The Basics of Healthcare Economics, Finance, and Budgeting for the New Physician Leader

Physicians are experts in clinical treatments and outcomes but often lack knowledge of healthcare-related finance and the skills to manage finance-related tasks.(1,2) Studies have shown that although critical, financial management is the weakest leadership competency among healthcare organization leaders.(3,4)

Improving healthcare finance literacy and the awareness of healthcare’s unique economic environment can enhance physicians’ ability to plan and implement fiscal decisions in new leadership positions.(1,5) Additionally, understanding the financial aspect of healthcare adds a significant competitive advantage for physician executive positions.(6)

This review provides an overview of the unique aspects of healthcare economics and a basic introduction to financial statements. Closing the gap with this practical basic know-how primer will serve new physician leaders well by providing information that will allow them to prepare for the increasing responsibilities associated with their new roles.

Supply and Demand in Normal Economic Markets

The economic principles of supply and demand in healthcare differ significantly from those in conventional economic markets. In conventional economic markets where there are no external market forces, the price of a product or service is determined by the supply and demand for said product or services. In short, price is the “great equalizer,” as it is price that establishes the equilibrium between supply and demand (see Figure 1).(7)

Figure 1. The equilibrium between supply and demand

Figure 2. Relationship between price and supply and demand

The microeconomics supply curve illustrated in Figure 2a depicts the relationship between price and quantity of a product or service. It is no surprise that more companies will be willing to enter the market and produce more quantities of a product as the price per unit of the product increases. On the other hand, as the price of a product increases, fewer consumers are willing to purchase it and the demand for the product decreases, as shown in Figure 2b. When these two curves are superimposed on the same graph (see Figure 2c), the point where the curves intersect denotes the price equilibrium — the single price point where the manufacturers’ willingness to produce the product is the same as the consumers’ willingness to purchase it. At this equilibrium price, there is a corresponding equilibrium quantity.

The economic principles of supply and demand assume there are near perfect market conditions with few external forces influencing price, and that the market price is determined by the willingness of the buyer(s) and seller(s) alone. In other words, market prices are the main mechanism for coordinating the market participants.(8) Adam Smith, in the 1700s, described this phenomenon as “the invisible hand” because the market, left to the nature influences of supply and demand, results in an efficient use of resources.(8,9)

Why Is Healthcare Unique?

In the simple microeconomic model, demand is driven by the consumer who desires the product, orders the product, and pays for the product while the supplier produces the product and collects payment for it. Both parties that determine the market are within the same monetary environment (see Figure 3a); no factors outside this environment influence the market.(7)

Figure 3. Models of monetary environment

In healthcare, the consumer and physician are not the only parties in a given transaction and therefore do not alone define the supply and demand market. The consumer (patient) desires and consumes the service but does not directly order or pay for it. In a private practice physician model of care (see Figure 3b), the physician provides or supplies a medical service to a consumer (patient) who is not directly paying for the service. Payment for the service is made by another party: a private insurance or government payer. Therefore, the patient (or consumer of the service) is outside the monetary environment.(8)

In this example, the insurance company is an external factor and the patient’s desire or need for the service has no influence on price. Instead, the price of the service is predetermined by contracting obligations not between the physician who supplies the service and the patient who receives the service, but rather by a third party. Here, the third-party payer is creating an external market force by participating in the transaction somewhat as a bystander influencing the price and yet not directly benefiting from the “buying” or “selling” part of the service.(8)

The monetary environment is further complicated in the healthcare model where care is delivered in a larger academic or clinic organization. In such an organization, both the provider and the patient are outside the monetary environment (see Figure 4).(7) The provider ordering a treatment may be compensated by a salary that is predominately fixed; therefore the provider does not receive direct payment for the service. The monetary exchange is between the organization employing the provider and the insurance or government entity paying for the service.

Figure 4. Monetary environment of a large clinic organization

In this scenario, neither the physician who orders the service nor the patient who receives it is involved in the monetary transaction associated with the service. Rather, only the insurance entity that pays for the service and the hospital that receives payment for the service are within the monetary environment. Because both the physician and patient are outside the monetary environment, it is easy to see how their respective decisions to order or consent to a specific treatment are not influenced by price. When external factors exist, there is a clear deviation from simple supply and demand principles because the “buyers” and “sellers” (the patients and physicians, respectively) neglect the external effects of their actions when making decisions about what and how much of the service to provide or consume.

The external market forces created by the complexity of the economic environment in healthcare results in inefficiencies.(8) With influence on payment rules, third-party payers likely play a more significant role in determining the allocation of healthcare resources than the individual ordering physician. As a result, typical market forces of supply may be less influential.

On the other end of the spectrum, patients (consumers) usually lack specialized medical training and are naive to the specifics of medical aliments and treatments options. Therefore, they don’t know what medical treatment they need. This lack of knowledge limits the consumer’s ability to exert normal demand market forces.(8)

These inefficiencies in healthcare economics potentially create the moral hazard and/or adverse selection.(10,11) When a patient purchases health insurance to cover medical services rendered, out-of-pocket costs often represent only a fraction of the total cost associated with the specific medical service because the insurance company bears most of the expense burden.

