Cost accounting helps ensure group practice profitability.

Physician practice managers are faced with the challenge of developing overall practice budgets, identifying strategies for the practice, and negotiating profitable managed care contracts. To accomplish these objectives, they need to understand and manage the costs associated with practice operations.

Physician group practice managers are responsible for evaluating the strategic and financial objectives of their group practices and measuring the impact of managed care contracts - particularly capitated contracts - on their businesses. However, contract profitability estimates determined without analyzing the costs associated with delivering care are likely to be little more than educated guesses.

Practice managers who use cost accounting methodologies as a basis for developing overall cost management processes are often more effective in ensuring practice profitability and can better position their group practices to enter into and thrive under risk-sharing arrangements.

To initiate an effective cost management program, practice managers first must be able to understand the true relationship of expenses to revenues. An accrual basis of accounting, which links cost drivers with their associated costs, can provide an accurate representation of the financial dynamics of the practice and can help form a solid foundation for any cost management program.

DEVELOPING UNIT OF SERVICE COSTS

Practice managers can use cost accounting to develop the costs associated with a unit of service, defined as a unit cost or procedure cost. This is sometimes referred to as "costing" a service. Units of service are specific patient care activities, such as office visits and immunizations.

Several steps are needed to develop unit of service costs:

Converting to an accrual basis of accounting. An accrual basis of accounting recognizes transactions when they actually occur rather than when cash is received or disbursed. This method of accounting links the event, or driver, with its corresponding financial impact. Accrual-basis cost accounting facilitates the cost management process by identifying the true relationship between revenues and expenses. Costs can then be better anticipated, monitored, and controlled to help the practice balance profitability, quality, and mission-related objectives.

Determining what services will be costed. In many primary care practices, office visits (either with or without physician intervention) and select inpatient interventions account for the majority of revenue-generating services. It is generally accepted that 80 percent of healthcare costs account for 20 percent of the services. From a productivity standpoint, it usually makes sense to develop costs for only these financially significant activities.

Defining cost centers. Cost centers are identifiable organizational units through which the activities of a group practice are performed. They can be comprised of a single employee or an entire department. Cost centers are the basis of cost accounting because practice costs are attributed to them.

Cost centers may be defined as either patient service centers (eg, laboratory and radiology) or support centers (eg, business office and housekeeping). Tracking costs to specific cost centers can be best accomplished when the group practice's chart of accounts identifies the cost centers by means of a special field or account designation as depicted in Exhibit 1.

Allocating support costs to patient service centers. Support costs should be allocated to patient service centers through a fair and understandable technique. There are several techniques for allocating costs, but the most practical are direct allocation and step-down allocation.

Direct allocation distributes support costs evenly to all patient service centers or allocates support costs directly to the unit of service level. This type of allocation results in every patient service center or unit of service carrying the same overhead burden in terms of dollars.

Step-down allocation is more equitable in assigning costs to cost centers. Costs are allocated in predetermined order based on utilization of the service's resources (eg, labor and equipment). All support centers have their costs allocated to patient service centers (see Exhibit 2).

The allocation basis used should reflect the most sensible method of allocation (eg, square footage for utilities or housekeeping). In many circumstances, step-down cost allocation is preferred over direct cost allocation because it is more specific but still relatively straightforward and easy to implement.

Determining procedure costs. There are numerous methodologies for determining costs for each unit of service or procedure. Two commonly used methodologies are ratio of cost to charges (RCC) and resource-based unit cost development.

RCC determines the ratio of gross charges associated with a given patient service center to its costs, both direct and allocated costs. This ratio is then applied to the charge of an individual unit of service to estimate the cost of that service (see Exhibit 3). RCC assumes that there is a reasonably direct relationship between the charges associated with a unit of service and the resources required to provide it.

Resource-based unit cost development methods can range from a relative-value-unit-based (RVU) methodology to discrete cost accounting, which assigns the actual resources required to produce a unit of service through time and motion studies and other such factors. In most cases, the benefit of discrete cost accounting does not justify the effort required to define and maintain it.

