Why Cost Cutting Doesn’t Work – And What Will Work

Cutting costs does not cut costs. If we hope to steer health care toward a better cheaper future, we have to wrap our minds around this conundrum: Slashing spending does not necessarily improve the bottom line.

Governments in Ireland and the United Kingdom have come up hard against this conundrum. They have both faced soaring deficits due to the economic downturn, because their tax revenues have fallen at the same time that their costs for unemployment and other kinds of social support have risen.

So they both did what might seem like the sensible thing: They attacked the problem by cutting spending, in the professed belief that such a move would also increase the financial markets’ confidence in the future, and thus pump up the economy, reduce unemployment, reduce the interest the government has to pay on its debt, and increase tax revenues.

Result? Their deficits have grown even larger. Why? Because what economist Paul Krugman likes to call “the confidence fairy” never showed up. The austerity measures tanked their economies even further. Firing a lot of people, it turns out, drives unemployment up and tax revenues down. The worsening debt picture increased the cost of borrowing. Many U.S. states are headed down the same path right now, slashing spending in order to slash deficits, and the U.S. Congress is famously and forever wrangling over the same formula.

Aim at Foot. Pull Trigger.

What is to notice here, from our perspective, as people who run health care systems? Two things:

• This conundrum (spending cuts lead to increased spending) happens when an entity cuts spending that is an input to the larger system to which the entity is responsive.
• This is a pattern that repeats in one way or another at all scales in the economy: National governments, states and provinces, health systems, individual businesses.

So a government cuts spending drastically, lays off workers, cuts salaries and restricts unemployment benefits. But a cut in spending by the government is a drop in income to the economy as a whole, the very economy on which the government depends for its tax revenues and its borrowing ability. A state finds its austerity spending program helps drive down its tax revenues, and drives up the number of people applying for Medicaid and other support programs. A business faced with a fall in sales lays off workers and cuts back investment in new equipment, inventory and its sales force, and finds that sales decline even further, while it has narrowed its own ability to respond with new products, more efficient and innovative production, or new revenue streams. A health system responds to cuts in reimbursement levels and shifting payer mix with the same tactics, laying off people and cutting back on new investment, and finds that it has actually decreased its efficiency, increased costly mistakes, and cut its ability to respond with new initiatives and revenue streams.

Health Systems: More Complex

But health systems’ cost situation has always been much more complex than other businesses, and has traditionally been drastically different, for one simple reason: Health care providers have been able to decant their excess costs to customers and payers.

Reimbursements are set based on various formulas, and negotiations based on the formulas. These, in turn are based on a number of factors, including such things as a vague idea of how different items generally are priced in a given market, what they cost last year, how much should be allowed for system overhead, and how able the payer is to beat up on the provider. These negotiated reimbursements have not been based on any actual accounting of the incremental cost of producing the service in a given setting. In fact, in the past, most systems have been incapable of producing any such realistic cost accounting. And there has been little real competition of the type that would demonstrate how efficiently a particular product or service could be delivered.

Hospitals and health systems always complain that the reimbursement is far too low; the payers that it is too high. Providers have dealt with the reimbursement squeeze by trying to cut costs in general, through strategic moves to change their payer mix (such as building facilities in growing suburbs and closing facilities in poor areas) and to perform more of well-reimbursed procedures and less of poorly reimbursed ones.

Overall, though, since health systems have continued to survive, we can conclude that the reimbursements have included the cost of their inefficiencies. If they did not, if payers were only paying for what a service would ideally cost in some ideally efficient system, we would all have closed our doors long ago.

No More Cost Decanting

That’s changing. Health care providers can no longer assume that they can decant their costs to the payers. Let’s take a look at how, exactly, that is changing.

There are three ways to cut costs in treating a given patient, and they are quite different in their effect on the provider’s bottom line. These three ways are efficiency, coordination and avoidance.

