Two fundamental items of financial data needed by a hospital manager are allocated costs by cost center (a program or department within a hospital) and the unit cost of hospital services. A unit of hospital services may be as small as one meal, or as broad as an entire inpatient stay. This topic explains how to allocate costs by cost center and how to compute unit costs. To perform these calculations precisely, the hospital needs an accurate and comprehensive financial accounting system. In many hospitals, however, existing accounting systems have gaps, such as excluding some costs or lacking the data to relate the costs to specific cost centers. In these cases, estimates are needed. This topic provides a number of suggestions for generating such approximations. It is organized based on seven steps for computing unit costs. The steps are:
1. Define the final product.
2. Define cost centers.
3. Identify the full cost for each input.
4. Assign inputs to cost centers.
5. Allocate all costs to final cost centers.
6. Compute total and unit cost for each final cost center.
7. Report results.
1. Define the Final Product
Define the Final Product of the Cost Analysis
What are the services or departments for which you are interested in computing unit costs? For example, do you want to know the unit cost for all inpatient services, or a separate unit cost figure for each ward or service? The decision will depend on two key questions:
Purpose of the Analysis: If you want to do a comparison of costs of certain hospital departments, you will want to compute unit costs for each department separately. If you wish to compare multiple hospitals with similar caseloads (e.g., all district hospitals within a particular state or region), it may be sufficient to compute a single unit cost for all inpatient care for each hospital.
Type of Data Available: Your ability to compute unit costs will be constrained by how aggregate or disaggregate the available data is for both costs and utilization. For example, in order to compute unit costs by ward, you would need to have at minimum utilization data by ward (e.g., actual total patient days for each ward for a particular budget year). If these data cannot be broken out by ward, it will make more sense to compute unit costs at the next higher level (e.g. all inpatient wards or units that house internal medicine patients or surgery patients).
In some cases, it may be unclear whether to compute a separate unit cost for a certain activity, or allocate its costs to some other output. For example, some studies have computed separate unit costs for lab and radiology departments, thereby excluding those costs from the cost per inpatient day or discharge. Others have treated lab and radiology as intermediate outputs, and fully allocated their costs to the inpatient cost centers. Again, the desirability of each approach depends on the purpose of the analysis, but it is important to be consistent. It may even be desirable to report results in both forms.
Units of Output: For each final cost center, one must define the unit of output (e.g., inpatient day, admission, and visit). For inpatient care, the usual choices are inpatient days or admissions. For outpatient care, number of visits is the unit of output. A variety of other output units have been used for other cost centers. Examples include the number of tests or exams (for laboratory and x-ray departments), the number of operations (for operating theaters), and the number of prescriptions (for pharmacy departments).
Data Period: One can analyze unit cost based on data for a single month, a quarter, or a year. The data period chosen will depend first upon how the available data are organized. Sometimes important data such as utility costs are only available on an annual basis, and to do a quarterly analysis, one would have to make assumptions about use patterns within the year. In such situations, it may make more sense to analyze data for a whole year rather than for each quarter.
A second consideration in the choice of the data period is the purpose of the analysis. If managers are trying to understand a rapid recent change in costs, then quarterly or monthly analysis may be appropriate. However, if the aim is to compare a particular hospital's costs to other hospitals, or fees paid by patients treated at similar health care settings, it may make more sense to use a longer time-period. Using annual data may help to "equalize seasonal variations" since each hospital is affected by these factors differently.
2. Define Cost Centers
The next step for computing unit costs is to determine the centers of activity in the hospital to which direct and/or indirect costs will be assigned. The major direct cost categories of most departments include salaries, supplies, and other (purchased services such as dues, travel, and rents). Indirect cost categories include depreciation and allocated costs of other departments.
