1: 440 Discussion

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C H A P T E R

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

• Describe the alternative forms of business organization and ownership. • Explain why taxes are important to healthcare finance. • Briefly describe the third-party-payer system. • Explain the different types of payment methods used by payers. • Describe the incentives created by the different payment methods and

their impact on provider risk. • Explain the importance and types of medical coding. • Briefly describe the purpose and key features of healthcare reform.

Introduction Fortunately, most of the basic concepts of healthcare finance are independent of the specific industry (for example, hospital versus long-term care versus medi- cal practice) and organizational setting. However, some aspects of healthcare finance are influenced by industry setting, while the unique ownership structure of healthcare providers influences specific applications of finance concepts. In this chapter, some background material is presented that creates the context in which finance is practiced in health services organizations.

The fact that many healthcare businesses are organized as not-for- profit corporations has a significant impact on the practice of finance. Thus, the chapter begins with a discussion of alternative forms of business organiza- tion and ownership. Because ownership affects taxes, tax laws also are briefly introduced. The chapter continues with a discussion of third-party payers, the reimbursement methods that they use, and the implications of alternative re- imbursement methods for provider behavior. The final sections cover medical coding and healthcare reform.

Alternative Forms of Business Organization 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 forms of business organization: proprietorship, partnership, and

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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. How- ever, many individual medical practices are organized as proprietorships, and partnerships and hybrid forms are common in group practices and joint ven- tures, so health services managers must be familiar with all forms of business organization.

Proprietorships and Partnerships

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

The proprietorship form of organization is easily and inexpensively formed, is subject to few governmental regulations, and pays no corporate income taxes. All earnings of the business, whether reinvested in the business or withdrawn by the owner, are taxed as personal income to the proprietor. In general, a sole proprietorship will pay lower total taxes than will a comparable, taxable corporation because corporate profits are taxed twice—once at the corporate level and again by stockholders (owners) at the personal level when profits are distributed as dividends and when the stock is sold.

A partnership is formed when two or more persons associate to con- duct a business that is not incorporated. Partnerships may operate under differ- ent degrees of formality, ranging from informal oral understandings to formal agreements filed with the state in which the partnership does business. Like a proprietorship, the major advantage of the partnership form of organization is its low cost and ease of formation. In addition, the tax treatment of a partner- ship is similar to that of a proprietorship: The partnership’s earnings are allo- cated to the partners and taxed as personal income regardless of whether the earnings are actually paid out to the partners or retained in the business.1

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 busi-

ness, 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 pro rata 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.

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

Partnership A nonincorporated business entity that is created by two or more indi- viduals.

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For these reasons, proprietorships and most partnerships are restricted to small businesses.2

These three disadvantages lead to the fourth, and perhaps the most important, disadvantage from a finance perspective: the difficulty that pro- prietorships and partnerships have in attracting substantial 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. Thus, many companies start out as sole propri- etorships or partnerships but then ultimately convert to the corporate form of organization.

Corporation

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.

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 addi- tion 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—un- limited life, ease of ownership transfer, and limited liability—corporations can more easily raise money in the financial markets than can sole proprietorships or partnerships.3

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, set- ting 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 proprietorship or partnership.

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

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Although a proprietorship or partnership can begin operations without much legal paperwork, 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.

The corporate charter includes the name of the business, its proposed activities, the amount of stock to be issued (if investor owned), and the num- ber and names of the initial set of directors. The charter is filed with the ap- propriate official of the state in which the business will be incorporated, and when it is approved, the corporation is officially in existence.4 After the cor- poration has been officially formed, it must file quarterly and annual reports with various governmental agencies.

The bylaws are a set of rules drawn up by the founders to provide guid- ance for the governing and internal management of the corporation. Bylaws include features such as how directors are to be elected, whether existing shareholders have the first right to buy any new shares that the firm issues, and the procedures for changing the charter or bylaws.

The value of any investor-owned business, other than a very small one, generally will be maximized if it is organized as a corporation, for the follow- ing reasons:

• Limited liability reduces the risks borne by equity investors (the owners); with all else the same, the lower the risk, the higher the value of the investment.

• A business’s value is dependent on growth opportunities, which in turn are dependent on the business’s ability to attract capital. Because corpo- rations can obtain capital more easily than other forms of business can, they are better able to take advantage of growth opportunities.

• The value of any investment depends on its liquidity, which means the ease at which it can be sold for a fair price. Because an ownership inter- est in a corporation is much more liquid than a similar investment in a proprietorship or partnership, the corporate form of organization creates more value for its owners.

Hybrid Forms of Organization

Although the three basic forms of organization—proprietorship, partnership, and corporation—have dominated the overall business scene, several hybrid forms of organization have become quite popular in recent years. Some of these forms are found in the health services industry.

Investment liquidity The ability to sell an investment quickly and at a fair price.

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Several specialized types of partnerships have characteristics somewhat different from a standard form of partnership. First, limiting some of the part- ners’ legal liability is possible by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners. The limited partners, like the owners of a corporation, are liable only for the amount of their initial investment in the partnership, while the general part- ners have unlimited liability. However, the limited partners typically have no control, which rests solely with the general partners. Limited partnerships are quite common in real estate and mineral investments; they are not as com- mon in the health services industry because finding one partner that is will- ing to accept all of the business’s risk and a second partner that is willing to relinquish control is difficult.

The limited liability partnership (LLP) is a type of partnership available in many states. In a limited liability partnership, 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 in- dividual malpractice actions, not those of the other partners. In spite of limited malpractice liability, the partners are jointly liable for the partner- ship’s debts.

The limited liability company (LLC) is another new type of business organization. It has some characteristics of both a partnership and a corpora- tion. The owners of an LLC are called members, and they are taxed as if they are partners in a partnership. However, a member’s liability is like that of a stockholder of a corporation because liability is limited to the member’s initial contribution in the business. Personal assets are only at risk if the member as- sumes specific liability, such as by signing a personal loan guarantee.

The professional corporation (PC), which is called a professional association (PA) in some states, is a form of organization that is com- mon among physicians and other individual and group practice healthcare professionals. All 50 states have statutes that prescribe the requirements for such organizations, which provide the usual benefits of incorporation but do not relieve the participants of professional liability. Indeed, the primary motivation behind the professional corporation, which is a rela- tively old business form compared to the LLP and LLC, was to provide a way for professionals to incorporate yet still be held liable for professional malpractice.