Efficiency relates to unit costs: How much does it cost to administer a given procedure or test (such as foot amputation for a diabetes patient)? In a fee-for-service system, being more efficient at each service is always a net gain for the provider. Whether the service is not really necessary or helpful to the patient, or even damages the patient, does not show up on the balance sheet. What shows up is whether you can produce the service for less than the average reimbursement for your payer mix.
The more fruitful economic strategy is the one that hospitals have followed for years: Determine which outcomes are already being delivered at a cost substantially below the reimbursement, and do more of those; do less of those that are delivered at a loss. That’s a lot easier than doing the hard work of becoming steadily more efficient at all your processes.

Coordination relates to bundled costs: How much does it cost to produce a particular solution to a problem (such as the entire foot amputation bundle, from intake and diagnosis, through imaging, anesthesia, operation and post-op care, through discharge and maintenance care)? Can we deliver this solution at the right level of acuity? Can we avoid duplicating services?

Avoidance relates to solution costs and system costs. Solution costs answer a different question: How much does it cost to solve the whole problem, including all possible solutions (such as aggressive early treatment of the foot abscesses, to avoid the need for amputation)? System costs answer an even wider question: How much would it cost to prevent the problem in the first place (through aggressive management of the diabetes, including regular foot exams)?

The Cost of Avoiding Costs

Take, for a moment, these few examples: 1) Complex back fusion surgery for simple chronic back pain, which works no better than simple decompression, yet costs up to 10 times as much and kills twice as many people. Or any surgery for simple chronic back pain, which has proven no better than medical management (ibuprofen, yoga, injected steroids) over any time span longer than a few months. Medicare shells out around $2 billion per year for such back surgeries. 2) Heartburn surgeries, shown by a large randomized clinical trial to work no better than over-the-counter drugs like Prilosec and Nexium. 3) Implanted defibrillators, which are literally life savers for most people who receive them. But a major study in the April 7, 2010 issue of the Journal of the American Medical Association found that 22 percent of Americans who get them don’t need them—they don’t fit the “evidence-based” profile of patients who would be helped and not hurt. Implanting the device is a major, invasive operation that involves sticking wires into your heart. It’s expensive, at an average cost of about $40,000, including the device, hospital charges, and the surgeons’ pay. It’s common, at about 100,000 operations per year. If 22 percent are not needed, they represent an unnecessary expense of about $880 million—nearly $1 billion per year for one common, unnecessary operation that, by the way, puts the patients at risk, as any operation does.

So in three quick examples we have identified wasted costs amounting to something like 4 percent of the $100 billion it is commonly thought it would take to pay for the health care of all uninsured Americans.

But traditionally, as a hospital, these are not your wasted costs. In a fee-for-service system, they are decanted to the payer. The only costs that really matter are your costs per reimbursable item: Can you get reimbursed for this? Can you get your costs of production significantly below your reimbursement? If an extra CT scan, or the whole operation, is not strictly necessary, you’re still fine as long as you can get reimbursed for it under the right code.

Cost savings through coordination and avoidance save money for the customers, for the payers and for the system at large, but if you are fee-for-service the money they are saving would have been your money. You could have charged for the inefficiencies, the unnecessary scan, the avoidable surgery. Forming an accountable care organization doesn’t change that. As long as it is fee-for-service, an ACO is just a way to get back a little of that money you didn’t make. You saved costs by driving down your own income.
As we enter a world with more bundled purchasing, value-based purchasing, mini-caps (such as disease management contracts) and full capitation, all of these deviations from a strict fee-for-service model bring the other ways of cutting costs to the fore.

How Do You Make Money by Saving Money?

To make money at coordinating care, or through avoiding solution costs and system costs, you have to be at risk for the cost of that size of solution. To make money at bundled payments, you have to be able to control the costs of all parts of the bundle. To make money through cutting solution and system costs, you have to be at risk for the entire solution. If you help a patient avoid a foot amputation by aggressively treating the foot abscesses, or by avoiding abscesses altogether, in a fee-for-service universe, your bottom line just took a huge hit. In a universe in which you are at risk for the health of that patient, because you have a capitated contract for their diabetes care or for their overall care, your bottom line looks better for every cost you can avoid.

