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CHAPTER

HEALTHCARE FINANCE BASICS

Introduction

In today’s healthcare environment, where financial realities play an important role in health services decision making, it is vital that managers at all levels understand the basic concepts of healthcare finance and how these concepts are used to enhance the financial well-being of the organization. In this chapter, we introduce readers to the book, including its purpose, goals, and organi- zation. Furthermore, we present some basic background information about healthcare finance and the health services system. We sincerely hope that this book will be a significant help to you in your quest to increase your profes- sional competency in the important area of healthcare finance.

Before You Begin

Before you begin the study of healthcare finance, here are a few tips about the book that will make the process easier.

1 Learning Objectives After studying this chapter, readers will be able to

• Describe the organization of this book and the learning aids contained in each chapter.

• Define the term healthcare finance as it is used in this book. • Describe the key characteristics of a business. • Discuss the structure of the finance department, the role of finance

in health services organizations, and how this role has changed over time.

• Describe the major players in the health services industry. • List the key operational issues currently faced by healthcare

managers. • Describe the alternative forms of business organization and

corporate ownership and their organizational goals. • Discuss the key elements of healthcare reform and its expected

effect on the provision of health services.

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C o p y r i g h t 2 0 1 6 . H e a l t h A d m i n i s t r a t i o n P r e s s .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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H e a l t h c a r e F i n a n c e4

Purpose of the Book Many books cover the general topics of accounting and financial management, so why is a book needed that focuses on healthcare finance? The reason is that while all industries have certain individual characteristics, the health services industry is truly unique. For example, the provision of healthcare services is dominated by not-for-profit corporations, both private and governmental, and such entities are inherently different from investor-owned businesses. Also, the majority of payments made to healthcare providers are not made by the indi- viduals who use the services but by third-party payers (e.g., employers, com- mercial insurance companies, government programs). Throughout this book, the ways in which the unique features of the health services industry influence the application of finance principles and practices are emphasized.

This book is designed to introduce students to healthcare finance, which has two important implications. First, the book assumes no prior knowledge of the subject matter; thus, the book is totally self-contained, with each topic explained from the beginning in basic terms. Furthermore, because clarity is so important when concepts are introduced, the chapters have been written in an easy-to-read fashion. None of the topics is inherently difficult, but new concepts often take some effort to understand. This process is made easier by the writing style used.

Second, because this book is introductory, it contains a broad overview of healthcare finance. The good news here is that the book presents virtually all the important healthcare finance principles that are used by managers in health services organizations. The bad news is that the large number of topics covered prevents us from covering principles in great depth or from includ- ing a wide variety of illustrations. Thus, students who use this book are not expected to fully understand every nuance of every finance principle and practice that pertains to every type of health services organization. Nevertheless, this book provides sufficient knowledge of healthcare finance so that readers will be better able to function as managers, judge the quality of financial analyses performed by others, and incorporate sound principles and practices into their own personal finance decisions.

Naturally, an introductory finance book does not contain everything that a healthcare financial manager must know to competently perform his or her job. Nevertheless, the book is useful even for those working in finance positions within health services organizations because it presents an overview of the finance function. Often, when one is working in a specific area of finance, it is too easy to lose sight of the context of one’s work. This book will help provide that context.

Organization of the Book In Alice’s Adventures in Wonderland, Lewis Carroll wrote: “If you don’t know where you are going, any road will get you there.” Because not just any road

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 5

will ensure that this book meets its goals, the destination has been carefully charted: to provide an introduction to healthcare finance. Furthermore, the book is organized to pave the road to this destination.

Part I, The Healthcare Environment, contains fundamental background material essential to the practice of healthcare finance. In essence, Part I intro- duces the book, provides insights into the uniqueness of the health services industry, and provides additional information on how healthcare providers obtain their revenues. Healthcare finance cannot be studied in a vacuum because the practice of finance is profoundly influenced by the economic and social environment of the industry, including alternative types of ownership and reimbursement methods.

Part II, Financial Accounting, begins the actual discussion of healthcare finance principles and practices. Financial accounting, which involves the cre- ation of statements that summarize a business’s financial status, is most useful for outsiders and for long-term planning and management. In this part, we discuss the format and interpretation of the four primary financial statements.

Part III, Managerial Accounting, which consists of four chapters, focuses on the creation of data used in the day-to-day management and control of a business. Here, the emphasis begins with the overall organization, then it shifts to the subunit (department) level, and finally it reaches the individual service level. The key topics in Part III include costing methods and behavior, profit planning, cost allocation, pricing and service decisions, and financial planning and budgeting.

In Part IV, Basic Financial Management Concepts, the focus moves from accounting to financial management. Here we first cover time value analysis, which provides techniques for valuing future cash flows. The second of the two chapters in this part discusses financial risk and required return. Taken together, these chapters provide readers with knowledge of two of the most important concepts used in financial decision making.

Part V, Long-Term Financing, turns to the capital acquisition process. Businesses need capital, or funds, to purchase assets, and this part examines the two primary types of financing—long-term debt and equity. In addition, the final chapter of Part V provides the framework for analyzing a business’s appropriate financing mix and assessing its cost.

Part VI, Capital Investment Decisions, considers the vital topic of how businesses analyze new capital investment opportunities (capital budgeting). Because major capital projects take years to plan and execute, and because these decisions generally are not easily reversed and will affect operations for many years, their impact on the future of an organization is profound. The two chapters in this part first focus on basic capital investment analysis concepts and then turn to project risk assessment and incorporation.

Part VII, Other Topics, covers two diverse topics. The first chapter in this part discusses the revenue cycle and the management of short-term

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H e a l t h c a r e F i n a n c e6

assets, such as cash and inventories, as well as how such assets are financed. The techniques used to analyze a business’s financial and operating condition are discussed in the book’s final chapter. Health services managers must be able to assess the current financial condition of their organizations. Even more important, managers must be able to monitor and control current operations and assess ways in which alternative courses of action will affect the organiza- tion’s future financial condition.

In addition to the printed text, two chapters are available from the publisher’s website for this book. Chapter 18, Lease Financing and Business Valuation, contains information on leasing and how to value entire businesses, and Chapter 19, Distributions to Owners: Bonuses, Dividends, and Repur- chases, discusses how profits in investor-owned businesses are returned to owners. To access these chapters, visit ache.org/books/HCFinance6.

How to Use This Book As mentioned earlier, the book is designed to introduce students to healthcare finance. The book contains several features designed to make the process as easy as possible.

First, pay particular attention to the Learning Objectives listed at the beginning of each chapter. These objectives provide a feel for the most impor- tant topics in each chapter and what readers should set as learning goals for the chapter.

Following each major section in a chapter (except the chapter’s Intro- duction), one or more Self-Test Questions are included. As you finish reading each major section, try to provide reasonable answers to these questions. Your responses do not have to be perfect, but if you are not satisfied with your answer, it would be best to reread the section before proceeding. Answers are not provided for the self-test questions, so a review of the section is indicated if you are in doubt about whether your answers are satisfactory.

It is useful for readers to have important equations both embedded in the text to illustrate their use and broken out separately to permit easy identi- fication and review. The Key Equation boxes can be used both for section and chapter review and as an aid to working end-of-chapter problems. In addi- tion, the book contains several types of boxes, such as For Your Consideration and Industry Practice boxes. Each of these boxes presents an important issue relevant to the text discussion and allows readers to pause for a few moments to think about the issue presented, generate opinions, and draw conclusions. Many instructors use these boxes to stimulate in-class discussions.

Within the book, italics and boldface are used to indicate importance. Italics are used whenever a key term is introduced; thus, italics alert readers that a new and important concept is being presented. Boldface indicates terms that are defined in each chapter’s running glossary, which complements the glossary at the back of the book, and is also occasionally used for emphasis.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 7

In addition to in-chapter learning aids, materials designed to help read- ers learn healthcare finance are included at the end of each chapter. First, each chapter ends with a summary section titled Key Concepts, which briefly sum- marizes the most important principles and practices covered in that chapter. If the meaning of a key concept is not apparent, you may find it useful to review the applicable section. Each chapter also contains a series of Questions designed to assess your understanding of the qualitative material in the chapter. In most chapters, the questions are followed by a set of Problems designed to assess your understanding of the quantitative material. Additionally, each chapter ends with a set of Resources. The books and articles cited can provide a more in-depth understanding of the material covered in the chapter. Finally, some chapters contain a Chapter Supplement, whose purpose is to present additional information pertaining to topics in the chapter that is useful but not essential.

Taken together, the pedagogic structure of the book is designed to make learning healthcare finance as easy and enjoyable as possible.

Defining Healthcare Finance

What is healthcare finance? Surprisingly, there is no single answer to that question because the definition of the term depends, for the most part, on the context in which it is used. Thus, in writing this book, the first step was to establish the definition of healthcare finance.

We began by examining the healthcare sector of the economy, which con- sists of a diverse collection of subsectors that involve, either directly or indirectly, the healthcare of the population. The major subsectors include the following:

• Health services. The health services subsector consists of providers of health services, including medical practice, hospital, nursing home, home health care, and hospice industries.

• Health insurance. The health insurance subsector, which makes most of the payments to health services providers, includes government programs and commercial insurers as well as self-insurers. Also included here are managed care companies, such as health maintenance organizations, which incorporate both insurance and health services (provider) functions.

1. Why is it necessary to have a book dedicated to healthcare finance?

2. What is the purpose of this book? 3. Briefly describe the organization of this book. 4. What features in the book are designed to make learning easier?

SELF-TEST QUESTIONS

Provider An organization that provides healthcare services (treats patients).

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H e a l t h c a r e F i n a n c e8

• Medical equipment and supplies. These subsectors include the makers of diagnostic equipment, such as X-ray machines; durable medical equipment, such as wheelchairs; and expendable medical supplies, such as disposable surgical instruments and hypodermic syringes.

• Pharmaceuticals and biotechnology. These subsectors develop and market drugs and other therapeutic products.

• Other. This category includes a diverse collection of organizations ranging from consulting firms to educational institutions to government and private agencies.

Most users of this book will become (or already are) managers at health services organizations or at companies such as insurance and consulting firms that deal directly with health services organizations. Thus, to give this book the most value to its primary users, we focus on finance as it applies within the health services subsector. Of course, the principles and practices of finance cannot be applied in a vacuum but must be based on the realities of the current healthcare environment, including how health services are financed. Further- more, insurance involves payment to healthcare providers; much of managed care involves utilization management of providers, either directly or through contracts; and most consulting work is done for providers, so the material in this book is also relevant for managers in industries related to health services.

Now that we have defined the healthcare focus of this book, the term finance must be defined. Finance, as the term is used within health services organizations and as it is used in this book, consists of both the accounting and financial management functions. (In many settings, accounting and finan- cial management are separate disciplines.) Accounting, as its name implies, is concerned with the recording, in financial terms, of economic events that reflect the operations, resources, and financing of an organization. In general, the purpose of accounting is to create and provide to interested parties, both internal and external, useful information about an organization’s operations and financial status.

Whereas accounting provides a rational means by which to measure a business’s financial performance and assess operations, financial management provides the theory, concepts, and tools necessary to help managers make better financial decisions. Of course, the boundary between accounting and financial management is blurred; certain aspects of accounting involve decision making, and much of the application of financial management theory and concepts requires accounting data.

Accounting The field of finance that involves the measuring and recording of events, in dollar terms, that reflect an organization’s operational and financial status.

Financial management The field of finance that provides the theory, concepts, and tools used by healthcare managers to make financial decisions.

1. What is meant by the term healthcare finance? 2. What is the difference between accounting and financial management?

SELF-TEST QUESTIONS

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 9

Concept of a Business

This book focuses on finance as practiced within health services businesses, so it is reasonable to ask this question: What is a business? If this question were asked to a group of accountants, the answer probably would involve financial statements, such as the income statement and balance sheet, which we cover in chapters 3 and 4. However, if the question were posed to a group of lawyers, the answer likely would include legal forms of business, which we describe later in this chapter.

From a financial (economic) perspective, a business can be thought of as an entity (its legal form does not matter) that (1) obtains financing (capital) from the marketplace; (2) uses those funds to buy land, buildings, and equip- ment; (3) operates those assets to create goods or services; and then (4) sells those goods or services to create revenue. To be financially viable, a business has to have sufficient revenue to pay all of the costs associated with creating and selling its goods or services.

Although this description of a busi- ness is surprisingly simple, it tells a great deal about the basic decisions that business managers must make. One of the first deci- sions is to choose the best legal form for the business. Then, the manager must decide how the business will raise the capital that it needs to get started. Should it borrow the money (use debt financing), raise the money from owners (or from the community if not- for-profit), or use some combination of the two sources? Next, once the start-up capital is raised, what physical assets (facilities and equipment) should be acquired to create the services that (in the case of healthcare providers) will be offered to patients?

Note that businesses are profoundly different from pure charities. A business, such as a hospital or medical practice, sus- tains itself financially by selling goods or services. Thus, it is in competition with other businesses for the consumer dollar. A pure charity, such as the American Heart Association, on the other hand, does not sell goods or services. Rather, it obtains funds by soliciting contributions and then uses

For Your Consideration Businesses, Pure Charities, and Governmental Entities

A healthcare business relies on revenues from sales to create financial sustainability. For exam- ple, if a hospital’s revenues exceed its costs, cash is being generated that can be used to provide new and improved patient services and the hos- pital can continue to meet community needs. On the other hand, pure charities, such as the Ameri- can Red Cross, rely on contributions for revenues, so the amount of charitable services provided (which typically are free) is limited by the amount of contributions received. Finally, most govern- mental units are funded by tax receipts, so, as with charities, the amount of services provided is limited, but in this case by the taxing authority’s ability to raise revenues. Yet, in spite of differ- ences, all three types of organizations must oper- ate in a financially prudent manner.

What do you think? From a finance perspec- tive, how different are these types of organiza- tions? How does the day-to-day functioning of their respective finance departments vary? Is finance more important in one type of organiza- tion than in another?

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H e a l t h c a r e F i n a n c e10

those funds to supply charitable (free) services. In essence, a pure charity is a budgetary organization in that the amount of contributions fixes its budget for the year.

Also, businesses are different from governmental agencies such as local public health departments. In general, governmental agencies do not receive revenues by selling services or by soliciting contributions. Rather, the reve- nues are derived from taxing the populations that benefit from the govern- mental services, so providing additional services typically uses resources with- out generating additional income. Thus, like a pure charity, a governmental agency has a budget that is fixed, but by appropriations rather than by contributions.

The Role of Finance in Health Services Organizations

The primary role of finance in health services organizations, as in all busi- nesses, is to plan for, acquire, and use resources to maximize the efficiency and value of the enterprise. As we discuss in the next section, the two broad areas of finance—accounting and financial management—are separate functions in larger organizations, although the accounting function usually is carried out under the direction of the organization’s chief financial officer and hence falls under the overall category of finance.

In general, finance activities include the following:

• Planning and budgeting. First and foremost, healthcare finance involves evaluating the financial effectiveness of current operations and planning for the future. Budgets play an important role in this process.

• Financial reporting. For a variety of reasons, it is important for businesses to record and report to outsiders the results of operations and current financial status. This is typically accomplished by a set of financial statements.

• Capital investment decisions. Although capital investment is more important to senior management, managers at all levels must be concerned with the capital investment decision-making process. Decisions that result from this process, which are called capital budgeting decisions, focus on the acquisition of land, buildings, and equipment. They are the primary means by which businesses

1. From a financial perspective, briefly describe a business. 2. What is the difference between a business and a pure charity?

Between a business and a governmental agency?

SELF-TEST QUESTIONS

Budget A detailed plan, in dollar terms, of how a business and its subunits will acquire and utilize resources during a specified period of time.

Financial statements Statements prepared by accountants that convey the financial status of an organization. The four primary statements are the income statement, balance sheet, statement of changes in equity, and statement of cash flows.

Capital budgeting The process of analyzing and choosing new long-term assets such as land, buildings, and equipment.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 11

implement strategic plans, and hence they play a key role in an organization’s financial future.

• Financing decisions. All organizations must raise capital to buy the assets necessary to support operations. Such decisions involve the choice between internal and external funds, the use of debt versus equity capital, the use of long-term versus short-term debt, and the use of lease versus conventional financing. Although senior managers typically make financing decisions, these decisions have ramifications for managers at all levels.

• Revenue cycle and current accounts management. Revenue cycle management includes the billing and collections function, while current accounts management involves the organization’s short-term assets, such as cash and inventories, and short-term liabilities, such as accounts payable and debt. Such functions and accounts must be properly managed both to ensure operational effectiveness and to reduce costs. Generally, managers at all levels are involved to some extent in revenue cycle and current accounts management.

• Contract management. In today’s healthcare environment, health services organizations must negotiate, sign, and monitor contracts with managed care organizations and third-party payers. The financial staff typically has primary responsibility for these tasks, but managers at all levels are involved in these activities and must be aware of their effects on operating decisions.

• Financial risk management. Many financial transactions that take place to support the operations of a business can themselves increase the business’s risk. Thus, an important finance activity is to control financial risk.

These specific finance activities often are summarized by the four Cs: costs, cash, capital, and control. The measurement and minimization of costs is vital to the financial success of any business. Rampant costs, as compared to revenues, usually spell doom for any business. A business can be profitable but still face a crisis due to a shortage of cash. Cash is the “lubricant” that makes the wheels of a business run smoothly—without it, the business grinds to a halt. Capital represents the funds used to acquire land, buildings, and equipment. Without capital, businesses would not have the physical resources needed to provide goods and services. Finally, a business must have adequate control mechanisms to ensure that its capital is being wisely employed and its physical resources are protected for future use.