An RVU-based methodology is a better option for [TABULAR DATA FOR EXHIBIT 2 OMITTED] practices that wish to perform more refined cost allocations than RCCs allow. An RVU typically defines the intensity of resources required to produce a unit of service in comparison to all other units of service. For example, the resource-based relative value scales (RBRVS) developed for use in the Medicare program are a series of RVUs that apply to procedures classified under the Physicians' Current Procedural Terminology, Fourth Edition (CPT) system. These RVUs have three main components that account for professional time, practice expense, and malpractice expense. They may be used to develop procedure costs as shown in Exhibit 4.

Resource-based unit cost development is the most accurate, but most resource-intensive, cost accounting methodology. An extreme application of this method may include conducting time and motion studies to determine labor consumption and direct material costing for supply items, which is the foundation for activity-based costing. While this is usually not the recommended approach, there may be instances where the RVUs do not accurately reflect resource consumption, and a hybrid of RVUs and direct costing may be appropriate. For example, actual drug costs may be more appropriate to use than an RVU in allocating costs for injections if the cost of the drug can be obtained easily. Therefore, the material cost may be assigned directly to a procedure, and the labor and other costs developed using an RVU methodology.

EXHIBIT 3: RATIO OF COST TO CHARGES (RCC) COST DETERMINATION

Total patient service center
charges                                   $100
Total costs (fully allocated)              $50
Department RCC                               0.5
Charge/unit of service                     $10
Estimated cost/unit of
service ($10 charge x 0.5 RCC)              $5

The more specifically direct costs can be assigned to units of service, the more accurate the cost accounting will be. However, the desirability of highly accurate results must be weighed against the incremental value to the practice of spending additional resources to obtain a higher level of refinement.

USES OF COST DATA

Accurate cost data can facilitate important group practice activities, including budgeting, strategic planning, quality improvement, and managed care contracting.

Budgeting. The cost data captured through cost accounting can be used to develop an overall practice budget. A practice budget allows the practice manager to:

* Set estimated, or expected, costs for each cost center and plan for each cost center to meet those estimated figures;

* Measure whether the estimates were met at the end of the accounting period and provide the necessary tools and information to investigate and explain variances;

* Monitor the overall financial performance of the cost center; and

* Control expenditures and identify cost-cutting opportunities.

EXHIBIT 4: RELATIVE VALUE UNIT (RVU)-BASED COST DETERMINATION

Total Costs Per Patient Service Cost Center = $100

                    Volume         RVU         Volume x RVU
Procedure 1           20           0.5              10
Procedure 2           25           1.0              25
Procedure 3           10           1.5              15

Total                 55                            50

Adjusted Cost Per Weighted RVU = $2 (100 cost / 50 weighted RVUs)

                                  Adjusted                Total
                      Adjusted      Cost/                Adjusted
               RVU    Cost/RVU    Procedure    Volume      Cost

Procedure 1    0.5       $2          $1          20         $20
Procedure 2    1.0       $2          $2          25         $50
Procedure 3    1.5       $2          $3          10         $30

Total                                            55         $100

Strategic planning. Cost data can help group practices identify strategic priorities and can be useful when decisions must be made about issues, such as service reductions or expansions, equipment purchases, and financial expenditures (eg, make versus buy decisions for laboratory tests). Strategic planning can help group practices anticipate market movements rather than react to them after the fact.

Quality improvement. Practice managers can compare cost information from the practice against prior performance and industry standards or benchmarks to move the practice toward continuous quality improvement and a best practices scenario. For example, by comparing the proportion of costs by cost category to those of similar group practices, disparate cost structures and potential problem areas can be identified and operational changes made to bring the practice into a competitive cost position.

