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Sand Bags and Hot Air: A Closer Look at Hospital Margins

Vizient Research Institute
12/12/17

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Tom Robertson, Executive Director, Vizient Research Institute

In the summer of 1783, two brothers from a French family of paper manufacturers, after noticing ash rising in paper fires, gave their first public demonstration of a balloon using hot air for buoyancy. On August 27 of the same year, in a Paris field where the Eiffel Tower now stands, a crowd of onlookers that included Benjamin Franklin cheered the release of the world’s first hydrogen balloon. The unmanned balloon drifted north for 45 minutes before descending in a nearby village where terrified residents attacked it with pitchforks and destroyed it.

It would be only a few months before the first manned balloons took flight; the first untethered free flight of a hot air balloon with human passengers occurred on November 21 while a manned flight of a hydrogen balloon was launched on the first of December. The physics behind those early lighter-than-air expeditions, specifically the ways they controlled their altitudes, have implications for hospitals now struggling with eroding operating margins.

After consecutive years of healthy profitability, in many cases multiple years of previously unsurpassed operating margins, hospitals are increasingly faced with sharply smaller bottom lines. The pervasiveness of the downward trend observed across multiple markets, and the relative quickness with which the downturn arrived, suggest that environmental factors may be at play. The Vizient Research Institute identified a number of converging factors contributing to the observed erosion of hospital operating margins. Considered independently, each of the environmental changes has a relatively small impact, but occurring together, the compound impact serves to undermine what turns out to be vulnerable hospital margins.

The core challenge facing hospitals is a slowing in the rate of increase in revenue. Annual increases in payment rates from commercial insurers were commonly 6 to 8 percent only a few years ago but those yearly adjustments have fallen below 5 percent for many hospitals today. Given the reliance by hospitals on commercial payment rates to subsidize losses in the government sector, this slowdown has far-reaching impact.

As baby boomers age into retirement, at the rate of 10,000 new Medicare beneficiaries per day, they move from higher-paying commercial insurers to lower-paying government programs. Medicaid expansion under the Affordable Care Act, initially welcomed almost universally by health care providers, may have arrived with unintended consequences. In addition to providing new sources of payment for the previously uninsured, the expanded coverage released pent-up demand. Academic medical centers and other hospitals that were already operating at capacity are seeing an influx of Medicaid admissions which, when the hospital is full, sometimes displace higher-paying commercial cases.

Subtle shifts in the mix of hospital admissions, with incrementally higher proportions of medical cases such as congestive heart failure or pneumonia and even slight declines in inpatient surgical volume, drive lower contribution margins per inpatient bed. Those substitution effects occur because of higher deductible benefit plans which dampen elective surgical demand, shifts to outpatient surgical settings, and the aging of the population resulting in more chronic conditions, many of which are medical in nature.

At the same time, unilateral decisions by Medicare that reclassify inpatient cases to outpatient observation status (at much lower payment rates) exacerbate the softening of hospital revenues. The observation patients are in the same beds that they occupied previously; the only thing to change was their payment rates.

It appears that the pace of cost reductions has lagged behind the rate at which revenue has slowed. Like two waves out of phase, cost reductions are chasing revenue declines. In the meantime, operating margins have fallen.

The solution to the problem can take a cue from the adventurous balloonists of 18th century Paris. When a hot air balloon begins to lose altitude, the pilot has two options, and may choose to employ both. They may toss sandbags overboard in an effort to lighten the load, or they more likely will turn up the flame, heating the air in the balloon to provide additional lift. More lift, in the form of higher prices and higher revenue, was the traditional solution for hospitals as well.

As we rapidly approach the point where cost shifting to the private sector is no longer an option, hospitals will find themselves facing the dilemma encountered by the pilot of the hydrogen balloon. Unable to add gas to the balloon, the only option is to begin throwing sandbags.

About the author and the Vizient Research Institute™. As executive director of the Vizient Research Institute, Tom Robertson and his team have conducted strategic research on clinical enterprise challenges for 20 years. The groundbreaking work at the Vizient Research Institute drives exceptional member value using a systematic, integrated approach. The investigations quickly uncover practical, tested results that lead to measurable improvement in clinical and economic performance.

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