In times of high profitability and abundant financial resources, the finance function tends to decline in importance. Thus, at the time when most healthcare providers were reimbursed on the basis of costs incurred, the role of

Capital The funds raised by a business that will be invested in assets, such as land, buildings, and equipment, that support the organizational mission.

Four Cs A mnemonic for the basic finance activities: costs, cash, capital, and control.

Cost A resource use associated with providing or supporting a specific service.

those funds to supply charitable (free) services. In essence, a pure charity is a budgetary organization in that the amount of contributions fixes its budget for the year.

The Role of Finance in Health Services Organizations

In general, finance activities include the following:

1. From a financial perspective, briefly describe a business. 2. What is the difference between a business and a pure charity?

Between a business and a governmental agency?

SELF-TEST QUESTIONS

Budget A detailed plan, in dollar terms, of how a business and its subunits will acquire and utilize resources during a specified period of time.

Capital budgeting The process of analyzing and choosing new long-term assets such as land, buildings, and equipment.

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H e a l t h c a r e F i n a n c e12

finance was minimal. The most critical finance function was cost identification because it was more important to account for costs than it was to control them. In response to payer (primarily Medicare) requirements, providers (primarily hospitals) churned out a multitude of reports both to comply with regulations and to maximize revenues. The complexities of cost reimbursement meant that a large amount of time had to be spent on cumbersome accounting, billing, and collection procedures. Thus, instead of focusing on value-adding activi- ties, most finance work focused on bureaucratic functions.

In recent years, however, providers have been redesigning their finance functions in recognition of the changes that have occurred in the health ser- vices industry. Although billing and collections remain important, to be of maximum value to the enterprise today the finance function must support cost containment efforts, third-party payer contract negotiations, joint venture decisions, and integrated delivery system participation. In essence, finance must help lead organizations into the future rather than merely record what has happened in the past.

In this book, the emphasis is on the finance function, but there are no unimportant functions in healthcare organizations. Senior executives must understand a multitude of other functions, such as operations, marketing, facilities management, and human resource management, in addition to finance. Still, all business decisions have financial implications, so all managers—whether in operations, marketing, personnel, or facilities—must know enough about finance to properly incorporate any financial implications into decisions made within their own specialized areas.

The Structure of the Finance Department

The size and structure of the finance department within health services organiza- tions depend on the type of provider and its size. Still, the finance department within larger provider organizations generally follows the model described here.

The head of the finance department holds the title chief financial officer (CFO) or sometimes vice president–finance. This individual typically reports directly to the organization’s chief executive officer (CEO) and is respon- sible for all finance activities within the organization. The CFO directs two senior managers who help manage finance activities. First is the comptroller (pronounced, and sometimes spelled, “controller”), who is responsible for

1. What is the role of finance in today’s health services organizations?

2. How has this role changed over time? 3. What are the four Cs?

SELF-TEST QUESTIONS

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 13

accounting and reporting activities such as routine budgeting, preparation of financial statements, payables management, and patient accounts management. For the most part, the comptroller is involved in those activities covered in chapters 3 through 8 of this text.

Second is the treasurer, who is responsible for the acquisition and man- agement of capital (funds). Treasurer activities include the acquisition and employment of capital, cash and debt management, lease financing, financial risk management, and endowment fund management (within not-for-profits). In general, the treasurer is involved in those activities discussed in chapters 11 through 17 of this text.

Of course, in larger organizations, the comptroller and treasurer have managers with responsibility for specific functions, such as the patient accounts manager, who reports to the comptroller, and the cash manager, who reports to the treasurer.

In very small businesses, many of the finance responsibilities are com- bined and assigned to just a few individuals. In the smallest health services organizations, the entire finance function is managed by one person, often called the business (practice) manager.

Health Services Settings

Health services are provided in numerous settings, including hospitals, ambu- latory care facilities, long-term care facilities, and even at home. Before the 1980s, most health services organizations were freestanding and not formally linked with other organizations. Those that were linked tended to be part of horizontally integrated systems that controlled a single type of healthcare facility, such as hospitals or nursing homes. Over time, however, many health services organizations have diversified and become vertically integrated through either direct ownership or contractual arrangements.

Most readers of this text are familiar with health services settings either through previous courses or by working in the field. For those readers who have not had exposure to health services settings, the Chapter 1 Supplement provides additional information.

1. Briefly describe the typical structure of the finance department within a health services organization.

SELF-TEST QUESTION

1. Name a few settings in which health services are provided. SELF-TEST QUESTION

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H e a l t h c a r e F i n a n c e14

Current Managerial Challenges

In recent years, the American College of Healthcare Executives (ACHE) has surveyed CEOs regarding the most critical concerns of healthcare manag- ers. Financial concerns have headed the list of challenges on every survey conducted since the survey began in 2002. When asked to rank their specific financial concerns, CEOs put reimbursement at the forefront, with Medicaid, Medicare, and bad debt losses as their top payer concerns. (Reimbursement is discussed in Chapter 2.)

In a survey of healthcare CFOs conducted by the Healthcare Finan- cial Management Association, they reported that their most pressing issue was balancing clinical and financial issues—in essence, determining how to improve financial performance without having a negative impact on clinical performance. Other issues of concern included improving the revenue cycle (billing and collecting on a timely basis) and developing different ways to access (raise) capital.

Taken together, the results of these surveys confirm the fact that finance is of primary importance to today’s healthcare managers. The remainder of this book is dedicated to helping you confront and solve these issues.

Alternative Legal Forms of Businesses

Throughout this book, the focus is on business finance—that is, the practice of accounting and financial management within business organizations. There are three primary legal forms of business organization: proprietorship, partner- ship, and corporation. In addition, there are several hybrid forms. Because most health services managers work for corporations and because not-for- profit businesses are organized as corporations, this form of organization is emphasized. However, some medical practices are organized as proprietor- ships, and partnerships and hybrid forms are common in group practices and joint ventures, so health services managers must be familiar with all forms of business organization.

Proprietorships A proprietorship, sometimes called a sole proprietorship, is a business owned by one individual. Going into business as a proprietor is easy—the owner merely begins business operations. However, most cities require even the

1. What are some important issues facing healthcare managers today?

SELF-TEST QUESTION

Proprietorship A simple form of business owned by a single individual. Also called sole proprietorship.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 15

smallest businesses to be licensed, and state licensure is required for most healthcare professionals.

Partnerships A partnership is formed when two or more persons associate to conduct a business that is not incorporated. Partnerships may operate under different degrees of formality, ranging from informal oral understandings to formal agreements filed with the state in which the partnership does business. Both the proprietorship and partnership forms of organization are easily and inex- pensively formed, are subject to few governmental regulations, and pay no corporate income taxes. All earnings of the business, whether reinvested in the business or withdrawn by the owner(s), are taxed as personal income to the proprietor or partner.

Proprietorships and partnerships have several disadvantages, including the following:

• Selling their interest in the business is difficult for owners. • The owners have unlimited personal liability for the debts of the

business, which can result in losses greater than the amount invested in the business. In a proprietorship, unlimited liability means that the owner is personally responsible for the debts of the business. In a partnership, it means that if any partner is unable to meet his or her obligation in the event of bankruptcy, the remaining partners are responsible for the unsatisfied claims and must draw on their personal assets if necessary.

• The life of the business is limited to the life of the owners. • It is difficult for proprietorships and partnerships to raise large

amounts of capital. This is no particular problem for a very small business or when the owners are very wealthy, but the difficulty of attracting capital becomes a real handicap if the business needs to grow substantially to take advantage of market opportunities.

Corporations A corporation is a legal entity that is separate and distinct from its owners and managers. The creation of a separate business entity gives these primary advantages:

• A corporation has unlimited life and can continue in existence after its original owners and managers have died or left the company.

• It is easy to transfer ownership in a corporation because ownership is divided into shares of stock that can be sold.

• Owners of a corporation have limited liability.

Partnership A nonincorporated business entity that is created by two or more individuals.

Corporation A legal business entity that is separate and distinct from its owners (or community) and managers.

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H e a l t h c a r e F i n a n c e16

To illustrate limited liability, suppose that an individual made an invest- ment of $10,000 in a partnership that subsequently went bankrupt, owing $100,000. Because the partners are liable for the debts of the partnership, that partner could be assessed for a share of the partnership’s debt in addition to the loss of his or her initial $10,000 contribution. In fact, if the other partners were unable to pay their shares of the indebtedness, one partner would be held liable for the entire $100,000. However, if the $10,000 had been invested in a corporation that went bankrupt, the potential loss for the investor would be limited to the $10,000 initial investment. (However, in the case of small, financially weak corporations, the limited liability feature of ownership is often fictitious because bankers and other lenders will require personal guarantees from the stockholders.) With these three factors—unlimited life, ease of own- ership transfer, and limited liability—corporations can more easily raise money in the financial markets than can sole proprietorships or partnerships.

The corporate form of organization has two primary disadvantages. First, corporate earnings of taxable entities are subject to double taxation—once at the corporate level and then again at the personal level. Second, setting up a corporation, and then filing the required periodic state and federal reports, is more costly and time consuming than what is required to establish a pro- prietorship or partnership.

Setting up a corporation requires that the founders, or their attorney, prepare a charter and a set of bylaws. Today, attorneys have standard forms for charters and bylaws on their computers, so they can set up a “no frills” corporation with modest effort. In addition, several companies offer online services that help with the incorporation process. Still, setting up a corporation remains relatively difficult when compared to a proprietorship or partnership, and it is even more difficult if the corporation has nonstandard features, such as multiple classes of stock.

Hybrid Forms of Organization Although the three basic forms of organization—proprietorship, partnership, and corporation—historically have dominated the overall business scene, sev- eral hybrid forms of organization have become quite popular in recent years.

In general, the hybrid forms are designed to limit owners’ liability with- out having to fully incorporate. For example, in a limited liability partner- ship (LLP), the partners have joint liability for all actions of the partnership, including personal injuries and indebtedness. However, all partners enjoy limited liability regarding professional malpractice because partners are only liable for their own individual malpractice actions, not those of the other part- ners. In spite of limited malpractice liability, the partners are jointly liable for the partnership’s debts. Other hybrid forms of organization include limited liability companies (LLCs), professional corporations (PCs), and professional associations (PAs).

Limited liability partnership (LLP) A partnership form of organization that limits the professional (malpractice) liability of its partners.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 17

Alternative Corporate Ownership

In the previous section, we discussed alternative legal forms of businesses. Now, we turn our attention to the two alternative ownership forms of cor- porations: for-profit and not-for-profit. Unlike other sectors in the economy, not-for-profit corporations play a major role in the healthcare sector, especially among providers. For example, about 60 percent of the hospitals in the United States are private, not-for-profit hospitals. Only 15 percent of all hospitals are investor owned; the remaining 25 percent are governmental. Furthermore, not-for-profit ownership is common in the nursing home, home health care, hospice, and health insurance industries.

Investor-Owned Corporations When the average person thinks of a corporation, he or she probably thinks of an investor-owned, or for-profit, corporation. For example, Ford, IBM, and Microsoft are investor-owned corporations. In health services, corporations such as HCA and Community Health Systems are examples of large for-profit hospital systems; Kindred Healthcare and Emeritus Senior Living are examples of long-term care providers; Select Medical and HealthSouth offer rehabilitation services; and MEDNAX offers pediatric services. Individuals become owners of for-profit corporations by buying shares of common stock in the company.

The stockholders (also called shareholders) are the owners of investor- owned corporations. As owners, they have two basic rights:

• The right of control. Common stockholders have the right to vote for the corporation’s board of directors, which oversees the management of the company. Each year, a company’s stockholders receive a proxy ballot, which they use to vote for directors and to vote on other issues that are proposed by management or stockholders. In this way, stockholders exercise control. In the voting process, stockholders cast one vote for each common share held.

• A claim on the residual earnings of the firm. A corporation sells products or services and realizes revenues from the sales. To produce these revenues, the corporation must incur expenses for materials, labor, insurance, debt capital, and so on. Any excess of revenues over expenses—the residual earnings—belongs to the shareholders of the business. Often, a portion of these earnings is paid out in the

Investor-owned (for-profit) corporation A corporation that is owned by shareholders who furnish capital and expect to earn a return on their investment.

1. What are the three primary forms of business organization, and how do they differ?

2. What is the purpose of hybrid forms?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e18

form of dividends, which are merely cash payments to stockholders, or stock repurchases, in which the company buys back shares held by stockholders. However, management typically elects to reinvest some (or all) of the residual earnings in the business, which presumably will produce even higher payouts to stockholders in the future. (See Chapter 19, which is available online at ache.org/books/HCFinance6, for more information about how corporate earnings are distributed to shareholders.)

When compared to not-for-profit corporations (discussed below), three key features make investor-owned corporations different. First, the owners (stockholders) of the corporation are well defined and exercise control of the business by voting for directors. Second, the residual earnings of the business belong to the owners, so management is responsible only to the stockholders for the profitability of the firm. Finally, investor-owned corporations are subject to various forms of taxation at the local, state, and federal levels.

Not-for-Profit Corporations If an organization meets a set of stringent requirements, it can qualify for incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt corporations are sometimes called nonprofit corporations. Because nonprofit businesses (as opposed to pure charities such as the American Red Cross) need profits to sustain operations, and because it is hard to explain why nonprofit corporations should earn profits, the term not-for-profit is more descriptive of such health services corporations. Examples of not-for-profit health services corporations include the Kaiser Foundation, Catholic Health Initiatives, and the Mayo Clinic Health System.

Tax-exempt status is granted to corporations that meet the tax definition of a charitable organization as defined by Internal Revenue Service (IRS) Tax Code Section 501(c)(3) or (4). Hence, such corporations are also known as 501(c)(3) or (4) corporations. The tax code defines a charitable organization as “any corporation, community chest, fund, or foundation that is organized and operated exclusively for religious, charitable, scientific, public safety, liter- ary, or educational purposes.” Because the promotion of health is commonly considered a charitable activity, a corporation that provides healthcare services can qualify for tax-exempt status, provided that it meets other requirements.

In addition to the charitable purpose, a not-for-profit corporation must be organized and run so that it operates exclusively for the public, rather than private, interest. Thus, no profits can be used for private gain and no direct political activity can be conducted. Also, if the corporation is liquidated or sold to an investor-owned business, the proceeds from the liquidation or sale must be used for charitable purposes. Because individuals cannot benefit

Tax-exempt (not-for-profit) corporation A corporation that has a charitable purpose, is tax exempt, and has no owners. Also called nonprofit corporation.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 19

from the profits of not-for-profit corporations, such organizations cannot pay dividends. However, prohibition of private gain from profits does not prevent parties, such as managers and physicians, from benefiting through salaries, perquisites, contracts, and so on.

Not-for-profit corporations differ significantly from investor-owned corporations. Because not-for-profit firms have no shareholders, no single body of individuals has ownership rights to the firm’s residual earnings or exercises control of the firm. Rather, control is exercised by a board of trustees that is not constrained by outside oversight, as is the board of directors of a for-profit corporation, which must answer to stockholders. Also, not-for-profit corporations are generally exempt from taxation, including both property and income taxes, and have the right to issue tax-exempt debt (municipal bonds). Finally, individual contributions to not-for-profit organizations can be deducted from taxable income by the donor, so not-for-profit firms have access to tax-subsidized contribution capital.

For-profit corporations must file annual income tax returns with the IRS. The equivalent filing for not-for-profit corporations is IRS Form 990, titled “Return of Organization Exempt from Income Tax.” Its purpose is to provide both the IRS and the public with financial information about not- for-profit organizations, and it is often the only source of such information. It is also used by government agencies to prevent organizations from abusing their tax-exempt status. Form 990 requires significant disclosures related to governance and boards of directors. In addition, hospitals are required to file Schedule H to Form 990, which includes financial information on the amount and type of community benefit (primarily charity care) provided, bad debt losses, Medicare patients, and collection practices. IRS regulations require not- for-profit organizations to provide copies of their three most recent Form 990s to anyone who requests them, whether in person or by mail, fax, or e-mail. Form 990s are also available to the public through several online services.

The financial problems facing most federal, state, and local governments have caused politicians to take a closer look at the tax subsidies provided to not-for-profit hospitals. For example, several bills have been introduced in Congress that require hospitals to provide minimum levels of care to the indigent to retain tax-exempt status. Such efforts by Congress prompted the American Hospital Association (AHA) in 2007 to publish guidelines for char- ity care that include (1) giving discounts to uninsured patients of “limited means”; (2) establishing a common definition of “community benefit,” which encompasses the full range of services provided to the population served; and (3) improving “transparency,” or the ability of outsiders to understand a busi- ness’s governance structure and policies, including executive compensation.

Likewise, officials in several states have proposed legislation that man- dates the minimum amount of charity care to be provided by not-for-profit

Form 990 A form filed by not-for-profit organizations with the Internal Revenue Service that reports on governance and charitable activities.

Schedule H An attachment to Form 990 filed by not-for-profit hospitals that gives additional information on charitable activities.

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H e a l t h c a r e F i n a n c e20

hospitals and the types of billing and collec- tions procedures applied to the uninsured. For example, Texas has established mini- mum requirements for charity care, which hold not-for-profit hospitals accountable to the public for the tax exemptions they receive. The Texas law specifies four tests, and each hospital must meet at least one of them. The test that most hospitals use to comply with the law requires that at least 4 percent of net patient service revenue be spent on charity care. Also, Ohio legislators have held hearings to discuss whether a law should be passed requiring Ohio’s not-for- profit hospitals to make “payments in lieu of taxes,” or PILOTS.

