Financial Analysis of Drug Management and Pharmacy Costs

September 2012 - Vol. 9 No. 9 - Page #12

Developing a process for evaluating drug spending and overall pharmacy expenditures is crucial to creating an effectively managed department. Moreover, financial analysis serves as a tool for measuring 16success from multiple perspectives. Monthly comparisons to budget provide valuable insight into whether pharmacy management and staff are effective in meeting departmental and organizational goals, while trend analysis over time may indicate areas that need improvement, identify exceptional performance, and demonstrate outcomes of newly implemented projects.

Parkview Regional Medical Center in Fort Wayne, Indiana is the 446-bed flagship hospital of an eight-hospital system. Patients receive medications through a decentralized distribution model utilizing ADCs, carousel inventory management, and pneumatic tube, robotic, and technician delivery systems. Accurately evaluating drug spending and other pharmacy costs is a top priority that is managed on a regular basis by pharmacy leadership.

Ensuring Accurate Budget Projections
Preparation for the new fiscal budget begins in the fall each year. In September, estimates for drug price increases, salary expense changes, and other factors that may significantly impact the budget are reviewed; levels are then submitted for finance and administrative approval. Aspects that may be reviewed include estimated workload volume for the upcoming year, the financial impact of any major organizational changes, and anticipated operational efficiencies. Estimates are created from researching pharmacy resources, such as journal literature, GPO data, and trends over the past few years that will likely influence costs in the upcoming year. For example, with more biotechnology drugs now coming on the market and fewer patents expiring over the next several years, drug expense increase projections will likely be higher than in the previous decade. 

The approved budget goes into effect in January and the results are reviewed monthly by the pharmacy director, the director’s C-suite leader, and a representative from the finance department. For any area with unsatisfactory results, an action plan for improvement is developed that includes metrics that have been approved by the team. Such plans are detailed and include steps to improve the baseline issue, a timeline to achieve success, and a measurable goal that will demonstrate success for the issue identified. The success or failure of this plan may have a direct impact on the pharmacy director’s annual performance review. 

Goal Setting and Performance Review Tools
Once the expense trends and annual estimates have been established, goal setting and performance review tools must be created. Our hospital encourages each department to develop its own goals based on the organization’s strategic plan and priorities for the upcoming year. Each goal must include an associated metric that delineates five levels of success, from a minimum (low) attainment to a stretch (high) level of achievement. If the goal is carried over from the previous year, the minimum goal is set to the level achieved at the end of the previous year. New goals are based on the minimum level expected or whatever level a hospital has already achieved. The high level is typically tied to best practice or applicable national standards.

Each department typically develops four to five goals for the year, which are reviewed and approved by the C-suite. For example, we created a goal that at least 90% of patient medications must be dispensed by the ADCs, with a stretch goal of 95%. When the stretch goal of 95% is met, the stretch goal increases. The management team and staff are rewarded financially, proportionate to the level achieved. Results are documented on a monthly, quarterly, and annual basis and posted within the department, so all staff members are aware of the department’s performance throughout the year.

Determining Expense and Revenue Budgets
Annual expense and revenue budgets are derived from a review of several factors. Salaries and drug expense comprise the largest portion of the pharmacy budget, with salary expenses significantly lower than drug expenses for most hospitals. Salary increases are determined by cost of living increases, the economic health of the hospital, and other factors on a local, state, and national level. Maintaining a close working relationship with one’s human resources department will assist in better understanding the bottom line impact of salary changes at a given facility. 

Drug expense increase projections require an understanding of your hospital’s drug usage by drug class, as well as by individual agent. If drug expenses have increased steadily for the past few years at a set percentage, there may be less of a need to evaluate those increases down to the micro level, compared with facilities whose percentage increases have varied dramatically from year to year. Most hospitals, however, have experienced large variability in individual product pricing, with some products rising in price by over 15% in one year while others increase only slightly or may even have decreased due to a newly negotiated contract, for example. Thus, the overall impact on the annual budget is challenging to determine, especially if the costs of thousands of items must be considered.  