For tax purposes, standard for-profit corporations are called C corpo- rations. If certain requirements are met, either one or a few individuals can incorporate but, for tax purposes only, elect to be treated as if the business were a proprietorship or partnership. Such corporations, which differ only in how the owners are taxed, are called S corporations. Although S corpora- tions are similar to LLPs and LLCs regarding taxes, LLPs and LLCs provide more flexibility and benefits to owners.

Limited partnership A partnership form of organiza- tion with general partners that have control and unlim- ited liability and limited partners that have no con- trol and limited liability.

Limited liability partnership (LLP) A partnership form of organiza- tion that limits the professional (mal- practice) liability of its partners.

Limited liability company (LLC) A corporate form of organization that combines some features of a partnership with others of a corpo- ration.

Professional cor- poration (PC) A type of corpo- rate business organization in which owners/ managers still have professional (medical) liability. Called a profes- sional association in some states.

S corporation A corporation with a limited number of stockholders that is taxed as a proprietorship or partnership.

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SELF-TEST QUESTIONS

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

2. What are some different types of partnerships? 3. What are some different types of corporations?

Alternative Forms of Ownership Unlike other sectors in the economy, not-for-profit corporations play a major role in the healthcare sector, especially among providers. As we discussed in Chapter 1, 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. Larger businesses (e.g., Ford, IBM, General Electric) are investor-owned corporations.

Individuals become owners of such businesses by buying shares of com- mon stock in the company. Common stock may be purchased when it is put up for sale by a company in what is called a primary market transaction. In such a transaction, the funds raised from the sale go to the corporation that sold the stock.5 After the shares have been initially sold by the corporation, they are traded in the secondary market. These sales typically take place on exchanges, such as the New York Stock Exchange (NYSE), or in the over-the- counter (OTC) market, which is composed of a large number of dealers/ brokers connected by a sophisticated electronic trading system.6 When shares are bought and sold in the secondary market, the corporations whose stocks are traded receive no funds from the trades because the transactions take place between individuals.

Investor-owned corporations may be either publicly held or privately held. The shares of publicly held companies are owned by a large number of investors and are widely traded. For example, Health Management Associ- ates, a large hospital chain, has about 240 million shares outstanding that are owned by some 30,000 individual and institutional stockholders. Drug com- panies, such as Merck and Pfizer; medical equipment manufacturers such as St. Jude Medical, which makes heart valves; and U.S. Surgical, which makes surgical stapling instruments, are all publicly held corporations.

Conversely, the shares of privately held (also called closely held) compa- nies are owned by just a handful of investors and are not publicly traded. In general, the managers of privately held companies are major stockholders. For

Primary market The market in which newly is- sued securities are sold for the first time.

Secondary market The market in which previously issued securities are sold.

Publicly held company A corporation whose shares are held by the gen- eral public, as op- posed to closely held, in which the shares are held by a small number of individuals, usu- ally the managers.

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example, HCA, the nation’s largest for-profit hospital chain, was a publicly held company until late 2006. At that time, the outstanding stock of the com- pany was purchased by a small group of investors, taking the company private. Another example is HCR Manor Care, which owns and operates more than 500 skilled nursing and rehabilitation centers and assisted living facilities and is owned by the Carlyle Group, a private investment firm.

In many ways, privately held companies are more similar to partner- ships than to publicly held companies as they are owned and usually man- aged by a small group of individuals. Often, a privately held corporation is a transitional form of organization that exists for a short time between a pro- prietorship or partnership and a publicly owned corporation in which the motivation to sell shares to the public is driven by capital needs. In the case of HCA, the small group of investors that took the company private planned to sell off poorly performing hospitals, improve the operations of the remain- ing hospitals, and then in several years go public again to cash out on their investment. In fact, that is exactly what happened as HCA became a publicly traded company in 2011.

The stockholders (also called shareholders) are the owners of investor- owned corporations. As owners, they have these 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 bal- lot, 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—belong to the shareholders of the business. Often, a portion of these earnings are paid out in the form of dividends, which are merely cash payments to stockhold- ers, 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 presum- ably will produce even higher payouts to stockholders in the future. (See Chapter 19, which is available online at ache.org/books/HC- Finance5, for more information about how corporate earnings are distributed to shareholders.)

• A claim on liquidation proceeds. In the event of bankruptcy and liq- uidation, shareholders are entitled to any proceeds that remain after all other claimants have been satisfied.

Proxy A document giving one person the authority to act for another—typically the power to vote shares of common stock.

Dividend The periodic payment paid to owners of com- mon and preferred stock.

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When compared to not-for-profit corporations, three key features make investor-owned corporations different. First, the owners (stock- holders) of the corporation are well defined and exercise control of the business by voting for directors. Second, the residual earnings of the busi- ness belong to the owners, so management is responsible only to the stockholders for the profitability of the firm. Finally, investor-owned cor- porations 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 cor- porations are sometimes called nonprofit corporations. Because nonprofit busi- nesses (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.

Tax-exempt status is granted to corporations that meet the tax defini- tion 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.7 The tax code defines a charitable organi- zation as “any corporation, community chest, fund, or foundation that is organized and operated exclusively for religious, charitable, scientific, public safety, literary, or educational purposes.” Because the promotion of health is commonly considered a charitable activity, a corporation that provides health- care 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 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 trust- ees that is not constrained by outside oversight as is the board of direc- tors of a for-profit corporation, which must answer to stockholders. Also, not-for-profit corporations are generally exempt from taxation, including

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both property and income taxes, and have the right to issue tax-exempt debt (municipal bonds). Finally, individual contributions to not-for-profit organi- zations can be deducted from taxable income by the donor, so not-for-profit firms have access to tax-subsidized contribution capital. (The tax benefits en- joyed by not-for-profit corporations are discussed in more detail in a later section on tax laws.)

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 benefits (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 re- cent 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 govern- ments 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 lev- els 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 charity care that include (1) giving discounts to uninsured patients of “limited means”; (2) establishing a common defini- tion of “community benefits,” which encompass the full range of services provided to the population served; and (3) improving “transparency,” or the ability of outsiders to understand a business’s governance structure and policies, including executive compensation.

Likewise, officials in several states have proposed legislation that man- dates the amount of charity care provided by not-for-profit hospitals and the billing and collections procedures applied to the uninsured. For example, Texas has established minimum 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 (PILOTS).”

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

Schedule H An attachment to Form 990 filed by not-for-profit hos- pitals that gives additional infor- mation on chari- table activities.

