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FINANCIAL MANAGEMENT OF HEALTH CARE ORGANIZATIONS
FINANCIAL MANAGEMENT OF
HEALTH CARE ORGANIZATIONS
AN INTRODUCTION TO FUNDAMENTAL TOOLS, CONCEPTS, AND APPLICATIONS
Fourth Edition
William N. Zelman, Michael J. McCue, Noah D. Glick, and Marci S. Thomas
Cover design by Jeff Puda Cover image : © imagewerks | Getty Copyright © 2014 by William N. Zelman, Michael J. McCue, Noah D. Glick, and Marci S. Thomas. All rights reserved.
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Library of Congress Cataloging-In-Publication Data Zelman, William N., author. Financial management of health care organizations : an introduction to fundamental tools, concepts, and applications / William N. Zelman, Michael J. McCue, Noah D. Glick, and Marci S. Thomas. – Fourth edition. p. ; cm. Includes bibliographical references and index. ISBN 978-1-118-46656-8 (cloth) – ISBN 978-1-118-46659-9 (pdf) – ISBN 978-1-118-46658-2 (epub) I. McCue, Michael J. (Michael Joseph), 1954- author. II. Glick, Noah D., author. III. Thomas, Marci S., 1953- author. IV. Title. [DNLM: 1. Health Facility Administration–economics. 2. Financial Management, Hospital– methods. 3. Practice Management, Medical–economics. WX 157] RA971.3 362.1068'1–dc23 2013025598
Printed in the United States of America
fourth edition
HB Printing 10 9 8 7 6 5 4 3 2 1
CONTENTS
Preface xiii Acknowledgments xix The Authors xxi
Chapter 1 The Context of Health Care Financial Management 1
Changing Methods of Health Care Financing and Delivery 3 Addressing the High Cost of Care 9 Establishing Value-Based Purchasing 21 Summary 23 Key Terms 24 Review Questions 24
Chapter 2 Health Care Financial Statements 27
The Balance Sheet 28 The Statement of Operations 51 The Statement of Changes in Net Assets 65 The Statement of Cash Flows 68 Summary 73 Key Terms 75 Key Equations 75 Review Questions and Problems 76 Appendix A: Financial Statements for Sample
Not-for-Profit and For-Profit Hospitals, and Notes to Financial Statements 86
Chapter 3 Principles and Practices of Health Care Accounting 103
The Books 103 An Example of the Effects of Cash Flows on Profit Reporting
under Cash and Accrual Accounting 106 Recording Transactions 110 Developing the Financial Statements 120 Summary 126
Contentsvi
Key Terms 127 Review Questions and Problems 127
Chapter 4 Financial Statement Analysis 137
Horizontal Analysis 138 Trend Analysis 143 Vertical (Common-Size) Analysis 144 Ratio Analysis 146 Liquidity Ratios 151 Revenue, Expense, and Profitability Ratios 161 Activity Ratios 172 Capital Structure Ratios 175 Summary 183 Key Equations 186 Key Terms 187 Review Questions and Problems 187
Chapter 5 Working Capital Management 209
Working Capital Cycle 209 Working Capital Management Strategies 211 Cash Management 215 Sources of Temporary Cash 216 Revenue Cycle Management 222 Collecting Cash Payments 225 Investing Cash on a Short-Term Basis 228 Forecasting Cash Surpluses and Deficits: The Cash Budget 230 Accounts Receivable Management 233 Methods to Monitor Revenue Cycle Performance 237 Fraud and Abuse 239 Summary 243 Key Terms 246 Key Equations 246 Review Questions and Problems 246
Chapter 6 The Time Value of Money 259
Future Value of a Dollar Invested Today 259 Present Value of an Amount to Be Received in the Future 266 Future and Present Values of Annuities 270 Future and Present Value Calculations and Excel Functions
for Special Situations 275 Summary 283
Contents vii
Key Terms 284 Key Equations 284 Review Questions and Problems 286 Appendix B: Future and Present Value Tables 291
Chapter 7 The Investment Decision 301
Objectives of Capital Investment Analysis 302 Analytical Methods 306 Using an NPV Analysis for a Replacement Decision 320 Summary 325 Key Terms 327 Key Equation 327 Review Questions and Problems 327 Appendix C: Technical Concerns in Calculating
Net Present Value 335 Appendix D: Adjustments for Net Working Capital 342 Appendix E: Tax Implications for For-Profit Entities
in a Capital Budgeting Decision and the Adjustment for Interest Expense 344
Appendix F: Comprehensive Capital Budgeting Replacement Cost Example 348
Chapter 8 Capital Financing for Health Care Providers 359
Equity Financing 362 Debt Financing 364 Bond Issuance Process 375 Lease Financing 387 Summary 392 Key Terms 393 Key Equations 394 Review Questions and Problems 394 Appendix G: Bond Valuation, Loan Amortization,
and Debt (Borrowing) Capacity 399
Chapter 9 Using Cost Information to Make Special Decisions 409
Break-Even Analysis 410 Product Margin 433 Applying the Product Margin Paradigm to Making
Special Decisions 438 Summary 445 Key Terms 446
Contentsviii
Key Equations 447 Review Questions and Problems 447 Appendix H: Break-even Analysis for Practice Acquisition 458
Chapter 10 Budgeting 465
The Planning-and-Control Cycle 465 Organizational Approaches to Budgeting 470 Types of Budgets 481 Monitoring Variances to Budget 489 Group Purchasing Organizations 491 Summary 493 Key Terms 495 Key Equation 496 Review Questions and Problems 496 Appendix I: An Extended Example of How
to Develop a Budget 498
Chapter 11 Responsibility Accounting 521
Decentralization 521 Types of Responsibility Centers 524 Measuring the Performance of Responsibility Centers 529 Budget Variances 532 Summary 544 Key Terms 546 Key Equations 546 Review Questions and Problems 547
Chapter 12 Provider Cost-Finding Methods 551
Cost-to-Charge Ratio 551 Step-Down Method 552 Activity-Based Costing 559 Summary 571 Key Terms 572 Review Questions and Problems 572
Chapter 13 Provider Payment Systems 579
Evolution of the Payment System 583 Risk Sharing and the Principles of Insurance 608 Evolving Issues 614 Technology 614 Summary 616
Contents ix
Key Terms 617 Review Questions and Problems 618 Appendix J: Cost-Based Payment Systems 619
Glossary 627 Useful Websites and Apps 653
Index 659
To our families, for their love and patience
To our students and colleagues, for their invaluable
insights and feedback
PREFACE
This book offers an introduction to the most used tools and techniques of health care financial management. It contains numerous examples from a variety of providers, including health maintenance organizations, hospitals, physician practices, home health agencies, nursing units, surgi- cal centers, and integrated health care systems. The book avoids complicated formulas and uses numerous spreadsheet examples so that these examples can be adapted to problems in the workplace. For those desiring to go beyond the fundamentals, many chapters offer additional information in appendices. Each chapter begins with a detailed outline and concludes with a detailed summary, followed by a set of questions and problems. Answers to the questions and problems are available for download to instructors at www.josseybass.com/go/zelman4e. Finally, a number of perspectives are included in every chapter. Perspectives—examples from the real world— are intended to provide additional insight into a topic. In some cases these are abstracted from professional journals and in other cases they are state- ments from practitioners—in their own words.
The book begins with an overview in Chapter One of some of the key factors affecting the financial management of health care organizations in today’s environment. Chapters Two, Three, and Four focus on the financial statements of health care organizations. Chapter Two presents an intro- duction to these financial statements. Financial statements are (perhaps along with the budget) the most important financial documents of a health care organization, and the bulk of this chapter is designed to help readers understand these statements, how they are created, and how they link together.
Chapter Three provides an introduction to health care financial accounting. This chapter focuses on the relationship between the actions of health care providers and administrators and the financial condition of the organization, examining how the numbers on the financial statements are derived, the distinction between cash and accrual bases of account- ing—and the importance of defining what is actually meant by cost. By the time students complete Chapters Two and Three, they will have been introduced to a large portion of the terms used in health care financial management.
