1. What is the estimate of the marginal cost of the Phase 4 hospital services? (Assume, as given in the case, that 60 percent of the designated costs are fixed and the remaining costs are variable.) 2. Create the underlying cost structure (cost behavior) equation. What is the relevant range for this structure? Does the structure change if the contract is expected to bring more than 30 additional transplant patients? 3. What fixed-cost proportion is required to force the average variable cost for Phase 4 hospital services to be $90,000? 4. Assume that the fixed-cost proportion is only 50 percent. What price must be set to cover variable costs? What if the fixed-cost proportion is 70 percent?

5. Return to the original assumption (60/40) regarding fixed-cost percentages. How do contract costs change if additional fixed costs are required when contract volume exceeds 30? Assume first that fixed costs increase by 15 percent, then assume 20 percent, and finally 25 percent. When answering this question, assume contract volumes of 31 and 60. 6. What role do the following factors play in the decision to use marginal cost pricing on the new contract? a. Reimbursement amounts paid by current transplant third-party payers b. The amount of excess capacity in the transplant unit 7. What is your final recommendation regarding the base rate for Phase 4 hospital services that should be built into the contract? When answering this question, be sure to consider (1) a long-term pricing strategy and (2) the effect of the contract on current payers, who are paying roughly $140,000 for the services. 8. Consider the outlier problem. a. What methodology should be used to handle outlier reimbursement? b. What threshold amount should be included in the contract? c. What payment amount should be included after the threshold is reached? 9. In your opinion, what are three key learning points from this case?

