2. from insurance companies, patients, and the government; paying
for medical equipment and
supplies; and covering the costs of operation, including wages
for support staff, the price of a
physical office space through a lease or a purchase, and other
expenses. Meanwhile, healthcare
managers must also contend with requests for purchases of new
equipment, increased space, and
a variety of additional items that may or may not be suited to a
healthcare organization’s goals.
Healthcare managers also oversee payroll, billing statements,
accounts payable and receivable,
third-party reimbursements, discounting systems, tax statements
and bills, and numerous finan-
cial and accounting activities. All of these tasks relate to the
process of cash flow management,
or working capital policy.
Working capital policy poses challenges for managers in every
type of industry. However, health-
care providers face additional obstacles that most private-sector
companies do not. For example,
any physician or pharmacy accepting Medicare and Medicaid
patients often encounters diffi-
culties in receiving reimbursements in a
timely fashion. The dilemma follows a com-
mon cycle: A patient receives care or fills
a prescription; reimbursement documents
are filed with the appropriate government
agency; then the wait begins, many times
for months. Meanwhile, supply bills, sala-
ries, utilities, and other expenses come due
and must be paid. Thus, any pharmacy or
medical practice that accepts Medicare or
Medicaid but that does not have a substan-
4. Financial Governance and Working Capital Policy Chapter 6
establish practices lacking cash reserves, and with other
organizations at the brink of default due
to such payment delays, many have called on Congress to
become involved and help resolve these
problems.
This chapter examines the natures of finance and accounting as
they apply to the field of health-
care. The first section outlines the forms, methods, and analyses
used in managing an orga-
nization’s financial system and presents working capital policy,
which directs the oversight of
day-to-day operations. Next, the chapter discusses pricing
issues and the types of financial
instruments that organizations may use to accomplish an
organization’s longer-term goals. The
final section describes the role of accounting in a healthcare
organization’s operations.
6.1 Financial Governance and Working Capital Policy
Financial governance in the field of healthcare involves two
primary responsibilities: (1) over-
sight of day-to-day operations that require financing and (2)
planning for and implementing
financial instruments that provide for the organization’s long-
term financial needs (Gapenski,
2003). Tending to a healthcare provider’s financial well-being
constitutes a primary concern
for managers in the healthcare system. The increasing
complexity of the economic and politi-
cal environments in the area of finance makes this task highly
demanding. Rigorous track-
ing of an organization’s financial activities constitutes one
crucial component in managing this
5. complexity.
Financial Documents and Statements
Finance and accounting departments prepare several documents
and statements that assist
healthcare managers in overseeing the organization’s monetary
well-being. Three forms that
assist the finance and accounting departments, as well as other
organizational leaders, include a
balance sheet, an income summary, and a ratio analysis.
Balance Sheet
A balance sheet summarizes an organization’s current status
with regard to assets, liabilities,
and equity. Figure 6.1 presents the items located in each portion
of a balance sheet. Note that
an organization’s total assets may be divided into what it owes
(total liabilities) and what it owns
(total equity) as follows:
Total assets = Total liabilities + Total equity
Balance sheets are typically prepared on an annual basis.
The balance sheet provides a financial manager with a snapshot
of the organization’s current
position in terms of debt and equity. When managers examine a
series of balance sheets that
have been prepared over several years, they can study trends
regarding growth of assets, changes
in levels of liability, and differences in levels of equity in order
to determine the organization’s
financial well-being over time (Weygandt, 2013).
6. Financial Governance and Working Capital Policy Chapter 6
Income Summary
An income summary is an accounting or financial statement that
provides a somewhat different
purpose for a profit-seeking organization than it does for a
nonprofit. Managers in nonprofit, or
not-for-profit, providers use an income summary to make sure
that revenues exceed expenses. In
a nonprofit, the manager works to make sure that organizational
funds (the amount by which rev-
enues exceed expenses) are being used wisely and efficiently,
with sufficient monies to subsidize
other goals, such as support of the less fortunate in the
community and the expansion of medical
services over time. A manager in a for-profit hospital, however,
wishes to understand whether
annual operations do indeed result in profits to be retained in
order to build share value growth
or to be distributed as dividends to shareholders. Figure 6.2
displays the elements of a standard
income summary.
Figure 6.1 Elements in a balance sheet
f06.01_HCA340.ai
Assets Liabilities Equity
Short-term assets
Cash
Marketable securites
7. Accounts receivable
Inventory
Short-term liabilities
Accounts payable
Payments due
trade credit
commercial paper
Common stock
Paid-in surplus
Preferred stock
Retained earnings
Long-term assets
Building
Equipment
Financial instruments
Long-term liabilities
Loans
Bonds
11. Total assets $38,000,000 Total liabilities $19,750,000 Total
equity $18,250,000
Financial Governance and Working Capital Policy Chapter 6
Healthcare organizations receive revenues from multiple
sources, including patients, insur-
ance providers, and government payments for services. As
Figure 6.2 shows, these revenues are
totaled. For a healthcare organization, the cost of goods sold
portion of an income summary
includes the total expenses for medical supplies and other items
directly related to the delivery
of health services. Depreciation is tallied for all buildings and
equipment, and a healthcare man-
ager may use several different methods to depreciate an asset
over time. Unusual expenses may
include a settlement of a lawsuit or other nonroutine payments,
while unusual income includes
any gifts or bequeaths that the organization receives. Note that
taxes are paid only by profit-seek-
ing health organizations. Thus, net income after taxes (NIAT) is
the bottom-line profit earned by
these organizations (Finney, 2012). However, the government
does not charge nonprofit organiza-
tions, such as many skilled nursing facilities, taxes. So instead
of NIAT, the bottom-line amount
reported is the total by which revenues exceed expenses.
Ratio Analysis
A ratio analysis combines information made available by the
finance and accounting depart-
12. ments to help managers evaluate various operations in the
organization. Healthcare managers
are usually interested in four categories of ratios:
• Liquidity ratio: Measures the organization’s ability to pay
its short-term obligations on time
• Activity ratio: Measures efficiencies in organizational
operations
• Leverage ratio: Measures organizational debt and risk
• Profitability ratio: Measures organizational profits
Although other ratios may be calculated, these four categories
offer healthcare managers a quick
look at an organization’s financial well-being. Managers should
avoid the tendency to overem-
phasize any single ratio; instead, they should look at the group
of ratios together. Managers can
compare ratios from the current year with those from previous
years or with averages in the
industry to gain further understanding of the organization’s
financial standing (Reilly, Minnick,
& Baack, 2011).
Figure 6.2 Elements of an income summary
f06.02_HCA340.ai
Sales (Revenues)
–Cost of goods sold
Gross profit
–Operating expenses
Gross operating income
13. –Depreciation
Net operating income
–Other unusual expenses
+Other unusual income
Net income before taxes
–Taxes
Net Income After Taxes (NIAT)
Patient payments
Insurance payments
Governmental reimbursements
$12,000,000
15,000,000
25,000,000
42,000,000
<12,000,000>
30,000,000
<18,000,000>
12,000,000
14. <5,000,000>
7,000,000
<1,000,000>
+3,000,000
9,000,000
<1,800,000>
$7,200,000
Financial Governance and Working Capital Policy Chapter 6
Working Capital Policy
Financial managers in both nonprofit and profit-seeking entities
have the duty of overseeing an
organization’s cash flow. This includes making sure the
organization maintains sufficient funds to
operate on a day-to-day basis through oversight of current
assets and current liabilities. Working
capital is a comparison of the amount of current assets an
organization has on hand in relation
to its current liabilities. Using the information from a balance
sheet, a financial manager can
compute the organization’s amount of working capital as
follows:
Working capital = Current assets – Current liabilities
15. Working capital can be generated in many ways, including
through selling new or additional
shares of stock, selling long-term bonds, or securing other types
of loans in order to generate the
funds needed to ensure that the organization remains liquid.
In many healthcare organizations, management of working
capital creates some difficulties,
which often emerge as a result of timing. For example, someone
who receives medical care may
be charged the copayment amount during the actual hospital
visit; however, that copay is only
a small part of the balance due for anything more complicated
than a routine examine. Often, a
considerable amount of time passes before the organization
receives any government or insur-
ance company payment. Only then is the patient billed for the
remaining balance so that payment
can be rendered. As noted earlier, Medicare and Medicaid can
be notoriously slow at rendering
payments. While waiting for this payment, the organization
must pay bills for medical supplies,
payroll expenses, and other costs, all of which are due nearly
immediately. Thus, working capital
requires extra attention by financial managers (McLean, 1997).
