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Optimizing Value-Based Contracts in the Transition to Risk

Given the market realities, it is evident that health systems need a focused, comprehensive value-based payment strategy as they seek to rein in costs, build new care delivery models and become the choice provider in their local market. However, transitioning to value-based payment contracts and new care delivery models is challenging. The biggest barrier being the lack of a clear, comprehensive and strategic roadmap for change which takes into account all value-based payment efforts.

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 – and one that comes with high stakes.

Let’s explore the quantitative and qualitative factors that must be weighed when determining financial targets and reimbursement rates in value-based contracts.

Understand the Margins Needed from Payers

Health systems must protect themselves from unexpected gaps in revenue, therefore allowing providers an opportunity to experiment with and implement value-based payment models without assuming an unworkable level of financial risk.

Most CFOs are familiar with at least one process for identifying the total revenue and margin needed from commercial contracts. For health systems that are new to having multiple value-based contracts with commercial payers, a simplified, pragmatic process for identifying an appropriate range of revenue and margin targets for those contract 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 the organization has minimal ability to negotiate with. The take home message here is to employ a range of margins with realistic low-end, target and high-end figures.

The remaining figure represents 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.

Set Revenue Goals for Each Contract

The next step is to take the range of calculated revenues and assign a portion to specific contracts. 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. However, a simple volume/discount rate paradigm works just as well, in which payers with lower volumes pay a higher per unit rate.

Whatever system the hospital currently has in place should be sufficient, so long as it arrives at a range of revenue targets for each contract and ensures to ties back to the total margin the system requires.

Prioritize the Payers

Once there is clarity on the margins needed and revenue goals for each commercial contract, an organization can begin to incorporate the “value-based” component of the contract. The first step is to prioritize the list of payers with whom to take risk. This is especially important for providers that are relatively new to value-based contracting, or interested in expanding (or narrowing) that number of contracts and amount of organizational risk.

Key Questions to Consider

  1. What is the relative size of the revenue at risk? The ideal payer candidate is not necessarily the one with the greatest revenue. The ideal amount of revenue to risk will vary based on whether the organization is contemplating upside only arrangements or two-sided risk. Most providers have not negotiated a significant number of value-based contracts and need more experience under their belts before assigning a significant portion of revenue at risk.
  2. What is your capacity to manage risk? Value-based contracts carry significant cultural, financial, and operational implications for practices, and providers need to be onboard for this change. For most organizations just entering into their first two-sided risk arrangement, a smaller payer may be a better partner
  3. What quality metrics are being used and how do they align with other contracts and institutional goals? A practical reality is that metrics will vary from payer to payer and providers’ ability to negotiate the underlying calculations may be limited. Strive to focus metrics in overlapping or complementary clinical areas, even if the metrics have different definitions, to create greater focus and alignment.
  4. What is the likelihood of achieving the revenue target for a particular payer without a value-based component? Do you have to put any of the revenue at risk or can you achieve the previously set goals without it? Is the reward worth the risk?
  5. Can your organization be successful under this arrangement or are there too many barriers? Often the targets are too high or change too quickly to be achievable. As an example, many payers are promoting Minimum Loss Rate (MLR) contracts. Under typical MLR arrangements, the provider is incentivized to lower expenditures to meet a threshold set at a percentage of that year’s premium. But, there are three challenges with this type of contract:
  • The target spend adjusts annually with the premium. It takes time and effort to reduce utilization and much of the reduction may come from lowered utilization for the health system. Providers should have 2-3 years to recoup their investments rather than having targets set annually.
  • Providers have no control over the premium. If the payer decides to lower the premiums in order to gain more market share, the provider could face an unattainable target.
  • The targets rarely take into consideration the provider’s current performance. There are enlightened payers willing to create bonuses for partial achievement, but that’s not common practice.

Determine Target Reimbursement Rates

The final step is to determine the target reimbursement rates. Relative success would be base rates that, at current volumes, meet the moderate target revenue with potential bonuses reaching the high end of the range. For providers new to value-based contracting, at a minimum, base rates must be sufficient to meet the low-end revenue targets and with achievable bonuses, enough to achieve the target revenue.

As health systems gain more experience with value-based contracts, additional tools and processes can be applied to this same methodology so that they are better equipped to take on more risk, with the possibility for more reward.

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