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SELF-TEST QUESTIONS

Finally, money-starved mu- nicipalities in several states have at- tacked the property tax exemption of not-for-profit hospitals that have “neglected” their charitable missions. For example, tax assessors are fight- ing to remove property tax exemp- tions from not-for-profit hospitals in several Pennsylvania cities after an appellate court ruling supported 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 hospitals had to pay taxes comparable to their investor-owned counterparts, local, state, and federal governments would garner an addi- tional $3.5 billion in tax revenues. This estimate explains why tax au- thorities in many jurisdictions are pursuing not-for-profit hospitals as a source of revenue.

The inherent differences be- tween investor-owned and not-for- profit organizations have profound implications for many elements of healthcare financial management, including organizational goals, fi- nancing 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 applica- tion of healthcare financial manage- ment theory and concepts will be addressed throughout the text.

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 is the purpose and content of IRS Form 990?

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

Many people have criticized not-for-profit hospitals for not

“earning” their charitable exemptions. In one of the latest

relevant court rulings, in 2010 the Illinois Supreme Court

concluded that Provena Covenant hospital, located in Ur-

bana, Illinois, was not a charitable institution for property

tax purposes. The court’s opinion reasoned that the primary

use of the hospital property was providing medical services

for a fee, while charity means providing a gift to the com-

munity. The opinion further pointed out that (1) the char-

ity 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 chari-

table 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 reason-

ing, the property tax exemption may well be hard to main-

tain. However, a partial dissent by two justices suggests

that this case is not the end of the story. The dissent ar-

gues that the plurality opinion impinges on the legislative

function of setting specific standards for tax exemption,

and the issue should be settled by legislative action rath-

er 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 main-

tain their tax-exempt status? If so, how might such standards

be specified?

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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 proprietorship, partnership, or small privately owned corporation, the owners of the business 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 one is hurt by such actions. (Of course, the business still has to satisfy its customers 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 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 in- terested 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 finan- cial decision rules.

The primary obstacle to shareholder wealth maximization as the goal of investor-owned corporations is the agency problem. An agency problem ex- ists when one or more individuals (the principals) hire another individual or group of individuals (the agents) to perform a service on their behalf and then delegate decision-making authority to those agents. Such a problem occurs between stockholders and managers of large investor-owned corporations be- cause the managers typically hold only a small proportion of the firm’s stock, and hence they benefit relatively little from stock price increases. On the other hand, managers benefit substantially from actions such as increasing the size of the firm to justify higher salaries and more fringe benefits; awarding them- selves generous retirement plans; and spending too much on office space, personal staff, and travel—actions that are often detrimental to shareholders’ wealth. Clearly, many situations can arise in which managers are motivated to take actions that are in their own best interests rather than in the best interests of stockholders.

Shareholders recognize the agency problem and counter it by creating compensation incentives, such as stock options and performance-based bonus plans, that encourage managers to act in shareholders’ interests. In addition,

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other factors, such as the threat of takeover or removal, work to keep manag- ers focused on shareholder wealth maximization.

Clearly, managers of investor-owned corporations can have motivations that are inconsistent with shareholder wealth maximization. Still, sufficient incentives and sanctions are in place to force managers to view shareholder wealth maximization as an important goal. Thus, shareholder wealth maximi- zation is a reasonable goal for financial decision making within investor-owned corporations.

Not-for-Profit Corporations

Not-for-profit 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 in- clude 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, who dictate the goal of shareholder wealth maximization.) While managers of investor-owned companies have to please primarily one class of stakeholders—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 firms have to please all of the firm’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 firms should not at- tempt 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 recog- nized, innovative healthcare leader dedicated to meeting the needs of the community. We strive to be the best comprehensive healthcare pro- vider through our commitment to excellence.

Although this mission statement provides 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 accomplish its mission, its managers have identified the fol- lowing five financial goals:

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SELF-TEST QUESTIONS

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 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 inexpen- sively 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 interest- ing 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 ser- vices and technologies. Furthermore, competition in the market for hospital services will not permit JRMC to charge appreciably more for services than its not-for-profit competitors.

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

2. What is the agency problem, and how does it apply to investor-owned firms?

3. What factors tend to reduce the agency problem?

Tax Laws The value of any investment—whether the investment is a savings account, a stock, or a magnetic resonance imaging (MRI) machine—depends on the usable cash flows that the investment is expected to provide. Because taxes reduce usable cash flows, both individuals and managers of for-profit busi- nesses must be concerned about taxes.

Tax laws are complicated and are constantly changing. Consequently, covering even the most basic features of our tax laws in an introductory finance book is impossible. However, what is important is to recognize that individuals

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must pay personal (individual) taxes to federal and state (in most states) authori- ties that can approach 50 percent of income. Thus, income from proprietorships and partnerships, as well as dividends and capital gains on stock investments, will be reduced when personal taxes are taken into account.8

To illustrate the effect of personal taxes, assume that an individual’s tax rate is 35 percent and he or she receives $100 in partnership income. Using the letter T to represent tax rate, that person must pay T × $100 = 0.35 × $100 = $35 in taxes on the income, which leaves him or her with only $100 – $35 = $65 after taxes. This analysis is summarized by the following equation:

AT = BT – (T × BT)

= BT × (1 – T),

where AT = after-tax and BT = before-tax. Using this equation, the after-tax income amount to the investor is AT = BT × (1 – T) = $100 × (1 – 0.35) = $100 × 0.65 = $65. (This equation can be applied to interest rates as well as dollar amounts. See Problem 2.3 as an example.) Clearly, taxes will influence investment decisions, so any differential tax implications on investment alter- natives must be considered in the decision process.

In addition to personal taxes paid by individuals, investor-owned (for- profit) corporations must pay both federal and state corporate taxes, which can exceed 40 percent of the corporation’s taxable income. Corporate taxes are paid on earnings before dividends are distributed, so corporate income is subject to double taxation—once at the corporate level and again when stockholders re-

Key Equation: Before-Tax to After-Tax Conversion

For taxable investors, the dollar return on an investment is reduced by the payment

of income taxes. Suppose you receive $50 interest on a bank certificate of deposit

(CD) and you pay taxes at a 30 percent rate. Your usable (after-tax) dollar return is

only $35:

AT = BT × (1 – T)

= $50 (1 – 0.30)

= $50 × 0.70

= $35.

Here, AT is the after-tax amount, BT is the before-tax amount, and T is the

tax rate (in decimal form). Note that this equation can be used to convert percentage

returns (yields) as well as dollar amounts. For example, if the $50 interest payment

above translates to a 5.0 percent before-tax yield, the after-tax yield would be 3.5

percent.

