Case Study of Physician Practice Management and Relative Value Unit Analysis In this assessment, you will evaluate the physicians?practice financial condition based on the following Relativ

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T his year the healthcare industry is expected

to account for 15.6% of GDP, and expendi-

tures for physician services are expected to

be $347.9 billion. A large part of that goes to

physician practices, and, because they are

such a large part of the economy, they represent an

opportunity for management accountants to assist

physicians in evaluating contracts with third-party pay-

ers and providing financial information for strategic

decisions. To do so, management accountants need to

understand the unique revenue, cost, and contractual

intricacies of physician practices.

While most businesses’ sources of revenue are sales

and fees, physician practices depend on the organiza-

tional structure of the healthcare revenue reimburse-

ment relationships among provider, patient, and

third-party insurer. Revenue reimbursements can come

from indemnity, preferred provider organizations

(PPOs), and/or healthcare maintenance organizations

(HMOs). In particular, to advise a physician or evaluate

profits, a management accountant must understand the

relationships between a practice’s revenues and its costs.

Because these revenue reimbursements are contractual-

ly determined, controlling costs is critical to the survival

of a physician’s practice. A management accountant can

help a physician calculate costs, select the appropriate

cost structure to manage costs, and help make tough

strategic decisions about the financial future of the prac-

tice. Once a management accountant understands the

source of revenues and the cost constraints, he or she

can then help a physician evaluate a revenue reimburse-

ment contract. For example, if the contract is from an

indemnity plan or a PPO, evaluation is relatively

straightforward if the management accountant under-

stands a practice’s organizational structures and cost con-

trol. But if the revenue comes from an HMO capitation

contract—that is, a fixed rate of payment to cover a

specified set of health services and procedures—

evaluating the contract requires additional analysis

because revenues are based on anticipated services.

PHYSICIAN GROUP REVENUES

In order to consult with a physician group, a manage-

ment accountant must have a good understanding of

How Management Accountants Make Physicians’ Practices More Profitable

Spring 2005

VOL.6 NO.3

Spring 2005

THE KEY TO PROFITABILITY IS TO USE COST ANALYSIS BY DETERMINING A PRACTICE’S

COST STRUCTURE AND USING THOSE COSTS TO EVALUATE CONTRACTS, ALLOCATE

BONUSES EQUITABLY, AND MAKE STRATEGIC DECISIONS ABOUT THE FINANCIAL FUTURE

OF THE PRACTICE GROUP.

B Y M A R S H A S C H E I D T , D B A , C M A , A N D G R E G T H I B A D O U X , P H . D .

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the sources of practice revenues. As noted previously,

there are three types of organizational structures for

healthcare: indemnity, PPOs, and HMOs. Each organi-

zational structure utilizes distinct methods of revenue

reimbursement: Indemnity uses fee for service, PPOs

use discounted fee for service, and HMOs use salaries,

capitation, and other financial controls.

Indemnity Plans

Under an indemnity plan, physicians historically have

been reimbursed primarily through third-party payers

such as insurance companies. The actual payers—

consumers and businesses—have insurance companies

handle reimbursement for two reasons. First, the insur-

ance company is able to handle the overwhelming

administration of the plan more efficiently, and, second,

it can spread the financial risk over a large pool of indi-

viduals. These plans are called indemnity because they

reimburse physicians after services are rendered, and

the reimbursement method is known as fee for service.

Payment is production based: the more services provid-

ed, the greater the revenues to the physician. Because

the payer is responsible for the cost of the services, the

payer assumes the financial risk. Notice that under an

indemnity plan there are no ties between the payer

(insurance company) and the provider (physician).

But spiraling physician costs led payers to institute

managed care plans that, for the first time, linked physi-

cians who provided medical services with the parties

who paid for those services. Under managed healthcare,

third-party payers, including insurance companies and

the federal government in some of its Medicare and

Medicaid programs, would control the flow of monies

by third-party payers to providers. It also dictated the

number of services that could be provided to the

patient, who could provide those services, and how

much physicians and hospitals would be paid for those

services. The strongest form of managed care is the

HMO, and the weakest is the PPO.

PPOs

In response to rising medical costs during the 1970s,

insurance companies developed a form of payment

known as the PPO. This type of healthcare plan differs

from traditional indemnity insurance in that payments

to physicians are based on a reduced fee schedule, dis-

counted from 10% to 40%. Other controls, such as larger

co-payments and deductibles for out-of-network ser-

vices, are instituted by third-party payers to encourage

patients to use PPO networks.

