HEALTHCARE FINANCE

HEALTHCARE FINANCE

FINANCE
FIFTH EDITION
JUDITH J. BAKER, PhD, CPA
R.W. BAKER, JD
NEIL R. DWORKIN, PhD
Basic Tools For Nonfinancial Managers
HEALTH CARE
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Library of Congress Cataloging-in-Publication Data
Names: Baker, Judith J., author. | Baker, R. W., author. | Dworkin, Neil R., author.
Title: Health care finance : basic tools for nonfinancial managers / Judith Baker, R.W. Baker, and Neil R. Dworkin.
Description: Fifth edition. | Burlington, Massachusetts : Jones & Bartlett Learning, [2018] | Includes
bibliographical references and index.
Identifiers: LCCN 2016054734 | ISBN 9781284118216 (pbk.)
Subjects: | MESH: Financial Management | Health Facilities–economics | Health Facility Administration |
United States
Classification: LCC RA971.3 | NLM W 80 | DDC 362.1068/1–dc23
LC record available at https://lccn.loc.gov/2016054734
6048
Printed in the United States of America
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iii
© LFor/Shutterstock
New to This Edition……………………………………………………………………………………………….xvii
Preface……………………………………………………………………………………………………………….. xix
Acknowledgments ………………………………………………………………………………………………… xxi
About the Authors ………………………………………………………………………………………………. xxiii
PART I—HEALTHCARE FINANCE OVERVIEW…………………………………………………………. 1
Chapter 1 Introduction to Healthcare Finance …………………………………………………….. 3
The History ……………………………………………………………………………………………. 3
The Concept………………………………………………………………………………………….. 4
How Does Finance Work in the Healthcare Business? ……………………………….. 4
Viewpoints……………………………………………………………………………………………… 4
Why Manage?…………………………………………………………………………………………. 5
The Elements of Financial Management………………………………………………….. 5
The Organization’s Structure ………………………………………………………………….. 5
Two Types of Accounting ………………………………………………………………………… 7
Information Checkpoint…………………………………………………………………………. 9
Key Terms………………………………………………………………………………………………. 9
Discussion Questions………………………………………………………………………………. 9
Notes…………………………………………………………………………………………………….. 9
Chapter 2 Four Things the Healthcare Manager Needs to Know About
Financial Management Systems ………………………………………………………11
What Does the Manager Need to Know?…………………………………………………. 11
How the System Works in Health Care……………………………………………………. 11
The Information Flow…………………………………………………………………………… 12
Basic System Elements…………………………………………………………………………… 14
The Annual Management Cycle…………………………………………………………….. 18
Communicating Financial Information to Others…………………………………… 20
Information Checkpoint……………………………………………………………………….. 20
Key Terms…………………………………………………………………………………………….. 20
Discussion Questions…………………………………………………………………………….. 20
Notes…………………………………………………………………………………………………… 21
Table of Contents
iv Table of Contents
Chapter 3 The Digital Age: Changing the Landscape of Healthcare
Finance ………………………………………………………………………………………23
High-Tech and High-Touch Approaches………………………………………………… 23
Patient Engagement……………………………………………………………………………… 23
Social Media…………………………………………………………………………………………. 24
Resource Allocation ……………………………………………………………………………… 25
Changes in Health Information Technology…………………………………………… 25
Population Health and the Digital Age: Crossing at
the Intersection………………………………………………………………………………… 26
Additional Trends and Complexities: Other Delivery Systems………………….. 27
Summary …………………………………………………………………………………………….. 27
Information Checkpoint……………………………………………………………………….. 28
Key Terms…………………………………………………………………………………………….. 28
Other Acronymns…………………………………………………………………………………. 28
Discussion Questions…………………………………………………………………………….. 28
Notes…………………………………………………………………………………………………… 28
PART II—RECORD FINANCIAL OPERATIONS………………………………………………………..31
Chapter 4 Assets, Liabilities, and Net Worth………………………………………………………..33
Overview ……………………………………………………………………………………………… 33
What Are Examples of Assets? ……………………………………………………………….. 34
What Are Examples of Liabilities? ………………………………………………………….. 35
What Are the Different Forms of Net Worth? ………………………………………….. 35
Information Checkpoint……………………………………………………………………….. 36
Key Terms…………………………………………………………………………………………….. 36
Discussion Questions…………………………………………………………………………….. 36
Chapter 5 Revenues (Inflow)……………………………………………………………………………37
Overview ……………………………………………………………………………………………… 37
Receiving Revenue for Services……………………………………………………………… 37
Sources of Healthcare Revenue……………………………………………………………… 39
Grouping Revenue for Planning and Control…………………………………………. 42
Information Checkpoint……………………………………………………………………….. 45
Key Terms…………………………………………………………………………………………….. 45
Discussion Questions…………………………………………………………………………….. 45
Notes…………………………………………………………………………………………………… 46
Chapter 6 Expenses (Outflow)………………………………………………………………………….47
Overview ……………………………………………………………………………………………… 47
Disbursements for Services……………………………………………………………………. 48
Grouping Expenses for Planning and Control………………………………………… 48
Cost Reports as Influencers of Expense Formats……………………………………… 52
Information Checkpoint……………………………………………………………………….. 53
Key Terms…………………………………………………………………………………………….. 54
Discussion Questions…………………………………………………………………………….. 54
Notes…………………………………………………………………………………………………… 54
Table of Contents v
Chapter 7 Cost Classifications ………………………………………………………………………….55
Distinction Between Direct and Indirect Costs………………………………………… 55
Examples of Direct Cost and Indirect Cost……………………………………………… 56
Responsibility Centers…………………………………………………………………………… 57
Distinction Between Product and Period Costs……………………………………….. 60
Information Checkpoint……………………………………………………………………….. 61
Key Terms…………………………………………………………………………………………….. 61
Discussion Questions…………………………………………………………………………….. 61
Notes…………………………………………………………………………………………………… 61
PART III—TOOLS TO ANALYZE AND UNDERSTAND FINANCIAL OPERATIONS ………63
Chapter 8 Cost Behavior and Break-Even Analysis ……………………………………………….65
Distinctions Among Fixed, Variable, and Semivariable Costs……………………. 65
Examples of Variable and Fixed Costs…………………………………………………….. 69
Analyzing Mixed Costs ………………………………………………………………………….. 71
Contribution Margin, Cost-Volume-Profit, and Profit-Volume Ratios………… 73
Information Checkpoint……………………………………………………………………….. 78
Key Terms…………………………………………………………………………………………….. 78
Discussion Questions…………………………………………………………………………….. 78
Notes…………………………………………………………………………………………………… 79
Chapter 9 Understanding Inventory and Depreciation Concepts ……………………………81
Overview: The Inventory Concept………………………………………………………….. 81
Inventory and Cost of Goods Sold (“Goods” Such as Drugs) ……………………. 82
Inventory Methods……………………………………………………………………………….. 83
Inventory Tracking ……………………………………………………………………………….. 84
Inventory Distribution Systems………………………………………………………………. 86
Calculating Inventory Turnover …………………………………………………………….. 87
Overview: The Depreciation Concept…………………………………………………….. 88
Book Value of a Fixed Asset and the Reserve for Depreciation …………………. 88
Computing Tax Depreciation………………………………………………………………… 92
Information Checkpoint……………………………………………………………………….. 93
Key Terms…………………………………………………………………………………………….. 93
Discussion Questions…………………………………………………………………………….. 93
Notes…………………………………………………………………………………………………… 93
Appendix 9-A A Further Discussion of Accelerated and
Units of Service Depreciation Computations………………………………………. 95
Accelerated Book Depreciation Methods……………………………………………….. 95
Chapter 10 Staffing: Methods, Operations, and Regulations………………………………….103
Staffing Requirements ………………………………………………………………………… 103
FTEs for Annualizing Positions ……………………………………………………………. 103
Number of Employees Required to Fill a Position: Another Way to
Calculate FTEs ……………………………………………………………………………….. 106
Regulatory Requirements Regarding Staffing……………………………………….. 111
vi Table of Contents
Summary……………………………………………………………………………………………. 113
Information Checkpoint……………………………………………………………………… 114
Key Terms…………………………………………………………………………………………… 114
Discussion Questions…………………………………………………………………………… 114
Notes…………………………………………………………………………………………………. 114
PART IV—REPORT AND MEASURE FINANCIAL RESULTS……………………………………..117
Chapter 11 Reporting as a Tool ………………………………………………………………………..119
Understanding the Major Reports ……………………………………………………….. 119
Balance Sheet …………………………………………………………………………………….. 119
Statement of Revenue and Expense……………………………………………………… 120
Statement of Changes in Fund Balance/Net Worth ………………………………. 122
Statement of Cash Flows ……………………………………………………………………… 123
Subsidiary Reports………………………………………………………………………………. 124
Summary……………………………………………………………………………………………. 125
Information Checkpoint……………………………………………………………………… 125
Key Terms…………………………………………………………………………………………… 126
Discussion Questions…………………………………………………………………………… 126
Notes…………………………………………………………………………………………………. 126
Chapter 12 Financial and Operating Ratios as Performance
Measures…………………………………………………………………………………..127
The Importance of Ratios……………………………………………………………………. 127
Liquidity Ratios…………………………………………………………………………………… 129
Solvency Ratios …………………………………………………………………………………… 130
Profitability Ratios………………………………………………………………………………. 132
Information Checkpoint……………………………………………………………………… 134
Key Terms…………………………………………………………………………………………… 134
Discussion Questions…………………………………………………………………………… 134
Chapter 13 The Time Value of Money ……………………………………………………………….135
Purpose ……………………………………………………………………………………………… 135
Unadjusted Rate of Return………………………………………………………………….. 135
Present-Value Analysis…………………………………………………………………………. 136
Internal Rate of Return……………………………………………………………………….. 137
Payback Period …………………………………………………………………………………… 137
Evaluations…………………………………………………………………………………………. 138
Resources…………………………………………………………………………………………… 139
Information Checkpoint……………………………………………………………………… 139
Key Terms…………………………………………………………………………………………… 139
Discussion Questions…………………………………………………………………………… 139
Note…………………………………………………………………………………………………… 140
Appendix 13-A Present-Value Table
(The Present Value of $1.00) …………………………………………………………… 141
Table of Contents vii
Appendix 13-B Compound Interest Table: Compound Interest
of $1.00 (The Future Amount of $1.00)……………………………………………. 143
Appendix 13-C Present Value of an Annuity of $1.00…………………………… 145
PART V—TOOLS TO REVIEW AND MANAGE COMPARATIVE DATA……………………….147
Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data …………………………149
Common Sizing………………………………………………………………………………….. 149
Trend Analysis…………………………………………………………………………………….. 150
Analyzing Operating Data……………………………………………………………………. 151
Importance of Forecasts………………………………………………………………………. 152
Operating Revenue Forecasts………………………………………………………………. 153
Staffing Forecasts ……………………………………………………………………………….. 156
Capacity Level Issues in Forecasting……………………………………………………… 158
Summary……………………………………………………………………………………………. 160
Information Checkpoint……………………………………………………………………… 160
Key Terms…………………………………………………………………………………………… 160
Discussion Questions…………………………………………………………………………… 160
Notes…………………………………………………………………………………………………. 160
Chapter 15 Using Comparative Data………………………………………………………………….161
Overview ……………………………………………………………………………………………. 161
Comparability Requirements……………………………………………………………….. 161
A Manager’s View of Comparative Data ………………………………………………… 162
Uses of Comparative Data……………………………………………………………………. 163
Making Data Comparable……………………………………………………………………. 168
Constructing Charts to Show the Data ………………………………………………….. 171
Information Checkpoint……………………………………………………………………… 173
Key Terms…………………………………………………………………………………………… 173
Discussion Questions…………………………………………………………………………… 174
Note…………………………………………………………………………………………………… 174
PART VI—CONSTRUCT AND EVALUATE BUDGETS ……………………………………………..175
Chapter 16 Operating Budgets …………………………………………………………………………177
Overview ……………………………………………………………………………………………. 177
Budget Viewpoints………………………………………………………………………………. 178
Budget Basics: A Review………………………………………………………………………. 179
Building an Operating Budget: Preparation …………………………………………. 180
Building an Operating Budget: Construction ……………………………………….. 181
Working with Static Budgets and Flexible Budgets ………………………………… 183
Budget Construction Summary ……………………………………………………………. 186
Budget Review ……………………………………………………………………………………. 186
Information Checkpoint……………………………………………………………………… 187
Key Terms…………………………………………………………………………………………… 187
viii Table of Contents
Discussion Questions…………………………………………………………………………… 187
Notes…………………………………………………………………………………………………. 188
Appendix 16-A Creating a DRG Budget for Respiratory Care:
The Resource Consumption Approach…………………………………………….. 189
Background ……………………………………………………………………………………….. 189
A DRG Budget for Respiratory Care …………………………………………………….. 190
Notes…………………………………………………………………………………………………. 193
Appendix 16-B Reviewing a Comparative Operating Budget
Report……………………………………………………………………………………………. 195
The Comparative Report to Review………………………………………………………. 195
Checklist Questions and Answers for the Comparative Budget
Review……………………………………………………………………………………………. 196
Chapter 17 Capital Expenditure Budgets ……………………………………………………………197
Overview ……………………………………………………………………………………………. 197
Creating the Capital Expenditure Budget …………………………………………….. 197
Budget Construction Tools………………………………………………………………….. 198
Funding Requests……………………………………………………………………………….. 200
Evaluating Capital Expenditure Proposals…………………………………………….. 202
Information Checkpoint……………………………………………………………………… 203
Key Terms…………………………………………………………………………………………… 203
Discussion Questions…………………………………………………………………………… 204
Note…………………………………………………………………………………………………… 204
Appendix 17-A A Further Discussion of Capital Budgeting
Methods…………………………………………………………………………………………. 205
Assumptions……………………………………………………………………………………….. 205
Payback Method …………………………………………………………………………………. 205
Unadjusted Rate of Return (AKA Accountant’s Rate of Return) …………….. 206
Net Present Value ……………………………………………………………………………….. 207
Internal Rate of Return……………………………………………………………………….. 207
PART VII—TOOLS TO PLAN, MONITOR, AND CONTROL FINANCIAL STATUS……..209
Chapter 18 Variance Analysis and Sensitivity Analysis……………………………………………211
Variance Analysis Overview………………………………………………………………….. 211
Three Types of Flexible Budget Variance ……………………………………………… 211
Two-Variance Analysis and Three-Variance Analysis Compared………………. 212
Three Examples of Variance Analysis……………………………………………………. 214
Summary……………………………………………………………………………………………. 218
Sensitivity Analysis Overview………………………………………………………………… 218
Sensitivity Analysis Tools ……………………………………………………………………… 218
Summary……………………………………………………………………………………………. 222
Information Checkpoint……………………………………………………………………… 222
Key Terms…………………………………………………………………………………………… 222
Discussion Questions…………………………………………………………………………… 222
Note…………………………………………………………………………………………………… 222
Table of Contents ix
Chapter 19 Estimates, Benchmarking, and Other Measurement Tools …………………….223
Estimates Overview……………………………………………………………………………… 223
Common Uses of Estimates …………………………………………………………………. 223
Example: Estimating the Ending Pharmacy Inventory …………………………… 224
Example: Estimated Economic Impact of a New Specialty in a
Physician Practice …………………………………………………………………………… 225
Other Estimates………………………………………………………………………………….. 226
Importance of a Variety of Performance Measures………………………………… 226
Adjusted Performance Measures Over Time…………………………………………. 227
Benchmarking……………………………………………………………………………………. 227
Economic Measures ……………………………………………………………………………. 229
Measurement Tools…………………………………………………………………………….. 229
Information Checkpoint……………………………………………………………………… 231
Key Terms…………………………………………………………………………………………… 231
Discussion Questions…………………………………………………………………………… 232
Note…………………………………………………………………………………………………… 232
Chapter 20 Understanding the Impact of Data Analytics and Big Data …………………….233
Introduction ………………………………………………………………………………………. 233
Defining Data Analytics……………………………………………………………………….. 233
Two Basic Approaches to Data Analytics……………………………………………….. 235
Data Analytics and Healthcare Analytics Serve Many Purposes……………….. 236
Data Mining……………………………………………………………………………………….. 237
Impacts of Healthcare Analytics ………………………………………………………….. 238
Challenges for Healthcare Analytics …………………………………………………….. 239
Information Checkpoint……………………………………………………………………… 239
Key Terms…………………………………………………………………………………………… 239
Discussion Questions…………………………………………………………………………… 240
Notes…………………………………………………………………………………………………. 240
PART VIII—FINANCIAL TERMS, COSTS, AND CHOICES ……………………………………….243
Chapter 21 Understanding Investment and Statistical Terms Used in Finance ……………..245
Investment Overview…………………………………………………………………………… 245
Cash Equivalents…………………………………………………………………………………. 245
Governmental Guarantor: The FDIC……………………………………………………. 246
Long-Term Investments in Bonds…………………………………………………………. 246
Investments in Stocks………………………………………………………………………….. 248
Privately Held Companies Versus Public Companies……………………………… 248
Investment Indicators …………………………………………………………………………. 249
Statistics Overview ………………………………………………………………………………. 250
Commonly Used Statistical and Other Mathematical Terms…………………… 251
Information Checkpoint……………………………………………………………………… 254
Key Terms…………………………………………………………………………………………… 254
Discussion Questions…………………………………………………………………………… 255
Notes…………………………………………………………………………………………………. 255
x Table of Contents
Chapter 22 Business Loans and Financing Costs ………………………………………………….257
Overview of Capital Structure………………………………………………………………. 257
Sources of Capital……………………………………………………………………………….. 257
The Costs of Financing ……………………………………………………………………….. 258
Management Considerations About Real Estate Financing…………………….. 259
Management Decisions About Business Loans………………………………………. 260
Information Checkpoint……………………………………………………………………… 260
Key Terms…………………………………………………………………………………………… 260
Discussion Questions…………………………………………………………………………… 260
Appendix 22-A Sample Amortization Schedule ……………………………………. 261
Chapter 23 Choices: Owning Versus Leasing Equipment……………………………………….263
Purchasing Equipment ……………………………………………………………………….. 263
Leasing Equipment …………………………………………………………………………….. 263
Buy-or-Lease Management Decisions……………………………………………………. 264
Accounting Principles Regarding Leases………………………………………………. 268
Information Checkpoint……………………………………………………………………… 269
Key Terms…………………………………………………………………………………………… 269
Discussion Questions…………………………………………………………………………… 269
Note…………………………………………………………………………………………………… 269
PART IX—STRATEGIC PLANNING: A POWERFUL TOOL………………………………………271
Chapter 24 Strategic Planning and the Healthcare Financial Manager……………………..273
Major Components of the
Strategic Plan: Overview………………………………………………………………….. 273
Introduction ………………………………………………………………………………………. 273
Six Major Components ……………………………………………………………………….. 273
Varied Approaches to Strategic Planning ……………………………………………… 275
Examples of Mission, Vision, and Value Statements……………………………….. 276
Recognizing a Special Status or Focus Within the Statements ………………… 276
Financial Emphasis Within the Statements……………………………………………. 278
Relaying the Message ………………………………………………………………………….. 279
The Strategic Planning Cycle and Its Process Flow ………………………………… 281
Process Flow for Creating Goals, Objectives,
and Action Plans…………………………………………………………………………….. 281
Process Flow for Creating Action Plans and Their
Performance Measures……………………………………………………………………. 282
The Planning Cycle Over Time ……………………………………………………………. 283
Managers’ Responsibilities ………………………………………………………………….. 284
Federal Governmental Agencies Must Prepare Strategic Plans ………………. 285
Why are Federal Planning Requirements Important to Us? ……………………. 285
Introduction: Requirements, Plans, and Performance…………………………… 285
An Example: The VA Office of Information Technology IT Strategic
Planning Cycle ……………………………………………………………………………….. 288
Introduction ………………………………………………………………………………………. 288
Table of Contents xi
The VA Office of Information Technology IT Strategic Planning Cycle:
An Example …………………………………………………………………………………… 288
The VA Planning Cycle’s Process Flow………………………………………………….. 288
Planning Cycle Definitions for this Example…………………………………………. 290
Management Responsibilities Within the Planning Cycle ………………………. 291
Tools for Strategic Planning: Situational Analysis
and Financial Projections………………………………………………………………… 292
Situational Analysis……………………………………………………………………………… 293
Financial Projections for Strategic Planning …………………………………………. 294
Case Study: Strategic Financial Planning in Long-Term Care …………………. 296
Appendix 24-A: Sample SWOT Worksheets and Question Guides…………… 296
Information Checkpoint……………………………………………………………………… 296
Key Terms…………………………………………………………………………………………… 297
Discussion Questions…………………………………………………………………………… 297
Notes…………………………………………………………………………………………………. 297
Appendix 24-A Sample SWOT Worksheets and Question Guides…………. 299
Introduction ………………………………………………………………………………………. 299
Scoring Summary Sheet for EHR Adoption and Implementation…………… 299
Three Internal Worksheets for Strengths and Weaknesses……………………… 299
Internal Worksheet for EHR Information
Technology (IT) Staff …………………………………………………………………….. 300
Internal Worksheet for Other Staff Involved in EHR……………………………… 302
Internal Worksheet for Technology and Capital Funding ………………………. 302
External Worksheet for Opportunities and Threats……………………………….. 304
Chapter 25 Putting It All Together: Creating a Business Plan That Is Strategic………….309
Overview ……………………………………………………………………………………………. 309
Elements of the Business Plan ……………………………………………………………… 309
Preparing to Construct the Business Plan……………………………………………… 310
The Service or Equipment Description ………………………………………………… 310
The Organization Segment …………………………………………………………………. 310
The Marketing Segment ……………………………………………………………………… 311
The Financial Analysis Segment…………………………………………………………… 311
The “Knowledgeable Reader” Approach to Your Business Plan………………. 313
The Executive Summary ……………………………………………………………………… 314
Assembling the Business Plan………………………………………………………………. 314
Presenting the Business Plan ……………………………………………………………….. 314
Strategic Aspects of Your Business Plan…………………………………………………. 315
Information Checkpoint……………………………………………………………………… 315
Key Terms…………………………………………………………………………………………… 316
Discussion Questions…………………………………………………………………………… 316
Chapter 26 Understanding Strategic Relationships: Health Delivery Systems,
Finance, and Reimbursement ………………………………………………………317
Introduction ………………………………………………………………………………………. 317
Defining Health Delivery Systems ……………………………………………………….. 317
xii Table of Contents
Defining the Area of Healthcare Finance……………………………………………… 319
Defining the Area of Healthcare Reimbursement …………………………………. 320
Strategic Relationship Between the Healthcare Delivery System and
Finance………………………………………………………………………………………….. 321
The Strategic Relationship Between Finance and Reimbursement…………. 323
Third-Party Reimbursement and Government Expenditures: Another
Strategic Relationship……………………………………………………………………… 325
A New Focus on the Relationship Between Finance and Healthcare
Delivery………………………………………………………………………………………….. 327
Reimbursement and Physicians: An Ongoing Strategic Challenge………….. 327
Information Checkpoint……………………………………………………………………… 328
Key Terms…………………………………………………………………………………………… 329
Other Acronyms…………………………………………………………………………………. 329
Discussion Questions…………………………………………………………………………… 329
Notes…………………………………………………………………………………………………. 330
PART X—INFORMATION TECHNOLOGY AS A FINANCIAL AND STRATEGIC TOOL…..331
Chapter 27 Understanding Value-Based Health Care and Its Financial and Digital
Outcomes………………………………………………………………………………….333
The Value-Based Concept: Introduction ………………………………………………. 333
Value-Based Progress in the Private Sector ……………………………………………. 334
Value-Based Progress in the Public Sector …………………………………………….. 335
Value-Based Education Efforts……………………………………………………………… 337
Value-Based Legislative Reform……………………………………………………………. 338
Quality Measurement: The Concept…………………………………………………….. 341
Value-Based Public Reporting in the Private Sector……………………………….. 343
Value-Based Public Reporting in the Public Sector ……………………………….. 344
Financial Outcomes ……………………………………………………………………………. 346
Digital Outcomes………………………………………………………………………………… 347
Value-Based Strategic Planning by the Private Sector …………………………….. 349
Value-Based Strategic Planning by the Public Sector ……………………………… 350
Conclusion: The Future………………………………………………………………………. 354
Information Checkpoint……………………………………………………………………… 354
Key Terms…………………………………………………………………………………………… 355
Other Acronyms…………………………………………………………………………………. 355
Discussion Questions…………………………………………………………………………… 355
Notes…………………………………………………………………………………………………. 355
Chapter 28 New Payment Methods and Measures:
MIPS and APMs for Eligible Professionals …………………………………….361
Introduction ………………………………………………………………………………………. 361
Legislative Reform and MACRA: An Overview………………………………………. 362
Payment Choices: MIPS Versus APMs …………………………………………………… 363
MIPS Incentives………………………………………………………………………………….. 363
How Are MIPS Physicians and Other Eligible Professionals Paid? …………… 366
Table of Contents xiii
MIPS Composite Performance Score……………………………………………………. 367
MIPS Performance Categories …………………………………………………………….. 368
How MIPS Scoring Works……………………………………………………………………. 370
MIPS Required Reporting Affects Payment ………………………………………….. 373
Data Submission…………………………………………………………………………………. 374
APM Incentives—(Choice #2)……………………………………………………………… 375
Eligible Professionals Within APMs………………………………………………………. 376
How Are Advanced APM EPs Paid? ………………………………………………………. 378
How Significant Participation Works…………………………………………………….. 380
Advanced APM Participation Standards ………………………………………………. 380
Scoring Standard for APMs………………………………………………………………….. 381
Creating Physician-Focused Payment Models (PFPMS) …………………………. 382
Building the Measurement Development Plan for MIPS and APMs:
Developing New Quality Measures …………………………………………………… 382
Timelines for Developing Quality Measures………………………………………….. 383
A Framework for MACRA Quality Measurement …………………………………… 384
Conclusion: Benefits and Costs of the Quality Payment Program……………. 388
Three Incentive Programs as They Existed Before MIPS: A Reference ……. 389
Alternative Payment Models: A Reference…………………………………………….. 390
Information Checkpoint……………………………………………………………………… 392
Key Terms…………………………………………………………………………………………… 392
Discussion Questions…………………………………………………………………………… 393
Notes…………………………………………………………………………………………………. 393
Appendix 28-A Meaningful Use: Modified and Streamlined with
a New Name …………………………………………………………………………………… 397
How Meaningful Use Has Evolved ……………………………………………………….. 397
Changes to Allowable MU Stages …………………………………………………………. 398
Changes to Meaningful Use Requirements ………………………………………….. 400
Conclusion: Advancing Care Information Becomes
the New Meaningful Use …………………………………………………………………. 401
Acronyms…………………………………………………………………………………………… 403
Notes…………………………………………………………………………………………………. 403
Chapter 29 Standardizing Measures and Payment in Post-Acute Care: New
Requirements ……………………………………………………………………………405
The Impact Act: New Directions for Post-Acute Care …………………………….. 405
Why Focus Attention on Post-Acute Care? ……………………………………………. 407
A New Alternative Payment Model for Four Care Settings ……………………… 408
Standardized Data and Interoperability: The Keys to PAC Reform………….. 410
Standardizing Assessment and Measure Domains for PAC Providers ………. 411
Electronic Reporting Timelines for PAC Providers………………………………… 413
Public Reporting: Impact Act Requirements…………………………………………. 414
Impact Act Benefits and Costs: A Summary …………………………………………… 415
Meeting Strategic Goals ………………………………………………………………………. 415
Conclusion: Innovation in the Digital Age ……………………………………………. 416
The Future: Change Is Inevitable…………………………………………………………. 418
xiv Table of Contents
Information Checkpoint……………………………………………………………………… 418
Key Terms…………………………………………………………………………………………… 419
Other Acronyms…………………………………………………………………………………. 419
Discussion Questions…………………………………………………………………………… 419
Notes…………………………………………………………………………………………………. 419
Chapter 30 ICD-10 Implementation Continues: Finance and Strategic Challenges
for the Manager …………………………………………………………………………421
ICD-10 E-Records Overview and Impact……………………………………………….. 421
Overview of the ICD-10 Coding System ………………………………………………… 421
ICD-10-CM and ICD-10-PCS Codes………………………………………………………. 421
E-Record Standards and the ICD-10 Transition……………………………………… 422
ICD-10 Benefits and Costs……………………………………………………………………. 423
ICD-10 Implementation: Systems Affected and Technology Issues………….. 425
Understand Technology Issues and Problems ………………………………………. 426
An Example: Comparison of Old and New Angioplasty Codes……………….. 428
ICD-10 Implementation: Training and Lost Productivity Costs ………………. 428
Who Gets Trained on ICD-10? ……………………………………………………………… 428
Costs of Training ………………………………………………………………………………… 429
Costs of Lost Productivity ……………………………………………………………………. 430
Introduction: About ICD-10 Key Performance Indicators ……………………… 430
Key Performance Indicators to Assess ICD-10 Progress………………………….. 431
Using KPIs to Track ICD-10 Implementation Progress ………………………….. 432
Reviewing KPI Results…………………………………………………………………………. 434
Creating Action Plans to Deal with Problems………………………………………… 435
Building Specific Action Plans to Correct Deficiencies…………………………… 435
ICD-10 Implementation: Situational Analysis………………………………………… 437
Implementation Planning Recommendations………………………………………. 437
Situational Analysis Recommendations ………………………………………………… 438
Commencing an Information Technology SWOT Matrix for ICD-10 ……… 440
Summary……………………………………………………………………………………………. 441
Information Checkpoint……………………………………………………………………… 441
Key Terms…………………………………………………………………………………………… 441
Discussion Questions…………………………………………………………………………… 442
Notes…………………………………………………………………………………………………. 442
Appendix 30-A ICD-10 Conversion Costs for a Midwestern
Community Hospital………………………………………………………………………..445
Authors’ Note …………………………………………………………………………………….. 445
Introduction ………………………………………………………………………………………. 445
The Scenario………………………………………………………………………………………. 445
Note…………………………………………………………………………………………………… 446
PART XI—CASE STUDIES…………………………………………………………………………………….447
Chapter 31 Case Study: The Doctor’s Dilemma …………………………………………………..449
The Offer: “Sell Your Practice to Us”…………………………………………………….. 449
Table of Contents xv
Seeking to Understand Healthcare Finance Reform ……………………………… 449
Researching Acquisition Viewpoints and Industry Trends ……………………… 450
Considering Other Physicians’ Reactions……………………………………………… 451
What Will Dr. Matthews Decide?…………………………………………………………… 451
Notes…………………………………………………………………………………………………. 451
Chapter 32 Case Study: Strategic Financial Planning in Long-Term Care …………………453
Background ……………………………………………………………………………………….. 453
Framework of the Board’s Mandate ……………………………………………………… 453
Industry Profile…………………………………………………………………………………… 454
Feasibility Determination…………………………………………………………………….. 454
Notes…………………………………………………………………………………………………. 457
Chapter 33 Case Study: Metropolis Health System……………………………………………….459
Background ……………………………………………………………………………………….. 459
MHS Case Study …………………………………………………………………………………. 461
Appendix 33-A Metropolis Health System’s Financial Statements
and Excerpts from Notes…………………………………………………………………. 471
Excerpts from Metropolis Health System Notes to Financial
Statements …………………………………………………………………………………….. 477
Appendix 33-B Comparative Analysis Using Financial Ratios and
Benchmarking Helps Turn Around a Hospital in the Metropolis
Health System ………………………………………………………………………………………. 483
Appendix 33-C Proposal to Add a Retail
Pharmacy to a Hospital in the Metropolis Health System …………………… 489
PART XII—MINI-CASE STUDIES …………………………………………………………………………..495
Chapter 34 Mini-Case Study 1: The Economic Significance of Resource
Misallocation: Client Flow Through the Women, Infants,
and Children Public Health Program……………………………………………..497
Confronting the Operational Problem…………………………………………………. 497
The Environment……………………………………………………………………………….. 497
The Peak-Load Problem ……………………………………………………………………… 498
Method………………………………………………………………………………………………. 499
Results……………………………………………………………………………………………….. 499
Chapter 35 Mini-Case Study 2: Technology in Health Care: Automating
Admission Processes …………………………………………………………………..503
Assess Admissions Process……………………………………………………………………. 503
Areas to Automate………………………………………………………………………………. 504
Fax and Document Management…………………………………………………………. 504
Communication Is Important………………………………………………………………. 504
Referral Tracking and Approval …………………………………………………………… 505
Analyzing Referral Activity ………………………………………………………………….. 505
Hours Saved……………………………………………………………………………………….. 505
xvi Table of Contents
Appendix A Checklists ……………………………………………………………………………………..507
Glossary ………………………………………………………………………………………………………………511
Examples and Exercises, Supplemental Materials, and Solutions…………………………………..525
Examples and Exercises………………………………………………………………………………………… 525
Supplementary Materials: The Mechanics of Percentage Computations…………………… 578
Solutions to Practice Exercises………………………………………………………………………………. 578
Index ………………………………………………………………………………………………………………….591
xvii
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New to This Edition
The Fifth Edition continues to provide practical information, with examples taken from real life in the healthcare
finance world. For example, we have added the following:
NEW MATERIAL IN THE 5TH EDITION:
• Chapter 3 “The Digital Age: Changing the Landscape of Healthcare Finance”—This new chapter is about
understanding the impact of data analytics and big data, along with other important trends in the changing landscape of healthcare finance. It is important to recognize that digital advancements in health care
are the drivers that enable innovation.
• Chapter 26 “Understanding Strategic Relationships: Health Delivery Systems, Finance and
Reimbursement”—This new chapter focuses upon describing the strategic relationships between and
among health delivery systems, finance, and reimbursement. This chapter assists a manager in recognizing both differences and interrelationships and in applying this recognition to their own organization’s
structure.
• Chapter 27 “Understanding Value-Based Health Care and Its Financial and Digital Outcomes”—Valuebased performance, the subject of this new chapter, is particularly important because it is the key to both
improving patient care and reforming payment systems. Healthcare organizations should define what
value means and make sure that definition is shared across the entire entity.
• Chapter 28 “New Payment Methods and Measures: MIPS and APMs for Eligible Professionals”—This new
chapter highlights significant legislation and regulations that change payment methods and performance
measures for physicians and other eligible professionals. The new payment method for physicians hinges
upon proper reporting of new performance measures. The new system is a true reform, as it replaces a
physician payment system that has been in effect for decades.
• Appendix 28-A “Meaningful Use: Modified and Streamlined with a New Name”—This new appendix describes the evolution of meaningful use before and after its transition into the new physician performance
measures that are described in Chapter 28.
• Chapter 29 “Standardizing Measures and Payment in Post-Acute Care: New Requirements”—This new
chapter is about important legislation and regulations that standardize measures and require studies about
payment reform for post-acute care. This means performance measures for skilled nursing facilities, home
health agencies, inpatient rehabilitation facilities, and long-term care hospitals are being standardized.
Models for a patient-centered payment system that cuts across all four care settings are also being created.
• Chapter 30 “ICD-10 Implementation Continues: Finance and Strategic Challenges for the Manager”—This
updated chapter focuses upon challenges for the manager within ICD-10 implementation. An all-new
section introduces useful Key Performance Indicators that are used to assess an organization’s ICD-10
implementation progress.
Other new material in this edition includes the following:
• Chapter 9 “Understanding Inventory and Depreciation Concepts”—A new section about drug distribution systems in use in hospitals has been added to this chapter.
• Chapter 10 “Staffing: Methods, Operations, and Regulation”—A new section has been added describing
legislation that requires reporting “verifiable and auditable” payroll information for the “Nursing Compare” website, along with information about existing Certificate of Need regulations.
xviii New to This Edition
• Appendix 16-A “Creating A DRG Budget for Respiratory Care: The Resource Consumption
Approach”—This new appendix sets out a step-by-step DRG budget methodology.
• Appendix 16-B “Reviewing a Comparative Operating Budget Report”—This new appendix describes the
review of a section from an actual operating budget report.
• Chapter 21 “Understanding Investment and Statistical Terms Used in Finance”—This chapter was originally only about investment terms; it now has a new section about understanding statistical terms.
• Chapter 31 “Case Study: The Doctor’s Dilemma”—This new case study is about a physician deciding
whether or not to sell his practice to a health delivery system.
MATERIAL OMITTED FROM THIS EDITION
• Two Fourth Edition chapters and a Fourth Edition appendix have been omitted because they are becoming
outdated. This includes the following: Chapter 24 “Information Technology and EHR: Adoption Requirements, Initiatives, and Management Decisions” has been replaced with the new value-based chapter.
• Appendix 24-A Accordingly, the e-Prescribing (eRx) appendix has also been omitted because the incentive program is ending.
• Chapter 25 “Electronic Health Records Framework: Incentives, Standards, Measures, and Meaningful
Use” has been omitted because the incentives are ending.
• Relevant additions and deletions have been made to the “Examples and Exercises” section.
To summarize: A fundamental theme in the Fifth Edition is that healthcare financing is embracing the digital
age. This is manifested by its coverage of electronic health records (EHRs), data analytics, value-based health
care, and social media, among other topics. In this era of population health and the resulting need for clinical
integration, data-driven collaboration has the potential to improve outcomes and lower costs, as well as more
effectively engage the patient. The upshot: Everything is connected.
xix
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Preface
Our world of work is divided into three parts: the healthcare consultant, the instructor, and the writer. Over
the years, we have taught managers in seminars, academic settings, and corporate conference rooms. Most of
the managers were mid-career adults, working in all types of healthcare disciplines. We taught them and they
taught us. One of the things they taught us was this: A nonfinancial manager pushed into dealing with the world
of finance often feels a dislocation and a change of perspective, and that experience can be both difficult and
exciting. We have listened to their questions and concerns as these managers grapple with this new world. This
book is the result of their experiences, and ours.
The book is designed for use by a manager (or future manager) who does not have an educational background in financial management. It has long been our philosophy that if you can truly understand how a thing
works—whatever it is—then you own it. This book is created around that philosophy. In other words, we intend
to make financial management transparent by showing how it works and how a manager can use it.
USING THE BOOK
All our examples are drawn from the healthcare industry. Thus users will find examples and exercises covering
many types of healthcare settings and providers, including hospitals, clinics, physician practices, long-term care
facilities, and home health agencies.
Standard Elements
Each chapter within these parts contains the following four elements:
• “Progress Notes” set out learning objectives at the beginning of each chapter.
• An “Information Checkpoint” segment at the end of each chapter tells the user three things: information
needed, where this information can be obtained, and how this information can be used.
• A “Key Terms” section follows the “Information Checkpoint.” Every Key Term is defined in the Glossary;
it is also bold faced the first time it appears in the text.
• The “Discussion Questions” segment inquires about practical uses of chapter material and encourages
responses based upon experience.
Structure and Topics
The book is structured in 12 parts, as follows.
Part I: Healthcare Finance Overview [Three chapters; one is new]
Part II: Record Financial Operations [Four chapters]
Part III: Tools To Analyze and Understand Financial Operations [Three chapters plus appendix; new text added to
two chapters]
Part IV: Report and Measure Financial Results [Three chapters plus three appendices]
Part V: Tools to Review and Manage Comparative Data [Two chapters]
Part VI: Construct and Evaluate Budgets [Two chapters plus two new appendices]
Part VII: Tools to Plan, Monitor, and Control Financial Status [Three chapters; one is new]
Part VIII: Financial Terms, Costs, and Choices [Three chapters; one entire new section]
xx Preface
Part IX: Strategic Planning: A Powerful Tool [Three chapters plus one appendix; one chapter is new]
Part X: Information Technology As A Financial and Strategic Tool [Four chapters plus two appendices; three chapters and
one appendix are all new and the fourth chapter has been substantially revised. In addition, two previous chapters
and a previous appendix that have become outdated have been omitted and replaced in the Fifth Edition.]
Part XI: Case Studies [One new case study about the doctor’s dilemma,one case study about strategic financial
planning in long-term care, and a group of four interrelated case studies about the Metropolis Health
System]
Part XII: Mini-Case Studies [Two mini-case studies; one concerns resource misallocation in a public health clinic
and the other is about automating admissions processes]
More About the Metropolis Health System Case Studies
A group of four case studies about the Metropolis Health System (MHS) represents a comprehensive suite of
information. This section includes the major case study about the system, followed by an appendix containing an
MHS financial statement and excerpts from notes. A second case study appendix shows how one MHS hospital
was turned around using comparative analysis of benchmarks and statistical data. A third case study appendix
describes a detailed proposal to add a retail pharmacy to another of the MHS hospitals. The Metropolis grouping thus provides an interactive suite of case study material.
Supplemental Resources
At the back of the book you will find additional resources as follows, all of which have been updated for the Fifth
Edition:
• An Appendix containing Checklists
• A Glossary
• Examples and Exercises, with Solutions
• Other Supplemental Materials
xxi
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Acknowledgments
With this edition we welcome Dr. Neil R. Dworkin as our coauthor. Neil brings a formidable combination of both
educational and practical on-the-ground experience in health care. He also brings fresh viewpoints that are as
valuable as his career achievements.
The Fifth Edition has evolved with the help of numerous instructors and students who give us feedback; we
listen. We owe a great debt of thanks to Mike Brown, our long-suffering and understanding publisher. And
we thank our Fifth Edition first readers, including Teresa Schroder, AuD, CCC-A, along with others who prefer
to be anonymous; you know who you are. The continuing support and suggestions of Janet Feldman, PhD,
RN, Vice President, Qualitas Associates, along with certain continuing technical support provided by Colleene
McMurphy, CPA, of McMurphy and Associates, are also appreciated.
The input from finance sessions we taught as Adjunct Faculty at Texas Woman’s University in Dallas also
contributed to shaping the content of the Fifth Edition. Our continued gratitude goes to Craig Sheagren, Senior
Vice President/CFO, McDonough District Hospital, Macomb, Illinois; and Nancy M. Borkowski, PhD, Professor, Department of Professional Management/Health Management, St. Thomas University, Miami, Florida, for
their encouragement, information, suggestions, and assistance with the original concept of the book. We also
thank John Brocketti, Chief Financial Officer, SUMA Health System, Akron, Ohio; Christine Pierce, Partner,
The Resource Group, Cleveland, Ohio; and Dr. Frank Welsh, Cincinnati, Ohio, for their ongoing information
and suggestions.
Many others also contributed suggestions, recommendations, and information to help shape and refine the
initial concept. We continue to acknowledge these individuals, listed below, including their original affiliations:
Ian G. Worden, CPA, Regional Vice President of Finance/CFO, PeaceHealth, Eugene, Oregon
Carol A. Robinson, Medical Records Director, Titus Regional Medical Center, Mt. Pleasant, Texas
John Congelli, Vice President of Finance, Genesee Memorial Hospital, Batavia, New York
Charles A. Keil, Cost Accountant, Genesee Memorial Hospital, Batavia, New York
George O. Kimbro, CPA, CFO, Hunt Memorial Hospital District, Greenville, Texas
Bob Gault, Laboratory Director, Hunt Memorial Hospital District, Greenville, Texas
Ted J. Stuart, Jr., MD, MBA, Northwest Family Physicians, Glendale, Arizona
Mark Potter, EMS Director, Hopkins County Memorial Hospital, Sulphur Springs, Texas
Leonard H. Friedman, PhD, Assistant Professor, Coordinator, Health Care Administration Program, Oregon
State University, Corvallis, Oregon
Patricia Chiverton, EdD, RN, Dean, University of Rochester School of Nursing, Rochester, New York
Donna M. Tortoretti, RNC, Chief Operating Officer, Community Nursing Center, University of Rochester
School of Nursing, Rochester, New York
Billie Ann Brotman, PhD, Professor of Finance, Department of Economics and Finance, Kennesaw State University, Kennesaw, Georgia

xxiii
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About the Authors
Judith J. Baker, PhD, CPA, has worked with healthcare systems, costing, finance, and reimbursement throughout her career. With over 40 years’ experience in health care, she is a co-founder of Resource Group, Ltd., a
healthcare consulting firm. As a CMS contractor, she has assisted in validation of costs for new programs and for
rate setting and has also consulted on cost report design. More recently, she has provided activity-based costing,
rate setting, and organizational systems expertise to national clients within the healthcare industry.
Judith’s doctorate is in human and organizational systems, with a concentration in healthcare costing systems. She has served as adjunct faculty at the University of Texas at Houston and the Texas Woman’s University
in Dallas, as well as the University of Rochester School of Nursing and the Case Western Reserve University Francis Payne Bolton School of Nursing.
Judith has written numerous peer-reviewed articles and has served as Consulting Editor for Aspen Publishers,
Inc. Her books include Activity-Based Costing and Activity-Based Management for Health Care, Prospective Payment for
Long-Term Care, Prospective Payment for Home Health Agencies, Management Accounting for Health Care Organizations
(with Robert Hankins) and Essentials of Cost Accounting for Health Care Organizations (with Steven Finkler and
David Ward). She is Editor Emeritus of the quarterly Journal of Healthcare Finance.
R. W. Baker, JD, is also a co-founder of Resource Group, Ltd., a healthcare consulting firm. He has more than
40 years of experience in health care and has designed, directed, and administered numerous financial impact
studies for healthcare providers. His early studies centered around facility-specific MDS data collection and
analysis. He and his firm subcontracted to the HCFA/CMS Nursing Home Case Mix and Quality Demonstration
for over nine years. More recently he has designed, implemented, and managed a series of national time studies
for pharmaceutical and medical device clients.
R. W. is the editor of continuing professional education seminar manuals and training manuals for facility
personnel and for research staff members. He served as a Consulting Editor with Aspen Publishers, Inc. and is
co-author of A Step-by-Step Guide to the Minimum Data Set (with Dr. Janet Feldman).
Neil R. Dworkin, PhD, is Emeritus Associate Professor of Management at Western Connecticut State University, where he was Coordinator of the Masters in Health Administration Program and where he taught Strategic
Management, Finance, Marketing, Health Policy, and Health Delivery Systems. He is presently an adjunct faculty
member at Charter Oak State College, which is part of the Connecticut State University System and where he
teaches Continuous Quality Improvement in Health Care and Health Care Systems and Administration.
Neil has hospital administration experience, and has been a nursing home administrator in New York and
Connecticut. He has over 40 years’ experience in the healthcare field. He was the lead author in a three-article
series on “Managerial Socialization in Short-Term Hospitals” that was published in Hospital Topics and Problems
and Perspectives in Management. Neil has also served as an editor of The Journal of Health Administration Education.

PART
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Healthcare
Finance
Overview
I

Progress Notes
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3
CHAPTER
Introduction to
Healthcare Finance
THE HISTORY
Financial management has a long and distinguished
history. Consider, for example, that Socrates wrote about
the universal function of management in human endeavors
in 400 b.c. and that Plato developed the concept of specialization for efficiency in 350 b.c. Evidence of sophisticated
financial management exists from much earlier times: the
Chinese produced a planning and control system in 1100
b.c., a minimum-wage system was developed by Hammurabi
in 1800 b.c., and the Egyptians and Sumerians developed
planning and record-keeping systems in 4000 b.c.
1
Many managers in early history discovered and rediscovered managerial principles while attempting to reach their
goals. Because the idea of management thought as a discipline had not yet evolved, they formulated principles of
management because certain goals had to be accomplished.
As management thought became codified over time, however, the building of techniques for management became
more organized. Management as a discipline for educational purposes began in the United States in 1881. In that
year, Joseph Wharton created the Wharton School, offering college courses in business management at the University of Pennsylvania. It was the only such school until 1898,
when the Universities of Chicago and California established
their business schools. Thirteen years later, in 1911, 30 such
schools were in operation in the United States.2
Over the long span of history, managers have all sought
how to make organizations work more effectively. Financial
management is a vital part of organizational effectiveness.
This text’s goal is to provide the keys to unlock the secrets
of financial management for nonfinancial managers.
After completing this chapter,
you should be able to
1. Discuss the three viewpoints
of managers in organizations.
2. Identify the four elements of
financial management.
3. Understand the differences
between the two types of
accounting.
4. Identify the types of organizations.
5. Understand the composition
and purpose of an organization chart.
3
CHAPTER
1
THE CONCEPT
A Method of Getting Money in and out of the Business
One of our colleagues, a nurse, talks about the area of healthcare finance as “a method of getting money in and out of the business.” It is not a bad description. As we shall see, revenues represent inflow and expenses represent outflow. Thus, “getting money in” represents the inflow
(revenues), whereas “getting money out” (expenses) represents the outflow. The successful
manager, through planning, organizing, controlling, and decision making, is able to adjust the
inflow and outflow to achieve the most beneficial outcome for the organization.
HOW DOES FINANCE WORK IN THE HEALTHCARE BUSINESS?
The purpose of this text is to show how the various elements of finance fit together: in other
words, how finance works in the healthcare business. The real key to understanding finance is
understanding the various pieces and their relationship to each other. If you, the manager, truly
see how the elements work, then they are yours. They become your tools to achieve management success.
The healthcare industry is a service industry. It is not in the business of manufacturing, say,
widgets. Instead, its essential business is the delivery of healthcare services. It may have inventories of medical supplies and drugs, but those inventories are necessary to service delivery, not
to manufacturing functions. Because the business of health care is service, the explanations
and illustrations within this book focus on the practice of financial management in the service
industries.
VIEWPOINTS
The managers within a healthcare organization will generally have one of three views: (1) financial, (2) process, or (3) clinical. The way they manage will be influenced by which view they
hold.
1. The financial view. These managers generally work with finance on a daily basis. The reporting function is part of their responsibility. They usually perform much of the strategic
planning for the organization.
2. The process view. These managers generally work with the system of the organization.
They may be responsible for data accumulation. They are often affiliated with the information system hierarchy in the organization.
3. The clinical view. These managers generally are responsible for service delivery. They
have direct interaction with the patients and are responsible for clinical outcomes of the
organization.
Managers must, of necessity, interact with one another. Thus, managers holding different views
will be required to work together. Their concerns will intersect to some degree, as illustrated by
Figure 1–1. The nonfinancial manager who understands healthcare finance will be able to interpret and negotiate successfully such interactions between and among viewpoints.
4 Chapter 1 Introduction to Healthcare Finance
In summary, financial management is a
discipline with a long and respected history.
Healthcare service delivery is a business, and
the concept of financial management assists
in balancing the inflows and outflows that
are a part of the business.
WHY MANAGE?
Business does not run itself. It requires a
variety of management activities in order to
operate properly.
THE ELEMENTS OF FINANCIAL
MANAGEMENT
There are four recognized elements of financial management: (1) planning, (2) controlling, (3)
organizing and directing, and (4) decision making. The four divisions are based on the purpose
of each task. Some authorities stress only three elements (planning, controlling, and decision
making) and consider organizing and directing as a part of the controlling element. This text
recognizes organizing and directing as a separate element of financial management, primarily
because such a large proportion of a manager’s time is taken up with performing these duties.
1. Planning. The financial manager identifies the steps that must be taken to accomplish
the organization’s objectives. Thus, the purpose is to identify objectives and then to identify the steps required for accomplishing these objectives.
2. Controlling. The financial manager makes sure that each area of the organization is following the plans that have been established. One way to do this is to study current reports
and compare them with reports from earlier periods. This comparison often shows where
the organization may need attention because that area is not effective. The reports that
the manager uses for this purpose are often called feedback. The purpose of controlling
is to ensure that plans are being followed.
3. Organizing and directing. When organizing, the financial manager decides how to use
the resources of the organization to most effectively carry out the plans that have been
established. When directing, the manager works on a day-to-day basis to keep the results
of the organizing running efficiently. The purpose is to ensure effective resource use and
provide daily supervision.
4. Decision making. The financial manager makes choices among available alternatives. Decision making actually occurs parallel to planning, organizing, and controlling. All types
of decision making rely on information, and the primary tasks are analysis and evaluation. Thus, the purpose is to make informed choices.
THE ORGANIZATION’S STRUCTURE
The structure of an organization is an important factor in management.
Figure 1–1 Three Views of Management Within an
Organization.
Financial
Clinical
Process
The Organization’s Structure 5
Organization Types
Organizations fall into one of two basic types: profit oriented or nonprofit oriented. In the
United States, these designations follow the taxable status of the organizations. The profitoriented entities, also known as proprietary organizations, are responsible for paying income
taxes. Proprietary subgroups include individuals, partnerships, and corporations. The nonprofit organizations do not pay income taxes.
There are two subgroups of nonprofit entities: voluntary and government. Voluntary
nonprofits have sought tax-exempt status. In general, voluntary nonprofits are associated
with churches, private schools, or foundations. Government nonprofits, on the other hand,
do not pay taxes because they are government entities. Government nonprofits can be
(1) federal, (2) state, (3) county, (4) city, (5) a combination of city and county, (6) a hospital
taxing district (with the power to raise revenues through taxes), or (7) a state university
(perhaps with a teaching hospital affiliated with the university). The organization’s type may
affect its structure. Exhibit 1–1 summarizes the subgroups of both proprietary and nonprofit
organizations.
Organization Charts
In a small organization, top management will be able to see what is happening. Extensive measures and indicators are not necessary because management can view overall operations. But in
a large organization, top management must use the management control system to understand
what is going on. In other words, to view operations, management must use measures and indicators because he or she cannot get a firsthand overall picture of the total organization.
As a rule of thumb, an informal management control system is acceptable only if the
manager can stay in close contact with all aspects of the operation. Otherwise, a formal
system is required. In the context of health
care, therefore, a one-physician practice
(Figure 1–2) could use an informal method,
but a hospital system (Figure 1–3) must use a
formal method of management control.
The structure of the organization will affect its financial management. Organization
charts are often used to illustrate the structure
of the organization. Each box on an organization chart represents a particular area of
management responsibility. The lines between
the boxes are lines of authority.
In the health system organization chart illustrated in Figure 1–3, the president/chief
executive officer oversees seven senior vice
presidents. Each senior vice president has vice
presidents reporting to him or her in each
Profit Oriented—Proprietary
Individual
Partnership
Corporation
Other
Nonprofit—Voluntary
Church Associated
Private School Associated
Foundation Associated
Other
Nonprofit—Government
Federal
State
County
City
City–County
Hospital District
State University
Other
Exhibit 1–1 Types of Organizations
6 Chapter 1 Introduction to Healthcare Finance
particular area of responsibility designated on the chart. These vice presidents, in turn, have an
array of other managers reporting to them at varying levels of managerial responsibility.
The organization chart also shows the degree of decentralization within the organization.
Decentralization indicates the delegating of authority for decision making. The chart thus illustrates the pattern of how managers are allowed—or required—to make key decisions within
the particular organization.
The purpose of an organization chart, then, is to indicate how responsibility is assigned to
managers and to indicate the formal lines of communication and reporting.
TWO TYPES OF ACCOUNTING
Financial
Financial accounting is generally for outside, or third party, use. Thus, financial accounting emphasizes external reporting. External reporting to third parties in health care includes, for example, government entities (Medicare, Medicaid, and other government programs) and health
plan payers. In addition, proprietary organizations may have to report to stockholders, taxing
district hospitals have to report to taxpayers, and so on.
Financial reporting for external purposes must be in accordance with generally accepted
accounting principles. Financial reporting is usually concerned with transactions that have already occurred: that is, it is retrospective.
Managerial
Managerial accounting is generally for inside, or internal, use. Managerial accounting, as its
title implies, is used by managers. The planning and control of operations and related performance measures are common day-by-day uses of managerial accounting. Likewise, the reporting of profitability of services and the pricing of services are other common ongoing uses
of managerial accounting. Strategic planning and other intermediate and long-term decision
making represent an additional use of managerial accounting.3
Managerial accounting intended for internal use is not bound by generally accepted accounting principles. Managerial accounting deals with transactions that have already occurred,
but it is also concerned with the future, in the form of projecting outcomes and preparing budgets. Thus, managerial accounting is prospective as well as retrospective.
Two Types of Accounting 7
Figure 1–2 Physician’s Office Organization Chart.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Reception
Scheduling
Billing
Accounting
Front
Office
Physician’s
Assistant
Registered
Nurse
Clinical
Services
Physician
8 Chapter 1 Introduction to Healthcare Finance
Figure 1–3 Health System Organization Chart.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Metropolis
Health System
President/CEO
Sr. Vice President
Service Delivery
Operations/COO
Inpatient
Operations
Ambulatory
Operations
Other
Operations
Operations
TQI
Sr. Vice President
Human Resources
Human Resources
Operations
HR Planning
& Placement
Learning
Services
Sr. Vice President
Medical
Management
Physician
Benefits
Physician
Recruitment
Integration
Sr. Vice President
General Counsel
Legal
Affairs
Risk
Management
Sr. Vice President
Human Affairs
Community
Outreach
Community
Health Council
Community Health
Improvement
Programs
Sr. Vice President
Information
Systems/CIO
Info Systems
Operations
Data
Management
Info Systems
Development
Sr. Vice President
Finance/CFO
Central
Business Office
Finance
Insurance
Managed Care
Real Estate
Facilities/
Development
Physician
TQI
INFORMATION CHECKPOINT
What is needed? Reports for management purposes.
Where is it found? With your supervisor.
How is it used? To manage better.
What is needed? Organization chart.
Where is it found? With your supervisor or in the administrative offices.
How is it used? To better understand the structure and lines of authority in
your organization.
KEY TERMS
Controlling
Decision Making
Financial Accounting
Managerial Accounting
Nonprofit Organization (also see Voluntary Organization)
Organization Chart
Organizing
Planning
Proprietary Organization (also see Profit-Oriented Organization)
DISCUSSION QUESTIONS
1. What element of financial management do you perform most often in your job?
2. Do you perform all four elements? If not, why not?
3. Of the organization types described in this chapter, what type is the one you work for?
4. Have you ever seen your company’s organization chart? If so, how decentralized is it?
5. If you receive reports in the course of your work, do you believe that they are prepared
for outside (third party) use or for internal (management) use? What leads you to
believe this?
NOTES
1. C. S. George, Jr., The History of Management Thought, 2nd ed. (Englewood Cliffs, NJ: Prentice Hall, 1972), 1–27.
2. Ibid., 87.
3. S. Williamson et al., Fundamentals of Strategic Planning for Healthcare Organizations
(New York: The Haworth Press, 1997).
Notes 9

Progress Notes
© LFor/Shutterstock
CHAPTER
Four Things the Healthcare Manager Needs to Know
About Financial
Management Systems
WHAT DOES THE MANAGER NEED TO KNOW?
Financial management is both an art and a science. You, as
a manager, need to perceive the structure and reasoning
that underlies management actions. To do so, you need to
be able to answer the following four questions:
1. What are the four segments that make a financial
management system work?
2. How does the information flow?
3. What are the basic system elements?
4. What is the annual management cycle for reporting
results?
This chapter provides answers to each of these four questions. It also discusses how to communicate financial
information to others. This ability is a valuable skill for a
successful manager.
HOW THE SYSTEM WORKS IN HEALTH CARE
The information that you, as a manager, work with is only one
part of an overall system. To understand financial management, it is essential to recognize the overall system in which
your organization operates. An order exists within the system,
and it is generally up to you to find that order. Watch for how
the information fits together. The four segments that make a
healthcare financial system work are (1) the original records,
(2) the information system, (3) the accounting system, (4) and
the reporting system. Generally speaking, the original records
provide evidence that some event has occurred; the information system gathers this evidence; the accounting system records the evidence; and the reporting system produces reports
After completing this chapter,
you should be able to
1. Understand that four
segments make a financial
management system work.
2. Follow an information flow.
3. Recognize the basic system
elements.
4. Follow the annual
management cycle.
11
CHAPTER
2
CHAPTER
of the effect. The healthcare manager needs to know that these separate elements exist and that
they work together for an end result.
THE INFORMATION FLOW
Structure of the Information System
Information systems can be simplistic or highly complex. They can be fully automated or semiautomated. Occasionally—even today—they can still be generated by hand and not by computer. (This last instance is becoming rare and can happen today only in certain small and
relatively isolated healthcare organizations that are not yet required to electronically submit
their billings.)
We will examine a particular information system and point out the basics that a manager
should be able to recognize. Figure 2–1 shows information system components for an
ambulatory care setting. This complex system uses a clinical and financial data repository; in
other words, both clinical and financial data are fed into the same system. An automated medical record is also linked to the system. These are basic facts that a manager should recognize
about this ambulatory information system.
In addition, the financial information, both outpatient and any relevant inpatient, is fed
into the data repository. Scheduling-system data also enter the data repository, along with any
relevant inpatient care plan and nursing information. Again, all of these are basic facts that a
manager should recognize about this ambulatory care information system.
These items have all been inputs. One output from the clinical and financial data repository
(also shown in Figure 2–1) is insurance verification for patients through an electronic data
Figure 2–1 Information System Components for an Ambulatory Care Setting.
OP, Outpatient; IP, Inpatient; OR, Operating Room.
Managed Care Systems
–Enrollment/eligibility
–Utilization management
–Demand management
–Algorithmic scheduling
support
Insurance
Verification
EDI
Link
Enterprise-Wide
Master Patient Index
Interface Engine
Clinical and Financial
Data Repository
Practice Management
System Scheduling
Ancillary Scheduling
Patient Accounting System
Financial (OP and IP)
OR Scheduling
Other Provider
Inpatient System
–Clinical order entry
–IP care plans
–IP nursing
Chart
Tracking
(IP and OP)
A
u
t
o
m
a
t
e
d
M
e
d
i
c
a
l
R
e
c
o
r
d
12 Chapter 2 Four Things the Healthcare Manager Needs to Know
information (EDI) link to insurance company databases. Insurance verification is daily operating information. Another output is decision-making information for managed care strategic
planning, including support for demand, utilization, enrollment, and eligibility, plus some statistical support. The manager does not have to understand the specifics of all the inputs and
outputs of this complex system, but he or she should recognize that these outputs occur when
this ambulatory system is activated.
Function of Flowsheets
Flowsheets illustrate, as in this case, the flow of activities that capture information.1 Flowsheets
are useful because they portray who is responsible for what piece of information as it enters
the system. The manager needs to realize the significance of such information. We give, as an
example, obtaining confirmation of a patient’s correct address. The manager should know that
a correct address for a patient is vital to the smooth operation of the system. An incorrect address will, for example, cause the billing to be rejected. Understanding this connection between
deficient data (e.g., a bad address) and the consequences (the bill will be rejected by the payer
and thus not be paid) illustrates the essence of good financial management knowledge.
We can examine two examples of patient information flows. The first, shown in Figure 2–2,
is a physician’s office flowsheet for address confirmation. Four different personnel are
involved, in addition to the patient. This physician has computed the cost of a bad address
as $12.30 to track down each address correction. He pays close attention to the handling of
this information because he knows there is a direct financial management consequence in his
operation.
Figure 2–2 Physician’s Office Flowsheet for Address Confirmation.
Initiates
Call
Mark
Superbill
if Change
Mark
Superbill
if Change
Patient
Enter
Corrected
Address in
Computer
Copy
Insurance
Card
Instruct
Patient
to
Correct
Financial
Data
Check
Address
Insurance
Review
Patient
Records
Record
Message
Receive
Call
Phone Intake
Entry/Exit
Receptionist
Ask
Address
Change
Ask
Address
Change
Medical
Assistant
Ask
Address
Change
Doctor
Type
Chart
Label
Coder
Ask
Insurance
Change
The Information Flow 13
The second example, shown in Figure 2–3, is a health system flowsheet for verification of
patient information. This flowsheet illustrates the process for a home care system. In this case,
the flow begins not with a receptionist, as in the physician office example, but with a central
database. This central database downloads the information and generates a summary report
to be reviewed the next day. Appropriate verification is then made in a series of steps, and any
necessary corrections are made before the form goes to the billing department. The object
of the flow is the same in both examples: that is, the billing department must have a correct
address to receive payment. But the flow is different within two different systems. A manager
must understand how the system works to understand the consequences—then good financial
management can prevail.
BASIC SYSTEM ELEMENTS
To understand financial management, it is essential to decipher the reports provided to the
manager. To comprehend these reports, it is helpful to understand certain basic system elements that are used to create the information contained in the reports.
Chart of Accounts—The Map
The chart of accounts is a map. It outlines the elements of your company in an organized manner. The chart of accounts maps out account titles with a method of numeric coding. It is designed to compile financial data in a uniform manner that the user can decode.
Figure 2–3 Health System Flowsheet for Verification of Patient Information.
Central intake enters
demographics at time
referral received
Patient Accounts
Clerk generates
Patient Information
Summary next day
Data downloads to
CDB overnight
Information on Patient
Information Summary
verified by
care manager at next
visit
Correct information
written in by staff
Information
Correct?
Form is placed in
appropriate
care manager’s
mailbox
Form turned in to
Patient Accounts
Representative
Data in CDB’s central
intake updated
by Patient Accounts
Representative
Form placed in
billing folder
New labels generated
if necessary
Yes No
14 Chapter 2 Four Things the Healthcare Manager Needs to Know
The groupings of accounts in the chart of accounts should match the groupings of the organization. In other words, the classification on the organization chart (as discussed in the
previous chapter) should be compatible with the groupings on the chart of accounts. Thus, if
there is a human resources department on your facility’s organization chart, and if expenses are
grouped by department in your facility, then we would expect to find a human resources grouping in the chart of accounts.
The manager who is working with financial data needs to be able to read and comprehend
how the dollars are laid out and how they are gathered together, or assembled. This assembly
happens through the guidance of the chart of accounts. That is why we compare it to a map.
Basic guidance for healthcare charts of accounts is set out in publications such as that of
Seawell’s Chart of Accounts for Hospitals.
2 However, generic guides are just that—generic. Every
organization exhibits differences in its own chart of accounts that express the unique aspects
of its structure. We examine three examples to illustrate these differences. Remember, we are
spending time on the chart of accounts because your comprehension of detailed financial data
may well depend on whether you can decipher your facility’s own chart of accounts mapping in
the information forwarded for your use.
The first format, shown in Exhibit 2–1, is a basic use, probably for a smaller organization. The
exhibit is in two horizontal segments, “Structure” and “Example.” There are three parts to the
account number. The first part is one digit and indicates the financial statement element. Thus,
our example shows “1,” which is for “Asset.” The second part is two digits and is the primary
subclassification. Our example shows “10,” which stands for “Current Asset” in this case. The
third and final part is also two digits and is the secondary subclassification. Our example shows
“11,” which stands for “Petty Cash—Front Office” in this case. On a report, this account number
would probably appear as 1-10-11.
The second format, shown in Exhibit 2–2, is full use and would be for a large organization.
The exhibit is again in two horizontal segments, “Structure” and “Example,” and there are now
Exhibit 2–1 Chart of Accounts, Format I
Structure
X XX XX
Financial Primary Secondary
Statement Subclassification Subclassification
Element
Example
1 10 11
Asset Current Petty Cash—
Asset Front Office
(Financial
Statement (Primary (Secondary
Element) Subclassification) Subclassification)
Basic System Elements 15
two line items appearing in the Example section. This full-use example has five parts to the account number. The first part is two digits and indicates the entity designator number. Thus, we
conclude that there is more than one entity within this system. Our example shows “10,” which
stands for “Hospital A.” The second part is two digits and indicates the fund designator number.
Thus, we conclude that there is more than one fund within this system. Our example shows
“10,” which stands for “General Fund.”
The third part of Exhibit 2–2 is one digit and indicates the financial statement element.
Thus, the first line of our example shows “4,” which is for “Revenue,” and the second line of
our example shows “6,” which is for “Expense.” (The third part of this example is the first part
of the simpler example shown in Exhibit 2–1.) The fourth part is four digits and is the primary
subclassification. Our example shows 3125, which stands for “Lab—Microbiology.” The number
3125 appears on both lines of this example, indicating that both the revenue and the expense
belong to Lab—Microbiology. (The fourth part of this example is the second part of the simpler example shown in Exhibit 2–1. The simpler example used only two digits for this part, but
this full-use example uses four digits.) The fifth and final part is two digits and is the secondary
subclassification. Our example shows “03” on the first line, the revenue line, which stands for
“Payer: XYZ HMO” and indicates the source of the revenue. On the second line, the expense
line, our example shows “10,” which stands for “Clerical Salaries.” Therefore, we understand
that these are the clerical salaries belonging to Lab—Microbiology in Hospital A. (The fifth part
of this example is the third and final part of the simpler example shown in Exhibit 2–1.) On a
report, these account numbers might appear as 10-10-4-3125-03 and 10-10-6-3125-10. Another
optional use that is easier to read at a glance is 10104-3125-03 and 10106-3125-10.
Exhibit 2–2 Chart of Accounts, Format II
Structure
XX XX X XXXX XX
Entity Fund Financial Primary Secondary
Designator Designator Statement Subclassification Subclassification
Element
Example
10 10 4 3125 03
Hospital General Revenue Lab—Microbiology Payer: XYZ HMO
A Fund
10 10 6 3125 10
Hospital General Expense Lab—Microbiology Clerical Salaries
A Fund
(Entity (Fund (Financial (Primary (Secondary
Designator) Designator) Statement Subclassification) Subclassification)
Element) Element)
16 Chapter 2 Four Things the Healthcare Manager Needs to Know
Because every organization is unique and because the chart of accounts reflects that uniqueness, the third format, shown in Exhibit 2–3, illustrates a customized use of the chart of accounts. This example is adapted from a large hospital system. There are four parts to its chart
of accounts number. The first part is an entity designator and designates a company within the
hospital system. The fund designator two-digit part, as traditionally used (see Exhibit 2–2), is
missing here. The financial statement element one-digit part, as traditionally used (see Exhibit
2–2), is also missing here. Instead, the second part of Exhibit 2–3 represents the primary classification, which is shown as an expense category (“Payroll”) in the example line. The third part of
Exhibit 2–3 is the secondary subclassification, representing a labor subaccount expense designation (“Regular per-Visit RN”). The fourth and final part of Exhibit 2–3 is another subclassification that indicates the department within the company (“Home Health”). On a report for this
organization, therefore, the account number 21-7000-2200-7151 would indicate the home care
services company’s payroll for regular per-visit registered nurses (RNs) in the home health department. Finally, remember that time spent understanding your own facility’s chart of accounts
will be time well spent.
Books and Records—Capture Transactions
The books and records of the financial information system for the organization serve to capture
transactions. Figure 2–4 illustrates the relationship of the books and records to each other. As a
single transaction occurs, the process begins. The individual transaction is recorded in the appropriate subsidiary journal. Similar such transactions are then grouped and balanced within
the subsidiary journal. At periodic intervals, the groups of transactions are gathered, summarized, and entered in the general ledger. Within the general ledger, the transaction groups
Exhibit 2–3 Chart of Accounts, Format III
Structure
XX XXXX XXXX XXXX
Company Expense Subaccount Department
Category
(Entity (Primary (Secondary (Additional
Designator) Classification) Subclassification) Subclassification)
Example
21 7000 2200 7151
Home Payroll Regular Home Health
Care per-Visit RN
Services
(Company) (Expense (Subaccount) (Department)
Category)
Basic System Elements 17
are reviewed and adjusted. After such review and adjustment, the transactions for the period
within the general ledger are balanced. A document known as the trial balance is used for this
purpose. The final step in the process is to create statements that reflect the transactions for the
period. The trial balance is used to produce the statements.
All transactions for the period reside in the general ledger. The subsidiary journals are so
named because they are “subsidiary” to the general ledger: in other words, they serve to support
the general ledger. Figure 2–5 illustrates this concept. Another way to think of the subsidiary
journals is to picture them as feeding the general ledger. The important point here is to understand the source and the flow of information as it is recorded.
Reports—The Product
Reports are more fully treated in a subsequent chapter of this text (see Chapter 11). It is sufficient at this point to recognize that reports are the final product of a process that commences
with an original transaction.
THE ANNUAL MANAGEMENT CYCLE
The annual management cycle affects the type and status of information that the manager is
expected to use. Some operating information is “raw”—that is, unadjusted. When the same
information has passed further through the system and has been verified, adjusted, and
Figure 2–4 The Progress of a Transaction.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Individual Transaction
[begins process]
Individual Transaction
Is Recorded
Similar Transactions
Are Grouped and Balanced
Groups of Transactions
Are Gathered and Summarized
Summarized Groups of Transactions
Are Reviewed and Adjusted
Adjusted and Reviewed Transactions
for Period Are Balanced
Statements Reflecting Transactions Are Created
[ends process]
Creates
Original Record
Into
Subsidiary Journals
Within the
Subsidiary Journals
Into the
General Ledger
Within the
General Ledger
Trial Balance Is Produced
from the General Ledger
for This Purpose
Statements Are Produced
from the Trial Balance
18 Chapter 2 Four Things the Healthcare Manager Needs to Know
balanced, it will usually vary from the initial raw data. These differences are a part of the process
just described.
Daily and Weekly Operating Reports
The daily and weekly operating reports generally contain raw data, as discussed in the preceding paragraph. The purpose of such daily and weekly reports is to provide immediate operating
information to use for day-to-day management purposes.
Quarterly Reports and Statistics
The quarterly reports and statistics generally have been verified, adjusted, and balanced. They
are called interim reports because they have been generated some time during the reporting
period of the organization and not at the end of that period. Managers often use quarterly reports as milestones. A common milestone is the quarterly budget review.
Annual Year-End Reports
Most organizations have a 12-month reporting period known as a fiscal year. A fiscal year, therefore, covers a period from the first day of a particular month (e.g., January 1) through the last
day of a month that is one year, or 12 months, in the future (e.g., December 31). If we see a
heading that reads, “For the year ended June 30,” we know that the fiscal year began on July
1 of the previous year. Anything less than a full 12-month year is called a “stub period” and is
fully spelled out in the heading. If, therefore, a company is reporting for a three-month stub
period ending on December 31, the heading on the report will read, “For the three-month period ended December 31.” An alternative treatment uses a heading that reads, “For the period
October 1 to December 31.”
Annual year-end reports cover the full 12-month reporting period or the fiscal year. Such
annual year-end reports are not primarily intended for managers’ use. Their primary purpose
is for reporting the operations of the organization for the period to outsiders, or third parties.
Figure 2–5 Recording Information: Relationship of Subsidiary Journals to the General Ledger.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Payroll
Journal
Accounts
Receivable
Journal
Cash
Receipts
Journal
Cash
Disbursements
Journal
Accounts
Payable
Journal
GENERAL LEDGER
SUBSIDIARY JOURNALS
THE BOOKS
The Annual Management Cycle 19
Annual year-end reports represent the closing out of the information system for a specific
reporting period. The recording and reporting of operations will now begin a new cycle with a
new year.
COMMUNICATING FINANCIAL INFORMATION TO OTHERS
The ability to communicate financial information effectively to others is a valuable skill. It is
important to
• Create a report as your method of communication.
• Use accepted terminology.
• Use standard formats that are accepted in the accounting profession.
• Begin with an executive summary.
• Organize the body of the report in a logical flow.
• Place extensive detail into an appendix.
The rest of this book will help you learn how to create such a report. Our book will
also sharpen your communication skills by helping you better understand how heathcare
finance works.
INFORMATION CHECKPOINT
What is needed? An explanation of how the information flow works in
your unit.
Where is it found? Probably with the information system staff; perhaps in the
administrative offices.
How is it used? Study the flow and relate it to the paperwork that you handle.
KEY TERMS
Accounting System
Chart of Accounts
General Ledger
Information System
Original Records
Reporting System
Subsidiary Journals
Trial Balance
DISCUSSION QUESTIONS
1. Have you ever been informed of the information flow in your unit or division?
2. If so, did you receive the information in a formal seminar or in an informal manner, oneon-one with another individual? Do you think this was the best way? Why?
20 Chapter 2 Four Things the Healthcare Manager Needs to Know
3. Do you know about the chart of accounts in your organization as it pertains to information you receive?
4. If so, is it similar to one of the three formats illustrated in this chapter? If not, how is it
different?
5. Do you work with daily or weekly operating reports? With quarterly reports and statistics?
6. If so, do these reports give you useful information? How do you think they could be
improved?
NOTES
1. J. J. Baker, Activity-Based Costing and Activity-Based Management for Health Care (Gaithersburg,
MD: Aspen Publishers, Inc., 1998).
2. L. V. Seawell, Chart of Accounts for Hospitals (Chicago: Probus Publishing Company, 1994).
Notes 21

Progress Notes
© LFor/Shutterstock
CHAPTER
The Digital Age:
Changing the
Landscape of
Healthcare Finance
HIGH-TECH AND HIGH-TOUCH APPROACHES
Healthcare systems are using high-tech and high-touch
approaches to reach patients where they are and with what
they need in an attempt to meet the challenges of patient
engagement. Digital platforms, including mobile apps and
social networks, are changing customer interactions and
expectations.
We characterize the current state of online technology
as Web 2.0, which goes beyond simply letting people access
information on the Internet (as was the case in the early
days of the Internet). The current state is now characterized
by greater user interactivity and collaboration, more pervasive network connectivity, and enhanced communication
channels.1
Social media, such as Facebook and Twitter, are the outgrowth of Web 2.0. The challenge to a healthcare organization’s marketing staff is to determine how to harness social
media to reach customers and turn social media content
into business value.
PATIENT ENGAGEMENT
Central to understanding the changes that are now occurring
due to the variety of digital impacts and changes in health
information technology is the concept of patient engagement. Technology and patient engagement go hand-in-hand.
An overarching objective of the healthcare digital age is to
make patient engagement more meaningful and effective.
The Engaged Patient
A truly engaged patient is one who is an active partner in his
or her own health care. It stands to reason that primary care
After completing this chapter,
you should be able to
1. Understand what drives
changes to health
information technology.
2. Identify types of high-tech
and high-touch digital
approaches.
3. Identify the digital impact
areas for patient
engagement.
4. Define digital media.
5. Understand the difference
between EMR and EHR.
6. Recognize how to effectively
manage population health.
This chapter explores major
digital age influences that are
impacting healthcare finance.
23
CHAPTER
3
CHAPTER
would be the specialty wherein this concept can most effectively be operationalized. Patients
who are punctual with their annual checkup and those with chronic diseases like diabetes who
are adhering to their regimens would be considered engaged patients.
Jacqueline Fellows assembled a comprehensive list of digital impact areas under the rubric
of “Patient Engagement Investments” and examined them by setting (e.g., hospital, physician
organization) and by net patient revenue.2 Among the areas that attracted the most interest
were patient portals, patient access to medical records, telemedicine, remote monitoring, and
telehealth to track patient health status.
The major factors driving the growth of the telehealth market appear to be the rise in aging
and chronically ill population and the shortage of physicians in some areas of the country.
However, there are reimbursement issues that must be overcome, which also encompass
telemedicine.
Rapid Change
Mobile technology has the potential to help healthcare providers manage risk, encourage
healthy behaviors, and engage with consumers. Garmin (producers of GPS programs), along
with various partners, has launched new products including a wide range of “wearables” to help
people reach their health and wellness goals. In one example, OffTheScale (OTS) has entered
into partnership with Garmin and its innovative healthcare platform that fights against obesity
and other chronic diseases. OTS provides a Garmin wearable device that measures steps taken
and combines it with user data to calculate distance walked and calories burned.3
Leaders in performance technology such as Garmin also produce remote monitoring
devices for patients with other conditions such as diabetes and heart failure. These types of
mobile technology have the true potential to improve wellness and to lower healthcare costs.4 It is
essential, however, that the devices and systems that are flooding the market (including apps)
be properly studied or vetted through clinical trials.
SOCIAL MEDIA
Recognizing the importance of social media is a first step in bringing a hospital, for example,
into the digital world. Social media can help a hospital manage the patient experience, connect
with community members and potential patients before they arrive, and manage their care
transactions after they leave. Providing an alternative mode of communication can help make
patient interactions more comfortable and less clinical. The intersection of health care and
social media is unavoidable. Social networks, blogs, discussion forums, and other social and
digital media highlight these alternative modes of communication.
Digital Media
Digital media may be defined as any type of information stored in a computer or mobile device,
including data, voice, and video.5 A common misconception related to social media is that it
requires the creation of additional content. Any content that is being used for print media
(newsletters, information packets, marketing materials, or other promotional items) can be
repurposed for digital media. An effective social media strategy is integral to managing a healthcare organization’s reputation.
24 Chapter 3 The Digital Age
What Do the Data Show?
It is estimated that between 70% and 75% of Internet users in the United States seek healthcare
information on line.6 According to a 2014 study, nearly 95% of hospitals had a Facebook page,
and just over 50% had a Twitter account.7 For all the good that may come from patients and
healthcare consumers use of social media, there are also risks and challenges. For example, it
can be difficult to control the quality of information that appears on patient social networks. In
addition, patient privacy and security of health-related information are major concerns.
RESOURCE ALLOCATION
The types of resources needed to grow a healthcare organization’s digital brand are technological and human resources-related. In addition, with the locus of responsibility for social media
typically residing in a marketing and/or communications department in a healthcare organization, full-time employee staff costs dedicated to electronic media should result in additional
budgetary expenses. These staff expenses are in addition to the cost of establishing and maintaining a website (purchasing a domain name, hosting fees, etc.). A website is a collection of
related Web pages, images, videos, or other digital assets that are addressed with a common
domain name or internet protocol (IP) address in an IP-based network.8 That said, in today’s
competitive environment, it isn’t enough just to have a Web presence. Instead, healthcare organizations need to have online visibility.
CHANGES IN HEALTH INFORMATION TECHNOLOGY
The changes that are occurring in health information technology are driven by health informatics, or the application of information technology to healthcare delivery. These changes
include the following:
• More open, cloud-based systems that facilitate data sharing
• Mobile devices and sensors that enable increased participation by patients
• Adoption of digital or electronic health records
Still another major technology change involves data mining. Electronic records are increasingly
being mined and analyzed to uncover new medical knowledge, promote evidence-based treatments, and determine the clinical and cost-effectiveness of care.9
(For additional information on
data mining, see the chapter entitled, “Understanding the Impact of Data Analytics and Big Data.”)
EMRs and EHRs
At the center of the health information technology evolution is the electronic health record
(EHR). A distinction has been made between the electronic medical record (EMR) and the
EHR. The EMR is essentially the digital version of the traditional paper chart, the electronic
record of a particular physician’s office. The EHR ideally represents the total health status of
the patient across all providers.10
Incorporating EMRs and EHRs into clinical practice will require large investments in new
technology, in addition to changes in existing systems and processes. These barriers tend to slow
EHR adoption rates. Moreover, in some instances, this technology may serve as a distraction
Changes in Health Information Technology 25
during care delivery. On the other hand, the hope is that EHRs will realize their potential to
improve quality, reduce medical errors, and lower administrative costs.
Interoperability
Interoperability, or the ability of two or more information systems to “talk” to each other
(exchange data), is the key to the future success of EHRs as is the effectiveness of health
information exchanges (HIEs). These exchanges are a key component of health informatics through which information from various electronic record systems is shared according to
nationally recognized standards.
POPULATION HEALTH AND THE DIGITAL AGE: CROSSING AT THE
INTERSECTION
Population health is now center stage in healthcare delivery, and it is transforming the industry.
This represents an industry-wide shift in focus; while health care used to be transactional and
focused on the individual, population health emphasizes outcomes—not just of a single patient,
but of an entire population.
This concept is being operationalized through the advent of Accountable Care Organizations (ACOs) and their rapid growth and maturation. ACOs are groups of hospitals, doctors,
and other healthcare providers who come together voluntarily to provide coordinated, highquality care to their (primarily) Medicare patients. At the time of this writing, there are approximately 750 ACOs in operation, covering 23.5 million lives.11
The Challenge
To fully appreciate the challenge, one must understand what the essence of population health
is. First, the provider has to define the population. Then, the care that the population is
receiving must be determined. Next, identify what gaps exist when comparing the care that the
population is receiving with the care that the population requires. Finally, the delivery system
should be able to address the care gaps.12 Improving the health of populations is one element
of the well-regarded Institute For Healthcare Improvement’s “Triple Aim,” the other two being
improving the patient experience and reducing the per-capita cost of health care.13 Taken
together, the three elements describe an approach to optimizing health system performance.
Assessing Information Technology Capabilities
In order to effectively engage in population health management, healthcare organizations
will have to assess their information technology (IT) capabilities and address the gaps therein.
Glaser14 maintains that efficient data sharing among multiple providers will be key; hospitals
working with other organizations such as provider groups, post-acute providers, and social services. That data will have to be combined to formulate a complete picture of the patient in
order to determine care planning, predict utilization patterns, and assess risk.
These imperatives go beyond the functionality of EHRs and envision real-time population
health management solutions that are intended to work in tandem with that certified technology.
26 Chapter 3 The Digital Age
Most assuredly, the use of big data analytics will be part of the enabling platform, as well as cloudbased applications and telemedicine.
ADDITIONAL TRENDS AND COMPLEXITIES: OTHER DELIVERY SYSTEMS
The trends and complexities related to population health and the digital age involve other
delivery systems. Most notably among them are urgent care, retail medicine clinics, and behavioral health.
Urgent Care Medicine
The growth and development of urgent care medicine has not been unexpected. For many
patients, there are long waits in the emergency room for nonemergent care, and there has been
a concomitant shortage of primary care physicians in parts of the country. Since 2008, the number of urgent care facilities has increased from 8,000 to 9,300.15
Further evidence of the continuing maturation of this type of care is that many centers are
now seeking accreditation. Urgent care centers offer imaging and other services not found in
retail outlets. However, the challenge therein lies in the ability of the centers to share clinical
data with a patient’s primary care physician in a timely manner for continuity of care purposes.
Retail Medicine Clinics
Retail medicine clinics may be found in drugstores, grocery chains, and even airports. They are
typically small clinics staffed by Nurse Practitioners. Retail health clinics, by definition, are clinics in which the consumer pays the provider directly at the point of sale.16 Hospital systems are
increasingly opening satellite care centers in retail locations, either partnering with chains like
Walmart on in-store centers or going it alone. Many consumers of retail medicine are uninsured
individuals looking for a fixed cost-of-care. There are also regulatory concerns and questions
about quality of care.
Behavioral Health
Behavioral health presents a myriad of unique challenges in the digital age. The nature of
behavioral health care (mental health care) makes the application of current health IT challenging. The use of EHRs in behavioral health is limited because of strict privacy concerns,
which cause persistent barriers to information sharing.17 Thus, few behavioral health organizations have formal linkages or agreements to securely share their information. A recent survey
found that while 97% of U.S. hospitals and 74% of physicians have implemented interoperable
EHRs, only 30% of behavioral health providers have implemented these systems.18
SUMMARY
Within the heathcare finance world, it is important to recognize the impact and consequences
of the Digital Age. To be successful today, managers must work toward fully recognizing and
understanding these significant trends.
Summary 27
INFORMATION CHECKPOINT
What Is Needed? Your healthcare organization’s online visibility.
Where Is It Found? Websites, blogs, discussion forums, Facebook, Twitter, and/or
LinkedIn.
How Is It Used? The particular online visibility sources will vary depending
upon your organization’s media strategy.
KEY TERMS
Digital Media
Electronic Health Record (EHR)
Electronic Medical Record (EMR)
Health Information Technology
Patient Engagement
Population Health
Social Media
OTHER ACRONYMNS
ACO: Accountable Care Organization
HIE: Health Information Exchange
IP: Internet Protocol
IT: Information Technology
DISCUSSION QUESTIONS
1. Does your organization have a social media marketing plan?
2. Are you aware of how widespread the use of electronic health records (EHRs) is in your
organization? Is it embraced by the medical staff?
3. Does your organization have a population health strategy?
NOTES
1. “Web 2.0,” WhatIs.com, http://whatis.techtarget.com/definition/Web-20-or-Web-2,
accessed January 5, 2016.
2. J. Fellows, “Meeting the Challenge of Patient Engagement,” Health Leaders, 18, no 6
(2015): 12–26.
3. OffTheScale, www.prnewswire.com/news-releases/groundbreaking-healthcare-platform
-offthescale-partners-with-Garmin-300136825.html, accessed September 2, 2015, and
http://site.garmin.com/en-US/wellness, accessed September 19, 2016.
28 Chapter 3 The Digital Age
4. Ibid.
5. Society for Healthcare Strategy & Market Development, A Hospital Leadership Guide to
Digital & Social Media Engagement (Chicago: American Hospital Association, 2015).
6. J. Glaser, “Five Reasons to ‘Like’ Patients Use of Social Media,” H&HN, April 11, 2016,
http://www.hhnmag.com/articles/7090-five-reasons-to-like-patients-use-of-social-media
7. Ibid.
8. C. B. Thielst, Social Media in Healthcare: Connect, Communicate, Collaborate (Chicago:
Health Administration Press, 2010).
9. M. L. Braunstein, Contemporary Health Informatics (Chicago: American Health Information Management Association, 2014).
10. Ibid.
11. J. Glaser, “All Roads Lead to Population Health Management,” H&HN, June 13, 2016,
http://www.hhnmag.com/articles/7332-all-roads-lead-to-population-health-management
12. M. Zeis, “Toward Population Health,” Health Leaders, 16, no 8 (2013): 24–28.
13. Institute for Healthcare Improvement, http://www.ihi.org/engage/tripleaim/pages
/default.aspx, accessed June 18, 2016.
14. J. Glaser (Op.Cit), June 19, 2016.
15. American Academy of Urgent Care Medicine, “Future of Urgent Care,” aaucm.org
/about/future/default.aspx, accessed June 18, 2016.
16. “How Retail Medicine Lost its Way,” Managed Healthcare Executive, June 17, 2015,
managedhealthcareexecutive.modernmedicine.com/managed-healthcare-executive
/news/how-retail-medicine-lost-its-way
17. P. A. Ranallo, A. M. Kilbourne, A. S. Whatley, and H. A. Pincus, “Behavioral Health Information Technology: From Chaos to Clarity,” Health Affairs, 35, no 6 (2016): 1106–1113.
18. Ibid.
Notes 29

