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Buy, lease, or rent: which way to go under DRGs? Prospective payment is changing the relative advantages and disadvantages of instrument acquistion alternatives

Medical Laboratory Observer, August, 1984 by J. Lloyd Johnson

The question must be asked each time an instrument acquisition is planned: Should a hospital laboratory purchase the instrument outright or opt for one of the two basic alternatives that became increasingly popular during the 1970s--leasing or a reagent rental? The correct answer may be worth a considerable amount of money to the hospital.

Title is held by the hospital in a purchase, by the leasing company in a lease, and by the manufacturer in a rental. The reagent rental agreement typically includes reagents, supplies, and maintenance service along with use of the instrument. (The box on page 37 discusses how leasing developed as an alternative to purchasing.)

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Superficially, it would appear that the laboratory merely has to determine the interest cost of each alternative and pick the least expensive. Interest cost is indeed an important consideration, but there are a host of other issues, including the useful life of the instrument, depreciable life, investment tax credits, and maintenance and supply convenience. Prospective payment is changing the relative importance of each of these issues. Let's examine them in turn:

* Interest cost. In the case of a purchase, this cost is what the hospital would have to pay for money borrowed to buy the instrument or, if the money comes from hospital surplus, the interest income the hospital would forgo. From the perspective of the laboratory, interest cost is equivalent to the hospital's internal rate of return, a percentage arbitrarily established by the chief financial officer to facilitate the evaluation of multiple demands for capital from all departments and services. The rate is modified as external interest rates (money market conditions) and the hospital's balance sheet change.

If the hospital is organized as a nonprofit insititution and has substantial unused borrowing capacity, tax-exempt money may be available at relatively low cost. But if the hospital has a moderately high debt-to-equity ratio, its banks may make capital available only at one or more percentage points above the prime rate. And if the debt-to-equity ratio is too high, any additional bank financing that the hospital can obtain must be reserved for short-term working capital requirements.

Figure I shows how interest cost is taken into account in a comparison of a purchase with with the best lease quotation available--$25 per month per thousand dollars for five years, with a 10 per cent purchase option at the end of the lease, for a $100,000 instrument. That's a $2,500 monthly lease payment, or $30,000 annually for five years, and an added 10 per cent of the original instrument cost, or $10,000 more, in the last year for the purchase option.

In making the comparison between purchasing and leasing, interest cost, at the hospital's internal rate of return, can be added to the purchase price or, as we have chosen, it may be discounted from the lease payments. The discount rate, which is compounded, reflects the fact that future fixed lease payments are worth progressively less than money paid out for a purchase today.

What if the hospital's internal rate of return is 15 per cent? Compounded over the course of a year of lease payments, and from year to year, at 15 per cent discount rate reduces the total lease cost from $160,000 to $102,500 for the five-year term. Since that's still $2,500 higher than the purchase price, the hospital lab is better off purchasing the instrument than leasing it, taking just the cost of money into consideration.

On the other hand, Figure I also shows that the two instrument acquisition options are financially equivalent when the hospital's internal rate of return is 16 per cent. The five-year lease cost comes down to a bit over $100,000.

The same process is employed in evaluating a rental. But since reagents and service are part of the arrangement, the two components must be separated from the capital component.

Let's assume the reagent rental quotation on the same $100,000 instrument is $5,000 per month. If the instrument were purchased, the manufacturer would charge $1,000 per month for a maintenance service contract and $1,500 per month for the reagents and supplies (at the expected instrument usage rate). Subtracting these items from the $5,000 monthly rental payment leaves the same $2,500 per month, or $30,000 a year, as in the lease option. Under the contract terms cited, if the hospital's internal rate of return is 16 per cent, the financial effects of purchasing, leasing, and renting are identical.

As we have noted, however, a number of other issues are involved. In the framework of these issues--such as useful life and depreciable life--purchasing, leasing, and renting have pros and cons that can be largely quantified into cost of money. With prospective payment, some of the advantages of lease and rental disappear, and some of the disadvantages have increased significance:

* Useful life. Here we estimate how long the laboratory will keep using the instrument. Useful life has mechanical and technical aspect. In the first instance, as any instrument ages, its parts fail and have to be replaced. Thus, the cost of maintaining the instrument increases with time.

Health Care Industry

Buy, lease, or rent: which way to go under DRGs? Prospective payment is changing the relative advantages and disadvantages of instrument acquistion alternatives

Medical Laboratory Observer, August, 1984 by J. Lloyd Johnson

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