What is driving our operating margin decline?

Healthcare operating margins averaged 1.5% in 2025, down from 3.2% in 2022. The three most common margin compressors are labor cost increases (averaging 8% YoY), supply chain inflation on surgical supplies, and payer mix shift toward lower-reimbursing plans.

The healthcare margin compression story from 2022–2025 is well documented in KaufmanHall Flash Reports, but understanding what is driving your specific organization's decline requires separating three fundamentally different mechanisms. Each responds to different interventions and has different timelines for improvement.

Labor cost increases are the most visible and most discussed driver. Healthcare labor costs rose an average of 8% annually from 2022–2025, driven by travel nurse dependency, wage compression from minimum wage increases, and retention bonuses that became permanent pay increases. For most hospitals, labor now represents 55–65% of net patient revenue—the upper end of the AHA's benchmark range. Productivity metrics (revenue per FTE, patient encounters per clinical FTE) are the leading indicators for labor cost trends, but most organizations report on labor cost in dollars rather than productivity ratios, which makes early warning difficult.

Supply chain inflation is the second driver, concentrated in surgical supplies. Implant costs, surgical instruments, and single-use sterile supplies have inflated 6–12% annually while CMS MS-DRG reimbursement updates average 2–3% per year. This creates a structural margin erosion for any service line that is supply-intensive—orthopedics, cardiovascular, spine. The inflation rate differential means that without supply standardization or implant cost controls, surgical service lines lose margin automatically every year even when volume and reimbursement remain flat.

Payer mix shift is the hardest margin driver to see in standard reporting, and it is often the most significant. When commercial patients transition to Medicare Advantage, Medicare, Medicaid, or self-pay—whether through aging demographics, employer insurance changes, or economic shifts—the volume at the practice stays the same but revenue per encounter drops 30–45%.

Volume dashboards show stable or growing patient counts, which masks the payer mix deterioration. Revenue dashboards show declining revenue per encounter, which is often attributed to denial rate or coding problems rather than the underlying payer mix shift. The correct diagnostic is to look at payer mix percentage by quarter (commercial vs. government vs. self-pay) and calculate revenue per encounter by payer category separately. When these two trend lines are layered together, the payer mix contribution to revenue per encounter decline becomes visible.

Supply cost per case is similarly hidden in aggregate supply expense numbers. Total supply costs may look stable, but if case mix has shifted toward higher-acuity cases with higher supply requirements, per-case costs are rising while aggregate numbers are masked by volume changes. Surgeon-level supply cost variance—same procedure, different surgeons—can span 40% without appearing in any standard financial report.

Establish a payer mix monitoring dashboard that tracks commercial, Medicare, Medicare Advantage, Medicaid, and self-pay as a percentage of total encounters quarterly. Set alert thresholds for any payer category that shifts more than 2 percentage points in a quarter. This converts payer mix change from a retrospective finding to an early warning signal that triggers proactive response—whether that is increasing commercial patient outreach, reviewing MA contract rates, or adjusting service line strategy.

For labor cost, shift from tracking total FTE count to tracking revenue and encounter volume per clinical FTE by department. Labor productivity metrics surface inefficiency before it appears in the cost-percentage numbers. A department with stable FTE count but declining encounters per FTE is accumulating excess labor capacity that won't become visible in aggregate labor cost reports until several quarters later.

Implement a supply standardization program for your top 5 highest-supply-cost procedure categories. Surgeon preference card reviews conducted annually with supply cost data visible to surgeons typically achieve 8–15% supply cost reduction without compromising clinical outcomes. Transparency— showing surgeons their individual supply cost per case compared to peers performing the same procedure—is the most effective mechanism identified by Premier Healthcare Alliance benchmarking data.