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Buy, lease, or rent: which way to go under DRGs? Prospective payment is changing the relative advantages and disadvantages of instrument acquistion alternatives.

The question must be asked each time an instrument acquisition is planned: Should a hospital laboratory purchase the instrument outright or opt for one of the two basic alternatives that became increasingly popular during the 1970s--leasing or a reagent rental? The correct answer may be worth a considerable amount of money to the hospital.

Title is held by the hospital in a purchase, by the leasing company in a lease, and by the manufacturer in a rental. The reagent rental agreement typically includes reagents, supplies, and maintenance service along with use of the instrument. (The box on page 37 discusses how leasing developed as an alternative to purchasing.)

Superficially, it would appear that the laboratory merely has to determine the interest cost of each alternative and pick the least expensive. Interest cost is indeed an important consideration, but there are a host of other issues, including the useful life of the instrument, depreciable life, investment tax credits, and maintenance and supply convenience. Prospective payment is changing the relative importance of each of these issues. Let's examine them in turn:

* Interest cost. In the case of a purchase, this cost is what the hospital would have to pay for money borrowed to buy the instrument or, if the money comes from hospital surplus, the interest income the hospital would forgo. From the perspective of the laboratory, interest cost is equivalent to the hospital's internal rate of return, a percentage arbitrarily established by the chief financial officer to facilitate the evaluation of multiple demands for capital from all departments and services. The rate is modified as external interest rates (money market conditions) and the hospital's balance sheet change.

If the hospital is organized as a nonprofit insititution and has substantial unused borrowing capacity, tax-exempt money may be available at relatively low cost. But if the hospital has a moderately high debt-to-equity ratio, its banks may make capital available only at one or more percentage points above the prime rate. And if the debt-to-equity ratio is too high, any additional bank financing that the hospital can obtain must be reserved for short-term working capital requirements.

Figure I shows how interest cost is taken into account in a comparison of a purchase with with the best lease quotation available--$25 per month per thousand dollars for five years, with a 10 per cent purchase option at the end of the lease, for a $100,000 instrument. That's a $2,500 monthly lease payment, or $30,000 annually for five years, and an added 10 per cent of the original instrument cost, or $10,000 more, in the last year for the purchase option.

In making the comparison between purchasing and leasing, interest cost, at the hospital's internal rate of return, can be added to the purchase price or, as we have chosen, it may be discounted from the lease payments. The discount rate, which is compounded, reflects the fact that future fixed lease payments are worth progressively less than money paid out for a purchase today.

What if the hospital's internal rate of return is 15 per cent? Compounded over the course of a year of lease payments, and from year to year, at 15 per cent discount rate reduces the total lease cost from $160,000 to $102,500 for the five-year term. Since that's still $2,500 higher than the purchase price, the hospital lab is better off purchasing the instrument than leasing it, taking just the cost of money into consideration.

On the other hand, Figure I also shows that the two instrument acquisition options are financially equivalent when the hospital's internal rate of return is 16 per cent. The five-year lease cost comes down to a bit over $100,000.

The same process is employed in evaluating a rental. But since reagents and service are part of the arrangement, the two components must be separated from the capital component.

Let's assume the reagent rental quotation on the same $100,000 instrument is $5,000 per month. If the instrument were purchased, the manufacturer would charge $1,000 per month for a maintenance service contract and $1,500 per month for the reagents and supplies (at the expected instrument usage rate). Subtracting these items from the $5,000 monthly rental payment leaves the same $2,500 per month, or $30,000 a year, as in the lease option. Under the contract terms cited, if the hospital's internal rate of return is 16 per cent, the financial effects of purchasing, leasing, and renting are identical.

As we have noted, however, a number of other issues are involved. In the framework of these issues--such as useful life and depreciable life--purchasing, leasing, and renting have pros and cons that can be largely quantified into cost of money. With prospective payment, some of the advantages of lease and rental disappear, and some of the disadvantages have increased significance:

* Useful life. Here we estimate how long the laboratory will keep using the instrument. Useful life has mechanical and technical aspect. In the first instance, as any instrument ages, its parts fail and have to be replaced. Thus, the cost of maintaining the instrument increases with time.

Maintenance cost includes not only the out-of-pocket expense of repairs but also the opportunity cost of losing instrument use during downtime. For a hospital lab serving an acute-care patient population, opportunity costs an be very high. In the absence of opportunity costs that might shorten the instrument's useful life, replacement is indicated when repairs are more expensive than acquiring a new instrument.

The technical aspect of useful life is a function of how soon current technology will be obsolete. There is always risk of obsolescence, for reasons within and without the specific technology.