PART
© LFor/Shutterstock
Record Financial
Operations
II

OVERVIEW
Assets, liabilities, and net worth are part of the language of
finance. As such, it is important to understand both their
composition and how they fit together. Short definitions
appear below, followed by examples.
Assets
Assets are economic resources that have expected future
benefits to the business. In other words, assets are what the
organization owns and/or controls.
Liabilities
Liabilities are “outsider claims” consisting of economic obligations, or debts, payable to outsiders. Thus, liabilities are
what the organization owes, and the outsiders to whom the
debts are due are creditors of the business.
Net Worth
“Insider claims” are also known as owner’s equity, or net
worth. These are claims held by the owners of the business.
An owner has a claim to the entity’s assets because he or she
has invested in the business. No matter what term is used,
the sum of these claims reflects what the business is worth,
net of liabilities—thus “net worth.”
The Three-Part Equation
An accounting equation reflects a relationship among
assets, liabilities, and net worth as follows: assets equal
33
Progress Notes
© LFor/Shutterstock
CHAPTER
4
CHAPTER
After completing this chapter,
you should be able to
1. Recognize typical assets.
2. Recognize typical liabilities.
3. Understand net worth
terminology.
4. See how assets, liabilities,
and net worth fit together.
Assets, Liabilities,
and Net Worth
liabilities plus net worth. The three pieces must always balance among themselves because this
is how they fit together. The equation is as follows:
Assets 5 Liabilities 1 Net Worth
WHAT ARE EXAMPLES OF ASSETS?
All of the following are typical business assets.
Examples of Assets
Cash, accounts receivable, notes receivable, and inventory are all assets. If the Great Lakes
Home Health Agency (HHA) has cash in its bank account, that is an economic resource—an
asset. The HHA is owed money for services rendered; these accounts receivable are also an
economic resource—an asset. If certain patients have signed a formal agreement to pay the
HHA, then these notes receivable are likewise economic resources—assets. All types of business
receivables are assets. The Great Lakes HHA also has an inventory of medical supplies (dressings, syringes, IV tubing, etc.) that are used in its day-to-day operations. This inventory on hand
is an economic resource—an asset. Land, buildings, and equipment are also assets. Exhibit 4–1
summarizes asset examples.
Short-Term Versus Long-Term Assets
Assets are often labeled either “current” or “long-term” assets. Current is another word
for “short-term.” If an asset can be turned into cash within a 12-month period, it is current, or short term. If, on the other hand, an asset cannot be converted into cash within a
12-month period, it is considered long term. In our Great Lakes HHA example, accounts
receivable should be collected within 1 year and thus should be current assets. Likewise,
the inventory should be converted to business use within 1 year; thus, it too is considered
short term.
Classification of the note receivable depends on the length of time that payment is promised. If the entire note receivable will be paid within 1 year, it is a short-term asset. Consider, however, what would happen if the note is to be paid over 3 years. A portion of the
note—that amount to be paid in the coming 12 months—will be classified as short-term,
or current, and the rest of the note—that amount to be paid further in the future—will be
classified as long-term.
The land, building, and equipment will
generally be classified as long-term because
these assets will not be converted into cash in
the coming 12 months. Buildings and equipment are also generally stated at a net figure
called book value, which reduces their historical cost by any accumulated depreciation.
(The concept of depreciation is discussed in
Chapter 8.)
Exhibit 4–1 Asset Examples
Cash
Accounts receivable
Notes receivable
Inventory
Land
Buildings
Equipment
34 Chapter 4 Assets, Liabilities, and Net Worth
WHAT ARE EXAMPLES OF LIABILITIES?
All of the following are typical business liabilities.
Examples of Liabilities
Accounts payable, payroll taxes due, notes payable, and mortgages payable are all liabilities.
The Great Lakes HHA owes vendors for medical supplies it has purchased. The amount owed
to the vendors is recognized as accounts payable. When the HHA paid its employees, it withheld
payroll taxes, as required by the government. The payroll taxes withheld are due to be paid
to the government and thus are also a liability. The HHA has borrowed money and signed a
formal agreement and thus the amount due is a liability. The HHA also has a mortgage on its
building. This mortgage is likewise a liability. In other words, debts are liabilities. Exhibit 4–2
summarizes liability examples.
Short-Term Versus Long-Term Liabilities
Liabilities are also usually labeled as either “current” (short-term) or “long-term” liabilities. In
this case, if a liability is expected to be paid within a 12-month period, it is current, or shortterm. If, however, the liability cannot reasonably be expected to be paid within a 12-month
period, it is considered long-term. In our Great Lakes HHA example, accounts payable and
payroll taxes due should be paid within 1 year and thus should be labeled as current liabilities.
Classification of the note payable depends on the length of time that payment is promised.
If the HHA is going to pay the entire note payable within 1 year, it is a short-term liability. But
consider what would happen if the note is to be paid over 3 years. A portion of the note—that
amount to be paid in the coming 12 months—will be classified as short-term, or current, and
the rest of the note—that amount to be paid further in the future—will be classified as longterm. The mortgage will be treated slightly differently. That portion to be paid within the coming 12 months will be classified as a short-term liability, while the remaining mortgage balance
will be labeled as long-term.
WHAT ARE THE DIFFERENT FORMS OF NET WORTH?
Net worth—the third part of the accounting equation—is labeled differently, depending
on the type of organization. For-profit organizations will have equity accounts with which
to report their net worth. (Equity is the ownership right in property or the money value of
property.) For example, a sole proprietorship or a partnership’s net worth may simply be
labeled as “Owners’ Equity.” A corporation,
on the other hand, will generally report two
types of equity accounts: “Capital Stock” and
“Retained Earnings.” Capital stock represents
the owners’ investment in the company, indicated by their purchase of stock. Retained
earnings, as the name implies, represents undistributed company income that has been
left in the business.
Exhibit 4–2 Liability Examples
Accounts payable
Payroll taxes due
Notes payable
Mortgage payable
Bonds payable
What Are the Different Forms of Net Worth? 35
Not-for-profit organizations will generally
use a different term such as “Fund Balance”
to report the difference between assets and
liabilities in their report. This is presumably
because nonprofits should not, by definition,
have equity. Governmental entities in the
United States may also use the term “Fund
Balance” in their reports. Exhibit 4–3 summarizes terminology examples for net worth as
just discussed.
INFORMATION CHECKPOINT
What is needed? A report that shows the balance sheet for your organization.
Where is it found? Probably with your supervisor.
How is it used? Study the balance sheet to find the assets and liabilities. Check
the equity section to see whether equity is listed as net
worth or as fund balance.
KEY TERMS
Assets
Equity
Fund Balance
Liabilities
Net Worth
DISCUSSION QUESTIONS
1. Do you ever work with balance sheets in your current position?
2. If so, is the balance sheet you receive for your department only or for the entire organization? Do you know why this reporting method (departmental versus entire organization)
was chosen by management?
3. If you receive a copy of the balance sheet, is one distributed to you once a month, once
a year, or on some other more irregular basis? What are you supposed to do with it upon
receipt?
4. Do you think the balance sheet report you receive gives you useful information? How do
you think it could be improved?
Exhibit 4–3 Net Worth Terminology Examples
For-profit sole proprietors or partnerships:
Owners’ Equity
For-profit corporations:
Capital Stock
Retained Earnings
Not-for-profit (nonprofit) companies:
Fund Balance
36 Chapter 4 Assets, Liabilities, and Net Worth
Progress Notes
© LFor/Shutterstock
CHAPTER
Revenues (Inflow)
OVERVIEW
Revenue represents amounts earned by an organization:
that is, actual or expected cash inflows due to the organization’s major business. In the case of health care, revenue is
mostly earned by rendering services to patients. Revenue
flows into the organization and is sometimes referred to as
the revenue stream.
Revenue is generally defined as the value of services
rendered, expressed at the facility’s full established rates.
For example, hospital A’s full established rate for a certain
procedure is $100, but Giant Health Plan has negotiated
a managed care contract whereby the plan pays only $90
for that procedure. The revenue figure—the full established rate—is $100. Revenues can be received in the form
of cash or credit. Most, but not all, healthcare revenues are
received in the form of credit.
RECEIVING REVENUE FOR SERVICES
One way that revenue is classified is by whether payment
is received before or after the service is delivered. The
amount of revenue received for services is often influenced
by this classification.
Payment After Service Is Delivered
The traditional payment method in health care is that of
payment after service is delivered. Two basic types of payment after service is delivered are discussed in this section:
fee for service and discounted fee for service. One evolved
from the other.
After completing this chapter,
you should be able to
1. Understand how receiving
revenue for services is a
revenue stream.
2. Recognize contractual
allowances and discounts
and their impact on revenue.
3. Understand the differences in
sources of healthcare
revenue.
4. See how to group revenue
for planning and control.
37
5
CHAPTER
1. Fee for service. The truly traditional U.S. method of receiving revenue for services is fee
for service. The provider of services is paid according to the service performed. Before
the 1970s, with very few exceptions, fee for service was the dominant method of payment
for health services in the United States.1
2. Discounted fee for service. In this variation on the original fee for service, a contracted
discount is agreed upon. The organization providing the services then receives a payment
that is discounted in accordance with the contract. Sometimes the contract contains fee
schedules. A large provider of services can have many different contracts, all with different discounted contractual arrangements. Many variations are therefore possible.
Payment Before Service Is Delivered
Traditional payment methods in the United States have begun to give way to payment before
service is delivered. There are multiple names and definitions for such payment. We have chosen to use a general descriptive term for payment received before service is delivered: predetermined per-person payment. The payment method itself and its rate-setting variations are
discussed in this section.
1. Predetermined per-person payment. Payment received before service is delivered is generally at an agreed-upon predetermined rate. Payment, therefore, consists of the predetermined rate for each person covered under the agreement. Thus, the amount received
is a per-head or per-person count at a particular point in time.
2. Rate-setting differences. Different agreements can use varying assumptions about the
group to be served, and these variations will affect the rate-setting process. Numerous
variations are therefore possible.
Contractual Allowances and Other Deductions from Revenue
Revenues are recorded at the organization’s full established rates, as previously discussed. Those
amounts estimated to be uncollectible are considered to be deductions from revenues and are
recorded as such on the books of the organization. (For purposes of the external financial statements released for third-party use, reported revenue must represent the amounts that payers [or
patients] are obligated to pay. Therefore, the terms gross revenue and deductions from revenue
will not be seen on external statements. The discussion that follows, however, pertains to the books
and records that are used for internal management, where these classifications will be used.)
Contractual allowances are the difference between the full established rate and the agreedupon contractual rate that will be paid. Contractual allowances are often for composite services.
Take the case of hospital A as an example. As discussed in the overview to this chapter, hospital
A’s full established rate for a certain procedure is $100, but Giant Health Plan has negotiated a
managed care contract whereby the plan pays only $90 for that procedure. The $10 difference
between the revenue figure ($100) and the contracted amount that the plan pays ($90) represents the contractual allowance.
It is not uncommon for different plans to pay different contractual rates for the same service.
This practice is illustrated in Table 5–1, which shows contractual rates to be paid for visit codes
99213 and 99214 for 10 different health plans. Note the variations in rates.
38 Chapter 5 Revenues (Inflow)
The second major deduction from revenue
classification is an allowance for bad debts,
also known as a provision for doubtful accounts. (Again, for purposes of the external
financial statements released for third-party
use, the provision for doubtful reports must
be reported separately as an expense item.
The discussion that follows, however, still pertains to the books and records that are used
for internal management, where the classification of deductions from revenue will be used.)
The allowance for bad debts is charged with
the amount of services received on credit (recorded as accounts receivable) that are estimated to result in credit losses.
Beyond contractual allowances and a provision for bad debts, the third major deduction
from revenue classification is charity service.
Charity service is generally defined as services
provided to financially indigent patients.
SOURCES OF HEALTHCARE REVENUE
Healthcare revenue in the United States comes from a variety of public programs (governmental sources) and private payers. The sources of healthcare revenue are generally termed payers.
Payer mix—the proportion of revenues realized from the different types of payers—is a measure that is often included in the profile of a healthcare organization. For example, “Hospital
A has a payer mix that includes 40% Medicare and 33% Medicaid” might be part of the profile.
Governmental Sources
The Medicare Program
Title XVIII of the Social Security Act is commonly known as Medicare. Actually entitled “Health
Insurance for the Aged and Disabled,” Medicare legislation established a health insurance program for the aged in 1965. The program was intended to complement other benefits (such as
retirement, survivors’, and disability insurance benefits) under other titles within the Social
Security Act.
The Medicare program currently has four parts. The first part, known as Part A, is hospital
insurance (HI) and is funded primarily by a mandatory payroll tax. The second part, known as
Part B, is called supplementary medical insurance (SMI). SMI is voluntary and is funded primarily by insurance premiums (usually deducted from monthly Social Security benefit checks
of those enrolled) supplemented by federal general revenue funds. Guidelines determine both
the services to be covered and the eligibility of the individual to receive the services under the
Medicare program. Medicare claims (billings) are processed by fiscal agents who act on behalf
Sources of Healthcare Revenue 39
Table 5–1 Variations in Physician Office Revenue
for Two Visit Codes
Visit Codes
Payer 99213 99214
FHP $25.35 $35.70
HPHP 42.45 58.85
MC 39.05 54.90
UND 39.90 60.40
CCN 44.00 70.20
MAYO 45.75 70.75
CGN 10.00 10.00
PRU 39.05 54.90
PHCS 45.00 50.00
ANA 38.25 45.00
Rates for illustration only.
of the federal government. These fiscal agents, known as Medicare Administrative Contractors
(MACs), process both Part A (HI) and Part B (SMI) Medicare claims.
Medicare’s third part, Part C, is known as “Medicare Advantage.” Medicare Advantage consists of managed care plans, private fee-for-service plans, preferred provider organization plans,
and specialty plans. Although Medicare Advantage is offered as an alternative to traditional
Medicare, coverage must never be less than what Part A and Part B (traditional Medicare)
would offer the beneficiary.
Medicare’s fourth part, Part D, is the prescription drug benefit, effective as of January 1,
2006. The prescription drug benefit represents expanded coverage. It is a voluntary program
that requires payment of a separate premium and contains cost-sharing provisions.
The Medicare program covers approximately 95% of the U.S. aged population along with
certain eligible individuals receiving Social Security disability benefits.2 Medicare is an important source of healthcare revenue to most healthcare organizations.
The Medicaid Program
Title XIX of the Social Security Act is commonly known as Medicaid. Medicaid legislation established a federal and state matching entitlement program in 1965. The program was intended to
provide medical assistance to eligible needy individuals and families.
The Medicaid program is state specific. The federal government has established broad national guidelines. Each state has the power to set eligibility, service restrictions, and payment
rates for services within that state. In doing so, each state is bound only by the broad national
guidelines. Medicaid policies are complex, and considerable variation exists among states. The
federal government is responsible for a certain percentage of each state’s Medicaid expenditures; the specific amount due is calculated by an annual formula. The state pays the providers
of Medicaid services directly. Thus, the source of Medicaid revenue to a healthcare organization
is considered to be the state government’s Medicaid program representative.
The Medicaid program is the largest U.S. government program providing funds for medical
and health-related services for the poor.3 Therefore, although the proportion of Medicaid services within the payer mix may vary, Medicaid is a source of healthcare revenue in almost every
healthcare organization.
Other Programs
There are numerous other sources of federal, state, and local revenues for healthcare
organizations. Generally speaking, for most organizations, none of the other revenue sources
will exceed the Title XVIII and Title XIX programs just discussed. Other programs include
the Department of Veterans’ Affairs health programs, workers’ compensation programs, and
state-only general assistance programs (versus the federal-and-state jointly funded Medicaid
program). Still other public programs are school health programs, public health clinics, maternal and child health services, migrant healthcare services, certain mental health and drug and
alcohol services, and special programs such as Native American healthcare services.
Managed Care Sources
In the 1970s, managed care began to appear in healthcare models in the United States. An
all-purpose definition of managed care is: managed care is a means of providing healthcare
services within a network of healthcare providers. The responsibility to manage and provide
40 Chapter 5 Revenues (Inflow)
high-quality and cost-effective health care is delegated to this defined network of providers.4
A central concept of managed care is the coordination of all healthcare services for an individual. In general, managed care plans receive a predetermined amount per member in
premiums.
Types of Plans
The most prevalent type of managed care plan today is the health maintenance organization
(HMO). Members enroll in the HMO. They prepay a fixed monthly amount; in return, they
receive comprehensive health services. The members must use the providers who are designated by the HMO; if they go outside the designated providers, they must pay all or a large
part of the cost themselves. The designated providers of services in turn contract with the
HMO to provide services at agreed-upon rates. Several different forms of HMOs have evolved
over time.
The preferred provider organization (PPO) is a type of plan found across the United States.
It consists of a group of providers called a panel. The panel members are an approved group of
various types of providers, including hospitals and physicians. The panel is limited in size and
generally has utilization review powers. If the patients in a PPO use health providers who are not
within the PPO itself, they must pay a higher amount in deductibles and coinsurance.
Types of Contracts
In the case of an HMO, the designated providers of health services contract with the HMO to
provide services at agreed-upon rates. The different types of HMOs—including the staff model,
the group model, the network model, the point-of-service model, and the individual practice association (IPA) model—have various methods of arriving at these rates. A PPO contracts with its
selected group, who are all participating payers, to buy services for its eligible beneficiaries on
the basis of discounted fee for service. A large healthcare facility will have one or more individuals responsible for managed care contracting.5
Other Revenue Sources
A considerable amount of healthcare revenue is still realized from sources other than Title
XVIII, Title XIX, and managed care:
• Commercial insurers. Generally speaking, conventional indemnity insurers, or commercial insurers, simply pay for the eligible health services used by those individuals who pay
premiums for healthcare insurance. They do not tend to have a say in how those health
services are administered.
• Private pay. This is payment by patients themselves or by the families of patients. Private
pay is more prevalent in nursing facilities and in assisted-living facilities than in hospital
settings. Physicians’ offices also receive a certain amount of private pay revenue.
• Other. Additional sources of revenue for healthcare facilities include donations ­received
by voluntary nonprofit organization, tax revenues levied by governmental nonprofit organizations, and grant funding.
Healthcare revenue is often reported to managers by source of the revenue. Table 5–2 presents such a revenue summary. This example covers all types of sources discussed in this section.
Both dollar totals and proportionate percentages by source are reported.
Sources of Healthcare Revenue 41
GROUPING REVENUE FOR
PLANNING AND CONTROL
Grouping revenue by different classifications
is an effective method for managers to use
the information to plan and to control. In the
preceding paragraphs, we have seen revenue
reported by source. Other classification examples are now discussed.
Revenue Centers
A revenue center classification is one form of a
responsibility center. In a responsibility center,
the manager is responsible, as the name implies, for a particular set of activities. In the case of a
revenue center, a particular unit of the organization is given responsibility for generating revenues
to meet a certain target. Actually, the responsibility in the healthcare setting is more for generating
volume than for generating a specific revenue dollar amount. (The implication is that the volume
will, in turn, generate the dollars.) Revenue centers tend to occur most often in special programs
where volume is critical to survival of the program.
Care Settings
Grouping revenue by care setting recognizes the different sites at which services are delivered. The
most basic grouping by care settings is inpatient versus ambulatory services. Exhibit 5–1, however,
illustrates a six-way classification of care setting revenues within a health system. In this case, hospital
inpatient, hospital outpatient, off-site clinic, skilled nursing facility, home health agency, and hospice
are all accounted for. A percentage is shown for each. This type of classification is useful for a brochure or a report that profiles the different types of healthcare services offered by the organization.
Exhibit 5–1 Revenues by Care Setting
42% 38% 4%
Hospital Hospital Off-Site
Inpatient Outpatient Clinic
8% 6% 2%
Skilled Home Hospice
Nursing Health
Facility Agency
Service Lines
In traditional cost accounting circles, a product line is a grouping of similar products.6 In the
healthcare field, many organizations opt instead for “service line” terminology. A service line is
a grouping of similar services. Strategic planning sometimes sets out service lines.
42 Chapter 5 Revenues (Inflow)
Table 5–2 Sample Monthly Statement of Revenue
by Source
Summary Year to Date %
Private revenue $100,000 2.9
HMO revenue 560,000 16.7
Medicare revenue 1,420,000 42.4
Medicaid revenue 820,000 24.5
Commercial revenue 400,000 12.0
Other revenue 50,000 1.5
Total $3,350,000 100.0%
Hospitals
A number of hospitals have adopted the major
diagnostic categories (MDCs) as service lines.
One advantage of MDCs is that they are a
universal designation in the United States.
MDCs also have the advantage of possessing
a standard definition. In another approach to
service line classification, a hospital recently
updated its strategic plan and settled on
five service lines: (1) medical, (2) surgical,
(3) women and children, (4) mental health,
and (5) rehabilitation (neuro-ortho rehab)
(Figure 5–1).7
Long-Term Care
A continuing care retirement community
(CCRC) can use its various levels of care as
a starting point. Thus, the CCRC usually has
four service lines, listed in the descending order of resident acuity: (1) skilled nursing facility,
(2) nursing facility, (3) assisted living, and (4) independent living. The skilled nursing facility
provides services for the highest level of resident acuity, and the independent living provides
services for the lowest level of resident acuity. One adjustment to this approach includes isolating subacute services from the remainder of skilled nursing facility services. Another adjustment
involves splitting independent living into two categories, one for Housing and Urban Development (HUD)–subsidized independent housing and the other for private-pay independent
housing. Figure 5–2 illustrates CCRC service lines by acuity level.
Figure 5–2 Long-Term Care Service Lines.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Skilled Nursing
Facility
Nursing
Facility
Assisted
Living
Independent
Living
Nonsubsidized
Subsidized
Balance of SNF
Subacute
Home Care
Numerous categories of service delivery can be considered “home care.” A practical approach
was taken by one home care entity—part of a health system—that defined its “key functions.”
Key functions can in turn be converted to service lines (Figure 5–3).
Grouping Revenue for Planning and Control 43
Figure 5–1 Hospital Service Lines.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Women
&
Children
Mental Health
Medical
Surgical
Rehabilitation
Figure 5–3 Home Care Service Lines.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Infusion Therapy
Mental Health
Pulmonary
Maternity Services
Wound Care
Diabetes Education
Standard Home Care Special Services Home Care
Physician Groups
Service delivery for physician groups will vary,
of course, with the nature of the group itself.
A generic set of service lines is presented in
Figure 5–4.
Other Service Designations
Other classifications may meet the needs of
particular organizations. Columbia/HCA is
now reported to classify its services in a disease
management approach. The classification consists of eight disease management areas: (1)
cancer, (2) cardiology, (3) diabetes, (4) behavioral health, (5) workers’ compensation, (6)
women’s services, (7) senior care, and (8) emergency services.8
Other Types of Revenue Groupings
Other healthcare organizations may have revenue groupings that are not service lines. An entity
that provides services is able to choose service lines as a method of grouping its revenue. But if
the entity sells or makes a product (rather than providing services), its revenue will have to be
classified differently. Two examples within the healthcare industry follow: a retail pharmacy and a
pharmaceutical manufacturer.
Figure 5–4 Physician’s Group Service Lines.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Office Visits
Surgical
Procedures
Emergency
Medicine
Laboratory
Radiology
44 Chapter 5 Revenues (Inflow)
Retail Pharmacy
A retail pharmacy’s revenue primarily comes from sales. A typical retail pharmacy may group
revenues into three major categories of sales: Prescription Drugs, Nonprescription (Over-theCounter, or OTC) Drugs, and Other Merchandise. (The major category of “Other Merchandise”
would then have subcategories such as Cosmetics, Greeting Cards, Gifts, etc.)
Pharmaceutical Manufacturer
A pharmaceutical manufacturer’s revenue groupings would likewise be specific to its type of
healthcare business. These organizations are producing a product rather than providing a service.
Its major categories of revenues will probably be by type of drug manufactured. The next subcategory might then either be national versus international revenues, or perhaps a classification of
revenues by U.S. geographic region.
In summary, the entity’s revenue classification system, whatever it may be, must be consistent
with the current structure and purpose of the organization.
INFORMATION CHECKPOINT
What is needed? A report that shows revenue in your organization.
Where is it found? With your supervisor.
How is it used? Examine the report to find various revenue sources; look for
how the contractual allowances and discounts are handled
on the report.
What is needed? A report that groups revenue by some type of classification.
Where is it found? With your supervisor, or in the information services division.
How is it used? Examine the report to discover the methods that are used for
grouping. You will probably find that these groupings are
used for performance measures. They can also be used for
control and planning.
KEY TERMS
Discounted Fee for Service
Fee for Service
Managed Care
Medicaid Program
Medicare Program
Payer Mix
Revenue
DISCUSSION QUESTIONS
1. Does your organization receive revenue mainly in the form of payment after service is
delivered or payment before service is delivered?
Discussion Questions 45
2. Why do you think this is so?
3. What do you believe the proportion of revenues from different sources is for your organization?
4. Do you believe that this proportion (payer mix) will change in the future? Why?
5. What grouping of revenue do you believe your organization uses (revenue centers, care
settings, service lines, other)?
6. From your perspective, would there be a better grouping possible? If so, why do you think
it is not used?
NOTES
1. Texas Medical Association, American Medical Association, Texas Medical Foundation,
and Texas Osteopathic Medical Association, A Guide to Forming Physician-Directed Managed
Care Networks (Austin, TX: Texas Medical Association, 1994), 3.
2. Health Care Financing Administration, Health Care Financing Review: Medicare and Medicaid Statistical Supplement (Baltimore, MD: U.S. Department of Health and Human Services, 1997), 8.
3. Ibid., 9.
4. D. I. Samuels, Capitation: New Opportunities in Healthcare Delivery (Chicago: Irwin
Professional Publishing, 1996), 20–21.
5. D. E. Goldstein, Alliances: Strategies for Building Integrated Delivery Systems (Gaithersburg,
MD: Aspen Publishers, Inc., 1995), 283; and Texas Medical Association, American Medical Association, Texas Medical Foundation, and Texas Osteopathic Medical Association,
A Guide to Forming Physician-Directed Managed Care Networks (Austin, TX: Texas Medical Association, 1994), 4–6.
6. C. Horngren et al., Cost Accounting: A Managerial Emphasis, 9th ed. (Englewood Cliffs, NJ:
Prentice Hall, 1998), 116.
7. When ICD-10 is fully implemented, it is possible that the term “major diagnostic categories” (MDCs) may have to be replaced with some other universal designation. Whether
these hospitals will change the names of their service line designations to match the new
titles is unknown at this point. We do know it will take time to decide upon such a change
and then additional time to implement the change.
8. A. Sharpe and G. Jaffe, “Columbia/HCA Plans for More Big Changes in Health-Care
World,” Wall Street Journal, 28 May, 1997, A8.
46 Chapter 5 Revenues (Inflow)
Progress Notes
© LFor/Shutterstock
CHAPTER
Expenses (Outflow)
OVERVIEW
Expenses are the costs that relate to the earning of revenue.
Another way to think of expenses is as the costs of doing
business. Just as revenues represent the inflow into the organization, so do expenses represent the outflow—a stream of
expenditures flowing out of the organization. Examples of
expenses include salary expense for labor performed, payroll tax expense for taxes paid on the salary, utility expense
for electricity, and interest expense for the use of money.
In fact, expenses are expired costs—costs that have been
used up, or consumed, while carrying on business. Revenues and expenses affect the equity of the business. The
inflow of revenues increases equity, whereas the outflow of
expenses decreases equity. In nonprofit organizations, the
term is fund balance rather than equity. This is because a
nonprofit organization, by its nature, is not in business to
make a profit. Thus, it should not have equity. However, the
principle of inflow and outflow remains the same. In the
case of nonprofits, the inflow of revenues increases fund balance, and the outflow of expenses decreases fund balance.
Many managers use the terms expense and cost
interchangeably. Expense in its broadest sense includes
every expired (used up) cost that is deductible from revenue. A narrower interpretation groups expenses into categories such as operating expenses, administrative expenses,
and so on. Cost is the amount of cash expended (or property transferred, services performed, or liability incurred)
in consideration of goods or services received or to be
received. As we have already said, costs can be either
expired or unexpired. Expired costs are used up in the current period and are thus matched against current revenues.
Unexpired costs are not yet used up and will be matched
against future revenues.1
After completing this chapter,
you should be able to
1. Understand the distinction
between expense and cost.
2. Understand how
disbursements for services
represent an expense stream
(an outflow).
3. Follow how expenses are
grouped in different ways for
planning and control.
4. Recognize why cost reports
have influenced expense
formats.
47
6
CHAPTER
For example, an electric bill for $500 is recorded in the books of the clinic as an expense.
The administrator sees the $500 as the cost of electricity for that month in the clinic. And
the administrator is actually correct in seeing the $500 as a cost because it has been used up
(expired) within the month.
Confusion also exists in healthcare reporting over the term cost versus the term charges.
Charges are revenue, or inflow. Costs are expenses, or outflow. Charges add; costs take away.
Because the two are inherently different, they should never be intermingled.
DISBURSEMENTS FOR SERVICES
There are two types of disbursements for services:
1. Payment when expense is incurred. If an expense is paid for at the point where it is incurred, it does not enter the accounts payable account. In large organizations, it is relatively rare to see payments when expenses are incurred. The only place where this usually
occurs is the petty cash fund.
2. Payment after expense is incurred. In most healthcare organizations, expenses are paid
at a later time and not at the point when the expense is incurred. If this is the case, the
expense is recorded in the accounts payable account. It is cleared from accounts payable
when payment is made. One measurement of operations is “days in accounts payable,”
whereby the operating expenses for the organization are reduced to a rate per day and
compared with the amount in accounts payable.
GROUPING EXPENSES FOR PLANNING AND CONTROL
Cost Centers
A cost center is one form of a responsibility center. In a responsibility center, the manager is
responsible, as the name implies, for a particular set of activities. In the case of a cost center, a
particular unit of the organization is given responsibility for controlling costs of the operations
over which it holds authority. The medical records division is an example of a cost center. The
billing and collection office might be another example. A cost center might be a division, an
office, or an entire department, depending on how the organization is structured.
In healthcare organizations, it is common to find departments as cost centers. This is often a
logical way to designate a cost center because the lines of authority are generally organized by
department. Cost centers can then be grouped into larger groups that have something in common. Within this method of grouping, the manager of a cost center may receive his or her own
reports and figures, but not those of the entire group. The director or officer that is in charge of
all of those particular departments receives the larger report that contains multiple cost centers.
The chief executive officer receives a total report because he or she is ultimately responsible for
overseeing the operations of all of the cost centers involved in that segment of the organization.
Exhibit 6–1 illustrates this concept. It contains 20 different cost centers, all of which are revenue producing. The 20 cost centers are divided into two groups: nursing services and other
professional services. There are five cost centers in the nursing services group, ranging from
operating room to obstetrics–nursery. There are 15 cost centers in the other professional services group. In the hospital that uses the grouping shown in Exhibit 6–1, however, not all of
48 Chapter 6 Expenses (Outflow)
the 20 cost centers are departments. Some
are divisions within departments. For example, EKG and EEG operate out of the same
department but are two separate cost centers.
Exhibit 6–2 shows 11 different cost centers
that are not directly revenue producing. (The
dietary department yields some cafeteria revenue, but that revenue is not central to the
major business of the organization, which is
to provide healthcare services.) The 11 cost
centers are divided into two groups: general
services and support services. The 6 cost centers in the general services group happen to
all be departments in this hospital. (Other
hospitals might not have security as a separate department. The other cost centers—
dietary, maintenance, laundry, housekeeping,
and medical records—would be separate
departments.) The 5 cost centers in the support services group include a “general” cost
center that contains administrative costs; the
remaining 4 are related to employee salaries
and wages. These 4 are insurance, Social Security taxes, employee welfare, and pension cost
centers, all of which will probably be in the
same department. It is the prerogative of management to set up cost centers specific to the
organization’s own needs and preferences. It is
the responsibility of management to make the
cost centers match the proper lines of authority.
Exhibit 6–2 illustrates two categories of
healthcare expense: general services and support. A third related category is operations
expense. An operations expense provides service directly related to patient care. Examples are radiology expense and drug expense. A general services expense provides services necessary to maintain the patient, but the service is not
directly related to patient care. Examples are laundry and dietary. Support services expenses, on
the other hand, provide support to both general services expenses and operations expenses. A
support service expense is necessary for support, but it is neither directly related to patient care
nor is it a service necessary to maintain the patient. Examples of support services are insurance
and payroll taxes.
Diagnoses and Procedures
It is common to group expenses by diagnoses and procedures for purposes of planning and
control. This grouping is beneficial because it matches costs against common classifications
Exhibit 6–1 Nursing Services and Other
Professional Services Cost Centers
Nursing Services Cost Center
Routine Medical-Surgical $390,000
Operating Room 30,000
Intensive Care Units 40,000
OB–Nursery 15,000
Other 35,000
Total $510,000
Other Professional Services
Cost Center
Laboratory $220,000
Radiology 139,000
CT Scanner 18,000
Pharmacy 128,000
Emergency Service 89,000
Medical and Surgical Supply 168,000
Operating Rooms and
Anesthesia 142,000
Respiratory Therapy 48,000
Physical Therapy 64,000
EKG 16,000
EEG 1,000
Ambulance Service 7,000
Substance Abuse 43,000
Home Health and Hospice 120,000
Other 12,000
Total $1,215,000
Grouping Expenses for Planning and Control 49
of revenues. Much of the revenue in many
healthcare organizations is designated by
either diagnoses or procedures. One prevalent method groups costs into cost centers
by major diagnostic categories (MDCs). The
23 MDCs serve as the basic classification system for diagnosis-related groups (DRGs).
(Each DRG represents a category of patients. This category contains patients whose
resource consumption, on statistical average,
is equivalent. DRGs are part of the prospective payment reimbursement methodology.)
Exhibit 6–3 provides a listing of the 23 MDCs.2
(The number of MDCs may increase when
ICD-10 coding is fully implemented.)
How does the hospital use the MDC grouping? Exhibit 6–4 shows a departmental and
cost center grouping in actual use. This hospital uses 27 cost center codes: the 23 MDCs
plus 4 other codes (“Special Drugs,” “HIV,”
“Unassigned,” and “Outpatient”). The special
drugs and HIV cost centers represent highcost elements that management wants to track
separately. Unassigned is a default category and should have little assigned to it. Outpatient is a
separate cost center at the preference of management.
Exhibit 6–5 illustrates the grouping of costs for MDC 18 (Infectious Diseases). The hospital’s departmental code is 18, per Exhibit 6–4. The DRG classification, ranging from
415 to 423, appears in the next column. The description of the particular DRG appears in the
third column, and the related cost appears in the fourth and final column. These costs can now
be readily matched to equivalent revenues.
Outpatient services in particular are generally designated by procedure codes. Procedure
codes, known as Current Procedural Terminology (CPT) codes, are commonly used to group
cost centers for outpatient services. (CPT codes represent a listing of descriptive terms and
identifying codes for identifying medical services and procedures performed.) However,
procedures can be—and are—also used for purposes of grouping inpatient costs, generally
within a certain cost center. A hospital example of reporting radiology department costs by
procedure code appears in Table 6–1. In this example, the procedure code is in the left column, the description of the procedure is in the middle column, and the departmental cost
for the particular procedure appears in the right column. These costs can now be readily
matched to equivalent revenue.
Care Settings and Service Lines
Expenses can be grouped by care setting, which recognizes the different sites at which services are delivered. “Inpatient” versus “outpatient” is a basic type of care setting grouping. Or
expenses can be classified by service lines, a method that groups similar services.3
Exhibit 6–2 General Services and Support
Services Cost Centers
General Services Cost Center
Dietary $97,000
Maintenance 92,000
Laundry 27,000
Housekeeping 43,000
Security 5,000
Medical Records 30,000
Total $294,000
Support Services Cost Center
General $455,000
Insurance 24,000
Social Security Taxes 112,000
Employee Welfare 188,000
Pension 43,000
Total $822,000
50 Chapter 6 Expenses (Outflow)
If revenues are grouped by care setting or by
service line, as discussed in the previous chapter, then expenses should also be grouped by
these categories. In that way, matching of revenues and expenses can readily occur. A more
detailed discussion of care settings and service
lines, with examples, was presented in the preceding chapter.
Programs
A program can be defined as a project that
has its own objectives and its own program
Exhibit 6–3 Major Diagnostic Categories
MDC 1 Diseases and Disorders of the
Nervous System
MDC 2 Eye
MDC 3 Ear, Nose, Mouth, and Throat
MDC 4 Respiratory System
MDC 5 Circulatory System
MDC 6 Digestive System
MDC 7 Hepatobiliary System and
Pancreas
MDC 8 Musculoskeletal System and
Connective Tissue
MDC 9 Skin, Subcutaneous Tissue,
and Breast
MDC 10 Endocrine, Nutritional, and
Metabolic
MDC 11 Kidney and Urinary Tract
MDC 12 Male Reproductive System
MDC 13 Female Reproductive System
MDC 14 Pregnancy, Childbirth, and
the Puerperium
MDC 15 Newborns and Other
Neonates with Conditions
Originating in the Perinatal Period
MDC 16 Blood and Blood-Forming
Organs and Immunological
Disorders
MDC 17 Myeloproliferative and
Poorly and Differentiated
Neoplasms
MDC 18 Infections and Parasitic
Diseases (Systemic or
Unspecified Sites)
MDC 19 Mental Diseases and Disorders
MDC 20 Alcohol/Drug Use and Alcohol/Drug-Induced Organic
Mental Disorders
MDC 21 Injuries, Poisoning, and Toxic
Effect of Drugs
MDC 22 Burns
MDC 23 Factors Influencing Health
Status and Other Contacts
with Health Services
Exhibit 6–4 Hospital Departmental Code List
Based on Major Diagnostic Categories
1 Nervous System
2 Eye
3 Ear, Nose, Mouth, and Throat
4 Respiratory System
5 Circulatory System
6 Digestive System
7 Hepatobiliary System
8 Musculoskeletal System and
Connective Tissue
9 Skin, Subcutaneous Tissue, and Breast
10 Endocrine, Nutritional, and
Metabolic
11 Kidney and Urinary Tract
12 Male Reproductive System
13 Female Reproductive System
14 Obstetrics
15 Newborns
16 Immunology
17 Oncology
18 Infectious Diseases
19 Mental Diseases
20 Substance Use
21 Injury, Poison, and Toxin
22 Burns
23 Other Health Services
24 Special Drugs
25 HIV
26 Unassigned
59 Outpatient
Grouping Expenses for Planning and Control 51
indicators. Within management’s functions of
planning, controlling, and decision making,
the program must stand on its own. A program
is often funded separately and for finite periods
of time. For example, funds from a grant might
fund a specific project for—as an example—
three years. Often programs—especially those
funded separately from the revenue stream of
the main organization—have to arrange their
expenses in a special format that is specified by
the entity that provides the grant funds.
Program expenses should be grouped in
such a way that they are distinguishable. Also,
if such programs have been specially funded,
the reporting of their expenses should not be
commingled. An example of a program cost
center is given in Exhibit 6–6. This cost center
example has received special funds and must
be reported separately, as shown.
COST REPORTS AS INFLUENCERS
OF EXPENSE FORMATS
Cost reports are required by both the Medicare program (Title XVIII) and the Medicaid
program (Title XIX). Every provider participating in the program is required to file
an annual cost report. A selection of providers who must file cost reports is illustrated in
Table 6–2. The arrangement of expense headings on the cost reports has been primarily
consistent since the advent of such reports
Exhibit 6–5 Example of Hospital Departmental Costs Classified by Diagnoses, MDC, and DRG
Hospital Departmental Code DRG Description Cost
18 INFECTIOUS DISEASES 415 O/R—INFECT/PARASITIC DIS $4,000
18 INFECTIOUS DISEASES 416 SEPTICEMIA 17 10,000
18 INFECTIOUS DISEASES 417 SEPTICEMIA 0–17 20,000
18 INFECTIOUS DISEASES 418 POSTOP/POSTTRAUMA INFECT 2,000
18 INFECTIOUS DISEASES 419 FEVER—UKN ORIG 17W/C 3,000
18 INFECTIOUS DISEASES 420 FEVER—UKN ORIG 17W/OC 6,000
18 INFECTIOUS DISEASES 421 VIRAL ILLNESS 17 4,000
18 INFECTIOUS DISEASES 422 VIR ILL/FEVER UNK 0–17 1,000
18 INFECTIOUS DISEASES 423 OT/INFECT/PARASITIC DX 3,000
Exhibit 6–6 Program Cost Center: Southside
Homeless Intake Center
Program: Southside Homeless
Intake Center
Department: Feeding Ministry
For the Month of: January 2XXX
Raw Food $14,050
Dietary Supplies 200
Paper Supplies 300
Minor Equipment 50
Consultant Dietitian 50
Utilities 300
Telephone 50
Program Total $15,000
Table 6–1 Example of Radiology Department
Costs Classified by Procedure Code
Procedure
Code
Procedure
Description
Department
Cost
557210 Ribs, Unilateral $ 60,000
557230 Spine Cervical Routine 125,000
557280 Pelvis 33,000
557320 Limb—Shoulder 55,000
557360 Limb—Wrist 69,000
557400 Limb—Hip, Unilateral 42,000
557410 Limb—Hip, Bilateral 14,000
557430 Limb—Knee Only 62,000
Total $460,000
52 Chapter 6 Expenses (Outflow)
in 1966. Therefore, this standard and traditional arrangement has strongly influenced the arrangement of expenses in many healthcare information systems.
The cost report uses a method of cost finding. Its focus is what is called a cost center. The
concept is not the same as the type of responsibility center “cost center” that has been discussed earlier in this chapter. Instead, the cost-finding “cost center” is, broadly speaking, a
type of cost pool used in the cost-finding process. The primary purpose of the cost pool/cost
center in cost finding is to assist in allocating overhead.
The central worksheets for cost finding are Worksheet A, Worksheet B, and Worksheet B-1.
Worksheet A contains the basic trial balance of all expenses for the facility. (Trial balances are
discussed in a preceding chapter.) The beginning trial balance is reflected in the first three
columns:
[Column 1] [Column 2] [Column 3]
“Salaries” 1 “Other” 5 “Total”
(all other expenses)
The trial balance is grouped at the outset into cost center categories. The placement of these
categories and their respective line items on the page stay constant throughout the flow of
Worksheets A, B, and B-1. The cost centers are grouped into seven categories:
1. General service
2. Inpatient routine service
3. Ancillary service
4. Outpatient service
5. Other reimbursable
6. Special purpose
7. Nonreimbursable
The line items within these seven categories represent the long-lived traditional arrangement that has strongly influenced the arrangement of expenses in so many healthcare information systems.
INFORMATION CHECKPOINT
What is needed? A report that shows expense in your organization.
Where is it found? With your supervisor.
How is it used? Examine the report to find various types of expenses; look for
how the expense flow is handled on the report.
Table 6–2 Selected Cost Report Forms
Type Form
Hospital and Hospital Healthcare Complex CMS 2552-10
Skilled Nursing Facility and Skilled Nursing Facility Complex CMS 2540-10
Home Health Agencies CMS 1728-94
Cost Reports as Influencers of Expense Formats 53
What is needed? A report that groups expenses by some type of classification.
Where is it found? With your supervisor or in the information services division.
How is it used? Examine the report to discover the methods that are used for
grouping. You will probably find that these groupings are
used for performance measures. They can also be used for
control and planning.
KEY TERMS
Cost
Diagnoses
Expenses
Expired Costs
General Services Expenses
Support Services Expenses
Operations Expenses
Procedures
Unexpired Costs
DISCUSSION QUESTIONS
1. Have you worked with cost centers in your duties? If so, how have you been exposed to
them?
2. Have you had to manage from a cost center type of report? If so, how was it categorized?
3. Do you believe that grouping expenses by diagnoses and procedures (based on type of
services provided) is better to use for control and planning than grouping expenses by
care setting (based on location of service provided)?
4. If so, why?
5. What grouping of expenses do you believe your organization uses (traditional cost centers, diagnoses/procedures, care settings, other)?
6. From your perspective, would there be a better grouping possible? If so, why do you think
it is not used?
NOTES
1. S. A. Finkler, Essentials of Cost Accounting for Health Care Organizations, 2nd ed. (Gaithersburg,
MD: Aspen Publishers, Inc., 1999).
2. At the time of this writing, 23 major diagnostic categories (MDCs) serve as the basic classification system for diagnosis-related groups (DRGs). When ICD-10 is fully implemented, it is
probable that the number of MDCs will be increased. It is also possible that the terminology
itself (MDCs) may be changed to some other designation.
3. G. F. Longshore, “Service-line Management/Bottom-line Management for Health Care,” Journal of Health Care Finance, 24, no. 4 (1998): 72–79.
54 Chapter 6 Expenses (Outflow)
Progress Notes
© LFor/Shutterstock
CHAPTER
Cost Classifications
DISTINCTION BETWEEN DIRECT
AND INDIRECT COSTS
Direct costs can be specifically associated with a particular
unit or department or patient. The critical distinction for
the manager is that the cost is directly attributable. Whatever the manager is responsible for—that is, the unit, the
department, or the patient—is known as a cost object.
The somewhat vague definition of a cost object is any
unit for which a separate cost measurement is desired. It
might help the manager to think of a cost object as a cost
objective instead.1 The important thing is that direct costs
can be traced. Indirect costs, on the other hand, cannot
be specifically associated with a particular cost object. The
controller’s office is an example of indirect cost. The controller’s office is essential to the overall organization itself,
but its cost is not specifically or directly associated with providing healthcare services. The critical distinction for the
manager is that indirect costs usually cannot be traced, but
instead must be allocated or apportioned in some manner.2
Figure 7–1 illustrates the direct–indirect cost distinction.
To summarize, it is helpful to recognize that direct costs
are incurred for the sole benefit of a particular operating
unit—a department, for example. As a rule of thumb, if the
answer to the following question is “yes,” then the cost is a
direct cost: “If the operating unit (such as a department)
did not exist, would this cost not be in existence?”
Indirect costs, in contrast, are incurred for the overall operation and not for any one unit. Because they are
shared, indirect costs are sometimes called joint costs or
common costs. As a rule of thumb, if the answer to the following question is “yes,” then the cost is an indirect cost:
“Must this cost be allocated in order to be assigned to the
unit (such as a department)?”
After completing this chapter,
you should be able to
1. Distinguish between direct
and indirect costs.
2. Understand why the
difference is important to
management.
3. Understand the composition
and purpose of responsibility
centers.
4. Distinguish between product
and period costs.
55
7
CHAPTER
EXAMPLES OF DIRECT COST
AND INDIRECT COST
It is important for managers to recognize
direct and indirect costs and how they are
treated on reports. Two sets of examples
illustrate the reporting of direct and indirect
costs. The first example concerns a rehab cost
center; the second concerns an ambulance
service center.
Table 7–1 represents a report of both direct
cost and indirect cost for a rehab cost center.
The report concerns three types of therapy—
physical, occupational, and speech therapy—
and a total. In this report, the manager
can observe the proportionate differences
between direct and indirect costs and can also
see the differences among the three types of
therapies.
Greater detail is provided to the manager in Table 7–2, which presents the method of allocating indirect costs and the result of such allocation. Managers should notice that the “Total
Indirect Costs” in Table 7–2 carry forward and become the “Indirect Costs” in Table 7–1. Thus,
this report showing allocation of indirect costs is considered a subsidiary report because it is
supporting, or subsidiary to, the preceding main report. This use of one or more supporting reports to reveal details behind the main report is quite common in managerial reports.
The allocation of indirect costs subsidiary report contains quite a lot of information. It shows
what particular expenses (clerical salaries, administrative salaries, computer services) are contained in the $185,000 total. It also shows how each of these expenses are allocated across the
three separate types of therapy. And the report also shows how each item was allocated; see the
Allocation Key containing codes A, B, and C. The basis for allocation is presented in the Key
(A 5 number of visits; B 5 proportion of direct costs, by percentage; C 5 number of computers
in service) and the computation detail by therapy type is also noted. This set of tables is worthy
of further study by the manager.
Figure 7–1 Assigning Costs to the Cost Object.
Cost Object
Are
Allocated
to
Are
Traced
to
Direct
Costs
Indirect
Costs
56 Chapter 7 Cost Classifications
Table 7–1 Examples of Rehab Cost Center Direct and Indirect Cost Totals
Rehab Cost Centers Direct Cost Indirect Cost Total
Physical Therapy (PT) $410,000 $107,500 $517,500
Occupational Therapy (OT) 190,000 44,000 234,000
Speech Therapy (ST) 120,000 33,500 153,500
Total $720,000 $185,000 $905,000
Note: Direct Cost proportions, rounded, are as follows:
PT = 57%/OT = 26%/ST = 17%/Total = 100%
Courtesy of J. J. Baker and R. W. Baker, Dallas, Texas.
Exhibit 7–1 sets out the direct costs for an ambulance service center. These costs, as direct
costs, are what the organization’s managers believe can be traced to the specific operation of the
freestanding center. Exhibit 7–2 sets out the indirect costs for a freestanding ambulance service
center. These costs are what the organization’s
managers believe are not directly attributable
to the specific operation of the freestanding
center. The decisions about what will and what
will not be considered direct or indirect costs
will almost always have been made for the
manager.3 What is important is that the manager understand two things: first, why this is
so, and second, how the relationship between
the two works. Remember the rule of thumb
discussed earlier in this chapter. If the answer
to the following question is “yes,” then the cost
is a direct cost: “If the operating unit (such as
a department) did not exist, would this cost
not be in existence?”
RESPONSIBILITY CENTERS
We previously discussed revenue centers,
whereby managers are responsible for generating revenue (or volume). We also previously
discussed cost centers, whereby managers are
Exhibit 7–1 Example of Ambulance Direct
Costs
Ambulance salaries & benefits $32,500
RN salaries & benefits 9,600
Vehicle expense 21,300
Supplies 5,000
Uniforms 1,200
Employee education 3,900
Purchased services 1,900
Purchased maintenance 2,600
Utilities & telephone 5,000
Vehicle depreciation 15,000
Miscellaneous expense 2,000
Total direct costs $100,000
Exhibit 7–2 Example of Ambulance Indirect
Costs
Administrative costs $12,000
Facility costs 8,000
Total indirect costs $20,000
Responsibility Centers 57
Table 7–2 Example of Indirect Costs Allocated to Rehab Cost Center
Clerical
Salaries
Administrative
Salaries
Computer
Services
Total Indirect
Cost
Allocation Basis: A B C
Indirect Cost to Be Allocated $60,000 $50,000 $75,000 $185,000
Allocated to:
Physical Therapy (PT) 34,000 28,500 45,000 107,500
Occupational Therapy (OT) 16,000 13,000 15,000 44,000
Speech Therapy (ST) 10,000 8,500 15,000 33,500
Proof Total $60,000 $50,000 $75,000 $185,000
Allocation Key:
A = # Visits (Volume): PT = 8500/OT = 4000/ST = 2500/Total = 15,000 (15,000 x $4.00 = $60,000)
B = Proportion of Direct Costs: PT = 57%/OT = 26%/ST = 17%/Total = 100% (% x $50,000)
C = # Computers in Service: PT = 9/OT = 3/ST = 3/Total = 15 (15 x $5,000 each = $75,000)
Courtesy of J. J. Baker and R. W. Baker, Dallas, Texas.
responsible for managing and controlling cost. The responsibility center (R/C) makes a manager responsible for both the revenue/volume (inflow) side and the expense (outflow) side of a
department, division, unit, or program. In other words, the manager is responsible for generating
revenue/volume and for controlling costs. Another term for responsibility center is profit center.
We will examine the type of information a manager receives about his or her own
responsibility center by reviewing the Westside Center operations. Westside Center offers two
basic types of services: an ambulatory surgery center (ASC) and a rehabilitation center. The
management of Westside is overseen by Bill, the director. Joe manages the ambulatory surgery
center. Bonnie manages the rehabilitation center. Denise, a part-time radiologist, provides radiology services on an as-needed basis. Joe, Bonnie, and Denise, the managers, all report to Bill,
the director. Figure 7–2 illustrates the managerial relationships.
To restate the relationships shown in Figure 7–2, Joe manages a responsibility center for
ambulatory surgery services. Bonnie manages a responsibility center for rehabilitation services.
These services represent the business of Westside Center. Denise manages the radiology services, but this is not a responsibility center in the Westside organization. Instead, it is a support
center. Bill, the director, manages a bigger responsibility center that includes all of the functions just described, plus the general and administrative support center.
Bill, the director, receives a managerial
report, shown in Exhibit 7–3. Bill’s “Director’s
Summary” contains the data for the entire
Westside operation.
Figure 7–3 illustrates the reports received
by each manager at Westside. Joe’s report
for the ambulatory surgery center is at the
top right of Figure 7–3. His report shows the
controllable revenues he is responsible for
($225,000), less the controllable expenses he
is responsible for ($155,000). The difference
is labeled “ASC Responsibility Center Surplus”
on his report. The surplus amounts to $70,000
($225,000 minus $155,000).
Exhibit 7–3 Director’s Summary of Westside
ASC and Rehab Responsibility Center
ASC R/C Surplus $70,000.00
Rehab R/C Surplus 85,000.00
Less G&A Support Ctr (80,000.00)
Less Radiology Support Ctr (20,000.00)
Net Surplus $55,000.00
Courtesy of Resource Group, Ltd., Dallas,
Texas.
Figure 7–2 Lines of Managerial Responsibility at Westside Center.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Westside
Center
Director
Westside
Ambulatory
Surgery Center
Responsibility
Center
Manager
General &
Administrative
Support Center
Radiology
Support Center
Manager
Westside
Rehab Center
Responsibility
Center
Manager
58 Chapter 7 Cost Classifications
Bonnie’s report for the rehabilitation center is the second report on the right of Figure 7–3.
Her report shows the controllable revenues she is responsible for ($300,000), less the controllable expenses she is responsible for ($215,000). The difference is labeled “Rehab Responsibility Center Surplus” on her report. The surplus amounts to $85,000 ($300,000 minus $215,000).
Figure 7–3 Westside Costs by Responsibility Center.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Director’s Summary of
Westside ASC & Rehab Center
ASC R/C Surplus $70,000.00
Rehab R/C Surplus 85,000.00
Less G&A Support Ctr (80,000.00)
Less Radiology Support Ctr (20,000.00)
Net Surplus $55,000.00
Westside ASC
Responsibility Center
Therapy Manager
Controllable revenues:
Patient fees $300,000.00
Controllable expenses:
Wages 120,000.00
Payroll taxes, other fringes 30,000.00
Billable supplies 50,000.00
Medical supplies 10,000.00
Continuing education 3,000.00
Licenses and permits 2,000.00
Total expenses 215,000.00
Rehab R/C surplus $85,000.00
Westside ASC
Responsibility Center
Medical/Surgical Manager
Controllable revenues:
Patient fees $225,000.00
Controllable expenses:
Wages 100,000.00
Payroll taxes, other fringes 25,000.00
Billable supplies 20,000.00
Medical supplies 10,000.00
Total expenses 155,000.00
ASC R/C surplus $70,000.00
General & Administrative
Support Center
Salaries $40,000.00
Payroll taxes, other fringes 10,000.00
Office supplies 1,200.00
Telephone 2,400.00
Rent 10,800.00
Utilities 4,800.00
Insurance 1,200.00
Depreciation 9,600.00
Total expenses $80,000.00
Radiology Support Center
Radiology Manager
Salaries $12,000.00
Payroll taxes, other fringes 3,000.00
Radiology supplies 5,000.00
Total expenses $20,000.00
Responsibility Centers 59
Denise’s report for radiology services is at the bottom right of Figure 7–3. Her report shows
the controllable expenses she is responsible for, which amount to $20,000. Her report shows
only expenses because it is a support center, not a responsibility center. Therefore, Denise is
responsible for expenses but not for revenue/volume.
Bill, the director, receives a report for the general and administrative (G&A) expenses, as
shown second from the bottom on the right of Figure 7–3. This report shows the G&A controllable expenses that Bill himself is responsible for at Westside, which amount to $80,000. The
G&A report shows only expenses because it also is a support center, not a responsibility center.
Therefore, Bill is responsible for expenses but not for revenue/volume in the case of G&A.
However, Bill is also responsible for the entire Westside operation. That is, the overall Westside operation is his responsibility center. Therefore, Bill’s director’s summary, reproduced on
the left side of Figure 7–3, contains the results of both responsibility centers and both support centers. The surplus figures from Joe and Bonnie’s reports are positive figures of $70,000
and $85,000, respectively. The expense-only figures from Bill’s G&A support center report and
from Denise’s radiology support center report are negative figures of $80,000 and $20,000,
respectively. Therefore, to find the result of operations for Bill’s entire Westside operation, the
$80,000 and the $20,000 expense figures are subtracted from the surplus figures to arrive at a
net surplus for Westside of $55,000.
Although the lines of managerial responsibility will vary in other organizations, the relationships between and among responsibility centers, support centers, and overall supervision will
remain as shown in this example.
DISTINCTION BETWEEN PRODUCT AND PERIOD COSTS
Product costs is a term that was originally associated with manufacturing rather than with services.
The concept of product costs assumes that a product has been manufactured and placed into
inventory while waiting to be sold. Then, whenever that product is sold, the product is matched with
revenue and recognized as a cost. Thus, cost of sales is the common usage for manufacturing firms.
(The concept of matching revenues and expenses has been discussed in a preceding chapter.)
Period costs, in the original manufacturing interpretation, are not connected with the manufacturing process. They are matched with revenue on the basis of the period during which the
cost is incurred (thus period costs). The term comes from the span of time in which matching
occurs, known as time period.
Service organizations have no manufacturing process as such. The business of healthcare service organizations is service delivery, not the manufacturing of products. Although the overall
concept of product versus period cost is not as vital to service delivery, the distinction remains
important for managers in health care to know.
In healthcare organizations, product cost can be viewed as traceable to the cost object of the
department, division, or unit. A period cost is not traceable in this manner. Another way to view
this distinction is to think of product costs as those costs necessary to actually deliver the service,
whereas period costs are costs necessary to support the existence of the organization itself.
Finally, medical supply and pharmacy departments do have inventories on hand. In their case,
a product is purchased (rather than manufactured) and placed into inventory while waiting to
be dispensed. Then, whenever that product is dispensed, the product is matched with revenue
and recognized as a cost of providing the service to the patient. Therefore, the product cost
concept is important to managers of departments that hold a significant amount of inventory.
60 Chapter 7 Cost Classifications
INFORMATION CHECKPOINT
What is needed? Example of a management report that uses direct/indirect cost.
Where is it found? With your supervisor, in administration, or in information services.
How is it used? To track operations directly associated with the unit.
What is needed? Example of a management report that uses responsibility centers.
Where is it found? With your supervisor, in administration, or in information services.
How is it used? To reflect operations that a manager is specifically responsible for
and to measure those operations for planning and control.
KEY TERMS
Cost Object
Direct Cost
Indirect Cost
Joint Cost
Responsibility Centers
DISCUSSION QUESTIONS
1. In your own workplace, can you give a good example of a direct cost? An indirect cost?
2. What is the difference?
3. Does your organization use responsibility centers?
4. If not, do you think they should? Why?
5. If so, do you believe the responsibility centers operate properly? Would you make
changes? Why?
NOTES
1. C. Horngren et al., Cost Accounting: A Managerial Emphasis, 9th ed. (Englewood Cliffs, NJ:
Prentice Hall, 1998), 70.
2. J. J. Baker, Activity-Based Costing and Activity-Based Management for Health Care (Gaithersburg,
MD: Aspen Publishers, Inc., 1998).
3. D. A. West, T. D. West, and P. J. Malone, “Managing Capital and Administrative (indirect)
Costs to Achieve Strategic Objectives: The Dialysis Clinic versus the Outpatient Clinic,” Journal of Health Care Finance, 25, no. 2 (1998): 20–24.
Notes 61

PART
© LFor/Shutterstock
Tools to Analyze
and Understand
Financial
Operations
III

Progress Notes
© LFor/Shutterstock
CHAPTER
65
8
CHAPTER
DISTINCTIONS AMONG FIXED, VARIABLE,
AND SEMIVARIABLE COSTS
This chapter emphasizes the distinctions among fixed,
variable, and semivariable costs because this knowledge is
a basic working tool in financial management. The manager needs to know the difference between fixed and variable costs to compute contribution margins and break-even
points. The manager also needs to know about semivariable
costs to make good decisions about how to treat these costs.
Fixed costs are costs that do not vary in total when activity levels (or volume) of operations change. This concept is
illustrated in Figure 8–1. The horizontal axis of the graph
shows number of residents in the Jones Group Home, and
the vertical axis shows total monthly fixed cost in dollars. In
this graph, the total monthly fixed cost for the group home
is $3,000, and that amount does not change, whether the
number of residents (the activity level or volume) is low or
high. A good example of a fixed cost is rent expense. Rent
would not vary whether the home was almost full or almost
empty; thus, rent is a fixed cost.
Variable costs, on the other hand, are costs that vary in
direct proportion to changes in activity levels (or volume)
of operations. This concept is illustrated in Figure 8–2. The
horizontal axis of the graph shows number of residents in
the Jones Group Home, and the vertical axis shows total
monthly variable cost in dollars. In this graph, the monthly
variable cost for the group home changes proportionately
with the number of residents (the activity level or volume)
in the home. A good example of a variable cost is food
for the group home residents. Food would vary directly,
depending on the number of individuals in residence; thus,
food is a variable cost.
After completing this chapter,
you should be able to
1. Understand the distinctions
among fixed, variable, and
semivariable costs.
2. Be able to analyze mixed
costs by two methods.
3. Understand the computation
of a contribution margin.
4. Be able to compute the costvolume-profit (CVP) ratio.
5. Be able to compute the
profit-volume (PV) ratio.
Cost Behavior
and Break-Even
Analysis
Semivariable costs vary when the activity levels (or volume) of operations change, but not in
direct proportion. The most frequent pattern of semivariable costs is the step pattern, where
the semivariable cost rises, flattens out for a bit, and then rises again. The step pattern of semivariable costs is illustrated in Figure 8–3. The horizontal axis of the graph shows number of
residents in the Jones Group Home, and the vertical axis shows total monthly semivariable cost.
In this graph, the behavior of the cost line resembles stair steps: thus, the “step pattern” name
for this configuration. The most common example of a semivariable expense in health care is
supervisors’ salaries. A single supervisor, for example, can perform adequately over a range of
rises in activity levels (or volume). When another supervisor has to be added, the rise in the step
pattern occurs.
It is important to know, however, that there are two ways to think about fixed cost. The usual
view is the flat line illustrated on the graph in Figure 8–1. That flat line represents total monthly
cost for the group home. However, another perception is presented in Figure 8–4. The top view
of fixed costs in Figure 8–4 is the usual flat line just discussed. The bottom view is fixed cost per
resident. Think about the figure for a moment: the top view is dollars in total for the home for
Figure 8–1 Fixed Costs—Jones Group Home.
0
$1,000
$2,000
$3,000
$4,000
$5,000
0 10 20 30 40 50 60
Number of Residents
Total Monthly Fixed Cost
Figure 8–2 Variable Cost—Jones Group Home.
0
$1,000
$2,000
$3,000
$4,000
0 10 20 30 40 50 60
Number of Residents
Total Monthly Variable Cost
66 Chapter 8 Cost Behavior and Break-Even Analysis
Figure 8–3 Semivariable Cost—Jones Group Home.
0
$3,000
$6,000
$9,000
$12,000
0 10 20 30 40 50 60
Number of Residents
Total Semivariable Cost
Figure 8–4 Two Views of Fixed Costs.
0
$100
$200
$300
$400
0 10 20 30 40 50 60
Number of Residents
Fixed Cost per Resident
Fixed Cost per Resident
0
$1,000
$2,000
$3,000
$4,000
$5,000
0 10 20 30 40 50 60
Number of Residents
Total Monthly Fixed Cost
Total Monthly Fixed Cost
Distinctions Among Fixed, Variable, and Semivariable Costs 67
the month, and the bottom view is fixed-cost dollars by number of residents. The line is no longer flat but declines because this view of cost declines with each additional resident.
We can also think about variable cost in two ways. The usual view of variable cost is the diagonal line rising from the bottom of the graph to the top, as illustrated in Figure 8–2. That steep
diagonal line represents monthly cost varying in direct proportion with number of residents
in the home. However, another perception is presented in Figure 8–5. The top view of variable
costs in Figure 8–5 represents total monthly variable cost and is the usual diagonal line just
discussed. The bottom view is variable cost per resident. Think about this figure for a moment:
the top view is dollars in total for the home for the month, and the bottom view is variable-cost
dollars by number of residents. The line is no longer diagonal but is now flat because this view
of variable cost stays the same proportionately for each resident. A good way to think about
Figures 8–4 and 8–5 is to realize that they are close to being mirror images of each other.
Semifixed costs are sometimes used in healthcare organizations, especially in regard to
staffing. Semifixed costs are the reverse of semivariable costs: that is, they stay fixed for a
time as activity levels (or volume) of operations change, but then they will rise; then they will
plateau; then they will rise. Thus, semifixed costs can exhibit a step pattern similar to that of
variable costs.1 However, the semifixed cost “steps” tend to be longer between rises in cost. In
Figure 8–5 Two Views of Variable Costs.
0 10 20 30 40 50 60
Number of Residents
Variable Cost per Resident
Variable Cost per Resident
0
$10,000
$20,000
$30,000
$40,000
0 10 20 30 40 50 60
Number of Residents
Total Monthly Variable Cost
Total Monthly Variable Cost
0
$200
$400
$600
$800
68 Chapter 8 Cost Behavior and Break-Even Analysis
summary, both semifixed and semivariable costs have mixed elements of fixed and variable
costs. Thus, both semivariable and semifixed costs are called mixed costs.
EXAMPLES OF VARIABLE AND FIXED COSTS
Studying examples of expenses that are designated as variable and fixed helps to understand the differences between them. It should also be mentioned that some expenses
can be variable to one organization and fixed to another because they are handled differently
by the two organizations. Operating room fixed and variable costs are illustrated in Table 8–1.
Examples of Variable and Fixed Costs 69
Table 8–1 Operating Room Fixed and Variable Costs
Account Total Variable Fixed Equipment
Social Security $ 60,517 $ 60,517 $ $
Pension 20,675 20,675
Health Insurance 8,422 8,422
Child Care 4,564 4,564
Patient Accounting 155,356 155,356
Admitting 110,254 110,254
Medical Records 91,718 91,718
Dietary 27,526 27,526
Medical Waste 2,377 2,377
Sterile Procedures 78,720 78,720
Laundry 40,693 40,693
Depreciation—Equipment 87,378 87,378
Depreciation—Building 41,377 41,377
Amortization—Interest (5,819) (5,819)
Insurance 4,216 4,216
Administration 57,966 57,966
Medical Staff 1,722 1,722
Community Relations 49,813 49,813
Materials Management 64,573 64,573
Human Resources 31,066 31,066
Nursing Administration 82,471 82,471
Data Processing 17,815 17,815
Fiscal 17,700 17,700
Telephone 2,839 2,839
Utilities 26,406 26,406
Plant 77,597 77,597
Environmental Services 32,874 32,874
Safety 2,016 2,016
Quality Management 10,016 10,016
Medical Staff 9,444 9,444
Continuous Quality Improvement 4,895 4,895
EE Health 569 569
Total Allocated $1,217,756 $600,822 $529,556 $87,378
Reproduced with the permission of Wolters Kluwer Law & Business from J.J. Baker, Activity-Based Costing and Activity-Based Management for Health Care, p. 191, © 1998, Aspen Publishers, Inc.
Thirty-two expense accounts are listed in
Table 8–1: 11 are variable, 20 are designated
as fixed by this hospital, and 1, equipment
depreciation, is listed separately.2 (The separate listing is because of the way this hospital’s accounting system handles equipment
depreciation.)
Another example of semivariable and
fixed staffing is presented in Table 8–2. The
costs are expressed as full-time equivalent
staff (FTEs). Each line-item FTE will be multiplied times the appropriate wage or salary
to obtain the semivariable and fixed costs
for the operating room. (The further use of FTEs for staffing purposes is fully discussed
in the chapter on staffing.) The supervisor position is fixed, which indicates that this is the
minimum staffing that can be allowed. The single aide/orderly and the clerical position are
also indicated as fixed. All the other positions—technicians, RNs, and LPNs—are listed as
semivariable, which indicates that they are probably used in the semivariable step pattern
that has been previously discussed in this chapter. This table is a good example of how to
show clearly which costs will be designated as semivariable and which costs will be designated
as fixed.
Another example illustrates the behavior of a single variable cost in a doctor’s office. In Table 8–3,
we see an array of costs for the procedure code 99214 office visit type. Nine costs are listed. The
first cost is variable and is discussed momentarily. The other eight costs are all shown at the
same level for a 99214 office visit: supplies, for example, is the same amount in all four columns.
The single figure that varies is the top line, which is “report of lab tests,” meaning laboratory
reports. This cost directly varies with the proportion of activity or volume, as variable cost has
been defined. Here we see a variable cost at work: the first column on the left has no lab report,
and the cost is zero; the second column has one lab report, and the cost is $3.82; the third column has two lab reports, and the cost is $7.64; and the fourth column has three lab reports, and
70 Chapter 8 Cost Behavior and Break-Even Analysis
Table 8–2 Operating Room Semivariable and
Fixed Staffing
Job Positions
Total No.
of FTEs Semivariable Fixed
Supervisor 2.2 2.2
Techs 3.0 3.0
RNs 7.7 7.7
LPNs 1.2 1.2
Aides, orderlies 1.0 1.0
Clerical 1.2 1.2
Totals 16.3 11.9 4.4
Table 8–3 Office Visit with Variable Cost of Tests
99214 99214 99214 99214
Service Code No Test 1 Test 2 Tests 3 Tests
Report of lab tests $0.00 $3.82 $7.64 $11.46
Fixed overhead $31.00 $31.00 $31.00 $31.00
Physician 11.36 11.36 11.36 11.36
Medical assistant 1.43 1.43 1.43 1.43
Bill 0.45 0.45 0.45 0.45
Checkout 1.00 1.00 1.00 1.00
Receptionist 1.28 1.28 1.28 1.28
Collection 0.91 0.91 0.91 0.91
Supplies 0.31 0.31 0.31 0.31
Total visit cost $47.74 $51.56 $55.38 $59.20
the cost is $11.46. The total cost rises by the same proportionate increase as the increase in the
first line.
ANALYZING MIXED COSTS
It is important for planning purposes for the manager to know how to deal with mixed costs
because they occur so often. For example, telephone, maintenance, repairs, and utilities are
all actually mixed costs. The fixed portion of the cost is that portion representing having the
service (such as telephone) ready to use, and the variable portion of the cost represents a
portion of the charge for actual consumption of the service. We briefly discuss two very simple
methods of analyzing mixed costs, then we examine the high–low method and the scatter
graph method.
Predominant Characteristics and Step Methods
Both the predominant characteristics and the step method of analyzing mixed costs are quite
simple. In the predominant characteristic method, the manager judges whether the cost is
more fixed or more variable and acts on that judgment. In the step method, the manager examines the “steps” in the step pattern of mixed cost and decides whether the cost appears to be
more fixed or more variable. Both methods are subjective.
High–Low Method
As the name implies, the high–low method of analyzing mixed costs requires that the cost be
examined at its high level and at its low level. To compute the amount of variable cost involved,
the difference in cost between high and low levels is obtained and is divided by the amount of
change in the activity (or volume). Two examples are examined.
The first example is for an employee cafeteria. Table 8–4 contains the basic data required for
the high–low computation. With the formula described in the preceding paragraph, the following steps are performed:
1. Find the highest volume of 45,000 meals at a cost of $165,000 in September (see Table
8–4) and the lowest volume of 20,000 meals at a cost of $95,000 in March.
2. Compute the variable rate per meal:
No. of Cafeteria
Meals Cost
Highest volume 45,000 $165,000
Lowest volume 20,000 95,000
Difference 25,000 70,000
3. Divide the difference in cost ($70,000) by the difference in number of meals (25,000) to
arrive at the variable cost rate:
$70,000 divided by 25,000 meals 5 $2.80 per meal
Analyzing Mixed Costs 71
4. Compute the fixed overhead rate as
follows:
a. At the highest level:
Total cost $165,000
Less: variable portion
[45,000 meals 3 $2.80 @] (126,000)
Fixed portion of cost $ 39,000
b. At the lowest level
Total cost $ 95,000
Less: variable portion
[20,000 meals 3 $2.80 @] (56,000)
Fixed portion of cost $ 39,000
c. Proof totals: $39,000 fixed portion at
both levels
The manager should recognize that large
or small dollar amounts can be adapted to
this method. A second example concerns
drug samples and their cost. In this example,
a supervisor of marketing is concerned about
the number of drug samples used by the various members of the marketing staff. She uses the
high–low method to determine the portion of fixed cost. Table 8–5 contains the basic data
required for the high–low computation. Using the formula previously described, the following
steps are performed:
1. Find the highest volume of 1,000 samples at a cost of $5,000 (see Table 8–5) and the lowest volume of 750 samples at a cost of $4,200.
2. Compute the variable rate per sample:
No. of
Samples Cost
Highest volume 1,000 $5,000
Lowest volume 750 4,200
Difference 250 $ 800
3. Divide the difference in cost ($800) by the
difference in number of samples (250) to
arrive at the variable cost rate:
$800 divided by 250 samples 5
$3.20 per sample
4. Compute the fixed overhead rate as follows:
a. At the highest level:
Total cost $5,000
Less: variable portion
[1,000 samples 3 $3.20 @] (3,200)
Fixed portion of cost $1,800
72 Chapter 8 Cost Behavior and Break-Even Analysis
Table 8–4 Employee Cafeteria Number of Meals
and Cost by Month
Month
No. of
Meals
Employee
Cafeteria Cost
($)
July 40,000 164,000
August 43,000 167,000
September 45,000 165,000
October 41,000 162,000
November 37,000 164,000
December 33,000 146,000
January 28,000 123,000
February 22,000 91,800
March 20,000 95,000
April 25,000 106,800
May 30,000 130,200
June 35,000 153,000
Table 8–5 Number of Drug Samples and Cost for
November
Rep. No. of Samples Cost ($)
J. Smith 1,000 5,000
A. Jones 900 4,300
B. Baker 850 4,600
G. Black 975 4,500
T. Potter 875 4,750
D. Conner 750 4,200
b. At the lowest level
Total cost $4,200
Less: variable portion
[750 samples 3 $3.20 @] (2,400)
Fixed portion of cost $1,800
c. Proof totals: $1,800 fixed portion at both levels
The high–low method is an approximation that is based on the relationship between the
highest and the lowest levels, and the computation assumes a straight-line relationship. The
advantage of this method is its convenience in the computation method.
CONTRIBUTION MARGIN, COST-VOLUME-PROFIT, AND PROFIT-VOLUME
RATIOS
The manager should know how to analyze the relationship of cost, volume, and profit. This
important information assists the manager in properly understanding and controlling operations. The first step in such analysis is the computation of the contribution margin.
Contribution Margin
The contribution margin is calculated in this way:
% of Revenue
Revenues (net) $500,000 100%
Less: variable cost (350,000) 70%
Contribution margin $150,000 30%
Less: fixed cost (120,000)
Operating income $30,000
The contribution margin of $150,000 or 30%, in this example, represents variable cost
deducted from net revenues. The answer represents the contribution margin, so called because
it contributes to fixed costs and to profits.
The importance of dividing costs into fixed and variable becomes apparent now, for a contribution margin computation demands either fixed or variable cost classifications; no mixed
costs are recognized in this calculation.
Cost-Volume-Profit (CVP) Ratio or Break Even
The break-even point is the point when the contribution margin (i.e., net revenues less variable costs) equals the fixed costs. When operations exceed this break-even point, an excess of
revenues over expenses (income) is realized. But if operations does not reach the break-even
point, there will be an excess of expenses over revenues, and a loss will be realized.
The manager must recognize there are two ways of expressing the break-even point: either by
an amount per unit or as a percentage of net revenues. If the contribution margin is expressed
as a percentage of net revenues, it is often called the profit-volume (PV) ratio. A PV ratio example follows this cost-volume-profit (CVP) computation.
Contribution Margin, Cost-Volume-Profit, and Profit-Volume Ratios 73
The CVP example is given in Figure 8–6. The data points for the chart come from the contribution margin as already computed:
% of Revenue
Revenues (net) $500,000 100%
Less: variable cost (350,000) 70%
Contribution margin $150,000 30%
Less: fixed cost (120,000)
Operating income $30,000
Three lines were first drawn to create the chart. They were total fixed costs of $120,000,
total revenue of $500,000, and variable costs of $350,000. (All three are labeled on the chart.)
The break-even point appears at the point where the total cost line intersects the revenue line.
Because this point is indeed the break-even point, the organization will have no profit and no
loss but will break even. The wedge shape to the left of the break-even point is potential net
loss, whereas the narrower wedge to the right is potential net income (both are labeled on the
chart).
CVP charts allow a visual illustration of the relationships that is very effective for the manager.
Profit-Volume (PV) Ratio
Remember that the second method of expressing the break-even point is as a percentage of net
revenues and that if the contribution margin is expressed as a percentage of net revenues, it
Figure 8–6 Cost-Volume-Profit (CVP) Chart for a Wellness Clinic.
Courtesy of Resource Group, Ltd., Dallas, Texas.
0
$100
$200
$300
$400
$500
0 1000 2000 3000 4000 5000
Variable Cost
Line
Fixed Cost
Line
Break-Even
Point
Revenue
Line
Net
Operating
Income
Net
Loss
Fixed Costs Variable Costs
Number of Visits
Revenue (in thousands of dollars)
74 Chapter 8 Cost Behavior and Break-Even Analysis
is called the profit-volume (PV) ratio. Figure 8–7 illustrates the method. The basic data points
used for the chart were as follows:
Revenue per visit $100.00 100%
Less variable cost per visit (70.00) 70%
Contribution margin per visit $ 30.00 30%
Fixed costs per period $120,000
$30.00 contribution margin per visit divided by $100 price per visit 5 30% PV Ratio
Figure 8–7 Profit-Volume (PV) Chart for a Wellness Clinic.
Courtesy of Resource Group, Ltd., Dallas, Texas.
+100
+90
+80
+70
+60
+50
+40
+30
+20
+10
0
–10
–20
–30
–40
–50
–60
–70
–80
–90
–100
–110
–120
–130
–140
–150
+100
+90
+80
+70
+60
+50
+40
+30
+20
+10
0
–10
–20
–30
–40
–50
–60
–70
–80
–90
–100
–110
–120
–130
–140
–150
Net Loss
(under break-even point)
Net Income
(over break-even point)
Net
Income
Net Loss
(due to
unrecovered
fixed costs)
Safety
Cushion
(before
break-even
point)
0 100 200 300 400 500 600 700
Revenue (in thousands of dollars)
Projected
Revenues
Break-Even
Point
Fixed Costs
Recovered
Contribution Margin, Cost-Volume-Profit, and Profit-Volume Ratios 75
On our chart, the profit pattern is illustrated by a line drawn from the beginning level of
fixed costs to be recovered ($120,000 in our case). Another line has been drawn straight across
the chart at the break-even point. When the diagonal line begins at $120,000, its intersection
with the break-even or zero line is at $400,000 in revenue (see left-hand dotted line on chart).
We can prove out the $120,000 versus $400,000 relationship as follows. Each dollar of revenue
reduces the potential of loss by $0.30 (or 30% 3 $1.00). Fixed costs are fully recovered at a revenue level of $400,000, proved out as $120,000 divided by .30 = $400,000. This can be written
as follows:
.30R 5 $120,000
R 5 $400,000 [120,000 divided by .30 = 400,000]
The PV chart is very effective in planning meetings because only two lines are necessary
to show the effect of changes in volume. Both PV and CVP are useful when working with the
effects of changes in break-even points and revenue volume assumptions.
Contribution margins are also useful for showing profitability in other ways. An example
appears in Figure 8–8, which shows the profitability of various DRGs, using contribution margins as the measure of profitability. Case volume (the number of cases of each DRG) is on the
vertical axis of the matrix, and the dollar amount of contribution margin per case is on the
horizontal axis of the matrix.3
Figure 8–8 Profitability DRG Volume/Margin Matrix.
Modified from R. Hankins and J. J. Baker, Management Accounting for Health Care Organizations (Sudbury, MA: Jones &
Bartlett, 2004), 189.
0 $1,000 $2,000 $3,000 $4,000 $5,000
Profitability DRG Volume/Margin Matrix
$6,000
0
50
100
150
200
250
300
450
400
350
Contribution Margin Per Case
Case Volume
DRG
089
DRG
127
DRG
088
DRG
014
DRG
116
DRG
430
DRG
462
Input key:
DRG $
014 $900
088 2,000
089 1,500
127 2,800
116 4,000
430 5,600
462 3,100
76 Chapter 8 Cost Behavior and Break-Even Analysis
Scatter Graph Method
In performing a mixed-cost analysis, the manager is attempting to find the mixed cost’s average rate of variability. The scatter graph method is more accurate than the high–low method
previously described. It uses a graph to plot all points of data, rather than the highest and
lowest figures used by the high–low method. Generally, cost will be on the vertical axis of the
graph, and volume will be on the horizontal axis. All points are plotted, each point being
placed where cost and volume intersect for that line item. A regression line is then fitted to
the plotted points. The regression line basically represents the average—or a line of averages.
The average total fixed cost is found at the point where the regression line intersects with the
cost axis.
Two examples are examined. They match the high–low examples previously calculated.
Figure 8–9 presents the cafeteria data. The costs for cafeteria meals have been plotted on
the graph, and the regression line has been fitted to the plotted data points. The regression
line strikes the cost axis at a certain point; that amount represents the fixed cost portion of
the mixed cost. The balance (or the total less the fixed cost portion) represents the variable
portion.
The second example also matches the high–low example previously calculated. Figure 8–10
presents the drug sample data. The costs for drug samples have been plotted on the graph, and
the regression line has been fitted to the plotted data points. The regression line again strikes
the cost axis at the point representing the fixed-cost portion of the mixed cost. The balance
(the total less the fixed cost portion) represents the variable portion. Further discussions of this
method can be found in Examples and Exercises at the back of this book.
The examples presented here have regression lines fitted visually. However, computer
programs are available that will place the regression line through statistical analysis as a
function of the program. This method is called the least-squares method. Least squares
means that the sum of the squares of the deviations from plotted points to regression line
is smaller than would occur from any other way the line could be fitted to the data: in other
words, it is the best fit. This method is, of course, more accurate than fitting the regression
line visually.
Figure 8–9 Employee Cafeteria Scatter Graph.
$195
$185
$175
$165
$155
$145
$135
$125
$115
$105
$95
$85
20,000 30,000 40,000 50,000
Volume
(Number of Meals)
Cost
(in thousands of dollars)
Contribution Margin, Cost-Volume-Profit, and Profit-Volume Ratios 77
INFORMATION CHECKPOINT
What is needed? Revenues, variable cost, and fixed cost for a unit, division,
DRG, and so on.
Where is it found? In operating reports.
How is it used? Use the multiple-step calculations in this chapter to compute
the CPV or the PV ratio; use to plan and control operations.
KEY TERMS
Break-Even Analysis
Cost-Profit-Volume
Contribution Margin
Fixed Cost
Mixed Cost
Profit-Volume Ratio
Semifixed Cost
Semivariable Cost
Variable Cost
DISCUSSION QUESTIONS
1. Have you seen reports in your workplace that set out the contribution margin?
2. Do you believe that contribution margins can help you manage in your present work? In
the future? How?
3. Have you encountered break-even analysis in your work?
Figure 8–10 Drug Sample Scatter Graph for November.
$5,250
$5,000
$4,750
$4,500
$4,250
$4,000
$3,750
$3,500
$3,250
$3,000
500 600 700 800 900 1000 1100
Volume
(Samples)
Cost
78 Chapter 8 Cost Behavior and Break-Even Analysis
4. If so, how was it used (or presented)?
5. How do you think you would use break-even analysis?
6. Do you believe your organization could use these analysis tools more often than is now
happening? What do you believe the benefits would be?
NOTES
1. C. Horngren et al., Cost Accounting: A Managerial Emphasis, 9th ed. (Englewood Cliffs, NJ:
Prentice Hall, 1998).
2. J. J. Baker, Activity-Based Costing and Activity-Based Management for Health Care (Gaithersburg,
MD: Aspen Publishers, Inc., 1998).
3. It is possible that the term “diagnosis-related groups” (DRGs) may be changed to some new
terminology as a consequence of ICD-10 implementation.
Notes 79

