Health Care Cost Accounting
Discuss three different methods of estimating costs in a health care
organization and provide the pros and cons of each.
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CHAPTER 12
PROVIDER COST-FINDING METHODS
LEARNING OBJECTIVES
• Identify three methods to estimate costs.
• Calculate costs using the step-down method.
• Calculate costs using activity-based costing.
• Understand the major advantages and disadvantages of activity-based costing.
Cost Object
Anything for which a cost is being estimated, such as a population, a test, a visit, a patient, or
a patient day.
Cost-to-Charge Ratio
A method to estimate costs that assumes costs are a certain percentage of charges (or
reimbursements).
Finding the costs to serve various populations (e.g., the elderly, Medicare patients,
rehabilitation patients), to produce various goods and services, and to work with various payors
(e.g., Medicaid, insurance companies) is an important activity for most health care providers. A
cost object is anything for which costs are being estimated, such as a population, a test, a visit,
a patient, or a patient day. This chapter discusses the three most commonly used approaches to
find costs for various cost objects: the cost-to-charge ratio, the step-down method, and activitybased costing.
Cost-to-Charge Ratio
Historically, the cost-to-charge ratio (CCR) is one of the most common methods used by
dentists and physicians to estimate costs. It is based on an assumed relationship of costs to
charges, usually determined by industry norms or special studies. CCR begins with charges
(or reimbursements) and assumes that costs are a certain percentage of this amount. For
example, a group planning a dental office might use the rule of thumb that all nondirect labor
expenses amounted to 22 percent of charges.
The main advantage of this approach is simplicity. The disadvantages include the following:
• Though the ratio used may be typical for the industry or a segment of the industry, it may
not apply as well to any particular organization.
• When the ratio has been determined by a study, to the extent that actual volume or
service mix deviates from the figures used in the study, the CCR may be inaccurate.
• To the extent that the fixed or variable cost composition has changed, the ratio may
provide an inaccurate measurement.
• To the extent that an overall ratio is used for all procedures, the CCR may underestimate
or overestimate the cost of individual procedures.
Although the CCR is relatively simple to implement, more complex health care organizations
usually use a step-down or an activity-based costing approach, either of which is commonly
thought to be more accurate but also more difficult to calculate.
Step-Down Method
A cost-finding method based on allocating costs that are not directly paid for to products or
services to which payment is attached. The method derives its name from the stair-step
pattern that results from allocating costs.
Step-Down Method
The step-down method is a cost-finding method based on allocating costs that are not directly
paid for (indirect costs) to products or services that are directly paid for (direct costs). The
example in Exhibit 12.1 shows three responsibility centers to which payment is not attached
(utilities, administration, and laboratory) and three to which revenues are attached (walk-in
services, pediatric services, and adolescent services). The goal of the step-down method is to
allocate the costs of the support centers (utilities, administration, and laboratory) fairly
among each of the three patient services. The full step-down allocation is shown in Exhibit
12.2.
EXHIBIT 12.1 EXAMPLE OF COSTS TO WHICH
PAYMENT IS NOT DIRECTLY ATTACHED AND COSTS TO
WHICH PAYMENT IS DIRECTLY ATTACHED
EXHIBIT 12.2 THE STEP-DOWN METHOD OF
ALLOCATING COSTS
a
Differences due to rounding.
There are four steps in allocating indirect costs to services for which payment is attached:
• Determine an allocation base and compile basic statistics.
• Convert basic statistics for the step-down approach.
• Calculate allocation percentages.
• Allocate costs from each support center to each of the centers below it (thus the down in
step-down).
These steps will now be followed to allocate utilities, administration, and laboratory costs,
respectively.
Allocation Base
A statistic (e.g., square feet, number of full-time employees) used to allocate costs because
it is assumed to be related to why the costs occurred.
Allocating Utilities
An allocation base is a statistic used to allocate costs because it is related to why the costs
occurred. Some common allocation bases are listed in Exhibit 12.3. The better the causeand-effect relationship between the cost occurrence and the allocation basis, the more
accurate the cost allocation. Because of their causal relationship to costs, allocation bases
are also called cost drivers (discussed in more detail below). For instance, a common base
for allocating utilities is square footage, on the assumption that actual utility usage is
proportional to the size of the space a service occupies.
EXHIBIT 12.3 SOME COMMON ALLOCATION BASES
a
Full-time equivalent employees.
b
Laboratory and nursing are frequently charged directly to patients, rather than being
allocated.