Effective management of working capital creates a series of
benefits. First, an effective working
capital policy means the healthcare provider will remain liquid,
which in turn means that the
organization will always have funds available to meet
obligations such as payroll and tax pay-
ments. Second, organizations that routinely pay bills on time
generate goodwill with suppliers,
manufacturers, and other vendors. The net outcome of this
goodwill can be that the hospital
16. will receive the most attentive care from those vendors. Third,
an effective working capital policy
establishes a line of credit over time, so that the organization
can borrow money in case of finan-
cial emergencies.
Bundled Reimbursements: A Potential New Working Capital
Challenge
In the past, when a person with an acute medical problem
arrived at the hospital, the individual
received the necessary care and was then made ready for
discharge. If the patient required additional
services, such as rehabilitation, a home health facility, or a
skilled nursing facility, each treating unit
(that is, the hospital and every other organization the patient
visits) billed the person and the gov-
ernment (such as Medicare) separately for each service, or
“silo” of care. Under a system proposed in
the U.S. legislature as an addendum to the Affordable Care Act,
the government (Medicare) would
pay one provider—typically the hospital—for the entire patient
episode, from entry into the system
to a return to health. The entity or hospital would then divide
the reimbursement among all orga-
nizations that served the patient. (This addendum has not yet
been passed or enacted.)
The reasoning behind the bundled payment system is to increase
efficiencies in care. Under
this plan, patients would no longer receive multiple billings,
and the government would only
make a single payment—all with the goal of reducing
redundancy in postoperative-care facilities
(Jackson, Greis, & Rawlings, 2009).
17. Long-Term Financial Governance Chapter 6
However, hospital administrators have raised major concerns
about how such a system would be
administered. Under the plan, each hospital would be placed in
a decision-making role regarding
the amount each connected unit should receive for a patient’s
care. Many healthcare administra-
tors have expressed concerns about conflicts with other
organizations, lowered levels of reim-
bursement, and the confusion created by the paperwork of such
a system.
This new proposal has elicited two suggested responses. The
first is a vertical integration system,
in which the hospital would purchase or establish the linking
levels of care under its ownership,
thereby keeping all payments within one billing entity. An
example of a vertical integration sys-
tem is a hospital that purchases a rehabilitation facility and an
extended-care organization. A
patient who becomes incapacitated would first stay in the
hospital, would then use the services
of the rehab center, and might finally be placed in an extended-
care setting. When the person is
finally discharged, the hospital would bill that patient for all
activities at once. The hospital would
then distribute monies received to each aspect of its operations.
The second response involves the development of network
embeddedness systems, in which
informal networks of organizations would divide
reimbursements on a routine basis (Dacin,
Ventresca, & Beal; 1999). An example of an embedded network
is an informal combination of
18. healthcare organizations under separate ownership in which
each receives reimbursements and
then the payments are distributed among the members.
In the bundled payment approach, the organization that receives
the payment often faces a chal-
lenge in deciding on the amount to be allocated to the other
units involved in the patient’s care.
One way to solve this problem is to devise a transactions cost
approach, in which each activity
is assigned a cost to be reimbursed as a percentage of the total
payment to the primary provider.
The percentage should take into account the costs and the
allowable reimbursements for each
unit that treated or cared for the patient.
Another continuing challenge with the bundled payment
approach involves working capital
issues. Each unit incurs expenses associated with the patient’s
care that are entitled to reim-
bursement. Unfortunately, a substantial amount of time might
pass before any payment is sent
by the primary organization (that is, the organization that
received the full bundled payment)
to the individual unit. Furthermore, disputes among managers
from individual units may arise
regarding exactly how much each unit should be granted as a
percentage of the patient’s total care
package. Estimating and keeping on hand the amount required
to maintain cash flow and make
payments under such a system adds an additional complication
to a system that already experi-
ences significant problems (Shay, 2013).
6.2 Long-Term Financial Governance
In addition to working capital policy, another major
19. responsibility held by financial managers in
both nonprofit and profit-seeking ventures involves ensuring
that the organization tries to achieve
consistent outcomes across all time horizons. This process
requires the manager to mesh short-
term operational duties with long term strategy making. In the
areas of finance and accounting,
managers work to integrate activities by obtaining funds for and
managing the organization’s
monetary well-being so that the organization’s top management
team can create effective strate-
gies that lead to future success. In the long term, two major
concerns of financial managers are
dealing with pricing issues and creating long-term financial
instruments.
Long-Term Financial Governance Chapter 6
Pricing
Pricing includes institutional marketing and financial
considerations. In some instances, govern-
ment programs determine the prices charged for medical
systems. For example, the Medicare
prospective payment system (PPS) method of reimbursement
establishes prices and payments
based on predetermined, fixed amounts. Payments for individual
services are based on the PPS
classification system for each service. The Centers for Medicare
and Medicaid provides separate
prospective payment systems for individual diagnostic related
groups (DRGs), such as acute inpa-
tient hospitals, home health agencies, hospice, hospital
outpatient, inpatient psychiatric facilities,
20. inpatient rehabilitation facilities, long-term care hospitals, and
skilled nursing facilities (Centers
for Medicare and Medicaid Services, 2013c).
In marketing, methods for setting prices may be based on costs,
profit goals, supply and demand,
or competition. Each approach assists the finance team in
pricing healthcare products and
services.
Costs
When calculating price based on cost, the first determination
involves the difference between
fixed costs and variable costs (Higgins, 2011). Fixed costs are
expenses incurred that are not
affected by the volume of sales; the provision of healthcare
services; or revenues from the patient,
the insurance company, and the government. Examples of fixed
costs include building payments
(fixed loan or lease payments), annual salaries, and utility bills.
An important component of fixed
costs involves deciding how much to allocate to each service.
For example, if a physician’s prac-
tice spent $200,000 per year on fixed costs, and the physician
had 8,000 appointments per year,
then the fixed cost per appointment would be $25 per
appointment ($200,000 ÷ 8,000). If the
physician were able to increase the number of appointments to
10,000 per year, the fixed cost
per appointment would drop to $20 per year ($200,000 ÷
10,000). Fixed-cost allocation applies to
hospitals, physician clinics, and any provider of medical
supplies or equipment.
Variable costs are directly related to volume or revenues. In
healthcare, variable costs include
21. billings for physician services; diagnostic procedures, such as
reading an X-ray or conducting a
blood test; medical supplies, including materials for bandages
and stitches; and other per-patient
or per-visit expenses. A greater number of patients incurs a
higher total variable cost, although
regardless of the number of patients, the variable cost per
patient remains relatively stable. Only
when a hospital pays extra expenses—such as overtime wages to
nurses and support staff mem-
bers in the case of a major emergency like an accident that
injures a great number of people—
would variable costs per patient rise.
Total costs are calculated by adding total fixed costs to total
variable costs. Total cost per patient
results from adding fixed costs per patient to variable costs per
patient. These figures may then
be used to set prices based on costs. Two forms of cost-based
pricing are markup pricing and
cost-plus pricing.
A markup pricing approach assigns a percentage to be added to
the total cost per item. Assume,
for example, that the total cost per patient visit is $40 ($25
fixed costs + $15 variable costs). The
practice believes that a 50% markup represents a reasonable
amount. Therefore, the patient would
be charged $60 for the office visit ($40 × 0.5 = $20; $40 + $20
= $60).
Another option is to assign markup to total costs rather than to
costs per visit. Suppose a walk-in
clinic’s total fixed costs amount to $500,000 per year, and its
total variable costs are $100,000 per
year. Its total costs would be $600,000 per year. If the
22. organization used the same 50% markup,
Long-Term Financial Governance Chapter 6
then it would add $300,000 ($600,000 × 0.5) to total charges,
resulting in a total amount of
$900,000. The $900,000 would then be divided by total patient
visits. If 100,000 patients visited
the clinic during the year, each would be charged $90 per visit
($900,000 ÷ 100,000). Such an
approach is unlikely, however, due to the wide variance in
variable costs per visit and per patient.
For example, an infection would incur one set of variable costs,
whereas setting a leg fracture,
complete with X-rays and other services, would lead to much
higher variable costs.
The main advantage of markup pricing is precision in pricing
for each action. The disadvantage is
the extra time involved in making calculations for each
individual item or service.
Cost-plus pricing adds a fixed amount to the total cost per
patient. Suppose the total cost per
patient visit is $40. The unit decides to charge each patient an
additional $25 per visit. Thus, the
charge for the visit would be $65 ($40 + $25).
Cost-plus pricing based on total costs adds a fixed
amount to total costs. If total costs equal $600,000
for the year, and the organization charges a total of
$400,000, then total charges would be $1,000,000. For
100,000 patients, the visit charge would become $100
($1,000,000 ÷ 100,000).
23. The primary advantage of cost-plus pricing is the ease
of calculation. The disadvantage is that some patients
might feel overcharged, while others are undercharged.