Prefacexiv
Building on Chapters Two and Three, Chapter Four focuses on inter- preting the financial statements of health care organizations. Three approaches to analyzing statements are presented: horizontal, vertical, and ratio analysis. Great care has been taken to show how the ratios are com- puted and how to summarize the results.
Chapter Five focuses on the management of working capital: current assets and current liabilities. This chapter emphasizes the importance of cash management and provides many practical techniques for managing the inflows and outflows of funds through an organization, including managing the billing and collections cycle and paying off short-term liabilities.
Chapter Six introduces one of the most important concepts in long- term decision making—the time value of money. Chapter Seven builds on this concept, incorporating it into the investment decision by presenting several techniques for analyzing investment decisions: the payback method, net present value, and internal rate of return. Examples are given for both not-for-profit and for-profit organizations.
Once an investment has been decided on, it is important to determine how this asset will be financed, and this is the focus of Chapter Eight. Whereas Chapter Five deals with issues of short-term financing, Chapter Eight focuses on long-term financing, with a particular emphasis on issuing bonds.
Chapters Nine through Twelve introduce topics typically covered in a managerial accounting course. Chapter Nine focuses on the concept of cost and on using cost information—including fixed cost, variable cost, and break-even analysis—for short-term decision making. In addition to cover- ing the key concepts, this chapter offers a set of rules to guide decision makers in making financial decisions. Chapter Ten explores budget models and the budgeting process. Several budget models are introduced, includ- ing program, performance, and zero-based budgeting. The chapter ends with an example of how to prepare each of the five main budgets: statistics budget, revenue budget, expense budget, cash budget, and capital budget. It also includes examples for various types of payors, including those with flat fee and capitation plans.
Chapter Eleven deals with responsibility accounting. It discusses the different types of responsibility centers and focuses on performance mea- surement in general and budget variance analysis in particular. Chapter Twelve discusses methods used by health care providers to determine their costs, primarily focusing on the step-down method and activity- based costing. This book concludes with Chapter Thirteen, “Provider Payment Systems.” This chapter, parts of which were combined with
Preface xv
Chapter Twelve in the first edition, describes the evolution of the payment system in the United States, especially under health reform, as well as the specifics of various approaches to managing care and paying providers.
Major Changes in the Fourth Edition As noted below, the major changes from the third edition involve
• New sections to reflect changes in the health care environment
• Updated data used in examples
• Updated data used in problems
• New problems
• New perspectives
Chapter One: The Context of Health Care Financial Management Changes to Chapter One, the introductory chapter, provide an updated and current view of today’s health care setting. Much has happened in the industry with the advent of value-based payment systems, population- based approaches to care, and the Patient Protection and Affordable Care Act (ACA). Other new concepts include patient-centered medical homes and accountable care organizations (ACOs).
Enhancements include updated statistics in the chapter text and all the pertinent exhibits. All perspectives have been replaced with ones that look at more recent events.
Chapter Two: Health Care Financial Statements Chapter Two has been updated to include recent changes in the literature issued by the Financial Accounting Standards Board (FASB). These changes address revenue recognition presentation of bad debt for many hospitals, increases in the level of charity care disclosure, and the guidance for self- insured risks. All perspectives and problems have been updated. There are also new key terms.
Chapter Three: Principles and Practices of Health Care Accounting In Chapter Three, the perspectives have been replaced with four updated versions. Problems 11 through 20 have been changed and updated.
Prefacexvi
Chapter Four: Financial Statement Analysis Chapter Four has been updated to include the latest hospital benchmark ratios from the 2013 Almanac of Hospital Financial and Operating Indica- tors (a reference work from Optum Inc.).
This chapter also addresses the change mentioned previously to the reporting of bad debt expense. All chapter problems have been updated as well. In addition, ratio problems 11 through 25 have been revised to provide a better picture of what each ratio analyzed means, beyond its being above or below the relevant benchmark.
Chapter Five: Working Capital Management Chapter Five has new sections on improving the revenue cycle manage- ment process and on fraud and abuse. All perspectives and problems have been revised and updated.
Chapter Six: The Time Value of Money Chapter Six now includes perspectives illustrating time value of money concepts in use, as well as a new section that explains the effective rate function. In addition, all the problem sets have been updated.
Chapter Seven: The Investment Decision Chapter Seven now offers an expanded discussion of how organizations measure the discount rate or cost of capital. This discussion also explains the weighted average cost of capital, which includes the cost of debt and the cost of equity. The key components of the capital asset pricing model, which is used to measure cost of equity, are presented as well. In addition, all perspectives have been updated, and problems have been changed and updated.
Chapter Eight: Capital Financing for Health Care Providers Chapter Eight now includes revisions to the explanation of interest rate swaps and a new section on bank qualified private placement loans. All the problems on lease financing and bond valuation have been revised and updated.
Chapter Nine: Using Cost Information to Make Special Decisions In Chapter Nine, the conceptual diagram and the related explanation for understanding breakeven have been substantially revised, and all perspec-
Preface xvii
tives have been replaced with updated versions. Most problems have updated figures, and three problems have been replaced with new ones. Also, a discussion of a new topic, physician practice valuation as it relates to the concept of breakeven, has been added as an appendix. This discus- sion also introduces the concepts of joint ventures and the value of downstream referrals.
Chapter Ten: Budgeting Though the organization of Chapter Ten remains essentially the same, the basic model on which this chapter is based has been almost totally revised. The new model is a hospitalist practice that has only two services, a sim- plification from the previous edition. The discussion of supply chain operations and maximizing savings from evaluation of group purchasing organization discounts has been retained, but the supplies budget has been dropped. All perspectives have been replaced with updated versions. The problems have been revised to reflect the new content, though the general format is the same.
Chapter Eleven: Responsibility Accounting The discussion of cost centers in Chapter Eleven has been modified slightly to recognize both service- and product-producing activities, and all per- spectives and problem sets have been updated.
Chapter Twelve: Provider Cost-Finding Methods The previous Chapter Twelve perspectives have been dropped, and two new ones have been added.
Chapter Thirteen: Provider Payment Systems Chapter Thirteen has been updated to provide a discussion of evolving issues in provider payment. Among these issues are value-based purchas- ing, changes in payment for hospital readmissions and never events, and bundled payments. There is a more robust discussion on the mechanisms that Medicare uses to pay for hospital inpatient, hospital outpatient, and physician services. All perspectives have been replaced with updated ver- sions. There are new key terms.
Glossary The glossary has been completely updated, and includes each term defined in a chapter sidebar and each key term.
Prefacexviii
Web Pages and Additional Materials The website for this book, including the instructor’s manual and Excel spreadsheets, is located at www.josseybass.com/go/zelman4e. Com- ments about this book are invited and may be sent to publichealth @wiley.com.
ACKNOWLEDGMENTS
We attempt throughout this book to challenge and enlighten. Quan-titative as well as qualitative issues are presented in an effort to help the reader better understand the wide range of issues considered under the topic health care financial management. We would like to thank the many students who over the past several years have pointed out errors, offered suggestions and improvements, and provided new ways to solve problems.
Our particular thanks go to Wafa Tarazi, Yurita Yakimin, Abdul Talib, Yen-Ju Lin, PhD, Tae Hyun Kim, PhD, and Julie Peterman, CFA, for their review of various chapters and problem sets. We also offer special thanks to Charles Walker, MBA, CPA, for his dedication and tireless efforts in reviewing the key chapters and problem sets of this book.
Proposal reviewers Steven D. Culler, Magdalene Figuccio, John Fuller, Kirk Harlow, Kelli Haynes, Robert Jeppesen, Charles Kachmarik, Eve Layman, David Lee, Cynthia Lerouge, Anne Macy, Michael Nowicki, William J. Oliver, Mustafa Z. Ounis, Theresa Parker, Kyle Peacock, Jen Porter, Patricia Poteat, Howard Rivenson, Judi Schack-Dugre, Robert Shapiro, Karen Shastri, Dean Smith, Sandie Soldwisch, Wendy Tietz, Bill Wakefield, and Steve Zuiderveen provided valuable feedback on the third edition and our fourth edition revision plan.