Progress Notes
© LFor/Shutterstock
CHAPTER
Understanding
Inventory and
Depreciation Concepts
OVERVIEW: THE INVENTORY CONCEPT
This overview concerns both the inventory concept and
types of inventories.
Concept of Inventory in Healthcare Organizations
“Inventory” includes all the items (goods) that an organization has for sale in the normal course of its business.
Inventory is an asset, owned by the company. It appears on
the balance sheet as a current asset, because the individual
items that compose the inventory are expected to be “used”
(sold) within a 12-month period.
Types of Inventory in Healthcare Organizations
Various healthcare organizations (or departments within
organizations) deal with inventory and must account for it.
The hospital gift shop and the cafeteria, for example, own
inventory and must account for it. All pharmacies (hospitalbased, retail brick-and-mortar, or mail order pharmacies)
own inventory in the normal course of their business.
In manufacturing companies, inventory typically consists of three parts: raw materials, work in progress, and the
finished goods that are for sale. We might think that most
inventory items for sale in a healthcare organization are not
manufactured, but are finished goods instead. However,
consider this example: the hospital cafeteria purchases
flour, eggs, butter, and so on (raw materials), mixes the
ingredients (work in progress), and produces a cake (finished goods) that is for sale. (Another example might be a
pharmacy that compounds drugs.)
After completing this chapter,
you should be able to
1. Understand the interrelationship between inventory and
cost of goods sold.
2. Understand the difference
between LIFO and FIFO
inventory methods.
3. Be able to calculate inventory
turnover.
4. Understand the interrelationship between depreciation
expense and the reserve for
depreciation.
5. Understand how to compute
the net book value of a fixed
asset.
6. Be able to identify the five
methods of computing book
depreciation.
81
9
CHAPTER
INVENTORY AND COST OF GOODS SOLD (“GOODS” SUCH AS DRUGS)
The interrelationship between inventory and cost of goods sold is at the heart of the inventory
concept.
Turning Inventory into Cost of Goods (or Drugs) Sold
The completed inventory item (“finished goods”) is sold. That is how an item moves out of inventory and is recognized as cost. When the item is recognized as cost, it becomes “cost of goods
sold.” (Also note that different terminology may be used. In some organizations cost of goods
sold is called “cost of sales.”) For a business such as a retail pharmacy, the cost of inventory sold
to its customers is the largest single expense of the business.
Recording Inventory and Cost of Goods (or Drugs) Sold
Recording inventory and cost of goods (or drugs) sold is a sequence of events. Figure 9–1 illustrates the sequence as follows:
• Beginning inventory (inventory at the start of the period) is recorded.
• Purchases during the period are recorded.
• Beginning inventory plus purchases equal “cost of goods available for sale.”
• Ending inventory (inventory at the end of the period) is recorded.
• Cost of goods available for sale less ending inventory equals “cost of goods sold.”
Purchases added to inventory will typically include “freight in,” or the shipping costs to
deliver the items to you. Any discounts received on the purchases should be subtracted from the
purchase cost. Thus the purchases become “net purchases”; that is, net of discounts.
Sometimes the ending inventory is estimated. An example of “Estimating the Ending Pharmacy Inventory” is shown in the chapter about estimates and benchmarking.
Inventory
Recorded
Purchases
Recorded Calculated Calculated Inventory
Recorded
Beginning
Inventory
Net
Purchases
Cost of Goods
Available
for Sale
Ending
Inventory
Cost of Goods
Sold + = − =
Purchases + Freight In − Discounts = Net
Figure 9–1 Recording Inventory in the Accounting Cycle.
82 Chapter 9 Understanding Inventory and Depreciation Concepts
Gross Margin Computation
Gross margin equals revenue from sales less the cost of goods sold. Gross margin is often
expressed as a percentage. Thus, a pharmacy’s gross margin might appear as follows:
Sales 100%
Cost of goods (drugs) sold 65%
Gross margin 35%
An organization’s gross margin percentage can be readily compared to industry standards.
INVENTORY METHODS
How is the inventory to be valued? The two most commonly used inventory valuation methods
are First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). The method chosen will affect the
organization’s financial statements, as explained in the following sections.
First-In, First-Out (FIFO) Inventory Method
The First-In, First-Out, or FIFO inventory costing method, recognizes the first costs placed into
inventory as the first costs moved out into cost of goods sold when a sale occurs. How will this
method affect the organization’s financial statements? Under FIFO, the ending inventory figure will be higher (because when the oldest inventory moves out first, the ending inventory will
be based on the costs of the latest purchases, which we assume will have cost more). Exhibit 9–1
illustrates this effect.
Last-In, First-Out (LIFO) Inventory Method
The Last-In, First-Out, or LIFO inventory costing method, recognizes the latest, or last, costs
placed into inventory as the first costs moved out into cost of goods sold when a sale occurs.
How will this method affect the organization’s financial statements? Under LIFO, the ending
inventory figure will be lower (because when the latest inventory moves out first, the ending
inventory will be based on costs of the earliest purchases, which we assume will have cost less).
Exhibit 9–2 illustrates this effect.
Other Inventory Treatments
Two other inventory treatments deserve mention, as follows.
Weighted Average Inventory Method
This inventory costing method is based on the weighted average cost of inventory during the
period. (The weighted average inventory method is also called the “average cost method.”) The
weighted average inventory cost is determined as follows: divide the cost of goods available for
sale by the number of units available for sale.
Inventory Methods 83
Assumptions FIFO Inventory Effect
Sales (Revenue) 20 units @$25 5 $500
Cost of Sales:
Beginning Inventory 10 units @$5 5 $50
Plus: Purchases 10 units @$10 5 $100 &
10 units @$15 5 $150 250
Subtotal $300
Less: Ending Inventory 10 units @$15 5 (150)
Cost of Sales 150
Gross Profit $350
Operating Expenses (50)
Earnings Before Tax $300
Income Tax (90)
Earnings After Tax $210
Note: Ending inventory computed as number of units in the beginning inventory plus
number of units purchased less number of units sold–count oldest units sold first.
Exhibit 9–1 FIFO Inventory Effect
No Method: Inventory Never Recognized
This inventory costing method is no method at all. That is, inventory is never recognized. For
example, a physician’s office may expense all drug purchases as supplies at the time of purchase
and never count such drugs as inventory. This treatment might be justified when such supplies were only a small part of the practice expenses. However, if the physician is purchasing
very expensive drugs and administering them in the office (infusing expensive drugs is a good
example), then not recognizing any such drugs being held as inventory on the financial statements is misleading.
INVENTORY TRACKING
The two most typical inventory-tracking systems are described as follows.
Perpetual Inventory System
With a perpetual inventory system, the healthcare organization keeps a continuous, or perpetual, record for every individual inventory item. Thus the amount of inventory on hand can
84 Chapter 9 Understanding Inventory and Depreciation Concepts
be determined at any time. (A real-time system is a variation of the perpetual inventory system,
whereby transactions are entered simultaneously.)
A perpetual inventory system requires, of course, a specific identification method for each
inventory item. Bar coding is often used for this purpose. You are most likely to find a perpetual
inventory system in the pharmacy department of a hospital.
Periodic Inventory System
With a periodic inventory system, the healthcare organization does not keep a continuous
record that identifies every individual inventory item on hand. Instead, at the end of the
period the organization physically counts the inventory items on hand. Then costs per item
are attached to the inventory counts in order to arrive at the cost of the inventory at the end of
the period (the ending inventory).
Necessary Adjustments
Certain inventory adjustments will commonly become necessary, as discussed here.
Exhibit 9–2 LIFO Inventory Effect
Assumptions LIFO Inventory Effect
Sales (Revenue) 20 units @$25 5 $500
Cost of Sales:
Beginning Inventory 10 units @$5 5 $50
Plus: Purchases 10 units @$10 5 $100 &
10 units @$15 5 $150 250
Subtotal $300
Less: Ending Inventory 10 units @$5 5 (50)
Cost of Sales 250
Gross Profit $250
Operating Expenses (50)
Earnings Before Tax $200
Income Tax (60)
Earnings After Tax $140
Note: Ending inventory computed as number of units purchased plus number of units
in the beginning inventory less number of units sold–count newest units sold first.
Inventory Tracking 85
Shortages
When the periodic inventory results are compared to the inventory balance on the financial statements, it is not uncommon to find that the actual physical inventory amount is
less than the amount recorded on the books. This difference, or shortage, is commonly
termed “shrinkage.” The inventory amount on the books must be reduced to the actual
amount per the periodic inventory, and the resulting shrinkage cost must be recorded as
an expense.
Obsolete Items
Most inventories will inevitably come to contain certain obsolete items. For example, the pharmacy inventory will contain drugs that have “sell by” or “use by” expiration dates. Obsolete
inventory items should be discarded. Their cost must be removed from the cost of inventory on
hand, and the resulting obsolescence cost must be recorded as an expense.
INVENTORY DISTRIBUTION SYSTEMS
The ability to track inventory is directly impacted by the type of documentation required for
removing items from inventory. Different types of inventory require different types of distribution systems. Thus, removing an item from a particular type of inventory needs documentation
that varies according to the level of permission and scrutiny required.
Distribution Using Sign-Off Forms
For example, drawing light bulbs from the Maintenance Department inventory does not require
a high level of permission and/or scrutiny. In one facility’s inventory distribution method, such
a requisition for light bulbs must always be attached to a Maintenance Department work order.
Some responsible person has signed off on this work order, and it shows the reason for the
inventory request. This method not only allows for inventory tracking, but also indicates who
was responsible for generating the order.
The distribution system for medical devices held in inventory typically requires a different
type of requisition. (One reason: Medical devices are more expensive than light bulbs.) The
inventory requisition is usually triggered by the doctor’s orders, and more than one level of
sign-off is typically required before the device is delivered to the operating room. Thus, tracking
this inventory item may require multiple steps.
Distribution Using Robotic Technology
This discussion about technology methods of inventory distribution centers upon drug distribution within a facility.
Background
Relative to drugs or pharmaceutical inventory, it should be noted that there are some characteristics that differentiate the pharmaceutical inventory from the rest of a hospital’s inventory
control mechanisms. The unit-dose drug distribution system is a particular example. In unitdose dispensing, medication is dispensed in a package that is ready to administer to the patient.
86 Chapter 9 Understanding Inventory and Depreciation Concepts
Unit-dose dispensing of medication was developed in the 1960s to support nurses in medication
administration and to reduce the waste of increasingly expensive medications.1
Robotic Automation
Although the unit-dose system provides many safeguards and advantages in delivering medications, as a manual system it is highly labor intensive. Automation has been developed to support
the patient care advantages of the system at a decreased cost, with pharmacy using robotics for
the bin-filling process. Advantages of the robotic cart‐filling method include improved accuracy in medication dispensing and accounting. Disadvantages include high startup costs partly
resulting from needed facility renovations, high continuing support costs, significant pharmacy
space requirements, and limited robot capacity.2
Cost/Benefit of a Robot
Capital expense or lease costs for robotic technology are high, limiting use to larger hospitals.
The decision to purchase and implement an automated bin fill system should be based on
a keen and insightful analysis of the financial benefits, return on investment, and potential for
demonstrated improvements in service quality and patient care. Although the cost of a robot
continues to decrease, information systems and other support costs will remain high enough to
make the decision to purchase or lease a robot hard to justify in many cases.
CALCULATING INVENTORY TURNOVER
Inventory turnover is a ratio that shows how fast inventory is sold, or “turns over.” The computation is in two steps as follows. Figure 9–2 illustrates the sequence.
Step 1. First compute “Average Inventory”:
Beginning Inventory plus Ending Inventory divided by two equals Average Inventory
Step 2. Next compute “Inventory Turnover”:
Cost of Goods Sold (or Cost of Sales) divided by Average Inventory equals Inventory Turnover
For example,
Step 1. $100,000 (beginning inventory) plus $150,000 (ending inventory) divided by 2 equals
$125,000 (average inventory).
Cost of Goods
Sold
Average
Inventory
Inventory
Turnover
divided
by
equals
Beginning
Inventory plus 2 equals Ending
Inventory
divided
by
Actual
Inventory
Answer is a
ratio that shows
how fast the
inventory is sold
Figure 9–2 Calculating Inventory Turnover.
Calculating Inventory Turnover 87
Step 2. $500,000 (cost of goods sold, or cost of sales) divided by $125,000 (average inventory)
equals 4.0 (inventory turnover).
An organization’s inventory turnover ratio can be readily compared to industry standards.
OVERVIEW: THE DEPRECIATION CONCEPT
Depreciation expense spreads, or allocates, the cost of a fixed asset over the useful life of that
asset, as discussed here.
Fixed Assets and Depreciation Expense
Fixed assets, also known as long-term assets, are classified as long term and placed on the balance sheet as such because they will not be converted into cash in the coming 12 months. The
purchase of a fixed asset is a capital expenditure. (Capital expenditures involve the acquisition
of assets that are long lasting, such as buildings and equipment.) “Capitalizing” means recording these assets as long-term assets on the balance sheet.
We recognize the cost of owning buildings and equipment through depreciation expense.
When the cost is spread, or allocated, over a period of years, each year’s financial statements (for
that period of years) recognize some portion of the cost, expressed as depreciation expense.
Useful Life of the Asset
The useful life determines the period over which the fixed asset’s cost will be spread. For example, a piece of laboratory equipment is purchased for $20,000. It has a useful life of five years. So
depreciation expense is recognized in each of the five years until the $20,000 is used up.
Salvage Value
Before depreciation expense can be calculated, we need to know whether the fixed asset will
have salvage value at the end of the depreciated period. Salvage value, also known as residual
value or scrap value, represents any expected cash value of the asset at the end of its useful life.
If the laboratory equipment is expected to have a salvage value of $1,000 at the end of its fiveyear useful life, then $19,000 will be spread over the five-year life as depreciation expense, and
the $1,000 will remain undepreciated at the end of that time.
BOOK VALUE OF A FIXED ASSET AND THE RESERVE FOR DEPRECIATION
This section describes important interrelationships between and among depreciation expense,
the reserve for depreciation, and net book value of an asset.
The Reserve for Depreciation
Depreciation expense over the years is accumulated into the reserve for depreciation. In other
words, the reserve for depreciation holds the cumulative amount of depreciation expense
that has been recognized over time, beginning with the date that the fixed asset was acquired.
88 Chapter 9 Understanding Inventory and Depreciation Concepts
Another way to think about this is to view the reserve for depreciation as holding all the depreciation expense that has been recognized and recorded over the useful life of the asset.
Interrelationship of Depreciation Expense and the Reserve for Depreciation
Depreciation expense for the year is recorded in the income statement. At the same time, an
equivalent amount is added to the cumulative amount that has been accumulating within the
reserve for depreciation on the balance sheet. These amounts should balance each other; that
is, if $25,000 is recognized as depreciation expense in the income statement, then $25,000
should be added to the reserve for depreciation on the balance sheet. This interrelationship is
illustrated in Figure 9–3.
Net Book Value of a Fixed Asset
The net book value (also known as book value) of a fixed asset is a balance sheet figure that
represents the remaining undepreciated portion of the fixed asset cost. The term derives from
value recorded on the books—thus “book value.”
The net book value of a fixed asset is computed as follows:
• Determine the original cost of the fixed asset on the balance sheet.
• Subtract the reserve for depreciation, which has accumulated depreciation expense as it
has been recognized.
• The result equals net book value at that point in time (Figure 9–4).
Also note that fully depreciated fixed assets may still remain on the books if they are still
in use. A fully depreciated fixed asset, of course, means that the depreciable cost has been
exhausted because all the depreciation expense over the asset’s useful life has already been
Figure 9–3 Interrelationship of Depreciation Expense and Reserve for Depreciation in the Accounting
Cycle.
Income Statement
Depreciation Expense
$25,000
This year’s
depreciation expense is
recognized on the
Income Statement
Balance Sheet
Reserve for Depreciation
$25,000
An equivalent amount is
added to the cumulative
Reserve for Depreciation
on the Balance Sheet
Book Value of a Fixed Asset and the Reserve for Depreciation 89
recognized. Thus, the net book value would either be zero or would amount to the remaining
salvage value of the asset.
Five Methods of Computing Book Depreciation
Just as “book value” means value that is recorded on the organization’s books, “book depreciation” means depreciation that is recorded on the books. Book depreciation is the depreciation
expense recorded in the financial accounting records and reflected on the financial statements.
“Tax depreciation,” on the other hand, is depreciation that is computed for tax purposes and
is reflected on the applicable tax returns of the organization. Tax depreciation methods are
discussed in the final section of this chapter.
You as a manager will most likely be using book depreciation in your planning, control, and
decision making. Five methods of computing book depreciation are described below.
Straight-Line Depreciation Method
The straight-line depreciation method assigns an equal or even amount of depreciation expense
over each year (or period) of the asset’s useful life. The expense is thus spread evenly—or in
a straight line—over the life of the asset. Table 9–1 illustrates the straight-line depreciation
method applied to a fixed asset costing $10,000 with a 5-year useful life and no salvage value.
The depreciation expense would thus equal $2,000 for each of the 5 years ($10,000 divided by
5 equals $2,000 per year).
Table 9–2 illustrates the straight-line depreciation method applied to a fixed asset costing $10,000 with a 5-year useful life and a $1,000 salvage value. The depreciation expense
would thus equal $1,800 for each year in this example, because we must leave $1,000 at the
end of the asset’s 5-year life ($10,000 less $1,000 equals $9,000 divided by 5 equals $1,800
per year.)
If the asset was acquired in the second half of the year, in some cases only a half-year of depreciation will be recognized in Year 1. If this is the case, the remaining half-year of depreciation
will be recognized in Year 6, in order to fully depreciate the asset.
Accelerated Book Depreciation Methods
As the name would imply, accelerated book depreciation methods write off more depreciation in the first part of the asset’s useful life. Thus, they “accelerate” recognizing depreciation expense. Three accelerated depreciation methods are briefly described here. Further
details about the computations for each method appear in Appendix 9-A at the end of this
chapter.
Figure 9–4 Net Book Value Computation.
Building & Equipment
Cost
Represents Fixed Asset
cost on the
Balance Sheet
Less Reserve for Depreciation
Accumulates depreciation
expense as it is recognized
Net Book Value
Represents remaining
undepreciated
Fixed Asset cost
Equals
90 Chapter 9 Understanding Inventory and Depreciation Concepts
Sum-of-the-Year’s Digits (SYD) Method The Sum-of-the-Year’s Digits (SYD) accelerated depreciation
method computes depreciation by multiplying the depreciable cost of the asset by a fraction.
Double-Declining Balance (DDB) Method The Double-Declining Balance (DDB) accelerated
depreciation method computes depreciation by multiplying the asset’s net book value at the
beginning of each year by a constant percentage, or factor. In the case of DDB, the constant
factor is twice the straight-line rate (thus “double-declining”).
150% Declining Balance (150% DB) Method The 150% Declining Balance (150% DB) accelerated
depreciation method also computes depreciation by multiplying the asset’s net book value
at the beginning of each year by a constant percentage, or factor. In the case of 150% DB,
however, the constant factor is half again or 150% of the straight-line rate.
Units of Service or Units of Production (UOP) Depreciation Method
The Units of Service or Units of Production (UOP) method computes depreciation by assigning
a fixed amount of depreciation to each unit of service or output that is produced by equipment.
Table 9–1 Straight-Line Depreciation: Five-Year Life with No Salvage Value
Cost
(to Be Depreciated)
Depreciation
Expense
per Year*
Accumulated
Depreciation
(Reserve for
Depreciation)
$10,000
Year 1 $2,000 $2,000
Year 2 2,000 4,000
Year 3 2,000 6,000
Year 4 2,000 8,000
Year 5 2,000 10,000
*$10,000 divided by 5 years = $2,000 per year.
Table 9–2 Straight-Line Depreciation: Five-Year Life with Salvage Value
Cost
(to Be Depreciated)
Depreciation
Expense
per Year*
Accumulated
Depreciation
(Reserve for
Depreciation)
Net Remaining
Undepreciated Cost
(Net Block Value)
$10,000 $10,000
Year 1 $1,800 $1,800 8,200
Year 2 1,800 3,600 6,400
Year 3 1,800 5,400 4,600
Year 4 1,800 7,200 2,800
Year 5 1,800 9,000 1,000**
*$9,000 divided by 5 years = $1,800 per year.
**Remaining salvage value.
Book Value of a Fixed Asset and the Reserve for Depreciation 91
“Units of Production” is a manufacturer’s term for manufacturing, or producing, a product.
“Units of Service” more properly describes the medical equipment providing services in healthcare organizations.
Instead of a useful life in years, equipment depreciated by the UOP method is assigned a
fixed total amount of units of service. This fixed amount is the overall total for the life of the
equipment. Then the number of units of service actually provided each year is depreciated.
COMPUTING TAX DEPRECIATION
The following discussion about tax depreciation is general in nature and is not to be utilized as
tax advice. Any additional details about tax depreciation are beyond the scope of this text.
Overview
“Tax depreciation,” as previously defined, means depreciation that is computed for tax purposes and is reflected on the applicable tax returns of the organization. The methods of tax
depreciation in effect at the time of this writing fall under the Modified Accelerated Cost Recovery System as described here.
Modified Accelerated Cost Recovery System (MACRS)
The Modified Accelerated Cost Recovery System (MACRS) is currently used to depreciate most
business and investment property for tax purposes. MACRS presently consists of two depreciation systems, both of which are briefly described here.
General Depreciation System (GDS)
The General Depreciation System (GDS) is the method generally used under the U.S. Internal Revenue Service rules and regulations, although there are certain exceptions. GDS provides
nine property classifications for useful life, including 3-, 5-, 7-, and 10-year property, and 15-, 20-,
and 25-year property, along with residential rental property and nonresidential real property. For
example, computers, calculators, and copiers fall into the 5-year property classification while office
furniture and fixtures such as desks, files, and safes fall into the 7-year property classification.3
The GDS method allows double-declining balance, 150% declining balance, and the straightline method of depreciation, depending upon what type of property is being depreciated. For
example, nonfarm 3-, 5-, 7-, and 10-year property can use any of the three methods in most (but
not all) circumstances.4
Alternative Depreciation System (ADS)
The Alternative Depreciation System (ADS) is required for particular properties including,
for example, any tax-exempt use property.5 ADS uses fixed ADS recovery periods, along with
straight-line depreciation. ADS can also be used for certain eligible property, even though the
property in question could come under GDS (certain restrictions apply).6
The tax law changes rapidly; thus, modifications to the tax depreciation methods described
in this section may have been placed into effect at any point in time. More information can be
obtained from the recent Internal Revenue Service Publication 946 “How to Depreciate Property.”
92 Chapter 9 Understanding Inventory and Depreciation Concepts
INFORMATION CHECKPOINT
What is needed? A depreciation schedule that includes depreciation expense,
reserve for depreciation, and net book value.
Where is it found? With your supervisor or in the accounting and/or administration offices.
How is it used? To reflect depreciation expense in order to complete the income statement.
KEY TERMS
Book Value
Depreciation
FIFO
Inventory
Inventory Turnover
LIFO
Salvage Value
Useful Life (of an asset)
DISCUSSION QUESTIONS
1. Do you or your supervisor have to deal with inventory? If so, please describe.
2. Have you ever had to count physical inventory? If so, please describe the process.
3. Do you or your supervisor have to deal with depreciation expense? If so, please describe.
4. Have you ever had to compute depreciation expense? If so, please describe the
circumstances.
NOTES
1. Agency for Healthcare Research and Quality. “National Healthcare Disparities Report,
2013, Chapter 10. Access to Health Care.” Content last reviewed May 2014, http://www
.ahrq.gov/research/findings/nhqrdr/nhdr13/chap10.html
2. L. F. Wolper, Health Care Administration: Managing Organized Delivery Systems (5th ed.)
(Sudbury, MA: Jones & Bartlett Publishers, 2011).
3. Department of the Treasury, Internal Revenue Service. How to Depreciate Property. Publication 946 (Washington, DC: U.S. Government, 2011).
4. Ibid., Table 4-1.
5. Ibid., “Required Use of ADS.”
6. Ibid., “Election of ADS.”
Notes 93

© LFor/Shutterstock
ACCELERATED BOOK DEPRECIATION METHODS
As the name would imply, accelerated book depreciation methods write off more depreciation in the first part of the asset’s useful life. Thus, they “accelerate” recognizing depreciation
expense. The computations of three accelerated depreciation methods are described in this
appendix as follows.
Sum-of-the-Year’s Digits (SYD) Method
The Sum-of-the-Year’s Digits (SYD) accelerated depreciation method computes depreciation
by multiplying the depreciable cost of the asset by a fraction. The fraction is the mechanism by
which the acceleration is computed. It is calculated as follows:
• The numerator of the SYD fraction starts with the asset’s useful life expressed in
years and decreases by one each year thereafter. (Thus, for a five-year useful life, the
numerators are 5, 4, 3, 2, and 1 respectively.)
• The denominator of the SYD fraction is the sum of the years’ digits of the asset’s life.
(Thus, for a five -year useful life, the sum of 5 + 4 + 3 + 2 + 1 equals 15, which is the
denominator.)
Table 9-A–1 illustrates the computation for each year. The depreciable cost of $10,000 is divided
by 15 to arrive at $666.66. Thus, one-fifteenth or $666.66 is multiplied by 5 for the first year ($3,333
depreciation expense), by 4 for the second year ($2,667 depreciation expense), and so on.
Double-Declining Balance (DDB) Method
The Double-Declining Balance (DDB) accelerated depreciation method computes depreciation by multiplying the asset’s net book value at the beginning of each year by a constant percentage, or factor. In the case of DDB, the constant factor is twice the straight-line rate (thus
“double-declining”).
Table 9-A–2 illustrates the computation for each year of a five-year useful life with no salvage
value. The double-declining factor is computed as follows:
• $10,000 cost of the fixed asset divided by the asset’s useful life of 5 years equals 20% or a
factor of 0.20.
• Multiply the 0.20 by 2 (or double) to arrive at the 0.40 double-declining factor.
APPENDIX
9-A A Further Discussion
of Accelerated and Units of Service Depreciation
Computations
95
Table 9-A–1 Sum-of-the-Years’ Digits Depreciation: Five-Year Life with No Salvage Value
Depreciation Computation
Sum-of- Accumulated Net Remaining
the-Years’ Annual Depreciation Undepreciated
Cost Depreciable Cost Digits* Depreciation (Reserve for Cost
(to Be Depreciated) (for Computation) Fraction** Expense Depreciation) (Net Book Value)
$10,000
Year 1 $10,000 5/15 $3,333 $3,333 $6,667
Year 2 10,000 4/15 2,667 6,000 4,000
Year 3 10,000 3/15 2,000 8,000 2,000
Year 4 10,000 2/15 1,333 9,333 667
Year 5 10,000 1/15 667 10,000 -0-
*Sum-of-the-Years’ Digits = 15 = (1 + 2 + 3 + 4 + 5).
**One-fifteenth of $10,000 = $666.66.
×
=
96 Chapter 9 Understanding Inventory and Depreciation Concepts
×
=
Table 9-A–2 Double-Declining Balance Depreciation: Five-Year Life with No Salvage Value
Depreciation Computation
Double Accumulated Net Remaining
Carry-forward Declining Annual Depreciation Undepreciated
Cost Book Value Balance Depreciation (Reserve for Cost
(to Be Depreciated) (for Computation) Factor Expense Depreciation) (Net Book Value)
$10,000
Year 1 $10,000 0.40* $4,000 $4,000 $6,000
Year 2 6,000 0.40 2,400 6,400 3,600
Year 3 3,600 0.40 1,440 7,840 2,160
Year 4 2,160 S/L** 1,080 8,920 1,080
Year 5 1,296 S/L 1,080 10,000 -0-
*$10,000 divided by 5 years equals 0.20 times 2 (double) equals 0.40 factor.
**Double-Declining Balance changes to straight-line method when straight-line yields a higher depreciation. (See Table 9-A–3.)
Accelerated Book Depreciation Methods 97
The computation continues as follows:
• For Year 1, $10,000 times 0.40 equals $4,000 Year 1 depreciation expense. Accumulated
depreciation for Year 1 also equals $4,000. The accumulated depreciation of $4,000 is
subtracted from the $10,000 cost to arrive at the net remaining undepreciated cost, or net
book value, of $6,000 at the end of Year 1.
• For Year 2, the factor of 0.40 is multiplied times the $6,000 net book value to equal $2,400
Year 2 depreciation expense. The Year 2 depreciation of $2,400 is added to the accumulated depreciation for a total of $6,400 ($4,000 plus $2,400 equals $6,400). The $6,400 is
subtracted from the $10,000 cost to arrive at the net remaining undepreciated cost, or net
book value, of $3,600 at the end of Year 2.
• For Year 3, the factor of 0.40 is multiplied times the $3,600 net book value to equal $1,440
Year 3 depreciation expense. The Year 3 depreciation of $1,440 is added to the accumulated depreciation for a total of $7,840 ($6,400 plus $1,440 equals $7,840). The $7,840 is
subtracted from the $10,000 cost to arrive at the net remaining undepreciated cost, or net
book value, of $2,160 at the end of Year 3.
The declining balance method has a peculiarity in that it switches back to the straight-line
method at the point where the straight-line computation yields a higher annual depreciation
than does the declining balance computation. Thus, as we arrive at Year 4 in this example, we
must test the double-declining computation against the straight-line computation.
• To compute Year 4 double declining, the factor of 0.40 is multiplied times the net book
value of $2,160 to arrive at a DDB of $864.
• To compute a comparative Year 4 by the straight-line method, the remaining net book
value of $2,160 is divided by the remaining years of useful life, which in this case would be
2 years. Thus $2,160 divided by 2 years equals straight-line depreciation per year for Year
4 and for Year 5 of $1,080 per year.
• The Year 4 straight-line method is greater ($1,080) than the Year 4 DDB ($864). Thus
the switch to straight line is made for the remaining Year 4 and Year 5, as illustrated in
Table 9-A–2.
The point at which the straight-line method overtakes the declining balance method varies,
of course, with the method and with the number of years of useful life. Table 9-A–3 illustrates
Table 9-A–3 Declining Balance Rates by Property Class
Property Class Method Declining Balance Rate Year*
3-year 200% DB 66.667% 3rd
5-year 200% DB 40.000% 4th
7-year 200% DB 28.571% 5th
10-year 200% DB 20.00% 7th
15-year 150% DB 10.0% 7th
20-year 150% DB 7.5% 9th
*Indicates the first year for which the straight-line depreciation method gives an equal or greater deduction.
Reproduced from Internal Revenue Service, Publication 964, “How to Depreciate Property,” p. 43.
98 Chapter 9 Understanding Inventory and Depreciation Concepts
the first year for which the straight-line depreciation method gives an equal or greater deduction. (Note that the Five-year Property Class [or Useful Life Class] for 200% declining balance
[or double-declining balance] shows the fourth year as the point at which the switch to straight
line would be made. This is consistent with our example in Table 9-A–2.)
150% Declining Balance Method
The 150% Declining Balance (150% DB) accelerated depreciation method also computes
depreciation by multiplying the asset’s net book value at the beginning of each year by a constant percentage, or factor. In the case of 150% DB, however, the constant factor is half again or
150% of the straight-line rate.
Table 9-A–4 illustrates the computation for each year of a five-year useful life with no salvage
value. The 150% DB factor is computed as follows:
• $10,000 cost of the fixed asset divided by the asset’s useful life of 5 years equals 20% or a
factor of 0.20.
• Multiply the 0.20 by 150% (or half again) to arrive at the 0.30 150% DB factor.
The 150% DB computation follows the same pattern as the double-declining example just
described, with two exceptions:
• The factor applied is 0.30 per year, as just explained.
• The 150% DB switches to straight line in Year 3 instead of Year 4 as in the previous
example.
Units of Service or Units of Production (UOP) Depreciation Method
The Units of Service or Units of Production (UOP) method computes depreciation by assigning a fixed amount of depreciation to each unit of service or output that is produced by equipment. The “Units of Production” is a manufacturer’s term for manufacturing, or producing, a
product. “Units of Service” more properly describes the medical equipment providing services
in healthcare organizations.
Instead of a useful life in years, equipment depreciated by the UOP method is assigned a
fixed total amount of units of service. This fixed amount is the overall total for the life of the
equipment. Then the number of units of service actually provided each year is depreciated.
Table 9-A–5 illustrates the UOP method. The depreciation per unit of service is computed
as follows:
• The total depreciable units of service over 5 years are determined to be 5,000 units. The
equipment cost to be depreciated of $10,000 is divided by 5,000 units to arrive at depreciation of $2.00 per unit.
• Units of Service in Year 1 total 1,000. Thus 1,000 units times $2.00 per unit equals $2,000
Year 1 depreciation.
• Units of Service in Year 2 total 900. Thus 900 units times $2.00 per unit equals $1,800 Year
2 depreciation.
The computation continues in this manner until the total 5,000 units of service are exhausted.
The equipment is then fully depreciated.
Accelerated Book Depreciation Methods 99
Table 9-A–4 150% Declining Balance Depreciation: Five-Year Life with No Salvage Value
Depreciation Computation
150% Accumulated Net Remaining
Carry-Forward Declining Annual Depreciation Undepreciated
Cost Book Value Balance Depreciation (Reserve for Cost
(to Be Depreciated) (for Computation) Factor Expense Depreciation) (Net Book Value)
$10,000
Year 1 $10,000 0.30* $3,000 $3,000 $7,000
Year 2 7,000 0.30 2,100 5,100 4,900
Year 3 4,900 S/L** 1,663 6,733 3,267
Year 4 3,267 S/L 1,633 8,366 1,634
Year 5 1,634 S/L 1,634 10,000 -0-
*$10,000 divided by 5 years equals 0.20 times half again (150%) equals 0.30 factor.
**150% Declining Balance changes to straight-line method when straight-line yields a higher depreciation.
×
=
100 Chapter 9 Understanding Inventory and Depreciation Concepts
Table 9-A–5 Units of Service (Units of Production) Depreciation: Five-Years of Service with No Salvage Value
Depreciation Computation
Accumulated Net Remaining
Annual Depreciation Undepreciated
Cost Units of Service Depreciation Depreciation (Reserve for Cost
(to Be Depreciated) per Year per Unit Expense Depreciation) (Net Book Value)
$10,000
Year 1 $1,000 $2.00* $2,000 $2,000 $8,000
Year 2 900 2.00 1,800 3,800 6,200
Year 3 800 2.00 1,600 5,400 4,600
Year 4 1,100 2.00 2,200 7,600 2,400
Year 5 1,200 2.00 2,400 10,000 -0-
Total Units 5,000
*$10,000 divided by total units (5,000) equals depreciation per unit of $2.00.
×
=
Accelerated Book Depreciation Methods 101

Progress Notes
© LFor/Shutterstock
Staffing: Methods,
Operations, and
Regulations
STAFFING REQUIREMENTS
In most businesses, a position is filled if the employee works
five days a week, generally Monday through Friday. But in
health care, many positions must be filled, or covered, all
seven days of the week. Furthermore, in most businesses,
a position is filled for that day if the employee works an
eight-hour day—from 9:00 am to 5:00 pm, for example. But
in health care, many positions must also be filled, or covered, 24 hours a day. The patients need care on Saturday
and Sunday, as well as Monday through Friday, and patients
need care around the clock, 24 hours a day.
Thus, healthcare employees work in shifts. The shifts are
often 8-hour shifts, because three such shifts times 8 hours
apiece equals 24-hour coverage. Some facilities have gone
to 12-hour shifts. In their case, two 12-hour shifts equal
24-hour coverage. The manager is responsible for seeing
that an employee is present and working for each position
and for every shift required for that position. Therefore,
it is necessary to understand and use the staffing measurement known as the full-time equivalent (FTE). Two different approaches are used to compute FTEs: the annualizing
method and the scheduled-position method. Full-time
equivalent is a measure to express the equivalent of an
employee (annualized) or a position (staffed) for the full
time required. We examine both methods in this chapter.
FTEs FOR ANNUALIZING POSITIONS
Why Annualize?
Annualizing is necessary because each employee that is eligible for benefits (such as vacation days) will not be on duty
for the full number of hours paid for by the organization.
After completing this chapter,
you should be able to
1. Understand the difference
between productive time and
nonproductive time.
2. Understand computing fulltime equivalents to
annualize staff positions.
3. Understand computing fulltime equivalents to
fill a scheduled position.
4. Tie cost to staffing.
5. Describe regulatory
requirements that affect
staffing.
103
10
CHAPTER
Annualizing thus allows the full cost of the position to be computed through a burden approach.
In the burden approach, the net hours desired are inflated, or burdened, in order to arrive at
the gross number of paid hours that will be needed to obtain the desired number of net hours
on duty from the employee.
Productive Versus Nonproductive Time
Productive time actually equates to the employee’s net hours on duty when performing the
functions in his or her job description. Nonproductive time is paid-for time when the employee
is not on duty: that is, not producing and therefore “nonproductive.” Paid-for vacation days,
holidays, personal leave days, and/or sick days are all nonproductive time.1
Exhibit 10–1 illustrates productive time (net days when on duty) versus nonproductive time
(additional days paid for but not worked). In Exhibit 10–1, Bob, the security guard, is paid for
260 days per year (total paid days) but works for only 235 days per year. The 235 days are productive time, and the remaining 25 days of holidays, sick days, vacation days, and education days
are nonproductive time.
Exhibit 10–1 Metropolis Clinic Security Guard Staffing
The Metropolis laboratory area has its own security guard from 8:30 am to 4:30 pm
seven days per week. Bob, the security guard for the clinic area, is a full-time Metropolis
employee.
He works as follows:
1. The area assigned to Bob is covered seven days per week for every week of the year.
Therefore,
Total days in business year 364
2. Bob doesn’t work on weekends (104)
(2 days per week 3 52 weeks 5 104 days)
Bob’s paid days total per year amount to 260
(5 days per week 3 52 weeks 5 260 days)
3. During the year Bob gets paid for:
Holidays 9
Sick days 7
Vacation days 7
Education days 2
(25)
4. Net paid days Bob actually works 235
Jim, a police officer, works part time as a security guard for the Metropolis laboratory
area. Jim works on the days when Bob is off, as follows:
Weekends 104
Bob’s holidays 9
Bob’s sick days 7
Bob’s vacation days 7
Bob’s education days 2
129
5. Paid days Jim works 129
6. Total days lab area security guard position is covered 364
104 Chapter 10 Staffing: Methods, Operations, and Regulations
FTE for Annualizing Positions Defined
For purposes of annualizing positions, the definition of FTE is as follows: the equivalent of one
full-time employee paid for one year, including both productive and nonproductive (vacation,
sick, holiday, education, etc.) time. Two employees each working half-time for one year would
be the same as one FTE.
Staffing Calculations to Annualize Positions
Exhibit 10–2 contains a two-step process to perform the staffing calculation by the annualizing
method. The first step computes the net paid days worked. In this step, the number of paid days
per year is first arrived at; then paid days not worked are deducted to arrive at net paid days
worked. The second step of the staffing calculation converts the net paid days worked to a factor. In the example in Exhibit 10–2, the factor averages out to about 1.6.
This calculation is for a 24-hour around-the-clock staffing schedule. Thus, the 364 in the step
2 formula equates to a 24-hour staffing expectation. Exhibit 10–3 illustrates such a master staffing plan.
Exhibit 10–2 Basic Calculation for Annualizing Master Staffing Plan
Step 1: How Many Net Paid Days Are Worked?
(a) A business year has 364 days.
(b) In this example the employee works five days per week. The other two days
off are not paid for. Thus two days off per week times 52 weeks equals 104
nonpaid days.
(c) Therefore, the number of paid days per year equals 364 less 104, or 260 days.
(d) But not all paid days per year are worked. In this example, each employee
(RN, LPN, and Nurse Assistant [NA]) receives 35 personal leave days.
(The personal leave days are intended to include holidays, sick leave,
and vacation days.)
(e) In addition, these employees are entitled to continuing professional education
(CPE) days. These are also paid days not worked, as follows: RNs 5 5 days;
LPNs 5 3 days; NAs 5 2 days.
(f) Therefore the net paid days worked are as follows:
RN 5 260 days (35) (5) 5 220
LPN 5 260 days (35) (3) 5 222
NA 5 260 days (35) (2) 5 223
Step 2: How Are Net Paid Days Worked Converted to a Factor?
The factor is calculated by dividing total days in the business year (364) by the net paid
days worked, as follows:
RN 5 364/220 5 1.6545
LPN 5 364/222 5 1.6396
NA 5 364/223 5 1.6323
Courtesy of J. J. Baker and R. W. Baker, Dallas, Texas.
FTEs for Annualizing Positions 105
NUMBER OF EMPLOYEES REQUIRED
TO FILL A POSITION: ANOTHER WAY
TO CALCULATE FTES
Why Calculate by Position?
The calculation of number of FTEs by the
scheduled-position method—in other words,
to fill a position—is used in controlling, planning, and decision making. Exhibit 10–4 sets
out the schedule and the FTE computation.
A summarized explanation of the calculation in Exhibit10–4 is as follows. One full-time
employee (as shown) works 40 hours per week. One 8-hour shift per day times 7 days per week
equals 56 hours on duty. Therefore, to cover 7 days per week, or 56 hours, requires 1.4 times a
40-hour employee (56 hours divided by 40 hours equals 1.4), or 1.4 FTEs.
Staffing Calculations to Fill Scheduled Positions
The term “staffing,” as used here, means the assigning of staff to fill scheduled positions. The
staffing measure used to compute coverage is also called the FTE. It measures what proportion
of one single full-time employee is required to equate the hours required (i.e., full-time equivalent) for a particular position. For example, the cast room has to be staffed 24 hours a day, 7
days a week because it supports the emergency room, and therefore has to provide service at
any time. In this example, the employees are paid for an 8-hour shift. The three shifts required
to fill the position for 24 hours are called the day shift (7:00 am to 3:00 pm), the evening shift
(3:00 pm to 11:00 pm), and the night shift (11:00 pm to 7:00 am).
Exhibit 10–4 Staffing Requirements Example
Emergency Department Scheduling for Eight-Hour Shifts:
24-Hour Scheduling
Shift 1 Shift 2 Shift 3
Day Evening Night 5 Total
Position:
Emergency Room Intake 1 1 1 5 3 8-hour shifts
To Cover Position
7 Days per Week
Equals FTEs of: 1.4 1.4 1.4 5 4.2 FTEs
One full-time employee works 40 hours per week. One 8-hour shift per day times 7 days
per week equals 56 hours on duty. Therefore, to cover 7 days per week or 56 hours
requires 1.4 times a 40-hour employee (56 hours divided by 40 hours equals 1.4),
or 1.4 FTEs.
Exhibit 10–3 Master Staffing Plan for
Nursing Unit
8-Hour Shifts RNs LPNs NAs
Day Shift 3 1 6
Evening Shift 2 2 5
Night Shift 1 2 2
24-Hour Total 6 5 13
Courtesy of J.J. Baker and R.W. Baker,
Dallas, Texas.
106 Chapter 10 Staffing: Methods, Operations, and Regulations
One 8-hour shift times 5 days per week equals a 40-hour work week. One 40-hour work week
times 52 weeks equals a person-year of 2,080 hours. Therefore, one person-year of 2,080 hours
equals a full-time position filled for one full year. This measure is our baseline.
It takes seven days to fill the day shift cast room position from Monday through Sunday, as
required. Seven days is 140% of five days (seven divided by five equals 140%), or, expressed
another way, is 1.4. The FTE for the day shift cast room position is 1.4. If a seven-day schedule is
required, the FTE will be 1.4.
This method of computing FTEs uses a basic 40-hour work week (or a 37-hour work week,
or whatever is the case in the particular institution). The method computes a figure that will
be necessary to fill the position for the desired length of time, measuring this figure against the
standard basic work week. For example, if the standard work week is 40 hours and a receptionist
position is to be filled for just 20 hours per week, then the FTE for that position would be 0.5
FTE (20 hours to fill the position divided by a 40-hour standard work week). Table 10–1 illustrates the difference between a standard work year at 40 hours per week and a standard work
year at 37.5 hours per week.
Tying Cost to Staffing
In the case of the annualizing method, the factor of 1.6 already has this organization’s vacation,
holiday, sick pay, and other nonproductive days accounted for in the formula (review Exhibit
10–2 to check out this fact). Therefore, this factor is multiplied times the base hourly rate (the
net rate) paid to compute cost.
In the case of the scheduled-position method, however, the FTE figure of 1.4 will be multiplied times a burdened hourly rate. The burden on the hourly rate reflects the vacation, holiday, sick pay, and other nonproductive days accounted for in the formula (review Exhibit 10–4
to see the difference). The scheduled-position method is often used in the forecasting of new
programs and services.
Actual cost is attached to staffing in the books and records through a subsidiary journal
and a basic transaction record. Exhibit 10–5 illustrates a subsidiary journal in which employee
hours worked for a one-week period are recorded. Both regular and overtime hours are noted.
No. of Annual Hours No. of Annual Hours
Job Position No. of FTEs Paid at 2,080 Hours* Paid at 1,950 Hours**
Supervisor 2.2 4,576 4,290
Techs 3.0 6,240 5,850
RNs 7.7 16,016 15,015
LPNs 1.2 2,496 2,340
Aides, orderlies 1.0 2,080 1,950
Clerical 1.2 2,496 2,340
Totals 16.3 33,904 31,785
*40 hours per week × 52 weeks = 2,080.
**37.5 hours per week × 52 weeks = 1,950.
Table 10–1 Calculations to Staff the Operating Room
Number of Employees Required to Fill a Position: Another Way to Calculate FTEs 107
Exhibit 10–5 Example of a Payroll Register
Metropolis Health System
Payroll Register
Week Ended June 10, ____
Deductions
Hours Worked Federal Employee Base Overtime Gross Income Social Medicare Net
No. Name Regular Overtime Total Rate Pay Premiums Earnings Tax Security Tax Pay
1071 J.F. Green 40 2 42 14.00 588.00 14.00 602.00 90.30 37.32 8.73 465.65
1084 C.B. Brown 40 40 14.00 560.00 560.00 84.00 34.72 8.62 432.66
1090 K.D. Grey 40 40 10.00 400.00 400.00 60.00 24.80 6.16 309.04
1092 R.N. Black 40 5 45 10.00 450.00 25.00 475.00 71.25 29.45 6.89 367.41
Courtesy of Resource Group, Ltd., Dallas, Texas.
108 Chapter 10 Staffing: Methods, Operations, and Regulations
The hourly rate, base pay, and overtime premiums are noted, and gross earnings are computed. Deductions are noted and deducted from gross earnings to compute the net pay for
each employee in the final column.
Exhibit 10–6 illustrates a time card for one employee for a week-long period. This type of
record, whether it is generated by a time clock or an electronic entry, is the original record
upon which the payroll process is based. Thus, it is considered a basic transaction record. In this
example, time in and time out are recorded daily. The resulting regular and overtime hours are
recorded separately for each day worked. Although the appearance of the time card may vary,
and it may be recorded within a computer instead of on a hard copy, the essential transaction is
the same: this recording of daily time is where the payroll process begins.
Exhibit 10–7 represents an emergency department staffing report. Actual productive time is
shown in columns 1 and 2, with regular time in column 1 and overtime in column 2. Nonproductive time is shown in column 3, and columns 1, 2, and 3 are totaled to arrive at column 4,
labeled “Total [actual] Hours.” The final actual figure is the FTE figure in column 5.
The report is biweekly and thus is for a 2-week period. The standard work week amounts
to 40 hours, so the biweekly standard work period amounts to 80 hours. Note the first line
Metropolis Health System
Time Card
Employee J.F. Green No. 1071
Department 3 Week ending June 10
Regular Overtime Hours
Day In Out In Out In Out Regular Overtime
Monday 8:00 12:01 1:02 5:04 8
Tuesday 7:56 12:00 12:59 5:03 6:00 8:00 8 2
Wednesday 7:57 12:02 12:58 5:00 8
Thursday 8:00 12:00 1:00 5:01 8
Friday 7:59 12:01 1:01 5:02 8
Saturday
Sunday
Total regular hours 40
Total overtime 2
Courtesy of Resource Group, Ltd., Dallas, Texas.
Exhibit 10–6 Example of a Time Record
Number of Employees Required to Fill a Position: Another Way to Calculate FTEs 109
PR 2301
Biweekly Comparative Hours Report
for the Payroll Period Ending Sept. 20, ____
Dept. No. 3421
Emergency Room
Actual
Productive Budget Variance
Job
Code
Regular
Time
(1)
Overtime
(2)
NonProductive
(3)
Total
Hours
(4)
FTEs
(5)
Productive
(6)
NonProductive
(7)
Total
Hours
(8)
FTEs
(9)
Number
Hours
(10)
Number
FTEs
(11)
Percent
(12)
Mgr Nursing Service 11075 80 0 0 80 1.0 69.8 10.2 80 1 0 0 0
Supv Charge Nurse 11403 383.2 0.1 79 462.3 5.8 456 64 520 6.5 57.7 0.7 11.1%
Medical Assistant 12007 6.2 0 0 6.2 0.1 0 0 0 0 –6.2 –0.1 100.0%
Staff RN 13401 2010.5 32.8 285.8 2329.1 29.1 2012.8 240.8 2253.6 28.2 –75.5 –0.9 –3.4%
Relief Charge Nurse 13403 81.9 4.3 0 86.2 1.1 0 0 0 0 –86.2 –1.1 100.0%
Orderly/Transporter 15483 203.8 38 20 261.8 3.3 279.8 35.3 315.1 3.9 53.3 0.6 16.9%
ER Tech 22483 244.6 27.5 67.9 340 4.3 336.2 34.5 370.7 4.6 30.7 0.3 8.3%
Secretary 22730 58.1 0 0 58.1 0.7 50.5 5.9 56.4 0.7 –1.7 0.0 –3.0%
Unit Coordinator 22780 555.1 35.6 74.9 665.6 8.3 505.4 53.8 559.2 7 –106.4 –1.3 –19.0%
Preadmission Testing
Clerk
22818 0 6.5 0 6.5 0.1 0 0 0 0 –6.5 –0.1 100.0%
Patient Registrar 22873 617.5 78.6 105.7 801.8 10.0 718.2 57.8 776 9.7 –25.8 –0.3 –3.3%
Lead Patient Registrar 22874 0 0 0 0 0.0 73.8 6.2 80 1 80.0 1.0 100.0%
Patient Registrar
(weekend)
22876 36.7 0 0 36.7 0.5 0 0 0 0 –36.7 –0.5 100.0%
Overtime 29998 0 0 0 0 0.0 38.5 0 38.5 0.5 38.5 0.5 100.0%
Department Totals 4277.6 223.4 633.3 5134.3 64.3 4541 508.5 5049.5 63.1 –84.8 –1.2 0.0
Courtesy of Resource Group, Ltd., Dallas, Texas.
Exhibit 10–7 Comparative Hours Staffing Report
110 Chapter 10 Staffing: Methods, Operations, and Regulations
item, which is for the manager of the emergency department nursing service. The actual hours
worked in column 4 amount to 80, and the actual FTE figure in column 5 is 1.0. We can tell
from this line item that the second method of computing FTEs—the FTE computation to fill
scheduled positions—has been used in this case. Columns 7 through 9 report budgeted time
and FTEs, and columns 10 through 12 report the variance in actual from budget. The budget
and variance portions of this report structure will be more thoroughly discussed in the chapter
about operating budgets.
In summary, hours worked and pay rates are essential ingredients of staffing plans, budgets,
and forecasts. Appropriate staffing is the responsibility of the manager.
REGULATORY REQUIREMENTS REGARDING STAFFING
As if staffing a healthcare organization wasn’t complex enough because of the typical need to
cover 24 hours a day, there are regulatory requirements that impact staffing configurations.
The IMPACT Act Staffing Report Requirements
This complexity is no more apparent than in the new (2016) skilled nursing facility staffing
requirements embodied in P.L. 113-185, the Improving Medicare Post-Acute Care Transformation Act of 2014 (the IMPACT Act). In essence, the Centers for Medicare and Medicaid Services
(CMS) are now seeking improved reporting on nursing home staffing.
Regulatory Specifics About Staffing Reports
The first set of regulatory specifics is contained in the Final Rule for the FY 2016 Prospective Payment System under the heading “Staffing Data Collection.”2 The regulation had its
genesis in the Affordable Care Act, P.L. 111-148. Section 1128I(g) specifies that a facility is
required to “electronically submit…direct care staffing information, including information
for agency and contract staff, based on payroll and other verifiable and auditable data in a
uniform format according to specifications established by the Secretary in consultation with
(stakeholders).”3
The direct care staffing information submitted to CMS then appears on the Nursing Home
Compare website.4 Note the phrase “verifiable and auditable data.” Previously, facilities could
self-report such staffing information, but this information did not have to be “verifiable and
auditable.”
Additional Reporting Requirements
Additional requirements are also spelled out in the statute. Specifications in the CMS regulation state that the following must be included in the report:
• The category of work a certified employee performs (such as whether the employee is a
registered nurse, licensed practical nurse, licensed vocational nurse, certified nursing assistant, therapist, or other medical personnel)
• Resident census data
• Information on resident case mix
• Information on employee turnover and tenure
• The hours of care provided by each category of certified employees per resident per day5
Regulatory Requirements Regarding Staffing 111
This information must be reported on a regular basis. Also, information for agency and contract staff must be kept separate from the information submitted for employee staffing.
We draw your attention to the two phrases requiring the following: the category of work
a certified employee performs and the hours of care provided by each category of certified
employees per resident per day. What can your organization do to ensure compliance with
these requirements that is both “verifiable and auditable”?
For example, which documentation within your system should be retained? To what level
of detail should it be retained, and for how long? What guidance can be found, either
from government sources or from your professional organizations? And if such guidance is
made available, how do your own records compare? What adjustments or additions should
be made?
We can also expect that these specific requirements will evolve over time. While the first set
of regulatory specifics is set out within the FY 2016 PPS final rule, we can expect that refinements to these requirements will be forthcoming over each succeeding year, as experience provides evidence for the needed adjustments.
Funding Provided for Report Improvements
The IMPACT Act provides a one-time allocation of $11 million to implement these improvements to the Nursing Home Compare website.6 (Additional details about the Nursing Home
Compare website and its 5-Star Rating appear in the chapter titled, “Standardizing Measures
and Payment in Post-Acute Care: New Requirements”.)
From a public domain perspective, Medicare.gov/Nursing Home Compare serves as a useful
reference enabling consumers to assess staffing results among Medicare and Medicaid participating nursing homes. Staffing data are submitted by the facility and are adjusted for the needs
of nursing home residents.
State Certificate-of-Need (CON) Laws and Regulations
Additional regulatory sources have had an impact on staffing. Central to health planning in the
United States are Certificate-of-Need (CON) regulations. To place CON in its proper context, a
brief overview of health planning is in order.
Health Planning Background
Shortly after Medicare was enacted into law in 1965, the Comprehensive Health Planning
and Services Act (CHP) was passed in 1966. It was noteworthy insofar as it encouraged states
to use health planning to remedy geographic disparities in access to care. This was an application of planning that went beyond just allocating funds for hospital construction as in the
historically important Hospital Survey and Construction Act of 1946, popularly known as the
Hill–Burton Act.7
Planning was carried out by state-level CHP-A agencies and local CHP-B agencies. The former was charged with developing a statewide, comprehensive plan for the delivery of health
services in each state; the latter were responsible for assessing the health-services needs of populations in their designated areas, determining the availability of resources, and developing a
plan that specified what was required to meet those needs.8
While it is beyond the scope of this text to analyze in depth why the CHP program didn’t
deliver as promised, suffice it to say that it had no resource development component. Resources
112 Chapter 10 Staffing: Methods, Operations, and Regulations
that were necessary to meet a community’s needs had to be sought outside the CHP program’s
parameters. In effect, then, CHP’s impact on staffing was immeasurable.
Congress sought to rectify CHP’s shortcomings by enacting the National Health Planning
and Resources Development Act in 1974. The Act created state-level organizations that were
charged with developing and implementing the state health plan. Operationally, though, it was
the health systems agencies (HSAs), local organizations, that served a regulatory function. They
were charged with developing annual plans to improve health services in their regions.9
The Certificate-of-Need (CON) Program
The regulatory leverage that states used to act on proposals for changes in health services was
(and is) the Certificate-of-Need (CON) program. The program was originally aimed at hospitals
and nursing homes that were permitted to spend funds on services, facilities, and equipment
only if a need had been identified in the HSA plan for their region. The basic assumption
underlying CON regulation is that excess capacity (in the form of facility overbuilding) directly
results in healthcare price inflation.10 The 1974 law required all 50 states to have a structure in
place involving the submitting of proposals and obtaining approval from a state health planning agency.
In 1986, the National Health Planning and Resources Development Act was repealed, along
with its federal funding. Despite numerous changes since, 36 states retain some type of CON
program, law, or agency according to the National Conference of State Legislatures.11 These
states tend to concentrate activities on outpatient facilities and long-term care. This is largely
due to the trend toward free-standing, physician-owned facilities that constitute an increasing
segment of the healthcare market.
How Do CON-Related Regulations Affect Staffing?
State CON-related regulations affect staffing across different types of facilities. For example, if a
hospital CON is filed seeking approval for a new surgical wing, staffing needs must be included
in the application along with facility and equipment requirements. If a nursing home is seeking to expand its bed capacity, new staff such as RNs, LPNs, and possibly even therapists will be
required. If a home care agency is seeking to increase its geographic reach and expand its program capacity, new nursing–related and social work staff will be required.
A prime example of state regulatory requirements on minimum staffing levels in nursing
homes may be found in Nursing Home Staffing Standards in State Statutes and Regulations.12
It depicts minimum staffing standards for skilled nursing or nursing facilities. For example, for
every state it lists three variables:
1. A Sufficient Staff Statement (i.e., Licensed to meet the needs of individual residents)
2. Staff Requirement (i.e., RN, LPN/LVN per hour/per bed)
3. Direct Care Requirements (i.e., Two people on duty at all times)
This site is a useful planning tool.
SUMMARY
Staffing operations throughout the U.S. are obviously impacted by regulations about staffing
and staffing reports. And desired expansion and related operational issues in 36 states are naturally affected by applicable certificate of need requirements.
Summary 113
INFORMATION CHECKPOINT
What is needed? The original record of time and the subsidiary journal
summary.
Where is it found? The original record can be found at any check-in point; the
subsidiary journal summary can be found with a supervisor
in charge of staffing for a unit, division, and so on.
How is it used? It is reviewed as historical evidence of results achieved. It is
also reviewed by managers seeking to perform future staffing in an efficient manner.
KEY TERMS
Certificate of Need (CON)
Full-Time Equivalents (FTEs)
Nonproductive Time
Productive Time
Staffing
DISCUSSION QUESTIONS
1. Are you or your immediate supervisor responsible for staffing?
2. If so, do you use a computerized program?
3. Do you believe a computerized program is better? If so, why?
4. Does your organization report time as “productive” and “nonproductive”?
5. If not, do you believe it should? What do you believe the benefits would be?
6. If your state has certificate-of-need (CON) regulations in place, has your organization
made a CON request in the recent past? If so, was it successful? Please describe.
NOTES
1. J. J. Baker, Prospective Payment for Long-Term Care: An Annual Guide (Gaithersburg, MD:
Aspen Publishers, Inc., 1999).
2. 80 FR 46462 (Aug. 4, 2015).
3. Ibid.
4. “What is Nursing Home Compare?”, Medicare.gov, http://www.medicare.gov/nursing
homecompare/About/What-Is-NHC.html
5. 80 FR 46462.
6. SSA Sec. 1819(i).
7. R. I. Field, Health Care Regulation in America: Complexity, Confrontation, and Compromise (New York, NY: Oxford University Press, 2007).
114 Chapter 10 Staffing: Methods, Operations, and Regulations
8. P. L. Barton, Understanding the U.S. Health Services System (4th ed.) (Chicago, IL: Health
Administration Press, 2010).
9. Field, Health Care Regulation.
10. Ibid.
11. National Conference of State Legislatures, “CON—Certificate of Need State Laws,”
http://www.ncsl.org/research/health/con-certificate-of-need-state-laws.aspx, accessed
June 9, 2016.
12. Charlene Harrington, “Nursing Home Staffing Standards in State Statutes and Regulations,”
The National Long-Term Care Ombudsman Resource Center, http://ltcombudsman
.org/uploads/files/support/Harrington-state-staffing-table-2010_(1).pdf, accessed
June 12, 2016.
Notes 115

© LFor/Shutterstock
PART
IV
Report and Measure
Financial Results

Progress Notes
© LFor/Shutterstock
Reporting as a Tool
UNDERSTANDING THE MAJOR REPORTS
It is not our intention to convert you into an accountant.
Therefore, our discussion of the major financial reports
will center on the concept of each report and not on the
precise accounting entries that are necessary to make the
statement balance. The first concept we will discuss is that
of cash versus accrual accounting. In cash basis accounting, a transaction does not enter the books until cash is
either received or paid out. In accrual accounting, revenue is recorded when it is earned—not when payment
is received—and expenses are recorded when they are
incurred—not when they are paid.1 Most healthcare organizations operate on the accrual basis.
There are four basic financial statements. You can think
of them as a set. They include the balance sheet, the statement of revenue and expense, the statement of fund balance or net worth, and the statement of cash flows. The four
major reports we are about to examine—the financial statements—have been prepared using the accrual method.
BALANCE SHEET
The balance sheet records what an organization owns, what
it owes, and basically, what it is worth (although the terminology uses fund balance rather than worth or equity for nonprofit organizations). The balance sheet balances. That is,
the total of what the organization owns—its assets—equals
the combined total of what the organization owes and what
it is worth—its liabilities and its net worth, or its fund balance. This balancing of the elements in the balance sheet
can be visualized as
Assets 5 Liabilities 1 Net Worth/Fund Balance
After completing this chapter,
you should be able to
1. Review a balance sheet and
understand its components.
2. Review a statement of revenue and expense and understand its components.
3. Understand the basic concept of cash flows.
4. Know what a subsidiary
report is.
119
11
CHAPTER
Another characteristic of the balance sheet is that it is stated at a particular point in time.
A common analogy is that a balance sheet is like a snapshot: it freezes the figures and reports
them as of a certain date.
Exhibit 11–1 illustrates these concepts. A single date (not a period of time) is at the top of
the statement (this is the snapshot). The clinic balance sheet reflects two years in two columns,
with the most current date on the left and the prior period on the right. Total assets for the current left-hand column amount to $963,000. Total liabilities and fund balance also amount to
$963,000; the balance sheet balances. The total liabilities amount to $545,000 and the total fund
balances amount to $418,000. The total of the two, of course, makes up the $963,000 shown at
the bottom of the statement.
Three types of assets are shown: current assets; property, plant, and equipment; and other
assets. Current assets are supposed to be convertible into cash within one year—thus “current”
assets. Property, plant, and equipment, however, represent long-term assets. Other assets represent noncurrent items.
Two types of liabilities are shown: current liabilities and long-term debt. Current liabilities
are those expected to be paid within the next year—thus “current” liabilities. Long-term debt
is not due within a year. (In fact, most long-term debt is due over a period of many years.) The
amount of long-term debt that will be due within the next year ($52,000) has been subtracted
from the long-term debt amount and has been moved up into the current liabilities section.
This treatment is consistent with the concept of “current.”
Once again, because our intent is not to make an accountant of you, we will not be discussing
generally accepted accounting principles (GAAP) either. Financial accounting and the resulting reports intended for third-party use must be prepared in accordance with GAAP. However,
managerial accounting for internal purposes in the organization does not necessarily have to
adhere to GAAP. One of the requirements of GAAP is that unrestricted fund balances be separated from restricted fund balances on the statements, so you see two appropriate line items
(restricted and unrestricted) in the fund balance section.
We should also mention that the standards underlying generally accepted accounting
principles within the United States are produced by the Financial Accounting Standards
Board (FASB). Sometime in the (probable) near future U.S. publicly held companies may
be required to adopt certain international accounting standards as produced by the International Accounting Standards Board (IASB). Benefits would include global comparability
and consistency in accounting standards and financial reports while barriers to such adoption include funding, maintenance, application, and governance.2 Any further discussion of
these accounting issues is beyond the scope of this text.
STATEMENT OF REVENUE AND EXPENSE
The formula for a very condensed statement of revenue and expense would look like this:
Operating Revenue 2 Operating Expenses 5 Operating Income
A statement of revenue and expense covers a period of time (rather than one single date or
point in time). The concept is that revenue, or inflow, less expenses, or outflow, results in an
excess of revenue over expenses if the year has been good, or perhaps an excess of expenses
over revenue (resulting in a loss) if the year has been bad.
120 Chapter 11 Reporting as a Tool
Exhibit 11–2 sets out the result of operations for two years, with the most current period
in the left column. If the balance sheet is a snapshot, then the statement of revenue and
expenses is a diary, because it is a record of transactions over the period of a year. Operating
Exhibit 11–1 Westside Clinic Balance Sheet
Assets December 31, 2034 December 31, 2033
Current Assets
Cash and cash equivalents $190,000 $145,000
Accounts receivable (net) 250,000 300,000
Inventories 25,000 20,000
Prepaid Insurance 5,000 3,000
Total Current Assets $470,000 $468,000
Property, Plant, and Equipment
Land $100,000 $100,000
Buildings (net) 0 0
Equipment (net) 260,000 300,000
Net Property, Plant, and Equipment 360,000 400,000
Other Assets
Investments $133,000 $32,000
Total Other Assets 133,000 32,000
Total Assets $963,000 $900,000
Liabilities and Fund Balance
Current Liabilities
Current maturities of
long-term debt $52,000 $48,000
Accounts payable and
accrued expenses 293,000 302,000
Total Current Liabilities $345,000 $350,000
Long-Term Debt $252,000 $300,000
Less Current Maturities of
Long-Term Debt 252,000 248,000
Net Long-Term Debt 200,000 252,000
Total Liabilities $545,000 $602,000
Fund Balances
Unrestricted fund balance $418,000 $298,000
Restricted fund balance 0 0
Total Fund Balances 418,000 298,000
Total Liabilities and Fund Balance $963,000 $900,000
Statement of Revenue and Expense 121
revenues and operating expenses are set out first, with the result being income from operations of $115,000 ($2,000,000 less $1,885,000). Then other transactions are reported; in this
case, interest income of $5,000 under the heading “Nonoperating Gains (Losses).” The total
of $120,000 ($115,000 plus $5,000) is reported as an increase in fund balance. This figure
carries forward to the next major report, known as the statement of changes in fund balance.
STATEMENT OF CHANGES IN FUND BALANCE/NET WORTH
Remember that our formula for a basic statement of revenue and expense looked like this:
Operating Revenue 2 Operating Expenses 5 Operating Income
The excess of revenue over expenses flows back into equity or fund balance through the
mechanism of the statement of fund balance/net worth. Exhibit 11–3 shows a balance at the
first of the year, then it adds the excess of revenue over expenses (in the amount of $115,000)
For the Year Ending
Revenue December 31, 2034 December 31, 2033
Net Patient Service Revenue $2,000,000 $1,850,000
Total Operating Revenue $2,000,000 $1,850,000
Operating Expenses
Medical/surgical services $600,000 $575,000
Therapy services 860,000 806,000
Other professional services 80,000 75,000
Support services 220,000 220,000
General services 65,000 60,000
Depreciation 40,000 40,000
Interest 20,000 24,000
Total Operating Expenses 1,885,000 1,800,000
Income from Operations $115,000 $50,000
Nonoperating Gains (Losses)
Interest Income $5,000 $2,000
Net Nonoperating Gains 5,000 2,000
Revenue and Gains in Excess of
Expenses and Losses $120,000 $52,000
Increase in Unrestricted Fund Balance $120,000 $52,000
Exhibit 11–2 Westside Clinic Statement of Revenue and Expenses
122 Chapter 11 Reporting as a Tool
plus some interest income (in the amount of $5,000) to arrive at the balance at the end of
the year.
If you refer back to the balance sheet, you will see the $418,000 balance at the end of the year
appearing on it. So we can think of the balance sheet, the statement of revenue and expenses,
and the statement of changes in fund balance/net worth as locked together, with the statement of
changes in fund balance being the mechanism that links the other two statements.
But there is one more major report—the statement of cash flows—and we will examine it next.
STATEMENT OF CASH FLOWS
To perceive why a statement of cash flows is necessary, we must first revisit the concept of accrual
basis accounting. If cash is not paid or received when revenues and expenses are entered on the
books—the usual situation in accrual accounting—what happens? The other side of the entry
for revenues is accounts receivable, and the other side of the entry for expenses is accounts payable. These accounts rest on the balance sheet and have not yet been turned into cash. Another
characteristic of accrual accounting is the recognition of depreciation. A capital asset—a piece
of equipment, for example—is purchased for $20,000. It has a usable life of five years. So depreciation expense is recognized in each of the five years until the $20,000 is used up, or depreciated. (Land is an exception to this rule: it is never depreciated.) Depreciation is recognized
within each year as an expense, but it does not represent a cash expense. This is a concept that
now enters into the statement of cash flows.
Exhibit 11–4 presents the current period cash flow. In effect, this statement takes the accrual
basis statements and converts them to a cash flow for the period through a series of reconciling
adjustments that account for the noncash amounts.
Understanding the cash/noncash concept makes sense of this statement. The starting point
is the income from operations, the subtotal from the statement of revenue and expense. Depreciation and interest are added back, and changes in asset and liability accounts, both positive
and negative, are recognized. These adjustments account for operating activities. Next, capital
and related financing activities are addressed, then investing activities are adjusted. The result
is a net increase in cash and cash equivalents of $45,000 in our example. This figure is added to
the cash balance at the beginning of the year ($145,000) to arrive at the cash balance at the end
of the year ($190,000). Now refer back to the balance sheet, and you will find the cash balance
is indeed $190,000. So the fourth major report—the statement of cash flows—interlocks with
the other three major reports.
Exhibit 11–3 Westside Clinic Statement of Changes in Fund Balance
For the Year Ending
Statement of Changes in Fund Balance December 31, 2034 December 31, 2033
Balance First of Year $298,000 $246,000
Revenue in Excess of Expenses 115,000 50,000
Interest Income 5,000 2,000
Balance End of Year $418,000 $298,000
Statement of Cash Flows 123
SUBSIDIARY REPORTS
The subsidiary reports are just that; subsidiary to the major reports. These reports support
the major reports by providing more detail. For example, patient service revenue totals on the
Exhibit 11–4 Westside Clinic Statement of Cash Flows
Statement of Cash Flows For the Year Ending
December 31, 2034 December 31, 2033
Operating Activities
Income from Operations $115,000 $50,000
Adjustments to reconcile income from
operations to net cash flows from
operating activities
Depreciation and amortization 40,000 40,000
Interest expense 20,000 24,000
Changes in asset and liability accounts
Patient accounts receivable 50,000 2250,000
Inventories 25,000 25,000
Prepaid expenses and other assets 22,000 21,000
Accounts payable and accrued
expenses 29,000 185,000
Net Cash Flow from Operating Activities $209,000 $43,000
Cash Flows from Noncapital Financing Activities 0 0
Cash Flows from Capital and Related
Financing Activities
Acquisition of equipment $ 0 $ (300,000)
Proceeds from loan for equipment 0 300,000
Interest paid on long-term obligations 220,000 0
Repayment of long-term obligations 248,000 0
Net Cash Flows from Capital and Related
Financing Activities 268,000 0
Cash Flows from Investing Activities
Interest income received $5,000 $2,000
Investments purchased (net) 2101,000 0
Net Cash Flows from Investing Activities 296,000 2,000
Net Increase (Decrease) in Cash and Cash
Equivalents $45,000 $45,000
Cash and Cash Equivalents, Beginning of Year 145,000 100,000
Cash and Cash Equivalents, End of Year $190,000 $145,000
124 Chapter 11 Reporting as a Tool
statement of revenue and expenses are often expanded in more detail on a subsidiary report.
The same thing is true of operating expense. These reports are called “schedules” instead of
“statements”—a sure sign that they are subsidiary reports.
SUMMARY
The four major reports fit together; each makes its own contribution to the whole. A checklist
for balance sheet review (Exhibit 11–5) and a checklist for review of the statement of revenue
and expense (Exhibit 11–6) are provided.
Exhibit 11–6 Checklist for Review of the Statement of Revenue and Expense
1. What is the period reported on the statement of revenue and expense?
2. Is it one year or a shorter period? If it is a shorter period, why is that?
3. Are there large discrepancies in balances between the prior year operations and the
current year operations?
4. Did total operating revenue increase over the prior year?
5. Did total operating expenses increase, decrease, or stay about the same? Is any
particular line item unusually large or small?
6. Did income from operations increase, decrease, or stay about the same?
7. Are there unusual nonoperating gains or losses?
8. Did the current year result in an excess of revenue over expense? Is it as much as the
prior year?
9. Did long-term debt increase or decrease significantly over the prior year?
Exhibit 11–5 Checklist for the Balance Sheet Review
1. What is the date on the balance sheet?
2. Are there large discrepancies in balances between the prior year and the current year?
3. Did total assets increase over the prior year?
4. Did current assets increase, decrease, or stay about the same?
5. Did current liabilities increase, decrease, or stay about the same?
6. Did land, plant, and equipment increase or decrease significantly over the prior year?
7. Did long-term debt increase or decrease significantly over the prior year?
INFORMATION CHECKPOINT
What is needed? A set of financial statements, ideally containing the four major
reports plus subsidiary reports for additional detail.
Where is it found? Possibly in the files of your supervisor or in the finance office
or in the office of the administrator.
Information Checkpoint 125
How is it used? Study the financial statement to see how they fit together;
use the checklists included in this chapter to assist in your
review. Understanding how the statements work will give
you another valuable managerial tool.
KEY TERMS
Accrual Basis Accounting
Balance Sheet
Cash Basis Accounting
Statement of Cash Flows
Statement of Fund Balance/Net Worth
Statement of Revenue and Expense
Subsidiary Reports
DISCUSSION QUESTIONS
1. Can you give an example of an asset? A liability?
2. Does the concept of revenue less expense equaling an increase in equity or fund balance
make sense to you? If not, why not?
3. Are you familiar with the current maturity of long-term debt? What example of it can you
give in your own life (either at work or at home)?
4. Do you get a chance to review financial statements at your place of work? Would you like
to? Why?
NOTES
1. S. A. Finkler, et al., Essentials of Cost Accounting for Health Care Organizations, 3rd ed. (Sudbury MA: Jones & Bartlett Publishers, 2007).
2. K. Tysiac, “Still in Flux: Future of IFRS in U.S. Remains Unclear After SEC report,”
Journal of Accountancy (September 2012), www.journalofaccountancy.com/Issues/2012
/Sep/20126059.htm
126 Chapter 11 Reporting as a Tool
Progress Notes
© LFor/Shutterstock
CHAPTER
Financial and
Operating Ratios as Performance Measures
THE IMPORTANCE OF RATIOS
Ratios are convenient and uniform measures that are
widely adopted in healthcare financial management.
They are important because they are so widely used,
especially because they are used for credit analysis. But a
ratio is only a number. It has to be considered within the
context of the operation. There is another caveat: ratio
analysis should be conducted as a comparative analysis.
In other words, one ratio standing alone with nothing to
compare it with does not mean very much. When interpreting ratios, the differences between periods must be
considered, and the reasons for such differences should
be sought. It is a good practice to compare results with
equivalent computations from outside the organization—
regional figures from similar institutions would be a good
example of such outside sources. Caution and good managerial judgment must always be exercised when working
with ratios.
Financial ratios basically pull together two elements of
the financial statements: one expressed as the numerator
and one as the denominator. To calculate a ratio, divide the
bottom number (the denominator) into the top number
(the numerator). The Case Study that is entitled “Comparative Analysis (Financial Ratios and Benchmarking) Helps
Turn Around a Hospital” uses financial ratios as indicators
of financial position. We highly recommend that you spend
time with this Case Study, as it will add depth and background to the contents of this chapter.
In this chapter we examine liquidity, solvency, and profitability ratios. Exhibit 12–1 sets out eight basic ratios that
are widely used in healthcare organizations: four liquidity
types, two solvency types, and two profitability types. All are
discussed in this chapter.
After completing this chapter,
you should be able to
1. Understand four types of
liquidity ratios.
2. Understand two types of
solvency ratios.
3. Understand two types of
profitability ratios.
4. Successfully compute ratios.
127
12
CHAPTER
Exhibit 12–1 Eight Basic Ratios Used in Health Care
Liquidity Ratios
1. Current Ratio
Current Assets
Current Liabilities
2. Quick Ratio
Cash and Cash Equivalents 1 Net Receivables
Current Liabilities
3. Days Cash on Hand (DCOH)
Unrestricted Cash and Cash Equivalents
Cash Operation Expenses 4 No. of Days in Period (365)
4. Days Receivables
Net Receivables
Net Credit Revenues 4 No. of Days in Period (365)
Solvency Ratios
5. Debt Service Coverage Ratio (DSCR)
Change in Unrestricted Net Assets (net income)
1 Interest, Depreciation, Amortization
Maximum Annual Debt Service
6. Liabilities to Fund Balance
Total Liabilities
Unrestricted Fund Balances
Profitability Ratios
7. Operating Margin (%)
Operating Income (Loss)
Total Operating Revenues
8. Return on Total Assets (%)
EBIT (Earnings Before Interest and Taxes)
Total Assets
Courtesy of Resource Group, Ltd., Dallas, Texas.
128 Chapter 12 Financial and Operating Ratios as Performance Measures
LIQUIDITY RATIOS
Liquidity ratios reflect the ability of the organization to meet its current obligations. Liquidity
ratios measure short-term sufficiency. As the name implies, they measure the ability of the organization to “be liquid”: in other words, to have sufficient cash—or assets that can be converted
to cash—on hand.
Current Ratio
The current ratio equals current assets divided by current liabilities. For instance, consider this
example:
Current Assets 5 $120,000 5 2 to 1
Current Liabilities $60,000
This ratio is considered to be a measure of short-term debt-paying ability. However, it must
be carefully interpreted. The standard by which the current ratio is measured is 2 to 1, as
computed.
Quick Ratio
The quick ratio equals cash plus short-term investments plus net receivables divided by current
liabilities:
Cash and Cash Eqivalents 1 Net Receivables 5 $65,000 5 1.08 to 1
Current Liabilities $60,000
The standard by which the quick ratio is measured is generally 1 to 1. This computation, at
1.08 to 1, is a little better than the standard.
This ratio is considered to be an even more severe test of short-term debt-paying ability (even
more than the current ratio). The quick ratio is also known as the acid-test ratio, for obvious
reasons.
Days Cash on Hand
The days cash on hand (DCOH) equals unrestricted cash and investments divided by cash operating expenses divided by 365:
Unrestricted Cash and Cash Equivalents 5 $330,000 5 30 days Cash Operating Expenses $11,000
4 No. of Days in Period
There is no concrete standard for this computation.
This ratio indicates cash on hand in relation to the amount of daily operating expense. This
example indicates the organization has 30 days worth of operating expenses represented in the
amount of (unrestricted) cash on hand.
Liquidity Ratios 129
Days Receivables
The days receivables computation is represented as net receivables divided by net credit revenues divided by 365:
Net Receivables 5 $720,000 5 60 days Net Credit Revenue/No. of Days in Period $12,000
This computation represents the number of days in receivables. The older a receivable is, the
more difficult it becomes to collect. Therefore, this computation is a measure of worth as well
as performance.
There is no hard and fast rule for this computation because much depends on the mix of
payers in your organization. This example indicates that the organization has 60 days worth of
credit revenue tied up in net receivables. This computation is a common measure of billing and
collection performance. There are many “days receivables” regional and national figures to
compare with your own organization’s computation.
Figure 12–1 shows how the information for the numerator and the denominator of each
calculation is obtained. It takes the Westside Clinic balance sheet and the statement of revenue and expense that were discussed in the preceding chapter and illustrates the source
of each figure in the four ratios just discussed. The multiple computations for days cash on
hand and for days receivables are further broken down into a three-step process. If you study
Figure 12–1 and work with the Case Study entitled “Comparative Analysis (Financial Ratios
and Benchmarking) Helps Turn Around a Hospital”, you will soon master this process.
SOLVENCY RATIOS
Solvency ratios reflect the ability of the organization to pay the annual interest and principal
obligations on its long-term debt. As the name implies, they measure the ability of the organization to “be solvent”: in other words, to have sufficient resources to meet its long-term
obligations.
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) is represented as change in unrestricted net assets
(net income) plus interest, depreciation, and amortization divided by maximum annual debt
service:
Change in Unrestricted Net Assets (Net Income)
1 Interest, Depreciation, and Amortization 5 $250,000 5 2.5
Maximum Annual Debt Service $100,000
This ratio is universally used in credit analysis and figures prominently in the Mini-Case
Study.
Each lending institution has its particular criteria for the DSCR. Lending agreements often
have a provision that requires the DSCR to be maintained at or above a certain figure.
130 Chapter 12 Financial and Operating Ratios as Performance Measures
Figure 12–1 Examples of Liquidity Ratio Calculations.
Courtesy of Resource Group, Ltd, Dallas, Texas.
Assets December 31, 20X2
Current Assets
Cash and cash equivalents $190,000
Accounts receivable (net) 250,000
Inventories 52 ,000
Prepaid Insurance , 5 000
Total Current Assets $470,000
Property, Plant, and Equipment
Land $100,000
Buildings (net) 0
Equipment (net) 260,000
Net Property, Plant, and Equipment 360,000
Other Assets
Investments $133,000
133,000
Total Other Assets
Total Assets $963,000
Liabilities and Fund Balance
Current Liabilities
Current maturities of long-term debt $52,000
Accounts payable and accrued expenses 293,000
Total Current Liabilities $345,000
Long-Term Debt $252,000
Less Current Maturities of Long-Term Debt (52,000)
Net Long-Term Debt 200,000
Total Liabilities $545,000
Fund Balances
Unrestricted fund balance $418,000
Restricted fund balance 0
Total Fund Balances 418,000
Total Liabilities and Fund Balance $963,000
For the Year Ending
Revenue December 31, 20X2
Net patient service revenue
$2,000,000
Total operating revenue
$2,000,000
Operating Expenses
Medical/surgical services $600,000
Therapy services 860,000
Other professional services 80,000
Support services 220,000
General services 65,000
Depreciation 40,000
Interest 20,000
Total operating expenses
$1,885,000
Income from Operations $115,000
Nonoperating Gains (Losses)
Interest Income $5,000
Net nonoperating gains 5,000
Revenue and Gains in Excess of
Expenses and Losses $120,000
Increase in Unrestricted Fund Balance $120,000
470,000
345,000
= 1.362
Current Assets
Current Liabilities
1. Current Ratio
Step 2
1,845,000
365
= 5,055
Step 3
190,000
5,055
= 37.5 days
Step 1
1,885,000
(40,000)
1,845,000
190,000 + 250,000
345,000
= 1.275
Cash and Cash Equivalent +
Net Receivables
Current Liabilities
2. Quick Ratio
3. Days Cash on Hand (DCOH)
Unrestricted Cash and Cash Equivalents
Cash Operating Expenses divided by #
days in period (365)
Step 2
1,800,000
365
= 4,931
Step 3
250,000
4,931
= 50.7 days
Step 1
2,000,000
× 90%
1,800,000 4. Days Receivables
Net Receivables
Net Credit Revenue divided by # days in period (365)
Percent of Credit Revenues
Information obtained elsewhere
Statement of Revenue and Expenses
Balance Sheet
Solvency Ratios 131
Liabilities to Fund Balance (or Debt to Net Worth)
The liabilities to fund balance or net worth computation is represented as total liabilities divided by
unrestricted net assets (i.e., fund balances or net worth) or total debt divided by tangible net worth:
Total Liabilities 5 $2,000,000 5 0.80
Unrestricted Fund Balances $2,250,000
This figure is a quick indicator of debt load.
Another indicator that is more severe is long-term debt to net worth (fund balance), which is
computed as long-term debt divided by fund balance. This computation is somewhat equivalent
to the quick ratio discussed previously in its restrictiveness to net worth computation.
A mirror image of total liabilities to fund balance is total assets to fund balance, which is computed as total assets divided by fund balance.
Figure 12–2 shows how the information for the numerator and the denominator of each
calculation is obtained. This figure again takes the Westside Clinic balance sheet and statement
of revenue and expense that were discussed in the preceding chapter and illustrates the source
of each figure in the two solvency ratios just discussed, along with each figure in the two profitability ratios still to be discussed. When multiple computations are necessary, they are further
broken down into a two-step process.
PROFITABILITY RATIOS
Profitability ratios reflect the ability of the organization to operate with an excess of operating
revenue over operating expense. Nonprofit organizations may not call this result a profit, but
the measurement ratios are still generally called profitability ratios, whether they are applied to
for-profit or nonprofit organizations.
Operating Margin
The operating margin, which is generally expressed as a percentage, is represented as operating
income (loss) divided by total operating revenues:
Operating Income (Loss) 5 $250,000 5 5.0%
Total Operating Revenues $5,000,000
This ratio is used for a number of managerial purposes and also sometimes enters into credit
analysis. It is therefore a multipurpose measure. It is so universal that many outside sources are
available for comparative purposes. The result of the computation must still be carefully considered because of variables in each period being compared.
Return on Total Assets
The return on total assets is represented as earnings before interest and taxes (EBIT) divided
by total assets:
EBIT 5 $400,000 5 10%
Total Assets $4,000,000
132 Chapter 12 Financial and Operating Ratios as Performance Measures
Figure 12–2 Examples of Solvency and Profitability Ratio Calculations.
Courtesy of Resource Group, Ltd, Dallas, Texas.
Balance Sheet
Assets December 31, 20×2
Current Assets $190,000
Accounts receivable (net) 250,000
Inventories 25,000
Prepaid Insurance 5,000
Total Current Assets $470,000
Property,Plant and Equipment
Land $100,000
Buildings (net) 0
Equipment (net) 260,000
Net Property, Plant and Equipment 360,000
Other Assets
Investments $133,000
133,000
Total Other Assets
Total Assets $963,000
Liabilities and Fund Balance
Current Liabilities
Current maturities of long-term debt $52,000
Accounts payable and accrued expenses 293,000
Total Current Liabilities $345,000
Long-term Debt $252,000
Less current maturities of long-term debt –52,000
Net Long-term Debt 200,000
Total Liabilities $545,000
Fund Balances
Unrestricted fund balance $418,000
Restricted fund balance 0
Total Fund Balances 418,000
Total Liabilities and Fund Balance $963,000
Statement of Revenue and Expenses
For the Year Ending
Revenue December 31, 20×2
Net patient service revenue $2,000,000
Total operating revenue $2,000,000
Operating Expenses
Medical/surgical services $600,000
Therapy services 860,000
Other professional services 80,000
Support services 220,000
General services 65,000
Depreciation 40,000
Interest 20,000
Total operating expenses 1,885,000
Income from Operations $115,000
Nonoperating Gains (Losses)
Interest Income $5,000
Net nonoperating gains 5,000
Revenue and Gains in Excess of
Expenses and Losses $120,000
Increase in Unrestricted Fund Balance $120,000
Step 1 5. Return on Total Assets (%)
120,000
20,000
140,000
Step 2
140,000
963,000
= 14.54%
6. Operating Margin (%)
115,000
2,000,000
5.75%
7. Liabilities to Fund Balance
545,000
418,000
= 1.304
Step 1 8. Debt Service Coverage Ratio (DSCR)
120,000
20,000
40,000
180,000
Step 2
180,000 Maximum Annual Debt Service
72,000 Information derived elsewhere
= 2.5
EBIT (Earnings Before Interest and Taxes)
Total Assets
Operating Income (Loss)
Total Operating Revenues
Total Liabilities
Unrestricted Fund Balance
Change in Unrestricted Net Assets (net income)
plus Depreciation-Amortization
plus Interest
Maximum Annual Debt Service
Profitability Ratios 133
This is a broad measure in common use. Note the acronym EBIT, as its use is widespread in
credit analysis circles. (Some analysts use an alternative computation for Return on Total Assets.
They compute this ratio as Net Income divided by Total Assets.)
This concludes the description of solvency and profitability ratios. Again, if you study Figure
12–2 and work with the Case Study entitled “Comparative Analysis (Financial Ratios and Benchmarking) Helps Turn Around a Hospital”, you will master this process too.
INFORMATION CHECKPOINT
What is needed? Reports that use ratios as measures.
Where is it found? Possibly in your supervisor’s file; in the administrator’s office;
in the chief executive officer’s office.
How is it used? Use as a measure against outside benchmarks (as discussed in
this chapter); also use as internal benchmarks for departments/divisions/units; also use as benchmarks at various
points over time.
KEY TERMS
Current Ratio
Days Cash on Hand (DCOH)
Days Receivables
Debt Service Coverage Ratio (DSCR)
Liabilities to Fund Balance
Liquidity Ratios
Operating Margin
Profitability Ratios
Quick Ratio
Return on Total Assets
Solvency Ratios
DISCUSSION QUESTIONS
1. Are there ratios in the reports you receive at your workplace?
2. If so, do you use them? How?
3. If not, do you believe ratios should be on the reports? Which reports?
4. Can you think of good outside sources that could be used to obtain ratios for comparative purposes? If the outside information was available, what ratios would you choose to
use? Why?
134 Chapter 12 Financial and Operating Ratios as Performance Measures
Progress Notes
© LFor/Shutterstock
The Time Value
of Money
PURPOSE
The purpose of these computations is to evaluate the use
of money. The manager has many options as to where
resources of the organization should be spent.1 These calculations provide guides to assist in evaluating the alternatives.
UNADJUSTED RATE OF RETURN
The unadjusted rate of return is a relatively unsophisticated
return-on-investment method, and the answer is only an
estimate, containing no precision. The computation of the
unadjusted rate of return is as follows:
Average Annual Net Income 5 Rate of Return
Original Investment Amount
OR
Average Annual Net Income 5 Rate of Return
Average Investment Amount
The original investment amount is a matter of record.
The average investment amount is arrived at by taking the
total unrecovered asset cost at the beginning of estimated
useful life plus the unrecovered asset cost at the end of
estimated useful life and dividing by two. This method has
the advantage of accommodating whatever depreciation
method has been chosen by the organization. This method
is sometimes called the accountant’s method because information necessary for the computation is obtained from the
financial statements.
After completing this chapter,
you should be able to
1. Compute an unadjusted rate
of return.
2. Understand how to use a
present-value table.
3. Compute an internal rate of
return.
4. Understand the payback
period theory.
135
13
CHAPTER
PRESENT-VALUE ANALYSIS
The concept of present-value analysis is based on the time value of money. Inherent in this concept is the fact that the value of a dollar today is more than the value of a dollar in the future:
thus the “present value” terminology. Furthermore, the further in the future the receipt of
your dollar occurs, the less it is worth. Think of a dollar bill dwindling in size more and more
as its receipt stretches further and further into the future. This is the concept of present-value
analysis.
We learned about compound interest in math class. We learned that
$500 invested at the beginning of year 1
.05 earns interest (assumed) at a rate of 5% for one year,
$525 and we have a compound amount at the end of year 1 amounting to $525,
.05 which earns interest (assumed) at the rate of 5% for another year,
$551 and we have a compound amount at the end of year 2 amounting to $551
(rounded), and so on.
Using this concept, it is possible to restate the present values of $1 to be paid out or received
at the end of each of these years. It is possible to use equations, but that is not necessary
because we have present-value tables (also called “look-up tables,” because one can “look-up”
the answer). A present-value table is included at the end of this chapter in Appendix 13-A.
All of the figures on the present-value table represent the value of a dollar. The interest rate
available on this version of the table is on the horizontal columns and ranges from 1% to 20%.
The number of years in the period is on the vertical; in this version of the table, the number of
years ranges from 1 to 30. To look up a present value, find the column for the proper interest.
Then find the line for the proper number of years. Then trace down the interest column and
across the number-of-years line item. The point where the two lines meet is the number (or
factor) that represents the value of $1 according to your assumptions. For example, find the
year 10 by reading down the left-hand column labeled “Year.” Then read across that line until
you find the column labeled “10%.” The point where the two lines meet is found to be 0.3855.
The present value of $1 under these assumptions (10 year/10%) is about 38.5 cents (shown as
0.3855 on the table).
Besides using the look-up table, you can also compute this factor on a business analyst calculator. A reference to business analyst calculators is contained in the Appendix entitled “WebBased and Software Learning Tools.” This can be found at the end of this text. Besides using
either the look-up table or the business calculator, you can use a function on your computer
spreadsheet to produce the factor. The important point is this: no matter which method you
use, you should get the same answer.
Now that you have the present value of $1, by whichever method, it is simple to find the
present value of any other number. You merely multiply the other number by the factor you
found on the table—or in the calculator or the computer. Say, for example, you want to find the
present value of $8,000 under the assumption used above (10 years/10%). You simply multiply
$8,000 by the factor of 0.3855 you found in the table. The present value of $8,000 is $3,084 (or
$8,000 times 0.3855).
A compound interest table is also included at the end of this chapter in Appendix 13-B,
along with a table showing the present value of an annuity of $1.00 in Appendix 13-C, so that
you have the tools for computation at your disposal.
136 Chapter 13 The Time Value of Money
INTERNAL RATE OF RETURN
The internal rate of return (IRR) is another return on investment method. It uses a discounted
cash flow technique. The internal rate of return is the rate of interest that discounts future net
inflows (from the proposed investment) down to the amount invested. The return for a particular investment can therefore be known. The IRR recognizes the elements contained in the
previous two methods discussed, but it goes further. It also recognizes the time pattern in which
the earnings occur. This means more precision in the computation because IRR calculates from
period to period, whereas the other two methods rely on an average investment.
The IRR computation is not very complicated. The computation requires two assumptions
and three steps to compute. Assumption 1: Find the initial cost of the investment. Assumption
2: Find the estimated annual net cash inflow the investment will generate. Assumption 3: Find
the useful life of the asset (generally expressed in number of years, known as periods for this
computation). Step 1: Divide the initial cost of the investment (Assumption 1) by the estimated
annual net cash inflow it will generate (Assumption 2). The answer is a ratio. Step 2: Now use
the look-up table. Find the number of periods (Assumption 3). Step 3: Look across the line for
the number of periods and find the column that approximates the ratio computed in Step 1.
That column contains the interest rate representing the rate of return.
How is IRR used? It can take the rate of return obtained and restate it. The restated figure
represents the maximum rate of interest that can be paid for capital over the entire span of the
investment without incurring a loss. (You can think of that restated figure as a kind of breakeven point for investment purposes.) The fact that a rate of return can be computed is the
benefit of using an IRR method.
PAYBACK PERIOD
The payback period is the length of time required for the cash coming in from an investment
to equal the amount of cash originally spent when the investment was acquired. In other
words, if we invested $1,000, under a particular set of assumptions, how long would it take to
get our $1,000 back? The payback period concept is used extensively in evaluating whether
to invest in a plant and/or equipment. In that case, the question can be restated as follows: If
we invested $1,200,000 in a magnetic resonance imaging machine, under a particular set of
assumptions, how long would it take to get the hospital’s $1,200,000 back?
The assumptions are key to the computation of the payback period. In the case of equipment, volume of usage is a critical assumption and is sometimes very difficult to predict.
Therefore, it is prudent to run more than one payback period computation based on different
circumstances. Generally a “best case” and a “worst case” run are made.
The computation itself is simple, although it has multiple steps. The trick is to break it into
segments.
For example, Doctor Green is considering the purchase of a machine for his office
laboratory. It will cost $300,000. He wants to find the payback period for this piece of equipment. To begin, Dr. Green needs to make the following assumptions. Assumption 1: Purchase
price of the equipment. Assumption 2: Useful life of the equipment. Assumption 3: Revenue
the machine will generate per year. Assumption 4: Direct operating costs associated with earning the revenue. Assumption 5: Depreciation expense per year (computed as purchase price
per Assumption 1 divided by useful life per Assumption 2).
Payback Period 137
Dr. Green’s five assumptions are as follows:
1. Purchase price of equipment 5 $300,000
2. Useful life of the equipment 5 10 years
3. Revenue the machine will generate per year 5 $10,000 after taxes
4. Direct operating costs associated with earning the revenue 5 $150,000
5. Depreciation expense per year 5 $30,000
Now that the assumptions are in place, the payback period computation can be made. It is in
three steps, as follows:
Step 1: Find the machine’s expected net income after taxes.
Revenue (Assumption #3) $200,000
Less
Direct operating costs
(Assumption 4) $150,000
Depreciation
(Assumption 5) 30,000
180,000
Net income before taxes $20,000
Less income taxes of 50% 10,000
Net income after taxes $10,000
Step 2: Find the net annual cash inflow after taxes the machine is expected to generate (in
other words, convert the net income to a cash basis).
Net income after taxes $10,000
Add back depreciation (a noncash expenditure) 30,000
Annual net cash inflow after taxes $40,000
Step 3: Compute the payback period.
Investment $300,000 Machine Cost* 5 7.5 year
Net Annual $40,000**
Cash Flow
after Taxes
*Assumption 1 above
**per Step 2 above
The machine will pay back its investment under these assumptions in 7.5 years.
Payback period computations are very common when equipment purchases are being evaluated. The evaluation process itself is the final subject we consider in this chapter.
EVALUATIONS
Evaluating the use of resources in healthcare organizations is an important task. There are never
enough resources to go around, and it is important to use an objective process to evaluate which
Payback Period
138 Chapter 13 The Time Value of Money
investments will be made by the organization. A uniform use of a chosen method of evaluating
return on investment and/or payback period makes the evaluation process more manageable.
It is important to choose a method that is understood by the managers who will be using it.
It is equally important to choose a method that can be readily calculated. If a multiple-page
worksheet has to be constructed to set up the assumptions for a modestly priced piece of equipment, the evaluation method is probably too complex. This comment actually touches on the
cost-benefit of performing the evaluation.
Sometimes a computer program is chosen that performs a uniform computation of
investment returns and payback periods. Such a program is a suitable choice if the managers
who use it understand the printouts it produces. Understanding both input and output is key for
the managers. In summary, evaluations should be objective, the process should not be too cumbersome, and the responsible managers should understand how the computation was achieved.
RESOURCES
Three look-up tables are presented as appendices to this chapter. They include the following:
A. Present-Value Table (the present value of $1.00)
B. Compound Interest Table (the future value of $1.00)
C. Present Value of an Annuity of $1.00
These tables provide an ongoing resource for you.
INFORMATION CHECKPOINT
What is needed? Information sufficient to perform these calculations.
Where is it found? In the files of your supervisor; also in the office of the financial
analyst; probably also in the strategic planning office.
How is it used? To measure the time value of money.
KEY TERMS
Internal Rate of Return
Payback Period
Present-Value Analysis
Time Value of Money
Unadjusted Rate of Return
DISCUSSION QUESTIONS
1. Can you compute an unadjusted rate of return now? Would you use it? Why?
2. Are you able to use the present-value look-up table now? Would you prefer a computer to
compute it?
Discussion Questions 139
3. Have you seen the payback period concept used in your workplace? If not, do you think it
ought to be used? What are your reasons?
4. Have you had a chance to participate in an evaluation of an equipment purchase at
your workplace? If so, would you have done it differently if you had supervised the
evaluation? Why?
NOTE
1. S. Williamson et al., Fundamentals of Strategic Planning for Healthcare Organizations
(New York: The Haworth Press, 1997).
140 Chapter 13 The Time Value of Money
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141
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.9803 0.9613 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2987
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351
22 0.8034 0.6468 0.5219 0.4220 0.3418 0.2775 0.2257 0.1839 0.1502 0.1228
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.2109 0.1703 0.1378 0.1117
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1971 0.1577 0.1264 0.1015
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923
26 0.7720 0.5976 0.4637 0.3607 0.2812 0.2198 0.1722 0.1352 0.1064 0.0839
27 0.7644 0.5859 0.4502 0.3468 0.2678 0.2074 0.1609 0.1252 0.0976 0.0763
28 0.7568 0.5744 0.4371 0.3335 0.2552 0.1956 0.1504 0.1159 0.0895 0.0693
29 0.7493 0.5631 0.4243 0.3207 0.2429 0.1846 0.1406 0.1073 0.0822 0.0630
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573
Present-Value Table
(The Present Value of $1.00) 13-A
APPENDIX
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944
3 0.7312 0.7118 0.6913 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787
4 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823
5 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019
6 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349
7 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791
8 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326
9 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938
10 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615
11 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346
12 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122
13 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935
14 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779
15 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649
16 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541
17 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451
18 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376
19 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313
20 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261
21 0.1117 0.0926 0.0768 0.0638 0.0531 0.0443 0.0370 0.0309 0.0259 0.0217
22 0.1007 0.0826 0.0680 0.0560 0.0462 0.0382 0.0316 0.0262 0.0218 0.0181
23 0.0907 0.0738 0.0601 0.0491 0.0402 0.0329 0.0270 0.0222 0.0183 0.0151
24 0.0817 0.0659 0.0532 0.0431 0.0349 0.0284 0.0231 0.0188 0.0154 0.0126
25 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105
26 0.0663 0.0525 0.0417 0.0331 0.0264 0.0211 0.0169 0.0135 0.0109 0.0087
27 0.0597 0.0469 0.0369 0.0291 0.0230 0.0182 0.0144 0.0115 0.0091 0.0073
28 0.0538 0.0419 0.0326 0.0255 0.0200 0.0157 0.0123 0.0097 0.0077 0.0061
29 0.0485 0.0374 0.0289 0.0224 0.0174 0.0135 0.0105 0.0082 0.0064 0.0051
30 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042
142 Chapter 13 The Time Value of Money
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143
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.156 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.120 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.728
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.632 10.835
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449
Compound
Interest Table
Compound Interest of $1.00
(The Future Amount of $1.00)
13-B
APPENDIX
Year 12% 14% 16% 18% 20% 24% 28% 32% 40% 50%
1 1.120 1.140 1.160 1.180 1.200 1.240 1.280 1.320 1.400 1.500
2 1.254 1.300 1.346 1.392 1.440 1.538 1.638 1.742 1.960 2.250
3 1.405 1.482 1.561 1.643 1.728 1.907 2.067 2.300 2.744 3.375
4 1.574 1.689 1.811 1.939 2.074 2.364 2.684 3.036 3.842 5.062
5 1.762 1.925 2.100 2.288 2.488 2.932 3.436 4.007 5.378 7.594
6 1.974 2.195 2.436 2.700 2.986 3.635 4.398 5.290 7.530 11.391
7 2.211 2.502 2.826 3.185 3.583 4.508 5.629 6.983 10.541 17.086
8 2.476 2.853 3.278 3.759 4.300 5.590 7.206 9.217 14.758 25.629
9 2.773 3.252 3.803 4.435 5.160 6.931 9.223 12.166 20.661 38.443
10 3.106 3.707 4.411 5.234 6.192 8.594 11.806 16.060 28.925 57.665
11 3.479 4.226 5.117 6.176 7.430 10.657 15.112 21.199 40.496 86.498
12 3.896 4.818 5.936 7.288 8.916 13.215 19.343 27.983 56.694 129.746
13 4.363 5.492 6.886 8.599 10.699 16.386 24.759 36.937 79.372 194.619
14 4.887 6.261 7.988 10.147 12.839 20.319 31.691 48.757 111.120 291.929
15 5.474 7.138 9.266 11.074 15.407 25.196 40.565 64.350 155.568 437.894
16 6.130 8.137 10.748 14.129 18.488 31.243 51.923 84.954 217.795 656.840
17 6.866 9.276 12.468 16.672 22.186 38.741 66.461 112.140 304.914 985.260
18 7.690 10.575 14.463 19.673 26.623 48.039 85.071 148.020 426.879 1477.900
19 8.613 12.056 16.777 23.214 31.948 59.568 108.890 195.390 597.630 2216.800
20 9.646 13.743 19.461 27.393 38.338 73.864 139.380 257.920 836.683 3325.300
25 17.000 26.462 40.874 62.669 95.396 216.542 478.900 1033.600 4499.880 25251.000
30 29.960 50.950 85.850 143.371 237.376 634.820 1645.500 4142.100 24201.432 191750.000
144 Chapter 13 The Time Value of Money
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145
Periods 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Periods
1 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.862 0.848 0.833 1
2 1.942 1.886 1.833 1.783 1.736 1.690 1.647 1.605 1.566 1.528 2
3 2.884 2.775 2.673 2.577 2.487 2.402 2.322 2.246 2.174 2.107 3
4 3.808 3.630 3.465 3.312 3.170 3.037 2.914 2.798 2.690 2.589 4
5 4.713 4.452 4.212 3.993 3.791 3.605 3.433 3.274 3.127 2.991 5
6 5.601 5.242 4.917 4.623 4.355 4.111 3.889 3.685 3.498 3.326 6
7 6.472 6.002 5.582 5.206 4.868 4.564 4.288 4.039 3.812 3.605 7
8 7.325 6.733 6.210 5.747 5.335 4.968 4.639 4.344 4.078 3.837 8
9 8.162 7.435 6.802 6.247 5.759 5.328 4.946 4.607 4.303 4.031 9
10 8.983 8.111 7.360 6.710 6.145 5.650 5.216 4.833 4.494 4.193 10
15 12.849 11.118 9.712 8.560 7.606 6.811 6.142 5.576 5.092 4.676 15
20 16.351 13.590 11.470 9.818 8.514 7.469 6.623 5.929 5.353 4.870 20
25 19.523 15.622 12.783 10.675 9.077 7.843 6.873 6.097 5.467 4.948 25
Present Value of an
Annuity of $1.00 13-C
APPENDIX

