Costing of Medical Services

Eero Linnakko

Costing of medical work has gained popularity in hospitals that are working under the purchaser provider split and contracts. Purchasers generally want to know from what services they are paying for. As a consequence, the providers must calculate the cost of these services for pricing and contracting purposes. However, price setting is not the only reason for cost calculations. Costs are calculated also for managerial purposes along different hospital departments. This is because the allocation of costs to products or services is not particularly useful for cost control purposes. Instead, costs should be traced to departments and to the person who is accountable for controlling costs within that department i.e. head of department.

Bookkeeping and cost accounting

The book keeping (financial accounting) provides the main information base for cost accounting (management accounting) but can not replace it. Bookkeeping and cost accounting together are identifying, measuring and communicating economic information to permit informed judgements and decisions. Bookkeeping provides information for the owners and other external parties outside the organisation like tax authorities but cost accounting is made for the internal use only.

The major differences between book keeping and cost accounting are that book keeping is a compulsory requirement for public and private enterprises to produce annual financial accounts but there is no legal requirement for cost accounting. Bookkeeping reports and describes the whole of the organisation when cost accounting focuses on reporting information for different units of it. Also, book keeping must be prepared in accordance with generally accepted accounting principles and it deals with historical information. Cost accounting places greater emphasis on reporting estimated future costs and revenues.

Consequently, cost accounting in hospitals has two different functions. First, provide relevant information to help managers make better decisions when analysing profitability, pricing products or services, deciding to make or buy and, finally, when deciding what to produce and how much. Second, provide information for planning, control and performance measurement where we can separate long -term and short-term planning (budgeting) and periodic performance reports for feedback and control.

How to calculate costs

A cost accounting system normally accounts for costs in two broad stages: Accumulating costs by classifying them into certain categories e.g. labour, materials and services and overheads and then assigning costs to cost objects. These objects can be cost centres/departments, services, products and customers. The calculation of the cost of the different departments is called cost centre accounting. It is done for management purposes only. Today in hospitals in Europe we generally have at least two management levels (whole hospital and subordinated clinical departments) and, consequently, two levels of budgets. The second class of cost objects is the actual services and products. The product and service costing is based on the information derived from a cost centre accounting. Product and service cost accounting is needed when a hospital start to sell services for customers e.g. rayon health administration, health insurance companies or patients. Therefore, cost centre accounting is also relevant in budget organisations but they hardly need a service costing because they derive incomes trough budget and not trough prices.

For cost accounting different hospital departments are usually classified in three categories: first, administrative and support services, second, clinical services (clinical laboratory, imaging, intensive care, operation theatres and pharmacy) and third, clinical departments. Inpatient and outpatient clinical departments are in hospital cost accounting called as final cost centres because they are producing services to clients outside hospitals. Support services are called initial or intermediate cost centres because they are producing services (mostly) for final cost centres only.

There are two main costing approaches. The first one is called the direct costing where the indirect costs are not assigned to cost objects. This method is appropriate where the majority of costs are direct that today is very seldom the case. Therefore, even being simple, the direct costing is mostly outdated. The second approach is called indirect costing method where a two-stage allocation procedure is required. In first stage overheads are assigned into initial cost centres. In second stage, cost centre overheads are allocated to cost objects (e.g. products or services) using second stage allocation bases/cost drivers. Applying the two-stage allocation process requires four steps. First, assigning all overheads to final production and service cost centres, second, reallocating the costs assigned to service cost centres to production (final) cost centres, third computing separate overhead rates for each production cost centre and finally, assigning cost centre overheads to products or other chosen cost objects.

Costing services, patients and patient groups

Evident precondition for costing of any medical services is that these services are defined. A medical service can be whatever activity aiming to maintain the patient vital functions, to provide knowledge about his or her health status or/and to improve it. These services are many: examinations, treatments, operations, tests, medications and hotel services like meals or bed-days. However, treated patient (or solved medical problem) can be defined to be the "final product" of hospitals and to be the main base of cost control - not the outputs- being they in days, laboratory examinations or operations. These services are only intermediate inputs for the final service.

