A DRG survival plan for the laboratory budget.
Until we understand the long-term impact of these changes, we can't make intelligent decisions on personnel, instrumentation, and other crucial factors. Management under DRGs is a whole new game with a new set of rules, and the winners will be the first to learn and follow them.
Effective managers will need a deeper and more detailed knowledge of the laboratory's economic structure. This article provides some basic guidelines. First, we'll examine the implications of prospective payment on lab revenue, test volume, and profits; second, we'll define the key concept of operating leverage and its budgetary impact; and last, we'll propose long-range strategies for fiscal survival and success.
This analysis is based on the data shown in Figure I for hypothetical 500-bed Valley Hospital. Valley's laboratory performs 500,000 tests per year and receives an average of $20 for each test, for a total annual revenue of $10 million. Since the laboratory's total costs are $8.5 million, it produces $1.5 million a year in excess revenue over expenses, or profit.
The lab calculates its total cost per test of $17 simply by dividing total costs by total number of tests. Traditionally, the hospital has controlled the lab's price per test and therefore its total revenue; to keep profits stable, it merely raised prices to match rising costs. In a moment, we'll see what can happen now that DRGs have limited this option.
Let's look at the laboratory's cost structure more closely. Of $8.5 million in total costs, $6.4 million are incurred directly in producing results. These direct costs include professional and technical salaries, reagents, and supplies. The lab also carries an additional $2.1 million in indirect institutional costs such as hospital administration, cafeteria, and housekeeping. Indirect costs range from 25 per cent to 40 per cent of direct costs, depending on how the hospital allocates them among various departments.
Direct and indirect costs split further into fixed and variable categories. Fixed costs are those incurred independently of test volume. For example, the cost of operating an automated instrument is the same whether performing 10 or 200 tests per day. Some 80 per cent of the lab's total costs are fixed. Variable costs, on the other hand, rise or fall with output. Supplies, reagents, and disposables fall into this group because they increase as more tests are performed.
These revenue-cost relationships are displayed on a typical breakeven graph in Figure II. The X axis plots test volume, and the Y axis plots revenue and costs in dollars. A straight horizontal line depicts total fixed costs.
Total revenue and volume have a direct relationship. Obviously, when the lab performs no tests, it receives zero revenue. At its actual workload of 500,000 tests per year, the lab receives $10 million in revenue. At the breakeven point, total revenue equals total cost, and the lab marks no profit or loss. For Valley Hospital's laboratory, the breakeven volume level is 408,000 tests per year. We can also determine the breakeven point with the standard equation in Figure III.
These basic principles are very familiar. Less well known, however, is another important budget concept: operating leverage, the factor that allows profits to rise or fall faster than revenue. For example, a 1 per cent change in Valley's lab revenue causes a 5.4 per cent change in profits; the leverage factor is 5.4.
We can calculate operating leverage at any revenue level using the second formula in Figure III. Leverage becomes greater as we move closer to the breakeven point, and profit becomes more sensitive to small revenue changes.
Operating leverage reflects the degree of risk a business is willing to take by investing in fixed costs. Since fixed costs remain the same regardless of volume, losses will result unless sales are sufficient to cover them. Theoretically, even if Valley's laboratory performed no testing at all, it would still have to absorb its fixed costs of $6.7 million. If sales and revenues increase, however, these fixed costs create the operating leverage needed for profits to rise at a faster rate than revenue.
For the last decade or so, clinical laboratories have operated in an economic climate favorable to growth. Testing revenues increased steadily each year because more tests were ordered as prices rose. The leverage factor justified the purchase of expensive automated instruments and the hiring of highly skilled technical personnel. But today's cost containment structures demand a different managerial approach.
These days, we must pay close attention to the effect of falling revenues on laboratory profits, since it's likely that prospective payment will reduce the flow of government dollars to hospitals. A smaller pot of revenue will have to be split among all departments and ancillary services. If private payers adopt a similar system, revenues will drop still further.