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Tools to Review
and Manage Comparative Data
PART
V

Progress Notes
© LFor/Shutterstock
Trend Analysis,
Common Sizing, and
Forecasted Data
COMMON SIZING
The process of common sizing puts information on the
same relative basis. Generally, common sizing involves converting dollar amounts to percentages. If, for example, total
revenue of $200,000 equals 100%, then radiology revenue
of $20,000 will equal 10% of that total. Converting dollars
to percentages allows comparative analysis. In other words,
comparing the percentages allows a common basis of comparison. Common sizing is sometimes called “vertical analysis” (because the computation of the percentages is vertical).
Although such comparisons on the basis of percentages
can, and should, be performed on your own organization’s
data, comparisons can also be made between or among
various organizations. For example, Table 14–1 shows how
common sizing allows a comparison of liabilities for three different hospitals. In each case, the total liabilities equal 100%.
Then the current liabilities of hospital 1, for example, are
divided by total liabilities to find the proportionate percentage attributable to that line item (100,000 divided by 500,000
equals 20%; 400,000 divided by 500,000 equals 80%). When
all the percentages have been computed, add them to make
sure they add to 100%. If you use a computer, computation
of these percentages is available as a spreadsheet function.
Another example of comparative analysis is contained in
Table 14-2. In this case, general services expenses for three
hospitals are compared. Once again, the total expense for
each hospital becomes 100%, and the relative percentage for each of the four line items is computed ($320,000
divided by $800,000 equals 40% and so on). The advantage
of comparative analysis is illustrated by the “laundry” line
item, where the dollar amounts are $80,000, $300,000, and
$90,000 respectively. Yet each of these amounts is 10% of
the total expense for the particular hospital.
After completing this chapter,
you should be able to
1. Understand and use common
sizing.
2. Understand and use trend
analysis.
3. Understand five types of
forecast assumptions.
4. Understand capacity level
issues in forecasts.
149
14
CHAPTER
TREND ANALYSIS
The process of trend analysis compares figures over several time periods. Once again, dollar
amounts are converted to percentages to obtain a relative basis for purposes of comparison, but
now the comparison is across time. If, for example, radiology revenue was $20,000 this period
but was only $15,000 for the previous period, the difference between the two is $5,000. The difference of $5,000 equates to a 33.3% difference because trend analysis is computed on the earlier of the two years: that is, the base year (thus, 5,000 divided by 15,000 equals 33.3%). Trend
analysis is sometimes called “horizontal analysis” (because the computation of the percentage
of difference is horizontal).
An example of horizontal analysis is contained in Table 14–3. In this case, the liabilities of hospital 1 for year 1 are compared with the liabilities of hospital 1’s year 2. Current liabilities, for example,
were $100,000 in year 1 and are $150,000 in year 2, a difference of $50,000. To arrive at a percentage
of difference for comparative purposes, the $50,000 difference is divided by the year 1 base figure of
$100,000 to compute the relative differential (thus, 50,000 divided by 100,000 is 50%).
Table 14–1 Common Sizing Liability Information
Same Year for All Three Hospitals
Hospital 1 Hospital 2 Hospital 3
Current liabilities $100,000 20% $500,000 25% $400,000 80%
Long-term debt 400,000 80% 1,500,000 75% 100,000 20%
Total liabilities $500,000 100% $2,000,000 100% $500,000 100%
Table 14–3 Trend Analysis for Liabilities
Hospital 1
Year 1 Year 2 Difference
Current liabilities $100,000 20% $150,000 25% $50,000 50%
Long-term debt 400,000 80% 450,000 75% 50,000 12.5%
Total liabilities $500,000 100% $600,000 100% $100,000 –
Table 14–2 Common Sizing Expense Information
Same Year for All Three Hospitals
Hospital 1 Hospital 2 Hospital 3
General services expense
Dietary $320,000 40% $1,260,000 42% $450,000 50%
Maintenance 280,000 35% 990,000 33% 135,000 15%
Laundry 80,000 10% 300,000 10% 90,000 10%
Housekeeping 120,000 15% 450,000 15% 225,000 25%
Total GS expense $800,000 100% $3,000,000 100% $900,000 100%
150 Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data
Another example of comparative analysis is contained in Table 14–4. In this case, general services expenses for two years in hospital 1 are compared. The difference between year 1
and year 2 for each line item is computed in dollars; then the dollar difference figure is divided
by the year 1 base figure to obtain a percentage difference for purposes of comparison. Thus,
housekeeping expense in year 1 was $120,000, and in year 2 was $180,000, resulting in a difference of $60,000. The difference amounts to 50% ($60,000 difference divided by $120,000 year
1 equals 50%). In Table 14–4, two of the four line items have negative differences: that is, year 2
was less than year 1, resulting in a negative figure. Also, the dollar figure difference is $100,000
when added down (subtract the negative figures from the positive figures; thus, $85,000 plus
$60,000 minus $10,000 minus $35,000 equals $100,000). The dollar figure difference is also
$100,000 when added across ($900,000 minus $800,000 equals $100,000).
ANALYZING OPERATING DATA
Comparative analysis is an important tool for managers, and it is worth investing the time to
become familiar with both horizontal and vertical analysis. Managers will generally analyze their
own organization’s data most of the time (rather than performing comparisons against other
organizations). With that fact in mind, we examine operating room operating data (no pun
intended) that incorporate both common sizing and trend analysis.
Table 14–5 sets out 32 expense items. The expense amount in dollars for each line item is set
out for the current year in the left column (beginning with $60,517). The expense amount in
dollars for each line item is set out for the prior year in the third column of the analysis (beginning with $68,177). The difference in dollars, labeled “Annual Increase (Decrease),” appears in
the sixth column of the analysis (beginning with [$7,660]). Vertical analysis has been performed
for the current year, and the percentage results appear in the second column (beginning with
4.97%). Vertical analysis has also been performed for the prior year, and those percentage results
appear in the fourth column (beginning with 5.70%). Horizontal analysis has been performed
on each line item, and those percentage items appear in the far right column (beginning with
12.66%). This table is a good example of the type of operating data reports that managers receive
for planning and control purposes.
Comparative analysis is especially important to managers because it creates a common
ground to make judgments for planning, control, and decision-making purposes. Using comparative data is the subject of the following chapter.
Table 14–4 Trend Analysis for Expenses
Hospital 1
Year 1 Year 2 Difference
General services expense
Dietary $320,000 40% $405,000 45% $85,000 26.5%
Maintenance 280,000 35% 270,000 30% (10,000) (3.5)%
Laundry 80,000 10% 45,000 5% (35,000) (43.5)%
Housekeeping 120,000 15% 180,000 20% 60,000 50.0%
Total GS expense $800,000 100% $900,000 100% $100,000 –
Analyzing Operating Data 151
IMPORTANCE OF FORECASTS
The dictionary defines “to forecast” as “to calculate or predict some future event or condition,
usually as a result of study and analysis of available pertinent data.”1
From the manager’s viewpoint, forecasted data are information used for purposes of planning for the future. Forecasting, to some degree or another, is often required when producing
budgets. (Budgets are the subject of two of the following chapters.) It is pretty simple today to
create “what if” scenarios on the computer. But the important thing for managers to remember
is that assumptions directly affect the results of forecasts.
Table 14–5 Vertical and Horizontal Analysis for the Operating Room
Comparative Expenses
Annual
12-Month 12-Month Increase % of
Account Current Year % Prior Year % (Decrease) Change
Social Security 60,517 4.97 68,177 5.70 (7,660) –12.66
Pension 20,675 1.70 23,473 1.96 (2,798) –13.53
Health Insurance 8,422 0.69 18,507 1.55 (10,085) –119.75
Child Care 4,564 0.37 4,334 0.36 230 5.04
Patient Accounting 155,356 12.76 123,254 10.30 32,102 20.66
Admitting 110,254 9.05 101,040 8.45 9,214 8.36
Medical Records 91,718 7.53 94,304 7.88 (2,586) –2.82
Dietary 27,526 2.26 35,646 2.98 (8,120) –29.50
Medical Waste 2,377 0.20 3,187 0.27 (810) –34.08
Sterile Procedures 78,720 6.46 70,725 5.91 7,995 10.16
Laundry 40,693 3.34 40,463 3.38 230 0.57
Depreciation—Equipment 87,378 7.18 61,144 5.11 26,234 30.02
Depreciation—Building 41,377 3.40 45,450 3.80 (4,073) –9.84
Amortization—Interest (5,819) –0.48 1,767 0.15 (7,586) 130.37
Insurance 4,216 0.35 7,836 0.65 (3,620) –85.86
Administration 57,966 4.76 56,309 4.71 1,657 2.86
Medical Staff 1,722 0.14 5,130 0.43 (3,408) –197.91
Community Relations 49,813 4.09 40,618 3.39 9,195 18.46
Materials Management 64,573 5.30 72,305 6.04 (7,732) –11.97
Human Resources 31,066 2.55 13,276 1.11 17,790 57.27
Nursing Administration 82,471 6.77 92,666 7.75 (10,195) –12.36
Data Processing 17,815 1.46 16,119 1.35 1,696 9.52
Fiscal 17,700 1.45 16,748 1.40 952 5.38
Telephone 2,839 0.23 2,569 0.21 270 9.51
Utilities 26,406 2.17 38,689 3.23 (12,283) –46.52
Plant 77,597 6.37 84,128 7.03 (6,531) –8.42
Environmental Services 32,874 2.70 37,354 3.12 (4,480) –13.63
Safety 2,016 0.17 2,179 0.18 (163) –8.09
Quality Management 10,016 0.82 8,146 0.68 1,870 18.67
Medical Staff 9,444 0.78 9,391 0.78 53 0.56
Continuous Quality Improvement 4,895 0.40 0 0.00 4,895 100.00
EE Health 569 0.05 1,513 0.13 (944) –165.91
Total Allocated 1,217,756 100.00 1,196,447 100.00 21,309 1.75
All Other Expenses 1,211,608 — — — — —
Total Expense 2,429,364 — — — — —
152 Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data
Forecasts Versus Projections
Forecasts are different than projections, although both are considered to be “prospective”
and thus “future” financial statements. Forecasts are based on assumptions that are expected
to exist, and that reflect actions that are expected to occur. Projections, on the other hand,
are views further into the future. Because they are further into the future, we “project” future
events, projects, or operations using a set of presumed, or hypothetical, assumptions.
We are discussing forecasts in this chapter rather than projections. Therefore, these forecasts
are relatively short term and can be based on realistic assumptions that we expect to exist, along
with actions that we can reasonably expect to occur.
Forecasting Approaches
The approach to producing a forecast usually involves three different sources of information
and forecast assumptions:
• The first level derives from the personnel who are directly involved in the department or
unit. They know the operation and can provide important ground-level detail.
• The second level comes from electronic and statistical information, including trend analysis. Electronic reports can provide a thicket of information, and there is a skill to selecting
relevant information for forecasting purposes.
• The third level represents executive-level judgment that is typically applied to a preliminary
rough draft of the forecast. For example, adjusting volume upward or downward due to the
anticipated future impact of local competition would most likely be an executive-level judgment.
The amount and type of electronic information that is readily available greatly affects the
forecast difficulty. Electronic templates and standardized worksheets may also greatly influence
the final forecast results.
Common Types of Forecasts in Healthcare Organizations
The three most common types of forecasts found in most healthcare organizations include revenue
forecasts, staffing forecasts, and operating expense forecasts. (The operating expense forecast, which
is not as common, would generally cover those operating expenses other than labor.) This section
will discuss revenue and staffing forecasts, as they are what most managers will need to deal with.
OPERATING REVENUE FORECASTS
Operating revenue forecasts are inputs into the operating budget. Forecast types and their
assumptions are discussed in this section.
Types of Revenue Forecasts
Forecasts of revenue will cover varying time periods. Longer-range multi-year forecasts are
useful for executive decision making regarding the future of the organization. Figure 14–1
illustrates a multi-year forecast.
A single-year forecast is generally for the coming year and is thus a short-range forecast. Reliable forecasts of revenue are a vital part of the organization’s planning process and are an input
Operating Revenue Forecasts 153
into the operating budget. Figure 14–2 illustrates a short-range forecast. Note that the graph in
Figure 14–2 could be by month instead of by quarter as shown.
Building Revenue Forecast Assumptions
Five important issues regarding revenue forecast assumptions are discussed here.
Utilization Assumptions
In health care, significant changes in utilization patterns can be occurring that need to be taken
into account in the manager’s forecast assumptions. The inexorable shift to shorter lengths
of stay for hospital inpatients over the last decade is an example of a basic shift in utilization
patterns.
Patient Mix Assumptions
It is important to specify anticipated patient mix as well as his or her anticipated utilization or
volume. By “patient mix” we mean whether the individual is a Medicare patient, a Medicaid
patient, a patient covered by private insurance, or a private pay patient. When payers are thus
identified, this information allows the appropriate payments to be associated with the service
utilization assumptions.
Contractual Allowance Assumptions
The forecasted utilization of a service (or its volume) assumption is multiplied by the appropriate rate, or charges, in order to arrive at forecasted revenue stated in dollars. A word of
154 Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data
Figure 14–1 Five-Year Operating Revenue Forecast.
$6,000,000
$5,000,000
$4,000,000
$3,000,000
$2,000,000
$7,000,000
$8,000,000
0 Year 1 Year 2 Year 3 Year 4
$1,000,000
Year 5
warning, however: revenue forecasted at “gross charges” is not a valid figure. Instead, revenue
stated at “allowed charges” is the proper figure to use. Virtually all payers, including Medicare, Medicaid, and private insurers, will pay a stipulated amount for a particular service. But
the amounts these different payers have agreed to pay for the same service will vary. How to
handle the issue? Through a contractual allowance, as defined here:
• Gross Charge: Amount for a service as shown on the claim form; a uniform charge generally greater than most expected payments received for the service.
• Allowed Charge: Net amount that the particular payer’s contract or participation agreement will recognize, or “allow,” for a certain service.
• Contractual Allowance: Difference (between the gross charge and the allowed charge) that
is recorded as a reduction of the gross charge within the accounting cycle.
(It should also be noted that part of the payer’s allowed charge is generally due from the patient,
and the remaining portion of the allowed charge is actually due from the payer.)
Trend Analysis Assumptions
One of the basic purposes of performing trend analysis is to compare data between or among
years and to see the trends. If such trends are found, then it makes sense to take them into
account in your forecast. A word of warning, however: the manager must determine whether
the data used for comparison in the trend analysis are comparable data.
Payer Change Assumptions
Trend analysis is retrospective; that is, it is using historical data from a past period. Forecasting
is prospective; that is, it is projecting into the future. If changes, say, in regulatory requirements
for payment are made this year, then that fact has to be taken into account.
Figure 14–2 One-Year Operating Revenue Forecast.
$1,500,000
$1,250,000
$1,000,000
$1,750,000
0 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Operating Revenue Forecasts 155
STAFFING FORECASTS
Staffing forecasts are also inputs into the operating budget. We have addressed staffing computations, costs, and reports in a previous chapter. This section builds upon that information in
order to produce a staffing forecast. Thus forecast considerations, components, and assumptions are addressed in this section.
Staffing Forecast Considerations
Staffing forecasts are a very common type of forecast required of managers. Three important
considerations when preparing staffing forecasts are discussed here.
Controllable Versus Noncontrollable Expenses
The concept of responsibility centers and controllable versus noncontrollable expenses
has been discussed earlier in this book. Essentially, controllable costs are subject to a manager’s own decision making, whereas noncontrollable costs are outside that manager’s
power. It is extremely difficult to make staffing forecasts with any degree of accuracy if
noncontrollable expenses are included in the manager’s forecast. The organization’s structure must be recognized and taken into account when setting up assumptions for staffing
forecasts. Shared services across lines of authority are workable in theory, but often do not
work in actuality. Figure 14–3 gives an example of the essential “business units” under the
supervision of a director of nurses. Note the responsibility centers and the support centers
on this organization chart.
Required Minimum Staff Levels
Regulatory healthcare standards may set minimum staff levels for providing service in a particular unit. These minimum levels cannot be ignored in the forecast process.
Figure 14–3 Primary Nursing Staff Classification by Line of Authority.
Courtesy of Resource Group, Ltd., Dallas, Texas.
Women’s
Health
Pediatric
Nursing
Ambulatory
Nursing
Medical
Surgical
Emergency
Nursing
TQI
Education
Recruitment
Support
Finance
Information
Systems
Support
Director
of
Nurses
156 Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data
Labor Market Issues in Staffing Forecasts
We most often hear about a chronic lack of adequate staff, and certain parts of the country do
have a continual shortage of certain qualified professional healthcare staff. Yet other parts of
the country can have an overabundance during that same period. The status of the local labor
market has a direct impact on staffing forecasts. The impact is in dollars: when there are plenty
of staff available, the hourly rate to attract staff may go down, but when there is a shortage of
available qualified staff, the hourly rate has to go up. As strange as it may seem, this elemental
economic fact is sometimes not taken into account in forecasting assumptions.
Staffing Forecast Components
In many cases a staffing plan is first created, and the staffing forecast follows after the plan is
reviewed and refined. Four components are typically required, as follows. Figure 14–4 illustrates the sequence.
Scheduling Requirements
Scheduling requirements should encompass all hours and days required to cover each position.
For example, see the exhibit in the discussion about staffing (Chapter 10) that illustrates a
single security guard position and the number of units required.
Master Staffing Plan
The master staffing plan should include all units and all hours and days required to cover all
positions within the units. For example, see the exhibit in the discussion about staffing that
illustrates entire units by shift, covering 24 hours per day times 7 days a week.
Figure 14–4 Components of the Staffing Forecast.
Staffing Forecasts 157
Scheduling
Requirements
Master Staffing
Plan
Includes FTEs
required per shift
Net Paid Days
Worked per Year**
Total Paid Days per Year
Less
Paid Days Not Worked*
Annualized Master
Staffing Plan
Staffing
Forecast
FTEs Required per
Shift from Master
Staffing Plan
times
Annual Factor
equals
Annualized FTEs
Total days in the
business year divided
by net paid days
worked per year
equals
Annual Factor
=
=
*Paid Days Not Worked = Nonproductive Days
**Net Paid Days Worked = Productive Days
Computation Sequence to Annualize the Master Staffing Plan
The annualizing sequence is as follows. (This sequence is illustrated visually in Figure 14–4. An
example in worksheet form appears in the chapter about staffing.)
• Compute Productive and Nonproductive Days and Net Paid Days
The proportion of productive days (net paid days) versus nonproductive days (paid days
not worked) will be based on the organization’s policy as to paying for days not worked.
For example, see Step 1 in the Staffing chapter’s exhibit for such a computation, including “Net Paid Days.” (Holidays, sick days, vacation days, and education days composed the
“Paid Days Not Worked” in the worksheet example within the Staffing chapter’s exhibit.)
• Convert Net Paid Days Worked to an Annual Factor
The total days in the business year divided by net paid days worked equals a factor. Step 2
in the Staffing chapter’s exhibit illustrates this computation.
• Calculate the Annual FTEs Using the Factors
Finally, use the factor to calculate the FTEs required to fully cover the position’s shifts all year
long. For example, in the Staffing chapter’s exhibit, the RN FTE would be 1.6 (1.6106195).
The resulting staffing forecast reflects 24 hour per day 7 days per week annual FTEs to cover all
shifts.
CAPACITY LEVEL ISSUES IN FORECASTING
In the manufacturing industry, capacity levels relate to the production of, say, widgets. In the
world of health care, capacity relates to services; that is, the ability to produce or provide specific
healthcare services.
Space and Equipment Availability
The ability to provide services is automatically limited by the availability of both space and the
proper equipment to provide certain specific services. Forecasts need to take a realistic view of
these capacity levels.
Staffing Availability
Capacity is a tricky assumption to make in staffing forecasts. In some programs, particularly
those in a startup phase, overcapacity (too much staff available for the amount of work
required) is a problem. In some other organizations, under capacity (a chronic lack of
adequate staff) is the problem. Forecasting assumptions, in the best of all worlds, take these
difficulties into account. See the Mini-Case Study that demonstrates this problem of staffing
in the context of the Women, Infants, and Children (WIC) federal program.2
Example of Forecasting Maximum Service Capacity
Exhibit 14–1 illustrates the array of elements that should be taken into account when computing maximum capacity levels. This computation is important because your forecast should take
maximum capacity into account. (Alternative assumptions can also be made, of course. See the
sensitivity analysis discussion in a following chapter.)
158 Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data
Exhibit 14–1 Capacity Level Checkpoints for an Outpatient Infusion Center
Outpatient Infusion Center Capacity Level Checkpoints
# infusion chairs……………………………… 3 chairs
# staff……………………………………………… 1 RN
# weekly operating hours…………………. 40 hours
# of hours per patient infusion…………. average 2 hours (for purposes of this example)
Work Flow Description
For each infusion the nurse must perform the following steps (generalized for this
purpose; actual protocol is more specific):
1. Obtain and review the patient’s chart
2. Obtain and prepare the appropriate drug for infusion
3. Interview the patient
4. Prepare the patient and commence the infusion
5. Monitor and record progress throughout the ongoing infusion
6. Observe the patient upon completion of the infusion
7. Complete charting
Work Flow Comments
It is impossible for one nurse to start patients’ infusions in all three chairs simultaneously. Thus the theoretical treatment sequence might be as follows:
• Assume one half-hour for patient number one’s Steps 1 through 4.
• Once patient number one is at Step 5, the nurse can begin the protocol for
patient number two.
• Assume another one half-hour for patient number two’s Steps 1 through 4.
• Once patient number two is at Step 5, theoretically the nurse can begin the
protocol for patient number three.
This sequence should work, assuming all factors work smoothly; that is, the appropriate
drugs in the proper amounts are at hand, the patients show up on time, and no one
patient demands an unusual amount of the nurse’s attention. (For example, a new
patient will require more attention.)
Daily Infusion Center Capacity Level Assumption
Patient scheduling is never entirely smooth, and patient reactions during infusions
are never predictable. Therefore, we realistically assume the following: Chair #1 5 3
patients per day, Chair #2 5 2 patients per day, and Chair #3 5 2 patients per day, for a
daily total of 7 patients infused.
Capacity Level Issues in Forecasting 159
SUMMARY
In summary, the ultimate accuracy of a forecast rests on the strength of its assumptions.
INFORMATION CHECKPOINT
What is needed? An example of a staffing forecast created in your organization.
Where is it found? In the files of the supervisor who is responsible for staffing.
How is it used? Use the example to learn the nature of the assumptions that
were used and the setup of the forecast itself.
KEY TERMS
Common Sizing
Controllable Expenses
Forecasts
Noncontrollable Expenses
Patient Mix
Trend Analysis
Vertical Analysis
DISCUSSION QUESTIONS
1. Do any of the reports you receive in the course of your work use trend analysis? Why do
you think so?
2. Do any of the reports you receive in the course of your work use common sizing? Why do
you think so?
3. Are you or your immediate supervisor involved with staffing decisions? If so, are
you aware of how staffing forecasts are prepared in your organization? Describe an
example.
4. Have you, in the course of your work, become involved in problems with capacity level
issues such as space and equipment availability? If so, would forecasting have assisted in
solving such problems? Describe why.
NOTES
1. Merriam Webster’s Collegiate Dictionary, 10th ed., s.v. “Forecast.”
2. B. A. Brotman, M. Bumgarner, and P. Prime, “Client Flow through the Women, Infants,
and Children Public Health Program,” Journal of Health Care Finance, 25, no. 1 (1998):
72–77.
160 Chapter 14 Trend Analysis, Common Sizing, and Forecasted Data
Progress Notes
© LFor/Shutterstock
Using Comparative Data
OVERVIEW
Comparative data can become an important tool for the
manager. It is important, however, to fully understand the
requirements and the uses of such data.
COMPARABILITY REQUIREMENTS
True comparability needs to meet three criteria: consistency, verification, and unit measurement. Each is discussed
in this section.
Consistency
Three equally important elements of consistency should be
considered as follows.
Time Periods
Time periods should be consistent. For example, a
10-month period should not be compared to a 12-month
period. Instead, the 10-month period should be annualized, as described within this chapter.
Consistent Methodology
The same methods should be used across time periods.
For example, the chapter about inventory discusses
the use of two inventory methods: first-in, first-out
(FIFO) versus last-in, first-out (LIFO). The same inventory method—one or the other—should always be used
consistently for both the beginning of the year and the
end of the year.
After completing this chapter,
you should be able to
1. Understand the three criteria
for true comparability.
2. Understand the four uses of
comparative data.
3. Annualize partial-year
expenses.
4. Apply inflation factors.
5. Understand basic currency
measures.
161
15
CHAPTER
Inflation Factors
Finally, if multiple years are being compared, should inflation be taken into account? The
proper application of an inflation factor is also described within this chapter.
Verification
Basically, can these data be verified? Is it reasonable? If an objective, qualified person reviewed
the data, would he or she arrive at the same conclusion and/or results? You may have to do a few
tests to determine if the data can in fact be verified. If so, you should retain your back-up data,
because it is the evidence that supports your conclusions about verification.
Monetary Unit Measurement
With regard to comparative data, we should ask: “Is all the information being prepared or
under review measured by the same monetary unit?” In the United States, we would expect all
the data to be expressed in dollars and not in some other currency such as euros (used in much
of Europe) or pounds (used in Britain and the United Kingdom). Most of the manager’s data
will automatically meet this requirement. However, currency conversions are an important part
of reporting financial results for companies that have global operations, and consistency in
applying such conversions can be a significant factor in expressing financial results.
A MANAGER’S VIEW OF COMPARATIVE DATA
It is important for the manager to always be aware of whether the data he or she is receiving (or
preparing) are appropriate for comparison. It is equally important for the manager to perform
a comprehensive review, as described here.
The Manager’s Responsibility
Whether you as a manager must either review or prepare required data, your responsibility is to
recall and apply the elements of consistency. Why? Because such data will typically be used for
decision making. If such data are not comparable, then relying upon them can result in poor
decisions, with financial consequences in the future. The actual mechanics of making a comparative review are equally important. The deconstruction of a comparative budget review follows.
Comparative Budget Review
The manager needs to know how to effectively review comparative data. To do so, the manager
needs to understand, for example, how a budget report format is constructed. In general, the
usual operating expense budget that is under review will have a column for actual expenditures,
a column for budgeted expenditures, and a column for the difference between the two. Usually,
the actual expense column and the budget column will both have a vertical analysis of percentages (as discussed in the preceding chapter). Each different line item will have a horizontal
analysis (also discussed in the preceding chapter) that measures the amount of the difference
against the budget.
162 Chapter 15 Using Comparative Data
Table 15–1 illustrates the operating expense budget configuration just described. Notice that
the “Difference” column has both positive and negative numbers in it (the negative numbers
being set off with parentheses). Thus, the positive numbers indicate budget overage, such as
the dietary line, which had an actual expense of $405,000 against a budget figure of $400,000,
resulting in a $5,000 difference. The next line is maintenance. This department did not exceed
its budget, so the difference is in parentheses; the maintenance budget amounted to $290,000,
and actual expenses were only $270,000, so the $20,000 difference is in parentheses. In this
case, parentheses are good (under budget) and no parentheses is bad (over budget).
USES OF COMPARATIVE DATA
Four common uses of comparisons that the manager will find helpful are discussed in this
section.
Compare Current Expenses to Current Budget
Managers are most likely to be responsible for comparing the current expenses of their department, division, unit, or program to their current budget. Of the four types of comparisons discussed in this section, this is the one most commonly in use.
Table 15–1 illustrates a comparison of actual expenses versus budgeted expenses. This format reflects both dollars and percentages, as is most common. Table 15–1 shows the grand
totals for each department (Dietary, Maintenance, etc.) contained in General Services expense
for this hospital. There is, of course, a detailed budget for each of these departments that adds
up to the totals shown on Table 15–1. Thus, for example, all the detailed expenses of the Laundry department (labor, supplies, etc.) are contained in a supporting detailed budget whose total
actual expenses amount to $45,000 and whose total budgeted expenses amount to $50,000.
The department manager will be responsible for analyzing and managing the detailed budgets of his or her own department. A manager at a higher level in the organization—the chief
financial officer (CFO), perhaps—will be responsible for making a comparative analysis of the
overall operations of the organization. This comparative analysis at a higher level will condense
each department’s details into a departmental grand total, as shown in Table 15–1, for convenience and clarity in review.
Table 15–1 Comparative Analysis of Budget Versus Actual
Hospital 1
Year 2 Actual Year 2 Budget Difference
$$ % $$ % $$ %
General Services Expense
Dietary $405,000 45 $400,000 46 $5,000 12.5
Maintenance 270,000 30 290,000 33 (20,000) (6.9)
Laundry 45,000 5 50,000 6 (5,000) (10.0)
Housekeeping 180,000 20 130,000 15 50,000 38.5
Total GS Expense $900,000 100 $870,000 100 $30,000 3.5
Uses of Comparative Data 163
The CFO may also convert this comparative data into charts or graphs in order to “tell the
story” in a more visual manner. For example, the total General Service expense in Table 15–1
can be readily converted into a graph. Figure 15–1 illustrates such a graph.
Compare Current Actual Expenses to Prior Periods in Own Organization
Trend analysis, as explained in the preceding chapter, allows comparison of current actual
expenses to expenses incurred in prior periods of the same organization. For example, consider total general services expenses of $800,000 for year 1 and $900,000 for year 2. The CFO
could easily convert this information into a graph, as shown in Figure 15–2. This information
might be even more valuable for decision-making input if the CFO used five years instead of the
two years that are shown here.
Compare to Other Organizations
Common sizing, as explained in the preceding chapter, allows comparison of your organization to other similar organizations. To illustrate, refer to the table in a preceding chapter
(Table 14–1) entitled “Common Sizing Liability Information.” Here we see the liabilities
of three hospitals that are the same size expressed in both dollars and in percentages.
Therefore, our CFO can convert the percentages into an informative graph, as shown in
Figure 15–3.
Be warned that the basis for some comparisons will be neither useful nor valid. For example,
see Figure 15–4. Here we have a graph of the grand totals from the table in a preceding chapter
(Table 14–2) entitled “Common Sizing Expense Information.” The percentages shown are for the
General Services departments of each hospital and have been common sized to percentages, as is
Figure 15–1 A Comparison of Hospital One’s Budgeted and Actual Expenses.
$820,000
$840,000
$860,000
$880,000
$900,000
$920,000
Year 2
Budgeted Expenses
$870,000
Year 2
Actual Expenses
$900,000
$800,000
164 Chapter 15 Using Comparative Data
perfectly correct. However, Figure 15–4 attempts to compare the total General Services expense
(the total of all four general services departments) in dollars. As we can see here, hospital 1 and
hospital 3 are both 100 beds, while hospital 2 is 400 beds. Obviously a 400-bed hospital will incur
much more expense than a 100-bed hospital, so this graph cannot possibly show a valid comparison among the three organizations.
Figure 15–3 A Comparison of Three 100-Bed Hospitals’ Long-Term Debt.
20%
40%
60%
80%
0%
100%
Hospital 1
(100 beds)
80%
Hospital 2
(100 beds)
75%
Hospital 3
(100 beds)
20%
Uses of Comparative Data 165
Figure 15–2 A Comparison of Hospital One’s Expenses Over Time.
$800,000
$600,000
$1,000,000
Year 1
$800,000
Year 2
$900,000
Figure 15–5 A Comparison of Three Hospitals’ Expenses per Bed.
Figure 15–4 A Comparison of Three Hospitals’ Total Expenses.
$1,000,000
$500,000
$1,500,000
$2,000,000
$2,500,000
$3,000,000
$0
$3,500,000
Hospital 1
(100 beds)
$800,000
Hospital 2
(400 beds)
$3,000,000
Hospital 3
(100 beds)
$900,000
$6,500
$7,000
$7,500
$8,000
$8,500
$9,000
$6,000
$9,500
Hospital 1
(100 beds)
$8,000
Hospital 2
(400 beds)
$7,500
Hospital 3
(100 beds)
$9,000
Instead, the CFO should find a standard measure that can be used as a valid basis for comparison. In this case, he or she can choose size (number of beds) for this purpose. The resulting graph
is shown in Figure 15–5. As you can see, hospital 1’s cost per bed is $8,000, computed as follows.
166 Chapter 15 Using Comparative Data
The total expense of $800,000 for hospital 1 is divided by 100 beds (its size) to arrive at the $8,000
expense per bed shown on the graph in Figure 15–5. Hospital 2 ($3,000,000 total expense divided
by 400 beds to equal $7,500 per bed) and hospital 3 ($900,000 total expense divided by 100 beds
to equal $9,000 per bed) have the same computations performed on their equivalent figures.
In actual fact, another step in this computation should be performed in order to make the
comparisons completely valid. A per-bed computation implies inpatient expenses incurred,
because beds are occupied by admitted inpatients. (Outpatients, on the other hand, use a
different mix of services.) Therefore, a more accurate comparison would adjust the overall total
expense using one subtotal for inpatients and another subtotal for outpatients. Let us assume,
for purposes of illustration, that the CFO of hospital 1 has determined that 70% of General
Services expense can be attributed to inpatients and that the remaining 30% can be attributed
to outpatients. Let us further assume that hospital 1’s General Services expense of $800,000 as
shown, is indeed a hospital-wide expense. The CFO would then multiply $800,000 by 70% to
arrive at $420,000, representing the inpatient portion of General Services expense.
Compare to Industry Standards
In the example just given in the paragraph above, the CFO has computed his or her own hospital’s percentage of inpatient versus outpatient utilization of General Services expense. But this
CFO may not have any way to know these equivalent percentages for hospitals 2 and 3. If this is
the case, computing the per-bed expense using overall expense, as shown in Figure 15–5, may
be the only way to show a three-hospital comparison.
The CFO, however, can use the 70% inpatient and 30% outpatient expense breakdown
for another type of comparison. It should be possible to find industry standards that break
Figure 15–6 A Comparison of Hospital One’s GS Inpatient Expenses with Industry Standards.
55%
60%
65%
70%
50%
75%
GS Inpatient Expense %
Hospital 1
70%
GS Inpatient Expense %
Industry Standard
60%
Uses of Comparative Data 167
out inpatient versus outpatient expense percentages. The use of industry standards is of
particular use for decision making because it
positions the particular organization within a
large grouping of facilities that provide a similar set of services.
Healthcare organizations are particularly well
suited to use industry standards because both the
federal and state governments release a wealth
of public information and statistics regarding the provision of health care. Figure 15–6
illustrates the CFO’s graph using such a standard. (The figures shown are for illustration
only and do not reflect an actual standard.)
MAKING DATA COMPARABLE
This section discusses annualizing partialyear expenses, along with using inflation factors, standardized measures, and currency
measures. The manager needs to know how
to make data comparable as a basis for properly preparing and/or reviewing budgets and
reports.
Annualizing
Because comparability requires consistency,
the manager needs to know how to annualize
partial-year expenses. Table 15–2 sets out the
actual 10-month expenses for the operating
room. But these expenses are going to be
compared against a 12-month budget. What
to do? The actual 10-month expenses are converted, or annualized, to a 12-month basis, as
shown in the second column of Table 15–2.
These computations were performed on a
computer spreadsheet; however, the calculation
is as follows. Using the first line as an example,
$50,431 is 10-months worth of expenses; therefore, 1 month’s expense is one-tenth of $50,431,
or $5,043. To annualize for 12-months worth
of expenses, the 10-month total of $50,431 is
increased by 2 more months at $5,043 apiece
($50,431 plus $5,043 for month 11, plus
another $5,043 for month 12, equals $60,517,
the annualized 12-month figure for the year).
Table 15–2 Annualizing Operating Room PartialYear Expenses
Expenses
Actual Annualized
Account 10 Month 12 Month
Social Security 50,431 60,517
Pension 17,229 20,675
Health Insurance 7,018 8,422
Child Care 3,803 4,564
Patient Accounting 129,463 155,356
Admitting 91,878 110,254
Medical Records 76,432 91,718
Dietary 22,938 27,526
Medical Waste 1,981 2,377
Sterile Procedures 65,600 78,720
Laundry 33,911 40,693
Depreciation—
Equipment 72,815 87,378
Depreciation—
Building 34,481 41,377
Amortization—
Interest (4,849) (5,819)
Insurance 3,513 4,216
Administration 48,305 57,966
Medical Staff 1,435 1,722
Community
Relations 41,511 49,813
Materials
Management 53,811 64,573
Human Resources 25,888 31,066
Nursing
Administration 68,726 82,471
Data Processing 14,846 17,815
Fiscal 14,750 17,700
Telephone 2,366 2,839
Utilities 22,005 26,406
Plant 64,664 77,597
Environmental
Services 27,395 32,874
Safety 1,680 2,016
Quality
Management 8,347 10,016
Medical Staff 7,870 9,444
Continuous Quality
Improvement 4,079 4,895
EE Health 474 569
Total Allocated 1,014,796 1,217,756
All Other Expenses 1,009,673 1,211,608
Total Expense 2,024,469 2,429,364
Reproduced with the permission of Wolters Kluwer Law & Business
from J.J. Baker, Activity-Based Costing and Activity-Based Management for Health Care, p. 190, © 1998, Aspen Publishers, Inc.
168 Chapter 15 Using Comparative Data
Inflation Factors
Inflation means “an increase in the volume of money and credit relative to available goods and
services resulting in a continuing rise in the general price level.”1 An inflation factor is used to
compute the effect of inflation.
Let’s assume that hospital 1’s General Services expenses for year 1 were $800,000, versus
$900,000 for year 2. We can assume that these amounts reflect actual dollars expended in each
year. But let us also now assume that inflation caused these expenses to rise by 5% in year 2. If
the Chief Financial Officer (CFO) decides to take such inflation into account, a government
source will be available to provide the appropriate inflation rate. (The 5% in our example is for
illustration only and does not reflect an actual rate.)
The inflation factor for this example is expressed as a factor of 1.05 (1.00 plus 5% [expressed
as .05] equals 1.05). The CFO might apply the inflation factor to year 1 in order to give it a
spending power basis equivalent to that of year 2. (Applying an inflation factor for a two-year
comparison is not usually the case, but let us assume the CFO has a good reason for doing so
in this case.) The computation would thus be $800,000 year 1 expense times the 1.05 inflation
factor equals an inflation-adjusted year 1 expense figure of $840,000.
However, if the CFO wants to apply an inflation factor to a whole series of years, he or she
must account for the cumulative effect over time. An example appears in Table l5–3. We assume
a base of $500,000 and an annual inflation rate of 10%. The inflation factor for the first year is
10%, converted to 1.10, just as in the previous example, and $500,000 multiplied by 1.10 equals
$550,000 in nominal dollars.
Beyond the first year, however, we must determine the cumulative inflation factor. For this purpose we turn to the Compound Interest Table. It shows “The Future Amount of $1.00,” and appears
in Appendix B of the chapter about time value of money. “The Future Amount of $1.00” table has
years down the left side (vertical) and percentages across the top (horizontal). We find the 10%
column and read down it for years one, two, three, and so on.
As shown in Table 15–3.2, the factor for year 2 is 1.210, for year 3 is 1.331, and so on. We carry
those factors to column C of Table 15–3.1. Now we multiply the $500,000 in column B times the
factor for each year to arrive at the cumulative inflated amount in column D. Thus $500,000 times
the year 2 factor of 1.210 equals $605,000, and so on.
Currency Measures
Monetary unit measurement, and the related currency measures and currency conversions, are
typically beyond most manager’s responsibilities. Nevertheless, it is important for the manager to
understand that consistency in applying such measures and conversions will be a significant factor
in expressing financial results of companies that have global operations.
Therefore, for comparative purposes we must determine if all the information being prepared or under review is measured by the same monetary unit. A few foreign currency examples
are illustrated in Exhibit 15–1. Currencies are typically converted for financial reporting purposes using the U.S.-dollar foreign exchange rates as of a certain date.
Exchange rates may be expressed in two ways: “in U.S. dollars” or “per U.S. dollars.” For
example, assume the euro is trading at 1.3333 in U.S. dollars and at 0.7500 per U.S. dollars.
That means if you were spending your U.S. dollar in, say, France (part of the “euro area”), it
would take a third as much (1.33) in your dollars to buy products priced in euros. If your French
friend, on the other hand, was spending euros for products priced in U.S. dollars, he or she
Making Data Comparable 169
Exhibit 15–1 Foreign Currency Examples
Country (or Area) Currency
Canada Canadian dollar
China Yuan
Euro Area Euro
Japan Yen
Mexico Peso
United Kingdom Pound
Table 15–3 Applying a Cumulative Inflation Factor
Table 15–3.1
SOURCE OF FACTOR IN COLUMN C BELOW:
From the Compound Interest Look-Up Table
“The Future Amount of $1.00” (Appendix 13-B)
Year Factors as shown at 10%
1 1.100
2 1.210
3 1.331
4 1.464
Table 15–3.2
(A) (B) (C) (D)
Real Cumulative Nominal
Year Dollars Inflation Factor* Dollars**
1 $500,000 (1.10)1 5 1.100 $550,000
2 500,000 (1.10) 2 5 1.210 605,000
3 500,000 (1.10) 3 5 1.331 665,500
4 500,000 (1.10)4 5 1.464 732,050
*Assume an annual inflation rate of 10%. Thus 1.00 + 0.10 = the 1.10 factor in Column C.
**Column D “Nominal Dollars” equals Column B times Column C.
could buy one-quarter more for his or her money (because the U.S. dollar would be worth only
three quarters [0.7500] of the euro at that particular exchange rate).
Standardized Measures
A final word about standardized measures. Standardized measures aid comparability. They
especially assist in performance measurement. Types of standardized measures include the typical hospital per-bed measure along with work load measures.
170 Chapter 15 Using Comparative Data
There is, of course, a whole array of uses for standardized measures. Managed care plans, for
example, may use a standard set of measures that are applied to every physician who contracts with
the plan. Each physician then receives a report from the plan that illustrates his or her performance.
Finally, electronic medical records (as further discussed in following chapters) depend upon
standardized input. The input into various fields is standardized (and thus made comparable)
by the very nature of the electronic system design.
CONSTRUCTING CHARTS TO SHOW THE DATA
Managers use charts to explain their projects and to report their results. Thus constructing
accurate and effective charts is a valuable skill.
Types of Charts
There are four basic chart styles as follows:
• Column chart
• Pie chart
• Bar chart
• Line chart
The column chart’s data is presented in vertical columns. The pie chart is typically circular
(like a pie, thus its name). The bar chart presents data in horizontal bars. The line chart generally uses multiple lines that track along a grid. Figures 15-7, 15-8, and 15-9 illustrate examples of
the pie chart, bar chart, and line chart respectively.
Distribution of DRG 0xx Cases by Physician
Quarter Ending 12/31/xx
MD1
MD 23 cases 5
25 cases
MD2
62 cases
MD3
12 cases
MD4
14 cases
Figure 15–7 Distribution of DRG 0xx Cases by Physician.
Modified from R. Hankins & J.J. Baker, Management Accounting for Health Care Organizations (Sudbury, MA: Jones &
Bartlett 2004). p. 375.
Constructing Charts to Show the Data 171
9,000
8,000
7,000
6,000
5,000
Cost (in $) 4,000
3,000
2,000
1,000
0
MD 1 MD 2
Med/Surg cost ICCU cost Ancillary cost Total cost
Physician
MD 3 M MD 4 D 5
Cost per Case by Physician for DRG 0xx
Quarter Ending 12/31/xx
Figure 15–8 Cost per Case by Physician for DRG 0xx.
Modified from R. Hankins & J.J. Baker, Management Accounting for Health Care Organizations (Sudbury, MA: Jones &
Bartlett 2004). p. 376.
Chart Content and Format
Constructing the chart means answering a series of questions about content and format, as
follows:
• What is the subject of the chart?
• What are the specific elements to be included?
• What type of chart will best serve my purpose?
• Is the information accurate and consistent?
• If applicable, is the information comparable?
• What are the dimensions of the chart?
• If applicable, what is the span between high and low?
Chart Templates
A variety of chart templates are now available online. They are generally found within office
suite programs. Each template typically offers a drop-down menu for specifics of the format and
a second drop-down menu for the chart’s data input. Electronic templates also provide quick
and easy color choices for your chart presentation. You can experiment with various colors to
reach the best combination for your project.
172 Chapter 15 Using Comparative Data
To summarize, the chart you construct can be simple or elaborate. It can be black and white
or it can be multi-colored. But whatever its style, your chart must contain accurate and comparable data.
INFORMATION CHECKPOINT
What is needed? Example of a detailed comparative budget review (comparing
budget to actual).
Where is it found? With the supervisor responsible for the budget.
How is it used? To find whether data are stated in comparable terms between
actual amounts and budget amounts.
KEY TERMS
Annualize
Inflation Factor
Monetary Unit
9,000
8,000
7,000
6,000
5,000
Cost (in $) 4,000
3,000
2,000
1,000
0
MD 1 MD 2
Total cost Average cost for DRG 0xx—all physicians
Physician
MD 3 M MD 4 D 5
Cost per Case by Physician for DRG 0xx
Quarter Ending 12/31/xx
Figure 15–9 Total Cost per Case by Physician for DRG 0xx.
Modified from R. Hankins & J.J. Baker, Management Accounting for Health Care Organizations (Sudbury, MA: Jones &
Bartlett 2004). p. 377.
Key Terms 173
DISCUSSION QUESTIONS
1. Do you believe your organization uses a flexible or static budget? Why do you
think so?
2. If you reviewed a budget at your workplace, do you think the major increases and
decreases could be explained? If so, why? If not, why not?
3. Have you ever in the course of your work reviewed a report that had been annualized? If
so, did you agree with how it appeared to be annualized?
4. Were you also able to see the assumptions used to annualize? If so, were you able to recalculate the results using the same assumptions?
5. Have you ever in the course of your work reviewed a financial report that applied inflation factors? If so, were you able to see the assumptions used to apply the factors? If not,
why not? Please describe.
NOTE
1. Merriam Webster’s Collegiate Dictionary, 10th ed., s.v. “Inflation.”
174 Chapter 15 Using Comparative Data
© LFor/Shutterstock
Construct and
Evaluate Budgets
PART
VI

Progress Notes
© LFor/Shutterstock
Operating Budgets
OVERVIEW
A budget is an organization-wide instrument. The
organization’s objectives define the specific activities to be
performed, how they will be assembled, and the particular
levels of operation, whereas the organization’s performance standards or norms set out the anticipated levels
of individual performance. The budget is the instrument
through which activities are quantified in financial terms.
Objectives for the Budgeting Process
A healthcare standard view of budgeting is illustrated by the
American Hospital Association’s (AHA’s) objectives for the
budgeting process:
1. To provide a written expression, in quantitative
terms, of a hospital’s policies and plans.
2. To provide a basis for the evaluation of financial performance in accordance with a hospital’s policies and
plans.
3. To provide a useful tool for the control of costs.
4. To create cost awareness throughout the organization.1
Operating Budgets Versus Capital Expenditure
Budgets
Operating budgets generally deal with actual short-term
revenues and expenses necessary to operate the facility. The
usual period covered is the next year (a 12-month period).
Capital expenditure budgets, on the other hand, may cover
the next year as well, but are linked into a more futuristic
view. Thus, capital expenditure budgets may cover a 5- or
even a 10-year period.
After completing this chapter,
you should be able to
1. Understand the difference
between operating budgets
and capital expenditure
budgets.
2. Understand what budget
expenses will most likely be
identifiable versus allocated
expenses.
3. Understand how to build an
operating budget.
4. Understand the difference
between static and flexible
budgets.
177
16
CHAPTER
BUDGET VIEWPOINTS
Responsibility Centers
In a responsibility center the manager is responsible for a particular set of activities. (We have
discussed responsibility centers in a previous chapter.) In the context of operating budgets there
are two common types of responsibility centers: cost centers and profit centers. As shown in
Figure 16–1, in cost centers the manager is responsible for controlling costs. In profit centers the
manager is responsible for both costs and revenues. Thus, we expect that a cost center operating
budget will show costs only, while a profit center budget should show both revenues and costs.
Transactions Outside the Operating Budget
Certain transactions are outside the operating budget, as shown in Figure 16–2. For example,
many grants received by healthcare organizations are restricted funds. The monies in a
restricted fund are not to be commingled with general operations monies. Also, a restricted
fund generally requires altogether separate accounting and reporting.
Foundation transactions are also outside the operating budget. Foundations are legally separate organizations that require separate accounting and reporting of their funds. Therefore, we
would not expect any of their costs to be included in operations.
Figure 16–1 Two Common Budget Responsibility Centers.
Common Types of Budget Responsibility Centers
Cost
Centers
Manager
responsible for
controlling costs
Manager
responsible for
both costs
and revenue
Profit
Centers
Figure 16–2 Transactions Outside the Operating Budget.
Transactions outside the Operating Budget
Grants
received
by the
organization
Restricted funds
require separate
accounting
Legally separate
organization requires
separate accounting
Foundation
transactions
178 Chapter 16 Operating Budgets
BUDGET BASICS: A REVIEW
A brief review of budget basics is advisable as we move into constructing an operating budget.
Identifiable Versus Allocated Budget Costs
Within a departmental budget, certain costs will be specifically identifiable while others will be
allocated instead, as shown in Figure 16–3:
• Direct patient care and supporting patient care should be mostly identifiable.
• General and administrative expense and patient-related expense will probably be mostly
allocated costs.
• Financial-related expense, such as interest expense, may not be included at all in the manager’s budget.
Fixed Versus Variable Costs
You will recall that fixed costs do not change in total,
even though volume rises or falls (within a wide range).
Variable costs, however, rise or fall in proportion to a
change (a rise or fall) in volume. You will further recall
that volume, in the case of healthcare organizations,
generally means number of procedures (outpatient
services) or number of patient days (inpatient services)
or perhaps, prescriptions filled (pharmacy services).
Figure 16–4 illustrates this principle, while Exhibit 16–1
provides examples of fixed and variable cost categories that would typically be found within an operating
budget.
Figure 16–3 Identified Versus Allocated Costs.
Departmental Operating Budget
General &
Administrative
Expense
Patient
Related
Expense
Mostly
allocated
costs
Financial
Related
Expense
May not
be
included
Direct
Patient Care
Supporting
Patient Care
Mostly
identifiable
costs
Figure 16–4 Fixed Versus Variable Costs.
Fixed Cost
Does not
change even
though
volume rises
or falls within
a wide range
Variable Cost
Rises or falls
in proportion
to a rise or
fall in
volume*
*Examples of volume: Number of procedures or patient days
Budget Basics: A Review 179
BUILDING AN OPERATING BUDGET: PREPARATION
Appropriate preparation is an important stage in building an operating budget. It is often
difficult for the manager to allow adequate time for budget preparation, because this effort
is above and beyond his or her daily responsibilities. Understanding the usual stages, or
sequence, of budget construction as listed here assists in predicting how much time will be
required.
Construction Stages
Operating budget construction stages include the following:
• Plan
• Gather information
• Prepare input
• Construct and submit draft version of budget
• Make required revisions to draft
• Present preliminary budget
• Make required revisions to preliminary budget
• Submit final budget
Input includes both assumptions and calculations; required revisions to the draft version
would occur after upper-level management has reviewed the draft. Additional revisions will typically be required after the preliminary budget has been presented. (The preliminary budget
almost never becomes the final version without some degree of revision.)
Construction Elements
What will your budget look like? Will it follow guidelines from last year, or will it take on a new
form? What will be expected of you, the manager? Understanding the budget construction elements will help you create a budget that is a useful tool.
Exhibit 16–1 Fixed and Variable Cost Examples
Operating Expenses Fixed Variable
Labor
Gross Salaries X
Employers’ Payroll Taxes X
Other Employee Benefits X
Part-Time Temporary Contract Labor X
Other Expenses
Drugs and Medical Supplies X
Rent X
Insurance X
Five-Year Equipment Lease X
180 Chapter 16 Operating Budgets
As part of the preparation process, you should determine the following:
• Format to be used
• Budget scope
• Available resources
• Levels of review
• Time frame
As to format, will templates be available for use? And if so, will they be required? As to budget
scope, will your budget become a segment only, to be combined and consolidated in a later
stage? If this is so, you may lose some of your line items as you lose control of the final product.
Necessary resources made available to you could include, for example, special data processing
runs or extra staff assistance to locate required information. The levels of review, along with how
many versions of the budget will be required, depend upon the structure and expectations of
the particular healthcare organization. And the time frame should be adequate.
BUILDING AN OPERATING BUDGET: CONSTRUCTION
Budget information sources, assumptions, and computations are all vital to proper operating
budget construction.
Budget Information Sources
Three primary sources of operating budget information are illustrated in Figure 16–5. They
include the Operating Revenue Forecast and the Staffing Plan or Forecast, along with a plan
or forecast of other operating expenses. As Figure 16–1 illustrated earlier in this chapter, the
manager who is responsible for both costs and revenues would require the revenue forecast. If,
however, the manager is responsible only for costs (and not for revenues), the revenue forecast
would not become part of his or her responsibility.
When the preliminary operating budget is under construction, the capacity-level checkpoints (discussed in a previous chapter) should also be taken into consideration. (This step may
be undertaken at a different level and thus may not be your own responsibility.)
Figure 16–5 Operating Budget Inputs.
Capacity Level Checkpoints
Other Operating Expenses
Staffing Plan or Forecast
Operating Revenue Forecast
Operating
Expenditures
Plan
Preliminary
Operating
Budget
Budget Assumptions and Computations
Budget assumptions and computations are somewhat intertwined.
Building an Operating Budget: Construction 181
Assumptions
Building a budget means making a series of
assumptions. The budget process should
begin with a review of strategy and objectives.
Forecasting workload is a critical part of
building a budget. The workload should tie
into expected volume for the new budget
period. Good information is necessary to forecast workload. For example, Table 16–1 presents total nursing hours by unit. But there is
not enough detail in this report to use because
it does not indicate, among other things,
hours by type of staff and/or staff level. Sufficient information at the proper level of detail
is essential in creating a budget.
Another critical assumption in building a budget is whether special projects are going to use
resources during the new budget period. Still another factor to consider is whether operations
are going to be placed under some type of unusual or inconvenient circumstances during the
new budget period. A good example would be renovation of the work area.
Computations
Computations should be supported by their assumptions and should be replicable; that
is, another individual should be able to reproduce your computations when using the same
assumptions. Computations must also be comparable; that is, the same type of computation
must be used by each unit or each department. Thus, when the departmental budgets are combined, they will all be stated on the same basis.
An example of computations that must be comparable is contained in Figure 16–6. Recall
information about preparation of the Staffing Forecast (an input to the operating budget),
which has been described in the preceding chapter about staffing. Now costs must be attached
to the forecast for budget purposes. As shown in Figure 16–6, the forecast should first contain annual FTEs and Total Paid Days Required. When cost is attached to the cost of Annual
Paid Days Required, that cost should include Gross Salaries and Employee Benefit Costs. If
Table 16–1 Nursing Hours Report
Unit Nursing Hours
No. Description Regular Overtime
620 S-MED-SURG DIV 5 72,509 6,042
630 N-MED-SURG DIV B 40,248 3,354
640 N-MED SURG DIV D 42,182 3,515
645 N-INTENSIVE CARE
UNIT 55,952 4,663
655 S-INTENSIVE CARE
UNIT 52,000 4,333
660 S-SURG ICU 21,840 1,820
665 S-STEPDOWN 52,208 4,351
Figure 16–6 Staffing Money in the Operating Budget.
Staffing
Forecast
Staffing Money
in the Operating
Budget
Attach Cost of
Number of Annual
Paid Days
Required
Includes
annualized
FTEs and
total paid
days per year
Includes Gross
Salaries +
Employee
Benefit Costs
=
182 Chapter 16 Operating Budgets
one department defines total employee benefit cost one way and another department defines
it more broadly, then the resulting combined budget’s staffing dollars will not have been computed on a comparable basis. That budget will be flawed.
Finalize and Implement the Budget
The final budget is approved for use after multiple reviews and adjustments of the preliminary
budget drafts. The final step is then to implement the new budget. It is important to explain the
contents to all involved personnel. It may also be necessary to provide training for new report
formats or similar issues.
WORKING WITH STATIC BUDGETS AND FLEXIBLE BUDGETS
Both static budgets and flexible budgets can be useful tools if wielded by a manager who understands both their strengths and their weaknesses.
Definitions and Uses
Definitions and uses of the static budget and the flexible budget are included in this section.
Static Budget
A static budget is essentially based on a single level of operations. After a static budget has been
approved and finalized, that single level of operations (volume) is never adjusted. Budgets are
measured by how they differ from actual results. Thus, a variance is the difference between
an actual result and a budgeted amount when the budgeted amount is a financial variable
reported by the accounting system. The variance may or may not be a standard amount, and it
may or may not be a benchmark amount.2
The computation of a static budget variance only requires one calculation, as follows:
Actual 2 Static Budget = Static Budget
Results Amount Variance
The basic thing to understand is that static budgeted expense amounts never change, when
volume actually changes during the year. In the case of health care, we can use patient days as
an example of level of volume, or output. Assume that the budget anticipated 400,000 patient
days this year (patient days equating to output of service delivery; thus, 400,000 output units).
Further assume that the revenue was budgeted for the expected 400,000 patient days and that
the expenses were also budgeted at an appropriate level for the expected 400,000 patient days.
Now assume that only 360,000, or 90%, of the patient days are going to actually be achieved for
the year. The budgeted revenues and expenses still reflect the original expectation of 400,000
patient days. This example is a static budget; it is geared toward only one level of activity, and the
original level of activity remains constant or static.
Static budgets may be used to plan. When utilized in this way, these budget figures represent
a goal for the budget period. Table 16–2 illustrates this concept. The table shows a goal of 100
Working with Static Budgets and Flexible Budgets 183
procedures to be performed during the budget period, along with the revenues and expenses
that support that goal.
Flexible Budget
A flexible budget is one that is created using budgeted revenue and/or budgeted cost amounts.
A flexible budget is adjusted, or flexed, to the actual level of output achieved (or perhaps
expected to be achieved) during the budget period.3 A flexible budget thus looks toward a
range of activity or volume (versus only one level in the static budget).
Flexible budgets became important to health care when diagnosis-related groups (DRGs)
were established in hospitals in the 1980s. The development of a flexible budget requires more
time and effort than does the development of a static budget. If the organization is budgeting
with workload standards, for example, the static budget projects expenses at a single normative level of workload activity, whereas the flexible budget projects expenses at various levels of
workload activity.4
The concept of the flexible budget addresses workloads, control, and planning. The budget checklists contained in Appendix 16–A are especially applicable to the flexible budget
approach.
To build a flexible budget that looks toward a range of volume, or activity, instead of a single
static amount, one must first determine the relevant range of volume, or activity:
• Thus, the outer limits of fluctuations are determined by defining the relevant range.
• Next, one must analyze the patterns of the costs expected to occur during the budget
period.
• Third, one must separate the costs by behavior (fixed or variable).
Finally, one can prepare the flexible budget—a budget capable of projecting what costs will be
incurred at different levels of volume, or activity.
Flexible budgets can readily be used to review the prior performance of the unit, the
department, or the organization. When utilized for this purpose, these budget figures will typically include the volume range (for example, a range of number of procedures or number of
patient days) discussed above. Table 16–3 illustrates this concept. The table shows a volume range
of 50, 100, and 150 procedures to be performed during the budget period, along with the perprocedure assumptions for revenues and variable expense plus the total fixed expenses that
would accompany these procedures.
Table 16–2 Static Budget: Can Be Used to Plan (a Goal)
Static Budget
Assumptions per Static Budget
Procedure Totals
# Procedures Performed 100
Net Revenue ($200 @) $200 per procedure = $20,000
Expenses [various] 15,000
Operating Income $5,000
Note: Dollar amounts shown for illustration only.
184 Chapter 16 Operating Budgets
Examples
Examples of both static budgets and flexible budgets appear in this section.
Static Budget Example
A static budget example for an open imaging center appears in Table 16–4. The net revenue is
computed using a dollar amount per procedure ($400) multiplied by the budgeted total number of procedures performed (1,000 procedures). The total expenses are derived from a variety
of sources.
Flexible Budget Example
A flexible budget example for an infusion center located within a physician practice appears
in Table 16–5. The table shows a volume range of 64, 80, and 96 procedures to be performed
Table 16–3 Flexible Budget—Used to Review Prior Performance
(1) (2) (3) (4)
Flexible Budget
Assumptions per Range of #s of Procedures
Procedure (Volume Range)
# Procedures Performed 50 100 150
Net Revenue $200 per procedure = $10,000 $20,000 $30,000
Variable Expense $150 per procedure = 7,500 15,000 22,500
Fixed Expense [fixed total amount] 1,500 1,500 1,500
Total Expense $9,000 $17,500 $24,000
Operating Income $1,000 $3,500 $6,000
Note: Dollar amounts shown for illustration only.
Table 16–4 Static Budget Example for an Open Imaging Center
Static Budget
Assumptions per Static Budget
Procedure Totals
# Procedures Performed 1,000
Net Revenue $400 per procedure = $400,000
Expenses
Salaries & Employee Benefits [various] $150,000
Supplies [various] 25,000
Insurance—General [various] 5,000
Insurance—Malpractice [various] 10,000
Depreciation—Building [various] 50,000
Depreciation—Equipment [various] 100,000
Total Expenses $340,000
Operating Income $60,000
Note: Dollar amounts shown for illustration only.
Working with Static Budgets and Flexible Budgets 185
during the budget period, along with the per-procedure assumptions for revenues and variable
expense, plus the total fixed expenses that would accompany these procedures.
BUDGET CONSTRUCTION SUMMARY
There is no one right way to prepare an operating budget. The budget construction depends
on factors such as the organizational structure, the reporting system, the manager’s scope of
responsibility and controllable costs, and so on. Exhibit 16–2 sets out a series of questions and
steps to undertake when commencing to build a budget.
It is also important to note that the budget for operations is usually part of an overall, or comprehensive, financial budget. Responsibility for the comprehensive financial budget always rests
with upper-level financial officers of the organization and is beyond the scope of this chapter.
BUDGET REVIEW
The questions discussed in constructing a budget also serve to evaluate an existing budget. Issues
of valid and replicable assumptions and comparability are especially essential. Comparative
Exhibit 16–2 Checklist for Building a Budget
1. What is the proposed volume for the new budget period?
2. What is the appropriate inflow (revenues) and outflow (cost of services delivered)
relationship?
3. What will the appropriate dollar cost be?
(Note: this question requires a series of assumptions about the nature of the operation for the new budget period.)
3a. Forecast service-related workload.
3b. Forecast non-service-related workload.
3c. Forecast special project workload if applicable.
3d. Coordinate assumptions for proportionate share of interdepartmental projects.
4. Will additional resources be available?
5. Will this budget accomplish the appropriate managerial objectives for the organization?
Table 16–5 Flexible Budget Example for Infusion Center Within a Physician Practice
(1) (2) (3) (4)
Flexible Budget
Assumptions per Range of #s of Infusions
Procedure (Volume Range)
# Procedures Performed 64 80 96
Net Revenue $2,250 per infusion = $144,000 $180,000 $216,000
Variable Expense $1,500 per infusion = 96,000 120,000 144,000
Fixed Expense [fixed total amount] 40,000 40,000 40,000
Total Expense $136,000 $160,000 $184,000
Operating Income $8,000 $20,000 $32,000
Note: Dollar amounts shown for illustration only.
186 Chapter 16 Operating Budgets
INFORMATION CHECKPOINT
What is needed? Example of variance analysis performed on a budget.
Where is it found? Probably with the supervisor who is responsible for the
budget.
How is it used? To see what type of budget it is and to see how it is constructed.
KEY TERMS
Capital Expenditures Budget
Flexible Budget
Operating Budget
Responsibility Center
Static Budget
DISCUSSION QUESTIONS
1. Do you believe your organization uses one or more operating budgets? Why do you
think so?
2. Do you believe your organization uses a flexible or a static budget? Why do you
think so?
Exhibit 16–3 Checklist for Reviewing a Budget
1. Is this budget static (not adjusted for volume) or flexible (adjusted for volume
during the year)?
2. Are the figures designated as fixed or variable?
3. Is the budget for a defined unit of authority?
4. Are the line items within the budget all expenses (and revenues, if applicable) that
are controllable by the manager?
5. Is the format of the budget comparable with that of previous periods so that several
reports over time can be compared if so desired?
6. Are actual and budget for the same period?
7. Are the figures annualized?
8. Test one line-item calculation. Is the math for the dollar difference computed correctly? Is the percentage properly computed based on a percentage of the budget
figure?
analysis, as examined in the preceding chapter, is an important skill to acquire. Exhibit 16–3
sets out a series of questions and steps to undertake when commencing to review and evaluate
a budget.
Discussion Questions 187
3. If you reviewed a budget at your workplace, do you think the major increases and
decreases could be explained?
4. If so, why? If not, why not?
NOTES
1. W. O. Cleverly, Essentials of Health Care Finance, 4th ed. (Gaithersburg, MD: Aspen Publishers, Inc., 1997).
2. C. Horngren et al., Cost Accounting: A Managerial Emphasis, 9th ed. (Englewood Cliffs, NJ:
Prentice Hall, 1998), 227.
3. Ibid., 228.
4. J. R. Pearson et al., “The Flexible Budget Process—A Tool for Cost Containment,” A. J. C.
P., 84, no. 2 (1985): 202–208.
188 Chapter 16 Operating Budgets
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BACKGROUND
This section provides background on how the budget uses diagnosis-related groups (DRGs) and
relative value units (RVUs).
Diagnosis-Related Groups
Diagnosis-related groups (DRGs) were developed in the early 1970s by Yale University to
describe all types of patient care provided in an acute care hospital.1 They form a patient classification system that can be used for several purposes, including planning and budgeting. This
system is an efficient way to measure case mix and it facilitates comparisons with other hospitals.
Specifically, price-per-case or episodes-of-care reimbursement is intended to represent the
resource intensity of hospital care utilized by patients who are classified in the specific DRG.
Thus, the case-mix methodology utilized to assign inpatients to DRGs assumes that the resources
used during their hospital stay will vary directly with length of stay.2 As a reimbursement system,
the DRG assignment ultimately determines the payment level that the hospital will receive. Yet
DRG reimbursement adds to the complexity of preparing an annual budget because the volume and mix of patients to be treated during the rate year is not always clear.
Relative Value Units
Relative Value Units (RVUs) are central to creating the DRG budget for respiratory care. They are
used to measure resource consumption as a method of budgeting or the resources consumed by
each product. RVUs are mistakenly thought to measure productivity. Every physician within a practice consumes resources, and RVUs therefore measure their resource consumption. RVUs may
also be thought of as a measurement of time and effort put in by a physician. Therefore, the value
of RVUs is in costing or accurately measuring consumption of resources.
How This Budget Uses DRGs and RVUs
The patient classification system of DRGs is used in this case to classify patients as to their overall
diagnosis grouping (thus DRG 190-192 for COPD, as below). Treatments are administered in
APPENDIX
16-A Creating a DRG
Budget for Respiratory
Care: The Resource
Consumption
Approach
189
the hospital’s outpatient Respiratory Care Department. Therefore, ICD-10-CM codes (International Classification of Diseases, 10th Revision, Clinical Modifications) are used to identify
their actual diagnosis for treatment within the department (thus ICD-10-CM J44.1 = chronic
bronchitis and J44.2 = emphysema as below).
In computing projected expenses, RVUs provide the number of minutes-per-treatment and
the computation method required in order to measure resource consumption. (Thus, volume
for each treatment is converted into RVUs by using minutes-per-treatment.) Departmental
expense totals can then be converted to expense per RVU for three categories: labor, supplies,
and overhead. (Gross revenues for this budget are computed using established charges as below.
Gross revenues are then adjusted by a percentage [“rate”] for each type of payer.)
A DRG BUDGET FOR RESPIRATORY CARE
The hospital’s outpatient Respiratory Care Department has been reorganized in response to the
increased incidence of DRG 190-192: Chronic Obstructive Pulmonary Disease (COPD). COPD
is a progressive disease without a cure, so that the staff’s main function will be to manage symptoms. COPD ICD-10 codes include J44.1 for chronic bronchitis and J44.2 for emphysema. This
year there were 620 admissions to the department. Treatments ranged from medication administration (65%), which takes 10 minutes; oxygen therapy (24%), which takes 30 minutes; and
bronchodilator administration (11%), which takes 15 minutes per treatment. The charges established by the Controller in consultation with the Chief Financial Officer are $61 per medication
administration, $310 per oxygen therapy treatment, and $85 per bronchodilator application.
Step 1: Project Volumes
(a) Calculate the current volume for each treatment.
Treatment Admissions Volume
Medication Administration 620 × .65 403
Oxygen Therapy 620 × .24 149
Bronchodilators 620 × .11 68
Total 620
(b) Convert the current volumes to RVUs.
Treatment Minutes Minutes/GCD* RVUs/Procedure Volume Total RVUs
Medication Administration 10 10/5 2 403 806
Oxygen Therapy 30 30/5 6 149 894
Bronchodilators 15 15/5 3 68 204
Total 620 1,904
*GCD = Greatest Common Denominator (equals 5)
(c) Calculate the projected volume for each treatment
With the expectation of a 6.2% increase in DRG 190-192 for the following year (620 × .062), the
department can anticipate an increase of 38 admissions, or 658 total.
190 Chapter 16 Operating Budgets
Treatment Admissions Volume
Medication Administration 658 × .65 428
Oxygen Therapy 658 × .24 158
Bronchodilators 658 × .11 72
Total 658
(d) Convert the projected volumes to RVUs
Treatment Minutes Minutes/GCD RVUs/Procedure Volume Total RVUs
Medication Administration 10 10/5 2 428 856
Oxygen Therapy 30 30/5 6 158 948
Bronchodilators 15 15/5 3 72 216
Total 658 2,020
Step 2: Convert Projected Volumes into Projected Revenues
Calculate the projected gross and net revenues by payer; in this example, COPD generally has
been an affliction of the elderly, so we are very interested in the projected and gross revenues
by Medicare, which covers 82% of our patients. (Note: Medicaid covers 13% of patients, and
self-pay patients equal 5%.)
Medicare
Treatment Projected Charge Projected Volume % Gross Revenue Rate* Net Revenue
Medication Admin. 61 428 .82 21,409 .80 17,127
Oxygen Therapy 310 158 .82 40,164 .80 32,131
Bronchodilators 85 72 .82 5,018 .80 4,014
Total 658 66,591 53,272
Note that Projected Charge, Gross Revenue, and Net Revenue are expressed in dollars.
*The DRG rate is 80% of charges.
Medicaid
Treatment Projected Charge Projected Volume % Gross Revenue Rate* Net Revenue
Medication Admin. 61 428 .13 3,394 .83 2,817
Oxygen Therapy 310 158 .13 6,367 .83 5,285
Bronchodilators 85 72 .13 796 .83 661
Total 658 10,557 8,763
Note that Projected Charge, Gross Revenue, and Net Revenue are expressed in dollars.
*The DRG rate is 83% of charges.
A DRG Budget for Respiratory Care 191
Self Pay
Treatment Projected Charge Projected Volume % Gross Revenue Rate* Net Revenue
Medication Admin. 61 428 .05 1,305 .93 1,214
Oxygen Therapy 310 158 .05 2,449 .93 2,278
Bronchodilators 85 72 .05 306 .93 285
Total 658 4,060 3,777
Note that Projected Charge, Gross Revenue, and Net Revenue are expressed in dollars.
*The Self-Pay rate is 93% because 7% don’t pay their bills.
Projected total revenue = $65,812 (53,272 + 8,763 + 3,777 = 65,812)
Step 3: Convert Projected Volumes into Projected Expenses
(a) Calculate current expenses per RVU
DRG 190-192 accounts for 35% of labor, supply, and overhead departmental expenses. The
OPD Respiratory Care Department’s labor expenses are $179,385, supply expenses are
$135,670, and overhead expenses are $286,770.
$179,383 × .35 = 62,784/1,904* = $32.97 labor expense/RVU
$135,670 × .35 = 47,485/1,904 = $24.94 supply expense/RVU
$286,770 × .35 = 100,370/1,904 = $52.72 overhead expense/RVU
(*1904 = Total RVUs)
(b) Calculate projected expenses per RVU for next year
Labor expenses are projected to increase 3% = 32.97 + .99 = 33.96
Supply expenses are projected to increase 5% = 24.94 + 1.25 = 26.19
Overhead expenses are not expected to increase = 52.72 + 0 = 52.72
Total $112.87
(c) Calculate projected expenses per treatment
Treatment Projected RVUs Projected Expense/RVU Total Projected Expense
Medication Admin. 856 $112.87 $96,617
Oxygen Therapy 948 112.87 107,001
Bronchodilators 216 112.87 24,380
Total 2020 $227,998
Step 4: Determine Profit/Loss
Net Revenues $65,812
Projected Expenses 227,998
Loss $162,186
192 Chapter 16 Operating Budgets
Next Steps
In the context of the hospital’s overall financial well being, the projected loss is untenable.
What strategies can help to mitigate the impact? Can expenses be reduced? Can revenue collection strategies be enhanced by adding more profitable treatments? Is the staffing level
optimal? Can we continue the service at a loss by having other profitable services subsidizing
Respiratory Care?
NOTES
1. J. A. Bielby, “Evolution of DRGs (2010 update),” Journal of the American Health Information Management Association, April 2010, http://library.ahima.org/doc?oid=106590#
.V7txWq46HE8
2. P. L. Grimaldi and J. A. Richardson, Diagnosis Related Groups: A Practitioner’s Guide
(Chicago: Pluribus Press, 1983).
Notes 193

