How Should Hospitals Report Financial Performance?

Consider these three hypothetical business press headlines:

Los Angeles Police Department posts $935M operating profit in Q1

Chicago Archdiocese exits the red with $356M Q4 gain

Disney’s Human Resources Department posts $20M operating loss in Q1

These feel off, right? Talking about profits in the case of public sector agencies, charities, and non-P/L corporate departments is nonsensical. Not that these entities don’t deal with money, or that they don’t benefit from financial metrics. But profit margin isn’t the *right* financial metric for these types of organisations.

But here’s the thing: these headlines weren’t completely made up. I copied them from actual recent healthcare newsletters, then changed the organization names. Here are the originals:

Kaiser posts $935M operating profit in Q1

Common Spirit exits the red with $356M Q4 gain  

SSM Health posts $20M operating loss in Q1

These headlines are just as absurd as my fake ones, because revenue and profit margin are bad summary measurements of performance for nonprofit healthcare systems. It’s misleading and it’s counterproductive.

To explain my logic, let’s start with the reasons why revenue and profit margin *do* make sense in the for-profit world. (At least, in the world of mature for-profit companies, as opposed to startups.)

In an efficient, well-functioning free market, where consumers make purchasing decisions based on quality and price, companies who produce higher quality goods at lower cost are able to sell more products at a higher profit margin. Revenue and profit margin are therefore direct reflections of the company’s performance in supplying superior goods and services at lower cost. To put it another way, financial performance and overall company performance are closely enough aligned that for metrics purposes we can safely treat them as if they were the same thing.

Why doesn’t this work with hospitals?

The short answer is, because the US hospital industry isn’t a true free market.

Here’s the longer answer: US hospital prices are primarily determined by factors unrelated to the quality of the services provided. Roughly half of healthcare pricing (Medicare and Medicaid) is set through central planning processes, similar to how bread prices were (badly) determined in the old Soviet Union. The other half of healthcare pricing is set based on the balance of power between a provider organization and private insurers. These negotiations are highly sensitive to monopoly effects, and therefore not a true free market either. Since revenue equals price times volume, the artificial nature of pricing means that revenue and margin are too decoupled from value to be reliable measures of hospital performance.

But are they reliable measures of hospital sustainability? Again, I’ll argue no. This is because the margin calculation bundles all expenditures together, including both clinical and nonclinical costs. Without knowing more detail about what hospitals are spending their money on, it’s impossible to say how efficient they are, or how current staffing levels (the largest driver of cost) compare to what’s needed for safe and sustainable care.

Here’s a simple illustration: Suppose a hospital decides to improve its profit margin by pressuring OR staff to speed up surgeries. Maybe they offer financial incentives to doctors and nurses based on hitting ever-more aggressive time-based goals, then threaten to fire anyone who resists. (If you think this is an implausible scenario, just look at what’s happened in emergency medicine under the control of private equity firms). Result: revenue and margin go up, as a simple consequence of more surgeries per day per amount of resource. Complication rates also go up, because the clinical teams were already working as fast as they could safely work, which means that the additional speed had to come at the expense of cutting corners. The complications lead to more more care delivery, including repeat surgeries. Which brings in even more revenue. (Yes, I know that CMS and other insurers have created penalties for infections and readmissions, but these rules are quite narrow, plus they don’t extend to outpatient care for these patients. So the general principle remains true that that there’s no positive correlation between quality and payment, and if anything there's a negative correlation.)

To summarise: In a free market, profit margins are determined by a company’s ability to deliver more value to customers at a lower production cost. In hospitals, on the other hand, the two ways for a hospital to increase their margin are to increase prices (mainly through consolidation which leads to more leverage with insurers, but also by gouging patient on out-of-pocket costs) and to cut clinical costs below the level needed for safe care. Both of which are the opposite of what communities and patients actually want from their hospitals. In other words, hospital revenue and profit margin can be negatively correlated with value. And so we should stop relying on these metrics.

What kinds of financial metrics should hospitals report instead?

What society expects from hospitals is to take care of the health needs of a community, and to do so efficiently (without wasting money). We want them to not go bankrupt, i.e. have some basic level of financial sustainability. We want hospitals to be positive contributors to the local economy. We also want fairness and equity across communities and subpopulations. How do finances relate to these goals?

1. Revenue: We know that bigger isn’t generally better in healthcare, and we also don’t want to reward hospitals and health systems for being extractive. Just as we wouldn’t want police departments to brag about revenue and revenue growth, we shouldn’t want hospitals and health systems to either. So instead of reporting what hospitals bring in, let’s instead report what they spend it on. (You can add the numbers for expenditures and savings to figure out the revenue, so there would be no loss of transparency.)
2. Costs: Not all expenditures are equally worthy. Spending money on patient care is a different from spending it on administrative overhead. So these two categories should be split out. Clinical care includes professional salaries, medications, supplies, and clinical facility costs. Pretty much everything else, including billing-associated expenses, is overhead. The other consideration here is that spending money locally, whether on worker salaries or local suppliers or taxes or real estate, contributes to the community's economy, and so finance reports should distinguish this from expenditures that leave the community.
3. Sustainability: Hospitals don’t need huge war chests (endowments, investment funds) to be sustainable. What they need are positive margins on average (not necessarily every single quarter), combined with enough cash on hand to deal with short-term volatility. A recent S&P analysis found that most nonprofit hospitals have at least 150-160 days of cash, which put them into the “strong” category. Any resources beyond that level should be returned to the community in some form (lower prices, more charity care, etc.) or on necessary facility upgrades. Activist investors get antsy when for-profit companies hoard more cash than they need to achieve their business goals, and communities should hold hospitals to the same standard. (Note that this is a moot point for the vast majority of hospitals. But there are a few large systems with big investment funds.)
4. Equity: By “equity” I don’t mean that every individual pays the same amount for healthcare, and I also don’t mean that every individual receives the same amount of healthcare resource. There will always be inequality in which people get sick and which people stay healthy. A better way to define equity starts with the ideal that care should be provided according to a patient’s needs, rather than their ability to pay. Therefore, healthcare revenue (insurance premiums, out-of-pocket, and tax funding) should generally be proportionate to ability to pay (some combination of income and wealth), whereas healthcare expenditures should be distributed according to medical needs.

Here’s my wish list of summary financial metrics that I’d like to see hospitals and news organizations highlight, in place of revenue and profit margin:

1. Expenditures on direct clinical care (total and percentage) compared to expenditures on administrative overhead (total and percentage).
2. Expenditures that remain within the community (total and percentage)
3. Sustainability questions: was the trailing 12 month margin positive, and is there enough cash on hand to remain liquid given the level of margin volatility?
4. Any cash and investments that exceed the 160 days cash-on-hand criterion (and what the plans are for that money).

Ideally, these metrics would be accompanied by community-based measures of spending on individuals and populations:

1. Total clinical expenditures per capita for the full community and for specific underserved subpopulations. For example, if high-income neighborhoods have higher expenditures than low-income neighborhoods, then something’s wrong, since we know that the latter have generally higher burdens of disease.

2. Total clinical and overhead expenditures per capita compared to national averages. For example, it’s reasonable to expect care to be a little more expensive in New York City than in rural Iowa due to higher labor and real estate costs, but it shouldn’t be multi-fold different. 

These proposed measures would require a bit of work on the part of both hospitals and communities, but they’re well within the range of existing accounting capabilities. By reporting these in place of traditional revenue and profit margin numbers, we could drive more constructive public dialog regarding hospitals, their finances, and how well they are accomplishing their mission.