Finally, money-starved municipalities in several states have attacked the property tax exemption of not-for-profit hospitals that have “neglected” their charitable mis- sions. For example, tax assessors are fighting to remove property tax exemptions from not-for-profit hospitals in several Pennsylva- nia cities after an appellate court ruling sup- ported the Erie School District’s authority to tax a local hospital that had strayed too far from its charitable purpose. According to one estimate, if all not-for-profit hospi- tals had to pay taxes comparable to their investor-owned counterparts, local, state, and federal governments would garner an additional $3.5 billion in tax revenues. This estimate explains why tax authorities in many jurisdictions are pursuing not-for- profit hospitals as a source of revenue.

The inherent differences between investor-owned and not-for-profit organi- zations have profound implications for many

elements of healthcare financial management, including organizational goals, financing decisions (i.e., the choice between debt and equity financing and the types of securities issued), and capital investment decisions. Ownership’s effect on the application of healthcare financial management theory and concepts is addressed throughout the text.

For Your Consideration Making Not-for-Profit Hospitals Do Good

Many people have criticized not-for-profit hos- pitals for not “earning” their charitable exemp- tions. In one of the latest relevant court rulings, in 2010 the Illinois Supreme Court concluded that Provena Covenant hospital, located in Urbana, Illinois, was not a charitable institution for prop- erty tax purposes. The court’s opinion reasoned that the primary use of the hospital property was providing medical services for a fee, while char- ity means providing a gift to the community. The opinion further pointed out that (1) the charity care being provided was subsidized by payments from other patients; (2) many patients granted partial charity care still paid enough to cover costs; and (3) the hospital’s community benefit activities, such as a residency program and an education program for emergency responders, also benefited the hospital and thus were not truly gifts to the community. Thus, the hospital property was not in charitable use.

Most not-for-profit hospitals today are, of course, primarily supported by payments for services rather than by charitable contributions. Under the opinion’s reasoning, the property tax exemption may well be hard to maintain. How- ever, a partial dissent by two justices suggests that this case is not the end of the story. The dis- sent argues that the plurality opinion impinges on the legislative function of setting specific stan- dards for tax exemption, and the issue should be settled by legislative action rather than by courts.

What do you think? Should not-for-profit hospitals lose their property tax or income tax exemptions? Should legislatures set standards that hospitals must meet to maintain their tax- exempt status? If so, how might such standards be specified?

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 21

Organizational Goals

Healthcare finance is not practiced in a vacuum; it is practiced with some objective in mind. Finance goals within an organization clearly must be con- sistent with, as well as supportive of, the overall goals of the business. Thus, by discussing organizational goals, a framework for financial decision making within health services organizations can be established.

Small Businesses In a small business, regardless of its legal form, the owners generally are also its managers. In theory, the business can be operated for the exclusive benefit of the owners. If the owners want to work very hard to get rich, they can. On the other hand, if every Wednesday is devoted to golf, no outside owner is hurt by such actions. (Of course, the business still has to satisfy its custom- ers or it will not survive.) It is in large, publicly held corporations, in which owners and managers are separate parties, that organizational goals become important to the practice of finance.

Publicly Held Corporations From a finance perspective, the primary goal of large investor-owned corpo- rations is generally assumed to be shareholder wealth maximization, which translates to stock price maximization. Investor-owned corporations do, of course, have other goals. Managers, who make the actual decisions, are inter- ested in their own personal welfare, in their employees’ welfare, and in the good of the community and society at large. Still, the goal of stock price maximization is a reasonable operating objective upon which to build financial decision-making rules.

Not-for-Profit Corporations Corporations consist of a number of classes of stakeholders, which include all parties that have an interest, usually of a financial nature, in the organization. For example, a not-for-profit hospital’s stakeholders include the board of trustees; managers; employees; physician staff; creditors; suppliers; patients; and even potential patients, which may include the entire community. An investor-owned hospital has the same set of stakeholders, plus stockholders,

1. What are the major differences between investor-owned and not- for-profit corporations?

2. What pressures recently have been placed on not-for-profit hospitals to ensure that they meet their charitable mission?

3. What are the purpose and content of IRS Form 990?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e22

who dictate the goal of shareholder wealth maximization. While managers of investor-owned companies have to please primarily one class of stakehold- ers—the shareholders—to keep their jobs, managers of not-for-profit firms face a different situation. They have to try to please all of the organization’s stakeholders because no single well-defined group exercises control.

Many people argue that managers of not-for-profit corporations do not have to please anyone at all because they tend to dominate the boards of trustees that are supposed to exercise oversight. Others argue that managers of not-for- profit corporations have to please all of the business’s stakeholders to a greater or lesser extent because all are necessary to the successful performance of the business. Of course, even managers of investor-owned corporations should not

attempt to enhance shareholder wealth by treating other stakeholders unfairly, because such actions ultimately will be detrimental to shareholders.

Typically, the goal of not-for-profit corporations is stated in terms of a mission statement. For example, here is the current mission statement of Riverside Memorial Hospital, a 450-bed, not-for-profit acute care hospital:

Riverside Memorial Hospital, along with its

medical staff, is a recognized, innovative health-

care leader dedicated to meeting the needs of

the community. We strive to be the best com-

prehensive healthcare provider through our

commitment to excellence.

Although this mission statement pro- vides Riverside’s managers and employees with a framework for developing specific goals and objectives, it does not provide much insight into the goal of the hospital’s finance function. For Riverside to accom- plish its mission, its managers have identified the following five financial goals:

1. The hospital must maintain its financial viability.

2. The hospital must generate sufficient profits to continue to provide the current range of healthcare services

For Your Consideration Does the Finance Function

Differ Among Providers?

Readers of this book understand the difference between for-profit and not-for-profit providers. Not-for-profit providers have a charitable mission, while for-profits are in business to make money for owners. Furthermore, all not-for-profit earn- ings must be reinvested in the enterprise, while some (or all) profits of for-profit health services businesses may be returned to owners in the form of dividends or stock repurchases. Although many studies have tried to assess which type of ownership is better for patients, no consensus has been reached.

But what about the finance function? That is, what about the day-to-day activities of opera- tional managers and the finance staff? Are these appreciably different at not-for-profit providers than at for-profit providers? What about different types of providers—say, medical group practices versus hospitals? If those activities differ, might you benefit from taking two healthcare finance courses—one for investor-owned providers and another for not-for-profit providers? Or should separate healthcare finance courses be offered for different types of providers, for example, one for hospitals and another for nursing homes?

What do you think? Is the finance function at not-for-profit providers appreciably different from that at for-profit providers, or is there an appre- ciable difference between types of providers? If there are differences, what are they?

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 23

to the community. This means that current buildings and equipment must be replaced as they become obsolete.

3. The hospital must generate sufficient profits to invest in new medical technologies and services as they are developed and needed.

4. Although the hospital has an aggressive philanthropy program in place, it does not want to rely on this program or government grants to fund its operations.

5. The hospital will strive to provide services to the community as inexpensively as possible, given the above financial requirements.

In effect, Riverside’s managers are saying that to achieve the hospital’s commitment to excellence as stated in its mission, the hospital must remain financially strong and profitable. Financially weak organizations cannot con- tinue to accomplish their stated missions over the long run.

What is interesting is that Riverside’s five financial goals are probably not much different from the financial goals of Jefferson Regional Medical Center (JRMC), a for-profit competitor. Of course, JRMC has to worry about providing a return to its shareholders, and it receives only a very small amount of contributions and grants. However, to maximize shareholder wealth, JRMC also must retain its financial viability and have the financial resources necessary to offer new services and technologies. Furthermore, competition in the market for hospital services does not permit JRMC to charge appreciably more for services than its not-for-profit competitors.

Healthcare Reform and Finance

The Patient Protection and Affordable Care Act (ACA) of 2010 has been called the most significant healthcare legislation since Medicare and Medicaid in 1965. The law, which was enacted on March 23, 2010, was designed to provide all US citizens and legal residents with access to affordable health insurance, to reduce healthcare costs, and to improve care and quality. This legislation puts in place comprehensive health insurance exchanges to expand coverage, hold insurance companies accountable for product cost and quality, lower costs across the system, guarantee more choices, and enhance the qual- ity of care—all of which are intended to transform the US healthcare system and make it more sustainable.

The ACA has numerous major aims. However, the central goal is to expand healthcare coverage through shared responsibility between government,

1. What is the difference in goals between investor-owned and not- for-profit businesses?

SELF-TEST QUESTION

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H e a l t h c a r e F i n a n c e24

individuals, and employers. This involves requiring all US citizens and legal residents to have health insurance coverage, which may be obtained through health insurance exchanges at an “affordable” cost if the individual does not have health insurance available from other sources.

Some of the benefits of the ACA include free preventive care, the ban- ning of preexisting-condition coverage limitations, prescription discounts for seniors, extended coverage for young adults, lifetime coverage on most benefits, prevention of coverage cancellation by insurers, transparency on increases in insurance premium rates, and patient selection (rather than insurer assignment) of primary care doctors from the provider network.

The major implications of the ACA for health insurance are addressed in Chapter 2, while the major implications for the delivery of healthcare ser- vices, and hence healthcare finance, are discussed in the following sections.

Accountable Care Organizations One of the ways the ACA seeks to decrease healthcare costs and increase quality is by encouraging providers to form accountable care organizations (ACOs). An ACO is a network of physicians, other clinicians, and hospitals and clinics that shares responsibility for providing coordinated care to patients. Providers in an ACO not only are jointly accountable for the health of their patients but also receive financial incentives to cooperate and reduce costs by avoiding unnecessary tests and procedures, eliminating duplication of services, and coordinating patient care.

An ACO can take one of many forms, such as the following:

• An integrated delivery system that has common ownership of hospitals and physician practices and uses electronic health records, offers team- based care, and makes available resources to support cost-effective care

• A multispecialty group practice that has strong affiliations with hospitals and contracts with multiple health plans

• A physician–hospital organization that is a subset of a hospital’s medical staff and that functions like a multispecialty group practice

• An independent practice association composed of individual physician practices that come together to contract with health plans

• A virtual physician organization that sometimes includes physicians in rural areas

ACOs are paid through the traditional fee-for-service system (see Chapter 2); however, they are offered bonuses as an incentive to reduce the cost of care. Doctors and hospitals have to meet specific quality benchmarks that focus on prevention and careful management of patients with chronic diseases. In other words, providers get paid more for keeping patients healthy and out of the hospital. If an ACO is unable to save money, it could be liable for the costs

Accountable care organization (ACO) A network of healthcare providers joined together for the purpose of increasing patient service quality and reducing costs.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 25

of the investments made to improve care; it also may have to pay a penalty if it does not meet performance and cost-savings benchmarks.

Medical Homes A medical home (or patient-centered medical home) is a team-based model of care led by a personal physician who provides continuous and coordinated care throughout a patient’s lifetime with the goal of maximizing health outcomes. The medical home is responsible for providing all of a patient’s healthcare needs or appropriately arranging care with other qualified professionals. This includes the provision of preventive services, treatment of acute and chronic illnesses, and assistance with end-of-life issues. It is a model of practice in which a team of healthcare professionals, coordinated by a personal physician, works collaboratively to ensure coordinated and integrated care, patient access and communication, quality, and safety. The medical home model is independent of the ACO concept, but it is anticipated that ACOs will provide an organi- zational setting that facilitates implementation of the model.

Supporters of the model claim that it will allow better access to health- care, increase patient satisfaction, and improve health. Although the develop- ment and implementation of the medical home model is in its infancy, its key characteristics at this time are the following:

• Personal physician. Each patient has an ongoing relationship with a personal physician trained to provide first-contact, continuous, and comprehensive care.

• Whole-person orientation. The personal physician is responsible for providing all of a patient’s healthcare needs or for appropriately arranging care with other qualified professionals. In effect, the personal physician leads a team of clinicians who collectively take responsibility for patient care.

• Coordination and integration. The personal physician coordinates care across specialists, hospitals, home health agencies, nursing homes, and hospices.

• Quality and safety. Quality and patient safety are ensured by a care- planning process, evidence-based medicine, clinical decision–support tools, performance measurement, active participation of patients in decision making, use of information technology, and quality improvement activities.

• Enhanced access. Medical care and information are available at all times through open scheduling, expanded hours of service, and new and innovative communications technologies.

• Payment-for-value methodologies. It is essential that payment methodologies recognize the added value provided to patients. Payments should reflect the value of work that falls outside of

Medical home A team-based model of care led by a personal physician who provides continuous and coordinated care throughout a patient’s lifetime with a goal of maximizing health outcomes.

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H e a l t h c a r e F i n a n c e26

face-to-face visits, should support adoption and use of health information technology for quality improvement, and should recognize differences in the patient populations treated within the practice.

Industry Consolidation The ACA is driving the consolidation of healthcare organizations. It has accel- erated health systems’ acquisition of hospitals and hospitals’ acquisition of physician practices, and that trend is likely to continue for many years. With the greater focus on clinical integration, quality of care, and changing reim- bursement methodologies, healthcare organizations are seeking to restruc- ture healthcare delivery to operate more efficiently and improve coordination between patients and providers. Healthcare organizations are looking to gain a competitive advantage from combining assets, staff, and resources. Consolida- tion not only provides organizations access to capital, economies of scale, and market share but also may lead to improvement in patient care by making it easier to share patient information, adhere to clinical practice guidelines (thus reducing variations in care), and access high-quality specialist physicians.

Population Health The ACA is moving providers toward the population health management approach to care provision. The goal of population health management is to shift from focusing on treating illness to maintaining or improving health. The idea is to prevent costly illnesses when possible and hence avoid unnecessary care, which is encouraged by reimbursement models such as capitation, payment bundling, and shared savings (discussed in Chapter 2). Instead of just provid- ing preventive and chronic care when patients come in for acute problems, ACOs track and monitor the health status of the entire patient population, requiring greater use of health information technology. The keys to success in population health management are greater awareness of the health status of the population and proactive intervention to reduce the use of provider resources and to achieve the best population outcomes.

Clinical Integration A fundamental component to achieving the goals of the ACA is clinical inte- gration. Clinical integration aims to coordinate patient care across conditions, providers, settings, and time to achieve care that is safe, timely, effective, efficient, and patient focused. New payment models and advances in health information systems are used to facilitate the transition to the clinical integra- tion model and to manage the continuum of care for patients. Provider pay- ments are tied to results for quality, access, and efficiency with the objective of establishing coordination between hospitals and physicians. Health informa- tion technology aims to capture patient information and make it accessible

Population health management The concept that the health of all individuals is improved when the health of the entire population is improved.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 27

to authorized providers at the point of care. Complete patient information facilitates optimal treatment strategies and reduces the chance of medication errors and conflicting treatment plans. There will be requirements for new and more comprehensive policies and procedures that protect patient privacy and that guarantee the security of data that are transferred between patients, caregivers, and organizations.

Data Analytics The emergence of ACOs and an increased emphasis on collaboration between clinicians and on quality patient care are making it necessary for healthcare organizations to invest in integrated information systems technology to collect large quantities of patient and provider data (so-called big data). Data ana- lytic systems are capable of analyzing large amounts of patient data to better understand clinical processes and to identify problems and opportunities for improvement in the provision of healthcare services. New, complex informa- tion technology will facilitate analysis of care coordination, patient safety, and utilization of healthcare services.

Staffing Shortages The ACA is expected to increase the number of patients who can access the healthcare system. Healthcare organizations will see an influx of formerly uninsured patients now seeking care because they have insurance or better coverage. As a result, the demand for healthcare professionals—especially physicians, nurse practitioners, and physician assistants—will likely increase. The ACA is also driving changes in hospital staffing by emphasizing preven- tion and value-based care, creating demand for primary care providers, emer- gency physicians, clinical pharmacists, and health information technology and data specialists. Some professional and industry associations are predicting that current shortages of various healthcare staff will worsen in the face of this growing demand. The ACA has identified several strategies to increase the supply of health professionals (including primary care physicians), such as scholarships and flexible loan repayment programs to help fund their educa- tion. However, many healthcare organizations likely will face great competition for some healthcare staff.

1. What is the primary purpose of healthcare reform? 2. Will reform have a greater impact on insurers or providers? 3. What is an accountable care organization (ACO), and what is it

designed to accomplish? 4. What is the medical home model, and what is its purpose?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e28

Key Concepts This chapter provided an introduction to healthcare finance. The key concepts of this chapter are as follows:

• The term healthcare finance, as it is used in this book, means the accounting and financial management principles and practices used within health services organizations to ensure the financial well- being of the enterprise.

• A business maintains its financial viability by selling goods or services, while a pure charity relies solely on contributions.

• The primary role of finance in health services organizations, as in all businesses, is to plan for, acquire, and use resources to maximize the efficiency and value of the enterprise.

• Finance activities generally include (1) planning and budgeting, (2) financial reporting, (3) capital investment decisions, (4) financing decisions, (5) revenue cycle and current accounts management, (6) contract management, and (7) financial risk management. These activities can be summarized by the four Cs: costs, cash, capital, and control.

• The size and structure of the finance department within a health services organization depend on the type of provider and its size. Still, the finance department within a larger provider organization generally consists of a chief financial officer (CFO), who typically reports directly to the chief executive officer (CEO) and is responsible for all finance activities within the organization. Reporting to the CFO are the comptroller, who is responsible for accounting and reporting activities, and the treasurer, who is responsible for the acquisition and management of capital (funds).

• In larger organizations, the comptroller and treasurer direct managers who have responsibility for specific functions, such as the patient accounts manager, who reports to the comptroller, and the cash manager, who reports to the treasurer.

• In small health services organizations, the finance responsibilities are combined and assigned to one individual, often called the business (practice) manager.

