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Healthcare operations management is important. Explain how the healthcare industry differs from other industries with operations and how payers impact the revenues. Why does an operations manager need to understand the financial side of the healthcare organization? How are the three financial statements related and what does the information measure?

Chapter 3

PART I

Operations, Systems, and Financial
Management

Part I of this text provides the reader with a foundation of operations management and explains
its role in improving health care’s financial and business condition. Health care activities and
processes are complex. To perform optimally, they must be managed as a system. Operations
and systems management requires knowledge of process improvement, quality, finance, and
many other business practices. As a service industry, financial outcomes are driven primarily
by labor and supply costs, so an understanding of the income statement and the use of key ratios
to manage these areas is provided. Understanding the concepts of operations management, and
its relationship to financial margins, is also explored.

Chapter 1 offers an overview of the discipline of operations and systems management and
that of management in general. Goals of operations management, from cost reduction to
network optimization, are described, as well as the key functions and roles performed by
operations managers. This chapter sets the stage for the rest of the text.

Chapter 2 provides an introduction to the health care marketplace. Because health care
organizations are businesses, they must generate revenues and sustain themselves financially,
as organizations do in other industries. This chapter defines the hospital and health care
organization and discusses the nature of its goods and services. This chapter provides an
overview of some of the significant health policies that affect patient operations, including the
Affordable Care Act. The concept of health care production, distinct from operations, is also
explored.

Chapter 3 provides a structured introduction to health care finance for the operations
manager. An understanding of the drivers of improved financial performance is essential to
effective operations management. This chapter addresses how hospitals earn revenue, and it
defines the basic terms used in health care finance. Of great importance, it explains the key
external financial statements that represent the financial condition of the organization, which
are used as data sources for a variety of operational analyses in this text.

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FIGURE P1–1 Operations Management in Health Care

Helton, Jeffrey, et al. Health Care Operations Management, Jones & Bartlett Learning, LLC, 2015. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/apus/detail.action?docID=4441334.
Created from apus on 2020-01-09 17:05:22.
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CHAPTER
1

Health Care Operations and Systems
Management

GOALS OF THIS CHAPTER
1. Describe the need for improved decisions and management systems.
2. Define health care operations management.
3. Describe the roles and responsibilities of health care operations managers.
4. Examine the management decision-making process.
5. Understand the goals of operations management.
6. Describe the management discipline and where operations management fits.

Health care operations management is a discipline that integrates scientific principles of
management to determine the most efficient and optimal methods to support patient care
delivery. Today, most hospital positions are roles that involve the coordination and execution
of operations. This chapter provides the rationale for operations management and describes its
evolving role in helping hospitals become more competitive.

THE ROLE OF HEALTH CARE OPERATIONS
MANAGEMENT
Health care operations is about management of interconnected processes, or systems. A system
is a set of connected parts that fit together to achieve a purpose. Health care operations and
systems management is the set of diverse and interrelated activities that allow for diagnosis,
treatment, payment, and administrative management in health care facilities.

Most hospitals are nonprofit in nature. Nearly 80% of hospitals are considered nonprofit
and exist solely to serve the community in which they operate, down from 85% a few years
ago. As nonprofits, these organizations are exempt from most federal and state taxation and are

not expected to show continuous positive growth rates or large profit margins, as most publicly
traded firms do. However, if a hospital or health care organization cannot show some return on
the capital or dollars invested, there will be negative consequences. For example, failure to
show reasonable margins will likely cause the public bond market (which finances most health
care growth today) to assign subpar credit ratings; therefore, the bonds themselves will have
poor yields, making hospitals less than stellar investments for bondholders.

Most important, the term limited profit margins implies that there will be fewer dollars to
invest back into the business to ensure that buildings are updated, equipment is replaced and
technology is modern, and clinical programs will continue to expand and be enhanced. Without
these investments, hospitals will likely be unable to attract the most qualified physicians and
administrators, which will continue the downward spiral. While some hospitals and health
care systems wait for changes in the public health policy to save them, the more competitive
and successful hospitals are acting now to protect their margins.

In this era of continual pricing pressures affecting the top line of the income statement, and
with a large majority of all hospitals reporting negative profit margins, it is essential that
hospitals begin to look toward more sophisticated business strategies to succeed.
Differentiated marketing programs and strategies, broader use of advertising, and more careful
and precise long-term planning about service lines are all strategies that must be utilized
(Rovin, 2001).

Equally as important, there must be a broader adoption of operations management
techniques into hospital business affairs. Monitoring and maximizing labor productivity for all
medical support and allied health professionals is critical to maintaining salary expenses.
Incorporating queuing theory and scheduling optimization methods helps drive waste and cycle
time out of hospitals. Incorporating logistical and supply chain management techniques helps
reduce operational expenses, eliminate excess safety stocks, and generally improve working
capital management. Most important, using technology to further automate and streamline all
processes in hospital operations can help reduce costs and maximize efficiencies.

Hospitals and other health care organizations cannot rely on extrinsic factors (such as
health policy, federal payer regulation changes, or shifts in managed care market structures) to
change their margin potential. Although these are important issues, they are covered in other
texts and will evolve regardless of the managerial behavior that hospitals employ. However,
equally significant to these macro-level issues are the micro-economic and organization factors
that can be affected by operations and logistics management. Operations management can help
organizations today.

Think of health care profit margins as a balloon, where a variety of extrinsic, or external,
factors cause deflationary pressure from the outside. On the inside is the set of decisions and
management systems put in place to combat these pressures and essentially inflate the balloon,
or expand the margin. In effect, operations management is the set of intrinsic, or internal,
processes and decisions that help address costs, process, technology, and productivity.
Strategic management, although equally important, is not a focus of this text. Figure 1–1 shows

conceptually the margin-expansion role that operations management plays.
Health care is primarily a service sector, in that the industry provides intangible or

nonphysical “goods,” as opposed to physical objects that can be seen or touched. Hospital
services primarily deliver care through providers to patients and therefore lack a
manufacturing or assembling process. These services are unique and somewhat differentiated
from other hospitals, knowledge based, and have high levels of customer interaction. Of
course, there is a physical good that accompanies the service, which is the focus of supply
chain management in hospitals that procures, replenishes, and stores medical supplies and
pharmaceuticals as well. In this regard, hospitals have a mix of both tangible and intangible
characteristics. All of these attributes make health care operations management somewhat
different from industries that strictly produce and market physical goods or widgets.

FIGURE 1–1 Operations Management Counters the Extrinsic Pressures Deflating Health
Care Margins

Health care operations management can therefore be defined as the quantitative
management of the supporting business systems and processes that transform resources (inputs)
into health care services (outputs). Inputs are defined as resources and assets such as labor and
capital, including cash, technology, personnel, space, equipment, and information. Outputs
include the actual production and delivery of health care services. Quantitative management
implies a heavy use of analytical and optimization tools, as well as extensive use of process

and quality improvement techniques to drive improved results.
Health care operations management is a discipline of management that integrates scientific

or quantitative principles to determine the most efficient and optimal methods to support
patient care delivery. This field is relatively new to health care, but it has existed in other
industries for nearly 100 years.

KEY FUNCTIONS OF HEALTH CARE OPERATIONS
MANAGEMENT
The scope of health care operations management includes all functions related to the
management systems and business processes underlying clinical care. This includes extensive
focus on the following: workflow, physical layout, capacity design, physical network
optimization, staffing levels, productivity management, supply chain and logistics management,
quality management, and process engineering. Table 1–1 summarizes these key functions and
illustrates some of the critical issues and questions that must be addressed for the health care
enterprise.

Health care operations management includes all of these business functions and provides
job opportunities for those with titles such as administrator, scheduling manager, operations
supervisor, vice president of support services, quality manager, operations analyst, director of
patient transportation, procurement manager, management engineer, inventory analyst, facilities
manager, supply chain consultant, and so on. Nurses, technicians, and other health providers
also play a key role in managing service operations. Operational management positions in
hospitals will continue to grow as the need for increased cost efficiency and accountability
rises.

Table 1–1 Key Functions and Issues in Health Care Operations Management

Operations
Management
Function

Objective or Issue to Consider

Workflow
process

• Are there too many departments or people performing the same task?
• Do we have an end-to-end map of our major business processes?
• How many manual processes exist?
• Are there ways to reduce cycle time, steps, and choke points for key processes?
• Can we improve speed and patient satisfaction?

Physical layout

• Are our facilities designed with the consideration of speed, capacity, traffic flow,
and operational efficiency?

• Are unit or floor layouts designed to eliminate redundancy (e.g., safety stock on
all resources)?

Capacity design
and planning

• How can we reduce bottlenecks to improve patient throughput for each area?
• In which cases should we increase the use of technology to improve labor
productivity?

Physical
network
optimizations

• Where should we position appropriate par locations, pharmacy satellites,
warehouses, and supplies to minimize resources and costs?

• Do we strategically utilize vendors and their facilities?
• How can we design and position optimal locations for clinics or resources to
ensure lowest total costs?

Staffing levels
and
productivity
management

• How much output can we expect from our staff?
• Have we maximized the use of automation and electronic commerce to increase
productivity?

• Have we implemented sophisticated analytical models to optimize labor and
resource scheduling?

Supply chain
and
management

• Have we built collaborative planning and forecasting logistics processes to
standardize items and reduce total costs?

• Should we operate just in time?
• Do we use automated, optimized replenishment of medical–surgical supplies to
increase turns and asset utilization?

• How much inventory of each item do we need?
• Do we use perpetual inventory systems to ensure stringent internal controls and
accurate financial reports?

Quality,
planning, and
process
improvement

• Do we use advanced tools for tracking projects?
• Are we measuring the right performance indicators to bring visibility to trends
and exceptions?

• Do we know how we compare to our key competitors?
• Have we identified the quality issues that affect our customer satisfaction and
efficacy goals, in addition to efficiency, costs, and speed?

THE NEED FOR OPERATIONS MANAGEMENT
The Future of Emergency Care report series produced by the Institute of Medicine of the
National Academies describes the problems facing health care today, especially the emergency
care arena. The report outlines several recommendations for solving the current crisis, and one
key recommendation notes, “Hospitals should reduce crowding by improving hospital
efficiency and patient flow, and using operational management methods and information
technologies” (Institute of Medicine, 2006, p. 2).

Others outside of the health care industry have also identified weaknesses in how health
care managers administer the processes and systems. IBM has recognized that the service
sector must focus more on applying management science to improve processes and outcomes

and is collaborating with universities to implement what it calls services science. Irving
Wladawsky-Berger, IBM’s Vice President for Technical Strategy and Innovation, was quoted
in The New York Times as saying,

All those processes [in a hospital] get done in a relatively ad hoc way. If we want to
apply information technology and engineering discipline to improve the quality of the
service to reduce errors and to improve productivity, you need people who know how
to design a hospital system. (Holstein, 2006, p. 10)

Clearly, even those on the periphery of the health care system understand the complexity and
the lack of sophistication that currently exist in the industry.

Many other researchers and associations have called for operations management to help
drive improvements and efficiencies in the health care system (Herzlingertt, 1999). The
purpose of this text is to help students and practitioners do just that.

GOALS OF THE OPERATIONS MANAGER
The operations manager may hold any number of the job titles discussed earlier, but
generically the term operations manager will be used to describe all such positions in this
text. A clinic manager who ensures that processes are in place so that patients efficiently move
from registration to treatment rooms to payment is an operations manager. An administrative
director who oversees financial operations is an operations manager. An operations manager is
any individual who directs and transforms processes to improve the delivery of patient care.
What else do operations managers do? They have a variety of broad goals and functions in the
hospital, including all of the following: reduce costs, reduce variability and improve logistics
flow, improve productivity, improve quality of customer service, and continuously improve
business processes. These are outlined in more detail in the following sections.

Reduce Costs
The primary role of operations managers is to take costs out of the health care system. Finding
waste, improving utilization, and generally stabilizing and reducing the overall cost of
delivering services are essential functions. A hospital with appropriate tracking and
management systems—that can isolate all personnel, material, and other resources utilized for
delivery of care—will be much more likely to reduce costs because it understands the
underlying cost structure. Identifying costs and eliminating unnecessary waste and effort is at
the forefront of an operations manager’s priority list.

Reduce Variability and Improve Logistics Flow
Operations managers continuously look for the most efficient and optimal paths for movement

of resources, whether those resources are physical or information flows. Similarly, there is a
continuous focus on reducing variability. Variability is the inconsistency or dispersion of
inputs and outputs. Variability threatens processes because it results in uncertainty, too many or
too few resources, and generally inconsistent results. If there are 10 patients typically seeking
care in a specific clinic within a certain time period, and then 20 appear the following period,
it will be difficult to staff, control waiting times, and manage patient flows.

Improving flow means seeking higher throughput or yields for the same level of resource
input. Throughput is the rate or velocity at which services are performed or goods are
delivered. If a hospital typically sees four patients an hour and can increase throughput to six
per hour, this is a 50% improvement in logistical flow and throughput. Similarly, if patient
volumes double but a hospital maintains the same historical inventory levels of pharmaceutical
supplies, this represents significant improvement in material flow, because assets have higher
utilization and turns.

Staffing and resource consumption should be tied directly to patient volumes and
workload: If patient volumes increase, so too should resources. Unfortunately, many health
care facilities do not understand patient volumes and the variability that exists from hour to
hour and day to day. Managing this variability allows an adjustment to staffing mix and
scheduling to accommodate the changes, without staffing at the peaks (which causes excessive
costs), staffing for the valleys or low points (which will cause long lines periodically due to
limited resources and therefore service quality issues), or staffing for the average (which is the
most common suboptimal approach). Figure 1–2 shows how variability changes over time,
which necessitates both capacity and demand analyses.

Logistics is defined as the efficient coordination and control of the flow of all operations,
including patients, personnel, and other resources. The role of operations managers is to
facilitate improved logistics and throughput by using streamlined process and facility designs
to increase capacity, workflow, and throughput.

