Pricing is important, but many healthcare firms lack direction. Pricing is a continuing challenge for healthcare organizations for three reasons. First, many managers do not have a clear pricing strategy. Second, many healthcare organizations have jumped directly from the hothouse of cost-plus or reimbursement-plus pricing to the real world of competitive bidding and contract negotiation. Third, the pricing strategy that is best for the organization may not be the pricing strategy various departments or clinics prefer. Managers of these units may have incentives to price products too high or too low. Without clear model of pricing, managers are unable to realize their firm’s goals. They do not know what their incremental costs are or what sort of price elasticity of demand their organization faces. As a result, they do not know what prices to charge. This reduces profits in two ways. The organization may have set its prices too high or too low. Alternatively, the organization may be participating in the wrong markets. It may be accepting contracts it should refuse or refusing contracts it should accept.
The Economic Model of Pricing
The economic model of pricing, marginal cost pricing, clearly identifies a pricing strategy that will maximize profits. This strategy also identifies the information needed to set prices. The economic model of pricing is quite simple. First, find out what the incremental costs are. Second, estimate the price elasticity of demand facing the organization’s product. Third, calculate the appropriate mark up, which will equal ε /(1+ ε). (Here, ε represents the price elasticity of demand for the organization’s product). Multiplying this markup times the organization’s incremental cost gives us the profit maximizing prices. The profit-maximizing price will equal [ε /(1+ ε) ] × MC, where MC represents the incremental cost.
Price discrimination is common in healthcare, as it is in other industries. Price discrimination refers to charging different customers different prices for the same product. Price discrimination makes sense if different customers have different price elasticities of demand and if resale of the product by customers is not possible. Most healthcare providers and their products meet these criteria. They contract with an array of individuals and insurance plans. The price sensitivities of those purchasers differ widely, and services can seldom be resold. So, profit-maximizing healthcare firms will want to explore opportunities for price discrimination (or more politely, different discounts for different customers). Price discrimination can increase profits.
Pricing and Managed Care
Are these issues relevant in markets dominated by managed care? Yes. One needs the same information to set a price or to evaluate a contract. It almost never makes sense to accept a contract in which marginal revenue is less than incremental cost because this reduces profit. Such contracts make sense only when these losses are really marketing expenses, and even in these cases the money probably could be better spent elsewhere. Similarly, it almost never makes sense to give a large discount to a buyer who is not sensitive to price. For example, a managed care plan that needs the organization’s participation in order to offer a competitive network is not in a good bargaining position and should not get the best discount.