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the Center, which is part of the University Healthcare System, is a regional leader in the very intense and medically sophisticated area of organ transplantation. All transplants are performed at Cambridge General Hospital, the 400-bed flagship of University. The administrative director of the Center, Josh Zimmerman, has been on the job for ten years, during which time significant growth has occurred in both the number of transplant programs and the volume of procedures performed. When Josh joined the Center, he was put in charge of a kidney transplant program that averaged 60 transplants per year and a heart transplant program that performed 40 transplants annually. Today, the Center performs more than 500 transplants per year, including transplants from liver, lung, and pancreas programs. Of all of the Centers organ programs, the liver transplant program is the most successful in terms of volume and revenue. Last year, volume totaled 120 transplants, bringing in more than $50 million in total revenues. This year, Josh is optimistic that the liver program can do even better. However, he knows that increased volume is largely dependent on the number of organ donors and on his success in negotiating a new contract with Lifecare Transplant Network (LTNET), the largest transplant benefits company in the nation. Although most health insurers can identify those patients who are good candidates for transplant services, only the largest health insurers have the expertise to manage the transplant process. Transplants are relatively rare compared with other, more conventional medical procedures. However, the costs to insurers for transplant services are typically very largeusually in the six- to seven-figure range. To ensure the best and most cost-effective management of transplant services, most insurers outsource transplant management to companies that specialize in these services, such as LTNET. Contracting for transplant services is unique and complex because of the sophistication of the medical procedures involved. Transplant services consist of five phases: (1) patient evaluation, (2) patient care while await- ing surgery, (3) organ procurement, (4) surgery and the attendant inpatient stay, and (5) one year of follow-up visits. The costs involved in Phase 1 are relatively simple to estimate, but the resource utilization, and hence costs, of the remaining phases, can be extremely variable because they differ in patient acuity and surgical outcomes. Historically, reimbursement for transplant services has been handled in a number of ways. Initially, many transplant providers bundled all five phases and offered insurers a single, global rate. This method simplified the contracting process, but the rate set for this method was often chosen on the basis of building market share rather than on covering costs. Indeed, many institutions could not even estimate with any confidence the true costs of providing transplant services. Ironically, success in gaining market share usually increases the financial risk of the transplant program because higher volumes increase the like- lihood of attracting higher-acuity patients. Furthermore, changes in the organ allocation system have promoted the acceptance of sicker patients into transplant programs. Although the total costs associated with all phases of a liver transplant average about $500,000, the amount can more than quadruple if the patient requires a re-transplant or if other complications occur. Because of this extreme variability in costs, outlier protection is a critical aspect of contract negotiations if the reimbursement methodology is a fixed prospective rate, such as a global rate. The LTNET contract requires the approval of Dr. Anjali Desai, the newly appointed surgical director of the liver transplant program. Fortunately, like Josh, Dr. Desai is enthusiastic about turning the liver transplant program into one of the largest in the country and is motivated to secure the contract. In his second meeting with Dr. Desai, Josh discussed the specifics of the current contract negotiations. Phases 1, 2, and 5 will be reimbursed at a set discount from charges. Furthermore, to reduce the amount of financial risk borne by the Center, Phase 3 (organ procurement) will be reimbursed on a cost basis, which makes sense because the cost of Phase 3 is almost completely uncontrollable by the Center. Thus, the primary focus of the negotiations, and the make-or-break part of the contract, is the reimbursement amount for Phase 4. (For more information on organ procurement, see the United Network for Organ Sharing website at www.unos.org.) Phase 4 costs are divided into two categories: hospital costs and physician costs. Physician reimbursement has already been agreed on, with LTNET committing to pay a fixed amount per physician work relative value unit (RVU). Thus, the primary matter at hand involves only Phase 4 hospital costs. To aid in the negotiations, Josh compiled the Phase 4 hospital costs of the 12 most recent liver transplant patients. These data are presented in exhibit 9.1. Dr. Desai was amazed when she read the numbers. A total average cost of $119,805 for 19 days average length of stay (ALOS) translates to a per diem average cost of more than $6,000. She was sure that LTNET would not be willing to sign a contract that paid the hospital $120,000 (or more) to cover Phase 4 hospital costs. Thus, she suggested that Josh reexamine the cost structure to see if these costs could be reduced. At first glance, it appeared that large cost savings could be realized by merely reducing ALOS. For example, Phase 4 hospital costs associated with a particular patient could be reduced by more than $12,000 by decreasing ALOS by two days. However, further analysis revealed that the costs associated with Phase 4 are not a linear function of ALOS. Internal studies at the Center indicated that the first day of Phase 4 is usually the most costly and the last day is usually the least costly. Indeed, roughly 70 percent of Phase 4 costs occur in the first 24 hours of hospitalization. When lowering Phase 4 hospital costs appeared to be difficult, Josh decided to pursue a different strategy. He believed that economies of scale are present in liver transplants, and hence the marginal cost of each transplant is lower than the average cost. Thus, he proposed that the Phase 4 hospital reimbursement amount be based on marginal rather than total (full) costs. You have been hired as a consultant to recommend a fixed reimbursement amount (the base rate) to propose during the contract negotiations for Phase 4 hospital services. To help in the analysis, Josh has indicated that approximately 60 percent of the nursing, ancillary, operating room and laboratory costs are fixed. The remaining costsradiology, drug, and other servicesare predominantly variable. Furthermore, current payers are reimbursing the hospital at roughly $140,000 for Phase 4 services. The Center has sufficient capacity to handle about 30 more transplants before fixed costs would increase by a meaningful amount. If the marginal volume exceeds 30 transplants, the best estimate is that fixed costs would increase somewhere between 15 and 25 percent. In addition, you have been asked to recommend a method for handling outliers, including the threshold amount and additional reimbursement scheme. Other programs within the Center use two methods for outlier payments. One method is to charge an additional per diem amount based on a length-of-stay threshold. Alternatively, some percentage of costs above the threshold can be charged when a cost threshold is reached. (For more information on how Medicare treats outliers, go to www.cms.hhs.gov/mln- geninfo and then search inpatient outliers.)