• All business decisions have financial implications, so all managers— whether in operations, marketing, personnel, or facilities—must know enough about finance to incorporate those implications into their own specialized decision-making processes.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 29

• Healthcare services are provided in numerous settings, including hospitals, ambulatory care facilities, long-term care facilities, and even at home.

• Recent surveys of health services executives confirm the fact that healthcare managers view financial concerns as the most important current issue they face.

• The three main forms of business organization are proprietorship, partnership, and corporation. Although each form of organization has its own unique advantages and disadvantages, most large organizations, and all not-for-profit entities, are organized as corporations.

• Investor-owned corporations have stockholders who are the owners of the corporation. As owners, stockholders have claim on the residual earnings of the corporation. Investor-owned corporations are fully taxable.

• Charitable organizations that meet certain criteria can be organized as not-for-profit corporations. Rather than having a well- defined set of owners, such organizations have a large number of stakeholders who have an interest in the organization. Not-for- profit corporations do not pay taxes; they can accept tax-deductible contributions, and they can issue tax-exempt debt.

• In lieu of tax filings, not-for-profit corporations must file Form 990, which reports on an organization’s governance structure and community benefit services, with the Internal Revenue Service.

• From a financial management perspective, the primary goal of investor-owned corporations is shareholder wealth maximization, which translates to stock price maximization. For not-for-profit corporations, a reasonable goal for financial management is to ensure that the organization can fulfill its mission, which translates to maintaining financial viability.

• Healthcare reform is federal legislation that was signed into law in 2010 and is expected to have a significant impact on health insurers and providers.

• Accountable care organizations (ACOs) are a method of integrating local physicians with other members of the healthcare community and rewarding them for controlling costs and improving quality.

• A medical home (or patient-centered medical home) is a team-based model of care led by a personal physician who provides continuous and coordinated care throughout a patient’s lifetime to maximize health outcomes.

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H e a l t h c a r e F i n a n c e30

In the next chapter, we continue the discussion of the healthcare environ- ment, with emphasis on health insurance and reimbursement methodologies.

Questions and Problems

1.1 Briefly describe the purpose and organization of this book and the learning tools embedded in each chapter.

1.2 a. What are some of the industries in the healthcare sector? b. What is meant by the term healthcare finance as used in this

book? c. What are the two broad areas of healthcare finance? d. Why is it necessary to have a book on healthcare finance as

opposed to a generic finance book? 1.3 What is the difference between a business and a pure charity? 1.4 a. Briefly discuss the role of finance in the health services industry. b. Has this role increased or decreased in importance in recent years? 1.5 What is the structure of the finance department within health services

organizations? 1.6 a. (Hint: the material reviewed in this question is covered in the

Chapter Supplement.) Briefly describe the following health services settings:

• Hospitals • Ambulatory care • Home health care • Long-term care • Integrated delivery systems

b. What are the benefits attributed to integrated delivery systems? 1.7 What are the major current concerns of healthcare managers? 1.8 What are the three primary forms of business organization? Describe

their advantages and disadvantages. 1.9 What are the primary differences between investor-owned and not-

for-profit corporations? 1.10 a. What is the primary goal of investor-owned corporations?

b. What is the primary goal of most not-for-profit healthcare corporations?

c. Are there substantial differences between the finance goals of investor-owned and not-for-profit corporations? Explain.

1.11 Briefly describe the main provisions of healthcare reform and its implications for the practice of healthcare finance.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 31

1.12 Describe the primary features of accountable care organizations (ACOs) and medical homes. What benefits are attributed to them?

Resources

For a general introduction to the healthcare system in the United States, see Barton, P. L. 2010. Understanding the U.S. Health Services System. Chicago: Health

Administration Press. Shi, L., and D. A. Singh. 2013. Essentials of the U.S. Health Care System. Burlington,

MA: Jones and Bartlett Learning.

For the latest information on events that affect health services organizations, see Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

For ideas on the future of healthcare in the United States and other information pertinent to this chapter, see Bisognano, M. 2011. “Finance is Key to Achieving Quality and Cost Goals.” Health-

care Financial Management (April): 68–71. Giniat, E. J. 2009. “Finance Needs to Sit at the Head Table.” Healthcare Financial

Management (May): 80–82. Kim, C., D. Majka, and J. H. Sussman. 2011. “Modeling the Impact of Healthcare

Reform.” Healthcare Financial Management (January): 51–60. Lee, J. G., G. Dayal, and D. Fontaine. 2011. “Starting a Medical Home: Better Health

at Lower Cost.” Healthcare Financial Management (June): 71–80. Mulvany, C. 2011. “Medicare ACOs No Longer Mythical Creatures.” Healthcare

Financial Management (June): 96–104. Nguyen, J., and B. Choi. 2011. “Accountable Care: Are You Ready?” Healthcare

Financial Management (August): 92–100. Reynolds, M. 2011. “Managing the Risks of Accountable Care.” Healthcare Financial

Management (July): 49–56. Selvam, A. 2013. “Reform Unease Fading Among CEOs: But Financial Challenges

Remain Top Concern in ACHE’s Annual Survey.” Modern Healthcare (Janu- ary 14): 22–23.

Smith, P. C., and K. Noe. 2012. “New Requirements for Hospitals to Maintain Tax- Exempt Status.” Journal of Health Care Finance (Spring): 16–21.

Song, P. H., S. D. Lee, J. A. Alexander, and E. E. Seiber. 2013. “Hospital Ownership and Community Benefit: Looking Beyond Uncompensated Care.” Journal of Healthcare Management (March/April): 126–42.

For current information on how the Internet affects health and the provision of health services, see Journal of Medical Internet Research, www.jmir.org.

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http://www.jmir.org

CHAPTER SUPPLEMENT

1 HEALTH SERVICES SETTINGS Introduction

Health services are provided in numerous settings, including hospitals, ambu- latory care facilities, long-term care facilities, and even at home. Before the 1980s, most health services organizations were freestanding and not formally linked with other organizations. Those that were linked tended to be part of horizontally integrated systems that controlled a single type of healthcare facility, such as hospitals or nursing homes. Recently, however, many health services organizations have diversified and become vertically integrated either through direct ownership or contractual arrangements.

Settings

Hospitals Hospitals provide diagnostic and therapeutic services to individuals who require more than several hours of care, although most hospitals are actively engaged in ambulatory (walk-in) services as well. To ensure a minimum standard of safety and quality, hospitals must be licensed by the state and undergo inspections for compliance with state regulations. In addition, most hospitals are accred- ited by The Joint Commission. Joint Commission accreditation is a voluntary process that is intended to promote high standards of care. Although the cost to achieve and maintain compliance with Joint Commission standards can be substantial, accreditation provides eligibility for participation in the Medicare program, and hence most hospitals seek accreditation.

Recent environmental and operational changes have created significant challenges for hospital managers. For example, many hospitals are experiencing decreasing admission rates and shorter lengths of stay, which result in excess capacity. At the same time, hospitals have been pressured to give discounts to private third-party payers, governmental payments have failed to keep up with the cost of providing services, and indigent care and bad debt losses have increased. Because of the changing payer environment and resultant cost containment pressures, the number of hospitals (and beds) has declined in recent years.

Hospitals differ in function, average length of patient stay, size, and ownership. These factors affect the type and quantity of assets, services offered,

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and management requirements and often determine the type and level of reimbursement. Hospitals are classified as either general acute care facilities or specialty facilities. General acute care hospitals, which provide general medi- cal and surgical services and selected acute specialty services, are short-stay facilities and account for the majority of hospitals. Specialty hospitals, such as psychiatric, children’s, women’s, rehabilitation, and cancer facilities, limit admis- sion of patients to specific ages, sexes, illnesses, or conditions. The number of specialty hospitals has grown significantly in the past few decades because of the increased need for such services.

Hospitals vary in size, from fewer than 25 beds to more than 1,000 beds; general acute care hospitals tend to be larger than specialty hospitals. Small hospitals, those with fewer than 100 beds, usually are located in rural areas. Many rural hospitals have experienced financial difficulties in recent years because they have less ability than larger hospitals to lower costs in response to ever-tighter reimbursement rates. Most of the largest hospitals are academic health centers or teaching hospitals, which offer a wide range of services, including tertiary services. (Tertiary care is highly specialized and technical in nature, with services for patients with unusually severe, complex, or uncommon problems.)

Hospitals are classified by ownership as private not-for-profit, investor owned, and governmental. Governmental hospitals, which make up 25 percent of all hospitals, are broken down into federal and public (nonfederal) entities. Federal hospitals, such as those operated by the military services or the US Department of Veterans Affairs, serve special populations.

Public hospitals are funded wholly or in part by a city, county, tax district, or state. In general, federal and public hospitals provide substantial services to indigent patients. In recent years, many public hospitals have converted to other ownership categories—primarily private not-for-profit—because local governments have found it increasingly difficult to fund healthcare services and still provide other necessary public services. In addition, the inability of politically governed organizations to respond quickly to the changing healthcare environment has contributed to many conversions as managers try to create organizations that are more responsive to external change.

Private not-for-profit hospitals are nongovernmental entities organized for the sole purpose of providing inpatient healthcare services. Because of the charitable origins of US hospitals and a tradition of community service, roughly 80 percent of all private hospitals (60 percent of all hospitals) are not-for-profit entities. In return for serving a charitable purpose, these hospitals receive numerous benefits, including exemption from federal and state income taxes, exemption from property and sales taxes, eligibility to receive tax-deductible charitable contributions, favorable postal rates, favorable tax-exempt financing, and tax-favored annuities for employees.

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The remaining 20 percent of private hospitals (15 percent of all hospitals) are investor owned. This means that they have owners (typically shareholders) that benefit directly from the profits generated by the business. Historically, most investor-owned hospitals were owned by physicians, but now most are owned by large corporations such as HCA, which owns about 160 hospitals; Community Health Systems, which owns about 130 hospitals; and Tenet Healthcare, which owns about 80 hospitals.

Unlike not-for-profit hospitals, investor-owned hospitals pay taxes and forgo the other benefits of not-for-profit status. However, investor-owned hospitals typically do not embrace the charitable mission of not-for-profit hospitals. Despite the expressed differences in mission between investor-owned and not-for-profit hospitals, not-for-profit hospitals are being forced to place greater emphasis on the financial implications of operating decisions than in the past. This trend has raised concerns in some quarters that many not-for-profit hospitals are now failing to meet their charitable mission. As this perception grows, some people argue that these hospitals should lose some, if not all, of the benefits associated with their not-for-profit status.

Hospitals are labor intensive because of their need to provide continu- ous nursing supervision to patients, in addition to the other services they provide through professional and semiprofessional staffs. Physicians petition for privileges to practice in hospitals. While they admit and provide care to hospitalized patients, physicians, for the most part, are not hospital employees and hence are not directly accountable to hospital management. However, physicians retain a major responsibility for determining which hospital services are provided to patients and how long patients are hospitalized, so physicians play a critical role in determining a hospital’s costs and revenues and hence its financial condition.

Ambulatory (Outpatient) Care Ambulatory care, also known as outpatient care, encompasses services provided to noninstitutionalized patients. Traditional outpatient settings include medical practices, hospital outpatient departments, and emergency departments. In addition, the 1980s and early 1990s witnessed substantial growth in nontradi- tional ambulatory care settings such as home health care, ambulatory surgery centers, urgent care centers, diagnostic imaging centers, rehabilitation/sports medicine centers, and clinical laboratories. In general, the new settings offer patients increased amenities and convenience compared with hospital-based services and, in many situations, provide services at a lower cost than hospitals do. For example, urgent care and ambulatory surgery centers are typically less expensive than their hospital counterparts because hospitals have higher overhead costs.

Many factors have contributed to the expansion of ambulatory services, but technology has been a leading factor. Often, patients who once required

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hospitalization because of the complexity, intensity, invasiveness, or risk associ- ated with certain procedures can now be treated in outpatient settings. In addi- tion, third-party payers have encouraged providers to expand their outpatient services through mandatory authorization for inpatient services and by pay- ment mechanisms that provide incentives to perform services on an outpatient basis. Finally, fewer entry barriers to developing outpatient services relative to institutional care exist. Ordinarily, ambulatory facilities are less costly and less often subject to licensure and certificate-of-need regulations (exceptions are hospital outpatient units and ambulatory surgery centers).

As outpatient care consumes an increasing portion of the healthcare dollar and as efforts to control outpatient spending are enhanced, the tra- ditional role of the ambulatory care manager is changing. Ambulatory care managers historically have focused on such routine management tasks as bill- ing, collections, staffing, scheduling, and patient relations, while the owners, often physicians, have tended to make the more important business decisions. However, reimbursement changes and increased affiliations with insurers and other providers are requiring a higher level of management expertise. This increasing environmental complexity, along with increasing competition, is forcing managers of ambulatory care facilities to become more sophisticated in making business decisions, including finance decisions.

Long-Term Care Long-term care entails the provision of healthcare services, as well as some personal services, to individuals who lack some degree of functional ability. It usually covers an extended period of time and includes both inpatient and outpatient services, which often focus on mental health, rehabilitation, and nursing home care. Although the greatest use is among the elderly, long-term care services are used by individuals of all ages.

Long-term care is concerned with levels of independent functioning, specifically activities of daily living such as eating, bathing, and locomotion. Individuals become candidates for long-term care when they become too mentally or physically incapacitated to perform necessary tasks and when their family members are unable to provide needed services. Long-term care is a hybrid of healthcare services and social services; nursing homes are a major source of such care.

Three levels of nursing home care exist: (1) skilled nursing facilities, (2) intermediate care facilities, and (3) residential care facilities. Skilled nursing facilities (SNFs) provide the level of care closest to hospital care. Services must be provided under the supervision of a physician and must include 24-hour daily nursing care. Intermediate care facilities (ICFs) are intended for individu- als who do not require hospital or SNF care but whose mental or physical conditions require daily continuity of one or more medical services. Residen- tial care facilities are sheltered environments that do not provide professional

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healthcare services and thus for which most health insurance programs do not provide coverage.

Nursing homes are more abundant than hospitals and are smaller, with an average bed size of about 100 beds, compared with about 170 beds for hospitals. Nursing homes are licensed by states, and nursing home administra- tors are licensed as well. Although The Joint Commission accredits nursing homes, only a small percentage participate because accreditation is not required for reimbursement and the standards to achieve accreditation are much higher than they are for licensure requirements.

The long-term care industry has experienced tremendous growth in the past 50 years. Long-term care accounted for only 1 percent of healthcare expenditures in 1960, but by 2010 it accounted for about 6 percent of expen- ditures. Further demand increases are anticipated, as the percentage of the US population aged 65 or older increases, from less than 15 percent in 2013 to a forecasted 20 percent in 2030. The elderly are disproportionately high users of healthcare services and are major users of long-term care.

Although long-term care is often perceived as nursing home care, many new services are being developed to meet society’s needs in less institutional surroundings, such as adult day care, life care centers, and hospice programs. These services tend to offer a higher quality of life, although they are not necessarily less expensive than institutional care. Home health care, provided for an extended time period, can be an alternative to nursing home care for many patients, but it is not as readily available as nursing home care in many rural areas. Furthermore, third-party payers, especially Medicare, have sent mixed signals about their willingness to adequately pay for home health care. In fact, many home health care businesses have been forced to close in recent years as a result of a new, less generous Medicare payment system.

Integrated Delivery Systems Many healthcare experts have extolled the benefits of providing hospital care, ambulatory care, long-term care, and business support services through a single entity called an integrated delivery system. The hypothesized benefits of such systems include the following:

• Patients are kept in the corporate network of services (patient capture). • Providers have access to managerial and functional specialists (e.g.,

reimbursement and marketing professionals). • Information systems that track all aspects of patient care, as well as

insurance and other data, can be developed more easily, and the costs to develop them are shared.

• Linked organizations have better access to capital. • The ability to recruit and retain management and professional staff is

enhanced.

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• Integrated delivery systems are able to offer payers a complete package of services (“one-stop shopping”).

• Integrated delivery systems are better able to plan for and deliver a full range of healthcare services to meet the needs of a defined population, including chronic disease management and health improvement programs. Many of these population-based efforts typically are not offered by stand-alone providers.

• Incentives can be created that encourage all providers in the system to work together for the common good of the system, which has the potential to improve quality and control costs.

Although integrated delivery systems can be structured in many different ways, the defining characteristic of such systems is that the organization has the ability to assume full clinical responsibility for the healthcare needs of a defined population. Because of current state laws, which typically mandate that the insurance function be assumed only by licensed insurers, integrated delivery systems typically contract with insurers rather than directly with employers. Sometimes, the insurer, often a managed care plan, is owned by the integrated delivery system itself, but generally it is separately owned. In contracts with managed care plans, the integrated delivery system often receives a fixed pay- ment per plan member and hence assumes both the financial and clinical risks associated with providing healthcare services.

To be an effective competitor, integrated delivery systems must minimize the provision of unnecessary services because additional services create added costs but do not necessarily result in additional revenues. Thus, the objective of integrated delivery systems is to provide all needed services to its member population in the lowest-cost setting. To achieve this goal, integrated delivery systems invest heavily in primary care services, especially prevention, early intervention, and wellness programs. The primary care gatekeeper concept is frequently used to control utilization and hence costs. While hospitals continue to be centers of technology, integrated delivery systems have the incentive to shift patients toward lower-cost settings. Thus, clinical integration among the various providers and components of care is essential to achieving quality, cost efficiency, and patient satisfaction.

1. What are some different types of hospitals, and what trends are occurring in the hospital industry?

2. What trends are occurring in outpatient and long-term care? 3. What is an integrated delivery system? 4. Do you think that integrated delivery systems will be more or less

prevalent in the future? Explain your answer.