The rationale for choosing centers of activity that correspond with the hospital's organizational and/or accounting structure is managerial. Hospitals are organized into departments and, since we want to strengthen the management of these departments, it is useful to have cost centers that correspond to the existing organizational structure of the hospital. This provides: (1) the road map by which costs can be routed, through the process of cost finding, to final cost centers; and (2) a framework for costing the distinct functions of each center. Following this road map shows individual managers how they are using available resources in relation to what has been budgeted and the services that they are providing. From an administrative standpoint, cost centers can be classified into the following groups and distinguished in this manner:
Each approach is explained as follows:
Department which generates income directly from the patients are called medical departments. These are also called as Profit centers. Examples are General Medicine, Gynaecology, Cardiology, Orthopaedic, Neurology, Nephrology etc. Income on CABG surgery to a patient under package will be the income of Cardiology department.
Income from LSCS (Lower Segment Caesarean Section) surgery to a patient will be an example of income of Gynaecology department.
Medical departments are further classified into Out Patient (OP) and In Patient (IP). Of course, Day Care Unit is considered as separate medical department.
These departments generally support medical departments. These also generate revenue from patients directly and hence these are also called as profit centres. However, in addition to revenue generation since these departments render supporting to main medical departments, resources are expended in these departments and hence will remain as cost centres also. Examples are Operation Theatre, Laboratory, Radiology, Physiotherapy, Blood bank, Pharmacy and Wards.
By doing X-ray to a walk in patient, Radiology department is generating income. At the same time Radiology department is contributing revenue to Cardiology department by doing X-ray for CABG patient under package.
Department which do not generate income directly but supports the Medical and Medical support departments to do their services effectively are known as Non- medical (service) departments. Examples are Medical Records, Business operations & Admin, Finance & Accounts, IT, Bio-medical Engineering, Maintenance, Housekeeping, Admission, HR, Purchase & Stores department etc.
Within each of the above groups, there are also decisions about how many cost centers to define. For example, if you are planning to analyze unit costs by ward, then you would need to treat each ward as a separate cost center. Or, if you want to distinguish ancillary costs by (type (e.g., x-ray vs. clinical laboratory), then establish separate cost centers for each.
The aim of unit cost analysis is to allocate hospital costs (direct and indirect) to centers whose costs are to be measured. Typically, you will be computing the unit cost mainly for medical department (e.g. maternity wards, outpatient clinics, or paediatric units). However, in some instances, you may need to know the cost per lab test or drug prescription, in which case unit costs are computed for medical support departments such as laboratory and pharmacy. On occasion, you may even need to know the unit cost of a non –medical department, like dietetics, if, for example, you are considering opening a competitive bidding process to contract food services rather than keeping it in-house, or you wish to compare the performance of dietetic departments across different hospitals.
In order to see the extent to which user charges (e.g., fees for room, board, and nursing [a daily rate inclusive of diagnostic and therapeutic services], drugs and dressings, x-ray, laboratory, and physical therapy) cover their associated costs, it may be necessary to have a cost analysis system that identifies
a. cost centers which produce revenue (i.e., Medical department and medical support department)
b. General cost centers that do not produce revenue (e.g. security, housekeeping and payroll). This identification is necessary when it is desirable to allocate all direct or indirect expenses incurred by the general cost center (non-revenue-producing centers) to revenue-producing centers which could be the final cost centers.
Finally, one may eventually want to compute two types of unit costs:
i. With allocation of all the department cost i.e., Medical, medical support and non- medical department.
ii. Or with allocation of only medical department cost.
For example, if calculating the cost per admission or inpatient stay, one figure could include laboratory and x-ray costs and one excluding them.
3. Identify the Full Cost for Each Input
An important part of computing unit costs is to make sure that you have cost data which are as complete as possible. Two issues are involved:
a. the conceptual issue of determining which expenditures should be counted as costs based on an economic sense of resources used up during production of health care, and
b. the actual measurement of true costs using available data (which may be incomplete or untrustworthy)
4. Assignment of Inputs to Cost Centers
At this point, you have presumably gathered information about the hospital's total costs, whatever the source of payment. This information alone may provide useful insights even before you start computing unit costs: for example, in identifying which line items account for most of cost and whether this is changing over time. However, to compute unit costs one must proceed to the next step: assigning costs from each line item to the relevant cost centers.