Most of all, we would like to thank our families for their encourage- ment and support and for their understanding during the countless hours we were not available to them.
The authors apologize for any errors or omissions in the above list and would be grateful for notifications to Michael McCue, at [email protected], of any corrections that should be incorporated in the next edition or reprint of this book and posted on the book’s webpage.
The authors and the publisher gratefully acknowledge the copyright holders for permission to reproduce material in the perspectives through- out the book.
THE AUTHORS
William N. Zelman is a full professor in the Department of Health Policy and Management, Gillings School of Public Health, Univer- sity of North Carolina at Chapel Hill. He specializes in health care financial management, focusing on management-related issues, including organiza- tional performance and cost management. He has served as director of the residential master’s degree programs at UNC and is past chair of the Asso- ciation of University Programs in Health Administration Task Force on Financial Management Education. He has authored or coauthored five books and numerous articles and has been an editorial board member or reviewer, or both, for a number of journals. He has extensive international experience, serving as a consultant to and presenting courses for academic, governmental, and other international organizations, primarily in South Asia and Central Europe.
Michael J. McCue is the R. Timothy Stack Professor of Health Care Administration in the Department of Health Administration at Virginia Commonwealth University in Richmond, Virginia. His research interests relate to corporate finance in the health care industry and the performance of hospitals, multihospital systems, and health plans. His previous research examines the determinants of hospital capital structure, the factors influ- encing hospitals’ cash flow and cash on hand, and the evaluation of hospital bond ratings. His current research examines the effects of health reform on the financial performance of commercial health plans.
Noah D. Glick is currently a senior health care consultant for FTI Consult- ing in its corporate finance division, where he is engaged in physician strategy and health care analytics. Previously, he was administrative direc- tor for Rehabilitation Medical Associates and the South Shore Hospitalist Group outside Boston. Prior to that, he was a senior consultant for Inte- grated Healthcare Information Services in Waltham, Massachusetts, and a staff member in the Department of Decision Support at the University of North Carolina at Chapel Hill. He also taught simulation modeling in the master’s in health administration program at UNC.
The Authorsxxii
Marci S. Thomas is a clinical assistant professor in the Department of Health Policy and Management at the University of North Carolina at Chapel Hill, where she teaches health care consulting, strategy, and finan- cial leadership. She is also a principal and director of quality control at Metcalf-Davis, CPAs. She consults with health care organizations, educa- tional institutions, and other not-for-profit organizations and their boards on internal control, vulnerability to risk and fraud, strategic planning, and governance issues. She is a nationally recognized speaker on managing accounting issues in health care and related not-for-profit entities and on auditing these organizations. Thomas is a coeditor of and contributor to Essentials of Physician Practice Management (Jossey-Bass). Her book Best of Boards: Sound Governance and Leadership for Nonprofit Organizations, was published by the American Institute of CPAs (AICPA) in June 2011. She is a certified public accountant and a chartered global management accountant (CGMA).
FINANCIAL MANAGEMENT OF HEALTH
CARE ORGANIZATIONS
CHAPTER 1
THE CONTEXT OF HEALTH CARE FINANCIAL MANAGEMENT
Never before have health care professionals faced such complex issues and practical difficulties in trying to keep their organizations competitive and finan- cially viable. With disruptive changes taking place in health care legislation and in payment, delivery, and social systems, health care professionals are faced with trying to meet their organizations’ health-related missions in an environment of uncertainty and extreme cost pressures. These circumstances are stimulating high-performing provider organizations to focus on innovation to help lower costs and find creative ways to deliver services to a population whose members, while aging, are more informed and more demanding of a voice in their care and value for dollars spent than ever before.
The Patient Protection and Affordable Care Act (ACA) is the largest effort toward reform of the health care system since the advent of government entitlement programs in the 1960s. The goal of the ACA is to provide mechanisms to expand access to care, improve quality, and control costs.
But even before the enactment of the ACA in 2010, the Centers for Medicare and Medicaid Services (CMS) had articulated a vision for health care quality: “the right care for every person every time.” CMS’s stated objective is to promote safe, effective, timely, patient-centered, effi- cient, and equitable care.
CMS also needs to control the rising cost of care, which has become unsustainable. To accomplish its objec- tives CMS has been working to replace its old financing system, which basically rewarded the quantity of care, with value-based purchasing (VBP), a system that improves the linkage between payment and the quality of care. The
LEARNING OBJECTIVES
• Identify key elements that are driving changes in health care delivery.
• Identify key approaches to controlling health care costs and resulting ethical issues.
• Identify key changes in reimbursement mechanisms to providers.
Chapter 1 The Context of Health Care Financial Management2
Deficit Reduction Act of 2005 authorized CMS to develop a plan for VBP for Medicare hospital services beginning in fiscal year 2009. The ACA provided the implementation plan.
Many of these changes have been the source of controversy and law- suits. Until President Obama’s reelection in 2012, state governments as well as many providers faced uncertainty about whether the ACA provisions, even though found to be constitutional earlier in 2012, would be repealed. Some hesitated to move forward with implementation plans.
Regardless of whether or not all parties agree about the legislative outcome, the goal of the U.S. health care system remains to finance and deliver the highest possible quality to the most people at the lowest cost (Exhibit 1.1). But responses to today’s challenges have resulted in a new business model that providers are embracing by controlling costs, develop- ing new service offerings, and implementing new information technology, thereby creating added value (see Perspective 1.1 and Exhibit 1.2).
EXHIBIT 1.1 HEALTH SYSTEM GOALS REMAIN UNCHANGED
AccessCost
Quality
To establish a context for the topics covered in this text, this chapter highlights key issues affecting health care organizations. It is organized into three sections: (1) changing methods of health care financing and delivery, (2) addressing the high cost of care, and (3) establishing value-based payment mechanisms. Without question the health care industry is under-
Changing Methods of Health Care Financing and Delivery 3
PERSPECTIVE 1.1 HEALTH CARE SYSTEM IN REFORM
No matter what their political view is, people generally agree that the financial platform on which the health care system rests cannot be sustained. There is a clear need to reduce the proportion of the gross domestic product (GDP) spent on health care. Since the 1960s, hospitals have experienced increases in utilization, accompanied by increases in payments from govern- ment as well as from commercial payors. Medicare market basket updates have increased an average of 3.2 percent annually since that time. Under Medicare’s new payment model, utiliza- tion and reimbursement are expected to decline over time, limiting market basket and utilization increases to only 1.5 percent to 2 percent a year. In addition, the value-based payment structure will reward those organizations with better quality while penalizing those with poorer scores. Since Medicaid and commercial payors tend to follow Medicare models, this effect will be magnified.
Several disruptive trends are changing the competitive landscape. Where commercial and not- for-profit providers had distinct differences, now they are both heavily focused on cost, quality, market share, and how quickly they can get innovative products to market. For example, Duke University Health System, a not-for-profit health system, and LifePoint Hospitals, Inc., a com- mercial health system, formed a joint venture, Duke LifePoint Healthcare, to provide community hospitals and regional medical centers with innovative means of enhancing services, recruiting and retaining physicians, and developing new service lines. Insurers such as Humana and private equity groups have acquired health systems. Certain integrated health care organiza- tions, such as the Mayo Clinic and Geisinger Health System, are directed by physicians. New technologies like mobile apps provide mid-level providers and consumers with the latest evi- dence-based guidance to aid in diagnosis and management of health issues. And hospitals are consolidating, taking the view that big is good, bigger is better, and biggest is better still.
Source: Adapted from K. Kaufman and M. E. Grube, The transformation of America’s hospitals: economics drives a new business model, in Kaufman, Hall, & Associates, Futurescan 2012: Healthcare Trends and Implications, 2012– 2017 (Health Administration Press, 2011).
going rapid change (Exhibit 1.3). The providers who are open-minded and informed, embrace change, and look for effective solutions will be the ones who thrive in this uncertain environment.
