Analyzing hospital expenses: Breaking down the important costs

An overview of the healthcare sector

The healthcare sector comprises different types of setups, such as hospitals, ambulatory services, emergency services, primary care providers, and long-term care. These setups can be either independent or vertically integrated to provide the entire suite of medical services.

Hospitals have always been one of the major cornerstones of the healthcare industry. According to a survey on national health expenditures by Centers for Medicare and Medicaid Services (or CMS), in 2011, hospital care accounted for a total of $850 billion of the total $2.7 trillion of national health expenditures. Analysts have projected that, by 2015, U.S. hospital care will be a trillion dollar subindustry.

The National Health Expenditure Projections 2012–2022, written by CMS, suggests that healthcare spending will pick up in 2014 and reach 6.2% year-over-year. Nine million Americans are projected to have access to health insurance. This will reduce out-of-pocket spending by 0.2 %, resulting in an assured revenue stream from the insurance programs and substantially reducing hospitals’ total bad debt expenses. This should remain at about 6% from 2015 through 2022.

Hospital care spending amounts to approximately one-third of total healthcare spending. As payment models evolve and hospitals strive to introduce cost efficiencies, analysts predict that growth in hospital care spending will be less than the remaining healthcare industry’s spending.

Major companies in the hospital sector

HCA Holdings (HCA), Tenet HealthCare (THC), Community Health Systems (CYH), LifePoint Hospitals Inc (LPNT), and Select Medical (SEM) are a few publicly traded companies in the hospital industry. These companies are major holding companies that operate hospitals and other healthcare entities. There are other companies in the space, like Adeptus Health Inc. (ADPT), Surgical Care Affiliates (SCAI), and Kindred HealthCare (KND), which operate in niche provider areas like emergency healthcare, surgical facilities, and transitional care hospitals.

5 major entities

The hospital industry functions through interactions with several other healthcare industry participants. The five major entities involved in the value chain are the payer, the intermediary, the hospital, the purchaser, and the producer.

Payers and intermediaries

The U.S. hospital industry is unique in the way it’s compensated. Unlike the normal business model prevalent in other industries, where the end user pays for the goods and services, this industry derives most of its payments from third-party payers such as employers, commercial insurance companies, and government programs.

Hospitals

Fundamentally, hospitals are healthcare providers equipped with trained staff and medical equipment to treat various ailments. Hospitals provide two types of services: inpatient and outpatient services. Patients that require care for more than a day are called “inpatients.” Patients that require care for a shorter period are called “outpatients.” Hospital companies like HCA Holdings (HCA), Tenet HealthCare (THC), Community Health Systems (CYH), LifePoint Hospitals Inc. (LPNT), and Select Medical (SEM) provide both inpatient and outpatient services.

Suppliers

Wholesale distributors, group purchasing organizations (or GPOs), and mail-order distributors assist hospitals in procuring drugs and medical devices from manufacturers forming up to 40% of hospital costs. GPOs assist hospitals in managing these expenses by implementing group buying policies.

Mail-order distributors adopt a different dispensing model than wholesale distributors. Mail-order distributors order drugs directly from manufacturers or other wholesalers.

Producers

According to Marketline, the global pharmaceutical industry is projected to reach $1.1 trillion in 2014. The global medical technology industry is continually evolving and has reached about $340 billion. Though both the pharmaceutical and medical technology industries have lately come under pressure to produce cost-effective drugs and devices, factors like aging population, investments in healthcare, and increasing coverage of health insurance are expected to provide decent margins.

Analyzing hospital expenses

After analyzing the contribution of major external factors to hospital profit margins, investors should consider the internal factors.

Break-up of total costs

You can break down average hospital costs into salary expenses, supply expenses, bad debt expenses, and miscellaneous expenses. Labor costs account for about 49% of expenses, and they’re the biggest expenses for hospitals.

Break-up of salary expenses

You can further divide salary costs into clinical, nursing, non-clinical, and physician costs. Clinical costs relate to the salaries paid to personnel working in hospital laboratories and those working on research activities. Non-clinical costs include salaries to personnel engaged mainly in administrative activities. Also, only physicians who are employees of a hospital are included in these expenses. Other affiliated physicians are paid directly by the patient or the insurance programs.

