The Importance of Healthcare Cost Accounting: A Comprehensive Guide

Understanding Healthcare Cost Accounting

Over the past few months, we’ve been discussing various elements of accounting, particularly the accounting issues related to the healthcare industry. As is well-known and reported in the media, the costs of receiving quality care can be high. But this is a two-way street. Delivering high-quality patient care is also expensive for healthcare providers and, if anything, continues to march higher. According to a May 2024 report by the American Hospital Association, hospitals and other healthcare businesses are facing increasing operational costs and various economic pressures (consider inflation) when providing care for their patients. To this point, healthcare cost accounting – the process of identifying, classifying, and reporting the costs associated with providing healthcare – is increasingly important to understand. Simply put, healthcare cost accounting consists of the analysis and recording of the labor, materials, and overhead costs to determine the actual cost a healthcare facility incurs for providing service. As we’ve mentioned in other articles on this site, the reason for conducting thorough accounting procedures and reviews (or audits) is for healthcare businesses to manage their financial resources wisely and to make better informed strategic decisions. Thus, management’s choices can offer better efficiencies and better patient outcomes.

Direct and Indirect Costs in Healthcare

In healthcare (like in many industries), costs can well be categorized into two main segments: direct and indirect costs. Direct costs are expenses that are specifically related to the delivery of patient care. Obvious ones include labor costs for physicians and nursing staff, medications and medical supplies, equipment costs such as the machinery used in operating room settings or monitoring devices in patient rooms, as well as diagnostic and various testing expenses. So, the salary of a heart surgeon who performs valve replacement operations, plus the expenses for the surgical instruments used, would be considered direct costs. Indirect costs, on the other hand, are those not directly related to the patient’s care but are indeed necessary to support the overall functions of the healthcare entity. For these, consider administrative salaries and benefits for employees from top managers to support staff and even outside consultants. Facility maintenance, rental costs (if necessary), and utilities would also be considered indirect costs of a healthcare business. Marketing and advertising expenses, information technology costs, and others are examples. Here, the salaries of the hospital’s admin staff and the cost of setting up and running the business’s IT infrastructure would be considered indirect costs. These direct and indirect costs must be accurately identified and reported through effective healthcare cost accounting procedures as they truly impact the financial performance of the organization – both positively and negatively. Tracking and allocating costs leads to informed decisions, better resource allocation, and pricing. Again, by doing this right, managers can see which areas have inefficiencies, optimize resource usage, and ensure the sustainability of the system.

Key Benefits of Quality Healthcare Cost Accounting Systems: Cost Data and Control

A high-quality cost accounting system plays a crucial role in assessing and managing a business’s costs involved with providing service. While it may sound jargony, this does indeed help with “data-driven decision making,” which leads to better expense management and improved patient care. That said, more expensive care doesn’t necessarily mean better care or better patient outcomes. For example, a hospital might use cost accounting data to compare multiple surgical procedures to determine which one is more expensive due to the inefficient use of supplies. This more expensive procedure isn’t necessarily better or more advanced, just more costly. Anotherplus with cost data analysis is that it can provide leverage when a provider is negotiating contracts with payers and optimizing revenue cycle management. What does this mean? Well, in healthcare, it means the process a facility will use to manage the “financial elements” of a patient’s care, from registering a patient to the final bill being paid. Elements of this include:
  • Reducing Denials and Errors so insurance claims are right and there is less of a chance to be denied service from an insurance company. Meticulous coding and billing practices are necessary.
  • Improving collections is another area to focus on, whether they are from patients or insurance providers. One strategy for this is better patient communication regarding their responsibilities to pay their share.
  • Quality Patient Registration and Data Management can help healthcare entities make sure data is correctly obtained and updated on an ongoing basis. This leads to better claims and billing management.
  • Using Advanced Analytics meanshaving data, not for data’s sake (which doesn’t help an organization), but using ongoing data and analytics gained from it to give managers the ability to deeply monitor and improve a range of financial issues.
All this leads to the reduction of time lost and the costs associated with revenue collection. It also leads to improved cash flow and enduring financial strength. This also helps with effective price setting, another crucial part of cost accounting, as it determines the costs associated with product components and supports various business functions, including cost control and negotiations. For instance, a hospital might use cost data to negotiate higher reimbursement rates for more costly procedures. Additionally, cost accounting data can assess and set prices for successful contract negotiations.

