Health Care Cost Accounting Discuss three different methods of estimating costs in a health care organization and provide the pros and cons of each. Remember to use two references. Your post must follow APA sixth edition style and formatting guidelines. 250 words 10 pt Arial 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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