For example, one patient visit may take a physician 30
minutes or more to resolve, while another only takes
5 minutes, yet the two patients are charged the same
amount. To some, this might seem unfair, even though
the real charge is for a doctor’s expertise more than for
his or her time.
Costs and Healthcare Pricing
Each type of healthcare provider can use costs to
develop charges (or the “price” of a service). The form of
pricing is adapted to the type of healthcare being pro-
vided. For example, dentists, physicians, psychiatrists,
and others might use markup or cost-plus pricing to establish
rates for office visits. Then, they
might examine individual services to set charges using one of
the two methods. The charge could
be based on the level of expertise and precision required,
combined with a charge for less-direct
costs, or an activity-based costing system (Canby, 1995). For
example, a dental procedure, such
as a root canal, would carry a higher price than a typical dental
visit due to the expertise required
to perform the procedure. In addition, the procedure requires
specialized equipment, the cost of
which would be partially allocated to the procedure. In this
case, variable costs include a charge
for the assistance of a dental technician, as well as the costs of
a numbing injection, gauze or cot-
ton, and other items.
When determining activity-based costs, financial officers bear
in mind that an established price
25. tional, meaning they have not had a complete recovery or are
still not healthy (Nof, Rone-Adams,
& Hart, 2007).
With regard to fairness concerns, the American Medical
Association (AMA) advocates accurate
valuations of all physician services. The AMA designed the
resource-based relative value scale
(RBRVS) to ensure that every physician service and specialty is
represented with regard to pay-
ment policies and systems. The RBRVS figures are based on
evaluations and recommendations
of the AMA and its Specialty Society Relative Value Scale
Update Committee and include any
new or revised services. The committee undertakes broad
reviews of the RBRVS every five years
(AMA, n.d.-c).
In addition, the Centers for Medicare and Medicaid (2013a)
provide the Healthcare Common
Procedure Coding System (HCPCS), a numeric coding system
maintained by the AMA. The
uniform coding system “consists of descriptive terms and
identifying codes that are used pri-
marily to identify medical services and procedures furnished by
physicians and other healthcare
professionals. These healthcare professionals use the system to
identify services and procedures
for which they bill public or private health insurance
programs.” The objectives of the system are
uniformity and fairness.
A payer mix refers to the amounts provided as payments by
various providers, including govern-
ment sources and insurance. The mix determines total revenues
that the healthcare organiza-
26. tion receives. Cost shifting, which is the practice of charging
private payers, such as insurance
companies, more in response to shortfalls in public payments,
has long been part of the debate
over healthcare policy. Although some evidence suggests that
the amounts of such shifts are not
dramatic, the subject remains controversial (Frakt, 2011).
An organization such as a pharmaceutical company might use a
form of pricing that is entirely
different from the activity-based approach. The development of
individual drugs often takes years
of research and testing, followed by government approval (by
the Food and Drug Administration).
Only then can the drug be released to the general public. In
addition to these costs, advertis-
ing and personal selling costs also accrue. The pharmaceutical
company’s management team
remains acutely aware that a window of 12 years is in place for
the organization to charge as much
as is needed to recover startup costs (12 years is the length of a
medical patent). After that win-
dow, other companies can manufacture generic versions of the
drug and offer them at much lower
prices. Thus, managers try to set prices that capture all startup
costs, plus a reasonable return
on investment in that 12-year period. This explains why new
drugs to the market are often quite
expensive for patients and hospitals.
Long-Term Financial Governance Chapter 6
In summary, the management team, working in conjunction with
the finance and accounting
27. departments, can set charges or prices using fixed and variable
costs as the starting point. Each
situation remains unique, however, and the pricing approach is
adjusted according to the type of
provider and the types of services being rendered.
Pricing Based on Profit Goals
Healthcare providers that seek to make profits, including
pharmaceutical companies, medical
equipment manufacturers, medical supply providers, some
hospitals, and private practitioners,
can incorporate cost information with desired profit targets, or
the amount of revenue they intend
to generate from a given product or service. Some hospital
managers may not use the term profits;
instead they refer to the degree to which revenues exceed
expenses. In either case, a common
method for analyzing profitability is a break-even analysis,
which identifies the point at which the
total costs incurred are equal to the revenue received. Figure 6.3
provides a visual portrayal of the
relationships among fixed costs, variable costs, volume, and
profits.
A break-even analysis can be calculated for individual services
and is valuable when making deci-
sions about how much to charge for the use of a major piece of
medical equipment, such as a mag-
netic resonance imaging machine. Break-even points can also be
calculated based on the volume
of revenues, which best fits a provider that offers a variety of
services. A break-even analysis also
has use for nonprofit settings, as managers can use the
information to set charges high enough to
create funds for altruistic purposes or for the expansion of
28. medical services offered rather than
profit goals (Van Horne, 1974).
Figure 6.3 Break-even analysis
f06.03_HCA340
D
Volume
B
C
A
Cost
Loss Profit
Key
Revenues
Break-even point
Total cost
Variable costs
Fixed costs
Long-Term Financial Governance Chapter 6
Competition-Based Pricing
29. In some instances, pricing based on the competition is most
appropriate for healthcare orga-
nizations. For example, many over-the-counter medicines
compete with generic drugs.
Insurance companies establish premium rates based, in part, on
what other competitors charge.
Psychologists, psychiatrists, dentists, and other providers are
often aware of the fee schedules of
others in a geographic region. However, as has been stated
earlier, the complicating factor for
most healthcare service providers is that the actual price may be
extremely difficult to identify.
Individuals with health insurance policies who seek care pay an
amount that is vastly different
from the fee or price of a service that appears on the indi-
vidual’s bill or statement. As a result, setting prices based on
competition becomes problematic.
Three competition-based pricing strategies include above the
competition, meet the competition, and below the competi-
tion. Highly exclusive plastic surgeons may routinely price
services above those charged by others, whereas eyeglass and
hearing aid providers often use competition-based pricing.
Some organizations advertise their prices to make it well-
known to the public that the products are being sold at the
lowest price in the area. In most other situations, however,
a healthcare provider does not want to be known as pricing
services on the cheap, because price does imply quality.
Supply and Demand Pricing
Although pricing based on supply and demand is common in
many private-sector industries, it only applies to a rare num-
ber of circumstances in healthcare. Most of the time, revenues
31. W E B F I E L D T R I P
Healthcare Blue Book provides a service that is intended to help
consumers determine fair prices
for healthcare services and to make comparisons between prices
in their area versus prices in other
areas. Visit http://www.healthcarebluebook.com, enter your zip
code, and search for the prices of
a few procedures and services. Then search the same procedures
and services in the area code of a
city or town that is very different from your own, whether in
size or geography.
• Is there a difference in price for the procedures and
services in your area versus those in other cit-
ies? What do you think might account for any differences?
Providing Financial Resources
Another primary function provided by the chief financial officer
involves the selection and imple-
mentation of the long-term financial instruments used to
provide for major capital expenses.
Such expenses include the purchase of a new building,
expansion of a current facility, the pur-
chase of expensive major medical equipment, and the
acquisition of any other large asset that
will be used over a period of years. The four primary long-term
financial instruments, or legal
documents representing monetary value, are bonds, loans,
stocks, and leases.
Bonds
Bonds are fixed-payment instruments that are issued and sold in
order to raise capital. A bond
instrument’s terms include the amount of the bond (money paid
32. to purchase it), a specified
interest rate, and the terms of repayment. Some bonds are
bought and sold by various financial
organizations. Buyers may find them more or less lucrative
depending on changes in prevailing
interest rates and the buyer’s trust in the bond issuer.
The first distinction in bond instruments depends on the nature
of the organization issuing them.
A for-profit bond’s interest payments provide taxable income to
bondholders. In contrast, a bond
issued by a nonprofit healthcare organization may offer tax-free
revenue or interest income to
those who purchase the bonds.
Bonds normally require funds to be set aside so that they are
repaid at a specified time. The bond’s
sinking fund represents these monies on the company’s balance
sheet. Coupon bonds require
regular interest payments (monthly, quarterly, annually) to
bondholders. Other bonds allow for
repayment of both the principal and the interest when the bond
is redeemed.
The primary benefit of a bond to a for-profit hospital or skilled
nursing facility is that the interest
paid on the instrument can be listed as an expense on an income
summary, which reduces the
real interest rate for the funds. For example, a bond that pays
5% would cost the organization 1
minus the tax rate times the interest level. Thus, if the
corporation paid a 20% tax rate on income,
then the effective rate for the bond would drop to 4% ([1 – 0.2]
× 0.05 = 0.04).
