DRG strategies from the Big 8 Essay

The furor aroused by introduction of prospective payment for
Medicare patients is finally beginning to abate. Hospitals and their
laboratories are settling down to the business of refitting their
operations to DRG economics.

And business is quite literally what it is. More detailed profit
and loss statements, data management systems that reveal pertinent new
trends, productivity studies, aggressive marketing efforts, joint
ventures–in short, the standard management tools of corporate
America–are the order of the day at many medical institutions.

Nowhere are such developments more evident than in the stepped-up
health care planning activities of the nation’s Big 8 accounting
firms. Hospitals are turning to these experts and others like them for
help in coping with prospective payment. Consultations range from
assessments of current practices to recommendations for complete

To find out what efforts are under way, which techniques have
proved the most successful, MLO interviewed key executives in the health
care planning divisions of the Big 8. Here’s the lineup: Cletus J.
Moll, a partner in the health care division of Arthur Andersen &
Co.; Neal F. Bermas, national director of health care planning and
productivity services for Arthur Young & Co.; Julie A. Micheletti,
manager of national health care practice for Coopers & Lybrand;
Albert A. Cardone, national director for health care services at
Deloitte Haskins & Sells; John Nackel, a partner in the national
health care practice division of Ernst & Whinney; John Mertens, the
partner responsible for reimbursement in the health care group of Peat
Marwick Mitchell; Jack Buelt, a partner at Price Waterhouse and chairman
of the firm’s hospital and medical services group; and Doug Newton,
a partner and director of the health care consulting services of the New
Jersey office of Touche Ross.

According to these experts, after the initial shock of going on an
inflexible budget, the majority of hospitals discovered that prospective
payment wasn’t quite as painful as they had feared. That’s not
to say it was easy–in fact, it required a complete rethinking of the
way almost every department was run.

“After all,” Jack Buelt (Price Waterhouse) explains,
“DRGs are the biggest revolution in health care since the original
Medicare regulations. Under the old system, you didn’t want to let
patients go too quickly; now that philosophy has undergone a complete

“We’ve seen a big increase in our hospital business since
prospective payment. All of a sudden, they’re interested in our
business services: cost accounting, productivity studies, staffing
assessments, and information systems. There’s also overall higher
interest in how to make better use of discharge planning and home health

These observations are echoed by all the other consultants we spoke
with. John Nackel (Ernst & Whinney) says his firm is being asked
for much more operations management advice than in the past. The four
areas included in the firm’s operations appraisal are staffing,
scheduling, organization, and policies and procedures.

Doug Newton (Touche Ross) reports his hospital clients look for
services that are oriented toward increasing productivity and supporting
economic decisions. “Hospitals are bringing us in when they have
questions about how a proposal will affect them economically. In data
processing, for example, they’re focusing more on the cost/benefit
relationship instead of just throwing money at the problem.”

Julie Micheletti (Coopers ; Lybrand) identifies three major
areas of study as operational and system management review, productivity
studies, and cost containment.

One thing these studies show hostapils: Application of good
business techniques can result in economies that don’t appreciably diminish the quality of patient care. “All you have to do to know
how inefficient a hospital might be is to be a patient there,”
Buelt says. “Inefficiency used to be the burden of the patient and
the payer alone. Now, if a hospital can speed up diagnosis, reporting,
and treatment, it can cut length of stay and improve its financial

The clinical laboratory can contribute directly to shorter stays
through preadmission testing and what Micheletti characterizes as
reflexive testing–an automatic follow-up procedure after an abnormal
result. For example, the laboratory may set a policy that a BUN
significantly outside normal limits be automatically followed by a
creatinine level. “If the attending physician were notified of the
result, he or she would likely order the second test anyway, so why not
do it immediately instead of letting all that extra time
elapse?”‘ Micheletti observes.

“If there’s any one area where cost can be most
controlled,” Nackel says in a similar vein, “it’s in
getting the patient out of the hospital as soon as possible.” So
important is the laboratory’s contribution to this effort that
Cletus Moll (Arthur Andersen & Co.) calls increased preadmission
testing “our primary recommendation” to clients.

Beyond savings per DRG, a less obvious advantage of shorter stays
is pointed out by Newton: “In an institution that’s very
heavily utilized (high occupancy rate), you can increase your admission
capacity if you reduce your length of stay through preadmission

He adds that the same does not hold true for a hospital with a low
occupancy rate. “In a hospital with low utilization, you have to
assume that they won’t be able to make use of that extra patient
day. In that case, what they have to do is manage costs.”

Micheletti suggests other moves the laboratory might make to cut
costs. “Review all standing orders. For example, some labs cancel
standing orders after three days, subject to the physician reordering the test.” She also recommends flagging standing orders that yield
normal values for, say, two days in a row and bringing them to the
attention of the attending physician.