Improve Productivity
Hospitals have a tendency to hire additional staff faster than in other industries. This is partly
driven by the highly structured organizations that are common in health care and partly because
of the historical lack of focus on costs. In years past, hospitals were reimbursed by the
government and other payers on a “cost-plus” basis—meaning that whatever the cost to
deliver, hospitals would be fully reimbursed along with a small profit margin.

FIGURE 1–2 Variability Creates Chaos and Inefficiency

When pricing is guaranteed to cover costs, there is not a tendency to be overly cost
conscious. Even though the industry continues to move toward a prospective payment system
and managed care, the mentality and behavior of many hospitals have been slow to adapt.
Productivity is defined as the ratio of outputs to inputs. Improving productivity implies a
search for higher levels of output from all employees and other assets. This is one of the most
vital roles of an operations manager.

Improve Quality of Customer Service
Health care cannot become so focused on cost and efficiency that quality starts to diminish.
Improved quality implies reduced medical errors and improved patient safety, in addition to
higher levels of patient satisfaction. Maintenance and improvement of high quality and service
levels, both from patient care and other business services (such as the cafeteria or admissions),
are expected from an operations manager. Across all industries, higher-quality services lead to
the ability to secure higher prices, which drives increased market shares and operating margins
(Buzzell & Gale, 1987).

Ensuring that services continue to improve patient satisfaction levels while simultaneously
reducing response and waiting times are key deliverables to providing higher-quality services.
The cost–quality continuum refers to a theoretical trade-off in which a focus on one side of
the equation leads to diminishing returns on the other. A focus on costs may lead a hospital to

reduce services provided, which may affect overall quality. Operations professionals must
balance both and help to make optimal decisions on many fronts.

Continuously Improve Business Processes
In highly structured organizations, business processes tend to be unique to each department and
are not highly cross functional or integrated. The operating room in one hospital may handle
procurement of goods one way, while the same hospital’s gynecology department handles it
another. There is typically no sharing of best practices internally, standardization of processes
that can lead to improved learning and economies of scale, and very little multidepartment
workflow automation. Each department in large hospitals today operates as an independent
business, which creates multiple efficiency problems. The role of operations management is to
find ways to carry out business processes while improving process efficiency and
effectiveness. Figure 1–3 shows the operations management process of converting inputs into
outputs.

FIGURE 1–3 The Operations Management Process

COMPETITIVE ADVANTAGE OF OPERATIONS
Overall, if a hospital is successful at delivering on each of these goals throughout the facility, it
will deliver improved operational effectiveness. Operations effectiveness is a measure of
how well the organization is run. It considers both the efficiency of resource inputs and usage
and the effectiveness of overall management in achieving desired goals and outcomes
(Kilmann & Kilmann, 1991). Operational excellence is a term often used to describe a
business strategy that focuses exclusively on maximizing operational effectiveness.

A hospital that is operationally effective is heading toward increased competitiveness.
Competitiveness is management’s ability to respond to environmental changes (such as
changes in reimbursement practices) as well as competitors’ actions (such as adding new
facilities or expanding existing service lines). If a hospital can achieve a competitive edge or
advantage over other hospitals—and sustain this position—it will have higher operating
margins and be able to continue improving, expanding, and surviving. Operations management
is critical to this outcome.

Competitiveness is often driven by innovation. Innovation is the continuous search for a
way to do new things or to do current things better. Organizations innovate by using new
technologies or finding ways to change the playing field so that processes that once were
considered essential are no longer necessary. The electronics industry is an example in which
firms continuously innovate. A firm that was competitive based on analog technology had its
perspective of the world shaken up considerably when digital technology was created, and the
products that the firm once made became completely irrelevant. In addition, continuous
innovation often results in hypercompetition, which ultimately is characterized by economics
wherein both prices and costs decline (D’Aveni, 1994). For example, when digital video disc
players were first introduced, prices were nearly $1,000. Today, they can be purchased for as
little as $30 in discount stores. The prices of smartphones, tablets, televisions, laptops, and
many other electronics all follow the same pattern. In health care, innovation also helps to
improve competitiveness.

FACTORS DRIVING INCREASED HEALTH CARE COSTS
Imagine that rather than a health care organization’s annual budget increasing between 5% and
15% (the range of industry average annual changes), expenses could be maintained and even
show signs of deflation, or negative price/cost growth. This would be very beneficial to a
hospital’s financial condition if it could reduce costs and maintain similar pricing levels.

The historical argument justifying continuously growing health care inflation rates typically
focuses on five points:

1. Consumers are aging and living longer and are increasingly utilizing a greater number
of services than in prior years.

2. The costs of medical technology and equipment continue to rise, and this represents a
growing percentage of capital budgets for most organizations.

3. The labor costs of key resources (such as physicians and nurses) are governed by
market shortages for these positions, which have increased steadily in the past few
decades.

4. Prices of pharmaceuticals, which represent a sizable portion of medical treatment
plans, continue to escalate to cover high costs of research and development, long U.S.
Food and Drug Administration approval cycles, and generally high industry margins

for pharmaceuticals.
5. Emphasis on strict managed care, which appeared to be the predominant model a

decade ago, is slowly shifting and diminishing in practice.

The result has been a steadily increasing cost of care. For example, the Bureau of Labor
Statistics tracks inflation growth through its consumer price index, a mathematical calculation
of the average pricing changes over time, using a market basket approach. The general
consumer price index for all items in years 1999 through 2005 showed an increase of less than
14% over 7 years, or around 2% per year (Bureau of Labor Statistics, 2014). Compare that
with the cost of medical care, which rose nearly 30% in that same time period—almost double
that of all the other goods tracked. Figure 1–4 shows this growth over time.

FIGURE 1–4 Controlling Exponential Price Increases in Health Care
Data from U.S. Department of Labor, Bureau of Labor Statistics, 2014.

Overall spending for health care in the United States has risen steadily. In 1993, health care
costs represented 13% of the national gross domestic product; in 2006, this number increased
to more than 16.5%; and today it is nearly 18–19% of the gross domestic product. Economists
project that this will double again in the next decade (Heffler et al., 2005). While some

hospitals wait for the national debate to continue, it is important to first look at the intrinsic
factors in the organization that are driving excessive costs: redundancy, inefficiency,
bureaucracy, waste, paper, limited productivity, lack of performance monitoring, poor
deployment of information technology, and generally unsophisticated levels of management.

LEARNING FROM OTHER INDUSTRIES
Although health care is unique and has its own set of challenges, hospitals can learn a great
deal from other industries that have evolved faster due to technology or process innovation,
industry economics, more aggressive competition, reduced barriers to entry and exit, or just
better trained business managers. For example, if managers looked at a hospital as being
similar to the retail industry, they could better understand how to lay out floors, design
configurations to achieve more efficient movement and handling, and use analytical forecasts to
drive all aspects of the business. There is a lot to learn from the more operationally effective
industries. The tools and techniques that are most similar should be borrowed and applied to
health care where appropriate.

For example, in the airline industry, thousands of planes move through the sky fairly
seamlessly. Planes land every few seconds at major airports throughout the world, and yet
there are very few accidents (as a percentage of total flights), very high levels of on-time rates
(given numerous factors such as weather and security), and very little lost baggage. Nearly 650
million passengers boarded planes in 2013 in the United States alone (Bureau of
Transportation Statistics, 2014). Airlines have learned to operate using speed and volume as
an advantage. When an airplane lands, there is very little time before it must be turned around
and readied to take off to another destination. This changeover process allows less than 30
minutes, on average, to completely refuel, check maintenance and mechanical conditions,
validate aviation systems, restock food and supplies, change over personnel, and unload and
reload hundreds of passengers. Think of this changeover as it relates to the process a hospital
goes through when changing out beds after a patient is discharged (i.e., admitting and bed
management process). A lot can be learned from how another industry approaches a somewhat
similar problem. Table 1–2 summarizes what operations managers in health care can learn
from other industries.

Table 1–2 Teaching from Other Industries

Retail Building layout and configuration, customer flows, use of forecasts and
planning, electronic commerce

Airlines Scheduling, logistics, strategic pricing (yield management)

Chemicals Efficiencies, economies of scale, extensive use of linear programming and
quantitative modeling

Electronics Technology innovation, product life-cycle management, pricing strategy

Telecommunications Command and control center

PRINCIPLES OF MANAGEMENT
Operations management is one discipline in the broader field of management. According to
most theorists, management concerns itself with four key functions: planning, organizing,
leading, and controlling. Planning involves the establishment of goals and a strategy to achieve
them. In health care, planning can be strategic (such as deciding which geographic region to
invest in a new facility), or it can be operational (such as how many employees to have on staff
for each shift). Organizing includes making decisions about which tasks will be done, where,
when, and by whom. Organizing uses a variety of tools, such as an organizational chart to
manage people’s roles and reporting relationships, process flowcharts for improving
activities, and Gantt charts for managing projects. Leading includes motivating employees,
building support for ideas, and generally getting things done through people. Providing
direction and clarification of expectations, as well as the role of change management, or
preparing the organization for changes to come, are instrumental in providing leadership in
hospital operations management. Controlling includes all tasks to monitor and track progress
toward goals, ensure performance improvement, and make corrective changes in strategy
where necessary. The use of status reports, budgets, procedures, and a multitude of other
tracking tools is useful in helping enhance management control.

Managers wear many hats and play many roles. They may serve as a figurehead, make
decisions, reward employees, and handle conflicts and solve problems. Managers help plan
tasks, organize and direct them, and continually adjust and control. Henry Mintzberg (1973),
one of the earliest researchers on management processes, described the nature of a manager’s
work as grouped around three key themes: informational, decisional, and interpersonal.
Informational refers to collecting, monitoring, and disseminating information from the external
and internal environments to work teams. Decisional refers to making key decisions for the
organization, such as allocation of scarce resources, rewards and penalties for employees, and
negotiations with employees and others. Interpersonal includes training and motivating
employees, serving as a spokesperson, facilitating communication exchanges among various

groups, and serving as a liaison.
The study of management continues to evolve. It has moved through a variety of schools of

thought: from scientific management to process focused to human behavior to decision or
management sciences theory to social and open systems (Certo & Certo, 2005). These schools
of thought represent different contexts or perspectives on which a manager’s role and tasks
should be based. For example, the systems theory schools emphasize that a manager views the
organization as a living organism, which is changing and adapting and that operates by an
integrated network of open processes. Behavioral schools tend to view management from a
psychological aspect, highlighting the importance of understanding what motivates employees
and how human and cognitive factors influence work environments.

For purposes of operations management and looking for ways to improve operational
effectiveness, the school of thought that is most relevant is that of scientific management.

THE SCIENTIFIC AND MATHEMATICAL SCHOOLS OF
MANAGEMENT
Operations management seeks to apply quantitative and analytical techniques to achieve the
goals of reduced costs, higher quality, higher productivity, improved processes, and improved
logistical flows. The role of mathematics started to drive concepts of industrial efficiency in
what is now known as the scientific management era, which began prior to the turn of the 20th
century.

Scientific schools of thought historically focused on use of concepts such as time and
motion studies, which measured how long business processes took, seeking ways to reduce the
variability of the results and continuously shrinking the times and associated costs. Early work
by Frank and Lillian Gilbreth helped drive a focus on continual improvements—finding ways
to do things faster and with fewer resources. In fact, the Gilbreths’ research has had a profound
effect on health care as well (Gilbreth & Carey, 1966). In the early 1900s, they were credited
as observing the productivity of surgeons and found that the introduction of changes in both
staffing and workflow could significantly alter physician productivity. The introduction of a
surgical nurse—to help provide surgical instruments and supplies when needed in order to free
up the surgeon, thereby improving overall productivity—was one of the key recommendations
made. In addition, the Gilbreths recommended other hospital improvements, such as a tray to
hold common surgical instruments. These are just two of the contributions made by scientific
management to health care.

Frederick Taylor, one of the original management researchers and the “father of scientific
management,” was often quoted as saying that scientific management is a great “mental
revolution” (Matteson & Ivancevich, 1996). By this, he meant that a scientific approach
encourages a different perspective or outlook that can change management behaviors and
results. This revolution led to some key concepts, such as specialization, division of labor, and
mass production. The concept of specialization suggests that if people repeatedly perform just

one task, they will be able to perform that task faster and with higher quality than others,
because they have repeated exposure to the process and have learned from their experiences.
Specialization, in many regards, is what leads hospitals to structure their organization around
units such as nursing or materials management. Continued specialization helps to produce
well-defined roles and tasks, concentrated work efforts, and higher efficiencies. This is also
known as division of labor. Mass production is the creation of rapid production processes
through the use of assembly-line techniques. Mass production has been embraced by most other
industries, but, in many respects, it is not relevant in health care.

The scientific era has been shown to have several failings and issues, which led to other
schools of thought. The lack of focus on human behavior, alignment of employee rewards with
those of the organization, and understanding the need for job rotations and expansion all are
major issues that well-rounded managers must consider. Thus, many of the analytical concepts
of scientific management remain vital to health care operations management. First, scientific
management suggests the need for a strong understanding of processes, their costs and resource
utilizations, constraints, and cycle times. Second, scientific management encourages an initial
focus on understanding expected outcomes and subsequently designing management systems
and business processes around this operational strategy. Third, the variability of processes has
to be smoothed out and consistently managed. Finally, scientific management shows that in
many cases quantitative approaches can help create mathematically optimal results for common
management decisions and problems. These four fundamental concepts are the foundation of
the operations management discipline.

MANAGEMENT DECISION MAKING
Management decision making is a process in an organization in which decisions are made
(Yates, 2003) and reflects the major processes involved in managing the work of organizations
(Szilagyi & Wallace, 1990). Decisions are the output of the process and are typically
described as a choice between two or more alternatives (Rowe, Boulgarides, & McGrath,
1984). Decisions can also be described as an “action” taken as a result of a process. As Hoch
and Kunreuther (2001) stated, “The strength or weakness of managerial decisions is the
linchpin of the business enterprise” (p. 9).

Herbert Simon (1960), one of the first researchers on decision making in organizations,
described the decision-making process as having three steps:

1. Finding occasions to make a decision.
2. Finding possible courses of action.
3. Choosing among many options.

Browne (1993) described it similarly as that “which occurs at the highest level of an
organization” (p. 2). Schwenk (1988) described management or strategic decisions as ill

structured, nonroutine, important to the organization, involving large resource commitments,
and generally very complex. A traditional management decision process, adapted from
Browne, is shown in Figure 1–5.