The system is, however, still production oriented like

traditional indemnity plans. Because revenues are relat-

ed to the number of services provided, PPOs are basical-

ly a form of discounted fee for service. Although PPOs

are less costly than indemnity plans, the payer is still

responsible for the cost of the services and assumes the

financial risk. Today, discounted fee for service plans are

the dominant method of revenue reimbursement.

HMOs

Unlike indemnity and PPO reimbursement plans, the

HMO links the payer and provider together as a team

to guide the patient through the healthcare system.

The HMO collects a premium from the enrolled mem-

ber and contracts with him or her to provide the neces-

sary healthcare services during the period of

enrollment. The HMO then contracts with the physi-

cians and pays them to provide the anticipated services

as needed for the period of enrollment. By agreeing to

accept reimbursement on a prospective basis, the

provider assumes the financial risk for the cost of future

services. Physician revenue reimbursement in an HMO

network is more complex and may be in the form of

salary, capitation, and/or other financial controls.

Salary is used frequently in HMOs. Straight salaries

are used in more than 10% of the groups, and guaran-

teed base salaries are used by about 20%. Under indem-

nity or PPO structures, salaries are used only in certain

scenarios or sectors, such as the Veterans Administration

or, possibly, a hospital for a doctor such as a hospitalist. A

hospitalist is an inpatient physician who directs the flow

of care for hospitalized patients and is paid by the hospi-

tal. HMOs have much greater financial control because

they provide the physician with either a salary or bonus-

es tied to the HMO’s physician productivity goals.

HMO capitation is a method of physician revenue

reimbursement based on a negotiated contract. The

provider receives a set amount of revenue calculated

per member per month for providing the necessary ser-

vices during the covered period of time. The capitation

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rate is commonly a fixed amount per member per

month. Most HMO capitation rate calculations take

members’ actuarial data, such as age, gender, geography,

and historical utilization rates, and costs to serve mem-

bers into account to predict the expected costs of ser-

vices. The HMO will then determine the average

monthly cost of services and an average cost of services

on a per member per month basis, which is the capita-

tion rate. Each month, the total revenue reimbursement

to the physician is the per member per month rate

times the number of members actually enrolled for the

month. This per member per month payment means

that a physician is obligated to provide specified ser-

vices to enrolled members as frequently as necessary. If

a member uses more services than expected, the physi-

cian usually is not paid an additional amount. Likewise,

if a member uses fewer services, the physician does not

refund the capitated amount.

HMO contracts for revenue reimbursement may also

include other financial controls, such as withholds

and/or bonuses. These controls are the two major types

of incentives designed to influence physician behavior

regarding ancillary services, such as laboratory tests and

referrals to specialists. A withhold involves keeping a

percentage of the capitation fee to be released only if

the physician group attains HMO productivity goals.

Withholds invoke partner risk, which is the possibility

that one physician’s performance will negatively affect

the group’s compensation. Another financial incentive

HMOs may use is bonuses based on the productivity

and quality of services the physicians provide.

PHYSICIAN GROUP SERVICE COST

Medical office management has changed significantly

with the implementation of managed care. Today physi-

cians operate primarily in a managed care environment,

receiving reimbursement for their services based on

PPO and/or HMO contractual relationships or in the

form of salary an HMO pays. It is estimated that about

85% of all patients today participate in some form of

managed care. Prior to managed care, physician billing

was based on the actual number and type of procedures

performed on patients and was known as fee for service.

In this type of financial environment, physicians’ rev-

enue was related directly to the number of procedures

and services they provided. The more the physician did

to the patient in terms of diagnostic and treatment pro-

cedures, the greater the revenue. In a fee-for-service

environment, low profit margins or, in some cases, nega-

tive profit margins could be offset by increasing the vol-

ume of other, more profitable services and procedures.

In essence, the actual cost of providing a service was

not particularly relevant as long as the physician group

could control the volume of all services provided. This

is not the case today because most physicians receive

reimbursement based on discounted PPO rates and

fixed capitation HMO contracts. Under these systems it

becomes crucial that the physician group knows the

cost of providing services in relation to the revenue

generated by those services.

For example, in a PPO contract, certain procedures

and office visits will provide much higher profit margins

than others. A surgeon might find that one type of

surgery is much more profitable than another even

though he or she may feel that each required a similar

amount of time, expertise, and diligence. Also under a

capitation contract, the fewer services rendered, the

greater the profit margin because, as noted above, rev-

enues do not vary with the volume of services per-

formed, only with the number of enrolled members. As

revenues are determined only by the number of

enrollees, profit margins will depend on how well the

group is able to control costs. In essence, the more ser-

vices and time spent per patient than is medically pru-

dent, the lower the profit margin.