She cites another area ripe for improvement: “Particularly in
larger facilities, it’s not uncommon to have a physician, a
consultant, and a resident all working on the same patient. Sometimes
this leads to duplicate ordering of tests. You can catch this in the
laboratory after requisitions are batched by having someone audit the
serial orders.”

This may imply that physicians are insensitive to cost
considerations. Not so, the consultants state. “Germany to what a
lot of people thought, physicians want to know what services cost,”
Nackel says. “That information wasn’t available to them
before. We’re finding that physicians are concerned about the cost
of care. Seeing this kind of information allows them to make better

“Physicians are definitely interested,” John Mertens
(Peat Marwick Mitchell), confirms, but he cautions that the way
information is presented may be the key to acceptance. “If you
just talk to them about coding, they’re not that interested. But
if you explain that steps they take to correct their coding will mean
another $1,000 in the hospital’s coffers, you make it very
relevant. They’re willing to listen, at least on the first
go-round, if you explain that the money lifeline of the institution is
directly affected when they don’t complete a chart properly or on

According to Neal bermas (Arthur Young & Co.), physician
understanding and cooperation in efforts to cut costs and increase
volume are central to hospital success under prospective payment.
“In order to survive, that’s going to be the name of the game.
Hospitals and doctors have to work together rather than compete or have
an adversarial relationship.”

One approach all the Big 8 firms advocate in the physician
education process is generation of computerized reports. Most of the
companies license or sell software for this purpose. At Ernst &
Whinney, for example, Nackel recommends a system that merges medical
records, billing, and cost information to produce profit and loss
statements by DRG classification, physician, or payer type. “We
look at volume of service and delivery patterns by individual DRGs. Then
we walk through those reports with physicians and work with them on
managing costs.”

Case-mix management systems are described in all kinds of
literature put out by the Big 8. Albert Cardone summarizes part of the
case-mix discussion in a 62-page Deloitte Haskins & Sells booklet
for hospital clients: “The cost of the specific service must be
computed before a hospital can determine teh relative profit or loss
contributions of various diagnoses or services.”

Fortunately, hospitals don’t have to determine the cost for
each of the 468 DRGs. Most hospitals treat no more than 50 different
diagnoses, with 25 of those representing the majority of cases, Deloitte
Haskins ; Sells notes.

Commenting on the computer’s expanding role, Newton says:
“There’s a tremendous amount of data needed just to respond to
the Federal system from a statutory standpoint. In addition,
there’s a big increase in the amount of information necessary to
manage under the system. For example, we need detailed information on
unit costs and what it costs to treat a particular DRG. Those needs
create accelerating demands on data processing. Hospitals are realizing
that the only way to manage aggressively in the future is to enhance
their data processing capabilities.”

Once computerized systems are in place, they can be used on a
day-to-day basis to cut costs. “Suppose that the lab and pharmacy
are computerized and coordinated with one another,” Micheletti
says. “In that case, if there are three alterantive drugs of choice
for a particular infection, the lab report that is printed out for the
physician will include not only the MIC, but the cost of each of those
drugs. The physician can then make a decision based not only on the
drug, but on the cost as well.”

Cost-cutting measures in the laboratory can range from the simple
expedient of group purchasing to analysis of individual tests. “We
encourage labs to look very closely at low-volume, high-cost tests and
determine if there’s a more economical way to do them,” Newton
says. “We explore instrument changes, as well as the classic
business evaluation of make-or-buy. Should you really be doing a test

Micheletti likewise sees hospital laboratories evaluating greater
use of reference labs. “There may be a trade-off in terms of
longer turnaround time. On the other hand, sending out the work may be
les costly–you have to balance your choices.” She also urges labs
to evaluate interchangeable illness-specific lab tests to discover which
are the most cost-effective.

Cost control is the tightening side of hospital operations.
Marketing is the expanding side. “Hospitals are really getting
into marketing their businesses now,” Bermas says. “Even
traditional strategic planning is taking on a much more market-driven

“Marketing is one of the areas where we have seen the most
activity,” Nackel affirms. “You pick up a newspaper or listen
to the radio, and there are ads for hospitals–preferred provider
organizations in particular. There’s one here in Cleveland that
advertises in the Sunday paper every week and runs ads constantly.
They’re pretty aggressive in terms of promoting their product.
Their pitch is to employers who want to reduce their medical costs and
still get quality care on a local level.”

By the same token, hospital laboratories are beginning to pursue
outside business aggressively. Many are exploring the possibility of
competing locally with reference laboratories for physicians’
office testing. Micheletti also reports that hospital labs are trying
to attract corporate business for employee and executive testing.

“Larger hospitals compete effectively with independent
labs,” Moll says. “They’re only looking at incremental
costs since they already have the equipment and staff.”

In New Jersey, Newton has seen a substantial increase in the number
of labs seeking outside revenue. “Some of the edge is taken off by
the reimbursement rules for outpatient labs. However, if your marginal
revenues are greater than your marginal costs, it’s a good thing to
do because it gives you some additional coverage of overhead.”

