Transfer Pricing Decision: Hospital Lab Cost Analysis

Background: The Post-Merger Structure

After Academic Hospital and Western Hospital merged, both facilities made minor adjustments by eliminating certain services. Academic Hospital eliminated its small maternity service, while Western Hospital eliminated most of its internal laboratory. Although both hospitals are now owned by a single parent organization, they continue to operate as two separate profit centers, each maintaining its own policies, procedures, and revenue streams.

A dispute arose when Western Hospital demanded a reduction in the fees Academic Hospital was charging for laboratory work associated with Amniocentesis testing, a procedure performed approximately 300 times per year. This procedure had historically been performed in the outpatient department at Western Hospital, but after the merger, most of the associated laboratory work shifted to Academic Hospital rather than remaining at Western.

The Transfer Pricing Dispute

Western Hospital subsequently identified an independent outside laboratory willing to perform the same tests for $375 per procedure, compared to the $400 Academic Hospital was charging. Because Western performs only 300 Amniocentesis tests annually, the dollar amount under discussion was not considered significant by the board. Nonetheless, the joint oversight committee — created when the two hospitals merged — agreed that established guidelines required a prompt decision to resolve the dispute and determine the best arrangement for this testing going forward.

The joint oversight committee determined that the direct variable costs of labor and supplies for performing the Amniocentesis laboratory work amounted to $300 per test. In addition, Academic Hospital was charging an extra $90 to cover fixed costs that would be incurred regardless of whether the laboratory work was performed at Academic, plus an additional $60 representing Academic's profit margin. Understanding the distinction between fixed and variable costs was central to the committee's evaluation.

Cost Breakdown and Committee Findings

The committee also noted that Western Hospital was currently earning $105 in profit for each complete test administered. It further calculated that Western could increase that profit by an additional $75 — achieving $180 per test — if it could obtain the laboratory work for $75 less, paying $300 at the outside laboratory rather than the $375 it had quoted.

In reviewing the spreadsheets comparing variable, mixed, fixed, negotiable, and total costs and patient charges for both hospitals, the committee conducted its own evaluation to help resolve the dispute. The analysis showed that if Western negotiated a price of $300 per test — $75 less than the $375 outside laboratory rate — it would earn a profit of $180 per test, generating total annual revenue of $144,000 across the 300 procedures.

Conclusion and Recommendation

With neither the negotiated price nor the market price at Western changing its overall earnings, allowing Academic Hospital to provide this laboratory service enables the parent organization to bring in $165,000 in annual profit — $21,000 more than Western can generate on its own. Because the testing remains profitable for at least one of the hospitals, the committee concluded that Academic Hospital should be the sole provider of Amniocentesis laboratory services, freeing Western Hospital to focus its resources on other priorities within its own facility. This outcome reflects how transfer pricing decisions in multi-entity organizations should prioritize the financial health of the parent company as a whole rather than optimizing for any single subsidiary.