HMGTY 240 DISC PART 1

Chapter 1 : Healthcare F inance Basics 11

is carried out under the direction of the organization’s chief financial officer and hence falls under the overall category of finance.

In general, finance activities include the following:

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

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

• Capital investment decisions. Although capital investment is typically handled by senior management, managers at all levels must be concerned with the capital investment decision-making process. Decisions that result from this process, which are called capital budgeting decisions, focus on the acquisition of land, buildings, and equipment. They are the primary means by which businesses implement strategic plans, and hence they play a key role in an organization’s financial future.

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

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

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

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

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

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

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

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

C o p y r i g h t 2 0 2 1 . A U P H A / H A P B o o k .

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

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G apenski ’s Healthcare F inance12

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

In times of high profitability and abundant financial resources, the finance function tends to decline in importance. Thus, at the time when most healthcare providers were reimbursed on the basis of costs incurred, the role of finance was minimal. The most critical finance function was cost identifica- tion because it was more important to account for costs than it was to control them. In response to payer (primarily Medicare) requirements, providers (primarily hospitals) churned out a multitude of reports both to comply with regulations and to maximize revenues. The complexities of cost reimburse- ment meant that a large amount of time had to be spent on cumbersome accounting, billing, and collection procedures. Thus, instead of focusing on value-adding activities, most finance work focused on bureaucratic functions.

Now, finance functions are typically much more strategic and sophisti- cated in recognition of the changes that have occurred in the health services sector. Although billing and collections remain important, to be of maximum value to the enterprise today, the finance function must support a much broader array of activities, including strategy development, cost containment efforts, third-party payer contract negotiations, joint venture decisions, risk manage- ment, and clinical integration. In essence, finance must help lead organizations into the future rather than merely record what has happened in the past.

In this book, the emphasis is on the finance function, but there are no unimportant functions in healthcare organizations. Senior executives must understand a multitude of other functions, such as operations, marketing, facilities management, quality improvement, and human resource manage- ment, in addition to finance. Still, all business decisions have financial impli- cations, so all managers—whether they are in finance or not—must know enough about finance to properly incorporate any financial implications into decisions made within their own specialized areas.

1. What is the role of finance in today’s health services organizations? 2. How has this role changed over time? 3. What are the four Cs?

SELF-TEST QUESTIONS

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

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

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Chapter 1 : Healthcare F inance Basics 13

The Structure of the Finance Department

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

The head of the finance department holds the title chief financial officer (CFO) or sometimes vice president of finance. This individual typi- cally reports directly to the organization’s chief executive officer (CEO) and is responsible for all finance activities within the organization.

The CFO directs two senior managers who help manage finance activi- ties. First is the comptroller (pronounced, and sometimes spelled, “control- ler”), who is responsible for accounting and reporting activities such as routine budgeting, preparation of financial statements, payables management, and patient accounts management. For the most part, the comptroller is involved in the activities covered in chapters 3–8 of this text. Second is the treasurer, who is responsible for the acquisition and management of capital (funds). The treasurer’s activities include the acquisition and employment of capital, cash and debt management, lease financing, financial risk management, and endowment fund management (within not-for-profits). In general, the trea- surer is involved in the activities discussed in chapters 11–17 of this text.

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

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

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

2. How does the structure of the finance department differ between small and large health services organizations?

SELF-TEST QUESTIONS

Health Services Settings

Health services are provided in a variety of settings, including hospitals, ambulatory care facilities, long-term care facilities, and even at home.

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G apenski ’s Healthcare F inance14

Before the 1980s, most health services organizations were independent and not formally linked with other organizations. Those that were linked tended to be part of horizontally integrated systems that controlled a single type of healthcare facility, such as hospitals or nursing homes. Over time, however, many health services organizations have diversified and become vertically integrated through either direct ownership or contractual arrangements.

Most readers of this text are familiar with health services settings either through previous courses or work in the field. For readers who have not had exposure to health services settings, the chapter 1 supplement, available online at ache.org/books/HCFinance7, provides additional information.

1. Name a few settings in which health services are provided. 2. Briefly describe horizontal and vertical integration.

SELF-TEST QUESTIONS

Current Managerial Challenges

In recent years, the American College of Healthcare Executives has surveyed CEOs regarding the most critical concerns of healthcare managers. Finan- cial concerns have headed the list of challenges every year since the survey began in 2002. When asked to rank their specific financial concerns, in 2018, CEOs put costs for staff, supplies, and other expenses; Medicaid reimburse- ment; and operating costs at the forefront.1 (Reimbursement is discussed in chapter 2.)

In a survey of senior healthcare executives conducted by the Advisory Board in 2019, respondents reported that their most pressing issues were revenue growth, population health, and accountable care organization strat- egy and cost containment.2 Finally, a survey conducted by the Healthcare Financial Management Association identified improving the accuracy of clini- cal documentation as a key revenue cycle (billing and collecting on a timely basis) concern.3

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

1. What are some important issues facing healthcare managers today? SELF-TEST QUESTION

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Chapter 1 : Healthcare F inance Basics 15

Legal Forms of Businesses

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

Proprietorships A proprietorship, sometimes called a sole proprietorship, is a business owned by one individual. Going into business as a proprietor is easy—the owner simply begins business operations. However, most cities require even the smallest businesses to be licensed, and state licensure is required for most healthcare professionals.