Decision-making theory has been defined by many perspectives: sociology, psychology,
economics, engineering, and business. Because management decisions are made within
organizations, organizational theorists early on shaped the field by suggesting a rational
approach where decision makers make decisions in the best interests of the organization and
emphasize “information processing.” More recently, there has been a strong emphasis on
decision making as a behavioral process, as decisions are made by individuals, where
personality and judgment represent both a source of bias and influence on decision processes.

Harrison (1987) described decisions as either “routine and programmable” or “complex
and unique.” If decisions are routine, then they are procedural and can use computation and
rational models for decision support. This area is well suited for operations research methods.
The latter is more unstructured and relies more on judgment and general problem-solving
approaches. This method has typically been considered to emphasize behavioral processes
over quantitative ones, because they involve ambiguity, conflict, negotiations, and bias created
by the interaction of individuals and personalities.

Similarly, Allison (1971) outlined three perspectives on strategic decision making:
rational, organizational, and political.

1. Rational. Barnes (1984) was one of the earlier researchers in this area, which defines
decisions as the product of a “conscious choice.” The rational, conscious choice
emphasizes a “search and selection” process that has limited alternatives, maximizes
decision outcomes, and adjusts for risks. Other researchers have outlined structured
methods for organizational decision makers to follow to reach optimal or maximizing
outcomes (see Christensen, Andrews, Bower, Hammermesh, & Porter, 1982).

FIGURE 1–5 Traditional Decision-Making Process

2. Organizational. Henry Mintzberg (1978) is generally recognized as one of the leading
researchers on decision making from an organizational theory perspective. This views
decisions as the outputs of organizational processes, not individual ones, and includes
adapting astrategy to the environment. The organizational approach emphasizes
satisficing. Satisficing is a process of making a less than optimal decision, but one that
can be supported and is acceptable because it meets the minimal criteria (e.g., the
decision is reached quickly, is adequate, and/or is the result of consensus between
parties). Satisficing terminates the search for alternative processes early. Ambiguity
plays a critical part, as does the concept of randomness, which leads to models of
decision making that are less than rational and that can be described as “organized
anarchies” or “garbage can” models (March & Olsen, 1979).

3. Political. From this perspective, decisions are the result of bargaining among
individuals attempting to achieve their own personal goals (Abell, 1975). This
includes social, nonprofit, educational, and other organizations. Political models tend
to redefine the decision processes, structures, and goals on a continual basis, making
evaluation difficult. Behavioral concepts, such as the roles of judgment, biases,
emotions, and heuristics, are often a component of this perspective. Bazerman (2005)
is one of the prominent researchers on individuals and behavior in decision-making
processes.

From both the organizational and political perspectives, the concept of bounded rationality
has emerged. Bounded rationality suggests that humans or individuals have only a limited,
finite capacity to understand all of the options available to them and process them in an
evaluation mode (Simon, 1979). Bounded rationality can also be described as limits on a
human’s ability to process and interpret large volumes of data (Bazerman, 2005). Theory
suggests that while rational models think all alternatives are known, they usually are not and
there is no known probability or consequences of the actions. In addition, goals are changing
and the process is not always as sequential as it would appear. The complexity of decision
processes is also often used to describe why rational models are not appropriate.

There are two components of bounded rationality: search and satisficing (Simon, 1979).
Search refers to how extensively a decision maker searches for information to guide decision
making (Tiwana, Wang, Keil, & Ahluwalia, 2007). Simon envisioned an “aspiration point”
where managers determine what is “good enough.” This process of terminating the search
process without incorporating more extensive information is called satisficing, as discussed
earlier. This can create biases and risks for managers.

The concept of trade-offs is related to satisficing (Simon, 1965). Trade-offs represent a
cognitive process of balancing the pros and cons of attributes or decision criteria in an effort to
accept less of something to get more of something else (Luce, Payne, & Bettman, 2001).

Browne (1993) described four models or perspectives in decision theory: normative,
descriptive, analytical, and behavioral. Normative models, or prescriptive models, describe
what managers should be doing to produce optimal outcomes. Browne suggested that
normative models are the contributions of scientific management. Simon (1965) argued that
rational models of management science are valuable contributions toward normative decision-
making theory. Descriptive models describe what actually occurs in organizations, not what
should occur. Analytical models, which are the contribution of management science, involve
risk and uncertainty in quantification and in the role of modeling decisions and predicting
outcomes. Finally, behavioral models examine the roles of bias and cognition in humans, as
well as how information is processed and used.

As theory has established, decision making is not necessarily a rational search and
evaluation process, where alternatives are clearly defined, evaluated, and then the best
alternative is selected. Brunsson (1985) argued that decision making is less about finding the
right choice and more about giving an impression of rationality in organizational processes. He
also described other more common irrational processes used by managers. In decision
sciences, decisions are sometimes categorized into one of two types: routine or complex.
Routine decisions have been described as “programmable” and are sometimes associated with
selection and evaluation methods that can be mechanized or automated (Harrison, 1987). These
routine decisions are often supported by methods such as operations research. The more
complex the decisions are, the greater the use of intuition or judgment in the process, and
presumably the less likely that methods such as operations research will be used. Discussion in
strategic management literature about the role of intuition versus analytics touches on this
subject but does not comprehensively address the role of quantitative methods using the
routine-complex dimension (Miller & Ireland, 2005).

In summary, organizational decision-making processes are complex and appear to be
variable in nature. In addition, the complexity of the decision and the cognitive capacity of the
decision makers both influence the form of decision processes. As a result, some health care
organizations may find a quantitative component of operations management decision making
more useful or relevant, while others may value it to a lesser extent.

POWER AND DECISION MAKING IN HEALTH CARE
Decisions in health care do not follow the traditional, logical processes used in industrial
organizations. In other industries, where profit maximization and shareholder wealth are the
primary motives, decisions are usually driven by goal alignment for both managers (those who
run the business) and owners (shareholders who invest in equity or debt and have a claim on
the profits and assets). Decision making tends to follow cost-benefit models and focus on risk
minimization, cash flows, and return on investment. Although disputes and conflicts may arise
because of incomplete or imperfect information (as described in the agency theory of
economics), these disputes can typically be minimized by changing incentives, behaviors, and

structural mechanisms.
In health care, however, there is incomplete alignment of goals between different agents, or

managers, in the organization because of three issues:

1. Goals are unclear. There are clinical goals, financial goals, educational or academic
goals, societal goals, community goals, and so on. The ambiguity that exists in terms of
priorities and focus makes goals much less acute than in other industries.

2. Organizations are complex. In industrial organizations, the organization is clearly
focused on the key aspects of buying, making, selling, and moving products to the
marketplace. In health care, reporting relationships often involve complex matrices and
dual-reporting structures. This is not the “command and control” structure, focused on
speed and efficiency of decision making, that might work in other places.

3. Relationships are ambiguous. Many business units in health care are interconnected,
but they often behave as if they were not. Independent departments and providers help
create an environment that is less team focused than in other industries, making
relationships important for purposes of mutual support as allies. There are also
continuous power struggles in the health care arena between different factions of
employees. This creates ambiguity in decision making.

Physicians are typically the most dominant players, given their clinical expertise and
control over the “production” of health care services, and they have a very substantial role in
most major organizational decisions (Young & Saltman, 1985). Power conflicts with nurses
and other providers are frequent and have developed (for structural reasons) in the struggle for
control over patients, their care, and overall patient management processes (Coombs, 2004).
As such, several formal power bases have emerged: business managers, who increasingly are
becoming more professional and sophisticated; physician leadership, which historically
dominates the power pendulum; and nursing leadership, which may have the most intimate
knowledge of patients and their needs.

Those who control the “production” process in most industries tend to have the most
influence and can control decision making for many things. In the production of health care
(i.e., delivery of treatments and provision of care) physicians are by far the dominant players,
yet their role in most operational management processes in most hospitals is waning as
professional business managers evolve.

Decision making in teaching hospitals and academic medical centers is even more
complicated due to the introduction of another dominant party: academic faculty and
researchers (Choi, Allison, & Munson, 1986). In the largest hospitals, this complexity in
decision making is complicated by large business infrastructures, which may employ hundreds
or thousands of individuals in all types of support functions from admissions to patient finance
to facilities.

Three characteristics define this complexity of decision processes: problematic

preferences, unclear technology, and fluid participation (Cohen, March, & Olsen, 1972). These
characteristics, together with “streams” of both problems and choices, can be combined in
unclear decision processes in a “garbage can,” where they can often address the wrong
problems at the wrong time. This garbage can tends to allow issues and solutions to resurface
in strange ways, which often results in a lack of clarity and focus.

With all of these dominant players and complexities, many hospitals have become large
bureaucracies. These bureaucracies make it difficult to make important decisions, address
financial and business issues, change behaviors and business processes, and implement new
technology.

Sophistication in operations and logistics management requires not only understanding
concepts and their application to health care, but also understanding the persuasive and
leadership characteristics necessary to navigate the bureaucracy, influence dominant power
groups, engage support for ideas, and ultimately gain approval for and acceptance of changes.
These changes will come only if business executives achieve more dominant power positions,
which can evolve only as operations and logistics executives are recognized for their
contributions, specialized education, professional expertise, and leadership skills.
Collaboration within these multidisciplinary organizations is just one way to retain more
control in the decision-making process.

THE ROLE OF TECHNOLOGY
With its focus on improvements, operations management rests highly on the use of technology
and automation. Many new technologies—including mobile devices, handhelds, scanning
capabilities, asset tracking, database management, health information exchanges, and electronic
health records—help managers improve their capture of data and transform it into improved
decisions. Decisions about capital investment in new information and management systems are
always at the forefront of the modern operations manager’s mind. Technology should be
considered whenever quality and efficiency is low. Processes that are repetitive in nature and
that can be replaced by less expensive automation are also suitable for a technology
investment. Technology often serves one of three roles:

1. Automate manual processes.
2. Improve transaction processing capabilities.
3. Improve the quality of analysis, reports, and decisions.

Technology has the ability to substantially alter the economics of a process. Processes that
can be mechanized allow for faster production or delivery, with less resource usage—two
keys to improving operational effectiveness. The decision to substitute capital, or technology,
for labor—especially in areas of business support services—is the only way to reduce
processing and transactional costs over the long run.

TRENDS IN OPERATIONS MANAGEMENT
There are several trends that are being widely considered and adopted in hospitals. These are
depicted in Table 1–3, and the trends correspond to the role or function of operations
management most closely related to it.

Table 1–3 Roles and Trends in Health Care Operations Management

Primary Role of Operations
Managers

Evolving Trends

1. Reduce costs
Standardization
Optimization
Resource tracking systems

2. Reduce variability and improve
logistical flow

Integrated service delivery
Analytics
Supply chain management

3. Improve productivity
Information technology; mobile devices; asset and patient
tracking systems
Return on investment

4. Provide higher-quality services
Evidence-based health care
Six Sigma

5. Improve business processes
Outsourcing
Globalization

Outsourcing is the contracting of an outside firm to perform services that were once
handled internally. Outsourcing is common in many industries, and in health care it has been
used successfully for cafeteria operations, bookstore management, investments, and even
nursing and other clinical care areas. Outsourcing is not a new concept, but it has a slow
adoption rate in health care, where decisions such as these are often difficult to make,
especially when they result in the dismissal of employees from hospital payrolls. However,
outsourcing, when used selectively to target the right areas, can be beneficial from a cost
perspective.

Outsourcing relies on the notion that a hospital should focus on its core competencies—
delivering clinical care—and not on some of the less mission-centric functions, such as
housekeeping, materials management, finance, and information technology. When analyzing
pre- and postperformance improvement, the evaluation of internally performed or selective
outsourcing costs must be undertaken to ensure that all options are explored and the most
operationally effective process remains.

Integrated service delivery is another trend that has developed over the past few years.
Many researchers have pointed to the excessive cost of care as being driven by the medical
community’s continued desire for specialization and concentration on discrete diseases and
treatments, rather than integrative, comprehensive care (Porter & Teisberg, 2006). In response
to this, hospitals are looking for ways to push care toward more integrative medicine,
including higher sharing of information, resources, and collaboration. The effect on operations
management will include redesign of business processes and changes in the number and
frequency of logistics networks.

Supply chain management is the integrated management of all products, information, and
financial flows in a network designed to pull products from manufacturers to consumers. In
health care, there has been widespread adoption of improved sourcing and inventory
techniques, designed to lower overall supply expense ratios (which typically account for 25%
to 50% of all hospital costs). Significantly more detail about the use of supply chain and
logistics management will be covered elsewhere in the text.

Another trend in health care operations management is globalization. The world is
becoming smaller, and vendors from all around the globe are competing for business in retail
and other industries. Health care has only recently felt the effects, but this trend will continue.
When firms look for outsourcing opportunities (e.g., in information technology), they are now
able to turn to vendors as far away as Ireland and India to help manage their information
technology operations infrastructure. Medical care that may once have required on-site
specialists is now only a television away, allowing physicians to practice medicine without
setting foot in the hospital. Vendors for certain medical supplies, pharmaceuticals, and
equipment are emerging and starting to compete for business as potential suppliers, requiring
hospital managers to understand global logistics. As more and more hospital services become
automated, the location of the technology does not matter. This is the true result of
globalization, and it will require adjustments by hospital management.

Investments in a hospital’s information technology infrastructure are common today.
Electronic medical records, computerized physician order entry, enterprise resource planning,
picture archival communication systems, supply chain management, and many other systems are
much more prevalent today than in years past. Investments in many lesser-known technologies
for admissions, cashiering, inventory management, and even bed management are also
becoming more common.

The basic premise of most technologies is that they provide some return that, when
quantified, is greater than the costs associated with it. In some cases, this is simple to
calculate, as when a system creates known financial value and has well-defined costs. In
others, when the information technology produces vague benefits (such as extending a system’s
end of life or improving clinical quality), the returns are more difficult to measure and quantify
and thus are more complex if creating a cost-benefit comparison. Regardless, the trend in
leading hospitals is to conduct thorough return on investment analyses that clearly define the
pre- and postenvironment and then make comparisons of the delivered or earned value for the
project.

