Health system leaders often think of the clinical laboratory as a cost center. Why, then, are commercial laboratories so eager to purchase laboratory operations? The truth is that fee-for-service testing contributes significantly to health system profit margins, and this business is what commercial labs are most interested in acquiring.
Understanding the contribution of fee-for-service testing to overall margin is important for leaders who are making decisions about keeping or selling—or growing—that business line. Unfortunately, recognizing the value in fee-for-service testing can be a challenge because that revenue and resulting contribution margin is often not tracked and measured separately by health systems.
Fee-for-service lab testing can include services such as:
- Testing in ambulatory care settings within the health system
- Ancillary outreach testing
- Testing from system draw centers that also support outside clients
Together, these service lines bring tremendous value to revenue and margin.
Revenue, expense, and margin
Along with accurately tracking fee-for-service revenue, health systems need to correctly allocate lab expenses. An often-employed approach is to simply calculate the average cost per test in a laboratory. However, that approach inaccurately attributes fixed expenses to fee-for-service testing, making it appear low-margin.
Health system laboratories must maintain a certain level of staffing and equipment to perform inpatient testing. These are fixed expenses that would not shrink beyond a firm baseline if fee-for-service testing was eliminated.
Sometimes health system leaders assume that they can reduce costs proportionally—that is, if they sell half their testing volume, they can then cut the laboratory budget in half. But that cannot happen in practice because the lab still needs to be staffed and equipped at a baseline level. Reducing testing volume may lead to some savings for reagents and a small portion of staff positions, but most expenses would largely stay the same.
With this understanding, it’s clear that fee-for-service testing is vital for keeping margins healthy.
What happens to margin when lab services are sold?
Let’s look at hypothetical numbers for a health system that we’ll call Amalgam Health, using a composite of the real-world data of several hospitals. Amalgam Health has an overall net patient revenue of $1.5 billion but operates with a razor-thin annual net margin of $2.12 million, or 0.1%.
Laboratory services delivered in ambulatory settings make up 64% of the total lab revenue ($60.1 million) yet make up only 32% of the total lab expense, after accounting for fixed costs. The resulting net income from ambulatory services comes to $39.5 million. If fixed expenses were inappropriately allocated to this testing, the resulting net income would be calculated at only $18.5 million, undervaluing the annual ambulatory lab profitability by $21 million.
What would happen to Amalgam Health’s overall margin if the ambulatory portion of the laboratory was sold? The system would lose $39.5 million in net income, which would drop its overall margin to -2.57%, with losses greater than $37 million.
Suppose Amalgam Health uses incorrect net income estimates to agree to a sale price of $90 million for the ambulatory portion of the lab business. The proceeds from the sale would only cover two years of lost income from the program, a much shorter timeframe than anticipated. Every year after that, it would lose $39.5 million in net income formerly provided by the ambulatory services, creating a lasting impact on margin.
Beyond this immediate impact, Amalgam Health would lose the opportunity to expand its ambulatory business. With a conservative estimate of organic growth, the ambulatory business would contribute $195 million to the bottom line over the next five years. After investments in outreach, that contribution could realistically climb to $220 million.
Understanding your lab’s value
ARUP Healthcare Advisory Services is experienced in helping laboratories understand the value of the lab to the health system. Our customized Preliminary Financial Assessment quantifies the worth of your laboratory fee-for-service operations and illustrates the potential impact of a laboratory sale on the bottom line.
Beyond this preliminary assessment, ARUP’s expert consultants can perform in-depth evaluations and consultations to help laboratories improve efficiency, achieve cost savings, and expand ambulatory outreach operations. Strengthening the lab’s financial position through greater efficiency and increased fee-for-service volumes enables the lab to grow its contribution to healthy and sustainable margins.
Request a Preliminary Financial Assessment to see the true impact of your laboratory on your health system’s bottom line or connect with ARUP consultants about our full portfolio of advisory services.
The post Know the True Value of Your Lab When an Offer Is on the Table appeared first on Becker's Hospital Review | Healthcare News & Analysis.
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