VA’s 157 medical centers serve about 2.3 million veterans each year at a cost of about $14 billion. The Albuquerque medical center provides a wide range of inpatient and outpatient care to about 31,000 veterans who reside primarily in New Mexico, the southern part of Colorado, and the western part of Texas. The center spends about $65 million annually. VA medical centers are authorized to enter into affiliation agreements with nearby medical schools. Through these agreements, VA centers and medical schools may share excess services as a means of improving efficiency of operations and providing patients access to advanced technologies. This may be done through joint acquisition of equipment or contracts that require one party to reimburse the other for the costs of services shared. According to hospital officials, the Albuquerque center currently shares more than 150 medical services, including lithotripsy, with the UNM medical school (see app. II for a detailed discussion of VA’s authority to share services with medical schools). Lithotripsy (in Greek, “stone crusher”) is a process that uses shock waves to fracture kidney stones into pieces small enough to pass through a patient’s urinary tract. While patients may be able to pass smaller stones on their own, many stones are too large to pass through the ureter, which is a gradually narrowing tube within the urinary tract. Before lithotripsy, surgical procedures were often used to remove such stones, requiring a hospital stay. Lithotripsy, by contrast, is generally performed as an outpatient procedure. A specialized piece of equipment—an extracorporeal shock-wave lithotripter—produces the shock waves that break up the kidney stone. Medical personnel needed for the procedure may include a technician to operate the lithotripter, a urologist to monitor and supervise the procedure, and an anesthesiologist or anesthesiology certified registered nurse to administer pain medications and monitor the patient’s overall health during the procedure. Two public and three private hospitals provide lithotripsy in Albuquerque. The Albuquerque VA center provides lithotripsy services to veterans who meet VA’s eligibility criteria. Veterans choosing not to use VA services and nonveterans can obtain lithotripsy services through four other hospitals in Albuquerque—the UNM Health Services Center, a state-operated institution, or three private hospitals (Kaseman Presbyterian, St. Joseph’s, and Lovelace). Each of the latter four hospitals contracts for the use of lithotripsy equipment from one of two sources. UNM has a contract to use VA’s lithotripter at the Albuquerque center; the three private hospitals use a lithotripter supplied under contract with Southwest Therapies, a for-profit company. VA and Southwest Therapies are the only equipment owners in Albuquerque. Previously, hospitals had to send patients needing lithotripsy to health care providers outside the Albuquerque area. The two contractual arrangements for lithotripsy equipment use in Albuquerque differ in several key aspects. The UNM/VA arrangement is based on treatment with a lithotripter permanently located at the Albuquerque center. Under this arrangement, VA provides the site, equipment, technician, nurses, anesthesiologist or anesthesiology certified registered nurse, recovery room, and facility support, while UNM provides the urologist and handles the patient billing services. The arrangement between each of the private hospitals and Southwest Therapies, by contrast, is based on treatment with a mobile lithotripter that is taken to each hospital on a regularly scheduled basis. Southwest Therapies provides the equipment and a technician, while the hospital provides the site, utilities, recovery room, nurses, and other facility support. Under this approach, the urologist and anesthesiologist are private physicians who bill the patient or the patient’s insurance separately for their services, as table 1 shows. Over one-quarter of all lithotripsy procedures for Albuquerque-area patients (353) in 1993 were performed using the Albuquerque center’s lithotripter (see table 2). The procedures were divided nearly equally between VA and UNM patients. Medical centers are generally required to recover the full variable and fixed costs of contract services provided to patients of affiliated medical schools, according to VA’s rate-setting policy. Specifically, the Albuquerque center should include all costs for staffing, equipment usage (including depreciation), supplies, and administration. Variable costs refer to expenses that are incurred only when a lithotripsy procedure is performed, such as staffing, supplies, and administration. For example, if the center used supplies costing $200 for an individual procedure, this amount should be included in the charge. Thus, if 10 procedures were performed, the total cost would be $2,000; likewise, there would be no cost if the center did not perform any procedures. By contrast, fixed