John JohnstonRecent news about hospital margins has been increasingly worrisome. At the end of 2017, Moody’s Investors Service predicted declining cash flow for hospitals while declaring a negative outlook for the industry. And in fact, just last week they announced that the median hospital operating cash flow margin fell from 9.5 percent in 2016 to 8.1 percent in 2017, its lowest level in ten years. The Medicare Payment Advisory Commission’s latest report to Congress reported aggregate hospital Medicare margins fell to negative 9.6 percent in 2016 and suggested the 2017 run rate could hit negative 11 percent. After several years of steady margins for not-for-profit hospitals and health systems, margins appear to be taking a downturn, and the issues are unlikely to be short lived.

Moody’s cited several factors underlying its negative outlook: low Medicare rates, declining commercial rates, and shifting of care from inpatient to outpatient locations are having a major impact on top line revenue, and few—if any—industry experts expect them to reverse course. Similarly, the forces driving higher costs—investment in physician practices, escalating pharmaceutical prices, and shortages in nursing labor—also appear to be settling in for the long haul.

All these developments mean we have to take a hard look at costs today, but with an eye to success in the long game. For many of us, it feels like we have been here before, and we must ask ourselves some difficult questions: How far can we push costs down before we get to rock bottom? What can we do differently to reduce costs in way that’s truly sustainable? 

In this new normal of margin pressure, hospital leaders cannot afford to be complacent about costs. We must adopt a posture of constant—and more aggressive—cost containment if we are to protect future margins. Last week at a conference, one finance executive of a large West Coast system described their financial situation this way: “In order to keep up, we need to cut at least $20 million out of our cost structure every year going forward.” It’s essential to move beyond short-lived cost-cutting initiatives and campaigns, and develop instead a strategy and an infrastructure that prioritizes high-impact changes that will continue to yield savings year over year. 

The next issue to address is where to find cost savings after years of tackling cost reduction. Although the specific answer to this question will depend on many variables, there is still a fairly consistent level of meaningful cost savings that can be achieved within five major areas of hospital operations: labor productivity, supply chain, purchased services, administrative overhead, and clinical care delivery. Although it’s certainly true that most organizations have already made cuts in these areas, there is still much room to improve.

Labor productivity is a prime example of the opportunity to be more rigorous. In the past two years, median productivity benchmarks have been getting more aggressive, so a department currently meeting a benchmark productivity target that was set more than two or three years ago may well have room to improve. 

It also is all too common for hospitals to allow all sorts of exceptions when comparing performance with benchmarks under the guise of being unique. A health system in the Northeast recently revisited its productivity targets and found substantial savings by being more rigorous—first, by updating its productivity targets using current benchmarks, which disclosed more than 80 FTEs of opportunity. Another consideration was that more than 10 percent of its total FTEs belonged to cost centers that did not have to meet productivity targets because they had previously been deemed exceptions. By taking a new look at these cost centers, the health system was able to identify another 50 FTEs of opportunity.

In purchased services, many leaders believe they have already captured the lion’s share of savings by outsourcing some services and functions. But in many cases, they have been missing out on significant savings because they have not pushed these contracts as far as possible. 

Several years ago, for example, a mid-size health system in the Southeast negotiated with a major vendor for a performance-based management contract for food and environmental services that yielded savings of $1 million through staff reductions and lower supply costs, as well as an additional $1.5 million investment in upgraded retail and patient dining. Leadership was very satisfied with the arrangement, so when it was suggested a few years later that they review the contract, they were skeptical that additional savings could be achieved. 

But through a very careful review, the system was able to win even more favorable terms on a five-year extension. With the new contract, the arrangement moved to a full-service model, with 400 of its hourly staff transitioning to the vendor’s payroll. This move generated an additional $900,000 in annual savings. The system was careful to make sure the affected employees were kept whole; not only did these employees keep their positions, they also retained their current hourly rates and original hire date and tenure and received an employment guarantee for 12 months. Finally, the system also secured another $1.4 million in investment for dining spaces, and established performance incentives to ensure the vendor met continuous performance improvement goals.

Health systems have taken millions of dollars out of their cost structures in the past. Astute leaders will look for savings everywhere, including places where they achieved savings in the past. And they will need to reinstill a rigorous cost discipline that will push their teams to drive meaningful savings that will bring year over year benefit to their organizations.


John Johnston, CPA, MHA is senior vice president at Optum Advisory Services, Washington, D.C.

Publication Date: Wednesday, May 02, 2018