Cost Allocation and Pricing Strategies in Healthcare

Direct cost

A cost that is tied exclusively to a subunit of an organization, such as the salaries of a department's employees.

Indirect (overhead) cost

A cost that is tied to shared resources rather than to an individual subunit of an organization (ex. Facilities costs).

Cost allocation

The process by which overhead costs are assigned to individual departments within an organization.

Cost pool

A group of overhead costs to be allocated (ex. Marketing costs).

Cost driver

The basis on which a cost pool is allocated (ex. Square footage for facilities costs).

Allocation rate

The numerical value used to allocate overhead costs (ex. $10 of facilities costs per square foot of occupied space).

Direct method

A cost allocation method in which all overhead costs are allocated directly from the overhead departments to the patient services departments with no recognition that overhead services are provided to other support departments.

Reciprocal method

A cost allocation method that recognizes all of the overhead services provided by one support department to another.

Step down method

A cost allocation method that recognizes some of the overhead services provided by one support department to another.

Profit center

A business unit that generates revenues as well as costs, hence its profitability can be measured.

Cost center

A business unit that does not generate revenues, hence only its costs can be measured.

Purpose of cost allocation

To find the full cost (both indirect and direct) of a department of service.

Methods of allocation

Direct method- easy but not accurate; Step down method- required by Medicare and Medicaid; Reciprocal method- extremely accurate, very difficult.

Determination of allocation order for step-down method

1. The department that serves the most other departments is allocated first; 2. If a tie, departments that spend the least amount of time serving self are allocated first; 3. If a tie, departments with the highest costs are allocated first.

Cost driver characteristics

Fair and encourages cost reduction.

Identification of cost drivers

The most important step in the cost allocation process.

Using square footage to allocate cost drivers

Advantages: it is easy to measure and doesn't change very often; Disadvantages: some patient services require greater support.

Steps in allocating overhead costs

1. Determine the cost pool; 2. Determine the cost driver; 3. Calculate the allocation rate; 4. Determine the allocation amount.

Contribution margin

Under fee-for-service, the dollar amount of each unit of service that is available first to cover fixed costs, and then to contribute to profit.

Pricing decisions

Managers must determine whether to offer volume discounts to valued payer groups, and how large these discounts should be.

Service decisions

Health services managers do not set prices but must decide whether the payment is sufficient to assume the risks associated with providing services to the covered population.

Cost to charge ratio (CCR)

A ratio used to estimate the overhead costs of individual services (service revenues).

Relative Value Unit (RVU) method

A method for estimating the overhead costs of individual services based on the intensity of the service provided, as measured by RVUs.

Traditional costing

A top down approach to costing that first identifies costs at the department level and then (potentially) assigns those costs to individual services.

Activity based costing (ABC)

A bottom up approach to costing that identifies the activities required to provide a particular service, estimates the costs of those activities, and then aggregates those costs.

Time driven activity based costing (TDABC)

A relatively new approach of estimating costs of treating individual patient diagnoses over time.

Price taker

A business that has no power to influence the prices set by the marketplace.

Price setter

A business that has the power to set the market prices for its goods or services.

Marginal cost pricing

The process of setting prices to cover only marginal costs.

Cross subsidization (price shifting)

A pricing approach in which some payers are charged more than full costs to make up for other payers that are paying less than full costs.

Target costing

For price takers, the process of reducing costs to the point at which a profit is earned on the market-determined price.

Full cost pricing

The process of setting prices to cover all costs plus a profit component.

Scenario analysis

A project risk analysis technique that examines alternative outcomes, as opposed to the most likely outcome.

Base case

Uses the most likely estimates for all input values.

CCR Formula

(indirect costs) / (total charges).

Steps required to implement ABC

Identify the relevant activities, estimate the costs of each activity, including both direct and indirect, assign cost drivers for each activity, collect activity data for each service, calculate the total cost of the service by aggregating activity costs.

Steps in the TDABC method

Select the medical condition to be studied, define the care delivery chain, develop process maps of each activity, estimate the cost of supplying the patient care resources, estimate the allocation rates of each activity, calculate the total cost of patient care.

Greatest value of target costing

Forces managers to recognize that the market, not the provider, is setting prices.

Pricing decisions analysis

Supported by analyses that use both managerial and actuarial accounting data, these analyses are: base case and scenario analyses.