Therefore, under managed care it is crucial that the

physician group knows the relative cost of its physi-

cians’ time and procedures to be able to make

informed decisions about how it wants to focus its prac-

tice. For example, a surgery group may make a strate-

gic decision based in part on financial considerations to

concentrate its efforts on a well-defined group of

patients. In order to make informed financial-based

decisions, physicians need crucial information about

the cost structures of their practice that management

accountants can provide.

DETERMINING THE COST OF SERVICES

To make informed decisions about contracts or the

strategic direction of the practice, physicians need, at a

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minimum, information about the average cost of ser-

vices they provide. In fact, to evaluate the contract

effectively, physicians should know the average cost of

services, the marginal costs of treating the new patients,

and whether any additional fixed costs will be incurred

by accepting the contract.

Traditionally, physician groups have tracked costs on

a line-item basis by classifying costs in functional cate-

gories such as salary, equipment costs, depreciation, cost

of materials, and drugs. Unfortunately, this type of

information is not particularly useful in relating a prac-

tice’s costs to the services it provides. In fact, for any

cost accounting system to be effective it must fulfill the

following criteria:

◆ A product must be carefully defined,

◆ The type and quantity of inputs required for prod-

ucts must be defined, and

◆ The costs must be attached to the inputs and the

product costed out.

Traditionally, physician groups have been concerned

only with tracking costs on a line-item basis, so there

has been no effective way to attach these costs to the

services produced. The problem is that, under this sys-

tem of accounting, there has been no defined product

measure, no measure of inputs, and no way to attach

the cost of inputs to the product. Fortunately, all this

changed in 1992, when Medicare changed the way it

reimbursed for physician services. Instead of paying on

a fee-for-service basis, it began to base its payment on a

resource-based relative value scale system. Under this

methodology, the amount of payment is tied to the

amount of resources that are expected to be used to

provide the service rendered. The actual product, ser-

vice, or office visit rendered is defined by the CPT

(common procedural terminology) code, the accepted

procedural codes used to bill patients. Each CPT code

represents an office visit, a service provided, a lab test,

or a procedure.

Relative value units (RVU) are the inputs required to

provide the service. A relative value unit takes into

account the amount of physician work required to pro-

vide the service, the practice expense, and the expense

of liability insurance. The code values were created rel-

ative to value of a standard office visit, which has a code

value of 1.00 RVU. A code allowing reimbursement for

four RVUs implies that it took an average of four times

more effort and cost to provide that service.

Today, most physician software billing systems will

allow the practice to link its billing codes to a database

that contains the number of RVUs allowed for each pro-

cedural billing code. By using such software, the prac-

tice can keep a running total of the number of RVUs

generated for any time period. The management

accountant can use these RVU totals to calculate the

cost per RVU and then calculate the cost per procedure

provided. For example, if it is determined that an aver-

age RVU costs $30 to provide, then an uncomplicated

office visit with an RVU of one would cost $30. In sum-

mary, by costing out the inputs (RVUs) required to pro-

duce a service (CPT code), a management accountant

can determine the actual cost to the practice of provid-

ing that service. This information can then be used to

evaluate PPO and capitation contracts and to make

strategic decisions.

Calculating Costs

To carry out an analysis of costs, the management

accountant must first calculate the average and marginal

costs per RVU. With the number of RVUs required by

the contract per CPT code known, a management

accountant can calculate the total average cost and the

total marginal cost per CPT code. He or she can use

this information to help the physicians make informed

decisions.

The following is a discussion of the steps required to

analyze physician group practice costs.

Step 1. Calculate the average and marginal costs per

RVU.

In cost accounting, there are two primary methods for

analyzing costs: the high-low method and regression.

The high-low method is an approximation based on two

points, and regression is a statistical method requiring at

least 30 points and one or more independent variables.

Because medical practices typically do not capture

information that lends itself to regression analysis, the

high-low method is usually more appropriate. We will

use it to illustrate a cost analysis, as follows.

High-low cost analysis of monthly data requires sev-

eral procedures.

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Procedure 1. Determine the Variable Cost for the Production of

One RVU:

a. Select the high production (the month with the

highest volume of RVUs).

b. Select the low production (the month with the

lowest volume of RVUs).

c. Subtract the difference between the total cost

incurred during the highest production (Y2) and

the total cost incurred during the lowest produc-

tion (Y1). Total costs will include all costs of the

practice, such as salary, depreciation, insurance,

drugs, supplies, etc.

d. Take the difference between the total RVUs

incurred during the highest production (X2) and

the total RVUs incurred during the lowest

production (X1).

e. Divide step c (the cost difference) by step d (the

RVUs difference).

f. The result is the variable cost for one RVU.

