The Concept of Breakeven Applied to Managed Care in the Healthcare Industry

University Degree Business and Administrative studies

Researched by Rachel Borris

ACCT305.WB2 - Spring 2003

May 9, 2003

Managed care is the integration of both the financing and delivery of healthcare within a system that seeks to manage the accessibility, cost, and quality of that care. There is a financial need to manage healthcare due to the increases in the cost of medical care, rapidly expanding technology, increases in medical malpractice lawsuits, and consumer expectations. A fundamental concept of managed healthcare is that healthcare is delivered through an integrated system of healthcare providers and healthcare plans. Thus, in managed care, the key players work together.

In managed care plans, the risk associated with providing medical care for members is generally shared between healthcare plans, employers and members. The two financing plans in the world of managed care are fee-for-service and capitation. Fee-for-service (FFS), used in traditional indemnity plans, can benefit the provider due to increased visits by an insured. The provider can be rewarded by excessive utilization of medical services. Concerning FFS plans, the employee, employer, insured, and provider share the cost of medical care. The goal is to reward providers who deliver quality, cost-effective care. Capitation is the payment for services based on the number of patients covered for specific services; the provider is compensated per person, per capita, not per service. The provider is paid the same monthly amount regardless how often the member receives care. The goal is to serve a high volume of members, keep them healthy, and to treat illnesses promptly.

As managed care, integrated systems, and integrated delivery networks become more the norm than the exception, there will be a continuing increase in the need to understand just how these structures operate, what it takes to ensure their operational and financial viability, and how to compare performance across these integrated systems. Organizational culture, risk, incentives, cooperation, and competition must all be considered when structuring the relationships between the various system components.

One of the questions routinely asked by managers around the world, and in virtually every business is, what is the breakeven point? Although this question also has been asked in the context of managed care, the answers have been more or less unsettled. The application of breakeven analysis to managed care requires casting the model of breakeven in a slightly different mold. In general, the evidence on profitability would indicate a positive relationship between size of a health maintenance organization (HMO) in terms of enrollment and financial performance. However, contrary to conventional wisdom, “the color of the bottom line for small and large HMOs can be black and red, respectively” (9). The traditional model of breakeven appears to be “dysfunctional in a managed care environment” (2). In most breakeven analyses, profitability would increase as volume is increased; such is not always the case in managed care. The traditional breakeven analysis needs to be expanded beyond the limitations of two dimensions and the assumptions associated with the two-dimensional concept.

The relationship between an organization's production function (which determines cost) and the price charged for the product (which determines revenue) is made clear in breakeven analysis. The concept of breakeven is that total revenues are equal to total expenses at particular levels of sales, the result being a net income of zero, or breakeven. The fixed cost and variable cost per unit of production are assumed to be constant and determined by a production function that is stable over all levels of production. The breakeven point in sales, however, can be increased or decreased by adjusting the price, fixed cost, or variable cost per unit. Breakeven pinpoints the number of units sold at which total revenues (TR) and total costs (TC) are equal, where there is no profit and no loss (TR = TC). If price (P), fixed cost (FC), and variable cost per unit (v) are known, the equation can be solved for that number of units (Q*) at which total revenues and total costs are equal: Q* = FC/(P-v). When price, fixed costs, or variable costs are manipulated, there is a movement of the breakeven point. For instance, an increase in price will increase the slope of the total revenue line, resulting in a lower breakeven point. As price is increased, breakeven is reached with fewer units sold. Both costs and revenues are determined by the same factor, namely quantity (in the case of health services, this is referred to as utilization). Under a fee-for-service (FFS) environment, both costs and revenues are related to the quantity of services provided.

It is more difficult to apply the breakeven model to the managed care environment because "the reimbursement mechanism complicates some of the assumptions of the traditional breakeven analysis" (6). Namely, costs and revenues are no longer determined by quantity. As is the case in the FFS environment, costs are determined by the quantity of services provided; revenues, however, are not. They are related to an additional factor, number of enrollees. Thus, the traditional two-dimensional formulation must be expanded into a three-dimensional construct.

While a three-dimensional construct is required to consider all the relevant variables, "there are at least two ways ...