costs refer to those expenses that the center incurs regardless of the number of procedures performed. These include equipment depreciation and maintenance, as well as building management. For example, depreciation represents the annual expense of using an asset, such as the lithotripter. Generally, annual depreciation costs are determined by dividing the equipment’s purchase price (less any salvage value) by the number of years of useful life. By allocating this cost evenly over the number of procedures performed, the center can recover its initial investment. The Albuquerque center included the appropriate fixed and variable cost components in its rate-setting process. Nonetheless, the center’s rates were not sufficient to recover all costs. For example, the center charged $1,469 for a basic lithotripsy procedure provided to each UNM patient receiving contract services in 1993. The center had unrecovered costs of $1,894 for each procedure, consisting of $1,670 in fixed costs and $224 in variable costs, as the following sections show. The Albuquerque center incurred total annual fixed costs of $360,387 for lithotripsy services in 1993. The center estimated that a charge of $655 would be sufficient to recover fixed costs in its overall charge for each lithotripsy procedure in 1993. Depreciation costs accounted for the majority of the fixed costs, as table 3 shows. Our analysis showed that a charge of $655 per lithotripsy procedure was not sufficient to recover the center’s fixed costs. This can be seen by comparing the revenues such a charge would produce against the total fixed costs of $360,387 that Albuquerque incurred. Collecting $655 for each of the 155 lithotripsy procedures conducted in 1993 would recover about $101,525, leaving a shortfall of about $258,862 or $1,670 per procedure. This shortfall occurred because the Albuquerque center’s charges were based on an unrealistically high estimate of the total number of lithotripsy procedures it would perform in 1993. The center assumed that its fixed costs would be spread over 882 procedures during the year; the number of procedures actually performed was 155, less than 20 percent of this estimated workload. When we asked how the estimate of 882 had been developed, officials at the center said they based it on a low estimate of the equipment’s annual capacity. VA policy recommends, but does not require, that workload be developed on the basis of a center’s actual usage during the previous year (historical workload) and expected usage under new sharing agreement(s) (potential demand). If this approach had been used by the Albuquerque center, workload would have been estimated at 256 procedures—140 veterans and military beneficiaries served in 1992 and 116 patients targeted in the UNM contract for 1993. Our discussions with center officials indicated that they were unaware of this suggested workload estimating methodology when they developed their 1993 workload estimates. VA’s policy also recognizes that the accuracy of projections will greatly affect the charges assessed for a service that is provided under a sharing agreement with an affiliated medical school. Accordingly, VA recommends that the projected total workload be reviewed quarterly and the charges be adjusted if the revised workload estimate shows the per-procedure cost would change by more than 5 percent. Officials at the center made no effort to revise the charges for the fixed-cost components during 1993 and said that they were unaware of this provision. During 1993, the number of procedures averaged 39 per quarter, with a low of 34 in the second quarter. That the number of procedures performed would be well below the estimated workload was clear early in 1993. Adjustments should have been made to the charges then but were not. To illustrate the effect of this overstated workload on the center’s recovery of contract lithotripsy costs, we examined the center’s charge of $1,469 for a basic lithotripsy procedure. The center’s basic charge may be divided into two cost categories—$755 for the lithotripter and technician and $714 for facilities support, including anesthesiology services. These categories are consistent with those used by other Albuquerque lithotripsy providers and they facilitate our comparative analysis with these providers. Each category contains variable costs (staffing, supplies, or administration) as well as fixed costs (equipment depreciation and maintenance or building management). To estimate the amount of unrecovered costs, we compared the center’s 1993 charges for these cost categories using the center’s workload estimate of 882 and its actual workload of 155 procedures. To fully recover the Albuquerque center’s fixed costs spread over the 155 procedures provided, the center would have needed to charge about $3,360 rather than the $1,469 it actually charged. These charges are summarized in table 4. In February 1994, the center revised its lithotripsy charge for UNM patients.