Managed care contracting. Accurate, comprehensive cost information can increase a practice's attractiveness to health plans if a good cost position can be demonstrated. Cost information can also be used to assess the profitability of a proposed managed care contract. By using actuarial information to estimate the amounts and types of services a given population will use and multiplying these estimates by the cost to provide each service, the practice can estimate its total service costs. Then, these costs can be compared to the capitated revenue to determine the potential financial impact of a capitated contract (see Exhibit 5). If the contract is estimated to be unprofitable for the practice, additional negotiations can be undertaken or potential cost efficiencies can be explored.

CONCLUSION

Developing an effective cost management program, with cost accounting at its core, is critical for primary care physician practices, which are likely to be capitated first in a market, and for small- and medium-size physician practices, which are less likely to have effective cost management processes in place. With a better understanding of service costs and the means to track and manage them, practice managers can position their physician practices for long-term success.

Full implementation of a cost management program is [TABULAR DATA FOR EXHIBIT 5 OMITTED] likely to span six months to several years, depending on the level of complexity pursued. A phased approach can provide practice managers with opportunities to identify needs, define objectives, and gain the support of physician leaders.

EXHIBIT I: DEFINED COST CENTERS

Below is a comprehensive list of cost centers to which a group practice might assign a special field or accounting designation. Not all the cost centers listed will apply to every group practice.

Medicine 01-19

Family Practice Pediatrics Internal Medicine Allergy and Immunology Psychiatry Ophthalmology Otolaryngology Occupational Medicine Preventive Medicine Dermatology Obstetrics and Gynecology

Surgery 20-39

General Surgery Orthopedic Surgery Thoracic Surgery Vascular Surgery Colon and Rectal Surgery Plastic Surgery Neurological Surgery

Radiology 40-44

Other Physician 45-49

Anesthesiology Pathology

Ancillary Medical Services 50-59

Laboratory Radiology Physical Therapy Optical EKG Allergy Psychology Radiation Therapy Nuclear Medicine

Health and Rehabilitation 60-64

Social Worker Patient Education Nutrition

Medical Support Services 65-69

Reception and Appointments Medical Records Medical Secretaries Record Audit

Occupancy and Use 70-79

Buildings and Grounds Maintenance Housekeeping Security

Administrative Services 80-89

Administration Personnel Employee Relations Accounting Electronic Data Processing Business Office Credit and Collections Insurance Purchasing Communications

Other 90-99

Source: Schafer, Eldon L., Dwight J. Zulauf, and Michael E. Gocke, Management Accounting for Fee-for-Service/Prepaid Medical Groups, p. 145. Copyright 1994 by the Center for Research in Ambulatory Health Care Administration, Englewood, CO. Reprinted by permission.

Suggesting Reading on Cost Accounting and Cost Management

Feuerstein, Thomas M. and Craig A., Anderson. Budgeting and Cost Management for Medical Groups, Englewood, CO: Center for Research in Ambulatory Health Care Administration, 1990.

Krohn, Richard W. "Eight essential rules of capitation contracting," Group Practice Journal, July/August 1995.

O'Conner, Kate. "Information management for managed care," MGM Journal, November/December 1995.

Schafer, Eldon L. Dwight J. Zulauf, and Michael E. Gocke. Management Accounting for Fee-for-Service/Prepaid Medical Groups, Englewood, CO: Medical Group Management Association, 1994.

The Cost Survey: 1995 Report Based on 1994 Data, Englewood, CO: Medical Group Management Association, September 1995.

Trowers, Eugene, A., Jr., Subhash C. Batra, John Buessler, and Lane K. Anderson. "Cost analysis for procedure comparisons," MGM Journal, 1995, November/December, 1995.

ABOUT THE AUTHORS

Katherine A. Conrad, MHA, CHE, is a senior consultant in the Kansas City, Missouri, office of KPMG Peat Marwick, LLP, the U.S. member firm of KPMG International.

Constance B. Nagle is a senior manager, KPMG Peat Marwick, LLP, Atlanta, Georgia.

Robert J. Wunar, Jr., MHA, is a consultant, KPMG Peat Marwick, LLP, Kansas City, Missouri, and a member of HFMA's Heart of America chapter.