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THE COMPARATIVE REPORT TO REVIEW
The following report provides figures for the Memorial Hospital’s Operating Room and Recovery Room.
Memorial Hospital Operating Budget
For the Fiscal Year October 1, 20xx to September 30, 20xx
Operating Room
Account # Item Actual Budget Variance %Variance
1010-020 RN Salaries 470,640 470,640 (10,930) (2.3)
1010-030 LPN Salaries 44,685 44,685 (3,451) (7.8)
1010-040 Other Nursing Salaries 68,390 56,937 11,453 20.1
1010-200 OR Supplies-Req. 54,350 57,162 (2,812) (4.9)
1010-220 Supplies-Direct Purchase 3,833 3,540 293 8.3
1010-221 Instruments 50,727 52,310 (1,583) (3.0)
1010-245 Uniform Expense 628 410 218 53.2
1010-605 Periodicals & Books 670 750 (80) (10.7)
1010-610 Employee Education 4,720 4,192 528 12.6
1010-620 Maintenance 6,387 5,940 447 7.6
1010-730 Purchased Maintenance 9,366 8,550 816 9.5
1010-740 Purchased Service 864 864 0 —
Recovery Room
1012-020 RN Salaries 173,527 174,807 (1,280) (0.7)%
1012-040 Other Nursing Salaries 26,155 21,617 4,538 21.0
1012-200 Recovery Room Supplies-Req. 10,114 12,375 (2,261) (18.3)
1012-213 Minor Equipment 422 422 0 —
1012-220 Supplies-Direct Purchase 482 295 187 63.4
1012-610 Employee Education 125 63 62 98.4
1012-620 Maintenance 1,037 758 279 36.8
1012-730 Purchased Maintenance 438 310 128 41.3
Note: Actual, Budget, and Variance are reported in dollars. Data in parentheses () represent negative values.
APPENDIX
16-B Reviewing a
Comparative Operating Budget Report
195
CHECKLIST QUESTIONS AND ANSWERS FOR THE COMPARATIVE BUDGET
REVIEW
1. Q. Is this budget static (not adjusted for volume) or flexible (adjusted for volume during
the year?
A. This budget should be flexible insofar as surgical volume is characterized by variation
because of elective surgery versus unplanned (emergency) surgery.
2. Q. Are the figures designated as fixed or variable?
A. The figures should be designated as fixed and variable (see Variance column).
3. Q. Is the budget for a defined unit of authority?
A. The budgets are for two interrelated units of authority: the operating and recovery
rooms, which fall under the aegis of the Department of Surgery.
4. Q. Are the line items within the budget all expenses (and revenues, if applicable) that
are controllable by the manager?
A. The line items are not all controllable by the manager; see Other Nursing Salaries,
Supplies, and Maintenance data, for example.
5. Q. Is the format of the budget comparable with that of previous periods so that several
reports over time can be compared if so desired?
A. The format is comparable. For example, one may compare fiscal year 2018 with 2017
and 2016.
6. Q. Are the actual and budget for the same period?
A. The actual and budget are for the same period.
7. Q. Are the figures annualized?
A. The figures are annualized.
8. Q. Test one line-item calculation. Is the math for the dollar difference computed correctly? Is the percentage properly computed based on a percentage of the budget
figure?
A. The calculations are properly computed. Note, for example, “Other Nursing Salaries”
in the operating room. The comparison of Actual versus Budget produces a variance
that is the most obvious and of the greatest magnitude and significance given the
importance of that line item. As a manager, you have to ask: What are the possible
causes of the variation?
Higher-than-budgeted Other Nursing Salaries may be comprised of per diems,
nurses’ aides, and certified nurse anesthetists (CNAs), the negative variance of which
may be attributed to a higher-than-normal absentee rate (nurse burnout) and/or
excessive demand.
9. Q. How are the “percent variance” figures calculated?
A. Using Account #1010-020, Operating Room RN Nursing Salaries, the variance of
($10,930) is divided by the budgeted amount of $470,640, resulting in a +2.3% variance expressed as a percent.
Likewise, for Account #1010-040, Other Nursing Salaries, the variance of $11,453
is divided by the budgeted amount of $56,937, resulting in a 220.1% variance
expressed as a percent.
196 Chapter 16 Operating Budgets
Progress Notes
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Capital
Expenditure
Budgets
OVERVIEW
Capital expenditures involve the acquisition of assets
that are long lasting, such as equipment, buildings, and
land. Therefore, capital expenditure budgets are usually
intended to plan, monitor, and control long-term financial issues. Decisions must be made about the future use of
funds in order to complete these types of budgets.
Operations budgets, on the other hand, generally deal
with actual short-term revenues and expenses necessary to
operate the facility. For example, the Great Shores Health
System’s operations budgets may usually be created to cover
the next year only (a 12-month period), while Great Shores1
capital expenditure budgets may be created to cover a
5-year span (a 60-month period) or even a 10-year span.
It is also important to note that the budget for capital
expenditures is usually part of an overall, or comprehensive, financial budget. Responsibility for the comprehensive financial budget always rests with upper-level financial
officers of the organization and is beyond the scope of this
chapter.
CREATING THE CAPITAL EXPENDITURE
BUDGET
The capital expenditure budget, which may sometimes
be identified by another name, such as “capital spending
plan,” usually consists of two parts. The first part of the budget represents spending for capital assets that have already
been acquired and are in place. This spending protects an
existing asset; you are essentially spending in order to protect that which you already have. The second part of the
budget represents spending for new capital assets. In this
After completing this chapter,
you should be able to
1. Recognize the reason that a
capital expenditure budget is
necessary.
2. Review the cash flow and the
startup cost concept.
3. Understand differences
between cash flow reporting
methods.
4. Recognize types of capital
expenditure budget
proposals.
5. Understand about evaluating
capital expenditure
proposals.
197
17
CHAPTER
case, you will be expending capital funds to acquire new assets such as equipment, buildings,
and land.
The “existing asset” part of the budget forces planning questions about whether existing
equipment and buildings should be kept in their present condition (which can involve repair
and maintenance expenses), renovated, or replaced. Renovating equipment or buildings
implies a large expenditure that would be capitalized. (To be capitalized means the expenditure would be placed on the balance sheet as an additional capital cost that is recognized as an
asset.)
The “new capital asset” part of the budget forces more planning questions. In this case, the
questions are about new assets. The reasons for new asset spending may involve the following:
• Expansion of capacity in a department or program
• Creation of a new facility, department, or program
• New equipment to improve productivity
• New equipment or space to comply with federal or state requirements
It should also be noted that acquiring new assets results in additional capital costs that will be
placed on the balance sheet as assets. For more information, refer to the chapter about assets,
liabilities, and net worth.
BUDGET CONSTRUCTION TOOLS
How the capital expenditure budget is constructed may be predetermined by requirements of
the organization. Your facility or practice may have a template that must be used. This takes the
decision out of your hands. Otherwise, you will have to decide which tool will be most effective
to build your capital expenditure budget.
One important tool is net cash flow reporting. The concept of cash flow analysis, usually an
important part of the capital expenditure budget, is described later. But how will the cash flow
be reported? Four methods are discussed in this section.
Cash Flow Concept
As its title implies, a cash flow analysis illustrates how the project’s cash is expected to move over
a period of time. Many analyses concentrate only on the cash expenditure for the equipment.
(This is, after all, a “capital expenditure” budget.) Other analyses, however, will also take revenue earned into account.
In any case, it is always important to report the net cash flow. While most line items will
usually be expenditures, called cash outflow, sometimes there will also be cash receipts, called
cash inflow. For example, if a new piece of equipment will replace an old one, and the old
replaced equipment will be sold for cash, the cash received from the sale will represent a cash
receipt.
Cash flow must also be reported as cumulative. This means the accumulated effect of
cash inflows and cash outflows must be added and/or subtracted to show the overall net
accumulated result. In our example mentioned previously: where the old equipment might
be sold, the cumulative cash flow is illustrated in Table 17–1. As you can see, the initial
expenditure or cash spent (outflow) is decreased by the cash received (inflow) to produce a
net cumulative result.
198 Chapter 17 Capital Expenditure Budgets
Cash Flow Reporting Methods
Cash flow is typically reported using one of four methods. They include the following:
• Payback method
• Accounting rate of return
• Net present value
• Internal rate of return
A previous chapter of this book has explained and illustrated each of the four methods.
Their advantages and disadvantages, for purposes of capital expenditure budgeting, are summarized later.
Payback Method
The payback method is based on cash flow. This method recognizes the cash flows that are
necessary to recover the initial cash invested. The payback method is advantageous because it is
easy to understand and highlights risks. However, it does not take either profitability or the time
value of money into account.
Accounting Rate of Return
The accounting rate of return is based on profitability. However, it does not take the time value
of money into account.
Net Present Value
Net present value, or NPV, is a discounted cash flow method. It is based on cash flows in that it
takes all the cash (incoming and outgoing) into account over the life of the equipment (or, if
applicable, over the life of the relevant project). Although the NPV is based on cash flows, it also
takes profitability and the time value of money into account.
Internal Rate of Return
Internal rate of return, or IRR, is also a discounted cash flow method that takes all incoming
and outgoing cash into account over the life of the equipment (or the project). It also takes
profitability and the time value of money into account.
The use of net present value, the internal rate of return, and so forth, is the vocabulary
of capital budgeting. It is also an important part of the language of finance. Therefore, it is
important to understand the differences between the four methods. Review the chapter about
the time value of money for more detail. Appendix 17-A at the end of this chapter presents a
step-by-step method for net present value computation that assists in this understanding.
Table 17–1 lllustration of Cumulative Cash Flow
Line Cash Spent Cash Received Cumulative
Number (Outflow) (Inflow) Cash Flow
1 Buy new equipment (50,000) — (50,000)
2 Sell old equipment that is being
replaced — +6,000 (44,000)
Budget Construction Tools 199
Budget Inputs
Capital expenditure budget inputs may have to be taken into consideration if the operating
budget requires additional capital equipment or space renovations. Figure 17–1 illustrates these
potential inputs.
Startup Cost Concept
If the proposal for capital expenditures incorporates operational expenses, the concept of
startup costs must also be taken into consideration. In these cases, management believes the
cost of starting up a new service line or a new program should be included as part of the original
investment. Although such operational costs do not fall into a strict definition of capital expenditure budgeting, the requirement is common enough to warrant discussion.
FUNDING REQUESTS
This section discusses the process of requesting capital expenditure funds and the types of proposals that might be submitted for consideration.
The Process of Requesting Capital Expenditure Funds
Different departments or divisions often have to compete for capital expenditure funding. The
hospital’s radiology department director may want new equipment, but so does the surgery
department director, and so on. The various requests for funding are often collected and subjected to a review process in order to make decisions about where, and to whom, the available
capital expenditure funds will go. While the upper levels of management make overall decisions
about future use of funds, the departmental funding requests represent the first step in the
overall process.
The process involved for capital expenditure funding requests varies according to the organization. Size plays a part. Due to its sheer size, we would expect a giant hospital to have a more
Figure 17–1 Capital Expenditures Budget Inputs.
Additional
Equipment
Required
Additional
Space or
Renovation of
Existing Space
Required
Operating Revenue Forecast
&
Staffing Plan
&
Capacity Level Checkpoint
No
Estimated
Capital Money
Required
Capital
Expenditures
Plan
Preliminary
Capital
Expenditures
Budget
Estimated
Capital Money
Required
Yes
No Yes
200 Chapter 17 Capital Expenditure Budgets
complex process than, say, a two-physician practice. The corporate culture of the organization
plays a part, too. Some organizations are extremely structured, while others are more flexible in
their management principles. And in some facilities, politics may also play a part in the process
of making and reviewing funding requests.
Types of Capital Expenditure Proposals
The type of proposal affects its size and scope. Proposal types commonly include the following
types of requests:
• Acquiring new equipment
• Upgrading existing equipment
• Replacing existing equipment with new equipment
• Funding new programs
• Funding expansion of existing programs
• Acquiring capital assets for future use
Certain of these types may sometimes be paired as either/or choices in capital expenditure
proposals. All six types of proposals are discussed in this section.
Acquiring New Equipment
The reason why new equipment is needed must be clearly stated. The acquisition cost must be a
reasonable figure that contains all appropriate specifications. The number of years of useful life
that can be reasonably expected from the equipment is also an important assumption.
Upgrading Existing Equipment
The reason why an upgrade is necessary must be clearly stated. What is the impact? What will
the outcomes be from the upgrade? The upgrade costs must be a reasonable figure that also
contains all appropriate specifications. Will the upgrade extend the useful life of the equipment? If so, by how long?
Replacing Existing Equipment with New Equipment
The rationale for replacing existing equipment with new equipment must be clearly stated.
Often a comparison may be made between upgrading and replacement in order to make a more
compelling argument. The usual arguments in these comparisons revolve around improvements in technology in the new equipment that are more advanced than available upgrades to
the old equipment. A favorite argument in favor of the new equipment is increased productivity
and/or outcomes.
Funding New Programs
A proposal for new program capital expenditures must take startup costs into account. This type
of proposal will generally be more extensive than a straightforward equipment replacement
proposal because it involves a new venture without a previous history or proven outcomes.
Funding Expansion of Existing Programs
A proposal for expansion of an existing program is generally easier to prepare than a proposal
for a new program. You will have statistics available from the existing program with which to
Funding Requests 201
make your arguments. In addition, any startup costs should be negligible for the existing program. The most difficult selling point may be comparison with other departments’ funding
requests.
Acquiring Capital Assets for Future Use
This type of proposal may be the most difficult to accomplish. Capital expenditures for future
long-term use are often postponed by decision makers in cash-strapped organizations who
must first fulfill immediate demands for funding. Consider, for example, a metropolitan hospital that is hemmed in on all sides by privately owned property. The hospital will clearly need
expansion space in the future. An adjacent privately owned property comes on the market at
a price less than its appraised value. Even though the expansion is not scheduled until several
years in the future, it would be wise to seriously consider this acquisition of a capital asset for
future use.
EVALUATING CAPITAL EXPENDITURE PROPOSALS
Management planning must involve the allocation of available financial resources for projects
that promise to reap returns in the future. This applies to both for-profit and not-for-profit
organizations.
Hard Choices: Rationing Available Capital
Most businesses, including those providing healthcare services and products, have only a limited amount of capital available for purposes of capital expenditure. It usually becomes necessary, then, to ration the available capital funds. Different organizations approach the rationing
process in different ways. However, most organizations will consider the following factors in
some fashion or other:
• Necessity for the request
• Cost of capital to the organization
• Return that could be realized on alternative investments
These three factors will probably be considered in a descending sequence of decision making. The overriding question is necessity. Necessity for the request pertains to the criticality of
the need. What are the basic reasons for contemplating the capital expenditure? Are these reasons necessary? If so, how necessary?
While necessity is an overarching consideration, the cost of capital to the organization for
the proposed capital expenditure is a computation of the sort we have previously discussed in
this section. Although the answer to “what is the cost of capital” is provided in the form of a
computation, the amount of the answer depends on the method selected to illustrate this cost.
The third element in management’s decision-making sequence is what return could be realized on alternative investments of the available capital. This concept is known as “opportunity
cost.” The term is appropriate. Assume a rationing situation where unlimited funds are not
available. Thus, when a choice is made to expend funds on capital project A, an opportunity is
lost to expend those same funds on project B or project C. The choice of A thus costs the opportunity to gain benefits from B or C.
202 Chapter 17 Capital Expenditure Budgets
To summarize, the decision makers must apply judgment in making all these choices. Thus, the
rationing of available capital becomes somewhat of a management art as well as a science.
The Review and Evaluation Process
The degree of attention paid to evaluation and the level of management responsible for making
the decisions may be dictated by the overall availability of capital funding and by the amount of
funds requested. Evaluation of capital expenditure budget proposals may be objective or subjective. An impartial review process is most desirable.
An objective method usually involves scoring and/or ranking the competing proposals. In
scoring, the basic approach generally focuses on a single proposal and evaluates it on a fixed
set of criteria. In ranking, the proposal is compared with other proposals and ranked in accordance with a looser set of criteria.
The objective review and evaluation may actually first involve scoring to eliminate the very
low-scoring proposals. The remaining higher scoring proposals may then be ranked in accordance with still another set of criteria.
The criteria may, in turn, contain quantitative items such as outcomes and/or productivity
and may also contain qualitative items such as whether the proposal is in accordance with the
organization’s core mission.
Finally, some authorities believe the source of financing the project (whether it is internal or
external, for example) should not be relevant to the investment decision. Real-world management, however, has a different view. How the project will be financed may be their first question
in the review and evaluation process.
INFORMATION CHECKPOINT
What is needed? An example of an entire capital expenditure budget or a capital
expenditure proposal for a particular project or a specific
piece of equipment.
Where is it found? Probably with your manager or the director of your department
or, depending on the dollar amount proposed, perhaps
with someone in the finance department.
How is it used? The use would probably be one time. Can you tell if this is so?
KEY TERMS
Accounting Rate of Return
Capital Budget
Capitalized Asset
Cash Flow Analysis
Cumulative Cash Flow
Internal Rate of Return
Net Present Value
Key Terms 203
Operations Budget
Opportunity Cost
Payback Method
Unadjusted Rate of Return
DISCUSSION QUESTIONS
1. Have you ever been involved in helping to create any part of a capital expenditure
budget?
2. If so, which type of proposal was it? Was the proposal successful?
3. Do you recall whether any of the four cash flow reporting methods were used? If so,
which one? Do you now think that was the best choice for the particular proposal?
4. If you were assigned to prepare a capital expenditure budget request, what two people
would you most want to have on your team? Why? How would you expect to use them?
NOTE
1. S. A. Finkler, “Flexible Budget Variance Analysis Extended to Patient Acuity and DRGs,”
Health Care Management Review, 10, no. 4 (1985): 21–34.
204 Chapter 17 Capital Expenditure Budgets
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A Further
Discussion of
Capital Budgeting
Methods
17-A
This appendix presents a further discussion of the four methods of capital budgeting computations presented in this chapter.
ASSUMPTIONS
Item: Assume the purchase of a new piece of laboratory equipment is proposed.
Cost: The laboratory equipment will cost $70,000.
Useful life: It will last five years.
Remaining value (salvage value): The lab equipment will be sold for $10,000 (its salvage value)
at the end of the five years.
Cost of capital: The estimated cost of capital for the hospital is 10%.
Cash flow: The addition of this new piece of equipment is expected to generate additional revenue. In fact, the increase of revenue over expenses is expected to amount to $20,000 per year
for the five years. The cash flow is therefore expected to be as follows: Year 0 5 ($70,000); year
1 5 $20,000; year 2 5 $20,000; year 3 5 $20,000; year 4 5 $20,000; year 5 5 $20,000. Note that
year 0 is a negative figure and years 1 through 5 are positive figures.
PAYBACK METHOD
The payback method calculates how many periods are needed to recover the equipment’s initial investment of $70,000. In this case, the periods to be counted are years; thus, there are five
years, or five periods as shown in Table 17-A–1.
The investment of $70,000 is recovered
halfway between year 3 and year 4, when the
remaining balance to be recovered equals
zero. Therefore, the payback period is three
and one-half years, expressed as 3.5 years.
Commentary: The payback method recognizes the cash flows that are necessary to
recover the initial cash invested. The payback
method is advantageous because it is easy to
APPENDIX
Table 17-A–1 Payback Method Input
Year Cash Flow Balance
0 (70,000) (70,000)
1 20,000 (50,000)
2 20,000 (30,000)
3 20,000 (10,000)
4 20,000 10,000
5 20,000 30,000
205
understand and highlights risks. However, it does not take either profitability or the time value
of money into account.
UNADJUSTED RATE OF RETURN (AKA ACCOUNTANT’S RATE OF RETURN)
The unadjusted, or accountant’s, rate of return is based on averages. The average
accounting income is divided by the average level of investment to arrive at the accounting
rate of return. Step 1 computes the average accounting income, Step 2 computes the average
level of investment, and Step 3 then calculates the accounting rate of return.
Step 1: In this example, the average accounting income is calculated by deducting depreciation
(a non-cash amount) from the annual cash flow.
Step 1.1: First, we must calculate the annual depreciation amount. In this example the
depreciation is computed on a straight-line basis, which means the total amount of depreciation will equal the equipment’s cost minus its salvage value.
The equipment’s cost is $70,000 and its salvage value at the end of its five-year life is estimated
to be $10,000. Therefore, the total amount to be depreciated is the difference, or $60,000. To
arrive at annual depreciation, the $60,000 is divided by the number of years of useful life, which
is five years in this example. Therefore, the annual amount of depreciation is $60,000 divided
by five years, or $12,000 per year.
Step 1.2: Next, we must use the depreciation amount to calculate the accounting income per
year. In this example, the accounting income represents the cash flow per year of $20,000 as
previously computed less the depreciation expense per year of $12,000. The remaining balance
net of depreciation is $8,000 as shown in Table 17-A–2.
Step 2: In this example, the average level of investment is determined by calculating the average
investment represented by the equipment. We determine the average investment by computing
its midpoint as follows:
Step 2.1: Determine the total investment by adding the initial investment of $70,000 and the salvage value of $10,000, for a total of $80,000.
Step 2.2: Now divide the total investment of $80,000 by 2. The answer of $40,000 indicates the
midpoint of the investment and is considered the average investment over the five-year period
of its useful life.
Step 3: The unadjusted or accounting rate of return is now calculated by dividing the average
income (Step 1) by the average investment (Step 2). In this example, the unadjusted or accounting rate of return amounts to $80,000 average
income divided by $40,000 average investment,
or a 20% rate of return.
Commentary: While the accounting rate of
return is based on profitability, it does not
take the time value of money into account.
That is why it is known as the “unadjusted”
rate of return. This method is used by many
capital expenditure budget decision makers.
Table 17-A–2 Accounting Income Input
Less Balance Net of
Year Cash Flow Depreciation Depreciation
1 20,000 12,000 8,000
2 20,000 12,000 8,000
3 20,000 12,000 8,000
4 20,000 12,000 8,000
5 20,000 12,000 8,000
206 Chapter 17 Capital Expenditure Budgets
NET PRESENT VALUE
Net present value, or NPV, is a discounted cash flow method. It is based on cash flows in that
it takes all the cash (incoming and outgoing) into account over the life of the equipment.
Table 17-A–3 shows the individual steps involved in the computation as follows:
Step 1: Enter the net cash flow on the table. (For this example, the net cash flow has already
been calculated; see the middle column of Table 17-A–1. Also enter the salvage value.)
Step 2: Determine the cost of capital (which is 10% in this example). Look up the present value factor for 10% for each period. Also, include the present value factor for the salvage value.
Step 3: Multiply the present value factor for each period times the period’s net cash flow.
Step 4: Compute the net present value by first adding the present value answers for each operating period (Years 1 through 5 plus the salvage value) and then by subtracting the initial cash
expenditure of $70,000 in Year 0 from the sum of the present value computations. In this example, $70,000 is subtracted from a total of $81,980 to arrive at the net present value of $11,980 as
shown in Table 17-A–3.
Commentary: Net present value takes all the cash (incoming and outgoing) into account over
the life of the equipment. Even though the net present value is based on cash flow, it also takes
profitability and the time value of money into account.
INTERNAL RATE OF RETURN
Internal rate of return, or IRR, computes the actual rate of return that is expected, or assumed,
from an investment. The internal rate of return reflects the discount rate at which the investment’s net present value equals zero.
The IRR computation will be compared against the cost of capital. In our example the cost of
capital is 10%, as set out in our initial assumptions.
The IRR seeks the rate of return that allows the net present value of the project to equal zero.
The IRR expresses the rate of return that the organization can expect to earn when investing in
the equipment (or the project, as the case may be).
The actual rate of return is determined by trial and error. The authorities say to “guess” and
work forward from your initial guess. An easier method to arrive at IRR is to use a business calculator or a computer program and let it perform the computation for you. It is cumbersome,
but possible, to arrive at the appropriate IRR by hand. An example follows.
Table 17-A–3 Net Present Value Computations
Salvage
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Value
Net Cash Flow (70,000) 20,000 20,000 20,000 20,000 20,000 10,000
Present value factor
(10% cost of capital) n/a 0.909 0.826 0.751 0.683 0.620 0.620
Present value answers (70,000) 18,180 16,520 15,020 13,660 12,400 6,200
Net present value = 11,980
Internal Rate of Return 207
This example solves for an initial investment of $70,000 and a positive cash flow of $20,000
per year for five years. Because the annual amount of $20,000 is the same for each of the five
years, we can use the “Present Value of an Annuity of $1” presented in Appendix 13-C for this
purpose.
The computation is approached in two steps as follows:
Step 1: Initial investment ($70,000) divided by the annual net cash inflow ($20,000) equals
the annuity present value (PV) factor for five periods. We compute 70,000 divided by 20,000
and arrive at a PV factor of 3.5.
Step 2: Now we refer to Appendix 13-C, the “Present Value of an Annuity of $1.” We look
across the “5” row (because that is the number of periods in our example). We are looking for
the column that most closely resembles our PV factor of 3.5. On our table we find 3.605 in the
12% column and 3.433 in the 14% column. Obviously 3.5 will fall somewhere between these
amounts. To find what 15% would be, we add the 3.605 to the 3.433 and divide by 2. The answer
is 3.519 (3.605 1 3.433 5 7.038; 7.038 divided by 2 5 3.519). Thus we have found, by trial and
error, that the rate of return in our example is approximately 15%.
As we have previously stated, an easier method to arrive at IRR is to use a business calculator
or a computer program and let it perform the computation for you. The business calculator or
computer program will quickly give you a precise answer.
Many capital expenditure budget proposals also compare the rate of return to the
organization’s cost of capital. In our example, the cost of capital is 10%, so the 15% IRR is
clearly greater.
Commentary: Internal rate of return is also a discounted cash flow method that takes all incoming and outgoing cash into account over the life of the equipment (or the project). It, too, takes
profitability and the time value of money into account.
208 Chapter 17 Capital Expenditure Budgets
© LFor/Shutterstock
Tools to Plan,
Monitor, and
Control Financial
Status
PART
VII

Progress Notes
© LFor/Shutterstock
Variance Analysis and Sensitivity Analysis
VARIANCE ANALYSIS OVERVIEW
A variance is, basically, the difference between standard
and actual prices and quantities. Variance analysis analyzes
these differences. This discussion assumes a flexible budget prepared in accordance with the steps described in the
chapters about budgeting.
Flexible budgeting variance analysis was conceived by
industry and subsequently discovered by health care. It provides a method to get more information about the composition of departmental expenses.
THREE TYPES OF FLEXIBLE BUDGET
VARIANCE
The method subdivides total variance into three types.
Volume Variance
The volume variance is the portion of the overall variance
caused by a difference between the expected workload
and the actual workload and is calculated as the difference
between the total budgeted cost based on a predetermined,
expected workload level and the amount that would have
been budgeted had the actual workload been known in
advance.1
Quantity (or Use) Variance
The quantity variance is also known as the use variance or
the efficiency variance. It is the portion of the overall variance that is caused by a difference between the budgeted
and actual quantity of input needed per unit of output, and
After completing this chapter,
you should be able to
1. Understand the three types of
flexible budget variance.
2. Perform budget variance.
3. Compute a contribution
margin.
4. Perform sensitivity analysis.
211
18
CHAPTER
is calculated as the difference between the actual quantity of inputs used per unit of output
multiplied by the actual output level and the budgeted unit price.
Price (or Spending) Variance
The price variance is also known as the spending or rate variance. This variance is the portion
of the overall variance caused by a difference between the actual and expected price of an input
and is calculated as the difference between the actual and budgeted unit price, or hourly rate,
multiplied by the actual quantity of goods, or labor, consumed per unit of output, and by the
actual output level.
TWO-VARIANCE ANALYSIS AND THREE-VARIANCE ANALYSIS COMPARED
Variance analysis can be performed as a two- or a three-variance analysis. (There is also a fivevariance analysis that is beyond the scope of this discussion.) The two-variance analysis involves
the volume variance as compared with budgeted costs (defined as standard hours for actual
production). The three-variance analysis involves the three types of variances defined above.
Figure 18–1 illustrates these elements.
Composition Compared
The makeup of the two-variance analysis is compared with the three-variance analysis in
Figure 18–2. As is shown, two elements (A and B) remain the same in both methods. The third
element (C) is a single amount in the two-variance method but splits into two amounts (C-1 and
C-2) in the three-variance method.
Computation Compared
Actual computation is illustrated in Figure 18–3 for two-variance analysis and Figure 18–4
for three-variance analysis. The A, B, C, C-1, and C-2 designations are carried forward from
Figure 18–2. In Figure 18–3, the two-variance calculation is illustrated, and a proof total
computation is supplied at the bottom of the illustration. In Figure 18–4, the three-variance
Figure 18–1 Elements of Variance Analysis.
Elements of
Three-Variance Analysis
1 Volume Variance
(Activity Variance)
2 Quantity Variance
(Use Variance, Efficiency
Variance)
3 Price Variance
(Spending Variance, Rate Variance)
Elements of
Two-Variance Analysis
1 Volume Variance
(Activity Variance)
2 Budget Variance
212 Chapter 18 Variance Analysis and Sensitivity Analysis
calculation is likewise illustrated, and a proof total computation is also supplied at the bottom
of the illustration. This set of three illustrations deserves study. If the manager understands the
concept presented here, then he or she understands the theory of variance analysis.
Different Names for the Three Variable Cost Elements
Another oddity in variance analysis that contributes to confusion is this: all three variable cost
elements—that is, direct materials, direct labor, and variable overhead—can have a price variance and a quantity variance computed. But the variance is not known by the same name in all
instances. Exhibit 18–1 sets out the different names. Even though the names differ, the calculation for all three is the same. Note, too, that variance analysis is primarily a matter of input–output
analysis. The inputs represent actual quantities of direct materials, direct labor, and variable
overhead used. The outputs represent the services or products delivered (e.g., produced) for
Figure 18–2 Composition of Two- and Three-Variance Analysis.
Composition of
Two-Variance Analysis
A = Actual Cost Incurred
B = Applied Cost
C = Budgeted Costs
(computed as standard hours
for actual production)
Composition of
Three-Variance Analysis
A = Actual Cost Incurred
B = Applied Cost
C-1 = Budgeted Costs
(computed as actual hours
for actual production)
C-2 = Budgeted Costs
(computed as standard
hours for actual production)
Figure 18–3 A Calculation of Two-Variance Analysis.
#1 A Actual Cost Incurred less C Budgeted Costs (computed as
standard hours for actual production)
#2 B Applied Cost less C Budgeted Costs (computed as
standard hours for actual production)
Total
Variance
(equals
both, either
combined
or netted)
Variance
Note: To obtain proof total, perform the following calculation:
A, Actual Cost Incurred, less B, Applied Cost = Total Variance
Two-Variance Analysis and Three-Variance Analysis Compared 213
the applicable time period, expressed in terms of standard quantity (in the case of materials) or
of standard hours (in the case of labor). In other words, the standard quantity or standard hours
equates to what should have been used (the standard) rather than what was actually used. This
is an important point to remember.
THREE EXAMPLES OF VARIANCE ANALYSIS
This section provides three useful examples of variance analysis. The Hospital Rehab Services
example is a flexible budget with all the variances expressed in Therapy Minutes (TMs). (Therapy
Minutes thus serve as uniform units of measure regarding rehab services.) One of the two examples that follow it is a static budget variance analysis, and the other is a flexible budget example—
both are carried forward from examples originating in the chapter about operating budgets.
Example 1: Hospital Rehab Services Variance Analysis
An example of variance analysis in a hospital system is given in Exhibit 18–2. It deals with price or
spending variance and quantity or use variance. The price variance is expressed in Therapy Minutes (TMs). The quantity variance is broken out into four subtypes—physical, occupation, speech,
Exhibit 18–1 Different Names for Materials, Labor, and Overhead Variances
Price or Spending Variance = Materials Price Variance [for direct materials]
Price or Spending Variance = Labor Rate Variance [for direct labor]
Price or Spending Variance = Overhead Spending Variance [for variable overhead]
Figure 18–4 Calculation of Three-Variance Analysis.
#1 A Actual Cost Incurred less C-1 Budgeted Costs
(computed as actual
hours for actual production)
#2 B Applied Cost less C-2 Budgeted Costs
(computed as standard
hours for actual production)
#3 C-1 Budgeted Costs
(computed as actual
hours for actual production)
less C-2 Budgeted Costs
(computed as standard
hours for actual production)
Total
Variance
(equals
both, either
combined
or netted)
Variance
Note: To obtain proof total, perform the following calculation:
A, Actual Cost Incurred, less B, Applied Cost = Total Variance
214 Chapter 18 Variance Analysis and Sensitivity Analysis
and recreational therapy—all of which are expressed in Therapy Minutes. Finally, it is assumed
that the budgeted activity level is equal to the standard activity level for purposes of this example.
The flexible budget calculation ($990,000) is based on actual quantity. When the $990,000
is compared with the actual cost of $920,000 for this activity center, a favorable price variance
of $70,000 is realized. When the $990,000 is compared with the budgeted cost of $937,500 for
this activity center, an unfavorable quantity variance of ($52,500) is realized. Exhibit 18–2 also
illustrates the computation of a net proof total amounting to $17,500.
Example 2: Static Budget Variance Analysis for an Open Imaging Center
An example of static budget variance analysis for an open imaging center is given in Table 18–1.
As shown, the static budget’s number of procedures performed totaled 1,000, while the actual
number totaled 1,100. The revenue per procedure is $400 for both budget and actual. The net
revenue variance is favorable in the amount of $40,000 ($440,000 less $400,000).
Exhibit 18–2 Variance Analysis for Hospital Rehab Services
Actual Cost _________ $920,000 (1)
[(3) 330,000 TM 3 (5) $2.79 per TM]
Flexible Budget _________ $990,000
(w/actual quantity as basis)
[(3) 330,000 TM 3 (6) $3.00 per TM]
Budgeted Cost ______ $937,500 (2)
[(4) 312,500 TM 3 (6) $3.00 per TM]
Price
Variance
$70,000
(favorable)
Quantity
Variance
($52,500)
(unfavorable)
KEY TO ASSUMPTIONS
Division: Rehab Services
(Physical, Occupational, Speech, and Recreational Therapy)
Cost Driver: Therapy Minutes (TM)
Overhead
Cost divided by # Therapy Minutes
(Activity Level) equals Cost per
Therapy Minute
Actual (1) $920,000 (3) 330,000 (5) $2.79
Budgeted (2) $937,500 (4) 312,500 (6) $3.00
Computation Proof Totals
Budgeted Cost $937,500 less Actual Cost $920,000 5 1$17,500
versus
Favorable Price Variance $70,000 less Unfavorable Quantity Variance ($52,500) 5 1$17,500
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Three Examples of Variance Analysis 215
The salaries and employee benefits expense line item exceeded budget by an unfavorable
balance of $20,000. Likewise, the supplies expense line item exceeded budget by an unfavorable balance of $15,000. The remaining expenses did not vary; thus the total expense variance
is an unfavorable $35,000. The operating income variance equals a favorable $5,000 (the net
difference between $40,000 favorable and $35,000 unfavorable).
Example 3: Flexible Budget Variance Analysis for an Infusion Center Within
a Physician Practice
An example of flexible budget variance using different terminology is given for an infusion
center within a physician practice in Table 18–2. Assumptions for revenue, variable expense,
and fixed expense are set out below the table itself. An explanation of the computations in
Table 18–2 follows.
As to Line 1, Number of Procedures:
Line 1 presents the number of planned procedures (80) and the number of actual procedures
(96). Thus the procedures sales volume difference is 16 (96 less 80), and is favorable.
As to Line 2, Net Revenue:
1. Eighty planned budget procedures at $2,250 revenue apiece totals line 2 column E
$180,000, while 96 actual procedures at $2,250 apiece totals line 2 column C $216,000.
2. The sales volume difference in column D totals $36,000 ($216,000 less $180,000).
3. To prove this figure, multiply the excess 16 procedures at the top of column D times
$2,250 apiece equals the $36,000.
As to Line 3, Variable Expense:
1. The budgeted variable expense for drugs was $1,500 per procedure. Thus, 80 planned
budget procedures times $1,500 drug expense apiece totals line 3 column E $120,000.
Table 18–1 Static Budget Variance Analysis for an Open Imaging Center
Actual Static Static Budget
Amounts Incurred Budget Totals Variance
# Procedures Performed 1,100 1,000 —
Net Revenue ($400/procedure) $440,000 $400,000 $40,000 F
Expenses
Salaries & Employee Benefits $170,000 $150,000 $20,000 U
Supplies 40,000 25,000 15,000 U
Insurance—General 5,000 5,000 -0-
Insurance—Malpractice 10,000 10,000 -0-
Depreciation—Building 50,000 50,000 -0-
Depreciation—Equipment 100,000 100,000 -0-
Total Expenses $375,000 $340,000 $35,000 U
Operating Income $65,000 $60,000 $5,000 F
Key: “F” = “Favorable” variance, while “U” = “Unfavorable” variance.
Note: Dollar amounts shown for illustration only.
216 Chapter 18 Variance Analysis and Sensitivity Analysis
The 96 actual procedures times the planned budget expense of $1,500 apiece totals line
3 column C $144,000. The 96 actual procedures times the actual increased variable drug
expense of $1,575 apiece totals line 3 column A $151,200.
2. The total variable expense difference is $31,200 (line 3 column A $151,200 less line 3
column E $120,000).
3. Of this difference, the sales volume difference is line 3 column D $25,200. It is represented by the 16 extra procedures (96 minus 80 equals the 16 extra) times the $1,575
actual variable expense ($1,575 times 16 equals $25,200).
4. The remaining difference is line 3 column B $6,000. It is represented by the rise in expense
attributed to the 80 planned budget procedures, or line 3 column B 80 procedures times
$75 apiece (the difference between $1,500 and $1,575) equals $6,000. Note that line 3
column B accounts for only the rise in expense for the planned procedures (80), while
line 3 column D accounts for the entire variable expense for the increase in sales volume
of the extra 16 procedures.
5. Proof total is as follows: the column B $6,000 and the column D $25,200 equals the entire
variable expense difference of $31,200 ($151,200 less $120,000 equals $31,200).
As to Line 4, Fixed Expense:
1. The entire $4,000 increase in line 4 fixed expense is attributed to the flexible budget variance, as it does not relate to sales volume.
2. The $4,000 excess expense is an unfavorable variance.
Table 18–2 Flexible Budget Variance Analysis for Infusion Center Within a Physician Practice
(A) (B) (C) (D) (E)
Static
Actual Flexible Flexible Sales Planning
Amounts at Budget Budget for Volume (Master)
Actual Prices Variance Actual Volume Variance Budget
# Procedures
1 Performed 96 — 96 16 F 80
2 Net Revenue $216,000 — $216,000 $36,000 F $180,000
3 Variable Expense $151,200 $6,000 U $144,000 $25,200 U 120,000
4 Fixed Expense 44,000 4,000 U 40,000 — 40,000
5 Total Expense $195,200 $10,000 U $184,000 $25,200 U $160,000
6 Operating Income $20,800 $10,000 U $32,000 $10,800 F $20,000
Flexible Budget Sales Volume
Variance = $11,200 U Variance = $12,000 F
Static Budget Variance = $800 F
Assumptions:
Revenue per procedure = $2,250 per static budget and per actual amounts (no increase).
Variable expense (drugs) = $1,500 per static budget; increase to $1,575 actual amounts.
Fixed expense = $40,000 total per static budget; increase in total to $44,000.
Key: “F” = “Favorable” variance, while “U” = “Unfavorable” variance.
Note: Dollar amounts shown for illustration only.
Three Examples of Variance Analysis 217
As to Line 5, Total Expense:
Total expenses on line 5 represents, of course, the total of variable and fixed expenses.
As to Line 6, Operating Income:
1. The entire operating income variance amounts to a favorable $800 (line 6 column E
static budget of $20,000 minus line 6 column A actual of $20,800 equals $800). The $800
represents the Static Budget Variance.
2. The Flexible Budget Variance equals an unfavorable $11,200 (line 6 column C $32,000
flexible budget for actual volume minus line 6 column A actual $20,800 equals the unfavorable variance of $11,200).
3. The Sales Volume Variance equals a favorable $12,000 (line 6 column C $32,000 less line
6 column E $20,000 equals the favorable variance of $12,000).
4. Proof total is as follows: favorable $12,000 variance less unfavorable variance $11,200
equals the overall static budget variance of $800.
SUMMARY
In closing, when should variances be investigated? Variances will fluctuate within some type of
normal range. The trick is to separate normal randomness from those factors requiring correction. The manager would be well advised to calculate the cost–benefit of performing a variance
analysis before commencing the analysis.
SENSITIVITY ANALYSIS OVERVIEW
Sensitivity analysis is a “what if” proposition. It answers questions about what may happen if
major assumptions change or if certain predicted events do not occur. The “what if” feature
allows the manager to plan for a variety of possibilities in different scenarios.
Forecasts almost always should be subjected to sensitivity analysis. As previously defined, a
forecast is a view of the organization’s future events. Because the future cannot be predicted
with absolute precision, forecasts will always contain a degree of uncertainty. Thus “what if”
analyses become important to the manager’s decision making. For example, “What will the
radiology department’s operating income be if the department’s revenue is 10% greater than
expected?” Or, conversely, “What will the radiology department’s operating income be if the
department’s revenue is 10% less than expected?”
A common example of sensitivity analysis is computing three levels of forecast revenue:
the basic, or most likely level, which is the planned goal; a high (best case) level; and a
low (worst case) level. A chart illustrating this three-level concept for revenue appears in
Figure 18–5.
SENSITIVITY ANALYSIS TOOLS
Manager’s tools involving sensitivity analysis that are described in this section include the contribution margin and the contribution income statement; target operating income using the
contribution margin method; and finding the break-even point using the contribution margin
method.
218 Chapter 18 Variance Analysis and Sensitivity Analysis
Contribution Margin and the Contribution
Income Statement
The contribution income statement specifically
identifies the contribution margin within the
income statement format. You will recall that the
contribution margin is the difference between revenue and variable costs. The remaining difference
is available for fixed costs and operating income.
For example, assume 100 units are sold at
$50 each for a total of $5,000 revenue. Further,
assume variable costs amount to $30 per unit. One
hundred units have been sold, so variable costs
amount to $3,000 (100 times $30/unit 5 $3,000).
The contribution margin equals $2,000 ($5,000
revenue less $3,000 variable costs). (For a further discussion of the contribution margin, refer
to the chapter about cost behavior and break-even analysis.) Now further assume that fixed
costs in this example amount to $1,200. Therefore, the operating income will amount to $800
($2,000 contribution margin less $1,200 equals $800). The format of a contribution margin
income statement will appear as follows:
Revenue $5,000
Variable costs 3,000
Contribution margin $2,000
Fixed costs 1,200
Operating income $800
Target Operating Income Using the Contribution Margin Method
A target operating income computation allows the manager to determine how many units
must be sold in order to yield a particular operating income. We will describe the contribution
margin method of computing target operating income. This method is particularly useful to
the manager because it is easily understood and can be applied in many circumstances. The
formula for the contribution margin method of determining target operating income is as
follows:
N 5 Fixed Costs 1 Target Operating Income
Contribution Margin per Unit
The necessary inputs for this formula include the following:
• Desired (target) operating income amount
• Unit price for sales
• Variable cost per unit
• Total fixed cost
Figure 18–5 Three-Level Revenue Forecast
(Sensitivity Analysis).
Time
Revenue (in dollars)
High Forecast
Basic Forecast
Low Forecast
Sensitivity Analysis Tools 219
Let us consider an example:
• Desired (target) operating income amount 5 $1,600
• Unit price for sales 5 $100
• Variable cost per unit 5 $60
• Total fixed cost 5 $2,000
The contribution margin per unit therefore amounts to $40 ($100 sales price per unit less
$60 variable cost per unit), and the formula will appear as follows:
N 5 $2,000 1 $1,600
$40
$40N 5 $3,600
N 5 $3,600 divided by $40 5 90 units
Therefore: 90 units times $100 unit price for sales 5 $9,000 required revenue.
We can then create a contribution income statement to prove the formula results, as follows:
Revenue $100/unit 3 90 units 5 $9,000
Variable costs $60/unit 3 90 units 5 5,400
Contribution margin $3,600
Fixed costs 2,000
Desired (target) operating income 5 $1,600
In summary, note that this formula is one type of cost-volume-profit (CVP) equation. (For a
further discussion of the CVP concept, refer to the chapter about cost behavior and break-even
analysis.)
Worksheet Example
Julie Smith is the Metropolis Health System’s Director of Community Relations. She has been
informed that the Health System will participate in the first area Wellness Gala, to be held at the
city convention center. The gala is an annual fundraising event in which a variety of nonprofit
organizations each have an opportunity to earn dollars for their cause. Individuals attending the
gala will be prepared to, and are expected to, purchase items from the various booths. Julie’s
boss wants their proceeds to go to the Health System’s auxiliary.
It is now Julie’s responsibility to make the financial arrangements and to coordinate the
Health System’s participation in the event. Last year the booth expense was $1,000, and
Julie uses this figure as her assumption of fixed cost for the coming year’s event. She finds
a local vendor who assembles unique gift baskets. Her wholesale cost per basket will be $30
apiece, if she can place the order within 10 days (otherwise, the cost rises after the 10 days
expires).
Julie believes the gift baskets will sell at the gala for a sales price of $50 apiece. She prepares
a worksheet to determine what dollar amount of sales would be required to earn three ranges
of operating income: $5,000, $6,250, and $7,500. Exhibit 18–3 illustrates Julie’s worksheet. Line
220 Chapter 18 Variance Analysis and Sensitivity Analysis
number 1 contains her first set of assumptions: $1,000 fixed cost for the booth rental and $30
variable cost for each basket.
The convention center representative now e-mails Julie with news: due to a recent renovation of the convention center, booth rental fees have increased. It will cost Julie $1,500 for the
booth. She then adds line 2 to her worksheet with a second set of assumptions: $1,500 fixed
cost for the booth rental and the same $30 variable cost for each basket. She is now prepared to
discuss her findings with her boss.
Break-Even Point Using the Contribution Margin Method
You will recall that the break-even point is the point at which operating revenues and costs
equal each other and operating income is zero. There is a graph method to illustrate the breakeven point (which was previously discussed in the chapter about cost behavior and break-even
analysis). In this sensitivity analysis section, we will describe another method to determine the
break-even point. It is called the “contribution margin method.” The advantage of this method
is its transparency. The manager can easily explain his or her results, because the computations
can be easily seen and understood.
It is understood that operating income is zero at the break-even point. It follows, then, that
the number of units at break-even point can be computed. The formula is as follows:
Break-Even Number of Units 5 Fixed Costs
Contribution Margin per Unit
To compute the contribution margin per unit, subtract the variable costs per unit from the
sales price per unit. In the Target Operating Income formula inputs as previously described,
the sales price per unit was $100 and the variable costs per unit were $60. Thus the contribution
margin per unit is $40 ($100 less $60 equals $40).
Using the same inputs, our break-even formula will now appear as follows:
Break-Even Number of Units 5 $2,000
$40
Thus the break-even number of units will equal $2,000 divided by $40 5 50 units.
Exhibit 18–3 Target Operating Income Worksheet
(A) (B) (C)
Variable At $50 Sales Price per Unit,
Fixed Cost $$ Sales Required to
Cost per Unit Earn Operating Income of:
(1) $1,000 $30 $5,000 $6,250 $7,500
(2) $1,500 $30 $6,250 $7,500 $8,750
Sensitivity Analysis Tools 221
We can create a contribution income statement to prove this formula’s results, as follows:
Revenue $100/unit 3 50 units 5 $5,000
Variable costs $60/unit 3 50 units 5 3,000
Contribution margin $2,000
Fixed costs 2,000
Operating income at break even 5 $-0-
SUMMARY
Sensitivity analysis, in its various forms, is a useful and flexible tool for planning purposes.
INFORMATION CHECKPOINT
What is needed? Example of variance analysis performed on a budget.
Where is it found? Possibly with the supervisor responsible for the budget. More
likely, it will be found in the office of the strategic planner or
financial analyst charged with actually performing the analysis.
How is it used? To find where and how variances have occurred during the
budget period, in order to manage better in the future.
KEY TERMS
Contribution Income Statement
Contribution Margin
Target Operating Income
Three-Variance Method
Two-Variance Method
Variance Analysis
DISCUSSION QUESTIONS
1. Do you believe variance analysis (or a better variance analysis) would be a good idea at
your workplace? If so, why? If not, why not?
2. Are any of the reports you receive in the course of your work ever in a format that includes
a contribution margin? If so, what were the circumstances?
3. Have you ever had to compute target operating income? If so, what were the
circumstances?
NOTE
1. S. A. Finkler, “Flexible Budget Variance Analysis Extended to Patient Acuity and DRGs,”
Health Care Management Review, 10, no. 4 (1985): 21–34.
222 Chapter 18 Variance Analysis and Sensitivity Analysis
Progress Notes
© LFor/Shutterstock
Estimates,
Benchmarking, and Other
Measurement Tools
ESTIMATES OVERVIEW
According to the dictionary, to estimate “… implies a judgment, considered or casual, that precedes or takes the place
of actual measuring or counting or testing out.”1
Such estimates may be of the following:
• amount
• value
• size
The first question should be, “Is it capable of being estimated?” Relying on estimates for input to reports (financial
statements, forecasts, budgets, internal monthly statements,
etc.) means sacrificing some degree of accuracy.
COMMON USES OF ESTIMATES
Using estimates often involves trade-offs, such as gaining a
quick answer that is less accurate. Four common uses of estimates are described here.
Timeliness Considerations
Deadlines may dictate the use of estimates because there
is no time allowed to develop more accurate figures. Some
managers call these “quick and dirty” results. The quick
and dirty estimates may then be followed at a later date by a
more detailed report.
Cost/Benefit Considerations
Estimates may be purposely used instead of a more formal
forecasting process discussed in a preceding chapter. Situations do arise where an estimate is adequate. The manager
After completing this chapter,
you should be able to
1. Understand four common
uses of estimates.
2. Estimate ending inventory.
3. Understand the concept of
financial benchmarking.
4. Understand the use of the
Pareto rule.
5. Compute quartiles for
measurement purposes.
223
19
CHAPTER
may decide upon using estimates instead of proceeding with the more formal forecasting process. After assessing the effort and time involved to gather and prepare a forecast, the manager
will be making a cost–benefit decision; that is, the cost (of forecasting) equivalent to the benefit
(of the more precise information)? Or will estimates adequately serve the purpose? Of course,
this manager’s decision will depend upon the intended purpose.
Lack of Data
Estimates may also be used out of necessity when there is not enough information available to
prepare a full forecast. In this case, there is no choice but to use estimates as an alternative.
Internal Monthly Statements
Estimates may be commonly used in the preparation of short-term financial statements. For
example, the monthly statements that managers receive often contain a number of estimated
figures that are derived from various ratios and percentages. These estimates will probably have
a historical basis because they are typically based on the organization’s prior years’ operating
history. Thus, if bad debts for the last two years averaged 2%, the monthly statements for the
current year may estimate bad debts at the same 2%.
EXAMPLE: ESTIMATING THE ENDING PHARMACY INVENTORY
Certain healthcare organizations (or departments) require accounting for inventory. The most
common example in health care, of course, is the pharmacy. Internal monthly statements of the
pharmacy are not usually expected to reflect the results of an actual physical inventory (unless
your organization has an electronic inventory program—and that is another story). So what to
do? Figure 19–1 illustrates the solution.
The computations contained in Figure 19–1 are described as follows:
1. We first add net drug purchases for the period to the beginning drug inventory, thus arriving at the cost of goods (drugs) available for sale. So far, the steps are the same and the
Figure 19–1 Estimating the Ending Pharmacy Inventory.
Beginning
Drug
Inventory
Net
Drug
Purchases
Estimated
Cost of Goods
(Drugs) Sold
Estimated Ending
Drug
Inventory
Cost of Goods
(Drugs)
Available
for Sale
$$ Sales × Estimated % Cost of Goods Sold = Estimated $$ Cost of Goods Sold
Inventory
Recorded
Purchases
Recorded
Calculated
Estimated
Cost of
Goods Sold
(% of Sales)
Calculated
Estimate
+ = = _
224 Chapter 19 Estimates, Benchmarking, and Other Measurement Tools
result would be the same as that in a preceding chapter, where Figure 9–1 illustrated how
to record inventory.
2. But now we will compute an estimated cost of goods (drugs) sold. To do this:
First, find the amount of net sales (sales after allowances, discounts, rebates, etc.) for
the period.
Then find the percent of net sales that represents cost of goods (drugs) sold in a prior
period. This percentage figure is your estimated assumption and it will probably come
from the last year’s financial report. (For example, $1,000,000 net sales and $800,000 cost
of goods [drugs] sold equals 80% cost of goods sold [drugs] for last year. The 80% is your
estimated assumption for this calculation.)
Apply this estimated assumption to the net sales for the period. (For example, if the
month’s drug sales amounted to $70,000, multiply the $70,000 by 80% to arrive at $56,000
for the estimated cost of goods [drugs] sold this month.)
3. Finally, we will compute the estimated ending drug inventory. We subtract the cost of
goods (drugs) sold (per Step 2 above) from the cost of goods (drugs) available for sale
(per Step 1 above) to arrive at the “Estimated Ending Drug Inventory” for the monthly
internal report.
EXAMPLE: ESTIMATED ECONOMIC IMPACT OF A NEW SPECIALTY
IN A PHYSICIAN PRACTICE
Estimates can be extremely general, or they can reflect considerable judgment, with line-item
detail that has been well thought out. Figure 19–2 illustrates an example of a general estimate
and its subsequent impact.
In this case we have a four-doctor physician practice. The four MDs decide to bring another
doctor into the practice. He is a pulmonary specialist. The county is growing rapidly, economically
Figure 19–2 Estimated Economic Impact of a New Specialist in a Physician Practice.
Estimated
Direct
Nursing Costs
Add one
half-time RN
10% overall
increase
Estimated
Administrative
Indirect Costs
Negative Impact
of
Unrecognized Indirect Costs
Administration
Coder training (new codes)
New super-bill setup
Medical transcription training
Billing training (new codes)
Front office:
Increased patient intake
New Pulmonary Specialist in a Physician Practice
Example: Estimated Economic Impact of a New Specialty in a Physician Practice 225
speaking, and the local hospital has just expanded. The doctors determine there is a sufficient
demand within this growing area to support the services of a pulmonary specialist. They want him
to join their practice, even though they have not previously had such a specialty within this practice.
One morning, the senior doctor asks the practice manager to estimate the expense involved
in adding the pulmonary specialist to the practice. He wants the report for their four o’clock
meeting that afternoon. They must make a decision quickly because the specialist has had
another offer.
The practice manager is trying to close the books for the month, but makes some time to
produce an estimate. The doctors already know the amount that the specialist wants as a guaranteed salary for the first year, and they have already projected what revenue he should produce
for the first year. There is an empty office available that was acquired in the initial lease for purposes of future expansion. Thus, the practice manager needs to estimate the impact on basic
practice operational costs. His “quick and dirty” estimate is in two parts.
Part 1: Add one half-time RN for direct support. Assume existing nursing staff can take up
any slack.
Part 2: Assume an overall 10% increase in practice administration operating costs. He has no
specific basis for the 10% estimate. Instead, he knows that labor is the greatest part of practice
administration costs. As a result of his “back of the envelope” calculation he thinks that administrative staff is not overworked at present and can handle tasks imposed by an additional physician. Since he disregards adding any administrative staff, he feels estimating an overall 10%
increase for administrative expenses of the practice is adequate.
Three months after the pulmonary specialist has arrived and joined the practice, the senior
doctor meets with the practice manager to complain. Operational costs to absorb the new specialist have far exceeded the original estimate. The doctors want an explanation from the practice manager for their meeting the next afternoon.
The practice manager realizes that his estimate did not allow for start-up costs. He composes
a memo explaining that the administrative expenses were impacted by start-up costs such as
coder training for the new pulmonary codes, the consultants’ fees for the new super-bill setup
in the office software, training about pulmonary services for the medical records transcriptionist, and training for the office biller regarding the new codes. He also notes the front office
problems arising from increased patient intake, which had been underestimated. The original
estimates and the negative impact of unrecognized indirect costs are illustrated in Figure 19–2.
OTHER ESTIMATES
Other commonly used computations are actually estimates. The weighted average inventory
method is a good example. Weighted average cost is determined by dividing the cost of goods
available for sale by the number of units available as described in the preceding chapter about
inventory. The resulting average cost of inventory is in fact an estimate.
IMPORTANCE OF A VARIETY OF PERFORMANCE MEASURES
If operations are to be managed most effectively, a variety of performance measures must be in
place for the organization. Generally, a broad variety of such measures are available, and different organizations tend to lean toward using one type over another. One healthcare organization, for example, may rely heavily on one type of measure, whereas another organization may
226 Chapter 19 Estimates, Benchmarking, and Other Measurement Tools
rely on a very different measurement profile. Generally speaking, a wider variety of performance
measures are evident in organizations that have adopted total quality improvement (TQI).
ADJUSTED PERFORMANCE MEASURES OVER TIME
We have previously discussed how measures over time are very effective when evaluating the use of
money. The example given in Figure 19–3 now combines these measures over time with a two-part
case mix adjustment. (Case mix adjustment refers to adjusting for the acuity level of the patient. It
may also refer to the level of resources required to provide care for the patient with the acuity level.)
In this case, the desired measure is cost per discharge. The vertical axis is cost in dollars. The horizontal axis is time, a five-year span in this case. Two lines are plotted: the first is unadjusted for case
mix, and the second is case mix adjusted. The unadjusted line rises over the five-year period. However, when the case mix adjustment is taken into account, the plotted line flattens out over time.
BENCHMARKING
Benchmarking is the continuous process of measuring products, services, and activities against
the best levels of performance. These best levels may be found inside the organization or outside it. Benchmarks are used to measure performance gaps.
There are three types of benchmarks:
1. A financial variable reported in an accounting system
2. A financial variable not reported in an accounting system
3. A nonfinancial variable
How to Benchmark
The benchmarking method is predicated on the assumption that an exemplary process, similar to the process being examined, can be identified and examined to establish criteria for
Figure 19–3 Adjusted Performance Measures over Time.
6,000
5,000
4,000
3,000
2,000
1,000
0
Year 1 Year 2 Year 3 Year 4 Year 5
Case Mix Adjusted
Unadjusted for Case Mix
Cost per Discharge
Cost ($)
Benchmarking 227
excellence. Benchmarking can be accomplished in one of several ways, including (1) studying
the methods and end results of your prime competitors, (2) examining the analogous process
of noncompetitors with a world-class reputation, or (3) analyzing processes within your own
organization (or health system) that are worthy of being emulated. In any of these three cases,
the necessary analysis will rely on one or both of the following methods: parametric analysis or
process analysis. In parametric analysis, the characteristics or attributes of similar services or
products are examined. In process analysis, the process that serves as a standard for comparison
is examined in detail to learn how and why it performs the way it does.
Benchmarking is used for opportunity assessment. Opportunity assessment, used for strategic planning and for process engineering, provides information about the way things should or
possibly could be. Benchmarking is a primary information-gathering approach for opportunity
assessment when it is used in this way.
Benchmarking in Health Care
Financial benchmarking compares financial measures among benchmarking groups. This is
the most common type of “peer group” healthcare benchmarking in use. An example of a
healthcare financial benchmarking report is provided in Table 19–1. The computation of ratios
included in this report has been discussed in preceding chapters. The computation of quartiles
is described later in this chapter.
Statistical benchmarking is a related method of benchmarking. In this case, the statistics of
utilization and service delivery, on which inflow and outflow are based, are compared with those
of certain other hospitals.
Table 19–1 Financial Benchmark Example
Indicator Total Upper Quartile Mid Quartile Low Quartile
No. of hospitals 500.0 105.0 305.0 90.0
Total margin (%) 4.1 11.0 4.5 –6.0
Occupancy (%) 64.5 65.7 64.0 56.1
Deductions from GPR (%) 29.0 28.5 29.2 31.3
Medicare (%GPR) 53.0 55.1 52.2 50.4
Medicaid (%GPR) 10.0 8.4 9.7 13.7
Self pay (%GPR) 7.0 8.5 7.1 6.4
Managed care plans (%GPR)* 16.0 13.0 17.0 17.5
Other third party (%GPR) 14.0 15.0 14.0 12.0
Outpatient revenue (%GPR) 22.0 25.0 21.8 17.7
No. of days in accounts receivable 75.0 70.0 74.0 80.0
Cash flow as a percentage of total debt 30.0 60.0 27.0 –0.5
Long-term debt as a percentage of
total assets 35.0 26.0 36.0 42.0
Change in admissions (2003–2007, %) –7.0 –3.7 –6.3 –15.8
Change in inpatient days (2003–2007, %) –6.0 –1.8 –6.5 –11.1
*Note: Managed care plans other than Title XVIII or Title XIX. All amounts are fictitious.
Reproduced with the permission of Wolters Kluwer Law & Business from J.J. Baker, Activity-Based Costing and Activity-Based Management for Health Care, p. 140, © 1998, Aspen Publishers, Inc.
228 Chapter 19 Estimates, Benchmarking, and Other Measurement Tools
In summary, benchmarking is a comparative method that allows an overview of the individual
organization’s indicators. Objective measurement criteria are always required for best practices
purposes.
ECONOMIC MEASURES
Other performance measures may be made outside the actual confines of the facility. A good
example of a widespread performance measure would be the role of community hospitals in
the performance of local economies. Nonprofit organizations in particular are concerned
about their ability to measure such performance. This case study gives a specific direction for
such measurement efforts.
MEASUREMENT TOOLS
Pareto Analysis
Creating benchmarks, especially in an organization committed to continuous quality
improvement, ultimately leads managers to explore how to improve some step in a process.
Pareto analysis is an analytical tool that employs the Pareto principle and helps in this exploration. Pareto was a 19th-century economist who was a pioneer in applying mathematics to economic theory. His Pareto principle states that 80% of an organization’s problems, for example,
are caused by 20% of the possible causes: thus the “80/20 Rule.”
The usual way to display a Pareto analysis is through the construction of a Pareto diagram. A
Pareto diagram displays the important causes of variation, as reflected in data collected on the
causes of such variation. Figure 19–4 presents an example of a Pareto diagram. This example
reinforces the idea behind the Pareto analysis: that the majority of problems are due to a small
number of identifiable causes.
The chief financial officer of XYZZ Hospital believes that the billing and collection
department is inefficient—or, to be more specific, that the process is probably inefficient. An
activity analysis is conducted. It shows that billing personnel are spending too much time on
unproductive work. This Pareto diagram displays the activities involved in resubmitting denied
bills. (Resubmitting denied bills is an inefficient and nonproductive activity, as we have discussed in a preceding chapter.)
Constructing a Pareto diagram is really simple. The first step is to prepare a table that shows
the activities recorded, the number of times the activities were observed, and the percentage
of the total number of times represented by each count. In Figure 19–4, the total number of
times these activities were observed is 43. The number of times that processing denied bills for
resubmission (coded as PDB) was observed is 22. Thus, 100 (22/43) 5 51%. Similar calculations complete the table. The table of observations is shown in its entirety within the figure.
The Pareto diagram has two vertical axes, the left one corresponding to the “No.” column in
the table, the right one corresponding to the “%” column in the table. On the horizontal axis, the
activities are listed, creating bases of equal length for the rectangles shown in the diagram. The
activities are listed in decreasing order of occurrence. Constructing the diagram in this manner
means that the most frequently observed activity lies on the left extreme of the diagram and the
least frequently observed activity on the right extreme. The heights of the rectangles are drawn to
show the frequencies of the activities, and then the sides of the rectangle are drawn.
Measurement Tools 229
Figure 19–4 Pareto Analysis of Billing Department Data.
40
30
20
10
0
PDB RWS LD CD
Number
Activity No. %
PDB 22 51
RWS 10 23
LD 6 14
CD 5 12
43 100%
Key to Activity Codes
PDB = Process Denied Bills
RWS = Review with Supervisor
LD = Locate Documentation
CD = Copy Documentation
100%
51%
The next step is to locate the cumulative percentage of the activities, using the right-hand
axis. The cumulative percent for the first rectangle, labeled PDB, is 51%. (The calculation of the
51% was previously explained.) For the second rectangle from the left, labeled RWS, the cumulative percentage is 51 1 23 5 74%. The 74% is plotted over the right-hand side of the rectangle
labeled RWS. The next cumulative percentage, for the third rectangle from the left, labeled LD, is
51 1 23 1 14 5 88%. The 88% is plotted over the right-hand side of the rectangle labeled LD. The
last cumulative percentage is, of course, 100% (51 1 23 1 14 1 12 5 100%), and it is plotted over
the right-hand side of the last rectangle on the right, labeled CD.
Now draw straight lines between the plotted cumulative percentages as shown in Figure 19–4.
The next step is to label the axes and add a title to the diagram. In Figure 19–4, the tallest rectangle could be lightly shaded to highlight the most frequent activity, suggesting the one that
may deserve first priority in problem solving.
In general, the activities requiring priority attention—the “vital few”—will appear on the left
of the diagram where the slope of the curve is steepest. Pareto diagrams are often constructed
before and after improvement efforts for comparative purposes. When comparing before and
after, if the improvement measures are effective, either the order of the bars will change or the
curve will be much flatter.
In conclusion, note that many authorities recommend that Pareto analysis take the costs of the
activities into account. The concern is that a very frequent problem may nevertheless imply less
overall cost than a relatively rare but disastrous problem. Also, before basing a Pareto analysis on
frequencies, as this example does, the analyst needs to decide that the seriousness of the problem
is roughly proportional to the frequency. If seriousness fails to satisfy this criterion, then activities
should be measured in some other way. Figure 19–4 underlines the importance of judging the
relevance of the measurements used in a Pareto analysis.
230 Chapter 19 Estimates, Benchmarking, and Other Measurement Tools
Quartile Computation
Reporting by quartiles is an effective way to show ranges of either financial or statistical results.
Quartiles represent a distribution into four classes, each of which contains one-quarter
of the whole. Each of the four classes is a quartile. Quartile computation is not very complicated, although several steps are involved. We can use the outpatient revenue line item in
Table 19–1 to illustrate the computation of quartile data. (Outpatient revenue, expressed
as a percentage of all revenue, is found on the tenth line down from the top in Table 19–1.)
We see from the first line that 500 hospitals were in the group used for benchmarking. The
median is found for the outpatient revenue of the entire group of hospitals. (Most computer
spreadsheet programs offer median computation as an available function.) Then each hospital’s revenue is identified as a percentage of this median. These percentages are arrayed.
In the case of this report, cutoffs were then made to arrange the arrayed percentages into
three groups. The percentages that were between 0 and 25% were designated as the lowquartile group. The percentages that were between 75 and 100% were designated as the
upper-quartile group. The percentages that were between 25 and 75% were designated as the
mid-quartile group.
The average (also known as the arithmetic mean) of each quartile group is then presented
in this report. Thus, the outpatient revenue (expressed as a percentage of gross revenue) for
the upper-quartile group in the report is 25.0; for the mid-quartile group, 21.8; and for the lowquartile group, 17.7. (A grand total of the entire 500 hospitals is also computed and presented
in the left-hand column; the grand total amounts to 22%.) In summary, quartiles are based on
a quantitative method of computation and are an effective way to illustrate a variety of performance measures.
INFORMATION CHECKPOINT
What is needed? An example of estimates, either used in some way in your
work, or published.
Where is it found? In your own files or from a public source.
How is it used? Use the example to examine how the estimate was determined, if possible.
KEY TERMS
Benchmarking
Case Mix Adjusted
Estimates
Pareto Analysis
Performance
Performance Measures
Quartiles
Key Terms 231
DISCUSSION QUESTIONS
1. Have you, in the course of your work, had to estimate items for reports? If so, what type of
items? How did you go about estimating?
2. Does your organization use measurements such as the case mix adjustment over time? If
not, do you believe they should? Why?
3. Does your organization use financial benchmarking? Would you use it if you had a chance
to do so? Why?
NOTE
1. Merriam Webster’s Collegiate Dictionary, 10th ed., s.v. “Estimate.”
232 Chapter 19 Estimates, Benchmarking, and Other Measurement Tools
Progress Notes
© LFor/Shutterstock
CHAPTER
Understanding the
Impact of Data
Analytics and Big
Data
INTRODUCTION
This chapter focuses upon the fast-moving field of data analytics and its impact upon the healthcare industry.
DEFINING DATA ANALYTICS
This section defines data analytics and big data.
What Is Data Analytics?
Data analytics represents the process of examining big data
to uncover hidden patterns, unknown correlations, and
other useful information that can be used to make better
decisions.1
What Are Healthcare Analytics?
Data analytics applied to the healthcare industry is referred
to as healthcare analytics. In addition to helping reveal
and understand historical data patterns, healthcare analytics enables new approaches toward strategic forecasting,
environmental analyses, competitor assessments, needs
assessments, patient-centered care, and improving market
knowledge about population health.
What Is Big Data?
Big data refers to large data sets that an organization
analyzes for patterns or trends.2 In other words, big data
enhances data analytics by applying more sophisticated
analysis techniques, by using new tools, and by sharing
expanded data sets that go beyond traditional claims data
and are obtained from multiple sources.3
After completing this chapter,
you should be able to
1. Define data analytics.
2. Describe healthcare
analytics.
3. Define big data and data
mining.
4. Recognize the differences
among retrospective,
predictive, and prospective
analytics.
5. Understand the impact of
healthcare analytics.
233
20
CHAPTER
Why Is Big Data Different?
Big data typically refers to volumes of data so large that traditional health information technologies and systems can no longer manage or process the information. Also characteristic of big
data is the speed at which data is created and must be processed, as well as the array of different
data sources and formats.
How Is Data Volume Measured?
The basic unit of data measure is the byte, and larger measures are generally expressed in ascending order, beginning with the byte. Thus, 1024 bytes equal one kilobyte (KB); 1024 kilobytes equal
one gigabyte (GB); 1024 gigabytes equals one terabyte (TB); and 1024 terabytes equal one petabyte (PB). The volume measures actually continue upward, as 1024 petabytes equal one exabyte
and so on through zettabytes and even yottabytes. Exhibit 20–1 illustrates these data measure units.
We need to know data volume amounts in order to allow for adequate data storage. While
gigabytes used to be adequate, terabytes are fast becoming the standard for data storage. Such
storage needs will only continue to grow. Consider, for example, Kaiser Permanente: This
health network, with over 9 million members, is believed to have between 26.5 and 44 petabytes
of data from electronic health records (EHRs). (And the data include images and annotations
along with figures.).4 To put such volume into perspective, using a byte converter app we find
that one terabyte equals 1,099,511,627,776 bytes.5 Can you imagine how many bytes are in just
one petabyte? (And KP has not just one, but 44 petabytes.)
However, health care should focus on the relevance of the data rather than the volume of
data collected. Using the data to help reduce costs and improve patient care should be of paramount importance.
What Is Big Data in the Healthcare Industry?
Healthcare industry data are of many types and are derived from many sources. A sampling of
these sources includes the following:
• Physicians’ written notes and prescriptions
• Medical imaging
• Laboratory data
• Pharmacy data
• Insurance and other administrative data
• Patient data in electronic patient
records
• Machine-generated and/or sensor
data, such as from monitoring vital
signs
• Social media posts (Twitter feeds,
blogs, and status updates on
Facebook)
• Website pages
• Information that is non-patient specific (emergency care data, news
feeds, and medical journal articles)6
Really Big Data, Illustrated
1024 Bytes 5 One Kilobyte (KB)
1024 Kilobytes 5 One Megabyte (MB)
1024 Megabytes 5 One Gigabyte (GB)
1024 Gigabytes 5 One Terabyte (TB)
1024 Terabytes 5 One Petabyte (PB)
1024 Petabytes 5 One Exabyte (EB)
Exhibit 20–1 Data Volume Measures
234 Chapter 20 Understanding the Impact of Data Analytics and Big Data
This totality of data related to patient health care and well being make up big data in the healthcare industry. Their appropriate use should lead to better-informed decisions.
TWO BASIC APPROACHES TO DATA ANALYTICS
This section explains two basic approaches to data analytics.
The Retrospective Analytics Approach
Retrospective Analytics identifies trends and problems. It looks at what has already happened
(past actions) and draws empirical conclusions. Thus, retrospective analytics, sometimes called
descriptive analytics, deals with historical information.
The retrospective-analytics approach can readily remove variations and standardize care. It
can be extremely effective in dealing with healthcare tasks such as inventory control or staffing
or billing.7
The Predictive Analytics Approach
The term often refers to the use of predictive analytics (sometimes used interchangeably with
data analytics) or other advanced methods to extract value from data. It does not tell you what
will happen in the future. Instead, it analyses the probability of what is likely to happen in the
future. We can think of the predictive approach as looking forward, while the retrospective
approach looks back. Figure 20–1 illustrates these approaches.
Working with many sets of data enables views of the organization’s operations that are not
possible when examining one set of data at a time. Such analysts are seeking relationships that
exist in the data. Analyzing data sets or using data analytics helps to find relationships that exist
in the data. Finding relationships such as new correlations and business trends, in turn, may
lead to opportunities to improve care, reduce costs, and improve operational performance.
Prospective Analytics: A Subset of Predictive Analytics
Prospective analytics is a decision-making tool that can deliver value by providing evidencebased solutions. The following example highlights the differences among retrospective, predictive, and prospective analytics.
Every year on Amateur Rodeo Night, this particular Emergency Department would get many
more patients—mostly orthopedic patients. Retrospective analytics allowed the hospital to see
Figure 20–1 Two Basic Approaches to Data Analytics.
Data Analytics Approaches
Retrospective Predictive
Two Basic Approaches to Data Analytics 235
how many patients were treated on Rodeo Saturday night compared to the previous 20 or 30
Saturday nights. In other words, retrospective analytics identified the ED’s problem.
Predictive analytics told the hospital what the likelihood was that it would need an increase in
certain services that would be relevant to these emergency room injuries. (Needing, for example, more X-rays, operating rooms, staff, etc.). In other words, predictive analytics anticipated
the problem and allowed future planning.
If, however, prospective analytics had been performed, the hospital could have seen how to
specifically adjust resources for the overload. For example, if the X-ray suites were all full, the
analytics would suggest which cases could have portable X-rays brought to bedside instead of
using the suites. In other words, prospective analytics would have provided possible solutions
to the problem that had been identified by retrospective analytics and anticipated by predictive
analytics.
DATA ANALYTICS AND HEALTHCARE ANALYTICS SERVE MANY PURPOSES
This section provides examples of how data analytics can be used.
Using Predictive Analytics to Answer a Patient Population Question
From a demographic perspective, predictive analytics can help answer a primary question: Who
are the most likely candidates for health services? For example, one hospital learned that their
self-pay population was split equally among men and women, with their ages falling mostly
between 18 and 26 years old, which led to bad debt problems as well as patients who were less
compliant with their care than other age groups. The hospital addressed the issue starting with
incentives to reduce bad debt and putting a program in place in which the patients agreed to
be compliant with their care if the provider helped them pay the cost of their prescriptions.7-8
Using Predictive Analytics in the Human Resources Department
An emerging domain for the application of big data is human resources. The practice of “people analytics” is already transforming how employers hire, fire, and promote.9 The application of predictive analytics to people’s careers is illustrated by the following example. In 2010,
Xerox switched to an online evaluation for job applicants that incorporated personality testing,
cognitive-skill assessment, and multiple-choice questions about how the applicant would handle
specific scenarios that he or she might encounter on the job. An algorithm (a process or set of
rules used in calculations) behind the evaluation analyzed the responses, along with factual
information gleaned from the candidate’s application—as used in conjunction with in-person
interviews.
Using a Combination of Retrospective and Prospective Data Analytics
For example, the use of analytics has allowed hospitals to correlate the patient risk of readmission with the actual readmission rate, the total cost of readmission encounters, and the clinical
drivers of readmissions. Analytics can also provide a financial model that calculates the overall
impact of readmission rate reductions on reimbursement, cost, and value-based purchasing
payments.10
236 Chapter 20 Understanding the Impact of Data Analytics and Big Data
Using a Sophisticated Analytics Approach to Combat Prescription Drug Fraud
Express Scripts, a national pharmacy benefit management organization, has created the
Express Scripts Fraud, Waste, & Abuse Team. The team uses “…industry-leading, proprietary
data analytics to uncover patterns of potential fraud or abuse, and scans for behavioral red
flags to identify when someone is involved in wrongdoing.”11 The proprietary data analytics
are combined with Express Script’s Health Decision Science platform (behavioral sciences,
clinical specialization, and actionable data) to identify 290 potential indicators of pharmacy
fraud.12
One case uncovered by the team involved a husband and wife. Over just eight months,
the wife obtained over 2,800 tablets from 8 physicians and 5 pharmacies, while the husband
obtained almost 4,000 tablets from 9 physicians and 12 pharmacies. The tablets included oxycodone, Endocet, and hydrocodone.13 The team member goes on to say “…upon contacting
several of the physicians we found that in several instances, the couple had signed agreements
that prohibited obtaining narcotics from other doctors. However, none of the physicians was
aware of the couple’s visits to the others.”14
DATA MINING
This section defines data mining and provides examples of its use.
What Is Data Mining?
The big data “revolution” encompasses yet another semantic variant: Data Mining. This is a
process used by organizations to turn raw data into useful information.
How Is Data Mining Used?
By using software to look for patterns in large batches of data, healthcare organizations can
learn more about their customers, develop effective marketing strategies, increase utilization,
and decrease costs. Data mining depends on effective data collection and working with many
sets of data in what is often called a data warehouse.
A Hospital’s Clinical Research Example of Data Mining
A noteworthy application of data mining to clinical medicine is occurring at Memorial-Sloan
Kettering (MSK) Cancer Center in New York City. MSK scientists leverage the massive amount
of data produced by tumor sequencing to learn more about the biology of cancer.15 They use
that leverage to take the genetic discoveries made through analysis and use them to produce
more-precise and cost-effective treatments for people with cancer more quickly.
Another Hospital’s Patient Safety Research Example of Data Mining
In yet another example, Boston Children’s Hospital has teamed with the nonprofit, federally
funded MITRE Corporation research center to tackle patient safety issues.16 In harnessing big
data to boost patient safety, they are pulling data together from multiple sources—electronic
health records, safety event reports, physiologic monitors, etc.—to gain insights into what may
have caused patient harm.
Data Mining 237
Developing a Protocol Through Data Mining
Using a combination of clinical experience and big data analytics research, The University of
Michigan Health System developed a protocol for the administration of blood transfusions.17
Associating Clinical Data with Cost Data
In another example illustrating the potential of big data, California-based Kaiser Permanente
generated a key data set by associating clinical data with cost data. The result of this important
analysis led to the discovery of adverse drug effects from Vioxx, an anti-inflammatory drug,
which led to its withdrawal from the market.18
IMPACTS OF HEALTHCARE ANALYTICS
The impact of healthcare analytics reaches across the entire industry. Three examples of such
impacts follow.
Corporate Acquisition
Noteworthy regarding the growth in the data analytics and cloud computing business is IBM’s recent
acquisition of Truven Health Analytics for $2.6 billion. The magnitude of the purchase is reflected
in the enhanced capabilities of the company’s Watson Health Unit, which is a digital repository of
health-related information for approximately 300 million patients. Truven’s contribution is to add
patient-related payment information to a database that already includes data from patients’ electronic medical records and medical imaging software.19 The ultimate goal is to have Watson’s artificial intelligence software assist physicians and administrators in improving care and curbing costs.
The Big Data Revolution
Big data creates opportunities and challenges. It’s revolutionary insofar that it gives healthcare
professionals the ability to use the data to solve problems much more quickly and in new ways
to gain greater business insight. It is a disruptive change for healthcare organizations in that it
requires new business models.20
New tools and statistical techniques are used to extract meaningful information from what
was unstructured data. An algorithm, or set of rules or processes, governs the greatly enhanced
speed with which problems are solved. The potential benefits in the realm of public health and
medicine are being defined in real time.
Collaborative Efforts
By necessity, the generation and utilization of big data in health care involves collaboration
between organizations. Optum Labs, a collaborative research and innovation center, has been
instrumental in integrating data, generating new knowledge, and translating knowledge into
practice. This has necessitated a shift in current patient care practices. Optum’s efforts have
focused on enabling physicians to utilize big data to improve the care of patients with comorbidities or chronic illnesses.21 A challenge for Optum amidst their collaborative efforts is to
assure an appropriate level of privacy regarding patient information.
238 Chapter 20 Understanding the Impact of Data Analytics and Big Data
Conclusion
Thus, analytics provide the data to reshape healthcare environments in the transition from
fee-for-service to value-based reimbursement, and in so doing can help by strategically targeting patients who need preventive care. The upshot is more effective patient-volume
forecasting.
Other impacts that result from enhanced data analytics and related data sharing include
better coordination of patient care, better use of available resources, better claims and benefit
management, and improved prevention of fraud and abuse.
CHALLENGES FOR HEALTHCARE ANALYTICS
The human resources challenge in the use of big data is well illustrated by AT&T’s Vision 2020
Plan. The essence of the challenge is to retrain its 280,000 employees to enable them to learn
coding skills and make quick business decisions based upon huge volumes of data that are all
sorted through software managed in the cloud.22 In an effort to keep up with competitors such
as Google and Amazon, AT&T executives are urging staff to spend 5–10 hours a week in online
learning relative to cloud computing. The company is willing to fund a good part of that training. The new systems facilitate collecting more data, quickly analyze information about what
people and things are doing, and react.
An ongoing challenge in the use of data analytics is to weigh progress versus privacy: Balancing the promise of big data with consumer privacy and security is an essential consideration.
Along with rising digital expectations of practitioners and patients, healthcare IT executives
know they face strict requirements related to patient privacy and data protection, leaving them
to ponder how to transform their infrastructures and keep data secure.
INFORMATION CHECKPOINT
What is needed? Find a document or report that shows it has applied data
analytics.
Where is it found? Perhaps in the IT department or in a manager’s office.
How is it used? Its use depends on the item you find. It could be used for
planning, for reference, for budgeting, or for training
purposes.
KEY TERMS
Big Data
Data Analytics
Data Mining
Healthcare Analytics
Predictive Analytics
Prospective Analytics
Retrospective Analytics
Key Terms 239
DISCUSSION QUESTIONS
1. Is your organization using big data resources to address clinical and/or administrative
issues? If so, for what purposes have they been utilized?
2. Have you or your area of work been involved in using big data and data analytics to
uncover and examine patterns or trends? Please describe.
3. Consider your organization and the context in which it operates. What would be your
recommendations for using big data?
NOTES
1. SAS, “Big Data Analytics,” www.sas.com/en_us/insights/analytics/big-data-analytics
.html (accessed November 15, 2015).
2. Z. Budryk, “5 Health IT Terms Every Hospital CEO Must Know” (June 24, 2015). www
.fiercehealthcare.com/healthcare/5-health-it-terms-every-hospital-ceo-must-know
(accessed September 17, 2016).
3. D. Hillblom, A. Schueth, S. M. Robertson, L. Topor, and G. Low, “The Impact of Information Technology on Managed Care Pharmacy: Today and Tomorrow,” Journal of Managed Care & Specialty Pharmacy, 20 (2014): 1076.
4. Institute for Health Technology Transformation (IHTT), “Transforming Health Care
Through Big Data: Strategies for Leveraging Big Data in the Health Care Industry,” 2013,
http://c4fd63cb482ce6861463-bc6183f1c18e748a49b87a25911a0555.r93.cf2.rackcdn
.com/iHT2_BigData_2013.pdf
5. What’s a Byte? http://www.whatsabyte.com/P1/byteconverter_App.htm (accessed February 17, 2016).
6. W. Raghupathi and V. Raghupathi, “Big Data Analytics in Healthcare: Promise and
Potential,” Health Information Science and Systems, 2 (2014): 3, http://www.hissjournal
.com/content/2/1/3
7. A. Bickmore, “Prospective Analytics: The Next Thing in Healthcare Analytics,”
www.healthcatalyst.com/using-prospective-analytics-to-improve-outcomes (accessed
February 17, 2016).
8. Healthcare Finance News, June 6, 2015.
9. D. Peck, “They’re Watching You at Work: What Happens When Big Data Meets Human
Resources?” The Atlantic, December 2013.
10. http://www.mentorhealth.com/control/category/~category_id=W_
HOSPITAL/~status=live (accessed December 16, 2016).
11. Express Scripts, “INFOGRAPHIC: Prescription Drug Fraud and Abuse,”
http://lab.express-scripts.com/insights/drug-safety-and-abuse/infographicprescription-drug-fraud-and-abuse (accessed February 16, 2016).
12. Ibid.
13. Express Scripts, “Rx Addiction: One Family’s 7,000 Pills,” http://lab.express-scrpts
.com/insights/drug-safety-and-abuse/rx-addiction-one-faily’s-7000-pills/ (accessed
February 16, 2016).
240 Chapter 20 Understanding the Impact of Data Analytics and Big Data
14. Ibid.
15. E. Kiesler, “Tumor Sequencing Test Brings Personalized Treatment Options to More
Patients,” Memorial Sloan Kettering Cancer Center News, June 12, 2014, https://www
.mskcc.org/blog/new-tumor-sequencing-test-will-bring-personalized-options-morepatients (accessed February 2015).
16. M. Stempniak, “Big Data Applied to Patient Safety in Children’s Hospitals,”
Hospitals and Health Networks, July 14, 2015, http://www.hhnmag.com/articles
/3335-big-data-applied-to-patient-safety-in-children-s-hospitals
17. Institute for Health Technology Transformation, “Transforming Health Care Through
Big Data: Strategies for Leveraging Big Data in the Health Care Industry,” http://c4fd63cb482ce6861463-bc6183f1c18e748a49b87a25911a0555.r93.cf2.rackcdn.com/iHT2_
BigData_2013.pdf
18. Ibid.
19. S. Lohr, “IBM Buys Truven for $ 2.6 Billion, Adding to Trove of Patient Data,” New York
Times, February 18, 2016, http://www.nytimes.com/2016/02/19/technology/ibm-buystruven-adding-to-growing-trove-of-patient-data-at-watson-health.html
20. J. Shaw, “Why ‘Big Data’ Is a Big Deal,” Harvard Magazine, March–April 2014, http://
harvardmagazine.com/2014/03/why-big-data-is-a-big-deal
21. N. D. Shah and J. Pathak, “Why Health Care May Finally Be Ready for Big Data,”
Harvard Business Review, December 3, 2014, https://hbr.org/2014/12/why-healthcare-may-finally-be-ready-for-big-data
22. Q. Hardy, “AT&T’s New Line: Adapt, or Else,” New York Times, December 16, 2016, www
.nytimes.com/2016/02/14/technology/gearing-up-for-the-cloud-att-tells-its-workersadapt-or-else.html?_r=0
Notes 241

