American Association for Physician Leadership

Finance

Cost Allocation Can Be Simple as A-B-C

Ellis M. Arjmand, MD, MMM, PhD, et al.

July 13, 2018


Summary:

What is activity-based costing? Learn how this accounting tool can uncover inefficiencies across the supply chain of your healthcare organization.





Activity-based costing allocates expenses incurred through providing goods and services, and can shed light on inefficiencies across supply chains and unlock excess capacity.

ABSTRACT: Cost allocation for health care professionals can be an enigma, but activity-based costing allocates expenses incurred through providing goods and services to the consumer, and it can shed light on inefficiencies across the supply chain and unlock excess capacity. This, in turn, can drive services provided toward generating more value for the hospital system. Time-dependent activity-based costing offers advantages of both the fee-for-service and capitation models to transition to a value-based system. ABC, however, comes with its own risks.

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Activity-based costing is an accounting tool that allocates costs incurred through a company’s practice of providing goods and services to the consumer.1 In health care, this often is based on services associated with patient care, which can be procedural or time-based. These include indirect costs, such as overhead expenses, and direct costs associated with a given clinical or business entity, such as those attributed to a given procedure from the expenses of the operating room.2 In most firms, direct costs are not allocated.

The accounting method can be tailored to focus upon a unit of measurement that holds value related to the company’s production method. This revolves around tasks performed during the production process. This unit of measurement can fall under the metric of time or space — minutes required for a procedure, or square feet associated with a given production — or the number of megabytes used for a given service. The challenge of applying ABC is in deciding which unit of measurement makes the most sense in telling the story of cost drivers for that given service.3 If appropriate metrics are identified, the ABC method provides insight about whether services provide enough value to customers. It also helps illustrate where strategic assets should be deployed.

Although it might be impossible to simplify patient care and hospital operations into assembly-line production, there is a benefit to calculating the costs of as many parts of the process possible with ABC methodology.

In a medical setting, the production method could be envisioned as the completion of a surgery, procedure or clinical intervention with the outcome as a benefit to the patient. This usually is paired with a payment for the given service that is a representation of the value. One method of obtaining information regarding the unit being measured is to survey employees directly involved in the production.4 The individuals can provide estimates for the percentage of time required to complete tasks along the production chain. The electronic medical record can affect the process greatly, with more accurate time estimates. Alternatively, examining time for surgery, time for the procedure, and time for workup in the emergency department also can help provide an estimate of a facility’s overall capacity to provide that service as a value to the patient.3

When considering a given service as a production line (for example, the process of completing a surgery through the perioperative environment), the patient must see the provider preoperatively, arrive for surgery and comply with follow-up care. All steps require time and are associated with their own direct costs related to the process, as well as indirect costs (such as administrative or marketing expenses). Across this theoretical surgical production line, an investigator can identify the cost of each section per unit of time and subsequently calculate estimated cost drivers of the given service.3 Once a cost driver is calculated, it can be applied to future production estimates by applying models of the known to the unknown. Perhaps more powerfully, it also can help identify areas of efficiency within the process being studied.

Although it might be impossible to simplify patient care and hospital operations into assembly-line production, there is a benefit to calculating the costs of as many parts of the process possible with ABC methodology. Through the breakdown of as many parts possible, one can pinpoint which aspects of care are contributing the highest and lowest margins.

Time-Driven Activity-Based Costing

Time-driven activity-based costing can identify where efficiencies may be gained within a production line, such that unit cost per time value can be reduced, decreasing the cost while increasing the value.5 In other words, Td-ABC can help identify excess capacity in the system upon which gains can be made to drive the value of a given service to the patient, the system and third-party payers.6

In the production industry, Td-ABC has provided cost and profit-enhancement opportunities by identifying unprofitable customer relationships, unprofitable processes, and influences in product design and portfolio products. Td-ABC lends itself to applying these same virtues across medicine and within the hospital system.7 In other words, service lines might need to be devised more competitively — either higher or lower, based on the revelation of value to the organization. In health care, Td-ABC can help achieve understanding and help identify contribution margins; however, it is unlikely to help eliminate service lines that are loss leaders, considering physicians must provide appropriate care to patients requiring low-margin procedures. Nevertheless, it can unlock the identity of higher-margin services and allow stakeholders to promote these services, offsetting losses incurred and enabling a sustainable practice that can serve people in need.

