International Journal of Health Care Quality AssuranceEmerald Article: Hospital cost structure in the USA: what's behind the costs? A business caseCharu Chandra, Sameer Kumar, Neha S. Ghildayal

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Hospital cost structure in theUSA: what’s behind the costs?

A business caseCharu Chandra

Department of Management Studies, College of Business,University of Michigan-Dearborn, Dearborn, Michigan, USA

Sameer KumarDepartment of Operations and Supply Chain Management,

Opus College of Business, University of St Thomas, Minneapolis,Minnesota, USA, and

Neha S. GhildayalSchool of Public Health, Division of Health Services Research,

Policy and Administration, University of Minnesota, Minneapolis,Minnesota, USA

AbstractPurpose – Hospital costs in the USA are a large part of the national GDP. Medical billing andsupplies processes are significant and growing contributors to hospital operations costs in the USA.This article aims to identify cost drivers associated with these processes and to suggest improvementsto reduce hospital costs.

Design/methodology/approach – A Monte Carlo simulation model that uses @Risk softwarefacilitates cost analysis and captures variability associated with the medical billing process(administrative) and medical supplies process (variable). The model produces estimated savings forimplementing new processes.

Findings – Significant waste exists across the entire medical supply process that needs to beeliminated. Annual savings, by implementing the improved process, have the potential to save severalbillion dollars annually in US hospitals. The other analysis in this study is related to hospital billingprocesses. Increased spending on hospital billing processes is not entirely due to hospital inefficiency.

Research limitations/implications – The study lacks concrete data for accurately measuring costsavings, but there is obviously room for improvement in the two US healthcare processes. This articleonly looks at two specific costs associated with medical supply and medical billing processes, respectively.

Practical implications – This study facilitates awareness of escalating US hospital expenditures.Cost categories, namely, fixed, variable and administrative, are presented to identify the greatest areasfor improvement.

Originality/value – The study will be valuable to US Congress policy makers and US healthcareindustry decision makers. Medical billing process, part of a hospital’s administrative costs, andhospital supplies management processes are part of variable costs. These are the two major costdrivers of US hospitals’ expenditures that were examined and analyzed.

Keywords Hospitals, Cost drivers, Cost analysis, Health services, United States of America

Paper type General review

IntroductionUS healthcare costs are increasing at a rate roughly three times inflation. In 2008,the US healthcare industry was estimated to be worth $2.3 trillion or 16.5 per cent of

The current issue and full text archive of this journal is available at

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Received 29 August 2009Revised 10 December 2009Accepted 23 December 2009

International Journal of Health CareQuality AssuranceVol. 24 No. 4, 2011pp. 314-328q Emerald Group Publishing Limited0952-6862DOI 10.1108/09526861111125624

gross domestic product (GDP) and is projected to be 17.9 per cent or $2.6 trillion by2010 (Foster and Heffler, 2009). In 2008, 43.8 million US people were uninsured – 17 percent of the total population, up 6 per cent from 2000 (Centers for Disease Control andPrevention, 2009a). In 2008, employer health insurance premiums increased 5 per cent– two times the rate of inflation. The annual premium for an employer health plancovering a family of four averaged nearly $12,700. The annual premium for singlecoverage averaged over $4,700 (The National Coalition on Health Care, 2009). Table Ishows US national health expenditure and GDP projected to 2010. It also showsnational health expenditure as: GDP percentage; and expenditure per capita, whichshows an alarming growth trend over 50 per cent and the health expenditure per capitaover 45 per cent, respectively. Healthcare is currently a major fiscal problem. If thistrend continues to 2010 and beyond then corporation managers will stop offeringhealthcare (some already have) to employees, or they will keep passing along premiumincreases to employees as many currently do (Murdock, 2008). If the healthcare burdenis left in the average consumer’s hands then it will cripple the economy. Approximately44 million US people either cannot afford healthcare, or simply do not have healthcarefor some reason. Consequently, they use hospital emergency rooms as their familyclinic (Lavey, 2006; Centers for Disease Control and Prevention, 2009b). This isobviously more expensive and inefficient than seeing a clinic family practice physician(Taheri et al., 2000). But, more importantly, it takes precious time away from patientswith potentially life-threatening problems.