Changing Methods of Health Care Financing and Delivery The push toward health care reform began back in the early 1990s during the Clinton administration. However, it did not make significant inroads
Chapter 1 The Context of Health Care Financial Management4
EXHIBIT 1.2 KEY ELEMENTS OF HEALTH CARE BUSINESS MODEL CHANGE
Old Medicare Business Model
New Post Reform Business Model
Value proposition More market share, more patients, more services, more revenues
Best possible quality at the lowest price
Direction of price Upward—Saks Fifth Avenue Downward—Walmart Cost environment Cost management Cost structure Direction of utilization Always up since 1966,
growth industry Flat/maybe down, mature industry
Relationship between hospital and doctors
Parallel play Highly coordinated and integrated
Payment Fee-for-service Something else System of care Patient services Patient/population management Organizing for value creation
One patient at a time Comprehensive health care for covered population
Importance of scale Small and medium hospitals could survive
Big, bigger, biggest
Source: Kaufman, Hall, & Associates, published in Futurescan 2012: Healthcare Trends and Implications, 2012–2017, Society for Healthcare Strategy and Market Development of the American Hospital Association and the American College of Healthcare Executives.
until President Obama signed the ACA into law in early 2010, though the ACA is complex and has numerous provisions. The provisions that are expected to have the most significant impact on the delivery and financing of care are noted in the following list and discussed in the remainder of this chapter.1
• Requirement that almost all individuals have insurance coverage. This individual mandate lies at the heart of the legislation.
• Requirement that states create insurance exchanges where individuals and small businesses can obtain coverage. The ACA contains require- ments for an essential benefits package and provides for changes to the tax law that include penalties for individuals who choose not to have insurance.
Changing Methods of Health Care Financing and Delivery 5
EXHIBIT 1.3 SELECTED FACTORS CONTRIBUTING TO HEALTH CARE INDUSTRY UNCERTAINTY
Health Reform
Health Information Technology
Health Insurance Exchanges
Expanded Medicaid Coverage
Value- Based Purchasing and ACOs
• Provisions for expansion of Medicaid coverage to all eligible individuals under age sixty-five. Since adults represent only 25 percent of those covered presently by Medicaid, this will be a significant expansion to include entire families. Federal funds will be made available for the expansion at a decreasing rate, down to 90 percent in 2020. This expan- sion is a state option and remains controversial as states realize that they will need to be equipped to shoulder the expense as the federal subsidies decrease.
• Provisions for medical loss ratio and premium rate reviews for health plans. Rebates will be paid to health plan enrollees by health plans that do not meet a required minimum level of spending on medical care.
• Establishment of payment mechanisms for bundled payments and a value-based purchasing system along with the restructuring of certain aspects of the Medicare payment system.
• Provisions for providers organized as accountable care organizations (ACOs) to share in cost savings that they achieve for the Medicare program.
Chapter 1 The Context of Health Care Financial Management6
Health Insurance Exchanges Between 2001 and 2010, the number of uninsured rose from 36 million to 50 million people, before decreasing slightly (Exhibit 1.4). This rise is due to several factors, including (1) health insurance and out-of-pocket costs becoming too costly for many individuals, even when they are working; (2) individuals being screened out by insurance underwriters because of pre- existing conditions; (3) employers either scaling back employees’ benefits or eliminating them altogether by hiring part-time workers; (4) state gov- ernments tightening Medicaid eligibility criteria; and (5) individuals voluntarily deciding not to purchase insurance for a variety of financial and nonfinancial reasons, including the assumption that they will not need care or that they will be taken care of by the “system” anyway. As a result, uncompensated care costs have doubled over the past decade (Exhibit 1.5), which has placed a tremendous burden on health care facilities, especially community hospitals.
The ACA authorizes a competitive insurance marketplace at the state level and provides for two types of exchanges, an individual exchange and
EXHIBIT 1.4 NUMBER OF UNINSURED, 2001–2011
30
35
40
45
50
N um
be r o
f U ni
ns ur
ed (in
m ill
io ns
)
Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Data from U.S. Census Bureau, Current Population Survey, 2012 Annual Social and Economic Supplement.
Changing Methods of Health Care Financing and Delivery 7
a small business exchange. The individual exchange provides a mechanism for implementing the individual mandate for those who either do not have access to health insurance through an employer plan or who are uninsured for other reasons. The small business exchange provides access for small businesses, enabling them to improve the quality of health insurance for their employees by pooling their buying power and providing multiple health insurance options.
States have the ability to choose whether they want to operate their exchanges themselves. For those that do not want to develop and manage their exchanges, the federal government will do it for them. These exchanges begin operation in 2014.
The ACA provides for a minimum benefits package; however, partici- pants will be able to shop for health insurance from among an array of commercial health insurance products with varying levels of deductibles, coinsurance, and additional benefits over and above the minimum. The benefit packages are referred to as bronze, silver, gold, and platinum, depending on how much participants choose to pay.
EXHIBIT 1.5 UNCOMPENSATED CARE COSTS FOR THE UNINSURED, 2001–2011
2001 2002 2003 2004 2005 2006 Year
$42
40
38
36
34
32
30
28
26
24
22
20
U nc
om pe
ns at
ed C
ar e
Co st
s ($
in b
ill io
ns )
2007 2008 2009 2010 2011
Source: Data from Health Forum, American Hospital Association Annual Survey Data, 1980–2011 (January 2013).
Chapter 1 The Context of Health Care Financial Management8
Tax credits are available to low-income consumers, phasing out at 400 percent of the federal poverty level. In addition, consumers will not need to worry about denial of coverage because of any preexisting conditions they may have. The exchanges should promote transparency, to assist the participants in making an informed decision.
The health insurance exchanges, along with other ACA provisions, are expected to make coverage available to 32 million previously uninsured people by 2019. If this works as intended, it should reduce the amount of charity care currently being provided by providers, especially hospitals. However, because the rules providing for a tax penalty for individual non- compliance with the insurance mandate have some exceptions, it is possible that the benefit to providers will not be as effective as originally forecast.
Accountable Care Organizations An ACO is a voluntary group of health care providers who come together to provide coordinated care to a patient population in order to improve quality and reduce costs by keeping patients healthy and by reducing unnecessary service duplication. This mechanism was initially created to serve Medicare beneficiaries but has now expanded into the non-Medicare population.
Participation is open to networks of primary care doctors, specialists, hospitals, and home health care services in which the network members agree to work together to better coordinate their patients’ care. In June 2012, there were 221 ACOs in the United States. The majority were spon- sored by hospital systems (118), followed by physician groups (70), insurers (29), and community-based organizations (4), and were located primarily in urban settings with relatively dense populations. By January 2013, there were more than 250 ACOs. As will be more fully discussed in Chapter Thirteen, ACOs are rewarded for reducing the cost of care while maintain- ing or improving quality under a variety of risk-based or risk-sharing mechanisms now being tested. Although certain medical groups, such as the Permanente Medical Group, Mayo Clinic, Intermountain Health Care, and Geisinger Health System, have shown positive correlations between practice organization and better performance, the ACO mechanism is too new to conclude that it will ultimately show the savings and quality improvements it was designed to achieve.2
Patient-Centered Medical Home The patient-centered medical home (PCMH) is a partnership between primary care providers (PCPs), patients, and their families to deliver a
Patient-Centered Medical Home A partnership between primary care providers (PCPs), patients, and patients’ families to deliver comprehensive care over the long term in a variety of settings.
Addressing the High Cost of Care 9
coordinated and comprehensive range of services in the most appropriate settings. The PCP takes full responsibility for the overall care of the patient over an extended period of time, including preventive care, acute and chronic care, and end-of-life support. The PCMH is a patient-centered model using evidence-based medicine, care pathways, updated informa- tion technology, and voluntary reporting of performance results. In 2011, the National Commission on Quality Assurance created a program that recognizes providers as PCMHs on one of three levels, based on meeting certain administrative standards and achieving a degree of quality report- ing. Practices with robust information technology, which includes electronic record keeping, electronic disease registries, internet communication with patients, and electronic prescribing, are the ones most likely to achieve level 3 status.
