In 1965, the federal government began to pay for the healthcare costs of the elderly under the Medicare Program. For almost two decades, hospital reimbursement was “cost-based,” and physician payments were based on “usual, reasonable, and customary” charges. Medicare disallowed certain costs and partially-covered others. In general, however, it paid all “reasonable” hospital costs and physician fees for its beneficiaries. Several other third party payers— most notably Medicaid (for the indigent) and Blue Cross (for the non-indigent, non-elderly, usually employed) —responded similarly. Each third party defined its allowable costs and reimbursable fees in a different way, and each presented providers with various other constraints, but they all followed essentially the same process.

Although Blue Cross indemnity reimbursement and Medicaid in some states remains cost-based for hospitals and charge-based for physicians, there was a shift in the 1980s toward fixed-price forms of reimbursement. One example was Medicare’s adoption in 1983 of a diagnosis-related-group (DRG) form of payment With DRGs, a hospital classifies each discharged patient into a relatively homogeneous group (the “DRG”) and each DRG has a different payment rate. At the moment there are over 450 groups, each of which has a unique price attached to it. With very limited exceptions, third parties using a DRG approach pay a hospital the DRG price for each patient discharged, and rarely adjust the payment for the costs a hospital actually incurs in providing care to the patient.

The financial environment of the 1980s included more than just DRGs. The 1980s also saw a variety of external constraints and threats that were applicable to both physicians and hospitals. These included pre-admission screening, second surgical opinion, third-party utilization review, and the rapid growth of managed care via health maintenance organizations (HMOs), preferred provider organizations (PPOs), and similar entities. HMOs and PPOs were particularly significant in that they represented collective purchasing power for a physician’s or hospital’s services. Because of this, they could induce a provider to offer extremely competitive prices.

One result of these changes is that both hospitals and physicians have recognized the need to determine “product line profitability.” That is, they have begun to identify clusters of patients who are classified as either “winners” or “losers.” Moreover, with the expansion of managed care programs, hospitals and physicians now need to understand cost behavior in terms of populations of patients so that they can bid successfully on proposed contracts. Indeed, for the first time in recent history, hospitals and physicians have a major incentive to control costs rather than just measure them.

Physicians, whether in group practice arrangements or as salaried members of a hospital’s medical staff, have been affected by these changes. In some parts of the country (e.g., California and Minnesota), the changes have been quite dramatic. In other areas, the changes have been slower to materialize, but can arrive quite suddenly and without warning. In response to either the present or potential threat to their livelihoods, some physicians have become affiliated with hospitals through physician-hospital organizations (PHOs). However, even without a PHO, a physician’s ability to practice successfully depends on the continued survival of the hospital to which he or she admits patients. Thus, the hospital’s concerns become the physician’s. Moreover, with capitation arrangements extending beyond hospitals and into group practices, some physicians have become concerned about cost control at both the ambulatory and inpatient levels of care.

Another result of the above changes is a need for several different cost accounting and control systems, shown in Exhibit 1. The first system, which has been developed by many hospitals and integrated delivery systems (IDSs), is an improved full-cost accounting system that assists in the determination of product line profitability. This system continues to report costs in the usual fashion, but with greater precision and with more accurate overhead allocations. In general, except for large multispecialty clinics, such a system is not especially useful in a physician practice, where there are few product lines, as such, and where overhead allocation either is not done or is not especially complicated.

The second system looks at differential costs, separating them into their fixed and variable components. It is used for competitive bidding purposes, contracting out decisions, and other similar alternative choice decisions. Few hospitals or IDSs have undertaken the development of this sort of system owing principally to its complexity. Yet, such a system can be quite useful, not only for hospitals, but for physician group practices that are considering decisions such as contracting out for their reception areas (as some are doing), operating their own laboratories, bidding on HMO contracts, or any of a variety of decisions that require careful analysis of cost behavior.

The third system is one that assigns costs to the agents responsible for them, and is used for cost planning . . .