The growth in deployment of resource tracking systems is also interesting. Information
systems and technology are being developed specific to health care to allow for tracking of
patients, equipment, supplies, pharmaceuticals, bed occupancy, and much more.
Microprocessor chips, bar-coding technology, global positioning systems, and radio frequency
identification systems are all technologies that are being slowly adopted in larger hospitals.
Many of these use existing wireless frequencies and infrastructure, so they are becoming easier
to implement at lower costs. These tracking systems allow for closer monitoring of utilization
patterns, location analysis, stationary or down times, and logistical flows, which thus helps
better manage the number, type, and mix of resources required. Improved operational
effectiveness results from improved utilization and higher asset productivities.

Another trend that is being followed closely in operations management is that of
standardization. Standardization is the use of consistent procedures, resources, and services
to achieve consistent results across multiple departments. In a system or network,
standardization suggests that two hospitals could use the same basic medical supplies for
multiple procedures, rather than a wide variety of them, which helps reduce inventory and
purchasing costs and creates some economies of scale. Standardization also refers to the use of
common standards for information systems, as well as personnel and operational processes.
Standardization helps ensure alignment among departments, promote familiarization and
learning curves, and reduce the number of transactions processed—all of which result in lower
costs and higher productivity.

Finally, many hospitals practice what is called evidence-based health care. Evidence-
based medicine applies the scientific method to medical practice and seeks to quantify the true
outcomes associated with certain medical practices by applying statistical and research
methods (Centre for Evidence-Based Medicine, 2014). Evidence-based health care, as it
applies to logistics or operations, emphasizes that prior to decisions being made, the options
are conscientiously analyzed for the effects each would have on operations. For example, if a
certain piece of equipment needs to be replaced, evidence-based medicine suggests that the
true costs and outcomes associated with this item be carefully analyzed over time; a
replacement piece of equipment undergoes the exact same controls to guarantee and quantify
the total effect of this change on the system. Evidence-based health care, in its use of
quantitative methods and in seeking to comprehensively analyze operations, is completely in
alignment with operations management theory. The use of quality management processes such
as Six Sigma, which attempts to improve processes and outputs through continuous
improvement techniques, is beginning to gain a solid foundation in the health care industry.

CHAPTER SUMMARY
Operations management is the quantitative management of the supporting business systems and
processes that transform resources into health care outputs. Operations management is about
coordinating diverse, complicated activities into a comprehensive system. It is focused on

achieving operational effectiveness—defined as lower costs, higher productivity, and
continuous process improvement. There are five key goals of the operations manager: reduce
costs, reduce variability and improve logistics flows, improve productivity, improve quality of
customer service, and continuously improve business processes. Operations management is a
field within the discipline of management, and it evolved initially from the scientific
management school of thought. The process of management decision making supports the
choices for how operations management occurs. The decisions made affect the quality and
efficiency of operations. With the increased emphasis on efficiency and quality in health care
organizations, operations management has progressed to become more comprehensive and
valuable. There are several evolving trends that are changing health care operations.

KEY TERMS
Competitiveness
Controlling
Cost–quality continuum
Decision making
Division of labor
Evidence-based medicine
Health care operations management
Innovation
Leading
Logistics
Mass production
Operational excellence
Operations effectiveness
Organizing
Outsourcing
Planning
Productivity
Satisficing
Specialization
Standardization
System
Throughput
Variability

DISCUSSION QUESTIONS

1. What is operations management in health care?
2. How is health care representative of a system?
3. What are the five key goals of operations managers?
4. Does operations management affect a hospital’s competitive advantage?
5. What are three of the key trends affecting hospital operations?
6. Who is considered the “father” of scientific management?
7. How are decisions made in organizations?
8. What are the basic steps of a rational management decision-making process?
9. What are the common sources of cost increases in health care?
10. How does the medical care consumer price index relate to cost increases for other

items?
11. What four things can be learned from scientific management?
12. What are the three reasons decision-making processes in health care are more

ambiguous than in other organizations?
13. How does evidence-based medicine support operations management techniques?

EXERCISE PROBLEMS

1. Health care organizations routinely make complex organizational decisions. As an
example, a decision to modify the physical layout or space of a department, or alter the
schedules of a nursing unit, will affect patient care in many ways. Because so many
stakeholders are involved, which process for making management decisions do you
think will be followed? How would you use the decision-making process to make
important decisions such as this in an organization?

2. Richmond Community Hospital currently receives more than 10,000 boxes of
pharmaceutical supplies per month. All of these items are manually inspected and
logged to ensure adequate receipt prior to payment. Eight employees manage receipts
and deliveries, while four employees manually record and track them. A new software
package that allows automated scanning of bar codes will replace all or some of the
employees used for manual tracking, or at least allow redeployment to other areas of
the hospital. What are some of the key questions that must be explored to fully
understand the effects of technology and whether a capital investment should be made
to substitute capital for labor?

REFERENCES
Helton, Jeffrey, et al. Health Care Operations Management, Jones & Bartlett Learning, LLC, 2015. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/apus/detail.action?docID=4441334.
Created from apus on 2020-01-09 17:05:22.

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CHAPTER
2

Health Care Marketplace

GOALS OF THIS CHAPTER
1. Define hospital.
2. Explain the different classifications of hospitals.
3. Describe what makes a teaching hospital unique.
4. Describe the roles of a business operations manager in health care.
5. Understand the health care regulatory and policy environment.

Those who find themselves working as business professionals in a health care setting for the
first time will undoubtedly be overwhelmed on the first day of employment. The first thing to
notice is that there is a much greater focus on medical activities than business activities in most
facilities. Another first impression is that the layout and design of workflow and facilities are
often extremely inefficient, cluttered, and almost an afterthought. The information systems in all
but the most advanced hospitals have not yet discovered or adopted electronic commerce,
process automation, and real-time operational reporting, as expected in retail or manufacturing
industries. In addition, hospitals have not yet begun to focus on key business issues as have
almost all other industries over the past few decades. This is good news for those just joining
the industry, because it promises significant change and opportunities for improvement.

Before operations management can help make a difference in health care—using
quantitative tools and techniques to drive improvements across all areas of the business—it is
important to understand the context of the modern hospital: what it is, how it started, and where
it is going.

HOSPITALS ARE BIG BUSINESS
Hospitals are large and complex organizations and differ from most traditional organizations in
many ways. First, hospital missions focus on the more abstract goals of improving community
health or curing and eliminating disease. Other types of companies typically have a two-

pronged mission of maximizing profits and satisfying stakeholders, which helps to clearly
focus employees and others on efficiencies, revenues, and cost reductions.

Hospitals also offer an intangible product, unlike a widget that can be easily packaged and
sold. This service, which is somewhat unique and not widely available, distinguishes the
production of health care from the production of other goods.

Typically, hospitals are not profit-maximizing entities, and historically most have not been
overly concerned about negative margins or breakeven income statements. Most other
organizations focus solely on maximizing the wealth of the owners or shareholders and to a
lesser degree on the social or public benefits that are derived from the production of their
goods or services.

In addition, the primary performance outcome of a hospital is measured in terms of quality,
which is abstractly determined by a wide range of mortality and morbidity indicators and not
by business metrics such as economic value, return on investment, or net income. This lack of
focus on the more common financial metrics separates health care from most other industries,
which use indexes that daily monitor the efficient flow of information about the organization
and communicate the value generated, as in a stock exchange. As a by-product, there is very
little free flow of information about most health care organizations, and this lack of perfect
information further distinguishes the health care industry.

Of great importance is that hospitals are governed to a large degree by professionals who
lack formal training in business management, unlike other firms where those educated and
professionally trained in business disciplines clearly govern all aspects of the business. This is
one of the primary reasons the financial and business implications of key decisions may
become secondary to the more relevant medical issues that dominate most physicians’ mind-
sets. The business managers who are recruited are often not trained as well in business or
financial acumen as those graduates who tend to migrate toward the traditional profit
industries, such as energy or banking.

Health care facilities also commonly work on a 24-hour-per-day basis, creating obvious
labor and scheduling inefficiencies. Some industrial organizations do this as well, but they do
so only to the extent that the decision to remain open generates positive cash flow. Decisions
about hours in health care are driven largely by societal needs and expectations for round-the-
clock medical service and availability of care at all times.

Finally, hospitals have community and other stakeholder interests that create goal
ambiguity. In most towns, hospitals are as sacred as a church or civic building and are not
admired as much for their economic engine as for their healing powers.

Nonetheless, hospitals have to manage the same set of business resources as any other type
of organization, from financial resources to personnel, equipment, supplies, technology, and
facilities. Hospitals employ hundreds or even thousands of people, with payrolls that can reach
several hundred million dollars. They serve as a marketplace and are suppliers of valuable
services to hundreds of customers daily. They are buyers, procuring a vast array of supplies,
pharmaceuticals, and technology. To function efficiently, hospitals have to manage people,

money, time, and business processes. They are economic engines that generate significant cash
flows and provide economic value for their organization and their community. In short,
hospitals are a business. Managing these business affairs, then, is a difficult challenge, and
historically there has not been much focus in this area.

Nearly 5,800 hospitals operate today, employing almost 5.5 million people and managing
gross revenues of more than $500 billion (American Hospital Association, 2013; Bureau of
Labor Statistics, 2004). These are significant resources, requiring dedicated and trained
business managers who can help ensure appropriate fiscal responsibility, maintain overall
costs, improve productivity, and ensure positive operating margins.

While the size of hospitals varies—anywhere from 10 beds to more than 1,000 beds—the
administrative organizations and operational managements are quite similar. Some have a large
network of outpatient clinics, while others focus exclusively on inpatient surgeries and
treatments. There may also be differences in funding sources, types of services offered, or mix
of patients served, but the overall aim of business operational management should be similar.
Finding methods and means for improving business operations should be the primary goal of
business officers in hospitals.

WHAT IS A HOSPITAL?
A hospital is an organization devoted to delivering patient care, and it serves as the central hub
for the entire health care industry. There is at least one hospital in nearly every city, and larger
cities may have several dozen. Historically, hospitals were viewed as a “facility” placed to
serve those who needed overnight stays (i.e., primarily inpatient) or surgery, or who were
otherwise extremely sick. The very early definition of hospitals was as a place people went to
die, but as the quality of care has improved so too have the national health outcomes, measured
primarily in terms of morbidity and mortality rates. Consequently, fewer people go to hospitals
to die than to get well or to prevent illness.

The basic definition of a hospital typically involves providing services clustered around
three key terms: observation, diagnosis, and treatment (Griffin, 2006). Observation involves
analyzing or studying patients and running tests and checks—all of which ultimately lead to a
diagnosis. The diagnosis is the physician’s or medical provider’s explanation for the cause or
source of the problem or symptoms. Treatment is the course of action that the hospital will
take to make the patient better, lessen the symptoms, or otherwise care for the patient. All of
the services that a hospital provides are typically organized around at least one of these areas.

The health care industry has become somewhat more integrated, or consolidated, in recent
years. Horizontal integration refers to consolidation, mergers, acquisitions, or alliances
among several competitive or cooperative hospitals. Horizontal integration has resulted in a
large number of multihospital systems, defined as an organized system of hospitals that share
central services, common ownership of assets, and/or centralized governance and management.
Vertical integration refers to the acquisition or alliances of other parties involved in other

phases of the health care value chain, such as payers, clinics, or physicians. Physician–hospital
alliances and hospital-sponsored health maintenance organizations (HMOs) are common
structures within vertically integrated systems. Whether vertically or horizontally integrated, an
integrated delivery network refers to any combination or integration between a hospital and
other providers or partners in the health care industry that works together collaboratively
across a spectrum of care to provide more competitive and comprehensive services.

In economic terms, the “production” capabilities (i.e., the conversion of supplies, labor,
and other resources into medical services) of health care are performed by physicians, nurses,
technicians, and a host of other allied health professionals. Physicians, of course, have
traditionally retained most of the power in health care because they have long played the
dominant and central role. They are the most academically qualified, spend the longest time in
training programs, and have the most systematic view of disease and anatomy. A physician is
also called a medical doctor or simply a doctor in most places.

The new role of the hospital is evolving, as hospitals have extended their ownership and
influence from a “facility” to a “system,” which may include multiple buildings, offices, or
practices distributed throughout a large geographic area. Hospitals now often include
ambulatory or outpatient clinics, physician offices, treatment centers, and other services that
are not necessarily housed in the primary hospital. Hospitals have come a long way since the
construction of the first hospital, the Pennsylvania Hospital in Philadelphia, in the mid-1700s.

From a business perspective, it is important to understand the type of hospital in order to
understand its mission, background, and orientation. There are several ways to classify
hospitals, but the most common is by ownership type, type of service or specialty offered, and
length of stay.

Most hospitals in the United States are primarily considered community hospitals, in that
they are available for use by an entire community. Community hospitals represent the
significant majority of all hospital-based care and include all nonfederal, short-term hospitals,
whether they are for-profit, nonprofit, or public. When people think of the “typical” hospital,
they are thinking of the community hospital. Community hospitals focus on short-term stays,
usually fewer than 30 days, and acute care, defined as being focused on a specific episode or
event requiring care. Sometimes both for-profit and nonprofit community hospitals are grouped
together and called private hospitals, to distinguish them from public and government-owned
facilities. In addition, churches control some of these private nonprofit hospitals. Well-known
health care systems are controlled by the Baptist, Catholic, Protestant, and Seventh Day
Adventist religions. Besides community, there are federally owned hospitals, such as the
Veterans Administration, which manages a network of more than 150 hospitals and nearly
1,000 clinics and other facilities (Department of Veterans Affairs, 2006).

Hospitals listed with the American Hospital Association (2006) fall into one of four
classifications:

1. General (providing a broad range of services for multiple conditions).

2. Specialty (services for a specific medical condition, such as oncology).
3. Rehabilitation (focused on restoring health).
4. Psychiatric (providing care for behavioral and mental disorders).