The US healthcare rising cost trend will continue unless the industry can find waysto reduce the burden placed on the consumer. People cannot continue to affordhealthcare at this increasing rate. One way to accomplish affordable healthcare is tofind ways to reduce costs and run a more efficient operation (Woolhandler andHimmelstien, 2007). Hospitals comprise about 30 per cent of the healthcare industry’sexpenditure (Figure 1). We examine healthcare’s rising costs, specifically related tohospital expenditure and focus on key hospital operations. Costs are broken down intofixed, variable and administrative overhead and spending – areas that are mostout-of-control. Medical billing and supplies processes are significant and growingcontributors to US hospital costs. We identify cost drivers associated with theseprocesses and suggest improvements to reduce hospital costs in the medical billing andsupplies processes areas. We use Monte-Carlo simulation models to analyze costsassociated with medical billing and supplies processes. These models provide lowerbound saving estimates for implementing improvements in these processes used in UShospital operations.

We examine the following questions to determine where hospital spending can besuccessfully trimmed: what hospital cost is fixed, variable and general overhead? Whathospital spending can be better controlled? How can the spending be controlled andwhat savings can be quantified by analyzing hospital spending?

Current industry trends: hospital costsCurrent industry trends reveal escalating healthcare costs. The entire US healthcareindustry accounts for 16-17 per cent, or approximately $1.9 trillion dollars GDP (Goldand Diller, 2006). Of that, hospital costs comprise roughly 30 per cent, which increasedover 9 per cent per year for the past five years and continue to increase (NationalHealth Expenditure Data, 2004-1960). There are three major expenses in a hospital:

Hospital coststructure in

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315

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Table I.Healthcare industryindicators

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(1) fixed;

(2) variable; and

(3) administrative/overhead costs.

We define administrative costs as non-patient contact costs incurred by hospital staff.These are non-revenue generating activities that need to be allocated to the revenuegenerating departments and are typically allocated according to users in eachdepartment or by facility space department staff use. There are some argumentsregarding costs that comprise administration: maintaining medical records; medicalrecords filing; billing; nursing administration; general and administration departments(IT, finance and plant operations); supplies ordering; and central services. A 2003 studyshows that hospital administrative costs range from 19.3 per cent to 24.8 per cent(Mehrotra et al., 2003). The US hospital administrative costs are approximately 8.4 percent to 11.1; 60 per cent higher than Canada’s and 97 per cent above Great Britain’s(Mehrotra et al., 2003). There are several reasons that US administrative costs are highrelative to other countries. Its insurance system consists of more than 1,500 serviceproviders through which insurance can be obtained. Each company markets, createsand sells its own insurance to US individuals and companies. To complicate mattersfor hospitals and their billing departments, most carriers have different billingrequirements (Mehrotra et al., 2003).

Hospital variable costs are expenses that vary by patient with different medicalneeds. In other words, variable expenses can be viewed as expenses that are outside thephysicians’ control. Examples include: laboratory tests; medications; medical suppliesand nursing expenses. Variable expenses account for approximately 35 per cent to 42per cent of total patient expenses (Roberts et al., 1999). Variable hospital expenses are asignificant issue for hospital managers who are reluctant to make changes to the wayvariable spending occurs because cutting them compromise patient care. Supplies arethe second largest expense for hospitals after salaries (McGourty and Shulkin, 2005).The problem is that many hospital managers allow each department to purchase theirown supplies, causing them to act independently creating wasted time and spending. If

Figure 1.Historical and forecast

NHE and hospitalexpenses for the USA

(1995-2010)

Hospital coststructure in

the USA

317

staff in each department order their supplies then managers lose purchasing power.Hospital staff rely on nurses and doctors to manage inventory as well as patient care,the latter is where clinicians’ focus should be.

Fixed and administrative costs are the most difficult to differentiate. Because offixed costs’ nature, these are also the most difficult spending areas to control. For ourpurposes, fixed costs are related to equipment amortization, facilities, building leases,utilities and building maintenance. Capital expenditure amortization can be affectedthrough capital spending cuts. Conscientious employees and corporate awareness canhelp curb utility expenses. Building leases are not changeable unless one can take lessspace or somehow adjust the contract. Building maintenance is a requirement and anongoing expense that is hard to control. Hospitals can keep the building wellmaintained to avoid extremely expensive unexpected repair costs. For these reasons,we focus on the variable and administrative costs. In the short term, there is more valuethat can be extracted from those two cost categories. Based on administrative andvariable costs data, it can be deduced that hospital fixed costs comprise 34 per cent to46 per cent of hospital expenses. These costs to change the way hospitals operate.Hospital managers have very little profit margin, not because their revenues are flat ordecreasing, but, because their costs are increasing at a rate more than three timesinflation. Each year, hospital costs are becoming a larger percentage of US GDP. By2010, healthcare costs will be nearly 20 per cent of GDP. In a country where, for themost part, people are wealthy, there is a concern because 45 million people cannotafford to buy healthcare (Lavey, 2006). We look at some specific expenses that can bereduced through more efficient operations and waste elimination. We use a statisticalmodel with scenario analysis to determine the potential savings related to changes inthe way hospitals treat their medical supply procurement process. The model is alsoused to determine potential savings related to hospital administration costs includingbill processing and the insurance claim process. These two spending areas wasteprocessing time and money spent. This model clearly pictures potential savings andsince scenario analysis is being used, there will be a most likely outcome and best andworst-case scenarios.