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SELF-TEST QUESTIONS

ceive dividends or when they make a profit upon sale of the stock. Not-for-profit corporations, for the most part, are not subject to in-

come or property taxes. In addition, such organizations benefit from being able to issue (take on) debt having interest payments that are exempt from lenders’ personal taxes. To illustrate this benefit, first consider the bonds issued by JRMC, an investor-owned hospital. Its debt carries an interest rate of 10 percent, so bond investors receive 0.10 × $100 = $10 in annual interest for every $100 worth of bonds that they own. For a bond investor who pays 40 percent in federal and state income taxes, each $10 of interest provides the investor with AT = BT × (1 – T) = $10 × (1 – 0.40) = $6 of after-tax interest.

However, if the bonds had been issued by Riverside Memorial Hospital, a not-for-profit corporation, the investor would have to pay no taxes on the interest and hence would keep the entire $10. If investors truly require a $6 after-tax return, Riverside can issue debt with an inter- est rate of only 6 percent and, with all else the same, investors in the 40 percent tax bracket would be as willing to buy these bonds as they are the JRMC 10 percent bonds. Thus, the interest rate that Riverside must set on its debt issues to sell them to investors is lower than the rate that JRMC must set because of the tax exemption on debt issued by not-for- profit corporations.

Finally, contributions that individuals make to not-for-profit corpora- tions are tax deductible to the donor. If John Brooks is in the 40 percent tax bracket, and he donates $1,000 to Riverside Memorial Hospital, his taxable income would be reduced by $1,000. A reduction in taxable income of this amount would save John T × $1,000 = 0.40 × $1,000 = $400 in taxes, so the effective cost of his contribution would only be $600. In effect, the govern- ment will pay John 40 cents for every dollar he contributes. Thus, not-for- profit corporations have access to a source of financing that, for all practical purposes, is not available to investor-owned businesses.

Because of the impact that taxes have on usable earnings of investor- owned businesses and because not-for-profit ownership has important tax consequences, tax implications are highlighted and explained as necessary throughout the book. What is most important now is to recognize that taxes will play a critical role in many topics to be discussed.

1. Why does a finance book have to consider taxes? 2. How is a before-tax amount converted into an after-tax amount? 3. Why is the ability to issue tax-exempt debt an advantage for not-for-

profit corporations? 4. What advantage accrues to businesses that qualify for tax-exempt

contributions?

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Third-Party Payers Up to this point in the chapter, basic concepts about the form and ownership of healthcare businesses and the impact of tax laws have been considered. A large proportion of the health services industry receives its revenues not di- rectly from the users of their services—the patients—but from insurers known collectively as third-party payers. Because an organization’s revenues are key to its financial viability, this section contains a brief examination of the sources of most revenues in the health services industry. In the next section, the types of reimbursement methods 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 dra- matically. Today, health insurers fall into two broad categories: private insur- ers 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 organizations trace their roots to the Great Depres- sion, when both hospitals and physicians were concerned about their patients’ abilities to pay healthcare bills.

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 pro- grams 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 communitywide, multihospital plans that were called hospital service plans. AHA recognized the benefits of such plans to hospitals, so a close relationship was formed between AHA and the organizations that offered hospital service plans.

In the early years, several states ruled that the sale of hospital services by prepayment did not constitute insurance, so the plans were exempt from regulations governing insurance companies. However, the legal status of hos- pital service plans clearly would be subject to future scrutiny unless their sta- tus was formalized. The states, one by one, passed enabling legislation that

Blue Cross/ Blue Shield

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provided for the founding of not-for-profit hospital service corporations that were exempt both from taxes and from the capital requirements mandated for other insurers. However, state insurance departments had—and continue to have—oversight over most aspects of the plans’ operations. 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 and the pro- fessional organization was the American Medical Association instead of the AHA. As of 2011, there are 39 Blue Cross/Blue Shield (the “Blues”) orga- nizations. Some offer only one of the two plans, but most offer both plans. The Blues are organized as independent corporations, 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 98 million people in all 50 states, the District of Columbia, and Puerto Rico.

Historically, the Blues were not-for-profit corporations that enjoyed the full benefits accorded to that status, including freedom from taxes. In 1986, however, Congress eliminated the Blues’ tax exemption on the grounds that they operated commercial-type insurance activities, but the plans were given special deductions that resulted in lower taxes than those paid by commercial insurance companies. In spite of the 1986 change in tax status, the national association continued to require all Blues to operate entirely as not-for-profit corporations, although they could establish for-profit subsidiaries. In 1994, however, the national association lifted its traditional ban on member plans becoming investor-owned companies, and four Blue Cross/Blue Shield cor- porations have since converted to for-profit status.

In spite of these conversions, it is unlikely that many more Blues will convert to for-profit status because of the legal problems inherent in conver- sion and because they already have the ability to create for-profit subsidiaries. The primary rationale for converting or creating for-profit subsidiaries is hav- ing access to investor-supplied equity capital, which many experts believe to be necessary for insurers to be competitive in today’s healthcare market.

Commercial health insurance is issued by life insurance companies, by casualty insurance companies, and by companies that were formed exclusively to write health insurance. Examples of commercial insurers include Aetna, Humana, and UnitedHealth Group. Commercial insurance companies can be orga- nized either as stock companies or as mutual companies. Stock companies are shareholder owned and can raise capital by selling shares of stock just like any other for-profit company. Furthermore, the stockholders assume the risks and responsibilities of ownership and management. A mutual company has no shareholders; its management is controlled by a board of directors elected by the company’s policyholders. Regardless of the form of ownership, com- mercial insurance companies are taxable entities.

Commercial Insurers

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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.

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 insur- ance 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. Individu- als, except the very wealthy, are not good candidates for self-insurance be- cause 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 whose costs are paid directly by the state. Blue Cross/Blue Shield is paid a fee to administer the plan, but the state bears all risks associated with cost and utilization uncertainty.

Many firms today are even going one or two steps further in their self-insurance programs. For example, Digital Equipment Corporation (now owned by Hewlett-Packard) negotiates discounts directly with hospitals and physicians and self-administers its program. Others, such as Deere & Compa- ny, a farm-implements manufacturer, have set up company-owned subsidiar- ies to provide healthcare services to their employees. These companies believe that they can lower healthcare costs by applying the kind of management attention to healthcare that they do to their core businesses.

Public Insurers

Government is a major insurer as well as a direct provider of healthcare ser- vices. For example, the government provides healthcare services directly to qualifying individuals through the Department of Veterans Affairs, Depart- ment of Defense, and Public Health Service medical facilities. In addition, the government either provides or mandates a variety of insurance programs, such as workers’ compensation and TRICARE (health insurance for uni- formed service members and families). In this section, however, the focus is on the two major government insurance programs: Medicare and Medicaid.

