Activity-Based Costing: The Rock Star of Payment Model Reform

Think you can’t afford to invest in a cost-accounting system? The truth is, you can’t afford not to. As Medicare and other payers increasingly tie payments to value, understanding and reducing your cost structure will become an even more urgent priority.

Let’s say your hospital is part of a bundled payments program that pays a single, predetermined price for each orthopedic surgery. So, a knee replacement that goes smoothly will be reimbursed the same as one that requires more time in the operating room and a longer post-operative stay. To succeed in that bundled arrangement, you will need to reduce those variations.

Do you have the data at your fingertips to know which procedures cost more and why? If your answer is ‘no,’ you’re not alone.

Traditionally, healthcare organizations have used the ratio of cost to charges as a proxy to estimate costs of delivering care. 

But this method can provide misleading information. Costs don’t necessarily increase or decrease in direct proportion to charges. They vary widely according to factors such as the severity of the underlying condition, the level of effort required to complete a procedure, and the physician’s choice of surgical materials. Since the ratio is generally calculated at the department or hospital level, it fails to identify variation between individual patients or doctors, or even service lines.

In fact, a 2013 study found that the cost-to-charge method led 85% of mid-sized community hospitals to overestimate the profitability of orthopedic surgery service lines. Those overestimates amounted to an average of $1.2 million per year per hospital.

Make Better Decisions Using Activity Based Costing

To make decisions such as how to allocate shared savings or at-risk penalties in alternative payment models, you need to be able to allocate costs on a much more granular level. That’s where activity-based costing (ABC) comes in.

Whereas the cost-to-charge ratio is a top-down approach to cost allocation—it begins with department or hospital-level aggregate costs—ABC starts with the activities required to deliver a service and traces the organization’s costs (both direct and indirect) to those activities.

Following are just a few examples of the types of decisions that can be enhanced by activity-based costing:

The picture painted by ABC can be dramatically different from that painted by the cost-to-charge ratio. Consider a hospital with two physicians following two different drug protocols. Under the cost-to-charge ratio method, the protocol used by Physician B seems to cost $280 less per case than that used by Physician A. But when all costs are accounted for, Physician B’s protocol actually costs $170 more per year. The misleading information provided by the cost-to-charge ratio might influence the hospital to recommend Physician A use the drug protocol used by Physician B, when in fact this is the more expensive approach.

Of course, care decisions cannot be made based on cost alone. Cutting cost is the quickest way to improve the value equation, but only if those cuts don’t result in negative outcomes that drive down quality. Your cost-accounting system must be integrated with a data analytics platform that enables analysis of cost alongside quality data.

Investments in cost-accounting and data analytics systems and personnel can seem steep. However, healthcare organizations often recoup those investments quickly by making smarter and more profitable decisions. Making these critical decisions with inaccurate or incomplete data is likely to result in false starts and unprofitable ventures in the world of value-based compensation.

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