SELF-TEST QUESTIONS

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CHAPTER

HEALTHCARE INSURANCE AND REIMBURSEMENT METHODOLOGIES

Introduction

For the most part, the provision of healthcare services takes place in a unique way. First, often only a few providers of a particular service exist in a given area. Next, it is difficult, if not impossible, to judge the quality of competing services. Then, the decision about which services to purchase is usually not made by the consumer but by a physician or some other clinician. Also, full payment to the provider is not normally made by the user of the services but by a healthcare insurer. Finally, for most individuals, health insurance from third-party payers is totally paid for or heavily subsidized by employers or government agencies, so many patients are partially insulated from the costs of healthcare.

This highly unusual marketplace for healthcare services has a profound effect on the supply of, and demand for, such services. In this chapter, we discuss the concept of insurance, the major providers of healthcare insurance, and the methods used by insurers to pay for health services.

2 Learning Objectives After studying this chapter, readers will be able to

• Explain the overall concept of insurance, including adverse selection and moral hazard.

• Briefly describe the third-party payer system. • Explain the different types of generic payment methods. • Describe the incentives created by the different payment methods

and their impact on provider risk. • Describe the purpose and organization of managed care plans. • Explain the impact of healthcare reform on insurance and

reimbursement methodologies. • Explain the importance and types of medical coding.

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H e a l t h c a r e F i n a n c e40

Insurance Concepts

Healthcare services are supported by an insurance system composed of a wide variety of insurers of all types and sizes. Some are investor owned, while oth- ers are not-for-profit or government sponsored. Some insurers require their policyholders, who may or may not be the beneficiaries of the insurance, to make the policy payments, while other insurers collect partial or total payments from society at large. Because insurance is the cornerstone of the healthcare system, an appreciation of the nature of insurance will help you better under- stand the marketplace for healthcare services.

A Simple Illustration To better understand insurance concepts, consider a simple example. Assume that no health insurance exists and you face only two medical outcomes in the coming year:

Outcome Probability Cost Stay healthy 0.99 $ 0 Get sick 0.01 20,000

Furthermore, assume that everyone else faces the same medical out- comes at the same odds and with the same associated costs. What is your expected healthcare cost—E(Cost)—for the coming year? To find the answer, we multiply the cost of each outcome by its probability of occurrence and then sum the products:

E(Cost) = (Probability of outcome 1 × Cost of outcome 1) + (Probability of outcome 2 × Cost of outcome 2) = (0.99 × $0) + (0.01 × $20,000) = $0 + $200 = $200.

Now, assume that you, and everyone else, make $20,000 a year. With this salary, you can easily afford the $200 “expected” healthcare cost. The problem is, however, that no one’s actual bill will be $200. If you stay healthy, your bill will be zero, but if you are unlucky and get sick, your bill will be $20,000. This cost will force you, and most people who get sick, into personal bankruptcy.

Next, suppose an insurance policy that pays all of your healthcare costs for the coming year is available for $250. Would you purchase the policy, even though it costs $50 more than your expected healthcare costs? Most people would. In general, individuals are risk averse, so they would be willing to pay a $50 premium over their expected costs to eliminate the risk of financial

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ruin. In effect, policyholders are passing to the insurer the costs associated with the risk of getting sick.

Would an insurer be willing to offer the policy for $250? If an insurance company sells a million policies, its expected total policy payout is 1 million times the expected payout for each policy, or 1 million × $200 = $200 mil- lion. If there were no uncertainty about the $20,000 estimated medical cost per claim, the insurer could forecast its total claims precisely. It would col- lect 1 million × $250 = $250 million in health insurance premiums; pay out roughly $200 million in claims; and hence have about $50 million to cover administrative costs, create a reserve in case realized claims are greater than predicted by its actuaries, and make a profit.

Basic Characteristics of Insurance The simple example of health insurance we just provided illustrates why indi- viduals would seek health insurance and why insurance companies would be formed to provide such insurance. Needless to say, the concept of insurance becomes much more complicated in the real world. Insurance is typically defined as having four distinct characteristics:

1. Pooling of losses. The pooling, or sharing, of losses is the heart of insurance. Pooling means that losses are spread over a large group of individuals so that each individual realizes the average loss of the pool (plus administrative expenses) rather than the actual loss incurred.

In addition, pooling involves the grouping of a large number of homogeneous exposure units—people or things having the same risk characteristics—so that the law of large numbers can apply. (In statistics, the law of large numbers states that as the size of the sample increases, the sample mean gets closer and closer to the population mean.) Thus, pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accuracy.

2. Payment only for random losses. A random loss is one that is unforeseen and unexpected and occurs as a result of chance. Insurance is based on the premise that payments are made only for losses that are random. We discuss the moral hazard problem, which concerns losses that are not random, in a later section.

3. Risk transfer. An insurance plan almost always involves risk transfer. The sole exception to the element of risk transfer is self-insurance, which is the assumption of a risk by a business (or an individual) itself rather than by an insurance company. (Self-insurance is discussed in a later section.) Risk transfer is transfer of a risk from an insured to an insurer, which typically is in a better financial position to bear the risk than the insured because of the law of large numbers.

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H e a l t h c a r e F i n a n c e42

4. Indemnification. The final characteristic of insurance is indemnification for losses—that is, reimbursement to the insured if a loss occurs. In the context of health insurance, indemnification takes place when the insurer pays the insured, or the provider, in whole or in part for the expenses related to an insured’s illness or injury.

Adverse Selection One of the major problems facing healthcare insurers is adverse selection. Adverse selection occurs because individuals and businesses that are more likely to have claims are more inclined to purchase insurance than those that are less likely to have claims. For example, an individual without insurance who needs a costly surgical procedure will likely seek health insurance if she can afford it, whereas an individual who does not need surgery is much less likely to purchase insurance. Similarly, consider the likelihood of a 20-year-old to seek health insurance versus the likelihood of a 60-year-old to do so. The older individual, with much greater health risk due to age, is more likely to seek insurance.

If this tendency toward adverse selection goes unchecked, a dispropor- tionate number of sick people, or those most likely to become sick, will seek health insurance, and the insurer will experience higher-than-expected claims. This increase in claims will trigger a premium increase, which only worsens the problem, because the healthier members of the plan will seek insurance from other firms at a lower cost or may totally forgo insurance. The adverse- selection problem exists because of asymmetric information, which occurs when individual buyers of health insurance know more about their health status than do insurers.

In today’s world of health reform, ushered in by the Patient Protection and Affordable Care Act (ACA; introduced in Chapter 1), which requires insur- ers to take on patients regardless of preexisting conditions, the best strategy for healthcare insurers to combat adverse selection is to create a large, well- diversified pool of subscribers. If the pool is sufficiently large and diversified, the costs of adverse selection can be absorbed by the large number of enrollees.

Moral Hazard Insurance is based on the premise that payments are made only for random losses, and from this premise stems the problem of moral hazard. The most common case of moral hazard in a casualty insurance setting is the owner who deliberately sets a failing business on fire to collect the insurance. Moral hazard is also present in health insurance, but it typically takes a less dramatic form; few people are willing to voluntarily sustain injury or illness for the purpose of collecting health insurance. However, undoubtedly there are people who purposely use healthcare services that are not medically required. For example, some people might visit a physician or a walk-in clinic for the social value of

Adverse selection The problem faced by insurance companies because individuals who are more likely to have claims are also more likely to purchase insurance.

Moral hazard The problem faced by insurance companies because individuals are more likely to use unneeded health services when they are not paying the full cost of those services.

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human companionship rather than to address a medical necessity. Also, some hospital discharges might be delayed for the convenience of the patient rather than for medical purposes.

Finally, when insurance covers the full cost or most of the cost of healthcare services, individuals often are quick to agree to an expensive MRI (magnetic resonance imaging) scan or other high-cost procedure that may not be necessary. If the same test required total out-of-pocket payment, individuals would think twice before agreeing to such an expensive procedure unless they clearly understood the medical necessity involved. All in all, when somebody else is paying the costs, patients consume more healthcare services.

Even more insidious is the impact of insurance on individual behavior. Indi- viduals are more likely to forgo preventive actions and embrace unhealthy behaviors when the costs of not taking those actions will be borne by insurers. Why stop smoking if the monetary costs associated with cancer treatment are carried by the insurer? Why lose weight if others will pay for the adverse health consequences likely to result?

The primary weapon that insurers have against the moral hazard problem is coinsurance, which requires insured indi- viduals to pay a certain percentage of eligible medical expenses—say, 20 percent—in excess of the deductible amount. (Insurers also use copayments, which are similar to coinsurance but are expressed as a dollar amount: $20 per primary care visit, for example.) To illustrate coinsurance, assume that George Maynard, who has employer- provided medical insurance that pays 80 percent of eligible expenses after the $100 deductible is satisfied, incurs $10,000 in medical expenses during the year. The insurer will pay 0.80 × ($10,000 − $100) = 0.80 × $9,900 = $7,920, so George’s responsibility is $10,000 − $7,920 = $2,080. The purposes of coinsurance and copay- ments are to reduce premiums to employers

For Your Consideration Who Should Pay for Health Services? Users or Insurers?

One of the most confounding questions that arises when discussing healthcare services is who should bear the responsibility for payment. Should the patient be responsible, or should some third party such as the government or an insurance company foot the bill?

Many people argue that when individuals bear the cost of their own healthcare, they will be responsible consumers and only pay for neces- sary services. In addition, they will choose pro- viders on the basis of cost and quality and hence create the incentive for providers to offer better yet less expensive services. It is estimated that this action alone would reduce total healthcare costs in the United States by some 20–30 per- cent, or even more.

Other people argue that individuals can- not make rational decisions regarding their own healthcare because they do not sufficiently understand the nature of illness and injury. Fur- thermore, there is insufficient information about provider quality and costs available to guide individuals to good decisions. Finally, individuals would skimp on routine preventive healthcare services to save money, which would create healthcare problems down the road and ulti- mately lead to higher future costs.

What do you think? Should individuals be held more responsible for their own costs of healthcare services? What about the arguments stated above? Is there some way of balancing the need for more consumerism in healthcare service purchases with the need to protect individuals against the very high costs of many services?

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H e a l t h c a r e F i n a n c e44

and to prevent overutilization of healthcare services. Because insured individuals pay part of the cost, premiums can be reduced. Additionally, by being forced to pay some of the costs, insured individuals will presumably seek fewer and more cost-effective treatments and embrace a healthier lifestyle.

Third-Party Payers

Up to this point in the chapter, we have focused on basic insurance concepts because a large proportion of the health services industry receives its revenues not directly from the users of their services—the patients—but from insurers known collectively as third-party payers. Because an organization’s revenues are critical to its financial viability, this section contains a brief examination of the sources of most revenues in the health services industry. In the next sec- tion, the reimbursement methodologies employed by these payers are reviewed in more detail.

Health insurance originated in Europe in the early 1800s when mutual benefit societies were formed to reduce the financial burden associated with illness or injury. Since then, the concept of health insurance has changed dramatically. Today, health insurers fall into two broad categories: private insurers and public programs.

Private Insurers In the United States, the concept of public, or government, health insurance is relatively new, while private health insurance has been in existence since the early 1900s. In this section, the major private insurers are discussed: Blue Cross/Blue Shield, commercial insurers, and self-insurers.

Blue Cross/Blue Shield Blue Cross/Blue Shield organizations trace their roots to the Great Depression, when both hospitals and physicians were concerned about their patients’ ability

1. Briefly explain the following characteristics of insurance: a. Pooling of losses b. Payment only for random losses c. Risk transfer d. Indemnification

2. What is adverse selection, and how do insurers deal with the problem?

3. What is the moral hazard problem, and how do insurers mitigate the problem?

SELF-TEST QUESTIONS

Third-party payer A generic term for any outside party, typically an insurance company or a government program, that pays for part or all of a patient’s healthcare services.

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to pay healthcare bills. One example is Florida Blue (formerly Blue Cross and Blue Shield of Florida), which offers healthcare insurance to individuals and families, Medicare beneficiaries, and business groups that reside in Florida.

Blue Cross originated as a number of separate insurance programs offered by individual hospitals. At that time, many patients were unable to pay their hospital bills, but most people, except the poorest, could afford to purchase some type of hospitalization insurance. Thus, the programs were initially designed to benefit hospitals as well as patients. The programs were all similar in structure: Hospitals agreed to provide a certain amount of services to program members who made periodic payments of fixed amounts to the hospitals whether services were used or not. In a short time, these programs were expanded from single hospital programs to community-wide, multihos- pital plans that were called hospital service plans. The Blue Cross name was officially adopted by most of these plans in 1939.

Blue Shield plans developed in a manner similar to Blue Cross plans, except that the providers were physicians instead of hospitals. Today, there are 37 Blue Cross/Blue Shield (“the Blues”) organizations. Some offer only one of the two plans, but most offer both plans. The Blues are organized as independent corporations, including some for-profit entities, but all belong to a single national association that sets standards that must be met to use the Blue Cross/Blue Shield name. Collectively, the Blues provide healthcare coverage for more than 100 million individuals in all 50 states, the District of Columbia, and Puerto Rico.

Commercial Insurers Commercial health insurance is issued by life insurance companies, by casu- alty insurance companies, and by companies that were formed exclusively to offer healthcare insurance. Examples of commercial insurers include Aetna, Humana, and UnitedHealth Group. All commercial insurance companies are taxable (for-profit) entities. Commercial insurers moved strongly into health insurance following World War II. At that time, the United Auto Workers negotiated the first contract with employers in which fringe benefits were a major part of the contract. Like the Blues, the majority of individuals with commercial health insurance are covered under group policies with employee groups, professional and other associations, and labor unions.

Self-Insurers The third major form of private insurance is self-insurance. Although it might seem as if all individuals who do not have some form of health insurance are self-insurers, this is not the case. Self-insurers make a conscious decision to bear the risks associated with healthcare costs and then set aside (or have available) funds to pay future costs as they occur. Individuals, except the very

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H e a l t h c a r e F i n a n c e46

wealthy, are not good candidates for self-insurance because they face too much uncertainty concerning healthcare expenses. On the other hand, large groups, especially employers, are good candidates for self-insurance. Today, most large groups are self-insured. For example, employees of the State of Florida are covered by health insurance, the costs of which are paid directly by the state. Florida Blue is paid a fee to administer the plan, but the state bears all risks associated with cost and utilization uncertainty.

Public Insurers Government is a major insurer as well as a direct provider of healthcare services. For example, the federal government provides healthcare services directly to qualifying individuals through the medical facilities of the US Department of Veterans Affairs; the US Department of Defense and its TRICARE program (health insurance for uniformed service members and their families); and the Public Health Service, part of the US Department of Health and Human Ser- vices (HHS). In addition, government either provides or mandates a variety of insurance programs, such as workers’ compensation. In this section, however, the focus is on the two major government insurance programs: Medicare and Medicaid.

Medicare Medicare was established by Congress in 1965 primarily to provide medical benefits to individuals aged 65 or older. About 50 million people have Medi- care coverage, which pays for about 17 percent of all US healthcare services.

Over the decades, Medicare has evolved to include four major coverages: (1) Part A, which provides hospital and some skilled nursing facility cover- age; (2) Part B, which covers physician services, ambulatory surgical services, outpatient services, and other miscellaneous services; (3) Part C, which is managed care coverage offered by private insurance companies and can be selected in lieu of Parts A and B; and (4) Part D, which covers prescription drugs. In addition, Medicare covers healthcare costs associated with selected disabilities and illnesses, such as kidney failure, regardless of age.

Part A coverage is free to all individuals eligible for Social Security ben- efits. Individuals who are not eligible for Social Security benefits can obtain Part A medical benefits by paying monthly premiums. Part B is optional to all individuals who have Part A coverage, and it requires a monthly premium from enrollees that varies with income level. About 97 percent of Part A participants purchase Part B coverage, while about 20 percent of Medicare enrollees elect to participate in Part C, also called Medicare Advantage Plans, rather than Parts A and B. Part D offers prescription drug coverage through plans offered by private companies. Each Part D plan offers somewhat differ- ent coverage, so the cost of Part D coverage varies widely.

Medicare A federal government health insurance program that primarily provides benefits to individuals aged 65 or older.

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The Medicare program falls under HHS, which creates the specific rules of the program on the basis of enabling legislation. Medicare is administered by an agency in HHS called the Centers for Medicare & Medicaid Services (CMS). CMS has eight regional offices that oversee the Medicare program and ensure that regulations are followed. Medicare payments to providers are not made directly by CMS but by contractors for 12 Medicare Administrative Contractor (MAC) jurisdictions.

Before we close our discussion of Medicare, note that many private insurers offer coverage called Medicare supplement insurance, or Medigap. Such insurance is designed to help pay some of the healthcare costs that traditional Medicare does not cover, such as copayments, coinsurance, and deductibles. In addition, some Medigap policies offer coverage for services that Medicare doesn’t include, for example, medical care when traveling outside of the United States. When an individual buys Medigap coverage, Medicare will first pay its share of the Medicare-approved amount for covered costs, and then the Medigap policy pays its share.

Medicaid Medicaid began in 1966 as a modest program to be jointly funded and operated by the states and the federal government that would provide a medical safety net for low-income mothers and children and for elderly, blind, and disabled individuals who receive benefits from the Supplemental Security Income (SSI) program. Congress mandated that Medicaid cover hospital and physician care, but states were encouraged to expand on the basic package of benefits either by increasing the range of benefits or extending the program to cover more people. States with large tax bases were quick to expand coverage to many groups, while states with limited abilities to raise funds for Medicaid were forced to construct more limited programs. A mandatory nursing home benefit was added in 1972.