If we want to get a accurate picture on the cost of the individual treatment all the directly patient related services must be registered on the patient level when they pass through various intermediate stages from the time they enter the hospital to the time they are assigned to patients. These intermediate stages must be identified to understand the true sources of hospital costs. However, for most practical purposes the services can be defined by broader categories related to the medical problem at hand and treatment delivered because of it. Instead of the individual patient cost are related different treatment/patient groups. The most well known grouping system today is the Diagnosis Related Groups (DRG) that is widely used for hospital management and reimbursement purposes in Europe and USA.

Above two levels - individual treatment or treatment group - define how the costs can be calculated and we, therefore, have two main approaches to the costing of medical services. The first can be defined as bottom up or micro costing method that relies on the costing of all individual services and use of these services by individual patients. This is mostly based on the computerised information systems that capture all data about the use of internal services by the patient. The data needed includes e.g. services provided by operating theatres, laboratories, radiology departments, wards, laundry, kitchen etc. This costing model does not come without cost and is relatively expensive to implement because of extensive need of information and data. However, that kind of costing approach is now under development in pilot hospitals of our project.

The second approach can be called as cost modelling. As compared with micro costing, cost modelling does not normally require the collection of additional service utilisation data by individual patients and this is today the case in most Ukrainian hospitals. The process used is a "top-down" one in which the total costs associated with a hospital's operations are distributed instead of the individual patient first, to the clinical cost centres like surgical or gynaecological departments and then to service groups (e.g. diagnostic related groups, DRG) using a variety of indicators and indexes of activity and costs from hospital statistics. The relationships between costs, activities and service groups are modelled. This means that a group of simplifying assumptions has to be made about these relationships to find out the service cost estimates.

In top-dawn costing exercise the way to control and monitor healthcare costs take place through the standard cost system (point and point values). A standard cost approach develops estimates for what a service should cost at the given desired/planned levels of quality and quantity of care. Once standard costs have been developed, we can compare actual total costs incurred and case mix standardised cost. The resulting differences, called variances, can be used to evaluate a hospital performance. Three major inputs needed in a standard costing process are: identification services (disease groups like DRG), their estimated resource requirements (based on medical standards) and costing of the resources identified. That kind of process is already on the way in Ukraine. Within EU project, based on existing Ukrainian medical standards, four categories of diagnosis related groups where derived for inpatient, policlinics, primary care and dental care. This grouping will be incorporated into the information system in pilot hospitals.

Standard costs (relative value units) are developed by measuring the intensity-of-care. There exist workload measurement systems to introduce e.g. cost weights and unit values for each service that are based on e.g. time average studies. The unit value might be the average number of productive minutes of technical, clerical and idle time required to complete the defined service. When the major determinant of cost is the time used, per hourly rate approach has been used for costing: total costs are divided by the number of hours or minutes to get the average cost of one time unit. Multiplying this average cost by the units of time for a specific procedure gives the cost of that service.

Often in practice the costing projects of medical services incorporate elements both from micro costing and top down models. However, neither cost modelling nor micro costing will provide the "true" costs of treating the patients included in each group. The purpose of top down cost modelling is to provide estimates of average costs of services only on a consistent and systematic basis. This will ensure that the results are comparable between institutions, and that the results are useful for management and reimbursement purposes. Each costing model must state which cost-items are included and which are excluded. Also, we have to know how the costs that are not directly associated with patient care should be allocated, and how joint production costs are to be distributed between the various products.

Relevance of cost information

Fortunately, for management purposes the crucial issue is not whether costs are calculated precisely. More important is whether the quantity is measured correctly. With a good measure of quantity consumed, the cost measure would have to be substantially in error before it would adversely affect managerial decisions. As long as clinical managers are charged based on an accurate quantity measure, they will probably not spend much time arguing about minor fluctuations in its unit price. Instead they will act to use the quantity of the resource they consume efficiently and effectively.

If, however, we measure the quantity inaccurately managers are not rewarded or punished for the quantity of the demands they place on service departments. In this case, the use of a surrogate measure of quantity has caused the cost signal to be ineffective in motivating operating efficiencies. Thus, cost attribution to clinical departments can be performed when an accurate quantity measure exists. Fortunately, in hospitals most of the quantity measures are related to the patients treated and modern IT technology offers economic way for registration of these activities.

Consequently, if hospital management or owners or purchasing authorities wants clinical managers to promote efficiency, improve productivity, and learn more about the characteristics of production processes under their control, then they must send them accurate measures of quantities and good estimates of cost of resources consumed.