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Issues to consider in internalization of a service.

In a staff-model HMO, the demand for services may be greater in one area than in another. Services with little demand and/or high cost are usually contracted to an external provider or institution. Equipment purchases or renovation of a facility to accommodate a new service sometimes go hand in hand with internalizing a service, and capital budgeting is an integral part of the process. The decision on when it is feasible to internalize services has to be considered on two levels: service and finance. This article will look at what issues affect the organization on these two levels and will consider the cost-benefit and legal issues that need to be considered when making such a decision. A work sheet that may be used as is or modified is included.

Internalizing a service in a staff-model health maintenance organization that is currently being performed by contracted external providers is an issue that needs to be carefully considered and should be part of the capital budgeting process. In a staff-model HMO, different departments have different needs, and a request for a new service (or equipment) needs to be carefully weighed from both a clinical and a cost-benefit aspect. The decision on when it is feasible to internalize services has to be considered on two levels: service and finance.

Service Level

On a service level, the considerations for internalizing a service being performed by an outside contractor are: Convenience to patients is of paramount importance. Does the external contractor come to the HMO offices to provide this service, or does the consumer need to go to an off-site building? (For example, a contract rheumatologist seeing patients at the HMO offices once or twice per week). If off-site, how convenient is the service to the population served by the HMO?

* If a service is provided in conjunction with a staff-model physician at an off-site building, there are two issues that need to be considered with regards to location: convenience to the patient and to the HMO provider. (For example, an HMO gastroenterologist going to a contracted hospital to perform upper endoscopy procedures.) The location of the external service may not be convenient for either the patient or the HMO provider. In that case, one has to ask how viable it is to provide the service internally, regardless of convenience.

There may be circumstances when it would be necessary to internalize a service because it would give the organization a competitive advantage. (For example, in-house physical therapy in an HMO-sponsored sports medicine clinic competing with fee-for service, full-spectrum sports medicine clinics.)

Current medical knowledge needs to justify continuing the service being considered for internalization. For relatively new procedures, a search of the literature will determine the current state of knowledge. (For example, photon electrospectroscopy versus dual photon absorptiometry for evaluation of osteoporosis.)

* An organization, in its efforts to provide greater service and/or decrease expenses, needs to ensure that providing a new service internally does not negatively affect other services.

Cost-Benefit Analysis

The purpose of the cost-benefit analysis is to show what it will cost to implement the service and to compare the cost of internalizing the service with the benefits to be drawn from it. An important financial issue that needs to be considered is the future value of money. We need to consider the opportunity costs involved in tying up the organizations money in order to internalize a service. Also, how would the organization invest its money if it does not spend it in providing the service internally? This is an integral part of the cost-benefit analysis, because it shows whether funds would be better spent by keeping the service externalized and investing the funds in a higher yielding operation. Most financial experts agree the most appropriate way to evaluate cost effectiveness is by using the net present value method rather than the internal rate of return or the payback method of analysis.(1-3)

Financial Level

From a business point of view, internalization of a service must have a solid financial basis. Hoffman outlines seven steps that should be taken in developing a capital budget proposal; these same recommendations can be applied to internalization of a service:

1. Gather all the pertinent data.

2. Develop alternative solutions.

3. Arrange solutions according to their priority.

4. Analyze costs and benefits.

5. Recommend a solution.

6. Develop an implementation plan.

7. Create an evaluation mechanism to ensure viability.

Adequate planning is the cornerstone of success when an organization is considering internalizing a service.

Too many times, the process goes from idea generation to implementation without the required planning stages. Some of the planning issues that need to be considered include:

The current volume of service needs to be of sufficient size to justify internalization.

Utilization needs to be on the increase or at the very least stable.

All of the direct and indirect costs associated with providing the service through an external contractor should be well understood.

In evaluating the costs related to an external service, some of the billing issues need to be clarified and the following questions need to be reviewed:

Who gets billed for these costs? Is the HMO the primary payer? In some cases, the HMO may not be responsible for the entire fee; it is divided between the HMO and another payer. A "financial responsibility" case mix should be determined.

What is the age mix of the popluation being provided with the external service? If most of the patients are 65 years or older, Medicare most likely is the primary insurer (unless the HMO is capitated by Medicare). The reimbursement relationship between the HMO and Medicare needs to be well understood by those making the decision. If the HMO does not have a risk contract with Medicare, the costs for the external service may not have a significant impact on the organization's finances as it relates to certain services. (For example, in a noncapitated relationship with Medicare, a radiologic procedure done at a hospital on an outpatient basis may affect the HMO as it relates to the radiologist's fees for interpretation of the study but not for the procedure itself. This may also apply for other hospital charges, such as biopsies done through the hospitals pathologist, if billed through the hospital.

What is the time from when the service is provided to when the bill is actually paid? The interval can be treated as an "interest-free" loan.

What are the physical requirements for internalizing the service? What is the cost of any physical plant modifications (e.g., electrical modifications, remodeling, etc.)?

