Friday, November 29, 2013

Simple Math with Scary Implications for Hospitals: What Value-Based Purchasing means for hospitals’ bottom lines

I spend a lot of my time exploring the drivers of top and bottom-line growth for payers. As a physician, I had a nagging curiosity to learn about what the economics look like for my (part-time) workplace. So I explored one of the biggest changes in hospital reimbursement reform, value-based purchasing (VBP).

Value-based purchasing is a reimbursement structure that is intended to reward improved clinical processes, outcomes, and patient satisfaction. In many cases, it is perceived as the inverse: a financial penalty for below average hospital performance. The following is some overly-simplified math than demonstrates how VBP works and more frighteningly, the implications of VBP for hospitals. This rudimentary analysis may serve as a useful backdrop for entrepreneurs trying to sell their software into hospitals, doctors considering how they can add value to their hospital, or patients who want to get empowered about the role of their opinion.

First, let’s start with how hospitals were paid before VBP was put in place. Medicare paid hospitals per discharge based on a diagnosis-related group (DRG) specific for a disease state. More elaborate admissions like heart surgery were reimbursed more than more benign admissions like a cellulitis.

With the introduction of VBP, hospitals will have their reimbursement go up or down depending on their performance in clinical processes, clinical outcomes, and patient satisfaction. The performance in each of these domains gets incorporated into a total performance score (TPS) for each hospital each year by Medicare. Depending on a hospital’s TPS compared to that of the national median TPS, a given hospital will have the reimbursement for each discharge systematically increased or decreased by some multiple (VBP Incentive Multiplier).

To incentivize better performance, Medicare is reducing the baseline reimbursement for each DRG by 1% starting in 2013. That reduction will worsen to 2% by 2017.

The combination of reimbursement based on the VBP Incentive Multiplier and the DRG Percent Reduction over the next few years results in the following overly-simplified formula:

VBP Incentive MultiplierHospital A =

1 + [Percent Reduction in DRG x (TPSHospital A/TPSNational Avg) - Percent Reduction in DRG]

This is where the scary part begins. Let’s fast forward to 2017 when the reduction in reimbursement for each discharge is at the full 2%. Let’s also assume that a given Hospital A is performing at an annual TPS of 25 while the national average is 50. Plugging our numbers into the above formula, the VBP Incentive Multiplier = 1 + [2% x 25/50 - 2%] = 1 + [0.02 x 0.5 - 0.02] = 1 + [0.01 - 0.02] = 1 - 0.01 = 0.99.

So in 2018, Hospital A will have each of its discharged diagnoses reimbursed at 99% of what the DRG reimbursement rate is for that year. If, for example, Hospital A has an operating budget of $100 mil, and if all of the revenue comes from clinical care (vs research funding), then Hospital A’s below-average performance would have just resulted in $100 mil x 0.99 = $99 mil actual operating budget, or a $1,000,000 penalty. With profit margins for highly profitable hospitals in the 2-3% range, a 1% hit on operating budget can be as much as a 50% decrease in the profit margin. The board of a hospital would not be happy with such numbers, the CEO may be out of a job, and more importantly, there may be less money to reinvest in expanding the hospital’s ability to serve vulnerable populations.

Let’s take a look at a slightly less gloomy scenario. I’ll return to 2013 for this example where the DRG reduction is just at 1%. Let’s assume that in 2013, Hospital A was performing above average with a TPS of 75 while the national average was 50. Plugging our numbers into the above formula again would yield a VBP Incentive Multiplier = 1 + [1% x 75/50 - 1%] = 1 + [.01x 1.50 - .01] = 1 + [.015-.01] = 1 + .005 = 1.005.

So, for 2014, Hospital A will have each of its discharges reimbursed at 1.005 times the baseline DRG reimbursement rate for that year. Assuming the same operating budget of $100 mil for Hospital A and assuming that all of its revenue comes from clinical care (vs research funding), then Hospital A’s above average performance would have turned its $100mil x 1.005 into $100,500,000 or $500,000 increase in operating budget. The resultant potential for a 25% increase in profit margin would make for a happy board, an employed CEO, and potentially reinvestment into interesting programming for needy patients.

But there’s a catch! I didn’t take into account the cost of what it would take to improve a hospital’s performance. If the hospital starts and remains above the median at the same level, it will continue to enjoy higher margins. But what about hospitals that need to improve? With improvement, in theory, the goal of VBP, underperforming hospitals have a very steep uphill battle.

For example, investments in improving clinical processes, outcomes, and patient satisfaction could include software, training, and evaluation costs, among others. Using EMR costs as a proxy for the range of cost for software, the cheaper EMRs cost about $4k per provider per year. If hospital A employes 100 providers, that's $400k per year, not to mention set up fees. My calculations are obviously over-simplified. But the point is that hospitals will have a difficult time achieving a positive ROI in the newly emerging reimbursement landscape. Even for hospitals that outperform the rest, their net gain from improving outcomes may be minimal at best.

There are many limitations to this analysis. I didn’t include the additional burden for hospitals due to the impact of efficiency metric that is due to roll out in 2015 and 30-day readmission penalties, among others.

 Although well intended, VBP has many unforeseen consequences that may disproportionally and negatively impact hospitals that serve disadvantaged patients. These unforeseen consequences and my rudimentary math exercise above are examples of why hospitals and the healthcare system as a whole may need to focus (even faster) on what happens before and after the admission.

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