MethodWe use @Risk Program (2007) Monte Carlo simulation modeling software, which is anadd-on tool, with a spreadsheet interface to run scenarios. Various business scenariosare studied to understand possible outcomes using average estimates and adding anelement of variability to them. By adding variability to the modeling, we can come upwith expected outcomes to give a more realistic view how the proposed changes affecthospital costs. Owing to hospital operation complexity, we model two businessprocesses. The first looks into the medical billing (administrative costs) and the secondmedical supplies (variable costs). There is other Monte Carlo simulation modelingsoftware having similar capabilities as @Risk. Standard statistics tools used toproduce similar results (Figures 2 and 3) will require more elaborate efforts comparedto @Risk or other similar software such as Crystal Ball, which are specificallydesigned to carry out Monte Carlo simulation and regression sensitivity analysisshown in these figures. Results shown in Figures 2 through 5 are based on runningMonte Carlo simulation using @Risk simulation modeling software.

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The first model reviews the hospital medical billing process – a process that is anadministrative expense because it is related to non-patient activities done behind thehospital scenes. Hospital administrative costs run around 19 per cent to 24 per cent oftotal hospital costs, which is significantly higher than other modern hospital coststructures. The reason this process is significant to analyze is because of the

Figure 2.Supply process modelresults for 2000-2004

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319

processes’ cumbersome nature. There are more than 1,500 US companies that marketand sell health insurance, which have multiple products that further compounds theconfusion – a problem primarily because most companies have their own billingrequirements as well. All insurance companies do not require the same data. Hospitalmanagers remain flexible and abide by this process because as a for-profit business

Figure 3.Medical billing processmodel results for2000-2004

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entity they need customers to generate revenue and remain profitable. The burdenhas been placed on hospital staff to comply with insurance carrier requirements.Figure 6 illustrates a Monte Carlo simulation model used to estimate total annual UShospital medical billing cost savings based on available estimates of various inputparameters.

The second model reviews hospital supply processes. Supply expenses are part ofthe hospital’s variable costs – a significant statistic to consider because hospitalsupply expense is the second largest next to salaries ( Johnson, 2004). Supply expensescomprise 18 per cent of US hospital total operating expenses (Editor, 2005). We look at

Figure 4.Estimated minimum,

average and maximumsupply cost savings for

years 2000 to 2004

Figure 5.Medical billing savings

(minimum, mean andmaximum) per year

Hospital coststructure in

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321

hospitals’ current inefficient supply process and offer a solution to make this processmore efficient and save hospitals significant capital. The model uses the streamlinedprocess and scenario analysis introducing variability in an attempt to measure costsavings. The reason supplies expense is an important factor is not only becauseexpenses are so high but also the process is inefficient. Most hospital managers let eachdepartment handle their own supply ordering. Hospitals lose buying power and fail touse centralized purchasing department staff expertise. Doctors and nurses spend hoursordering supplies, thereby taking away significant time from patients. Using theprocess in this article, hospital managers will be able to free time and use a moreefficient process (Efficiency cure, 2004). Figure 7 illustrates a Monte Carlo simulationmodel that estimates total annual US hospital supply cost savings based on availableestimates of various input parameters.