80/20 Approach to Drug Expense Evaluation 
Depending on how much time can realistically be dedicated to focusing on budget control, one may consider adopting the 80/20 approach. Closely analyze the financial impact or percent drug expense increase based on the top 20% of drug usage rather than trying to consider the entire drug inventory. This method is less time consuming, while still accurately predicting annual drug expense increases. 

Remember to also consider any factors that could affect drug expenses that are outside of pharmacy’s direct purview. For example, does the oncology department, or other higher volume hospital entity, plan to expand over the next year? Is your hospital close to the eligibility threshold for 340B status? These factors must be considered regardless of which drug expense evaluation approach is chosen. 

Expanding Clinical Programs
Expanding existing programs or offering new clinical programs impacts both salary and revenue projections. Most hospital leaders focus on ensuring the return on investment realized from new or expanded programs will be several times greater than the expense per year. However, with the ever-increasing rapidity of change within the health care industry, more scrutiny to any factor that may cause a greater than five percent budget increase deserves a thorough review of its potential impact on the next budget year. Providing executive summaries of these analyses, both to the C-suite and pharmacy staff, will promote better understanding, teamwork, and overall success. 

Data Warehouse Projects
Many hospitals seek to expand their abilities to compile various data warehouse information into summary reports for trend analysis on a host of subjects. Because data warehouse compilations can capture massive amounts of information, the goal of capture projects should be to select a few key metrics to track and trend. The financial metrics that have proven most useful for our pharmacy department over the past few years include:

  • Orders processed (departmental driver statistics)
  • Total hours paid
  • Drug expense
  • Total revenue over expenses
  • Total expense per unit (per order)

Trending each of these metrics to previous months, as well as to the annual budget, provides valuable insights. For example, if the orders processed increase significantly, one would expect the total hours paid, drug expense, and total revenue over expenses also to increase proportionately. Total expense per order, however, may remain stable or even decrease due to economies of scale or improved efficiencies. If any metrics do not adjust as expected, delving deeper into the analysis and observing operations may be warranted, as continual evaluation leads to continual improvement. 

Applying lean principles identifies waste in the current processes and further increases operational efficiency. For example, if a technician requires thirty minutes to deliver a medication to a hospital unit at the far end of the facility and twenty products per day must be delivered to that unit, it may be prudent to consider using robotics or batch delivery. Having a technician individually deliver all products would require ten hours per day or about seventy hours per week, which is about 1.75 FTEs. Robotics would cost about $25,000 per year compared to over $60,000 for this FTE. So combining robotics with employee delivery options increases the net revenue over expenses, and reduces the total expense per unit.

The ability to understand and accurately evaluate a variety of reports is crucial to robust financial planning. 

  • Financial reports are run monthly and measure a host of parameters related to pharmacy expenses, revenue, and the ratios associated with each.
  • Performance reports focus on the expense and revenue generated compared with budget, which includes monthly comparisons as well as year-to-date comparisons. 
  • Work productivity reports break down the hours worked by each job code within the department; regular hours, overtime, and paid time off are identified from the total hours paid. Close evaluation of this information is useful when evaluating whether the pharmacy has the proper combination of pharmacists, technicians, and support personnel. Further comparison to various staffing models and benchmarking can provide justification when requesting additional personnel or a change in this combination. 

Evaluating the Purchasing Process 
Drug Inventory Turns
Financial analysis in relation to drug purchasing patterns may involve multiple perspectives. The ideal inventory turn level has been debated for many years. Overall, inventory turns should range between 10 and 12 in today’s environment. One needs to balance the workload required to maintain the inventory turn level with the actual opportunity savings from reducing the inventory. 

As the environment becomes more stable, inventory turns should increase, as the higher the number of inventory turns, the less capital must be invested at any given time. One source has suggested that hospitals should aim for a minimum of 14 turns, and ideally, over 16.1 However, given the rising number of national drug shortages, it may be more prudent to lower turns closer to 10 to allow for adequate supplies within a given year. This level assumes that there are sources available to supply medications for extended periods—ideally until the shortage is over—before the shortage actually occurs. Keeping a seven- to 10-day supply of commonly used (and in supply) medications within a hospital may be an accurate barometer of appropriate resource stewardship for today’s environment. For rare items, such as snake venom antidote, one turn a year may be appropriate. 