According to the American Hospital Association (the AHA), hospital revenues at the national level positively correlate with costs. Both revenue and costs per admission grew at a rate of 5% per year from 2000 to 2009. As labor costs vary across regions, hospital prices also differ, with higher prices in regions with costlier labor. This variation reflects in higher revenue per admissions in regions with higher costs.

Hospitals like HCA Holdings (HCA), Tenet HealthCare (THC), Community Health Systems (CYH), LifePoint Hospitals Inc. (LPNT), and Universal Health Services (UHS) are attempting to reduce labor costs. Their strategies include deploying automation technologies and data analytics to improve scheduling, reduce time spent on staffing, and efficiently allocate resources. Various functions—such as payroll management, leave management, and staffing—are coordinated through an integrated workforce management system. Staff utilization is improving in order to reduce overheads like overtime payments use resources optimally.

Breaking down supply expenses

Hospital supplies include food and food service supplies, drugs, and other patient care equipment. Hospitals use wholesale distributors or group purchasing organizations (or GPOs) to source these supplies at optimal costs.

Industry structure

You can differentiate hospitals in the U.S. based on their functionality, size, and ownership. Along with the government programs that a hospital participates in, the geography and demographics of the region and the length of patient stay determine the types of services hospitals provide. They also determine the type and level of reimbursement they receive for these services.

Hospital classification based on functionality

According to the American Hospital Association (the AHA), there are a total of 5,724 hospitals in the U.S. You can classify hospitals into three different types, depending on their functionality. A general hospital treats many kinds of diseases. It mostly has an emergency department to deal with cases that need immediate attention. Specialized hospitals involve trauma centers, rehabilitation hospitals, children’s hospitals, seniors’ hospitals, and hospitals to address specific conditions. A teaching hospital is generally attached to a medical school to train medical students and nurses.

Size and ownership hospital types

The type, size, and location of hospitals are closely related. General hospitals tend to be bigger in size, each having more than 100 beds. Specialty hospitals and rural hospitals tend to be smaller. According to the AHA, out of the total of 4,999 U.S. Community hospitals, there are 1,980 hospitals in rural areas of the U.S. Of these hospitals, 1,328 hospitals are critical-access hospitals (or CAHs) with no more than 25 beds. CAHs are hospitals in rural areas that receive reimbursement from the government as a percentage of the costs they incur.

Hospital classification based on ownership type

Hospitals are also categorized by the nature of ownership, such as government hospital, non-profit hospital, and for-profit hospital. Government hospitals are further categorized as federal and non-federal entities, with the former being operated by government programs like military services or the Department of Veterans Affairs. The latter is operated by state and local governments.

AHA statistics show that in 2012, there were 2,903 non-profit hospitals, 1,025 for-profit hospitals, 1,045 non-federal hospitals, and 211 federal government hospitals in the U.S. Generally, non-profit hospitals tend to be bigger than for-profit hospitals. Hospitals like HCA Holdings (HCA), Tenet HealthCare (THC), Community Health Systems (CYH), LifePoint Hospitals Inc. (LPNT), and Universal Health Services (UHS) are major for-profit hospital systems. On the other hand, hospitals like UPMC, Ascension Health, and Dignity Health are among the leading non-profit hospitals in the U.S.

Understanding industry drivers

Analyzing the impact of various external and internal factors on hospital revenue growth will help you better understand the industry drivers.

Economic factors affecting hospital revenues

Out-of-pocket spending isn’t a major payer for the hospital industry, yet the state of the economy affects public spending policies, which indirectly influence hospital revenues. Hospitals display muted revenue growth when new laws are implemented. New provisions lead to a change in hospitals’ reimbursement policies.

Major hospital systems like HCA Holdings (HCA), Tenet HealthCare (THC), Community Health Systems (CYH), LifePoint Hospitals, Inc. (LPNT), and Universal Health Services (UHS) displayed reduced revenue growth rates in 2010. You can directly attribute this reduction to the change in external environment resulting from the passage of the Patient Protection and Affordable Care Act (or ACA), or “Obamacare,” on March 23, 2010.