Sometimes this means adding process costs to save the system costs. The Vermont Blueprint is a good example. This project places community health teams in primary care offices. Led by nurses, these teams are charged with tracking chronic patients and offering whatever help they need to manage their situation, as well as coordinating the physicians’ offices with community prevention efforts. The cost, which is borne by the payers, is roughly $350,000 per team per year. Each team can cover about 20,000 people. Do the arithmetic: $17 per patient per year. Result: better health, 22 percent lower cost in inpatient admissions, 36 percent lower cost in emergency visits, 11.6 percent lower costs overall. That’s big.

Or the Special Care Center in Atlantic City, N.J.: This clinic offers special attention, team-based care, and walk-in immediacy to the top 5 percent of health care spenders among the employees of the casinos and of the AtlantiCare Medical System, all for no co-pay, no deductibles, even the drugs free. Result: a 25 percent drop in overall costs for this top-spending 5 percent.

If you are a hospital in a fee-for-service system, those are hits to your bottom line. If you are at risk for those costs, saving them turns into profit.

It’s About to Get Really Complicated

This is about to get really complicated for most of us. If you are Kaiser, or the Veterans Administration, or Group Health of Puget Sound, fully capitated for most of your users, the calculations are complex, but they have a simple basis: How do you deliver the best possible health and health care at the lowest possible cost? Most of us are not in that situation.

Most of us are in a fee-for-service universe, and are not going to become another fully capitated Kaiser any time soon. But over the next few years we will find ourselves taking up various types of risk-based contracts, coming to count on pay-for-performance bonuses as a major revenue stream, offering bundled products, and competing for “value based purchasing.” Each of these flips some part of the incentives with some part of our users and some part of our suppliers (including physicians, and other providers with whom we join in bundles or any kind of risk-based contracts).

In the face of this vastly more complex price picture, we realize that we are driving systems whose very complexity makes them relatively inflexible. A car company, for instance, can design a cheap-as-dirt car for the Indian market, say, and a range of products from basic pickups to a line of luxury sedans for the U.S. and world market. No problem. But a health system with some users under risk contracts and others fee-for-service finds those patients intermixed through all their facilities. And the fee-for-service patients from different payers come with different levels and kinds of incentives in their co-pays and deductibles, and different pay-for-performance and value-based purchasing incentives from their plans. It can become very difficult to tell whether any particular avoided cost helps you or hurts you.

Re-designing the system to avoid unnecessary costs is hard enough. Designing it to avoid some costs for some patients and not for others is impossible. Kaiser of Northern California has a medically sound, guideline-based program that helps steer patients with knee problems away from unnecessary and unhelpful MRIs, operations and total knee replacements. This saves Kaiser a lot of money and helps the patients improve their knees. If you put such a program in place, would it save you money or just cost you reimbursements? This can become extremely difficult to tell.

We haven’t been trained for this. Our training and experience is in a different universe. We are just feeling our way forward here.

So What Is a Hospital Executive Team to Do?

Three core strategies:

First, get fierce about efficiency, the first type of cost. Driving down the process cost of everything you do is a good thing no matter how you make your money. And the improvements in quality that come out of such efficiency efforts will help you with pay-for-performance, with ACO kickbacks if you are aiming for them, with all types of value-based purchasing.

Second, clarify your situation strategically, driving toward simplifying your patient flow and major contracts, so that you can easily grasp your cost situation with the various populations you serve.

Finally, judiciously take on risk for costs you can help control. Then vigorously control those costs, using all the tools available to avoid unnecessary operations and procedures, duplicated tests, and treatments at the wrong level of acuity. In becoming at risk for some populations and some parts of your services, you will have to learn to act as if you are at risk for all of it. You will have to drive your whole system toward greater efficiency and effectiveness, at the same time that you are finding various ways to profit from that efficiency and not be driven bankrupt by it.

None of this will be easy, or exactly fun, but it sure will be educational.

(This article first appeared in the American Hospital Association’s H&HN Daily, July 21, 2011)

As a healthcare speaker, writer, and consultant, Joe Flower has explored the future of healthcare with clients ranging from the World Health Organization, the Global Business Network, and the U.K. National Health Service, to the majority of state hospital associations in the U.S.  Joe writes at imaginewhatif.