Over the years, Medicaid has provided access to healthcare services for many low-income individuals who otherwise would have no insurance cover- age. Furthermore, Medicaid has become an important source of revenue for healthcare providers, especially for nursing homes and other providers that treat large numbers of indigent patients. However, Medicaid expenditures have been growing at an alarming rate, which has forced both federal and state policymakers to search for more effective ways to improve the program’s access, quality, and cost.

Medicaid A federal and state government health insurance program that provides benefits to low-income individuals.

1. What are some different types of private insurers? 2. Briefly, what are the origins and purpose of Medicare? 3. What is Medicaid, and how is it administered?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e48

Managed Care Plans

Managed care plans strive to combine the provision of healthcare services and the insurance function into a single entity. Traditional plans are created by insurers who either directly own a provider network or create one through contractual arrangements with independent providers.

One type of managed care plan is the health maintenance organiza- tion (HMO). HMOs are based on the premise that the traditional insurer– provider relationship creates perverse incentives that reward providers for treating patients’ illnesses while offering little incentive for providing preven- tion and rehabilitation services. By combining the financing and delivery of comprehensive healthcare services into a single system, HMOs theoretically have as strong an incentive to prevent illnesses as to treat them. However, from a patient perspective, HMOs have several drawbacks, including a limited network of providers and the assignment of a primary care physician who acts as the initial contact and authorizes all services received from the HMO.

Another type of managed care plan, the preferred provider organiza- tion (PPO), evolved during the early 1980s. PPOs are a hybrid of HMOs and traditional health insurance plans that use many of the cost-saving strategies developed by HMOs. PPOs do not mandate that beneficiaries use specific providers, although financial incentives are created that encourage members to use those providers that are part of the provider panel—those providers that have contracts (usually at discounted prices) with the PPO. Furthermore, PPOs do not require beneficiaries to use preselected gatekeeper physicians. In general, PPOs are less likely than HMOs to provide preventive services and do not assume any responsibility for quality assurance because enrollees are not constrained to use only the PPO panel of providers.

In an effort to achieve the potential cost savings of managed care plans, most insurance companies now apply managed care strategies to their conventional plans. Such plans, which are called managed fee-for-service plans, use preadmission certification, utilization review, and second surgical opinions to control inappropriate utilization.

Although the distinctions between managed care and conventional plans were once quite apparent, considerable overlap now exists in the strate- gies and incentives employed. Thus, the term managed care now describes a continuum of plans, which can vary significantly in their approaches to provid- ing combined insurance and healthcare services. The common feature in man- aged care plans is that the insurer has a mechanism by which it controls, or at least influences, patients’ utilization of healthcare services.

Managed care plan A combined effort by an insurer and a group of providers with the purpose of both increasing quality of care and decreasing costs.

1. What is meant by the term managed care? 2. What are some different types of managed care plans?

SELF-TEST QUESTIONS

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Healthcare Reform and Insurance

The ACA introduced a number of provisions to expand insurance coverage and improve insurance affordability and access. Here are some of the act’s provisions that focus on healthcare insurance.

Insurance Standards A number of new insurance standards have been specified in the ACA. In terms of coverage, these include the following:

• Children and dependents are permitted to remain on their parents’ insurance plans until their twenty-sixth birthday.

• Insurance companies are prohibited from dropping policyholders if they become sick and from denying coverage to individuals due to preexisting conditions.

• Individuals have a right to appeal and request that the insurer review denial of payment.

In terms of costs, the standards include the following:

• Insurers are required to charge the same premium rate to all applicants of the same age and geographic location, regardless of preexisting conditions or sex.

• Insurers are required to spend at least 80 percent of premium dollars on health costs and claims instead of on administrative costs and profits. If the insurer violates this standard, it must issue rebates to policyholders.

• Lifetime limits on most benefits are prohibited for all new health insurance plans.

In terms of care, the standards include the following:

• All plans must now include essential benefits, such as ambulatory patient services; emergency services; hospitalization; maternity and newborn care; mental health and substance use disorder services; prescription drugs; laboratory services; preventive and wellness services; chronic disease management; and pediatric services, including oral and vision care.

• Preventive services, such as childhood immunizations, adult vaccinations, and basic medical screenings, must be available to patients free of charge.

• Individuals are permitted to choose a primary care doctor outside the plan’s network.

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H e a l t h c a r e F i n a n c e50

• Individuals can seek emergency care at a hospital outside the health plan’s network.

Individual Mandate All eligible individuals (US citizens and legal residents) who are not covered by an employer-sponsored health plan, Medicaid, or Medicare are required to have a health insurance policy. If they do not maintain minimum essential coverage for themselves and their dependents, they face tax penalties assessed by the Internal Revenue Services at the end of each tax year.

Health Insurance Exchanges Health insurance exchanges (HIEs) are an important part of ensuring that healthcare access is available to all Americans and legal immigrants. People who have no employer-sponsored insurance, the unemployed, or the self-employed can purchase coverage through an exchange. HIEs are online marketplaces where people can research and review their options and purchase health insur- ance. It is estimated that more than 10 million people are using HIEs to buy healthcare insurance coverage. To ensure price transparency, all participating insurance companies are required to post on HIEs the rates for their various health insurance plans. This mandate permits individuals and businesses shop- ping for insurance to compare all plans and rates side by side and select plans that are affordable and meet their needs.

There are different types of HIEs. Public exchanges are created by state or federal government and are open to both individuals seeking personal insurance and small-group employers seeking insurance for their workers. All plans listed on an HIE are required to offer core benefits—called essential health benefits—such as preventive and wellness services, prescription drugs, and hospital stays. Private exchanges, on the other hand, are created by private- sector firms, such as health insurance companies. Private HIEs are expected to increase in number over time as more employers offer defined healthcare contribution plans (discussed in a later section in this chapter) to their employ- ees, who then must purchase health insurance on their own.

Medicaid Expansion One of the provisions of the ACA is the expansion of Medicaid. Nearly all US citizens and legal residents between the ages of 19 and 64 who have house- hold incomes below 133 percent of the federal poverty level now qualify for Medicaid. This expansion benefits childless adults who previously did not qualify for Medicaid regardless of their income level as well as low-income parents who previously did not qualify even if their children did qualify. As a result, it is estimated that an additional 16 million people will receive cover- age through Medicaid.

Health insurance exchange (HIE) An online marketplace created primarily by the states or the federal government that insurers use to post plan details and consumers use to purchase healthcare insurance.

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Originally, under the ACA, Medicaid expansion was mandatory for all states; states that did not comply were to be penalized by the federal govern- ment. However, the US Supreme Court ruled that states can opt out of the Medicaid expansion, leaving this decision to participate in the hands of the state’s leaders. As of 2015, 31 states have participated in the Medicaid expan- sion program. The managed Medicaid market may be an area of high growth potential for insurance companies as more states move Medicaid beneficiaries into managed care plans.

High-Deductible Health Plans Many individuals are now choosing high-deductible health plans (HDHPs) for their health insurance coverage. HDHPs are growing in popularity because they are among the least expensive options available on HIEs. In fact, the rate of enrollment in HDHPs has more than doubled since 2009. These plans have low premiums and high deductibles and are linked with savings accounts established to pay for healthcare services. HDHPs aim to provide individuals more control over their healthcare expenditures and hence may offer an incentive to control healthcare costs.

New Insurance Markets Before health reform, the health insurance industry focused on selling group plans to employers. Now it must re-create itself to cater to an entirely new, huge market of individual consumers. Many insurers have little idea how costly it is to provide coverage to these new customers, many of whom are not working and have not been insured for a long time (or even at all). One of the biggest challenges that insurance companies will face is attempting to accurately price and administer these plans without dramatic premium increases. Another problem is that the newly insured often need education about how to use their health plan effectively and how to access different types of care.

Focus on Chronic Care As insurers and providers continue to partner in new accountable care orga- nizations (ACOs), the shared savings programs will likely increasingly focus on consumers with chronic conditions. That means implementing more patient- centered medical homes that aim to manage chronic conditions with specific care pathways that address behavioral health needs and decrease hospital admis- sions and emergency department visits. ACOs and medical homes will also increasingly make use of personal health coaches, who motivate patients on a one-on-one basis and help coordinate patient care with all caregivers.

1. Briefly describe the impact of the ACA on health insurance. 2. What is a health insurance exchange (HIE)?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e52

Generic Reimbursement Methodologies

Regardless of the payer for a particular healthcare service, only a limited number of payment methodologies are used to reimburse providers. Payment methodologies fall into two broad classifications: fee-for-service and capita- tion. In fee-for-service payment, of which many variations exist, the greater the amount of services provided, the higher the amount of reimbursement. Under capitation, a fixed payment is made to providers for each covered life, or enrollee, that is independent of the amount of services provided. In this section, we discuss the mechanics, incentives created, and risk implications of alternative reimbursement methodologies.

Fee-for-Service Methods The three primary fee-for-service methods of reimbursement are cost based, charge based, and prospective payment.

Cost-Based Reimbursement Under cost-based reimbursement, the payer agrees to reimburse the provider for the costs incurred in providing services to the insured population. Reim- bursement is limited to allowable costs, usually defined as those costs directly related to the provision of healthcare services. Nevertheless, for all practical purposes, cost-based reimbursement guarantees that a provider’s costs will be covered by payments from the payer. Typically, the payer makes periodic interim payments (PIPs) to the provider, and a final reconciliation is made after the contract period expires and all costs have been processed through the provider’s managerial (cost) accounting system.

During its early years (1966–1982), Medicare reimbursed hospitals on the basis of costs incurred. Now most hospitals are reimbursed by Medicare, and other payers, using a per diagnosis prospective payment system (see the later subsection on this topic). However, critical access hospitals, which are small rural hospitals that provide services to remote populations that do not have easy access to other hospitals, are still reimbursed on a cost basis by Medicare.

Charge-Based Reimbursement When payers pay billed charges, or simply charges, they pay according to a rate schedule established by the provider, called a chargemaster. To a certain extent, this reimbursement system places payers at the mercy of providers in regards to the cost of healthcare services, especially in markets where competition is limited. In the early days of health insurance, all payers reimbursed providers on the basis of billed charges. Some insurers still reimburse providers accord- ing to billed charges, but the trend for payers is toward other, less generous reimbursement methods. If this trend continues, the only payers that will be

Fee-for-service A reimbursement methodology that provides payment each time a service is provided.

Capitation A reimbursement methodology that is based on the number of covered lives as opposed to the amount of services provided.

Cost-based reimbursement A fee-for-service reimbursement method based on the costs incurred in providing services.

Charge-based reimbursement A fee-for-service reimbursement method based on charges (chargemaster prices).

Chargemaster A list of all items and services provided by a health services organization containing their gross (list) prices.

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expected to pay billed charges are self-pay, or private-pay, patients. Even then, low-income patients often are billed at rates less than charges.

Some payers that historically have reimbursed providers on the basis of billed charges now pay by negotiated, or discounted, charges. This is especially true for insurers that have established managed care plans. Additionally, many conventional insurers have bargaining power because of the large number of patients that they bring to a provider, so they can negotiate discounts from billed charges. Such discounts generally range from 20 to 50 percent, or even more, of billed charges. The effect of these discounts is to create a system similar to hotel or airline pricing, where there are listed rates (chargemaster prices for providers, and rack rates or full fares for hotels and airlines) that few people pay.

Prospective Payment In a prospective payment system, the rates paid by payers are established by the payer before the services are provided. Furthermore, payments are not directly related to either costs or chargemaster rates. Here are some common units of payment used in prospective payment systems:

• Per procedure. Under per procedure reimbursement, a separate payment is made for each procedure performed on a patient. Because of the high administrative costs associated with this method when applied to complex diagnoses, per procedure reimbursement is more commonly used in outpatient than in inpatient settings.

• Per diagnosis. In the per diagnosis reimbursement method, the provider is paid a rate that depends on the patient’s diagnosis. Diagnoses that require higher resource utilization, and hence are more costly to treat, have higher reimbursement rates. Medicare pioneered this basis of payment in its diagnosis-related group (DRG) system, which it first used for hospital inpatient reimbursement in 1983.

• Per day (per diem). If reimbursement is based on a per diem payment, the provider is paid a fixed amount for each day that service is provided, regardless of the nature of the service. Note that per diem rates, which are applicable only to inpatient settings, can be stratified. For example, a hospital may be paid one rate for a medical/surgical day, a higher rate for a critical care unit day, and yet a different rate for an obstetrics day. Stratified per diems recognize that providers incur widely different daily costs for providing different types of care.

• Bundled. Under bundled payment, payers make a single prospective payment that covers all services delivered in a single episode, whether the services are rendered by a single provider or by multiple providers. For example, a bundled payment may be made for all obstetric services

Prospective payment A fee-for-service reimbursement method that is established beforehand by the third-party payer and, in theory, not related to costs or charges.

Per diem payment A fee-for-service reimbursement method that pays a set amount for each inpatient day.

Bundled (global) payment The fee-for-service payment of a single amount for the complete set of services required to treat a single episode.

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H e a l t h c a r e F i n a n c e54

associated with a pregnancy provided by a single physician, including all prenatal and postnatal visits as well as the delivery. For another example, a bundled payment may be made for all physician and hospital services associated with a cardiac bypass operation. Finally, note that, at the extreme, a bundled payment may cover an entire population. In this situation, the payment becomes a global payment, which, in effect, is a capitation payment as described in the next section.

Capitation Up to this point, the prospective payment methods presented have been fee-for-service methods—that is, providers are reimbursed on the basis of the amount of services pro- vided. The service may be defined as a visit, a diagnosis, a hospital day, an episode, or in some other manner, but the key feature is that the more services that are performed, the greater the reimbursement amount. Capitation, although a form of prospective payment, is an entirely different approach to reimbursement and hence deserves to be treated as a separate category. Under capitated reimbursement, the provider is paid a fixed amount per covered life per period (usually a month) regardless of the

amount of services provided. For example, a primary care physician might be paid $15 per member per month for handling 100 members of an HMO plan.

Capitation payment, which is used primarily by managed care plans, dra- matically changes the financial environment of healthcare providers. It has implica- tions for financial accounting, managerial accounting, and financial management. Discussion of how capitation, as opposed to fee-for-service reimbursement, affects healthcare finance is provided throughout the remainder of this book.

For Your Consideration Creating the Proper Provider Incentives

An article in the Wall Street Journal (February 18, 2015, page A1) describes how one patient in a Kindred Healthcare long-term care hospital was discharged after 23 days of treatment for compli- cations from a previous knee surgery. According to family members, the timing of his release did not appear to be related to any improvement in his medical condition. However, it did result in a higher reimbursement that the hospital received for his stay.

According to billing documents, Kindred collected $35,887.79 from Medicare for his treat- ment, the maximum amount it could earn for treating patients with his condition. Under Medi- care’s reimbursement rules, if the patient had left the hospital one day earlier, Kindred would have received a per diem rate that would have resulted in a total payment of roughly $20,000. If he had stayed longer than 23 days, the hospital likely would not have received any additional reimbursement other than the $35,887.79 single payment for an “extended” stay.

What do you think? What incentives are created for providers under the reimbursement method used by Medicare for long-term (as opposed to acute care) hospitals? Can you think of a payment system that would encourage long- term care hospitals to discharge patients at the appropriate time?

1. Briefly explain the following payment methods: • Cost based

SELF-TEST QUESTIONS

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Provider Incentives Under Alternative Reimbursement Methodologies

Providers, like individuals and businesses, react to the incentives created by the financial environment. For example, individuals can deduct mortgage interest from income for tax purposes, but they cannot deduct interest payments on personal loans. Loan companies have responded by offering home equity loans that are a type of second mortgage. The intent is not that such loans would always be used to finance home ownership, as the tax laws assumed, but that the funds could be used for other purposes, including paying for vacations and purchasing cars or appliances. In this situation, tax laws created incen- tives for consumers to have mortgage debt rather than personal debt, and the mortgage loan industry responded accordingly.

In the same vein, it is interesting to examine the incentives that alter- native reimbursement methods have on provider behavior. Under cost-based reimbursement, providers are given a “blank check” in regard to acquiring facilities and equipment and incurring operating costs. If payers reimburse providers for all costs, the incentive is to incur costs. Facilities will be lavish and conveniently located, and staff will be available to ensure that patients are given “deluxe” treatment. Furthermore, as in billed charges reimbursement, services that may not truly be required will be provided because more services lead to higher costs and hence lead to higher revenues.

Under charge-based reimbursement, providers have the incentive to set high charge rates, which lead to high revenues. However, in competitive markets, there will be a constraint on how high providers can go. But, to the extent that insurers, rather than patients, are footing the bill, there is often considerable leeway in setting charges. Because billed charges is a fee-for- service type of reimbursement in which more services result in higher revenue, a strong incentive exists to provide the highest possible amount of services. In essence, providers can increase utilization, and hence revenues, by churn- ing—creating more visits, ordering more tests, extending inpatient stays, and

• Charge based and discounted charges • Per procedure • Per diagnosis • Per diem • Bundled • Capitation

2. What is the major difference between fee-for-service reimbursement and capitation?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e56

so on. Charge-based reimbursement does encourage providers to contain costs because (1) the spread between charges and costs represents profits, and the more the better, and (2) lower costs can lead to lower charges, which can increase volume. Still, the incentive to contain costs is weak because charges can be increased more easily than costs can be reduced. Note, however, that discounted charge reimbursement places additional pressure on profitability and hence increases the incentive for providers to lower costs.