Some inputs can be assigned directly to certain cost centers. For example, if 'Dietician' is a cost center, then the line item 'food' could all be assigned to that cost center. More often, inputs are used by several cost centers, and the analyst must seek to assign spending for an input across those centers. Correct assignment is most important for those inputs which account for a larger share of costs, such as Staff and Pharmaceutical drugs.
Drugs: Drug usually account for a substantial share of hospital resources, so it matters how their costs are treated in your analysis. If you are hoping to compute a unit cost per prescription, then you will definitely need to create a separate cost center for drugs (say, 'pharmacy'). If you are not treating drugs as an 'output', then you can choose between two approaches:
Each approach has different advantages. The first approach is simpler, in that pharmacy costs will eventually be allocated based on a single statistic (e.g., each ward's share of prescriptions written). The second approach has value if you have better information, and know you can do better than allocating drugs based on a single statistic. For example, if you have data on the value of each department's actual drug purchases, you could assign the currency amounts to each department at this stage. However, against this, there is a managerial issue: the pharmacy is usually a separate hospital department run by a manager or responsible person, who should be able to track (and account for) use of the resources provided. The pharmacy manager will be better able to manage resources if the pharmacy is treated as a separate cost center. In addition, identifying Pharmacy as a separate cost center in all hospitals would help regional and national managers to monitor and compare the relative performance of pharmacy departments in different hospitals. Therefore, we would regard this as the preferred option, barring exceptional circumstances.
5. Allocation of All Costs to Final Cost Centers
The next step is to reallocate all indirect costs to the final cost centers. In this way, the unit cost will include overhead costs incurred in producing an admission, day or visit, not just direct costs. Indirect costs will include all costs which could not be allocated directly to final cost centers at an earlier stage. In some hospitals, this will only comprise services such as administration and laundry. In others, medical support services such as pharmacy and radiology may also need allocating at this point, with little or no information about how much of their workload was generated by each of the medical departments.
Allocation Basis: Where each department's use of an indirect cost center is unknown, one must devise some rule to allocate the indirect costs across departments. The rule is called an 'allocation basis', and is intended to reflect whatever factors determine each department's use of the indirect (i.e., medical support or non-medical) cost center. These factors may differ depending on the center. For example, most studies allocate laundry costs among wards based on the percentage distribution of total patient-days in each ward, since patients who stay longer use more laundry services. On the other hand, cleaning services are often allocated according to each department's floor area, since more spacious departments cost more to clean. (Of course, this may involve measuring the floor area of each department if such information is not readily available from sources such as building plans).
Allocation Using Direct Cost: A more rough-and-ready approach is to allocate all indirect costs based on a department's percentage share of direct costs. This approach is to be recommending only when other data are not available for allocating direct costs.
Step-Down Sequence: The order in which centers are allocated may affect final results, and therefore deserves some consideration. Step-down analysis basically assumes that resource flows are 'one-way', and that one can therefore make use of this in choosing the step-down sequence. Below table illustrates this by showing flows among overhead cost centers at our hospital. The first row shows that the administration cost center serves all others, so it should be allocated first. The next two rows show that the Cleaning cost center serves the Pharmacy, but does not receive drugs in return. The Cleaning cost center should therefore be allocated before the Pharmacy cost center. The order of the remaining rows does not matter since they will not be allocated (they are final output centers).
Table 1: Resource Flow in a Hospital
Department providing service |
Department receiving service |
||
Administration |
Cleaning |
Kitchen |
|
Administration |
------- |
X |
X |
Cleaning |
|
------- |
X |
Kitchen |
|
|
------- |
Note: X denotes flow of resources from ‘provider’ to ‘recipient’ department.