The moral hazard arises when this arrangement results in the perverse incentive for patients to seek and consume additional healthcare services because the care appears to cost less than the true cost, leading to excess healthcare utilization.(12)

Adverse selection refers to the imbalance of high-risk, chronically ill insurance policy holders compared to the number of healthy policy holders in a given population.(12) With this imbalance, more policies are purchased by chronically ill patients who utilize more healthcare services relative to the number of polices purchased by healthy individuals who need less health coverage. When this happens, the overall healthcare costs are higher than anticipated, resulting in financial risk which in turn may result in even higher health insurance premiums for all consumers.(12)

As long as the end consumer of healthcare services is outside the monetary environment, there is a risk of excessive demand, which can drive up healthcare costs.(7,13) While uncontrolled demand for healthcare is not the sole contributor to the extraordinary rising cost of healthcare in the United States, it appears to be a factor that has led to increasing healthcare expenditures; such medical excess could threaten the health system.(13-17)

Healthcare reform is often noted to be a potential solution to this growing problem. Such reform is probably outside the influence of the individual physician leader; however, new physician leaders can influence local environments by understanding these challenges.

The Financial Statements

In addition to understanding the basics of healthcare economics, new physician leaders should develop financial literacy. A sound understanding of financial statements will facilitate a better understanding of an organization’s financial health and promote the ability to contribute to optimizing the delivery of healthcare services efficiently.

Three key financial reports help evaluate the financial health of any organization: the income statement, the balance sheet, and the cash flow statement. Each of these reports serves a specific purpose.

The Income Statement

The income statement (see Figure 5) summarizes the organization’s earnings over a period of time, such as a month, quarter, or year. The statement includes the revenue earned during the time period, usually generated primarily from patient care services, and the offsetting expenses associated with earning said revenue. Large multidisciplinary group practices and academic medical centers can have multiple sources of revenue in addition to revenue from patient services, including directorship fees and grants.

Figure 5. The simple income statement

The difference between the earned revenue and the offsetting expenses is the margin. When revenues exceed expenses, the margin results in a profit; if expenses exceed revenue, the resulting margin is a loss.

When evaluating the income statement of a healthcare organization, it is important to distinguish between gross revenue and net patient revenue. Gross revenue is a healthcare organization’s sum of all charges generated by the care provided to patients over a defined period of time. However, as noted in the above discussion, monetary transactions in healthcare are not solely between the healthcare organization and the patient. Third-party payers are an external factor and negotiate set prices for specific healthcare services. These set prices are agreed upon by healthcare organizations and memorialized by contracts between third-party payers and the organization.

Government payers also have set prices. As a result of these set prices, healthcare organizations do not expect to collect revenue equal to the total charges (gross revenue) generated for services. Rather, some portion of their gross revenue charges will be offset by pricing discounts established by payer contracts. These offsets are called contractual allowances. Figure 6 depicts the typical income statement for a healthcare organization that accounts for contractual allowances.

Figure 6. Outline of a typical income statement for a healthcare organization

If a division is part of a larger organizational structure, the division’s income statement demonstrates how the division’s operations contribute to the financial performance. In such a case, the division’s income statement includes the division revenue (from specific patient services) and offsetting variable expense (such as salaries and supplies). Fixed expenses not directly related to generating revenue, such as utilities, may not be included in the divisional income statements. In such a situation, the resulting margin after variable expenses are deducted from revenue is often referred to as a contributing margin. It is important for division leaders to closely monitor the division’s contributing margin so they are keenly aware of how the division’s revenue and expenses are contributing to the larger organization’s overall financial performance.

The Balance Sheet and Accrual Accounting

The balance sheet is a snapshot of an organization’s financial position on a specific date. It includes an organized list of all the organization’s assets, liabilities, and net equity. Assets include all property of value owned by the organization such as money due for accounts receivable, cash, equipment, buildings, and other assets. Virtually all organizations also owe money to others. These are liabilities such as accounts payable to vendors for supplies or debt on property.

The difference between an organization’s total assets and its total liabilities is equal to the organization’s net equity, which is akin to an individual’s net worth. Hence, a balance sheet always “balances” such that the following fundamental accounting equation always holds: Assets = Liabilities + Equity.

The asset side of the balance sheet is often organized into current assets, or those assets from which an organization will derive short-term benefit, and long-term assets, which will provide benefit for more than a year.(7) Accounts receivable is among the larger current assets on the balance sheet of healthcare organizations and represents the amount of revenue earned from services provided but not yet paid by third-party payers. Medication and medical supply inventory are other examples of current assets.

Because healthcare organizations are very reliant on equipment to provide care, capital assets are usually the largest long-term asset on a balance sheet. These capital assets such as complicated diagnostic imaging machines will have a useful life of more than one year. Organizations that own their own real estate include it as a long-term asset.

