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Copyright 2013 by FACHE 6/15/12

Case 2

University Hospital(Marginal Cost Pricing)

Uni ver s i t y Hospi t al i s a r egi onal l eader i n t he ver y i nt ense and medi cal l y

sophi st i cat ed ar ea of or gan t r anspl ant s. Mar k Lewi s, t he di r ect or of t he

Tr anspl ant Center , has been wi t h t he Hospi t al f or t en years. When Mark j oi ned

t he Hospi t al he was put i n charge of a ki dney and heart t r anspl ant pr ogr am

t hat was aver aged 50 t r anspl ant s per year . Today, t he Transpl ant Cent er

per f or ms over 200 tr anspl ant s annual l y, i ncl udi ng t r anspl ant s f r omt he newl y

i ni t i at ed l i ver , l ung, and pancreas progr ams.

The l i ver t r anspl ant program i s t he most successf ul of al l or gan programs i n

t erms of vol ume and revenues. Last year, vol ume tot al ed 100 t r anspl ant s, and

t hi s year Mar k i s opt i mi st i c t hat t he l i ver pr ogr am can do even bet t er .

However , he knows t hat i ncreased vol ume i s l argel y dependent on t he number of

organ donors and hi s success i n negot i at i ng a new cont r act wi t h t he

Tr anspl ant Management Cor porat i on ( TMC) , t he l argest t r anspl ant - benef i t s

company i n t he nat i on.

Because t r anspl ant s ar e r el at i vel y rar e i n compar i son wi t h other , more

convent i onal medi cal t r eat ment s, onl y t he l ar gest heal t h i nsurer s have t he

exper t i se t o manage t r anspl ant servi ces. However , t he costs t o i nsur er s f ort r anspl ant ser vi ces ar e typi cal l y ver y l ar geusual l y i n the si x- t o- seven-

f i gur e range. To ensure t he best and most cost - ef f ect i ve management of

t r anspl ant servi ces, most heal t h i nsurer s out sour ce t r anspl ant management t o

compani es, such as TMC, t hat speci al i ze i n t hese servi ces.

Cont r act i ng f or t r anspl ant servi ces i s uni que and compl ex because of t he

sophi st i cat i on of t he medi cal pr ocedur es i nvol ved. Tr anspl ant ser vi ces

consi st of f i ve phases: ( 1) pat i ent eval uat i on, ( 2) pat i ent car e whi l e

awai t i ng sur ger y, ( 3) organ pr ocur ement , ( 4) surger y and the at t endant

i npat i ent st ay, and ( 5) one year of f ol l ow- up vi si t s. The cost s i nvol ved i n

Phase 1 are r el at i vel y si mpl e t o est i mate, but t he r emai ni ng phases can beext r emel y var i abl e i n terms of r esour ce ut i l i zat i on, and hence cost s, because

of di f f er ences i n pat i ent acui t y and sur gi cal out comes.

Hi st or i cal l y, r ei mbur sement f or t r anspl ant ser vi ces has been handl ed i n a

number of di f f er ent ways. I ni t i al l y, many pr ovi der s bundl ed al l f i ve phases

t oget her and of f er ed i nsur er s a si ngl e, gl obal r at e. Al t hough t hi s met hod

si mpl i f i ed t he cont r act i ng pr ocess, t he rat e set was of t en chosen more on t he

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basi s of bui l di ng mar ket shar e t han on cover i ng cost s. I ndeed, many pr ovi ders

coul d not even est i mat e wi t h any conf i dence t he t r ue cost s of pr ovi di ng

t r anspl ant ser vi ces.

Somewhat i r oni cal l y, success i n gai ni ng mar ket shar e usual l y i ncr eases t he

f i nanci al r i sk of t he t r anspl ant pr ogr am because hi gher vol umes i ncrease the

l i kel i hood of hi gher acui t y pat i ent s. Al t hough t he t ot al cost s associ at ed

wi t h al l phases of a l i ver t r anspl ant average about $400, 000, t he amount can

more than quadr upl e i f t he pat i ent r equi r es a r e- t r anspl ant or i f ot her

compl i cat i ons occur . Because of t hi s ext r eme var i abi l i t y i n cost s, out l i er

pr ot ect i on i s a cri t i cal aspect of cont r act negot i at i ons i f t he r ei mbur sement

methodol ogy i s a f i xed pr ospect i ve r at e.