Figure 6.Monte Carlo simulationmodel for total US hospitalmedical billing savings

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AnalysisIn the current supply procurement process, departments operate independently whenpurchasing supplies and assuring adequate stock. Hospitals operate this wayprimarily because different departments need different supplies and doctors andnurses may prefer different product brands. This sounds a reasonable approach atfirst, but, from an operational perspective, there are many problems. First, the basicsupply needs in different departments are primarily the same. Department-specificitems are what differentiate them. Second, having nurses and doctors order suppliescauses concern. Supply chain processes in hospitals should be centralized. It will bemore efficient and less expensive than the current process. Hospital departments areoperating in silos as decentralized functions. They need to have communication andconsistency between departments to create an efficient supply purchasing

Figure 7.Monte Carlo simulation

model for total US hospitalsupply cost savings

Hospital coststructure in

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environment. The centralized supply chain process will effectively integrate theprocurement activities across all departments in a hospital as it will force economy ofscale, economy of scope and improved negotiating capabilities with suppliers for theentire hospital operation (Efficiency cure, 2004). Both hospital supply chain processefficiency and effectiveness will be enhanced through centralized supply procurementbusiness model. This process, however, is not without costs. To implement this processhospital staff may have to invest in inventory management and automated supplyordering systems. However, these two systems will free up time for doctors and nursesso they are able to focus solely on patient care. Hospital managers will need to hire afull-time experienced supply manager in charge of the entire vendor maintenanceprocess, vendor management procurement process, terms and conditions negotiation,etc. This process also allows the materials manager to consolidate suppliers, reducebrand variation and total items and makes the process more efficient (Contino, 2001).

Variable hospital costs are approximately 35-42 per cent of total hospital costs(Roberts et al., 1999; Alexander, 2006). Supplies are the second largest hospital expenseat 18 per cent of operating expenses (Editor, 2005). Using @RISK software to estimatecost savings allows users to provide value ranges for any analysis (we use 2000-2004spending data). Table II lists various inputs to the supply cost model. The variable costpercentage is the mean value of the ranges given in the literature. Using the @RISKsoftware, a distribution is fitted to the variable cost percentage that coincides withvalue ranges given. Estimated cost savings is a per cent savings estimate after processimplementation discussed above. Savings are conservatively estimated at 10 per cent.There is also a slight distribution fit to the expense savings to give that value somevariability.

The first graph in Figure 2 depicts outcome values based on the above data.Standard deviation varies because the potential savings are relatively unknown, butare perceived to be potentially large. The graphs were done using a lognormaldistribution because multiple factors affect the three input variables. Distributionshows that with 90 per cent certainty, the result, based on these inputs, byimplementing the new supply process, will save between $3bn and $20bn dollars peryear – significant savings that cannot be ignored. The second graph in Figure 2 is aregression sensitivity tornado graph, which highlights the variables that carry themost weight in the outcome analysis. In the healthcare example, estimated expensesavings variable is the biggest cost savings driver by a significant margin.

Our second analysis is related to hospital medical billing processes and relatedexpenses that are part of the hospital’s administrative expenses. We saw earlier thatthe hospital administrative expenses are 19 per cent to 24 per cent of total hospitalexpenses (Mehrotra et al., 2003; Alexander, 2006). The medical billing process iscumbersome and costly to hospitals. Data in Table III were used as inputs to themedical billing process cost model. Hospital managers have to make sure that different

Input variables Estimated averageVariability

(standard deviation)

Percent hospital care of total healthcare expense 30 5Supply cost per cent of total hospital expenses 18 2Estimated per cent cost savings 10 5

Table II.Inputs to the supply costsavings model

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paperwork and requests from each insurance company are correct so they will bereimbursed for their services. Salary per employee was gathered from the Almanac ofHospital Financial and Operating Indicators (Alexander, 2006).The salary informationwas adjusted for wage index and reduced to account for the medical billing specialist’slower wage. A statistical distribution was fitted to the medical biller’s salary to accountfor salary variability. We also looked at Medical Biller Salary (2006) on Salary.com.The time savings was an estimate based on the process’s cumbersome naturedescribed in the literature. This conservatively estimates the time saved. A distributionwas also fitted to this number to account for time saving variability. Full-timeemployees was also estimated and averaged based on hospital size. Some variabilitywas also added to this figure because hospitals are managed differently and thenumber of employees needed for billing can vary greatly.

The model’s average savings were $900 million to $1 billion dollars a year bystreamlining the medical billing process. The distribution graph in Figure 3 shows thatwithin a 90 per cent certainty, based on information in Table III, savings resulting fromstreamlining the medical billing process will be within $300 million to $2 billion dollarsannually, which are significant. The regression sensitivity tornado graph in Figure 3shows that the estimated time saved carries most weight. The next largest factor isemployee number and the salary per employee is least.

Figure 5 shows estimated minimum, mean and maximum medical billing expensesavings for years 2000 to 2004.

