Insights into the retail pricing strategies of 156 hospitals and health systems points to the need for a thoughtful approach to balancing prices, costs, and operating margins.

Hospital pricing strategies have become more complex in recent years due to mounting pressures from a number of parties—including patients, payers, physicians, and the business community—to compete on prices and reduce the cost to consumers. 

We have recognized that, when developing a pricing strategy, many hospitals focus first on retail services, or frequently used patient services that are delivered by multiple providers in different settings. Retail services are price-sensitive, meaning that some patients will choose where to have the service performed based on price.

We conducted a survey of hospital executives to find out more about their retail pricing strategies, pressures, and concerns. We received responses from 58 hospital executives representing 156 hospitals and health systems. Most respondents (83 percent) indicate that addressing retail pricing is of moderate to high concern.

To dig deeper, we compared the executives’ survey responses to their hospital charges and operating margins. Given the correlations that we saw, we can draw three conclusions: First, retail services face strong market pressures. Second, prices for these retail services exceed costs substantially. Finally, hospitals must balance maintaining operating margins with establishing a retail pricing strategy. 

Retail Price Pressures

When asked what services they identify as retail services, more than 80 percent of hospital executive respondents cited laboratory testing and diagnostic imaging (see the exhibit below).

Where Hospitals Are Experiencing Retail Price Pressure
Where Hospitals Are Experiencing Retail Price Pressure

Medicare cost report data helps shed some light on why many hospitals are looking to reduce prices for these services. The price-to-cost relationship for hospital services is the highest for radiology and laboratory services with prices at 7.72 times cost and 7.19 times cost, respectively (see the exhibit below). Hospitals have arrived at this large mark-up because these services are more often reimbursed on a percent-of-charge basis.

U.S. Hospital Price-to-Cost Relationships
U.S. Hospital Price-to-Cost Relationships

You will find the opposite of this in routine care where the markup is 1.41 times cost because inpatient services have generally been paid under fixed payment terms, such as MS-DRGs or per diems.

Price Pressure Versus Charges

Our survey results suggest that the greatest pressure to reduce prices comes from patients, payers, and free-standing providers (see the exhibit below).

Sources of Hospital Price Pressure
Sources of Hospital Price Pressure

Retail services, such as lab and radiology, are typically performed in the outpatient setting. Since these patients are ambulatory, they are more likely to “shop-around” for the best value. With the continued growth in high-deductible health plans, we don’t expect this trend to subside.

To provide context to the survey responses, we looked at the 2013 Hospital Charge Index® (HCI) for each hospital that participated. The HCI compares the Medicare charge per discharge and Medicare charge per visit (both adjusted for case complexity and wage index differences) to the U.S. median hospital.

A higher HCI indicates higher prices. We found that survey respondents who reported feeling strong price pressure from patients work at hospitals with the highest HCI median of 105.8, compared to a median of 95.3 for all hospitals in the survey.

Defense Strategies

When asked how their hospitals are defending their current pricing strategy (see the exhibit below), the majority of respondents report using one or more of these three strategies: 

  • By comparing their prices to peer prices
  • By showing a cost-based relationship
  • By using a value proposition (i.e., higher-quality) argument

Only 21 percent use an ROI approach, which is similar to how public utilities set their rates.

Hospital Pricing Defenses
Hospital Pricing Defenses

Looking again at HCI, we found that the hospitals using the value proposition and cost-based relationship defenses had the lowest median HCIs of 92 and 96, respectively, while those that use the ROI approach had the highest average HCI of 100.8.

Interestingly, those that use the cost or value defenses also had the lowest average operating margins of 5.6 percent, compared to those that use a peer-pricing (6.6 percent) or ROI approach (8.2 percent). Those hospitals that have kept their prices lower likely have a lower price-to-cost relationship since we found no significant differences in cost position among the hospitals that use different methods to defend their current pricing position.

We also asked executives if they believed their hospitals’ current pricing position was defensible. Sixty-four percent responded “yes,” while 36 percent said “no.” The “no” responses came from hospitals with a higher-average HCI of 101, compared to the average HCI of 96 at hospitals with executives who said their prices were defensible.

Pricing Strategies

Some of the hospitals surveyed had already implemented retail pricing strategies, while others are in the planning stages (see the exhibit below). Strategies being used include:

  • Reducing outpatient price to compete for volume
  • Reducing inpatient and outpatient prices
  • Building, purchasing, or entering into a joint venture with the competition to retain some of the volume and profit from services that have migrated out of the hospital
  • Promoting the value and quality of hospital services as a differentiator for being higher priced in some areas

Those facilities that had already created lower outpatient prices had the highest average 2013 HCI scores among the hospitals participating in the survey. We assume these hospitals recognized their position and responded by lowering prices.

Hospital Pricing Strategies
Hospital Pricing Strategies

Concerns About Margins/Revenue

When asked what was preventing a hospital from implementing a retail service strategy, the top response (80 percent) was pressure to maintain or improve operating margins. The next two reasons (tied at 62.5 percent) were uncertainty that volumes would increase enough to offset losses in net revenue and concerns that contracts would need to be renegotiated so that the hospitals did not take a hit to net revenue from reducing prices.

Interestingly, about 14 percent of respondents indicated that they could charge more than free-standing providers for their services because of better quality and/or reputation. These hospitals also had an operating margin (9.6 percent) that was almost twice the average of the group (5.4 percent).

Regarding hospitals’ desires related to retail services, 86 percent of those responding to the survey hope to experience an increase in volumes, 66 percent hope to minimize or eliminate negative publicity related to their prices, and 59 percent want to see an enhancement to net revenue as a result. Other anticipated outcomes include appeasing referring physicians (45 percent) and establishing better relationships with payers (41 percent).

Case Example

As seen in the survey results, multiple retail solutions exist for hospitals. But it is vital to analyze the potential outcome before pursuing any strategy.

We recently performed a procedure-pricing study for a rural hospital client. The hospital leaders asked us to estimate the volume increase for CT and MRI procedures that would be required to remain net revenue neutral if they reduced their prices to the state average for free-standing imaging centers.

This hospital has a majority of commercial contracts that pay on discount-from-billed charges so the net revenue impact was significant. To reduce current charges to the state average for free-standing imaging centers, the hospital would see an average price reduction of almost 60 percent.

We then determined that this hospital would need to increase volume for CT and MRI procedures by an estimated 33 percent to breakeven from such a significant price decrease. Hospital leaders were left questioning if there was even enough volume in the market to make this a reality.

A Careful Balance

This is the type of analysis that hospitals should be performing before making large price reductions. Other hospital leaders we’ve worked with thought that price reductions would have little, if any, impact to net revenue because many of their contract terms were fixed payment arrangements. But then an analysis showed that significant price reductions would cause prices to fall below the commercial fee-schedule payment rates. The hospitals would then be paid at their charge rate because it was lower than the fee-schedule payment, leaving a gap in net revenue between the new lower charge amount and the fee-schedule payment.

Hospitals must balance the need to respond to market pressures and maintain operating margins with the reality of contracted payment arrangements. All three must be carefully coordinated to avoid a financial shock.

Scott Houk, CPA, is director, consulting services, Cleverley & Associates, Worthington, Ohio, and a member of HFMA’s Central Ohio Chapter.

Sean Gardner, MBA, is regional account executive, Cleverley & Associates, and a member of HFMA’s Arizona Chapter.

Publication Date: Tuesday, June 02, 2015