Allocation Methods in Healthcare

Topics: Costs, Cost accounting, Management accounting Pages: 5 (972 words) Published: February 17, 2015

To stay afloat in today’s economy, healthcare organizations need to reorganize and simplify inefficient processes and understand the types and amount of resources they need to deliver care across the establishment. This can only be achieved by applying effective cost allocation methods to indirect costs, including direct allocation and the step-down method. Further, in regard to patient-level costs, these organizations should practice common cost allocation methods by taking into account cost drivers, such as relative value units, the ratio of cost to charges and activity-based costing. Under the direct method of allocating costs, the cash flows from all operating activities need to include the amounts for lines such as cash from customers and cash paid to suppliers, while providing a reconciliation of net income to the cash provided by those operating activities. “The direct method requires use of the financial accounting system to record all directly assignable expenses for each cost pool and to select a cost driver for each indirect cost pool” (Smith, 2014, sec. 4.3). In this method, costs are allocated among departments only, so there is nothing lost or gained for the entire organization. While the direct method is simple and easy to apply, it does not produce numbers as accurately as the step-down method. On the other hand, the step-down allocation method allows support departments to allocate costs to each other, and ultimately to the operating departments. The departments are ranked based on the percentage of costs that they each incur to support other departments. The main thing this method has in common with the direct method is that costs are only allocated among departments, leaving the total costs for the organization unaffected. While this method is more accurate and thorough than the direct method, it can be quite confusing to explain and apply. Allocation to the lowest level of details can provide the greatest amount of flexibility in reporting. Estimating cost is important for improving health system performance, and since different patients have different health care needs depending upon their health conditions, a patient-level costing system is needed for appropriate resource allocation in order to determine cost drivers. Although some cost allocation methods may overlap each other, they can be categorized into: relative value units (RVUs), ratio of cost to charges (RCCs) and activity-based costing (ABC). RVUs indicate a comparative level of time, skill, training and strength a physician is required to give in order to provide a given service, basically calculating the volume of work or effort a physician uses in treating patients. For example, a routine check-up visit at the doctor’s office would be assigned a lower RVU than a triple-bypass surgery at the hospital. A physician caring for two or three complex patients would accumulate more RVUs than one caring for ten “simpler” patients, as work is measured and rewarded rather than a higher quantity of patients. “The essence of an RVU is that costs associated with providing services are compiled for all services, and costs for each service are measured against the average” (Smith, 2014, sec. 4.4). It takes some serious time and effort to develop RVU assessments, but when carried out using an in-depth history of service costs, it can result in accurate estimates for a patient. Another cost driver to consider is the ratio of cost to charges, which are derived from hospital cost charts, broken down into inpatient and outpatient services, and are determined by dividing the costs by the charges. The RCC is then multiplied by the patient charge to obtain the average cost of the service. Every patient’s bill contains revenue center charges, converted to costs using this method. The ratio between what a day in the hospital costs and what the hospital actually charges is an example of this. A lower RCC can be caused by over-charging,...

References: Chartered Global Management Accountant. (2011-2014). Activity-based costing. Retrieved from
Smith, D. G. (2014). Introduction to healthcare financial management. San Diego, CA: Bridgepoint Education, Inc. Retrieved from
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