Thus f ar , sever al el ements of t he proposed cont r act wi t h TMC have been

f i nal i zed. Speci f i cal l y, Phases 1, 2, and 5 wi l l be r ei mbur sed at a set

di scount f r omchar ges. Fur t her mor e, t o reduce t he amount of f i nanci al r i sk

borne by Uni ver si t y Hospi t al , Phase 3 (organ pr ocur ement ) wi l l be rei mbur sed

on a cost basi s. Thi s makes sense because t he cost of Phase 3 i s al mostcompl et el y uncont r ol l abl e by the Cent er . I n gener al , Phase 4 cost s ar e

di vi ded i nt o t wo cat egor i es: hospi t al cost s and physi ci an cost s. Physi ci an

cost s have al r eady been agr eed on, so what needs t o be hammered out ( and t he

make- or- br eak par t of t he cont r act ) i s t he hospi t al r ei mbur sement amount f or

Phase 4.

The key t o a sound negot i at i on wi t h TMC i s t o i dent i f y r el evant cost s. Mark

pl ans t o be aggr essi ve i n pr i ci ng t hese ser vi ces, because he want s t he

cont r act . He f eel s t hat t he addi t i onal vol ume wi l l l ower per t r anspl ant cost

and hence i ncrease t he Cent er s pr of i t abi l i t y. St i l l , he want s t o set a pr i ce

t hat does not degr ade t he cur r ent pr of i t abi l i t y of t he Cent er , whi ch i s goodbut not spect acul ar .

To hel p wi t h t he deci si on, Mark compi l ed t he Phase 4 hospi t al cost s of 12

r ecent l i ver t r anspl ant pat i ent s. I n r evi ewi ng t hese dat a, shown i n Tabl e 1,

Mark not ed t hat a t otal average cost of $119, 805 f or 19 days aver age l engt h

of st ay t r ansl at es t o a st agger i ng per di em ( per day) aver age cost of over

$6, 000.

Mark i s convi nced that a pr i ce cl ose t o $120, 000, whi ch woul d cover t otal

costs, woul d not be accept abl e to TMC. So, he exami ned the possi bi l i t y of

l oweri ng cost s by reduci ng t he average l engt h of st ay ( LOS) . However, t hecost s associ at ed wi t h Phase 4 ar e not a l i near f unct i on of LOS. The f i r st day

of Phase 4 i s usual l y the most cost l y whi l e t he l ast day i s usual l y t he l east

cost l y. I ndeed, over hal f of Phase 4 cost s occur i n t he f i r st 24 hour s of

hospi t al i zat i on.

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Because i t woul d be di f f i cul t t o l ower Phase 4 hospi t al cost s by reduci ng

LOS, Mark deci ded t o pur sue a di f f er ent st r at egy. Hi s exper i ence at t he

Tr anspl ant Center has convi nced hi m t hat t here are economi es of scal e present

i n l i ver t r anspl ant s, and hence t he mar gi nal cost of each t r anspl ant i s l ower

t han t he average cost . Thus, Mark bel i eves t hat he can base t he cont r act

pr i ce on mar gi nal cost s r at her t han t ot al ( f ul l ) cost s. Such a r at e woul d

( hopef ul l y) be at t r act i ve t o TMC yet , at t he same t i me, pr eserve the Cent er s

pr of i t abi l i t y.

Assume t hat you have been hi r ed as a consul t ant t o r ecommend a f i xed pr i ce

( t he base rat e) t hat shoul d be pr oposed i n t he cont r act negoti at i ons f or

Phase 4 hospi t al ser vi ces. To hel p i n t he anal ysi s, Mar k has i ndi cat ed t hat

appr oxi mat el y 60 per cent of nur si ng, anci l l ar y, operat i ng r oom, and

l abor at or y cost s ar e f i xed. The r emai ni ng cost s- - r adi ol ogy, dr ug, and ot her

ser vi ces- - ar e pr edomi nant l y var i abl e.