The PCMH is a good way for a primary care provider to distinguish itself as a quality practice. Until recently there has been little payment advantage associated with being a PCMH; however, programs run by various Blue Cross Blue Shield plans and other insurers are demonstrating that the concept pays off. For example, in late 2012, Horizon Blue Cross Blue Shield of New Jersey identified savings due to reduced emergency department use (26%) and reduced hospital readmissions (26%). At the same time, CMS announced that 500 practices with over 2,000 total physi- cians will participate in the comprehensive primary care initiative. WellPoint is expanding its program after announcing that it earned $2.50 to $4.50 for every dollar invested in its PMCH program.3
Addressing the High Cost of Care Over the last decade health care costs have increased faster than has general inflation (Exhibit 1.6). The cost to keep people healthy has approxi- mately doubled from 2001 to 2011 (Exhibit 1.7), although the average life expectancy of the general population has risen by only approximately five years since 1980. Even though the increases in the medical inflation rate are higher than those for the Consumer Price Index, the rate of growth has slowed, declining from approximately 5 percent at the turn of the century to 3.5 percent a decade later. However, looking ahead, forecasters are uncertain of what will happen. Certain factors tend to increase costs and others tend to lower them (see Exhibit 1.8).
Factors That Could Contribute to an Increase in Costs
• The population is continuing to age. As a person ages, the care he or she requires becomes significantly more costly. By the year 2035, 20
Chapter 1 The Context of Health Care Financial Management10
EXHIBIT 1.6 CONSUMER PRICE INDEX VERSUS MEDICAL CARE INFLATION, 2001–2012
0
1
2
3
4
5
6
7
8
9
10%
Pe rc
en ta
ge In
cr ea
se
Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Consumer Price Index Medical care ination
Source: Data from U.S. Labor Department, Bureau of Labor Statistics (January 2013).
EXHIBIT 1.7 ANNUAL HEALTH CARE EXPENDITURES IN THE UNITED STATES, 2001–2011
To ta
l A nn
ua l H
ea lth
C ar
e Ex
pe nd
itu re
s ($
in b
ill io
ns )
$2,700 2,600 2,500 2,400 2,300 2,200 2,100 2,000 1,900 1,800 1,700 1,600 1,500 1,400
Year
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Data from Centers for Medicare and Medicaid Services, Office of the Actuary, 2012.
Addressing the High Cost of Care 11
EXHIBIT 1.8 FACTORS AFFECTING THE COST OF CARE
Factors Contributing to Decreases in Costs
• Value-based purchasing
• Management of physician preference in medical devices
• Genric drugs coming onto the market
• More robust use of health IT to manage populations and prevent medical errors
• Lean/Six Sigma initiatives
• Informed consumers responsible for more of the cost of care
• Workplace wellness and employer programs
Factors Contributing to Increases in Costs
• Emerging medical technology
• Chronic diseases
• Aging population
• Inux of participants into the market due to extended coverage and insurance mandate
• Professional liability and malpractice costs
percent of the population is expected to be sixty-five or older. However, research also supports the notion that the many baby boomers are demanding wellness and life enhancement services in order to be able to continue to work into their seventies or eighties, which may help. Nevertheless, as people live longer, their medical issues become more complex and costly.
• New consumers will enter or reenter the marketplace. Once fully implemented, the ACA will bring millions of newly insured people into the system. As they obtain services, their needs will likely raise total health care costs. The expectation is that receiving the appropriate care in the appropriate setting at the appropriate time will, in the end, reduce costs.
Chapter 1 The Context of Health Care Financial Management12
• The medical technology industry continues to develop new systems. Some of these advances, such as the positron-emission tomography (PET) scan, proton beam therapy for prostate cancer, and defibrillator implants, may improve outcomes for some patients, but not all. And more and more hospitals are performing robotic surgery, which may be highly effective. But all this use of advanced technology comes at a high cost.
• Chronic disease contributes to the high cost of care. Many chronic conditions, such as heart disease, are associated with the elderly, but long-term issues affect younger populations as well. A 2011 article in Academic Pediatrics stated that 43 percent of children have a chronic disease.4 The top five chronic diseases reported in 2011 for adults were arthritis, cardiovascular disease, diabetes, asthma, and obesity,5 and the effect and expense of chronic disease are compounded when multiple diseases are present. Chronic disease often requires costly drugs and monitoring over the span of a person’s entire life. Higher rates of chronic disease also lead to higher rates of organ failure, and transplants have become one of the most expensive medical proce- dures. AIDS and mental health issues are also very costly chronic illnesses.
Factors That Could Contribute to a Decrease in Costs
• Certain behaviors have begun to change, spurred in large part by employers who can no longer afford to pay for employee health care the way they have in the past. Employers are shifting health care costs to their employees through changes in benefit plan design. Some larger companies offer workplace wellness centers, while others build well- ness programs into insurance options that have incentives behind them. For example, to help reduce the cost of medical care associated with employees who smoke, are obese, or who have other unhealthy behaviors, some employers with self-funded health plans have raised the stakes by penalizing them unless they begin a behavior remediation program.
• Employees faced with paying for a larger portion of their health care costs have become more informed and better consumers. Consumers are demanding more price transparency and are comparing providers. Some go to alternate sites of care, such as a CVS/pharmacy retail clinic where they can see a nurse practitioner for a fraction of the cost of a traditional physician visit. Some are receiving cost reductions or bonuses to travel overseas where their health plans have negotiated
Addressing the High Cost of Care 13
lower rates for procedures that are especially expensive; this has become known as medical tourism.
• Providers are using health information technology (IT) in a more robust way. Providers are making large capital investments in technology to better understand costs, improve quality, reduce medical errors, and provide the information needed to participate in value-based purchas- ing initiatives. Both insurers and providers are working, oftentimes together, toward increased connectivity. Many are making use of popu- lation and disease management techniques to provide the appropriate level of care and enhance quality, which should continue to lower cost.
• Pharmaceuticals are going off patent, creating opportunities for cost savings with generic drugs.
• Providers are embracing lean, Six Sigma and other techniques so that they can deliver better quality care with fewer resources. The effects of these initiatives can be to streamline operational processes. For example, a project to improve the discharge process could result in freeing up beds to be used by other patients, thereby enhancing revenue. Other initiatives aimed at reducing medical errors and improving quality could also pay additional dividends on the reim- bursement side of the equation.
• Hospitals are overriding physician preferences in medical supplies. Because medical supplies can amount to 40 percent of the cost of a procedure, the ability to achieve economies of scale by bulk purchases can have a significant impact on hospital costs. Many hospitals use the services of a group purchasing organization.
Information Technology For the last several years providers have made significant investments in information technology, and perhaps the largest investment of time and resources in this area is the electronic health record (EHR). The HITECH Act (2009) was enacted with the goal of creating and expanding the current health care IT infrastructure, promoting electronic data exchange, and substantially and rapidly increasing EHR adoption to 90 percent for physi- cians and 70 percent for hospitals by 2019. The provisions of the act are intended to increase efficiency and reduce medical errors, at an expected savings to the government of billions of dollars. In addition, the HITECH Act substantially expanded HIPAA (Health Insurance Portability and Accountability Act of 1996) privacy and security rules and increased the penalties for HIPAA violations.
Electronic Health Record (EHR) Also called an electronic medical record (EMR), this online version of patients’ medical records can include patient demographics, insurance information, dictations and notes, medication and immunization histories, ancillary test results, and the like. Under strict security permissions, the information can be accessed either in-house or in private office settings.
Medical Tourism Travel to a foreign country to obtain normally expensive medical services at a steep discount. Even with a family member escorting the patient (and getting the added benefit of foreign travel), the total cost is typically less than it would be at home.
Chapter 1 The Context of Health Care Financial Management14
The HITECH Act provides incentives for providers (hospitals, physi- cians, and other eligible providers) to achieve meaningful use. Meaningful users are those able to demonstrate that their EHR technology has been implemented in a manner that improves the quality of the health care they provide. This meaningful use includes, for example, e-prescribing, elec- tronic exchange of health information, and submission of quality measures to CMS.
