Activity Based Management in Healthcare Industry – Cost to serve a patient

The hospital’s goal is to deliver high quality care at low cost; and that’s where Activity Based Costing helps in getting the visibility into the costs.  This article is based on a simplistic approach to show how Activity Based Costing (ABC) can be used to arrive at the cost to serve a patient. The same concept can be extrapolated for cost of a service line such as Emergency Department, Geriatric outpatients and Neurology acute. This is similar to line of business P&L in other service organizations such as Banks. When the organization matures with ABM, the next step is to get into activity based budgeting/forecasting. We will cover activity based budgeting/forecasting in the next article.

Overview of Costing 

In an hospital, you would have Revenue centers and Support centers. Profit/Revenue center brings in revenue for the hospital where as support center enables the profit center to bring in the revenue. For instance, Human resources department, a support center does not serve the patient directly; however without that department you will not be able to recruit and sustain the workforce required for the patient care. Hence, you need to distribute the cost of having an HR department to profit centers and cost centers, such that the accurate cost of the center is reflected.

Cost Center                                                                 Profit Center

(Service Provider)                                                    (Service User)

Billing Operating Room
Information Technology Blood Bank
House Keeping Laboratory
Social Services Pharmacy

Why do we need to allocate costs?

 Allocating costs helps in –

  1. Accurate costing of an profit/cost  center
  2. Improving resource utilization
  3. Rationing limited resources

 The intent of ABC in the hospitals is to understand and streamline the activities; the gist is to either reduce the cost of activities or streamline the activities. This in turn results in the reduction in cost to serve the patient.  In addition, since you ‘un-bundle’ your costs, the data will enable you in greater understanding of the activities and resource usage. Remember you have limited resources and optimum use of them would certainly help in keeping the costs lower.

One of the changes that will slowly start occurring during/after ABC implementation is the change in data capture pattern – potentially your forms will start capturing additional information about an event. For instance, in an imaging request form, you might ask if the request is for teaching purpose/research & development or patient care. This will help in demarcating the radiology costs associated with teaching and patient care; in other words it’s un-bundling of costs.

Difference between traditional vs Activity based costing:

 In traditional costing, the overhead cost was allocated based on single predetermined rates. If the overhead expense is attributable to other service providers then apportionment is used to distribute the overheads. This works fine in manufacturing process where direct labor is major chunk of the costs. However, the direct labor costs have come down and customized products have increased in the last three decades; and this methodology will not suffice for accurate costing. Moreover, there is some intuition and arbitrary decisions that are taken during re-apportionment. On the contrary, in ABC, the overhead costs are allocated to activities (also called cost pools) and then to products using cost drivers. Cost pools are similar to departments but you will have more number of cost pools than equivalent departments in traditional approach. The one big difference between traditional absorption costing and ABC is that, ABC uses multiple absorption rates and traditional uses just one.

One of the challenges

The number of activities performed in Hospital are vast; the collecting, counting, classifying of the data is going to be time consuming and expensive. Hence, a phased approach will help in a win –win situation. Here we are looking to analyze the cost to serve a patient who has come for emergency surgery; hence this can be considered as a phased approach. As you complete this phase successfully, you will accumulate some lessons learned; mitigating the risks arising out of this effort will help in moving swiftly with next phases such as line of service costing.

One of the important milestones in ABC implementation

An important milestone in this implementation is to make sure the Managers of the cost centers are on board with – cost policies/allocation methodologies and the data. The Managers need to have input in the policies and should be able to trust the data that is being used. The discussions surrounding the allocation methodologies is going to be based on several factors – culture of the organization, ability of the project sponsor to address or drive the behavior change, data availability and the ability to make informed decisions based on the reports. There will be contentious issues that need to be handled especially as to how the overhead be allocated.

Line of Service – Emergency Room

In this article we will consider an Emergency department visit by the patient who will have an emergency surgery. The article will show how to calculate the cost to serve a patient.  You may also encounter situations where more than one service line is involved in treating the patient.  The challenge here is have appropriate allocation methodology in place to handle these scenarios since the dominant department (Emergency department) will get the income but the other service line may just go unnoticed. Ideally, the income and cost need to be allocated between the service lines so that there is fair amount of representation based on activities.  These need to be finalized during allocation policies meetings.

The picture below shows how resources, activities, drivers’ line up with cost objects.

Activity Based Management in Emergency rooom


Direct Costs: Direct costs are expenses directly related to the delivery of the activity to patients such as medication, procedure specific equipment and specialist’s salaries.

Indirect Costs: Indirect costs are expenses not directly related to delivery of activity such as administration, corporate overheads, housekeeping and buildings.

Cost Driver/Allocation Base: It is the activity/item that causes a cost to be incurred.

Allocation: Involves spreading costs from one to many based on predetermined methodology.

Activity: Activity can be defined as work performed by people, equipment, technologies or facilities.

Cost Object: Any product, service, customer or other work unit for which a separate cost measurement is desired.

Cost Pool: A logical grouping of Resources or Activities aggregated to simplify the assignment of resources to activities or activities to cost objects.

Summary of Steps for Implementing Activity-Based Costing

i.            Identify cost objects.

ii.            Identify and define activities and activity cost pools (cost allocation base).

iii.            Wherever possible, directly trace costs to activities and cost objects.

iv.            Assign costs to activity cost pools (cost allocation base).

v.            Calculate activity rates.

vi.            Assign costs to cost objects using the activity rates and activity measures.

vii.            Prepare reports

Acitivity based costing Health care Industry

Detailed steps for Implementing Activity Based Costing

Step 1: Selecting the cost object:  Assume that you need to find out the cost per patient who comes to Emergency department for surgery.