EXHIBIT 12.4 STEPS IN THE STEP-DOWN PROCESS
RELEVANT TO THE ALLOCATION OF UTILITY COSTS
Exhibit 12.4 highlights those parts of Exhibit 12.2 relevant to allocating utilities. Because
administration occupies 1,000 of the 10,000 square feet of the facility (Exhibit 12.4,
columns A and D), it is allocated 10 percent (column G) of the $50,000 indirect cost of
utilities, which is $5,000 (column K). Similarly, because the laboratory and the walk-in
services each occupy 2,000 of the 10,000 square feet (columns A and D), each is allocated
20 percent (column G), which is $10,000 (column K). Finally, because the pediatric and
adolescent services each occupy 2,500 square feet (columns A and D), each is allocated 25
percent (column G), which is $12,500 (column K).
Allocating Administrative Costs
Exhibit 12.5 highlights those parts of Exhibit 12.2 relevant to allocating administrative
costs. Note that instead of allocating just the $100,000 in administrative costs that were
there at the beginning of the allocation (column J), $105,000 is now being allocated from
administration: $100,000 in original administrative costs, and the additional $5,000 that has
been allocated to administration from utilities.
EXHIBIT 12.5 STEPS IN THE STEP-DOWN PROCESS
RELEVANT TO THE ALLOCATION OF ADMINISTRATIVE
COSTS
The allocation base used to allocate administration is direct costs of the responsibility
centers (see Exhibit 12.5, column E), based on the assumption that administrative costs are
incurred by each of the other responsibility centers in the same proportion as are their direct
costs. Another allocation base sometimes used to allocate administrative costs is the
number of FTEs (full-time equivalent employees) in each responsibility center. This
assumes that administrative costs are incurred in proportion to the number of employees
working in each responsibility center.
Although the procedure here is similar to allocating utilities, there is one major difference.
Note that in column B of Exhibit 12.5, there is $1,025,000 in costs, including $50,000 in
utilities and $100,000 in administrative costs, whereas in column E there is only $875,000
in costs because utilities and administrative costs have been omitted. This is done for two
reasons: First, by convention, the step-down allocation method always proceeds downward
from one responsibility center to those below it. Thus, no administrative costs are allocated
(upward) to utilities. Therefore, the $50,000 in utilities cost is excluded (column E) when
determining the proportional share of administration to be allocated on the basis of direct
costs. Second, because administration is fully allocated to the services below it, it cannot
give any of its cost to itself. Therefore, in using direct costs as the basis to determine what
percentage of the administrative costs being allocated go to the services below it, the
$100,000 in administrative indirect costs are omitted (column E).
Without the $150,000 of utilities and administration, there is $875,000 in costs over which
to allocate administration. Laboratory has $175,000 in costs (column E), and thus it
receives $175,000 / $875,000, or 20 percent (column H), of the $105,000 in administration
being allocated, which is $21,000 (column L). The walk-in services clinic has $200,000 of
direct costs (column E), so it receives $200,000 / $875,000, or 22.9 percent (column H), of
the $105,000 in administrative costs being allocated, which is $24,000 (column L). The
remaining administrative costs are allocated to the pediatric and adolescent services in a
similar manner (column L).
Allocating Laboratory Costs
The only costs that have not yet been allocated are those of the laboratory. Note that in
Exhibit 12.2, instead of the original $175,000 in indirect laboratory costs, $206,000 is
being allocated (column M). That is because, in addition to its own costs, laboratory also
includes $10,000 in costs allocated from utilities and $21,000 in costs allocated from
administration.
Laboratory costs are allocated on the basis of lab tests under the assumption that the fair
share of the laboratory costs due to each of the three services is in proportion to the number
of tests each service ordered (see Exhibit 12.2, column C). Using lab tests as a basis, the
walk-in services clinic is allocated 25 percent (column I) of the $206,000 (column M),
which is $51,500 (column M). The pediatric services and the adolescent services clinics are
allocated 45 percent and 30 percent, respectively (column I), of the $206,000 (column M),
which are $92,700 and $61,800, respectively (column M).
Fully Allocated Cost
The cost of a cost object that includes both its direct costs and all other costs allocated to
it.
Fully Allocated Cost
After all the indirect costs of the support services that are not directly paid for have been
allocated to those services that are paid for, the totals are summed (see Exhibit 12.2,
column N). Rather than the $200,000 it costs to deliver walk-in services when only direct
costs are considered, the fully allocated costs are $285,500. Similarly, pediatric services
changed from $200,000 to $329,200, and adolescent services changed from $300,000 to
$410,300 when allocated costs are included. Thus, the fully allocated cost reflects both the
original direct costs and all allocated indirect costs, but the total cost, $1,025,000, remains
the same as before.