Any cut in revenue changes the character of the breakeven graph. Let's assume that the laboratory's revenue per test drops by 10 per cent and test volume stays at 500,000. Total revenue falls from $10 million to $59 million, but costs are unchanged. In response, profits fall from $1.5 million to $500,000, while the breakeven volume creeps upward to 465,000 tests a year. The operating leverage at this revenue level now stands at 14.5. This high leverage marks a steep increase in the lab's financial risk; a further drop in revenue of only 5 per cent will slash profits by a disproportionate 73 per cent!
Many hospital laboratories soon will find themselves in a similar situation. Most managers, if questioned about the effects of DRGs, reply that they're tightening belts, but foresee no massive layoffs or other major cutbacks. They realize that prospective payment will require them to maximize laboratory service and minimize costs. Many believe that automation will boost productivity, lower costs, and improve service. Unfortunately, this line of thinking is a fallacy.
If we measure productivity as the level of output per unit of input, it becomes clear that automation enhances productivity only if test volume increases--or if labor decreases. Test volume, for reasons we'll discuss shortly, is likely to decrease over the next few years. And while instrument manufacturers claim that automation cuts required labor, it often does no such thing.
In reality, a costly automated instrument often replaces a less versatile, cheaper one, while the labor force remains essentially intact. The blood bank may soon prove the exceptionu to this trend, as automated type and crossmatch capabilities reduce the need for skilled personnel in coming years. But in heavily automated sections like chemistry and hematology, managers too often choose empty automation that does nothing for productivity.
Moreover, the purchase of these expensive instruments raises both fixed costs and operating leverage. The lab's business risk increases with each sophisticated new acquisition--perhaps to dangerous levels. The higher the operating leverage, the more vulnerable the business becomes to revenue and volume swings.
Next, let's examine the expected impact of prospective payment on test volume. So far, most hospital laboratories operating under DRGs report stable volume. In New Jersey, where an all-payer prospective payment system has been phased in over the past three years, test volume has even increased in many of the state's hospital laboratories. But it's almost inevitable that this situation won't last long.
In the past 18 months, patient census has fallen at many hospitals around the country, primarily from a decrease in the average length of stay, rather than from a drop in admissions. Since the bulk of testing is done early in a patient's stay, slightly shorter hospitalization cuts only marginally into total test volume. In the long run, however, a powerful combination of factors will drive inpatient test volume downward (Figure V).
The first will be a movement by cost-conscious administrators to cut ordering of esoteric tests. Most of these tests have little hearing on diagnosis or care, and are ordered for reasons ranging from medical research to mere curiosity. Under the tough new payment system, they'll be an easy target.
Second, most hospitals are tightening up internal controls. When insurers paid for every test ordered, there was little incentive to crack down on clerical foul-ups that resulted in unnecessary multiple orders. Now that institutions must absorb excess costs, they will certainly improve methods to detect and eliminate them.
Progressive test profiling will also assume new importance. After an initial battery of tests, follow-up work will be performed automatically according to predetermined protocols. Cost-efficient algorithms will be designed to gain the most diagnostic information from the least number of tests. This method, as opposed to hit or miss testing, will help reduce total volume.
in a related development, utilization committees will monitor how each physician uses the laboratory on a case-by-case basis. They will aim to standardize the amount of lab resources spent on each DRG. The final result: less laboratory testing.
The last and gravest threat to hospital test volume will be the growth of health maintenance organizations (HMOs), preferred provider organization (PPOs), and other prepaid health plans. These plans put physicians on a limited per-case budget, and offer a powerful motive for extensive preadmission testing. If commercial facilities can perform these lucrative diagnostic tests for less than the hospital laboratory, then the hospital will be the loser.
Let's see how the profit picture at Valley Hospital laboratory responds to an eventual 25 per cent drop in test volume, added to the previous 10 per cent drop in revenue per test (Figure VI). The lab mow performs 375,000 procedures a year, well below the breakeven point of 465,000 tests. The botton line has changed from $500,000 in the black to a hefty $1.3 million in the red. Profits have plunged disproportionately by more than 300 per cent.
