The Relevance of Activity Based Costing to Healthcare

When you hear activity based costing, most people would think of the manufacturing industry. Manufacturing companies utilize activity based costing to assign direct and indirect costs to products based on the activities that go into making it. You divide the process into activity cost pools, and then allocate direct and indirect costs to each pool. You then identify the activity cost driver of each pool, and assign a portion of each activity cost pool to each product based on the corresponding cost driver.

Stepping back to healthcare, a new way of capturing and analyzing cost is vital, and activity based costing is the solution. Focusing on the patient’s entire journey through your system, sometimes across departments, for treatment allows us to gain insight into inefficiencies and lower margin activities. The struggle is to allocate the indirect (overhead) costs between the activity pools. For certain activity pools, it may be logical to “develop algorithms that use the length of time that the patient spends in each care location to allocate costs for staffing and service utilization”, as the University of Pittsburgh Medical Center did.[i] For others, it may be a simpler driver, such as the number of patients in the period, so that the cost is allocated to each patient equally.

The real advantage of activity based costing is the focus on cause and effect, and how that aligns so closely with the current goal of the industry to improve efficiency and decrease waste. If a patient presents with certain symptoms, then certain treatments and tests are prescribed. Further, the treatments and tests prescribed may depend on the provider the patient sees. And if you are able to track a patient along their entire journey through your system, then you can slice the cost data into any variable you like. You could see cost by diagnosis, and then further drill down to the provider level. Or you could compare costs for the same diagnosis at different locations. Since each patient would have a cost assigned to them, you can use any attribute of patients’ records to quantify the data. The challenge is in the initial setup, in developing the activity cost pools, cost drivers, and establishing the allocation methods. But once established, the insight into the cost of delivering care is well worth the effort.

As the healthcare industry moves from volume based reimbursement to value based reimbursement, providers need to manage financial risk. How can risk be managed without understanding the true cost of delivering care? Contact us if you would like to explore development of activity based cost analysis for your organization.

[i] Health Catalyst (2016). Service Lines and Activity-Based Costing Reveal True Cost of Care for UPMC. Retrieved from https://www.healthcatalyst.com/success_stories/activity-based-costing-in-healthcare-upmc