For example, T and B cell analyzers are at high risk for technological obsolescence. In this case, the threat comes from within the field--the present rapid expansion of T and B cell identification and quantification technology. In an increasing number of instances, new technologies will replace instruments that have long been common features of the clinical laboratory.

With a purchase, the laboratory assumes all the risk of obsolescence. With a lease, the risk is limited to the term of the contract. With rental, it is limited to the cancellation penalties in the agreement. Such potential costs must be included in the comparative evaluation.

In general, the shorter the expected useful life, the more favorable the outlook for rental versus lease or purchase. This is particularly true when the laboratory's estimate of useful life is shorter than the manufacturer's or when the technology is unproved, such as a new approach to fluorescence immunoassay.

Leasing with an option to buy is favored in situations of moderate technological risk, particularly when the leasing company is assigning a relatively high residual value to the instrument at the end of the lease. When the risk of obsolescence is low or nonexistent, purchase is favored.

* Depreciable life. The Internal Revenue Service sets the standards governing how for-profit entities can depreciate assets and the minimum depreciable life of each type of asset. The Health Care Financing Administration and its Medicare intermediaries adopted the IRS standards for hospital cost reimbursement. These guidelines were generally appropriate for mechanical useful life but excessively long for many types of laboratory-purchased instrumentation where technological obsolescence was the primary determinant of useful life. The Medicaid programs of most states and many Blue Cross plans followed the Medicare criteria.

Thus, whenever obsolescence occurred, the instrument's utility ended before it was fully depreciated for cost reimbursement purposes. Such under-depreciation resulted either in a reimbursement delay, dictated by the third-party payers' depreciation schedule, or a loss of some reimbursement in cases where payers disallowed further depreciation once the instrument was replaced.

These considerations don't apply to lease or rental payments, which have been treated as reimbursable costs for as long as they are incurred. So lease or rental was favored in the past when expected useful life was less than the depreciable life allowed by third-party payers. That advantage over purchasing will end when prospective payment is fully implemented, since hospital revenue will remain the same regardless of depreciation allowances.

* Under-funded depreciation. In theory, depreciating capital assets will fairly reflect the loss in value that occurs with usage and time. If an asset loses all of its value in five years, then the actual cost of operation each year includes 20 per cent of the value of that asset. In other words, the depreciation could be pocketed from year to year, and exactly enough money would accumulate to replace the worn-out old asset with an identical new one.

Unfortunately, money also depreciates in value because of inflation. At replacement time, the accumulated depreciation (determined by the original cost of the old asset) is only a fraction of the replacement cost. Funds to make up the difference between accumulated depreciation and replacement cost have had to come from sources other than those insurers who were reimbursing at cost.

Leasing and rentals, because they have been reimbursable costs and their preset rates extend into the future, have provided a hedge against inflation. That advantage over purchasing will also end under prospective payment. Again, hospital revenue will remain the same regardless of costs.

* Investment tax credit. For-profit corporations can deduct a percentage from their Federal income tax liability--currently 8 per cent if full depreciation allowances are to be retained--of the cost of acquiring qualified assets. Lab instruments and equipment are among the types of assets that qualify for this favored treatment.

Since nonprofit hospitals have no income tax liability, they cannot benefit directly from this provision of the tax code. The benefit can be obtained, however, by the company leasing an instrument, or the manufacturer renting to a hospital lab. Rates quoted for leases and rentals will reflect the investment tax credit benefit at least in part, through competitive pricing. So the investment tax credit is indirectly received by nonprofit hospitals--a point that encourages leasing or rentals.

* Maintenance and supply convenience. Put aside reagent rentals for a moment. Leasing and purchasing an instrument entail the same logistical problems. Separate arrangements must be made for maintenance service and reagents and supplies. If the instrument fails, the service representative must be contacted, as supplies run low, they must be reordered. The problem is that the interests of the lab and its vendors are never exactly congruent.

Under a full-service maintenance contract, the contractor wishes to minimize labor and travel costs--and that wish is incongruent with short downtimes. The shortest downtime would be achieved by having a largely idle service representative with a full inventory of spare parts in the laboratory at all times. It's not an economically viable arrangement for the service organization.

Reagent and other suppliers want the lab to maintain a large stock and order in large quantities with plenty of lead time, so that they can minimize inventory costs and ship slow and cheap. The laboratory would prefer to keep less material on hand and have instantaneous delivery any time requirements are miscalculated.

A reagent rental draws the interests of the laboratory and the vendor closer together. Ordinarily, payments under a reagent rental agreement are based on a charge per specimen analyzed. Thus, if the specimen counter is not clicking for any reason, the vendor has a strong economic incentive to get it going again. This convenience for the laboratory comes at a premium, however. In the past, when rental costs were wholly reimbursed, the premium may have been insignificant. It should be reexamined now, as we will explain shortly.