Historically, hospitals have been owned by either nonprofit, church, or government agencies
and have been considered organizations offering public or social goods. This mix has been
changing over the past three decades. In 1976, approximately 13% of community hospitals
were for-profit or investor owned. In 1986, there were nearly 15%; in 2006, there were 17%
investor owned; and in 2012, 19% of all hospitals were investor owned (American Hospital
Association, 2013). As this mix shifts, a higher level of competitiveness and financial focus
will continue. The largest for-profit hospital systems are Hospital Corporation of America,
Tenet, Health Management Associates, Triad, and Community Health. Of these, the most
prominent, Hospital Corporation of America, had annual revenues exceeding $33 billion in
2012 with nearly 204,000 employees in 162 hospitals (Hospital Corporation of America,
2005). Figure 2–1 shows the hospital breakdown by type in 2012.

FIGURE 2–1 Hospital Breakdown by Ownership Type, 2012
Data from American Hospital Association, 2013.

TEACHING HOSPITALS
The largest major hospitals tend to fit into another classification called teaching hospitals,
which suggests that a fairly large percentage of resources are devoted to academic and
research missions, in addition to patient care.

Teaching hospitals were once thought of as the “cornerstone” of the American health care
system (Iglehart, 1993). As the health care industry continues to evolve, this leadership role
may be in jeopardy, as teaching facilities struggle to gain a competitive position with the other
entities in the industry, including group practices, independent primary care clinics, and
ambulatory surgery centers.

Teaching facilities are usually the largest, most sophisticated hospitals in the
predominantly urban markets they serve (Langabeer & Napiewocki, 2000). They are almost
always significantly larger than their non-teaching-hospital competitors in terms of number of
employees, types of service lines offered, number of beds, number of admissions and
discharges, size of financial budget, and most other measures of scale. Teaching hospitals have
significantly more resources invested in facilities and technologies to provide advanced
treatments for the unusually complex cases that they serve.

Teaching hospitals are committed to the principles of higher education. This means that the
medical doctor–practitioners are primarily teachers and research faculty members who are
affiliated with an accredited school of medicine, whose goal is to educate and formally train
licensed medical doctors. Currently, there are more than 126 university medical schools
accredited by the Association of American Medical Colleges in the United States and another
16 in Canada. Teaching hospitals offer medical residencies—training programs specially
designed to instruct graduate medical trainees in clinical settings before they are legally
licensed to practice medicine. Most major teaching hospitals have at least four residency
programs. The Council of Teaching Hospitals of the Association of American Medical
Colleges maintains a list of more than 400 major hospitals and many more “minor” ones (i.e.,
those with fewer than four residency programs). The Council of Teaching Hospitals
membership requirements include a documented affiliation agreement with a medical school
accredited by the Liaison Committee on Medical Education. For a complete listing of all of the
major teaching hospitals, see Appendix A.

The other core component of academic medicine is a focus on applied clinical and even
basic biomedical research that can help improve the ability to observe, diagnose, and treat
patients in the future. Advancing knowledge for new treatments, practices, and techniques will
help improve the state of practice in the future and is a critical academic concern for teaching
hospitals.

Many factors distinguish a teaching hospital from other community hospitals. First, they are
the largest and have the broadest scale and scope (as discussed earlier). Second, they train
physicians and provide research, which are not always well reimbursed and funded. Third,
they have complex organizations because they are typically partnered with medical schools
and academic health centers, which have collaborative arrangements. Fourth, they have more
stakeholders than most community hospitals, given the broader mission that they serve. Fifth,
given their three-pronged mission (research, education, and patient care), they tend to have a
more financially difficult time balancing all three needs than most single-focused community
hospitals. Figure 2–2 shows the percentage of funding that hospitals received industrywide in
2012.

What does all of this mean for hospitals? It means that hospitals have to become focused on
all aspects of the profit margin. We are entering an era of competitiveness in health care, where
efficiency and margins have to become primary performance indicators. Hospitals will have to
continue to squeeze all possible revenue from each procedure delivered and negotiate using
competitive and analytical data on costs and outcomes to maximize pricing rates in the Charge
Description Master, which lists all prices for all services and supplies the hospital provides.
On the cost side, hospitals have to reduce total cycle time and service delivery time; automate
as much of the business process as possible; reduce labor costs associated with service lines
that have low reimbursements; and, by using the most sophisticated budgeting and financial
tools, continually drive improvements to the bottom line.

Together, reimbursement rates represent gross patient revenues for a hospital, but
deductions are nearly always taken by payers for volume, exclusions, and pricing discounts to
reflect the payer’s contractual terms. In addition to gross patient revenues, a significant source
of revenue for hospitals comes from donations and fundraising efforts, parking and cafeteria
operations, gift shops, and especially interest and investment income. According to 2005 data
from the Centers for Medicare and Medicaid Services’ National Health Statistics Group, 7%
of all health care reimbursement was from other private sources such as these. The typical
hospital has significant working capital: Large amounts of cash are constantly moving in and
out of accounts. Investing these dollars wisely often means the difference between a hospital
that makes money and one that does not. Without all of these sources of nonoperating revenues,
most U.S. hospitals would have significantly negative overall profit margins annually.

FIGURE 2–2 Funding Sources for U.S. Hospitals, 2012
Data from Centers for Medicare and Medicaid, 2005.

Many thought that the advent of managed care created devastating turbulence in hospitals,
but managing the hospital business will only become more difficult.

HOSPITAL BUSINESS OPERATIONS
The management of hospital business operations can be broken down into a few major roles
and responsibilities, including finance and accounting, business logistics and supply chain
management, physical plant or facilities, human resources, information technology, and
business planning and performance improvement. There are several job opportunities in each
of these areas for a typical hospital.

Finance and Accounting
Finance and accounting represents a large and growing portion of health care. Finance
professionals are responsible for managing a wide variety of functions, including accounting,
billing, collections, financial reporting, payroll, treasury and cash management, investment
management, records management, budgeting, and accounts payable. While some of these focus
on transaction processing, such as accounting, payables, and payroll, others are more focused
on analysis and reporting, such as investments and budgeting. Financial analysts, accountants,
and other professionals can find many challenges in this area of health care.

Logistics and Supply Chain Management
Supply chain management is one of the fastest growing sectors in health care. The search for
cost savings of key resources and supplies and for better management of goods and services in
the physical supply chain is responsible for creating job opportunities for analysts and
professionals interested in a wide number of fields, including purchasing, receiving, inventory,
transportation, distribution, logistics, and laundry and linen.

Physical Plant or Facilities
As hospitals continue to expand beyond just single, multifloor buildings, the need for
additional resources and different types of facilities expertise keeps growing. Many hospitals
are part of systems or networks with several facilities, each of which has a need for design,
planning, construction, maintenance, housekeeping, and security operations. Roles for
architects, engineers, and general business managers to help run these business support
services continue to increase.

Human Resources
The average hospital employs about 1,000 people, although that number can range from 50 to
more than 10,000. As large employers, there is continued need for business skills focused on
providing general personnel management, as well as specialized services such as recruitment,
compensation, and benefits. Organizational development and training are also common in
larger hospitals.

Information Technology
Information needs require management of telecommunications, data services, information
reporting, systems project management, and infrastructure support. Significant improvements in
labor productivity can be gained by investing appropriately and wisely in technology to
automate manual processes, as well as other technologies to improve access to information and

workflow.

Business Planning and Performance Improvement
Although not typically a department in smaller hospitals, there is a much stronger focus on
continuous improvement today given the financial condition and competitive environments
most hospitals face. As this occurs, there has been a strong rise in demand for professionals
who can help provide internal analyses and decision support in areas such as strategic
planning, business process reengineering, process improvement, competitive intelligence,
performance benchmarking, accreditation preparation, and quality management. This area is a
small but growing opportunity for students and other professionals with keen analytical,
people, and facilitation skills.

Each of these areas involves substantial levels of resources and commitment. By no means
are these all of the opportunities for those interested in business careers in hospitals, but they
are some of the most common.

HOSPITAL POLICIES AND REGULATIONS
Hospitals operate within strict financial, legal, and regulatory environments. The high-stakes
products and services resulting from hospital operations are a matter of health and, often, of
resuming a measure of quality of life. As such, hospital administrators must have a strong
background in and understanding of health care policies and regulations and how they affect
business operations. Policies provide broad guidelines that are used to create specific
procedures within a system, whereas regulations are authorized instructions for how
something should be carried out.

Contemporary policy influence can be traced back to the Health Insurance Portability
and Accountability Act (HIPAA) of 1996. HIPAA established national standards to protect
personal health information and outlined safeguards for transmitting and storing protected
health information—defined liberally as including any information that can be used to
discover the identity of an individual patient. Examples of protected health information include
a patient’s name, address, social security number, date of birth, insurance number, or medical
record number. HIPAA changed the business processes of hospitals, doctors’ offices, and
health care insurance enities by affecting the way they communicate information surrounding
patient care. All employees working in a health care environment must recognize HIPAA
implications. Similar to a credit report, under HIPAA, patients are given explicit ownership of
their information. Patients may request copies of their health records, or charts, as well as
changes to amend incorrect information. In addition to providing patients with access to their
medical records, HIPAA also restricts the uses for which patient information can be exchanged
among providers. These restrictions allow the exchange of patient information for physicians
to treat a patient, for insurance companies to pay for care, and for the administrative or

operational duties of patient care. It is against most hospital policies and procedures to access
or discuss patient information outside of these contexts.

Another modern act, or enacted health care law, that has had significant influence on health
care operations is the Health Information Technology for Economic and Clinical Health
(HITECH) Act. This act was signed in 2009 by President Barack Obama to stimulate and
encourage greater efficiencies in health care for the United States. HITECH’s main focus is to
develop a national health information technology infrastructure. The concept of health
information technology was brought to national awareness when President George W. Bush
proclaimed his vision for all Americans to have a personal electronic health record by 2014.
Although the United States has not met the original goal laid out by President Bush, the
HITECH Act has hastened progress. A specific goal of the HITECH Act is to assist physicians
and hospital systems to convert paper health records to electronic ones. To offset the cost of
purchasing new technology, the act allowed a financial incentive provision for using the
technology in a way that creates enhancements in the quality of efficient patient care.
Depending on the population demographics served, eligible providers may receive payments
up to $44,000 from Medicare and up to $65,000 from Medicaid. In order to collect these
incentives, providers must use their electronic records to send prescriptions to pharmacies
electronically, exchange patient information with another provider electronically, or otherwise
use their electronic systems to track certain quality metrics designed to enhance patient care. In
addition to financial incentives for purchasing and utilizing new technology, HITECH will
enact penalties for noncompliance with electronic standards beginning in 2015. Public
reimbursement programs such as Medicaid and Medicare will penalize hospitals that do not
convert from paper records to electronic ones with a 1% reduction in payments in 2015 and a
3% reduction in 2017 and in all subsequent years thereafter. This will have substantial
ramifications in the financial operating controls of any health care system.

CHAPTER SUMMARY
Hospitals represent society and community interests, but they are also a business. They
consume significant resources and require extensive management over a wide range of
functions. There is variety in patient populations, with some hospital specialization. In general,
hospitals serve the following patient needs: general acute illness or trauma, specialty diseases
such as cancer, rehabilitation, or psychiatry. Teaching hospitals are another class with a large
percentage of resources dedicated to academic research and higher education. Managing these
resources and functions requires employees new to the industry, and those currently employed,
to upgrade their knowledge of finance, management, business operations management, and
health care policy to help the industry continue to thrive, as well as to weather the turbulence
that threatens a hospital’s ability to survive. Only by using all available advanced tools,
methods, and techniques will hospitals be able to use business operations management to
improve their competitiveness and financial position in the health care industry.

KEY TERMS
Act
Acute care
Charge Description Master
Community hospitals
Diagnosis
Health Information Technology for Econimic and Clinical Health (HITECH) Act
Health Insurance Portability and Accountability Act (HIPAA) of 1996
Horizontal integration
Hospital
Integrated delivery network
Observation
Policies
Protected health information
Regulations
Teaching hospitals
Treatment
Vertical integration

DISCUSSION QUESTIONS

1. Is health care a “business”?
2. What are five of the key factors that distinguish a hospital from other industrial

organizations?
3. Define an “average” hospital in terms of size (employees, revenue, beds).
4. Which types of hospitals exist, and whom do they serve?
5. What is the role of a teaching hospital in the health care industry?
6. What makes governance of academic hospitals more complex than that for community

hospitals?
7. Which recent policies or acts have influenced health care operations management?

REFERENCES
American Hospital Association. (2006). Guide to the health care field. Chicago, IL:

Author.

American Hospital Association. (2013). Hospital statistics. Chicago, IL: Author.
Bureau of Labor Statistics. (2004). 2004 career guide. Washington, DC: U.S. Department

of Labor.
Centers for Medicare and Medicaid Services. (2005). Monthly trend report for

Medicare, Medicaid, and SCHIP. Washington, DC: U.S.
Department of Veterans Affairs. (2006). Organizational briefing book. Washington, DC:

Author.
Griffin, D. (2006). Hospitals: What they are and how they work (3rd ed.). Sudbury, MA:

Jones and Bartlett.
Hospital Corporation of America. (2005). 2005 annual report. Retrieved from

http://media.corporate-ir.net/media_files/irol/63/63489/pdfs/05AnnualReport
Iglehart, J. K. (1993). The American health care system: Teaching hospitals. New

England Journal of Medicine, 329(14), 1052–1056.
Langabeer, J. R., & Napiewocki, J. (2000). Competitive business strategy for teaching

hospitals. Westport, CT: Quorum Books.

http://media.corporate-ir.net/media_files/irol/63/63489/pdfs/05AnnualReport

CHAPTER
3

Health Care Finance for the
Operations Manager

GOALS OF THIS CHAPTER
1. Discuss the concept of a hospital as a business and the need for financial

management of health care businesses.
2. Define how health care organizations are paid for services.
3. Understand the varying types of reimbursement to hospitals and the operational

challenges of these payment methods.
4. Describe the three primary financial statements and what they measure.
5. Define working capital and discuss how operations management influences it.
6. Identify sources of financial data for use in operational analyses.