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While a three-dimensional construct is required to consider all the relevant variables, "there are at least two ways of understanding breakeven analysis in a two-dimensional framework, each of which requires holding either utilization or the number of enrollees constant" (3). In the first case, utilization is held constant, and the breakeven point is determined by the same general formulation discussed in the traditional breakeven analysis:

TR=TC and TR=P*Q where P = Premium per member per month and Q = Number of enrollees

TC = FC + (v*Q)

Total revenues increase as the total membership is increased. Total revenues are determined by the number of enrollees, who are covered by the insurance plan, and the premium that is charged for that insurance. The total costs are determined by the volume and cost of services provided to the enrollees in order to meet their health care needs. In the case of a staff model of an HMO, "the fixed costs are significant due to the capital costs and relatively large salaried staff of both physicians and other medical and non-medical staff" (4). The fixed cost might also be made up of capitation rates paid to hospitals or other health care providers. A key assumption of this formulation is that there is a constant volume of service and associated cost being provided to each enrollee. Thus, both total revenues and total costs are a function of the number of enrollees.

A second formulation of breakeven in managed care is total revenue is assumed to be a constant because the number of enrollees is fixed, while total costs are assumed to increase as utilization of services is increased. This results in the "common complaint about managed care that there is an incentive to reduce the provision of health care services" (5). The total cost curve is the product of two values--a utilization rate and a cost per unit of utilization. This is an oversimplification since utilization must include all services, the cost of each unit of service, and the mix of services included in the utilization rate. Each unit of utilization is assumed to have some variable costs associated with it, while fixed costs (in the short run), by definition, are not impacted by utilization rates.

TR=TC and TR=P*E where P = Monthly premium per enrollee and E = Number of enrollees AND

TC=FC + {(v*U) * E} where v = Variable cost per unit of utilization, U = Units of utilization and FC = fixed cost

The breakeven point can be determined for a variety of levels of enrollment and utilization rates. The driving force is the utilization rate, with breakeven being expressed in terms of number of enrollees. Thus, breakeven for managed care can be determined by the following formula: E* = FC / (P – vU). This formulation results in an infinite number of breakeven combinations between enrollments and utilization rates, assuming that fixed costs, premium, and per unit variable costs are constant. That is, as utilization rates increase, the number of enrollees required for breakeven will increase. This will hold true as long as utilization does not result in utilization costs (vU) becoming greater than the monthly premium (P). In this case, there is no breakeven level of enrollees. More accurately, “the breakeven is determined by the variable cost associated with the utilization rate--the product of variable cost per unit of utilization, and utilization” (10). As this product becomes closer to the premium, the breakeven approaches infinity, and the organization cannot reach breakeven. As total variable costs approach the value of premiums received, the contribution toward paying for the fixed costs becomes smaller and smaller, thereby requiring an ever-increasing number of enrollees. Whenever total variable costs become greater than the premium, any increase in enrollees will only increase the loss the organization suffers. In this case, the minimum loss is when enrollments are zero and the total loss is equal to the fixed cost. Breakeven is based on the concept of contribution. With each unit of service or product there is a certain price charged. Also associated with each unit of service or product is a variable cost--so-called because it is directly related to the unit of service, and varies directly with the product. Thus, a price is received for a service or product, and the provision of the service or product creates a cost. The difference between the price and the variable cost can be used to help liquidate the fixed cost. Once the fixed cost is eliminated, the difference between price and variable cost is profit. Thus, the quantity referred to as contribution, is used to liquidate the fixed cost and generate a profit. Should the variable cost become equal to the premium, there is nothing contributed toward covering the fixed cost, and breakeven can never be achieved. With variable cost greater than the price, negative profits increase for every unit of service provided.

Total cost will increase as utilization increases, with no change in the number of enrollees, and will increase as the number of enrollees increase, with no change in utilization per enrollee. Total costs can be divided into two major components--medical costs and administrative costs. Administrative costs are associated with those items necessary to maintain the paperwork and managerial capabilities associated with maintaining the organization. These costs include compensation, interest, depreciation, and marketing expenses. These costs are made up of both fixed and variable components, and “generally are in the range of 10 percent to 15 percent of premium revenues” (7). The medical and hospital costs include physician services, other professional services, outside referrals, emergency department, out of area, inpatient, reinsurance, plus any incentive pool distributions. These costs are also made up of both fixed and variable components.

Variability over time is a major concept involved in evaluating breakeven and its stability. It is important to realize that a breakeven point is valid at only a point in time, with the associated premium, fixed costs, variable costs, and utilization rates. We live in a dynamic world, where the economy, utilization rates, and costs are in a constant state of change. While stability is valued for its predictability, it is not an accurate representation of reality. Of those factors listed as variable, “the utilization rate is the most volatile” (1).