Here are some final comments regarding the step-down allocation method:
•
To the extent that services use different allocation bases, the order in which the
services are allocated makes a difference in the final costs. For example, if administration
were placed ahead of utilities in the allocation order, the costs of walk-in, pediatric, and
adolescent services would be different from those in the example. There are two
sometimes conflicting rules of thumb to help with choosing a reasonable order: first,
rank-order the centers being allocated from highest dollar amount to lowest dollar amount
(according to this rule, in the example, laboratory and then administration should have
been listed ahead of utilities); or second, list the centers from highest to lowest in an
order that reflects the number of other centers they affect. It was for this reason that the
centers were ordered as they were in the example, with laboratory being last.
•
The allocation basis used to allocate costs makes a difference in the final costs. If
instead of direct costs, the number of FTEs were the allocation basis for administration,
and if there were a low correlation between the two, then the costs of walk-in, pediatric,
and adolescent services would be different.
•
The number of centers to which costs are allocated makes a difference. For
example, if there were four services instead of three, then the costs allocated to the
original three services (walk-in, pediatric, and adolescent) would be different (probably
less).
•
Although the step-down method is the most widely used, because it has been
associated with Medicare reporting, there are several other related methods available to
providers to calculate costs. These are the direct method, the double apportionment
method, and the reciprocal method. Because they are used relatively infrequently, they
are not discussed here.
•
The step-down method is useful for pricing and reimbursement-related decisions
but is less useful for controlling costs. There are other methods, including activity-based
costing, that are better for cost control.
Most inpatient facilities use the step-down method to report their Medicare costs. However,
as shown in Perspective 12.1, network integration has added to the complexity of costfinding methodologies as services are being offered across a variety of settings. Perspective
12.2 illustrates problems that may arise in using a cost report as the basis for calculating a
cost-to-charge ratio.
Activity-Based Costing
PERSPECTIVE 12.1 STEP-DOWN APPROACH MAY BE
OUTDATED WITH CONTINUUM OF CARE FROM
PROVIDERS
The movement to bundle systems based on episode of care across a continuum of providers
is making the historical, step-down cost allocation models less effective in assessing true
cost of care. This movement toward provision and coordination of care across a multitude
of providers requires managers to not only analyze the location of the care but also to
demonstrate how to reduce cost in the provision of care away from the hospital setting.
Now health care managers need to investigate whether the various types of costs—fixed
versus variable, direct versus indirect—possess a common definition across providers. For
example, if a hospital has contracted with a rehab unit and a home health agency to provide
post-acute care services, managers must measure whether these providers have
implemented costing systems that can measure costs for each unit of service. If these
providers have not implemented a cost accounting system, managers will need to develop a
proxy measure for each unit of care. Finally, electronic health records and payment systems
will help these providers and health care systems to maintain timely standards of costs
based on monthly data rather than prior year fiscal-year data.
Source: Adapted from J. Glaser and A. Sett, Using technology to reveal true costs,
Healthcare Financial Management, 2012;66(2):44–49.
Although the step-down method of cost allocation is widely used to find the cost of services
for pricing and reimbursement purposes, a newer cost-finding method, called activity-based
costing (ABC), is receiving increased attention from health care providers. ABC is based on
the paradigm that activities consume resources and products consume activities (Exhibit
12.6). Therefore, if activities or processes are controlled, then costs will be controlled.
Similarly, if the resources an activity uses can be measured, a more accurate picture of the
actual costs of services can be found, as compared with traditional cost allocation.
PERSPECTIVE 12.2 COST-TO-CHARGE RATIO: QUICK
APPROACH TO MEASURE DEPARTMENTAL
PERFORMANCE
Can departmental managers assess their performance utilizing their hospital's Medicare
cost report? Yes, this report is a quick and readily available assessment tool for a hospital's
costs and a department's performance. For ancillary departments such as laboratory,
radiology, operating room, and so forth, a health care manager can identify those
departments with a ratio of costs to charges of less than 1.00, for profitable departments,
and a ratio of greater than 1.00, for unprofitable areas. A ratio value greater than 1.00
indicates that a department's total costs exceed its gross charges and it is losing money,
while a ratio value less than 1.00 means the hospital department is profitable. For
unprofitable departments, health care managers can take action by lowering costs, raising
charges, and/or eliminating the department. Typically, hospital ancillary departments, such
as a skilled nursing facility (SNF), home health agency, clinic, or hospice, have values less
than 1.00, to be certain their charges exceed the fully allocated costs, which include both
direct costs of the department and allocated overhead expenses such as laundry and
maintenance. Since departmental managers are unable to directly manage allocated
expenses, top management may consider assessing the performance of departmental
managers on the costs they can control, specifically the direct cost-to-charge ratio.