For achieving meaningful use, hospitals can receive up to $2 million, plus additional amounts calculated in accordance with each hospital’s Medicare discharges. Medicaid permits up to six years of incentive pay- ments. To achieve these incentives, a hospital must increase its use of comprehensive EHR systems from 10 percent to 55 percent by 2014.
Eligible physicians (a category that excludes physicians who are hos- pital based or in hospital-owned practices) and other eligible providers can receive incentive payments ranging up to $44,000 over five years under Medicare, or $63,750 over six years under Medicaid. Incentive payments are gradually reduced each year, ceasing in 2016.
Meaningful use is achieved in three stages. Stage 1 should have been achieved by 2012. Through July 2012, approximately 117,000 eligible pro- fessionals and 3,600 hospitals received some sort of incentive payment.
The stage 2 final rule, issued in 2012, requires hospitals, physicians, and other eligible providers to continue to increase interoperability among disparate forms of data, increase standardization of electronic formats, and demonstrate that they are relying on the EHR to improve patient care.
Stage 2 begins in 2014, and Medicare will impose penalties for not achieving meaningful use by 2015. A third and final stage of meaningful use is scheduled to begin in 2016.
Cost-Accounting Systems Many hospital accounting systems have a strong billing and collections component but a weak cost-accounting system. This is due in large part to the fact that, historically, financial incentives were typically put in place to maximize reimbursement, not to control costs. Now that the environ- ment has changed, providers have found it increasingly important to understand their costs at a more granular level. As a result there has been a major movement to separate cost-accounting systems from financial accounting systems and to move away from traditional allocation-based cost systems to activity-based cost systems (discussed in more depth in Chapter Twelve). Although this is an expensive endeavor, declining reimbursement is forcing hospitals to invest in more sophisticated cost-accounting systems.
Health Insurance Portability and Accountability Act (HIPAA) A set of federal compliance regulations enacted in 1996 to ensure standardization of billing, privacy, and reporting practices as institutions convert to electronic systems.
Addressing the High Cost of Care 15
Group Purchasing Organizations With the rapid advances in computer hardware and software applications, many institutions have invested in information technologies in an effort to receive the most accurate information as quickly as possible. Most applica- tions revolve around materials management, budgeting, accounts payable, payroll, patient registration, and human resource needs. An organization must track the flow of materials through its system and purchase supplies in the most cost-effective manner. Hospitals can keep funds longer and reduce inventory costs by incorporating just-in-time ordering techniques, and opportunity exists for cost savings by joining group purchasing orga- nizations (GPOs) that can negotiate cost discounts through large volumes (discussed in more detail in Chapter Ten). When organizations can more accurately follow the flow of materials through the organization, they can better track costs and have better reporting and control over their budgets.
Reengineering or Redesigning Health care organizations have been redesigning their work processes in order to achieve efficiencies and reduce cost. Common techniques include process analysis, layout redesign, work redesign, total quality management and care mapping, and layoffs of unnecessary personnel.
One such method that has gained widespread attention is Six Sigma, including the related concept of lean thinking, which offers a systematic approach to analysis and performance improvement. The five major com- ponents of the Six Sigma approach are define, measure, analyze, improve, and control (nicknamed DMAIC). Lean thinking breaks processes down into identifiable steps to ensure that each component is a value-added activity. A main tenet of lean thinking and Six Sigma is to reduce the varia- tion in how activities are conducted, an important step toward quality improvement.
Mergers and Acquisitions Mergers and acquisitions among health care organizations have increased significantly in response to health reform and especially since the passage of the ACA and the Health Care and Education Reconciliation Act of 2010. According to Levin Associates, there were 453 mergers and acquisitions in 2010, and Fierce Health Finance reported nearly 1,000 in 2011.6 Health insurers and private equity firms are responsible for many of them.
From an accounting perspective, a merger requires that neither of the parties coming together has control. The two (or more) entities merge to start an entirely new entity with no step-up in basis of the assets. The new
Chapter 1 The Context of Health Care Financial Management16
entity comes into being on the date of the merger. In an acquisition, there is a controlling party, and the assets and liabilities are marked to fair value. Acquisitions are more common than mergers in the health care industry. Health care systems are consolidating to be larger players in the market in order to
• Spread fixed technology and administrative costs over a larger revenue base.
• Strengthen market penetration.
• Gain better access to capital.
• Add new service lines.
• Obtain better contracts from commercial payors.
According to Becker’s Hospital Review, although health systems acquire other health systems, transactions also exist whereby smaller community hospitals are acquired by larger systems. In addition, currently the biggest area of acquisition for community hospitals is in physician groups (see Perspective 1.2); such acquisitions were up 200 percent in 2011.7
Retail Health Care Doctors’ offices and hospitals are no longer the only settings where health care services are being provided. Given the tendency of con- sumers to use shopping malls, various retail outlets such as CVS/pharmacy and Walmart, which had already been providing pharmacy services for years, have expanded by offering basic preventive health care services in some of their stores. These retail health care outlets hire licensed professionals, such as nurse practitioners, to offer flu shots and provide remedies for minor ailments like a sore throat or the common cold. These sites of care are popular among the uninsured, students, and those who are simply in a hurry. The retailers also reap additional benefits by providing patients with convenient in-store purchase options for medications.
Litigation Unfortunately, the ACA falls short when it comes to malpractice reform. The legislation addresses medical liability in two ways:
Retail Health Care Walk-in medical services for basic preventive health care provided in a retail outlet, such as a pharmacy, by a licensed care provider.
Addressing the High Cost of Care 17
PERSPECTIVE 1.2 LIFE IN THE “GAP”
In discussing accountable care organizations, economic futurist Ian Morrison refers to a hospi- tal’s “life in the gap.” The “gap” is the period of time during which payments are still being made largely on a fee-for-service basis but health care organizations are being pressured to lower costs and improve quality. The question is how to prepare. Some hospitals and health systems have become pioneer accountable care organizations, while others have developed programs with commercial payors such as Cigna. Many are acquiring other health care organizations to become larger or are focusing on building relationships with physicians and community organizations.
Greater Baltimore Medical Center formed an ACO, the Greater Baltimore Health Alliance, which sought approval for Medicare’s Shared Savings Program. It is the only ACO in Maryland with a hospital component and is working to increase the number of primary care access points it has in Maryland. The risk is that it may drive down utilization of services and then not be paid adequately for doing it.
The preparation for the future could involve a number of moves:
1. Drive out waste.
2. Implement new payment models, such as participating in CMS pilots like Pioneer ACOs or with insurers.
3. Collaborate with other health care providers such as physician practices, ambulatory centers, and rehab facilities. This will help when the organization later may need to be responsible for the continuum of care.
4. Partner with past competitors to combine resources, find creative ways to gain better operational effectiveness, and negotiate with payors.
5. Invest in primary care. By improving coordination of care with primary care practices and integrated health information systems, hospitals may be able to reduce unnecessary read- missions and utilization.
6. Develop health data analytics to assist in decision making. Hospitals can develop better ways to measure, track, analyze, and apply data to patient care.
7. Establish employee health programs, which may be a springboard toward beginning to prepare for population management, and which carry less risk. Hospitals can lower insur- ance costs for employees who perform certain wellness activities, such as going to a wellness center or having a nutrition consultation.
8. Begin a cultural revolution. The challenge is to develop a focus on the whole patient and wellness rather than on a single episode of care and sickness. This is a cultural shift as well as a financial one.
Source: Adapted from S. Rodak, Managing the transition to value-based reimbursement: 8 core strategies to mind the gap, Becker’s Hospital Review, October 2, 2012, accessed November 25, 2012, from www .beckershospitalreview.com/strategic-planning/managing-the-transition-to-value-based-reimbursement-8 -core-strategies-to-mind-the-gap.html.
Chapter 1 The Context of Health Care Financial Management18
• Extension of federal malpractice protections to nonmedical personnel working in free clinics.