Social factors affecting hospital margins

U.S. national spending on healthcare is the highest in the world—both in dollar terms and also as a percentage of GDP. Public healthcare spending in the U.S. is almost double Norway’s. Norway has the second-highest dollar spending on healthcare in the world. This difference is a result of a shift in the demographic mix in the U.S. as the Baby Boomer population continues to age. People are afflicted with chronic diseases such as diabetes and heart conditions, mainly due to lifestyle choices like irregular food and exercise patterns.

Pharmaceutical drug pricing mechanisms also differ in the U.S. and Europe. Prices in Europe are regulated by governments. However, in the U.S., pharmaceutical companies negotiate with payers to fix prices that turn out to be higher than regulated prices. Changing demographics, coupled with the high prices of drugs, are expected to lead to a further increase in U.S. healthcare spending.

Entry barriers

Analyzing entry constraints leads you to a better understanding of the hospital industry’s current competitive forces and future competitive environment.

The graph above shows that the total number of community hospitals in the U.S. has been fairly stable, with a slight decrease in count from 5,010 in fiscal 2008 to 4,999 in fiscal 2012. With a stable, competitive landscape, hospital systems like HCA Holdings (HCA), Tenet HealthCare (THC), Community Health Systems (CYH), LifePoint Hospitals, Inc. (LPNT), and Universal Health Services (UHS) continue to post EBITDA[1. Earnings before interest, tax, depreciation, and amortization] margins up to 18%.

Capital-intensive business structure and barriers to entry

Hospitals are a capital-intensive business with substantial investments in real estate, skilled labor, and medical equipment. According to an annual capital survey for 2012 by the U.S. Census Bureau, out of the $90.7 billion invested in the healthcare sector, $56.7 billion was invested in the hospital industry. Other services included home healthcare, child care, and psychiatric and substance abuse services.

A total of $47.9 billion was invested in structures and $42.8 billion in equipment in the healthcare sector. With huge investments at stake, hospitals have to analyze patient switching costs, access to acclaimed physicians, and cost disadvantages resulting from lack of scale before entering the sector.

Regulatory barriers to entry

A certificate of need (or CON) is a legal document required in 36 U.S. states to allow for constructing new facilities or expanding through acquisitions.

The government uses CONs to control the number of hospital facilities in a particular geography, as it expects market oversaturation to lead to unnecessary patient hospitalizations. CONs act as a regulatory barrier to new entrants in the industry.

Hospitals’ supply chains

Medical supplies account for 17% of total hospital expenses. As this constitutes a substantial portion of the total cost structure, hospitals tend to focus on their supply chain to remove inefficiencies and reduce costs.

Hospitals sourcing contracts through group purchasing organizations (or GPOs) amount to more than $100 billion in value. According to the 2014–2015 economic report on pharmaceutical wholesalers and specialty distributors, the wholesale distribution industry is about $300 billion in value with AmerisourceBergen (ABC), McKesson (MCK), and Cardinal Health (CAH) accounting for 85% of the total business. With such large amounts at stake, McKinsey & Company claims that hospitals can improve profit margins from 12% to 21% by improving their supply chain.

Cost-savings using GPO

According to Healthcare Supply Chain Association (or HSCA), GPOs act as an intermediary for about 71.71% to 80% of the total hospital dollars spent on medical supplies. GPOs make use of economies of scale, greater negotiating power, higher expertise in purchasing function, and lower combined administrative costs to reduce the cost of procurement of the supplies.

This translates in savings of 10% to 18% of the total supplies-related expenses for the hospitals. In 2012, this saving was estimated to be about $25 billion to $55.2 billion. Novation Companies (NOVC), Premier Inc. (PINC), MedAssets Inc (MDAS), HealthTrust, and Amerinet Inc. are the five leading GPOs in the U.S. based on number of hospital beds.

Hospitals and distributors

There are two types of distributors in the healthcare industry—namely, full-line wholesalers and specialty distributors. Full-line wholesalers purchase, store, and sell off manufacturers’ entire drug product line to a pharmacy or to hospitals through a GPO. Specialty distributors provide specialty drugs, used to treat chronic or difficult health conditions, to physicians and hospitals.

Oncology drugs account for 50% of the total sales of specialty distributors. According to Modern Distribution Management, AmerisourceBergen Corporation’s Specialty Group and McKesson Specialty contribute about 75% of the total specialty distributor sales. These are specialty divisions of full-line wholesalers.