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 cov- erages: (1) Part A, which provides hospital and some skilled nursing home

Self-Insurers

Medicare

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coverage; (2) Part B, which covers physician services, ambulatory surgical ser- vices, 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 plan offers somewhat different cov- erage, so the cost of Part D coverage varies widely.

The Medicare program falls under the federal Department of Health and Human Services (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 di- rectly by CMS but by contractors for 15 Medicare Administrative Contractor (MAC) jurisdictions.

Medicaid began in 1966 as a modest program to be jointly funded and oper- ated 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 In- come (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 cover- age to many groups, while states with limited abilities to raise funds for Med- icaid 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

Medicare A federal govern- ment health insur- ance program that provides benefits to individuals aged 65 or older.

Medicaid A federal and state government health insurance program that pro- vides benefits to low-income indi- viduals.

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SELF-TEST QUESTIONS

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?

Managed Care Plans Managed care plans strive to combine the provision of healthcare servic- es and the insurance function into a single entity. Traditionally, such plans have been created by insurers who either directly own a provider network or create one through contractual arrangements with independent providers. Recently, however, providers in some areas have banded together to form integrated delivery systems (IDSs) capable of offering both insurance and healthcare services.

One type of managed care plan is the health maintenance organization (HMO). HMOs are based on the premise that the traditional insurer–provider relationship creates perverse incentives that reward providers for treating pa- tients’ illnesses while offering little incentive for providing prevention and reha- bilitation 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.

Because of the many types of organizational structures, ownership, and financial incentives provided, HMOs vary widely in cost and quality. HMOs use a variety of methods to control costs. These include limiting patients to particular providers by using gatekeeper physicians who must authorize any specialized or referral services, using utilization review to ensure that services rendered are appropriate and needed, using discounted rate schedules for pro- viders, and using payment methods that transfer some risk to providers. In general, services are not covered if beneficiaries bypass their gatekeeper physi- cian or use providers that are not part of the HMO.

The federal Health Maintenance Act of 1973 encouraged the develop- ment of HMOs and created a great deal of interest in the concept by provid- ing federal funds for HMO-operating grants and loans. In addition, the Act required larger employers that offer healthcare benefits to their employees to include a federally qualified HMO as a healthcare alternative, if one was avail- able, in addition to traditional insurance plans.

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, which are those

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SELF-TEST QUESTIONS

providers that have contracts (usually at discounted prices) with the PPO. Un- like HMOs, PPOs do not require beneficiaries to use preselected gatekeeper physicians who serve as the initial contact and authorize all services received. 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.

HMOs and PPOs grew rapidly in number and size during the 1980s and 1990s; however, both the number of HMOs and the number of enroll- ees have fallen significantly since 2000. Still, hybrids of HMOs and PPOs continue to develop. For example, exclusive provider organizations (EPOs) are PPO-like plans that require members to use only participating providers but do not designate a specific gatekeeper. Also, point of service (POS) plans permit enrollees to obtain services either from within the HMO panel or to bear higher out-of-pocket costs to obtain services outside the panel.

In an effort to achieve the potential cost savings of managed care plans, most insurance companies now apply managed care strategies to their conven- tional plans. Such plans, which are called managed fee-for-service plans, are using pre-admission 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 strategies and incentives employed. Thus, the term managed care now describes a continuum of plans, which can vary significantly in their ap- proaches to providing combined insurance and healthcare services. The com- mon feature in managed care plans is that the insurer has a mechanism by which it controls, or at least influences, patients’ utilization of healthcare services.

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

Alternative Reimbursement Methods Regardless of the payer for a particular healthcare service, only a limited num- ber of payment methods are used to reimburse providers. Payment methods fall into two broad classifications: fee-for-service and capitation. In fee-for- service payment methods, of which many variations exist, the greater the amount of services provided, the higher the amount of reimbursement. Un- der 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 methods.

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.

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Cost-based reimbursement A reimbursement methodology based on the costs incurred in providing ser- vices.

Fee-for-Service Methods

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

Under cost-based reimbursement, the payer agrees to reimburse the pro- vider for the costs incurred in providing services to the insured population. Reimbursement 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 by other payers, using a per diagnosis prospective payment system (see below). 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.

When payers pay billed charges, or just 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 according to billed charges, but the trend for payers is toward other, less-generous reimbursement methods. If this trend contin- ues, the only payers that will be 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 such as HMOs and PPOs. HMOs and PPOs, as well as some conventional insurers, often 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 (rack rates or full fares) that few people pay.

In a prospective payment system, the rates paid by payers are determined by the payer before the services are provided. Furthermore, payments are not

Cost-Based Reimbursement

Charge-Based Reimbursement

Prospective Payment

Charge-based reimbursement A reimbursement methodology based on charges (chargemaster prices).

Chargemaster A provider’s offi- cial list of charges (prices) for goods and services ren- dered.

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directly related to either reimbursable 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 com- plex 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 pay- ment 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 rate, the provider is paid a fixed amount for each day that service is provided, regardless of the nature of the services. 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 (global) pricing. Under bundled pricing, payers make a single prospective payment that covers all services delivered in a single episode, whether the services are rendered by a single or by multiple providers. For example, a bundled payment may be made for all obstet- ric services 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 global payment may cover an entire population, 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 provided. The service may be defined as a visit, a diagnosis, a hospital day, or in some other manner, but the key feature is that the more services that are performed, the greater the reimburse- ment 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 pro- vider is paid a fixed amount per covered life per period (usually a month)

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

Per diem A reimbursement methodology that pays a set amount for each inpatient day.

Bundled (global) pricing The payment of a single amount for the complete set of services required to treat a single episode. Also sometimes applied to an entire population (capitation).

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

Capitation payment, which is used primarily by managed care plans, dramatically changes the financial environment of healthcare providers. It has implications for financial accounting, managerial accounting, and financial management. A discussion of how capitation, as opposed to fee-for-service reimbursement, affects healthcare finance is provided throughout the remain- der of this book. (In addition, see Chapter 20, which is available online, for a more in-depth look at capitation.)

Provider Incentives

Providers, like individuals and businesses, react to the incentives created by the financial environment. For example, individuals can deduct mortgage in- terest from income for tax purposes, but they cannot deduct interest pay- ments 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 as- sumed, 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 incentives 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 regards 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 mar- kets, 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 consider- able 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 churning—creating more visits, ordering more tests, extending inpatient stays, and 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 bet- ter, 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

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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 reimbursement, the profitability of indi- vidual procedures varies depending on the relationship between the actual costs incurred and the payment for that procedure. Providers, usually physi- cians, have the incentive to perform procedures that have the highest profit potential. Furthermore, the more procedures the better, because each proce- dure typically generates additional profit. The incentives under per diagnosis reimbursement are similar. Providers, usually hospitals, will seek patients with those diagnoses that have the greatest profit potential and discourage (or even discontinue) those services that have the least potential. Furthermore, to the extent that providers have some flexibility in selecting procedures (or assigning diagnoses) to patients, an incentive exists to upcode procedures (or diagnoses) to ones that provide the greatest reimbursement.