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

Proprietorships and partnerships have several disadvantages, including the following:

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

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

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 individuals.

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G apenski ’s Healthcare F inance16

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

of capital. This is generally not a problem when the business is very small or when the owners are very wealthy; however, the difficulty of attracting capital becomes a real handicap if the business needs to grow substantially to take advantage of market opportunities.

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

• A corporation has an 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.

• The owners of a corporation have limited liability.

To illustrate limited liability, suppose that an individual made an investment of $10,000 in a partnership that subsequently went bankrupt, owing $100,000. Because the partners are liable for the debts of the partner- ship, that partner could be assessed for a share of the partnership’s debt in addition to the loss of his or her initial $10,000 contribution. In fact, if the other partners were unable to pay their shares of the indebtedness, one part- ner 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.) Because of these three factors— unlimited life, ease of ownership transfer, and limited liability—corporations can more easily raise money in the financial markets than can sole proprietor- ships or partnerships.

The corporate form of organization has two primary disadvantages. First, corporate earnings of taxable entities are subject to double taxation— once at the corporate level and then again at the personal level. Second, 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.

Setting up a corporation requires that the founders, or their attor- ney, prepare a charter and a set of bylaws. Today, attorneys have standard

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

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Chapter 1 : Healthcare F inance Basics 17

templates for charters and bylaws, 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 compared with a proprietorship or partnership, and it is even more difficult if the corporation has nonstandard features, such as mul- tiple classes of stock.

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

In general, the hybrid forms are designed to limit owners’ liability without having to fully incorporate. For example, in a limited liability part- nership (LLP), the partners have joint liability for all actions of the partner- ship, including personal injuries and indebtedness. However, all partners enjoy limited liability regarding professional malpractice because partners are only liable for their own individual malpractice actions, not those of the other partners. In spite of limited malpractice liability, the partners are jointly liable for the partnership’s debts. Other hybrid forms of organization include limited liability companies (LLCs), professional corporations (PCs), and pro- fessional associations (PAs).

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

2. What is the purpose of hybrid forms of business organization?

SELF-TEST QUESTIONS

Corporate Ownership

In the previous section, we discussed the different legal forms of businesses. Now, we turn our attention to the two ownership forms of corporations: for-profit and not-for-profit. Unlike other sectors in the economy, not- for-profit corporations play a major role in the healthcare sector, especially among providers. For example, about 56 percent of the community hos- pitals in the United States are private, not-for-profit hospitals. Only 25 percent of all community hospitals are investor owned; the remaining 19 percent are government hospitals.4 Furthermore, not-for-profit ownership is common in the nursing home, home health care, hospice, and health insur- ance industries.

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

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G apenski ’s Healthcare F inance18

Investor-Owned Corporations When you think of a corporation, an investor-owned, or for-profit, cor- poration likely comes to mind. For example, Ford (www.ford.com), IBM (www.ibm.com), and Microsoft (www.microsoft.com) are investor-owned corporations. In health services, corporations such as HCA Healthcare (https://hcahealthcare.com) and Community Health Systems (www.chs. net) are examples of large for-profit hospital systems; Kindred Health- care (www.kindredhealthcare.com) and Brookdale Senior Living (www. brookdale. com) are examples of long-term care providers; Select Medical (www.select medical .com) and Encompass Health (www.encompasshealth. com) offer rehabilitation services; and MEDNAX (www.mednax.com) offers pediatric services. Individuals become owners of for-profit corporations by buying shares of common stock in the company. The stockholders (also called shareholders) are the owners of investor-owned corporations. As owners, they have two basic rights:

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

• A claim on the residual earnings of the firm. A corporation sells products or services and realizes revenues from the sales. To produce these revenues, the corporation must incur expenses for materials, labor, insurance, debt capital, and so on. Any excess of revenues over expenses—the residual earnings—belongs to the shareholders of the business. Often, a portion of these earnings is paid out in the form of dividends, which are cash payments to stockholders, or stock repurchases, in which the company buys back shares held by stockholders. However, management typically elects to reinvest some (or all) of the residual earnings in the business, which presumably will produce even higher payouts to stockholders in the future.

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

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

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Chapter 1 : Healthcare F inance Basics 19

Not-for-Profit Corporations If an organization meets a set of stringent requirements, it can qualify for incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt corporations are sometimes called nonprofit corporations. Because nonprofit businesses (as opposed to pure charities such as United Way) need profits to sustain operations, and because it is hard to explain why nonprofit corpora- tions should earn profits, the term not-for-profit better describes such health services corporations. Examples of not-for-profit health services corporations include Kaiser Permanente (https://healthy.kaiserpermanente.org), Catholic Health Initiatives (www.catholichealthinitiatives.org), and the Mayo Clinic Health System (www.mayoclinic.org).

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 501(c)(4). Hence, such corporations are also known as 501(c)(3) or 501(c)(4) corporations. The tax code defines a charita- ble organization 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 pro- vides healthcare services can qualify for tax-exempt status, provided that it meets other requirements.

