What Is Cost in Health Care?

May 26th, 2015 / By Kristine Daynes

Although cost is a common topic in health care, it is not commonly understood. As one man’s trash is another man’s treasure, similarly, in health care, one man’s cost is another man’s gain. Costs to a payer become revenue for a care provider, as do the co-payments and other shared costs paid by consumers. The perception of “cost” depends entirely on who is paying. Not only that, the definition of cost depends on who is measuring. And everyone measures it differently.

Payers historically have considered whatever they pay out as cost. With the shift to value-based care, they are moving toward a system-wide view called total cost of care (TCC). TCC aggregates the actual costs of all services and materials used in the delivery of care. This includes the portion of cost paid by the insurer and any co-payments or other out-of-pocket expenses paid by the patient. TCC spans all service settings too, from physician visits and testing through inpatient admissions to ambulatory follow-up care and prescriptions. TCC allows the overall experience of care to be evaluated against the overall cost of care. This is especially useful in making sure that costs aren’t merely shifted from one care setting to another or from one stakeholder to another.

Cost is a different metric to a hospital or physician. In other business sectors, cost usually means the cost of producing goods or services. In health care, though, a provider is likely to think of cost as some ratio of listed charges (the price he charges to a payer) or as some portion of reimbursement (the discounted payment he receives from the payer). That is because cost-plus and fee-for-service payment systems encourage providers to focus more attention on optimizing reimbursement than on measuring internal costs. As a result, many providers have developed only rudimentary ways of allocating costs to individual services (such as applying the average cost to charge ratio). They lack cost accounting systems to accurately measure their actual expenses for different types of services and procedures.

Charges do not correlate with the real cost of providing care. In fact, a recent analysis on charge-setting practices shows that the average mark-up on charges is over three time the overall operating costs. In 2011, $1,000 in cost was typically charged at $3,430. We know that U.S. hospitals don’t have an operating income 2.5 times their operating costs. That means the charges have to be grossly out of line with real costs, or that hospitals don’t accurately measure (or report) their internal costs. Whatever the explanation, it suggests that using an average cost-to-charge ratio to estimate the cost of delivering care is very, very inaccurate.

Patients and consumers are slowly gaining better price transparency, or visibility into the costs of care. For example, Catalyst for Payment Reform reports that 97% of health plans have a cost calculator for consumers to estimate out-of-pocket expenses. But public information on health care costs can still be very confusing. Published costs for common medical procedures use widely different methods. It’s often not clear whether the costs represent the full procedure, including anesthesiology, medications, and medical equipment. Publishers rarely show how costs can vary based on the patient’s underlying health or the risk of complications. Some websites report averages based on Medicare rates. Other organizations use the charge description master. A handful of states, non-profits, and Internet companies offer pricing information based on insurer data such as submitted claims or rates paid by insurers to providers.

One type of cost that is invisible to consumers and easy for payers and policymakers to overlook is the administrative cost of managing health care. The Commonwealth Fund estimates that 25% of costs in the U.S. are associated with coding, billing, and other administrative activities such as securing capital funds. The U.S. has the highest rate worldwide. Unfortunately higher administrative costs are not associated with higher quality of care. They are due directly to the complexity of negotiating with, billing, and reporting to multiple payers.

Health care reform needs to promote more consistency in how costs are measured and discussed. Reforms also need to eliminate some of the wasteful cost and undue complexity of our multi-payer payment system—not add to it. The degree of true cost transparency, and whether it makes U.S. health care better, depends on several factors, especially:

  • Access within a service network to claims and cost data by facility, provider, and medical procedure, including medications and medical equipment
  • Ability of hospitals, care facilities, and physicians to calculate operating costs by unit of service
  • Standardized ways to calculate and report costs and prices
  • Payment systems that encourage spending on preventive and necessary care

Kristine Daynes is marketing manager for payer and regulatory markets at 3M Health Information Systems.