Hospital Intelligence Brief
How Labor Expense Changes Can Affect Operating Margins
Labor is the largest cost in most hospitals, so small changes in rate, hours or mix move margin more than almost anything else. Knowing which one moved is the first step.
Short answer
Labor is the largest hospital cost, at about 56 percent of total hospital costs according to the American Hospital Association, so a small percentage change in wage rates, hours per case, overtime, contract labor or skill mix can swing operating margin more than most other costs. Separating those causes is the first step to a response.[1]
Why does labor dominate hospital margins?
For most hospitals, labor is the single largest expense. The American Hospital Association’s 2025 Cost of Caring report states that total compensation and related expenses now account for 56 percent of total hospital costs, even as drug and other non-labor costs grow quickly.[1] A change that looks small as a percentage can be large in dollars, and unlike supplies, labor rarely falls when volume dips, because units must be staffed to safe levels regardless of the daily census.
The consequence for margin is easy to calculate. If labor is 56 percent of costs and costs are, say, 95 percent of revenue, then labor is about 53 percent of revenue. A 3 percent increase in labor cost with no change in revenue lowers operating margin by roughly 1.6 percentage points. The numbers are illustrative, but the sensitivity is real.
What are the sources of a labor cost change?
A labor increase can come from very different places, and they look the same on the income statement. Wage rates may rise because of market adjustments or union contracts. The AHA reports that advertised salaries for registered nurses have grown 26.6 percent faster than inflation over the past four years, a figure from its analysis of Lightcast data.[1] Hours per case may rise because of higher acuity or longer stays. Overtime and contract or agency labor may rise because of vacancies. And skill mix may shift toward more expensive roles.
MedPAC’s data show how large the premium-labor swing can be. The commission reported that growth in hospitals’ labor costs slowed to under 2 percent in 2024 from about 9 percent in 2023, driven by an $8 billion decline in hospitals’ spending on direct patient-care contract labor, a drop of about 25 percent.[2] A hospital that saw labor cost jump in 2023 and ease in 2024 may be seeing exactly that pattern. A hospital whose labor cost keeps climbing is more likely seeing rate or hours growth.
How do you separate rate, hours and mix?
Separating the sources needs data many hospitals already hold but seldom put side by side: employed versus contract and agency labor, overtime hours, hours per case and per patient day by department, average hourly rate by role, and vacancies and turnover. With that data, a simple variance analysis splits the change in labor cost into a rate effect (price paid per hour), an efficiency effect (hours per unit of volume), a volume effect and a mix effect.
Without that detail, a useful first analysis compares labor growth with volume growth and sizes how sensitive margin is to labor. That does not explain the cause, but it shows how much it matters. If labor cost per adjusted discharge rose 5 percent while volume rose 1 percent, the question becomes where that 5 percent sits.
Is labor the only cost pressure?
No. Kaufman Hall’s August 2026 report said non-labor expense per adjusted discharge rose 6 percent year to date compared with 2025, with supply expense up 5 percent and drug expense up 6 percent.[3] A hospital attributing its entire margin decline to labor may be missing supply and drug trends. The reverse is also true: a supply cost initiative will not offset a labor increase that is larger.
The practical approach is to rank cost categories by their contribution to the total cost increase, not by their growth rate alone. A category growing 10 percent but representing 2 percent of expense contributes less than one growing 4 percent that represents 56 percent.
What responses fit each cause?
If the cause is premium labor from vacancies, the response is recruitment, retention and scheduling, not wage cuts. If it is hours per case, the response is workflow, staffing models and length-of-stay management. If it is wage rates, the response is a decision about market position and productivity targets. If it is mix, the response is role design. Each has different timing and trade-offs, which is why identifying the cause comes before setting a savings target.
The interactive example at the end of this page lets you vary labor cost, volume and revenue to see their effect on margin. It uses invented figures for illustration.
Frequently asked questions
What percent of hospital costs is labor?
The American Hospital Association reports that total compensation and related expenses account for 56 percent of total hospital costs.[1]
How much do hospital labor costs affect margin?
A lot: with labor near 56 percent of costs, a few percentage points of labor cost growth with flat revenue can reduce operating margin by more than a point.
What happened to hospital contract labor spending recently?
MedPAC reported an $8 billion decline in direct patient-care contract labor spending in 2024, about 25 percent.[2]
Are non-labor costs also rising?
Kaufman Hall reported non-labor expense per adjusted discharge up 6 percent year to date through August 2026, with supplies up 5 percent and drugs up 6 percent.[3]
How can a hospital tell why labor costs rose?
Split the change into rate, hours, volume and mix effects using department-level hours, rates, overtime and contract labor data.
What to do next
- Compare labor cost growth with volume growth by department.
- Pull overtime, contract labor and vacancy data.
- Split the change into rate, hours and mix effects.
- Rank all cost categories by their contribution to the total increase.
Optional · interactive example
See it in an interactive example.
Hospital Financial Investigator: a working dashboard, scenario simulator, evidence-linked answers from APIS, and a sample executive brief, all on synthetic data.
The experience below is built on a synthetic hospital, “Demo Community Hospital,” with two fiscal years of data. Nothing in it is real, so you can explore freely.
- In the Scenario tab, raise the labor cost rate by 3% and note how much operating income falls.
- Now raise volume by 5%. Does the volume gain cover the labor increase?
- On the Dashboard, select the Labor row in the expense table and see its share of the total increase.
Explore Your Hospital’s Opportunities
Two Pillars can help hospital leadership investigate market, financial, operational and strategic questions using relevant organizational data, public information and a structured assessment process. A good first step is a short financial performance review that places revenue, expense, volume and margin side by side and shows where the pressure actually sits.
Sources
- American Hospital Association, The Cost of Caring: Challenges Facing America’s Hospitals in 2025. Accessed October 2026.
- Medicare Payment Advisory Commission (MedPAC), Report to the Congress, March 2026, Chapter 3: Hospital inpatient and outpatient services. Accessed October 2026.
- Kaufman Hall (Vizient), National Hospital Flash Report: August 2026 Data (October 13, 2026). Accessed October 2026.
Sources checked October 2026. This guide is general information for healthcare leaders and is not legal, financial, clinical or compliance advice. Figures and rules are cited to the sources below and may have changed since they were accessed, so confirm anything you rely on against the current source. Two Pillars & Co is independent of the organizations cited. See our editorial policy.