Case 2 – Marginal Cost Pricing
University Hospital is a regional leader in the very intense and medically sophisticated area of organ transplants. Mark Lewis, the director of the Transplant Center, has been with the Hospital for ten years. When Mark joined the hospital, he was put in charge of a kidney and heart transplant program that averaged 50 transplants per year. Today, the Transplant Center performs over 200 transplants annually, including transplants from the newly initiated liver, lung, and pancreas programs.
The liver transplant program is the most successful of all organ programs in terms of volume and revenues. Last year, volume totaled 100 transplants, and this year Mark is optimistic that the liver program can do even better. However, he knows that increased volume is largely dependent on the number of organ donors and his success in negotiating a new contract with the Transplant Management Corporation (TMC), the largest transplant-benefits company in the nation.
Because transplants are relatively rare in comparison with other, more conventional medical treatments, only the largest health insurers have the expertise to manage transplant services. However, the costs to insurers for transplant services are typically very large—usually in the six-to-seven-figure range. To ensure the best and most cost-effective management of transplant services, most health insurers outsource transplant management to companies, such as TMC, that specialize in these services.
Contracting for transplant services is unique and complex because of the sophistication of the medical procedures involved. Transplant services consist of five phases: (1) patient evaluation, (2) patient care while awaiting surgery, (3) organ procurement, (4) surgery and the attendant inpatient stay, and (5) one year of follow-up visits. The costs involved in Phase 1 are relatively simple to estimate, but the remaining phases can be extremely variable in terms of resource utilization, and hence costs, because of differences in patient acuity and surgical outcomes.
Historically, reimbursement for transplant services has been handled in a number of different ways. Initially, many providers bundled all five phases together and offered insurers a single, global rate. Although this method simplified the contracting process, the rate set was often chosen more on the basis of building market share than on covering costs. Indeed, many providers could not even estimate with any confidence the true costs of providing transplant services.
Somewhat ironically, success in gaining market share usually increases the financial risk of the transplant program because higher volumes increase the likelihood of higher acuity patients. Although the total costs associated with all phases of a liver transplant average about $400,000, the amount can more than quadruple if the patient requires a re-transplant or if other complications occur. Because of this extreme variability in costs, outlier protection is a critical aspect of contract negotiations if the reimbursement methodology is a fixed prospective rate.
So far, several elements of the proposed contract with TMC have been finalized. Phases 1, 2, and 5 will be reimbursed at a set discount from charges. Furthermore, to reduce the amount of financial risk borne by University Hospital, Phase 3 (organ procurement) will be reimbursed on a cost basis. This makes sense because the cost of Phase 3 is almost completely uncontrollable by the Center. In general, Phase 4 costs are divided into two categories: hospital costs and physician costs. Physician costs have already been agreed on, so what needs to be hammered out (and the make-or-break part of the contract) is the hospital reimbursement amount for Phase 4.
The key to a sound negotiation with TMC is to identify relevant costs. Mark plans to be aggressive in pricing these services, because he wants the contract. He feels that the additional volume will lower per-transplant cost and hence increase the Center’s profitability. Still, he wants to set a price that does not degrade the current profitability of the Center, which is good but not spectacular.
To help with the decision, Mark compiled the Phase 4 hospital costs of 12 recent liver transplant patients. In reviewing these data, shown in Table 1, Mark noted that a total average cost of $119,805 for 19 days’ average length of stay (LOS) translates to a staggering per diem (per day) average cost of over $6,000.
Mark is convinced that a price close to $120,000, which would cover total costs, would not be acceptable to TMC. So, he examined the possibility of lowering costs by reducing the average LOS. However, the costs associated with Phase 4 are not a linear function of LOS. The first day of Phase 4 is usually the most costly, whereas the last day is usually the least costly. Indeed, over half of Phase 4 costs occur in the first 24 hours of hospitalization.
Because it would be difficult to lower Phase 4 hospital costs by reducing LOS, Mark decided to pursue a different strategy. His experience at the Transplant Center has convinced him that there are economies of scale present in liver transplants, and hence the marginal cost of each transplant is lower than the average cost. Thus, Mark believes that he can base the contract price on marginal costs rather than total (full) costs. Such a rate would (hopefully) be attractive to TMC yet, at the same time, preserve the Center’s profitability.
Assume that you have been hired as a consultant to recommend a fixed price (the base rate) that should be proposed in the contract negotiations for Phase 4 hospital services. To help in the analysis, Mark has indicated that approximately 60 percent of nursing, ancillary, operating room, and laboratory costs are fixed. The remaining costs—radiology, drug, and other services—are predominantly variable. See Excel spreadsheet for Phase 4 Hospital Costs.
1. What is the estimate of the marginal cost of the Phase 4 hospital services, given the case assumption that 60 percent of the designated costs are fixed and the remaining costs are variable?
2. Assume that the agreed-upon price is $90,000. What is the expected profit on the contract assuming that it brings in 20 new patients? (Assume for now that no new fixed costs would be required.)
3. Now assume that the additional patients will add $200,000 in total to the Center’s fixed costs. Now what is the expected profit on 20 new patients? On 40 new patients? (No new fixed costs are required to support the second group of 20 patients.)
4. What role do the following factors play in the decision regarding whether to use marginal cost pricing on the new contract?
a. Reimbursement amounts paid by current transplant third-party payers
b. The amount of excess capacity in the transplant unit
5. What is your final recommendation regarding the base rate for Phase 4 hospital services that should be built into the contract?