The health care industry today is second only to national defense in its share of the U.S.
economy, totaling 17.2% of the gross domestic product as of 2012, with estimates going as
high as 19.6% by 2021. The rapid growth of health care costs—for which hospitals account for
31.5%—is an area of great concern for government leaders and may become the cause of
future constraints on payments to hospitals (Centers for Medicare and Medicaid Services,
2013). Considering some of the unique characteristics of the hospital organization, limits in
payment growth, or even outright reductions in payments, pose a significant challenge for the
operations manager in today’s health care organization

HOW HOSPITALS ARE PAID
Providers of health care services (and hospitals in particular) are in many ways unique in the
U.S. economy in that they routinely provide services for which they incur costs at the time of
service but are not paid for those services for a period of weeks or months thereafter. Because
providers pay the costs of rendering care at or before the time of service, payments to the

provider are usually termed reimbursements. The gap in time between the provision of
services and reimbursement for those services is a result of the organization of the U.S. health
care system where a third-party insurer (usually called the payer) pays for services on behalf
of the patient. Although the patient may have some nominal amount to pay for hospital services,
the vast majority of payments for hospital services come from third-party payers.

Payers for hospital services are generally classified as government or nongovernment
insurers. There are two major government insurers that together fund the majority of hospital
services: Medicare and Medicaid. Medicare is the federal government health insurance plan
that offers care to more than 40 million patients who are elderly, disabled, or with end-stage
renal disease. Medicare has three primary components: Parts A, B, and D. Part A provides
inpatient hospital coverage for participants, as well as some posthospital treatment and
hospice care. Part A is paid for by a required payroll tax deduction from the entire American
population. Part B is a supplemental insurance program that requires monthly premium
contributions by the participant and covers physician services, emergency room services, and
outpatient visits. Part D is Medicare’s prescription drug benefit program, which offers
discounts on outpatient drugs to lower-income seniors and disabled individuals. Of the three
parts, Medicare Part A funds the largest portion of hospital reimbursements.

The federal government also funds and oversees Medicaid. Medicaid is designed to meet
the health care needs of certain individuals with low incomes or disability who otherwise may
not have the ability to pay for care. General tax revenues from both federal and state
governments finance this insurance program, where the federal government funds the majority
of costs (between 50% and 83%, depending on the state) and states pick up the remainder. The
federal portion of the funding formula is inversely related to per capita state income, where
wealthier states pay a larger proportion of Medicaid costs in those states. States are otherwise
able to control their own policies, so reimbursement for services (and which services are
reimbursed) varies from state to state.

Nongovernment payers are called commercial insurers and collectively fund between
30% and 40% of the nation’s hospital services. The majority of these commercial insurance
plans in the United States are made available as an employment benefit. Because commercial
insurers represent the interests of many employers in the economy, they exert significant
influence on the health care marketplace, aggressively negotiating discounted fees for services
in exchange for patient referrals. In addition, commercial insurers have adopted policies to
control the level of patient access to services and even which services are reimbursed to
providers. Some such insurers are organized primarily around the management of health care
access and cost and are called managed care organizations.

Each of these different types of payers has a certain degree of leverage based on the size of
its network, the number of enrollees or members in the plan, and the number and type of
patients covered. Therefore, each payer has a varying level of ability to influence and establish
hospital reimbursements. The same services and supplies provided to two different patients
may have the same prices billed on the hospital invoice for both patients, but the ability for a
hospital to collect the total amount is entirely based on the individual payer that is reimbursing

the hospital. One payer might cover 60% of all costs billed, while another might reimburse the
entire amount. Negotiations, settlements, and preestablished reimbursement programs for all
payers govern the extent to which costs will be reimbursed.

In general, Medicaid is considered to be the payer that reimburses the lowest for all
services—in most cases not even fully reimbursing providers for the total cost to deliver care
(in 2012, this approximated 85% of the costs of providing care). Other payers may reimburse
at cost for specific services that may be specialized or hard to find but reimburse significantly
less for services that are very competitive and general. Also, despite passage of the Patient
Protection and Affordable Care Act of 2010 (PPACA), in excess of 10% of the U.S. population
remains uninsured. Such individuals often pay very little, if any, of the costs of their care and
receive only the minimal amount of care necessary to treat an emergency condition under
federal law. To the extent that a hospital has a mission of serving the poor and uninsured, the
demand for strong financial management to support operations management can determine if a
hospital can stay in business.

FROM RETROSPECTIVE TO PROSPECTIVE
Since the introduction of the prospective payment system (PPS) by Medicare in 1983, there
have been continued financial pressures placed on hospitals. Prior to this legislation, Medicare
paid hospitals on a retrospective or cost-plus reimbursement system. In this context,
retrospective literally means to look backward at all costs incurred. This means that
regardless of the total cost to deliver services, including both operational and capital
components, insurers would fully compensate actual costs, plus a component to represent a
small profit margin. In an era where revenue was unconstrained, there was no need for cost
efficiencies or fiscal discipline in spending or utilization patterns. Fee-for-service (FFS) was
the original reimbursement method used by commercial insurers, where hospitals are paid
directly for every service performed—essentially a “piece rate” system. Later iterations of this
payment methodology called for discounts off of provider routine fees. FFS payment creates an
incentive for health care providers to expand the number of services offered in order to
increase collected fees. Rapid growth in payments to hospitals in the late 1960s and throughout
the 1970s precipitated a call for changes away from both the retrospective and FFS methods of
payment to hospitals, resulting in PPS only a few years later.

Prospective payment represents a methodology in which fee schedules are calculated
based on treatment type or illness classification and are paid in advance of the treatment
without regard to actual costs incurred. Since implementation of PPS, hospitals have endured a
variety of reimbursement practices, all aimed at reducing costs and improving efficiency. One
such practice is capitation. Capitation is a method of reimbursement that transfers financial
risk of care to the provider and away from health plans or insurers by limiting payments to a
fixed-dollar amount. Capitation reimburses the provider on a per-member per-month basis,
such that a flat payment is made per capita to a defined population for a specified menu of

services over a specific period of time. Although capitation is very favorable to the payer, it
creates a strong incentive on the part of the provider to limit the amount of services offered to
the patient.

Per diems are fixed daily payments to cover all services and procedures performed. They
are essentially daily rates that limit the exposure for a payer but provide revenue caps for the
hospital. They are effective in some cases, but much like FFS payment, per diems create an
incentive for a hospital to treat patients longer, generating higher average lengths of stay, in
order to maximize revenue.

Closely related to the per diem method is the case rate, which is a prospectively
determined amount that is paid for all services associated with a hospital admission,
regardless of the costs for that occasion of care. Case rates are often used for specific types of
services, such as childbirth or organ transplants. A similar payment method—on which the
original PPS was formed—is the use of diagnosis-related groups to adjust case rate payments
to reflect the expected resource needs of a particular patient’s condition. The diagnosis-
related group (DRG) is a classification scheme primarily used for inpatient treatment that
categorizes all patients through principal and secondary diagnosis, procedures provided, age,
sex, and other factors. Although DRGs are the basis for payment under Medicare, they are also
used by several commercial insurers and payers because of their comprehensive classification
schema.

Under the DRG system, hospital rates are set based on the patient’s illness and the length of
time required to treat that illness in an inpatient setting. Many private insurers prefer fixed per
diems for inpatients, where a fixed daily “allowance” is provided for all services performed
and supplies consumed. Private insurers tend to use negotiating and contract management
processes to establish pricing; they use contracts where negotiated discount provisions are
based on market coverage, type of service, and volume of activity. In general, the use of a
standard fixed rate reimbursement for each type of service performed, adjusted for case
complexity, is the standard for most hospitals.

The per diem, case rate, and DRG mechanisms all relate to reimbursement for inpatient
hospital services. Similar approaches apply to outpatient and ambulatory facilities where
fixed, prospective amounts are paid for outpatient services such as diagnostic testing,
emergency room visits, and ambulatory surgery procedures. These services are usually
reimbursed on a flat per procedure rate that varies by the type of service, similar to the case
rate mechanism used for inpatient care. Similar to the DRG mechanism, outpatient per
procedure fees may be adjusted to reflect the relative severity or resource intensity of services
using the Ambulatory Payment Classification (APC) system. Under prospective payment
mechanisms, including per diem, case rate, DRG, per procedure, and APC mechanisms,
providers have an incentive to limit the operating costs incurred to provide services.

Passage of PPACA introduced a new model of health care delivery that mixes many of the
payment mechanisms mentioned here—the Accountable Care Organization (ACO). An ACO
is a group of various health care providers (sometimes called a network) who share financial

responsibility for the care of a designated group of patients on behalf of an insurer. Providers
may be reimbursed for services using any of the methods described here, though the payment
amounts may be reduced to account for patient satisfaction or quality of care incentives built
into ACO payment agreements. However, the overarching theme for reimbursement in an ACO
is toward cost reduction for a population. That cost reduction focus will lead to lower direct
payment rates to providers, with possible additional payments for meeting ACO incentive
goals. Similarly, the ACO may be responsible for penalties if incentive goals are not met.
Much like a capitation payment, the ACO arrangement in general creates an incentive to reduce
the amount of care provided and maintain a fairly static level of operating costs.

The financial implications from use of prospective payment mechanisms for hospital
reimbursement are enormous. The risk and pressure of holding costs below collected net
revenue is being transferred from the payer to the provider. This change calls for a different
type of administrator and the need for managing costs, maximizing staff productivity, and
limiting unnecessary processes.

PROFIT MARGINS
Profit margins are found by subtracting expenses from revenues, and they represent the
residual value to fund future operations and capital investment. Since the 1980s, the average
profit margins for community hospitals have been extremely unsatisfactory. Economics suggest
that with long-term industry profit margins near 0% on average, hospitals exit the market
because it is unattractive to both new entrants and current organizations. Hospitals exit through
bankruptcy, acquisition by a competitor, or simply dissolution. According to financial
statements filed by hospitals in their annual reports to the Centers for Medicare and Medicaid
Services (2014), more than one-third (34.6%) of all hospitals experienced negative profit
margins during 2012.

That is exactly what continues to happen over time to U.S. hospitals. Significant
consolidation of both beds and hospitals continues each year. In 1991, there were greater than
5,300 community hospitals and more than 920,000 beds. In 2001, that number had dropped to
nearly 4,900 hospitals and 840,000 beds (American Hospital Association, 2006). By 2012, the
decline in the number of hospitals had stabilized, with 4,999 in operation at that time, although
the number of beds in operation had declined slightly to 800,566 (American Hospital
Association, 2013). Meanwhile, demand continues to rise. The number of admissions rose
from 31 million in 1997 across all community hospitals to nearly 35 million in 2004 and
remained at that level in 2012 (American Hospital Association, 2006, 2013). The rise in
outpatient volumes has grown even more quickly, to nearly 101 million visits in 2012 (Centers
for Disease Control and Prevention, 2014). Figure 3–1 shows the change in hospital demand
and supply over recent years.

When supply is consolidated yet demand remains strong, pricing and margins typically
rebound. That is exactly what we have seen in hospitals recently. Profit margins shrank from

around 4% in 2001 to 2.7% in 2012. While supply is starting to stabilize (the number of
community hospitals has remained around 4,900 for the last 8 years), the industry is seeing
declines in profit margins after some increases in the prior decade (see Figure 3–2). It is
hoped that this trend will moderate, although payment decreases mandated under PPACA will
challenge the operations management field to maintain margins at current levels.

FIGURE 3–1 Hospital Industry Economics: Inpatient Supply Falling and Demand Rising
(Community Hospitals)

Data from American Hospital Association Trendwatch Chartbook, 2014.

Yet this tells only half of the story. Some research suggests that nearly 50% of large
hospitals have negative operating margins (Langabeer, 2006). Investment income and ancillary
sources of revenue can typically contribute between 20% and 50% of total margins for an
average hospital. Therefore, real operating income margins at current levels are usually
between 0.5% and 1.5% across the board. With the continued rising cost of medical
technologies, equipment, and other capital costs, sustaining an organization for the long term at
single digit margins is nearly impossible.

FIGURE 3–2 Average Hospital Profit Margins
Data from Modern Healthcare, 2012.

INCOME STATEMENTS
It is important to understand all of the components of a hospital’s financials. This includes
being able to look at all of the key statements—income statement, balance sheet, and cash flow
—in order to utilize metrics and line items to fully understand a hospital’s operation. The
income statement is one of the most important, because it measures a hospital’s profitability
by tracking revenues, expenses, and margins. It works off of the basic accounting principle:

Beginning with the top line of the income statement, a hospital reports gross revenues.
Gross revenues represent the gross or total billings to all government and private insurers for

patient care activities. Gross revenue is typically reported separately for outpatient and
inpatient activities. Gross revenue is the sum of all services rendered, through bills issued to
payers for every DRG, current procedural terminology, and Healthcare Common Procedure
Coding System code. These codes represent the hospital, professional, and technical services
provided, and they are billed based on the pricing maintained in each hospital’s Charge
Description Master (CDM). This CDM is a listing of all services and prices that the hospital
delivers; it is essentially a price list, based on gross charges to be billed to payers. An
assumption for private payments or for co-pays or other out-of-pocket costs is that all billings
that are the patient’s responsibility will be paid in full.

A hospital’s gross billings, however, do not represent what will be realized, given that
sizable discounts are taken based on contract negotiations (i.e., for private insurers) and for
other rate caps, allowances, exclusions, or limitations. A discount or deductions category
appears that reflects an allowance for payments that will likely not be collected. This could be
because of exclusions, contractual adjustments, discounts, or other deductions for the
difference between what is billed and what the insurer will pay. Deductions for many hospitals
in 2012 averaged between 30% and 70%, depending on the payer mix and types of services
offered. For example, if a hospital’s CDM shows a price for a specific service, such as a chest
x-ray for $2,500, that is the gross revenue expected and would be consolidated with all other
services performed to calculate the top line on the income statement. Based on the payer mix
represented in the services offered in a specific period, there would be an adjustment to
discount this based on the reality of what the payer will reimburse. For instance, if the $2,500
service was reimbursed by a payer at $1,000, then $1,500 would appear in the deductions line
accumulated with all other deductions, and $1,000 would be added to net patient revenue.