The relationship between breakeven in dollars, number of enrollees, and utilization rate can be visualized by examining “the reflection of the intersection of the total revenue and total cost surfaces on each of three planes: the utilization-enrollee plane, the utilization-dollar plane, and the dollar-enrollee plane” (4). As the utilization rate increases, the contribution margin decreases (due to increasing variable costs), thereby increasing the number of enrollees necessary to achieve breakeven. As the rate of utilization increases, thereby generating costs approaching the annual premium, the breakeven number of enrollees increases exponentially. Eventually, there is no possibility of achieving breakeven because the contribution margin is zero. As the utilization rate increases, eventually there becomes no possibility of ever achieving breakeven, since total costs are increasing faster than total revenues (variable costs > premium, or vU > P). Under capitation net income increases with either increasing enrollments or decreasing utilization. Under both the traditional fee-for-service system and capitation, net income increases with more clients (i.e., enrollees for capitation, patients for fee-for-service). However, under fee-for-service, net income increases with increased rather than decreased utilization. Herein lies the dilemma. Both systems have incentives to increase net income, with “underutilization (for capitation) and overutilization (for fee-for-service)” (8).

“The shape of the zero profits curve is important for management decision making” and the potential for any organization to achieve breakeven (10). It indicates that there is a broad range of values for utilization at which breakeven is attainable; but at some rate of utilization, the breakeven number of enrollees increases at a dramatic rate. This curve, referred to as a "breakeven curve," shows the relationship between utilization rate and number of enrollees: it is a composite of different breakeven combinations of utilization and enrollments. The number of new enrollees necessary to breakeven for each additional increment in utilization rate is ever increasing. As the utilization rate rises considerably, the increase in number of new enrollees necessary to breakeven becomes enormous.

The concept of breakeven is important, because it provides evidence of what everyone involved in managed care already knows--it is a risky business, and has many areas of risk. “Fee for service results in a relatively static situation” (1), where breakeven is fairly constant (under fee for service), resulting in a situation where net income is increased as long as either the number of patients or the utilization rate of services of existing patients is increased. In this case, number of enrollees and utilization rate are substitutes for one another. As utilization rate increases, the breakeven number of enrollees is decreased. Managed care results in a more dynamic breakeven relationship, “strictly driven by the utilization rate of existing enrollees and the cost per unit of utilization” (7). The breakeven number of enrollees under managed care increases as the utilization rate increases. Net income can be increased by either reducing the rate of service utilization of existing patients, reducing cost of the service utilization of existing patients, or increasing the number of enrollees (as long as there is a positive contribution margin).

Why would decision makers in managed care organizations be interested in breakeven analysis, particularly when it must be interpreted within a three-dimensional construct? Conventional two-dimensional breakeven analysis indicates the quantity of goods or services (i.e., a particular level of product) necessary to "breakeven." Three-dimensional breakeven analysis can be interpreted in a way so as to trace the effect on profits of a growth in the organization. In this sense, the methodology may be useful for strategic planning to anticipate how a growth in enrollments is likely to effect profitability at various levels of utilization.

The concept of utilization elasticity of enrollments at breakeven, would be a useful tool for managers, particularly in highly competitive health care markets where there is a significant penetration of managed care alternatives, or in other markets where there is high enrollee turnover. If enrollments fall due to migration of enrollees to other plans or areas of the country, this will have an effect on profitability, unless the utilization of remaining enrollees can be reduced. The degree to which utilization must be curtailed compared to changes in enrollments is referred to as elasticity. It is a measure of the type of response necessary to deal with changes in enrollments, in order to retain the same level of profits.

The applications of breakeven in managed care may seem to imply that financial decision makers and strategic planners equipped with three-dimensional breakeven analysis can make calculated decisions on how to adjust utilization in response to changes in enrollments. Any changes in utilization depend upon provider cooperation and incentive plans, not to mention the levels of disease and disability within the covered population. Furthermore, there would be serious ethical problems, and public relations disasters, associated with an organization that made a point of cutting services in response to declining enrollments. Any reduction in utilization associated with fewer enrollees has both short- and long-term components. Obviously, in the short term one would want to reduce unnecessary utilization. A long-term strategy might involve renewed commitments to preventive medicine and the proactive encouragement of positive life-style changes among enrollees.

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