts
receivable and that finally are collected in the form of cash revenues.
■ Manage the liquidity of an organization, that is, “how quickly assets can be converted into
cash” (Zelman et al., 2003, p. 488).
The second set of purposes involves enhancing “goodwill” toward the organization by:
■ Paying vendors and employees on time; and,
■ Demonstrating to lenders that the organization is “creditworthy” by showing it has sufficient
resources to repay loans or at least pay interest on short-term funds.
Why Is Working Capital Management in Health Care Environments
Problematic?
Managing working capital tends to be more problematic with health care organizations because,
with the exception of patient copays, which are miniscule in the big picture of the organization’s
finances, health care organizations generate very little immediate cash. This is largely due to the
huge preponderance of third-party payers and the substantial delays in payment. Also, even if
paid by private parties, the large costs incurred for most medical services result in payment after
the billing cycle, by credit card, or in negotiated installments.
Another area where working capital can get complicated is deciding what capital to purchase. In
health care there are always many choices of different services to provide and what capital is
needed to provide those services. Being able to determine the best service and capital
investment is an important part of financial management. In most instances, only the capital
options which would provide a positive return should be considered, and the capital that would
provide the greatest return should be chosen. For not-for-profit organizations, sometimes an
additional evaluation based on which will provide the greatest community benefit will be used.
Managing Accounts Receivable
Accounts receivable (A/R) are funds that are owed to the health care organization but have not
yet been received. The largest A/R balances for health care organizations are for services
rendered to patients, leaving a balance either owed by insurance or the patient. With the move to
alternative payment methods such as capitation and payments based on quality of care, A/R
balances are being reduced overall, yet still play a large role in health care. Also called patient
accounts in many health care organizations, accounts receivable provides no interest for the
provider unless they have been converted into interest-bearing loans to allow patients to pay out
their debts for services over time. Therefore, management of A/R becomes exceedingly important
in order to collect revenues generated to ensure cash flow for management of the operations of
the organization. It is essential to note that the ultimate collection of A/R becomes less likely as
the amount of time since services were rendered increases. More and more providers are
becoming aggressive about collecting these revenues, sometimes resorting to telephone scripts
more typical of collection agencies to obtain payments.
Major Steps in Accounts Receivable (A/R) Management
Managing accounts receivable involves collaboration and cooperation among almost all
departments of a health care organization, although some departments are more directly involved
than others. TABLE 10-5 provides examples of involvement in a typical hospital setting.
TABLE 10-5 Hospital Departmental Involvement in Managing Accounts Receivable
| Department | A/R Involvement |
| Contracts | Relationships and contract negotiation with third-party payers |
| Admissions/registration | Precertification, preadmission, insurance verification |
| Patient care unit (medical care, nursing, lab, radiology, rehab, etc.) |
Documentation capture, charge capture for services rendered |
| Medical records | Coding utilization review, QA (quality assurance audits) and review of medical record completeness |
| Billing | Coding review, bill preparation, billing audits |
| Compliance | Fraud and abuse internal audits |
| Collections | Collection policy and procedures, financial counseling, third party, and self-pay follow-up |
| Legal | Contracts, litigation policy, federal regulations, patient rights |
Some additional thoughts and clarification are warranted concerning the overriding importance of
managing accounts receivable in all departments:
■ Documentation capture emphasizes the importance of the quality of the written or electronic
record of patient care by all health care professionals. The primary financial function of
documentation is to provide supporting information for billing purposes. In case of an audit, all
services should be adequately documented in the patient’s medical records. Proper
documentation can also reduce the delay in A/R, i.e., the time to collect on money owed,
because when the service is billed, an insurance company will not need to request further
documentation which would delay the payment process.
■ Ultimately, interdependence among departments affects the reduction in the A/R collection
period. For example, accurate documentation supports the coding, and the timeliness of the
coding greatly affects the ability of the billing department to send out a timely bill. Sending out
clean claims, i.e., billing claims which are properly coded and supported by documentation, is
the biggest contributing factor to reducing an organization’s A/R balance. Cooperation among
managers is essential.
■ AR outcomes are often measured by first determining a baseline of the progress to be
measured and then monitoring the outcomes periodically by looking at the organization’s
balance sheet and income statements. This process is often referred to as benchmarking, in
which the current year’s results can be measured against prior results to see whether things
are getting better or worse.
Supply Chain Management and Inventory
Formerly referred to as inventory management and more recently designated as supply chain
management, materials management refers to the process of managing the clinical and nonclinical goods and inventory purchased and used by the personnel of a health care organization in
order to perform their duties.
Why Is Supply Chain Management Important?
There are at least three reasons why supply chain management is so important to the health care
organization. The first involves delivery of appropriate patient care, for which the organization
must have the right kind and right amount of supplies, delivered in the right timeframe. Stockouts (not having enough of a product) are considered totally unacceptable in health care
organizations, as they may result in unnecessary deaths or poor outcomes. A second reason
involves cost control. Inventory, a non-productive asset, loses value over time, increasing the
costs to the health care facility. If items spend too much time in inventory, they may become
contaminated, lost, stolen (referred to as “shrinkage”), or expired. Furthermore, cash tied up in
excessive inventory cannot be used for assets that produce income. The third reason involves
improvement of the organization’s profitability. Through proper inventory supply chain
management, only the minimum supply needed is kept on hand, therefore freeing up cash for
other activities to support the health care organization.