One effort that has helped keep our drug expense increases lower than average has been the reduction of non-credited medications through better inventory turns and control. Over the past two years, inventory turns have increased from six and a half to over 12, and our average days’ supply of most medications is seven to fifteen days. This improvement has reduced our total no credit returns from $1.3 million to less than $400,000 per year. 

Planning for Capital Purchases
Large expenses—such as new robotics, other automation, and equipment—are usually capitalized over several budget years, so their impact on a specific year is not a significant factor to evaluate, except possibly in the initial year. Evaluating which capital purchases are required hospital-wide requires active, regular communication between pharmacy and each department affected by these purchases. 

Purchasing or leasing automation involves a multiple level approval process. Pharmacy must educate all stakeholders—including the C-suite, finance, information technology, human resources, and possibly other departments—on how the automation may impact the organization in general and their department in particular. The higher the dollar expense of the request, the greater the scrutiny of the request and its alignment with the organization’s strategic plan. Each request should meet specific guidelines and requirements that support a unified approach to the use of technology and automation within the organization. 

Involve the IT department in discussions about what additional automation may be required to interface with existing technology and to avoid duplicating functions already in existence. Also, ensure that adequate IT resources will be available for installation and maintenance before the automation is approved for purchase. If pharmacy happens to submit such a request in a year where multiple departments are undertaking other significant IT projects, even though pharmacy’s request is itself justifiable, the request may be postponed or denied. 

Data Limitations 
While having access to accurate, robust data is an important component of financial planning, data also has its limitations, as it is rarely perfect or complete. Critics may suggest that data can be massaged to support any hypothesis or request, or attack the natural weakness of presented data because the time frame of the study was not long or short enough, because patients’ medication needs have changed since the study was conducted, that the available data does not permit correlation with all of the desired parameters, and so on. Other critics may simply believe that the data does not apply to their facility or that they trust their own experiences more than the data. 

Despite these criticisms, most pharmacy directors would prefer to have access to better data—for example, a larger data warehouse and sophisticated data mining tools that allow a nearly unlimited ability to easily select parameters to compare and analyze across a spectrum of conditions. Computer technology and data management software continue to mature, navigating us toward that ideal. Storing all hospital data in one warehouse promotes win-win scenarios for the patient, pharmacy, and hospital. However, at this time, most EMR systems do not yet provide this level of sophistication. 

Unfortunately, it is not currently realistic to expect to be able to easily capture all inpatients within the last two years who were on two or more drugs in the same class and compare their average overall cost of care, length of stay, and readmission rates, for example. But this depth of data would support more prudent decision making in terms of prescribing habits and drug expenses. Such data may demonstrate that the wisest course is to allow a higher drug expense for that drug class than in previous years, if the overall net gain from a bundled payment for health care environment exists, which may be the case as health care reform evolves. In this scenario, the patient would exhibit better health outcomes while the hospital would remain financially stable to serve future patients, despite the financial analysis suggesting that pharmacy drug expenses were rising higher than expected. 

Preventing Downsizing
In the event of an organization-wide downsizing, the pharmacy director should collect and present relevant data to administration to protect its interests and future vision. Data suggest that pharmacy tends to provide a better bottom line for a hospital when FTEs increase rather than decrease, due to pharmacy’s clinical services promoting better drug expense stewardship; also be sure to note that drug expenses are typically a hospital’s largest budget item. Trend data from one’s own facility as clinical pharmacy services expanded may be the most persuasive evidence. This data may allow pharmacy to increase or maintain FTE levels when other departments are forced to downsize. This trend is the opposite for most other departments, where salary expenses are higher than any other budget item. Another strategy to prevent pharmacy staff downsizing is to provide references in the literature that suggest that downsizing actually costs the organization more in the long term versus the short-term savings gained from such an action in terms of lost work productivity, low morale of remaining employees, customer image, severance pay, and future staff recruitment costs.2 Downsizing is also contrary to the pharmacy profession’s vision for the future where more clinical services will be provided.3,4 Keep in mind that highlighting the perspectives of financial experts, in addition to pharmacy staff, will lend more credibility to pharmacy’s arguments. 