In all prospective payment methods, providers have the incen- tive to reduce costs because the amount of reimbursement is fixed and independent of the costs actu- ally incurred. For example, when hospitals are paid under per diag- nosis 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 typi- cally are more costly than the later days, the later days are more prof- itable. However, as mentioned pre- viously, hospitals have the incentive to reduce costs during each day of a patient stay.

Under bundled pricing, pro- viders do not have the opportunity to be reimbursed for a series of separate services, which is called unbundling.

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 Medicare pays

healthcare providers. For the first time, 3,500 hospitals

across the country will be paid for inpatient acute care ser-

vices based on care quality, not just the quantity of the ser-

vices provided.

“Changing the way we pay hospitals will improve the

quality of care for seniors and save money for all of us,” said

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 hos-

pitals work to improve quality, all patients—not just Medicare

patients—will benefit.” The initial measures to determine qual-

ity focus on how closely hospitals follow best clinical practices

and how well hospitals enhance patients’ care experiences. 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 mea-

sured? Should the additional reimbursement to high-quality

providers be obtained by reductions in reimbursement to

low-quality providers?

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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 sub- mitted for diagnosis, 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 pro- viders (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.

Financial Risks to Providers

A key issue facing providers is the impact of various reimbursement methods on financial risk. For now, think of financial risk in terms of the effect that the reimbursement methods have on profit uncertainty—the greater the chance of losing money, the higher the risk. (Financial risk is discussed in detail in Chapter 10.)

Cost- and charge-based reimbursement methods are the least risky for providers because payers more or less ensure that costs will be covered, hence profits will be earned. In cost-based systems, costs are automatically covered, and a profit component typically is added. In charge-based systems, provid- ers typically can set charges high enough to ensure that costs are covered, although discounts introduce uncertainty into the reimbursement process.

In all reimbursement methods except cost-based, providers bear the cost-of-service risk in the sense that costs can exceed revenues. However, a primary difference among the reimbursement types is the ability of the pro- vider to influence the revenue–cost relationship. If providers set charge rates for each type of service provided, they can most easily ensure that revenues exceed costs. Furthermore, if providers have the power to set rates above those that would exist in a truly competitive market, charge-based reimburse- ment could result in higher profits than might cost-based reimbursement.

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Prospective payment adds a second dimension of risk to reimburse- ment contracts because the bundle of services needed to treat a particular patient may be more extensive than that assumed in the payment. However, when the prospective payment is made on a per procedure basis, risk is mini- mal because each procedure will produce its own revenue. When prospective payment is made on a per diagnosis basis, provider risk is increased. If, on av- erage, patients require more intensive treatments, and for inpatients a longer length of stay (LOS), than assumed in the prospective payment amount, the provider must bear the added costs.9

When prospective payment is made on a per diem basis, even when stratified, one daily rate usually covers a large number of diagnoses. Because the nature of the services provided could vary widely, both because of vary- ing diagnoses as well as intensity differences within a single diagnosis, the provider bears the risk that costs associated with the services provided on any day exceed the per diem rate. Patients with complex diagnoses and greater intensity tend to remain hospitalized longer, and per diem reimbursement does differentiate among different LOSs, but the additional days of stay may be insufficient to make up for the increased resources consumed. In addition, providers bear the risk that the payer, through the utilization review process, will constrain LOS and hence increase intensity during the days that a patient is hospitalized. Under per diem, compression of services and shortened LOS can put significant pressure on providers’ profitability.

Under bundled pricing, a more inclusive set of procedures, or provid- ers, are included in one fixed payment. Clearly, the more services that must be rendered for a single payment—or the more providers that have to share a single payment—the more providers are at risk for intensity of services.

Finally, under capitation, providers assume utilization risk along with the risks assumed under the other reimbursement methods. The assumption of utilization risk has traditionally been an insurance, rather than a provider, function. In the traditional fee-for-service system, the financial risk of provid- ing healthcare is shared between purchasers and insurers. Hospitals, physi- cians, and other providers bear negligible risk because they are paid on the basis of the amount of services provided. Insurers bear short-term risk in that payments to providers in any year can exceed the amount of premiums col- lected. However, poor profitability by insurers in one year usually can be off- set by premium increases to purchasers the next year, so the long-term risk of financing the healthcare system is borne by purchasers. Capitation, however, places the burden of short-term utilization risk on providers.

When provider risk under different reimbursement methods is discussed in this descriptive fashion, an easy conclusion to make is that capitation is by far the riskiest to providers, while cost- and charge-based reimbursement are by far the least risky. Although this conclusion is not a bad starting point for analysis, financial risk is a complex subject, and its surface has just been scratched. One of the key issues throughout the remainder of this book is financial risk, so

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readers will see this topic over and over. For now, keep in mind that different payers use different reimbursement methods. Thus, providers can face conflict- ing incentives and differing risk, depending on the predominant method of reimbursement.

In closing, note that all prospective payment methods involve a trans- fer of risk from insurers to providers that increases as the payment unit moves from per procedure to capitation. The added risk does not mean that provid- ers should avoid such reimbursement methods; indeed, refusing to accept contracts with prospective payment provisions would be tantamount to or- ganizational suicide for most providers. However, providers must understand the risks involved in prospective payment arrangements, especially the effect on profitability, and make every effort to negotiate a level of payment that is consistent with the risk incurred.

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

3. What provider incentives are created under each of the payment methods previously listed?

4. Which of these payment methods carries the least risk for providers? The most risk? Explain your answer.

Medical Coding: The Foundation of Fee-for-Service Reimbursement Medical coding, or medical classification, is the process of transforming de- scriptions 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 doc- tor’s notes, laboratory results, and radiological tests. In practice, the basis for most fee-for-service reimbursement is the patient’s diagnosis (in the case of hospitals) or the procedures performed on the patient (in the case of outpa- tient settings). Thus, a brief background on clinical coding will enhance your understanding of the reimbursement process.

Medical coding The process of transforming med- ical diagnoses and procedures into universally recog- nized codes.

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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 cer- tificates. (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. (It is expected that conversion to ICD-10 codes will occur in 2013. The conversion is expected to be time 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.) 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.