The primary disadvantage of a bond, to both for-profit and
33. nonprofit organizations, is that pay-
ments to sinking funds must be set aside and cannot be used for
other purposes. This limits the
organization’s financial flexibility to some extent. Furthermore,
failure to make interest payments
or to redeem bonds places the organization in default, which
means bonds imply at least some
http://www.healthcarebluebook.com
Long-Term Financial Governance Chapter 6
level of risk. Bond-rating organizations specify the degree of
that risk. The lower the rating, the
greater the level of risk. Investors expect a risk premium, or a
higher level of interest, for bonds
with lower ratings (Marlowe & Matkin, 2013).
Loans
Financial institutions (e.g., banks, savings and loans) and other
lenders make loans to individual
organizations. Loans are less structured than bonds, with more
flexible terms. Hospitals acquire
loans to cover shortfalls in working capital and other financing
needs. Many features of loans are
the same as those for bonds, with the amount, duration, and
interest rate spelled out in a loan
contract between the healthcare and financial organizations.
Healthcare organizations offer collateral to ensure loan
repayments. A hospital with a debt-free
building could use that facility as collateral to secure a loan for
some other purpose, such as
the acquisition of a cutting-edge piece of medical equipment.
This feature of loans provides the
34. healthcare financial officer with additional flexibility.
Loan interest is tax deductible for profit-seeking organizations.
Each loan carries with it a level of
risk, however, due to the possibility of default.
Stock
A relative minority of healthcare organizations issues stock.
The issuance of stock allows the
organization to collect funds for long-term projects. In
exchange, shareholders expect to receive
dividends, or earnings distributions, which are not tax
deductible for the organization that issues
the stock. Dividends are paid out of an organization’s after-tax
profits. In addition, shareholders
expect a risk premium, which further increases the cost to the
healthcare facility. The primary
benefit of stock is that it is issued in perpetuity, which means
no sinking fund or repayment is
required. Not-for-profit healthcare organizations cannot issue
stock.
Leases
Any number of healthcare organizations can benefit from
leasing
arrangements. A leasing arrangement can help an organization
obtain
not only major medical equipment but also office equipment,
such as
copiers and computers. In some instances, leases may apply to
build-
ings that house medical services. Lease terms specify an amount
to
be paid, the length of the lease, and any special arrangements,
such as
maintenance and repair.
36. provide funding for parts of a hospital (e.g., a wing or a medical
practice) and other larger pur-
chases, often in exchange for naming rights or for having the
donor’s name prominently displayed
in some way. Fund-raising programs can be used to finance
shortfalls in year-to-year operations,
as well as larger projects and tangible organizational features.
The benefits of donations include increased visibility in the
community for both the donor and the
healthcare provider. Some funds can be set aside in savings and
investment programs. The pro-
ceeds can then accumulate until a major purchase can be made
or the proceeds can be invested
into the organization’s general fund. The costs associated with
donations are those incurred in
fund-raising programs, often including the salary of the person
in charge. It is important to note
the dramatic impact donations have on the healthcare
community, including many local and
charitable hospitals.
C A S E
The Skin Rejuvenation Center
Dr. Richard Jorgenson opened his dermatology practice nearly a
decade ago. Early in the process,
he advertised extensively in the local newspaper, on the radio,
and in a regional magazine. Over
time, physician and former patient referrals helped his practice
grow to the point at which he was
able to retain two skilled nurses and an office staff consisting of
three additional individuals.
In the past year, a new opportunity arose: Dr. June Lee, a
37. recently graduated dermatologist, opened
a practice on the other side of the city. Focusing on female
patients and children with skin prob-
lems, her practice was growing steadily.
Dr. Lee approached Dr. Jorgenson with a proposal: The two
could combine to open The Skin
Rejuvenation Center in the middle of town. The center would
provide beautification services related
to dermatology, such as dermal abrasion, chemical peels, Botox
injections, and laser resurfacing.
These treatments would help those with aging-based problems,
such as wrinkles, age spots, sun
damage, and skin problems resulting from smoking.
To supplement these programs, the center would also provide
other services, such as facials, body
scrubs, body masks, and body wraps. The organization would
also sell skin products, including
moisturizers, acne medicines, and various oils and waxes. The
Skin Rejuvenation Center would also
sell safer tanning products that do not require sun exposure.
A third element of the operation would involve minor surgeries,
including permanent makeup; hair
removal; and treatments for warts, moles, and beauty marks.
This would make the center a nearly
full-service beautification operation.
Dr. Lee noted that some of the services would qualify for
insurance benefits, while others would
not. She also pointed out that some of the services would
receive payments as they were rendered.
Dr. Jorgenson wondered whether the company would primarily
benefit Dr. Lee’s patients, or if oth-
ers would be inclined to visit the center.
38. After consideration by both sides, The Skin Rejuvenation
Center opened. The two physicians
located a building in which they could create a lease-purchase
contract. They needed to renovate
(continued)
Accounting in Healthcare Chapter 6
6.3 Accounting in Healthcare
Healthcare administrators consider both short-term and long-
term financial decisions care-
fully. Part of this process includes planning annual budgets,
overseeing cash flows, and working
to ensure that costs remain at acceptable levels. Both nonprofit
and profit-seeking organiza-
tions maintain accounting records and conduct other activities
that support the organization’s
operational, tactical, and strategic intent. This section examines
accounting practices related to
budgeting, accounts receivable management, accounts payable
management, cost controls, and
auditing of operations.
Budgeting
Budgeting represents the area in which financial and accounting
activities overlap the most. In
addition, managers from other departments, including human
resources and those who oversee
clinical, administrative, and support staffs, are often involved in
the process. Each manager seeks
sufficient funding to effectively operate his or her individual
39. department. As a group, these indi-
viduals identify the needs of the organization, as well as the
costs of those items, both for annual
operations and the long term. In larger healthcare organizations,
two types of budgets require
attention: the capital budget and the operating budget.
Capital Budget
A capital budget assists in planning for major expenditures and
acquiring the funds needed to
finalize such purchases and lease arrangements. Capital
budgeting programs incorporate mana-
gerial plans with accounting and financing arrangements
(Gapenski, 2009). Healthcare manag-
ers, working in conjunction with other leaders, identify the
major (fixed) assets to acquire, such as
a building, a renovation, a fleet of ambulances, or other medical
equipment. The capital budgeting
process involves the following steps:
1. Identify the required asset(s) and the funding needed to
purchase them.
2. Estimate the useful life of the asset(s).
3. Determine the method of depreciation that applies to the
asset.
4. Specify the nature of payments to be made.
The required resources are based on the price of the asset(s) to
be obtained. Managers make deci-
sions about how to procure the assets, whether through bonds,
loans, stock issues, or leases. The
the interior to meet the medical and aesthetic requirements for
this type of business. The two der-
matologists knew they had entered a new and exciting period in
their careers.
40. In answering the following questions, it may be helpful to
review Sections 6.1, 6.2, and 6.3.
1. How would the combination of business services and
products assist in the area of working
capital?
2. What method of pricing should apply to each of the three
types of services The Skin
Rejuvenation Center plans to offer?
3. Beyond the lease for the building, what type of financing
should the two physicians use to
acquire the necessary equipment and furnishings? What
advantage would there be to the lease?
To the other forms of financing?
4. Identify the fixed and variable, direct and indirect costs
associated with this new company.
Accounting in Healthcare Chapter 6
goal is to maintain a reasonable cost of capital that balances
costs with risks, fixed obligations,
and other considerations, such as donations.
The asset’s useful life should be estimated and established
between the healthcare organization
and the vendor selling the asset. The length of the life
determines in part how the item will be
depreciated and the method of payment to be made.
The method of depreciation varies according to the following:
41. asset’s years of useful life, whether
an asset retains or quickly loses value after its purchase, the
organization’s tax situation, and
managerial preference. Accelerated depreciation methods are
employed for assets that quickly
lose value or by organizations seeking to reduce immediate tax
liabilities by front-loading the
expensing of items. Organizations employ straight-line
depreciation when the useful life delivers
a consistent value over its life span. Accelerated depreciation
applies to circumstances in which
an asset quickly loses value or when doing so improves an
organization’s tax situation for the
early years of the asset’s life (Oliver & Horngren, 2010).
The nature of payments results from the type of financial
instrument. A bond requires a sinking
fund. A loan and a lease will feature monthly, quarterly,
semiannual, or annual fixed obligations.
Stocks include a dividend policy stating how and when
dividends will be paid to shareholders.
All of these payments are built into the operating budget
prepared by the accounting office for
each year.
An additional major capital expenditure that has become
increasingly common in the healthcare
system occurs when a major facility, such as a hospital,
purchases the practice of an independent
physician, thereby bringing that practice under its operating
umbrella. Capital must be raised to
make such purchases.