Categories: Uncategorized

Tagged as: ,

29 replies »

  1. Decreased spending only works when everyone is willing to cut cost. Why (tongue in cheek) reuse Q-tips if the next guy throws them out, HA?

  2. As a younger man I was an administrator then moved into the world of medical equipment. I think it is getting more complex but I see two problems. First, if the hospitals or anyone starts making more money the politicians will take it away “for the good of all”. Second, I do believe you can do more to become more efficient through re-organizing, better procedures and practices but I think you are missing the big picture. The whole model is built upon keeping people between illness and death. If I invented the ideal pharmacy agent tomorrow that would cure most or all illness in one treatment who would use it? Who would make it? Based upon today’s model it would put everyone out of the healthcare business. You can keep squeezing the system and “reforming” it all you want I do not think you will get where I think it should go. We somehow need to reinvent the model to reward people for solutions that cure illness. Healthier people will reduce the health cost plus add to everything we do. I will not pretend I have the solution but I think I have the right direction.

  3. Margalit –

    I’m not an expert on Kaiser but I think they did have a significant cost advantage at one time and they may still. Jonathan Halvorson, Matthew Holt or Nate, among others, may be able to shed some light on that. I’ve heard a couple of insurance brokers tell me that Kaiser may have an insured population that is older than its competitors’ which could, by itself, account for insurance rates that may offset any advantage it has in its costs per hospital day or hospital based procedure.

    Separately, in the past under the pure FFS payment model, hospitals actually got paid more when they had to do rework after screwing up or readmitting a patient. Bundled pricing for surgical procedures would put a stop to that as would no longer paying for so-called never events like wrong site surgery. Shared risk and shared savings create more of a perceived need to improve hospital processes than under FFS as well.

  4. yes and no

    Can they be done on paper without all the hassle of an ACO, of course

    In reality can these different parties work together and compensate those doing additional work without breaking laws, no

    ACO regs are basically more laws that allow us to comply with current laws and keep the government happy. Government could get out of the way and we wouldn’t need any of this but that is not the direction they are interested in going

  5. “ACO’s with risk sharing and shared savings contracts probably have the most potential to move hospital based care in this direction.”

    That may be true, and its also true that there are no ACOs yet, so its hard to say. However, the Kaiser system is the closest thing, actually exceeding the ACO definition, since they take all the risk, not just a safe portion of it.

    So, since Kaiser hospitals has employed physicians and are diligently working on those things on Barry’s list, or so it seems, have they been able to cut any costs?
    In not, then why are we assuming that less integrated ACO systems will do better?
    If yes, then why are they still charging people the same as everybody else?

  6. The potential opportunities for lower hospital system costs would include the following:

    1. Reduce duplicate testing and adverse drug interactions. Electronic records would be critical here.

    2. Reduce infection rates. Diligent hand washing would help with this.

    3. Reduce surgical complications and readmissions by doing the job right the first time.

    4. Use checklists and timeouts, especially in the OR to avoid wrong site surgeries and checklists in the ICU when inserting central lines.

    It would probably be easier for a hospital to get physician buy-in for #2, 3 and 4 if the docs were salaried employees instead of independent contractors with practice privileges. Cost reduction will come mainly from process improvement, not from less staff or lower compensation. With fewer mistakes and duplication, the same hospital staff and infrastructure can treat more patients. ACO’s with risk sharing and shared savings contracts probably have the most potential to move hospital based care in this direction.

  7. technically I don’t think there is an ACO in the country yet so no, no evidence yet

  8. Is there examples/evidence that ACO hospitals operate at significantly less system costs?

  9. Insurers for the most part try to have every hospital in network becuase they have never been very successful at steering patients to one or another. There are some exceptions like hospital owned insurance companies but for the most part hospitals compete for patients.

    Under the new system envisioned this shouldn’t change, they will still be trying to convince patients if you need an X we are the best hospital to come to. I don’t think patients understand or even care to the financial system behind the curtain, if its ACO or FFS it doesn’t matter to them they could care less.