The difference between gross revenues and discounts and deductions is what is called net
patient revenues. Net patient revenues are the actual expected revenues (gross revenues less
deductions and allowances) for a hospital system and are more commonly used for hospital
comparisons than gross revenues. Net patient revenue is the same as operating revenue.

Under the expense side of the income statement, hospitals typically place their highest
expenses first, followed by lesser categories. For instance, if personnel expense was $17
million and supply expense was $15 million, then personnel expense would be the first
expense category reported.

Depending on the level of detail that a hospital reports internally and externally, all
expense categories can be hidden or aggregated to “total operating expense.” Typically, the
major categories that should be itemized include medical supply and drug expense, personnel
or labor expense, administrative expense, general service expense, teaching expense, nursing,
depreciation, and other operating expense. In other statements, the separate major divisions are
detailed individually, such as intensive care unit, emergency, or obstetrics/gynecology. The
two largest operating expenses in most hospitals are typically personnel and supplies. Labor
expenses can account for nearly 60% of all costs, while supply and pharmaceutical expenses
typically average around 20% to 30%.

The difference between net patient revenue and total operating expense is operating income
or operating margin. Operating margin reflects the profits cleared in the course of normal
business or operations and is one of the most important metrics for determining a hospital’s
financial health. As stated earlier, almost one-third of all hospitals had negative operating
margins in the most recent year of publicly available financial data. An average operating
margin of between 1% and 3% is very common for most hospitals, especially larger urban
ones. Smaller, rural hospitals tend to have even lower margins.

Most hospitals are able to improve their financial performance by maximizing the non-
operating- or non-patient-related activities. These activities are commonly called below the
line because they are not operating activities and are not reported in operating income. They
include fundraising and donations, which can total between 5% and 10% of net income for a
hospital or, based on industry-average calculations, between $250,000 for a community
hospital and $10 million for a larger teaching hospital. In addition, investment and interest
income is a major source of nonoperating revenue. Many hospitals have an in-house treasury or
investment management professional to help direct the movement of cash, manage working
capital, support bond and debt offerings, and invest in various equity markets. The role of
treasury professionals in hospitals is a fairly small field, but its effect can be quite significant,
adding as much as 20% to operating income. A sample hospital income statement is shown in
Table 3–1.

Table 3–1 Hospital Income Statement

ABC Hospital

Income Statement August 31, 2013

Inpatient revenue $1,500,300,000

Outpatient revenue $430,320,200

Total patient revenue $1,930,620,200

Deductions, discounts, and allowances ($1,000,000,000)

Net patient revenues $930,620,200

Total operating expenses ($830,220,200)

Operating income $100,400,000

Other income (donations, contributions, gifts) $5,200,500

Income from investments $15,000,500

Government appropriations $0

Auxiliary and nonpatient revenue $3,000,000

Total nonpatient revenue $23,201,000

Total other expenses ($124,400,000)

Net income or (loss) ($799,000)

INCOME STATEMENT RATIO ANALYSIS
Ratio analyses are important management control activities to ensure that operations are
headed in the right direction and that they are competitive with other organizations. Ratios
allow the details from statements to be put into common formulas that help track financial
health and condition. There are several key ratios that should be monitored to assess an
organization’s financial condition, including profitability, liquidity, and efficiency.
Specifically, ratios that measure profit margins, return on capital, labor productivity, and
supply expense are vital in health care operations management.

Profit Margin Ratios
One of the most common ratios examines operating margin and total margin percentages.

Operating margin is defined as:

In the sample income statement shown in Table 3–1, total operating or net patient revenue was
$930.6 million, and total operating expenses were $830.2 million. The margin was $1.4
million, or 10.8% of the operating margin percentage—which, if this were a real hospital,
would be an excellent margin percentage. Total margin percentage is very similar and is
calculated as:

Again using the data in Table 3–1, where total revenues were $953,821,000 and total costs
were $954,620,200, the total margin in dollars was a loss of $799,000. Dividing this by the
total revenue yields a 20.1% total margin percentage.

This is why it is important to understand the difference between total and operating
margins. It is possible for a hospital to lose money in operations and still have positive total
margins, or vice versa. Understanding this is essential to knowing which area to focus on and
how cost conscious the hospital will have to be to reduce operating costs.

Return on Capital
Return on capital (ROC) is a measure of the level of financial return generated by a hospital’s
operations in a specific accounting period. This return produces a ratio that can be compared
with all hospitals and across other industries. The higher a hospital’s ROC, the better that
hospital performed relative to the competition (although it is impossible to determine if a true
economic profit—not accounting profit—has been earned without analyzing the cost of
capital).

ROC is measured by multiplying a hospital’s operating margin, expressed as a percentage,
by the total asset turnover ratio. Although a more direct method of calculating ROC would be
to simply divide invested capital by net income, the effects of accounting changes, depreciation
methods, and financing policies tend to distort the ratio, thereby reducing reliability and
accuracy. ROC combines both income statement and balance sheet variables and produces a
reasonably optimal estimate of financial viability. Operating margin is calculated by
subtracting operating expenses from the total operating revenue and dividing this figure by the
total revenue generated. Total asset turnover is calculated by dividing total revenues by total
assets, which will be discussed in the balance sheet section.

Labor Productivity Ratios
Other key analyses using income statement data involve analyzing the labor and nursing costs.
Using a combination of the personnel expense labor line plus hospital volume and activity
indicators (e.g., number of discharges, number of beds, number of adjusted patient days), key
staffing and productivity analyses can be conducted to see if the hospital is improving over
time or relative to competition.

Consider this example. A hospital with 10,000 annual discharges incurred a labor expense
of $15 million. The labor cost per discharge (or labor cost) would then be $1,500 per
discharge. If the same figures were $14.7 million and 8,200 discharges a year earlier, then the
ratio would be $1,793. This means that the hospital became more efficient or otherwise had
lower labor intensity from one year to the next. If, however, the hospital across the street,
which offers the same set of services and is relatively the same size, has a labor cost per
discharge of $1,200, then there is still significantly more work to be done to reduce costs and
improve overall competitiveness. The lower the figure, the better, assuming that lower-paid
employees does not translate into lower-quality care or other service outcomes. Other similar
ways to analyze personnel expense are to use net patient revenue divided by the number of full-
time equivalent employees (FTEs) to calculate revenue per employee. An FTE is a measure of
the total number of hours that an employee should work (e.g., an employee who works 40 hours
is considered 1.0 FTE, while a part-time 10-hour-per-week employee is considered 0.25).
Most hospitals typically average between $80,000 and $120,000. The higher the figure, the
better the ratio and the more competitive the hospital.

Supply Expense Ratios
Because medical supplies and pharmaceutical expenses contribute so significantly to overall
cost behaviors in hospitals, it is essential to analyze these expense categories separately
(Healthcare Financial Management Association, 2005). A key metric that should be analyzed is
supply cost per unit of patient activity. Typically, if a hospital were primarily inpatient based,
the best denominators for all ratios would be inpatient days, number of admissions, or number
of discharges.

Supply costs include the sum of all purchases of surgical supplies, general medical
supplies, laboratory supplies, oxygen and gases, linens, dietary products, radiology supplies,

and office supplies (Association for Healthcare Resource and Materials Management, 2005).
The added costs of freight and tax, less rebates and discounts, are also included in this supply
expense category.

Because supply expenses can account for 15% to 50% of a hospital’s operating expenses,
depending on the type of specialty and patient acuity, it is important to focus on this area.
Chapters elsewhere in this text will help to focus efforts around:

• Reducing supply acquisition costs.
• Reducing costs of holding inventory and storing materials.
• Speeding up the turn rates for supplies to improve working capital and gain overall
higher asset efficiencies.

To calculate supply ratios, there are several common options for the denominator, such as
supply expense per discharge, supply expense per bed, supply expense as a percentage of total
operating expense, and supply expense per adjusted patient discharge. Alternatively,
pharmaceutical or drug expense could be divided by the same denominators.

If a hospital has a total medical supplies and drug expense of $15 million, total operating
revenues of $1 million, and 15,000 annual discharges, it would have a 15% cost-to-revenue
ratio and a $1,000 cost per discharge ratio. Compared with a similar hospital in the same
geographic region with an $800 supply cost per discharge, the competing hospital would be
seen as more efficient and probably have a greater profitability.

This all assumes, of course, that the complexity or intensity of the types of patients the
hospitals serve are relatively the same. An adjustment is necessary to make these figures
relative so that they can be compared across institutions. In theory, the greater the intensity, the
more medical supplies that will be consumed; the lower the intensity, the fewer the supplies. A
common way to adjust for patient mix differences between hospitals is to calculate a case mix
index (CMI). CMI is calculated by averaging the DRG weighting for all patients served over
the course of an accounting period. All patients are coded with a DRG (representing the
resource consumption requirements based on a patient’s diagnosis, treatment, age, gender, and
procedures performed), so the DRG weights are the best-known indexes to adjust for case mix.
They typically are used only for Medicare reimbursement, but the calculations can be applied
to all costs.

If the CMI turns out to be less than 1.0, then the supply cost per discharge would be greater
than the original calculation. The formula is:

For example, if supply expense per discharge was $800, as in the previous example, and the
CMI for all DRGs performed was 0.77, then the total supply cost per discharge would be
$1,038. If another hospital had a supply cost per discharge of $1,200 but a CMI of 1.4, then the

adjusted cost would be $857. The second hospital would be considered to be more efficient in
supply utilization.

BALANCE SHEET
Users of hospital financial statements cannot make informed decisions about the organization’s
financial condition without examining the balance sheet in addition to the income statement
(Finkler & Ward, 2006). A balance sheet is a representation of the accounting equation:

Equity is often called net assets in government organizations. There are simply too many
interrelationships among revenues, expenses, assets, and liabilities to ignore either of these
statements. For example, assume that supply expenses reported on the income statement were
low one month, but looking at the balance sheet you see an unusually high accounts payable
balance. Accounting entries commonly balance figures between both statements. For instance,
purchasing expenses can be accrued and put on the balance sheet, and supplies or
pharmaceutical expenses can be held in inventory on the balance sheet. These temporary
differences require users to understand and interact with both statements simultaneously.

The purpose of financial statements is to maintain a historical perspective of financial
performance over time, using standards to allow for comparison purposes, which let one
diagnose the strengths and weaknesses of a firm. A balance sheet, as one of the key statements,
is designed to show how the assets, liabilities, and equity of the hospital are distributed at a
specific point in time. It is often called the statement of financial position. It is usually
prepared at regular intervals, such as each quarter, the end of each month, and especially at the
end of an accounting year. Most hospitals are either on an academic-year (i.e., September 1
through August 31) or calendar-year basis (i.e., January 1 through December 31).

When looking at the balance sheets, assets are listed first, and they are arranged based on
categories in decreasing order of liquidity, based on how quickly they can be turned into cash.
Cash, therefore, is the first asset that appears under the asset section. Liabilities are listed
second and are arranged in order of how soon they must be repaid or are due. Equity, or net
assets, is listed third on the balance sheet. A sample balance sheet appears in Table 3–2.

An asset is anything the hospital owns that has immediate or long-term monetary value.
Examples of assets are cash, marketable securities and investments, prepaid expenses,
accounts receivable, inventories, fixed assets (also called plant, property, and equipment),
and other assets. Assets can be further divided into current and long-term, or long-lived,
assets. Current assets are those that will be converted into cash within 12 months or the current
operating cycle, whichever is longer. Long-term assets are all those that are longer than 1 year
or the current operating cycle.

Liabilities are the claims of all vendors and creditors against the assets of the business and

represent all debts owed by the hospital. Current liabilities are debts that must be paid within
1 year, such as accounts payable, short-term notes payable, accrued expenses, taxes payable,
and the current payment on long-term debt. Long-term liabilities are amounts owed with a
maturity of more than 1 year, such as mortgages payable and long-term bank notes.

The difference between an organization’s assets and its liabilities is the net assets, equity,
or net worth of the business. It represents the investment of the owners, plus any profits
retained, minus any losses incurred.

Table 3–2 Hospital Balance Sheet

2013 Assets (Millions)

Current assets:

Cash and equivalents $325

Short-term investments $175

Accounts receivable, net $550

Inventories $250

Prepaid expenses $50

Total current assets $1,350

Long-term assets:

Land and buildings, net $750

Property and equipment, net $500

Investments $200

Total long-term assets $1,450

Total Assets $2,800

Liabilities and Equity/Net Assets

Current liabilities:

Accounts payable $360

Taxes and other payables $40

Accrued liabilities $80

Other short-term liabilities $10

Total current liabilities $490

Long-term liabilities:

Long-term debt $180

Other long-term obligations $20

Total long-term liabilities $200

Total Liabilities $690

Equity/net assets $2,110

Total Liabilities and Net Assets $2,800

WORKING CAPITAL
Working capital is an important concept for operations management. Working capital is
calculated by subtracting current liabilities from current assets. The excess of what will soon
be converted to cash (current assets) minus the liabilities that will consume cash (current
liabilities) is working capital. Conceptually, it is the funds necessary to finance the operating
cycle for a hospital—from delivering services to receiving funds to paying invoices for
materials used. The higher the figure, the more liquid a business is considered and the higher
its ability to pay its debts.

Working capital represents the levels of inventory, cash, and accounts receivable on the
books at any point in time. The current liabilities primarily represent payments to be made for
accounts payable, such as supplies, materials, or services. From a supply chain perspective,
both sides of the working capital equation are important because they reflect how efficiently
the hospital is ordering, storing, and paying for goods and services. From a financial
perspective, the amount of money in cash should be limited to as little as possible while still
being able to make all required payments; the rest of the funds are held in marketable securities
or accounts that have higher yielding interest and investment income. The key to working
capital management is to match the amount of money needed in the short term with the amount
of funds available and to keep all other assets in assets with higher returns, such as investing in
a new building that will produce clinical revenue or in an equity fund.