Operating Budget and Revenues
An operating budget maps expected revenues and then allocates
the funds to individual depart-
42. ments and activities for their expenses, normally over a one-
year period. The annual document
specifies the nature of all revenues to be received. Revenues
accrue from third-party reimburse-
ments and patient payments. Third-party reimbursements take
various forms, including those
itemized in Table 6.1.
Table 6.1 Forms of third-party reimbursement
Form Explanation Example
Fee for services Full charge for a service Annual exam
Per diem Dollar amount per day for care Hospital room charge
Nursing facility daily charge
Per diagnosis Amount charged for a diagnostic
service
Read an X-ray
Bundles Fixed amount shared by providers Set of doctors, one
patient
Capitation Fixed amount per enrollee per
month for specified services
Managed-care organization charge
per patient
Government Reimbursement
Medicare
43. Medicaid
Accounting in Healthcare Chapter 6
Accounts receivable includes amounts due for all services that
have been rendered or items
that have been sold for which payment has not yet been made.
Accounts receivable management
constitutes a critical activity in the accounting department of
most healthcare organizations
(Sachdeva & Gitman, 1981). Receivables are collected from
third-party reimbursement organi-
zations, from government organizations, and then from patients.
A fully developed accounts
receivable program incorporates the activities detailed in Table
6.2.
Table 6.2 Elements of accounts receivable management
Element Explanation
Precertification Prior to admission; verifies the patient has
insurance
Medical records Coding of all evaluations, treatments,
medicines, and other medical
services
Billing Itemized statements sent to patients, insurance
providers, and government
agencies
Collection Receipt and deposit of funds sent; financial
counseling to patients
44. (including setting up payment programs)
Accounting entries Recording of all payments and nonpayments
for accounting purposes
Legal Oversight of contracts, litigation policies, federal
regulations, and patient
rights
Compliance Detection and reporting of fraud and abuse
Operating Budgets and Expenses
After the accounting office establishes the total amount of
expected revenues for the upcom-
ing year, operating budgets for individual departments and
activities can be established. Three
potential forms of allocation can be made for these units:
across-the-board, relative-amount, and
variable or flexible budgets.
An across-the-board operating budget estimates the growth,
stability, or decline of revenues
expected in the coming year. Each department then receives a
budget allocation that mirrors
the change in revenues. For example, if a hospital board expects
a 3% increase in revenues, then
each department would receive a 3% increase in its annual
operating budget. The same type of
adjustment would be made for budget decreases or for a flat
budget. Across-the-board budgets are
common in government organizations, including Medicare and
Medicaid.
A relative-amount operating budget allocates funds to various
departments based on need. To
determine need, financial management often conducts a cost–
45. benefit analysis, which involves
adding the benefits of a business-related program or action and
then subtracting the costs asso-
ciated with that program or action. If, for example, a cost–
benefit analysis determined that a
laboratory had been underfunded, and services to patients and
physicians had suffered as a result,
then additional resources would be allocated to that unit, and
other units would receive lower
allocations.
A variable or flexible operating budget adjusts departmental
allocations during the course of
the year. If higher-than-expected revenues occur, then budgets
are adjusted upward. If revenues
decline, the budgets reflect that change as well. Both across-
the-board and relative-amount bud-
gets can be adjusted using the variable approach.
Accounting in Healthcare Chapter 6
Healthcare managers in various departments become quickly
familiar with how budget alloca-
tions for expenses are made. Each year they make budget
requests that often include requests for
extraordinary expenditures. It becomes the role of top
management to make judgments about
which applications are most viable.
Cost Allocations and Cost Control
Healthcare accountants hold two major responsibilities in the
area of costs. First, they are charged
with allocating costs in as precise a manner as possible for each
form of healthcare. Second, they
46. assist in trying to reduce or manage the costs of various
materials and activities.
The previous section described concepts regarding fixed and
variable costs and pricing meth-
ods based on those costs. In addition to those costs, accountants
provide information regarding
direct and indirect costs. Direct costs in healthcare are those
that can be attributed to a specific
treatment format for a patient or activity. Direct costs include
physician fees, medical supplies,
medical equipment, nursing care, and any other item directly
associated with helping a patient.
Indirect costs in healthcare constitute those that cannot be
attributed to a specific patient or
form of service, such as most support staff
activities, including patient safety, food ser-
vice, and janitorial services. Calculations of
direct and indirect costs compile impor-
tant information for billing practices and
third-party payment requests that are sent
to insurers and governmental agencies.
To help control costs, accounting manag-
ers compute important numbers regard-
ing inventories, payroll figures, and other
expenses, such as supplies for bathrooms
for visitors. Inventory control constitutes
a key activity provided by the accounting
department. The management of medical
supplies balances two key factors: main-
taining sufficient inventory and not carry-
ing excess inventory. Sufficient inventory
is needed so that the organization does not
experience a stock out, or the failure to have a crucial medicine
or medical supply on hand. A
48. who cannot afford it to be a primary altruistic mission of the
organization. In profit-seeking set-
tings, however, decisions regarding who receives care are, in
part, dictated by the government.
For example, emergency rooms are mandated to treat anyone
needing emergency care, regardless
their ability to pay (Hadley & Holahan, 2004).
Auditing
Healthcare organizations engage in two forms of auditing:
internal and external. An internal
audit seeks to ensure that accounting and financial operations
and statements are accurate and
that the systems in place protect against intentional or
unintentional malfeasance. Internal audits
may be conducted either by an accountant specifically retained
by the organization to provide
such services or by an outside provider that has been retained
by the organization. For example,
the Catholic Healthcare Audit Network provides internal audits
for numerous Catholic health-
care organizations and facilities.
External audits are imposed by an outside force, such as for a
government requirement. Any
healthcare organization that participates in Medicare becomes
subject to an annual external
audit. Many financial organizations require external audits
before an organization can receive a
loan or assistance in the sale of bonds or common stock. For
both internal and external audits,
typical inspections are made in the following areas:
• Accuracy of financial records
• Accuracy of human resource records, including time
cards, sick leave pay, and accruals
49. of benefits
• Management of physical assets, including maintenance
• Management of purchasing procedures
• Analysis of uncompensated care
• Protection against financial conflicts of interest by
various parties
• Protection against fraud perpetrated against outside
organizations (e.g., against the govern-
ment or insurance companies)
• Protection against fraud perpetrated against the healthcare
organization
• Protection against inurement, or gaining a financial
advantage through insider status
Audit reports tend to be sweeping documents covering these
areas. Auditors point out problems
and make recommendations regarding potential solutions. It is
then up to the organization’s
financial, accounting, and corporate executives to make sure
that problems and deficiencies are
corrected. Cases of illegal activities must be reported to the
appropriate government agency.
Chapter Summary Chapter 6
Chapter Summary
Financial governance in the field of healthcare involves
oversight of day-to-day operations that
require financing and planning for and implementation of
instruments that provide for the orga-
nization’s long-term financial needs. Healthcare managers
employ balance sheets to understand
50. the organization’s basic standing with regard to assets and
liabilities. They use the income sum-
mary to determine whether revenues exceed expenses. And they
use ratios to evaluate other
monetary circumstances of the organization.
Working capital policy oversees the organization’s cash flow,
ensuring that sufficient funds are
available to pay bills as they come due. Healthcare managers
understand that cash inflows often
lag outflows; as such, they take the necessary steps to make
sure the organization remains solvent.
C A S E
Accounting for Altruism
John Mulvaney faced a unique challenge. As the chief financial
officer (CFO) for Merciful Hospital,
he had been given the directive to make certain the organization
stayed true to its name. The board
of directors had established a policy that 10% of the hospital’s
excess of revenues over expenses (in
essence, the “profits” for this nonprofit organization) would be
directed to granting care to those
without insurance, those with low incomes, and others in
difficult financial circumstances.
On the surface, the mandate seemed fairly straightforward;
however, several issues quickly
emerged. First, if the policy were widely publicized in the
community, would some patients believe
they were being charged extra so that others could receive free
medical care? This might lead some
to seek treatment elsewhere. How might that decision affect
revenues?
51. Second, the hospital had to accept many payments as dictated
by government forces. Medicare,
Medicaid, and other payers have established set amounts for
various treatments, and these orga-
nizations are often categorized as low payers. How would it be
possible to create circumstances in
which costs would be sufficiently low so that revenues would
exceed expenses for those services?
Third, the most lucrative procedures (in terms of revenues
versus costs) are those that are not nor-
mally covered by insurance, such as elective surgeries for
cosmetic appearance. How should these
be priced relative to other treatments?
