Contractual Allowances

Example 4A: Contractual Allowances

Contractual allowances represent the difference between the full established rate and the agreed-upon contractual rate that will be paid. An example was given in the text of Chapter 4 by which the hospital’s full established rate for a certain procedure is $100, but Giant Health Plan has negotiated a managed care contract whereby the plan pays only $90 for that procedure. The contractual allowance is $10 ($100 less $90 = $10). Assume instead that Near-By Health Plan has negotiated its own managed care contract whereby this plan pays $95 for that procedure. In this case the contractual allowance is $5 ($100 less $95 = $5).


Assignment Exercise 4–1: Contractual Allowances

Physician office revenue for visit code 99214 has a full established rate of $72.00. Of 10 different payers, there are 9 different contracted rates, as follows:

Payer Contracted Rate
FHP $35.70
HPHP 58.85
MC 54.90
UND 60.40
CCN 70.20
MO 70.75
CGN 10.00
PRU 54.90
PHCS 50.00
ANA 45.00
Rates for illustration only.


  • 1. Set up a worksheet with four columns: Payer, Full Rate, Contracted Rate, and Contractual Allowance.
  • 2. For each payer, enter the full rate and the contracted rate.
  • 3. For each payer, compute the contractual allowance.

The first payer has been computed below:

Full Contracted Contractual
Payer Rate (less) Rate (equals) Allowance
FHP $72.00 $35.70 $36.30

Example 4B: Revenue Sources and Grouping Revenue

Sources of healthcare revenue are often grouped by payer. Thus, services might be grouped as follows:

  • Revenue from the Medicare Program (payer = Medicare)
  • Revenue from the Medicaid Program (payer = Medicaid)
  • Revenue from Blue Cross Blue Shield (payer = Commercial Insurance)
  • or
  • Revenue from Blue Cross Blue Shield (payer = Managed Care Contract)


Assignment Exercise 4–2: Revenue Sources and Grouping Revenue

The Metropolis Health System (MHS) has revenue sources from operations, donations, and interest income. The revenue from operations is primarily received for services. MHS groups its revenue first by cost center. Within each cost center the services revenue is then grouped by payer.


  • 1. Set up a worksheet with individual columns across the top for six revenue sources (payers): Medicare, Medicaid, Other Public Programs, Patients, Commercial Insurance, and Managed Care Contracts.
  • 2. Certain situations concerning the Intensive Care Unit and the Laboratory are described below. Set up six vertical line items on your worksheet, numbered 1 through 6. Six situations are described below. For each of the six situations, indicate its number (1 through 6) and enter the appropriate cost center (either Intensive Care Unit or Laboratory). Then place an X in the column(s) that represents the correct revenue source(s) for the item. The six situations are as follows:
    • (1) ICU stay billed to employee’s insurance program.
    • (2) Lab test paid for by an individual.
    • (3) Pathology work performed for the state.
    • (4) ICU stay billed to member’s health plan.
    • (5) ICU stay billed for Medicare beneficiary.
    • (6) Series of allergy tests run for eligible Medicaid beneficiary.

    Headings for your worksheet:

    Medicare Medicaid Other Public Programs Patients Commercial Insurance Managed Care Contracts

    Example 6A: Direct and Indirect CostsReview the chapter text regarding direct and indirect costs. In particular, review the example of ambulance direct costs (Exhibit 6–1) and indirect costs (Exhibit 6–2). Remember that indirect costs are shared and are sometimes called joint costs or common costs. Because such costs are shared they must be allocated. Also, remember that one test of a direct cost is to ask: “If the operating unit (such as a department) did not exist, would this cost not be in existence?”

    Practice Exercise 6–I: Identifying Direct and Indirect Costs

    Make a worksheet with two columns: Direct Cost and Indirect Cost. Place each of the following items in the appropriate column:

    • • Managed care marketing expense
    • • Real estate taxes
    • • Liability insurance
    • • Clinic telephone expense
    • • Utilities (for the entire facility)
    • • Emergency room medical supplies

    Assignment Exercise 6–1: Allocating Indirect Costs

    Study Table 6–1, Table 6–2, and review the chapter text describing how the indirect cost is allocated. This assignment will change the allocation bases input for (A) Number of Visits (Volume), (B) Proportion of Direct Costs, and (C) Number of Computers in Service.


    • 1. Compute the costs allocated to cost centers “Clerical Salaries,” “Administrative Salaries,” and “Computer Services” using the new allocation bases shown below. Use worksheet #1 that replicates the set up in Table 6–2. Total the new results. The new allocation bases are:
      • A = # Visits (Volume): PT = 9,600/OT = 4,000/ST = 2,400/Total = 16,000 (16,000 × $3.50 = $56,000)
      • B = Proportion of Direct Costs: PT = 60%/OT = 25%/ST = 15%/Total = 100% (% × $55,000)
      • C = # Computers in Service: PT = 10/OT = 3/ST = 3/Total = 16 (16 × $5,000 each = $80,000).
    • 2. Using worksheet #2 that replicates the set up in Table 6–1, enter the new direct cost and the new totals for indirect costs resulting from your work. Total the new results.

    Practice Exercise 6–II: Responsibility Centers

    The Metropolis Health System has one director who supervises the areas of Security, Communications, and Ambulance Services. This director also supervises the medical records relevant to Ambulance Services, the educational training for Security and Ambulance Services personnel, and the human resources for Security, Communications, and Ambulance Services personnel.


    Of the duties and services described, all of which are supervised by one director, which areas should be responsibility centers and which areas should be support centers? Draw them in a visual and indicate the reporting requirements.

    Assignment Exercise 6–2: Responsibility Centers

    Choose among the Case Study in Chapter 27, the clinic in Mini-Case Study 2, or the Metropolis Health System information as contained in its Case Study and the Appendix that contains its financial statements. Designate the responsibility centers and the support centers for the organization selected. Prepare a rationale for the structure you have designed.


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