• Authorization of $50 million over five years for HHS to award demon- stration project grants. These grants would be provided to states to develop, implement, institute, and evaluate alternatives to the present system used in the United States to resolve charges against physicians and other health care providers of wrongdoing to patients.
As the health care system moves closer to the practice of evidence- based medicine, certain demonstration projects could help to reduce health care errors by encouraging the collection and analysis of data on patient safety. But many believe that evidence-based medicine is not likely to do much.
Compliance Providers spend a significant amount of time and expense on processes needed to comply with governmental regulations in such areas as the pro- vision of care, billing, privacy, security, accounting standards, and the like. Examples of compliance requirements are
• HIPAA, the Health Insurance Portability and Accountability Act
• Health and safety regulations
• EMTALA, the Emergency Medical Treatment and Active Labor Act, also known as the patient anti-dumping law
• Billing, coding, and other standards designed to eliminate the follow- ing: charging for items or services not provided, providing medically unnecessary treatment, upcoding, diagnosis related group (DRG) creep, improperly providing outpatient services in connection with inpatient stays (in violation of the seventy-two-hour window rule), failure to follow teaching physician and resident requirements for teaching hospitals, duplicate billing, false cost reports, billing for dis- charge in lieu of transfer, failure to refund credit balances, providing hospital incentives that violate the anti-kickback statute, improper financial arrangements between hospitals and hospital-based physi- cians, and violations of the Stark physician self-referral law.
• Billing standards such as the move to ICD-10 (deferred to 2014), as discussed later in this chapter.
Recovery Audit Contractors For over a decade now, significant media and public attention has been focused on the hospital industry due to ongoing investigations related to
Compliance The process of abiding by governmental regulations, whether in the provision of care, billing, privacy, accounting standards, security, or any other regulated area.
Recovery Audit Contractor (RAC) Program A program created under the Medicare Modernization Act of 2003 to identify and recover improper Medicare payments to health care providers.
Addressing the High Cost of Care 19
referrals. CMS’s recovery audit contractor (RAC) program is designed to reduce overpayments (and underpayments) by addressing the root cause of provider billing errors. This program, which became permanent under the Tax Relief and Health Care Act of 2006, has been rolled out to all hos- pitals and to other targeted providers as well. In 2010, the RAC program was extended to Medicaid through the ACA.
RAC auditors are independent contractors hired by CMS to focus primarily on clinical documentation supporting billings under the Medi- care program. They use proprietary software and systems in order to determine what areas to review, but they cannot simply randomly select claims or focus just on high-dollar claims. Instead, the purpose is to iden- tify improper payments related to incorrect amounts, noncovered services (including services that may not be reasonable or necessary), incorrectly coded services, and duplicate services.
There are two types of reviews: automated and complex. The auto- mated review requires no medical records. The complex review ensues when the automated review provides evidence of a high likelihood that the service received improper payment or that there is no Medicare policy, Medicare article, or Medicare-sanctioned coding guideline for the service provided. The RACs use medical literature and apply clinical judgment to make claims determinations, and a RAC can go on site to view or copy the medical records or request that the provider do so. When a RAC identifies an overpayment, it provides written notification requesting repayment in full. Providers can appeal within thirty days of the demand letter.
RACs are paid on a contingency basis: the more they find, the more they collect. As a result the provider community has had difficulties with the concept since the inception of the program, believing that RACs tend to focus on claims and services most likely to result in error to enhance their chances of payment.
Provider concern over the RACs has led to a significant increase for providers in personnel time, consulting fees, and new technologies to “scrub” claims prior to submission, not to mention the time it takes to research and defend claims identified by the RACs. The American Hospital Association believes that hospitals are experiencing a significant number of inappropriate denials, which has resulted in hundreds of unfair recoup- ment payments, with approximately 75 percent of the RACs’ assessments being overturned by Medicare. Unfairly requested payments are returned to the hospitals.
The Medicare Audit Improvement Act of 2012 was designed to promote transparency and fairness in RAC reviews, and if passed, it would establish
Chapter 1 The Context of Health Care Financial Management20
a penalty for a RAC’s failure to follow the program requirements. It would also, among other things:
• Establish a consolidated limit for medical record requests.
• Require medical necessity audits to focus on widespread payment errors.
• Allow denied inpatient claims to be billed as outpatient claims when appropriate.
• Require physician review for Medicare denials.
Value-Based Payment Mechanisms The introduction of Medicare and Medicaid in 1965 was in large part intended to guarantee health care coverage to the country’s most vulner- able populations: the poor and the elderly. Unfortunately, many officials at the time failed to recognize that these “Great Society” programs would become the impetus for health care costs rising far beyond any costs ever predicted. The role of the federal government in health care has changed from being a small participant before the mid-1960s to being a major force in both setting amounts of payment and defining payment systems. Since that time numerous payment mechanisms have been used to compensate providers for services to patients. As more fully discussed in Chapter Thir- teen, fee-for-service, flat fee, cost-based, and capitation reimbursement methodologies have been used for years by governmental and private payors, with varying degrees of success (see Exhibit 1.9).
EXHIBIT 1.9 PAYMENT SYSTEMS INTRODUCED BY MEDICARE SINCE THE 1960s
1960s 1980s–1990s
Fee-for-service (FFS) and cost-based reimbursement
Prospective payment (DRGs) Capitation and global payments
2000s 2013
Ambulatory payment classifications (APCs) and pay for performance (P4P) Pay for reporting (P4R)
Value-based payment Accountable care organizations Shared savings programs
Establishing Value-Based Purchasing 21
Movement to a New DRG System In 2008, CMS changed the way it paid hospitals. The new system, based on Medicare severity-adjusted diagnosis related groups (MS-DRGs), has 25 major disease categories, 745 diagnosis related groups, and 3 subclasses of complications and comorbidities. It is intended to more closely align reimbursement to patient severity of illness, which means that certain hospitals will earn more but many will earn less.
The purpose of the Deficit Reduction Act of 2005 was to reduce overall hospital costs by improving care, thus combining quality and cost control and improving equity. Under this act and in response to rising health care costs and knowing that the aging population would be consuming more health care services in the coming years, CMS began piloting new forms of reimbursement in 2005 with the objective of obtaining better quality care for patients at a lower cost. The value-based purchasing system was initially rolled out to hospitals for their inpatient services in demonstration projects, under the expectation that some sort of value-based system would improve quality and reduce costs. In this demonstration phase, the mechanisms being tried were referred to as pay for performance, or P4P.
Establishing Value-Based Purchasing As more fully discussed in Chapter Thirteen, the ACA of 2010 established the inpatient Hospital Value-Based Purchasing Program, which became effective for discharges in late 2012. MS-DRGs form the basis of payments for this system, and providers are still reimbursed on this basis. However, the reimbursement is reduced in order to provide a pool of money to be used for value-based incentive payments.
The ACA requires that the total amount of value-based incentive payments available for distribution be equal to the total base operating DRG payments reduction, making this change budget neutral. Base operat- ing payments represent payments for the health care services rendered. Hospitals also receive capital payments, which are not a part of this incen- tive calculation. The first incentive payments were based on hospital performance from mid-2011 to early 2012.
For high-performing hospitals, preparation for the new system has been expensive and challenging. Smaller hospitals oftentimes have found it next to impossible, forcing many of them into acquisitions by larger systems.
The federal government, of course, is not the only payor for hospital services, but its policies and reimbursement mechanisms for services
Value-Based Purchasing (VBP) A payment methodology designed to provide incentives to providers for delivering quality health care at a lower cost. The financial rewards come from funds being withheld by the payor; these funds are then redistributed on providers’ achievement of and improvement on specific performance measures, including patient satisfaction.
Chapter 1 The Context of Health Care Financial Management22
greatly influence the practices of other payors, including state governments and major insurance companies.
Although the initial push in value-based purchasing was toward inpa- tient services, demonstration projects and data collection have already started and will continue to be rolled out for other hospital services as well, and eventually to other providers over time. Additional VBP initiatives are being conducted in hospitals for services other than inpatient services and in physicians’ offices, nursing homes, home health organizations, and dial- ysis facilities.