Under prospective payment reimbursement, provider incentives are altered. First, under per procedure reim- bursement, the profitability of individual procedures varies depending on the rela- tionship between the actual costs incurred and the payment for that procedure. Provid- ers, usually physicians, have the incentive to perform procedures that have the highest profit potential. Furthermore, the more pro- cedures the better, because each procedure typically generates additional profit. The incentives under per diagnosis reimburse- ment are similar. Providers, usually hospitals, will seek patients with those diagnoses that have the greatest profit potential and dis- courage (or even discontinue) those services that have the least potential. Furthermore, to the extent that providers have some flex- ibility in selecting procedures (or assigning diagnoses) to patients, an incentive exists to up code procedures (or diagnoses) to ones that provide the greatest reimbursement.

In all prospective payment methods, providers have the incentive to reduce costs because the amount of reimbursement is fixed and independent of the costs actually incurred. For example, when hospitals are paid under per diagnosis reimbursement, they have the incentive to reduce length of stay and hence costs. Note, however, when per diem reimbursement is used, hospitals have an incentive to increase length of stay. Because the early days of a hospitalization typically are more costly than the later days, the later days are more profitable. However,

For Your Consideration Value-Based Purchasing

Value-based purchasing rests on the concept that buyers of healthcare services should hold providers accountable for quality of care as well as costs. In April 2011, HHS launched the Hospital Value-Based Purchasing program, which marks the beginning of a historic change in how Medi- care pays healthcare providers. For the first time, 3,500 hospitals across the country are being paid for inpatient acute care services based on care quality, not just the quantity of the services provided.

“Changing the way we pay hospitals will improve the quality of care for seniors and save money for all of us,” said former HHS Secretary Kathleen Sebelius. “Under this initiative, Medi- care will reward hospitals that provide high- quality care and keep their patients healthy. It’s an important part of our work to improve the health of our nation and drive down costs. As hospitals work to improve quality, all patients— not just Medicare patients—will benefit.” The ini- tial measures to determine quality focus on how closely hospitals follow best clinical practices and how well hospitals enhance patients’ care experi- ences. The better a hospital does on its quality measures, the greater the reward it will receive from Medicare.

What do you think? Should providers be reimbursed based on quality of care? How should “quality” be measured? Should the additional reimbursement to high-quality providers be obtained by reductions in reimbursement to low- quality providers?

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as mentioned previously, hospitals have the incentive to reduce costs during each day of a patient stay.

Under bundled pricing, providers do not have the opportunity to be reimbursed for a series of separate services, which is called unbundling. For example, a physician’s treatment of a fracture could be bundled, and hence billed as one episode, or it could be unbundled with separate bills submitted for making the diagnosis, taking x-rays, setting the fracture, removing the cast, and so on. The rationale for unbundling is usually to provide more detailed records of treatments rendered, but often the result is higher total charges for the parts than would be charged for the entire package. Also, bundled pricing, when applied to multiple providers for a single episode of care, forces involved providers (e.g., physicians and a hospital) to jointly offer the most cost-effective treatment. Such a joint view of cost containment may be more effective than each provider separately attempting to minimize its treatment costs because lowering costs in one phase of treatment could increase costs in another.

Finally, capitation reimbursement totally changes the playing field by completely reversing the actions that providers must take to ensure financial success. Under all fee-for-service methods, the key to provider success is to work harder, increase utilization, and hence increase profits; under capitation, the key to profitability is to work smarter and decrease utilization. As with prospective payment, capitated providers have the incentive to reduce costs, but now they also have the incentive to reduce utilization. Thus, only those procedures that are truly medically necessary should be performed, and treat- ment should take place in the lowest-cost setting that can provide the appro- priate quality of care. Furthermore, providers have the incentive to promote health, rather than just treat illness and injury, because a healthier population consumes fewer healthcare services.

Medical Coding: The Foundation of Fee-for-Service Reimbursement

Medical coding, or medical classification, is the process of transforming descriptions of medical diagnoses and procedures into code numbers that can be universally recognized and interpreted. The diagnoses and procedures are usually taken from a variety of sources within the medical record, such as doctor’s notes, laboratory results, and radiological tests. In practice, the basis for most fee-for-service reimbursement is the patient’s diagnosis (in the

1. What are the provider incentives created under fee-for-service reimbursement? Under capitation?

SELF-TEST QUESTION

Medical coding The process of transforming medical diagnoses and procedures into universally recognized numerical codes.

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H e a l t h c a r e F i n a n c e58

case of inpatient settings) or the procedures performed on the patient (in the case of outpatient settings). Thus, a brief background on clinical coding will enhance your understanding of the reimbursement process.

Diagnosis Codes The International Classification of Diseases (most commonly known by the abbreviation ICD) is the standard for designating diseases plus a wide variety of signs, symptoms, and external causes of injury. Published by the World Health Organization, ICD codes are used internationally to record many types of health events, including hospital inpatient stays and death certificates. (ICD codes were first used in 1893 to report death statistics.)

The codes are periodically revised; the most recent version is ICD-10. However, US hospitals are still using a modified version of the ninth revision, called ICD-9-CM, where CM stands for Clinical Modification. The ICD-9 codes consist of three, four, or five digits. The first three digits denote the disease category, and the fourth and fifth digits provide additional information. For example, code 410 describes an acute myocardial infarction (heart attack), while code 410.1 is an attack involving the anterior wall of the heart. (However, the conversion to ICD-10 codes will occur October 1, 2015, although hospitals will not be penalized if they continue to use ICD-9 codes for one additional year. The conversion process is consuming and costly because there are more than five times as many individual codes in ICD-10 as in ICD-9. Of course, the information provided by the new code set will be more detailed and complete.)

In practice, the application of ICD codes to diagnoses is complicated and technical. Hospital coders have to understand the coding system and the medical terminology and abbreviations used by clinicians. Because of this complexity, and because proper coding can mean higher reimbursement from third-party payers, ICD coders require a great deal of training and experience to be most effective.

Procedure Codes While ICD codes are used to specify diseases, Current Procedural Terminol- ogy (CPT) codes are used to specify medical procedures (treatments). CPT codes were developed and are copyrighted by the American Medical Associa- tion. The purpose of CPT is to create a uniform language (set of descriptive terms and codes) that accurately describes medical, surgical, and diagnostic procedures. CPT and its corresponding codes are revised periodically to reflect current trends in clinical treatments. To increase standardization and the use of electronic health records, federal law requires that physicians and other clinical providers, including laboratory and diagnostic services, use CPT for the coding and transfer of healthcare information. (The same law also requires that ICD codes be used for hospital inpatient services.)

International Classification of Diseases (ICD) codes Numerical codes for designating diseases plus a variety of signs, symptoms, and external causes of injury.

Current Procedural Terminology (CPT) codes Codes applied to medical, surgical, and diagnostic procedures.

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To illustrate CPT codes, there are ten codes for physician office visits. Five of the codes apply to new patients, while the other five apply to established patients (repeat visits). The differences among the five codes in each category are based on the complexity of the visit, as indicated by three components: (1) extent of patient history review, (2) extent of examination, and (3) difficulty of medical decision making. For repeat patients, the least complex (typically shortest) office visit is coded 99211, while the most complex (typically lon- gest) is coded 99215.

Because government payers (Medicare and Medicaid) as well as other insurers require additional information from providers beyond that contained in CPT codes, an enhanced version called the Healthcare Common Proce- dure Coding System (HCPCS, commonly pronounced “hick picks”) was developed. This system expands the set of CPT codes to include nonphysi- cian services and durable medical equipment such as ambulance services and prosthetic devices.

Although CPT and HCPCS codes are not as complex as the ICD codes, coders still must have a high level of training and experience to use them cor- rectly. As in ICD coding, correct CPT coding ensures correct reimbursement. Coding is so important that many businesses offer services, such as books, software, education, and consulting, to hospitals and medical practices to improve coding efficiency.

Specific Reimbursement Methods

There are many specific reimbursement methods in use today. Typically, the methods differ from one insurer to another. In addition, insurers use differ- ent methods for different types of providers and services, such as hospitals versus physicians or even hospital inpatients versus outpatients. In this sec- tion, we discuss the specific methods used by Medicare to reimburse hospitals for inpatient services and physicians for all services. We discuss other specific reimbursement methods used by Medicare in the chapter supplement.

Hospital Inpatient Services The Medicare inpatient prospective payment system (IPPS) is a prospective payment methodology based on an inpatient’s diagnosis at discharge. It starts with two national base payment rates (operating and capital expenses), which

Healthcare Common Procedure Coding System (HCPCS) A medical coding system that expands the CPT codes to include nonphysician services and durable medical equipment.

1. Briefly describe the coding system used in hospitals (ICD codes) and medical practices (CPT codes).

2. What is the link between coding and reimbursement?

SELF-TEST QUESTIONS

Inpatient prospective payment system (IPPS) The method, based on diagnosis, that Medicare uses to reimburse providers for inpatient services.

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H e a l t h c a r e F i n a n c e60

are then adjusted to account for two factors that affect the costs of providing care: (1) the patient’s condition and treatment and (2) market conditions in the facility’s geographic location (Exhibit 2.1).

Discharges are assigned to one of 751 Medicare severity diagnosis-related groups (MS–DRGs), which designate the diagnoses of patients with similar clinical problems and, hence, who are expected to consume similar amounts of hospital resources. Each MS–DRG has a relative weight that reflects the expected cost of inpatients in that group. The payment rates for MS–DRGs in each local market are determined by adjusting the base payment rates to reflect the local input price level and then multiplying them by the rela- tive weight for each MS–DRG. The operating and capital payment rates are increased for facilities that operate an approved resident training program

+ + =

Adjusted for geographic factors

Adjusted for case mix

Adjustment for transfers

Policy adjustments for hospitals that qualify

If case is extraordinarily

costly

Wage index ≥ 1.0

Wage index ≤ 1.0

Indirect medical

education payment

Disproportionate share payment

Full LOS

Short LOS and discharged

to other acute IPPS hospital or post-acute

care*

Operating base

payment rate

Adjusted base

payment rate

Per case payment

rate

Payment**

High- cost

outlier (payment

+ outlier

payment)

Per diem

payment rate

Hospital wage index

Adjusted base

payment rate

MS–DRG

Patient characteristics

69.6% adjusted for area wages

62% adjusted for area wages

Principal diagnosis Procedure Complications and comorbidities

Non-labor- related portion

Base rate adjusted

for geographic

factors

MS–DRG weight

EXHIBIT 2.1 Medicare

Hospital Acute Inpatient Services Payment

System

Note: MS–DRG (Medicare severity diagnosis-related group), LOS (length of stay), IPPS (inpa- tient prospective payment system). Capital payments are determined by a similar system.

* Transfer policy for cases discharged to post-acute care settings applies for cases in 275 selected MS–DRGs.

** Additional payment made for certain rural hospitals.

Source: Reprinted from MedPAC. 2014. “Hospital Acute Inpatient Services Payment System.” Figure 1. Revised October. www.medpac.gov/documents/payment-basics/hospital-acute- inpatient-services-payment-system-14.pdf.

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or that treat a disproportionate share of low-income patients. Rates are reduced for various transfer cases, and outlier payments are added for cases that are extraordinarily costly to protect providers from large finan- cial losses due to unusually expensive cases. Both operating and capital payment rates are updated annually.

The IPPS rates are intended to cover the costs that reasonably efficient provid- ers would incur in providing high-quality care. If the hospital is able to provide the services for less than the fixed reimburse- ment amount, it can keep the difference. Conversely, if a Medicare patient’s treat- ment costs are more than the reimburse- ment amount but do not meet the definition of an outlier, the hospital must bear the loss.

Physician Services Medicare pays for physician services using a resource-based relative value scale (RBRVS) system. In the RBRVS system, payments for services are determined by the resource costs needed to provide them as measured by weights called relative value units (RVUs). RVUs consist of three components: (1) a work RVU, which includes the skill level and training required along with the intensity and time required for the service; (2) a practice expense RVU, which includes equipment and supplies costs as well as office support costs, including labor; and (3) a malpractice expense RVU, which accounts for the relative risk and cost of potential malpractice claims. To illustrate, the (total) RVU is 0.52 for a minimal office visit, 1.32 for an average office visit, and 3.06 for a compre- hensive office visit. Furthermore, the average office visit RVU is composed of a work RVU of 0.67, a practice expense RVU of 0.62, and a malpractice expense RVU of 0.03.

The RVU values then are adjusted to reflect variations in local input prices, and the total is multiplied by a standard dollar value—called the con- version factor—to arrive at the payment amount. Medicare’s payment rates may also be adjusted to reflect provider characteristics, geographic

Relative value unit (RVU) A measure of the amount of resources consumed to provide a particular service. When applied to physicians, a measure of the amount of work, practice expenses, and liability costs associated with a particular service.

Industry Practice Using RVUs for Physician Compensation

Traditionally, there have been a number of ways of estimating physician productivity when tying com- pensation to performance. For many years, productiv- ity was measured by volume-based metrics such as number of patients seen or amount of revenue billed. Today, however, physician productivity measures and compensation models are rapidly moving toward models based on relative value units (RVUs).

Work RVUs, which are one of three components of RVUs, measure the relative level of time, skill, train- ing, and intensity required of a physician to provide a given service. As such, they are a good proxy for the training required and volume of work expended by a physician in treating patients. A routine well-patient visit, for example, would be assigned a lower RVU than an invasive surgical procedure would. Given this relative scale, a physician seeing two or three com- plex or high-acuity patients per day could accumulate more RVUs than a physician seeing ten or more low- acuity patients per day. Thus, the nature of the work, rather than number of patients or billings, is being measured and hence used for compensation levels.

According to the Medical Group Manage- ment Association (MGMA), well over half of all physicians are compensated, at least in part, on the basis of productivity as measured by work RVUs. Usually, work RVUs are combined with other productivity and quality measures in determining productivity and compensation, but there is little doubt that work RVUs have the dominant role.

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H e a l t h c a r e F i n a n c e62

designations, and other factors. The provider is paid the final amount, less any beneficiary coinsurance (Exhibit 2.2).

Healthcare Reform and Reimbursement Methods

In addition to improving healthcare delivery through focusing on access and quality, the ACA has significantly changed the way providers are reimbursed. The key reforms include a move from a fee-for-service model to a prospective payment model, which may include bundled payments or capitation. These new payment methods aim to move reimbursement from that based on the amount of services provided (volume) to that based on value and better outcomes.

1. Briefly describe the method used by Medicare to reimburse for inpatient services.

2. Explain the method used by Medicare to reimburse for physician services.

SELF-TEST QUESTIONS

+ +× × × ×

Complexity of service

and expenses

Geographic factors

Provider type Geographic Service type

Payment

Adjusted for:

Conversion factor

Payment modifier

Adjusted fee schedule

payment rate

Adjusted fee schedule

payment rate

Total RVUs from physician fee schedule

Policy adjustments (multiplicative)

Work RVU

PE RVU

PLI RVU

PLI GPCI

PE GPCI

Work GPCI

(decreases)

Nonphysician Nonparticipating HPSA bonus Primary

care Major surgical

procedures

(increases) (increases)

EXHIBIT 2.2 Medicare Physician

Services Payment

System

Note: RVU (relative value unit), GPCI (geographic practice cost index), PE (practice expense), PLI (professional liability insurance), HPSA (health professional shortage area). This figure depicts Medicare payments only. The fee schedule lists separate PE RVUs for facility and nonfacility settings. Fee schedule payments are reduced when specified nonphysician practitioners bill Medicare separately, but not when services are provided “incident to” a physician.

Source: Reprinted from MedPAC. 2014. “Physician and Other Health Professionals Payment System.” Figure 1. Revised October. http://medpac.gov/documents/payment-basics/physician- and-other-health-professionals-payment-system-14.pdf.

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The new payment methods are specifically designed to accomplish the following:

• Encourage providers to deliver care in a high-quality, cost-efficient manner

• Support coordination of care among multiple providers • Adopt evidence-based care standards and protocols that result in the

best outcomes for patients • Provide accountability and transparency • Discourage overtreatment and medically unnecessary procedures • Eliminate or reduce the occurrence of adverse events • Discourage cost shifting

The sections that follow describe a few of the important implications for provider payments.

Value-Based Purchasing Value-based purchasing (VBP) is a Medicare initiative that rewards acute care hospitals with incentive payments for providing high-quality care to Medicare beneficiaries, which should lead to better clinical outcomes for all hospital- ized patients. The amounts of these payments are based on how closely the institution followed best clinical practices, how well it enhanced patients’ care experiences, how well it achieved quality goals, and how much it improved on each measure compared to its performance during the baseline period. Note that some VBP programs are paired with shared savings programs (discussed later) to reward cost reduction as well as quality of care.

Quality-Based Clinician Compensation In addition to VBP for hospitals, the ACA requires Medicare to factor quality into payments for physicians and most other clinicians. Quality-based com- pensation is part of Medicare’s effort to shift medicine away from the volume- based focus, where clinicians are paid for each service regardless of quality. Clinicians can earn additional compensation based on the quality of care they provide to their patients. Bonuses and penalties are calculated on the basis of performance on quality measures, which vary by specialty. As with VBP programs for hospitals, quality-based clinician reimbursement programs can be paired with shared savings programs.

Shared Savings Programs Shared savings is an approach to reducing healthcare costs and, potentially, a mechanism for encouraging the creation of ACOs. Under shared savings, if a provider reduces total healthcare spending for its patients below the level

Value-based purchasing (VBP) An approach to provider reimbursement that rewards quality of care rather than quantity of care.

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H e a l t h c a r e F i n a n c e64

that the payer expected, the provider is then rewarded with a portion of the savings. The benefits are twofold: (1) The payer spends less than it would oth- erwise, and (2) the provider gets more revenue than it expected. The savings can arise from the more efficient, cost-effective use of hospital or outpatient services that enhance quality, reduce costs over time, and improve outcomes. It can be applied to hospital episodes of care, including physician services, or to physician office care.

