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    7-2 Brookwood Medical Center

    "In 1990, a major insurer asked us to bid on performing all of their open-heart surgeries in the Southeast United States. We prepared a bid by puiling charges on all (not just Medicare) patients we had treated in the four diagnostic related groups (DRGs) and applying the hospital-wide cost-to-charge ratio. We did not get the bid and had no idea whether to be disappointed or relieved. From talks with third-party payers and major employers, we believed that by the mid-1990s we would be bidding for portions of business, like open-heart surgeries, on a regular basis. We real­ ized that we needed a much better understanding of costs at the DRG and individual patient levels if we're to be able to compete effectively."


    --Carolyn Johnson, Vice President of finance

    By the end of the 1980s, cost management had become one of the most important issues faced by Brookwood Medical Center (BMC) administrators. BMC faced pressure from managed care providers such as health mainte­ nance organizations (HMOs) and preferred provider organizations (PPOs) to keep medical costs low while continu­ ing to provide high-quality health care services. For the first time, BMC was asked to bid on specific health care services for members of managed care insurance plans. To provide bids that were competitive yet profitable, hospi­ tal administrators needed detailed cost information about specific health care procedures. In addition, Medicare and other insurance providers moved to fixed fee reimbursement schedules, paying a defined fixed rate depending on a patient's diagnostic related group (DRG) and severity level. The use of fixed payment rates provided incentives for BMC to identify costs associated with providing health care to specific patients in each DRG. Health care providers realized that reductions in the average length of stay (ALOS) as a result of shorter inpatient hospital stays and in­ creased outpatient services could decrease costs without decreasing the quality of care.

    As more payers moved to a fixed fee form of reimbursement, BMC administrators determined the existing cost system was not providing sufficiently accurate or detailed cost information. The old methodology provided aggre­ gated cost data by department; but no reliable method existed to trace costs to individual patients or diagnostic groups. The new health care environment required hospitals to compete for managed care contracts and to make strategic decisions based on a solid understanding of costs.

    Jan Kelly, Director of cost accounting, identified the following issues to support the need for a new cost man­
    agement system:

    â?¢ Unexplained variation in practice patterns. Physicians largely drove the health care delivery process through treatment protocols and medical orders that determined patient charges and length of stay. A new cost system could help identify costs associated with specific physician practice patterns.
    â?¢ Concern with costs and more appropriate care. BMC recognized the opportunity to reduce tests and proce­ dures for patients (e.g., ordering a component test rather than a whole profile on blood work). Some inpa­ tient testing and care could be effectively done on an outpatient basis due to advances in medications and other technology. Many diagnostic tests and longer inpatient stays may not result in better patient out­ comes.
    â?¢ Questions regarding effectiveness. Questions concerning the effectiveness of care, especially when evaluat­ ing new technology or treatments, were becoming increasingly commonplace. Thus. BMC required more sophisticated cost management tools.
    â?¢ Beliefs regarding cost vs. value of cure. Balancing the quality of care â?¢vith the costs of providing care was a fundamental concern for BMC. For example, if a new surgical procedure allows early discharge or little

    1 Prepared by Thomas L. Albright and Robin Cooper. C Institute of Management Accountants. 1998. Used with permission.

    scarring but costs I 0 times more than an old procedure, is it necessary for the hospital to offer the new pro­ cedure and incur additional costs? Executives had to identify a strategy for new technology and the existing methodology, management began to explore alternatives to the old cost accounting methodology. They re­ quired a cost system that would provide a product-line focus, i.e., open heart surgery, diabetes care, reha­ bilitation, or respiratory therapy, and that would permit segmentation of the patient population. Details of Mason's oncological study were reviewed, and the results reinforced the belief that costs calculated on a fa­ cility-wide basis were not helpful for making decisions that were DRG-specific.