TABLE 1

Uni ver si t y Tr anspl ant Cent er

Phase 4 Hospi t al Cost s

Tot al Nur si ng Anci l l ar y OR Lab Radi ol ogy Dr ug Ot her

Pati ent Age LOS Cost s Cost Cost Cost Cost Cost Cost Cost s

A 61 25 $141, 092 $10, 261 $65, 416 $6, 770 $13, 712 $1, 483 $20, 992 $22, 458

B 56 15 139, 306 11, 969 63, 668 8, 501 7, 409 2, 261 24, 504 20, 994

C 42 12 74, 259 6, 939 33, 661 3, 128 5, 279 668 6, 964 17, 620

D 52 13 115, 349 7, 221 54, 063 5, 779 6, 112 903 7, 638 33, 633

E 12 26 172, 613 28, 205 72, 204 6, 847 10, 550 1, 766 23, 061 29, 980

F 59 22 83, 807 16, 858 33, 474 4, 654 6, 211 1, 397 9, 698 11, 515

G 41 25 136, 060 9, 645 63, 208 6, 489 13, 091 1, 382 20, 127 22, 118

H 35 17 139, 308 11, 969 63, 669 8, 501 7, 409 2, 261 24, 505 20, 994

I 52 12 74, 259 6, 939 33, 660 3, 128 5, 280 668 6, 964 17, 620

J 38 13 115, 348 7, 221 54, 063 5, 778 6, 111 903 7, 639 33, 633

K 59 25 166, 224 26, 909 69, 657 6, 765 10, 061 1, 677 22, 007 29, 148

L 60 21 80, 034 15, 629 32, 202 4, 531 5, 937 1, 293 9, 122 11, 320

Average 47 19 $119,805 $13,314 $53,245 $5,906 $8,097 $1,389 $15,268 $22,586

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QUESTI ONS

1. What i s t he est i mat e of t he mar gi nal cost of t he Phase 4 hospi t al servi ces

assumi ng, as gi ven i n the case, t hat 60 per cent of t he desi gnated cost s

ar e f i xed and t he r emai ni ng cost s are var i abl e?

2. Assume t hat t he agr eed- upon pr i ce i s $90, 000. What i s t he expected pr of i t

on t he cont r act assumi ng that i t br i ngs i n 20 new pat i ent s? ( Assume f or

now t hat no new f i xed cost s woul d be requi r ed. )

3. Now assume t hat t he addi t i onal pat i ent s wi l l add $200, 000 i n t otal t o t he

Cent er s f i xed cost s. Now what i s t he expect ed pr of i t on 20 new pat i ent s?

On 40 new pat i ent s? ( No new f i xed cost s ar e r equi r ed t o suppor t t he second

gr oup of 20 pat i ent s. )

4. What r ol e do t he f ol l owi ng f act or s pl ay i n the deci si on as t o whet her or

not t o use mar gi nal cost pr i ci ng on the new cont r act ?

a. Rei mbursement amount s pai d by cur r ent t r anspl ant t hi r d- part y payers .b. The amount of excess capaci t y i n t he t r anspl ant uni t .

c. The potent i al r eact i on by cur r ent payer s t o a new, l ower pr i ce

cont r act.

5. What i s your f i nal r ecommendat i on r egardi ng the base r ate f or Phase 4

hospi t al ser vi ces t hat shoul d be bui l t i nt o t he cont r act ?

6. Shoul d you wor r y onl y about t he cont r act s f i r st year pr i ci ng, or shoul d

you devel op a l ong- t erm pr i ci ng st r ategy f or TMC? What are some possi bl e

f eat ur es of a l ong- t er m pr i ci ng st r at egy?

7. Br i ef l y descr i be how out l i er payment s mi ght be handl ed to ensure t hat t heCent er does not suf f er l ar ge l osses on out l i er s ( pat i ent s wi t h unusual l yhi gh cost s) . ( Hi nt : Cost out l i er s ar e i dent i f i ed by havi ng cost s t hatexceed a speci f i ed threshold. Then, i n addi t i on t o the st andard payment ,t he pr ovi der i s r ei mbur sement f or somepercentage of t he cost s above t het hr eshol d. For t hi s quest i on, you must choose a cost t hr eshol d and out l i erpayment per cent age. )