Cost stands between revenue and profit. Keeping revenue constant, the higher the cost, the lower the profit. For healthcare providers, cost and price tango together in a seemingly precarious, but actually predictable, style.
The total cost of a provider consists of direct labor cost, direct supply cost, and fixed cost (overhead). Numerous factors influence cost. Take a hospital for example: hiring travel nurses increases its direct labor cost; purchasing physician-administered drugs at discounts through the 340B Drug Pricing Program decreases its direct supply cost; quality reporting, regulatory compliance, executive compensation, depreciation, and paying taxes all add to its overhead.
Output volume affects how much overhead is averaged to each unit. Assuming two surgical practices incur the same overhead, if one operates 50% more procedures than the other, then the former’s overhead per procedure would be one-third lower than the latter, reflecting the essence of economies of scale. Therefore, different providers delivering the same healthcare services can have widely different unit costs. Even for the same provider, unit cost varies from one period to the next. It also changes according to the overhead allocation methodology, which involves subjectivity and judgement.
While providers have discretion over their costs, how they use the discretion to manage costs is determined by the pricing mechanism they live in. Cost management, in turn, can affect providers pricing behavior. Such dynamics is described in four scenarios:
Scenario I: Cost-Based Pricing. Just like Medicare paying critical access hospitals at 101% of cost and physician-administered drugs at 106% of cost, when price is based on cost, providers not only have little incentive to contain costs, but may also prefer higher costs for a wider margin. Consequently, both costs and prices steadily rise.
Scenario II: Price Control. When price is unilaterally determined by governments, such as the Medicare fee-for-service reimbursement rates, providers attempt to cut costs below the set price to remain financially viable, rather than to attract new business. Therefore, the incentive to lower costs is present but weak. If the price is set too low, providers will leave the market, leading to extremely high opportunity cost for patients due to restricted access (care is unpurchasable).
Scenario III: Regulatorily Protected Pricing. Providers enjoy a top-dog position when regulators erect barriers to deter potential competitors, such as certificate of need laws and restrictions on physician-owned hospitals. Because of the insurmountable nature of regulatory barriers, incumbent providers have limited incentive to cut cost or price. Nonprofit providers, facing neither equity market discipline nor takeover threats common to for-profit entities, have even less incentive. Consequently, costs and prices rarely drop.
Scenario IV: Market-Based Pricing. When providers are free to compete, all top dogs are challengeable. To survive, providers must offer competitive prices, which imposes downward pressure on costs and stimulates innovations. In fact, all innovations are cost-cutting achievements—newly developed cures slash the treatment cost from infinity (cure was impossible). Competition causes providers to voluntarily, continuously lower prices and costs.
Healthcare cost and price can appear precariously linked, but, in fact, tango together to the tune set by policymakers. Competition mandates from markets, not pricing mandates from governments, can bring down cost and price.