Value Drivers for Healthcare Services and Medical Practices

and Business Valuations

This article delves into the key factors that shape the value of healthcare services, from cost behavior to pricing strategies, and offers insights into how valuation professionals can navigate this complex terrain.

“Healthcare services are a fundamental necessity, and understanding the key drivers of value in medical practices and healthcare businesses is essential for conducting a robust valuation analysis.”

This article delves into the key factors that shape the value of healthcare services, from cost behavior to pricing strategies, and offers insights into how valuation professionals can navigate this complex terrain.

Healthcare services are delivered within a growing and competitive market environment. Medical practices are at the forefront of delivering healthcare services to individuals and communities. They encompass various specialties, including primary care, specialized medicine, surgical services, and more. While the primary mission of medical practices is to provide quality healthcare, they are also businesses that must be financially viable to sustain their operations and continue serving patients effectively. The healthcare industry’s intricacies, including the evolving regulatory landscape, shifting reimbursement models, and the pivotal role of patient care, require a nuanced approach to determine the true worth of medical practices.

Understanding the significance of business valuation for medical practices requires a holistic perspective that considers the clinical aspects of care and the financial, operational, and strategic dimensions of these organizations. When determining the fair market value of a medical practice, we must consider the core factors that drive the value of businesses in the healthcare sector, enabling a robust and thoroughly prepared valuation analysis.

Healthcare services receive a large portion of their revenue from third-party payers, including government sources and private payers. The concept of insurance takes its roots in the ancient world. The first forms of insurance were recorded by the Babylonian and Chinese traders. To minimize the loss of goods, merchants would divide their items among various ships to cross treacherous waters. A more modern-day concept of healthcare insurance originated in Europe in the early 1800s. Today, health insurers fall into two general categories: private and public. Medicare and Medicaid are two government-funded healthcare programs in the United States, each designed to provide healthcare coverage to specific groups of individuals. Medicare is a federal health insurance program primarily for people aged 65 and older and some younger individuals with disabilities. It is funded through payroll taxes and premiums paid by beneficiaries.

Medicaid is a joint federal and state program that provides healthcare coverage to low-income individuals and families. It is funded through a combination of federal and state funds.

Private health insurance plays a significant role in financing and providing coverage for healthcare services. In the United States, several well-known private health insurance companies offer a range of insurance plans to individuals, families, and employers, including United Healthcare, Aetna, Cigna, Humana, etc. However, some healthcare costs are paid directly by patients out of their own pockets. These may include copayments, deductibles, and expenses for services not covered by insurance.

In the United States, healthcare businesses and medical practices have historically operated under two primary payment models: fee-for-service (FFS) and capitated revenue models. These models have different payment structures and implications for providers, patients, and payers.

In the FFS model, healthcare providers bill and receive payment for each individual service, procedure, or consultation they provide to patients. Providers submit claims to insurance companies or government programs for reimbursement based on the specific services rendered. Payment is typically determined by fee schedules, which outline the amount the provider will be reimbursed for each service.

In the capitated revenue model, healthcare providers receive a fixed, predetermined payment for each patient under their care over a specified period, typically per month (per-member-per-month, or PMPM). These fixed payments are negotiated and agreed upon in contracts with insurance companies, government programs, or other payers.

The interplay between public and private insurance options creates a complex reimbursement landscape for healthcare providers. Understanding the differences in payment models, coverage, and reimbursement rates is essential for accurate valuation.

Pricing Strategies

Pricing decisions determine both the business’s strategic direction and the medical practice’s ability to survive and continue operating efficiently. One standard method for setting prices, especially for medical practices, is to use the relative value units (RVU) technique. An RVU measures the amount of resources consumed to provide a particular service. Therefore, RVU pricing aims to create prices that reflect the cost of the resources used to provide a service. The methodology can be used well when RVU values have already been estimated, such as for procedures performed by physicians.

Let’s review an example: for Clinic ABC, management defines one (1) RVU to equal five (5) minutes of the provider’s time, $x worth of equipment, and $x worth of supplies. Next, given what has been said, the determination is made as to the time, equipment, and supplies required to perform a given procedure in terms of RVUs. The number of RVUs is then multiplied by the number of procedures performed annually and summed to obtain the total RVUs for the year for Clinic ABC. Let’s assume an annual cost, including overhead, is $500,000. We can estimate the cost per RVU at $1.90 ($500,000/262,500=$1.90).

Procedure	Number of RVUs	Number of Procedures Performed Annually	Total RVUs
Procedure 1	5	5,000	25,000
Procedure 2	25	4,000	100,000
Procedure 3	75	1,000	75,000
Procedure 4	250	250	62,500
		Total	262,500

The cost estimate for each procedure is merely the number of RVUs assigned to the procedure multiplied by the $1.90 per RVU cost.

If Clinic ABC wants to make a 25% profit margin on its procedure services, the profit-adjusted charge (price) per RVU becomes $2.38 ($1.90 x 1.25 = $2.38). For example, a simple procedure would be priced at $11.90, while a complex procedure can be priced at $595.

Procedure	Number of RVUs	Price per RVU	Price Estimate
Procedure A	5	$2.38	$11.90
Procedure B	25	$2.38	$59.50
Procedure C	75	$2.38	$178.50
Procedure C	250	$2.38	$595.00

A valuation professional should consider evaluating revenue variance year-over-year when performing a valuation analysis and reviewing the practice’s historical performance. It would be pertinent to know if the greater-than-expected or less-than-expected revenues were due to greater-than-expected volume or greater-than-expected prices (reimbursements). Hence, a valuation professional should discuss with management to examine and decompose revenue variance into volume and price variances. A potential outcome is that higher volume at lower prices may have resulted in higher revenue than the prior year (period).