Step 2: Identify the direct costs associated with the patient:

  1. Cost of medicines provided to a patient
  2. Fee for the Surgeon/Anesthesiologist
  3. Cost of medical supplies used in surgery
  4. Specialty equipment used in procedure is directly charged to patient. However some non-chargeable equipment such as high powered lights, surgery table costs are allocated based on utilization.

Step 3: Identify activity pools (cost allocation base):  Some of the activity pools are – 

–          Patient admission process such as check in and discharge

–          Clinical Labs

–          Surgery

–          Patient care after the surgery

These are the activities that occur for each patient. ‘Grain’ of the activities is something that needs to be decided during planning phase. The lower the grain of activities, the more accurate the cost wold be; however it also would involve larger effort in gathering those activities.

Step 4: Identify costs associated with each activity pool:  Activity pools are consolidated costs that relate to a single activity measure in the ABC system. Following costs can be identified and grouped into activity cost pools. Usually activities are maintained as hierarchies.  

–          Patient Admission Cost Pool: Cost of staff associated with admission activity, depreciation/ rent of the space occupied (allocated proportionately), cost of stationery used for patient admission, cost for telephone calls etc.

–          Emergency room cost pool:  Cost of staff associated with endoscopy activity such as taking blood samples, depreciation of medical equipment required for endoscopy, depreciation/ rent of the space) occupied (allocated proportionately), accessories used for surgery activities, printing & stationery for patient reports etc.

–          Similarly costs associated with surgery, patient care after surgery, patients check in and discharge may be identified and grouped into respective activity cost pools.

–          Types: You may have to subdivision the patient type to have right costs assigned.  The types could be General and complex. Complex type involves extended examinations thereby increasing the cost.

Using the above approach, the following costs have been identified (hypothetical) with respective to cost pools:

Activity pools Associated indirect costs ($)
Patient admission  $ 20,000
Diagnostics $ 20,500
Surgery $ 350,000
Patient care after the surgery $ 10,000
Patients check in and discharge $ 25,000
Total $ 425,500

Step 5: Identify rate per unit of cost allocation base: For each activity pools, the costs identified in step 4 will be allocated based on cost allocation base or cost driver shown below.  Cost drivers are often very rough measures of resource consumption. They include casual factor that increase the total costs of the associated activity pool.

Activity pools (A) Associated indirect costs* ($) (B) Cost drivers (C) Quantity of cost drivers * (D) Rate per unit of cost driver (B÷D)
Patient admission $ 20,000 No. of patients admitted 10,000 Patients $2/ patient
Diagnostics $ 20,500 Direct labor time (hours) 500 Hrs $41/ Hour
Surgery $ 350,000 Patient –days 500patient-days $700/ patient-days
Patient care after the surgery $ 10,000 Patient –days 500 patient-days $20/patient-days
Patients check in and discharge $ 25,000 # of patients checked in and discharged 500 Patient $50/ patient

*We have taken quantity of cost drivers and associated indirect costs per month basis. It may be taken for annual basis as well. Result will be the same.

Step 6: Compute the indirect costs allocated to a patient:

A)     The activity rates that are computed in above step will be used to assign overhead costs to a cost object. Assume that a patient consumes 90 minutes for Diagnostics, ½ day for surgery, 3 days for patient care after surgery. So the total indirect costs allocated to one patient would be as follows:

Activity pools (A) Quantity of cost drivers * (B) Rate per unit of cost driver (C) Allocated cost ($)         (B X C)
Patient admission 1 Patient $2/ patient 2.00
Diagnostics 1.5 Hr. $41/ Hour 61.50
Surgery ½ patient-days $700/ patient-days 350.00
Patient care after the surgery 3 patient-days $20/patient-days 60.00
Patients check in and discharge 1 Patient $50/ patient 50.00
Total $ 473.50

B)      Another way of allocating overhead costs is by taking Manager/Subject Matter Experts (SME) Estimates (in percentages) who have firsthand knowledge of the activities and allocate them to activity cost pools.  These estimates are obtained by interviews and may change over a period of time.  For instance the salaries (overhead) for 4 contract nurse practitioners are $200,000 per year.  This data can be sourced from your sourcing and procurement system.  Manager estimates for these four nurses are 10% in front office and 90% in diagnostic activities – what that means is they work in front office for 10% of the time and rest of the time they assist in the diagnostic activities.  Your first stage allocation would result in $20,000 being allocated to front office and rest being allocated to diagnostic cost pool.

C)      Step Down method is used to allocate costs from some service departments to other service departments. For instance allocating Information Technology costs to Billing if they have implemented a new system or upgraded the current system. We will discuss this methodology in greater detail in next article. The following shows the schematic of allocating Ancillary services/ Admin/Medical service costs using step down methodology.

Step down allocations

Step 7: Compute the total cost per patient: Sum up Direct expenses and allocated indirect to arrive at total cost per patient as follows:

Direct expense per patient

Cost of medicines (from step 2)                               $ 100

Fees for Surgeon/consultant (from step 2)          $ 500

Total direct costs                                                              $ 600

Allocated indirect costs per patient (step 6)        $  473.50


Total cost per patient (Emergency Surgery)       $ 973.50

The above example shows the simplistic version of allocating costs and arriving at the total cost per patient.  Similarly, you will be able to do departmental costing or service line costing. In the next few articles we will cover the service line costing and advanced costing concepts.


Translate this post