Td-ABC has been heralded as a tool the health care sector can use to transition from a fee-for-service business model to a value-based model.7 If it is possible to identify the value that a given service line procedure or department is offering through analysis with Td-ABC, presenting this value to a third-party insurance provider should have an impact on the quality patients receive.8 Applying this approach with multiple iterations and to different service lines, a given organization or service line could approach a third-party payer and demonstrate the value and quality of the institution. This should result in better contracts and increased patient flow from the third-party payer to the hospital system.9 Yu, et al., at Texas Children’s Hospital demonstrated success in applying Td-ABC to workup and treatment of appendicitis/appendectomy patients (see Figure 1 ) for a 17 percent reduction in costs when compared to the standard RVU approach. Similarly, Donovan, et al., at Cleveland Clinic reported a 10 percent reduction in costs for heart valve surgeries.10

FIGURE 1: PHASE OF CARE: EMERGENCY ROOM

Emergency room workup of appendicitis at Texas Children's Hospital.

Source: Journal of Pediatric Surgery

Most health care professionals understand the current system of fee-for-service transactions — a patient pays a fee for a given service. This is a clear, concise way to allocate value to a service. The system inherently rewards the providers for delivering service based on volume — more service provided, more payment delivered.6 The drawback of this system is that there’s no built-in disincentive from scaling service that may come with sacrifice in quality. In this incentive structure, quality is not a driving component. Payment parties have no accounting for the quality of the service rendered, only that the services were indeed provided and therefore payment must be remitted.11

This model has the tendency to escalate costs without having to define quality. A study by Zuvekas, et al., found that 95 percent of all physician office visits in 2013 were billed under a fee-for-service model. Since that time, the U.S. Department of Health and Human Services has urged transition from that model, although it remains the dominant modality.12 It is not uncommon to hear about hyperinflated bills and exaggerated costs associated with a procedure, hospital, personnel or device used. The litany of patients dissatisfied with their outcomes and facing bankruptcy from colossal hospital bills is staggering.

Capitation, Value and More

Another system used in U.S. health care is the capitation model. Those health care providers who participate in this model have a set fee to provide service, but services are capitated for pricing delivered from a top-down hierarchy. Executives decide how much money will be deployed for given services and how those services are valued. The incentive stems from decreasing use.13 As a result, more of the membership payment is retained by the organization. This, however, can lead to denial of care, which has no disincentive in this model. The incentive for quality is delivered only through the members’ perception of it. The argued benefit is health care cost containment as the driving incentive and not necessarily defining quality offered.14

In a value-for-care system, a single “bundled” payment is given for that particular service. A bundled payment is defined as the reimbursement of health care providers on the basis of expected costs for clinically defined episodes of care.15 It can be used in a variety of specialties and works best in those where a systematic approach to care can be reproduced universally. Given high-quality outcomes, the system is rewarded by the bundled payment.16 If complications arise, or decreased efficiency is encountered, the system is penalized and the health care organization bears the risk for the variance.

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Bundled payment rewards systems that can encourage the delivery of reliable, high-quality services while deterring entities from molding into a system that can simply accommodate volume irrespective of the value added. Value-for-service reimbursement advocates a system that creates self-governing feedback, thereby ensuring maximum reward to both patient and institution.17 In 2013, it was estimated that one-third of all health care reimbursements in the United States used bundled methodology.18 Although this concept already exists in health care, we believe a ground-level view will help encourage physician onboarding.

In an ideal system, the risks of both the fee-for-service system and the capitation model would be minimized while the benefits are maximized. This is the promise of a value-based delivery system, where hypothetically high-quality-outcome services are provided in a way that incentivizes necessity of surgery around that episode of care. A major driver in the creation of a value-based system centers on activity-based costing.7 ABC allows a hospital system to identify, with a higher degree of precision, the actual costs to deliver a service. This enables a hospital to approach a third-party payment system with a high-quality marker for a lower price, thereby not only containing the cost but also delivering higher quality care.9

The Limitations

One must be cautious about approaching value-based medicine through the lens of time-driven activity-based costing, which has some limitations.

One is shown within calculating capacity. It is common for employees to erroneously report that tasks directly related to production take up 100 percent of their capacity. This often neglects idle time, which includes travel time, training, breaks, pauses between cases, case turnovers, and the like. Accurate times for a given service can be drastically overestimated, resulting in an overestimated cost driver.8

There are measures that can be applied to estimate practical capacity: Some argue 20 percent of reported capacity accounts for idle time. This standard leaves a large margin for error that might not reveal itself until after the point for which decisions must be made and relied upon from the models created by Td-ABC.3 This is especially true when it applies to medicine as well as creating business cases for third-party payers.

Further, applying Td-ABC in an industry that historically operates on a small margin (health care and hospital systems are estimated as low as 8 percent) carries some risk19 — including some that an organization’s leadership might not have the appetite to experiment with.14 To paint an accurate picture of value in a given production line is significantly demanding in terms of time and cost. To create and maintain the Td-ABC model itself might require a dedicated budget line item and its own devoted capital expenditure.