Findings and limitationsHealthcare industry spending, specifically hospitals, can be improved. We have lookedat three types of hospital spending:

(1) administrative;

(2) variable; and

(3) fixed costs.

We examined medical billing process and expenditures specifically, which are part of ahospital’s administrative costs. The other analysis was related to hospital suppliesexpense processes, which is a variable cost. Based on our research, those two specificcosts were the most problematic that needed to change. Data gathered in the literature,supported by our analysis, show that changing the medical supply process has asignificant impact on the industry. Waste is endemic to the entire process and needs tobe eliminated. We believe that improving processes will likely result in a cost savingsbetween $2 and $20 billion. Our other analysis – the hospital billing process – showedthat increased spending in this area is not entirely a hospital inefficiency fault. The

Input variablesEstimated input

(mean)Variability

(standard deviation)

Medical billing salary (salary.com) ($) 26,813-30,287 3,000Estimated time saved (%) 30 10Medical billers (employees) 15 4.5Number of hospitals (from US Census Bureau, 2005) 7,569 0

Table III.Medical billing process

inputs

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health insurance industry with their multiplicity of complex requirements andadministrative paperwork is a primary factor. But, hospital managers need to confrontthe insurance industries. The US administrative costs are double Canada’s, so bystreamlining medical billing processes, we believe that hospitals could save $600-$700million annually. However, we were limited by meager concrete and current data forestimating cost savings. We were still able to estimate significant lower bounds forannual savings from Monte Carlo Simulation model based on available data byimproving hospital supply and billing processes in the US healthcare delivery systemfacing increasing operational inefficiencies and rapidly escalating costs every year.

We make two recommendations; first, hospital managers need to implement thenew supply chain process immediately. Let clinicians do what they are paid to do andtake care of patients. There is a need to hire full-time supply chain managers to handleand monitor the entire process through an inventory tracking and automated orderingsystems, which increases buying power. Our second recommendation is to make themedical billing process consistent and cohesive, which increases process efficiency andreduces potential errors. We covered only two specific types of spending. A morecomprehensive hospital cost and process study should be done to ensure the greatestefficiency. More detailed research is needed to examine healthcare system successes inother countries. Plans to change US healthcare should be based on proven methodscurrently in operation to ensure feasibility and cost efficiency. The US serviceproviders cannot afford to let healthcare costs escalate. If significant changes are notundertaken to improve this economic sector then this industry will continue to affectthe US economy negatively.

ConclusionOur study points to an awareness of increasing US hospital operation costs. The UShospital total operation expenditure fell into three categories: fixed; variable andadministrative, which helps us identify the areas for greatest improvement. We tried toelevate this awareness to a level where action is undertaken. Solving the problem isvital to healthcare and the US economy, overall. We only looked at two specific costsassociated with medical supply and medical billing processes, respectively. There aremany other costs to consider and analyze. Using a simple Monte Carlo simulationmodeling framework, we identified major cost drivers within a US hospital associatedwith the processes we studied. The model showed significant potential savings inhospital operations. Inefficiencies can be corrected in an effort to stop US healthcarecosts escalating.

We looked at US hospital spending trends, which are alarming. Healthcare, the US’largest industry, is 16 per cent of GDP and hospitals are 30 per cent of the healthcareindustry and growing rapidly, around 9 per cent per year. We looked further intohospital and two particular costs, namely, the medical billing process (administrative)and the medical supplies spending (variable) were then analyzed. For each cost weanalyzed, @RISK Monte Carlo simulation modeling software was used to simulate thepotential savings from process streamlining. The medical billing process is a challengeand hospital managers need to confront insurance carriers who have complexprocessing claim procedures. A streamlined process will cut hospital administrativecosts significantly. The medical supplies spending process has the greatest savingspotential.

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Most hospital managers allow departmental staff to purchase supplies. Investing inan automated supply ordering system and a supplies manager allows nurses anddoctors to concentrate on patient care. A supply chain person would streamline theprocess, reduce costs, utilize buying power by negotiating lower pricing and add otherpotential benefits to hospitals. Hospital spending is out of control, but the good news isthat this is known. There is time to correct this trend before the problem worsens. Allhospital processes need to be streamlined into the most cost effective method whileallowing the highest patient care level possible. That is really the bottom line.Americans want to say that they have “quality, affordable healthcare”.

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Corresponding authorSameer Kumar can be contacted at: skumar@stthomas.edu

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