Cost Behavior

The relationship between cost and volume is known as cost behavior. Cost behavior analysis is a fundamental aspect of understanding the financial dynamics of a medical practice. In the context of business valuation, comprehending how costs behave is crucial for assessing the practice’s financial health and to it for forecasting purposes, which, ultimately, may assist in determining the medical practice’s fair market value. Some costs are volume-sensitive, and some are not. This analysis is invaluable in medical practices because various factors, including patient volume, service mix, and reimbursement models, influence healthcare costs. Medical practitioners and valuation professionals can make informed decisions regarding pricing, profitability, and overall financial management by understanding how costs behave.

Contribution margin is a central concept in cost behavior analysis and business valuation. It is a critical link between medical practices’ costs, revenue, and profitability. The contribution margin is defined as the difference between per-unit revenue and per-unit variable cost (the variable cost rate). Essentially, it is the dollar amount available to cover the medical practice’s fixed costs. That is, only after the fixed costs are covered does the contribution margin contribute to profit. Let’s review an example for Clinic ABC, which estimates 75,000 patient visits per year, with an average revenue of $100 per visit and an estimated variable cost of $25 per visit.

Revenue	$7,500,000 ($100 x 75,000)
Less: Total Variable Cost	$1,875,000 ($25 x 75,000)
Equals: Total Contribution Margin	$5,625,000
Less: Fixed Cost	$4,850,000
Profit	$775,000

In this illustration, the contribution margin per visit is $75 ($100-$25). Our calculation shows that Clinic ABC generates sufficient earnings to cover fixed costs. After fixed costs have been covered, any additional visits contribute to Clinic ABC’s profit at a rate of $75 per visit.

Forecasting and Volume Projections

Effective valuation analysis relies on accurate volume projections. Forecasting patient volume is the starting point for estimating revenue and cost projections. Healthcare organizations can make informed revenue and cost estimates by understanding historical patient patterns and utilization rates.

For example, for Clinic ABC, let’s assume the expected patient volume can come from two sources: (1) a FFS population of 36,000 visits and (2) a capitated population of 30,000 members. Let’s say, historically, annual utilization by the capitated population has averaged 0.15 visits per member-month, thereby resulting in 54,000 visits (30,000 members x 12 months x 0.15). Therefore, Clinic ABC’s patient base is expected to produce 90,000 visits per year. Armed with this knowledge of volume projections, an analyst can proceed with revenue and cost projections.

If Clinic ABC’s net collection for each FFS visit averages $25, 36,000 visits would produce $900,000 ($25 x 36,000) in FFS revenues.

If the premium for the capitated population is $5 PMPM, Clinic ABC would generate $1,800,000 ($5 x 360,000 member-months).

Considering both patient sources, total revenues for Clinic ABC would be forecasted at $2,700,000 ($900,000 + $1,800,000) for the year.

Now, let’s look at the simplified illustration on the expense side. To support the forecasted 90,000 visits, let’s assume Clinic ABC is expected to use 50,000 hours of medical labor at an average cost of $25 per hour. This results in a total labor expense of $1,250,000 (50,000 x $25). Thus, labor costs are expected to average $1,250,000 / 90,000 = $13.89 per visit. For supplies expenses, the bulk of which are inherently variable in nature, let’s assume a historical average of about $2.50 per bundle (unit) of supplies, and 100,000 units are expected to be used to support 90,000 visits. Thus, supplies expense is expected to total $250,000 or $2.78 per visit ($250,000 / 90,000). The Clinic’s ABC’s labor and supplies variable costs are forecasted to be $15.00 per visit ($13.89 + $2.78 = $16.67).

If Clinic ABC is expected to incur $500,000 in fixed costs, the total cost (fixed and variable) is forecasted at $2,000,000.

Valuing medical practices is a complex and multifaceted endeavor that combines financial analysis, industry knowledge, and compliance considerations. By considering factors such as financial performance, patient demographics, reimbursement models, and compliance with healthcare regulations, valuation professionals can arrive at a comprehensive assessment of a medical practice’s value. As the healthcare landscape evolves, accurate and reliable valuations play an increasingly pivotal role in facilitating mergers, acquisitions, partnerships, and other decisions within the healthcare sector.

---

Nataliya Kalava, CVA, ABV, MAFF, is an expert in the fields of business valuation and finance, with about 15 years of experience. She has led and contributed to numerous valuations for diverse purposes, including gift and estate tax planning, management planning, M&A transactions, SBA valuations, financial reporting, and litigation support.

Ms. Kalava’s passion lies in helping business owners navigate ownership transitions, guiding them through challenges, and uncovering opportunities for growth. Her expertise is honed through a rich career journey, having worked with renowned organizations such as Equinix Inc., Humana Inc., BDO LLP, Sigma Valuation Consulting Inc., and PwC.

Ms. Kalava’s dedication to her profession extends to education and community engagement. She has been an Adjunct Finance faculty member at the University of Tampa, imparting her knowledge to undergraduate students on corporate finance and investment. Furthermore, she organizes Continuing Legal Education (CLE) courses on business valuation topics accredited by the Florida Bar.

Ms. Kalava can be contacted at (813) 999-1144 or by e-mail to nkalava@one10firm.com.