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 Termi- nology (CPT) codes are used to specify medical procedures (treatments). CPT codes were developed and are copyrighted by the American Medical As- sociation. The purpose of CPT is to create a uniform language (set of descrip- tive terms and codes) that accurately describes medical, surgical, and diagnos- tic procedures. CPT terminology and codes are revised periodically to reflect current trends in clinical treatments. To increase standardization and the use of electronic medical 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 re- quires that ICD-9-CM codes be used for hospital inpatient services.)

To illustrate CPT codes, there are ten codes for physician office vis- its. 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

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

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

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complex (typically shortest) office visit is coded 99211, while the most com- plex (typically longest) 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 correctly. As in ICD coding, correct CPT coding ensures correct re- imbursement. 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.

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?

Healthcare Reform Healthcare reform is a generic term used to describe the actions taken by Congress in 2009 and 2010 to “reform” the healthcare system. The messy legislative process was completed in early 2010, when President Barack Obama signed the Patient Protection and Affordable Care Act on March 23. Because of the difficulties in passing legislation that was acceptable to both the House and Senate, a second law was required. This legislation, the Health Care and Education Reconciliation Act of 2010, was signed into law on March 30, 2010.

Healthcare reform includes a large number of provisions that will, if not changed, take effect over the next several years with the primary goal of help- ing an additional 32 million Americans obtain health insurance. The provisions include expanding Medicaid eligibility, subsidizing insurance premiums, pro- viding incentives for businesses to provide healthcare benefits, prohibiting de- nial of coverage based on pre-existing conditions, establishing health insurance exchanges, and providing financial support for medical research. For the most part, reform focuses on the insurance side of the healthcare sector as opposed to the provider side. Thus, many people believe that the legislation should be called “insurance reform” rather than “healthcare reform.”

In addition to the provisions affecting the insurance side, other provi- sions are designed to offset the costs of reform by instituting a variety of taxes,

Healthcare Com- mon Procedure Coding System (HCPCS) A medical cod- ing system that expands the CPT codes to include nonphysician ser- vices and durable medical equip- ment.

Healthcare reform A generic term used to describe the actions taken by Congress in 2010 to transform the healthcare system. Also known as the Patient Protection and Affordable Care Act (ACA).

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fees, and cost-saving measures. Examples of such measures include new Medi- care taxes for high-income earners, taxes on indoor tanning services, cuts to the Medicare Advantage Plan (Part C) program, fees on medical devices and pharmaceutical companies, and tax penalties on citizens who do not obtain health insurance. Finally, there are other provisions that fund pilot programs to test various changes to provider systems and reimbursement methodol- ogies (primarily Medicare) designed to both increase quality and decrease costs. Some of the provisions likely to have the greatest impact on providers and how they are reimbursed include the establishment of pilot programs to explore the feasibility of accountable care organizations, the effectiveness of payment bundling, and the quality gain potential of the medical home model.

Note that the reform law contains some provisions that went into ef- fect more or less immediately, but most provisions are to be phased in over time until 2018, when the last provisions are slated to take effect. In addition, detailed guidance will be provided by the government departments that are responsible for implementation of the legislation, primarily DHHS. Thus, we will not know most of the details until the implementing regulations are promulgated and, as you know, the devil is in the details. Finally, it is possible that legislative changes will occur before some of the provisions of the law are even implemented. All of this creates uncertainty for insurers and providers, but the good news is that the finance principles and concepts contained in this book remain valid regardless of the ultimate outcome of healthcare reform.

Accountable Care Organizations

Accountable care organizations (ACOs), one of the cornerstones of health- care reform, are a method of integrating local physicians with other mem- bers of the healthcare community and rewarding them for controlling costs and improving quality. While ACOs are not radically different from other at- tempts to improve the delivery of healthcare services, their uniqueness lies in the flexibility of their structures and payment methodologies along with their ability to assume risk. Similar to some managed care organizations and inte- grated healthcare systems such as the Mayo Clinic, ACOs are responsible for the health outcomes of the population served and are tasked with collabora- tively improving care to reach cost and clinical quality targets set by the payer.

To help achieve cost control and quality goals, ACOs can distribute bonuses when targets are met and impose penalties when targets are missed. To be effective, an ACO should include, at a minimum, primary care phy- sicians, specialists, and typically, a hospital. In addition, it should have the managerial systems in place to administer payments, set benchmarks, mea- sure performance, and distribute shared savings. A variety of federal, region- al, state, and academic hospital initiatives are investigating how to implement ACOs. Although the concept shows potential, there are still many legal and managerial hurdles that have to be overcome for ACOs to live up to their initial promise.

Accountable care organization (ACO) A method of inte- grating physicians with other health- care providers with a goal of control- ling costs and im- proving quality.

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One of the features of healthcare reform is a plan for a shared savings program in which Medicare pays a fixed (global) payment to ACOs that cov- ers the entire cost of care of an entire population. In such a program, cost tar- gets are first established and then any cost savings (costs that are below target costs) are shared between the payer (Medicare) and the ACO. In addition to the global payment and shared savings, bonuses are paid if the ACO meets quality and patient satisfaction scores.

Medical Home Model

A medical home (or patient-centered medical home) is a team-based model of care led by a personal physician who provides continuous and coordinat- ed care throughout a patient’s lifetime to maximize health outcomes. The medical home practice 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 physi- cian, 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 would pro- vide an organizational 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 devel- opment and implementation of the medical home model is in its infancy, it appears that its key characteristics are as follows:

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

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

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

• Quality and safety. Quality and patient safety are ensured by a care plan- ning process, evidence-based medicine, clinical decision-support tools, per- formance 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 in- novative communications technologies.

Medical home A team-based model of care led by a personal phy- sician who pro- vides continuous and coordinated care throughout a patient’s life- time to maximize health outcomes.

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

Several ongoing pilot projects are assessing the effectiveness of the medical home and ACO models, and a great deal of information is available online.10

1. What is the primary purpose of healthcare reform? 2. Will reform have a greater impact on insurers or providers? 3. Does healthcare reform have a significant impact on the principles

and concepts applicable to healthcare finance? 4. What is an accountable care organization (ACO), and what is it de-

signed to accomplish? 5. What is the medical home model, and what is its purpose?

Key Concepts In this chapter, important background material was presented that will be used throughout the remainder of the book. The key concepts of this chapter are as follows:

• The three main forms of business organization are proprietorship, part- nership, 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. Stockholders exercise control through the proxy process in which they elect the corporation’s board of directors and vote on matters of major consequence to the firm. As owners, stockholders have claim on the residual earnings of the corporation. Investor-owned corpora- tions 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.

