People & Opinions

DRG - based contracting:
A theoretical model
for low margin
service lines

by Nalin Kulasekara, MBA

CMS continues to challenge margins that providers must make in order to remain profitable. More costly and technologically advanced medical products are being introduced at an increasing rate. Hospital providers across the nation are looking at the profitability of their service lines and asking themselves if they should continue to offer loss leading service lines. The reason some service lines are not profitable can be directly attributed to the cost of supplies. The chart below shows a few common service lines that are being impacted:

Click for full size chart

The traditional method of contracting has been to trade market share with a vendor in order to get lower prices on products. In order to achieve lower prices, most hospitals benchmark using external databases. This model has worked well on commodity type products. However, the model becomes increasingly difficult to implement on preference type products (Reference Girard Senn’s Article). Very rarely do supply chain managers look at DRG payments or the impact on profitability in the contracting process. The exception recently has been in contracting for orthopedic implants (DRG 209). Hospitals have identified that the cost of an implant must be in the region of 35% of the DRG payment if the hospital is to make the desired margins in that line of business (Guthrie et al, 2005, 42).

The method of trading market share for price really doesn’t look at the profitability of service lines. Many supply chain managers achieve savings (using historical data) by negotiating with suppliers, but we typically do not look at the impact the savings have on margins. Using Cardiac Rhythm Management products for example, supply chain managers typically want to reduce cost by a certain percentage, say 10%. Assume the total spent on CRM products for an organization is $20 million. Driving cost down by 10% will yield $2 million in savings. The savings may appear significant but unless it is linked to profitability of the service line, you really haven’t seen the full impact of your efforts.

Tying supply cost to DRG payments

With regard to orthopedic service lines, we know that for most hospitals the cost of orthopedic implant supplies have to be in the region of 35% of the DRG payment in order for that service line to be a profitable business venture. What about other service lines where the cost of a few supplies accounts for a very high percentage of the DRG? Dawn Terry RN, BSN, MBA, Senior Clinical Associate, Cardiovascular Services at Premier Inc., explains that profit margins continue to decline despite product cost savings through negotiations and utilization. She further notes that in a recent study conducted by Premier of its members the top decile performers DRG 558 (PCI with DES w/o major CV DX) had a supply cost to DRG payment ratio of 25%. These hospitals actively manage their utilization through physician involvement. The top quartile performers in the same study had a supply cost to DRG payment ratio of 31%. For DRG 552 (Permanent pacemaker implant) the top decile supply cost to DRG payment ratio was 51% and the top quartile was 54%. As it relates to DRG 515 (CRT-D w/ ICD9 codes 00.51 or 00.54), 2006 saw another reduction in DRG payments due to the elimination of new technology add-ons. Now the top decile supply cost to DRG payment ratio was 102% and the top quartile ratio was 108%.

The above analysis shows that supply chain managers and other administrative staff will need to develop savings goals and strategies in order to bring supply cost to the profitability benchmark level.

How can this model work?

Suppliers need to be profitable. Physicians need to practice medicine and providers need to offer services without incurring a loss. The challenge is that we have one type of prospective payment system. The new model of contracting will require providers, suppliers and physicians to come together in an unprecedented way and share clinical and financial data to determine the cost of products and services. It will then be possible to determine the cost of the supply items as a percentage of the DRG payment in order for the hospital to continue to provide the service. Hospital supply chain managers will need to work with their CFOs and reimbursement professionals more closely than ever before in order to continuously tie supply cost to DRG payments and ultimately profitability.

In the past, manufacturers have continued to manufacture products assuming hospitals will purchase their products as long as there is demand from patients and physicians. The focus has been to increase shareholder equity, physician marketing and patient marketing. Unfortunately, these types of supply and demand dynamics have kept the provider from having a voice in the process. Providers have been caught in the middle of having to provide service so that they don’t alienate physicians and patients. Due to the immense impact these service lines have on profitability of hospitals, the time is now for suppliers and providers to resolve the issue by tying supply cost to DRG payments. Physicians, suppliers and providers have a responsibility to keep services open and must figure out a way to continue to provide them to our patients. If this does not happen, providers will continue to question the viability of certain service lines.

Obviously, this model will not work on every service line but it does hold true for many areas where supply cost is the major factor affecting profitability or the DRG payment.

With proposed cuts in reimbursement around the corner a new model for supply chain contracting must be developed for these service lines. Otherwise, many hospitals will not be able to provide some services.

So, where do we begin?

It all depends on your situation and culture. Of the three stakeholders (hospital, supplier and physician), hospitals have to align themselves with at least one in order for this model to work. If physicians are routinely engaged in clinical supply chain decisions and incentives are properly aligned, your job will be much easier. Incentives don’t necessarily mean direct payments to physicians. They can be in the form of assisting physicians with dedicated nurses, arranging block times and specialized units for acute care and decreased paperwork (Guthrie, 2005, 3). Therefore, if the hospital and the physician leaders are aligned, implementing DRG based contracting has a much higher probability of succeeding.

On the other hand, if the hospital can align with the suppliers without involving the physician, it’s a quick win, but the probability of this happening in the current business climate is far reaching.

If the culture of your organization is not to upset the medical staff you will have a much more difficult time implementing such a program because of preference and relationship issues.

You will need to begin by collecting data with regard to your high cost service lines. Data are the building blocks for your strategy. The data will tell you if your service lines are profitable, where you need to reduce cost and by how much. You will then need to share this information with physician leaders to develop win-win strategies to implement DRG-based contracting.

GPOs can also utilize this model for contracting as well. The current method of volume/tier based contracting by most GPOs is not effective in delivering a great deal of value to members. GPOs are in a much greater position than individual hospitals or smaller IDNs to aggregate volume to develop this type of contracting model.

The potential efect of proposed changes in reimbursement

The proposed changes in reimbursement affect hospitals and not physicians. This will require hospitals to monitor physician practice (product selection) which will deteriorate hospital-physician relationships. If the proposed reimbursement changes stand profitability on these service lines will further deteriorate. Dawn Terry of Premier Inc. expects the top decile performers to have a supply cost to reimbursement ratio of 120% for DRG 515 if the proposed reimbursement reductions go through. Similarly, for DRG 558 those hospitals who had a supply cost to DRG payment ratio of 30% will now see their ratio increasing to around 40%, thus affecting profitability to an extent that is unhealthy to sustain.

This is a wakeup call to our industry. Supply costs have risen and are continuing to increase at a much higher rate than reimbursement. Shutting down heavily impacted service lines is only a short-term fix and may not be the most prudent decision. DRG-based contracting offers a way to address the root cause of this problem through collaboration by hospitals, physicians and manufacturers. HPN

About the Author:

Nalin Kulasekara is director of supply chain management, SSM Health Care, St Louis, Missouri.

References:

Guthrie, M., Senn, G., Fronberger, P. ABCs of TJR – Physician Involvement Helps Build a Profitable Program. The Physician Executive. May-June 2005, 42-47.

Guthrie, M. Engaging Physicians in Performance Improvement – American Journal of Medical Quality. July/August 2005, V.20 No. 4.

SG2 Newsletter: Cardiac Interventional, Cardiac Surgery Procedures Take Biggest Hit in CMS’ Medicare Payment Overhaul May 1, 2006

Terry, Dawn. Poster Abstract at American College of Cardiovascular Administrators (ACCA) 17th ACCA Cardiovascular Administrators’ Leadership Conference March 8 -10, 2006, Atlanta, GA