Source: Adapted from K. J. LaBrake and H. S. Pokrandt, Using the Medicare cost report to
improve financial performance, Healthcare Financial Management, 2010;64(10):72–78.
Activity-Based Costing
A method of estimating the costs of a service or product by measuring the costs of the
activities it takes to produce that service or product.
Traditional cost allocation is called a top-down approach because it begins with all costs and
allocates them downward into various services for which payment will be received (Exhibit
12.7a). ABC, conversely, is called a bottom-up approach because it finds the cost of each
service at the lowest level, the point at which resources are used, and aggregates them
upward into products (Exhibit 12.7b).
For example, in Exhibit 12.8, the service “Normal Delivery” comprises three intermediate
products (or processes): prenatal visit, labor and delivery, and postpartum care. Each of these
intermediate products encompasses a number of activities. For example, the prenatal visit
includes a urinalysis, a complete blood count (CBC), vital signs, recent history, and so forth.
Each of these activities might also include a portion of what are usually considered indirect
costs, such as those associated with ordering supplies, updating medical records, or providing
financial counseling.
EXHIBIT 12.6 PRODUCTS RESULT FROM ACTIVITIES
AND PROCESSES, WHICH RESULT FROM THE
UTILIZATION OF RESOURCES
EXHIBIT 12.7a TRADITIONAL COSTING
EXHIBIT 12.7b ACTIVITY-BASED COSTING
EXHIBIT 12.8 EXAMPLES OF INTERMEDIATE
PRODUCTS AND ACTIVITIES FOR A NORMAL DELIVERY
Direct Costs
Costs (e.g., nursing costs) that an organization can trace to a particular cost object (e.g., a
patient).
Indirect Costs
Costs that cannot be traced to a particular cost object. Common indirect costs are billing,
rent, utilities, information services, and overhead. Typically, these costs are allocated to
cost objects according to an accepted methodology (e.g., the step-down method).
Cost Driver
That which causes a change in the cost of an activity.
Costing Terminology
Before continuing, it is important to understand three key terms: direct costs, indirect costs,
and cost drivers. Direct costs are costs (e.g., nursing costs) that an organization can trace to
a particular cost object (e.g., a patient). Indirect costs are costs that an organization is not
able to trace directly to a particular cost object. For example, many health care
organizations have great difficulty tracing to a particular patient or service such items as
the cost of the billing clerk, rent, or information systems. Thus, a cost is not direct or
indirect by its nature but by the ability or inability of the organization to trace it to a cost
object.
An important difference between traditional cost allocation and activity-based costing is
how each handles indirect costs. Traditional cost allocation methods usually deal with
indirect costs by allocating them to cost objects using relatively gross cause-and-effect
relationships, as described earlier. ABC attempts to overcome this problem by more
directly tracing costs to their cost objects or by finding more precise cost drivers. Cost
drivers are things that cause a change in the cost of an activity.
For example, under traditional step-down costing, purchasing costs might be bundled with
other administrative costs and allocated to a service based on the relative size of its budget.
Under ABC, it is more likely that the costs of purchasing would be allocated to that service
more precisely on the basis of the number of purchase orders emanating from that service
or even more precisely by measuring the number of minutes spent processing purchase
orders from that department.
An Example
Exhibit 12.9 compares the results of a traditional cost allocation approach with the results
of an ABC approach. In this example, the organization is offering three outpatient services:
an initial visit, a routine regular visit, and an intensive visit. It is assumed that labor and
materials can be directly traced to each type of visit and therefore that labor and materials
costs do not vary between the two cost-finding approaches. Thus, the main difference
between the two approaches (as is often the case in practice) is in the allocation of
overhead. As explained below, the traditional approach, on the one hand, uses a single cost
driver, visits, and thus assigns the same overhead cost per visit ($17.50) to all three services
(row 3, columns A, B, and C). The ABC approach, on the other hand, uses three cost
drivers and derives an overhead cost per visit of $34.56 for an initial visit, $11.73 for a
regular visit, and $15.75 for an intensive visit (row 3, columns D, E, and F). Thus, relative
to the traditional approach, the ABC approach estimates overhead cost to be $17.06 higher
than the average $17.50 for an initial visit, and $5.78 and $1.75 lower for a regular and
intensive visit, respectively (row 3, columns G, H, and I).
(Zelman 551-569)
Zelman, William N., Michael McCue, Noah Glick, Marci Thomas. Financial Management of
Health Care Organizations: An Introduction to Fundamental Tools, Concepts and
Applications, 4th Edition. Jossey-Bass, 2013-12-30. VitalBook file.
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