What Are the Basic Tenets of Supply Chain Management?
It is also important to adopt the most appropriate method for stocking inventory. This includes
keeping a safety stock level of inventory, below which the health care facility will not allow units on
hand to fall. It further involves understanding and adopting one of the commonly accepted
methods for valuing inventory:
■ FIFO, or “first-in, first-out,” in which the first item put in inventory is the first taken out; it
produces an inventory of newer items and thus values the cost of inventory at the price paid
for the newest items;
■ LIFO, or “last-in, first-out,” in which the last item put in inventory is the first taken out; it
produces an inventory of older items and thus values the cost of inventory at the price paid for
the oldest items;
■ Weighted average, in which the average cost of inventory items is multiplied by the number of
units in inventory; and,
■ Specific identification, in which the actual cost of each item is included. This tends to be
used with high-cost (and relatively few) items.
Finally, adopting the most appropriate method for stocking inventory includes application of either
the JIT or ABC inventory methods in terms of when to order or deliver products to the health care
facility:
■ Just-in-time (JIT): With this technique, products are literally delivered to the organization “just
in time” for use. This method is preferred by Berger (2002) in order to decrease the “chance
for obsolescence and shrinkage (theft)” (p. 306) and to reduce holding costs associated with
warehousing items in the health care facility.
■ ABC inventory method: With activity-based costing (ABC), each supply item is categorized
as belonging to one of three groups. Group A includes very expensive items that must be
monitored closely, such as certain expensive drugs. Group B consists of intermediate-cost
items, which while not as high end as Group A, should still be monitored in terms of quantity
and usage (e.g., supplies for dietary services and nutritional supplements). Group C, the
largest group, consists of items that represent little cost but are important to the day-to-day
operations of the health care organization (e.g., bandages, tissues, pain relievers). Zelman et
al. (2003) and Nowicki (2004) describe the ABC method in detail, providing examples of how it
is applied.
While it may be the ultimate responsibility of the supply chain manager to ensure that all goods
needed by both the clinical and non-clinical users in a health care facility are available when
required and in the most cost-efficient manner, every manager in the organization must be held
accountable for timely ordering and judicious use of materials. Physicians and other users of
high-cost equipment and supplies should also be educated about the procedures involved in the
ordering and stocking process. TABLE 10-6 provides examples of the most commonly used
inventory management techniques.
TABLE 10-6 Supply Chain Management Techniques
Managing Budgets
One of the most critical functions for managers in health care organizations is management of the
departmental or division budget. While the facility’s Finance Department is generally involved in
working with the manager in developing both operational and capital budgets for the department,
it is the responsibility of each manager to ensure that expenditures (for items such as labor,
equipment, and supplies) and revenues (if the department supplies services or products for
patients/consumers) are monitored carefully on an ongoing basis.
Sorting Out the Definitions and Distinguishing Characteristics of
Budgeting
Budgeting means different things to different people, even in health care organizations, and it
does not help that not all authors or organizations utilize the same terms in discussing their
budgeting processes. The purpose of the current section is to try to sort out some common
budgeting terms that are used in the financial management departments of health care entities.
Budgeting is, quite simply, the process of converting the goals and objectives of the
organization’s operating plan into financial terms: revenues, expenses, and cash flow projections.
The budget, then, is a financial plan for turning these objectives into programs for earning
revenues and expending funds. Listed below are characteristics of budgeting important to health
care managers.
■ The budget should be a dynamic working document, to be utilized on an ongoing basis by
every manager in the organization.
■ Managers must have access to their departments’ budget and last year’s data regarding
volumes, revenues, expenses, and cash flows on a monthly basis to provide guidance for their
departments’ budgeting process.
■ Budgets provide a tool for ex post facto evaluation of managers concerning their performance
in efficiently running their departments and for assessing how well the organization as a whole
has met its financial performance goals.
■ The budget period is typically one fiscal year but budgets for multiple years or for projects are
often created.
■ A budget planning calendar is a tool utilized to schedule activities that must be completed in
order to develop a budget. Most often, budget planning calendars are utilized by larger health
care organizations with complex budgets, however, it is also a good tool for organizations of
any size. Included in this calendar are the budget activities, timeframe expectations, the
parties responsible, and follow-up meeting times.
What Are the Specific Types of Budgets?
The master budget includes everything: the income statement, balance sheet, and statement of
cash flows. This budget looks at everything financial related in an organization. The master
budget is typically created for an upcoming fiscal year and can be broken down to quarterly or
even monthly timeframes. The preparation of the master budget can vary from organization to
organization but should always include input from all corners of the organization. This budget is
always prepared and managed by the finance department.