While Valley's laboratory managers have lost control over revenue and volume, they can still control costs--to a limited extent. At this point, they will try to cut fixed costs to offset the laboratory's large operating losses. Unfortunately, they will find that fixed costs really are fixed, for two reasons.
First, a full-service hospital laboratory requires a critical number of people on staff, and any significant personnel cut will hurt quality of service. Second, the automated instruments performing much of the workload have a wide range of cost efficiency independent of test volume. The lab incurs the same fixed costs no matter how many tests it runs on the instrument; but it can lose substantial amounts of income if volume drops by only 20 to 30 per cent.
This brings us to our concluding point. As test volume inevitably drops, one must ask not how to cut the cost of testing, but rather, should we be performing the test at all?
At this juncture, the reasonable hospital administrator starts looking for less costly alternatives to a full-service, in-house laboratory. The laboratory was well liked when it was a profit center, and tolerated as it gradually became a cost center. Few administrators, however, will continue to subsidize multimillion-dollar losses when commercial labs offer cheaper alternatives.
It's an alarming scenario. Fortunately, these changes won't happen overnight. The full impact of DRGs may not hit clinical laboratories until the end of the decade. The laboratory manager's first priority is to blunt the negative effects of prospective payment in the interim.
We must begin by accepting the fact that maintaining the status quo will be a losing battle under the new payment structure. Crisis management and "belt tightening" are options doomed to failure by falling revenue and test volume and high operating leverage. These factors will eventually combine to make in-house testing a prohibitively expensive luxury.
Laboratory management must make a concentrated effort to reduce total costs and, where feasible, to shift fixed costs into the variable category. This requires development of a good accounting system to accurately classify and measure the lab resources consumed by each type of test. Most laboratories still lack such sophisticated systems, and as a result many vital management decisions are based on intuition and guesswork.
One way to decrease total costs is for hospitals to share laboratory services and resources. There are already signs of a movement toward lab mergers and cluster labs. (See "The Cluster Lab: A Model for the DRG Era?" MLO, November 1983.) Less specialized personnel will also contribute to cost efficiency. Technologists or technicians who can work in all areas of the lab are more flexible than those working only in chemistry or hematology. This greater versatility converts more labor expenses to variable costs.
Clinical laboratories will have to reorganize services into Stat and routine sections. This division will improve productivity far more effectively than automation, by segregating disruptive. Divisions between disciplines such as chemistry, hematology, and hematology will give way to those emphasizing commonality of test methodology.
A third strategy will be to increase test volume from sources outside the hospital, to compensate for cuts in inpatient volume. In the past, lab managers have tended to look upon outside testing ventures as bothersome at best. But as inpatient testing dwindles, this attitude will change.
To increase test volume, laboratories must aggressively market their services. Marketing is not as difficult as it may sound; the hospital lab; despite its built-in drawbacks, has several distinct advantages in its favor. Thanks to a low quotient of variable costs, it can adopt a competitive outpatient pricing strategy without hurting revenue. Personnel and instrumentation in many hospital labs are considerably underutilized. Most sections can easily handle 20 to 25 per cent more test volume without adding personnel or equipment.
Finally, the laboratory of the 1980s will have to take unprecedented care in purchasing expensive instruments. It's all too easy to believe manufacturers' claims of increased productivity. Explore cheaper, less risky ways to improve service. If automation is necessary, consider reagent rental and lease agreements, which tend to shift costs from fixed to variable.
To sum up: Prospective payment is changing the relationships between laboratory costs, test volume, and profits. We must understand these changes and respond appropriately. If we continue on the traditional course of high fixed costs and operating leverage, we will steer a course toward economic disaster.
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|Author:||Sharp, James W.|
|Publication:||Medical Laboratory Observer|
|Date:||Sep 1, 1984|
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