Looking for margin in all the wrong places

As practice leaders work to improve their bottom line, they often task their business offices to examine practice costs and revenue to identify which product lines provide the most income over expenses or margin. Ideally, the results identify which areas are most profitable so they can be expanded and, conversely, identify product lines that have minimal or no positive contribution to the organization.

Unfortunately, most practices find that the process of identifying margin is complicated and, after exhausting work, abandon the project having looked for margin (to paraphrase a certain country western song) in all the wrong places.

Identifying the margin for a procedure is complex; even identifying revenue generated by a procedure is difficult. In most businesses, tracing revenue is simply computing sales volume times price. This is not the case in healthcare, as each government and commercial insurance payer has a fee schedule unrelated to the practice’s charge master. 

While tracing revenue is complex, identifying expenses is much more difficult. Almost universally, medical and surgical procedures have infinitesimal direct costs. Consider the costs of a 99213 office visit (4 feet of paper for the exam table, a tongue depressor, sheaths for a thermometer and otoscope, and a couple squirts of hand sanitizer) compared to the larger costs that must be allocated (such as nursing staff, facility space, insurance and use of equipment), not to mention the overall administrative overhead of the practice, billing office and the EHR, billing and practice management systems.

Complex problems require complex solutions, and the MGMA DataDive Pro Cost and Revenue 2016 uses a sophisticated cost allocation methodology to trace costs. The activity-based cost model allocates expenses based on the type of procedure (medical, surgical, laboratory or imaging) and whether the procedure took place inside or outside the practice. Costs are allocated to each procedure type based on activity (the gross charges for each procedure compared to total gross charges for all procedures).1

Figure 1 depicts the volume of revenue for physician-owned multispecialty groups with primary and specialty care by type of procedure and where the procedure is performed. Since these practices have a large percentage of primary care and medical specialists, it is not surprising that medical procedures performed inside the practice represented 43.5% of total gross charges. Because of the shift of performing complex procedures in the office and not in a hospital, only 3.6% of total gross charges came from medical procedures performed in a facility outside the practice. Surgery performed in the hospital or ambulatory surgery center (14.1% of total gross charges) generates almost twice the volume of office surgery (7.6% of total gross charges). Ancillary service revenue in these practices were substantial with median laboratory charges being 10.4% of total gross charges and radiology/imaging producing 8.5% of gross charges. Nonprocedural activities — chiefly charges for chemotherapy, arthritis and other infused drugs, durable medical equipment and service contracts — represented 12.8% of total revenue.

While examining where revenue is produced may be interesting, finding where the practice generates its profits is exciting information (Figure 2).

Since data are reported for the survey in aggregate, the amount of collections is estimated by multiplying the total gross charges for the procedures by the overall gross collection ratio. This methodology does not require the precision bookkeeping of attempting to trace every payment while providing an accurate estimate for the total revenue attributed to the procedures. As expected, surgical procedures have the greatest revenue per procedure, while laboratory procedures have the least.

There is a similar pattern in direct and allocated operating costs per procedure. The cost allocation model assigns costs on the ability to pay, so a surgical procedure with high gross charges would pay a greater share of an allocated expense than a medical procedure. Procedures performed in the practice have greater allocated expenses than similar procedures performed in a hospital or other setting outside the practice. This is due to the allocation of the nursing and receptionist staff costs and the cost of drugs, medical supplies, furniture and building expenses to these procedures where these costs are paid by another entity when the procedure is performed outside the practice. 

Most interesting is what happens when you calculate median total medical revenue after operating cost per procedure. Procedures performed outside the practice have a greater margin since their costs are lower. Even with a full allocation of operating costs, both laboratory and radiology/imaging have a considerable margin, while surgical procedures performed inside the practice had almost no margin since allocated operating costs are so great. And, unfortunately, while medical procedures performed inside the practice represent the largest percentage of gross charges and revenue, these procedures had a very low margin, confirming what most practice administrators have learned from observation and experience.

How can a practice leader use this information? First, it reinforces the importance of cost management to minimize expenses in the practice’s facilities, so medical and surgical procedures performed there will have a greater margin. Second, investments in laboratory and radiology/imaging will generate a good return. Third, hospital surgery pays much of the common overhead.

Understanding where a practice generates its revenue is important, but perhaps even more critical to the success of a practice is recognizing what procedures generate the most margin and have the greatest contribution to the practice’s financial success.