The operating budget is generally a budget which looks at only the income statement revenues
and expenses but does not look at the balance sheet; assets, liabilities and equity. Berger (2002)
describes 24 steps in preparing the operating budget, including five distinct “segments”: strategic
planning, administrative, communications, operational planning, and budgeting segments. He
further asserts that these steps “involve managers in every facet of operations. In addition, a
critical set of stakeholders who must be accessed, solicited, and appeased are the physicians
linked to the organization, either in an employment capacity or in an affiliate relationship” (pp.
145–148).
Cash budget is a term sometimes used interchangeably with “operating budget,” but it is
specifically distinguished from the latter by some authors and organizations. The primary purpose
of a cash budget is to ensure that ample cash is available to support the operations of an
organization. You may have heard the phrase, “cash is king” and that is because, if a health care
organization doesn’t have enough cash-on-hand, it cannot pay its bills and therefore cannot keep
its doors open. This 52-week budget attempts to forecast the receipts (most often from third-party
payers) and disbursements (expenses) of the organization. These budgets comprise the
following:
■ An expense budget, which is a prediction of the total expenses that the organization will incur,
typically includes such items as labor, supplies, and acuity levels (case mix) and is included on
the left-hand side (the debit side) of accounting entries. Remember, an expense is an outflow
or an asset that has been used up, and a cost is the resources necessary to provide the
service or product you are producing.
■ A revenue budget, shown on the right-hand (credit) side of accounting entries, includes data
on forecasted utilization of specific services within the organization and third-party payer mix.
Three other terms generally associated with cash budgets are:
■ Cash outflows, which include such expenses as mortgage payments or rents, salaries and
wages, benefits, utilities, supplies, and interest paid out;
■ Cash inflows, which include cash payments up front, 30-day and 60-day collections,
government appropriations, donations, and any interest earned each month; and,
■ Ending cash, which comprises both the cash balance at the end of the month and the
following month’s beginning cash level. The following formula is used to determine this
amount: Ending cash = Beginning cash + Cash inflows – Cash outflows.
There are two other types of budgets with which health care managers should become familiar.
The term statistics budget is given to the initial statistics delineated in the operating plan that
forecasts service utilization (by service type, acuity level or case mix, and payer mix), resource
use, and policy data (employment data, occupancy rates, staffing ratios, etc.). The capital
budget refers to the plan for expenditures for new facilities and equipment (often referred to as
fixed assets). The following discussion will focus on the latter.
The Importance of Capital Budgeting
Capital budgeting may be defined as the process of selecting long-term assets, whose useful
life is greater than one year, according to financial decision rules. The capital budget determines
funding amounts, what capital equipment will be acquired, what buildings will be built or
renovated, depreciation expenses, and the estimated useful life to be assigned to each asset. The
primary purpose of capital budgeting is to determine the fiscal impact of a capital purchase on the
finances of an organization. A problem most health care organizations face is that there are
multiple projects and associated capital which can be purchased. Determining which project and
capital should be purchased is key; this is where capital budgeting can be instrumental. In
general, the project and capital which adds the greatest value to the organization should be
chosen. However, a capital project which would have the least financial loss may be chosen if it is
determined it provides another value such as a community benefit.
The following are types of items typically included in such budgets:
■ Land acquisition, including land to be used for expansion of service offerings;
■ Physical plant or facility construction, expansion, acquisition, renovation, or leasing, possibly
including medical office space for physician practices;
■ Routine capital equipment, including items used in clinical areas (radiology, lab, surgery,
rehab, and nursing departments);
■ Information technology infrastructure or upgrades for financial systems, medical records, and
clinical use; and,
■ Recruitment and acquisition of staff physicians (more recently included), either through
purchasing existing physician practices or establishing new practices by employing
physicians.
While the capital budgeting process often involves substantial outlays of time by managers at
different levels of the organization, it is important to consider some essential steps that are
frequently followed. Determination of the capital budget often begins with a wish list of various
items requested by staff, physicians, or any other individuals who must obtain or use equipment
within the department. It is important to note that engaging physician leaders in this process
cannot be overemphasized, because they ultimately make the majority of diagnostic and clinical
decisions regarding patient care in health care organizations.
Department managers must then complete and submit designated capital budget requests to the
Finance Department. Once all requests have been submitted, the finance staff reviews them for
consistency and completeness. Reviewers of the technical aspects of the capital requests make
sure each contains all of the data required. This group often includes accounting staff, information
systems management, materials management, and facilities management. Designated evaluators
assess the merits of the requests, how each request compares to all other project requests on a
criteria basis, and whether each adheres to strategic plan criteria. Administrative approval and
approval by the governing body completes the process.
While there are a number of methods utilized to make capital budgeting decisions, most health
care organizations establish criteria-based decision rules. These range from a simple
accept/reject decision, which merely addresses “whether or not to acquire an asset or initiate a
project,” to capital rationing, in which a fixed dollar amount is placed on annual capital spending
by governing bodies and those with the highest profitability index are selected (McLean, 2003,
pp. 193–195). However, as a “safety valve” in the decision process, some organizations have
found that it is necessary to include a mechanism that allows some needed capital acquisitions
“to be purchased no matter what,” that is, despite not being able to meet formal evaluation
criteria. Berger (2002) calls this non-criteria-based capital budgeting.