Health Systems Need to Completely Reassess How They Manage Costs

A recent Navigant survey found that U.S. hospitals and health systems experienced an average 39% reduction in their operating margins from 2015 to 2017. This was because their expenses grew faster than their revenues, despite cost-cutting initiatives. As I speak with industry executives, a common refrain is “I’ve done all the easy stuff.” Clearly, more is needed. Cost reduction requires an honest and thorough reassessment of everything the health system does and ultimately, a change in the organization’s operating culture.

When people talk about having done “the easy stuff,” they mean they haven’t filled vacant positions and have eliminated some corporate staff, frozen or cut travel and board education, frozen capital spending and consulting, postponed upgrades of their IT infrastructure, and, in some cases, launched buyouts for the older members of their workforces, hoping to reduce their benefits costs.

These actions certainly save money, but typically less than 5% of their total expense base. They also do not represent sustainable, long-term change. Here are some examples of what will be required to change the operating culture:

Contract rationalization. Contracted services account for significant fractions of all hospitals’ operating expenses. The sheer sprawl of these outsourced services is bewildering, even at medium-size organizations: housekeeping, food services, materials management, IT, and clinical staffing, including temporary nursing and also physician coverage for the ER, ICU and hospitalists. More recently, it has come in the form of the swarms of “apps” sold to individual departments to solve scheduling and care-coordination problems and to “bond” with “consumers.” There is great dispersion of responsibility for signing and supervising these contracts, and there is often an unmanaged gap between promise and performance.

An investor-owned hospital executive whose company had acquired major nonprofit health care enterprises compared the proliferation of contracts to the growth of barnacles on the bottom of a freighter. One of his company’s first transition actions after the closure of an acquisition is to put its new entity in “drydock” and scrape them off (i.e., cancel or rebid them). Contractors offer millions in concessions to keep the contracts, he said. Barnacle removal is a key element of serious cost control. For the contracts that remain, and also consulting contracts that are typically of shorter duration, there should be an explicit target return on investment, and the contractor should bear some financial risk for achieving that return. The clinical-services contracts for coverage of hospital units such as the ER and ICU are a special problem, which I’ll discuss below.

Eliminating layers of management. One thing that distinguishes the typical nonprofit from a comparably-sized investor-owned hospital is the number of layers of management. Investor-owned hospitals rarely have more than three or four layers of supervision between the nurse that touches patients and the CEO. In some larger nonprofit hospitals, there may be six. The middle layers spend their entire days in meetings or on conference calls, traveling to meetings outside the hospital, or negotiating contracts with vendors.

In large nonprofit multi-hospital systems, there is an additional problem: Which decisions should be made at the hospital, multi-facility regional, and corporate levels are poorly defined, and as a consequence, there is costly functional overlap. This results in “title bloat” (e.g., “CFOs” that don’t manage investments and negotiate payer or supply contracts but merely supervise revenue cycle activities, do budgeting, etc.). One large nonprofit system that has been struggling with its costs had a “president of strategy,” prima facie evidence of a serious culture problem!

Since direct caregivers are often alienated from corporate bureaucracy, reducing the number of layers that separate clinicians from leadership — reducing the ratio of meeting goers to caregivers — is not only a promising source of operating savings but also a way of letting some sunshine and senior-management attention reach the factory floor.

However, doing this with blanket eliminations of layers carries a risk: inadvertently pruning away the next generation of leadership talent. To avoid this danger requires a discerning talent-management capacity in the human resources department.

Pruning the portfolio of facilities and services. Many current health enterprises are combinations of individual facilities that, over time, found it convenient or essential to their survival to combine into multi-hospital systems. Roughly two-thirds of all hospitals are part of these systems. Yet whether economies of scale truly exist in hospital operations remains questionable. Modest reductions in the cost of borrowing and in supply costs achieved in mergers are often washed out by higher executive compensation, more layers of management, and information technology outlays, leading to higher, rather than lower, operating expenses.

A key question that must be addressed by a larger system is how many facilities that could not have survived on their own can it manage without damaging its financial position? As the U.S. savings and loan industry crisis in the 1980s and 1990s showed us, enough marginal franchises added to a healthy portfolio can swamp the enterprise. In my view, this factor — a larger-than-sustainable number of marginal hospital franchises — may have contributed to the disproportionate negative operating performance of many multi-regional Catholic health systems from 2015 to 2017.

In addition to this problem, many regional systems are comprised of multiple hospitals that serve overlapping geographies continue to support multiple, competing, and underutilized clinical programs (e.g., obstetrics, orthopedics, cardiac care) that could benefit from consolidation. In larger facilities, there is often an astonishing proliferation of special care units, ICUs, and quasi-ICUs that are expensive to staff and have high fixed cost profiles.

Rationalizing clinical service lines, reducing duplication, and consolidating special care units is another major cost-reduction opportunity, which, in turn, makes possible reductions in clinical and support personnel. The political costs and disruption involved in getting clinicians to collaborate successfully across facilities sometimes causes leaders to postpone addressing the duplication and results in sub-optimal performance.

Clinical staffing and variation. It is essential to address how the health system manages its clinicians, particularly physicians. This has been an area of explosive cost growth in the past 15 years as the number of physicians employed by hospitals has nearly doubled. In addition to paying physicians the salaries stipulated in their contracts, hospitals have been augmenting their compensation (e.g., by paying them extra for part-time administrative work and being on call after hours and by giving them dividends from joint ventures in areas such as imaging and outpatient surgery where the hospital bears most of the risk).

The growth of these costs rivals those of specialty pharmaceuticals and the maintenance and updating of electronic health record systems. Fixing this problem is politically challenging because it involves reducing physician numbers, physician incomes, or both. As physician employment contracts come up for renewal, health systems will have to ask the “why are we in this business” and “what can we legitimately afford to pay” questions about each one of them. Sustaining losses based on hazy visions of “integration” or unproven theories about employment leading to clinical discipline can no longer be justified.

But this is not the deepest layer of avoidable physician-related cost. As I discussed in this HBR article, hospitals’ losses from treating Medicare patients are soaring because the cost of treating Medicare patient admission is effectively uncontrolled while the Medicare DRG payment is fixed and not growing at the rate of inflation. The result: hospitals lost $49 billion in 2016 treating Medicare patients, a number that’s surely higher now.

The root cause of these losses is a failure to “blueprint,” or create protocols for, routine patient care decisions, resulting in absurd variations in the consumption of resources (operating room time; length of stay, particularly in the ICU; lab and imaging exams per admissions, etc.).

The fact that, hospitals have outsourced the staffing of the crucial resource-consuming units such as the ICU and ER makes this task more difficult. Patients need to flow through them efficiently or the hospital loses money, often in large amounts. How many of those contracts obligate the contractual caregivers to take responsibility for managing down the delivered cost of the DRG and reward them for doing so? Is compensation in these contracts contingent on the profit (or loss avoidance) impact of their clinical supervision?

These are all difficult issues, but until they are addressed, many health systems will continue to have suboptimal operating results. While I am not arguing that health systems abandon efforts to grow, unless those efforts are executed with strategic and operational discipline, financial performance will continue to suffer. A colleague once said to me that when he hears about someone having picked all the low-hanging fruit, it is really a comment on his or her height. Given the escalating operating challenges many health systems face, it may be past time for senior management to find a ladder.