Budget Time

It's budget-making time in the hospital world, as many of us prepare for the fiscal year starting October 1. I suppose there was an era when this was easy, but those days are long gone. To put it simply, the cost curve is going up faster than the revenue curve. Other types of business deal with this by adding new product lines, enhancing the value of those products already offered, increasing marketing to gain market share, and garnering efficiencies in the production process. Most of those options are not so available in the hospital sector, and particularly for academic medical centers.

Like other hospitals, we at BIDMC have five revenue sources, in size order, clinical services, research, current use philanthropy, investment returns on our cash assets, and royalty or equity payments from the sale or licensing of intellectual property. Of our $1.2 billion in revenues, though, the first two predominate by far. About $1 billion comes from delivery of inpatient and outpatient care, and $200 million comes from research grants. The remaining three items are measured in the $10's of millions, all together.

The business model for academic medical centers has been to enhance clinical revenues by building sufficient bed and clinic capacity to increase both the volume and acuity of patient visits. On the research side, the business model had been to take a loss-leader for several years by providing laboratory space and salary support for the best scientists, with the expectation that they will be sufficiently productive over time to cover both their direct costs and also contribute to overall corporate revenues through indirect cost recovery.

Thus, hospitals faced a clear growth imperative. As long as your incremental revenues from treating more patients exceeded the incremental costs of treating those patients, each year could show improvement over the last. Likewise, as long as you could count on those new researchers to get off the dole and eventually cover their space and personnel expenses with ever-increasing grant revenues, all would be fine. Indeed, the expanding research enterprise would contribute enhanced indirect revenues to help offset the hospital's fixed overhead costs.

For years, all was well on the clinical side of the house. While government payers (Medicare and, especially, Medicaid) did not cover their full cost of service, payments from private insurers would make up the difference. Now, though, we can project a declining rate of payment increase from both the federal and state governments, increasing the needed subsidy for those elderly and poor patients -- but precisely at the time private insurers are recoiling from doing so because of pressure they feel from their business and individual subscribers. Private insurers are making clear that they don't want their rates to increase faster than their estimate of overall (not health care) inflation, and, also, they feel less obligation to make up the shortfall in government payments.

The private payers are also more and more interested in move towards some kind of capitated rate system (i.e., paying $x per year for the full spectrum of medical care) for those patients covered by their insurance products. In the past, if their rate was a bit too low, selling more units of care to an ever more service-demanding population could make up the difference. Now, though, they are looking to control the product (rate X units) and therefore want to move to a more global fee per patient per year.

On the research front, a dramatically slower growth rate in NIH funding for biomedical research means that many more of those bright researchers you recruited or were just about to recruit into the research labs you just constructed will find themselves unfunded for longer periods of time. You either have to cover their salaries, lab expenses, and space costs from general hospital revenues, or lay off scientists and just cover their now empty space costs -- all the while explaining to your highly skeptical faculty that you remain fully committed to a strong research program.

What, then, is a business plan that is most likely to produce overall positive net income for a hospital over the coming years, income that is essential for capital investment for renewal, replacement, and enhancement of clinical and research functions? (For the accountants out there, think about a target of funding 130% to 140% of depreciation each year -- requiring an operating margin of at least 4%. Please note that I am talking about a hospital in good standing, not one that is engaged in a financial turnaround.)

1) Focus on growth in clinical services that are most suitable for a high level tertiary facility, those that coincidentally produce the best margins. Meanwhile, stabilize, reduce, decant, or eliminate those that do not. But decisions here must reflect the interdependencies of low-margin and high-margin specialties. For example, you cannot eliminate the low-margin nephrology division if you intend to expand your high-margin kidney transplant program. And, you can't eliminate money-losing psychiatry at all, given the pervasive co-morbidity of mental illness with many physical illnesses, especially among the elderly.

2) Optimize use of space. To the extent you can avoid expensive new construction (currently priced at over $1000 per square foot for construction costs alone) by reconfiguring space use, you avoid new fixed costs and are able to expand volume at lower incremental cost.

3) Achieve operational efficiencies. No, not by an administrative fiat that reduces staffing, but by application of LEAN methods or other improvement programs that tap the know-how and creativity of your front line staff. But, you need to aim for double-digit improvement, not just 1 or 2 percent per year.

4) Work to eliminate preventable harm. When hospital acquired infections, for example, are avoided, the extra costs of extended lengths of stay are also avoided. Even under most current insurance payment methodologies, the business case for harm-avoidance is compelling.

5) To the extent insurance rates move toward capitation, learn to coordinate and manage care across the spectrum of services. This is really hard when you don't control, say, that nursing home that receives your discharged patients. But get ready for the day, by enhancing interoperability of medical record systems and building cooperative relationships among the physicians along the spectrum of care.

6) Meanwhile, research must also be managed, not just to produce higher revenue per square foot, but also to ensure that the research agenda is consistent with the hospital's clinical priorities. There is probably, too, an optimum range in the overall size of the research program for a given overall hospital size. Analyze this, and head towards that target over time.

7) Understand that philanthropy is the fourth line of business -- along with clinical care, research, and teaching -- if an academic medical center is to thrive in doing those functions society expects of it. Whether enhancing the income statement with current-use unrestricted donations or relieving capital budgets with restricted-use investment gifts, philanthropy is an essential component of hospitals' futures given other economic trends. Generally, investments in philanthropy yield about 16 times their annual cost and therefore represent one of the highest and best uses of operating funds.

I don't think that anything I have said here is new or controversial among hospital administrators or their Boards. However, it has become clear to me that many of these concepts are outside of the realm of experience of many hospital doctors, scientists, and other staff. If you are reading this and it is new or strange to you, please comment. If you are reading this and are involved in hospital management or governance and have something to add or subtract, please comment, too.