The Effect of Service Capability on Operating Costs: An Empirical Study of Ontario Hospitals*

We examine variations in the relation between a hospital's level of service capability and the operating costs of its departments and activities (e.g., surgery, laboratory, laundry). We propose a model of the hospital as a set of concentric, interrelated services organized around a core mission to provide patient care. We hypothesize that increases in service capability (i.e., complexity of operations) will increase overall operating costs. At the departmental level, we expect variations in service capability to have a greater cost impact in departments that are closer to the patient. We examine these issues using 1986 data from 154 acute-care hospitals. We disaggregate total operating costs into 18 pools that together account for 84 percent of all operating costs. We find that models with aggregate drivers explain about 90 percent of the variance in overall hospital costs. Complexity is found to be a significant determinant of overall operating costs. At the departmental level, models with department-specific drivers dominate models that employ aggregate drivers. We find that approximately 45 percent of hospital operating costs are significantly associated with the complexity of care provided. There is only limited support for the claim that the effect of the complexity of care provided on operating costs increases as the extent of a department's direct contact with the patient increases. Hence, although our results suggest that the complexity of care should be accounted for in any cost allocation and reimbursement scheme, they also suggest that finding, the "right" level of adjustment is a difficult task because complexity differentially affects costs in the various departments.