Procedure 2. Determine the Total Fixed Costs:

a. Take the total cost incurred during the highest pro-

duction (Y2) and subtract the estimated total vari-

able costs for the highest production (total variable

costs equals the variable cost per RVU times the

number of RVUs).

b. The remainder is the total fixed cost.

Procedure 3. Determine the Total Cost Formula:

Total Costs = Total Fixed Costs plus (variable cost

per RVU times number of RVUs).

Procedure 4. Calculate the Average and Marginal Costs per

RVU:

The average cost per RVU is calculated as follows:

Using the total cost formula determined in Procedure

3 and the number of RVUs expected, a management

accountant can calculate total costs expected for that

level of RVUs. The average cost per RVU is simply

the total costs as calculated above divided by the

expected level of RVUs. The marginal cost per RVU is

the incremental costs of producing an RVU. At a mini-

mum, marginal costs are the variable cost per RVU as

calculated in Procedure 1(f). If a new contract requires

additional fixed or variable costs, then those incremen-

tal costs will be averaged over the new contract RVUs

and increase the marginal costs.

Step 2. Determine the number of RVUs required.

The contract will specify the number of RVUs per ser-

vice CPT code. The number of RVUs allowed will be

defined by the contract under consideration or the gov-

ernmental healthcare reimbursement scheme, such as

Medicare.

Step 3. Calculate the total average cost and the total

marginal cost per CPT code.

The full cost of a visit or procedure is calculated by

multiplying the average cost per RVU times the num-

ber of RVUs that are allowed per procedure. The mar-

ginal cost of a visit or procedure is simply the variable

costs per RVU times the number of RVUs that are

allowed per procedure.

Step 4. Assist the physicians in using these costs

appropriately in making informed decisions.

Management accountants can provide a wealth of infor-

mation to physicians to assist them in evaluating con-

tracts and making strategic decisions.

The following is an example of the four steps man-

agement accountants can use to analyze a physician’s

practice.

Assume that during 20X1, U.R. Well, P.C.’s costs

were historical $672,000 when 10,000 RVUs were pro-

duced and $782,000 when 12,000 RVUs were produced.

Step 1. Calculate the average and marginal costs per

RVU.

Procedure 1. Determine the Variable Cost for the Production of

One RVU:

Y2 – Y1 = $782,000 – $672,000 = $110,000

X2 – X1 = 12,000 RVUs – 10,000 RVUs = 2,000 RVUs

Variable cost per unit = Cost difference divided by

production difference

= $110,000 ÷ 2,000 RVUs = $55 per RVU

Procedure 2. Determine the Total Fixed Costs:

Fixed Costs = $782,000 – ($55 * 12,000 RVUs)

= $782,000 – $660,000 = $122,000

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Procedure 3. Determine the Total Cost Formula:

Total Costs = Total Fixed Costs plus (variable cost

per RVU times number of RVUs).

Total = $122,000 + $55 per RVU times number of

RVUs

Procedure 4. Calculate the average and marginal cost per proce-

dure. The average cost per relative value unit is deter-

mined using the projected number of RVUs for the

coming month in the above formula. For example, if

during the coming month it is expected that the prac-

tice will generate 11,000 RVUs, the average cost would

be as follows:

Average cost per RVU = {$122,000 + ($55)(11,000)} ÷

11,000 RVUs = $66.09 per RVU.

The marginal cost per RVU is simply the variable

costs or $55.00 per RVU.

Step 2. Determine the number of RVUs required by

the contract per CPT code:

For example, the contract may state that a particular

CPT code allows six RVUs.

Step 3. Calculate the total average cost and the total

marginal cost per CPT code.

The cost per procedure is the cost per RVU times the

number of relative value units allowed per procedure.

For example, if a procedure allows six RVUs then the

average cost for the procedure would be 6 * $66.09 =

$396.55, and the marginal costs would be 6 * $55 =

$330.00.

Step 4. Assist the physicians in using these costs

appropriately to make informed decisions.

The management accountant can help the physician

group make informed financial decisions about poten-

tial contracts. The nature of the decision will depend

on whether it is a PPO or HMO contract under

consideration.

CONSIDERATIONS OF CAPITATION CONTRACT

Once the cost of the RVU has been calculated, this

information can be used to evaluate PPO contracts. If

the group is operating at full capacity, then any addi-

tional contracts either will have to replace existing con-

tracts or will require the practice to expand. In order to

justify accepting a contract, the proposed reimburse-

ment per procedure should generate an acceptable mar-

gin in excess of the average practice cost per procedure.

Any reimbursement less than the average cost per pro-

cedure will result in lower margins and will endanger

the recovery of fixed costs. If the practice is considering

adding physicians, the contrac

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