* Prospective payment. Cost reimbursement, although not yet dead, is heading for extinction. When prospective payment is fully implemented, a hospital's costs will no longer affect revenue levels but will have a one-to-one impact on operating surplus. Rates paid by Medicare and in time by all other payers will be determined by the collective cost experience of all hospitals.

The individual hospital is increasingly in competition with other providers, including physicians' offices, freestanding emergency centers, independent labs, and other hospitals. Cost-effectiveness will prove to be a common ingredient of successful hospitals. The inefficient will close as a combination of technological advances and reimbursement-stimulated alternative forms of health care lead to an almost continuous decline in short-term patient days through the rest of the decade.

This new cost-sensitive environment changes the relative advantages and disadvantages of the different methods of financing instrument acquisitions.

Congress has given itself until Oct. 1, 1986, to determine how the cost of capital assets will be handled under the prospective payment system. Despite the uncertainty, some basic hospital steps are obviously called for. Other policies can be established through a most likely "what if" scenario and modified when congress sets the actual ground rules.

Pending the Congressional decision, Medicare will continue to pay hospitals for capital expenses on a cost basis. It will keep on paying its fair share of depreciation charges and interest. But the prospective payment law specifically warned hospitals not to count on cost-based payments for capital projects initiated after March 1, 1983.

Congress has two broad reimbursement options available for capital cost:

1. Add on capital expense payments to the DRG rate schedule.

2. Tailor capital expense payments to the individual hospital.

Because of the inflation in construction costs over time, the former approach would over-reimburse hospitals with older facilities. Conversely, it would penalize hospitals with newer facilities or with plans to construct additional facilties.

Separately determining capital expense payments for each hospital would present the hospital and third-party payers with another kind of problem: large administrative expenses, even if only facility costs are reimbursed in this manner. An attempt to go further and reimburse instrument and equipment costs on a hospital-by-hospital basis would turn into an administrative/accounting nightmare.

Therefore, it is almost certain that Congress will mandate increases in DRG rates for all hospitals to cover the instrument and equipment component of capital costs. Reimbursement for facility costs may be more hospital-selective, integrated with a modified Certificat of Need process.

What are the implications for reagent rentals and instrument leases? During the remaining time that Medicare's share of capital expenses is reimbursed at cost, the capital cost portion of reagent rental contracts should in theory be covered by payments over and above DRG payments. But such reimbursement will occur only if the capital cost portion of the reagent rental is separated from the operating cost portion.

Granted, a hospital accounting change could accomplish this. Nevertheless, it may be more prudent to rewrite reagent rental agreements and explicity separate capital and operating cost components.

The key long-term question, though, has to do with the rental's operating cost components. They are no longer reimbursed retrospectively; rather, a hospital has to budget for them out of its DRG payments.

What, then, is the true cost of the rental, as opposed to lease or purchase options? An accurate breakdown of maintenance service, reagent, and supply expenses may reveal that the convenience of rentals comes at a fairly high cost.

In the instrument cost analysis cited earlier, the three methods of acquisition were financially equivalent when the hospital's internal rate of return was 16 per cent, on the assumption that the reagents and supplies in the rental would cost $1,500 per month if purchased separately. If the reagents and supplies could be purchased from a reliable source--other than the renting manufacturer--for $1,000, then the convenience of the reagent rental is costing $500 a month or $6,000 annually. This calculation assumes the manufacturer would not demand a higher price for the service contract if his reagents and supplies were not being used.

As for prospective payment's impact on leasing arrangements, we have already noted that two major benefits of leasing will be eliminated: assurance that depreciation costs are fully recovered and that the hospital does not suffer the entire inflation penalty. If the hospital is earmarking instrument leases as operating instead of capital costs, it should reverse this accounting treatment. Otherwise, the hospital will lose some capital cost reimbursement for as long as Medicare continues to pay its share of capital costs separately from DRG rates.

The decision whether to purchase, lease, or rent in this new environment comes down to a comparative cost of money, adjusted for the risk of technological obsolescence. Reagent rentals will still be the most attractive option in certain high-risk circumstances. As long as the investment tax credit is in force, leasing may be a lower-cost source of funding instrument acquisitions than bank borrowing for a purchase, even if the leasing company is borrowing at the same rate.

But the really cost-effective hospital may be so awash in cash as a result of prospective payment that its internal rate of return is well below the prime bank rate. In that case, instrument acquisitions should take the form of purchases.

In short, we have to identify all the costs of acquiring an instrument. If we are paying for convenience, we must find out what that cost amounts to and determine whether the convenience is worth the price. It is the only way to make an informed, cost-effective decision.
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Author:Johnson, J. Lloyd
Publication:Medical Laboratory Observer
Date:Aug 1, 1984
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