Question

What is cost allocation in a healthcare setting? Explain it’s methodology and why it the best method.

Answer 1

Cost Allocation In Healthcare Setting:

Cost allocation, also known as cost finding, is a method to determine the full cost of operating a profit center. This method allows health care organizations to allocate the costs of cost centers (i.e., overhead departments that do not generate revenues but do incur costs) to profit centers (i.e., patient-services departments that do generate revenues and also incur costs).

Methodology of Cost Allocation:

Two prominent methods of cost allocation are:

1. Direct method of cost allocation: This “top-down” approach starts with the costs of overhead departments and allocates these indirect costs to the profit centers

2. Activity-based costing (ABC) method: This “upstream” approach is based on the activities performed to provide a patient service. This method is more complex than the direct method, and will not be covered in this course

** Basics of Cost Allocation

To conduct a cost allocation, it's necessary to determine the following four elements, in the order listed:

1. Cost pool: A grouping of costs from an overhead department to be allocated

2. Cost driver: Criterion upon which the cost allocation from an overhead department is made

3. Allocation rate: The percentage of a cost pool that is allocated from an overhead department to a profit center

4. Allocation amount: The amount of the overhead-department cost allocated to the patient-services department

Cost Pool:

The cost pool consists of the costs for each of the overhead departments, as well as the total costs of these departments

Cost Drivers:

The cost driver is the criterion used to allocate the cost of each overhead department in the cost pool to a patient-services department. The identification of meaningful cost drivers is an important step in developing a sound cost-allocation system. The cost driver should reflect the extent to which the cost from an overhead department is used by each specific profit center. An example of a cost driver might be area (square footage). A department that occupies twice as much space as other departments will be allocated twice the cost as other departments.

Allocation Rate:

The allocation rate is the proportion of the cost pool used by the profit center.

Necessity of cost allocation in healthcare setting:

Cost allocation is necessary in order to know the full cost of producing a patient service. Knowing the full cost of producing a patient service allows a health care organization to determine if a payment is adequate. In our example of the pediatric unit above, cost allocation would be used to determine 1) which overhead costs to allocate to the unit and 2) how to determine the total amount that should be allocated.

There are numerous ways to conduct cost allocation. The three principles common to all costallocation methods are:

1. The goal of a cost-allocation system is to apportion overhead costs to the activities that create the need for the costs.

2. A cost-allocation system should be fair so that profit-center managers believe that the overhead allocation for their department reflects the amount of overhead services needed by their department.

3. The allocation process should foster a cost-reduction mind-set within the organization