In addition to the charitable purpose, a not-for-profit corporation must be organized and run so that it operates exclusively for the public, rather than private, interest. Thus, no profits can be used for private gain, and no direct political activity can be conducted. Also, if the corporation is liquidated or sold to an investor-owned business, the proceeds from the liqui- dation or sale must be used for charitable purposes. Because individuals can- not benefit from the profits of not-for-profit corporations, such organizations cannot pay dividends. However, the prohibition of private gain from profits does not prevent parties, such as managers and physicians, from benefiting through salaries, perquisites, contracts, and so on.

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

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

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G apenski ’s Healthcare F inance20

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 gover- nance and boards of trustees. In addition, hospitals are required to file Sched- ule H to Form 990, which includes financial information on the amount and type of community benefit (primarily charity care) provided, bad debt losses, Medicaid patients, and collection practices. IRS regulations require not-for- profit organizations to provide copies of their three most recent Form 990s to anyone who requests them, whether in person or by mail, fax, or email. Form 990s are also available to the public through several online services.

The financial problems facing most federal, state, and local govern- ments have prompted politicians to take a closer look at the tax subsidies pro- vided to not-for-profit hospitals. The Patient Protection and Affordable Care Act (ACA) of 2010 added four requirements that must be met for hospitals to maintain their tax-exempt status: (1) conducting a community health needs

assessment every three years and develop- ing plans for implementation; (2) establish- ing a written financial assistance policy; (3) charging patients who qualify for financial assistance amounts similar to what insured patients are charged; and (4) not engag- ing in aggressive collection efforts before making an effort to determine whether a patient is eligible for financial assistance.5

Likewise, officials in several states have proposed or enacted legislation man- dating the minimum amount of charity care to be provided by not-for-profit hospi- tals and the types of billing and collections procedures that can be applied to the unin- sured.6 For example, Texas has established minimum requirements for charity care that hold not-for-profit hospitals account- able 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

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

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

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

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

(continued)

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Chapter 1 : Healthcare F inance Basics 21

least 4 percent of net patient service rev- enue be spent on charity care.

Finally, municipalities in several states have attacked the property tax exemptions of not-for-profit hospitals that have “neglected” their charitable mis- sions. For example, in 2015, a tax court in New Jersey canceled a not-for-profit hos- pital’s property tax exemption because it was found to have substantial “for-profit” elements and characteristics that made it ineligible for the exemption.7 According to one estimate, if all not-for-profit hos- pitals had to pay taxes comparable to their investor-owned counterparts, local, state, and federal governments would receive an additional $17.9 billion in tax revenues.8 This estimate explains why tax authorities in many jurisdictions are pursuing not- for-profit hospitals as a source of revenue.

The inherent differences between investor-owned and not-for-profit organizations have profound implications for many elements of healthcare financial management, including organizational goals, financing decisions (i.e., the choice between debt and equity financing and the types of securities issued), and capital investment decisions. Ownership’s effect on the applica- tion of healthcare financial management theory and concepts is addressed throughout the text.

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

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

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

SELF-TEST QUESTIONS

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,

Most not-for-profit hospitals today are primarily supported by payments for ser- vices rather than by charitable contributions. Under the opinion’s reasoning, the property tax exemption may well be hard to maintain. However, a partial dissent by two justices sug- gests that this case is not the end of the story. The dissent argues 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 rather than by courts.

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

(continued from previous page)

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G apenski ’s Healthcare F inance22

by discussing organizational goals, a framework for financial decision-making within health services organizations can be established.

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

Publicly Held Corporations From a finance perspective, the primary goal of large investor-owned corpo- rations is generally assumed to be shareholder wealth maximization, which translates to stock price maximization. Investor-owned corporations do, of course, have other goals. Managers, who make the actual decisions, are interested 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 on which to build financial decision-making rules.

Not-for-Profit Corporations Corporations consist of a number of classes of stakeholders, which include all parties that have an interest, usually of a financial nature, in the orga- nization. For example, a not-for-profit hospital’s stakeholders include the board of trustees, managers, employees, physician staff, creditors, suppliers, patients, and even potential patients, which may include the entire com- munity. 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 lead the boards of trustees that are supposed to exercise oversight. Others argue that managers of not-for- profit corporations have to please all of the business’s stakeholders to a greater or lesser extent because all are necessary to the successful performance of the business. Of course, even managers of investor-owned corporations should not

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Chapter 1 : Healthcare F inance Basics 23

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

Typically, not-for-profit corpora- tions state their goals in terms of a mission statement. For example, here is the current mission statement of Riverside Hospital, a 450-bed, not-for-profit acute care hospital:

To care for others as we would care for those

we love—to enhance their well-being and

improve their health.

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 accom- plish its mission, its managers have identi- fied the following five financial goals:

1. The hospital must maintain its financial viability.

2. The hospital must generate sufficient profits to continue to provide the current range of healthcare services 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 high-quality services to the community as inexpensively as possible, given the financial requirements.

In effect, Riverside’s managers are saying that to achieve the hospital’s commitment to excellence as stated in its mission, it must remain financially

For Your Consideration Does the Finance Function Differ Among Providers?

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

But what about the finance function? That is, what about the day-to-day activities of opera- tional managers and the finance staff? Are these appreciably different at not-for-profit providers than at for-profit providers? What about different types of providers—say, medical group practices versus hospitals?

