Implications of severity-graded DRGs for service line structure, Part II

Mark T. Morgan, Rita E. Numerof, and Stephen Rothenberg, for HealthLeaders Media, July 28, 2008

Editor's note: This is the second in a two-part series that examines the service line structure and implications associated with severity-graded DRGs. Part I detailed the idea of service line management as an organizing concept.

The new severity-graded DRG reimbursement structure, which went into effect October 1, 2007, represents one of the most significant changes introduced by CMS to the system since its implementation. The changes are meant to better tie Medicare payments to hospital costs and more accurately reflect the severity of illness. The changes, however, also bring with them the need for reorganization of healthcare infrastructures based on the old charge-based DRGs. Part I of this article examined the challenges service line structures face in today's healthcare systems. In Part II we continue our discussion of how to improve quality of service and patient care by restructuring service lines in response to the new cost-based DRG system.

Opportunities abound

Taking advantage of the new, margin-neutral environment means several things. First, because the new system is cost-based (rather than charge-based), charge systems that were intended to "subsidize" unprofitable departments and service lines (e.g. general medicine) should be dropped. That will remove a layer of complexity, drastically simplifying the evaluation of profitability across the services you provide, and making it easier to focus on those areas that offer the greatest opportunities for gains in efficiency.

Second, restructure your service lines to fit the community in which you provide services. You no longer need to compete strenuously for specific patient segments—almost all of them should be profitable. Instead, you can seek to distinguish yourself in any niche, or you can provide a full array of services without fear of gross under-reimbursement in any one of them.

Third, consider specializing in specific service lines to drive increased volume. The reason for this hasn't changed—efficiency of resource utilization will increase as your volume increases—but its effectiveness as a strategy will improve. Neutralization of financial incentives may point you toward specializing in the treatment of formerly unprofitable niches, and the first to recognize these opportunities will be positioned to capture the greatest economies of scale. Moreover, because the pressure to compete for a few highly profitable segments will decrease, there will be increased willingness on the part of competing hospitals to "yield" market space to competitors who aggressively chase a specific segment, making the "high-volume, specialized service" model more realistic.

Shaking-out period ahead

This process of specialization will take some time to shake out, but the implications for cost and quality of care, especially within large urban areas, are enormous. Resources and expertise needed to care for particular patient populations will be centralized, and higher volumes will help to justify capital investment and workflow optimization that will drive down cost. The result will be better care, at lower cost, across all areas of care. The benefits obviously are not restricted to CMS patients. Every patient who comes through your doors benefits from your ability to work better and work toward higher quality standards more efficiently.

Finally, take the opportunity to maximize the extent to which you forward your mission. Push care toward earlier intervention--that is, toward cases that are uncomplicated—and relax controls that protected you against the runaway cost of treating those with the most complications. Where previously this was a money-losing proposition, it is now effectively margin-neutral. On the "early intervention" end, there may even be a chance to push for more cross-hospital coordination in education and preventive efforts, such as cooperative community-based initiatives focused on cardiovascular health or diabetes prevention. It's easier to agree to efforts that may reduce your revenues when operations are broadly profitable than when you're struggling to get by.

CMS's revisions will increase operational flexibility by creating nearly guaranteed profitability—regardless of specialist or generalist focus, and regardless of precisely what a specialist hospital specializes in. The imperative—keeping all-in costs below reimbursement—becomes much more straightforward now that the impact of patient characteristics is greatly reduced.

And what about those who currently specialize in highly profitable niches to the exclusion of other lines of business? These groups will need to focus on efficiency of operation, expand the services they provide along the continuum of care, and seek to increase revenues by maximizing volume. They are unlikely ever again to see the outsized margins they have in the past, but with appropriate adaptations to the new reality most will remain profitable.

Careful of the caveats

There are two caveats to this hopeful scenario. First, while CMS believes that these changes will make it easier to update payments on a regular basis, there is a real risk that CMS will once again allow its IPPS to become hopelessly behind the times. This would once again cause certain diagnoses to become highly profitable while others become unprofitable. It is in the best interests of the healthcare system as a whole to avoid this outcome, so it is incumbent on the heads of hospitals and hospital systems to agitate for regular revision to the IPPS to reflect true costs of treatment, assuming efficient operations.

Secondly, while the changes to the DRG system and IPPS will reduce the inequities inherent in the system, they will not entirely eliminate them. There will certainly be some lines of service that are relatively profitable, and some may remain unprofitable. Despite the improvements, specific moves may or may not make sense for your hospital, and due care should be taken before setting a bold new course.

Despite these cautions, the importance of these changes should not be underestimated. The first hospitals to recognize that neutralization of financial incentives changes the shape of the playing field and opens up opportunities to move aggressively into formerly unprofitable niches stand to position themselves as leaders in the coming years (and profit as well). For many of you, CMS' overhaul of its payment system brings your financial imperatives back into alignment with your mission and frees you to provide the right care at the right time—while keeping your head above water at the same time.

Mark Morgan is a senior business analyst, Rita E. Numerof is president, and Stephen Rothenberg is a business analyst for Numerof & Associates Inc., a strategic management consulting firm in St. Louis. They may be reached at
For information on how you can contribute to HealthLeaders Media online, please read our Editorial Guidelines.
Facebook icon
LinkedIn icon
Twitter icon