Does any equipment need to be purchased? In some cases, little or no equipment needs to be ordered; in other cases, this could be a major expenditure.

What are the maintenance costs associated with any new equipment? Doll(5) recommends analyzing six areas in relation to the service contract of new equipment purchases:

* The qualifications of the vendor.

* The parts of the equipment that will be covered.

* The term of the agreement.

* The specifics of the coverage.

* The terms and conditions of the agreement.

* The cost of the agreement.

Other issues related to equipment purchase are:

What is the expected lifespan of this equipment? This is important useful life is used in calculating the depreciation schedule.

Is the technology changing in such a way that it will become obsolete before its useful physical life has been expended? If the technology is changing fast, one may be using an outdated machine very soon. An outdated machine may put the organization at risk for liability.

Can the equipment be used for other procedures? If so, what is the total expected annual usage of this equipment?

What are the ongoing costs for supplies.

What are the training requirements for the provider and support staff in order to provide this new service? Who is responsible for this training and who will train replacements for staff lost through attrition? What are costs for training both in actual dollars and manpower hours?

Will additional personnel have to be hired to provide the internal service? What are the short- and long-term costs of this?

What are the options in obtaining the new equipment (purchasing versus leasing)?

Any time a capital investment is going to be made, the organization needs to look at its financial expectations. The organization's cost of capital (internal rate of return) has to enter into the cost-effectiveness equation for a new service. Also, one always has to look at alternatives to internalization, such as continuing to provide the service externally and renegotiating the contract at more favorable rates. One area that can affect the internalization decision is tax liabilities incurred when the HMO no longer has to pay (and thus deduct) for the externally provided service.

Legal Issues

When considering adding a new service, the HMO needs to consider the legal implications involved. Liability can affect the organization's employees (what are the risks of operating a new piece of equipment) as well as its patient's (if the HMO is going to be doing angiograms in-house, who will interpret the films and does this person have experience interpreting the studies)?


When deciding on providing a new service, members of the organization who make the decision need to work as a team. Those representing the clinical departments, as well as those representing the finance departments, need to be aware of each others' needs, priorities, and concerns. Azzara, referring to a hospital's capital budget requisitions, says, "Every administrator is familiar with the tirade of an influential physician demanding the latest piece of equipment-two weeks after the budget has been approved .... Denying these requests by simply stating 'the budget won't allow it' does not solve the problem. A workable procedure--a 'contingency fund'--to handle these unplanned or unanticipated requests must be available." (6) One must also ensure that the purchase of a piece of equipment or the implementarian of a new service is justified beyond an influential physician's just "wanting it." Whitcomb states, "Until recently, hospital administrators generally have been free to ally themselves with members of the medical staff as this issue has been considered within the community. Priorities for capital expenditures by hospitals have often been influenced to a great degree by the desire of the hospital's medical staff to have access to the latest technology, regardless of the validity of the rationale for acquiring it." (7) The same can be said for internalizing services. Whitcomb mentions that a decision not to purchase a new technology will lead to conflicts between administrators and physicians who are denied new technology (or internalization of a service) and that resolution of this conflict will depend on how this message is delivered and on educating the medical staff in the realities of modem-day medicine and budgetary constraints.

The organization itself has to have in place all the necessary mechanisms to be able to arrive at decisions in a smooth manner. All the information needed to reach a conclusion needs to be accessible with ease. This will decrease some of the problems associated with making solid financial and clinical decisions. If it is too difficult to obtain timely information, crucial steps will be overlooked. In the end, everyone will benefit from an orderly, "user-friendly" process.


1. Carroll, J., and Newbould, G. "NPV vs IRR: With Capital Budgeting, Which Do You Choose?" Healthcare Financial Management 40(11):62-8, Nov. 1966.

2. Garrison, R. Managerial Accounting: Concepts for Planning, Control, Decision Making, 5th Edition. Piano, Tex.: Business Publications, Inc., 1988.

3. Neumann, B., and others. Financial Management: Concepts and Applications for Health Care Providers. Baltimore, Md.: National Health Publishing, 1988, pp. 425-455.

4. Hoffman, F. "The Capital Budget-- Developing a Capital Expenditure Proposal." AORN Journal 44(4):604,606-7,610, Oct. 1986.

5. Doll, W. "Analyzing the Service Contract When Buying Equipment." Healthcare Financial Management 41(11):42-4,46,48, Nov. 1987.

6. Azzara, M. "The Capital Budget: A Case Study in Physician Involvement." Hospital Medical Staff 8(4):10-5, April 1979.

7. Whitcomb, M. "Health Care Technology Acquisition: Issues and Challenges." Frontiers of Health Services Management 4(4):3-41, Summer 1988.
COPYRIGHT 1993 American College of Physician Executives
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Author:Diaz, Victor A.
Publication:Physician Executive
Date:May 1, 1993
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