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

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G apenski ’s Healthcare F inance24

strong and profitable. Financially weak organizations cannot continue to accomplish their stated missions over the long run.

Riverside’s five financial goals are probably not much different from the financial goals of Jeffersonville Health System (JHS), a for-profit competitor. Of course, JHS 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, JHS also must maintain its financial viability and have the financial resources necessary to offer new ser- vices and technologies. Furthermore, competition in the market for hospital services does not permit JHS 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. Briefly describe the differences in key stakeholders between investor-owned and not-for-profit businesses.

SELF-TEST QUESTIONS

Healthcare Reform and Finance

The Affordable Care Act has been called the most significant healthcare leg- islation since Medicare and Medicaid were enacted in 1965. The ACA, which became law on March 23, 2010, was designed to provide all US citizens and legal residents with access to affordable health insurance, reduce healthcare costs, and improve care and quality. The legislation put in place comprehen- sive health insurance exchanges to expand coverage, enacted provisions to hold insurance companies accountable for product cost and quality, required that everyone buy insurance through an individual mandate (this provision was repealed in 2017 as part of the Tax Cuts and Jobs Act), and offered sub- sidies to low-income individuals. All of these components of the ACA were intended to transform the US healthcare system and make it more affordable and sustainable.

The ACA had numerous aims. However, the central goal was to expand healthcare coverage through shared responsibility among govern- ment, individuals, and employers.

Since the ACA’s passage, several congressional efforts have been made to repeal and replace the law; however, none has been passed. While the future of healthcare reform is uncertain, major provisions of the ACA remained in effect in 2020. The major implications of healthcare reform for

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Chapter 1 : Healthcare F inance Basics 25

health insurance and provider payments are addressed in chapters 2 and 3, respectively. The major implications of healthcare reform for the institutional setting and the delivery of healthcare services are discussed in the next sec- tion of this chapter.

Key Trends Following the Affordable Care Act

Sector Consolidation Since its passage, the ACA has driven the consolidation of healthcare organi- zations. It has accelerated health systems’ acquisition of hospitals and hospi- tals’ acquisition of physician practices—a trend that is likely to continue for many years. As a result of their greater focus on clinical integration, quality of care, and changing reimbursement methodologies, healthcare organizations are now seeking to restructure healthcare delivery to operate more efficiently and to improve coordination between patients and providers. Healthcare organizations are also looking to gain a competitive advantage by combining assets, staff, and resources.

Consolidation not only provides organizations with access to capital, economies of scale, negotiating power with payers, and market share, but also it may lead to improvements in patient care by making it easier to share patient information, adhere to clinical practice guidelines (thus reducing variations in care), and access high-quality specialist physicians. There is, however, a notable downside to consolidation: increases in prices as health- care organizations gain greater market share and negotiating power.

Population Health The ACA is moving providers toward the population health management approach to care provision. The goal of population health management is to shift the focus of healthcare from treating illness to maintaining or improving health. The idea is to prevent costly illnesses when possible and hence avoid unnecessary care. This approach is supported by reimbursement models such as capitation, payment bundling, and shared savings (discussed in chapter 2). Instead of providing only preventive and chronic care when patients seek out healthcare for acute problems, healthcare practices that adopt the population health management approach track and monitor the health status of their entire patient population. Doing so requires greater use of health informa- tion technology (IT). Key to the success of population health management are greater awareness of the health status of the population and proactive intervention to reduce the use of provider resources and achieve the best population outcomes.

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

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G apenski ’s Healthcare F inance26

Social Determinants of Health In response to increasing incentives to manage healthcare utilization and costs, health systems, government payers, and insurers are taking steps to address the social determinants of health. Scholars and healthcare provid- ers increasingly are recognizing that social, economic, and environmental factors such as housing, education, income, and food security have a power- ful influence on health outside the healthcare system. Examples of initiatives to address the social determinants of health include screening patients or populations for social needs (e.g., healthy food, housing) and then connect- ing individuals with resources (e.g., food pantries, information and referral services) in sectors outside healthcare. This goal is consistent with the popu- lation health management approach, which focuses on preventing costly ill- nesses, improving health, and reducing health inequities.

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

Health IT supports clinical integration by capturing patient informa- tion and making it accessible to authorized providers at the point of care. Complete patient information facilitates optimal treatment strategies and reduces the chance of medication errors and conflicting treatment plans. However, the sharing of patient data requires that policies and procedures be in place to protect patient privacy and to guarantee the security of data transferred among patients, caregivers, and organizations.

Technology Technology has a major impact on the delivery and financial management of healthcare, as shown by the adoption of electronic health record systems starting in the 2000s; however, healthcare as a sector has been slow to adopt new technology because of privacy and safety concerns. A new technology, blockchain, has the potential to drastically change the way healthcare pro- viders protect their data and communicate with each other. Blockchain is a system of securing data by linking pieces of data together in chains; thus, a change to one piece of data will update the rest of the chain. While this technology has the potential to revolutionize the sharing of electronic health data, there are still some concerns about ensuring patient privacy.

social determinants of health Social, economic, and environmental conditions in the places where people are born, live, grow, learn, work, and play that affect health.

