Building Blocks of Success for Two-Sided Risk Models– Part 2: Value-Based Contracting

April 3, 2018 Bryan Smith

How to Identify Revenue and Margin Targets

In an on-going blog series on building two-sided risk models, Premier experts are providing insight on how to ready your health system for a successful transition. Here, we focus on a critical operational challenge – setting financial targets and reimbursement rates in the era of value-based contracts.

Providers and health systems are accustomed to identifying target fee-for-service rates. However, with value-based models comes a different way of billing and paying for care. Providers are usually required to sacrifice a portion of the base reimbursement rate in exchange for the opportunity to achieve bonus payments for meeting specific performance goals. But reconciling these financial targets and determining the appropriate trade-off between base rates and potential bonuses is a struggle for providers – and one that comes with high stakes.

As a guide to health systems who are new to value-based contracts with commercial payers, the following is a simplified, pragmatic process for identifying an appropriate range of revenue and margin targets for those contracts. The process outlined here aims to help health systems protect themselves from unexpected gaps in revenue, therefore allowing providers an opportunity to experiment with population health without assuming an unworkable level of financial risk.

Step 1.  Understand the Margins Needed from Commercial Payers

Most CFOs are familiar with at last one process for identifying the total revenue and margin needed from commercial contracts. For the purpose of this article, a simplified model is below which starts with the range of margins the system would realistically like to generate (in absolute dollar terms), and then subtracts the margin generated by payers with whom you have minimal ability to negotiate. The key take home message here is to employ a range of margins with realistic low end, target, and high end figures.

The remaining figure represents the total dollars, including both base rates and incentive payments that need to be achieved.  Divide that by the average operating margin for the commercial payers to see the revenue needed from the commercial payers.

Step 2.  Set the Revenue Goals for Each Contract

Once you have a grasp of the margins needed, the next step is to take the range of calculated revenues and assign a portion to specific contracts.

Of course there are numerous qualitative factors to consider when contemplating what rate increases may be possible, including variables such as: the relative increase gained in the last contracting period, the current payment rates relative to the rest of the market and the payer’s market position.  I personally like to use a simple volume/discount rate paradigm in which payers with lower volumes pay a higher per unit rate (see example below). But, whatever system the hospital currently has in place should be sufficient, so long as you arrive at a range of revenue targets for each contract.

With this information the system can set expectations for the range of revenue expected from each agreement and ensure it ties back to the total margin the system requires.

Once you have calculated your margin and revenue ranges, you are ready to tackle decisions around the “value-based” components of value-based contracts. Stay tuned for an accompanying blog post on additional, qualitative considerations as you navigate the financial elements of two-sided risk models and value-based contracts.

Do you have additional questions about transitioning to a risk-based arrangement? Download our white paper “Building Successful Two-Sided Risk Models,” and listen to our webinar from January 11, “Preparing to Take Two-Sided Risk.”

Author information

Bryan Smith

Bryan Smith

Principal, Premier Performance Partner at Premier, Inc.

I’m a consultant who helps physicians and health systems achieve greater operational, financial and strategic alignment. When I’m not working you’ll find me with my wife looking for the best restaurants in the Dallas/Fort Worth area or scouring the local bookstores. Connect with me on LinkedIn.


The post Building Blocks of Success for Two-Sided Risk Models– Part 2: Value-Based Contracting appeared first on Action For Better Healthcare.

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