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Background

Activity Based Costing (ABC) began appearing as a costing methodology in industries other than healthcare in the 1990’s. Since then ABC has continued to evolve, now encompassing Time-Driven ABC and Activity-Based Management (ABM).  Many healthcare executives continue to ask how ABC can be applied in healthcare and how it relates to existing costing methods. Some hope it can offer a breakthrough or at least advantages over current methods, which are perceived variously as inaccurate or too costly to build and maintain.

ABC proponents are correct in their criticism of traditional hospital costing methods that embody too closely these characteristics of state and federal cost reports:

-Single cost component
-Ratios of departmental Costs to Charges (RCC)
-No split of direct versus indirect costs
-Cost apportionment based on price of charge code items
-Statistics and allocation methods from the HCFA 2552

Costs developed in this manner are likely to be inaccurate, and are also not easily traced back to their roots, because fixed/variable and direct/indirect distinctions are not carried through the process. These characteristics also make it impossible to model the effects of activity changes.

ABC offers advantages over traditional costing because it relates costs to activity drivers rather than just fixed and variable designations. Traditional methods of costing tend to bury overhead in product costs through very general allocations. In contrast, ABC attempts to tie areas usually thought of as overhead to their own activity measures. ABC attempts to reveal all activities contributing to cost, allowing managers to eliminate activities that do not add value, and thus ABC is often heard in connection with reengineering efforts. By identifying each activity, ABC can also better reveal expected or modeled resource use through Activity Based Modeling (ABM). ABC is also often mentioned in connection with supply chain management, as a means of identifying non-value-adding steps in the supply chain.

Terminology

Knowing some ABC terminology is helpful in any costing discussion:

Cost Drivers: Activities that drive cost in the department. In industry, inspections, tests, set ups, clean ups, number of items in inventory, engineering changes are typical cost drivers. In healthcare examples include number of patients, number of surgeries and hours of surgery.

In ABC, costs fall into one of four major categories, each of which will have a driver:

1-Unit Level-costs directly associated to each unit of output. In most service departments, a unit of output is a diagnostic or therapeutic activity that is captured through order management and patient accounting functions. Film in a radiology exam is an example of a unit level cost. Other examples could include a labor Relative Value Unit (RVU), estimated or studied minutes to complete the procedure.

2-Batch Level-costs associated with a batch of activities, regardless of the size of the batch.
Some activities such as patient billing, dietary and medical records might be assigned directly to patients as a batch level expense, based on statistics like patient days, number of meals or number of diagnoses and procedures coded.

3-Product Level-costs associated with a service line, regardless of number of batches or unit output. Many center of excellence programs have specialized staff and expenses that are not used by other programs. Examples would be academic residencies, program marketing and promotion and specialized imaging and diagnostic equipment and facilities.  Product level costs could be allocated using statistics like equivalent patient days for patients meeting specific criteria for a given service line.

4-Production Sustaining-costs that cannot be directly associated to a product in any other way.
Examples in healthcare might be general marketing, administration and personnel.

Depending on the ABC expert you ask it is possible that interpretation of these terms could vary. It's also important to remember that the degree to which a costing system is ABC is best measured along a continuum and that no system is completely perfect in its ABC compliance. The degree to which ABC ideals are achieved depends on economics: will the value of the increased goodness of the data be greater than the cost of collecting it? The degree to which ABC is achieved depends as much on available data and implementation as it does software capabilities. To call one system ABC while suggesting another of not being ABC is usually oversimplification or labeling to suit some other purpose.

Good News for Healthcare ABC

Fortunately, most healthcare providers have been working over the last three decades to implement costing methods that embody ABC concepts, without calling it ABC. For example, licensees of TRENDSTAR Horizon Performance Manager (HPM) are capable of doing a reasonably good job of handling ABC costing methods. Typical implementations include:

-Multiple cost components
-User-defined cost component names
-Segregation of direct and indirect costs
-Use of charge codes and other user-defined cost drivers
-User-defined activity measures and statistics
-Use of price, RVUs, estimated minutes or studied standards
-Rollup of actual activities by patient
-Modeling of activities and cost consequences

Of course, availability of data will determine the ease with which ABC principles are met. Here are some examples in which obtaining healthcare data is likely to be a challenge:

Unit cost level: ABC practitioners prefer to use discrete activities like transport, making appointments, analyzer calibration, communicating results and so on. Unfortunately automated capture methods for such measures do not generally exist in healthcare; where they do, they are buried in many different systems, often not by patient.