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Chapter 1 : Healthcare F inance Basics 27

Electronic health data are still hard to share among providers. How- ever, the increasing emphases on collaboration among clinicians and on quality patient care are spurring healthcare organizations to invest in inte- grated health IT systems to collect large quantities of patient and provider data (so-called big data). Data analytic systems are capable of analyzing large amounts of patient data to better understand clinical processes and to identify problems and opportunities for improvement in the provision of healthcare services. New, complex IT systems and applications of artificial intelligence will facilitate the analysis of care coordination, patient safety, and healthcare utilization.

Staffing Shortages Healthcare reform has increased the number of patients who can access the healthcare system. As a result, healthcare organizations are seeing an influx of formerly uninsured patients who are now seeking care because they have insurance or better coverage. As a result, the demand for healthcare professionals—especially primary care physicians, nurse practitioners, and physician assistants—has increased.

Healthcare reform is also driving changes in hospital staffing by emphasizing prevention and value-based care, creating demand for primary care providers, emergency physicians, clinical pharmacists, social workers and care coordinators, and health IT and data specialists. Several strategies may increase the supply and distribution of health professionals (including primary care physicians): scholarships, flexible loan repayment programs, and debt forgiveness have been identified as ways to increase the number of providers and attract them to underserved areas. However, many healthcare organizations likely will face great competition for some healthcare staff.

Key Programs of the Affordable Care Act

Accountable Care Organizations Accountable care organizations (ACOs), a cornerstone of healthcare reform, integrate local physicians with other members of the healthcare com- munity and reward them for controlling costs and improving quality. While ACOs are not radically different from other attempts to improve the delivery of healthcare services, they are unique in the flexibility of their structures and payment methodologies and in their ability to assume risk while meeting quality targets. Similar to some managed care organizations and integrated healthcare systems such as the Mayo Clinic, ACOs are responsible for the health outcomes of a specific population and tasked with collaboratively improving care to reach cost and quality targets set by Medicare. To help

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

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G apenski ’s Healthcare F inance28

achieve cost control and quality goals, ACOs can distribute bonuses when targets are met and impose penalties when targets are missed.

One feature of healthcare reform is a shared savings program in which Medicare pays a fixed (global) payment to ACOs that covers the full cost of care for an entire population. This program establishes cost and quality targets. Any cost savings (i.e., costs that are below the target) are shared between Medicare and the ACO, as long as the ACO also meets its quality targets. If an ACO is unable to save money, it could be liable for the costs of the investments made to improve care; it also may have to pay a penalty if it does not meet performance and savings benchmarks.

To be effective, an ACO should include, at a minimum, primary care physicians, specialists, and a hospital, although some ACOs are being estab- lished solely by physician groups.

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

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

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

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

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

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

ACOs should have managerial systems in place to administer pay- ments, set benchmarks, measure performance, and distribute shared savings. A variety of federal, regional, state, and academic hospital initiatives are investigating how best to implement ACOs. Although the concept shows potential, many legal and managerial hurdles must be overcome for ACOs to live up to their promise.

Medical Homes A medical home (or patient-centered medical home) is a team-based model of care that is led by a personal physician who provides continuous and coordinated care throughout a patient’s lifetime with the goal of maxi- mizing health outcomes. The medical home is responsible for meeting all of a patient’s healthcare needs or appropriately arranging care with other qualified professionals. This includes the provision of preventive services,

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

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Chapter 1 : Healthcare F inance Basics 29

treatment of acute and chronic illnesses, and assistance with end-of-life care. It is a model of practice in which a team of healthcare professionals, coordi- nated by a personal physician, works collaboratively to ensure coordinated and integrated care, patient access and communication, quality, and safety. The medical home model is independent of the ACO concept, but most ACOs provide an organizational setting that facilitates implementation of the model.

Supporters of the medical home model argue that it allows better access to healthcare, increases patient satisfaction, and improves health. The Agency for Healthcare Research and Quality defines a medical home as a model of primary care that encompasses the following functions and attributes:9

• Comprehensive care. The medical home includes a team of providers that are responsible for meeting a majority of the patients’ physical and mental healthcare needs.

• Patient-centered. The medical home partners with patients and families to help patients actively engage in care decisions and manage their care.

• Coordinated care. The medical home coordinates care across specialists, hospitals, home health agencies, nursing homes, hospices, and community services.

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

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

• Payment-for-value methodologies. Payment methodologies must recognize the added value provided to patients. Payments should reflect the value of work that falls outside of face-to-face visits, support the adoption and use of health IT for quality improvement, and recognize differences among the patient populations treated within the practice.

1. What is the primary purpose of healthcare reform? 2. What is an accountable care organization (ACO), and what is it

designed to accomplish? 3. What is the medical home model, and what is its purpose?

SELF-TEST QUESTIONS

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G apenski ’s Healthcare F inance30

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

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

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

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

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

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

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

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

• All business decisions have financial implications, so all managers—whether they are in finance or not—must know enough about finance to incorporate those implications into their own specialized decision-making processes.