Like assets, liabilities on a balance sheet are organized into current (less than one year) and long-term liabilities. Current liabilities are those that will typically be paid off within one year and often include amounts due to vendors, also known as accounts payable. Long-term liabilities include organizational debt that is due to be paid more than one year hence and most often include mortgages on real estate or leases on equipment.

Accrual accounting is a key accounting principle used to prepare income statements and balance sheets. It differentiates these two financial statements from the cash flow statement.(7,18) Accrual accounting requires that revenue and expenses be recorded when they occur. Thus, the expected revenue and expense associated with a service are reported on the income statement as occurring at the time the care is provided, even though the actual cash received for the service would not pass hands until a later date.

Depreciation is an expense that warrants particular attention. The large pieces of equipment common in healthcare organizations require considerable one-time upfront cost. Once purchased, the equipment is considered an asset that is used for patient care over many years, as it has a multi-year life expectancy. Depreciation is an accrual accounting expense that allows the large expense to be spread over many years, even though no physical cash is spent during the years subsequent to the purchase date. Hence, deprecation is considered a “non-cash” expense during these subsequent years.

Cash Flow Statement

The cash flow statement is a more accurate way than an accrual income statement to represent the actual amount of cash the organization generates over a specific time period. The cash flow statement can be compared to an individual’s bank checking account statement that details the physical cash inflows and outflows over a set time period.

Cash flow refers to the timing of physical cash inflow and outflow into the organization and must be managed closely so the organization has enough money to pay bills when due. In large organizations, cash flow is not managed by physician leaders or their administrators; rather, it is a centralized function typically managed by the chief financial officer’s (CFO) team, including the accounts payable and revenue cycle personnel, the latter of whom are responsible for processing the charges for medical services.

The physician leader can help contribute to the organization’s overall well-being and cash flow by ensuring that providers submit the charges in a timely manner and appropriately document their clinical activity so the charges generated accurately reflect the clinical work provided. Physicians who lead physician groups or divisions are wise to meet with the revenue cycle team regularly to review charges and collections with an eye toward how providers’ documentation and charging workflows may be improved. Better documentation and more rapid collections result in more timely receipt of payment (cash), which can improve the organization’s overall cash flow.

To better understand cash flow, division chiefs should meet with their CFOs. Because cash flow accounting only pertains to physical cash changing hands, it will not include the non-cash expense of depreciation. Therefore, an organization that has large annual depreciation expense will have larger cash balances on a cash flow statement because the depreciation expense is not included.

The Operating Budget

A division’s operating budget is an educated prediction of future revenue, expenses, and resulting margin.(7) The operating budget is among the most important financial tools for the physician leader, as it provides a framework to plan for future growth as well as manage and prioritize resources, including personnel, supplies, and other expenses.

Because physician leaders are among those most knowledgeable about their divisions’ medical operations, they usually play a pivotal role in budget development, which should be based on historical performance. If significant growth is included in a budget plan, it is imperative to have a sound rationale. Once established, an annual budget should be spread out over 12 months with seasonality considerations from one month to another (because of weather, conferences, vacations, etc.) if needed.

The operating budget also provides a valuable reference tool when the planned operational budgeted performance is compared to actual financial performance on a regular interim basis (monthly or quarterly). While administrators are quite capable of preparing and monitoring budget performance, the physician leader should “know the numbers” by monitoring the performance to budget activity on an interim basis and explain the rationale for any variances. Using such data to adjust operations on a regular basis is essential to operating a group or division and may be among the most important fiscal responsibilities of the physician leader, as it requires providing feedback to clinicians or more actively managing expenses.

Divisional operating budgets may look different between organizations. For example, some divisions do not operate independently as a business entity, and their budgets may be part of a bigger budget of the department or the organization. As a result, expenses such as rent for office space or utilities that are included as an expense for the organization at large may not be included as an itemized expense in the divisional operating budget. Instead, one practice is to allocate a proportion of institutional overhead expense or granted subsidies rather than itemizing the individual expenses in its budget or statement of operations. The division managers should be aware of the allocation mechanism.

Capital and Capital Budgeting

In addition to an operating budget, a healthcare organization has a distinctly separate capital budget the organization uses to plan investments toward its long-term asset needs for the future.(7) All healthcare organizations require large amounts of capital to cover expensive equipment purchase, facilities and renovations; however, funds for capital expenditures are not typically generated from operations. Rather, they are generated from profit margins.

The purpose of capital budget planning is to use the projected income statement (operating budget) and resulting profit to predict the total amount of funds available at the end of the given time period that can be used for capital expenditures. The physician leader’s role in creating a capital budget may involve submitting requests for larger specific capital expenditures required to replace or upgrade equipment or facilities. Understanding the sources of capital and how a capital budget differs from an operational budget is important for any division chief.

Conclusions

Understanding the basics of healthcare economics enhances a physician leader’s competence. Understanding how to interpret financial statements should help physician leaders better control healthcare costs and practice net revenue. Gaining knowledge in these areas is essential for all new physician leaders seeking leadership positions and is foundational for physician leaders with growing responsibilities in the executive offices of healthcare organizations.

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