John also considered other sources of revenues not directly
related to patient care. He believed
it would be wise to establish a foundation with the sole purpose
of funding altruistic care. His
dilemma was how to account for monies received with regard to
an income summary. John hoped
that donations would be placed into an ongoing fund, with only
the interest received being used to
support the altruistic program.
In the end, John was pleased by his organization’s desire to take
care of the most vulnerable. His
task was to figure out how to account for and finance the
intention.
1. How should free or reduced-price services be calculated on
accounting forms? Which portion
would be revenue? Which portion would be cost?
2. How might these altruistic programs affect the organization’s
52. working capital?
3. How would the organization account for direct and indirect
costs for services provided free of
charge?
4. What sources of financing, beyond donations, might be useful
for the altruistic care program?
Key Terms Chapter 6
Healthcare pricing is typically based on costs, profits, or the
competition. Managers evaluate
fixed and variable costs and assign them to individual services,
thereby establishing a base price,
or charge. In some settings, prices are set to match, exceed, or
undercut the competition. Rarely
do supply-and-demand forces affect charges in healthcare
settings.
When acquiring large assets, healthcare financial officers
consider the use of bonds, loans, com-
mon stocks, and leasing. Each option creates differing costs,
risks, and cash flow issues.
Accounting practices in healthcare include budgeting, accounts
receivable management, accounts
payable management, cost controls, and auditing of operations.
Capital budget and operating
budgets represent the two main forms of accounting practices.
The capital budget assists in plan-
ning for major expenditures and acquiring the funds needed to
finalize such purchases and lease
arrangements. An operating budget maps expected revenues and
then allocates the funds to
53. individual departments and activities for their expenses.
Healthcare accountants are charged with allocating costs in as
precise a manner as possible for
each form of healthcare. They also assist in trying to reduce or
manage the costs of various mate-
rials and activities. This task includes inventory control and
uncompensated healthcare.
An internal healthcare audit seeks to ensure that accounting and
financial operations and state-
ments are accurate and that the systems in place protect against
intentional or unintentional
malfeasance. External audits are imposed by an outside force,
such as a government require-
ment. Both forms examine a variety of organizational operations
and make recommendations for
improvements and necessary changes.
Key Terms
accounts receivable amounts due for all services that have been
rendered or items that have
been sold for which payment has not yet been made
activity-based costing setting prices for healthcare services
based, in part, on the level of
expertise and precision required
capital budget a finance and accounting instrument that assists
in planning for major expen-
ditures and in acquiring the funds needed to finalize such
purchases and lease arrangements
cost-plus pricing a pricing approach that adds a fixed amount to
the total cost of a product or
service
54. direct cost healthcare cost that can be attributed to a specific
treatment format for a patient or
activity
financial governance management of two primary
responsibilities: (1) oversight of day-to-day
operations that require financing and (2) planning for and
implementing long-term financial
needs
fixed cost incurred expense that is not affected by the volume of
sales or revenues
indirect cost healthcare cost that cannot be attributed to a
specific patient or form of service
markup pricing a pricing approach that assigns a percentage to
add to the total cost per item
Critical Thinking Chapter 6
operating budget finance and accounting instrument that maps
expected revenues and allo-
cates funds to individual departments and activities for their
expenses, normally over a one-
year period
uncompensated healthcare a situation in which uninsured
individuals receive medical treat-
ment but cannot pay for it or in which others fail to pay their
portion of the expense, such as
coinsurance
55. variable cost cost directly related to volume or revenue
working capital a comparison of an organization’s current assets
to its current liabilities
Additional Resources
American Accounting Association http://www.aaahq.org
Federation of Schools of Accountancy http://www.thefsa.org
Financial Management Association International
http://www.fma.org
Institute of Management Accountants http://www.imanet.org
International Federation of Accountants http://www.ifac.org
Management and Accounting Web (database of articles
pertaining to management and
accounting) http://www.maaw.info
National Association of State Boards of Accountancy
http://www.nasba.org
Critical Thinking
Review Questions
1. What two activities are involved in financial governance?
2. What three financial instruments do financial officers use to
examine an organization’s
monetary well-being?
3. Define working capital.
4. How do managers calculate the amount of working capital an
organization holds?
5. Define fixed costs, variable costs, and total costs.
56. 6. Define markup pricing and cost-plus pricing.
7. What is a break-even point?
8. What are the advantages and disadvantages of bonds as
financial instruments?
9. What are the advantages and disadvantages of loans as
financial instruments?
10. What are the advantages and disadvantages of common
stock as a financial instrument?
11. What are the advantages and disadvantages of leasing as a
financial instrument?
12. What are the differences between a capital budget and an
operating budget?
13. What elements are included in accounts receivable
management?
14. What are direct and indirect costs in healthcare operations?
15. What is uncompensated healthcare?
http://www.aaahq.org
http://www.thefsa.org
http://www.fma.org
http://www.imanet.org
http://www.ifac.org
http://www.maaw.info
http://www.nasba.org
Critical Thinking Chapter 6
Analytical Exercises
1. A healthcare organization has $250,000 in the bank, $500,000
in accounts receivable, and
$100,000 in on-hand medical supplies. The value of its building
is $1,400,000, and the medi-
cal equipment on hand is worth $700,000. The organization
57. owes $150,000 in accounts
payable. The mortgage for the building has a $900,000 balance.
The organization also owes
$400,000 for its medical equipment on a bank note. Based on
these figures, calculate this
organization’s amount of equity.
2. An independent physician’s practice earned $975,000 in the
past year. The physician paid
$50,000 for all supplies. Rent for the physician’s office space
was $60,000 for the year. Office
salaries totaled $300,000. The physician received a one-time
payment of $100,000 for an
office building that she had previously owned. Her income tax
rate is 40%. Calculate the
NIAT for this medical practice.
3. A skilled nursing facility has $450,000 of current assets on
hand. The organization has
$150,000 in current liabilities on the books. Calculate the
organization’s level of working
capital.
4. Which pricing method do you believe is most appropriate for
the following types of
organizations?
• Dental surgeon providing intricate procedures
• Skilled nursing facility for those with moderate medical
needs
• Drug store selling over-the-counter medicines and
pharmacy drugs
• Pharmaceutical company creating new drugs
5. How would a break-even analysis be valuable to the
accounting department of a nonprofit
hospital operated by a religious group?
58. 6. A local for-profit mental health center’s management team is
considering the purchase of
a building that could be used as a lockdown facility for patients
requiring careful, 24-hour
scrutiny, such as those at risk of suicide. The building has a life
expectancy of 20 years. What
form of financing should be used to acquire the building? What
method of depreciation
should be used? Would your answer change if the managers
knew that several major costs
would occur in about seven years, including providing a new
roof and upgrading the plumb-
ing system? Why or why not?
7. How would management views of uncompensated care differ
in a for-profit healthcare pro-
vider as opposed to a nonprofit healthcare provider?
Marketing and Competitive
Strategies and Tactics
Chapter Objectives
After reading this chapter, you should be able to
1. Describe the nature of marketing.
2. Apply strategic marketing concepts to the healthcare
industry.
3. Create tactical activities that support the strategic health
marketing program using mar-
60. money we cannot support our mission. (cited in Doyle, 2012)
Many critics believe that these advertising practices have little
value. According to Dr. Sidney
Wolfe, director of the health research group at Public Citizen:
“Hospitals seem to be spending
money left and right trying to get more patients. Absent
significant cost controls, there’s nothing to
stop them. . . . It’s siphoning money
away from healthcare. Advertising
shouldn’t be confused with taking
care of patients or improving patient
care” (cited in Doyle, 2012).
Samuel Steinberg, a Florida-based
hospital finance consultant, also
remained skeptical about the bene-
fits of advertising: “It’s very difficult
to be able to demonstrate that these
things are worth the investment. . . .
Hospitals and health systems that
put a lot of money into advertising
say it is beneficial. But when you ask
them to prove it, there’s a real short-
age of good research that verifies that it’s worth it.” But the
Missouri Hospital Association created
the following response: “Marketing and advertising is core to
our mission to educate the pub-
lic, [including] promoting better public health by reminding
patients of the need for preventive
screenings such as mammograms” (cited in Doyle, 2012).
In this era of the proliferation of medical advertising for such
things as Viagra and Cialis, jokes
62. suggests that the goal of marketing
should be to develop relationships with an organization’s
customers and other publics. This con-
cept could also be applied to the nature of healthcare. In the
past, however, a more traditional
definition (Armstrong & Kotler, 2012) for marketing has been:
1. Discovering consumer needs and wants
2. Creating the goods and services that meet those needs and
wants
3. Pricing, promoting, and delivering the goods and services
According to this definition, marketing begins with an
understanding of consumer needs and
wants. Thus, the foundation of any marketing management
program consists of identifying
groups of consumers that share a common desire for a good or
service. Only then can the goods
or services be created and sold.
