Payer Contracting: What are Acceptable Rates?

The use of a contribution margin financial analysis helps evaluate opportunity.

By Maureen Waddle, BSM Consulting

In an environment in which reimbursement rates are falling below Medicare “allowed” levels, it's more important than ever for ASCs to scrutinize new provider agreements before signing on the dotted line. While strategic and qualitative decision-making considerations are vital to the assessment process, understanding the contract's financial impact deserves priority attention.

This article provides instruction on conducting a contribution financial analysis with the goal of better understanding the current financial situation of an ASC in relation to a proposed reimbursement. A contribution margin analysis is an evaluation that subtracts variable expenses from revenues to determine the contribution to fixed expenses and profits. Whether the facility is positioning itself to take on a capitated contract as part of an Accountable Care Organization (ACO) or evaluating a recent proposal from a health insurer, having meaningful financial knowledge will help managers make better decisions.

Case Study

To demonstrate how to use contribution analysis to evaluate contracting opportunities, a fictitious ASC — Eye Surgery Center — will be used. Table 1 provides the pertinent financial and volume information about the Eye Surgery Center. The center is owned by three ophthalmologist partners, although one is retired; two are currently using the center.

In this case, the two partners each perform about 50 cataract cases a year at a local hospital because, the Center doesn't have a provider agreement with a certain insurance plan that covers those patients. To rectify this situation, Eye Surgery Center requests a provider agreement for evaluation. While many of the services are quoted at Medicare reimbursement rates, the allowable amount for cataract surgery with IOL implant (66984) is only $850. Since Medicare's allowed reimbursement for their center is $950, the ASC decides to refuse the agreement after approaching the payer and having the request for a rate increase denied. Let's go through a contribution margin analysis to determine if that's the right decision.

What is a Contribution Margin Analysis?

Many ASCs may be under the impression that they need only divide the center's total expenses by the number of cases to determine cost per case. This is a common misunderstanding. Because of the behavior of fixed and variable expenses, this calculation becomes inaccurate with any change in volume or service mix. For a more accurate calculation, it's better to use a contribution margin analysis. This formula removes fixed expenses from the equation. The formula for contribution margin analysis is CM = R -minus VE: revenue (R) less variable expenses (VE) equals the contribution margin (CM) — or the amount that is being contributed toward fixed costs (and profit).

To truly understand why contribution analysis is used, it is important to understand how expenses behave.

1. Variable Costs: Variable costs are titled as such because the total dollars for variable costs vary with volume, while the per-unit cost remains the same. Examples of variable expenses in a surgery center include disposable items, medications, patient forms, surgical supplies and OLs. An IOL, with shipping and tax, may cost $125 per unit; but centers don't know the total variable expenses until the end of the year when they multiply the per-unit expense by the total units used.
2. Fixed Costs: Fixed costs are expenses that don't change with the level of business activity. Rent, equipment leases (those not on a per-use basis), insurance and administrative staff expenses are all examples of fixed costs. Because of the behavior of fixed expenses, the facility's ability to generate a profit increases once a center performs enough procedures to cover the fixed expenses. The break-even analysis graph shows how profitability can rapidly increase as volume increases (Figure 1).

Figure 1. A break-even analysis graph.

Financial experts define staff expenses as “semi-variable.” A segment of staffing expenses (typically administrative duties) is fixed and a portion (clinical time) can be allocated as variable. When evaluating services and payer contracts, it's important to allocate staffing expenses to the variable category where feasible. This becomes even more important when using a contribution analysis approach to study the efficiency of OR usage or when evaluating a service line of procedures to determine potential profitability. For purposes of this analysis, the cost of OR personnel is allocated in the variable expenses.

The Contribution Margin Financial Evaluation

The surgery center tracks variable expenses per cataract procedure in Table 2. The higher-than-average expense per cataract procedure (national benchmarks for supplies and medications average $200 per case) indicates there is room for improvement. Nonetheless, even if the center doesn't reduce expenses, they still may consider accepting this provider agreement. If they're able to reduce variable expenses, then the financial picture would be even better.

As indicated above, the payer's proposed reimbursement per case will be $850. Therefore, the contribution per case is $332 ($850 revenue minus $518 variable expenses). From previous information, we also see that signing the new agreement would add about 100 cases. For each of those 100 cases completed, there is $332 that will contribute to the fixed expenses — and in this instance — profits. Assuming other volume and fixed expenses remain the same, signing this new agreement would add 100 cases per year and generate an additional $33,200 ($332 x 100) in incremental income by the end of the year. Therefore, each partner would receive about $15,067 ($45,200 divided by 3) rather than the $4,000 distribution from the current year ($12,000 divided by 3).

Unique Situations

In this particular example, we know there are only two surgeons using the facility and through benchmarking, it's clear that the center has excess capacity. Excess capacity is always a key consideration in evaluating opportunities. If the additional cases require capital for expansion or purchase of new equipment, then a full feasibility analysis should be conducted before making a decision. Though Eye Surgery Center is running profitably, adding volume could substantially improve its financial position as long as fixed expenses remain flat. Each facility's financial position is unique, and therefore it's important to learn the process of conducting a contribution analysis in order to evaluate each situation independently. This case study took a simplistic approach for instructive purposes. Qualitative considerations haven't truly been evaluated. The financial impact assessment would lead to a decision to accept the rates, but there may be some other considerations that could still cause the center to stay with its original decision to decline participation.

More Uses for Contribution Margin Analysis

Once a manager becomes comfortable with the contribution analysis concept, other uses for this information will surface. A contribution analysis will help in making better decisions about whether or not to add a service line, whether to continue a current service line, evaluating OR efficiency and how to price cash services/procedures. Table 3 includes a contribution analysis of the different service lines for Eye Care Center. This would certainly make a case for recruiting additional cataract surgeons to the center.

An Exercise in Financial Discipline

Contribution margin analysis is a valuable multi-use tool that is highly effective in evaluating payer contracts. Utilizing this tool before making a snap judgment regarding a payer contract is an exercise in the kind of financial discipline regularly practiced by successful ASCs. Consistently using such tools will have a substantial impact on the financial success of any center. ◊