Unlocking cost savings hidden in hospital tier contracts

Hospitals face significant pressure to reduce operational costs, particularly medical supply costs, which account for up to 40% of a hospital's expenses and continue to grow. In this paper, we present a new and practice-oriented approach to combatting high medical supply costs by exploiting cost-saving opportunities hidden in complex hospital procurement contracts. We first propose a four-dimensional structure to capture the complex and diverse requirements in multi-tier contracts. We then formulate a mixed-integer programming (MIP) model to optimize procurement decisions while taking into account a number of real-world complexities, including complicated tier pricing schemes, physician preference items (PPIs), and asymmetric product substitutability. A process is then presented to identify cost-critical PPIs by quantifying their financial impacts. We apply our approach to four regional and nationwide health systems and obtain the following findings: (a) the proposed model presents a new opportunity to reduce hospital procurement costs by up to 35%; (b) the financial impact of a PPI can be quantified; (c) not all PPIs are responsible for inflating costs, with the impact of an PPI ranging from none to 13% on the total cost of a clinical product category; (d) the optimal number of suppliers varies, with some health systems benefiting from fewer suppliers while others better with a larger pool of suppliers; and (e) under the current contracting structure, reducing product variety does not necessarily decrease product acquisition costs, and the current contracts may not encourage product standardization for which hospitals have long been striving.