Primary Marketing Activities and Components
The traditional definition of marketing implies six major topics,
as shown in Figure 5.1.
Figure 5.1 Healthcare marketing
Markets
(patients as
consumers)
f05.01_HCA340
Distribution
Products
63. (goods and
services)
Pricing
Promotion
People
The Nature of Marketing Chapter 5
Markets consist of people (or businesses) with wants and needs,
financial resources, and the will-
ingness to spend those resources to satisfy their wants and
needs. The most common method for
discovering individual markets is to divide them into various
consumer and business-to-business
segments. In healthcare, however, methods used to identify
markets differ from standard for-profit
operations. Although most hospitals feature a community or
regional focus, many hospitals and
smaller healthcare operations also specialize in the treatment of
certain illnesses (cancer, heart
disease, mental health) or try to reach certain categories of
patients (athletes, pregnant women,
children, elderly). These groups have wants and needs that can
be specified and documented.
Products are the physical goods sold to consumers and other
organizations, as well as the services
that are offered to individual consumers, other businesses, and
the government. Physical goods
include both durable goods that last more than one year and
nondurable goods with shorter
64. uses. In healthcare, an example of a durable good is the medical
equipment a person purchases
for long-term care, such as a wheelchair. Nondurable goods
include convenience items, shopping
goods, and specialty products. Convenience items include
frequently purchased products that
feature low prices. In healthcare, convenience items would
include over-the-counter medicines
and other low-cost health aids, such as heating pads. Shopping
goods require consumers to make
some level of effort in their choices and purchases. For
example, going to a pharmacy to purchase
prescriptions, or deciding to purchase a hot tub or exercise
equipment to improve one’s health.
Orthodontist care would also qualify as a shopping good, due to
the increasing availability of
options. Specialty products are sold at unique outlets and
require a more concerted effort by the
individual consumer to find them and purchase them. Few
specialty items are associated with
healthcare.
Services, the intangible items that are sold to others, constitute
the primary form of product that
is marketed in healthcare. Examples of health services include
ambulance delivery of patients,
insurance, and most forms of medical care, including regular
physician practices, specialists,
nursing home care, dentistry, psychiatric care, and
rehabilitation services.
Prices of goods and services are normally based on costs,
demand and supply, competition, and
profit goals. As mentioned earlier, patients, or consumers,
rarely know the actual price of a health-
care service. Pricing complications arise from methods of
65. billing, the type of insurance cover-
age, government payments, and provider write-offs. In addition,
the healthcare provider, such as
a hospital, may offer the exact same service at a price that is
vastly different from that charged
by other similar organizations (James, 2013). When a healthcare
facility provides a new good or
service, the organization’s leaders can decide whether they want
to use a skimming method, in
which the price charged is as high as possible, or penetration
pricing, in which the price is set as
low as the firm can afford. In the unique setting of healthcare,
however, neither strategy seems
particularly applicable. Instead, costs are allocated across the
number of patients served over
time by the item or service.
Place, or distribution, involves deciding where, how, and when
products will be made available
to potential customers. In a standard marketing program,
distribution includes a decision about
the type of distribution approach that will be used: intensive,
selective, or exclusive. Intensive
distribution means selling the product in every available
location and is often associated with
convenience goods. Selective distribution involves placing
products in outlets that are believed to
be profitable or that project a certain image, and not using other
outlets. Exclusive distribution
restricts the availability of the product to a highly select group
of outlets—normally only one per
geographic region.
The Nature of Marketing Chapter 5
66. Some healthcare products that feature intensive distribution are
daily or regular-use products,
such as aspirin, dental rinse, or a toothbrush. Selective
distribution in healthcare occurs when a
small number of physicians provides a specific service, such as
physical rehabilitation, in a given
area. Hospitals tend to operate single locations or a central
facility with additional satellite sites.
Many types of healthcare services are distributed exclusively, in
that only one provider operates
in a geographic area.
The second activity associated with distribution is the physical
distribution program, which
involves choosing methods of transportation, types of
warehouses, forms of inventory control,
and methods of billing and payment. These processes apply to
medical suppliers that provide
products to larger health facilities.
Promotion, another major component of marketing, includes
creating and supporting advertis-
ing programs, consumer and trade promotions programs,
personal selling tactics, and public
relations efforts. The most recent trend in promotion involves
carefully combining all of these
elements into an integrated marketing communications plan
(Clow & Baack, 2014). Promotional
activities have been strongly influenced by the availability of
new alternative media outlets.
Traditional advertising and promotional programs have been
adapted in response to new tech-
nologies and new methods of making contact with customers.
The final, and perhaps most critical, component of effective
67. marketing is people. In a service
industry, such as healthcare, the people performing the services
play crucial roles. To a manufac-
turer of major medical equipment, the people who operate the
machines, deliver the products,
and design the marketing program are the key. In a nonprofit
operation, the people providing the
services to the public, along with the volunteers who help, are
the ones who make the organiza-
tion successful. Without people, an organization cannot
continue to survive.
In recent years, customer satisfaction and customer retention
have received a great deal of atten-
tion. Numerous articles and books focus on what a company or
organization should do to achieve
customer satisfaction and customer retention. Most of this
information can be summarized by
these words: product quality and customer service. Without
product or service quality, there is
no customer satisfaction and no customer retention. Without
customer service, the importance
of product quality quickly diminishes. Thus, these factors are
key components in the healthcare
industry (Clow & Baack, 2010).
Strategic Marketing and Healthcare
In the area of planning, marketing strategies outline the services
to be offered and the tar-
get markets for those services. Marketing strategies provide
broad sweeping plans based on an
organization’s mission and vision statements, as described in
Chapter 4. The mission statement
expresses the primary reasons for the formation and operation
of an organization. The vision
68. statement outlines the organization’s intended future and offers
direction about where the orga-
nization seeks to go and what executives hope the organization
will become and achieve. These
two statements outline the most general direction for the
marketing department and program.
Together, an organization’s mission statement, vision statement,
and marketing strategies outline
its key values.
Marketing tactics include all of the midrange or medium-term
(one- to three-year) efforts
designed to support marketing strategies. Many product design
issues are tactical issues. In
Strategic Marketing Activities Chapter 5
standard marketing programs, tactics include changing the
product’s packaging or label, revising
or creating new advertising taglines, and improving the methods
used to support promotional
efforts. Marketing tactics vary across healthcare organizations,
as many organizations seek to
strengthen a specific brand and engender high levels of
confidence regarding the quality of care
they provide. Often, healthcare marketing tactics involve public
relations efforts, including vari-
ous programs that raise awareness of health concerns and teach
preventive care. Although most
midlevel marketing managers are not involved in developing
marketing strategies, they can be
heavily involved in creating and implementing marketing
tactics.
69. Operational plans, or short-term plans, are created to carry out
marketing strategies and tactics.
Typical short-term plans include departmental budgets, projects,
and programs, such as plans for
the marketing department’s day-by-day activities. A marketing
budget establishes a financial map
outlining the amount of money available for the program and
how funds will be spent, such as for
advertisements, promotional programs, website development
and maintenance, and other more
routine activities. Projects, or single-use plans, are short-term
plans created for one-time activi-
ties. An example of a project is a plan for a one-time health
seminar on a specific topic. Once the
seminar has been held, the project plan is complete. Another
project could be the renovation and
upgrading of a specific medical service area, such as an
operating room. A program consists of a
set of projects that leads to a permanent new course of action.
An example of a marketing pro-
gram is the entire process surrounding the development of a new
medical service. The projects
associated with that marketing program include developing the
service, potentially choosing a
name or a brand for that service, creating an advertising
program to inform the community of its
existence, and other activities (Ferrell, 2013).
5.2 Strategic Marketing Activities
Strategic marketing and strategic management overlap in many
areas. Effective healthcare
administration requires that the two efforts mesh in order to
achieve the organization’s strategic
and marketing communication objectives. In Chapter 4,
strategic management was described in
terms of:
70. • Analysis and diagnosis—strengths, weaknesses,
opportunities, threats (SWOT) analysis
• Generating strategic alternatives
• Strategy evaluation and choice
• Strategy implementation
To complement these activities, marketers begin by conducting
a supporting program known as
a strategic marketing analysis.
Strategic Marketing Analysis
A strategic marketing analysis program consists of an
environmental analysis; a competitive and
industry analysis; a segmentation, targeting, and positioning
analysis; and a customer analysis
(Clow & Baack, 2010). The program also combines elements of
a SWOT analysis in that it assesses
the external environment and various internal company
operations. However, a strategic mar-
keting analysis focuses less on strengths, weaknesses,
opportunities, and threats, and more on
the discovery of how the organization interacts with its
environment, its markets, and specific
customers. Executives seek to gauge how organizational leaders
can create new relationships with
Strategic Marketing Activities Chapter 5
patients and customers while also building on current
relationships. Such an analysis can be
extremely helpful to marketing managers in a healthcare system.