    In March 1991, BMC executives hired an Atlanta-based CPA firm to work with Kelly to gain an understanding of departmental operating costs and to build cost stand: rds. They backloaded cost data for 20 months and identified two types of costs, direct and indirect. Meetings were held twice a week with key hospital administrators and clini­ cians to determine activities that caused costs.
    BMC used a computerized information system known as Transition I (TSI) to assist with standard costing, fi­ nancial modeling, and forecasting. The software allowed cost managers at BMC to identify activities, link activities to costs, and categorize costs based on predetermined or specific allocation bases. The system also generated simul­ taneous algebraic equations used to allocate indirect costs to revenue-generating departments. TSI allowed the crea­ tion of a database with cost and demographic information that could be sorted by both traditional and nontraditional demographic elements. Detailed information allowed BMC to obtain more accurate measurements of costs to pro­ vide care and to monitor and improve the quality of care provided to patients. For example, the patient number, length of stay, total charges, direct costs, and indirect costs for all appendectomy patients treated during a specific time period were summarized by the TSI system (see Table I).

    Direct costs could be traced to a patient or procedure and included resources consumed in providing testing ser­ vices, supplies, pharmaceuticals, and nursing care. Costs for patient testing and procedures (including X-ray, labora­ tory services, operating room costs, labor and delivery room costs) were associated with each patient, using the in­ ternally calculated direct cost for each test or procedure. Major supplies and pharmaceuticals were individually as­ signed to the patient based on the actual cost of the supply or drug.
    Nursing care costs were driven to the patient level through daily patient classification and room rate charges. These charges were based on the nursing skill level required to care for patients in each specialty area, as well as the average acuity levels in each specialty area. Nursing staff skill levels were divided into three classifications as fol­ lows: registered nurse (RN), licensed practical nurse (LPN), and aide. Examples of specialty areas were obstetrics, surgical, psychiatric, and cardiovascular. BMC divided six acuity levels according to the level of clinical attention required by the patient. For example, a direct cost of $123 per day was incurred in the Nursing-MED/SURG de­ partment acuity level 1 (see Table 2).
    The cost system produced departmental reports identifYing the daily rate by acuity level and the underlying as­ sumptions of the allocation routine (see Table 3). Because the number of minutes required to attend patients varied across acuity levels, the estimated (budgeted) volume of patient days was adjusted for daily service levels, expressed in minutes. The department's budgeted cost was allocated to each acuity level as a percentage of total budgeted min­ utes. Finally, a daily rate for each acuity level was calculated by dividing the allocated costs by the budgeted volume of days within each acuity level.

    Indirect costs such as depreciation, administrative, and general were allocated to revenue-producing activities using simultaneous algebraic equations. The calculations were performed by BMC's computerized accounting sys­ tem using allocation percentages based on the amount of services provided to other departments. The system allo­ cated costs among several departments with reciprocal service relationships. For example, assume an organization has two support departments, housekeeping, information systems (IS), and two revenue-producing departments, operating room (OR) and emergency room (ER). The IS department manager estimated the housekeeping depart­ ment consumed I 0% of the IS department's activities. while the ER and OR required 40% and 50%. respectively. Thus. the IS department's direct costs of'SlOO.OOO were allocated to housekeeping, OR, and ER consistent with the resources demanded (see Table 4). Next, the housekeeping department's direct ($60,000) and allocated ($10,000) costs of $70,000 were allocated to IS, OR, and ER using 30%, 40%, and 30%, respectively. Though the IS depart-

    ment had allocat :J all costs total $100,000 in the first step, the housekeeping department transferred costs ($21 ,000) back into the depanment that had to be reallocated in the second iteration. Iterations continued until the costs re­ maining in the support departments were too small to be significant. Thus, after multiple iterations, all support de­ partment costs were transferred to the OR and ER (see Table 4).
    The cost system used by BMC simultaneously allocated costs associated with all indirect activities to revenue­
    producing activities based on cost drivers identified by BMC. For example, the education department allocated its costs to various departments including pain management, diabetic services, and emergency room using the percent­ age of paid hours within each department as the allocation base. Though the process required multiple iterations (see Table 4), the cost management system produced reports atter each allocation iteration (see Table 5). When the allo­ cation procedure had completed the final iteration, all costs for support-related departments were contained in the accounts of revenue-producing departments. Thus, education costs were included in the emergency room indirect cost per hour of$142 (see Table 2).
    As the health care environment changed, new information demands were placed on the cost reporting system. The Mason study (discussed in the BMC Introduction) added length of stay as well as direct costs within DRG cate­ gories to the cost-to-charge ratio. According to Kelly, "TSI represented a significant step toward understanding and managing the costs of delivering health care services at BMC."