PART
© LFor/Shutterstock
Financial Terms,
Costs, and Choices
VIII

Progress Notes
© LFor/Shutterstock
245
21
CHAPTER
INVESTMENT OVERVIEW
The language of investment is an integral part of the finance
world. Being knowledgeable about the meaning that lies
behind investment terms allows you a wider view of finance
transactions. This chapter concerns a selection of common investment terms. We will briefly explore investment
terminology and related meanings for cash equivalents,
long-term investments in bonds, investments in stocks, and
company ownership (public or private) in the context of
investing, along with investment indicators.
Investments should be recorded as either current assets
or long-term assets on the balance sheet of the organization. You will recall from a previous chapter that current
assets involve cash and cash equivalents, along with shortterm securities (those that will mature in one year or less).
These items should all appear as current assets on the balance sheet. Long-term investments, on the other hand,
involve longer-term securities that will mature in more than
one year. These investments should appear as long-term
items on the balance sheet.
CASH EQUIVALENTS
Cash equivalents are termed liquid assets; that is, they can
be liquidated and turned into cash on short notice when
needed. Healthcare organizations need to keep operating monies on hand. But it is not usually practical to hold
those monies in a non-interest-bearing checking account.
Instead, the chief financial officer will probably decide to
temporarily place the monies in some type of liquid asset
(a cash equivalent) in order to earn a little interest.
Actual cash includes not just currency (the dollar bills
in your wallet), but also monies held in bank checking
After completing this chapter,
you should be able to
1. Define cash equivalents.
2. Understand what the FDIC
does and does not insure.
3. Understand the difference
between municipal bonds
and mortgage bonds.
4. Understand the difference
between privately held
companies and public
companies.
5. Define Gross Domestic
Product (GDP).
6. Understand the difference
between deciles and
quartiles.
7. Describe the differences
among mean, median,
and mode.
Understanding
Investment and
Statistical Terms Used
in Finance
accounts and savings accounts, plus coins, checks, and money orders. Cash equivalents include
the following:
• Certificates of deposit (CDs) from banks
• Government securities (including both Treasury bills and Treasury notes)
• Money market funds
All of these short-term investments should be not only very liquid, but low risk. (A prudent chief
financial officer should, of course, seek low-risk investments.)
Certificates of deposit can be purchased for various short periods of time (30 days, 60 days,
90 days, etc.). The certificates earn interest and can be withdrawn (cashed) after the short
period, or term, expires, without paying a penalty.
Government securities that rank as cash equivalents include both Treasury bills and Treasury
notes. Treasury bills are typically issued with maturities of 3, 6, or 12 months. There is a minimum dollar amount to purchase. A Treasury bill pays the full amount invested if redeemed at
maturity. If the bill is redeemed prior to maturity, however, the amount received may be either
higher or lower than your cost, depending upon the current market.
Treasury notes are typically issued with longer maturities—years instead of months. The
shortest maturity period for a Treasury note is one year. A one-year note would be classified as
short-term and could be recorded as a current asset.
Money market funds are supposed to invest in conservative instruments such as commercial
bank CDs and Treasury bills. A money market fund should invest in an assortment of such conservative instruments. Portfolio managers, who are expected to manage responsibly and thus
select only low-risk investments, manage these funds. Money market funds are somewhat of a
hybrid, as these funds typically allow check-writing privileges. Thus, the investor is able to withdraw funds by writing what is actually a draft against the fund, although most everyone thinks
of this draft as a check.
GOVERNMENTAL GUARANTOR: THE FDIC
In the United States, the Federal Deposit Insurance Corporation (FDIC) “preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift
institutions … by identifying and monitoring and addressing risks to the deposit insurance funds;
and by limiting the effect on the economy and the financial system when a bank or thrift institution fails.”1 The FDIC insured deposits in banks and thrift institutions for at least $250,000
through December 31, 2009. However, this was supposed to be a temporary increase and the
FDIC deposit insurance was supposed to be restored to its usual limit of $100,000 after that date.
Savings, checking, and other deposit accounts are combined to reach the deposit insurance limit.
“Deposits held in different categories of ownership—such as single or joint accounts—may be
separately insured. Also, the FDIC generally provides separate coverage for retirement accounts,
such as individual retirement accounts (IRAs) and Keoghs.”2 It is important to note that not all
institutions—and thus not all funds—are insured by the FDIC. Exhibit 21–1 sets out these facts.
LONG-TERM INVESTMENTS IN BONDS
A bond is a long-term debt instrument under which a borrower agrees to make payments of
interest and principal on particular dates to the holder of the debt (the bond). We have titled
246 Chapter 21 Understanding Investment and Statistical Terms
this section “long-term investments in bonds,” but in actuality the bondholder is a creditor,
because bonds are liabilities to the issuing company.
Because these are long-term contracts, bonds typically mature in 20 to 30 years, although
there are exceptions. In general, interest is paid throughout the term, or life, of the bonds, and
the principal is paid at maturity. (Although there are exceptions to this rule of thumb, too.)
Three types of bonds are discussed below.
Municipal Bonds
Municipal bonds are long-term obligations that are typically used to finance capital projects.
Municipal bonds are issued by states and also by political subdivisions. The political subdivision
might be, for example, a county, a bridge authority, or the authority for a toll road project.
General Obligation Bonds
General obligation bonds are backed, or secured, by the “full faith and credit” of the municipality that issues them. This means the bonds are backed by the full taxing authority of the municipality that issues them.
Revenue Bonds
Revenue bonds, as their name implies, are backed, or secured, by revenues of their particular
project. Eligible healthcare organizations that are not-for-profit can sometimes issue revenue
bonds through a local healthcare financing authority.
Mortgage Bonds
Mortgage bonds, as their name implies, are backed, or secured, by certain real property. When
first mortgage bonds are issued, this means the first mortgage bondholders have first claim to
the real property that has been pledged to secure the mortgage. If second mortgage bonds are
also issued, this means the second mortgage bondholders will not have a claim against the real
property until the claims of the first mortgage bondholders have been paid.
Exhibit 21–1 The FDIC: Insured or Not Insured?
FDIC-Insured
• Checking Accounts (including money market deposit accounts)
• Savings Accounts (including passbook accounts)
• Certificates of Deposit
Not FDIC-Insured
•  Investments in mutual funds (stock, bond, or money market mutual funds),
whether purchased from a bank, brokerage, or dealer
• Annuities (underwritten by insurance companies, but sold at some banks)
•  Stocks, bonds, Treasury securities or other investment products, whether purchased
through a bank or a broker/dealer
Reproduced from the Federal Deposit Insurance Corporation. “The FDIC: Insured or Not Insured?: A Guide to What Is and Is Not Protected” (April 2011).
Long-Term Investments in Bonds 247
Debentures
Debentures are bonds that are unsecured. Instead of being backed by real property, debentures
are backed by revenues that the issuing organization can earn. Unlike bondholders, holders of
debentures are unsecured. Subordinated debentures are even further unsecured, in that these
debentures cannot be paid until any and all debt obligations that are senior to the subordinated
debentures have been paid.
INVESTMENTS IN STOCKS
Stocks represent equity, or net worth, in a company. This is in contrast to bonds. Generally speaking,
a bondholder is a creditor, because bonds are liabilities to the issuing company. On the other hand,
an individual or organization that buys stock in that company becomes an investor, not a creditor.
Common Stock
A purchaser of common stock expects to receive a portion of net income of the company who issues
the stock. The proportionate share of net income will be paid out as a dividend. (Note that start-up
companies that do not pay dividends are not part of this discussion about investments in stocks.)
Preferred Stock
Preferred stock, as its name implies, has preference over common stock in certain issues such as
payment of dividends. In actual fact, preferred stock is a type of hybrid, in that it generally has
a fixed-rate dividend payment, much like a bond’s interest payment. But like common stock, it
also expects to receive a portion of net income of the company who issues the stock, up to the
amount of the fixed-rate dividend payment. (Also note that the preferred stock dividends are
paid before the common stock dividends.)
Convertible preferred stock is a type of preferred stock that can be exchanged for common shares. The exchange is usually at a particular time and price, and the exchange ratio of
preferred-to-common is also stipulated.
Stock Warrants
Stock warrants allow the owner of the warrant to purchase additional shares of stock in the
company, generally at a particular price and prior to an expiration date. Warrants do not pay
dividends. They are often part of the compensation package awarded to executives.
PRIVATELY HELD COMPANIES VERSUS PUBLIC COMPANIES
Whether a stock is listed on a stock exchange or not is a function of ownership and size of the
organization. These distinctions are described here.
Privately Held Companies
A small company with common stock that is not traded is known as a “privately held” company.
Its stock is termed “closely held” stock.
248 Chapter 21 Understanding Investment and Statistical Terms
Public Companies
Companies with publicly owned common stock are known as “public companies.” The stocks of
many larger public companies may be listed on one of several stock exchanges. Stock exchanges
exist to trade the stock of publicly held companies. At the time of this writing, besides multiple regional exchanges such as the Chicago Stock Exchange, there is the American Stock
Exchange, known as AMEX, along with the New York Stock Exchange, known as the NYSE.
(At the time of this writing it is probable that the New York Stock Exchange will be acquired by
the Intercontinental Exchange [ICE]. If so, the NYSE acronym may be changed to reflect the
new ownership.)3
Smaller public companies, however, may not be listed on a stock exchange. The stock of
these companies is considered to be unlisted; instead, their stock is traded “over the counter,”
or OTC. The National Association of Securities Dealers (NASD) oversees this market. The OTC
stock market uses a computerized trading network called NASDAQ, which stands for the “NASD
Automated Quotation system.”
Published stock tables typically reflect the composite regular trading on the stock exchanges
as of closing. A stock table will generally contain four columns: the first column is an abbreviation of the public company’s name, the second column is the company’s symbol (an alpha
symbol), the third column is the stock’s price as of closing for that day, and the fourth column is
the net change of the stock price when compared to close of the previous day. Using healthcare
organizations as examples, Johnson & Johnson’s symbol is “JNJ,” while Humana, Inc.’s symbol
is “HUM.”
Governmental Agency as Overseer
At the time of this writing, the overseer of the stock market in the United States is the U.S. Securities and Exchange Commission (SEC). (It is possible that in the future the SEC may be reorganized as a somewhat different entity with somewhat different responsibilities.) The mission of
the SEC is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”4 The SEC oversees “the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here, the
SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud.”5
INVESTMENT INDICATORS
The annual rate of inflation (or deflation) is a typical investment indicator, as is the gross
domestic product measure. Both are discussed here.
Inflation Versus Deflation
Inflation means “an increase in the volume of money and credit relative to available goods and
services resulting in a continuing rise in the general price level.”6
“Indexed to inflation” means these monies will rise in accordance with an inflationary
increase. For example, Social Security payments are indexed to inflation. Excessive inflation is
feared because it reduces or devalues the spending power of the dollars you possess.
Investment Indicators 249
Deflation, on the other hand, means “a contraction in the volume of available money and
credit that results in a general decline in prices.”7 Deflation is feared because the contraction
in volume of available money and credit generally results in a fall in prices that limits and/or
reduces the country’s economic activity.
Gross Domestic Product (GDP)
The GDP measures “the output of goods and services produced by labor and property located
in the United States.”8 Investors watch the GDP because this measure is considered to be the
“gold standard” measure of the country’s overall economic fitness. The Bureau of Economic
Analysis (BEA), located within the U.S. Department of Commerce, releases quarterly estimates
of the GDP. The BEA is also responsible for the price index for gross domestic purchases. The
price index measures “prices paid by U.S. residents,”9 and is also released on a quarterly basis.
STATISTICS OVERVIEW
This overview provides an introduction to statistics, along with a discussion of mathematics
versus statistics.
Introduction
This section contains general definitions of statistical and other terms that may commonly be
used within the finance department. It is important to understand that our usage of statistical
terms in the world of healthcare finance is a specialized view. (For instance, in the case of one
example, we are concerned with how statistical analysis is used to score performance measures.)
In other words, we need enough information to understand the general process and what the
terms mean in general usage. As such, the following definitions are not technical, but instead
are intentionally generalized.
The Field of Mathematics Versus the Discipline of Statistics
The field of mathematics is broad and varied. The National Council of Teachers of Mathematics
(NCTM) has developed a set of mathematical standards for teaching and learning mathematics. These
standards are important because they help to understand the breadth and depth of mathematics.
The NCTM has set two categories of standards: thinking math and content math. Thinking
math standards are problem solving, communication, reasoning, and connections. Content
math standards are statistics and probability, fractions and decimals, estimation, number sense,
geometry and spatial sense, measurement, and patterns and relationships.10 As you can see, the
field of mathematics includes, among other disciplines, those of statistics and probability as well
as that of basic arithmetic.
• Statistics is the branch of mathematics that deals with collecting, summarizing, and analyzing numerical data, along with estimating probability and interpreting analytical results.
• Arithmetic, on the other hand, is the branch of mathematics that covers the basic functions of multiplication, division, addition, subtraction, and so on.
250 Chapter 21 Understanding Investment and Statistical Terms
In other words, statistics often provides sophisticated analytical results, while arithmetic provides the results of basic calculations.
COMMONLY USED STATISTICAL AND OTHER MATHEMATICAL TERMS
This section includes a variety of mathematical terms that are commonly used in finance
departments.
Mean, Median, and Mode
Mean, median, and mode are basic statistical concepts, but they are often confused for one
another. The following descriptions are intended to clarify the differences among them.
In order to begin our description of mean, median, and mode, first imagine a set of numbers that are arranged, or ranked, in order. They can be arranged either from the highest to
the lowest, or vice versa. Now visualize this set of numbers as they apply to the following three
descriptions.
Mean: The mean is the average of numbers, or values. To obtain the average, all the values are
added together to obtain the total. Then the total is divided by the number of line items to
obtain the average, or mean. This method is known as the “arithmetic mean” and is the most
commonly used. (Two other analytical methods, known as the geometric mean and the harmonic mean, are obtained through statistical formulas.)
Median: The median occupies a position in a ranked series of values (numbers) in which the
same number of values appear above the median as appear below it. Or, to put it another way,
there are an equal number of values (numbers) above and below the median. (In a situation
where there is no one middle number [as in the case of an even number of values], the median
instead is the average of the two middle numbers within the ranked series of values.)
Mode: The mode is the number, or value, that appears for the most times (is the most frequent)
within a series of numbers or values.
Illustrating the Difference
We show these differences in Table 21–1. Here you see a series of physicians’ scores. Their
scores represent a set of numbers, ranked from high to low as previously described. Within the
table you can see the mean, the median, and the mode each indicated within the ranked data
set of scores.
Other Statistical Analysis Terms
These descriptions pertain to other types of statistical analysis terminology.
Algorithm: A problem-solving, step-by-step process, or a set of formulas used in calculations, particularly in computer programs.
Domain: A subgroup of a whole group that is of particular interest for research or for measurement purposes. For example, the domain of safety is one subgroup of an entire patient care
grouping.
Commonly Used Statistical and Other Mathematical Terms 251
Measure: A unit of analysis, such as a measurement standard.
Measurement: The process of assigning numbers to something, such as to variables. (In other
words, measurement is how we get the numbers we analyze using statistical methods.)
Standard Deviation: Measures the average amount that a set of data within a distribution may
deviate from the mean. The further apart the values are, the larger the standard deviation will
be. A formula is used to compute the standard deviation (SD).
Standardized Measure or Scale: A statistical method that can compare data measured on different scales or instruments. (For example, the method of comparison could be a score or a
percentage.)
Statistically Significant: In general terms, a result or relationship is found to be reliable, and
thus statistically significant, if it is either bigger or smaller than if the equivalent result could be
attributed to chance alone. In other words, the finding is a result that is not merely attributable
to random chance alone.
Variable: A finding or quantity that can vary, or is apt to vary. Examples of variables include just
about anything that is capable of being measured. (Note that a constant is the opposite of a variable, because it does not vary [and thus is constant].)
Variance: The difference between a standard value and an actual value. The difference is typically arrived at through statistical analysis.
Terms About Distributions
These descriptions pertain to distribution terms, such as those used to explain scoring
methodology.
Frequency Distribution: A count of how many times (how frequently) a number appears in a group
of numbers.
Physicians’ CPIA Scores
Physician
#
Score
(in points)
1 55
2 50
3 50 Mode (The most common score)
4 50
5 45 Median (The middle score)
6 35
7 30
8 25
9 20
Total 360 divided by 9 = 40 è Mean (The average score)
Modified from W. Vogt, Dictionary of Statistics & Methodology, p. 178.
r
Table 21–1 Illustration of Mean, Median, and Mode
252 Chapter 21 Understanding Investment and Statistical Terms
Decile: A distribution into 10 classes, each of which contains one-tenth of the whole; any one of
the 10 classes is a decile.
Quartile: A distribution into four classes, each of which contains one-quarter of the whole; any
one of the four classes is a quartile.
Terms Used in Mathematical (Arithmetic) Computations
These descriptions pertain to computation terms, such as those sometimes used to explain
reporting-measures methods.
Decimal: The decimal system subdivides into tenth or hundredth units. A decimal point number
is typically expressed with a decimal point to show units that have a value of less than one. For
example, one dollar is equal to 100 cents. Thus, 30 cents can be expressed as a decimal (0.30)
because it has a value (30) that is less than the 100 cents that represents 1. Thus, the 30 that is
shown to the right of the decimal point has a value of less than 1 (1 dollar, in this example).
Fraction: Indicates both part of a whole (the numerator, which is the top part) and the entire
whole (the denominator, which is the total number of parts to be divided). For example, 30
cents can be written as a fraction (30/100) because the numerator is the part (30) and the
denominator is the whole (100 cents, or 1 dollar).
Numerator: The top part of a fraction. The numerator indicates the portion of the total under
consideration. See also Denominator.
Denominator: The bottom part of a fraction. The denominator indicates all the values under
consideration. See also Numerator.
Percent (Percentage): Typically 1 part or unit in every 100 parts or units. For example, 50% means
50 parts per 100.
Terms About Data
These descriptions pertain to data. Note that the word “data” is plural. (This means that we
should say “The data are showing” instead of “The data is showing.”)
Data: The factual information being analyzed. This information is typically used to measure
and/or calculate, although it may also be used for reasoning and/or discussion.
Data Base (also Database): A particular set of computerized data organized in a manner designed
for efficient retrieval.
Data Entry: The process of recording data, generally by electronic means.
Data Mining: A process used by organizations to turn raw data into useful information.
Data Processing: Generally speaking, taking raw data and converting it into a form that can be
readily used by computer software (processing). The processing can take place in magnetic,
optical, or mechanical form.
Data Set: A group of data (a set) gathered together for a like purpose.
Data Standardization: The process that converts data into a standard, such as the creation of
standard scores.
Big Data: Large data sets that are analyzed for patterns or trends.
Commonly Used Statistical and Other Mathematical Terms 253
Terms About Time Measurements
These descriptions pertain to terms about time measurements.
Period: A unit of time.
Baseline Period: A unit of time (period) used as a basis for comparison.
Base Year: A 12-month unit of time (year) used as a basis for comparison.
Performance Period: A unit of time during which performance is measured.
Illustrating Analytical Results
Graphics summarize and assist in interpreting statistical results. In fact, “graphing is another
way to show and see information mathematically.”11 There are multiple types of graphics available for this task. The most common types include the following:
Pie Chart: Presents data as portions of a circle
Bar chart: Presents data as horizontal bars
Line chart: Presents data as multiple lines that track along a grid
Column chart or table: Presents data as columns
Scatterplot: Shows the relationship between two data sets via a graph that plots points along both
the horizontal and vertical axes
Venn diagram: Shows the relationships between data points as a series of overlapping circles
Illustrated examples of a pie chart, bar chart, and line chart are found in the chapter, “Using
Comparative Data.”
To summarize, we may not tend to design a graphic for its particular use. Instead we may rely
on two or three formats that are used over and over. However, we should try to design a graphic
that communicates results that are often complex in a precise, clear and efficient manner.12
INFORMATION CHECKPOINT
What is needed? A copy of the Wall Street Journal.
Where is it found? At a newsstand or possibly within the offices of your own
organization.
How is it used? Locate the “Stock Tables” section of the Journal. Review the column headings in the tables and locate the names of various
stock exchanges that are included in the findings.
KEY TERMS
Common Stock
Debentures
Decile
Deflation
Denominator
Federal Deposit Insurance
Corporation (FDIC)
254 Chapter 21 Understanding Investment and Statistical Terms
Gross Domestic Product
(GDP)
Inflation
Mean
Median
Mode
Money Market Funds
Municipal Bonds
Numerator
Quartile
Preferred Stock
Securities and Exchange
Commission (SEC)
Stock Warrants
DISCUSSION QUESTIONS
1. Do you know if your own monies on deposit are FDIC insured? If you do not know, how
would you go about finding out?
2. Do you know of a healthcare company whose stock is publicly held? If you do not know,
how would you go about finding out?
3. Do you know if any healthcare company that you have worked for (now or previously)
had issued revenue bonds that were purchased by investors? If you do not know, how
would you go about finding out?
4. Do you agree with the distinction between thinking math and content math? What
type(s) of mathematics have you ever studied?
NOTES
1. Federal Deposit Insurance Corporation, “Who Is the FDIC?” Federal Deposit Insurance
Corporation, http://www.fdic.gov/about/index.html
2. Ibid.
3. Wall Street Journal Opinion, “ICE Buys NYSE,” Wall Street Journal, December 21, 2012,
A18.
4. U.S. Securities and Exchange Commission, “The Investor’s Advocate: How the SEC
Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation.” Last
modified June 10, 2013, www.sec.gov/about/whatwedo.shtml
5. Ibid.
6. Merriam Webster’s Collegiate Dictionary, 10th ed., s.v. “Inflation.”
7. Ibid., “Deflation.”
8. U.S. Department of Commerce, Bureau of Economic Analysis (BEA). News Release: Gross
Domestic Product: Fourth Quarter 2008 (Final), http://bea.gov/newsreleases/national
/gdp/gdpnewsrelease.htm
9. Ibid.
10. “What Is Mathematics?” p. 1, www.2.ed.gov/pubs/EarlyMath/whatis.html (accessed July
12, 2016).
11. Ibid., p. 7.
12. R. Hawkins and J. J. Baker. Management Accounting for Health Care Organizations: Tools and
Techniques for Decision Support. (Boston: Jones & Bartlett Publishers, 2004). p. 376.
Notes 255

Progress Notes
© LFor/Shutterstock
Business Loans and
Financing Costs
Business loans, as the term implies, represent debts
incurred to assist in running a business. Whether to take on
debt and how much to take on are common and necessary
parts of financial planning. This type of planning involves
the organization’s capital structure, as discussed in the following section.
OVERVIEW OF CAPITAL STRUCTURE
“Capital” represents the financial resources of the organization and is generally considered to be a combination of
debt and equity.
“Capital structure” means the proportion of debt versus
equity within the organization. The phrase “capital structure”
actually refers to the debt–equity relationship. For example,
if a physician practice partnership owed $500,000 in debt and
also had $500,000 in partner’s equity, the partnership capital
structure, or debt–equity relationship, would be 50–50.
Different industries typically have different debt–
equity relationships. In the case of health care, the chief
financial officer of the organization is usually responsible
for guiding decisions about the proportion of debt. The
chief financial officer will take into account various sources
of capital, as discussed in the next section.
SOURCES OF CAPITAL
Sources of capital traditionally include four methods of
obtaining funds:
• Borrowing from a lending institution
• Borrowing from investors
• Retaining the excess of revenues over expenses
• Selling an additional interest in the organization
After completing this chapter,
you should be able to
1. Understand what capital
structure means.
2. Recognize four sources of
capital.
3. Explain an amortization
schedule.
4. Understand loan costs.
257
22
CHAPTER
Borrowing from a lending institution is generally classified by the length of the loan. Shortterm borrowing is commonly expected to be repaid within a 12-month period. Long-term borrowing is usually to finance land, buildings, and/or equipment. Long-term borrowing for these
purposes is usually accomplished by obtaining a mortgage from the lending institution.
Borrowing from investors assumes the organization is big enough and has the proper legal
structure to do so. A common example of borrowing from investors is that of selling bonds.
Bonds represent the company’s promise to pay at a future date. When bonds are sold, the purchaser expects to receive a certain amount of annual interest and also expects that the bonds
will be redeemed on a certain date, several years in the future.
Retaining the excess of revenues over expenses represents retaining operating profits to a
proprietary, or for-profit, company. (Of course this assumes there is an excess of funds to retain.)
A not-for-profit organization may be bound by legal limitations on the retention of its funds.
However, the not-for-profit organization can also sometimes rely on a different income stream.
Church-affiliated not-for-profits, for example, may be able to solicit donations. This example
represents a unique method of raising capital.
Selling an additional interest in the organization depends on its legal structure. Typically, this
method involves a for-profit corporation selling additional shares of common stock to raise funds.
Not-for-profit organizations are bound by legal limitations and may not be able to follow this route.
THE COSTS OF FINANCING
Financing costs typically involve interest expense and usually also involve loan costs, as described
in this section.
Interest Expense
Payments on a business loan typically consist of two parts: principal and interest expense. The
principal portion of the loan payment reduces the loan itself, while the rest of the payment is
made up of interest on the remaining balance due on the loan.
The amount of principal and the amount of interest contained in each payment are
illustrated in an “amortization schedule.” For example, assume the purchase of equipment for
$60,000. Monthly payments will be made over a 3-year period, and the annual, or per-year, interest rate will be 12%. The first 6 months of the amortization schedule for this loan is illustrated in
Table 22–1. The entire 36-month amortization schedule is found in Appendix 22-A at the end
of this chapter.
The interest expense for each monthly payment is computed on the principal balance
remaining after the principal portion of the previous payment has been subtracted. The
“Remaining Principal Balance” column shows the declining balance of the principal. Now refer
to the “Remaining Principal Balance” column and compare it with the “Interest Expense Portion of Payment” column. Remember that the 12% annual interest rate in this example amounts
to 1% per month. You can see how 10% of $60,000.00 amounts to a $600.00 interest payment
for month 1; 10% of $58,607.14 amounts to a $586.07 interest payment for month 2; and so on.
The remainder of the payment amount—after interest expense—is then deducted from the
principal amount due, as shown in Table 22–1. Thus, of the $1,992.86 monthly payment 1, if
$600.00 is interest, then $1,392.86 is the principal portion, and of the $1,992.86 monthly payment 2, if $586.07 is interest, then $1,406.79 is the principal portion, and so on.
258 Chapter 22 Business Loans and Financing Costs
Not all amortization schedules are set up in the same configuration. The columns that are
shown can vary. For example, the entire 36-month amortization schedule for the Table 22–1
loan is contained in Appendix 22-A. Refer to this appendix to see how the columns are different
from Table 22–1. While the basic information necessary for computation is shown, the layout of
the schedule is different.
Loan Costs
The term “loan costs” covers expenses necessary to close the loan. Loan closing costs generally
include some expenses that would be reported in the current year and some other expenses
that should be spread over several years.
Suppose, for example, the Great Lakes Home Health Agency bought a tract of land
for expansion purposes. The home health agency paid a 20% down payment and obtained
mortgage financing from a local bank for the remainder of the purchase price. When
the loan was closed, meaning the transaction was completed, the statement that lists closing
costs included prorated real estate taxes and “points” on the loan. Points represent a certain
percentage of the loan amount paid, in this case to the bank, to cover costs of the financing.
The prorated real estate taxes represent an expense to be reported in the current year by
the HHA. The points, however, would be spread over several years. How would this multipleyear reporting be handled? The total would first be placed on the balance sheet as an amount
not yet recognized as expense. Each year a certain portion of that amount would be charged
to current operations as an “amortized expense.” Amortization expense is a noncash expense
that is assigned to multiple reporting periods. It works much the same way as depreciation
expense.
MANAGEMENT CONSIDERATIONS ABOUT REAL ESTATE FINANCING
Real estate financing typically occurs in the form of real estate mortgages. Management must
take several important considerations into account when contemplating a real estate purchase
that involves a mortgage. These considerations include the following:
• What would the return on investment (ROI) be for this purchase?
• What is the cost of money (i.e., the interest rate) for this mortgage?
• What would the return of capital (equity) computation amount to?
• What is the liquidity prospect (i.e., the ability to sell this property)?
Payment Total Principal Interest Expense Portion Remaining
Number Payment Portion of Payment of Payment Principal Balance
Beginning balance = $60,000.00
1 $1,992.86 $1,392.86 $600.00 $58,607.14
2 1,992.86 1,406.79 586.07 57,200.35
3 1,992.86 1,435.07 572.00 55,779.49
4 1,992.86 1,449.42 557.79 54,344.42
5 1,992.86 1,463.91 543.44 52,895.00
6 1,992.86 1,478.55 528.95 51,431.09
Table 22–1 Loan Amortization Schedule
Management Considerations About Real Estate Financing 259
• What is the potential risk factor (if any) involved in the purchase and/or the mortgage
financing?
• Is there an income tax factor to be considered? If so, what is the impact?
Repayment of a mortgage is typically a long-term liability, and this fact is yet another element
in management’s decision-making process.
MANAGEMENT DECISIONS ABOUT BUSINESS LOANS
Decisions concerning how to obtain capital are an important part of financial management decision making. The chapter on capital expenditures budgets discussed how new capital often has to
be rationed within an organization. Repaying long-term loan obligations will impact the facility’s
cash flow for years to come, and decisions to undertake a large debt load should not be made
lightly. Therefore, most institutions and/or companies have put a formal approval process into
place that generally begins with the chief financial officer and his or her staff and progresses
upward all the way to board of trustees’ approval, depending on the amount of the debt proposed.
Because of the implications, management decisions about business loans are often interwoven with strategic planning.
INFORMATION CHECKPOINT
What is needed? An example of the details of a loan.
Where is it found? In the department responsible for the organization’s finances.
How is it used? Loan information is used by your financial decision makers.
KEY TERMS
Amortization Schedule
Bonds
Capital
Capital Structure
Equity Ratio
Loan Costs
Long-Term Borrowing
Short-Term Borrowing
DISCUSSION QUESTIONS
1. Have you ever been informed of details about business loans in your unit or division?
2. If so, did you receive the information in the context of a new project (a new business loan
that was made for purposes of the new project)?
3. Do the operating reports you receive contain information about loan costs, such as interest expense?
4. If so, do you think the interest expense seems reasonable for the operation? Why?
260 Chapter 22 Business Loans and Financing Costs
© LFor/Shutterstock
Principal borrowed: $60,000.00
Annual payments: 12
Total payments: 36
Annual interest rate: 12.00%
Periodic interest rate: 1.0000%
Regular payment amount: $1,992.86*
Final balloon payment: $0.00
The following results are estimates that do not account for values being rounded to the nearest
cent. See the amortization schedule for more accurate values.
Total repaid: $71,742.96**
Total interest paid: $11,742.96
Interest as percentage of principal: 19.572%
*
Take any line item on the next page. If you add the amount in the principal column and the amount in the interest
column together, the total will amount a payment of $1,992.86.
**($60,000 principal plus $11,742.96 equals $71,742.96.)
261
Sample Amortization
Schedule 22-A
APPENDIX
Payment Cumulative Cumulative Principal
Number Principal Interest Principal Interest Balance
1 $1,392.86 $600.00 $1,392.86 $600.00 $58,607.14
2 $1,406.79 $586.07 $2,799.65 $1,186.07 $57,200.35
3 $1,420.86 $572.00 $4,220.51 $1,758.07 $55,779.49
4 $1,435.07 $557.79 $5,655.58 $2,315.86 $54,344.42
5 $1,449.42 $543.44 $7,105.00 $2,859.30 $52,895.00
6 $1,463.91 $528.95 $8,568.91 $3,388.25 $51,431.09
7 $1,478.55 $514.31 $10,047.46 $3,902.56 $49,952.54
8 $1,493.33 $499.53 $11,540.79 $4,402.09 $48,459.21
9 $1,508.27 $484.59 $13,049.06 $4,886.68 $46,950.94
10 $1,523.35 $469.51 $14,572.41 $5,356.19 $45,427.59
11 $1,538.58 $454.28 $16,110.99 $5,810.47 $43,889.01
12 $1,553.97 $438.89 $17,664.96 $6,249.36 $42,335.04
13 $1,569.51 $423.35 $19,234.47 $6,672.71 $40,765.53
14 $1,585.20 $407.66 $20,819.67 $7,080.37 $39,180.33
15 $1,601.06 $391.80 $22,420.73 $7,472.17 $37,579.27
16 $1,617.07 $375.79 $24,037.80 $7,847.96 $35,962.20
17 $1,633.24 $359.62 $25,671.04 $8,207.58 $34,328.96
18 $1,649.57 $343.29 $27,320.61 $8,550.87 $32,679.39
19 $1,666.07 $326.79 $28,986.68 $8,877.66 $31,013.32
20 $1,682.73 $310.13 $30,669.41 $9,187.79 $29,330.59
21 $1,699.55 $293.31 $32,368.96 $9,481.10 $27,631.04
22 $1,716.55 $276.31 $34,085.51 $9,757.41 $25,914.49
23 $1,733.72 $259.14 $35,819.23 $10,016.55 $24,180.77
24 $1,751.05 $241.81 $37,570.28 $10,258.36 $22,429.72
25 $1,768.56 $224.30 $39,338.84 $10,482.66 $20,661.16
26 $1,786.25 $206.61 $41,125.09 $10,689.27 $18,874.91
27 $1,804.11 $188.75 $42,929.20 $10,878.02 $17,070.80
28 $1,822.15 $170.71 $44,751.35 $11,048.73 $15,248.65
29 $1,840.37 $152.49 $46,591.72 $11,201.22 $13,408.28
30 $1,858.78 $134.08 $48,450.50 $11,335.30 $11,549.50
31 $1,877.37 $115.49 $50,327.87 $11,450.79 $9,672.13
32 $1,896.14 $96.72 $52,224.01 $11,547.51 $7,775.99
33 $1,915.10 $77.76 $54,139.11 $11,625.27 $5,860.89
34 $1,934.25 $58.61 $56,073.36 $11,683.88 $3,926.64
35 $1,953.59 $39.27 $58,026.95 $11,723.15 $1,973.05
36 *$1,973.05 $19.73 $60,000.00 $11,742.88 $0.00
*The final payment has been adjusted to account for payments having been rounded to the nearest cent.
Table 22-A–1 36-Month Sample Amortization Schedule
262 Chapter 22 Business Loans and Financing Costs
263
Progress Notes
© LFor/Shutterstock
23
CHAPTER
Choices: Owning
Versus Leasing Equipment
After completing this chapter,
you should be able to
1. Understand what purchasing
equipment involves.
2. Understand what leasing
equipment involves.
3. Recognize a for-profit
organization.
4. Recognize a not-for-profit
organization.
PURCHASING EQUIPMENT
Purchasing equipment means taking title to, or assuming
ownership of, the item. In this case, the asset representing
the equipment is recorded on the organization’s balance
sheet. The purchase could take place by paying cash from
the organization’s cash reserves, or the organization could
finance all or part of the purchase. If financing occurs, the
resulting liability is also recorded on the balance sheet.
LEASING EQUIPMENT
When is a lease not a lease? When it is a lease-purchase, also
known as a financial lease. This is a very real question that
affects business decisions. The financial lease is described
in the next section, and it is followed by a description of the
operating lease.
Financial Lease
The lease-purchase is a formal agreement that may be
called a lease, but it is really a contract to purchase. This
contract-to-purchase transaction is also called a financial
lease. The important difference is this: the equipment must
be recorded on the books of the organization as a purchase.
This process is called “capitalizing” the lease.
A financial lease is considered a contract to purchase.
Generally speaking, a lease must be capitalized and thus
placed on the balance sheet as an asset, with a corresponding
liability, if the lease contract meets any one of the following
criteria:
1. The lessee can buy the asset at the end of the lease
term for a bargain price.
2. The lease transfers ownership to the lessee before the lease expires.
3. The lease lasts for 75% or more of the asset’s estimated useful life.
4. The present value of the lease payments is 90% or more of the asset’s value.
Operating Lease
The cost of an operating lease is considered an operating expense. It does not have to be capitalized and placed on the balance sheet because it does not meet the criteria just described.
An operating lease is treated as an expense of current operations. This is in contrast to the
financial lease just described that is treated as an asset and a liability. A payment on an operating
lease becomes an operating expense within the time period when the payment is made.
BUY-OR-LEASE MANAGEMENT DECISIONS
Leasing is an alternative to other means of financing. When analyzing lease-versus-purchase
decisions, it is usually assumed that the money to purchase the equipment will be borrowed. In
some cases, however, this is not true. The organization might decide to use cash from its own
funds to make the purchase. This decision would, of course, change certain assumptions in the
comparative analysis.
Another differential in comparative analysis concerns service agreements. Sometimes the
service contracts or service agreements (to service and/or repair the equipment) are made
a part of the lease agreement. This feature would need to be deleted from the total agreement before the comparison between leasing and purchasing can occur. Why? Because the
service agreement would be an expense, regardless of whether the equipment would be leased
or purchased.
An Example
The question for our example is whether a clinic should purchase or lease equipment. We
examine two clinics: Northside Clinic, a for-profit corporation, and Southside Clinic, a not-forprofit corporation.
For both Northside and Southside, assume that the equipment’s cost will be $50,000 if it is
purchased. Likewise, assume for both Northside and Southside that if the equipment is leased,
the lease will amount to $11,000 per year for five years.
We also need to make assumptions about depreciation expense for the purchased equipment. We further assume straight-line depreciation in the amount of $10,000 for years
2 through 4. For the initial year of acquisition (year 0), we assume the half-year method
of depreciation, whereby the amount will be one-half of $10,000, or $5,000. We will further assume the purchased equipment will be sold for its salvage value of 10%, or $5,000,
on the first day of year 5. (Therefore, the full amount of [prior] year 4’s depreciation can
be taken.)
The difference between the for-profit Northside and the not-for-profit Southside is that the
for-profit is subject to income tax. We assume the federal and state income taxes will amount to
a total of 25%. Thus, the depreciation taken as an expense results in a tax savings amounting to
one-quarter of the total expense in each year. The depreciation expense and its equivalent tax
264 Chapter 23 Choices: Owning Versus Leasing Equipment
savings are shown by year in Table 23–1. Also, the same rationale is applicable for the leasing
expense in the for-profit organization.
In the following section, we compare two financial situations that affect the way the analysis
is performed: a for-profit, or proprietary, clinic and a not-for-profit clinic. For purposes of this
analysis, what is the major difference? As we have previously stated, the for-profit practice realizes tax savings on expense items such as depreciation. The not-for-profit clinic does not realize
such tax savings because it does not pay taxes. Consequently, one analysis later here (the forprofit) includes the effect of tax savings on depreciation, and the other analysis (the not-forprofit) does not.
Computing the Comparative Net Cash Flow Effects of Owning Versus Leasing
This description results in computation of the net cash flow for owned equipment versus leased
equipment in a for-profit organization compared with that of a not-for-profit organization.
Table 23–2–A.1 and Table 23–2–A.2 first illustrate the comparative net cash flow effects of owning versus leasing in a for-profit organization. Table 23–2–A.1 illustrates the cost of owning. The
equipment purchase price of $50,000 in year 0 (line 1) and the salvage value of $5,000 in year 5
Table 23–1 Depreciation Expense Computation
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Depreciation expense $5,000 $10,000 $10,000 $10,000 $10,000 —
Depreciation expense tax savings $1,250 $2,500 $2,500 $2,500 $2,500 —
Table 23–2–A.1 Cost of Owning—Northside Clinic (For-Profit)—Comparative Cash Flow
Line
Number Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1 Equipment purchase price ($50,000)
2 Depreciation expense
tax savings $1,250 $2,500 $2,500 $2,500 $2,500 —
3 Salvage value — — — — — $5,000
4 Net cash flow ($48,750) $2,500 $2,500 $2,500 $2,500 $5,000
Table 23–2–A.2 Cost of Leasing—Northside Clinic (For-Profit)—Comparative Cash Flow
Line
Number Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
5 Equipment lease (rental)
payments ($11,000) ($11,000) ($11,000) ($11,000) ($11,000) —
6 Lease expense tax
savings $2,750 $2,750 $2,750 $2,750 $2,750 —
7 Net cash flow ($8,250) ($8,250) ($8,250) ($8,250) ($8,250) —
Buy-or-Lease Management Decisions 265
Table 23–2–B.1 Cost of Owning—Southside Clinic (Not-for-Profit)—Comparative Cash Flow
Line
Number Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
8 Equipment purchase price ($50,000)
9 Depreciation expense
tax savings n/a n/a n/a n/a n/a —
10 Salvage value — — — — — $5,000
11 Net cash flow ($50,000) — — — — $5,000
Table 23–2–B.2 Cost of Leasing—Southside Clinic (Not-for-Profit)—Comparative Cash Flow
Line
Number Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
12 Equipment lease (rental)
payments ($11,000) ($11,000) ($11,000) ($11,000) ($11,000) —
13 Lease expense tax
savings n/a n/a n/a n/a n/a —
14 Net cash flow ($11,000) ($11,000) ($11,000) ($11,000) ($11,000) —
(line 3) are shown. The for-profit’s net cash flow is also affected by tax savings from depreciation expense, as was previously explained and as is shown on line 2. The resulting net cash flow
by year is shown on line 4.
Table 23–2–A.2 illustrates the cost of leasing in the for-profit organization. The equipment
lease or rental payments are shown on line 5. The for-profit’s net cash flow is affected by tax savings from the lease payments, as is shown on line 6. The resulting net cash flow by year is shown
on line 7.
Table 23–2–B.1 and Table 23–2–B.2 now illustrate the comparative net cash flow effects of
owning versus leasing for the not-for-profit organization. Table 23–2–B.1 illustrates the cost
of owning. The equipment purchase price of $50,000 in year 0 (line 8) and the salvage value of
$5,000 in year 5 (line 10) are shown. The not-for-profit’s net cash flow is not affected by tax savings from depreciation expense because it is exempt from such income taxes. Therefore, the
depreciation expense tax savings entry on line 9 is shown as not applicable, or “n/a.” The resulting net cash flow by year is then shown on line 11.
Table 23–2–B.2 illustrates the cost of leasing in the not-for-profit organization. The equipment lease or rental payments are shown on line 12. The not-for-profit’s net cash flow is not
affected by tax savings from the lease payments because it is exempt from such income taxes.
Therefore, the lease expense tax savings entry on line 13 is shown as not applicable, or “n/a.”
The resulting net cash flow by year is then shown on line 14.
Computing the Comparative Present Value Cost of Owning Versus Cost of Leasing
This continuing description results in computation of the present value cost of owning versus leasing equipment in a for-profit organization compared with that of a not-for-profit
organization.
266 Chapter 23 Choices: Owning Versus Leasing Equipment
Table 23–2–C.1 and Table 23–2–C.2 now illustrate the present value cost of owning versus
leasing for the for-profit organization. Table 23–2–C.1 first carries forward (on line 15) the net
cash flow computed on line 4. Line 16 then shows the present value factor for each year at 8%,
which is the assumed cost of capital in this example. Line 17 contains the present value answers,
which result from multiplying line 15 times line 16. The overall present value cost of owning
(derived by adding all items on line 17) is shown on line 18.
Table 23–2–C.2 illustrates the present value cost of leasing in the for-profit organization.
Table 23–2–C.2 first carries forward (on line 19) the net cash flow computed on line 7. Line 20
then shows the present value factor for each year at 8%, which is the assumed cost of capital in
this example. Line 21 contains the present value answers, which result from multiplying line 19
times line 20. The overall present value cost of owning (derived by adding all items on line 21)
is shown on line 22.
Finally, Table 23–2–C.3 compares the for-profit organization’s cost of owning to its cost of
leasing. In the case of the for-profit, the net advantage is to leasing by a net amount of $1,489.
The tables now illustrate the present value cost of owning versus leasing for the not-for-profit
organization. Table 23–2–D.1 illustrates the present value cost of owning. It first carries forward
(on line 24) the net cash flow computed on line 11. Line 25 then shows the present value factor
for each year at 8%, which is the assumed cost of capital in this example. Line 26 contains the
present value answers, which result from multiplying line 24 times line 25. The overall present
value cost of owning (derived by adding all items on line 26) is shown on line 27.
Table 23–2–C.1 Cost of Owning—Northside Clinic (For-Profit)—Comparative Present Value
Line For-Profit
Number Cost of Owning Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
15 Net cash flow (from line 4) ($48,750) $2,500 $2,500 $2,500 $2,500 $5,000
16 Present value factor (at 8%) n/a 0.926 0.857 0.794 0.735 0.681
17 Present value answers = ($48,750) $2,315 $2,143 $1,985 $1,838 $3,405
18 Present value cost of owning = ($37,064)
Table 23–2–C.2 Cost of Leasing—Northside Clinic (For-Profit)—Comparative Present Value
Line For-Profit
Number Cost of Leasing Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
19 Net cash flow (from line 7) ($8,250) ($8,250) ($8,250) ($8,250) ($8,250) —
20 Present value factor (at 8%) n/a 0.926 0.857 0.794 0.735 —
21 Present value answers 5 ($8,250) ($7,640) ($7,070) ($6,551) ($6,064) —
22 Present value cost of leasing 5 ($35,575)
Table 23–2–C.3 Comparison of Costs—Northside Clinic (For-Profit)
Line Number Computation of Difference
23 Net advantage to leasing = $1,489 (37,064) (line 18) less (35,575) (line 22) equals 1,489
Buy-or-Lease Management Decisions 267
Table 23–2–D.2 illustrates the present value cost of leasing in the not-for-profit organization. It
first carries forward (on line 28) the net cash flow computed on line 14. Line 29 then shows the
present value factor for each year at 8%, which is the assumed cost of capital in this example. Line
30 contains the present value answers, which result from multiplying line 28 times line 29. The
overall present value cost of owning (derived by adding all items on line 30) is shown on line 31.
Finally, Table 23–2–D.3 compares the not-for-profit organization’s cost of owning to its cost
of leasing. In the case of the not-for-profit, the net advantage is to owning by a net amount of
$676. It might be noted that the net difference of $676 is so small that it might be disregarded
and considered as a nearly neutral comparison between the two methods of financing.
In summary, the tax effect on cash flow of for-profit versus not-for-profit will generally (but
not always) be taken into account in comparative proposals for funding.
ACCOUNTING PRINCIPLES REGARDING LEASES
As previously explained, financial statements used for external purposes in the United States
must follow generally accepted accounting principles, or GAAP. The treatment of equipment
leases for such accounting purposes would, of course, fall under GAAP, and the technical
aspects of such reporting are beyond the scope of this text. Be aware, however, that sometime
in the near future, U.S. publicly held companies may be required to adopt certain international
accounting standards as produced by the International Accounting Standards Board (IASB).1
The treatment of leases is a particular issue within these potential adoption requirements and
is, of course, beyond the scope of this text.
Table 23–2–D.3 Comparison of Costs—Southside Clinic (Not-for-Profit)
Line Number Computation of Difference
32 Net Advantage to Owning = $676 (47,271) (line 31) less (46,595) (line 27) equals 676
Table 23–2–D.2 Cost of Leasing—Southside Clinic (Not-for-Profit)—Comparative Present Value
Line Not-for-Profit
Number Cost of Leasing Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
28 Net cash flow (from line 14) ($11,000) ($11,000) ($11,000) ($11,000) ($11,000) —
29 Present value factor (at 8%) n/a 0.926 0.857 0.794 0.735
30 Present value answer = ($11,000) ($10,186) ($9,427) ($8,573) ($8,085) —
31 Present value cost of leasing = ($47,271)
Table 23–2–D.1 Cost of Owning—Southside Clinic (Not-for-Profit)—Comparative Present Value
Line Not-for-Profit
Number Cost of Owning Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
24 Net cash flow (from line 11) ($50,000) — — — — $5,000
25 Present value factor (at 8%) n/a — — — 0.681
26 Present value answer = ($50,000) — — — — $3,405
27 Present value cost of owning = ($46,595)
268 Chapter 23 Choices: Owning Versus Leasing Equipment
INFORMATION CHECKPOINT
What is needed? An example of a buy-or-lease management decision analysis.
Where is it found? Probably with your manager or your departmental director.
How is it used? Study the way the analysis is laid out and the method of comparison used.
KEY TERMS
Buy-or-Lease Decisions
Depreciation
Equipment Purchase
Financial Lease
For-Profit Organization
Lease-Purchase
Not-for-Profit Organization
Operating Lease
Present Value
DISCUSSION QUESTIONS
1. In the examples given in the chapter, there is not much monetary difference between
owning versus leasing. In these circumstances, which method would you recommend?
Why?
2. Have you ever been involved in a lease-or-buy decision in business? In your personal life?
3. If so, was the decision made in a formal reporting format, or as an informal decision?
4. Do you think this was the best way to make the decision? If not, what would you change?
Why?
NOTE
1. K. Tysiac, “Still in Flux: Future of IFRS in U.S. Remains Unclear After SEC report,”
Journal of Accountancy, p.4 (September 2012). www.journalofaccountancy.com/Issues
/2012/Sep/20126059.htm
Note 269