It may help you to draw up a similar grid for overhead cost centers at your hospital. (You need not include the final cost centers since their costs will not be allocated anyway, but it may be useful to include them anyway because this will help your to see clearly which are the ‘receiving’ departments). Notice the shaded cells in table, which have no X's in them. If you find the equivalent area on your grid has many X's, you should try to reduce the number of X's by swapping rows (i.e., changing the order in which you list the departments in the column and row headings). The reason is that X's below the diagonal introduce inaccuracy into the step-down, because you would be forced to ignore some resource flows where the receiving center would have already had all its costs allocated. It is possible that even after swapping rows, some X's will remain below the diagonal of cells with dashes in them. This is because in reality, most hospitals do have some two-way resource flows (for example, the administrative cost center does receive services from cleaning, when its offices are cleaned). This is an unavoidable source of inaccuracy in simple step-down analysis, but probably small in magnitude and deserving of less attention compared to more basic issues of cost measurement.
Cost centre for allocation
Methodology of allocation/apportionment of major expenses (due weightage to be given wherever applicable)
Types of Expense |
Basis for allocation/ apportionment to profit centers & ancillary services |
Medicines |
Actual |
Doctor consultation fees |
Procedure-wise, Ward-wise actual / standard rate chart |
Direct Medical Consumables |
Actual |
Direct Staff Wages and Salaries |
Cost Centre - wise, category-wise actual / based on standard strength |
Indirect Medical consumables |
Technical Estimates |
Pathological Testing Material |
Direct to Pathology Deptt. |
Air Conditioning and Power |
Technical Estimates |
Steam |
Technical Estimates |
Repairs and Maintenance (Incl. AMC) |
Cost Center wise asset value |
Property Tax |
Floor area |
Depreciation |
Cost Centre-wise, Asset-wise Depreciation |
Below table shows an Illustrative list of cost centers and its cost drivers (due weightage to be given wherever applicable)
Non-Medical service cost centers |
Cost driver for reallocation to profit centers only |
Admission |
No. of Patients |
Kitchen |
Patient Days |
Cafeteria |
Patient Days |
Laundry and Linen |
Patient Days |
Pharmacy |
In the ratio of cost of medicine |
Blood Bank |
Actual use of no. of blood bottles |
Housekeeping |
Floor area |
Maintenance |
Asset value (Depreciation value) |
AC |
Technical estimates |
Power |
Technical estimates |
Steam |
Technical estimates |
Security |
Floor area |
Residential Rooms |
Manpower employment |
Administrative Department |
No. of OP and IP visits & admissions (with due weightage) |
Marketing Department |
No. of OP and IP visits & admissions (with due weightage) |
6. Computing Unit Cost for Each Cost Center
At this point you know the total costs that were incurred at each of the final cost centers. What is the output of each center, in days, discharges, lab tests etc.? This requires incorporating utilization data into the analysis.
In reality, you will have used the utilization data already by this point, for example in order to allocate laundry costs across wards in proportion to bed-days. However, this is the point at which any problems with the utilization data become particularly important, because they directly alter the unit costs.
Several studies encountered problems with utilization data. In some cases, the number of admissions seemed accurate, but admission and discharge dates had not been carefully recorded, causing measurement of bed-days to be inaccurate. Correct measurement of bed-days requires that staff count how many beds are occupied in every ward, every 24 hours at the same time of day.
Once you have obtained the utilization data, the unit cost can be computed. For each of the final cost centers, divide its fully allocated cost by its units of service.
7. Reporting Results
At this point it is important to remind yourself and any readers what items are and are not included in the unit costs you have calculated. For example, your unit cost does not include drugs and x-rays unless you specifically allocated the costs of those services to other final cost centers.
Similarly, if you are not reporting outputs for certain final cost centers (e.g. teaching, public health clinic) then it is worth saying so in a footnote. Otherwise, readers may assume these centers' costs have been allocated to the services for which you do report unit costs.
ROLE OF CMA’S IN HOSPITAL
CMA’s can play a key role in framing business solution from cost management perspective. CMA’s can enable to solve the difficulties faced by the hospital industry in following ways
Some of the difficulties faced by this industry would be:
With the increasing changes in the industries and complexities of businesses, costing becomes important for managements to take appropriate decisions, planning and control and having effective cost management measures in place. |