    I. Why didn't the cost data make any sense?
    2. What motivated the managers to build a new cost system?
    3. How does the TSI system attach costs to a patient or procedure? What are the major design issues?
    4. How is the daily rate determined for the Nursing Med/Surg department acuity level I?
    5. How does the reciprocal method allocate indirect costs to revenue-producing departments?
    6. Given your understanding of the manner in which TSI allocates costs to patients, would you classify Brook­
    wood's cost system as activity based?

    Table 1 Brookwood Medical Center: Appendectomy Patient Listing
    Direct Cost

    Number Length of
    Stay Total
    Charges Direct Cost
    Variable Direct Cost
    Indirect Cost
    Total Cost
    3 $8,486 751 164 1,187 2,102
    2 4 18,394 2.960 566 3,106 6,631
    3 2 7,297 926 245 1,280 2,451
    4 2 12,350 2,069 25g 1,556 3,884
    5 2 5,854 765 210 1,152 2,126
    6 3 14,574 1,966 395 2,160 4,522
    7 2 14.289 2.440 332 1.577 4.349
    8 5,772 856 102 661 1,619
    9 2 11.589 1.404 325 1,553 3,282
    10 2 8,398 1,192 365 2,045 3,601
    II 2 8,771 1,033 225 901 2,159
    12 3 14,920 2.626 295 2,546 5,466
    13 3 10,320 [,751 487 2,644 4,882
    14 3 8,871 I,O'J7 178 1,460 2,735
    15 9,103 1,998 221 1,647 3,865
    16 2 8,365 1,563 168 1,050 2,781
    17 5 13,355 2.195 687 3,237 6,119
    18 2 11.235 2.414 258 2,195 4,867
    19 8.976 1.170 201 L067 2.438
    20 5 18,033 3,123 563 3,457 7,143
    21 4 11,756 1.739 229 1,279 3,247
    22 8.068 1,698 210 1.350 3.258
    23 8.133 1.669 247 1.257 3.174
    24 7,396 1.232 160 825 2.217
    25 6,926 911 147 637 1,695
    26 7,558 1,268 188 1,141 2,598
    27 5 20,140 3,151 468 3,419 7,037
    28 2 6,211 718 167 843 1,728
    29 2 8.740 1.324 189 L212 2,724
    30 6,931 779 140 736 1,656
    31 8,493 1,345 152 1,013 2.510
    32 I 6,580 1.041 153 863 2.056
    33 2 8,646 1.328 195 1,200 2,723
    34 2 11.319 1.214 247 1,424 2.885
    35 7,435 1.042 161 817 2.020
    36 2 11,765 1.564 267 1,647 3.478
    37 9,822 1.443 165 1.143 2.752
    38 2 10,354 1,929 184 1,669 3,782
    39 3 9,117 1,117 126 1,309 2,552
    40 11.097 1.623 348 1.847 3,818
    41 9,030 900 141 859 1,901
    42 7.659 1.558 112 1.045 2.716
    43 2 9.943 1.619 174 1,217 3.010
    44 _L 11.238 J.J11 202 1.273 2.651
    Total 91 $443.309 67.688 11.017 66.506 145.210
    Source: sample of appendectomy patients from TSI data.

    able 2. DRG 470- Appendectomy Utilization Report

    Department Description Product Description Direct Cost Indirect Cost Quantity Total Cost