All of the consultants stress that careful study should precede a
marketing decision. Newton warns of the pitfalls. “Where most
hospitals run into trouble is a failure to understand what it takes to
compete in a commercial environment. There are a lot of logistical requirements, such as computerization of results and pickup of
specimens, that you need to look after if you are going to compete.
Labs that are doing well are taking a very aggressive and thorough
business approach.”

What it takes to compete–at least in southern California–may be
deluxe treatment, according to an example offered by Bermas.
“There’s a hospital here that’s trying to make its
outpatient services, including the laboratory, more palatable by
offering patients valet parking and a separate, easily accessible
entrance to the outpatient department!

“Although that sounds comical, it’s the right thing to
do. People never went to hospitals for outpatient lab work if they
could avoid it because it was such a pain in the neck. It was easy to
get lost in the institution, and they usually had to wait a long time to
get anything done. Now, they can drive right up, walk in, and get
handled quickly, efficiently, and pleasantly. All the incentives are

This high-powered marketing approach to health care often demands a
new kind of executive to run the hospital itself and oversee major
departments. According to the experts we talked with, though, this is
just part of a natural progression. “It might temporarily speed
things up,” explains Mertens, “but requirements for chief
executive officers and chief financial officers have been steadily
changing ever since Medicare was introduced. What’s happening is
that the hospital administration is becoming a true management team
rather than just a caretaker.”

The result is a hospital administration comfortable with exploring
new business options. Moll reports that a number of his firm’s
clients are exploring joint venture arrangements with pathologists,
either on or off site.

For the most part, however, such set-ups are more talk today than
action. Bermas was highly enthusiastic about the idea. He feels that
creative joint ventures are of the utmost importance and that
laboratories are perfectly suited for such an arrangement.

The kind of joint venture he envisions would exclude investment by
pathologists. “You need incentives to induce doctors to use your
laboratory rather than someone else for their outpatient work,” he
says. “That’s why the joint venture should include a number
of your key physicians as investors. Then all concerned have an
interest in seeing the venture succeed. Pathologists’ revenues
increase as use of their services grows, while the hospital and other
physicians as investors maximixe their position. In this arrangement,
everyone benefits.”

Of course, some hospitals will be better able than others to adjust
to prospective payment. As Buelt sees it: “Those with low cost and
high volume are doing very well because the DRGs are based on averages.
We just did a study for a hospital in Oklahoma. It’s a good area
because the volume is going up and they have low regional costs.
They’re going to do very well under prospective payment. Low
occupancy, on the other hand, realy hurts a hospital, even fi they keep
their costs down.”

“Small community hospitals that are not part of a health care
system may have more problems than large institutions that are,”
Moll says. He also predicts difficulties for northern institutions
(because of higher regional costs) and for teaching programs. So does

“Teaching programs will not go unaffected by the pressures on
health care costs. Although they’re relatively stable so far, I
don’t see that continuing. The Feds are scrutinizing teaching
programs to determine whether it’s appropriate for Medicare to
continue funding them. As they pursue that line of questioning,
they’ll find ways to reduce the premium that hospitals now get to
continue teaching programs.”

Other predictions for the future of prospective payment vary, but
all the consultants we interviewed agreed on one thing: Prospective
payment in here to stay, although some fine-tuning will take place over
the next few years. Mertens and Micheletti, for example, think the
system will have to change to take into account the acuity level within
a particular DRG.

Mertens also reports a great deal of interest in prospective
payment on the part of other third-party payers. “We have
performed studies for Blue Cross plans across the country. As the
Federal Government stabilizes its prices, they will be even more
interested. Economically, they won’t be able to ignore it.”

Bermas goes even further: “My own view is that prospective
payment under the Feds is kid stuff compared to what private payers are
going to begin to come up with. We’re already seeing fairly
aggressive attempts from the business community in certain parts of the
country to demand cost containment–either directly from providers or
through intermediate payers.”

Cardone’s firm, too, is cautioning clients not to limit their
planning to a Medicare-only system: “Some states and Blue Cross
plans are already planning to implement prospective payment systems
based on DRGs. It is rapidly becoming clear that hospitals must plan
ahead, identify their management needs, and make every effort to insure
that they can adapt quickly to the changing environment.”

The question is, will hospitals and laboratories have the time they
need to make the necessary changes? As Bermas points out, “It took
the auto industry 10 to 11 years to get their cost accounting systems
into shape; hospitals are trying to do it in three years (the Medicare
prospective payment phase-in period). The hospital adjustments
we’re talking about are just the beginning stages here. I think
quite a few institutions aren’t even doing this much.

“Predictions are that 2,000 hospitals will close because they
won’t be able to function under prospective payment. You can
already start to get an idea of which hospitals are endangered, based on
a lack of activity. On the other hand, we are helping many of our
clients to become more aggressive and creative in operating in this new


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