Financial analysis efforts have yielded several positive results at Parkview Regional Medical Center over the past two years. Drug expense increases over the past five years have been nearly nonexistent, while the majority of hospitals nationally have experienced a steady increase averaging over 5% annually or over 20% cumulatively throughout that period. Pharmacy FTEs have expanded for outpatient services, along with a significant volume increase of more than 20%. Our anticoagulation clinic FTE is expanding with new home monitoring device services; this is anticipated to nearly double the total number of patients served, as well as standardize the care of those patients within the health system. 

Our financial analysis and effective drug contract negotiations have supported these successes. Due to these results, future plans include significant expansion of the clinical pharmacy program. 


  1. Managed Healthcare Executive Web site. Beyond purchasing—managing hospital inventory. Accessed August 20, 2012.
  2. Manson BJ. Downsizing Issues: The Impact of Employee Morale and Productivity (Studies on Industrial Productivity). New York, NY: Garland Publishing, Inc; 2000.
  3. Shane R. Critical requirements for health system pharmacy practice models that achieve optimal use of medicines. Am J Health-Syst Pharm. 2011;68(12):1101-1111. 
  4. ASHP Foundation. Pharmacy Practice Model Initiative. Accessed August 21, 2012.


Timothy G. Cmelik, RPh, MBA, is the director of corporate pharmacy for the Parkview Health System in Fort Wayne, Indiana. He received his pharmacy degree from the University of Iowa and his MBA from Iowa State University. Tim provides leadership for pharmacy services across an eight-hospital system, involving inpatient, outpatient, and various clinical services.


The Challenge of Effective Communication 

Multiple challenges may be encountered when performing financial analysis of drug management. Understanding the metrics, statistics, and being able to translate the information into executive summaries with recommendations for administration is essential. An effective executive summary is concise and focused on the primary issue at hand, similar to an SBAR (Situation, Background, Assessment, Recommendation) evaluation tool, and includes a section for describing the situation, its background, an assessment, and recommendations for action. 

Effective communication is fundamental to accurate evaluation of financial needs and future planning. Networking actively within your hospital will make pharmacy more successful in predicting and developing its budget, performance goals, and customer services. Speaking the appropriate language to the stakeholder audience is extremely important, even more so than the actual content of the request. Framing the information in terms that the audience will relate to allows stakeholders to more easily buy into the request and promotes approval. 

The most common mistake that pharmacy directors make when requesting funds is framing the conversation in pharmacy speak— language that is familiar to pharmacy but could be misconstrued by the intended audience. The most effective method of gaining approval is to listen to the audience first, note their concerns, and then frame your speech accordingly. For example, if the goal of the request is to obtain additional pharmacy staff, a pharmacy director may highlight the fact that volume has increased, and therefore pharmacy needs more staff in proportion to the new volume. However, consider that the C-suite may be hearing this same request from multiple departments while only having a set amount in the budget for overall staff increases; thus, the pharmacy director must be able to describe specifically how increasing pharmacy staff will add more value to the organization versus adding staff in another department. A focus on reducing length of stay or readmission rates may be an effective strategy, since these improvements directly impact staffing levels in patient care areas. The pharmacy director also must correlate how pharmacy impacts these metrics and be able to defend these statements using hard data if the pharmacy request is to be approved. Communicating an understanding of the stakeholder’s position will more effectively promote approval of pharmacy’s request, compared with that of another department. 

Despite these best efforts, pharmacy’s request still may be denied. But a denial must not be the end of the process—use the experience as an opportunity to improve your ability to secure funds moving forward. Ask questions to ensure you fully appreciate why the request was denied. Keep in mind that stakeholders are more likely to support requests that benefit them while aligning with the organization’s strategic goals and priorities. 


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