Total OR Lab Other Age LOS (years) (days) Nursing Cost Ancillary Cost Radiology Cost Drug Cost Patient Costs Cost Cost Costs A 61 25 B 56 15 $1,483 2,261 668 42 12 D 52 13 903 E 12 26 F 59 22 $141,092 139,306 74,259 115,349 172,613 83,807 136,060 139,308 74,259 115,348 166,224 80,034 $10,261 11,969 6,939 7,221 28,205 16,858 9,645 11,969 6,939 7,221 26,909 15,629 $65,416 63,668 33,661 54,063 72,204 33,474 63,208 63,669 33,660 54,063 69,657 32,202 $6,770 8,501 3,128 5,779 6,847 4,654 6,489 8,501 3,128 5,778 6,765 4,531 $13,712 7,409 5,279 6,112 10,550 6,211 13,091 7,409 5,280 6,111 10,061 5,937 $20,992 24,504 6,964 7,638 23,061 9,698 20,127 24,505 6,964 7,639 22,007 9,122 $22,458 20,994 17,620 33,633 29,980 11,515 22,118 20,994 17,620 33,633 29,148 11,320 G 1,766 1,397 1,382 2,261 668 41 25 . 35 17 52 12 38 13 903 59 25 1,677 1,293 L 60 21 Mean 47 19 $119,805 $13,314 $53,245 $5,906 $8,097 $1,389 $15,268 $22,586 LOS: length of stay; OR: operating room 1. What is the estimate of the marginal cost of Phase 4 hospital services (assuming 60 percent of the costs are fixed and 40 percent are variable)? 2. What is the underlying cost structure or cost behavior of this service? What is the relevant range for this structure? Does the structure change if the contract is expected to bring in more than 30 additional transplant patients? 3. What fixed-cost proportion is required to force the average variable cost for Phase 4 hospital services to $90,000? 4. Assume the fixed cost proportion is only 50 percent. What price must be set to cover variable costs? What if the fixed cost proportion is 70 percent? 5. What role do current reimbursement amounts paid for transplants play in the decision to use marginal cost pricing? What about excess capacity? 6. What is your recommendation for the base rate for Phase 4 services that should be contracted? Make sure to consider long-term pricing strategies as well as the effect on those who are currently paying about $140,000 for the services. 7. How should outliers be determined/defined for the contract? What payment should be sought for outliers? Total OR Lab Other Age LOS (years) (days) Nursing Cost Ancillary Cost Radiology Cost Drug Cost Patient Costs Cost Cost Costs A 61 25 B 56 15 $1,483 2,261 668 42 12 D 52 13 903 E 12 26 F 59 22 $141,092 139,306 74,259 115,349 172,613 83,807 136,060 139,308 74,259 115,348 166,224 80,034 $10,261 11,969 6,939 7,221 28,205 16,858 9,645 11,969 6,939 7,221 26,909 15,629 $65,416 63,668 33,661 54,063 72,204 33,474 63,208 63,669 33,660 54,063 69,657 32,202 $6,770 8,501 3,128 5,779 6,847 4,654 6,489 8,501 3,128 5,778 6,765 4,531 $13,712 7,409 5,279 6,112 10,550 6,211 13,091 7,409 5,280 6,111 10,061 5,937 $20,992 24,504 6,964 7,638 23,061 9,698 20,127 24,505 6,964 7,639 22,007 9,122 $22,458 20,994 17,620 33,633 29,980 11,515 22,118 20,994 17,620 33,633 29,148 11,320 G 1,766 1,397 1,382 2,261 668 41 25 . 35 17 52 12 38 13 903 59 25 1,677 1,293 L 60 21 Mean 47 19 $119,805 $13,314 $53,245 $5,906 $8,097 $1,389 $15,268 $22,586 LOS: length of stay; OR: operating room 1. What is the estimate of the marginal cost of Phase 4 hospital services (assuming 60 percent of the costs are fixed and 40 percent are variable)? 2. What is the underlying cost structure or cost behavior of this service? What is the relevant range for this structure? Does the structure change if the contract is expected to bring in more than 30 additional transplant patients? 3. What fixed-cost proportion is required to force the average variable cost for Phase 4 hospital services to $90,000? 4. Assume the fixed cost proportion is only 50 percent. What price must be set to cover variable costs? What if the fixed cost proportion is 70 percent? 5. What role do current reimbursement amounts paid for transplants play in the decision to use marginal cost pricing? What about excess capacity? 6. What is your recommendation for the base rate for Phase 4 services that should be contracted? Make sure to consider long-term pricing strategies as well as the effect on those who are currently paying about $140,000 for the services. 7. How should outliers be determined/defined for the contract? What payment should be sought for outliers