New Bundled Payment Models Bundled payment models are a form of fee-for-service reimbursement in which a single sum covers all healthcare services related to a specific procedure. The objective of bundled payments is to promote more efficient use of resources and reward providers for improving the coordination, quality, and efficiency of care. If the cost of services is less than the bundled payment, the physicians and other providers retain the difference. But if the costs exceed the bundled payment, physicians and other providers are not compensated for the difference.

In some circumstances, an ACO may receive the bundled payment and subsequently divide the payment among participating physicians and providers. In other situations, the payer may pay participating physicians and provid- ers independently, but it may adjust each payment according to negotiated predefined rules to ensure that the total payments to all the providers do not exceed the total bundled payment amount. This type of reimbursement is called virtual bundling. For providers, the challenges of bundled payments include determining who owns the episode of care and apportioning the pay- ment among the various providers.

Readmission Reduction Program With the passage of the ACA, Medicare now has the authority to penalize hospitals if they experience excessive readmission rates compared to expected levels of readmission. The readmissions are based on a 30-day readmission measure for heart attack, heart failure, and pneumonia.

Hospital-Acquired Conditions In a relatively new initiative, hospitals will be penalized by Medicare for hospital- acquired conditions. Hospital-acquired conditions include bedsores, infections, complications from extended use of catheters, and injuries caused by falls. Hospitals will face a 1 percent reduction in Medicare inpatient payments for all discharges if they rank in the top 25 percent of hospital-acquired conditions for all hospitals in the previous year.

1. Briefly describe the impact of the ACA on payments to providers. SELF-TEST QUESTION

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Key Concepts This chapter covers important background material related to healthcare insurance and provider reimbursement. The key concepts of this chapter are as follows:

• Health insurance is widely used in the United States because individuals are risk averse and insurance firms can take advantage of the law of large numbers.

• Insurance is based on four key characteristics: (1) pooling of losses, (2) payment for random losses, (3) risk transfer, and (4) indemnification.

• Adverse selection occurs when individuals most likely to have claims purchase insurance while those least likely to have claims do not.

• Moral hazard occurs when an insured individual purposely sustains a loss, as opposed to a random loss. In a health insurance setting, moral hazard is more subtle, producing such behaviors as seeking more services than needed and engaging in unhealthy behavior because the costs of the potential consequences are borne by the insurer.

• Most provider revenue is not obtained directly from patients but from healthcare insurers, known collectively as third-party payers.

• Third-party payers are classified as private insurers (Blue Cross/ Blue Shield, commercial, and self-insurers) and public insurers (Medicare and Medicaid).

• Managed care plans, such as health maintenance organizations (HMOs), strive to combine the insurance function and the provision of healthcare services.

• Third-party payers use many different payment methods that fall into two broad classifications: fee-for-service and capitation. Each payment method creates a unique set of incentives and risk for providers.

• When payers pay billed charges, they pay according to a schedule of rates established by the provider called a chargemaster.

• Negotiated charges, which are discounted from billed charges, are used by insurers with sufficient market power to demand price reductions.

• Under a cost-based reimbursement system, payers agree to pay providers certain allowable costs incurred when providing services to the payers’ enrollees.

(continued)

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H e a l t h c a r e F i n a n c e66

Because the managers of health services organizations must make finan- cial decisions within the constraints imposed by the economic environment, the insurance and reimbursement concepts discussed in this chapter will be used over and over throughout the remainder of the book.

• In a prospective payment system, the rates paid by payers are determined in advance and are not tied directly to reimbursable costs or billed charges. Typically, prospective payments are made on the basis of the following service definitions: (1) per procedure, (2) per diagnosis, (3) per diem (per day), or (4) bundled pricing.

• Capitation is a flat periodic payment to a physician or another healthcare provider; it is the sole reimbursement for providing services to a defined population. Capitation payments are generally expressed as some dollar amount per member per month, where the word member typically refers to an enrollee in some managed care plan.

• Medical coding is the foundation of fee-for-service reimbursement systems. In inpatient settings, ICD codes are used to designate diagnoses, while in outpatient settings, CPT codes are used to specify procedures.

• Medicare uses the inpatient prospective payment system (IPPS) for hospital inpatient reimbursement. Under IPPS, the amount of the payment is determined by the patient’s Medicare severity diagnosis- related group (MS–DRG).

• To provide some cushion for the high costs associated with severely ill patients within each diagnosis, IPPS includes a provision for outlier payments.

• Physicians are reimbursed by Medicare using the resource-based relative value scale (RBRVS). Under RBRVS, reimbursement is based on relative value units (RVUs), which consist of three resource components: (1) physician work, (2) practice expenses, and (3) malpractice insurance expenses. The RVU for each service is multiplied by a dollar conversion factor to determine the payment amount.

• The ACA is having a significant impact on health insurance and on the way providers are reimbursed. More people now have access to insurance coverage, and the new provider payment methods emphasize value and patient outcomes over volume.

(continued from previous page)

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Questions

2.1 Briefly explain the following characteristics of insurance: a. Pooling of losses b. Payment only for random losses c. Risk transfer d. Indemnification 2.2 What is adverse selection, and how do insurers deal with the

problem? 2.3 What is the moral hazard problem? 2.4 Briefly describe the major third-party payers. 2.5 a. What are the primary characteristics of managed care plans? b. Describe different types of managed care plans. 2.6 What is the difference between fee-for-service reimbursement and

capitation? 2.7 Describe the provider incentives under each of the following

reimbursement methods: a. Cost based b. Charge based (including discounted charges) c. Per procedure d. Per diagnosis e. Per diem f. Bundled payment g. Capitation 2.8 What medical coding systems are used to support fee-for-service

payment methodologies? 2.9 Briefly describe how Medicare pays for the following: a. Inpatient services b. Physician services

2.10 What are some features of the ACA that affect healthcare insurance and reimbursement?

Resources

For the latest information on events that affect the healthcare sector, see Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

Other resources pertaining to this chapter include

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H e a l t h c a r e F i n a n c e68

Beagle, J. T. 2010. “Episode-Based Payment: Bundling for Better Results.” Healthcare Financial Management (February): 36–39.

D’Cruz, M. J., and T. L. Welter. 2010. “Is Your Organization Ready for Value-Based Payments?” Healthcare Financial Management (January): 64–72.

———. 2008. “Major Trends Affecting Hospital Payment.” Healthcare Financial Management (January): 53–60.

Harris, J., I. Elizondo, and A. Isdaner. 2014. “Medicare Bundled Payment: What Is It Worth to You?” Healthcare Financial Management (January): 76–82.

Kentros, C., and C. Barbato. 2013. “Using Normalized RVU Reporting to Evaluate Physician Productivity.” Healthcare Financial Management (August): 98–105.

Kim, C., D. Majka, and J. H. Sussman. 2011. “Modeling the Impact of Healthcare Reform.” Healthcare Financial Management (January): 51–60.

Mulvany, C. 2013. “Insurance Market Reform: The Grand Experiment.” Healthcare Financial Management (April): 82–88.

———. 2010. “Healthcare Reform: The Good, the Bad, and the Transformational.” Healthcare Financial Management (June): 52–57.

Patton, T. L. 2009. “The IRS’s Version of Community Benefit: A Look at the Rede- signed Form 990 and New Schedule H.” Healthcare Financial Management (February): 50–54.

Pearce, J. W., and J. M. Harris. 2010. “The Medicare Bundled Payment Pilot Program: Participation Considerations.” Healthcare Financial Management (September): 52–60.

Ronning, P. L. 2011. “ICD-10: Obligations and Opportunities.” Healthcare Financial Management (August): 48–51.

Saqr, H., O. Mikhail, and J. Langabeer. 2008. “The Financial Impact of the Medicare Prospective Payment System on Long-Term Acute Care Hospitals.” Journal of Health Care Finance (Fall): 58–69.

Shoemaker, P. 2011. “What Value-Based Purchasing Means to Your Hospital.” Health- care Financial Management (August): 61–68.

Tyson, P. 2010. “Preparing for the New Landscape of Payment Reform.” Healthcare Financial Management (December): 42–48.

Wilensky, G. R. 2011. “Continuing Uncertainty Dominates the Healthcare Landscape.” Healthcare Financial Management (March): 34–35.

Williams, J. 2013. “A New Model for Care: Population Management.” Healthcare Financial Management (March): 69–76.

Woodson, W., and S. Jenkins. 2010. “Payment Reform: How Should Your Organiza- tion Prepare?” Healthcare Financial Management (January): 74–79.

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CHAPTER SUPPLEMENT

2ADDITIONAL MEDICARE PAYMENT METHODS

Introduction

In Chapter 2, we discussed the inpatient prospective payment system (IPPS) and the resource-based relative value scale (RBRVS) system used by Medicare to reimburse hospitals for inpatient services and physicians for all services. In this supplement, we provide information on the other primary reimbursement methods used by Medicare.

Outpatient Hospital Services

The outpatient prospective payment system (OPPS) is essentially a fee schedule. The unit of payment under the OPPS is the individual service as identified by the Healthcare Common Procedure Coding System (HCPCS), which contains codes for about 6,700 distinct services. Medicare groups services into ambulatory pay- ment classifications (APCs) on the basis of clinical and cost similarity. Each APC has a relative weight that measures the resource requirements of the service and is based on the median cost of services in that APC. The Centers for Medicare & Medicaid Services (CMS) sets payments for individual APCs using a conversion factor that translates the relative weights into dollar payment rates with adjustments for geographic differences in input prices. Hospitals also can receive additional payments in the form of outlier adjustments for extraordinarily high-cost services and pass-through payments for selected new technologies (Exhibit S2.1).

Ambulatory Surgery Centers

Medicare pays for surgery-related facility services provided in ambulatory sur- gery centers (ASCs) based on the individual surgical procedure. Each of the nearly 3,600 approved procedures is assigned an APC from the same payment groups as used for hospital outpatient services. The relative weights for most procedures in the ASC payment system are the same as the relative weights used in the OPPS. Like the OPPS, the ambulatory surgical center payment system sets payments for individual services using a conversion factor and adjustments for geographic differences in input prices. Note that the payment for facilities services is separate from the payment for physician services.

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h ap

te r

2 S

u p

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Inpatient Rehabilitation Facilities

Inpatient rehabilitation facilities are paid predetermined, per discharge rates based primarily on the patient’s condition (diagnoses, functional and cognitive status, and age) and market area wages. Discharges are assigned to one of 92 intensive rehabilitation categories called case-mix groups (CMGs), which are groups of patients with similar clinical problems. Within each of these CMGs, patients are further categorized into one of four tiers on the basis of comor- bidities, with each tier having a specific payment that reflects the costliness of patients in that tier relative to others in the CMG.

Psychiatric Hospital Services

Medicare uses the inpatient psychiatric facility prospective payment system for psychiatric hospital services, which is based on a per diem rate plus additional payments for ancillary services and capital costs. A base per diem payment is adjusted to account for cost-of-care differences related to patient character- istics, such as age, diagnosis, comorbidities, and length of stay, and facility characteristics, such as local wages, geographic location, teaching status, and emergency department status.

+ + + +× =

Hospital wage index

APC

Payment Conversion

factor

High- cost

outlier (payment

+ outlier

payment)

Adjusted for geographic factors

Payment adjusted for complexity of service

Policy adjustments for hospitals that qualify

If patient is extraordinarily costly

60% adjusted for area wages

40% non-labor-

related portion

Measures resource

requirements of service

Conversion factor

adjusted for geographic

factors

APC relative weight

7.1% add-on

for rural SCHs

Hold harmless for cancer

and children’s hospitals

EXHIBIT S2.1 Medicare

Outpatient Hospital Services Payment

System

Note: APC (ambulatory payment classification), SCH (sole community hospital). The APC is the service classification system for the outpatient prospective payment system. Medicare ad- justs outpatient prospective payment system payment rates for 11 cancer hospitals so that the payment-to-cost ratio (PCR) for each cancer hospital is equal to the average PCR for all hospitals.

Source: Reprinted from MedPAC. 2014. “Outpatient Hospital Services Payment System.” Figure 1. Revised October. www.medpac.gov/documents/payment-basics/outpatient-hospital-services- payment-system.pdf.

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71C h a p t e r 2 S u p p l e m e n t : A d d i t i o n a l M e d i c a r e P a y m e n t M e t h o d s C

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Skilled Nursing Facility Services

Medicare uses a prospective payment system for skilled nursing facilities (SNFs) that pays facilities a predetermined daily rate for each day of care, up to 100 days. The rates are expected to cover all operating (nursing care, rehabilitation services, and other goods and services) and capital costs that efficient facilities would incur in providing SNF services. Various high-cost, low-probability ancil- lary services are covered separately. Patients are assigned to one of 66 categories, called resource utilization groups (RUGs), on the basis of patient characteristics and services used that are expected to require similar resources. Nursing and therapy weights are applied to the base payment rates of each RUG. Daily base payment rates are also adjusted to account for geographic differences in labor costs.

Home Health Care Services

Medicare uses a prospective payment system that pays home health agen- cies a predetermined rate for each 60-day episode of home health care. If fewer than five visits are delivered during a 60-day episode, the home health agency is paid per visit, by visit type. Patients who receive five or more visits are assigned to one of 153 home health resource groups, which are based on clinical and functional status and service use as measured by the Outcome and Assessment Information Set (OASIS). The payment rates are adjusted to reflect local market input prices and special circumstances, such as high-cost outliers.

Critical Access Hospitals

The Balanced Budget Act of 1997 created a new category of hospitals called critical access hospitals (CAHs), which operate primarily in rural areas. Each of the approximately 1,300 CAHs is limited to 25 beds, and patients are limited to a four-day length of stay. The limited size and short length-of-stay require- ments are designed to encourage CAHs to focus on providing inpatient and outpatient care for common, less complex conditions while referring more complex patients to larger, more distant hospitals. Unlike most other acute care hospitals (which are paid using prospective payment systems), Medicare pays CAHs on the basis of reported costs. As of this writing, each CAH receives 99 percent of the costs it incurs in providing outpatient, inpatient, laboratory, and therapy services and post-acute care. The cost of treating Medicare patients is estimated using cost accounting data from Medicare cost reports. The purpose of the different reimbursement system for CAHs is to enhance the financial performance of small rural hospitals and thus reduce hospital closures.

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Hospice Services

Medicare pays hospice providers a daily rate for each day a beneficiary is enrolled in the hospice program, regardless of the amount of services provided, even on days when no services are provided. The daily payment rates are intended to cover costs of providing services included in patients’ care plans. Payments are made according to a fee schedule for four different categories of care: routine home care, continuous home care, inpatient respite care, and general inpatient care. The four categories of care differ by the location and intensity of the services provided, and the base payments for each category reflect variation in expected input cost differences.

Ambulance Services

Medicare pays for ambulance services using a dedicated fee schedule, which has set rates for nine payment categories of ground and air ambulance trans- port. Historical costs are used as the basis to establish relative values for each payment category. These relative values are multiplied by a dollar amount that is standard across all nine categories and then adjusted for geographic differences. This amount is added to a mileage payment to arrive at the total ambulance payment amount. Medicare payments for ambulance services may also be adjusted by one of several add-on payments based on additional geo- graphic characteristics of the transport.

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PART

II FINANCIAL ACCOUNTING

Part I discusses the unique environment that creates the framework for the practice of healthcare finance. Now, in Part II, we begin the actual coverage of healthcare finance by discussing financial accounting, which involves the preparation of a business’s financial statements. These statements are designed to provide pertinent financial information about an organization both to its managers and to the public at large.

The coverage of financial accounting extends over several chapters. Chapter 3 begins the coverage with an introduction to basic financial account- ing concepts and an explanation of how organizations report financial perfor- mance, specifically revenues, expenses, and profits. Then, in Chapter 4, the discussion is extended to the reporting of financial status, which includes an organization’s assets, liabilities, and equity. In addition, Chapter 4 covers the way in which organizations report cash flows. Finally, note that Chapter 17 is related to financial accounting in that it also discusses financial statements, but the focus is on how interested parties use financial statement data to assess the financial condition of an organization. That material has purposely been placed at the end of the book because the nuances of financial statement analysis can be better understood after learning more about the financial workings of a business. Part II and Chapter 17, taken together, will provide readers with a basic understanding of how financial statements are created and used to make judgments regarding the operational status and financial condition of health services organizations.

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CHAPTER

THE INCOME STATEMENT AND STATEMENT OF CHANGES IN EQUITY

Introduction

Financial accounting involves identifying, measuring, recording, and com- municating in dollar terms the economic events and status of an organization. This information is summarized and presented in a set of financial statements, or just financials. Because these statements communicate important informa- tion about an organization, financial accounting is often called “the language of business.” Managers of health services organizations must understand the basics of financial accounting because financial statements are the best way to summarize a business’s financial status and performance.

Historical Foundations of Financial Accounting

It is all too easy to think of financial statements merely as pieces of paper with numbers written on them, rather than in terms of the economic events and physical assets—such as land, buildings, and equipment—that underlie the

Financial accounting The field of accounting that focuses on the measurement and communication of the economic events and status of an entire organization.

3 Learning Objectives After studying this chapter, readers will be able to

• Explain why financial statements are so important both to managers and to outside parties.

• Describe the standard-setting process under which financial accounting information is created and reported, as well as the underlying principles applied.

• Describe the components of the income statement—revenues, expenses, and profitability—and the relationships within and among these components.

• Explain the differences between operating income and net income, and between net income and cash flow.

• Describe the format and use of the statement of changes in equity.

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