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West, T. D. and D. A. West. 1997. Applying ABC to healthcare. Management Accounting (February): 22, 24-26, 28-30, 32-33.

Summary by William Beck
Master of Accountancy Program
University of South Florida, Summer 2002

ABC Main Page | Healthcare Cost Main Page



The purpose of this article is to illustrate the need to use new costing methods in the health care industry and to illustrate the need to apply additional thought to applying activity based costing (ABC) to areas outside of manufacturing. The article examined the application of ABC to alternative treatments at a renal dialysis clinic.

The change in managed care plans has created the necessity to apply more accurate costing methods, such as ABC, in the health care industry. Prior to the early 1980s most health care providers operated on a retrospective payment basis. This method based reimbursement on the cost of providing health care services. Medicare made a switch to a prospective service plan with hospitals receiving payments based on the Diagnosis Related Group (DRG) of the patient and not the cost of the services provided. In the 1990s, managed care plans refined DRGs further by making fixed payments, or capitations, for each member. Because hospitals/clinics must maintain costs below the capitation payments received to be profitable, it has become increasingly important for proper costing methods to be employed for better decision making. With health care providers working to contain costs, there is a danger of discontinuing services or promoting other services based on improper cost allocation.

A study was made of a dialysis clinic that had been spun off from a hospital in 1983 because the hospital did not feel operating this unit was profitable. Today the clinic realizes profits of $225,000 on $3 million in revenues (p. 24). Two forms of treatment are available for renal dialysis, Hemodialysis (HD) and peritoneal dialysis (PD). HD is administered at the clinic and requires three visits a week, while PD can be administered by the patients at home and requires seven treatments per week. The problem perceived by the clinic was how to interpret existing cost information to determine the true cost effectiveness of HD and PD (p. 25). The authors indicate the value of the new cost system must be measured in terms of whether it satisfies two conditions:

1. Does the system more accurately measure the costs of services delivered, and

2. Does the system optimize the incentives and behaviors (treatment selection and cost containment) of those involved in treatment delivery (p. 25).

Medicare Costing: RCC

Medicare requires the reporting of aggregated costs, made up of general overhead, durable equipment, and nursing services, with the use of a ratio-of costs-to-charges (RCC). Treatment costs are measure by departments by applying RCC (indirect costs divided by total charges) to treatment revenues. Three assumptions are needed when applying RCC: 1) indirect costs comprise a single pool (allocated costs are interchangeable), 2) reimbursement rates reflect treatment intensity, and 3) each treatment type consumes indirect costs in the same proportion (p. 26). Applying this method to the clinic studied showed that HD treatments were twice as profitable as PD treatments. The implication of these differences in profitability could lead providers to be more inclined to promote HD over PD. A further drawback of RCC is the assumption that all resources are used equally by the two treatments, a fact which may not be true. HD requires in house treatment to the patients and requires the use of capital intensive machines. For this reason, HD may consume a larger amount of the clinics resources.

Implementing ABC

A two step approach was used to implement ABC to the dialysis clinic. First, ABC, as it is used in manufacturing, was applied directly to the general overhead of the clinic (28% of the clinics total service costs), but not to nursing services (32% of the clinics total service costs), or durable equipment. The authors labeled this method of allocation M-ABC. Standard and episodic supplies were traced directly to the treatments. General overhead was identified and cost pools were created. Cost drivers were then identified to assign these costs to the two treatments. The remaining service costs, durable equipment and nursing services, were allocated at the best estimate of the clinics staff (85% to HD and 15% to PD). The results of this analysis shifted 2.5% of the general overhead costs from HD to PD and a much larger shift of 23% in the cost of nursing services from PD to HD. The resulting analysis showed HD as being unprofitable because of the nature by which the treatment consumed the resource of the clinic. This is a shift from the assumption that HD was more profitable derived from the RCC method required by Medicare.

The second step called for greater analysis of the previously unanalyzed nursing services costs. The authors labeled this method H-ABC. By applying ABC analysis to nursing services, it was found that the clinics staff over allocated nursing services to HD by 13% which had originally made the treatment appear to be unprofitable. The new analysis shows that in fact both treatments are profitable.

The following data was provided by the authors illustrating the results of their analysis:

RCC Analysis M-ABC Analysis H-ABC Analysis
HD PD HD PD HD PD
Total Revenue 1,860,287 1,146,488 1,860,287 1,146,488 1,860,287 1,146,488
Standard Supplies 512,619 152,281 512,619 152,281 512,619 152,281
Episodic Supplies 98,680 212,015 98,680 212,015 98,680 212,015
General Overhead 466,610 319,215 466,610 319,215
Durable Equipment 1,117,463 688,688 116,489 20,557 102,785 34,261
Nursing Services 750,788 132,492 661,966 221,314
Total Service Cost 1,728,762 1,052,984 1,945,186 836,560 1,842,660 939,086
Net Income 131,525 93,504 -84,899 309,928 17,627 207,402
Avg. charge per treatment 129.70 55.59 129.70 55.59 129.70 55.59
Avg. cost per treatment 120.53 51.06 135.62 40.56 128.47 45.53
Profit (loss) pre treatment 9.17 4.53 (5.92) 15.03 1.23 10.06

Accountants Must Assist MDS

Accountants can assist management in better decision making by:

1. Highlighting opportunities for participation in the cost containment process,

2. Facilitating an understanding by collaborative teams of properly specifying cost model assumptions,

3. Illustrating that organizational changes may be inappropriate if they are based upon misspecified costs, and

4.  Providing evidence to support the potential for ABC applications in managed care environments (p. 32).

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Related summaries:

Caltrider, J., D. Pattison and P. Richardson. 1995. Can cost control and quality care coexist? Management Accounting (August): 38-42. (Summary).

Davenport, T. H. and J. Glaser. 2002. Just-in-time delivery comes to knowledge management. Harvard Business Review (July): 107-111. (Summary).

Kershaw, R. 2000. Using TOC to ‘cure’ healthcare problems. Management Accounting Quarterly (Spring): 22-28. (Summary).

MacArthur, J. B. and H. A. Stranahan. 1998. Cost driver analysis in hospitals: A simultaneous equations approach. Journal of Management Accounting Research (10): 279-312. (Summary).

Ruhl, J. M., B. P. Hartman. 1998. Activity-based costing in the service sector. Advances in Management Accounting (6): 147-161. (Summary).

Sedatole, K. L. 2003. The effect of measurement alternatives on a nonfinancial quality measure's forward-looking properties. The Accounting Review (April): 555-580. (Summary).