(continued)

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Chapter 1 : Healthcare F inance Basics 31

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

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

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

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

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

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

• Healthcare reform—such as the Affordable Care Act (ACA), federal legislation that was signed into law in 2010—is having a significant impact on health insurers and providers.

• Accountable care organizations (ACOs) integrate local physicians with other members of the healthcare community and reward 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.

(continued from previous page)

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G apenski ’s Healthcare F inance32

In chapter 2, we continue the discussion of the healthcare environment, with an emphasis on health insurance and reimbursement methodologies.

Questions

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

1.2. a. What are some of the subsectors that make up the healthcare sector?

b. What is meant by the term healthcare finance as it is used in this book?

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

opposed to a generic finance book? 1.3. What is the difference between a business and a pure charity? 1.4. a. Briefly discuss the role of finance in the health services sector.

b. Has this role increased or decreased in importance in recent years?

1.5. What is the structure of the finance department within health services organizations?

1.6. a. (Hint: The material reviewed in this question is covered in the chapter 1 supplement online.) Briefly describe the following health services settings: • Hospitals • Ambulatory care • Home health care • Long-term care • Integrated delivery systems

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

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

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

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

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

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Chapter 1 : Healthcare F inance Basics 33

1.11. Briefly describe the main provisions of the Affordable Care Act and its implications for the practice of healthcare finance.

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

Notes

1. American College of Healthcare Executives. 2019. “Survey: Healthcare Finance, Governmental Mandates, Personnel Shortages Cited by CEOs as Top Issues Confronting Hospitals in 2018.” Published January 25. www.ache.org/about-ache/news-and-awards/news-releases/top -issues-confronting-hospitals-in-2018.

2. Advisory Board. 2019. “We Asked 90 C-Suite Executives About Their Biggest Concerns. Here’s What They Told Us.” Published June 13. www.advisory.com/research/health-care-advisory-board/blogs/at -the-helm/2019/06/c-suite.

3. Healthcare Finance Management Association. 2013. “HRMA’s Executive Survey: Clinical Documentation Meets Financial Performance.” Published November. www.hfma.org/content/dam /hfma /document/research_reports/PDF/20158.pdf.

4. American Hospital Association. 2020. “Fast Facts on U.S. Hospitals, 2020.” Accessed January 13. www.aha.org/statistics/fast-facts -us -hospitals.

5. James, J. 2016. “Nonprofit Hospitals’ Community Benefit Requirements.” Health Policy Brief, Health Affairs. Published February 25. www.healthaffairs.org/do/10.1377/hpb201 60225 .954803/full/healthpolicybrief_153.pdf.

6. Hilltop Institute. 2015. “Community Benefit State Law Profiles.” Published January. www.hilltopinstitute.org/wp-content/uploads /publications/CommunityBenefitStateLawProfiles-January2015.pdf.

7. Chiesa Shahinain & Giantomasi. 2015. “Tax Court Ruling Cancels Property Tax Exemption for Non-Profit Hospital.” Published July. www.csglaw.com/hospital-tax-exemption.

8. Rosenbaum, S., D. A. Kindig, J. Bao, M. K. Byrnes, and C. O’Laughlin. 2015. “The Value of the Nonprofit Hospital Tax Exemption Was $24.6 Billion in 2011.” Health Affairs 34 (7): 1225–33.

9. Agency for Healthcare Research and Quality, Patient-Centered Medical Home Resource Center. 2020. “Defining the PCMH.” Accessed January 13. https://pcmh.ahrq.gov/page/defining-pcmh.

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G apenski ’s Healthcare F inance34

Resources

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

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

MA: Jones & Bartlett Learning.

For the latest information on events that affect health services organizations, see Modern Healthcare, published weekly by Crain Communications Inc.: www .crain.com/brands/modern-healthcare/.

For current information about the Affordable Care Act, see the Kaiser Family Foundation: www.kff.org/.

For information about the patient-centered medical home model of care, see the Agency for Healthcare Research and Quality’s Patient-Centered Medical Home Resource Center: https://pcmh.ahrq.gov/page/defining-pcmh.

For discussion of the future of healthcare in the United States and other infor- mation pertinent to this chapter, see Bisognano, M. 2011. “Finance Is Key to Achieving Quality and Cost Goals.” Health-

care Financial Management 65 (4): 68–71. French, M. T., J. Homer, G. Gumus, and L. Hickling. 2016. “Key Provisions of the

Patient Protection and Affordable Care Act (ACA): A Systematic Review and Presentation of Early Research Findings.” Health Services Research 51 (5): 1735–71.

Hegwer, L. R., and N. Hut. 2019. “The Healthcare CFO of the Future: How Finance Leaders Are Adapting to Relentless Change.” Healthcare Financial Management. Published September 1. www.hfma.org/topics/hfm/2019 /september/the-healthcare-cfo-of-the-future.html.

Kim, C., D. Majka, and J. H. Sussman. 2011. “Modeling the Impact of Healthcare Reform.” Healthcare Financial Management 65(1): 51–60.

Korenstein, D., K. Duan, M. J. Diaz, R. Ahn, and S. Keyhani. 2016. “Do Health Care Delivery System Reforms Improve Value? The Jury Is Still Out.” Medi- cal Care 54 (1): 55–66.