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

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

• An agency problem is a conflict of interest that can arise between principals and agents. One type of agency problem that is relevant to healthcare finance is the conflict between the owners of a large for-profit corporation and its managers.

• The value of any income stream depends on the amount of usable, or after-tax, income. Thus, tax laws play an important role in financial management decisions.

• 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 health- care 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.

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

• Healthcare reform is legislation that was signed into law in 2010 and is expected to have a significant impact on health insurers. However, its final form will not be known for a number of years.

• Accountable care organizations (ACOs) are a method of integrating lo- cal 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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Because the managers of health services organizations must make financial decisions within the constraints imposed by the economic environment, these background concepts will be used over and over throughout the remainder of the book.

Questions 2.1 What are the three primary forms of business organization? Describe

their advantages and disadvantages. 2.2 What are the primary differences between investor-owned and not-for-

profit corporations? 2.3 a. What is the primary goal of investor-owned corporations? b. What is the primary goal of most not-for-profit healthcare corpora-

tions? c. Are there substantial differences between the finance goals of investor-

owned and not-for-profit corporations? Explain. d. What is the agency problem? 2.4 a. Why are tax laws important to healthcare finance? b. What three major advantages do tax laws give to not-for-profit

corporations? c. What is Form 990? 2.5 Briefly describe the major third-party payers. 2.6 a. What are the primary characteristics of managed care plans? b. Describe different types of managed care plans. 2.7 What is the difference between fee-for-service reimbursement and capi-

tation? 2.8 Describe provider incentives and risks under each of the following re-

imbursement methods: a. Cost-based b. Charge-based (including discounted charges) c. Per procedure d. Per diagnosis e. Per diem f. Bundled payment g. Capitation 2.9 What medical coding systems are used to support fee-for-service pay-

ment methodologies? 2.10 Briefly describe the main provisions of healthcare reform and its impli-

cations for the practice of healthcare finance. 2.11 Describe the primary features of accountable care organizations (ACOs)

and medical homes. What benefits are attributed to them?

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Problems 2.1 Assume that Provident Health System, a for-profit hospital, has $1

million in taxable income for 2011, and its tax rate is 30 percent. a. Given this information, what is the firm’s net income? (Hint: net

income is what remains after taxes have been paid.) b. Suppose the hospital pays out $300,000 in dividends. A stockholder

receives $10,000. If the stockholder’s tax rate on dividends is 15 percent, what is the after-tax dividend?

2.2 A firm that owns the stock of another corporation does not have to pay taxes on the entire amount of dividends received. In general, only 30 percent of the dividends received by one corporation from another are taxable. The reason for this tax law feature is to mitigate the effect of triple taxation, which occurs when earnings are first taxed at one firm, then its dividends paid to a second firm are taxed again, and finally the dividends paid to stockholders by the second firm are taxed yet again. Assume that a firm with a 35 percent tax rate receives $100,000 in dividends from another corporation. What taxes must be paid on this dividend, and what is the after-tax amount of the dividend?

2.3 John Friedman is in the 40 percent personal tax bracket. He is consid- ering investing in HCA bonds that carry a 12 percent interest rate.

a. What is his after-tax yield (interest rate) on the bonds? b. Suppose Twin Cities Memorial Hospital has issued tax-exempt

bonds that have an interest rate of 6 percent. With all else the same, should John buy the HCA or the Twin Cities bonds?

c. With all else the same, what interest rate on the tax-exempt Twin Cities bonds would make John indifferent between these bonds and the HCA bonds?

2.4 Jane Smith currently holds tax-exempt bonds of Good Samaritan Health- care that pay 7 percent interest. She is in the 40 percent tax bracket. Her broker wants her to buy some Beverly Enterprises taxable bonds that will be issued next week. With all else the same, what rate must be set on the Beverly bonds to make Jane interested in making a switch?

2.5 George and Margaret Wealthy are in the 48 percent tax bracket, con- sidering both federal and state personal taxes. Norman Briggs, the CEO of Community General Hospital, has been aggressively pursuing the couple to contribute $500,000 to the hospital’s soon-to-be-built Cancer Care Center. Without the contribution, the Wealthys’ taxable income for 2011 would be $2 million. What impact would the contri- bution have on the Wealthys’ 2011 tax bill?

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Notes 1. A tax-exempt corporation can be one partner of a partnership. In this situ-

ation, profits allocated to the tax-exempt partner are not taxed, but those allocated to taxable partners are subject to taxation.

2. Although most partnerships are small, there are some very large business- es that are organized as partnerships or as hybrid organizations. Examples include the major public accounting firms and many large law firms.

3. Financial markets bring together people and businesses that need money with other people and businesses that have funds to invest. In a developed country such as the United States, a great many financial markets exist. Some markets deal with debt capital and others with equity (ownership) capital, some deal with short-term capital and others with long-term capi- tal, and so on. How financial markets operate and their benefit to health services organizations are discussed throughout the book.

4. More than 60 percent of corporations in the United States are chartered in Delaware, which over the years has provided a favorable political and legal environment for corporations. A firm does not have to be headquar- tered or conduct business operations in its state of incorporation.

5. Stock sales are discussed in much more detail in Chapter 12. 6. The OTC market is also known as NASDAQ, which stands for National

Association of Securities Dealers Automated Quotation (System). 7. This entire chapter could easily be filled with the details of obtaining and

maintaining tax-exempt status, but that is not the purpose of this book. Enough information is provided to show the ways in which not-for-profit status has an impact on financial decisions, but the details concerning tax- exempt status are left to outside readings or other courses.

8. Note that ordinary income, which consists primarily of wages and income distributed from proprietorships and partnerships, is taxed at higher rates than income from dividends or capital gains that result from corporate stock ownership. (A capital gain is realized when stock is sold at a price greater than the purchase price.) For example, in 2011 an individual in- vestor in the 35 percent tax bracket for ordinary income would pay only 15 percent taxes on income from dividends and capital gains.

9. Most prospective payment systems contain outlier clauses, whereby pro- viders receive additional reimbursement when costs are far above average for a particular patient. However, such extra payments typically do not cover the full amount of the cost differential.

10. For example, for more information on medical homes see the American College of Physicians website at www.acponline.org/running_practice/ pcmh. For more information on ACOs, go to www.cms.gov and search for accountable care.

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http://www.acponline.org/running_practice/pcmh

http://www.cms.gov

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Chapter 19: Distributions to Owners: Bonuses, Dividends, and Repurchases Chapter 20: Capitation, Rate Setting, and Risk Sharing

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