How does a hospital make money?

By Samuel H. Steinberg, Ph.D..

This is one of the more confusing areas of discussion regarding hospital practice. Unlike most businesses, the hospital makes its money in unusual and arcane ways. They do not simply place a price on a service based on its cost and its desired mark-up or profit margin. Instead, complicated algorithms must be calculated and various formulas applied, each separately based upon the insurance company paying the bill. Much of the confusion is historically based and not worth much time to discuss, but if you wish, there are many papers written on hospital finance that deal with the history of the development of such things as cost-based reimbursement and DRGs. A great deal of the lack of business clarity comes from the involvement of multiple players with multiple agendas and perspectives. This includes the federal and state governments and legislatures, employers, insurance companies, and individuals themselves. All of these parties contribute to the bewildering state of hospital finance and, ultimately, to how hospitals make money.

As my goal here is to make a complicated issue more readily understood, I choose to bypass lots of clutter and “cut to the chase.” Simple rules can guide us here, even though the reimbursement regulations and insurance company guidelines are constantly changing. The following represents a few principles to understand how the hospital will try to make a profit from your patients.

Some insurance plans are better then others. This is a widely understood rule of thumb and does not require much discussion. Depending on your locale and the roster of insurance programs available to your patients, both physicians and hospitals will make more or less money taking care of certain patients rather then others. This is not often an entirely controllable situation, often due to geography, but all parties will strive to have a better payor mix, i.e., a greater number of patients whose insurance pays more for the activity performed. It should be noted that some physicians are choosing to bypass insurance programs and are only accepting cash payment from their patients. They represent a small percentage of the total physician population and it remains to be seen if it will become a significant trend. Hospitals are particularly on the lookout for physicians whose patient population contains better paying payors, as generally both the doctor and the hospital benefits here. Hospital administrators are also very sensitive to physicians who admit one type of patient to a certain institution and a better-insured patient to another.

Surgical patients are better them medical patients. In general, hospitals make more money from your patients who will undergo surgery. The procedures are usually reimbursed at a higher rate then a typical medical patient who only generates a daily room rate for their care. While both medical and surgical patients may generate a case or bundled rate (a fixed payment results regardless of the care delivered or the length of stay); rather then a daily charge with tests and procedures reimbursed separately, the surgical patient’s rate includes the operative procedure amount, generally a better moneymaker. Now, while these are all generalizations, they are accurate often enough to be used as rules of thumb. Yes, length of stay matters, as does many other issues, but the hospital that has more surgical patients then medical patients makes more money. Conversely, hospitals that have a higher proportion of general medical patients will have a difficult time financially.

The more procedures the better. Patients who undergo tests and procedures generate what is known as both technical and professional fees. The physician who oversees the test or reads the results of the procedure will generally receive the professional fee, while the hospital usually receives the much larger technical portion of the fee. (This could be a separate rule: Technical fees are better then professional fees.) This is an issue being more readily understood by physicians, as many of them are building freestanding facilities that are designed to capture both portions of the fees paid. For hospitals, this is a serious concern as they make a very large percentage of their money from these technical fees and they are very reluctant to see them go or even share them with the physician that generated the procedure. While not the topic herein, the potential sharing of such revenues is carefully regulated and requires appropriate legal guidance prior to entering into any relationship. Nevertheless, for this discussion, the more things that happen to the patient (tests, diagnostic or therapeutic procedures, or operations), the more money the hospital makes.

Shorter stays are better then longer ones. This generalization is the result of all the focus on length of stay and the evolution of payment schemes that reward shorter stays within specific diagnoses and may even penalize the hospital for lengths of stay over the guideline for a particular diagnosis. The term for this is denied days and physicians who generate lots of them are on the wrong list when it comes to being valued by the institution. There is a target length of stay for every patient, particularly for those patients on a case rate, and a sizeable bureaucracy within the hospital that attempts to manage the care of the patient to stay within this target. Be aware of this and know that patients that overstay their targeted length of stay will require documentation from the attending physician as to why. Readily provide this information when asked and you will be a star!

Patients need to have a place to go when their care is over. A corollary to the above rule is that some patients, often the underinsured and indigent, represent large potential money losses to the hospital, which can worsen if they do not have a place to go after their care is completed. This may be their home or another type of facility, but regardless, the patient who lingers in the hospital is costing them money as their ongoing care needs do not justify them to be there, and they may also be blocking a bed from receiving another, better paying patient. It is not uncommon for a hospital to have a number of patients who have no place to go after their hospitalization. An experienced physician is armed with this knowledge and tries to assist the institution in finding the appropriate disposition for their patients. Again, hospital administrators know which physicians generate those patients who are disposition problems and do not look favorably on them at best, and, at worst, may actively seek to limit the admissions of those types of patients.

Complex cases are better then simple ones. Many conditions that might have been accepted for inpatient care in the past are now taken care of as outpatients. Getting their inpatient stay approved will take a great deal of effort by the hospital staff, as well as the attending physician and are likely to be viewed negatively. Conversely, complicated cases, often those that require a surgical procedure, frequently result in enhancing a measure known as case mix index (CMI). This statistic is a calculation of the severity of illness of the patientdiagnosis and results in increased payments from certain payors to the hospital as the number increases. It is easy to understand that sicker patients require more resources and the insurers pay more for the care of these patients. For example, organ transplant patients and heart surgery patients are among the highest assigned case mix index, as are patients who receive a tracheotomy. The higher the CMI, the better the hospital’s opportunity to make more money. Sadly, physicians do not automatically receive higher professional fees for these cases, something that has never passed the logic test for me as the physician’s efforts for the care of the patient also increases. Physicians who generate better paying patients are always in demand by a hospital administrator.

As noted before, this is a greatly oversimplified discussion of how a hospital creates revenues and the potential for a profit. It ignores the arcane and complicated formulas and algorithms that are often used by insurers and third party payers to determine how much money the hospital receives, as this information is useless to the typical physician or manager on a daily basis. In fact, this is the type of information frequently used to confuse the parties. Nonetheless, these rules summarize the information needed by all parties to understand what is going on and how the hospital generates its bottom line. Hospitals that do not have a patient population that follows these rules will have a more difficult time making a profit and can often be in financial difficulty.

It also becomes clear that physicians and hospitals need to work together to best take care of their patients within the constructs presented here for all parties to have a harmonious relationship and a successful financial result.