Cost Accounting and Management Decision Support

Diving a bit deeper into cost accounting in the healthcare area is reporting functions. By looking at data over time, managers can report detailed analyses of the costs associated with patient care. For example, by analyzing cost accounting, a hospital may discover that some procedures they offer are more cost-effective when performed in an outpatient setting rather than inpatient. (Inpatient, as in procedures that require admission to a hospital facility for at least one night, versus outpatient or ambulatory procedures that do not require overnights and are often simpler.) Some procedures can be performed either as an inpatient or outpatient, such as an endoscopy, which is often done on an outpatient basis. However, if complications arise, it may necessitate inpatient care. Joint replacement is another example. With advances in laparoscopy, these can be done quickly and efficiently as outpatient procedures. Yet, depending on the patient’s health status and the complexity of the procedure itself, an overnight stay (or several) may be necessary. Ongoing analysis of cost data can be a tool in such decision-making processes. Getting more granular, hospitals generally use a combo of cost methods and include activity-based costing (or ABC) and job order costing. ABC can help hospitals allocate costs based on activities that actually drive costs, while job order costing is typically employed for specific patient treatments or procedures.

Pricing in Relation to Healthcare Cost Accounting

Quality healthcare cost accounting aids in the development of accurate pricing strategies. If you understand the actual costs of the services you provide, healthcare entities can set prices that reflect the true value (or nearer to) the care provided. Seems like it would be obvious that organizations would be able to price services accurately, but in complex medical institutions, knowing the all-in costs is immensely difficult. The financial managers in such environments must be able to look at the situation both holistically (and see where costs are coming from the top down) and also to get precise in identifying the many incidentals that make up the facility’s overall budgeted expenses. As it can be a daunting challenge, managers often turn to qualified outside expertise such as accounting firms steeped in healthcare accounting best practices.

Implementing a Healthcare Cost Accounting System

Implementing a cost accounting system requires thorough knowledge of the organization’s financial and operational processes. Costs must be identified for the specific services offered and then classified into different and relevant categories. Overlaps in accounting for costs must be eliminated. Also, cost accounting systems need to be integrated with a business’s other functions, such as clinical decision support systems and patient engagement procedures (billing, reimbursement, etc.). Advanced cost accounting capabilities, such as data analytics and reporting, also help. For example, a hospital can implement a cost accounting system that becomes part of their electronic health record (EHR) process, which gives clinicians real-time cost data. Again, working with qualified accountants can help, as can implementing suitable healthcare accounting software.

Challenges in Healthcare Cost Accounting

Now for the flip side. One of the biggest challenges in healthcare cost accounting is the complexity of the industry itself. There are many moving parts, many different stakeholders, lots of regulatory issues, and, of course, the pressures of treating or even saving the lives of patients. Another issue is that many businesses don’t always use up-to-date cost accounting methods but rather end up relying instead on outdated or unhelpful procedures. Take what is called a ratio of cost to charge approach (or RCC). This method estimates a service’s cost by dividing the total cost of delivering that service by the total associated charges. This becomes a ratio that can tell a healthcare provider what they spend to give it, versus the price they actually charge for it. It offers a method to allocate costs within a care facility across different departments. However, it’s considered a more simplistic approach by healthcare executives who often ignore such data, knowing that RCC isn’t always an accurate picture of a facility’s costs. Needless to say, there are many challenges facing healthcare businesses that have to work hard to survive and strive; effective cost accounting can be a help. Leaders must have a thorough understanding of their accounting processes and how they impact their overall financial performance. Take, for instance, a hospital that isn’t accurately tracking the cost of care for patients with severe or complex medical conditions. There are a lot of elements that will go into that total care cost. Without quality cost accounting, it is virtually impossible to get an accurate end statement. Several case studies have shown that healthcare businesses that maintain superior cost accounting systems do indeed reduce costs and better their financial performance. A hospital in the northeast, for example, rigorously reviewed and implemented a new cost accounting system that was able to pinpoint the fact that its emergency room was overstaffed during specific hours. By adjusting its staffing levels, the facility was able to reduce labor costs without compromising patient care.

The Future of Healthcare Cost Accounting

The future of healthcare cost accounting is likely to change via an increased usage of technology and big data analytics. AI may come into play in the near future as well. As has been the case for some time, there is and will be a greater emphasis on “value-based care” and population health management. Healthcare will continue to evolve, particularly with an aging population and strained federal and state budgets. These pressures will drive a more accountable system for costs and reimbursements that is transparent and accessible to both patients and other payers. Cost accounting systems may be required to provide customers with detailed cost breakdowns for treatments and procedures in the future. This can both help a medical facility determine areas of waste (or even abuse) and give them a superior understanding of the costs involved in supplying services. It can also give patients more data to make better-informed decisions about their care.  

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