In healthcare, the specific outputs of a service department are captured automatically in the form of order/billing items.  These have become the de facto activity drivers because they are economically feasible. New activity capture systems have been suggested many times over the years, but an important caveat in healthcare data capture is that valid activity data must be a byproduct of patient care activities. Otherwise compliance by busy caregivers and service staff will be nonexistent. If little confidence exists in the existing order/charge management systems' quality or applicability, it may be time to revise the order/charge description master with an eye toward better activity costing support, as well as addressing the issues of timely coding, regulatory compliance and pricing.

Nursing labor is the single most expensive resource in any hospital, yet costing of patient care activities remains the most underdeveloped costing area of all. Part of the reason for this may be failed prior efforts to use easily-gamed acuity systems. The good news is that there is a reasonable solution available for users of automated patient care documentation systems. As these systems become more widely available, they track all activities performed for a patient by the nursing staff (e.g., ambulate 50 feet, IV site management, patient education) and can thus supply highly accurate activity data as a byproduct.

Batch and Product level: New statistics must be captured and interfaced to the decision support system to support these cost levels. The level of detail required is fairly reasonable if it is kept to major departmental outputs, and is therefore generally both economical and useful.

The Production Sustaining level is the where overhead allocations are performed. The ABC approach is to make many departments typically thought of as overhead into service departments with activity drivers, including medical records, interns and residnets, medical management, and program management. New statistics are generally needed to support this. For the remaining overhead departments, stringent ABC practitioners may call for capture of new statistics for allocation, while others may be satisfied with more traditional measures such as the traditional square footage and other direct or accumulated expenses.

The good news is that existing systems can be moved gradually toward greater ABC compliance. Prioritization and planning with the owners of the information systems providing the activity data are vital to keep the cost system evolution moving in the right direction and in the right order.  In the interim, additional activity feeds by patient can meet demand for improved information where it is feasible to do so.

Healthcare ABC Opportunity

Departmental productivity is an area that has been well covered in healthcare for many years. Costing of activities ties in nicely to productivity by supplying a core set of labor measures for both purposes, making both applications more worthwhile to maintain. ABC practitioners also need to recognize a larger opportunity, which is that it may be easier, for example, to do 10 percent fewer diagnostic tests than do them 10 percent cheaper.

To do this, hospitals have to streamline the patient care process, to determine the effectiveness (e.g. value added) of the individual patient care activities. Tremendous strides have already been made in this area, and much more remains to be done. Evidence based medicine is the domain of caregivers, physicians, patient care and other clinical staff. The cost accountant provides support to the process via accurate cost data and clinical utilization so that clinicians can judge the clinical value versus economic costs of discrete clinical activities.

By applying the cost driver concept to clinical decision making, users may be able to obtain new uses of cost accounting data. Essentially, one clinical decision can drive a chain of events, so the cost of the decision is not limited to the initial decision or a single dose of a drug. For example, the decision to give a patient a particular antibiotic may also create a need to monitor serum levels of the antibiotic, and may trigger adverse reactions, all of which contribute more cost than the antibiotic itself. Clinical decisions are often drivers of many, many related activities and costs.

By summing up the costs of all the related activities, the total cost of the initial cost driver decision can be arrived at. Weighting the cost of adverse events with probability of events may also be appropriate for some higher risk therapies. Many hospitals already supply physicians with the unit costs of various common tests and drugs to raise awareness and introduce some cost/benefit judgement at the point of order. However, informing the physician of the true downstream costs associated with the original clinical decision may be even more enlightening and valuable. This is quite likely the greater promise of ABC for healthcare.

Finally, tools for activity based costing should be coupled with tools for activity based modeling (ABM).  As an example, McKesson's Horizon Performance Manager(HPM) provides a complete cost accounting solution and ABM in the form of its Encounter Based Budgeting (EBB) application.  EBB supports modeling of changes in case volume by service line, physician and other dimensions, clinical utilization to the charge code level, as well as differences in patient care and overhead departments.  Typical applications include revenue budgeting, service line budgeting, project budgets and performance measurement through variance of actual results to modeled and achievement of project financial and activity goal metrics.

Time-Driven Activity-Based Costing, Robert S. Kaplan and Steven R. Anderson, 2007, Harvard Business School Press