71. Environmental Analysis
An environmental analysis begins with careful monitoring of all
external variables that have an
impact on the healthcare industry. Assessments of all political,
social, economic, technological,
and semicontrollable forces should be made, much in the same
format as a SWOT analysis. The
information gathered should reflect specific issues that affect
healthcare marketing programs,
rather than overall strategic implications.
For example, when examining political forces, marketers look to
laws that directly apply to vari-
ous activities, such as advertising. They must become familiar
with what can, and what cannot,
be said in a commercial for a hospital. The term puffery, for
instance, means that an organization
can make untestable claims, such as that a hospital is the
“friendliest” or that it offers “the most
compassionate care,” as no method can be used to verify or
disprove such statements.
Healthcare marketers also consider shifting demographics,
cultural trends and changes, and ris-
ing educational levels to assess the impact of the marketing on
their intended programs. Economic
forces include economic conditions and how these might affect
consumer choices, such as the
decision to have an elective surgery to improve one’s
appearance. Healthcare marketers are con-
sistently asked to get the word out regarding new services,
service improvements, improvements
in the delivery of those services, and technological
advancements in medical care.
Competitive and Industry Analysis
73. Strategic Marketing Activities Chapter 5
might require such services. Segmentation involves identifying
all potential customer groups that
are viable for the purposes of marketing products and services.
Most healthcare organizations
cannot create enough services to reach every available type of
patient. Thus, a market segment
analysis categorizes customers into groups and identifies the
characteristics of members of the
groups (Myron & Truax, 1996).
In traditional marketing programs, a segmentation analysis
includes demographic characteris-
tics, psychographic variables, behavioral actions, and
geographic location. In healthcare, other
categories, such as illness type and patient characteristics (some
of which are demographic, such
as seniors, children, and women), are more useful. The
segments can be examined for potential to
increase revenues based on the match of the service to the local
community, the size of the seg-
ment, growth potential, reachability, consumer responsiveness,
retention potential, and levels of
competition. For example, a local hospital could decide to
provide a mobile magnetic resonance
imaging (MRI) unit to travel around a county or specified
geographic region. A market segment
analysis would reveal whether sufficient need exists to justify
such a purchase and the employ-
ment of specialists to operate the equipment.
After segmentation, the targeting component of the STP
74. approach can proceed. Targeting
includes selecting the market segments (e.g., diseases or groups
of patients) that the organization
intends to target or reach. For example, a mobile MRI unit
would target various injuries, includ-
ing those related to sports, accidents, and the aging process.
Positioning involves creating perceptions in the minds of
consumers about the nature of the orga-
nization, its brand, and its products and services. Positioning
must match the characteristics of the
selected target markets. Continuing the example, a mobile MRI
operation would be positioned as
a high-quality method of diagnosing injuries that would ensure
the best possible care. Marketing
programs would note that MRI imaging is superior to X-rays
and computed tomography (CT)
scans, thus granting the physician greater precision in
diagnosing and treating an injury.
A positioning analysis discovers the place of an organization
and its services in the minds of
consumers and relative to the competition. Four components to
be considered during this part of
the STP analysis include the target audience, the organization
itself or the service being offered,
the frame of reference or category, and points of differentiation
or uniqueness. Once completed,
positioning strategies may be put in place.
A perceptual map may assist in identifying the position of a
healthcare organization in com-
parison to the competition. A perceptual map typically employs
two axes representing the key
variables that affect perceptions of a service. In traditional
marketing, price and quality serve
75. as the two axes. Figure 5.2 provides a perceptual map
containing various providers of the same
service—psychiatric care—using two common healthcare
factors: affordability and accessibility.
Affordability measures the degree to which a patient believes he
or she can reasonably pay for
healthcare services. Accessibility measures perceptions that a
patient could obtain the needed
service from a specific healthcare provider. These two concepts
can be combined as surrogates
for price and then be compared with perceptions of quality to
provide a useful analysis.
As shown, an individual psychiatrist is perceived as being the
least affordable and accessible (the
highest price), even though the psychiatrist might be perceived
as providing the highest level of
care. An individual psychologist costs less and would be more
accessible; however, the quality of
care might also be viewed as being somewhat lower.
(Remember, however, that a patient would
be able to examine insurance coverage to see if this changes the
costs of each.) A support group
Strategic Marketing Activities Chapter 5
in a hospital probably would be reasonably affordable and
accessible (moderately priced) and
would only hold an advantage over an unlicensed counselor if
perceptions were that the quality
of care was better. The unlicensed counselor would be perceived
as being the most affordable and
accessible (lowest price) but may be perceived as providing the
least effective quality of care. More
76. precise perceptual maps would incorporate the names of specific
psychiatrists and psychologists.
A quality STP analysis allows an organization to avoid brand
parity, or the perception that ser-
vices provided by other institutions or physicians are basically
the same. Healthcare organiza-
tions are best served when marketers are able to build brand
equity, or the perception that a
given provider is different and better (Schultz, 2009). Any
dentist or physician holding such an
advantage probably has a highly successful practice, as would
any practice group or hospital.
Customer Analysis
A quality customer analysis provides marketers with an in-depth
understanding of an organiza-
tion’s customers, or patients in the healthcare system. The
“W’s” and “H’s” of a customer analysis
include understanding the who, what, when, and where of
patients seeking medical services, as
well as how those services are obtained. In other words,
marketers should ask, “Who are our
patients? What services do they seek? When do they seek them
(e.g., emergency vs. routine visit)?
Where are they located? How are the services obtained?” The
answers to these questions help a
marketing manager in healthcare establish a target audience to
reach.
An effective marketing program necessitates careful study of
the consumer buying decision-
making process for purchasing a service (Clow & Baack, 2014,
pp. 53–81). Each step offers the
potential to reach and attract customers. Figure 5.3 details the
steps of a purchasing process, as
77. modified to fit healthcare circumstances.
Figure 5.2 A perceptual map for psychiatric care
f05.02_HCA340
Affordability and Accessibility (Price)
High
Quality
Low
Low High
Unlicensed counselor
Individual psychiatrist
Individual psychologist
Hospital-guided support group
Strategic Marketing Activities Chapter 5
Consider a person who experiences blurred vision. The
individual recognizes that her eyesight
has deteriorated. She considers the services of an individual
optometrist, an individual ophthal-
mologist, or a company such as Pearle Vision Center, which
offers both an eye exam and subse-
quent fulfillment of an eyeglass prescription. Next, she reviews
her healthcare coverage to find
out whether eye exams and glasses are included, which would
78. affect her subsequent choice. If she
is poor or unemployed or if her policy does not cover eye care,
she may consider a public health
facility that offers eye exams for free.
When the patient evaluates alternatives, she considers the cost
of each option, along with the level
of care. If she worries that a new problem has emerged, such as
glaucoma, she may wish to see a
more advanced medical professional, depending on the type of
insurance she has. If she believes
it is simply a matter of obtaining a new prescription, other
options become viable. A person with
no or low income will also think about the amount of time she
would wait in a public health facil-
ity and whether she might have to take time off from work to
take advantage of the free service.
After she makes her choice and resolves the problem, she will
review her experience. If she spent
a long time in a waiting room and encountered a terse, distant
eye care professional, she may tell
others not to go to such a place. If her vision does not improve
or is not corrected, postpurchase
dissatisfaction will be high. She might decide to post her story
on social media and websites that
evaluate various eye care providers to tell friends and family
about the episode.
Figure 5.3 The consumer purchasing decision process:
Applications to healthcare
f05.03_HCA340
Step 1: Problem recognition
Recognize a health Issue
79. Step 2: Information search
Examine potential healthcare providers
and options that could resolve the health issue
Step 3: Evaluation of alternatives
Consider the advantages and disadvantages
of each type of healthcare provider
Step 4: Purchase decision
Seek medical care
Step 5: Postpurchase evaluation
Consider recovery, degree of wellness, satisfaction with
provider
Strategic Marketing Activities Chapter 5
In recent times, many healthcare organizations
take into consideration the steps of the buying
process in some form, with particular atten-
tion paid to postpurchase evaluation. A variety
of techniques may be used to ascertain levels of
patient satisfaction with the services and service
providers.
Additional Factors
When considering customers and patients,
healthcare administrators can benefit from meth-
ods that help them understand market potential
and market demand. Market potential consists of
the total number of patients that might require a