PART
© LFor/Shutterstock
Strategic Planning:
A Powerful Tool
IX

273
Progress Notes
© LFor/Shutterstock
Strategic Planning
and the Healthcare
Financial Manager
MAJOR COMPONENTS OF THE
STRATEGIC PLAN: OVERVIEW
This chapter will cover the six major components of planning and their process flows, along with various examples
of mission, value, and vision statement types. A federal governmental agency planning example will be presented. The
chapter also discusses strategic planning tools, including
situational analysis and financial projections.
INTRODUCTION
Strategic planning is vital for any organization. There are multiple approaches to accomplish such planning, and there is
often confusion about the terminology used in these different
approaches. In this section we will describe the typical components of strategic planning. We will also discuss the confusion
about differences in approach and related terminology.
SIX MAJOR COMPONENTS
The ultimate result of strategic planning is an actual plan,
presented in report form. The major components of a strategic plan include the following:
• Mission Statement
• Vision Statement
• Organizational Values
• Goals
• Objectives
• Action Plans and/or Performance Plans and/or
Initiatives
These components are illustrated in Figure 24–1 and are
further described as follows.
After completing this chapter,
you should be able to
1. Describe the six major
components of strategic
planning.
2. Understand the purpose
and relationship between
mission, vision, and value
statements.
3. Describe the strategic planning
cycle and its process flow.
4. Understand why the
governmental planning
requirements are important.
5. Identify the four components
of a SWOT analysis.
6. Recognize the difference
between a financial forecast
and a financial projection.
24
CHAPTER
Mission Statement
The mission statement explains the purpose of the organization. In other words, it explains
“what we are now.” Generally speaking, the mission statement will cover a near-future period,
usually three to five years.
Vision Statement
The vision statement explains “what we want to be” or perhaps “what we aspire to be.” It is a
look further into the future, perhaps 10 years from now. Not all organizations publicize a vision
statement.
Organizational Values
Values express the philosophy of the organization. There seems to be two approaches to
expressing values: either they are summarized into just a few meaningful phrases or they are
quite lengthy and “wordy.”
Goals
A goal is “…a statement of aim or purpose included in a strategic plan.”1 Goals support the
mission statement. While strategic goals are necessarily broad in nature, nevertheless each goal
Figure 24–1 The Six Major Components of Strategic Planning.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Mission
Statement
Vision
Statement
Values
Goals
Objectives
Action
Plans
274 Chapter 24 Strategic Planning and the Healthcare Financial Manager
should tie directly into an element of the mission statement. Every goal should be considered
an outcome that can be accomplished in the future.
Objectives
A strategic objective further defines intended outcomes in order to achieve a goal. Each objective must support—and thus tie directly into—a particular strategic goal. There are typically
several objectives associated with each goal.
Action Plans
An Action Plan is a detailed plan of operations that shows how one part of a particular objective
will be accomplished. It supports a subcomponent of the overall objective. It is a short-term plan
that provides details (actions) about how a specific area of a particular objective will be carried
out. Action plans are often called by other names, such as “Operational Plans,” “Performance
Plans” or “Initiatives.” They may also be called “Targets.”
VARIED APPROACHES TO STRATEGIC PLANNING
How strategic planning is approached may be affected by the organization type and/or the
program or project type.
Governmental Versus Nongovernmental
Governmental entities are guided by regulatory restrictions. Among these restrictions are federal regulations that mandate strategic planning. These regulations apply to federal governmental organizations and specify the format, contents, and timing of the required strategic
plans. On the other hand, nongovernmental entities are not covered under these mandated
requirements.
For-Profit Versus Not-For-Profit
A for-profit company is in business to make a profit (supposedly, anyway) and is answerable to its
owners. Its owner may be shareholders (for corporations) or partners (for partnerships) or possibly sole proprietors. This company’s mission will generally be proprietary in nature.
A not-for-profit organization, on the other hand, is expected to have a mission that is broadly
charitable in nature. It is typically answerable to the stakeholders who are impacted in one way
or another by its mission.
Specific Programs or Projects
In some cases the type of program or project or initiative will define the basic approach to
strategic planning. Funding sources and/or regulations may also make such demands. For
example, in some states construction of healthcare facilities is controlled by a regulatory Certificate of Need process. In these states, then, strategic planning for a new facility would be
Varied Approaches to Strategic Planning 275
a specific project. The outcome would be uncertain—because there is competition, success
would be unknown—so the project would be specially treated within the plan.
EXAMPLES OF MISSION, VISION, AND VALUE STATEMENTS
This section introduces various types of mission, vision, and value statements. The organization
and the length of statements can vary. Their terminology and their emphasis can also vary. One
set of examples that follow recognizes a special status or focus, another recognizes a financial
emphasis, and a third shows how the message is relayed.
RECOGNIZING A SPECIAL STATUS OR FOCUS WITHIN THE STATEMENTS
The following five examples each recognize a special status or focus within the statements.
Recognizing Non-Profit Status: Sutter Health
Sutter Health is a network of doctors and hospitals located in Northern California. Sutter’s mission statement specifically points out its not-for-profit commitment.
Mission
We enhance the well-being of people in the communities we serve through a not-for-profit commitment to compassion and excellence in healthcare services.
Vision
Sutter Health leads the transformation of health care to achieve the highest levels of quality,
access and affordability.
Values
• Excellence and Quality
• Innovation
• Affordability
• Teamwork
• Compassion and Caring
• Community
• Honesty and Integrity2
[Note: Sutter’s values are arranged in a circular graphic, with “Honesty & Integrity’’ in the middle of the
circle.]
Recognizing For-Profit Status: Tenet Healthcare Corporation
Tenet Healthcare Corporation is a publicly held corporation that is listed on the New York
Stock Exchange (NYSE:THC). As a for-profit corporation operating a healthcare delivery system, Tenet specifically mentions providing a return to its shareholders.
276 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Mission
At Tenet, our business is health care. Our mission is to improve the quality of life of every
patient who enters our doors. Our approach makes us unique and defines our future.
Values
As we seek to improve the quality of our patients’ lives, to serve our communities, to provide an
exceptional environment for our employees and affiliated physicians, and to provide an attractive return to our shareholders, we are guided by five core values.3
Recognizing Hospital Taxing-District Status: Parkland Hospital
Parkland Hospital is the tax-supported hospital serving Dallas County, Texas. As such, Parkland
first states its mandate from the taxpayers.
Mandate
To furnish medical aid and hospital care to indigent and needy persons residing in the hospital
district.
Mission
Dedicated to the health and well-being of individuals and communities entrusted to our care.
Vision
By our actions, we will define the standards of excellence for public academic health systems.
Guiding Principles
Our values and principles reflect our shared responsibility to achieve healthcare excellence for
our patients and communities.4
Recognizing the Vision and Intent of Their Founders: Mayo Clinic
The Mayo Clinic, a large nonprofit organization with a long history, provides medical care,
research, and education at locations including the Midwest, Arizona, and Florida. The Mayo
Clinic is research oriented and is known for treating difficult cases.
Mission
To inspire hope and contribute to health and well-being by providing the best care to every
patient through integrated clinical practice, education, and research.
Primary Value
The needs of the patient come first.
Value Statements
These values, which guide Mayo Clinic’s mission to this day, are an expression of the vision and
intent of our founders, the original Mayo physicians and the Sisters of Saint Francis.5
Recognizing a Special Status or Focus Within the Statements 277
Recognizing Patient and Community Commitment: Regions Hospital
Regions Hospital is a private not-for-profit hospital in St. Paul, Minnesota, that is over 100 years
old. Regions’ commitment to both patients and community is very clear.
Mission
Our mission is to improve the health of our patients and community by providing high quality
health care, which meets the needs of all people.
Vision
Our vision is to be the patient-centered hospital of choice of our community.6
FINANCIAL EMPHASIS WITHIN THE STATEMENTS
This section presents two examples of financial emphasis within the statements, as follows.
A Foundation’s Financial Responsibility: Saint Barnabas Medical
Center Foundation
A healthcare foundation typically exists to receive and manage charitable gifts. This foundation
exists to support a specific hospital: Saint Barnabas Medical Center, a major teaching hospital
located in Livingston, New Jersey.
Mission
The Saint Barnabas Medical Center Foundation is a charitable organization dedicated to
nurturing philanthropic support for the programs and services of Saint Barnabas Medical
Center.
These programs provide the communities we serve with the highest quality, most compassionate health care. To accomplish our mission, the Foundation will:
• Ensure that charitable gifts are used effectively, responsibly, and as directed by the
donor; and
• Carefully manage the endowed funds entrusted to us.7
A Medical Practice Network Emphasizes Financial Structure: Texas Oncology
Texas Oncology specializes in oncology patients through a network of physicians that covers the state of Texas. This organization places its vision first and mission second, as follows.
Note also that evidence-based, or scientific, care is contained within the mission statement.
Vision
To be the first choice for cancer care.
Mission
To provide excellent, evidence-based care for each patient we serve, while advancing cancer care
for tomorrow.
278 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Texas Oncology has three Core Values, consisting of Patient Care, Culture, and Business.
The Business Core Value is of particular interest to us. At the time of this writing, it reads as follows: Business—Our practice values professional management that:
• Promotes convenient access at rural and urban sites.
• Provides leadership in efficient care delivery and improves all aspects of cancer care.
• Provides a financial structure to expand services to our patients.
• Is competitive in all aspects of our business.8
These values clearly recognize the fact that an organization must have the financial structure
and resources to endure and to succeed.
RELAYING THE MESSAGE
The results of strategic planning as expressed in the mission statement, vision, and values are of
little use unless people know about them and what they say. This section focuses upon relaying
that message.
Introducing the Message
This section presents three examples of introducing the message within the statements, as
follows.
An Overall Title for the Message: Aetna Insurance Company
Aetna is a national insurance company over 150 years old that offers health insurance plans.
This company has wrapped their mission, values, and goals together under one overall title
called The Aetna Way, as follows:
Our company’s mission, values and goals are expressed through The Aetna Way. The Aetna
Way, comprising the elements below, encompasses our shared sense of purpose and provides
clarity as we pursue our operational and strategic goals.9
Emphasizing Areas of Focus: American Medical Association
The American Medical Association (AMA) is, according to its website, “…the largest physician
organization in the nation.”10 It provides a wide variety of resources and support for its members.
The AMA has created a five-year strategic plan, “…which aims to ensure that enhancements
to health care in the United States are physician-led, advance the physician-patient relationship,
and ensure that health care costs can be prudently managed.”11
This plan places emphasis on three particular “core areas of focus,” which include the
following:
• Improving health outcomes
• Accelerating change in medical education
• Enhancing physician satisfaction and practice sustainability by shaping delivery and payment models12
The plan was posted electronically, and an AMA member could click on any of the three focus
areas to read more. The AMA also provided a members-only feedback form in order to receive
input.
Relaying the Message 279
Explaining the Terms: Good Samaritan Society
The Good Samaritan Society is the largest not-for-profit provider of senior care and services in
the United States.
There is an important paragraph that appears before Good Samaritan’s Strategic statements.
That paragraph explains the purpose of each term contained with the statements, as follows:
• Our Mission states why the Society exists.
• Our Vision defines the desired outcome of our work.
• Our Strategic Direction defines where we want to be as an organization.
• And our Hallmark Values and related Core Principles identify the values that we strive to
integrate into all aspects of our work.13
Mission Expressed as a Motto
Mottos are an effective way to communicate the organization’s mission. However, composing
such a short piece is much more difficult than it seems at first. Two examples follow.
A Six-Word Motto: Good Samaritan Society
The Good Samaritan Society has also created a pithy concise motto consisting of only six words.
Grounded in Mission
Centered in Values14
A Three-Phrase Motto: Providence Healthcare Network
Providence Healthcare Network is a member of Ascension Health, “…the nation’s largest Catholic and largest nonprofit health system.”
A mission of compassion.
Compassion is perfected by excellence.
Because excellence goes beyond the will to help others by providing the determination and
tools to succeed where the heart takes you.15
The Message Available as Website Downloads
Website downloads make the information available to anyone who has access to a computer.
This section presents two examples of making the message available as a website download.
Downloadable Summaries from Duke Medicine
The umbrella term “Duke Medicine” actually covers three components—the Duke University
Health System, the Duke University School of Medicine, and the Duke University School of Nursing, all based in the Raleigh-Durham, North Carolina area. Duke Medicine has created both a mission and a vision that encompasses all these components. Then each component also has its own
strategic plan that feeds in turn into the combined plan.
At the time of this writing an overview of these plans was available in booklet form. The
booklet, entitled “Thinking Big” could be downloaded from the Duke Medicine website as a
280 Chapter 24 Strategic Planning and the Healthcare Financial Manager
PDF file.16 Summaries of each strategic plan could also be downloaded. Thus Duke provides
transparency and useful summaries in a readily accessible electronic format.
Downloadable Visuals from Johns Hopkins Medicine
Johns Hopkins also uses a single name—John Hopkins Medicine—for its overall medical
enterprise. This enterprise, based in Baltimore, Maryland, includes the Johns Hopkins Health
System along with the John Hopkins University School of Medicine.
Johns Hopkins Medicine has created a mission, vision, and core values for the entire enterprise. At the time of this writing it was possible to download and print out the Johns Hopkins
Medicine mission, vision, and core values in one of three ways:
• A Wall-Mounted Poster (large)—24” 3 36”
• A Framed Desk-top Poster (small)—8” 3 10”
• A Pocket Card—2.5” 3 3.5”17
Thus the message is definitely relayed, and in three possible forms, for three different display
purposes. It keeps the message visible as a reminder.
THE STRATEGIC PLANNING CYCLE AND ITS PROCESS FLOW
The basic elements of strategic planning can be visualized as a series of process flows. Thus by
visualizing the process involved, the planning function can be broken into its various manageable components.
PROCESS FLOW FOR CREATING GOALS, OBJECTIVES,
AND ACTION PLANS
Figure 24–2 illustrates these initial three components of the strategic plan.
Establishing Goals
You will recall that a goal is a statement of aim or purpose. In order to establish such a goal, it is
important to define how it will accomplish a particular segment of the mission statement. Establishing the actual goal involves the following:
• Define the goal.
• Determine that there is a clear and distinct connection to the mission statement.
• Decide how long it will take to accomplish this goal; that is, will it take one year, two years,
three years?
• Compose and condense final wording of the goal to properly express it in a concise
manner.
Broad Goals Become Narrower Objectives
A strategic objective further defines a particular strategic goal. Thus a single broad goal is segmented into several narrower and more defined objectives, as illustrated in Figure 24–2.
Process Flow for Creating Goals, Objectives, and Action Plans 281
Narrower Objectives Become Detailed Action Plans
You will also recall that an action plan provides a detailed plan of operations that shows how to
achieve one part of a particular objective. Thus a single defined objective is segmented into a
number of even more detailed action plans. This step shows how part of the objective will actually be accomplished. The action plan’s relationship to objectives and to goals is also illustrated
in Figure 24–2.
PROCESS FLOW FOR CREATING ACTION PLANS AND THEIR
PERFORMANCE MEASURES
Figure 24–3 illustrates the multiple performance measures that make each action plan operational.
The Action Plan Must Relate to Its Objective
As previously discussed, an action plan should always directly relate to the relevant component of its specific strategic objective. Details will be organized into subcomponents
as necessary and, as its title implies, the action plan will demonstrate how actions will be
accomplished.
Detailed Action Plans Will Contain Multiple Performance Measures
So how will the action plan demonstrate that its actions will be accomplished? The required
actions, or operations, will be linked to a series of performance measures, as illustrated in
Figure 24–3. The performance measures provide accountability.
When these measures are properly designed, performance can be reported as outcomes.
This achieves desired accountability and one cycle of the planning process flow is thus
complete.
Figure 24–2 Process Flow for Creating Goals, Objectives, and Action Plans.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Goal
Objective
# 1
Action Plan (A)
Action Plan (B)
Objective
# 2
Action Plan (D)
Action Plan (C)
282 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Figure 24–3 Process Flow for Creating Action Plans and Their Performance Measures.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Performance Measure 7
Performance Measure 6
Performance Measure 9
Performance Measure 8
Performance Measure 10
Action Plan (C)
Action Plan (D)
Action Plan (A) Performance Measure 2
Performance Measure 1
Performance Measure 3
Performance Measure 4
Performance Measure 5
Action Plan (B)
THE PLANNING CYCLE OVER TIME
We visualize the ideal strategic planning cycle itself as a never-ending process. In other words,
a completed plan is not set in stone, never to change. Instead, there should be a “refresh and
renew” approach to such planning. Incidentally, planning cycle segments may be called by different names, but they are still in a cycle. Look past the names to see the “skeleton” of the overall process.
Goals, Objectives, and Action Plans Interact and Repeat
The interaction of goals, objectives, and action plans should take feedback into account. This
feedback should be obtained as is appropriate from all levels of management within the organization. However, internal managers are not the only stakeholders involved with the strategic plan.
The Planning Cycle Over Time 283
Planning Revisions and Updates Are Necessary
The capability for planning revisions and updates should ideally be built into the plan itself. Unanticipated events can occur—both internally and externally—that require major revisions if the plan
is to be kept operational. Updates, on the other hand, are to be expected and allowance should be
made for them in order to keep the plan.
Stakeholders Provide Input Within the Cycle
Stakeholders can be both internal and external. In order to maintain a manageable planning
cycle, questions need to be answered. For example, how many external stakeholders need input
into the plan? Who, specifically are they? How will they provide this input?
Likewise, how many internal stakeholders need to provide input and/or feedback to the
plan? Who, specifically, are they? What departments or divisions do they represent within the
organization? Is this representation a good balance? And how will they provide this input?
Programming and Budgets Support the Planning Cycle
It makes sense that planning should be supported by budgets and the related funding. It is also
logical that programming should in turn support these budgets. We can then ask: “What goal
and what objective does this particular program and this budget support?”
Financial Aspects of the Plan
A plan must, above all, be operational. And to be operational, it must have financial support. How
will this financial support be provided? Will another division or project be cut in order for this to
happen? Can the consequences be predicted? If so, what will they be?
Related Timeframes
Necessary timeframes are appropriate for the particular portion of strategic planning. For
example, the plan itself typically covers a period of 4 to 5 years. If there is a vision statement, it
should be much further into the future, perhaps out to 10 years. Yet the managers’ accountability should be at least annually, and in fact may be quarterly.
MANAGERS’ RESPONSIBILITIES
Responsibility for the various segments can be assigned. The manager’s responsibility will generally rest in one of three management areas as follows.
Planning
The manager may contribute to planning by gathering data or by analyzing the data to provide specific information that is desired and necessary for the plan. In other words, the manager is participating in the planning function by doing his/her part in the preliminary segment of the process.
Decision Making
The manager may or may not be able to participate in the actual decision making for the plan,
depending upon his/her staff level within the organization. However, he/she may be assigned
284 Chapter 24 Strategic Planning and the Healthcare Financial Manager
to work on a planning committee or a task force that contributes directly to the decision makers
in the organization. This type of assignment is an important responsibility.
Providing Accountability
The manager can definitely contribute in suggesting criteria for performance measures. The
action plan will require performance measures in order to provide the necessary accountability.
And the manager is the best person to understand what measures are needed within his/her
department or division.
A well-designed planning process will also include milestones. The milestones signify the
completion of plan segments within a designated timeframe for completion of the entire plan.
The manager can and should be responsible for assisting in reaching certain milestones on
a timely basis. This function (one hospital CEO called it “ramrodding”) is another type of
accountability responsibility.
FEDERAL GOVERNMENTAL AGENCIES MUST PREPARE STRATEGIC PLANS
Agencies in the federal government are required by law to prepare strategic plans. They are also
required by law to provide reports on performance that tie to the strategic plans. This section
explains the importance of the federal planning cycle and describes its planning and performance requirements. It also provides an example of an agency strategic planning cycle.
WHY ARE FEDERAL PLANNING REQUIREMENTS IMPORTANT TO US?
The federal government’s planning requirements are important to us because they provide guidance in the form of well-thought-out and time-tested regulated concepts and a framework for
strategic planning.
INTRODUCTION: REQUIREMENTS, PLANS, AND PERFORMANCE
Legislative requirements for strategic planning and related performance reporting are
discussed as follows.
Legislative Requirements: Overview
Congress has enacted a law that provided for the establishment of strategic planning and
performance measurement in the federal government. This law, known as the Government
Performance and Results Act (GPRA) of 1993, required each agency of the federal government to prepare a strategic plan for program activities. These strategic plans were then to
be submitted to Congress and to the Director of the Office of Management and Budget
(OMB).18
Legislative Requirements for Strategic Planning
Each agency’s strategic plan must contain the following:
• A comprehensive mission statement
• General goals and objectives for major functions and operations
Introduction: Requirements, Plans, and Performance 285
• A description of how these goals and objectives are to be achieved
• Key factors external to the agency and beyond its control that might significantly
affect achieving these goals and objectives19
Strategic Plan Timeframes
The original 1993 Act required that the strategic plan cover a period of not less than five years
forward from the fiscal year in which it would be submitted. (You will recall that the federal government’s fiscal year is not a calendar year. Instead it begins on October 1st and ends on September
30th.) In addition the plan was to be updated and revised at least every three years.20
The plan’s timeframe has been subsequently revised to four years by the GPRA Modernization Act of 2010. At the time of this writing, the specific requirement is as follows: “…The plan
shall cover a period of not less than four years following the fiscal year in which the plan is
submitted.”21
Plans’ Impacts on Budgets and Funding
Governmental managers must reconcile their budget requests with their applicable part of the
strategic plan. The projects for which they are responsible can’t (usually) be funded if they are
not approved in the budget.
A common problem involves maintaining a project’s carry forward over sequential annual
budgets. In other words, a multi-year project will need to be recognized for funding in each
annual budget as the project progresses. This can be a real problem, considering the multiple levels of bureaucracy within the government that hinder the approval process.
We can also turn the concept of “impact” around the other way. Instead of asking
“What is the impact of the plan on budgets and funding,” we can ask the opposite questions.
They include, “Does the intent of the plan actually get funded? And stay funded?”
How Agency Strategic Plans Are Tied to Performance
This section describes performance reporting requirements for federal agencies.
Legislative Requirements for Performance Reporting
The 1993 Act actually had three elements: besides requiring strategic plans that covered multiple years, it also required that performance plans and program performance reports be submitted. These requirements actually make the strategic plan itself operational because they hold
the agencies accountable.
Agency Performance Plans Are Required
The GPRA Modernization Act of 2010 legislation requires the agency performance plans to be
submitted annually. The performance plans are to be posted on the Agency’s website.22
Agency Performance Reports Are Also Required
The Agency is also required to prepare an update report that compares actual performance achieved with performance goals as established in the performance plan. This
report is also to be posted on the Agency’s website.23
286 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Unmet Goals May Require a Performance Improvement Plan
Each fiscal year the Office of Management and Budget (OMB) is supposed to determine
whether the Agency has met the performance goals and objectives of the performance
plan. The OMB produces a review report. If goals are not met according to the OMB
report, the Agency must then prepare and submit a Performance Improvement Plan to
increase program effectiveness for each unmet goal. The plan must include measurable
milestones.24
Strategic Mission Statements: Two Federal Departmental Examples
Two departmental examples of governmental strategic mission statement appear in this section.
The first example belongs to the Department of Health and Human Services (HHS). This mission statement is of interest because the Centers for Medicare and Medicaid Services (CMS) is
an agency within the HHS department. The Medicare and Medicaid programs administered by
CMS are frequent subjects of interest in this book.
The second example belongs to the Department of Veterans Affairs (VA). We include this
example as background information because the VA’s Office of Information Technology is
the subject of the governmental planning cycle example that appears in the next section of
this chapter. Note the necessarily broad wording within both of these departmental mission
statements.
Department of Health and Human Services (HHS)
The Department of Health and Human Services (HHS) is “…the United States government’s
principal agency for protecting the health of all Americans and providing essential human services, especially for those who are least able to help themselves.”25
There are more than 300 programs within HHS, including both the Medicare and the Medicaid programs.
Department of Health and Human Services (HHS) Mission Statement
The mission of the U.S. Department of Health and Human Services (HHS) is to enhance the
health and well-being of Americans by providing for effective health and human services and
by fostering sound, sustained advances in the sciences underlying medicine, public health, and
social services.
HHS accomplishes its mission through several hundred programs and initiatives that cover a
wide spectrum of activities, serving the American public at every stage of life.26
Department of Veterans Affairs (VA)
The Department of Veterans Affairs (VA) oversees benefits and services, including health care,
for the nation’s veterans. There are three VA sub-agencies within the Department as follows.
The Veterans Health Administration (VHA) manages veterans’ health care and services. The
Veterans Benefits Administration (VBA) manages veterans’ benefits, including life insurance
and pensions. The National Cemetery Administration (NCA) oversees both burials and memorials for veterans.27
Introduction: Requirements, Plans, and Performance 287
Department of Veterans Affairs (VA) Mission Statement
“Our mission at VA is to serve Veterans by increasing their access to our benefits and services,
to provide them the highest quality of health care available, and to control costs to the best of
our abilities.”28
AN EXAMPLE: THE VA OFFICE OF INFORMATION TECHNOLOGY IT
STRATEGIC PLANNING CYCLE
This section contains a governmental planning cycle example. Elements of the cycle are then
defined and discussed. The section concludes with a summary of management responsibilities.
INTRODUCTION
You will recall that federal planning requirements are especially important to us because these
requirements provide guidance through a time-tested and regulated framework for strategic
planning. We are about to provide a real-life illustration of the planning cycle.
We present the illustrated cycle as an excellent example of the planning process. This example is drawn from a VA Directive concerning strategic planning. The entire scope of the Directive’s requirements is, of course, well beyond the scope of this text. We have had to generalize
the required process in order to provide this example. In generalizing, we are forced to disregard additional explanations, terminology, and background details contained in the Directive.
Please refer to it as a source for further details.
The elements within this VA illustrated example include components that we have described
earlier in this chapter. The components include the following:
• Set Broad Goals and Narrower Objectives for Programs
• Set Performance Measures to Achieve the Goals and the Objectives
• Determine External Key Factors That Are Significant
• Prepare Annual Performance Plan
• Prepare Periodic Performance Reports
• Revise and Update as Needed
THE VA OFFICE OF INFORMATION TECHNOLOGY IT STRATEGIC
PLANNING CYCLE: AN EXAMPLE
Figure 24–4 illustrates the planning cycle in accordance with VA Directive 6052. The Directive’s
version used here is dated 2009. While there will inevitably be future updates and revisions, this
example of the planning cycle process serves our purpose very well.29
THE VA PLANNING CYCLE’S PROCESS FLOW
Figure 24–4 shows the overall VA Strategic Plan and Goals at the top of the visual. This overall
plan and its goals then flow to four “administrative strategic plans.” The four plans include one
apiece for the three subagencies (VHA, VBA, and NCA), plus a fourth plan for the VA Staff
Office.
288 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Figure 24–4 VA Office of Information Technology IT Strategic Planning Cycle.
Reproduced from the Department of Veterans Affairs. VA Directive 6052 Appendix A (April 23, 2009).
Legislative
Changes
5-Year Planning
Cycle
3-Year Planning
Cycle
(Base/YR+1/
Target)
Annual End of
Fiscal Year
VHA
Strategic Plans
VBA
Strategic Plans
NCA
Strategic Plans
VA Staff Office
Strategic Plans
VA Strategic Plan and Goals
VA Key Business Priorities/Goals/Objectives
IT Strategic Plan
(IT Goals/Objectives/Strategies)
IT Performance Plans (Measures)
IT Management Accountability Report
EA/Multiyear
Programming/IT
Capability (BRM)
Budget
Program/Operational Plans
DAS/DCIOs/Executive Directors
IT Directors and Managers
Tactical Plans
Each of the four plans flow to, and relate to, VA key business priorities, goals, and objects.
The Information Technology (IT) Strategic Plan contains IT goals, objectives, and strategies.
Its multi-year planning cycle (shown on Figure 24–4 as a five-year cycle) flows back in and out of
the four Administrative Strategic Plans, as indicated by the two-way arrows.
The VA Planning Cycle’s Process Flow 289
Program and Operational Plans that support the IT Strategic Plan are the responsibility of
the Deputy Assistant Secretary (DAS), the Deputy Chief Information Officers (DCIOs) and the
Executive Directors. These plans are shown on a three-year planning cycle.
IT Performance Plans and their related Performance Measures are an outgrowth of the Program
and Operational Plans. They are on a shorter cycle that we interpret as the base year plus one target.
The Tactical Plans that will carry out the Performance Plans are the responsibility of the IT
Directors and Managers. Finally, an IT Management Accountability Report is required annually
at the end of each fiscal year.
The Legislative Changes (an external factor that influences the process) are shown in a box on
the left-hand side of the visual. Their influence feeds into and impacts the overall process.
Finally, the box on the dotted line to the left reads “EA/Multiyear Programming/IT
Capability (BRM) Budget.” We understand this is a budget that contains multi-year programming. We further understand it references IT Capability. The remaining portion of the acronym references the “One VA EA Business Reference Model,” or BRM. The BRM was developed
in part to provide a common set of process definitions. It thus assists in making “…the complex
integration between business processes transparent.”30
PLANNING CYCLE DEFINITIONS FOR THIS EXAMPLE
The following definitions are contained in the Office of Information Technology IT Planning
Directive. While they are specific to the Directive’s purpose, they provide greater depth to an
overall understanding of the illustrated cycle and its process flow.
Strategic Planning
Strategic planning is a continuous process by which IT determines direction and operational
focus over the next three to five years consistent with priorities established by the Secretary of
Veterans Affairs as expressed in the Departmental Strategic Plan. There is one IT Strategic Plan;
however, strategic planning involves all parts of VA Administrations and Staff Offices.
IT Mission
A mission statement is brief, defines the basic purpose of the organization, and corresponds
directly with the organization’s core programs and activities. An organization’s program goals
should flow from the mission statement. The mission defines the approach and means IT will
take to fulfill the mission of VA as a whole.
IT Vision
The vision defines the ideal state for IT. (It is) what an organization desires to accomplish in
the future.
IT Strategic Goals
A goal is a statement of aim or purpose included in a strategic plan (required under GPRA).
The strategic goal defines how an agency will carry out a major segment of its mission over a
290 Chapter 24 Strategic Planning and the Healthcare Financial Manager
period of time. The goal is expressed in a manner that allows a future assessment to be made of
whether the goal was or is being achieved. Most strategic goals will be outcomes and are longterm in nature. IT goals define the forward-thinking and transformational outcomes IT pursues
to achieve its mission over a period of time.
IT Strategic Objectives
Strategic objectives are strategy components or continuous improvement activities that are
needed to create value for the customers. IT objectives further define intended program outcomes to achieve IT goals.
Program Plans
A program plan consists of planned activities or related projects managed in a coordinated way to include an element of ongoing work products or projects. A program plan is
designed to accomplish a predetermined objective or set of objectives.
Operational Plans
An operational plan is a detailed action plan to accomplish the specific objectives. The plan is a
derivative of the strategic plan describing short-term business strategies, showing how the strategic plan will be put into operation and serving as a basis for an annual operating budget. An
operational plan may comprise a three-year rolling plan to be completed by a small subgroup of
people with expertise and/or a stake relating to a major goal.
Performance Measures
Performance measures are valid and reliable metrics for evaluating the extent to which goals
and objectives are achieved. The measures should be SMART (Specific, Measurable, Achievable, Results-oriented, Time-limited).
IT Management Accountability Report
The IT management accountability report (IT MAR) is an annual report that provides OI&T
performance information (i.e., strategic goals, objectives, fiscal year performance goals, and
outcomes). The IT MAR is a management tool that will provide a basis for assessing the organization’s effectiveness.
Environmental Scan: Feedback and Assessment
An environment scan is an ongoing internal and external customer feedback and assessment process conducted at all levels of the organization for use in developing vision, goals, and objectives.31
MANAGEMENT RESPONSIBILITIES WITHIN THE PLANNING CYCLE
This section concludes with a generalized view of planning responsibilities by three levels of
management. Figure 24–5 illustrates the three levels. Any planning cycle should reflect these
levels, as does the previous example.
Management Responsibilities Within the Planning Cycle 291
Upper-Level Responsibilities
Top-level management represents those individuals at the top of the organization chart.
These upper-level individuals should provide overall direction for the organization’s mission,
vision, and strategic framework. They should be responsible for policymaking and supervisory guidance issues.
Mid-Level Responsibilities
Mid-level individuals are basically accountable to those above, while they operate in a supervisory mode to those below them in the organization chart. Mid-level management should
typically provide the strategies to accomplish goals, performance measures, and operational
plans.
Managerial-Level Responsibilities
The managers, meanwhile, are accountable to all those above them on the organization chart.
The managerial level should typically develop the subordinate plans that will align with midlevel operational plans. Other responsibilities include managing the activities that are designed
to meet strategic goals, initiatives, and performance targets.
TOOLS FOR STRATEGIC PLANNING: SITUATIONAL ANALYSIS
AND FINANCIAL PROJECTIONS
Situational analysis and feasibility studies are discussed in this section, with an emphasis on their
roles in strategic planning.
Figure 24–5 Primary Planning Responsibilities by Management Levels.
Top Level
Mid-Level
Managerial Level
Provides mission, vision, strategic
framework, policy, and guidance
Provides strategies to accomplish
goals, performance measures, and
operational plans
Develops subordinate plans to align
with mid-level operational plans and
manages the activities designed to
meet strategic goals, initiatives, and
performance targets
292 Chapter 24 Strategic Planning and the Healthcare Financial Manager
SITUATIONAL ANALYSIS
This section defines situational analysis (SWOT) and discusses its components.
Definition
A situational analysis does two things. It reviews the organization’s internal operations for
strengths and weaknesses and it explores the organization’s external environment for opportunities and threats. (Thus SWOT: strengths-weaknesses-opportunities-threats.) A situational analysis
allows management to, literally, analyze the organization’s situation.
SWOT Analysis as a Strategic Tool
A SWOT analysis, properly performed, can be an excellent strategic tool. The four components
of a SWOT analysis include the following:
• Strengths
• Weaknesses
• Opportunities
• Threats
The basic SWOT analysis format is illustrated in Figure 24–6. Here we see that the “Strengths”
and “Weaknesses” sectors of the matrix are labeled “Internal,” while the “Opportunities” and
“Threats” sectors are labeled “External.”
Figure 24–6 Basic SWOT Analysis Format.
Internal
External
Strengths Weaknesses
Opportunities Threats
Sample SWOT Worksheets Are Contained in Appendix 24-A
Appendix 24-A contains Sample SWOT Worksheets. The worksheets and their supplemental
Question Guides concern Electronic Health Records (EHR) adoption and implementation.
These worksheets can, however, be easily adopted for other purposes.
Appendix 24-A contains three “Internal Worksheets” for analyzing strengths and weaknesses,
and an “External Worksheet” for analyzing external opportunities and threats. Supplemental
Question Guides are also included for each worksheet. A Scoring Summary Sheet is included
to complete the analysis.
Sequential Steps in the SWOT Analysis Project
The following steps pertain to both the internal and external components of the analysis:
1. First, decide if the sample worksheets and the supplemental question guides need to be
customized; if so, do so.
Situational Analysis 293
2. Gather necessary information.
3. Fill in the worksheets, utilizing the question guides as needed.
4. Reach agreement, or consensus, on the final score for each line item on the
worksheets.
5. Summarize the scores.
6. Enter the final net scores on the Scoring Summary Sheet.
7. Report the results.
Commencing the SWOT Analysis Project Process
In order to commence the SWOT analysis project’s process, a number of decisions must be
made. They include the following:
1. What type of task force or committee does the project need?
2. Who will be appointed to this task force?
3. What types of data/information should be gathered for this project?
4. Who will gather the information that is needed?
5. Will the scoring process be subjective or objective? (This may depend on the amount and
type of available data.)
6. Will the same task force members that are involved in recording the worksheet information also be involved in the scoring process, or will a separate group be appointed to carry
out the scoring function?
7. Who prepares the final report?
8. Who receives the report?
9. Who is responsible for taking appropriate action after the analysis and its report are
completed?
Conclusion
Situational analysis is particularly appropriate for the analysis of electronic records implementation because such implementation requires the collaboration of multiple knowledge areas. A
meeting of the minds can better occur with the discipline that a situational analysis can impose.
It is a powerful tool when properly applied.
We should also acknowledge that there are a variety of approaches to performing a situational analysis, and this brief discussion features only a single approach. No matter what
approach is utilized, the results of the situational analysis are what count.
FINANCIAL PROJECTIONS FOR STRATEGIC PLANNING
The type of financial projection that we discuss is this section is produced internally. These projections are intended for internal use during the planning process, and are thus not intended
for any use outside the organization.
Definition
Projections are views into the future. We “project” future events, projects, or operations using a
set of presumed, or hypothetical, assumptions.
294 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Projections are different than forecasts, although both are considered to be “prospective”
(thus “future”) financial statements. Forecasts are based on assumptions that are expected to
exist, and that reflect actions that are expected to occur.32
Projections, on the other hand, are often prepared to answer a “what-if” question, such as
“what if…this service/program/initiative were to be adopted?” In these “what-if” situations
several projections may be prepared, each based on a different set of hypothetical assumptions
and each reflecting the actions that might occur, based on such assumptions.33
Build a Planner’s Projection
An eight-step process for building a financial projection to be used internally for planning purposes is described as follows. The process is also illustrated in Figure 24–7.
Determine the Future Timeframe
What should the future start and end dates be for this projection? Is the time period to be covered long enough? Or is it too long for reasonable assumptions to be made?
Determine the Focus
Focus on what the plan (or planner) needs to know in order to go forward. Let that focus determine
the direction your search for information will take. (Also note that sometimes a different agenda
can redirect the focus.)
Gather Enough Information
You will need enough information to make informed decisions about your projection. The
range of subjects may vary, but the information should be as up-to-date as possible.
Make Reasonable Assumptions
By “reasonable assumptions” we mean no wildly unattainable assumptions. For example, in most
instances “we will increase revenue by 200% in the
fourth quarter of next year” is an assumption that
will not be accomplished thus is not reasonable.
Document the Assumptions
Assumptions used for the projection are key to
its success. Documenting the assumptions is an
indication of a well-constructed projection. The
documentation adds validity to the final product. It also provides a record of the overall process of information-gathering that underlies the
assumptions themselves.
Prepare the Projected Statements
Projected financial statements are then assembled using the documented assumptions. In
accountant’s terminology this is known as “compiling” the projections.
Figure 24–7 Build a Planner’s Financial Projection.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
1) Determine the future time frame
2) Determine the focus
3) Gather enough information
4) Make reasonable assumptions
5) Document the assumptions
6) Prepare the projected statements
7) Review for reasonableness
8) Create alternative scenarios
Financial Projections for Strategic Planning 295
Review for Reasonableness
For example, ask: “Is this assumption reasonable for an organization of my type and size?” This
type of review may be subjective, but it is a logical part of the process. Appropriate members
of the organization may also perform a review in order to highlight any weak spots within the
assumptions.
Create Alternative Scenarios
It is often helpful to produce multiple versions of the projections (“Model A,” “Model B,” etc.).
In this case, certain key assumptions are changed for each model. Thus the “what if” question is
answered in several different ways.
Financial Projections as Strategic Tools
These internal planning projects may be used to better make informed decisions. If properly
constructed, they can provide information that is laid out in a logical format, supported by
assumptions that are properly explained for the knowledgeable reader. To summarize, projections can be an important tool to inform and support the planning process.
CASE STUDY: STRATEGIC FINANCIAL PLANNING IN LONG-TERM CARE
Chapter 32, “Case Study: Strategic Financial Planning in Long-Term Care” later in this volume
involves a case study about strategic financial planning in long-term care. The case study is
authored by Dr. Neil R. Dworkin, Emeritus Associate Professor of Management at Western Connecticut State University. His case study merits your close attention, as it will utilize planning
concepts that have been discussed within this chapter.
APPENDIX 24-A: SAMPLE SWOT WORKSHEETS AND QUESTION GUIDES
Appendix 24-A contains four Sample SWOT Worksheets (three internal and one external) concerning EHR adoption and implementation, along with a Scoring Summary Sheet.
A Question Guide is also included for each Worksheet. Electronic medical records adoption
is a good subject for situational analysis. The sample worksheets in this Appendix can assist in
beginning such a project.
INFORMATION CHECKPOINT
What is needed? A “set” of an organization’s mission statement, vision statement, and values.
Where is it found? In the planning and policy division or within the administration office.
How is it used? These documents are used to guide the organization.
296 Chapter 24 Strategic Planning and the Healthcare Financial Manager
KEY TERMS
Action Plan
Financial Forecast
Financial Projection
Goal
Innovation
Mission Statement
Situational Analysis
Strategic Objective
SWOT Analysis
Values Statement
Vision Statement
DISCUSSION QUESTIONS
1. Do you know if your organization has a mission statement and a vision statement? If so,
how are they communicated? Are they printed, posted on a website, or available in some
other format? Please describe.
2. Have you ever been involved in a strategic planning session? If so, please describe
how the group and the session were structured (but without revealing proprietary
information).
3. Have you ever been involved in (or have observed) the process of a situational analysis
(SWOT)? If so, please describe how the group went about performing the analysis (but
again without revealing proprietary information).
NOTES
1. Department of Veterans Affairs (VA), VA Directive 6052 Appendix A (April 23, 2009).
2. Sutter Health, www.sutterhealth.org/about/mission (accessed May 31, 2012).
3. Tenet Health, www.tenethealth.com/about/pages/missionandvalues.aspx (accessed
July 30, 2012).
4. Parkland, www.parklandhospital.com/whoweare/mission_vision.html (accessed
June 7, 2012).
5. Mayo Clinic, www.mayoclinic.org/about/missionvalues.html (accessed July 30, 2012).
6. Regions Hospital, www.regionshospital.com/rh/about/index.html (accessed May 31,
2012).
7. Saint Barnabas Medical Center, www.saintbarnabasfoundation.org/about/mission.html
(accessed July 30, 2012).
8. Texas Oncology, www.texasoncology.com/about-txo/vision-mission-history.aspx
(accessed December 3, 2012).
9. Aetna, www.aetna.com/about-aetna-insurance/aetna-corporate-profile/aetna_mission
_statement (accessed July 30, 2012).
10. AMA Press Release November 26, 2012, www.ama-assn.org (accessed January 16, 2013).
11. American Medical Association, www.ama-assn.org/ana/pub/about-ama/strategic-focus
.page? (accessed October 17, 2012).
12. Ibid.
Notes 297
13. Good Samaritan Society, www.good-sam.com/index.php/about_us/ (accessed July 30,
2012).
14. Ibid.
15. Providence Healthcare Network, http://www.providence.net/about/ (accessed January
16, 2013).
16. Duke Health, www.dukemedicine.org/AboutUs (accessed July 30, 2012).
17. John Hopkins Medicine, www.hopkinsmedicine.org/se/util/display_mod.cfm?
MODULE=/se-server/mod/mod (accessed July 30, 2012).
18. Public Law 103-62. 103 P.L. 62; 107 Stat. 285—Section 3(a), The language of the Act
says “every agency,” but in fact certain Executive agencies were excluded, including the
Central Intelligence Agency, the General Accounting Office, the Panama Canal Commission, the United States Postal Service, and the Postal Rate Commission. [See 103 P.L.
62 Section 3(f).]
19. P.L. 62—Section 3(a) (1), (2), (3), (5).
20. P.L. 62—Section 3(a) (6b).
21. P.L. 111-352 Section 2(b).
22. Ibid. Section 3(b)(1).
23. Ibid. Section 4(b).
24. Ibid. Section 4(g).
25. U.S. Department of Health & Human Services (HHS), HHS Agencies & Offices,
http://www.hhs.gov/about/whatwedo.html (accessed December 4, 2012).
26. U.S. Department of Health & Human Services (HHS), HHS Strategic Plan, http://www
.hhs.gov/secretary/about/introduction.html (accessed May 25, 2012).
27. Administrative Law Review, www.administrativelawreview.org/publicresources/
index.php?option=com_content&view=article&id=21&Itemid=28 (accessed
February 2, 2013).
28. Department of Veterans Affairs, Strategic Plan: Refresh, FY 2011–2015, http://www
.amvets.org/pdfs/legislative_pdfs/2012/VA-Strategic-Plan-Refresh-FY-2011-2015
.pdf (accessed November 21, 2016).
29. Department of Veterans Affairs (VA), “VA Directive 6052, Information Technology Strategic Planning” (April 23, 2009), http://www.itstrategy.oit.va.gov/docs/directive_6052
.pdf, p. 6 (accessed December 4, 2012).
30. M Powered Strategies, www.mpoweredstrategies.com/news/2011/12/one-va-ea-businessreference-model/ (accessed February 2, 2013).
31. Ibid.
32. American Institute of Certified Public Accountants (AICPA), “Financial Forecasts
and Projections” AT Section 301 (c)(d), http://www.aicpa.org/Research/Standards
/AuditAttest/DownloadableDocuments/AT-00301.pdf
33. Ibid. AT Section 301 (d)(f).
298 Chapter 24 Strategic Planning and the Healthcare Financial Manager
© LFor/Shutterstock
The following Sample SWOT Worksheets and their supplemental Question Guides concern
Electronic Health Records (EHR) adoption and implementation. However, the worksheets and
question guides can be readily adapted for other purposes.
INTRODUCTION
Situational analysis explores an organization’s internal operation for strengths and weakness
and observes the organization’s external environment for opportunities and threats. The analysis process is often called “SWOT,” for strengths-weaknesses-opportunities-threats. To be effective, the analysis must be objective and realistic.
Electronic medical records adoption is a good subject for situational analysis. The sample
worksheets in this Appendix provide assistance in commencing such a project.
This Appendix contains four Sample SWOT Worksheets (three internal and one external)
concerning EHR adoption and implementation, along with a Scoring Summary Sheet. A Question Guide is also included for each Worksheet. The Guides are intended to commence the
process of analysis. Other questions may be added to customize the analysis for a particular
process, situation, or department.
SCORING SUMMARY SHEET FOR EHR ADOPTION AND IMPLEMENTATION
Exhibit 24-A–1 collects and summarizes the SWOT analysis scores. Both the internal and
external worksheets are to be scored for each item appearing on that particular worksheet.
The scores range from 1 to 5, as follows: 1 = very good; 2 = good; 3 = fair; 4 = poor; and
5 = very poor. These scores are then summarized and the final net score is entered on the
Exhibit 24-A–1.
THREE INTERNAL WORKSHEETS FOR STRENGTHS AND WEAKNESSES
Three internal worksheets present the results of the SWOT strengths and weaknesses internal analysis. These worksheets represent four important subjects that are relevant to EHR.
The first two worksheets concern staff members involved in some capacity with EHR. The third
worksheet addresses both technology and capital funding. These subjects are, of course, separate
from the staffing issues. Each worksheet is described below.
Sample SWOT
Worksheets and
Question Guides 24-A
APPENDIX
299
INTERNAL WORKSHEET FOR EHR INFORMATION
TECHNOLOGY (IT) STAFF
Exhibit 24-A–2 specifically addresses the information technology staffing. These staff members
are the ones who must make electronic health records implementation work. The responsible
staff are divided into three levels, depending upon the type of work they are expected to perform. The three levels represent “IT operations staff,” who are the most directly involved; the
“hands-on managers,” who manage the operations staff day-to-day; and the “upper-level supervisory IT management,” who manage from afar, but who are responsible for results.
Question Guide for EHR Information Technology Staff
Exhibit 24-A–3 contains 10 questions about IT staff. The questions are to be answered as is
appropriate for the various staff levels described in the preceding paragraph.
1 2 3 4 5
INTERNAL STRENGTHS SCORES
IT Department Staff □ □ □ □ □
Financial, Clinical, and Administrative Staff □ □ □ □ □
EHR Technology □ □ □ □ □
Capital Funding □ □ □ □ □
INTERNAL WEAKNESSES SCORES
IT Department Staff □ □ □ □ □
Financial, Clinical, and Administrative Staff □ □ □ □ □
EHR Technology □ □ □ □ □
Capital Funding □ □ □ □ □
EXTERNAL OPPORTUNITIES SCORES
Government □ □ □ □ □
Economy □ □ □ □ □
Competition □ □ □ □ □
Other Funding Sources □ □ □ □ □
EXTERNAL THREATS SCORES
Government □ □ □ □ □
Economy □ □ □ □ □
Competition □ □ □ □ □
Other Funding Sources □ □ □ □ □
Score 1 to 5 with 1 being very good and 5 being very poor
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–1 SWOT Scoring Summary Sheet for EHR Adoption and Implementation
300 Chapter 24 Strategic Planning and the Healthcare Financial Manager
IT OPERATIONS STAFF (for each type of position listed)
Overall Computer Skills
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
Specific EHR Skills
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
Staffing Capacity
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
HANDS-ON IT MANAGERS
Background and Experience
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
EHR Proficiency and Support
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
Coverage (Man Hours Available)
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
UPPER-LEVEL SUPERVISORY IT MANAGEMENT
Background and Experience
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
EHR Proficiency and Support
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
Coverage (Man Hours Available)
Strengths ____________________________________________________________________
Weaknesses __________________________________________________________________
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–2 EHR Internal Operations Analysis: Worksheet for Information
Technology (IT) Department Staff
Internal Worksheet for EHR Information Technology (IT) Staff 301
INTERNAL WORKSHEET FOR OTHER STAFF INVOLVED IN EHR
Exhibit 24-A–4 addresses responsible staff in three other departments of the organization.
These staff members are the ones who must make electronic health records implementation work within their own departments. The responsible staff members in each of these
three departments (financial, clinical, and administrative) are again divided into three levels,
depending upon the type of work they are expected to perform. The three levels represent
“Staff responsible for some aspect of EHR,” who are the most directly involved; the “handson managers,” who are responsible for some aspect of EHR; and the “upper-level supervisory
management,” who manage from afar, but who are responsible for results.
Question Guide for Financial, Clinical, and Administrative Staff
Exhibit 24-A–5 contains 14 questions about relevant staff members within these three departments. This guide and its accompanying worksheet would, of course, be reproduced with as
many copies as would be necessary in order to answer these questions for each department.
INTERNAL WORKSHEET FOR TECHNOLOGY AND CAPITAL FUNDING
Exhibit 24-A–6 addresses two subjects: computer technology and capital funding resources. The
computer technology section concerns hardware, software, space requirements, and vendors.
The section is then divided into two parts: one for overall computer systems and one for specific
EHR computer resources.
Staff questions (Answer the questions about IT staff as appropriate for the various
staff levels: IT operations staff, hands-on IT managers, and upper-level supervisory
IT management.)
□ Possess advanced computer operations concepts?
□ Possess basic computer operations concepts?
□ Understand EHR technical computer applications in depth?
□ Understand basic EHR technical computer applications?
□ Understand the concept of EHR calculations?
□ Cooperate/support multidisciplinary EHR adoption and implementation
efforts?
□ Resist/ignore EHR process and procedures?
□ Sufficient IT staffing for EHR implementation?
□ Sufficient IT staffing for EHR ongoing support?
□ Acceptable productivity for EHR implementation?
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–3 Question Guide for EHR Internal Operations Analysis: Information Technology (IT) Department Staff
302 Chapter 24 Strategic Planning and the Healthcare Financial Manager
STAFF RESPONSIBLE FOR SOME ASPECT OF EHR
Overall Computer Skills
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Specific EHR Skills
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Staffing Capacity
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
HANDS-ON MANAGERS RESPONSIBLE FOR SOME ASPECT OF EHR
Background and Experience
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
EHR Proficiency and Support
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Coverage (Man Hours Available)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
UPPER-LEVEL SUPERVISORY MANAGEMENT RESPONSIBLE FOR SOME
ASPECT OF EHR
Background and Experience
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
EHR Proficiency and Support
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Coverage (Man Hours Available)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–4 Worksheet for EHR Internal Operations Analysis: Financial, Clinical, and
Administrative Staff
Internal Worksheet for Technology and Capital Funding 303
The capital funding section of the worksheet addresses both short-term and long-term funding resources. The short-term funding requirement concerns EHR transition cash flow. The
long-term funding requirement concerns what fixed capital may be specified for EHR implementation. Both are important to success.
Question Guide for Technology and Capital Funding Resources
Exhibit 24-A–7 contains eight questions about computer systems and four questions about capital funding resources. Additional customized questions may supplement this initial guide’s
content.
EXTERNAL WORKSHEET FOR OPPORTUNITIES AND THREATS
Exhibit 24-A–8 addresses four external environment subjects, including Government, Economy,
Competition, and Funding Sources Other than Patient Revenue. Other subjects may, of course,
be added as desired.
Staff questions (Answer the questions about staff as appropriate for the various financial, clinical, and administrative staff levels: workers; hands-on managers, and upperlevel supervisory management.)
□ Possess advanced financial management concepts?
□ Possess basic financial management concepts?
□ Possess advanced clinical management concepts?
□ Possess basic clinical management concepts?
□ Understand EHR technical applications in depth from the financial view?
□ Understand basic EHR technical applications from the financial view?
□ Understand EHR technical applications in depth from the clinical view?
□ Understand basic EHR technical applications from the clinical view?
□ Understand the concept of EHR calculations?
□ Cooperate/support multidisciplinary EHR adoption and implementation
efforts?
□ Resist/ignore EHR process and procedures?
□ Sufficient relevant staffing for EHR implementation?
□ Sufficient relevant staffing for EHR ongoing support?
□ Acceptable productivity for EHR implementation?
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–5 Question Guide for EHR Internal Operations Analysis: Financial, Clinical, and
Administrative Staff
304 Chapter 24 Strategic Planning and the Healthcare Financial Manager
OVERALL COMPUTER SYSTEMS
Hardware and Software
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Space Requirements
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Vendor Contractual Agreements (if applicable)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Vendor Performance (if applicable)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
SPECIFIC EHR COMPUTER RESOURCES
Hardware and Software
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Additional Space Requirements (if applicable)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Vendor Contractual Agreements (if applicable)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Vendor Performance (if applicable)
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
CAPITAL FUNDING
Short-Term EHR Transition Cash Flow Requirements
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Long-term Fixed Capital Specified for EHR Implementation
Strengths ____________________________________________________________________________
Weaknesses __________________________________________________________________________
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–6 Worksheet for EHR Internal Operations Analysis: Resources Other than Staff
External Worksheet for Opportunities and Threats 305
Question Guide for EHR External Environment Analysis
Exhibit 24-A–9 contains a total of 22 questions about various components of the external environment. This guide may also be augmented with customized questions that relate to issues
within the specific organization under analysis.
OVERALL COMPUTER SYSTEMS
□ Sufficient equipment (hardware and software) for general operations?
SPECIFIC EHR COMPUTER RESOURCES
□ Sufficient equipment (hardware and software) for EHR implementation?
□ Sufficient equipment (hardware and software) for EHR ongoing support?
□ Equipment operates adequately?
□ Equipment costly to maintain? To operate?
□ If applicable, are vendor contracts costly to maintain (updates, add-ons, etc.)?
□ Does the equipment produce desired results? Timely results?
□ If applicable, does the vendor produce desired results? Timely results?
CAPITAL FUNDING
□ Have the short-term EHR transition cash flow requirements been accurately
projected?
□ Are these cash flow requirements accurately presented in the organization’s budget?
□ Are the long-term fixed capital specified for EHR implementation accurately
projected?
□ Are these long-term fixed capital requirements acknowledged in the strategic plan?
Attach sheets to document the additional information used for this analysis
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–7 Question Guide for EHR Internal Operations Analysis: Resources Other than
Staff
306 Chapter 24 Strategic Planning and the Healthcare Financial Manager
GOVERNMENT (EHR impact for each governmental element listed)
Medicare Program
Opportunities _______________________________________________________________________
Threats _____________________________________________________________________________
Medicaid Program
Opportunities ________________________________________________________________________
Threats ______________________________________________________________________________
Regulations About Electronic Standards (Version 5010 and ongoing versions)
Opportunities ________________________________________________________________________
Threats ______________________________________________________________________________
Other Federal/State Regulations
Opportunities ________________________________________________________________________
Threats ______________________________________________________________________________
ECONOMY (as to continuing need for and impact of EHR)
Opportunities ________________________________________________________________________
Threats ______________________________________________________________________________
COMPETITION (relevant to EHR)
Opportunities ________________________________________________________________________
Threats ______________________________________________________________________________
FUNDING SOURCES OTHER THAN PATIENT REVENUE (impact, if any, on EHR)
Opportunities ________________________________________________________________________
Threats ______________________________________________________________________________
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–8 Worksheet for EHR External Environment Analysis
External Worksheet for Opportunities and Threats 307
GOVERNMENT (EHR impact for each governmental element listed)
Medicare Program
□ What EHR implementation costs are related to this program initiative?
□ What revenues from EHR governmental sources are related to this program initiative?
□ What savings in work flow or processes are related to adopting EHR?
□ Additional changes to the EHR Medicare Initiative are scheduled to occur at various
points in the future. How will these initiative changes impact the organization?
Medicaid Program
□ What EHR implementation costs are related to this program initiative?
□ What revenues from EHR governmental sources are related to this program
initiative?
□ What savings in work flow or processes are related to adopting EHR?
□ Additional changes to the EHR Medicaid Initiative are scheduled to occur at various
points in the future. How will these initiative changes impact the organization?
Regulations About Electronic Standards (Version 5010 and ongoing versions)
□ What EHR implementation costs are related to these requirements?
□ What savings in work flow or processes are related to adopting these standards?
□ Additional changes to the regulatory electronic standards are scheduled to occur at various points in the future. How will these initiative changes impact the organization?
Other Federal/State Regulations
□ What other federal and/or state regulations affect EHR implementation?
□ How do these regulations impact the organization?
ECONOMY (as to continuing need for and impact of EHR)
□ Will EHR affect continuing need for medical services? If so, how?
□ What impact is EHR implementation projected to have on the medical services economy nationally? Regionally?
COMPETITION (relevant to EHR)
□ What are your three biggest competitors?
□ How do the services they provide compare to your services?
□ What do you predict the impact of EHR adoption will be on each?
□ How have they prepared for EHR initial implementation?
□ How does their preparation and impact affect your own organization?
OTHER FUNDING SOURCES (impact, if any, on EHR)
□ Does your organization have such funding sources?
□ If so, what impact, if any, will EHR adoption have on such sources?
Attach sheets to document the additional information used for this analysis.
Courtesy of J.J. Baker and R.W. Baker, Dallas, Texas.
Exhibit 24-A–9 Question Guide for EHR External Environment Analysis
308 Chapter 24 Strategic Planning and the Healthcare Financial Manager
Progress Notes
© LFor/Shutterstock
Putting It All Together: Creating a Business
Plan That Is Strategic
OVERVIEW
A business plan is a document typically prepared in order
to obtain funding and/or financing. A traditional business
plan typically contains information about three major elements: the proposed project’s organization, marketing, and
financial aspects. However, the actual business plan is generally constructed in a series of segments, each involving a
particular type of information. The overall business plan is
built up as these individual segments are completed. The
segments are described in this chapter.
ELEMENTS OF THE BUSINESS PLAN
A traditional business plan typically contains three major
elements:
• Organization plan
• Marketing plan
• Financial plan
The organization segment should describe the management team. The marketing segment should discuss who
may use the service and/or product. The financial segment
should contain the numbers that illustrate how the project
is expected to operate over an initial period of time. We
believe that it is also important to begin the business plan
with an executive summary that outlines key points, plus a
clear and concise description of the service and/or product
that is the subject of the plan.
After completing this chapter,
you should be able to
1. Understand the construction
of a business plan.
2. Describe the organization
segment of a business plan.
3. Describe the marketing
segment of a business plan.
4. Describe the financial segment of a business plan.
309
25
CHAPTER
PREPARING TO CONSTRUCT THE BUSINESS PLAN
The planning stage will shape a business plan’s content. The initial decisions, such as those
shown in Exhibit 25–1, will determine your approach to the plan. For example, if your
organization requires a certain type of format and preexisting blank spreadsheets, many of
the initial decisions have already been made for you. Otherwise, the checklist contained in
Exhibit 25–1 will assist you in making initial decisions for the business plan’s approach.
It is important to note that the level of sophistication for the overall plan should be based on
the decision makers who will be the primary audience. Another practical consideration involves
creating a grid or matrix to assist in gathering all necessary information. The grid or matrix
could also include which individuals are responsible for helping to create or collect the required
information. Finally, it is important to create a file at the beginning of the project in which all
computations, backup information, dates, and sources are kept together in an organized fashion.
THE SERVICE OR EQUIPMENT
DESCRIPTION
The service and/or equipment description
should do a good job of describing what the
heart of the business plan is about. If the business plan is for a project or a new service line,
then this description would expand to include
the entire project or the overall service line.
Information that should always be included in
the description is contained in Exhibit 25–2.
The test of a good description is whether
an individual who has never been involved in
your planning can read the description and
understand it without additional questions
being raised.
THE ORGANIZATION SEGMENT
The organization segment should describe the
management team. But it should also describe
how the proposed service or equipment fits
into the organization. Who will be charged
with the new budget? Who will be responsible
for the controls and reporting for this proposal? It is important to provide a clear picture
that informs decision makers about how the
proposed acquisition will be managed. Basic
facts to explain are included in Exhibit 25–3.
Visual depictions of the chain of authority
and supervisory responsibilities provide helpful illustrations for this segment.
Exhibit 25–2 Basic Information for the
Service or Equipment Description
Service or Equipment Description
• What the service specifically
provides
• Why this service is different and/or
special
• What the equipment specifically
does
• Why this equipment is different
and/or special
• Required training, if applicable
• Regulatory requirements and/or
impact, if any
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
Exhibit 25–1 Initial Decisions for the
Business Plan
Business Plan Initial Decisions
• Outline necessary format
• Decide on length
• Decide on level of sophistication
• Determine what information is
needed
• Determine who will provide each
piece of information
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
310 Chapter 25 Putting It All Together: Creating a Business Plan
THE MARKETING SEGMENT
The marketing segment should describe the
available market, that portion of the market
your service or equipment should attract,
and that portion of the market occupied
by the competition. This segment should
achieve a balance between describing those
individuals who will be availing themselves of
the service or equipment and a description of
the competition. A description of who will be
responsible for the marketing is also valuable
information for the decision makers. Strive
for a realistic and objective appraisal of the
situation. Basic facts to include are illustrated
in Exhibit 25–4.
Of all areas of the business plan, the marketing segment is most likely to be overoptimistic in its assumptions. It is wise to be
conservative about estimations of physician
and patient acceptance and usage. And it is
equally wise to be realistic when assessing the
competition and its likely impact.
THE FINANCIAL ANALYSIS SEGMENT
The financial segment should contain the
numbers that illustrate how the project is
expected to operate over an initial period of
time. Financial plans may range from a projected period of 1 year to as much as 10 years.
A 1-year projection is often too short to show
true outcomes, whereas a 10-year projection
may be too long to meaningfully forecast.
Your organization will usually have a standard
length of time that is accepted for these projections. The standard forecasted periods for
high-tech equipment, for example, often range from 3 to 5 years. Why? Because advances in
technology may render them obsolete in 5 years or less. Therefore, the forecast is set for a realistically short time period.
The financial analysis for a business plan should contain a forecast of operations.
The forecast may be simple, such as a cash flow statement, or it may be more extensive.
A more extensive forecast would also require a balance sheet and an income statement.
The required statements and schedules will depend on two factors: the size and complexity
of the project and the usual procedure for a business plan presentation that is expected in
your organization.
Exhibit 25–3 Basic Information for the
Organization Segment
Organization Segment Information
• Physical location where service will
be provided
• Physical location of the equipment
• The department responsible for the
budget
• The division responsible for
operations
• The directly responsible supervisor
• Composition of the overall management team
Courtesy of J.J. Baker and R.W. Baker,
Dallas, Texas.
Exhibit 25–4 Basic Information for the
Marketing Segment
Marketing Segment Information
• Physicians who will use the service
or equipment
• New patients who will use the
service or equipment
• Established patients who will use the
service or equipment
• Estimated portion of the market to
be captured
• Competition and its impact
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
The Financial Analysis Segment 311
The Projected Cash Flow Statement
As we have just stated, it is possible that the forecast of operations may simply consist of the cash
flow statement. In any case, the statement can be complex, with many detailed line items, or
it can be condensed. The condensed type of statement is most often found in a business plan.
Keep in mind, however, that a detailed worksheet—the source of the information on the condensed statement—may well be filed in the supporting work papers for the project. Necessary
cash flow assumptions are illustrated in Exhibit 25–5.
The Projected Income Statement
What income statement assumptions will your
business plan’s financial analysis require? The
basic assumptions for a healthcare project’s
income statement are illustrated in Exhibit 25–6.
The “revenue type” in Exhibit 25–6 refers to
whether, for example, the revenue is derived
entirely from services or whether part of the
revenue is derived from drugs and devices.
The “revenue sources” refers to how many
payers will pay for the service and/or drug
and device, and in what proportion (such
as Medicare 60%, Medicaid 15%, and commercial payers 25%). The “revenue amount”
refers to how much each payer is expected to
pay for the service and/or drug and device. The total amount of revenue can then be determined by multiplying each payer’s expected payment rate times the percentage of the total
represented by that payer.
In regard to the “expenses” in Exhibit 25–6,
the labor cost will usually be determined
by staffing assumptions. The required staffing should be set out by type of employee
and the pay rate for each type of employee.
The number of full-time equivalents (FTEs)
for each type of employee will then be
established. The FTEs will be multiplied times
the assumed pay rate to arrive at the labor cost
assumption.
“Supplies” refers to the necessary supplies required to perform the procedure or
service. “Cost of drug or device” refers to the
cost to the organization of purchasing the
drug or device (if a drug or device is necessary to the service). The labor, supplies, and
cost of drug or device are costs that can be
directly attributed to the service that is the
Exhibit 25–6 Basic Assumptions for Business
Plan Income Statement Projections
Income Statement Assumptions
• Revenue type
• Revenue source(s)
• Revenue amount
• Expenses:
• Labor
• Supplies
• Cost of drug or device
(if applicable)
• Equipment
• Space occupancy
• Overhead
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
Exhibit 25–5 Basic Assumptions for Business
Plan Cash Flow Statement Projections
Cash Flow Statement Assumptions
• Number of years in the future to
forecast
• Capital asset purchase or lease
information
• Capital asset salvage value (if any)
• Cash inflow
• Cash outflow
• Cost of capital (if applicable)
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
312 Chapter 25 Putting It All Together: Creating a Business Plan
subject of the business plan. Likewise, the “equipment” cost refers to the annual depreciation
expense of any equipment that is directly attributed to the service that is the subject of the
business plan.
“Space occupancy” refers to the overall cost of occupying the space required for the service
or procedure. “Space occupancy” is a catchall phrase. It includes either annual depreciation
expense (if the building is owned) or annual rent expense (if the building is leased) of the
square footage required for the service. Space occupancy also includes other related costs such
as utilities, maintenance, housekeeping, and insurance. Security might also be included in this
category. The actual forecast might group these expense items into one line item, or the forecast might show each individual expense (depreciation, housekeeping, etc.) on a separate line.
If the expenses are grouped, a footnote or a supplemental schedule should show the actual
detail that makes up the total amount.
“Overhead” refers to the remaining expenses of operation that are necessary to produce
the service but that are not directly attributable to that service. Examples of such overhead in a
physician’s office might include items such as postage and copy paper. This amount of indirect
overhead may be expressed as a percentage; for example, “overhead equals 10%.” Whether the
“space occupancy” example or the “overhead” example discussed previously here are grouped
or detailed in the forecast will probably depend on how large the amount is in relation to the
other expenses, or it might depend instead on the usual format that your organization expects
to see in a typical business plan that is presented to management.
The Projected Balance Sheet
What balance sheet assumptions will your business plan’s financial analysis require? The basic
assumptions for a healthcare project’s balance sheet are illustrated in Exhibit 25–7.
The elements of a balance sheet (assets, liabilities, and equity) are described in a previous
chapter. If a full projected set of statements is required for the business plan, the balance sheet
entries will in large part be a function of the income statement projections discussed in the
preceding section of this chapter. For example, accounts receivable would be primarily determined by the revenue assumptions, while accounts payable would be primarily determined
by the expense assumptions. Likewise, acquisition of equipment or other capital assets
will affect capital assets (property and equipment), while their funding assumptions will
affect either or both liability and equity totals
on the projected balance sheet.
THE “KNOWLEDGEABLE READER”
APPROACH TO YOUR BUSINESS
PLAN
We believe a good business plan should
answer the questions that occur to a knowledgeable reader. Thus, the information you
include in the business plan should reflect
Exhibit 25–7 Basic Assumptions for Business
Plan Balance Sheet Projections
Balance Sheet Assumptions
• Cash
• Accounts Receivable
• Inventories
• Property and Equipment
• Accounts Payable
• Accrued Current Liabilities
• Long-Term Liabilities
• Equity
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
The “Knowledgeable Reader” Approach to Your Business Plan 313
the choices that you made in selecting the
assumptions for your financial analysis. For
instance, an example of considerations for
forecasting an equipment acquisition is presented in Exhibit 25–8. The content of the
final business plan should touch upon these
points in describing your assumptions that
underlie the financial analysis.
THE EXECUTIVE SUMMARY
The executive summary should contain a wellwritten and concise summary of the entire
plan. It should not be longer than two pages;
many decision makers consider one page
desirable. Some people like to write the executive summary first. They tend to use it as an
outline to guide the rest of the content. Other
people like to write the executive summary
last, when they know what all the detailed content contains. In either instance, the executive
summary should tell the entire story in a compelling manner.
ASSEMBLING THE BUSINESS PLAN
The business plan should be assembled into
a suitable report format that is determined by
many of your initial decisions, such as length
and level of sophistication. A sample format
appears in Exhibit 25–9.
If an appendix is desired, it should contain detail to support certain contents in the
main part of the business plan. In preparing
the final report, certain other logistics are
important. It is expected, for example, that
the pages should be numbered. (You might
also want to add the date in the footer and
perhaps a version number as well.) Although
the report may or may not be bound, it should
have all pages firmly secured.
PRESENTING THE BUSINESS PLAN
You may be asked to present more than once.
Sometimes you will have to prepare a short
Exhibit 25–8 Considerations for Forecasting
Equipment Acquisition
Considerations for Forecasting Equipment Acquisition
• Only one location?
• Equipment single purpose or multipurpose?
• Technology: new, middle-aged, old
(obsolete vs. untested)?
• Equipment compatibility?
• Medical supply cost?
• High or low capital investment?
• Buy new or used (refurbished)?
• Buy or lease?
• Lease for number of years or lease
on a pay-per-procedure deal?
• How much staff training is required?
• Certification required?
• Square footage required for
equipment?
• Is the required square footage
available?
• Cleaning methods and equipment
(and staff level required)?
• Repairs and maintenance expense
(high, medium, low)?
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
Exhibit 25–9 Sample Format for a
Business Plan
A Sample Business Plan Format
• Title Page
• Table of Contents
• Executive Summary
• Service and/or Equipment
Description
• The Organizational Plan
• The Marketing Plan
• The Financial Plan
• Appendix (optional)
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
314 Chapter 25 Putting It All Together: Creating a Business Plan
form and a long form of the plan, depending on the audience. Tips on presenting your
business plan are presented in Exhibit 25–10.
It is especially important to practice your
presentation in advance. When you leave time
for questions and for discussion, you also want
to be well prepared for anticipated questions.
By constructing a well-thought-out business
plan, you have substantially increased your
chances for a successful outcome.
STRATEGIC ASPECTS OF YOUR
BUSINESS PLAN
Your business plan must fit into your organization’s strategic plan. To begin to do so, you
might answer the following questions:
• How does my business plan fit into
the overall strategic plan (the “master
plan”) for my organization?
• How does my business plan specifically
fit into my department or division’s segment of the organization’s overall strategic plan/master plan?
• Does the proposed timing of my business plan coincide with the strategic plan’s time
frames?
• Does the proposed funding of my business plan fit into available funding resources mentioned in the strategic plan?
• What competition will my business plan face, strategically speaking, within my organization? Does my plan provide a good defense against this competition?
• Are there external competition and/or legislative aspects mentioned in my business
plan that are also addressed within the strategic plan? If so, does my plan’s treatment of
these external aspects coordinate with that of the strategic plan? If not, have I explained
why not?
The previous chapter explored Strategic Planning in some depth. Other aspects contained
in that chapter may also be applicable to your business plan.
INFORMATION CHECKPOINT
What is needed? A sample of a business plan.
Where is it found? Probably with your manager or the departmental director.
How is it used? Study the way the business plan was distributed. Who received
it? What did they do with it? What was the result?
Exhibit 25–10 Tips on Presentation of the
Business Plan
Tips on Presenting Your Business Plan
• Determine who will be attending
ahead of time
• Determine how long you will have
for the presentation
• Be sure you have a copy for each
attendee
• Decide upon whether to use audio/
visual aids
• LCD projector and PowerPoint
slides?
• Flip chart and markers?
• Other methods?
• Practice your presentation in
advance
• Leave time for questions and for
discussion
Courtesy of J.J. Baker and R.W. Baker, Dallas,
Texas.
Information Checkpoint 315
KEY TERMS
Business Plan
Overhead
Revenue Amount
Revenue Sources
Revenue Type
Space Occupancy
Supplies
DISCUSSION QUESTIONS
1. Have you ever been involved in the creation of a business plan?
2. If so, did the plan include all three segments (organizational, marketing, and finance)? If
not, why do you think one or more of the segments was missing?
3. Have you ever attended the formal presentation of a business plan? If so, was it successful
in obtaining the desired funding?
4. Was the plan that was presented similar to what we have described in this chapter? What
would you have changed in the presentation? Why?
316 Chapter 25 Putting It All Together: Creating a Business Plan
Progress Notes
© LFor/Shutterstock
Understanding Strategic Relationships:
Health Delivery Systems, Finance, and Reimbursement
INTRODUCTION
We begin this chapter by defining three areas: health delivery systems, finance, and reimbursement. We include these
definitions in order to illustrate where finance and reimbursement fit into the overall system. We will then describe
the various strategic relationships that are involved.
By its very nature, the complexion and purpose of a
health delivery system cannot be considered separately
from the range of values and issues surrounding finance
and reimbursement, including the magnitude of government involvement. Healthcare finance is the linchpin of
the United States healthcare delivery system. While there
are some similarities to corporate finance (i.e., budgeting;
financial planning), there are major differences.
DEFINING HEALTH DELIVERY SYSTEMS
This section defines the health delivery system before
observing its strategic relationships within an overall system.
What Is a Health Delivery System?
A health delivery system typically contains different levels
of patient care and different sites of service, all operating
under one integrated system for the delivery of health care.
A more formal definition is as follows:
A delivery system which “provides or aims to
provide a coordinated continuum of services
to a defined population and are willing to be
held clinically and fiscally accountable for the
outcomes and the health status of the population served.”1
After completing this chapter,
you should be able to
1. Define health delivery
systems.
2. Define the area of healthcare
finance.
3. Understand the strategic
relationship between
healthcare delivery systems
and finance.
4. Understand the strategic
relationship between finance
and reimbursement.
5. Recognize the strategic
relationship between
third-party reimbursement
and government expenditures.
6. Recognize a new focus on
the relationship between
finance and healthcare
delivery.
317
26
CHAPTER
A successful health system that functions properly needs the six following elements:
• Trained health workers who are motivated
• A well-managed infrastructure
• A reliable supply of medicines and technologies
• Adequate funding
• Evidence-based policies
• Strong health plans, including strong updated strategic plans2
Who Are the Stakeholders in Health Delivery Systems?
Stakeholders in health delivery systems can be divided into two categories: internal and external. The internal stakeholders consist of those delivering care (clinicians), those who support
the care deliverers (administrators), and those receiving care (the patients).
External stakeholders are varied and numerous. Their motivations may vary, but their interests still center upon the delivery of care within the internal system. Figure 26–1 illustrates 12
different types of external stakeholders. They include the following:
• Insurance providers
• Government providers
• Government policy makers
• Government overseers
• The pharmaceutical industry
• The medical device industry
• Other health industry suppliers
• Professional organizations
• Educators
Figure 26–1 Stakeholders in Health Delivery Systems. Government Providers
Professional
Organizations
Government
Overseers
Insurance
Providers
Pharmaceutical
Industry
Other Health
Industry Suppliers
Consumers
Government
Policy Makers
Caregivers
Investors
Educators
Medical Device
Industry
Internal Healthcare
Delivery: Clinicians,
Administrators &
Patients
318 Chapter 26 Understanding Strategic Relationships
• Investors
• Caregivers
• Consumers
Insurance company providers include such organizations as Aetna, United Health, etc. Government providers include federal agencies such as Medicare, Medicaid, and TRICARE, along
with state agencies. Government policy makers include Congress and many supporting federal agencies such as the Office of Management and Budget (OMB), while individual states
also determine relevant health policy. Other government agencies oversee various elements
of our public health; they include the Centers for Disease Control and Prevention (CDC), the
National Institute of Health (NIH), and various others.
Health care is a huge industry in the United States. Figure 26–1 highlights three types of
industry: pharmaceutical, medical device, and all other health industry suppliers. The “all
other” includes both services and supplies, as varied as computer services to food and cleaning
supplies.
Numerous professional organizations provide support for both clinicians and administrators; examples include the American Hospital Association (AHA) and the American Medical
Association (AMA), though there are many more and they play an important supporting role.
Academia is a stakeholder for its educational role in both medical schools and business schools.
Investors play an important stakeholder role, as they provide funding. Caregivers have a personal interest in the health delivery system. And consumers are stakeholders because they are
impacted by rising costs of the healthcare industry as a whole.
DEFINING THE AREA OF HEALTHCARE FINANCE
This section defines the area of healthcare finance within the overall system.
What Are the Responsibilities Associated with Finance?
There are four major responsibilities typically associated with healthcare finance. They include:
• Planning
• Controlling
• Organizing and directing
• Decision making3
One of our colleagues, a nurse, talks about the area of healthcare finance as “a method of getting money in and out of the business.” It is not a bad description, because the Finance Department
is primarily responsible for achieving the most beneficial financial outcome for the organization.
What Are the Duties Associated with Finance?
The duties associated with healthcare finance revolve around the successful management of
planning, controlling, organizing and directing, and decision making. Specific duties for a
financial officer will depend upon the type of organizational structure where he or she works.
For example, is the organization large and consolidated, with a head office? If so, some (or
all) of the planning and decision making around planning will probably be handled in the
Defining the Area of Healthcare Finance 319
head office. The onsite financial officer’s duties will then center mostly upon operational matters such as controlling and organizing and directing. Such a large organization may have a
treasurer in addition to a chief financial officer. Or is the organization smaller, without a head
office? If so,the financial officer may have to direct all financial matters. He or she would have to
direct planning and related decision making in addition to the day-to-day operational matters.
The individual performing these duties may have one of several different job titles. A description of three such titles follows.
Chief Financial Officer: Responsible for operations (administrative, financial, and risk management), including both financial and operational strategies; determining the metrics that
are related to the strategies; and developing and monitoring internal control systems.4
Controller: Responsible for the organization’s accounting functions; includes producing accurate financial reports that adhere to appropriate standards, maintaining the accounting
system, and overseeing controls and budgets.5
Treasurer: Responsible for a higher level of the organization’s financial activities, mainly
centering upon financial liquidity, investments, and risk management.6
DEFINING THE AREA OF HEALTHCARE REIMBURSEMENT
This section defines the area of healthcare reimbursement within the overall system. The term
“reimbursement” basically means a method of paying (reimbursing) a healthcare provider for
services or procedures provided. Payment is made upon receipt of a claim (bill) from the service provider. This claim typically contains codes for specific procedures and services that tie to
relevant payment amounts. Payment of the claim may be made by a third-party payer or by the
patient directly.7
What Are the Responsibilities Associated with Reimbursement?
Simply put, there are three major responsibilities associated with reimbursement:
• Prepare correct and complete claims
• Get these claims to the correct payer(s) in a timely manner
• Collect the proper payment that is due in a timely manner
In addition, the reimbursement personnel are responsible for carrying out any directives
received from the Finance Department, including those of strategic planning.
What Are the Duties Associated with Reimbursement?
Reimbursement duties within the system may be split up into different positions. For example,
the following job titles may typically be responsible for these duties. (Note: other job titles also
exist that describe these same duties.)
• Data entry clerk: Enters codes and insurance information
• Medical coder: Enters service and procedure codes onto a claim
• Medical biller: Verifies the patient’s insurance coverage; prepares the bill (claim form);
reviews unpaid claims and/or appeals those that are denied
320 Chapter 26 Understanding Strategic Relationships
• Billing supervisor or coordinator: Oversees scheduling, monitoring, and training of
personnel
• Medical claims specialist or examiner: Reviews samples of claims for accuracy; documents
information for legal actions; provides legal support when required (this position functions outside the regular day-to-day operations and may work directly from the Finance
Department)
Other reimbursement duties involve management of monies received (or not received).
Incoming payments of claims must be reconciled and matched to the organization’s records of
billings. And nonpayments (past-due bills) must have collection efforts made. These payment
duties are typically handled by different personnel.
It is also possible that the billing and collection duties may be performed by an outside contractor. One specialist physician that we know uses such an outside contractor.
Both medical information and billing information can now be generated in real time. For
example, the doctor may have a data entry person right in the exam room with him. (Sometimes this is a nurse who has many other duties as well, but other doctors may use a “scribe”
whose only job is the data entry.) The doctor dictates medical notes as he performs his examination and the assistant enters the information into the computer. At the end of the visit, he
refers to his super bill.(The super bill is a customized form that contains procedure and diagnosis codes specific to a particular practice and/or specialty. A super bill allows information to
be recorded quickly and efficiently). He calls off the codes to be billed for this examination,
including any lab work ordered, etc. The data entry assistant also enters this coding information
into the computer. The billing codes are then transmitted electronically, either to the internal
billing department or to the outside billing service. And if transmitted externally, the outside
billing service is then typically responsible for all billing and collection—for a fee, of course.
While the above encapsulates the essence of healthcare reimbursement, two caveats are
worth mentioning. When healthcare reimbursement involves a third party, consumers may be
largely unconcerned with the costs of their care, knowing that their bills are paid by another
party. Moreover, third-party transactions may also remove providers from concerns about the
cost of care, as they may not need to confront a patient covered by insurance with the actual
charges, no matter how high. One may assume that these third-party concerns should be mitigated by the further implementation of value-based purchasing.
STRATEGIC RELATIONSHIP BETWEEN THE HEALTHCARE DELIVERY
SYSTEM AND FINANCE
This section discusses strategic relationships and their impacts across the system.
Relationship Cause-and-Effect: An Example
This relationship can be described as a circular cause-and-effect. That is, finance department
actions often affect the overall delivery system, and the overall delivery system in turn often
affects the finance department. We illustrate this cause-and-effect with an example. In this
example, particular elements of the overall delivery system will affect the strategic positioning
of the finance department.
Value-based programs are an important current trend in payment for U.S. healthcare services. Briefly, the programs rely upon digitally recorded performance measures, including
Strategic Relationship Between the Healthcare Delivery System and Finance 321
certain quality measures, to reflect value provided by the system. That value is then basically
rewarded by a bonus payment or penalized by a negative payment.
It follows, then, that accurate and timely recording of such quality measures will ultimately affect
total payments, which will affect the finance department’s financial strategic planning. But the
finance department has no control over how (or when) these measures are recorded. They happen
elsewhere within the system. This strategic relationship is illustrated step-by-step in Figure 26–2.
Note that the information generated in this example is used both internally and externally.
Steps are as follows:
Step 1: A medical service is performed by a clinician. This professional is assigned to a
medical department somewhere within the system.
Step 2: The data generated from this service is recorded within an electronic health record
(EHR). It includes the service itself plus specific quality information (quality measures).
Step 3.1: The data is reported in two parts. First, the medical service portion is transmitted to the Reimbursement Division, who then bills the third-party payer.
Figure 26–2 The Strategic Relationship of Value-Based Programs, Quality Measures, Finance, and
Reimbursement.
To Reimbursement Division
who bills the third-party payer
To third-party payer
From third-party payer
Of the Finance Department
By the Finance Department &
the Reimbursement Division
Medical Services Data
Quality Measures
For Value & Performance
As shown by data analytics
Data Analyzed
Data Reported
Outcome of Analysis
Becomes Actionable
Results in Pay for
Performance
(with Bonus/Penalty)
Payment Impacts Revenues,
Budgets, & Forecasts
Affects Strategic Positioning
By clinician assigned to a
medical department Medical Service Performed
Data Generated From service performed
Data Recorded By digital means to an EHR
322 Chapter 26 Understanding Strategic Relationships
Step 3.2: In the second part of this step, the quality measures portion of the data is
transmitted to the third-party payer, who accumulates it for future analysis.
Step 4: At a future point in time, the third-party payer analyzes the accumulated quality
measure data.
Step 5: The outcome of this analysis becomes actionable by the payer, as shown by the
data analytics.
Step 6: The resulting action is a pay-for-performance bonus or penalty from the
third-party payer.
Step 7: This payment result impacts the finance department’s revenues, budgets, and
forecasts.
Step 8: The resulting financial impact affects strategic positioning by the finance
department.
The resulting financial impact also, of course, impacts the financial position of the overall
system. Thus, the strategic relationship of the entire system versus the finance department is
cause-and-effect. Accurate reporting of good quality measures by an entirely separate department trickles down to affect dollars received (or not received), which in turn affects both the
finance department and the entire system.
Strategic Analysis Relationships Within the System
The previous example illustrated a relationship that resulted in payment impacts from a payer
outside the health delivery system itself. However, the same data can and should be analyzed for
internal strategic uses. Figure 26–3 illustrates this type of analysis as follows:
a. The medical service data is generated and recorded via EHRs, using software installed by
the organization.
b. The accumulated data is analyzed for value-based purposes. This analysis may be performed internally by the IT department or by an outside contractor.
c. The outcome of such analysis, as shown by data analytics, becomes actionable. This is an
internal analysis, generated for internal use.
d. The strategic action plan is then revised. Revisions are undertaken by the personnel who
are responsible for strategic planning within the system.
e. Strategic positioning results from plan revisions.
Such analysis highlights strategic relationships between and among the various departments
within the system. While the positioning in this example may be most likely to affect the Finance
Department and its Reimbursement Division, as shown, that might not always be the case. The
result of the internal strategic analysis may reveal faults in the process and workflow at the
clinical level. Strategic relationships should then be activated to remedy the faults, wherever
they may lie.
THE STRATEGIC RELATIONSHIP BETWEEN FINANCE AND
REIMBURSEMENT
At first glance, the strategic relationship between finance and reimbursement seems like a oneway street. That is, finance personnel provide the lead in strategy and reimbursement personnel
must follow.
The Strategic Relationship Between Finance and Reimbursement 323
However, what happens if the reimbursement division fails in its responsibilities? Answer:
Cash flow for the organization is reduced. (And, in some cases, the reduction in cash flow
can be significant.) In this case, finance must react to the reimbursement situation instead of
providing the lead. Finance personnel will have to find funding to make up the cash shortfall.
Strategic planning must be revised while remedial action is taken.
Inasmuch as the Chief Financial Officer (or Vice President of Finance in a larger organization) is responsible for all finance activities within the organization, it is incumbent upon that
person to raise the necessary funds and to ensure that those funds are effectively used. Specific applications may include the acquisition of capital, cash and debt management, and lease
financing among strategic alternatives.
It is worth noting that some things are beyond the organization’s control. A case-in-point
is the Centers for Medicare and Medicaid Services’ (CMS’s) Readmission Reduction Program. Penalties are levied against hospitals for excessive readmissions within 30 days of
discharge.8
Figure 26–3 Internal Strategic Analysis for Value-Based Programs.
Affects Strategic
Positioning
By The Finance
Department &
The Reimbursement
Division
Overall
Medical Service
Data Generated
& Recorded
Via EHRs and
software installed by
the organization
Data Analyzed
For
Value-Based Purposes
By ITT department or
outside contractor
Outcome of Analysis
Becomes Actionable
For Internal Use
As shown by data
analytics
Strategic Action Plan
Is
Revised
By the personnel
responsible for
strategic planning
324 Chapter 26 Understanding Strategic Relationships
THIRD-PARTY REIMBURSEMENT AND GOVERNMENT EXPENDITURES:
ANOTHER STRATEGIC RELATIONSHIP
This section discusses third-party reimbursement and government expenditure relationships.
Reliance on Third-Party Reimbursement
Reliance on third-party reimbursement sets healthcare finance apart from its corporate brethren. It plays the dominant role in the configuration of finance flow in the healthcare industry.
Without third-party reimbursement, inclusive of private insurance carriers, healthcare finance
and the delivery system that it supports would take on a very different complexion, one that
would not be sustainable.
Reimbursement Methods Have Evolved
Historically, different methods of reimbursement have had attendant risks and incentives associated with them. They have gone through an evolution of sorts, beginning with the retrospective cost-based or cost-plus method, moving on to charge-based methods (using negotiated rates
that sometimes reflect discounts), and evolving into the prospective payment system that pays
a predetermined, fixed amount.9 (The retrospective system pays after the service is provided,
while the prospective payment system pays before the service is provided.) These three types of
reimbursement mechanisms are indicative of a fee-for-service framework.
Two additional types of reimbursement that are relevant to the interplay between health
delivery systems and finance are capitation and pay-for-performance (P4P). In the former, the
provider is typically paid a fixed per-member-per-month payment for each covered participant.
This payment is to cover all medical services that have been contracted for the period.10 In P4P,
providers receive payment incentives when they meet specific performance measures that show
they are delivering high-quality, efficient care. Thus, pay-for-performance is also referred to as
value-based purchasing (VBP), in that it “…connects reimbursement to the quality of patient
care rather than just the quantity of services received.”11
Government Support in Healthcare Spending
The magnitude of government support, of which third-party reimbursement is a central feature, is illustrated by the following data. Healthcare spending in the United States grew 5.3% in
2014, reaching $3 trillion or $9,523 per person. As a share of the nation’s Gross Domestic Product (GDP), health spending accounted for 17.5%, up from 17.3% in 2013.12 See Figure 26–4 for
a visual representation of these data.
The CMS predicts annual healthcare costs will be $4.64 trillion by 2020, which would be
nearly 20% of the U.S. GDP. Moreover, Medicare’s major role in the health delivery system is
illustrated by its accounting for 20% of total health spending in 2014, the majority of which
was spent on hospital care (27%) and physician services (23%).13 In fiscal year 2014, Medicaid accounted for 16% of national health expenditures, comprised of acute care (68.2%),
long-term care (28.1%), and Disproportionate Share Hospital (DSH) payments (3.7%).14
Figure 26–5 illustrates these health-spending percentages.
Third-Party Reimbursement and Government Expenditures: Another Strategic Relationship 325
In the latter context, federal law requires that state Medicaid programs make DSH payments to qualifying hospitals that serve a larger number of Medicaid and uninsured individuals. Although there has been a noticeable slowing in the rate of increase in annual healthcare
expenditures, the largest spending increase in 2014 was registered for prescription drugs
(12.2%, compared to 2.4% growth in 2013).15
Figure 26–5 Medicare and Medicaid Spending for Fiscal Year 2014.
Data from CMS. NHE 2014 Highlights.
4%
28%
68%
Medicaid Spending
Physician
Services
23%
Hospital
Care
27%
All other
services
50%
Medicare Spending
Disproportionate Share Hospitals
Long-Term Care
Acute Care
Medicaid
16%
Medicare
20% All other
payors
64%
Figure 26–4 Total U.S. Healthcare Spending for Fiscal Year 2014.
Data from CMS. NHE Fact Sheet (12-03-15).
326 Chapter 26 Understanding Strategic Relationships
A NEW FOCUS ON THE RELATIONSHIP BETWEEN FINANCE AND
HEALTHCARE DELIVERY
This section describes a new relationship focus.
Trending Forward Toward the Future
Medicare and Medicaid just turned 50. No statutes have had more of an impact on American
health care and well-being. That said, it should be noted that the Affordable Care Act, signed
into law in March 2010, created new areas of focus between the relationship of finance to delivery. It is the largest change in healthcare financing and accessibility to health care since 1965.
CMS unveiled its Accountable Care Organization (ACO) program in 2012. The ACO model
stresses primary care coordination, primarily for the chronically ill, and beneficiary engagement opportunities, as well as advancing the managed care concept by rewarding providers for
measurably improving care quality and efficiency rather than simply for saving money.16 The
groups of providers who are integral to ACOs come together voluntarily. Recent revisions are
designed to test whether stronger incentives can improve outcomes and cut costs for Medicare
beneficiaries. As of July 2015, there were over 750 ACOs.17
The New Finance–Delivery Link Is a Challenge
As such, this new focus on the finance–delivery link reflects the ongoing challenge for healthcare leaders to integrate clinical and business data. It’s the shift to value-based care that is making this integration an imperative. An important part of this shift entails at-risk payments, such
as those that characterize the aforementioned ACOs, both upside risk (sharing in savings) and
downside risk (reimbursement penalties).18 The presence of risk causes providers, such as physician organizations, to increase their dependence on analytics modules. We need to know the
cost of care if we’re going to be at risk.
REIMBURSEMENT AND PHYSICIANS: AN ONGOING STRATEGIC
CHALLENGE
This section discusses a particularly important strategic challenge.
The Sustainable Growth Rate and Physician Reimbursement
Healthcare finance and reimbursement is anathema to many physicians. Aspects of Medicare
illustrate the complexity that many physicians contend with. An ongoing feature of the program
has been the Sustainable Growth Rate (SGR), which was used by CMS to control growth in
Medicare physician service expenditures. Generally, this was a method to ensure that the yearly
increase in expense per Medicare beneficiary did not exceed the growth in the GDP.19
On March 1 of each year, the physician fee schedule was updated accordingly. This has been
euphemistically known as a “doc fix.” Physician groups, including the AMA and the American
Osteopathic Association (AOA) have lobbied for a permanent reform to the SGR so that physician payment rates are not subject to annual cuts; a permanent doc fix.
Reimbursement and Physicians: An Ongoing Strategic Challenge 327
The SGR Has Been Replaced
A 1.5% or less annual update in payment rates has been common over the last 10 years.20 Predictably, these low increases in Medicare payments have consequences: while fewer physicians
may take on new Medicare patients, other physicians may withdraw entirely from the program.
On April 14, 2015, Congress ended the doc fix by passing the Medicare Access and Children’s
Health Insurance Program (CHIP) Reauthorization Act (MACRA). This Act put an end to the
SGR physician payment formula. Providers would have seen Medicare reimbursement rates drop
by 21% starting on April 15, 2015, had this legislation not been enacted. The Act establishes an
automatic 0.5% raise annually in provider reimbursement rates from 2015 through 2019.21
The New Performance-for-Payment Reimbursement Method Presents Different
Physician Challenges
From 2019 on, payments to providers are adjusted based on performance under a two-part
Quality Payment Program (QPP). The QPP thus includes certain payment adjustments under
the Merit-Based Incentive Payment System (MIPS). The program also provides certain payment
adjustments for “Advanced” Alternative Payment Model (APM) entities. What QPP underscores, potentially further vexing physicians, is CMS’s objective to tie the majority of reimbursement to quality outcomes and increased beneficiary access to quality care.
The program may also present practice management challenges to providers and their business partners. For example, starting in 2019, MIPS mandates negative payment adjustments
for providers who fall below certain performance thresholds. By 2022, some providers may see
payments cut by up to 9%. (For more detail about QPP, see the chapter entitled “New Payment
Methods and Measures: MIPS & APMs for Eligible Professionals.”)
Physician Leadership Is Needed
Concurrent with the change to value-based payment and the resulting value-focused organization should be a shift in leadership roles that involves more physicians. Physicians should
be employed as leaders. They have unique insight into the needs of the patient population.
Their knowledge of optimal patient outcomes and how to achieve them are critical to effectively
adopting to the new reimbursement climate based on value. Building an effective “Physician
Enterprise” wherein new management structures are physician directed and led requires that
the resulting organization be both flexible and transparent enough to achieve both cost reduction and better outcomes.22
In conclusion, CMS’s attempt to remake the nation’s heathcare finance system based upon
value-based payments is a “sea change”. Strategic relationships are very much affected by this
sea change. Recognizing the importance of such change and how it impacts various areas of the
organization is an important step in revising the strategic plan.
INFORMATION CHECKPOINT
What is needed? A description of your organization’s health delivery system,
finance department, or reimbursement division.
328 Chapter 26 Understanding Strategic Relationships
Where is it found? This information may be present on your organization’s website or within a brochure prepared for the public. In the
case of the health delivery system, it may even be found
within a PowerPoint presentation, but be careful about
proprietary use if that is the case.
How is it used? Use will depend upon the item you find. Typically, it could be
used for marketing, for training, or even for recruitment
purposes.
KEY TERMS
Capitation
Electronic Health Record
Finance
Gross Domestic Product
(GDP)
Health Delivery System
Information Technology
(IT)
Pay-for-Performance (P4P)
Reimbursement
Super Bill
Stakeholder
Sustainable Growth Rate
(SGR)
OTHER ACRONYMS
ACO: Accountable Care Organization
AHA: American Hospital Association
AMA: American Medical Association
AOA: American Osteopathic Association
APM: Alternative Payment Model
CDC: Centers for Disease Control and Prevention
CHIP: Children’s Health Insurance Program
MACRA: Medicare Access and CHIP Reauthorization Act
MIPS: Merit-Based Incentive Payment System
NIH: National Institutes of Health
OMB: Office of Management and Budget
QPP: Quality Payment Program
WHO: World Health Organization
DISCUSSION QUESTIONS
1. If you work in a healthcare organization, do you know how your finance operation is
organized? Please describe.
2. Discuss the essence of the relationship between the healthcare delivery system and thirdparty reimbursement.
3. Do you think that the transition from fee-for-service payment to value-based payment is
feasible?
4. If you work in a healthcare organization, what percentage of your revenue is derived from
third-party reimbursement?
Discussion Questions 329
NOTES
1. F. Lega, “Organizational Design for Health Integrated Delivery Systems: Theory and Practice,” Health Policy, 81 (2007): 258–279.
2. World Health Organization (WHO), “Health Systems Service Delivery,” www.who.int
/healthsystems/topics/delivery/en/, accessed December 15, 2016.
3. Note that these areas of responsibility are more fully discussed under “The Elements of
Financial Management” in the introductory chapter of this text.)
4. Accounting Tools, “Chief Financial Officer (CFO) Job Description,” www.accountingtools
.com/job-description-cfo, accessed March 1, 2016.
5. Ibid.
6. Ibid.
7. Note: The term “reimbursement” implies that a claim is being paid, or reimbursed, for
services already rendered. We now have prospective reimbursement whereby payment
may be made for services that will be rendered in the future. Nevertheless, “reimbursement” is still being used as a descriptive term even though the payment method may be
prospective.
8. CMS, Hospital Readmissions Reduction Program, www.medicare.gov/hospitalcompare
/readmission-reduction-program.html, accessed September 17, 2016.
9. Health Care Financing & Organization (HCFO) & Robert Wood Johnson
Foundation (RWJF), “Learning from Medicare: Prospective Payment,” May
2011; also: CMS, “Hospital Value-Based Purchasing,” www.cms.gov/Medicare
/Quality-Initiatives-Patient-Assessment-Instruments/hospital-value-based-purchasing/,
accessed June 28, 2016.
10. J. McCally, Capitation for Physicians (Chicago: Irwin Professional Publishing, 1996), 176.
11. HCFO & RWJF, “Learning from Medicare.”
12. CMS, “National Health Expenditures 2014 Highlights,” https://www.cms.gov/research
-statistics-data-and-systems/statistics-trends-and-reports/nationalhealthexpenddata
/downloads/highlights.pdf, accessed February 7, 2016.
13. Ibid.
14. Ibid.
15. Ibid.
16. H. Larkin, “ACO or No?” Hospitals & Health Networks, 88, no. 5 (2014): 26–31.
17. S. Shortell, “The Next Frontier: Creating Accountable Communities for Health,” Hospitals & Health Networks, 89, no. 7 (2015): 12.
18. M. Zeis, “The Certainty of Analytics,” HealthLeaders, 18, no. 3 (2015): 32–36.
19. CMS, “Estimated Sustainable Growth Rate and Conversion Factor, for Medicare Payments to Physicians in 2015,” p. 1, www.cms.gov/medicare/medicare-fee-for-servicepayment/sustainablegratesconfact/downloads/sgr2015.pdf, accessed September 17,
2016.
20. Ibid., Table 6, p. 8.
21. Medicare Access and CHIP Reauthorization Act of 2015, Pub. L. No. 114-10 (2015).
22. P. Betbeze, “Building an Effective Physician Enterprise,” HealthLeaders, 18, no. 3 (2015):
38–42.
330 Chapter 26 Understanding Strategic Relationships
PART
© LFor/Shutterstock
Information
Technology as
a Financial and
Strategic Tool
X

Progress Notes
© LFor/Shutterstock
Understanding ValueBased Health Care
and Its Financial and
Digital Outcomes
THE VALUE-BASED CONCEPT: INTRODUCTION
To many financial managers, the term “value-based” has
come to mean a combination of both quality and cost. If
you are shopping, whether for a box of cereal or a car, you
will probably consider this combination. In the case of lowcost items, like the cereal, you might first consider quality
(taste and so on) and then its cost; with larger purchases,
such as a car, you may consider the cost first and then its
quality. Either way, both cost and quality will usually enter
into your equation.
Healthcare organizations have used a variety of methods
to determine cost and to measure the quality of care delivery over the years. However, in the past few years, the concept of value-based health care has come about. A primary
feature of a “value-based” approach is to recognize both
quality and cost, just as you might in your personal life.
Meanwhile, in today’s healthcare world, the term “valuebased” actually has come to have multiple definitions. The
particular definition depends upon the particular focus.
For purposes of healthcare finance, value-based concepts
can be, and are, applied to value-based purchasing (as with
your car and the cereal), payment adjustments, pricing,
strategy, and patient care. When we speak of value-based
healthcare financial management, we may be referring to
different aspects of all these concepts. We can even view the
broad span of value-based population health and the role
that financial management can play.
This chapter, therefore, addresses different facets of
the value-based concept in healthcare finance and related
financial management. We have divided the chapter into
several parts, and each part builds upon your understanding
After completing this chapter,
you should be able to
1. Describe value-based
progress and programs in
the private and public sector.
2. Distinguish among different
types of value-based
education efforts.
3. Understand the basics of
value-based legislative
reform.
4. Describe quality
measurement in the public
and private sectors.
5. Recognize various possible
digital outcomes.
6. Identify types of financial
outcomes.
7. Describe elements of
strategic planning in the
public and private sectors.
333
27
CHAPTER
of the value-based concept. The remainder of the chapter will discuss the following value-based
health concepts:
• Progress in the private sector
• Progress in the public sector
• Education efforts
• Legislative reform
• Quality measurement concept
• Public reporting efforts
• Financial and digital outcomes
• Strategic planning approaches
VALUE-BASED PROGRESS IN THE PRIVATE SECTOR
Leaders in innovation within the private sector have adopted a variety of value and quality efforts.
This section discusses value-based progress in implementing, research, and collaboration.
Implementing Value-Based Approaches
Two examples appear below.
An Organizational System Approach
The Mayo Clinic’s “Value Creation System” and Office of Value Creation are the direct result
of this improvement strategy. The Office of Value Creation was originally tasked with owning
the various value-based projects. As time went on, however, responsibility and accountability
for quality and value efforts shifted to operational levels. This left the Office of Value Creation
available to monitor quality and value within the organization. Thus, Mayo’s system has been in
place long enough that progress has moved to a second, higher value-based level.1
A Data-Driven Approach
The Geisinger Health System has implemented an approach to health care that is data driven.
As a Wall Street Journal article commented, Geisinger’s “…decades of investment in technology
and integration have made it a pioneer in the use of electronic medical records and other
data.”2 And that is a true statement: Geisinger is indeed a pioneer. The system utilizes datadriven management and achieves value through standardization and care coordination.
Value-Based Research Centers
Two examples appear below.
A Center for Value-Based Care Research
The Cleveland Clinic supports its own Center for Value-Based Care Research. The Center’s
researchers focus on not only identifying high-value health care, but also disseminating the
information obtained. That focus is reflected in the Center’s mission statement: “to make
quality healthcare possible for all Americans by conducting research to identify value in
healthcare.”3
334 Chapter 27 Understanding Value-Based Health Care
A Comparative Effectiveness Research Center
The Brigham and Women’s Hospital has established its own Patient-Centered Comparative
Effectiveness Research Center (PCERC). As its name suggests, the Center focuses upon comparative effective research (CER) and patient-centered outcomes research (PCOR) at the hospital.
This Center provides value in that it studies both the comparable effectiveness of treatment
options for individual patients and the outcomes of healthcare practices. The Center’s overall
approach is to improve the quality of health care.4
Value-Based Collaboration and Affiliation
A definite effort toward both collaboration and affiliation among organizations is underway.
Two examples follow.
The High Value Healthcare Collaborative
This collaboration actually began in late 2010 with four organizations: the Mayo Clinic, Denver
Health, Intermountain Healthcare, and the Dartmouth Institute for Health Policy and Clinical
Practice (TDI). The group wanted to achieve high value by improving health care and lowering
costs. They also wanted to “move best practices out to the national provider community.”5 Since
its formation, the collaborative has expanded to almost 20 health systems.
Network Affiliations
The National Comprehensive Cancer Network (NCCN) is a “not-for-profit alliance of 27 of the
world’s leading cancer centers devoted to patient care, research and education.” The NCCN is
dedicated to “improving the quality, effectiveness and efficiency of cancer care so that patients
can live better lives.”6 Network membership such as this is a type of affiliation that can provide
significant value-based benefits, especially in the areas of evidence-based treatment and quality
of care.
VALUE-BASED PROGRESS IN THE PUBLIC SECTOR
At the time of writing, the Centers for Medicare and Medicaid Services (CMS) have a total of
seven value-based programs (VBPs): Five programs are already implemented and two are in the
planning and development stages. The
seven programs are illustrated in Exhibit
27–1. These programs tie payment to
value (thus “value-based”). They represent an important trend, because they
are part of the movement toward paying
for quality of patient care.7
These VBPs are important because
they have aided in showing the way
toward value. Their structure has
provided an important foundation
to build upon. In other words, they
helped to make today’s rapid changes
possible.
1. Hospital Value-Based Purchasing
(HVBP)
2. Hospital Readmission Reduction (HRR)
3. Hospital Acquired Conditions (HAC)
4. Physician Value-Based Modifier (PVBM)
5. Skilled Nursing Facility Value-Based
Program (SNFVBP)
6. Home Health Value-Based Program
(HHVBP)
7. End-Stage Renal Disease (ESRD)
Quality Initiative
Exhibit 27–1 Seven Federal Value-Based Programs
Value-Based Progress in the Public Sector 335
Three Hospital Value-Based Programs
Three hospital programs are among the first value-based programs to be implemented by CMS.
A brief description of each follows.
Hospital Value-Based Purchasing Program
This program provides incentive payments for acute care hospitals. The payment adjustments
are based on quality of care, and are part of the Inpatient Prospective Payment System (IPPS).
In other words, the hospital value-based purchasing (HVBP) program links payment to performance. The performance measures are adjusted (and typically increased) yearly. CMS has set a
timeline for these adjustments that runs out to the year 2022.8
Hospital Readmission Reduction Program
The hospital readmission reduction (HRR) program provides incentive payments in order to
reduce hospital readmissions, which are costly and may be unnecessary. Reductions may be
accomplished in two ways: improving the coordination of transitions of care to other care settings
and improving the quality of care provided.9
Hospital Acquired Conditions Program
This program works in reverse: It reduces payments instead of making incentive payments. In this
case, those hospitals whose patients get the most hospital-acquired conditions are penalized. In
other words, the hospitals that rank worst in hospital acquired conditions (HACs) are the ones
that have their payments reduced.10
Four Other Value-Based Programs
These four programs cover multiple care settings, as described below.
Physician Value-Based Modifier Program
This program for physicians is also one of the original value-based programs to be implemented by CMS. The program payments began in 2015 and have been paid to ever-expanding
groups of physicians over 2016 and 2017. The program expands to include other clinicians
in 2018.
As the title implies, when an eligible claim is submitted, the payment is adjusted, or modified,
based on particular quality and cost measures performance. In other words, when the modifier
is applied to payment, it rewards both lower costs and higher quality performance. (Note that
the Physician Value-Based Modifier (PVBM) Program is also known as the Value-Modifier [VM]
Program.)11
Skilled Nursing Facility Value-Based Program
This program provides incentive payments to skilled nursing facilities (SNFs). The payments
reward SNFs based on the quality of care provided. In other words, payment is received for quality of care, not quantity of care. At the time of this writing, the skilled nursing facility value-based
program (SNFVBP) continues to develop. This development is expected to progress in stages.12
However, the IMPACT Act is moving post-acute care facilities (PACs) toward standardization
and interoperability. This legislation, which includes SNFs, may affect certain aspects of the SNF
value-based program due to standardization efforts.
336 Chapter 27 Understanding Value-Based Health Care
Home Health Value-Based Program
This program was first implemented on January 1, 2016, as a home health value-based program
(HHVBP) model in nine states. Payment for those participating in the model is based on quality
performance. In an interesting concept, the participating home health agencies (HHAs) will
compete on value in order to receive quality performance incentive payments.
At the time of this writing, the HHVBP continues to develop. This development is expected
to progress in stages.13 However, as with SNFs, the HHA value-based program may be impacted
by legislative efforts toward standardization and interoperability.
End-Stage Renal Disease Quality Initiative Program
The End-Stage Renal Disease (ESRD) Quality Initiative Program is a disease-specific program.
It concerns outpatient dialysis or ESRD facilities , and it too was one of the original programs to
be implemented by CMS. This program provides incentive payments for better quality of care,
and it also reduces payments to those facilities that do not meet particular standards of performance. In other words, this program also links payment to performance.14
Value-Based Payments
The traditional method to pay for service delivery is by volume. Instead, CMS is now beginning to pay for value and quality. For example, CMS announced two related goals for Medicare
fee-for-service payments, as follows.
Payment Goal One
“Thirty percent of Medicare payments are tied to quality or value through alternative payment
models…by the end of 2016, and 50% [will be] by the end of 2018.”15 (The various types of alternative payment models are described elsewhere in this chapter.) According to CMS estimates,
this aggressive 2016 timeline was actually exceeded.16
Payment Goal Two
Eighty-five percent of all traditional Medicare fee-for-service payments have been tied to quality
or value by the end of 2016, and 90% will be by the end of 2018. This goal was accomplished
through certain CMS programs, including the HVBP and the HRRP.17 (These programs are also
described elsewhere in this chapter.)
VALUE-BASED EDUCATION EFFORTS
The following examples illustrate just a few value-based education efforts. Note the digital
impact of each, as all these examples are obtained online.
A Certificate in the Fundamentals of Value-Based Health Care
The Dartmouth Institute for Health Policy and Clinical Practice (TDI) offers the TDI Certificate in the Fundamentals of Value-Based Health Care. To obtain the certificate, students
must take six sequential online courses that center upon understanding and navigating highvalue patient-centered healthcare delivery. Value-based improvement is measured by achieving
Value-Based Education Efforts 337
outcomes that are not only better, but are achieved with the same or lower costs. And that
improvement should be “…both scientifically and ethically sound and sustainable.”18
An Online Course That Earns Continuing Education Credit
The Center for Continuing Education at Cleveland Clinic provides online courses that earn
continuing education credits for healthcare professionals. One topic provided is entitled,
“Value-Based Health Care”; this particular online course is included in the Disease Management Clinical Decisions series and is in the form of an interactive case study.19
Education Directed to Patients and Their Families
The Patient and Family Health Education Center at Cleveland Clinic provides information on a
variety of healthcare topics. One topic is “Value-Based Care.” The patient-directed information
includes defining value-based care and explaining how such care reduces costs.20
Governmental Education for Professionals
CMS provides healthcare professional education products through the Medicare Learning Network, or MLN.21 The MLN offers a wide variety of topics, many as either electronic downloads
or print versions. Some provide continuing education credits as well. At this point in time,
value-based information is most commonly found within quality measurement and/or regulatory payment updates.
VALUE-BASED LEGISLATIVE REFORM
Legislation is moving toward even more value-based programs. These programs accomplish
their aims through both reporting and payments.
How Value-Based Reporting and Payments Came About: The Legislative Background
The following summary of legislative progress helps you to see the step-by-step progress toward
value-based reform.
Initial “Digitizing” Steps
The early efforts toward “digitizing” health care covered a period of several years. One of the
more important developments during this time was requiring Medicare providers to submit
their claims for payment electronically. We consider this the first real step toward “digitizing,” as
every Chief Financial Officer wants to get claims paid, and a the conversion to electronic claim
forms was thus established throughout the country.
HITECH Legislative Funding
The Health Information Technology for Economic and Clinical Health (HITECH) Act was part
of the American Recovery and Reinvestment Act that was signed into law on February 17, 2009.
The HITECH Act promoted the adoption and use of health information technology (HIT)
338 Chapter 27 Understanding Value-Based Health Care
and electronic health records (EHRs) through payment incentives. CMS described these EHR
Incentive Programs in a single sentence: “The Medicare and Medicaid EHR Incentive Programs
provide incentive payments to eligible professionals, eligible hospitals and critical access hospitals (CAHs) as they adopt, implement, upgrade or demonstrate meaningful use of certified
EHR technology.”22
The HITECH Act’s legislative funding provided approximately $17 billion in incentives for
hospitals and physicians. This law will impact future healthcare information management for
many years to come (up to 2021 in the case of one program).
Value-Based Legislative Reform: The MACRA Act
A further legislative reform to the Medicare payment structure is now in place through the
Medicare Access and CHIP Reauthorization Act of 2015 (MACRA). This Act is briefly described
below. Note that the Act ends a method of payment to physicians that has been in place since
the beginning of the Medicare program in the 1960s. This is truly a reform.
More Value-Based Legislative Reform: The IMPACT Act
Yet another legislative reform is now in place through the Improving Medicare Post-Acute Care
Transformation (IMPACT) Act of 2014. This Act is also briefly described below. Note that, for
the first time, interoperability will be required between and among the four types of post-acute
facilities. This is another true reform.
Quick Facts About Physicians and the MACRA Act, MIPS, and APMs
MACRA reforms Medicare payments to physicians and certain clinicians via the following:
• Repealing the Sustainable Growth Rate (SCR) method of payment
• Replacing the SGR method with a new payment framework that emphasizes “giving better
care, not just more care”
• Combining existing quality reporting programs into the single new payment framework.23
For the first two years, the individuals affected by the MACRA Act include physicians, physician assistants, nurse practitioners, clinical nurse specialists, and certified registered nurse anesthetists. Groups that include these eligible professionals are also included. In a second phase
(from the third year onward), the Secretary can add more eligible professionals such as social
workers, certified audiologists, and others.
The MACRA reforms help CMS to move toward the value-based goal of paying for both value
and for better care. Physicians and other eligible professionals (EPs) can choose one of two
quality programs: either the Merit-Based Incentive Payment System (MIPS) or the Alternative
Payment Models (APMs). Both MIPS and APMs will go into effect over a period from mid-2015
through 2021 and beyond.24
What Is MIPS?
This new value-based program combines certain parts of existing quality reporting programs.
The programs involved include certain sections of the Physician Quality Reporting System
(PQRS), the Value Modifier (VM; also known as the Value-based Payment Modifier), and the
Medicare Electronic Health Record (EHR) incentive program. (These stand-alone programs
will be sunsetted, or ended, when they are combined into the new value-based program.)
Value-Based Legislative Reform 339
Physicians and other eligible professionals will be measured in four areas. These performance areas include quality, resource use, meaningful use of certified EHR technology, and
clinical practice improvement. (The first three areas come from the existing quality reporting
programs, but the clinical practice improvement area is new.)
The MIPS payment method includes an automatic base increase for the period 2015 through
2019, followed by an additional increase applied from 2026 onward. These EPs are also at risk
for positive or negative performance adjustments to their payments beginning in 2019.
What Are APMs?
APMs provide new methods of payment from Medicare to physicians and other eligible professionals. The MACRA Act considers the following entities to be APMs that are generally eligible
for incentive payments:
• CMS Innovation Center Models
• Shared Savings Program Tracks
• Certain statutorily required demonstrations25
Specific types of entities within these general categories are then set out annually in a rule
published by CMS. These “Advanced APMs” are considered to be advanced because they accept
financial risk along with rewards (the rewards being the incentive payments).
The APM payment methods include a lump-sum incentive payment for some participating
providers for the period 2019 to 2024. In addition, beginning in 2026, some providers can
receive higher annual payments. In the future we can expect increased transparency of such
physician-focused payment models (PFPMs). We can also anticipate the development of additional PFPMs as time goes on.
Other Provisions of the Act
Other provisions of the Act are detailed elsewhere, as the additional provisions are beyond the
scope of this particular chapter.
Meaningful Use Is Not Dead, But Is Evolving
Meaningful use still exists. At a healthcare conference in the spring of 2016, CMS acting
Administrator, Andy Slavitt, said that “the meaningful use program, as it has existed, will now be
effectively over and will be replaced with something better.”26 However, various media sources
reported only that meaningful use was dead, which is incorrect.27 What Slavitt meant was that
meaningful use is being incorporated into the MACRA Act’s programs. Thus, meaningful use
still exists, but its role has evolved. To see more about how this change has come about, see
Appendix 28-A.
Quick Facts About Post-Acute Care and the IMPACT Act
The IMPACT Act of 2014 requires that standardized patient assessment data be reported by
four types of post-acute care facilities, including SNFs, HHAs, inpatient rehabilitation facilities
(IRFs), and long-term care hospitals (LTCHs). Note that hospice, another type of post-acute
care facility, is not included in these requirements.
340 Chapter 27 Understanding Value-Based Health Care
Data Interoperability
The Act specifies that “certain data elements must be standardized and interoperable to allow
for the exchange and use of data among these PAC and other providers.”28 This will facilitate
coordinated care and will “improve the long-term outcomes of beneficiaries receiving postacute services across different care settings.”29 (Standardized data ensure that wording is comparable for purposes of assessment and scoring. Interoperability makes transmitting data across
different systems possible.)
Transparency and Public Reporting
Transparency and public reporting is another important element in the IMPACT Act. The Act
stipulates that there must be public reporting of PAC provider performance on both valuebased aspects: quality measures and resource use.30
Other Provisions of the Act
Other provisions of the Act are detailed elsewhere. However, note that the Act also provided
funding for much greater specificity in the reporting of nurse staffing.
QUALITY MEASUREMENT: THE CONCEPT
As one of the two foundations of value-based care, quality must be able to be studied and quantified. (The other value-based foundation is cost.) Note that types of quality measures can vary, as
discussed within this section. Also note that developing quality measures is not just the first step
in the process, but is an ongoing project. We hope that, in the future, public/private alignment
will become commonplace.
Quality Measures in the Private Sector
This section discusses measures use linked to payment in a large alternative payment model and
quality measures as used by an accrediting organization.
The California-Based Integrated Healthcare Association
The integrated healthcare association (IHA), working with health plans and physician organizations, launched a statewide pay-for-performance initiative over 15 years ago. This alternative
payment model is based upon four elements, including “a common set of measures and benchmarks, health plan incentive payments, public reporting and public recognition awards.”31
The IHA Value-Based Pay-for-Performance (P4P) program measures quality, cost, and
resource use. The program’s common measure set is evidence based and includes four major
elements:
• Clinical quality
• Patient experience
• Meaningful use of HIT
• Resource use and total cost of care
To put the size of this program into perspective, participation in the Value-Based P4P includes
“10 health plans and 200 California physician organizations with 35,000 physicians caring for
Quality Measurement: The Concept 341
9 million Californians enrolled in commercial health maintenance organization (HMO) and
point of service (POS) products.”32
The National Committee for Quality Assurance
The National Committee for Quality Assurance (NCQA) is a private 501(c)3 not-for-profit organization that accredits health plans and that provides annual statistics about the quality of care
delivered by these plans. The Committee has developed quality standards and performance
measures for an array of healthcare organizations.
According to the NCQA website:
• Health plans earning NCQA accreditation at the present time must address
an array of more than 60 standards, and reports on their performance are
required in over 40 areas.
• Health plans are accredited in every state, the District of Columbia and Puerto
Rico.
• These plans cover 109 million Americans.
• That figure accounts for 70.5% of all Americans in health plans.33
Quality Measures in the Public Sector
Value and quality are often intertwined when discussing value-based efforts. Certain quality
measures have already been established for specific providers. These measures must first be
recorded by the provider and then transmitted as appropriate. Within the public sector, CMS
has a number of such quality reporting programs in place as follows.
Quality Reporting Programs
Examples of CMS Quality Reporting Programs are listed below. Note that additional programs
may be developed in the near future. It is also expected that existing programs will be revised
and refined, also in the near future.
Existing programs at the time of this writing include the following:
• Hospital Inpatient Quality Reporting (HIQR) Program
• Hospital Outpatient Quality Reporting (HOQR) Program
• Physician Quality Reporting System (PQRS)
• Long-Term Care Hospital (LTCH) Quality Reporting Program (QRP)
• Inpatient Rehabilitation Facility (IRF) Quality Reporting Program (QRP)
• Home Health Quality Reporting Program (HHQRP)
• Hospice Quality Reporting Program (HQRP).34
We understand that upgrading efforts are ongoing for these reporting programs. Such upgrades
include greater transparency and ease of access.
Challenges in Quality Measure Implementation
The staff at CMS has identified a number of challenges that may occur in quality measure
implementation from their viewpoint. This useful list of challenges can be divided into three
segments as follows:
342 Chapter 27 Understanding Value-Based Health Care
Issues related to patients and providers
Engaging patients in the measure development process
Reducing provider burden
Issues related to shortening and streamlining processes
Shortening the period for measure development
Streamlining data acquisition for measure testing
Issues related to development
Developing meaningful outcome measures
Developing patient-reported outcome measures (PROMS) and appropriate use measures
Developing measures that promote shared accountability across settings and providers35
Challenges for the Manager
We cannot deny that challenges to quality measure implementation exist. The manager must
deal with a whole variety of management issues related to these measures. The manager faces
problems and challenges in both the development and implementation of quality measures. By
their very nature such measures are metrics, and metrics must involve digital changes. Examples
of the problems involved for the manager include the following:
• Hardware issues
• Software issues
• Training
• Staff stability and related turnover
• Uniform reporting during digital changes
To succeed, managers involved in measure development and implementation need support
from the highest levels within the organization. This support must include funding for both
required digital infrastructure and related staffing.
VALUE-BASED PUBLIC REPORTING IN THE PRIVATE SECTOR
Sharing information about quality reporting programs with the public is another important
method of supporting value-based efforts. In this section, we discuss three different types of
value-based public reporting.
Public Reporting by Providers and Health Plans
Two types of reporting about value-based efforts are described below. There are, of course, a
number of other existing examples.
Annual Reporting of Program Results
The California-based Integrated Healthcare Association (IHA), in association with the California
Office of the Patient Advocate (OPA), publicly reports value-based pay-for-performance results
each year. These reports allow comparison between and among various health plans and providers. The intent is to “allow health care purchasers and consumers to make informed decisions
Value-Based Public Reporting in the Private Sector 343
about providers based on value.”36 Other reporting efforts by this partnership include reports
on total cost of care performance by physician organizations and the Medical Group Medicare Report Card for “medical groups caring for seniors and people with disabilities enrolled
in Medicare Advantage health plans.”37 In addition, each year the IHA also recognizes topperforming and most-improved physician organizations. Another IHA public recognition effort
is the Excellence in Healthcare Award.38
An Overview of Annual Facts and Statistics
This type of report is typically an overview. The website containing the overview then allows
the viewer to go to specific information about items of interest, including value-based efforts
for the particular year. For example, Cleveland Clinic publishes an annual year-end “Facts +
Figures” report. The two-page report provides a snapshot of the organization. Included, for our
purposes, besides Mission, Vision, and Values, is a section titled “Quality, Safety, Transparency.”
This section mentions Quality and Patient Safety accountability that oversees improvement in
quality and safety, all data driven. It also mentions “relentless focus on monitoring, recording
and reporting quality and safety data.”39
Public Reporting of Quality and Value by Other Organizations
A variety of other organizations also provide public reporting of quality and associated value.
They include, among others, the National Quality Forum, the National Committee for Quality
Assurance, the Leapfrog Group for Patient Safety, the Informed Patient Institute, and the Commonwealth Fund.40
Public Reporting of Physician Credentials and Experience
Another type of public reporting that websites provide is background information on physician
groups and on individual doctors. To experiment, we typed our own GP’s name into Google
and seven websites came up that contained his credentials and experience.
These sites provide a type of value-based information, in that they can readily tell you, the
consumer, important facts about the healthcare professional. Most sites contain information
about specialties, experience, and credentials. You can find whether the physician has any sanctions, malpractice suits, or board actions against him or her. The site may also provide the
results of patient satisfaction surveys or reviews, and possibly a comparative rating.
VALUE-BASED PUBLIC REPORTING IN THE PUBLIC SECTOR
This type of public reporting provides another layer of value by disseminating value-based information to interested parties. Within this section, we describe both national and state reporting
examples as follows.
National Reporting Examples
Value-based quality measurement can be readily linked to public reporting. You may be familiar
with one of the CMS “Compare” websites that publishes these quality measures. A brief description of four “Compare” sites follows.
344 Chapter 27 Understanding Value-Based Health Care
Hospital Compare
The Hospital Compare website contains information about quality of care for over 4,000 hospitals in the United States.41 The site contains a profile of each hospital. Besides general facility
information and certain other measures that are reported, the particular measure of interest
to us is “Payment and Value of Care.”42 This value-based measure is in three parts: “Medicare
spending per beneficiary,” “Payment measures,” and “Value of care.” The “Value of care” part is
a combination of payment measures and quality-of-care measures.43
Physician Compare
At the time of writing, group practices are present on the “Physician Compare” CMS website.
There are plans to add individual physicians and other healthcare professionals in the future.
Also note that the site only includes those who are enrolled in the Medicare program.44 The site
contains a profile of each physician, including specialties, board certification, medical school
and residency, and other information.45
The particular item of interest to us concerns participation in quality activities. If the physician or group practice participates in one or more of four quality activities, there is a green
check mark on the profile page. (The site is careful to say, however, that “participation alone
does not mean quality care has been achieved. Showing a commitment to quality is the first step
in achieving quality care.”)46
Nursing Home Compare
According to CMS, the Nursing Home Compare website contains information about both quality of care and staffing for all 15,000-plus nursing homes in the United States that are Medicare
and Medicaid participating.47 The site provides a five-star quality rating that covers quality measures, staffing, and health inspections. Each of these three elements is given an individual rating, and the three ratings are then combined to create an overall rating. The star rating is on a
scale of 1 to 5, with 1 being the lowest and 5 being the highest score.48 (The site does point out
that there can be variation among states as to the inspection process and as to Medicaid program differences. Thus, it is best to compare facilities within a single state.)49
Home Health Compare
The Home Health Compare website contains information about the quality of care that is provided by home health agencies throughout the United States that are Medicare certified.50 The
site contains a profile of each agency, including type of ownership and services offered. The
particular items of interest to us include information about quality measures, plus a “quality
of patient care star rating.”51 The star rating is on a scale of 1 to 5, with 1 being the lowest and
5 being the highest score. Scores are based upon how the performance of a particular home
health agency compares to that of other agencies.52
A State Reporting Example
According to an article in Health Affairs, just about one-half of the states in the United States
have created some type of public reporting program.53 As you might suspect, the content of
these programs varies state by state. We provide one example, as follows.
The Utah Department of Health provides a Public Health Outcome Measures Report
(PHOM). The report includes 109 public health measures in an online format that is easy
Value-Based Public Reporting in the Public Sector 345
to use. In this case, the purpose of public reporting is to “promote an understanding of the
health status of the Utah population.”54 These measures, or indicators, are taken from another
of Utah’s websites, “Indicator-Based Information System for Public Health (IBIS-PH),” which
contains even more detail.
FINANCIAL OUTCOMES
This section discusses several types of value-based financial outcomes.
A Financial Outcome Example
Intermountain Health (IH) provides an example of documented positive financial outcomes
as follows. Intermountain Health is a Utah-based not-for-profit health system with 22 hospitals
and 185 clinics in the Intermountain Medical Group, along with health insurance plans from
SelectHealth. (Although it is not relevant to the example, IH is a pioneer in the use of telemedicine.) Intermountain piloted an integration of mental health with primary care a number of
years ago. Every primary care patient at the Intermountain Medical Group clinics receives this
screening, whether or not they are members of Intermountain’s health plan. This value-based
coordinated care model has improved outcomes for patients. Furthermore, Intermountain’s
financial outcomes are positive. Specifically, while costs per member are $22 higher up front,
per-member costs are $115 lower overall annually. The annual reduced cost is due to fewer
emergency room visits and other care.55
An Overview of Financial Outcomes as a Value-Based Business Model
The Harvard Business Review has published an article entitled “Turning Value-Based Health Care
into a Real Business Model.”56 The authors begin by saying the shift from volume-based health
care to value-based health care is inevitable. (We agree with this view.) While they discuss benefits in patient care, they also point out that sometimes short-term financial losses may be part
of this shift to a value-based approach. In some cases, of course, the short-term loss may be offset
by a long-term gain. The Intermountain example above is one of those cases.
The authors conclude that organizations’ short-term financial losses were strategic. The benefits of these value-based strategic decisions include, for example, risk-management experience.
Risk management is an integral part of many pay-for-performance alternative payment models,
and gaining such experience would be valuable. Relationship building is another strategic benefit.
Collaboration and alignment with stakeholders and physicians takes time and becomes even more
important in moving toward a population-health approach. There is also a competitive advantage.
In other words, in this value-based business model, each organization will gain competitively in
the long run. This is because it will have already embraced and adapted to a value-based financial
approach (the business model) while other organizations who have not done so will be left behind.
Large Interactive Systems Require Investment Dollars
Because of their size, large healthcare systems need large electronic health record systems. It follows
that these large electronic systems require a substantial investment. In this section, we discuss two
examples of such investments, both of which can be considered value-based financial outcomes.
346 Chapter 27 Understanding Value-Based Health Care
Duke University Health System’s Investment
North Carolina–based Duke University Health System (Duke) includes three hospitals along
with physician practices, home care, hospice care, and support services.57 In July 2012, Duke
began a multi-year information systems project to unify electronic medical records across the
health system. The new technology was to be implemented in three phases, from mid-2012 to
spring 2014.58 The project stayed on schedule; as of spring 2014, the system was operational in
all three hospitals and 223 outpatient facilities.59
The investment in this project was widely reported to be $500 million. However, when the
Duke Chief Medical Information Officer discussed related financial issues in a newspaper interview, he acknowledged $500 million as the gross cost, but also said the net cost was estimated at
approximately $300 million, as follows.
He explained that the $500 million figure represented total ownership costs over a seven-year
period. This amount included, therefore, the cost to maintain and upgrade the system over seven
years, in addition to the initial costs to acquire and begin to use the technology. He also explained
that the $500 million was the gross investment figure. If you add up all the costs to maintain
and to support the 135 applications that are being replaced, and if you then subtract that cost
from the $500 million, you wind up with a net new investment that is “a little bit more than
$300 million.”60 Finally, he also pointed out that the project should be eligible to receive tens of
millions of dollars in federal funding” that would help to partially cover costs of the investment.61
Kaiser Permanente’s Investment
California-based Kaiser Permanente (KP) is a non-profit integrated health plan that includes
38 hospitals and over 600 medical office buildings and other facilities that are located in eight
states plus the District of Columbia. The plan serves almost 10 million people.62
Kaiser Permanente claims that HealthConnect, the plan’s comprehensive electronic record,
is “one of the largest private electronic health systems in the world.”63 It took 10 years to build
and became fully operational in 2010.64
InfoWorld interviewed Philip Fasano, the Chief Information Officer of KP, about the plan’s
EHR systems. The interviewer asked how much it cost to build the system, to which Fasano
replied, “about $4 billion, a substantial amount of money, but we have 9 million members [so
it costs about $444 per member].”65 (Note that the interview occurred three years prior to the
time of this writing, so the member count is different.) The CIO went on to make another
important point: that it is necessary to continuously invest in the system during its lifetime.
DIGITAL OUTCOMES
This section discusses value-based digital outcomes that are important for physicians and for
large healthcare systems.
How Would Digital Outcomes Benefit a Physician’s Practice?
Value-based alternative payment models rely upon an array of performance measures that are
reported electronically. The electronic submissions represent the record of the provider’s performance. Thus, appropriate data collection and submission represents the positive digital outcome that should result in payment advantages.
Digital Outcomes 347
For example, physicians and other eligible professionals are in the midst of transition to
value-based payment models due to MACRA. This transition relies heavily upon electronic submission of performance data, which provides certain benefits. Specifically, the physicians who
use certified EHRs and/or qualified clinical data registries (QCDRs) should benefit in two ways:
• Reduce data collection and the associated reporting burden
• Support timely performance
Figure 27–1 illustrates these points.
What Are Value-Based Digital Outcome Examples in Large Healthcare Systems?
This section provides outcome examples for two large systems.
Duke University Health System
Duke University Health System’s (Duke’s) information system project cost has been discussed in the preceding investment section. In this section, we discuss the project’s digital
outcomes.
The information system project’s purpose was to unify electronic medical records across
the system. It accomplished this purpose. Value-based outcomes include medical record
access that is both seamless and in real time. Medical information can now be exchanged
across all care settings. As the Duke press release states, quality, safety, speed, and efficiency
have all been improved with implementation of the new system. In addition, 130 old clinical information systems became obsolete and were eliminated when the new system went
online.66
The patient experience has been improved via the system’s new online tool, “Duke MyChart.”
The patient can, among other features, view and/or request appointments, view their medical
reports, request prescription refills, and send messages to healthcare providers.67
Finally, the organization’s commitment to the project is underscored by another statistic.
Duke provided 173,000 hours of training to faculty and staff in order to ensure a smooth transition. And it worked, too; the press release says neither patient care nor patient billing was significantly disrupted during the implementation process of this value-based system.68
Reduce data
collection &
reporting burden
Support timely
performance
feedback
EPs That Use
Certified EHR
Technologies and
QCDRs
Figure 27–1 MACRA Electronic Specifications Provide Benefits.
348 Chapter 27 Understanding Value-Based Health Care
Kaiser Permanente
The cost of KP’s “HealthConnect” project has been discussed in the preceding investment
section. In this section we discuss the digital outcomes for the entire KP online system. Note
that KP covers the spectrum of care, as it is both a health plan (payer) and a provider of care.
KP also has amassed a huge amount of electronic data that are being used for value-based
purposes.
For example, HealthConnect is part of KP’s online portal called “My Health Manager.” This
portal allows patients online access to such features as appointment scheduling, refills of prescriptions, messages to care providers, and so on. However, another valuable feature, called the
online Patient Action Plan (oPAP), is also available. This web-based system concerns preventive
care that is personalized for the individual patient in a health action plan. Researchers who
studied the use of this patient-enabled health management tool found improved patient outcomes for preventive care.69
Clinicians also benefit from KP HealthConnect features. They have access to information
about latest treatments and preventive care, and that access is already proving valuable. For
example, in one pilot project, this access to information helped physicians to reduce coronary
artery disease death by 76%.70
Another Outcome: Electronic Transmission Standards Must Be Updated
and Maintained
Electronic transmission standards are important because they directly impact providers, health
plans, and other stakeholders. These standards are coordinated with and are the beginning
point for certified EHR technology. Both financial and digital outcomes depend upon such
technology. Specific versions of the standards are acceptable for certified EHR technology at
different points in time. As such, it is imperative that the related standards are updated and
maintained at all times.
VALUE-BASED STRATEGIC PLANNING BY THE PRIVATE SECTOR
Leaders in the private sector already have their value-based strategic planning underway. We
provide some examples of such planning within this section. Note that while there may be different approaches, the value-based aims are similar.
Recognizing That Value-Based Care Is a Long-Term Goal
The Cleveland Clinic has integrated the value-based concept throughout its organization,
including research, education, and care delivery. Dr. Tony Cosgrove, President and CEO of
Cleveland Clinic, has written in a blog that value-based health care is a “breakthrough that
will change the face of medicine” and that “ whether providers like it or not, healthcare is
evolving from a proficiency-based art to a data-driven science.”71 Finally, one of the Cleveland
Clinic’s web pages summarizes the organization’s strategic positioning: “[T]he ideal result
is fewer readmissions, less frequent hospitalization and trips to the ER. Value-based care is a
long-term goal.”72
Value-Based Strategic Planning by the Private Sector 349
Taking a Patient-Centered View of Value
At the Mayo Clinic, it seems obvious that the Office of Value Creation must play an important
role in value-based strategic planning. However, this Office does not operate within a silo. One
of the “Quality at Mayo Clinic Update: How the Mayo Value Creation System Is Improving
Patient Care” publications a few years ago makes this clear.
It says the organization, at that time, was working to define value, and the Office of Value
Creation, the Value Program in the Center for the Science of Healthcare Delivery, Government
Affairs, and Contracting were all working together toward this effort. Strategically speaking, “at
this point, we are trying to take a patient-centered view of value at the levels of the care pyramid.”73 (And their concept at that point in time was a care “pyramid” consisting of complex
care, intermediate care, and population health, with value definitions and detail for each level.)
There is no doubt that this strategic approach has further evolved over time.
Focusing Upon Population Health as a Value-Based Strategy
Dartmouth-Hitchcock describes a focus upon population health that is strategic. This organization believes in the achievement of a sustainable health system. To quote one comment, “we
believe the focus of organizations such as D-H should no longer be just on treating illness. We
have an obligation to ensure health.”74
Dartmouth-Hitchcock is a leader in value-based alternative-payment models that are risk
based. This organization clearly believes that the incentives under such models will “move to
keeping defined populations health as a way of controlling costs. Defined populations under
new payment models are those ‘attributed’ to us because we are the entity responsible for their
health and health care costs.”75
VALUE-BASED STRATEGIC PLANNING BY THE PUBLIC SECTOR
A “national quality strategy” exists and this strategy guides planning throughout the U.S. Department of Health and Human Services (DHHS). The value-based and quality programs that are
discussed within this chapter are an important part of CMS planning. Thus, because CMS is a part
of DHHS, these value-based and quality issues are tied into national quality strategy as well. This
section illustrates how CMS has fit its quality strategy goals into the national quality priorities.
National Quality Strategy
The National Quality Strategy (NQS) is led by the Agency for Healthcare Research and Quality
(AHRQ) on behalf of the U.S. DHHS.76 The NQS structure is summarized below.
Three Aims and Six Priorities
To summarize, the NQS is structured with three aims and six priorities. The three overarching
aims are as follows:
• Better care
• Healthy people/healthy communities
• Affordable care77
350 Chapter 27 Understanding Value-Based Health Care
Details about the six priorities for NQS are discussed in the following section, especially as to
how they interrelate to the CMS quality strategy.
Nine Strategic Levers
The NQS also created nine “levers.” Used in this sense, the term “levers” may be core business
functions, resources, and/or actions, any of which may be activated in order to align to the quality strategy. These strategic alignment elements are as follows:
• Measurement and feedback
• Payment
• Health information technology
• Innovation and diffusion
• Public reporting
• Learning and technical assistance
• Certification, accreditation, and regulation
• Consumer incentives and benefit designs
• Workforce development
The strategic levers are also summarized in Exhibit 27–2.
The Agency has included a phrase for each lever, as follows, to better describe how the levers
work should work. Table 27–1 illustrates the appropriate phrase for each of the nine levers.78
Why Are the NQS Levers Important?
The levers are important because they show how all aspects of value-based and quality programs
fit into the national strategic plan. We can recognize one or more of these nine levers in each of
the private and public sector value-based efforts that are discussed within this chapter.
How Do CMS Quality Strategy and Goals Fit into the National Strategy?
CMS quality strategy coordinates with the national quality strategy’s priorities. In other words,
the CMS strategy fits into the national
strategy because CMS has adopted the
NQS priorities as the six CMS goals. A
description of this sequence follows.
National Quality Strategy Priorities Are
Converted into Domains
In order to implement these priorities,
they are converted into domains. Six
domains represent the priorities of the
NQS. These domains, as described in the
CMS Quality Strategy, are as follows:79
• Efficiency and Cost Reduction
Domain
• Care Coordination Domain
Nine levers that can be activated for
strategic alignment:
1. Measurement & feedback
2. Payment
3. Health information technology
4. Innovation & diffusion
5. Public reporting
6. Learning & technical assistance
7. Certification, accreditation, & regulation
8. Consumer incentives & benefit designs
9. Workforce development
Exhibit 27–2 Nine Strategic Levers
Value-Based Strategic Planning by the Public Sector 351
The Lever How It Should Work
Measurement and Feedback Provide performance feedback to plans and providers to improve care
Payment Reward and incentivize providers to deliver highquality, patient-centered care
Health Information Technology Improve communication, transparency, and efficiency for better coordinated health and health care
Innovation and Diffusion Foster innovation in healthcare quality improvement and facilitate rapid adoption within and across
organizations and communities
Public Reporting Compare treatment results, costs, and patient experience for consumers
Learning and Technical Assistance Foster learning environments that offer training,
resources, tools, and guidance to help organizations achieve quality improvement goals
Certification, Accreditation, and Regulation Adopt or adhere to approaches to meet safety and
quality standards
Consumer Incentives and Benefit Designs Help consumers adopt health behaviors and make
informed decisions
Workforce Development Investing in people to prepare the next generation
of healthcare professionals and support lifelong
learning for providers
Reproduced from The National Quality Strategy: Fact Sheet, AHRQ Publication No. 14-M006-EF, www.ahrq.gov/workingforquality/nqs
/nqsfactsheet.htm
Table 27–1 How the Strategic Levers Should Work
• Clinical Quality of Care Domain
• Safety Domain
• Person and Caregiver Centered Experience and Outcomes Domain
• Population and Community Health Domain
Detail for each of these domains is contained in Table 27–2.
Strategic Goals for Quality
This section discusses various national and agency aspects of strategic goals.
Linking National and CMS Strategies
To take this coordination a step further, CMS has adopted the domains just described as its
“framework for measurement.” This methodology is important because it links NQS strategy—
and resulting domains—directly and efficiently to CMS strategic goals and their measurement.
Thus, each National Quality Priority Domain as just described is linked to a specific CMS Quality Strategy Goal. In other words, six national domains equal six CMS goals. Details for each of
these CMS goals are contained in Table 27–3.
352 Chapter 27 Understanding Value-Based Health Care
National Priority Domains Details
Efficiency & Cost Reduction Cost
Efficiency
Appropriateness
Care Coordination Patient and family activation
Infrastructure and processes for care coordination
Impact of care coordination
Clinical Quality of Care Care type (preventive, acute, post-acute, chronic)
Conditions
Subpopulations
Safety All-cause harm
HACs
HAIs
Unnecessary care
Medication safety
Person and Caregiver Centered Experience
and Outcomes
Patient experience
Caregiver experience
Preference and goal-oriented care
Population and Community Health Health behaviors
Access
Physical and social environment
Health status
Table 27–2 National Quality Strategy Priorities Are Converted to Domains
Table 27–3 National Quality Strategy Domains Are Linked to CMS Quality Strategy Goals
National Priority Domains CMS Goals
Efficiency & Cost Reduction Make care affordable
Care Coordination Promote effective communication & coordination
of care
Clinical Quality of Care Promote effective prevention & treatment of
chronic disease
Safety Make care safer by reducing harm caused while
care is delivered
Person and Caregiver Centered Experience and
Outcomes
Help patients & their families be involved as
partners in their care
Population and Community Health Work with communities to help people live
healthily
More About CMS Strategic Quality Measure Development
This chapter provides an overview of NQS Priorities and Domains. The national priorities
are converted into six national domains (see Table 27–2). This chapter also shows how these
Value-Based Strategic Planning by the Public Sector 353
domains can then be linked to CMS goals (see Table 27–3). (Note that CMS goals are part
of CMS’s own quality strategy.) (Also note that Exhibits 27–1 and Table 27–1 in this chapter
address another aspect of strategic planning. These two exhibits describe “levers” that can be
activated to better achieve important strategic alignment.)
CONCLUSION: THE FUTURE
This section contains a brief look into the future.
Required Implementation Changes Still to Come
Future legislative and regulatory changes will certainly occur. Some are predictable at this time,
while others are not. At the time of writing, for example, we cannot reasonably predict the
direction that multiple value-based alternative payment models may take. Likewise, we cannot
predict the outcome over the next few years of the current multiple challenges to other aspects
of healthcare legislation.
Leadership: The Essential Ingredient
One thing is clear, however. If an organization is to meet its value-based goals, leadership
support and encouragement is essential. This quote sums it up very well: “[T]he investment
required is as much in leadership as in dollars.”80
The “Glide Path”
In conclusion, we expect interpretations of the various value-based and health information
technology strategic priorities, along with their supporting rules and regulations, to emerge
over a considerable period of years. A formidable base of knowledge has been laid as a foundation for these directions. One official, who must have had an aviation background, was reported
to have said we were now on the “glide path” to success in the area of health information technology, meaning that the sailing (or flying) would be smooth from now on. We hope he was
correct.
INFORMATION CHECKPOINT
What is needed? A descriptive document about value-based health care.
Where is it found? In the planning office or in the financial division; possibly on
the organization’s website. (But be careful not to borrow
proprietary information that belongs to the organization.)
How is it used? Its use depends upon the item you have found. Potential uses
include strategic planning or an analysis of potential financial impacts. Other uses could be for informational or
educational purposes.
354 Chapter 27 Understanding Value-Based Health Care
KEY TERMS
Alternative Payment Model
(APM)
Electronic Health Record
(EHR)
Eligible Professional (EP)
IMPACT Act
MACRA
Meaningful Use (MU)
Merit-Based Incentive
Payment System (MIPS)
Value-Based Program
(VBP)
Value Modifier (VM)
OTHER ACRONYMS
ESRD-QIP: End-Stage Renal Disease Quality Initiative Program
HAC: Hospital Acquired Conditions Program
HIQRP: Hospital Inpatient Quality Reporting Program
HHQRP: Home Health Quality Reporting Program
HHVBP: Home Health Value-Based Program
HOQR: Hospital Outpatient Quality Reporting Program
HQRP: Hospice Quality Reporting Program
HRR: Hospital Readmission Reduction Program
HVBP: Hospital Value-Based Purchasing Program
IRF-QRP: Inpatient Rehabilitation Facility Quality Reporting Program
LTCH-QRP: Long-Term Care Hospital Quality Reporting Program
PQRS: Physician Quality Reporting System
PVBM: Physician Value-Based Modified Program
SNFVBP: Skilled Nursing Facility Value-Based Program
DISCUSSION QUESTIONS
1. Using your organization as a point-of-reference, how would you define “value-based
care”?
2. If senior management appointed you to chair a committee to adopt such a concept,
whom would you include?
3. How would you describe a patient-centered view of value?
4. Identify the essential elements of a National Quality Strategy. Describe how they are
interrelated.
5. Describe the recent key elements to legislative reform of the Medicare payment structure.
6. Why are value-based digital outcomes important for healthcare providers?
NOTES
1. Mayo Clinic, “Quality at Mayo Clinic: 2013 Update: How the Mayo Value Creation System Is Improving Patient Care,” publication # MC6312-33rev0413, www.mayo.edu/pmts
/mc6300-mc6399/mc6312-33.pdf, accessed April 14, 2016.
Notes 355
2. C. Weaver, “A Health-Care Model in Coal Country,” The Wall Street Journal, September
27, 2015.
3. Cleveland Clinic, “Center for Value-Based Care Research,” https://my.clevelandclinic
.org/services/medicine-institute/research/Center-for-Value-Based-Care-Research,
accessed April 14, 2016.
4. Brigham and Women’s Hospital, “Patient-Centered Comparative Effectiveness Research
Center,” www.brighamandwomens.org/research/centers/pcerc/default.aspx, accessed
April 14, 2016.
5. Dartmouth-Hitchcock, “Our Collaborations,” www.dartmouth-hitchcock.org/about
_dh/what_is_population_health.html, accessed April 14, 2016.
6. National Comprehensive Cancer Network, “About NCCN,” www.nccn.org/about
/default.aspx, accessed April 14, 2016.
7. Centers for Medicare and Medicaid Services [CMS], “CMS’ Value-Based Programs,”
https://www.cms.gov/Medicare/Quality-Initiatives-Patient-Assessment-Instruments
/Value-Based-Programs/Value-Based-Programs.html
8. CMS, “Hospital Value-Based Purchasing,” last modified October 30, 2015, https://www
.cms.gov/Medicare/Quality-Initiatives-Patient-Assessment-Instruments/hospital-value
-based-purchasing/index.html?redirect=/Hospital-Value-Based-Purchasing/
9. CMS, “Readmissions Reduction Program (HRRP),” last modified April 18, 2016,
https://www.cms.gov/medicare/medicare-fee-for-service-payment/acuteinpatientpps
/readmissions-reduction-program.html
10. CMS, “Hospital-Acquired Condition (HAC) Reduction Program,” www.cms.gov/Medicare
/Quality-Initiatives-Patient-Assessment-Instruments/Value-Based-Programs/HAC
/Hospital-Acquired-Conditions
11. CMS, “The Value Modifier (VM) Program,” https://www.cms.gov/Medicare/Quality
-Initiatives-Patient-Assessment-Instruments/Value-Based-Programs/VMP/Value
-Modifier-VM-or-PVBM.html
12. CMS, “The Skilled Nursing Facility Value-Based Purchasing Program (SNFVBP),”
https://www.cms.gov/Medicare/Quality-Initiatives-Patient-Assessment-Instruments
/Value-Based-Programs/Other-VBPs/SNF-VBP.html
13. CMS, “The Home Health Value-Based Purchasing (HHVBP) Model,” https://www
.cms.gov/Medicare/Quality-Initiatives-Patient-Assessment-Instruments/Value-Based
-Programs/Other-VBPs/HHVBP.html
14. CMS, “End-Stage Renal Disease (ESRD) Quality Incentive Program (QIP),” https://
www.cms.gov/Medicare/Quality-Initiatives-Patient-Assessment-Instruments/Value
-Based-Programs/Other-VBPs/ESRD-QIP.html
15. CMS, “What Are the Value-Based Programs?” www.cms.gov/Medicare/Quality
-Initiatives-Patient-Assessment-Instruments/Value-Based-Programs/MACRA-MIPS
-and-APMs
16. U.S. Department of Health and Human Services, “HHS Reaches Goal of Tying 30 Percent of Medicare Payments to Quality Ahead of Schedule, March 2016, www.hhs.gov
/about/news/2016/03/03/hhs-reaches-goal-tying-30-percent-medicare-payments-quality
-ahead-schedule.html
17. Ibid.
18. The Dartmouth Institute, “The TDI Certificate in the Fundamentals of Value-Based
Health Care,” accessed April 14, 2016, www.tdiprofessionaleducation.org/tdi-certificate
-program.html
356 Chapter 27 Understanding Value-Based Health Care
19. Cleveland Clinic Center for Continuing Education, “Disease Management Clinical
Decisions: Value-Based Health Care,” www.clevelandclinicmeded.com/online/casebased
/decisionmaking/value-based-care, accessed April 14, 2016.
20. Cleveland Clinic Patient and Family Health Education Center, “Diseases and Conditions: Value-Based Care,” https://my.clevelandclinic.org/health/diseases_conditions
/hic-value-based-care, accessed April 14, 2016.
21. MLN Homepage, Centers for Medicare and Medicaid Services, www.cms.gov/outreach
-and-education/medicare-learning-network-min/mingeninfo/index.html, accessed
September 17, 2016.
22. CMS, “EHR Incentive Programs: Getting Started,” www.cms.gov/Regulations-and-Guidance
/Legislation/EHRIncentivePrograms/Getting-Started.html
23. CMS, “What Are the Value-Based Programs?”
24. Ibid.
25. P.L. 114-10 (April 16, 2015) 129 STAT 121
26. B. Ahier, “Meaningful Use Isn’t Quite Dead Yet,” March 1, 2016, www.healthdata
management.com/opinion/meaningful-use-isnt-quite-dead-yet
27. Ibid.
28. CMS, “IMPACT Act Spotlights and Announcements,” last modified August 31, 2016, https://
www.cms.gov/Medicare/Quality-Initiatives-Patient-Assessment-Instruments/Post-Acute
-Care-Quality-Initiatives/IMPACT-Act-of-2014/Spotlights-and-Announcements-.html
29. Ibid.
30. P.L. 113-185 Sec. 2(g)(1) (October 6, 2014).
31. Integrated Healthcare Association, “Fact Sheet: Value Based Pay for Performance in California,” September 2015, www.iha.org/sites/default/files/resources/vbp4-fact-sheet
-final-20150925.pdf
32. Ibid.
33. National Committee for Quality Assurance, “About NCQA,” www.ncqa.org/about-ncqa,
accessed May 18, 2016.
34. 80 Federal Register (FR) 22067 (April 20, 2015).
35. Adapted from CMS, “CMS Quality Measure Development Plan (MDP),” December 18,
2015, page 8.
36. Integrated Healthcare Association, “Fact Sheet: Total Cost of Care,” April 2015, www.iha
.org/sites/default/files/resources/fact-sheet-total-cost-of-care-2015.pdf
37. Integrated Healthcare Association, “Results and Public Reporting,” accessed May 9,
2016, www.iha.org/our-work/accountability/value-based-p4p/results-public-reporting
38. Integrated Healthcare Association, “Fact Sheet: Total Cost of Care.”
39. Cleveland Clinic, “Facts + Figures: 2015 Year-End,” updated March 16, 2016, https://
newsroom.clevelandclinic.org/wp-content/uploads/sites/4/2016/4/16-CCC-332-Facts
-and-Figures_04.01.2016.pdf
40. Health Affairs, “Health Policy Briefs: Public Reporting on Quality and Costs,” March 8,
2012, www.healthaffairs.org/healthpolicybriefs/brief.php?brief_id=65
41. Medicare.gov, “What is Hospital Compare?” www.medicare.gov/hospitalcompare
/About/What-Is-HOS.html, accessed May 10, 2016.
42. Medicare.gov, “What Information Can I Get About Hospitals?” www.medicare.gov
/hospitalcompare/About/Hospital-Info.html, accessed May 10, 2016.
43. Ibid.
Notes 357
44. Medicare.gov, “About Physician Compare,” www.medicare.gov/physiciancompare
/staticpages/aboutphysiciancompare/about.html, accessed May 10, 2016.
45. Medicare.gov, “Information Available on Physician Compare,” www.medicare.gov
/physiciancompare/staticpages/aboutphysiciancompare/informationavailable,
accessed May 10, 2016.
46. Medicare.gov, “About the Data,” www.medicare.gov/physiciancompare/staticpages/data
/aboutthedata.html, accessed May 10, 2016.
47. Medicare.gov, “What is Nursing Home Compare?” www.medicare.gov/nursinghomecompare
/About/What-Is-NHC.html, accessed May 10, 2016.
48. Medicare.gov, “What are the 5-Star Quality Ratings?” www.medicare.gov/Nursing
HomeCompare/About/Ratings.html, accessed May 10, 2016.
49. Medicare.gov, “Strengths and Limitations,” www.medicare.gov/NursingHomeCompare
/About/Strengths-and-Limitations.html, accessed May 10, 2016.
50. Medicare.gov, “What is Home Health Compare?” www.medicare.gov/homehealthcompare
/About/What-Is-HHC.html, accessed May 10, 2016.
51. Medicare.gov, “What Information Can I Get About Home Health Agencies?” www.medicare
.gov/HomeHealthCompare/About/What-Information-Is-Available.html, accessed May
10, 2016.
52. Medicare.gov, “Quality of Patient Care Star Ratings,” www.medicare.gov
/HomeHealthCompare/About/Patient-Care-Star-Ratings.html, accessed May 10, 2016.
53. Health Affairs, “Health Policy Briefs: Public Reporting on Quality and Costs,”
www.healthaffairs.org/healthpolicybriefs/brief.php?brief_id=65, accessed March 8,
2012.
54. Utah Department of Health, “Public Health Outcome Measures Report,” April 2014,
http://ibis.health.utah.gov/phom/Introduction.html
55. L. S. Kaiser and T. H. Lee, “Turning Value-Based Health Care into a Real Business
Model,” Harvard Business Review, October 8, 2015, https://hbr.org/2015/10/turning
-value-based-health-care-into-a-real-business-model
56. Ibid.
57. Duke University Health System, “Duke Human Resources: About Duke University
Health System,” https://www.hr.duke.edu/jobs/duke_durham/duhs.php, accessed
May 10, 2016.
58. Duke University Health System, “Duke Starts to Transfer to Digital Electronic Health
Records,” www.wral.com/lifestyles/goaskmom/blogpost/11364264/?comment_order
=forward, accessed September 17, 2016.
59. Duke University Health System, “Duke Medicine Completes Implementation of Electronic
Health Records Across All Outpatient Facilities and Duke University Hospital,” http://
corporate.dukemedicine.org/news_and_publications/news_office/news/duke-medicine
-completes-implementation-of-electronic-health-records-across-all-outpatient-facilities
-and-duke-university-hospital/view, accessed May 18, 2016.
60. D. Ranii, “Duke Kicks Off Digital Health Records Plan,” www.ecu.edu/cs-admin/news
/clips/upload/071812.pdf, accessed September 17, 2016.
61. Ibid.
62. Kaiser Permanente, “Who We Are,” www.kaiserpermanentejobs.org/who-we-are.aspx,
accessed May 19, 2016.
358 Chapter 27 Understanding Value-Based Health Care
63. Kaiser Permanente, “About Us: Connectivity,” https://share.kaiserpermanente.org
/total-health/connectivity/, accessed May 19, 2016.
64. InfoWorld, “How Kaiser Bet $4 Billion On Electronic Health Records—And Won,” May
2, 2013, http://www.infoworld.com/article/2614353/ehr/how-kaiser-bet–4-billion-on
-electronic-health-records—-and-won.html
65. Ibid.
66. Duke University Health System, “Duke Medicine Completes Implementation.”
67. Duke University Health System, “Duke’s New Medical Records System Improves Patient
Experience,” http://corporate.dukemedicine.org/news_and_publications/news
_office/news/duke-s-new-medical-records-system-improves-patient-abilities-and-access
-to-providers, accessed May 19, 2016.
68. Duke University Health System, “Duke Medicine Completes Implementation.”
69. Kaiser Permanente, “Patient Access to Online Health Action Plans Enhances Rate of
Preventive Care,” https://share.kaiserpermanente.org/article/patient-access-to-online
-health-action-plans-enhances-rate-of-preventive-care/, accessed May 19, 2016.
70. Kaiser Permanente, “About Us: Connectivity.”
71. Z. Budryk, “How Value-Based Care Will Change Healthcare,” September 26, 2013,
http://www.fiercehealthcare.com/healthcare/how-value-based-care-will-change
-healthcare/
72. Cleveland Clinic, “Diseases and Conditions: Value-Based Care.”
73. Mayo Clinic, “Quality at Mayo Clinic.”
74. Dartmouth-Hitchcock, “What Is Population Health?” www.dartmouth-hitchcock.org
/about_dh/what_is_population_health.html, accessed April 14, 2016.
75. Ibid.
76. U.S. Department of Health and Human Services, “The National Quality Strategy:
Fact Sheet,” last updated September 2014, www.ahrq.gov/workingforquality/nqs
/nqsfactsheet.htm
77. Ibid.
78. Ibid.
79. 80 FR 68667 (November 5, 2015).
80. L. S. Kaiser and T. H. Lee, “Turning Value-Based Health Care into a Real Business
Model.”
Notes 359