One common working capital indicator used to measure efficiency is the number of days of
working capital that a hospital holds. If a hospital has $22 million in current assets, $15
million in current liabilities, and an average monthly operating expense of about $26 million,
then the calculation would be:

Alternatively, working capital can be measured by its separate components, such as number
of days of cash on hand or number of days of inventory. Understanding which component of
working capital is increasing or decreasing over a period of time, or relative to competitor
hospitals, will help determine the drivers of change to working capital and focus operational
management efforts.

OTHER FINANCIAL RATIOS
Common analyses performed on the balance sheet for operations management purposes include
working capital indicators, debt ratio, inventory utilization, and asset management, among
others.

An important measure for health care operations examines the percentage of debt that the
organization maintains to sustain operations. The debt ratio examines the percentage of total
assets financed by debt and is calculated as follows:

For example, the balance sheet in Table 3–2 showed $690 million in total liabilities and
$2,800 in total assets, which gives a 25% debt ratio. The lower the figure, the more equity is
used to finance operations, which could suggest inefficient use of debt. On the other hand, too
high a ratio suggests greater debt exposure, which tends to exaggerate earnings artificially.

Another important balance sheet ratio is the inventory turnover ratio. The simplest way to
calculate inventory turns is:

Cost of goods sold is the term used to represent the cost of the materials or supplies that
are stored in inventory, and average inventory is the mean value reported between two
financial reports. For example, on the balance sheet in Table 3–2, the inventory was reported
at $250 million. The previous year it was also $250 million, so the mean inventory is $250
million. Assuming that total cost of goods sold was $2,500, the inventory turnover ratio would
be 10 ($2,500 ÷ $250).

Accounts receivable (AR) is an important component to analyze because it represents
Helton, Jeffrey, et al. Health Care Operations Management, Jones & Bartlett Learning, LLC, 2015. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/apus/detail.action?docID=4441334.
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future revenue to be recognized. The faster that this can be converted into cash, the better. The
most common AR calculation is called days sales outstanding (DSO) or average collection
period, which defines how long on average the hospital has to wait to convert the receivables
into cash. It is calculated as:

Using the earlier figure, total accounts receivable is $550 million and daily revenue
averages are $2,585,056 ($930,620,200 ÷ 360). Therefore, the DSO calculation is 212 days.
In most modern hospitals, an average of days of AR outstanding is somewhere between 30 and
75 days.

The last common balance sheet ratio focuses on the relationship between current assets and
current liabilities because it suggests how solvent or liquid the hospital is. The current ratio is
calculated as:

Using the data in Table 3–2, current assets are $1,350 and current liabilities are $490 million.
Therefore, the current ratio is 2.75. In general, a higher ratio indicates a larger safety margin,
but it may also suggest inefficient use of assets because the higher-returning assets typically are
long-term investments.

CASH FLOW STATEMENT
The third and most common financial statement is the statement of cash flows (also known as
the cash flow statement or the funds statement). Cash is required to pay short-term bills, fund
payroll, and finance daily operations. But monitoring the cash balance sitting in bank accounts
is not sufficient to fully understand how it is being earned and used.

For public companies traded on stock exchange markets, the Securities and Exchange
Commission requires disclosure and reporting of a company’s cash flows. In the health care
industry, which is primarily nonprofit, there is significantly less use of the statement of cash
flows; even if it is not required, it should be utilized.

The statement of cash flows represents all of the cash inflows a hospital receives from its
ongoing business activities and investments, as well as its cash outflows for expenditures,
labor, and other activities. The cash flow statement shows both sources and uses of funds and
reconciles both the income statement and the balance sheet back to changes in cash flow.

The cash flow statement is very useful to help analyze whether business activities are
positively or negatively affecting a hospital’s cash position. With most hospitals maintaining
cash reserves of several days to several weeks of operations, it is important that business

managers closely examine their efforts to ensure they are positively contributing to cash flows
over time.

Information from this statement helps a hospital better manage its cash position, which is a
critical component of working capital. It is a vital metric that hospital administrators must
focus on to ensure that more cash is being “earned than burned.” Knowing whether a change in
cash position is due to operations (i.e., inflows and outflows related directly to services
provided in the normal course of observing, diagnosing, and treating patients) or to investments
or financing activities is essential to understanding a hospital’s true financial position. A
sample statement of cash flows is provided in Table 3–3.

Cash flow statements can be produced in two formats: direct and indirect. The indirect
method is the most commonly used, likely because of its simplicity. The indirect method
reconciles net income as the top line and makes adjustments for all entries that do not affect
cash. Depreciation, for example, reduces net income, but because it is a noncash activity it will
be added back to reconcile to the cash flow position. The direct method reports cash outflows
and inflows only, without attempting to make reconciling adjustments back to net income. Both
methods produce the same results, which is net cash used or provided by all types of operating,
investing, and financing activities.

Under the operating activities, the indirect method sums all cash inflows and outflows
primarily from the income statement items (e.g., net income, adjustments), but it also looks at
changes in current assets and liabilities. The calculation of cash flows for operating activities
formula looks at the beginning and ending income statement and balance sheet and performs the
following computation:

Table 3–3 Statement of Cash Flows

Cash Flow from Operations

$1,500,000

Net earnings

Depreciation $45,000

Decrease in accounts receivable $15,000

Increase in taxes payable $2,000

Less decrease in accounts payable ($25,000)

Less increase in inventory ($15,000)

Net Cash from Operations $1,522,000

Cash Flow from Investing

Equipment ($400,000)

Cash Flow from Financing

Notes payable $15,000

Cash Flow from FY2013, Net $1,137,000

Similarly, a calculation for investing activities looks at both long-term assets bought or
sold, as well as short- and long-term investments. Finally, a net cash flow from financing

activities explores the changes in long-term liabilities; any dividends payable; and any issuing
stock, treasury stock, and debt (although these are less common in most nonprofit hospitals).
The net cash flow sums all three of the components to see the changes in net cash flow used or
provided by operating, investing, and financing activities, and it gives a clear picture of
whether the organization generated or burned cash during the period.

AUDITED FINANCIAL STATEMENTS
All of the three financial statements described in this chapter—income statement, balance
sheet, and statement of cash flows—help show the overall financial health and condition of a
hospital. However, obtaining these statements for benchmark comparisons with other hospitals
is very difficult. For-profit, or publicly traded, firms are required to disclose their statements
to the public as a condition of being listed on a stock exchange, but most hospitals are
nonprofit and so are not regulated by the same rules. However, because most hospitals secure
financing through debt, or the public bond market, audited financial statements are nearly
always required to obtain financing through bond rating agencies. Hospital financial statements
can be obtained directly from the hospital, from the Internal Revenue Service for certain
charitable hospitals that file a Form 990, from an organization designated as a nationally
recognized municipal securities information repository by the Securities and Exchange
Commission, or from the Medicare cost report.

The best source of information to use for conducting operational analyses is audited
financial statements, which are prepared or reviewed by an independent accounting firm. The
independent accountant attests, based on examinations and reviews, that the statements fairly
present the financial condition as of a certain period and were compiled in accordance with
accounting principles. Audited financial statements give some reassurance that the overall
financial statements are presented fairly, which is a potential problem for organizations that do
not have to comply with generally accepted accounting principles.

DEBT IN HEALTH CARE
One of the most common ways to finance capital investments for the future is through debt.
Debt is recorded on the balance sheet and can be payable in the near term (less than 1 year) or
the long term (amortized over a period of greater than 1 year). There is a cost to finance the
business using debt, as there is with all sources of funds, although some forms of debt are
better than others. Simple forms of debt financing entail using organizational purchasing cards
from banks with revolving lines of credit and an associated interest charge. Short-term
working capital loans are offered by financial institutions to cover short-term imbalances in
asset and liability accounts, primarily when AR is slower moving than accounts payable.
Hospitals tend to use capital equipment leases for large items when vendors offer attractive
terms, but for very large investments (e.g., new building, new major pieces of equipment) the

use of public health care bonds is usually the desired debt vehicle.
Bonds are debt instruments issued by a health care organization to the public; the

organization is obligated to repay the original principal plus interest for the period the debt
was outstanding. Bonds can be very complex and often require both external legal and
financial assistance in their offers. The amount of interest that organizations must repay is
directly related to their credit ratings: Organizations that are the most successful, profitable,
and the most creditworthy will have the best ratings and, therefore, lower interest rates. This is
because the public views these organizations as being more stable and less risky; thus, they are
willing to take a smaller return. Contrary to this, the more risky firms (i.e., those that have
lower credit ratings) will have higher interest.

Credit ratings in health care financing are typically conducted by one of four organizations:
Standard and Poor’s, Moody’s Investor Services, AM Best Company, and Fitch IBCA. Each of
these organizations has developed separate rating schedules to evaluate the volatility and
worth of those seeking credit. For example, Standard and Poor’s uses AAA as the highest
overall rating given to an organization, which represents the least amount of total risk, down to
B2 for those that are most risky and speculative.

IMPLICATIONS FOR OPERATIONS AND LOGISTICS
MANAGEMENT
All departments, functions, and managers play a role in improving the financial condition of
hospitals. Understanding the effect of operational activities and how they translate into the
financial statements of the hospital (which measure the changes in financial performance over
time) are requirements for improving the level of competitiveness and operational
effectiveness for a hospital. Operations managers, however, must take the leadership role in
this effort.

The relationship between operations and working capital must be well defined and
managed. When analyzing any project for a department, the working capital consumed must be
calculated for that area to examine how it contributes, positively or negatively, to the
institution. Similarly, operations managers must check that AR and accounts payable align and
match to ensure that money is not being paid out faster than it comes in. Exploring changes in
inventories for key nursing units and materials management departments is also necessary to
ensure that supplies are being used properly and that there is an efficient utilization or turnover
in assets.

The linkage between the revenue cycle and the supply chain must also be integrated faster
and with less manual effort. There should be real-time integration between supply charges and
patient medical records when dispensed so that, as new items are added to the item master,
they are seamlessly integrated with the CDM, eliminating unnecessary manual steps and
reviews.

Also, focusing on increasing the labor productivity for staff in support and clinical areas
can mean reducing wait times for patients and lowering labor costs for the hospital.
Understanding where these costs are stored in the institution’s financial systems and reports is
essential so that operations managers can use the right data in their analyses.

CHAPTER SUMMARY
The role that business operations managers play in improving a hospital’s financial condition
is a continuous and ever-increasing process. Operations managers must know where financial
data reside in their hospitals—in which systems and financial reports—if they are to use them
in quantitative analyses focused on operational efficiencies. A hospital’s revenue is being
constrained by all payers’ attempts to reduce utilization of services and use competitive means
to reduce reimbursement rates. This translates into lower revenues and profit margins. A
hospital, therefore, has to continually focus on maximizing financial performance to ensure its
survival and avoid bankruptcy and other financial distress. The financial condition of a
hospital is measured through one of three key statements: the income statement, the balance
sheet, and the statement of cash flows. Working capital is an important concept that focuses on
operational efficiency. Ratio analyses help analyze whether the hospital is profitable, liquid,
burdened with debt, or nearing bankruptcy. Analyzing the effect that operational management
has on a hospital’s overall performance and financial health is evident only by understanding
these statements and by using ratios and metrics that show trends over time.

KEY TERMS
Accountable Care Organization (ACO)
Ambulatory Payment Classification (APC)
Asset
Balance sheet
Bonds
Capitation
Case mix index (CMI)
Case rate
Charge Description Master (CDM)
Commercial insurers
Cost of goods sold
Deductions
Diagnosis-related group (DRG)
Fee-for-service (FFS)

Income statement
Liabilities
Managed care organizations
Medicaid
Medicare
Net patient revenues
Payer
Per diems
Profit margins
Prospective payment
Reimbursements
Retrospective
Statement of cash flows
Statement of financial position
Working capital

DISCUSSION QUESTIONS

1. Why should operations managers understand financial statements?
2. What constrains a hospital’s revenue?
3. Compare and contrast the incentives to health care providers under a fee-for-service

reimbursement mechanism versus a prospective payment mechanism.
4. What are the three key financial statements that business managers should be aware of,

and how are they related?
5. What is the logic of the order of the assets listed on the balance sheet?
6. What is a financial ratio? What value does it provide?
7. Why do organizations have their statements audited? What assurance does it provide?
8. What is the principal difference between the direct and indirect methods for preparing

the cash flow statement?

EXERCISE PROBLEMS

1. A hospital has $25 million in gross revenues and $12 million in net patient revenues.
What is the average deduction percentage for that period?

2. The same hospital has $40 million in current assets and $30 million in current
liabilities. During a 30-day month, it incurred total operating expenses of $10 million.

How many days of working capital did it maintain this period?
3. Using the income statement and balance sheet examples provided in the chapter,

calculate the return on capital in 2013.

REFERENCES
American Hospital Association. (2006). Chartbook. Chicago, IL: Author.
American Hospital Association. (2013). Factbook. Chicago, IL: Author.
Association for Healthcare Resource and Materials Management. (2005). Supply expense

benchmarking study. Chicago, IL: Author.
Centers for Disease Control and Prevention, National Center for Health Statistics. (2014).

Hospital utilization. Retrieved from www.cdc.gov/nchs/fastats/hospital.htm
Centers for Medicare and Medicaid Services. (2013). National health expenditures

2012 highlights. Washington, DC: Department of Health and Human Services.
Centers for Medicare and Medicaid Services. (2014). Hospital cost report information

system. Washington, DC: Department of Health and Human Services.
Finkler, S. A., & Ward, D. M. (2006). Accounting fundamentals for health care

management. Sudbury, MA: Jones and Bartlett.
Healthcare Financial Management Association. (2005). 2005 supply chain benchmarking

survey. Washington, DC: Author.
Langabeer, J. R. (2006). Predicting financial distress in teaching hospitals. Journal of

Health Care Finance, 33(2), 84–92.
Modern Healthcare. (2012). By the Numbers: 2012–2013 Supplement. Chicago, IL:

Crain Communications.

http://www.cdc.gov/nchs/fastats/hospital.htm

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