Lee, J. G., G. Dayal, and D. Fontaine. 2011. “Starting a Medical Home: Better Health at Lower Cost.” Healthcare Financial Management 65 (6): 71–80.

Mulvany, C. 2011. “Medicare ACOs No Longer Mythical Creatures.” Healthcare Financial Management 65 (6): 96–104.

Nguyen, J., and B. Choi. 2011. “Accountable Care: Are You Ready?” Healthcare Financial Management 65 (8): 92–100.

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Chapter 1 : Healthcare F inance Basics 35

Rauh, S. S., E. B. Wadsworth, W. B. Weeks, and J. N. Weinstein. 2013. “The Savings Illusion—Why Clinical Quality Improvement Fails to Deliver Bottom-Line Results.” New England Journal of Medicine 365 (26): e48.

Smith, P. C., and K. Noe. 2012. “New Requirements for Hospitals to Maintain Tax- Exempt Status.” Journal of Health Care Finance 38 (3): 16–21.

Song, P. H., S. D. Lee, J. A. Alexander, and E. E. Seiber. 2013. “Hospital Ownership and Community Benefit: Looking Beyond Uncompensated Care.” Journal of Healthcare Management 58 (2): 126–42.

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

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CHAPTER

37

2HEALTHCARE INSURANCE AND REIMBURSEMENT METHODOLOGIES

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

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

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

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

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

Introduction

Compared with other services, the provision of healthcare services is unique. First, often only a few providers of a particular service exist in a given area. Next, it is often difficult to judge the quality and cost of competing services, although new tools aim to facilitate service comparison.1 Then, the decision about which services to purchase is usually not made by the consumer but by a physician or some other clinician. Also, full payment to the provider is not normally made by the user of the services but by a healthcare insurer. Finally, for most individuals, health insurance from third-party payers is paid for or subsidized by employers or government agencies, so many patients are partially insulated from the costs of healthcare.

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

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G apenski ’s Healthcare F inance38

Insurance Concepts

Healthcare services are supported by an insurance system composed of a wide variety of organizations and payers. Because insurance is the cornerstone of the healthcare system, a general understanding of insurance will help you better comprehend the marketplace for healthcare services.

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

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

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

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

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

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

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Chapter 2: Healthcare Insurance and Reimbursement Methodologies 39

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

Basic Characteristics of Insurance This simple example of health insurance illustrates why individuals would seek health insurance and why insurance companies would be formed to pro- vide such insurance. Needless to say, the concept of insurance is much more complicated in the real world. Insurance is typically defined as having four distinct characteristics:

1. Pooling of losses. The pooling, or sharing, of losses is the basis of insurance. Pooling means that losses are spread over a large group of individuals, so that each individual realizes the average loss of the pool (plus administrative expenses) rather than the actual loss incurred. In addition, pooling involves the grouping of a large number of homogeneous exposure units—people or things having the same risk characteristics—so that the law of large numbers applies. (In statistics, the law of large numbers states that as the size of the sample increases, the sample mean gets closer and closer to the population mean.) Thus, pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accuracy.

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

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

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G apenski ’s Healthcare F inance40

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

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

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

The best strategy for healthcare insurers to combat adverse selection is to create a large, well-diversified pool of subscribers. If the pool is sufficiently large and diversified, the costs of adverse selection can be absorbed by the large number of enrollees. Many current health policies, such as health insur- ance exchanges, attempt to limit adverse selection by creating or requiring these large, diversified risk pools.

Moral Hazard Insurance is based on the premise that payments are made only for random losses, and from this premise stems the problem of moral hazard. An exam- ple of moral hazard in a casualty insurance setting is the owner who delib- erately sets a failing business on fire to collect the insurance. Moral hazard is also present in health insurance, but it typically takes a less dramatic form; few people are willing to voluntarily sustain injury or illness for the purpose of collecting health insurance proceeds. However, undoubtedly there are people who purposely use healthcare services that are not medically required. For

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

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

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Chapter 2: Healthcare Insurance and Reimbursement Methodologies 41

example, some people might visit a physician or a walk-in clinic for the social value of human companionship rather than to address a medical necessity. Also, some hospital discharges might be delayed for the convenience of the patient rather than for medical purposes.

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

Even more insidious is the poten- tial impact of insurance on individual behavior. Individuals may be more likely to forgo preventive actions and embrace unhealthy behaviors when the costs of not taking those actions will be borne by insurers. For example, individuals may be less motivated to stop smoking if the monetary costs associated with smoking- related illnesses are carried by the insurer.

The primary tool that insurers have to combat the moral hazard problem is coinsurance, which requires insured indi- viduals to pay a certain percentage of eligi- ble medical expenses—say, 20 percent—in excess of the deductible (the amount that individuals pay before their insurance plan starts to pay). Insurers also use copayments, which are similar to coinsurance but are expressed as a dollar amount: $20 per pri- mary care visit, for example. To illustrate coinsurance, assume that Juan Pérez, who has employer-provided medical insurance that pays 80 percent of eligible expenses after the $100 deductible is satisfied, incurs $10,000 in medical expenses during

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

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

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

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

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

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G apenski ’s Healthcare F inance42

the year. The insurer will pay 0.80 × ($10,000 − $100) = 0.80 × $9,900 = $7,920, so Juan’s responsibility is $10,000 − $7,920 = $2,080. The pur- poses of coinsurance and copayments are to reduce premiums (monthly fees for purchasing the insurance plan) to employers and to prevent overutiliza- tion of healthcare services. Because insured individuals pay part of the cost, premiums can be reduced. Additionally, by being forced to pay some of the costs, insured individuals will presumably seek fewer and more cost-effective treatments and embrace a healthier lifestyle.