361
Progress Notes
© LFor/Shutterstock
New Payment Methods and Measures:
MIPS and APMs for Eligible Professionals
INTRODUCTION
This chapter explores how new payment methods and quality measures work for physicians and other eligible professionals. The chapter has several parts, as follows, and each
part contributes to an understanding of the choices among
MIPS, APMs, and the related measures that determine their
payment. Chapter parts include the following:
• Overview of MACRA and the payment choices that
must be made
• Choice #1 is for MIPS incentives: how this choice is
structured, who is eligible for MIPS, and facts about
payment and reporting
• Details of the MIPS scoring process and how the
scores become payment adjustments for the individual practitioner
• Details about the MIPS performance categories, how
the related quality measures are created, and their
timelines
• Choice #2 is for APM incentives: how this choice is
structured, the various APM models, and facts about
payment and reporting
• Details about the Advanced APM participation
requirements and scoring standards
In conclusion, two reference sections are included: one for
the three incentive programs as they existed before MIPS
and one for existing alternative payment models.
This chapter should be read in conjunction with the
preceding chapter, “Understanding Value-Based Health
Care and Its Financial and Digital Outcomes.” While this
chapter describes how MIPS and APMs work, the preceding
chapter provides a view of the healthcare industry’s overall
After completing this chapter,
you should be able to
1. Distinguish between the two
pay-for-performance choices
in the Quality Payment
Program.
2. Recognize the three existing
incentive programs that were
combined into MIPS.
3. Identify the four MIPS
performance categories.
4. Describe how the MIPS
Composite Performance Score
uses weighted averages.
5. Identify the Advanced APM
“significant participation”
requirements.
6. Understand the Scoring
Standards for APMs.
7. Discuss the framework for
MACRA Quality Measurement.
28
CHAPTER
value-based effort, along with the legislative sequence that came before the MACRA requirements. (See the section entitled “Value-Based Legislative Reform” in the preceding chapter.)
LEGISLATIVE REFORM AND MACRA: AN OVERVIEW
This section provides an overview of legislative reform as it pertains to MACRA.
The Legislative Act
The Medicare Access and CHIP Reauthorization Act of 2015 (MACRA) was signed into law on
April 16, 2015. The law is grouped into categories, and each category is identified by a title number and heading. This chapter concerns new pay-for-performance incentives (MIPS and APMs)
for physicians and other eligible professionals, which is located under Title I.1
The Repeal of SGR
Repeal of the Sustainable Growth Rate, or SGR, is a true legislative reform. The short history of
SGR that follows explains why reform was necessary.
The SGR was a formula used to calculate Medicare payments to physicians. Each year, the
formula compared increases or decreases in physician spending to increases or decreases in the
gross domestic product (GDP). If the GDP increase exceeded the increase in physician spending, then the physicians’ base rate payment amount would increase. However, if the physicians’
spending increase exceeded the increase in the GDP, then the physicians’ base rate payment
amount would decrease.
An abbreviated SGR timeline looks like this:
1997: The SGR formula came into existence.
2002: The formula results in a 4.8% cut in the Medicare base payment rate (a wake-up call).
2003: A law blocking the formula’s cuts was passed.
2004–2005: Congress passes annual “fixes” that disregard the formula’s cuts.
2006: Another law was passed that made the annual cuts cumulative.
2009–2010: Congress passes annual “fixes” that disregard the cumulative cuts.
2015: The SGR formula is repealed by law.2
The problem with cumulative annual cuts is the resulting excessive reduction in base payment rates. This meant, for example, if last year’s blocked cut was 4% and this year’s cut was 5%,
then the pay cut would now amount to a cumulative total cut of 9%, and so on, year after year.
Basically, at this point the SGR formula was broken. It was not sustainable. And to repeal it
and replace the long-standing SGR formula with an entirely different approach to physician
payment, as MACRA does, is true legislative reform.
New Pay-for-Performance Incentives (MIPS and APMs)
MACRA provides new physician pay-for-performance incentives that replace the repealed
SGR formula. There are two methods, or types, of participation. The first type of
362 Chapter 28 New Payment Methods and Measures
participation is in the new Merit-Based Incentive Payment System, or MIPS. The second type
allows incentive payments when requirements are met to be a qualifying participant in an
Advanced Alternative Payment Model (APM).3 The two payment methods and their related
performance measures and/or requirements are described in the following sections of this
chapter.
Other Provisions of the Act
As previously explained, subjects covered by this law are grouped into categories, and each
category is identified by a title number and heading. Four other categories, and titles, are
included in the Act. Title II concerns “extenders”; in other words, a series of programs and
other funding efforts receive an extension within this title. Title III concerns an extension, or
reauthorization, of the Children’s Health Insurance Program (CHIP). (You will notice that
CHIP is in the title of the law.) Title IV concerns offsets; these include certain limitations,
updates and adjustments. The final Title V is labelled as “miscellaneous” and covers an array of
other various subjects.4
PAYMENT CHOICES: MIPS VERSUS APMs
MACRA provides for two value-based pay-for-performance initiatives: MIPS and APMs. The
new name for this overall payment approach is the Quality Payment Program. In other words,
the Quality Payment Program includes both MIPS and APM types of incentive payments.
Because MACRA provides two choices for payment, eligible professionals must generally opt for
one or the other of these choices. Figure 28–1 illustrates the two choices. Note that the start date
(“Year 1”) for both MIPS and APM incentive payments is 2019.
MIPS INCENTIVES
This section describes the MIPS payment structure and those eligible professionals who may be
included and/or excluded from this initiative.
Figure 28–1 Physicians Can Choose One of Two Pay-for-Performance Incentive Tracks.
Track # 1
Merit-Based Incentive
Payment System
(MIPS)
Track #2
Alternative Payment
Models (APM)
Beginning
In
Year 1
MIPS Incentives 363
MIPS Payment Structure
The MIPS payment structure consists of modified inputs from three existing programs, plus one
new category. The three existing incentive programs whose modified measures are combined
into MIPS inputs are described below. The fourth, new MIPS category is called Clinical Practice
Improvement Activities. It is further described later in this chapter. Figure 28–2 illustrates the
four elements that provide inputs for the MIPS payment structure as of 2019.
Three Existing Incentive Programs Are Combined into MIPS
Many modified features of three existing incentive programs are combined into MIPS. They
include the: Physician Quality Reporting System (PQRS) program, the Value Modifier program,
and the Meaningful Use and Electronic Health Records Initiative.
These Three Programs End as Stand-Alones as MIPS Begins
At the time of this writing, payments will end in 2018 for these three programs. In other words,
these programs became obsolete because the new Quality Payment Program (including both
MIPS and APMs) takes over. Figure 28–3 illustrates the changeover.
The payment penalties associated with the three existing incentive programs will also disappear as features of the programs are rolled into the MIPS payment structure. Figure 28–4
illustrates the dissolution of such penalties.
Figure 28–2 Four Pay-for-Performance Inputs Are Combined into MIPS.
Physician
Quality
Reporting
System
(PQRS)
Physician
Value-Based
Payment
Modifier
(VBPM)
Meaningful Use
Electronic
Health
Records
(MU/EHR)
Clinical
Practice
Improvement
Activities
As of 2019
Inputs Combined Into The
Merit-Based Incentive
Payment System
(MIPS)
Existing New
364 Chapter 28 New Payment Methods and Measures
Eligible Professionals for MIPS
This section describes both eligible professionals included and excluded from MIPS as follows.
Note that the Centers for Medicare and Medicaid Services (CMS) have chosen to use the term
“eligible clinicians” instead of “eligible professionals.” The description below uses the legislative
term “eligible professionals.”
Figure 28–3 Three Incentive Program Payments End as MIPS Is Established in 2019.
Three Incentive Payments End
PQRS
VM
Meaningful
Use of EHR
MIPS Payment Is
Established
in
2019
Figure 28–4 Some Payment Penalties Disappear at the End of 2018.
Some Payment Penalties
Disappear at the end of 2018
2% Penalty for failure
to report PQRS quality
measures ends
3% Penalty for failure to
meet EHR meaningful use
requirements ends
Certain penalties
(“negative modifiers”)
associated with ValueBased Modifier end
MIPS Incentives 365
Eligible Professionals Categories Subject to MIPS Will Increase
Five categories of eligible professionals (EPs) are
subject to MIPS for the first two payment years.
As of the third year, however, the Secretary has
the right to add other types of eligible professionals, and eight more professional categories
have been suggested for addition in the third
year. Exhibit 28–1 lists the five EPs types included
in years one and two, plus the eight types that
have been suggested beginning in year three.
Who May Be Excluded from MIPS?
As discussed previously, physicians and certain other eligible professionals have a choice
between two payment methods; either MIPS or
APMs. Therefore, certain eligible professionals who chose the APM methods may also be
excluded from MIPS. In addition, some professionals will fall below the low-volume threshold
and will be excluded. (The low-volume threshold
is discussed in more detail in a following section
of this chapter.) Finally, an eligible professional
who is in the first year of participation in Medicare may be excluded from MIPS. Exhibit 28–2
illustrates some reasons for exclusion.
HOW ARE MIPS PHYSICIANS
AND OTHER ELIGIBLE
PROFESSIONALS PAID?
This section summarizes performance scores
and payment adjustments.
EPs Are Scored on Performance
Eligible professionals for MIPS are scored
on performance. Their performance will be
rated on a scale that ranges from maximum
positive to neutral to maximum negative.
Summary of MIPS Payment Adjustments
and Their Timelines
MIPS EPs receive an automatic base increase
of 0.5% from 2015 through 2019. At the time
Exhibit 28–1 MIPS Eligible Professionals
Inclusion Varies by Timeline
Definitely Included
For Years One & Two (2019 & 2020)*
• Physician
• Physician assistant
• Nurse practitioner
• Clinical nurse specialist
• Certified registered nurse
anesthetist
• Groups that include such professionals
Possibly Included
From the third year onward (2021)*
• The Secretary can add other EPs
such as:
• Physical therapists
• Occupational therapists
• Certified audiologists
• Clinical psychologists
• Speech-language pathologists
• Clinical social workers
• Nurse midwives
• Dietitians or nutrition professionals
*Timeline may change
SSA Section 1848 (g)(1)(c)(i)
Exhibit 28–2 Professionals Who May Be
Excluded from MIPS
An eligible professional may be
excluded from MIPS if he or she:
• Is a qualifying APM participant
• Is a partial-qualifying APM
participant
• Is below the low-volume threshold
for the performance period
• Is in the first year of Medicare
participation
SSA Section 1848 (g)(1)(c )(ii)
366 Chapter 28 New Payment Methods and Measures
of this writing there is zero automatic base increase from 2020 through 2025, with a 0.25%
increase applied from 2026 onward.
These EPs are then at risk for performance adjustments to their payments beginning in 2019.
These payments are budget neutral. That means the total dollars paid out to successful providers will equal total dollars that reduce payments to unsuccessful providers. Thus, the budget
neutral payments range from 4% maximum and minimum in 2019 increasingly upward to 9%
maximum and minimum in 2025. The payment percentage amounts by year are illustrated
in Figure 28–5.
MACRA also allows an extra bonus for exceptional performance. The bonus amount of $500
million dollars is exempt from budget neutrality and can be paid out over the first five years of the
program. Participants become eligible for the bonus based on increases in their MIPS performance
scores. (The scoring increase for exceptional performance is topped at an additional 10%.)5
MIPS COMPOSITE PERFORMANCE SCORE
This section provides an overview of the MIPS composite performance score.
Payment Adjustment Is Determined by Four Performance Categories Within the
Composite Performance Score
The MIPS composite performance score (CPS) consists of four parts. Each part is a separate
performance category within the composite score. (Note that some of their descriptive titles
have changed, as indicated.)
• Quality
• Advancing Care Information (a.k.a. Meaningful Use of Electronic Health Records)
• Clinical Practice Improvement Activities
• Cost (a.k.a. Resource Use)
Each part (category) of the score is discussed in more detail in the following sections.
Figure 28–5 MIPS Payment Adjustments and Timelines.
Modified from CMS, “Path to Value: The Medicare Access & CHIP Reauthorization Act of 2015,” p. 9 and p. 18.
MIPS Payment Adjustment Timelines
MIPS 2015–2018* 2019 2020 2021 2022–2024 2025 2026 & Onward
(1) Automatic** Base Increase 0.5% 0.5% 0.0% 0.0% 0.0% 0.0% 0.25%
PLUS (2) Three Levels of
Performance Adjustments at RISK
Maximum Positive Adjustment*** +4% +5% +7% +9% +9%
Neutral Adjustment 0.0% 0.0% 0.0% 0.0% 0.0%
Maximum Negative Adjustment*** –4% –5% –7% –9% –9%
*Note: PQRS, VM, and EHR remain in effect for the period 2015 to 2018.
**Automatic annual base conversion factor increase of 0.5% also in effect for period 2015–2018.
***Annual totals must be budget neutral.
MIPS Composite Performance Score 367
The payment adjustment illustrated in Figure 28–5 begins with the clinician’s (or group’s)
CPS. The CPS is a unified scoring system that converts measures and/or activities into points,
allows partial credit, and provides advance information about what is needed for top-performance scoring.
MIPS Scoring Uses Weighted Averages
MIPS scoring uses weighted averages within the CPS that will change the performance
categories weighting from year to year. Figure 28–6 illustrates these changes. The figure
shows how the distribution of weighted averages may shift from 2019 to 2021. In other words,
the two years in this illustration show a different set of weighted averages among the four
categories.
MIPS PERFORMANCE CATEGORIES
Each performance category is made up of a series of individual measures. The clinician chooses,
within limits, which measures to report within each category. A brief summary about each category follows. The four categories are also illustrated in Figure 28–7.
Quality
This category contains streamlined measures from the PQRS and the Quality portion of the
Value Modifier (VM) program. Required reporting for this category consists of six measures,
rather than the nine measures previously required by PQRS. There is also more emphasis on
outcome measurement. The Year 1 proposed weight of 50% subsequently became 60%.
As initially proposed, the eligible clinicians (EPs) or groups are allowed to choose the six
measures that best reflect their practice. There are certain limitations to this choice. Of the six,
one has to be either an outcome or a high-quality measure, and another has to be a crosscutting measure. (A crosscutting measure is one that can be applied across a number of providers
and/or specialties; thus, these measures “cut across.”) There is another available choice for
specialists: they can choose a set of measures related to their particular specialty.6
Figure 28–6 Weighted Averages for the MIPS Score Measures as Initially Proposed.
50%
25%
15%
10%
30%
15% 25%
30%
2019
Quality
Meaningful EHR Use*
Clinical Improvement
Resource Use
2021
Quality
Meaningful EHR Use*
Clinical Improvement
Resource Use
*As modified: now known as “Advancing Care Information”
368 Chapter 28 New Payment Methods and Measures
Advancing Care Information (also known as Meaningful Use of Electronic Health
Records)
Meaningful use has gained a new name: Advancing Care Information (ACI). The ACI measures,
originally derived from the Meaningful Use EHR program, have been modified and streamlined
for use within MIPS. Quarterly reporting has been eliminated, as has the “all-or-nothing” threshold measurement of electronic health record (EHR) technology. Redundant measures and two
objectives have been eliminated to reduce the reporting burden. The Year 1 weight is 25%.
For purposes of MIPS reporting, eligible clinicians or groups can choose measures that are
most important within their practice. These customized choices will represent key measures
of interoperability and information exchange. Flexible scoring has been implemented for all
measures. The flexibility will help to promote care coordination. Thus better care coordination
should result in better patient outcomes.7
Clinical Practice Improvement Activities (CPIA)
The new Clinical Practice Improvement performance category contains six types of activities
proposed for Year 1:
• Expanded Practice Access
• Population Management
Figure 28–7 MIPS Performance Categories.
Quality
Streamlined measures
from PQRS & Quality
portion of VM
Cost*
Replaces cost portion of
Value Modifier Program
Advancing Care
Information**
Streamlined measures
from Meaningful Use
EHR Program
Clinical Practice
Improvement
Activities
New category with 6
activities & 90 options
*Cost a.k.a. Resource Use
**Advancing Care Information a.k.a. Meaningful Use
MIPS Performance Categories 369
• Care Coordination
• Beneficiary Engagement
• Patient Safety and Practice Access
• Participation in an APM
The Year 1 weight is 15%.
The CMS proposed rule sets out measures of more than 90 activities within this category.
Eligible clinicians or groups can choose six measures among these that best reflect goals for the
practice. (At least one activity must be chosen in order to avoid a zero score.)8
Cost (also known as Resource Use)
The cost category will assess all the applicable resource use measures that are applicable to the
particular clinician or group. This category replaces the cost portion of the Value Modifier
program. Over 40 episode-specific measures have been added in order to address specialty concerns. Year 1 weight proposed at 10% subsequently became zero.
The eligible clinician or group does not have to report measures for this category. Instead,
CMS performs the calculation. To do so, CMS will compare resource use across practices that
involve similar care episodes and similar clinical condition groups.9
HOW MIPS SCORING WORKS
The clinician’s (or group’s) chosen measures, as reported, are accumulated into annual totals.
The clinician’s totals from each category’s measures as reported are converted into points.
How Do Points Earned Become Percentage Scores?
The next step is for points earned to become percentage scores. You will recall that there
are weighted averages within the composite performance score. Figure 28–6 illustrates these
weights for both 2019, which is Year 1 for the Quality Payment Program and MIPS, and for 2021.
Accordingly, the Year 1 maximum score possible for each performance category will equal
that category’s weight within the overall score (the Composite Performance Score). The Year 1
maximum percentage scores are therefore proposed as follows:
Quality = 50%, subsequently changed to 60%.
Advancing Care Information = 25%
Clinical Practice Improvement Activities = 15%
Cost = 10%, subsequently changed to zero.
(Note that these percentages are as shown in Figure 28–6.)
Points are turned into percentage scores in this manner. First, the clinician earns points
by reporting his or her chosen measures for the first three performance categories listed
previously. (You will recall that the “Cost” category does not require the reporting of measures
because it is calculated by CMS from claims and volume information.)
There are a certain number of points needed to reach the maximum score for each of the
first three performance categories listed above. An example follows.
370 Chapter 28 New Payment Methods and Measures
Quality = 80 to 90 points (depending on group size)
Advancing Care Information = 100 points
Clinical Practice Improvement Activities = 60 points
Table 28–1 illustrates the Year 1 proposed percentages and total points as just discussed.
Dr. Brown’s Scores: An Example
The points earned by an individual (or a group) are mathematically converted into the relevant
percentage. For example, Dr. Brown’s practice earns all 60 points in the Clinical Practice Improvement Activities category, so that portion of his weighted composite performance score will be
the full 15%. But due to office staff errors, some measures for the Advancing Care Information
(a.k.a. Meaningful Use) category were not properly reported for part of the performance period.
As a result, Dr. Brown’s practice only earned 50 points, or one-half, of the 100 points that are
needed in order to reach the maximum score. Therefore, his percentage score for this category
will be 12.5%, or one-half of the 25% maximum possible score. (Refer to the left-hand column
in Table 28–1 to further understand the maximum possible scores as expressed in percentages.)
All told, Dr. Brown’s four performance category percentage scores looked like this:
Quality = 37.5%
Advancing Care Information = 12.5%
Clinical Practice Improvement Activities = 15.0%
Cost = 8.0%
The four performance category composite scores would then be converted into a total composite score using the weighted averages as shown in Figure 28–6. How Dr. Brown’s scores affect
his payment adjustment is the subject of the next section.
How Do Scores Become Payment Adjustments?
This section discusses the overall process of computing scores and converting them into payment adjustments.
Table 28–1 MIPS Scoring by Performance Category: An Example
MIPS Performance Category Maximum Possible Score
(stated as a percentage)
Total Points Needed to Reach
the Maximum Score
Quality 50 80 to 90*
Advancing Care Information
(a.k.a. Meaningful Use) 25 100
Clinical Practice Improvement
Activities 15 60
Cost (a.k.a. Resource Use) 10
CMS calculates average score
of all resource measures that
can be attributed
*Depending on group size.
Modified from CMS Quality Program Executive Summary Table 1, p. 10 (May 2016).
How MIPS Scoring Works 371
Measures Are Submitted During the Performance Period
First, the physician (or group) records and submits selected measures during the performance
period. (We have already discussed how each practice can choose measures to report within
the four performance categories. More detail about performance periods appears in a following section.) After all these data are collected, properly reported measures are analyzed and
outcomes are calculated. The resulting computations are then converted into scores and the
scores, in turn, are converted into payment adjustments. An overview of this process follows.
(While the following section provides a general descriptive overview, the actual computations
are quite sophisticated and are beyond the scope of this text.)
Five Steps from Measures to MIPS Payment Adjustment
This section provides a general overview of five steps that would generally convert submitted
measures into MIPS payment adjustments. For purposes of our description, we will assume that
Analyst Jane works for CMS and is going to perform all five steps. (This is not realistic, of course,
as individual teams of analysts would be segmenting the process into individual team responsibilities.) We will also assume that Dr. Brown’s individual composite score is the end result of this
example.
Step 1: First, Analyst Jane and her team will analyze the submitted measures from all over
the country. These represent measures for the Quality, Advancing Care Information, and Clinical Practice Improvement Activities performance categories as submitted during the performance period. The national analysis will, of course, include Dr. Brown’s submitted measures
for the performance period. (The team will also compute relevant benchmarks for comparative
purposes.)
Step 2: Analyst Jane and her team will compute costs and certain other outcomes from CMS
data sources. These calculated outcomes primarily represent the Resource Use (Cost) performance category. (Note that some of these computations may be based on the prior year’s data
rather than performance period data.)
Step 3: Analyst Jane and her team will have already standardized the data from the four performance categories and will have performed a series of statistical analyses. Now they compute
the national means and medians. They divide the results of this analysis into quartiles. Using
the quartile results, they apply standard deviation computations to divide their analysis into
three national tiers. The three tiers are labelled as high, average, and low.
Step 4: Next, Analyst Jane does two things. First, she finds the individual physician or group’s
composite, or multiple-part, performance score. In our example, that would be Dr. Brown’s
composite performance score. Then, she assigns the doctor’s score to one of the three national
tiers. The doctor’s score will thus fall into a high, average, or low tier.
Step 5: Now that Analyst Jane knows which tier Dr. Brown’s score is in, she will compute
the doctor’s payment adjustment. (Her computation must also take budget neutrality into
account.) This payment adjustment will have one of three possible outcomes: it will result in a
positive, neutral, or negative payment adjustment for Dr. Brown.10
Figure 28–8 illustrates the five-step process just described. Note that this process would be
repeated each time a performance period ends. (Note also that the exact process will probably
be modified over time.)
At the time of this writing we understand that first, an eligible MIPS participant should
be able to view preliminary results, and second, that there may be certain appeal rights
established.
372 Chapter 28 New Payment Methods and Measures
MIPS REQUIRED REPORTING AFFECTS PAYMENT
This section discusses required reporting and the related performance periods.
Required Reporting
Reporting on required measures is important because the reported measures directly impact
future payment adjustment amounts. Complete reporting—that is, reporting on every measure
that is has been previously selected—is necessary in order for the measures to be recognized
when they are submitted. In other words, an incomplete set of measures may not be counted.
Accuracy in recording is equally important, of course.
What Is a Performance Period?
A performance period is a designated time span that is used to capture data. The data that are
captured measure how well that facility or professional or group is performing. At the time of
this writing, for example, the MIPS program performance period covers a one-year period, and
that period is a calendar year.11
How Does Performance Period Reporting Affect Payments?
This section discusses the reporting and scoring timeline along with feedback opportunities.
Timeline
The measures reported during a performance period are analyzed to help determine a payment adjustment that is based on quality and value performance. CMS has provided an example of the timeline for the first performance period under MIPS as follows.
The first MIPS performance period, for example, is calendar year 2017. CMS uses the following year (2018 in this example) for analysis and scoring of the data collected in the prior
year. Then the next year (2019 in this example) is when the first MIPS payment adjustments are
made. In other words, the performance period reporting made two years ago directly affects the
payment adjustments received in a current year.12
Feedback
CMS is expected to provide feedback to the physicians and groups who are MIPS participants.
At the time of this writing, the first feedback was anticipated in the middle of the performance
Figure 28–8 How MIPS Scoring Works: An Overview.
Find the individual
physician or group
composite scores
Compute the individual
physician or group
payment adjustment
Assign the score
to
High-Avg-Low
tiers
Results in
Positive
Neutral
Negative
Payment adjustment
Results in
High-Avg-Low
tiers
Analyze submitted
measures
Calculate
outcomes and costs
Find the national
means & quartiles
MIPS Required Reporting Affects Payment 373
period year. (This would give an opportunity for adjustments to the participant’s reporting process.) The second feedback was then anticipated in the middle of the analysis-and-scoring year
(the year in between the performance period and the payment-adjustment year).
Sunsetting Existing Programs
In discussing timelines, it is important to understand that previously existing incentive programs remain in existence for the period 2015 through 2018. During that four-year period,
providers are still being paid under these programs. (The three programs include the PQRS,
the Value-Modifier, and the Meaningful Use of EHR.)
DATA SUBMISSION
This section describes the allowable options proposed for submitting required data.
Individual Reporting
Individuals can choose among various options for data submission. The four performance categories differ somewhat in available options. These differences are described as follows.
Quality Performance Category Options
Data submission choices include submission through EHRs or through a Qualified Registry
or Qualified Clinical Data Registry (QCDR). Claims submitted by providers are also part of
quality data submission, as are administrative claims. (“Administrative claims” means CMS
will perform any needed computations, and no special submission is required from the
participant.)
Advancing Care Information (ACI) Performance Category Options
Submission choices for ACI include through EHRs, a Qualified Registry, or a QCDR. Attestation
is another available choice for this category. Administrative claims are also part of the process,
but, again, no special submission is required.
Clinical Practice Improvement Activities (CPIA) Options
Submission choices for CPIA also include through EHRs, a Qualified Registry, a QCDR, or
through attestation. Once again, administrative claims are part of the process but no action is
required on the part of the participant.
Resource Use (Cost) Performance Category Options
The Resource Use category entirely uses the administrative claims computation process, so no
action at all is required by the participant.13
Group Reporting
Groups have a couple of additional options. In the case of the Quality Performance category,
groups may also choose the CAHPS for MIPS Survey option. Groups of 25 or more may use the
CMS Web Interface when submitting data for the Quality, ACI, and CPIA categories.14
374 Chapter 28 New Payment Methods and Measures
Reporting by Intermediaries
CMS has proposed to allow certain intermediaries to submit performance category data on behalf
of eligible clinicians. At the time of this writing, the allowable intermediaries include health information technology (HIT) vendors who obtain their data from the eligible clinicians’ certified
EHR technology, CMS-approved (certified) survey vendors, Qualified Registries and QCDRs.15
APM INCENTIVES—(CHOICE #2)
These alternative payment models, or APMs, represent innovations in how to compensate physicians and other eligible professionals.
Advanced APMs According to MACRA
MACRA considers the following to be Advanced APMs:
• CMS Innovation Center Models under section 1115A (other than a healthcare innovation
award)
• The Shared Savings Program
• A demonstration under section 1866C
• Demonstrations required by Federal law
These APMs are considered “advanced” because the participants accept risks along with rewards
(the rewards being the incentive payments). To be eligible for such payment, particular criteria
about EHR usage and reporting of quality measures must be met.16
Eligible Advanced APMs Proposed for Year 1
CMS proposes specific criteria for Advanced APMs through rulemaking. These criteria fit within
MACRA’s description of entities as listed above. At the time of writing, the eligible Advanced
APMs proposed for Year 1 are as follows:
• Comprehensive Primary Care Plus (CPC+)
• Medical Shares Savings Programs—Tracks 2 and 3
• Next Generation ACO Model
• Comprehensive End-Stage Renal Disease Care (CEC) Model
• Oncology Care Model
It is important to note that the Comprehensive End-Stage Renal Disease Care Model is a
large dialysis organization arrangement. Likewise, the Oncology Care Model is a two-sided risk
arrangement. Figure 28–9 summarizes these models. It is also important to note that some
changes to the types of Year 1 proposed models may occur before actual implementation.
The eligibility for Advanced APMs will be reviewed annually. Thus, while these models are
proposed for Year 1, we are still at the beginning of this transition to value-based performance
payment models. As such, we can expect a series of modifications, expansions, and revisions
as time goes on. We can therefore expect that the choices among future multiple payment
approaches will increase. We can also expect increased transparency through public reporting
as these models develop and mature.17
APM Incentives—(Choice #2) 375
Other Payer Advanced APMs: An Upcoming Option
Another interesting option is expected to be in effect for payment in 2021. (If so, this means the
relevant performance-reporting period may be two years prior, or 2019.) This proposed option is
another type of APM, called Other Payer Advanced APMs. As the name suggests, data from payers
other than Medicare could be taken into account when determining a provider’s participation
status. These other payers could be either private insurers or particular state Medicaid programs.
Participation requirements for these Other Payer Advanced APMs would be as follows:
• Use certified EHR technology.
• Provide payment based on quality measures that are comparable to measures in the MIPS
quality performance category.
• Bear more than a nominal amount of risk for monetary losses (or be a particular comparable type of Medicaid Medical Home Model.)18
ELIGIBLE PROFESSIONALS WITHIN APMs
Eligible Professionals for APMs fall into one of two categories: Qualifying (QEPs or QPs) and
Partial Qualifying (PQEPs). This distinction is important because APM payment adjustments
and their related timelines vary between QEPs and PQEPs. Also, note that MACRA refers to Eligible Professionals. However, CMS proposes to use a different term within its rule making. The
equivalent CMS term is “Eligible Clinicians.”
Qualifying Eligible Professionals (a.k.a. Qualifying Eligible Clinicians) Defined
Qualifying eligible professionals (QEPs) meet all thresholds (as defined in the scoring section
of this chapter) and are at risk. “At risk” means financially at risk. In other words, the eligible
professional/clinician will bear some financial burden based on performance.
Partial Qualifying Eligible Professionals (a.k.a. Partial Qualifying Eligible Clinicians)
Defined
Partial qualifying eligible professionals (PQEPs) meet slightly reduced thresholds and are at
risk. They also bear some financial burden based on their performance.
Figure 28–9 Advanced Alternative Payment Models (APMs) as Proposed for Year 1.
*Other models may subsequently be included.
**A large dialysis organization arrangement.
***A two-sided risk arrangement.
Advanced Alternative Payment Models (APMs)
As Proposed for Year 1*
Comprehensive
Primary Care
Plus
Medical Shared
Savings
Program-Track 2
Medical Shared
Savings
Program-Track 3
Next
Generation
ACO Model
Comprehensive
End Stage Renal
Disease Care
Model**
Oncology
Care
Model***
376 Chapter 28 New Payment Methods and Measures
The Pathway Toward Becoming a Qualifying APM Participant (QP)
It is important to understand that the EPs/ECs within an Advanced APM entity may collectively
meet the necessary threshold for participation. In other words, everyone who is eligible within
a particular Advanced APM may receive the same score and thus the same payment adjustment. This is a key distinction that can easily be overlooked or misunderstood. The sequence of
progression, or pathway, for eligible clinicians toward becoming a Qualifying APM Participant
(QP) is illustrated in Figure 28–10.
19
Four Steps to Find if the Eligible Clinician Will Become a Qualifying APM
Participant
CMS has published four steps that illustrate whether or not an eligible clinician within an
Advanced APM will become a QP. (Remember that these clinicians will be collectively meeting
the necessary thresholds.) The four steps are as follows:
1. QP determinations are made at the Advanced APM Entity level.
2. CMS calculates a Threshold Score for each Advanced APM Entity.
3. The Threshold Score for each method is compared to the corresponding QP threshold.
4. All the eligible clinicians in the Advanced APM Entity become QPs for the payment year.20
Figure 28–10 Qualifying APM Participant (QP) Pathway.
Modified from 81 Federal Register 28295 Figure B (May 9, 2016).
APM meets advanced AMP criteria
APM entity participates in advanced APM
Eligible clinicians advanced entity collectively meet
QP threshold of participation
Alternative Payment Model (APM)
Advanced APM
Advanced APM Entity
Qualifying APM Participant (QP)
Eligible Professionals Within APMs 377
The result: If the threshold scores for the Advanced APM Entity are above the appropriate
threshold, then all the eligible clinicians in the Advanced APM Entity will become QPs for that
particular payment year. However, if the threshold scores for the Advanced APM Entity are
below the corresponding QP threshold, then none of the eligible clinicians will become QPs for
that payment year. In other words, the determination is all or nothing at the time of this writing.
It is also important to understand that the threshold scores are derived each year from a calendar year performance period. The performance period will be two years prior to the payment
year, and is thus aligned with the MIPS performance period.21
HOW ARE ADVANCED APM EPs PAID?
This section discusses payment adjustments and timelines. Note that the following comments
about payment refer to scoring thresholds. A description of such thresholds appears in the scoring section of this chapter.
Qualifying Eligible Professionals (QEPs) Payments
This section describes payment details for QEPs.
Incentive Payments 2019 Through 2024
If QEPs meet their thresholds, they receive an annual lump sum incentive payment of 5.0%
from 2019 through 2024. These QEPs will also be excluded from MIPS adjustments. At the
time of this writing, beginning in 2026, qualifying participants may receive higher fee schedule
updates.22 A timeline payment summary appears later in this section.
QEP Incentive Payment Base Period Versus QP Performance Period
It is important to understand the difference between base period and performance periods for
Advanced APM Qualifying Professionals/Clinicians. The performance period will be two years
prior to the payment year, as previously discussed, and is aligned with MIPS performance periods.
The incentive payment base period is for a different purpose. It is used to calculate how much the
5% incentive lump sum will be. To do so, the relevant payments for services are added up; then 5%
of that figure equals the 5% incentive lump sum to be received. (The relevant payments to be added
up are based on “the estimated aggregate payments for professional services furnished the year
prior to the payment year…e.g. the 2019 APM Incentive Payment will be based on 2018 services.”23
This cycle is repeated each year. For example, as CMS explains it, the first cycle would be as follows: 2017 = QP Performance Period; 2018 = Incentive Payment Base Period (to calculate the 5%);
2019 = Payment Year. Then the second cycle starts. It would be: 2018 = QP Performance Period;
2019 = Incentive Payment Base Period; 2020 = Payment Year. And the cycle would keep repeating for the duration of the 5% incentive payments.24
Partial Qualifying Eligible Professionals (PQEPs) Payments
This section describes payment details for PQEPs.
Some eligible professionals/clinicians may be participating in an Advanced APM that does
not meet the standard threshold as previously described. Instead, this Advanced APM meets a
378 Chapter 28 New Payment Methods and Measures
slightly reduced threshold. Therefore, these eligible professionals/clinicians are considered to
be Partial Qualifying Eligible Professionals/Clinicians, or PQEPs.
The PQEPs receive no lump sum incentive payment. They can either choose to participate
in MIPS, or they can choose to opt out of MIPS. If they choose to participate in MIPS, they will
receive favorable weights in the MIPS scoring. If they choose to opt out instead, they will be held
harmless. In other words, they would receive no favorable payment adjustment, but neither
would they be subject to a MIPS negative adjustment.25
Summary of APM Payment Adjustments and Their Timelines
In discussing timelines, it is important to understand that any previously existing payment methods remain in existence for the period 2015 through 2018. In other words, during that four-year
period, providers are still being paid under these methods.
At the time of this writing, the APM payment adjustments are scheduled to commence in
2019. As previously discussed, these APM payment adjustments are based upon the results of
reporting for a performance period two years prior to 2019. Thus, measures reported in 2017
represent the performance period for Year 1 (2019) APM incentive payments. Table 28–2
summarizes both the payment information and the timelines as discussed.
What Is the “Intermediate Option” for Payment Adjustment Choices?
“Intermediate Option” is the term for flexibility of choice between the MIPS and APM tracks.
First, as we have previously described, partially qualifying EPs can choose whether or not they
want to receive the MIPS payment adjustment. Second, the APM/MIPS participants would get
credit toward their score within the category of Clinical Practice Improvement Activities. CMS
has proposed aligning MIPS standards and APM standards in order to “make it easy for clinicians to move between them.”26
Table 28–2 APM Payment Adjustments and Timelines (as Proposed)
APMs
Payment Adjustments 2015–2018* 2019 2020 2021 2022–
2024 2025 2026 Onward
Qualifying EPs (QEPs; meet
all thresholds and are at risk)
Annual Lump Sum Payment
5.0%
Higher fee
schedule
updates starting
in 2026
Partial Qualifying EPs
(PQEPs; meet slightly
reduced thresholds
and are at risk)
No lump sum payment; can choose to participate
in MIPS OR No lump sum paid; can opt out of
MIPS and be held harmless
To be determined
*Note: PQRS, VM & EHR remain in effect for the period 2015 to 2018.
Modified from CMS, “Path to Value: The Medicare Access & CHIP Reauthorization Act of 2015,” p. 18.
How Are Advanced APM EPs Paid? 379
HOW SIGNIFICANT PARTICIPATION WORKS
This section discusses Advanced APM participation requirements.
What Is Significant Participation in an Advanced APM?
Significant participation is expressed in terms of ever-increasing percentages. In other words, participation must be met in each applicable payment year in either of the following two ways: percentage of payments through an Advanced APM or percentage of patients through an Advanced APM.
At the time of this writing, participation percentages for APM payments range from 25% to
75% over a six-to-seven year period. Likewise, participation percentages for APM patients range
from 20% to 50% over the same six-to-seven year period. Table 28–3 illustrates the progression
of these timelines.
Will These Requirements Change Over Time?
It is to be expected that specific requirements will be edited and perhaps modified as time goes
on. In addition, “CMS will continue to modify models in coming years to help them qualify as
Advanced APMs.”27
ADVANCED APM PARTICIPATION STANDARDS
This section discusses participation standards that are applicable to Advanced APMs.
Participation Standards for Advanced APMs
The initial proposed standards for Advanced APMs include three particular areas, as follows.
Financial Risk
The financial risk standards involve the level of financial risk. If financial risk requirements are not
met, then CMS could take action in several ways. Possible CMS actions include requiring repayment, withholding current payments due, or reducing future rates to equal the required repayment
penalty. In other words, the APM would lose money. (Of course, if the APM exceeds the standards,
it should gain, because it would receive incentive payments.) The proposed initial financial risk
standards must be met in three ways, including total risk, marginal risk, and a minimum loss rate.
Table 28–3 Advanced APMs: Required Participation by Year (as Proposed)
Payment Years
Required participation through an
Advanced APM*
2017 2018 2019 2020 2021 2022 & Later
Percentage of payments 25% 25% 50% 50% 75% 75%
OR
Percentage of patients 20% 20% 35% 35% 50% 50%
*Requirements for percentage of significant participation, by year.
Modified from CMS Quality Payment Program Overview Fact Sheet Table 1, p. 5 (October 14, 2016).
380 Chapter 28 New Payment Methods and Measures
Comparable Measures
This standard requires that the APM measures be comparable to MIPS measures within
the quality performance category. As you will recall, to be comparable the measures must always
be valid and reliable. They must also be evidence-based and at least one of the measures must be
an outcome measure (assuming there is an appropriate measure available).
Certified EHR Technology (as Proposed)
This standard requires that in the first year of the performance period, 50% of the APM clinicians must use certified EHR technology. And for the second year of the performance period 75
percent of the APM clinicians must use certified EHR technology.28
Required Reporting for the First Year
CMS has proposed that all EPs will be reporting through MIPS for the first year. This requirement is imposed because they want to determine whether the particular EP (or group) can
actually meet the Advanced APM requirements.
Accurate and complete reporting of measures is always important. However, complete
reporting is especially important when the provider is attempting to qualify for participation as
an Advanced APM. Overall scoring standards for APMs are the subject of the following section.
SCORING STANDARD FOR APMs
The APM scoring standard implements uniformity across the various types of APMs. Goals
include reducing reporting burdens while maintaining the goals and objectives of the individual APM entity. (Meeting the requirements for this standard can also be viewed as a necessary
first step toward becoming an Advanced APM.)
Criteria for Eligibility
Eligibility criteria for APM entity scoring standards include the following:
• The APM participates in an agreement with CMS.
• The APM bases its payment incentives on performance, using quality and cost-utilization
measures.
• The APM includes at least one eligible MIPS clinician on a CMS participation list.
(Note that the eligible clinician’s name must be on an APM participation list by the end of the MIPS
performance year. If not, the clinician has to report under standard MIPS methods instead.)29
Types of APM Entities That Qualify
At the time of this writing, the following types of APM entities qualified for the APM scoring
standard:
• Comprehensive Primary Care Plus (CPC+)
• Medical Shares Savings Programs (all tracks)
• Next Generation ACO Model
• Comprehensive End-Stage Renal Disease Care (CEC) Model
Scoring Standard for APMs 381
• Oncology Care Model (OCM)
• All other APMs that meet the criteria for the scoring standard
The Standard Aggregates Scores
Under the standard, all MIPS scores for eligible clinicians are combined, or aggregated;
weighted; and averaged to arrive at a single score at the level of the APM entity. This means
that all the eligible clinicians within that APM will receive the exact same MIPS composite performance score. The standard has streamlined both reporting and scoring. Also, wherever possible, the scoring standard uses performance measures that are related to that APM.
Performance scores under the standard use the same performance categories as does MIPS.
At the time of this writing, it appears that the Resource Use category will usually be not applicable and thus will not contribute to the score. The remaining three categories (Quality, ACI,
and CPIA) will be weighted when computing the final composite score. However, the weights
may vary according to the type of APM entity.
CREATING PHYSICIAN-FOCUSED PAYMENT MODELS (PFPMS)
This section focuses upon how more physician-focused payment models may be created.
Legislative Intent
The underlying legislative intent is to encourage the creation of physician-focused payment
models (PFPMs) as per the following quotation. Alternative Payment Models “provide incentive payments for certain eligible professionals (EPs) who participate in APMs, by exempting
EPs from the MIPS if they are qualifying APM participants, and by encouraging the creation of
physician-focused payment models (PFPMs).”30
A New Committee
The overall phrase used to describe these models is “physician-focused payment models”
or PFPMs. A new committee will have the responsibility for reviewing and assessing possible new models. Its title is the “Physician Focused Payment Model Technical Advisory
Committee.”31
BUILDING THE MEASUREMENT DEVELOPMENT PLAN FOR MIPS AND APMs:
DEVELOPING NEW QUALITY MEASURES
Measuring quality and value are important for MIPS and APMs because quality and value
are the foundation of the new payment system for EPs. Since MIPS measures are more fully
developed than those of APMs, there are differences between MIPS and APMs as to their implementation timelines. MIPS measures are more developed and are ready for the first stages of
implementation. APMs, on the other hand, are taking longer in the initial stages of development. Our focus on measuring quality and value centers upon MIPS for that reason.
382 Chapter 28 New Payment Methods and Measures
What Is the Measure Development Plan (MDP)?
The Measure Development Plan (MDP) has been created in response to a MACRA requirement. The law requires that a draft plan for the development of quality measures be developed
and posted on the CMS.gov website.32 A final plan is then posted at a later date. The final plan
is supposed to take comments regarding the draft plan into consideration. The plan’s full title is
“CMS Quality Measure Development Plan: Supporting the Transition to the Merit-based Incentive Payment System (MIPS) and Alternative Payment Models (APMs) (Draft).”33 Introductory
commentary states that the law provides
both a mandate and an opportunity for the Centers for Medicare & Medicaid Services
(CMS) to leverage quality measure development as a key driver to further the aims of
the CMS Quality Strategy:
• Better Care,
• Smarter Spending, and
• Healthier People.34
The purpose of the MDP is twofold: “to meet the requirements of the statute and serve as a
strategic framework for the future of clinician quality measure development to support MIPS
and APMs.”35
Creating New Quality Measures for MIPS
New quality measures are an important part of the MIPS payment structure. The basic sequence
for creating these new measures is as follows:
• First, start with existing measures. These are contained in the PQRS, in the VM program,
and in the Meaningful Use (MU) requirements of the Medicare EHR Incentive Program.
• Next, align and harmonize these measures. In other words, the existing measures may be
combined, expanded, and/or enhanced.
• Then add new measures. New measures will be needed to fill gaps. A process is in place
to identify these “identified measure and performance gaps.”36 When adding the new
measures, stakeholder comments may be considered. (Such comments may be gathered
in response to a published Request for Information, or RFI.) In addition, measures that
private payers are using may be considered.
New MIPS quality measures will result from this process. Figure 28–11 illustrates the process just
described. Note also that any quality measures developed for APMs must be comparable.
TIMELINES FOR DEVELOPING QUALITY MEASURES
This section discusses various measure development timelines.
Timelines Initially Set by MACRA
MACRA called for the initial draft Measure Development Plan (MDP) to be published as of
January 1, 2016. A comment period followed. Then the final MDP was published in May 2016.
Timelines for Developing Quality Measures 383
The Act further called for updates to the MDP to be published annually or otherwise as appropriate.37 Thus we expect to see annual updates, as required, published on a regular annual
schedule. Any updates that might be otherwise appropriate, of course, are unpredictable.
Procedural Timelines
CMS has another set of procedural timelines to comply with. A final rule about quality measure
development will be published each year by CMS no later than the first of November.38 Within
the regulatory rule-making process, a Call for Measures will be published in the first half of each
year. This allows stakeholders to submit their input. After the Call for Measures ends in June
of each year, a proposed rule will most probably be published with a multi-month comment
period. Only then will the final rule be ready to be published on the first of November.
A FRAMEWORK FOR MACRA QUALITY MEASUREMENT
This section discusses quality measurement concerning a framework for measurement along
with related priorities and domains.
Required Priorities and Domains for Quality Measures Development
MACRA sets out specific requirements for development of quality measures as follows.
MACRA-Required Priorities for Types of Measures
The Measure Development Plan (MDP) required by MACRA has been described in a previous
section of this chapter. MACRA further requires that the Measure Development Plan take four
priorities into account when creating the quality measures. The four priorities are as follows:
Figure 28–11 Building the MDP for MIPS and APMs: Creating New Quality Measures.
I. Building the MDP for MIPS
II. Quality measures to be developed for APMs must be comparable
Start with
• PQRS
• VM
• Meaningful
Use of EHR
Align &
Harmonize
these Measures
Add New Measures
• Utilize RFI
comments
• Consider
Pr
Measur
ivate Payer
es
New MIPS
Quality
Measures
• Combine
• Expand
• Enhance
+ =
384 Chapter 28 New Payment Methods and Measures
• Outcome measures (including patient reported outcome and functional status measures)
• Patient experience measures
• Care coordination measures
• Measures of appropriate use of services (including measures of over use)39
Figure 28–12 illustrates this requirement.
MACRA-Identified Quality Domains
MACRA also sets out specific quality domains for use in quality measure development. MACRA
says “the term quality domains means at least the following domains” and five domains are then
listed as follows.
• Clinical care
• Safety
• Care coordination
• Patient and caregiver experience
• Population health and prevention40
• An additional sixth quality domainis under consideration by CMS. It is: efficiency and
reduction
(Note that this addition is permissible, as the legislative wording is “…at least the following….”)
Figure 28–13 illustrates these requirements. The addition of an efficiency and reduction
domain is especially logical, because it ties into the National Quality Strategy (NQS) domains.
In other words, with this addition, these six domains mirror the six NQS domains that are the
subject of the next section in this chapter.
A Framework for Quality Measurement
CMS has published a Framework for MACRA quality measurement that is linked to NQS domains.
The framework is mapped to the six National Quality Strategy (NQS) domains as follows. Note
that the details following each domain’s title are a part of CMS’s framework. (Note also that
some domain titles vary slightly as they are expanded from the NQS titles as listed above.)
Figure 28–12 Four Priorities for Types of Quality Measures as Identified by MACRA.
Data from MACRA Section 102(1)(D)(4-16-15).
Priorities for Types of Measures as Identified by MACRA
Outcome Care
Coordination
Patient
Experience
Appropriate
Use of
Services
A Framework for MACRA Quality Measurement 385
Clinical Quality of Care
• Care type (preventive, acute, post-acute, chronic)
• Conditions
• Subpopulations
Safety
• All-cause harm
• Hospital-acquired conditions (HACs)
• Hospital-associated infections (HAIs)
• Unnecessary care
• Medication safety
Care Coordination
• Patient and family activation
• Infrastructure and processes for care coordination
• Impact of care coordination
Person- and Caregiver-Centered Experience and Outcomes
• Patient experience
• Caregiver experience
• Preference- and goal-oriented care
Population and Community Health
• Health behaviors
• Access
• Physical and social environment
• Health status
Efficiency and Cost Reduction
• Cost
• Efficiency
• Appropriateness41
Figure 28–13 Six Quality Domains for Quality Measures Development.
Data from SSA Section 1848 (s)(1)(D).
Clinical
Care Safety
Care
Coordination
Patient &
Caregiver
Experience
Population
Health &
Prevention
Efficiency
& Cost
Reduction
Also
considered by
CMS
Quality Domains Identified by MACRA
386 Chapter 28 New Payment Methods and Measures
We have illustrated this linkage in Figure 28–14. CMS has published two more comments concerning the framework:
• Measures should be patient-centered and outcome-oriented whenever possible.
• Measure concepts in each of the six domains that are common across providers and settings can form a core set of measures.42
Other Measure Development Considerations
Other measure development considerations include the following:
• Coordinate across various measure developers.
• Consider how clinical practice guidelines and best practices can be used in the measures.
• Use an evidence-based approach for certain measures where relevant.
It is also important to realize that measures will be reassessed and revised over time. We
can therefore expect that more future efforts toward standardization and ease of use for all
measures.
More About National Quality Strategy’s Priorities and Domains
This chapter uses a four-part sequence to show how CMS develops quality measures.
First, the Measure Development Plan for MIPS is described. (See Figure 28–11.) Second,
the priorities for quality measures that are identified (and thus required) by MACRA are
described. (See Figure 28–12.) Third, the quality domains that are identified (and thus
required) by MACRA legislation are described. (See Figure 28–13.) And fourth, this chapter
then shows how the CMS framework for measurement ties back into the six NQS domains.
(See Figure 28–14.)
Figure 28–14 CMS Framework for Measurement Mapped to National Quality Strategy Domains.
Modified from 80 FR 68668 (November 5, 2015).
Person &
Caregiver Centered
Experience &
Outcomes
Care
Coordination
Clinical Quality
Of Care
Safety
Population
&
Community Health
Efficiency & Cost
Reduction
A Framework for MACRA Quality Measurement 387
CONCLUSION: BENEFITS AND COSTS OF THE QUALITY PAYMENT
PROGRAM
Implementing the Quality Payment Program results in both benefits and costs.
Benefits and Costs
One benefit of the new MIPS program is an increase in the attention to quality of care. The
measures’ metrics provide information that may be used for internal comparative performance
purposes. Another benefit concerns the program feedback about cost of care. The cost of care
as computed by CMS may provide financial information based on a national benchmark. Comparing this national baseline financial information to the provider’s own costs, also as computed
by CMS, may be especially valuable for future financial planning.
Costs of program participation include costs of new software plus potential hardware
upgrades. Staff training is essential and is of course another cost. The potential time lag in cash
flow at the point of implementation should also be recognized.
Public reporting can be considered either a benefit or a cost. This depends upon the organization’s public image and the results that are posted within the public reporting venue.
Ingredients for Success
Success of this value-based program begins with proper measure choices and continues with
measure development and implementation. Proper implementation first means the right
choices. Another crucial element is sufficient training of a focused staff who understands the
implications.
Success Also Depends Upon the Use of Qualified Electronic Transmission
Standards
Success also depends upon complying with all digital requirements involving use of qualified electronic transmission standards. Funding must be made available for sufficient hardware and software, along with proper training of staff. Timely updates on software and
staff training are essential. In addition, an electronic disaster plan should be in effect and
up-to-date.
Organizational Implications
Leadership must be responsible for seeing that quality and financial incentives align properly.
Such alignment could well result in a move away from so-called “silo,” or vertical, departmental responsibilities. Assigning responsibilities differently (not departmentally) could potentially
result in horizontal networks of responsibility that are organized around patient groups with
similar needs.
Finally the organization’s leadership must recognize that the digital age has arrived. It is
here, and the inevitable change that it brings must be recognized and dealt with in order to
achieve success.
388 Chapter 28 New Payment Methods and Measures
THREE INCENTIVE PROGRAMS AS THEY EXISTED BEFORE MIPS:
A REFERENCE
This information is provided to serve as a bridge between what came before MIPS and what has
followed. It can be used for both comparative and reference purposes.
Physician Quality Reporting System (PQRS)
The Physician Quality Reporting System (PQRS) is a quality reporting program concerning covered professional services within the Medicare Part B Physician Fee Schedule (MPFS).43 PQRS
applies to both individual EPs and group practices and is intended to improve the quality of
care provided to patients. CMS considered the following factors as the minimum when EPs are
selecting measures for reporting. The minimum factors include:
• Clinical conditions usually treated
• Types of care typically provided (e.g., preventive, chronic, acute)
• Settings where care is usually delivered (e.g., office, emergency department [ED], surgical
suite)
• Quality improvement goals for 2016
• Other quality reporting programs in use or being considered44
Practitioners can see, after the fact, how often they met a particular quality measure and thus
can assess their overall quality performance.
Beginning in 2015, the program applied a negative payment adjustment to certain individual
EPs and PQRS group practices. Those practitioners received negative payment adjustments
because they did not satisfactorily report data on quality measures for the relevant performance
period. Each year’s results stand alone, so a negative adjustment in one year does not necessarily mean a negative result for the following year. In other words, reporting satisfactorily for the
2016 performance period year would avoid a negative payment adjustment in the 2018 PQRS
program year. Finally, for those who might be wondering, PQRS originally had another name:
It was previously known as the Physician Quality Reporting Initiative.
Value-Based Payment Modifier (Value Modifier)
The Value-Based Payment Modifier, or Value Modifier (VM), provides a budget-neutral
payment adjustment to a physician (or group) based upon “the quality of care compared
to the cost of care furnished to Medicare fee-for-service beneficiaries during a performance
period.”45
The VM uses a two-part composite score. The quality composite score is primarily calculated
from submitted PQRS data. (The quality score also includes three outcome measures that are
calculated by CMS from Medicare claims data.)46 The cost composite score includes performance cost measures and is calculated by CMS by primarily using claims data. The cost measures, also calculated by CMS, include six performance cost measures.
The VM provides eligible practitioners with a positive, neutral, or negative payment adjustment. It is important to note that the VM adjustment is separate from the PQRS as described
previously. However, the quality measures for the two programs have been aligned. The VM was
Three Incentive Programs as They Existed Before MIPS: A Reference 389
phased in; it first applied to groups of 100 or more eligible professionals. By 2016, the VM was
applicable to groups of 10 or more eligible professionals.47
Meaningful Use (MU) and the Electronic Health Records (EHR) Incentive Program
The EHR Incentive Programs were first implemented in 2011. The program was designed to
encourage providers to “adopt, implement, upgrade and demonstrate meaningful use of certified EHR technology.”48 Medicare EHR incentive program payments to eligible professionals,
eligible hospitals, and critical access hospitals have come to an end. Meaningful use, as defined
above, was still required, however, and at the time of this writing negative payment adjustments
have been imposed for non-use through 2018. (Note, however, that Medicaid incentive program payment adjustment continues until 2021.)
Meaningful use is determined by reporting upon certain objectives and measures. Within the
Medicare program, implementation progresses in three stages: Stage 1, Stage 2 (now Modified
Stage 2), and Stage 3. (The numerous Medicaid program variations are beyond the scope of
this book.) At first, the Medicare EHR Incentive Program required choices among “core” and
“menu” objectives and measures. However, as of 2016, the program has been streamlined. All
providers are now required to attest to a single set of objectives and measures.49 The streamlining also means that the number of objectives has been reduced.
Meaningful Use measures have been modified and incorporated into the new Quality Payment
Program (MIPS and APMs), a Medicare program that is presently scheduled to commence payment in 2019. And MU has gained a new name within the Quality Payment Program. It becomes
“Advancing Care Information” instead. For more details about the current status of Meaningful
Use in its new Advancing Care Information form, see Appendix 28-A at the end of this chapter.
ALTERNATIVE PAYMENT MODELS: A REFERENCE
This information is provided to serve as a bridge between existing APM models and those models that qualify for incentive payments as Advanced APMs. In other words, these models were in
operation before new Quality Payment Program criteria were set. We intend this information to
be used for both comparative and reference purposes.
A brief description of various models follows. (A full discussion of such models is beyond the
scope of this text.)
Accountable Care Organizations (ACOs)
The Medicare program offers various ACO programs, as follows.50
Medicare Shared Savings Program
Under this program, hospitals, eligible providers, and suppliers can come together in a Shared
Savings Program ACO. The program was created to “facilitate coordination and cooperation
among providers to improve the quality of care for Medicare Fee-For-Service (FFS) beneficiaries and reduce unnecessary costs.”51 The ACO that meets performance standards and lowers
the growth in costs will be rewarded. Note also that data about the shared savings program
ACOs is made public.52
390 Chapter 28 New Payment Methods and Measures
Advance Payment ACO Model
This interesting model came about through input from stakeholders. There was concern that
smaller ACO groups would not be able to pay for the necessary investment in infrastructure
and staff. (This investment would be required in order to achieve the desired care coordination.) Therefore, this Advance Payment ACO model is intended to assist rural providers and
physician-based groups by providing cash up front. This cash is not a grant or a gift; instead it is
cash advanced from the shared savings that the ACO group is expected to earn.53
Furthermore, the advance payment design recognizes that there are both fixed start-up costs
and variable start-up costs. For that reason, according to CMS, each of these ACOs will receive
the following three types of advance payments. Note that two are upfront, one fixed and one
variable, while the third payment is monthly. The ACO will receive:
• An upfront, fixed advance payment
• An upfront, variable advance payment that is based on beneficiary numbers
• A monthly variable advance amount that is based on the size of the ACO54
Pioneer ACO Model
This model is intended for a more sophisticated group of organization and providers who
are experienced in care coordination. In other words, they do not have a learning curve.
Two design elements are especially interesting in this model. First, these groups are expected
to move more quickly from the shared savings plan into a population-based payment model.
That expectation is due to their prior experience. While the model is flexible, generally speaking, participants in the initial two years are held to a higher level of both shared savings and risk
than those participants in the “regular” shared savings plan.55
The second interesting element is that this model is supposed to work in cooperation with
private payers. It does that by “aligning provider incentives, which will improve quality and
health outcomes for patients across the ACO, and achieve cost savings for Medicare, employers
and patients.56 (Note that at the time of this writing, this model was closed to new applicants.)
Patient-Centered Medical Homes
The easy-to-use phrase “patient-centered medical homes” actually refers to a CMS demonstration project with a long title. The demonstration’s formal name is “The Federally Qualified
Health Center Advanced Primary Care Practice, or FQHC APCP. It has a three-year life, unless it
is subsequently extended and/or expanded. As the title suggests, only federally qualified health
centers (FQHCs) can participate, and there is a strict set of criteria, terms, and conditions. Once
accepted into the demonstration, each FQHC receives a monthly management fee for each
applicable eligible Medicare beneficiary. The fee is paid quarterly and payment is automatic.57
Four Bundled Payment Models
The Bundled Payments for Care Improvement (BPCI) Initiative presently covers four care models. Payment is linked, or bundled, for multiple services that occur during a patient’s episode
of care. Organizations agree to episode-of-care payments that include both performance and
financial accountability.58 A brief comment about each of the four care models follows.
Alternative Payment Models: A Reference 391
For Model #1, the episode of care equals the inpatient stay in an acute care hospital. Payment
to the hospital is discounted from the usual Inpatient Prospective Payment System and payment
to physicians is made separately under the Medicare Physician Fee Schedule.
Model #2 takes a different approach, as its payment is retrospectively bundled. The episode
of care includes the inpatient stay, plus the post-acute care, plus all related services for are bundled for a period of up to 90 days after discharge from the hospital. The retrospective bundled
payment adjustment is made after comparison to the target price, and such payment adjustment can either be positive or negative.
Model #3 is also retrospectively bundled and the episode of care is designated, or triggered,
by a hospital stay. However, unlike the previous model, in this case the episode of care concerns
only post-acute care provided to the patient. Once again, the retrospective bundled payment
adjustment is made after comparison to a target price, and such payment adjustment can either
be positive or negative.
Model #4 differs from that of Model #1. In this case one bundled payment is made to the
hospital. This payment covers all the episode-of-care services, including those of the physicians.
The hospital then pays the physicians and other professionals, using part of the bundled payment that it has received for this episode of care. (For those who are wondering, to complete
the entire cycle the physicians must send a “no-pay” claim form to Medicare that sets out what
services they performed.)59
Other New APM Models
Other new APM models will be developed in the near future. At the time of this writing, CMS
has recently issued a “RFI” or Request for Information that seeks input about possible new
physician-focused payment models or PFPMs.60
INFORMATION CHECKPOINT
What is needed? Some description of the MACRA legislation, the Quality Payment Program, and/or MIPS and APMs.
Where is it found? A newsletter or a training announcement or a planning committee report.
How is it used? The use depends upon the particular item. Typical uses would
be for general information or for training or planning
purposes.
KEY TERMS
Accountable Care
Organizations (ACOs)
Alternative Payment Model
(APM)
Bundled Payment
Composite Performance
Score
Eligible P