    In thery an ACO should perform better then FFS, ACO is taking risk so cost to insurer should be lower unless they really screw this up, so insurance premiums for ACOs might be slightly lower then FFS.

    “How do you convert the mentality of a for profit hospital from bill-till-you-puke to integrating care, costs, results, profit, and doctor reimbursements?”

    The only way they understand, do this or you will stop getting paid and here is your X billion dollar government handout to stop whinning to every reporter you can find how this will bankrupt you. Many hospitals already are risk bearing so I don’t think this is going to be such a huge jump as some people think. Those that can’t figure it out will probably just be bought by those who have

  10. “The integration and better care initially will be a leg up on the competition, once your competitor adapts you will have to follow suit, who would choose a non integrated hospital with less emphasis on quality and outcomes when the one acorss the street is”

    Do hospitals now compete only for patients, then let insurers knock on the door wanting a piece of that patient business? Who will they compete for in an ACO that’s different from the present system; self insured employers wanting a better deal, insurance companies wanting lower disbursements, patients wanting lower co-pays, better care, more choice? I can see single-pay needing to act more as an ACO, but independent hospital competitors with multiple payers who have different goals? How do you convert the mentality of a for profit hospital from bill-till-you-puke to integrating care, costs, results, profit, and doctor reimbursements? If one hospital is ACO and one fee-for-service why will patients care on which one to go to – will they notice a difference?

  11. In virtually every other industry in the world there are 3 things that US hospitals have managed to evade: cost transparency, a clear understanding of the unit cost of delivering services and a recognition that unless you have the very best people in every job you can’t win. In every other industry product costs go down over time as products mature and become commodified; not so in hospitals. Whether any form of “ACO” is the answer remains to be seen, but if hospitals can’t run like real businesses, they will be the casualties of the changing healthcare system. they simply cannot afford to remain ignorant to the cost of operating at the unit of service level or reliant on staff or clinicians who have been there forever but use antiquated or non-competitive approaches to delivering treatment. The world is changing and the definition of insanity is doing the same thing repeatedly and expecting a different result.

  12. In my humble opinion, the ACO concept is DOA for most hospitals and physicians. It is different, of course, for Kaiser, the VA, and other tightly integrated systems in which the organization is payer, employer, and owner of all parts of the system. Bundled payments, on the other hand, might work, if the big centralized organization owns the primary care component and specialists depend completely on the referrals from the owned-primary care base. If both hospitals and specialists lose money on the ACO deal, it’s no way, Jose. Unless forced economically, most physicians don’t want to be part of a Kaiser-like culture. For more on these cultural issues, you might want to read my new book The Health Reform Maze (Greenbranch Publishing), Baltimore, MD.

  13. and now that that I don’t have to type on an iPhone, I am also wondering what the writing on the wall really means. If hospitals, or more accurately health systems, as there will be very few stand alone hospitals remaining, must accept risk, why shouldn’t they just accept all risk? What will be the remaining role for insurers? Reinsurance?
    It seems to me that if left to its own devices the market will gravitate to the most profitable solution, which is indeed vertically integrated entities like Kaiser. Maybe a handful of really big ones and some boutique providers for the discriminating palates….
    On one hand this is not a pretty picture, on the other hand, from there it will be just one more step to have government pay the systems with tax dollars instead of individuals having to do the paying.
    Is this the writing you see on the wall, Jonathan? I agree it’s not at all graffiti, but I can’t make out the lettering from where I am.

  14. A ACO as defined by the federal government subject to the Berwick rules? I agree I have no idea why someone would subject themselves to that.

    The concept of an ACO which can be marketed to the private market and eventually maybe used for governemnt plans offers a number of interesting opportunities

    Participate in risk which I think will be a necessary not optional revenue stream.

    The integration and better care initially will be a leg up on the competition, once your competitor adapts you will have to follow suit, who would choose a non integrated hospital with less emphasis on quality and outcomes when the one acorss the street is

    excuse to spend billions of dollars, its in hospital DNA to spend large sums of money on marginally or unproven technology and ideas, I don’t think they can resist the siren’s call


  15. If the providers take the risk and you price the risk at the same level as the previous insurance any savings in rendered care would be profit from the risk side. You wouldn’t grow your income but you could maintain it.