Another potential weakness in applying Td-ABC to the U.S. marketplace in light of the Affordable Care Act is the changing landscape of third-party payers and the value they perceive. For example: a national insurance company that has changed its business model from seeking health care services for its members to acting as a health care brokerage that transacts its members to other medical insurance companies.

Though complicated, the impact of this is striking: The third-party insurer that the health care system assumes would value and seek quality care at the lowest costs (value for service vs. fee for service) is now in a position as a broker and might value simply the transaction of connecting a patient to a tertiary health insurer.16 Value-for-service might have become transaction-for-service.

The stage has been set for large health care insurance houses to lower their risk rather than look for value within that delivery of care. Thus, the transition of the marketplace using Td-ABC to show value might fall upon deaf ears and will not be an effective, freestanding tool on the road to a value- and quality-based model for health care.

Predictability Enlightening

ABC typically is applied to repetitive processes that are predictable in their outcomes, such as manufacturing. In medicine, procedures such as total joint replacement lend themselves nearly seamlessly with this model.

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To understand the parts necessary to provide a given service requires some time talking to the people who deliver that service — for instance, interviewing a nurse to understand how much labor time it takes to bring a patient with appendicitis from the ER to the OR. Further, what is the measure of “idle time,” where services lagged to be delivered? Was this because of excess capacity, or inefficiencies in the system? Can those inefficiencies be fixed?

Herein lies a hidden tool within value-based costing. In uncovering the time associated with known activities in a service line, the manager finds out how and why it takes a certain amount of time in different phases along the value chain.20 This reveals crucial information:

  • Is there excess capacity?

  • Where are the inefficiencies?

Understanding these two metrics alone can have a profound impact on cost and might be cornerstones for delivering the bundled payment.7 Specifically, the cost of unused capacity has a greater value in a bundled payment system when leaders learn why high-dollar-value employees such as physicians and nurses have idle time that could be applied to productive activity.

It is estimated up to 70 percent of hospital costs are for personnel , so identifying opportunities to decrease the costs of unused capacity would theoretically improve the contribution margin for the hospital typically running under 8 percent.9 Applying ABC could show not only the activity cost of a given service but perhaps could show areas of inefficiency and excess capacity.

Regardless of whether a given system believes in value-based medicine and bundled payments, ABC as an enterprise commitment from top leaders shows considerable value to not only strategic decision-making but also activity improvement and cross containment. When applied to a process, ABC, though consuming resources itself, can help enlighten leaders about which services are associated with the lowest cost.14

Smarter Redeployment

In identifying areas of excess capacity, and coupling that with net payments for lower-cost services, strategic decisions can be made to fill idle capacity with cases that have greater margin — thereby enhancing the overall profit of the health care system. This will be critical to leadership teams making budget decisions to strategically deploy resources. It is essential that staff members, as well as administrators, understand the value of ABC in identifying rational decisions for sustainability.3

Allocations of costs are important in the accurate assessment and application of Td-ABC. Cost allocation for health care professionals can be an enigma within the health care system. Arguments have been made that the costs for goods and services provided in health care are determined by realized reimbursements of the past.16 A 2011 manuscript, “How to Solve the Cost Crisis in Healthcare,” states that “the inability to properly measure cost and compare cost with outcomes is at the root of the incentive problem in health care and has severely retarded the shift to more effective reimbursement approaches.”16

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In delivering health care, the focus for medical providers is patient outcome above all. Adhering to this mandate while concurrently applying Td-ABC can provide better insight into the cost required to produce optimal outcomes. A clear benefit of Td-ABC, in the current health care landscape, is its ability to identify inefficiencies in a given production line, thereby identifying opportunities to provide further benefit and value to the patients. This clearly rolls into the bottom line, in creating a more streamlined and resonant value proposition.

Regardless of the condition of reimbursement, using Td-ABC as a method for uncovering inefficiencies will help the delivery of care.1 Subsequently, this might help set the cost structure among many of the players in health care delivery, therefore influencing the health care ecosystem. We must not overlook the flaws of this accounting system, but also use its strength to improve the model of health care.9 Therefore, we encourage the application of this method broadly; however, we issue a caution to apply the tool toward health care’s advancement, and not to its demise.

Ellis M. Arjmand, MD, MMM, PhD, is chief of service for pediatric otolaryngology at Texas Children's Hospital. He also is the Bobby Alford endowed chair in pediatric otolaryngology and professor of otolaryngology and pediatrics at Baylor College of Medicine in Texas.

Stephen A. Hillegeist, PhD, is an associate professor of accounting in the W.P. Carey School of Business at Arizona State University.

Mallory Caldwell, JD, is senior vice president of Texas Children's Hospital.

