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Overcome overhead angst by choosing the best allocation method for your group practice

Group Practice Solutions Discontinued, October 1, 2005

Rent, utilities, staff salary, marketing, and other items not related to compensation all generate expenses—known as overhead—necessary to run a medical practice. Most healthy practices collect enough revenue to pay the overhead and still pay the doctors.

However, groups often struggle with how to allocate overhead—which is deducted from physicians' revenue—fairly.

Equal isn't always fair

Groups employ a number of methods to meet this challenge. The simplest approach is to divide the overhead evenly among physicians. For example, in a four-doctor group, each physician would pay 25% of the overhead costs, regardless of how much overhead each physician actually incurs.

"It works fine in practices that are generally equally productive," says Martin Brown, 1 a shareholder for consulting firm Pershing, Yoakley, & Associates. However, groups' efficiency and productivity are rarely this in sync, he adds.

As a solution, groups may look to divide overhead commensurate with each physician's productivity. Under this system, a physician who generates 60% of the group's net revenue would pay 60% of the total overhead. But Brown says this method is also flawed because it doesn't account for the difference between fixed (e.g., office rent) and variable costs (e.g., medical supplies).

Higher productivity alone doesn't mean a doctor incurs higher costs, he says. For example, a physician who sees only 10 patients per day doesn't use any less electricity (a fixed cost) than a colleague who sees 20, so this system unfairly penalizes the more productive doctor.

Variable costs, on the other hand, should be lower for less productive physicians. For example, the 10-patient-per-day doctor will use half of the tongue depressors, needles, and paper for patient bills as the 20-patient doctor, thus eliminating half of his or her overhead.

Therefore, Brown recommends groups allocate only fixed costs on a pro rata (equal) basis and divide the remaining variable costs based on productivity.

Pitfalls of cost accounting

Don't scrutinize variable costs too closely, Brown warns. Not only can overzealous cost accounting harm the culture of your group (who wants to account for every paperclip?), but it can also inhibit achieving your strategic objectives. "Practices that are constantly worrying about managing their expenses are the ones that miss opportunities to invest in their practice and grow it," he says.

For example, consider a multigenerational practice that is considering buying a large piece of equipment. Although the physicians in their early 40s may willingly enter a new 20-year lease for the sake of a business opportunity, those in their late 50s—who may also be group leaders or have significant influence—may balk at investing in an item that will only benefit them for three or four years (assuming they haven't arranged to allocate costs as the equipment is used), Brown says.

To maintain a healthy perspective, focus on whether your practice spends in a way that gives you the greatest patient throughput (to maximize revenue), rather than expending too much energy on keeping costs down, says Geoffrey T. Anders, 2 JD, CPA, CHBC, consultant with the Health Care Group in Pennsylvania.

Classifying costs a challenge

In theory, fixed costs won't fluctuate if your practice treats slightly more or fewer patients, whereas variable costs will correspond with the number of patients doctors actually see. In reality, many costs don't fit neatly into one category or the other, Anders says.

For example, take a two-doctor practice in which Dr. A spends most of his time seeing patients in the hospital, while Dr. B is always in the office. Should both doctors pay the same amount for office space?

Although Dr. A could not practice without an office and the rent is constant regardless of the number of patients he sees—or where he sees them—the fact is that he uses the exam rooms, office phones, etc., perhaps 20% of the time, yet pays only 50% of the cost.

Here's another conundrum: Suppose a practice rents or finances an x-ray machine. The cost of the machine is fixed. But most equipment has a finite capacity (e.g., an x-ray machine may be good for 100,000 films). Should two partners each pay half if one doctor takes two-thirds of the pictures (thus using up two-thirds of x-ray's capacity) and the other doctor only takes one-third?

The list of such "semivariable" or "semifixed" costs—those that flip from variable to fixed or vice versa depending on how they're used—continues. And deciding how to classify these costs can be confusing, to say the least, Anders says.

Overhead wrong focus

Further, the idea of allocating overhead shouldn't be your group's focus, Anders says. He advises groups to concentrate on profits.

"The entire group needs to be concerned with controlling overhead—spending not the least amount possible, but the right amount on any particular overhead category—and maximizing profits," he says.

In essence, Anders says the best way to allocate overhead is to not allocate it at all. Instead, simply take all the money that comes in the door of the practice, subtract all of the overhead (e.g., variable, fixed, semivariable, etc.), and then decide how you will distribute the remaining profits to the doctors, he says.

By using factors such as productivity to divide the profits, you will automatically divide the overhead proportionately without ever getting into complicated cost accounting for compensation purposes—although thorough accounting is still needed to ensure that overhead costs are appropriate.

This approach is particularly useful for groups that are looking to hire another physician—an endeavor that will generate significant startup costs until the new doctor develops a profitable patient base. Charging that doctor an equal or proportional share of overhead could easily overcome that doctor's compensation until that doctor fully develops his or her practice.

Although many groups grant new doctors a grace period before they begin to charge overhead, it's difficult to determine a fair arrangement because the time it takes to build a patient base varies widely in different specialties and locations, Anders says.

There are other factors that are easier to adjust for by dividing profits rather than overhead, he adds. Consider a physician with a large patient base whose colleagues treat the patients that the doctor doesn't have time to see. Although other physicians actually see these overflow patients, the overbooked doctor is partly responsible for attracting them to the practice, Anders says.

Align whichever approach you take in handling overhead with your group's values and keep the matter in perspective. If you find your group becoming too preoccupied with overhead and cost accounting, remember that a true business-partner relationship constitutes much more than just an overhead-sharing arrangement, Brown says.