Should Healthcare Services be Priced at Identical Cost Markups?

Over the last 25 years our firm has received a large number of proposed pricing strategies from our clients. One of those strategies is to set all prices for their Charge Description Master (CDM) codes at a constant markup from cost. To put this in perspective, the 2021 US median hospital markup for acute care hospitals not designated as Critical Access was 3.80. For the average US acute care hospital that would equate to every charge code priced at 3.8 times its defined cost. As expected, there is a great deal of variation in markups across hospitals that is primarily related to payer mix. Hospitals with heavy governmental payer mixes will usually post higher markups that are the result of cost shifting.

The logic for constant markup pricing is often based on three key assumptions. First, it should be simple to do and can therefore be the basis for all future pricing decisions. Second, with most revenue based on fixed fee schedules, net revenues should not be affected materially. Third, it represents a defensible and equitable pricing policy that can be explained and justified to the public.

Let us examine these points to assess their validity. First, is it easy to do? The underlying assumption is that the hospital has an accurate measure of cost for each CDM charge code. Most of our clients can now provide us with a value for cost at the charge code level, and in many cases may even provide both direct and fully allocated cost measures. The data does seem to be available, but is it accurate? Costing thousands of specific charge codes will invariably involve a good deal of averaging and in many cases a portion of that averaging is related to current cost to charge relationships. Changing prices will therefore change cost measures which involves a bit of circular logic. When our firm tests alternative pricing strategies, we always test at least one cost model. The results of that model will usually produce large price swings, perhaps minus 90% to plus 200% or more. One can argue that this result is legitimate and reflects prior pricing strategies based more on revenue maximization than cost, and that would be true to a degree. Explaining this to an imaging director who just witnessed 80% of their charges vanish can however be a tough task. To the extent that revenue departments use charges as a measure of activity to assess performance, large price swings will affect current performance evaluation.

The second reason for setting all CDM rates to a constant markup of cost is the belief that there will be little to no impact on the provider’s net revenue because most revenue is related to a fixed fee payment arrangement. On the surface, this makes intuitive sense, but is most often false. While not always true, most price reductions usually occur in ancillary service areas—imaging, lab, and surgery. These are all areas with higher relative outpatient volume and greater levels of percentage of charge payment. The largest areas of increase are generally room rates and other services with heavy inpatient volume. To understand how large swings in prices could affect net revenues in cases where most payment is based on fixed fee arrangements, let us identify three specific areas that will be affected. First, large price swings can and often do impact the number and size of outlier payments. Since outlier payments are usually the greatest in inpatient claims, it is possible that large increase in room rates and other inpatient procedures could increase payments.

A second area is lesser than provisions. Increased prices could reduce the number of claims hitting lesser than values and increase payment. However, large decreases in imaging, lab, surgery, and emergency can also increase lesser than claims causing reduced payment. The third area are claims paid on a percentage of charge (POC) basis and would include contracted commercial payers that pay for all or a portion of service on a POC basis, noncontracted commercial payers, auto liability claims, and self-pay. These areas will have greater volumes of outpatient ancillary services and would show reduced levels of net revenue that would result from constant markup cost-based pricing. Some may reason that replacing percent of charge terms with fixed fee payment terms would be a wise strategy to reduce any revenue impact from cost- based pricing. Our firm’s position has always been that negotiating for more fixed fee schedule payments has never been in the best interests of health care providers (see the January 2020 issue of Healthcare Financial Management “Why Removing Percent of Charge Provisions Will Not Reduce Hospital Prices”. This paper provides empirical data demonstrating greater levels of fixed fee payments lead to higher and not lower prices.).

Finally, the third reason cited for using cost-based pricing is that it will enhance defensibility and acceptance by the public. While cost based pricing may be explainable to the public, I am not certain that this will lead to the desired outcome of defensibility. At the end of the day, the ultimate litmus test is the relationship of prices to prices in other providers. For example, in a recent hospital study setting CDM prices to a constant markup of cost resulted in large increases in procedures which were deemed to be very price sensitive and subject to close public scrutiny. In the current era of hospital transparency reporting price comparisons are more visible and pricing decisions should incorporate competitor prices.

So, do we recommend cost based pricing to our clients? The answer is yes, but with moderation and over an extended time frame. Few hospitals can afford large reductions to their net patient revenue which is often the outcome. Ultimately, pricing decisions are determined by the need for profit and market forces.