Glossary of Frequently Used Financial Terms

Terms Definitions

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Costs: Variable Fixed Marginal Average Total Direct Indirect

These terms (variable, fixed, marginal, total) are often used somewhat inconsistently. The following brief definitions may help. Variable cost refers to costs that vary with volume of services; resource use is proportional to volume. Variable costs plus fixed costs = total costs. Total costs / total units of service = average costs. Marginal cost is very similar to variable cost but refers to the cost of the next unit of service (If one more/less MRI is performed, what costs are added/not incurred? Lease payments on the machine will not change, but supplies will.) Over longer periods of time and bigger increments of volume, all costs are variable, even buildings. Saving one day may not affect labor costs; the marginal cost impact is negligible, but saving 3000 days may allow a unit to be closed or a new service to be added without additional space and staff. Most cost accounting systems attempt to allocate fixed and variable costs across all services such that all expenses are allocated. This results in an estimate of average cost. When you are modeling savings or impact, you may initially use average cost. However, whether your institution will give you credit for average costs, vs. a lower number that represents their sense of marginal or variable cost savings depends on how they do business, how easily they can replace volume, etc. Fixed costs do not vary with volume. A very simple assumption in hospital settings might be to assume that about half of total costs are variable. Direct costs typically refer to the costs specifically identified with a service. For example, an acute care bed day includes costs of nursing, housekeeping, food service, medications, etc. Indirect costs are overhead, administration, financing (capital costs of buildings) that are incurred, and must be spread over all services, but are not directly attributable to the services. It is not unusual for these services to represent 30-50% of costs. This is where the Deans Tax for academic medical centers would be classified. If units of service are reduced, such as fewer bed days, these costs do not go down, so that the costs allocated per remaining unit would actually increase. The key point is to clarify the definition and source of the data you are given, and to ASK the finance leaders for advice on how to use it to model your programs impact. You simply want to be an informed and cautious user of the data. In general, the closer to capacity your hospital runs, the more likely you are to be able to use average figures. The more your hospital is in a cost-cutting position with empty beds, the more

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Opportunity Costs

This term is also used loosely, but the concept is important. What is the cost of not acting? What is the cost/benefit of the next best thing you could be doing with resources? For a leader to allocate funds to your program, they have to make a judgment call that the benefit from your program exceeds the next best option. Every action should be evaluated against its next best option, rather than against the status quo, or zero. What is the opportunity cost of being full and having excessive LOS? It is the cost of missed revenues from diverted cases, and the lower profit margin that results from higher than optimal costs. What is the opportunity cost of under-resourcing a quality initiative? It is the missed opportunity to care for more patients and have a bigger impact on hospital quality and resource use. There is also an opportunity cost to your time and your staffs time. If you redeploy existing resources to participate in a pilot, there are no net new resources required, but the cost is not free. The cost is the value of the next best thing you could have them doing.

Capacity

Diversions

Hospitals measure average occupancy rate. Full occupancy is often estimated as between 85-90% occupancy, because at this level, beds are almost always full at some times of day, given necessary turnaround times in cleaning rooms and moving patients. Often systems above 80% occupancy are completely full on certain days of the week (Wednesdays) but have some empty beds on the weekends. Some systems have available beds in some units, but have bottlenecks or capacity constraints in the ICUs, or in Operating Rooms. The more full a hospital is, the more likely that expensive delays occur in the ER and in bed transfers. Diversions occur when the hospital, ER, or OR is full and urgent cases are sent to other hospitals. This represents lost revenue or added expense for the hospital, and also usually has marketing and physician satisfaction implications. Very full hospitals are highly receptive to initiatives that improve throughput or reduce length of stay.

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Cost Avoidance

Most healthcare decisions are based upon increasing revenue (adding billable services to profit centers) or reducing cost per unit in cost centers. Many quality initiatives rely primarily on a credible, but subtle argument of cost avoidance. Basically, by doing something (improving communication and expediting decision making on a plan of care, for example) you cause something else to NOT happen; for example, LOS or cost per day decreases because of this action. Once it doesnt happen, it is hard to measure. This is particularly true in year-to-year budgeting, where the pressure is to reduce costs from the current years level. What are we doing and what would happen if we did not do it? The cost we are avoiding need to always exceed the cost of doing the intervention. This is why it is important to get a reliable baseline (results BEFORE you intervene) and measure the cost reductions, or cost avoidance.

Costs Per Day Costs Per Case

Clinical, operational, or direct costs are tracked on a per case basis, and can then be broken down per day. Depending on the quality of your hospitals cost accounting system this breakdown can be very accurate (specifically attributing actual resource utilization by patient) or can be an elaborate system of approximating costs based upon some formula of estimated utilization. Understanding how this is done (and its reliability) is important as you choose measures of impact and performance tracking measures. Think about electric company meter reading: Often this is done based upon past usage and estimates for monthly household electric bills, and then it is spot-checked with periodic physical meter readers. Similar methods can exist in accounting.

Gross Revenue

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Net Revenue Profit Margin

Hospitals have fee schedules and create bills reflecting billed charges. The sum of billed charges represents gross revenues, or revenues before contractual discounts, bad debt, etc. Given that most hospitals net revenue (funds actually received in payment for services) average 30-50% of billed charges, gross revenues is a very inflated and unreliable source for estimating impact. However, it is an easily available number. Often, net revenue is NOT available down to the per day or per service level, although it is tracked on a per case level. Therefore some reports generated by finance may include gross charges. Be very cautious about using this for anything, and ask for advice. Net revenue is also important if your program reduces some utilization and volume that would be reimbursed by a FFS payer (not Medicare). You may need to estimate lost revenue as well as cost savings. Ask for help; dont try and do this on your own. The profit margin is the difference between net revenue and total cost per case.

Measures: Operational Financial Utilization

Operational measures are also sometimes called process measures whereas financial measures might be outcome measures and utilization measures could be either. From the standpoint of making the business case the key concept is that operational and utilization measures track the activities (inputs, resource uses) that drive different outcomes. To manage your program and to garner financial support for it, you need to measure what you do, and show that it causes or is correlated with a different result (outcome). This is imperfect, but important. Operational measures might be such items as number of patients who received the intervention, or percentage of time that nursing staff spend with direct patient care. These indicate the scope, scale, and impact of the program, and are building blocks for quality and financial measures. Financial measures might be cost per day, average daily pharmacy costs for patients with the intervention, or nursing

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(Measures continued)

hours per patient day, which is a key building block to cost per day. Utilization measures are building blocks for financial measures, and include length of stay, number of prescriptions per patient, readmission rates, etc. Utilization measures focus on per patient and per patient population and relate most directly to clinical quality measures. The key concept to remember is that financial measures are driven by many variables, so that it is hard to take full credit or blame for changing results. However, if you set goals for utilization measures, manage and track operational measures, and do these concurrent with tracking quality measures, you will have information needed to manage your program (plan for staffing, evaluate use of time) and to provide a credible backdrop to financial results. Financial measures will be more retrospective and periodic (quarterly, annually). However, establishing a baseline of financial measures, and tracking them consistently is critical to making your business case.

Length of Stay (LOS)

Within hospitals LOS is a critical measure of efficiency and profitability and also one of the measures by which similar cases are compared across hospitals for benchmarking. It refers to the total and average days per case. Quality organizations look for targeted LOS that is appropriate to the case, neither too long nor too short. Reductions in LOS result in creating capacity for more cases per year, or create the ability to rearrange resource use in labor or in beds. Because Medicare pays based upon DRGs, and pays a case rate regardless of LOS, reductions in LOS almost always have a positive financial impact on hospital financial outcomes.

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