Case 9 Cambridge Transplant Center

CAMBRIDGE TRANSPLANT CENTER MARC INAL COST PRICING ANALYSIS TRANSPLANT (ENTER (the Center), which is part of University Health- care System, is a regional leader in the very intense and medically sophisticated area of organ transplantation. All transplants are performed at General Hospital, the 400-bed agship of University. The administrative director ofthe Center, Josh Zimmerman, has been on the job for ten years, during which time signicant growth has occurred in both the num- ber of transplant programs and the volume of procedures performed. When Josh joined the Center, he was put in charge ota kidney transplant program that aver- aged 60 transplants per year and a heart transplant program that performed 40 transplants annually. Today, the Center performs more than 500 transplants per year, includingtransplants from liver, lung, and pancreas programs. Of all of the Center's organ programs, the liver transplant program is the most successful in terms of volume and revenue. Last year, volume totaled 120 transplants, bringing in more than $50 million in total revenues. This year, Josh is optimistic that the liver program can do even better. However, he knows that in- creased volume is largely dependent on the number of organ donors and on his success in negotiating a new contract with Lifecare Transplant Network (LTN ET), the largest transplant benets company in the nation. Although most health insurers can identify those patients who are good candie dates for transplant services, only the largest health insurers have the expertise to manage the transplant process. Transplants are relatively rare compared with other, more conventional medical procedures. However, the costs to insurers for trans, plant services are typically very largHusually in the six, to sevenrgure range. To ensure the best and most costieffective management of transplant services, most insurers outsource transplant management to companies that specialize in these services, such as LTNET. Contracting for transplant services is unique and complex because of the sophistication ofthe medical procedures involved. Transplant services consist of ve phases: (1) patient evaluation, (2) patient care while awaiting surgery, {3) organ procurement, (4) surgery and the attendant inpatient stay, and (5) one year offoli lowiup visits. The costs involved in Phase 1 are relatively simple to estimate, but the resource utilization, and hence costs, of the remaining phases can be extremely appointed surgical director of the liver transplant program. Fortunately, like Josh, variable because they differ in patient acuity and surgical outcomes. Dr. Desai is enthusiastic about turning the liver transplant program into one of the Historically, reimbursement for transplant services has been handled in a num- largest in the country and is motivated to secure the contract. In his second meet- ber of ways. Initially, many transplant providers bundled all five phases and offered ing with Dr. Desai, Josh discussed the specifics of the current contract negoti insurers a single, global rate. This method simplified the contracting process, but ations. Phases 1, 2, and 5 will be reimbursed at a set discount from charges. Fur- the rate set for this method was often chosen on the basis of building market share thermore, to reduce the amount of financial risk borne by the Center, Phase 3 rather than on covering costs. Indeed, many institutions could not even estimate (organ procurement) will be reimbursed on a cost basis, which makes sense be- with any confidence the true costs of providing transplant services. cause the cost of Phase 3 is almost completely uncontrollable by the Center. Thus, Ironically, success in gaining market share usually increases the financial risk of the primary focus of the negotiations, and the make-or-break part of the contract, is the transplant program because higher volumes increase the likelihood of attract- the reimbursement amount for Phase 4. (For more information on organ procure- ing higher-acuity patients. Furthermore, changes in the organ allocation system ment, see the United Network for Organ Sharing website at www.unos.org.) have promoted the acceptance of sicker patients into transplant programs. Al- Phase 4 costs are divided into two categories: hospital costs and physician though the total costs associated with all phases of a liver transplant average about costs. Physician reimbursement has already been agreed on, with LTNET commit- $500,ooo, the amount can more than quadruple if the patient requires a re- ting to pay a fixed amount per physician work relative value unit (RVU). Thus, the transplant or if other complications occur. Because of this extreme variability in primary matter at hand involves only Phase 4 hospital costs. To aid in the negoti costs, outlier protection is a critical aspect of contract negotiations if the reim- ations, Josh compiled the Phase 4 hospital costs of the 12 most recent liver trans- bursement methodology is a fixed prospective rate, such as a global rate. plant patients. These data are presented in exhibit 9.1. The LTNET contract requires the approval of Dr. Anjali Desai, the newlyDr. Desai was amazed when she read the numbers. A total average cost ot $119,305tor1g days average length of stay {ADDS} translates to a per diem average cost of more than $6,000. She was sure that LTNET would not be willing to sign a contract that paid the hospital $120,000 [or more] to cover Phase 4 hospital costs. Thus, she suggested that josh reexamine the cost structure to see it these costs could be reduced. At rst glance, it appeared that a large cost savings could be realized by merelyr reducing ALGS. For example, Phase 4 hospital costs associated with a particular patient could be reduced by more than $12,000 by decreasing ALDS by two days. However, further analysis revealed that the costs associated with Phase 4 are not a linear function otALDS. Internal studies at the Center indicated that the rst day of Phase 4 is usually the most costly and the last day is usually the least costly. In deed, roughly }0 percent of Phase 4 costs occur in the rst 24 hours of hospital ization. 1When lowering Phase 4 hospital costs appeared to be difcult, josh decided to pursue a different strategy. He believed that economies of scale are present in liver transplants, and hence the marginal cost of each transplant is lower than the aver- age cost. Thus, he proposed that the Phase 4 hospital reimbursement amount be based on marginal rather than total (full) costs. You have been hired as a consultant to recommend a xed reimbursement amount (the base rate) to propose during the contract negotiations for Phase 4 hospital services. To help in the analysis, Josh has indicated that approximately 60 percent of nursing, ancillary, operating room, and laboratory costs are xed. The remaining costsradiology, drug, and other servicesare predominantly variable. Furthermore, current payers are reimbursing the hospital at roughly $140,000 for Phase 4 services. The Center has sufcient capacity to handle about 30 more transplants before xed costs would increase by a meaningful amount. It marginal volume exceeds 30 transplants, the best estimate is that xed costs would increase somewhere be, tween 15 and 25 percent. In addition, you have been asked to recommend a method for handling outliers, including the threshold amount and additional reimbursement scheme. Other pro, grams within the Center use two methods tor outlier payments. One method is to charge an additional per diem amount based on a length-ofstay threshold. Alterna- tively, some percentage of costs above the threshold can be charged when a cost threshold is reached. (For more information on how Medicare treats outliers, go to www.cms.hhs.govmlngeninfo and then search "inpatient outliers\") As you think about the problem at hand, several other issues will come to mind. First, is it useful to identity the underlying cost structure of the Phase 4 hospital services? (It might help in thinking about the relevant issues.) Second, should the hospital worry about a long-term pricing strategy, or is it sufcient to think only of the rst-year contract? Finally, ifthe price is set signicantly lower than the average reimbursement amount paid by current payers, what impact would that have on tue ture negotiations with those payers