Originally published in Becker’s Hospital Review

By Tony Colarossi 

The healthcare industry has struggled for years to cut excesses amid the $3.2 trillion spent annually on healthcare, but it’s time to get serious.

Incremental cuts on the order of 5% won’t make a real difference, especially given that so many have fallen well short of even that modest goal. The industry must target transformational cost cutting, on the order of 20% or more over the next five years, or struggle amid the coming dislocation.

The good news is that transformational cost cutting, while maintaining safety, quality and patient satisfaction, can regenerate a health system and empower it with a new cost-conscience mindset that can help it thrive. But from where will these cuts originate?

Amazon was expected to help bring an efficiency to hospitals through an Amazon Pharmacy initiative, although reports said on Monday the e-commerce giant was abandoning that initiative.

To date, most cost cutting efforts have focused on the 55% of health system budgets that are spent on patient care, largely ignoring the remaining 45% of spending that goes to administration, clinical support and non-cash items. This non-clinical expense provides the appropriate lens for health systems to evaluate what represents value to the consumer, and what truly is non-integral to the core mission of the enterprise.

True cost transformation, not incremental improvement, will occur by applying one of three strategies over the next decade:

• Regional Partnerships: Openness to resolving low-volume and under-funded programs through community and competitor collaboration
• Addressing Overhead: Tenacious evaluation of necessity and alternatives to administrative, corporate and support service expense, including service and space consolidation
• Target Price Costing: Creating products with requisite features in order to arrive at the maximum price (cost + margin) that a product can have to obtain market equilibrium

Targeting the right services

In the 1970s, the Boston Consulting Group pioneered the concept that a company’s business units can be classified into four categories based on their potential market growth and market share. This identifies each of these categories with an avatar: Stars are the top performing business units which should be fed capital for growth, Dogs are those that lag behind and should be rationed of capital, Question Marks call for further evaluation, and Cash Cows are those units that should be nurtured for future growth.

Modifying this matrix to apply to today’s healthcare market requires minor but meaningful revision; exchanging market share in the X axis with margin. As the industry wrestles with the generational challenges of a consumerist mind, the need to finally incorporate price (cost) into the value equation, and acknowledge that not all community health issues require a competitive solution, the traditional operating model could be visualized as four segments: Doves, Ants, Wolves and Vultures.

• Doves: Low margin/low growth services, such as behavioral health and pediatrics, where it’s difficult to obtain reimbursement that covers costs in a very distributed market. Doves benefit from expansive partnerships, and health systems should evaluate joining with community services, non-profits and other health providers to deliver these services in better, more cost-efficient manner. Whenever the health system is not the preferred provider, and is unlikely to achieve market primacy alone, partnerships enable organizations to consolidate staff in one location, centralize expertise, and improve services, when volume alone can significantly enhance margins.
• Ants: Low margin/high growth services, such as home health services and imaging, differ from Doves specifically because they are projected to grow in volume even while suffering from low margins. Ants have high-cost components to their service delivery, are performed in unnecessarily high cost space, or are performed using antiquated methodologies. Ants can also benefit from partnerships, but without a specific emotional attachment to the community, they lend themselves favorably to a commercial joint venture approach with other health systems or for-profit enterprises.
• Wolves: High margin/low growth services, such as cardiology and orthopedic surgery, where high barriers to entry mean competition will likely only come from other health systems. Leadership should work to differentiate these services while also cutting overhead to boost margins. As, on average, administrative overhead represents 25% of all system expenses, and clinical support an additional 10% — the reduction of overhead throughout the system can in itself, significantly improve margins — for example, a 20% cut in administrative overhead increases overall margins by 5%. Overhead costs are ripe for pruning, with outsourcing and reducing brick and mortar footprint representing the most direct means. The historical attachment to insourcing lags other industries focus on core mission, and reducing space brings a cascade of lower costs on everything from heating and cleaning to the number of support staff needed.
• Vultures: High margin/high growth areas, such as clinical lab services, which are likely to attract disruption from the likes of Amazon. For services designated Vultures, it’s essential that a health system orient itself to competing on price. Force pricing through managed care contracting and geographic market leverage will no longer be effective as consumers react to new service and technology breaking the traditional barriers. Implementing Target Price Costing begins with conducting market research to know what product features patients want and need, and a minimal threshold and those that they are willing to purchase under a reference pricing mechanism. Applying the product research to developing the right design will lead to configuring the maximum price the market will sustain. (For health services, that’s typically between the price paid by Medicare and Medicaid.) Finally, the health system has to optimize processes in order to deliver a service to perform and obtain the target cost and margin.

True transformation requires different expectations from both health system boards and the broader community. Boards must resolve themselves to shift their focus on growing volume and turn instead to improving margins. Communities need to understand that improving efficiencies and creating better health services is now a requirement for long-term success, not an option.

On balance, the right type of transformational cost cutting will ensure that the coming disruption to healthcare benefits everyone.

Tony Colarossi leads Plante Moran’s acute healthcare consulting services.