Sohail R. Shah, MD, MSHA, is an assistant professor of surgery and pediatrics at Texas Children's Hospital/Baylor College of Medicine.

Edward Reece, MD, EMBA, is an associate professor of plastic surgery, chief of adult plastic surgery and the Josephine Abercrombie endowed professor in plastic surgery research for Baylor College of Medicine in Texas.

Larry H. Hollier Jr., MD, is the associate surgeon-in-chief for clinical affairs in the surgery department, chief of plastic surgery, and the S. Baron Hardy chair of plastic surgery for Texas Children's Hospital. He also is professor and chief of the plastic surgery divison for Baylor College of Medicine in Texas.

Faryan Jalalabadi, BBA, MD, is a resident physician of plastic surgery at Baylor College of Medicine in Texas.

Ronald E. Hoxworth, MD, is an associate professor of plastic surgery, chief of plastic surgery and director of the abdominal wall reconstruction program at the University of Texas Southwestern Medical Center.

Allen L. Milewicz, MD, is the chief of community surgery at Texas Children’s Hospital, chief surgical officer at Texas Children's Hospital West Campus, and associate professor of surgery and pediatrics at Baylor College of Medicine in Texas.

REFERENCES

  1. Kaplan RS, Kaplan RS, Witkowski ML, Abbott M, Guzman AB, Higgins LD, Meara JG, Padden E, Shah AS, Waters P, Weidemeier M, Wertheimer S, Feeley TW. (2014). Using Time-Driven Activity-Based Costing to Identify Value-Improvement Opportunities in Healthcare. Journal of Healthcare Management, 399–413.

  2. Najjar PA, Strickland M, Kaplan RS. (2016). Time-Driven Activity-Based Costing for Surgical Episodes. JAMA Surgery.

  3. Kaplan RS, Feeley TW, Witkowski ML, Albright HW. (2013). Intelligent Redesign of Health Care. Harvard Business Review.

  4. Zuvekas SH, Cohen JW. (2016). Fee-For-Service, While Much Maligned, Remains the Dominant Payment Method for Physician Visits. Health Aff (Millwood).

  5. Porter ME, Lee TH. (2013). The Strategy that will Fix Health Care. Harvard Business Review.

  6. Porter ME, Kaplan RS. (2016). How to Pay for Health Care. Harvard Business Review.

  7. Miller HD. (2009). From volume to value: better ways to pay for health care. Health Aff (Millwood).

  8. Kaplan RS, Porter ME. (2011). Big Idea: How to Solve the Cost Crisis in Health Care. Harvard Business Review.

  9. Haas DA, Kaplan RS. (2015). Getting Bundled Payments Right in Health Care. Harvard Business Review.

  10. Baggot D. (2012). Top 10 Considerations for Clinical Service-Line Leaders. GE Healthcare Camden Group.

  11. Schneller ES, Smeltzer LR. (2006). Repositioning Supply Chain in Health Care Systems, Health Sector Supply Chain Research Consortium, 2010. In E. Schneller, Strategic Management of the Healthcare Supply Chain.

  12. Kaplan RS. (2014). Improving Value with TDABC. Healthcare Financial Management, 76–83.

  13. Noreen E, Brewer P, Garrison R. (2014). Managerial Accounting for Managers. In E. B. Noreen, Managerial Accounting for Managers (pp. 203-265). New York: McGraw Hill.

  14. Argyris C, Kaplan RS. (1994). Implementing New Knowledge: The Case of Activity-Based Costing. Accounting Horizons, 83–105.

  15. Kaplan RS, Anderson SR. (2004). Time-Driven Activity-Based Costing. Harvard Business Review.

  16. Kaplan RS, Porter ME. (2017). Measuring Healthcare Costs and Value. Strategic Finance.

  17. Kaiser LS. Lee TH. (2015). Turning Value-Based Health Care into a Real Business Model. Harvard Business Review.

  18. Kaplan RS. (2015). Value-Based Health Care: Reconciling Mission and Margin. Harvard Business Review.

  19. Kaplan RS, Witkowski ML. (2014). Better Accounting Transforms Health Care Delivery. Accounting Horizons, 365–383.

  20. Yu YR, Abbas PI, Smith CM, Carberry KE, Ren H, Patel B, Nuchtern JG, Lopez ME. (2017). Time-Driven activity based costing: A dynamic value assessment model in pediatric appendicitis. Journal of Pediatric Surgery.

Ellis M. Arjmand, MD, MMM, PhD, et al.

Ellis M. Arjmand, MD, MMM, PhD, is chief of service for pediatric otolaryngology at Texas Children's Hospital. He also is the Bobby Alford endowed chair in pediatric otolaryngology and professor of otolaryngology and pediatrics at Baylor College of Medicine in Texas.

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