  16. Yes, but we then need to negotiate such a deal with each separate insurer. Unless there is real motivation to do so, we will stay with the current model.


  17. Margalit, that is a strange notion of voluntary you seem to be working with. Hospitals are engaged in negotiations with payers over prices and other aspects of remuneration. They get the best deal they can. But the best deal ten years ago is not the same as the best deal today, and the best deal today won’t look the same as the best deal five years from now. Is the writing not on the wall? I’m sure reading something on the wall. Are you suggesting it is just graffiti and hospitals can continue as they have?

  18. “Wouldn’t the hospital make even more money if it could improve efficiency AND experience no decline in payment? If so, why voluntarily accept decline in payment?”

    Margalit –

    Longer term, hospitals won’t have that option. The whole point behind ACO’s is to move toward global payments and more coordinated care. The same is true for bundled pricing of surgical procedures. In the shorter term, we will likely see more shared risk with shared savings contracts. Hospitals know this is the future. Any who resist are likely to find themselves out-of-network eventually which will mean they are paid less than what in network providers are paid for similar work. While they can balance bill the patient for the rest of their charges, good luck trying to collect most of it.

  19. Wouldn’t the hospital make even more money if it could improve efficiency AND experience no decline in payment? If so, why voluntarily accept decline in payment?

  20. Just to clarify, a hospital could make more money from bundled pricing even if it is less than they received under FFS reimbursement before as long as it can also cut its costs through eliminating unnecessary tests and improving efficiency by more than the decline in the payment.

  21. “One of my proposals involves saving money on pre-op testing. Most patients have way too much done. The problem I found in my proposal was that cutting out many of those tests would cost the hospital income.”

    With bundled pricing for surgical procedures, the hospital would have a clear economic incentive to embrace your ideas. Whether they make more or less profit than they do now would depend on how the new bundled price compares to the previous average total of their FFS reimbursements for the procedure and related services.

    “I have found administrators to be more heavily focused on safety than ever before. At a time when I thought costs would be more important, they are emphasizing safety.”

    From a patient safety standpoint, this is very good news and, I think, long overdue.

    On its most recent earnings conference call, UnitedHealth Group management commented that hospitals are showing increasing interest in taking on risk based contracts but they are looking for help in assessing risk to help them determine what makes financial sense for them. This is an area where insurers have considerable expertise which is likely available for hire.

  22. Joe, I may have missed the point, but I don’t see how this works.
    Why would providers agree to take risk? By definition, this will reduce the volume of services, which means that to maintain the same profit as before, you would need to increase the margin, either by increasing charges or driving your costs down. Increasing charges will not be acceptable and managing costs down is hard. On top of that, if I can manage my costs down, in the current model I get to increase my profit, not just keep it from dropping.

    Your example of Kaiser, the VA and Group Health are of entities that are providers and payers at once. These types of entities indeed have a reason to reduce volume (and costs), so they can keep a larger part of the premium. Purely provider organizations will only have the same drivers if, and only if, they are forced to accept risk and the global payment is capped. It is not going to happen voluntarily, and this is the problem I see with ACO – they require providers to work harder, more efficiently, with better results, for less profit. How does that make any sense?

  23. I have been writing papers/proposals for my department and my hospital on these issues. As hospitals convert from revenue centers to cost centers, we will need to change (assuming that is the way we go). One of my proposals involves saving money on pre-op testing. Most patients have way too much done. The problem I found in my proposal was that cutting out many of those tests would cost the hospital income. So, I have those tucked away for the future.

    The other thing of note for my area is that I have found administrators to be more heavily focused on safety than ever before. At a time when I thought costs would be more important, they are emphasizing safety. That may just be a function of my area, I am not sure. We, and our competitors, are absorbing several small facilities, almost small enough to qualify as critical access hospitals. Administrators seem quite pleased with our proposals to improve quality. (Some of these places had no QI program in place)