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

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

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

SELF-TEST QUESTIONS

Third-Party Payers

Up to this point in the chapter, we have focused on basic insurance concepts. A large proportion of the health services sector receives its revenues not directly from the users of their services—the patients—but from insurers, which are known collectively as third-party payers. Because an organiza- tion’s revenues are critical to its financial viability, this section briefly exam- ines the sources of most revenues in the health services sector. In the next section, the reimbursement methodologies employed by third-party payers are reviewed in more detail.

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

Private Insurers In the United States, the concept of public, or government-provided, 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 (www.bcbs.com), commercial insurers, and self-insurers.

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

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Chapter 2: Healthcare Insurance and Reimbursement Methodologies 43

Blue Cross Blue Shield Blue Cross Blue Shield organizations trace their roots to the Great Depres- sion, when both hospitals and physicians were concerned about their patients’ ability to pay healthcare bills. One example is Florida Blue (www. floridablue.com) (formerly Blue Cross and Blue Shield of Florida), which offers healthcare insurance to individuals and families, Medicare beneficiaries, and business groups that reside in Florida.

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

Blue Shield plans developed in a manner similar to Blue Cross plans, except that the providers were physicians instead of hospitals. Today, there are 36 Blue Cross Blue Shield organizations (referred to as “the Blues”). Some offer only one of the two plans, but most offer both plans. The Blues are organized as independent corporations, including some for-profit entities, but all belong to a single national association that sets standards that must be met to use the Blue Cross Blue Shield name. Collectively, the Blues provide healthcare coverage for more than 106 million individuals in all 50 states, the District of Columbia, and Puerto Rico.2

Commercial Insurers Commercial health insurance is issued by life insurance companies, casu- alty insurance companies, and companies that were formed exclusively to offer healthcare insurance. Examples of commercial insurers include Aetna, Humana, and UnitedHealth Group. All commercial insurance companies are taxable (for-profit) entities. Commercial insurers entered the health insur- ance market 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. Also following the war, the Internal Revenue Service ruled that employer-provided health insurance was not taxable, giving employers an incentive to offer this tax-free benefit. Like those covered under Blue Cross Blue Shield, the majority of individuals with commercial health insurance are covered under group policies negotiated by employee groups, professional and other associations, and labor unions.

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G apenski ’s Healthcare F inance44

Self-Insurers The third major form of private insurance is self-insurance. Although it might seem as if all individuals who do not have some form of health insurance are self-insurers, this is not the case. Self-insurers make a conscious decision to bear the risks associated with healthcare costs and then set aside (or have available) funds to pay future costs as they occur. Individuals, except the very wealthy, are not good candidates for self-insurance because they face too much uncertainty concerning healthcare expenses. On the other hand, large groups, especially employers, are good candidates for self-insurance. Today, most large groups are self-insured. For example, employees of the State of Florida are covered by health insurance whose costs are paid directly by the state. Florida Blue is paid a fee to administer the plan, but the state bears all the risks associated with cost and utilization uncertainty.

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

Medicare Medicare was established by Congress in 1965 primarily to provide medical benefits to individuals aged 65 or older. About 44 million people have Medi- care coverage, which pays for about 21 percent of all US healthcare services.

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

Part A coverage is free to all individuals who are eligible for Social Security benefits. Individuals who are not eligible for Social Security ben- efits can obtain Part A medical benefits by paying monthly premiums. Part

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

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Chapter 2: Healthcare Insurance and Reimbursement Methodologies 45

B is optional for all individuals who have Part A coverage, and it requires a monthly premium from enrollees that varies with income level. About one- third of Medicare enrollees elect to participate in Part C, also called Medicare Advantage Plans, rather than Parts A and B. Part D offers prescription drug coverage through plans offered by private companies. Each Part D plan offers somewhat different coverage, so the cost of Part D coverage varies widely.

Administration of the Medicare program falls under the HHS, which creates the specific rules of the program on the basis of enabling legislation. Medicare is administered by an agency within the HHS called the Centers for Medicare & Medicaid Services (CMS). CMS has ten regional offices that oversee the Medicare program and ensure that regulations are followed.3 Medicare payments to providers are not made directly by CMS but by con- tractors for 12 Medicare Administrative Contractor (MAC) jurisdictions.

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

Medicaid Medicaid began in 1966 as a modest program to be jointly funded and operated by the states and the federal government. The goal was to provide a medical safety net for low-income mothers and children and for elderly, blind, and disabled individuals who receive benefits from the Supplemental Security Income (SSI) program. Congress mandated that Medicaid cover hospital and physician care, but states were encouraged to expand the basic package of benefits, either by increasing the range of benefits or by extending the program to cover more people. 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.

It is important to note that both Medicare and 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 programs’ access, quality, and cost.

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

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