    NURSING - MEDISURG Acuity level I --daily rate $123.00 $190.00 $313.00
    Acuity level 2 --daily rnte 140.00 229.00 2 738.00

    OPERATING ROOM Major surgery -- I hour 174.00 170.00 344.00

    Basic surgical pack 17.00 6.00 23.00
    Additional OR supplies* 118.00 50.00 168.00

    Recovery lcvd II -- 114 hours

    Central st0re supplies*

    Blood protile. potassium. renal protile

    EKG 3 channel wlo physician in


    Incentive spirometer

    New start spirometer & oxygen 6.00 4.00 10.00

    ER visit level II -- intensive

    Daily hospital service

    Daily hospital service
    * Detail of specific items charged collapsed into one line item.

    7 _f)

    Table 3. Brookwood Medical Center, Department 6103, Nursing MED/SURG

    Budget $95,759

    Description Budgeted Volume in Days Minutes Daily Ser- vice




    Acuity level 1 18 346 ? ? ? '>
    Acuity level 2 264 394 ') ? ? ?
    Acuity level 3 199 464 92,336 0.343 $32,864 $165
    Acuity level 4 25 547 13,675 0.051 4,867 195
    Observation 165 40 6,600 0.025 2,349 14
    Observation 133 30 3,990 O.QJ5 1,420 II
    All others 211 200 42,200 0.157 15,020 71
    Total 269,045 1.000 95,759

    Table 4. Calculations for Reciprocal Service Department Allocation

    IS Service Departments
    OR Revenue Departments
    Beginning balance 100,000 60,000 0 0
    IS allocation (100,000) 10,0001 50,0002 40,0003
    Balance after allocation 0 70,000 50,000 40,000
    Housekeeping allocation 21,000 (70,000 28,0005 21,00061
    Balance after allocation 21,000 0 78,000 61,000
    2nd IS allocation (21,000) 2,100 10,500 8,400
    Balance after allocation 0 2,100 88,500 69,400
    2nd housekeeping allocation 630 (2,100} 840 630
    Balance after allocation 630 0 89,340 70,030
    3rd IS allocation {630) 315 252
    Balance after allocation 0 63 89,655 70,282
    3rd housekeeping allocation 19 (63) 25 19
    Balance after a/location 19 0 89,680 70,301
    Transfer minimal balances ( 19) 0 10 9
    Ending balance 0 0 89,690 70,310

    1$100,000 * 10%
    2 $100,000 * 50%

    3$100,000 * 40%
    $70,000 * 30%

    5$70,000 * 40% "$70,000 * 30%

    Table 5. Brookwood Medical Center, Education Allocation to Emergency Room
    Allocation base: paid hours
    Budget-- $500,000

    Department Paid Hours Percentage of paid hours by department

    Amount allocated

    Pain Management Diabetic Services Emergency Room Monitoring Services Quality Assurance Dietary
    Outpatient Registration
    All others





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    Solution Preview

    1. The cost data didn't make any sense because the cost system simultaneously allocated costs associated with all indirect activities to revenue producing activities based on cost drivers identified by BMC. For example, there was no sense in distributing the education department cost to departments like pain management, diabetic services or the emergency room. The cost data did not make sense because of the system of allocating indirect costs to revenue-producing activities based on the amount of services provided to other departments. From another point of view the cost data did not make sense because Brookwood Medical Center calculated cost for making a bid by pulling charges on all not just Medicare patients they had treated in the four diagnostic related groups and applying the hospital-wide-cost-to-charge ratio. In short the overheads were not properly allocated.
    2. There were strong motivations to the managers to build a new cost system. Major insurer's asked Brookwood Medical Center to bid on performing all open-heart surgeries in Southeast United States, however, Brookwood Medical Center lost the bid. Further, there were pressures from managed care providers such as HMOs and preferred provider organizations to keep medical costs low while continuing to provide high-quality health care services. In short Brookwood Medical Center was under pressure to make bids that were competitive and yet profitable. The motivation to build a new cost system was that the managers required detailed cost ...

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