Even critical access hospitals that presently receive cost-based reim- bursement, and other hospitals that are excluded from value-based purchasing owing to their low number of measures and cases, could at some point be subject to this legislation, given that demonstration proj- ects, a precursor to implementation for these institutions, are already underway.
ICD-10 The World Health Organization’s International Statistical Classification of Diseases and Related Health Problems (ICD) is a coding system for dis- eases that is used in the United States for health insurance claim reimbursement. Currently the United States uses the ninth version of the codes, which was developed in the 1970s. However, the ninth version has constraints in terms of structure and space limitations that hamper its ability to accommodate advances in medical knowledge and technology.
The tenth version, ICD-10, addresses these issues and also assists in morbidity and mortality data reporting, another important facet of what these codes were designed to do. The fact that the United States still uses ICD-9 while other countries are already using the more advanced version is also making it difficult to compare U.S. health information with informa- tion from other countries.
The final rule adopting ICD-10 as the U.S. standard was published in January 2009, with an original compliance date set for October 2013. This date was then pushed back by a full year because the government was concerned about the administrative burdens placed on providers in the midst of all of the other regulatory changes; however, health insurers, large hospitals, and large medical practices appear to have the majority of their planning complete. The American Health Information Management Asso- ciation (AHIMA) has noted that the cost to the industry related to the delay is likely to be between $1 billion and $6.6 billion.8 Nevertheless, there should also be some savings since earlier implementation could have
Shared Savings A payment strategy that offers incentives for providers to reduce health care spending for a defined patient population; these incentives are a percentage of the net savings realized as a result of provider efforts.
Prospective Payment System (PPS) The payment system used by Medicare to reimburse providers a predetermined amount. Several payment methods fall under the PPS umbrella,, including methods based on DRGs (for inpatient admissions), APCs (for outpatient visits), a resource-based relative value scale (RBRVS) (for professional services), and resource utilization groups (RUGs) (for skilled nursing home care). Use of DRGs was the first method that fell under this type of predetermined payment arrangement.
Summary 23
resulted in health care providers and health plans having to process health care claims manually in order to be paid. In addition, small health care providers might have had to take out loans or apply for lines of credit in order to continue to provide health care in the face of delayed payments.
Once this standard is effective, entities covered under the Health Insurance Portability and Accountability Act of 1996 (HIPAA) will be required to use the ICD-10 diagnostic and procedure codes.
Key Point Pay for reporting is a precursor to value-based purchasing. Before the beginning of VBP, Medicare’s Reporting Hospital Quality Data for Annual Payment Update (RHQDAPU) program, which is a pay-for-reporting (P4R) program, provided an incentive for hospitals to report on the care they provide to all adults, regardless of payor. Originally, hospitals reported on ten clinical performance measures to avoid a reduction in the Medicare annual payment update for inpatient services. In 2007, hospitals were required to report on twenty-one measures in order to receive their full payment update, or else face a penalty of 2 percent for failing to do so.
Summary The health care administrator today and in the future will be faced with numerous complex issues to consider when making strategic and financial decisions. This is an exciting time to be in the health care field, and provid- ers appear to be embracing a new business model. High-performing organizations will evaluate the possibilities of doing business a different way, focusing on populations instead of individuals, rightsizing the costs of the organization, focusing the necessary resources on the implementa- tion of technology to ensure interoperability, and using data to manage costs and care. Through it all, the administrator must constantly maintain a high ethical standard in all decisions, not only for the obvious health and financial impacts but also for the myriad personal, professional, commu- nity, and societal implications.
The remainder of this book focuses on essential health care financial management topics such as how to analyze financial statements, manage internal funds, make sound business investments, borrow funds, analyze costs, and prepare a budget. It also provides in-depth analyses of the ways in which regulations and restrictions affect the operation of health care institutions. Although this knowledge is essential in the financial decision-making process, health care administrators always need to care- fully weigh nonfinancial factors as well.
Chapter 1 The Context of Health Care Financial Management24
REVIEW QUESTIONS
1. Definitions. Define the terms listed in the key terms list.
2. Increased costs. What are several factors that have led to increased health care costs?
3. Cost control. What are several of the efforts that have been attempted by payors to control costs?
4. Malpractice reform. What specific impacts will the provisions of the ACA have on mal- practice reform?
5. Information technology. What is the trend of information technology usage in health care, and what effects are likely from that trend?
6. Mergers and acquisitions. What advantages do health care organizations seek to obtain by merging with each other or by acquiring or being acquired by another health care organization?
7. Process techniques. What are two or more techniques that health care organizations can implement to increase operational efficiency?
KEY TERMS
a. Accountable care organization (ACO)
b. Capitation
c. Care mapping
d. Compliance
e. Electronic health record (EHR)
f. Evidence-based medicine
g. Group purchasing organization (GPO)
h. Health insurance exchange
i. Health Insurance Portability and Accountability Act (HIPAA)
j. ICD-10
k. Malpractice reform
l. Medical tourism
m. Medicare severity-adjusted diagnosis related groups (MS-DRGs)
n. Patient-centered medical home
o. Patient Protection and Affordable Care Act (ACA)
p. Pay for performance (P4P)
q. Pay for reporting (P4R)
r. Prospective payment system (PPS)
s. Recovery audit contractor (RAC) program
t. Retail health care
u. Shared savings
v. Value-based purchasing (VBP)
25Notes
Notes 1. The full text of the ACA can be found at www.kaiserhealthnews.org/
final-health-reform-bill-patient-protection-and-affordable-care-act.aspx (last accessed June 9, 2013).
2. J. J. Crosson and L.A. Tollen, eds., Partners in Heath: How Physicians and Hospitals Can Be Accountable Together (San Francisco: Jossey-Bass, 2010).
3. R. S. Raskas, L. M. Latts, J. R. Hummel, D. Wenners, H. Levine, and S. R. Nussbaum, Early results show WellPoint’s patient-centered medical home pilots have met some goals for costs, utilization, and quality, Health Affairs, 2012;31(9):2002–2009, doi: 10.1377/hlthaff.2012.0364.
4. C. D. Bethell, M. D. Kogan, B. B. Strickland, E. L. Schor, J. Robertson, and P. W. Newacheck, A national and state profile of leading health problems and health care quality for US children: key insurance disparities and across-state variations, Academic Pediatrics, 2011;11(3 Suppl):S22–33.
5. H.-Y. Chen, D. J. Baumgardner, and J. P. Rice, Health-related quality of life among adults with multiple chronic conditions in the United States, Behav- ioral Risk Factor Surveillance System, 2007, Preventing Chronic Disease, 2011; 8(1):A09, retrieved November 24, 2012, from www.cdc.gov/pcd/issues/2011/ jan/09_0234.htm
6. Irving Levin Associates, Inc., Health care M&A accelerates in second quarter after passage of reform according to new report by Irving Levin Associates, Inc. (Press release), July 28, 2010, retrieved August 6, 2013, from www .levinassociates.com/pr2010/pr1007mamq2; R. Shinkman, Healthcare M&A finishes healthy in 2011, FierceHealthFinance, January 17, 2012, retrieved August 6, 2013, from www.fiercehealthfinance.com/story/healthcare-ma -finishes-healthy-2011/2012-01-17
7. 10 biggest hospital stories of 2011, Becker’s Hospital Review, November/ December 2011, retrieved August 6, 2013, from www.becker’shospitalreview .com/pdfs/hospital-review/Nov_Dec_2011_HR.pdf
8. C. Dimick, HHS announces ICD-10 delayed one year, Journal of AHIMA, August 24, 2012, retrieved August 6, 2013 from journal.ahima.org/2012/08/24/ hhs-announces-icd-10-delayed-one-year
8. Overall costs. Which two factors may have the strongest tendency to increase health care costs? Which two may particularly decrease those costs? Why?
9. The “gap.” Describe the “gap” that health care organizations are facing. What unique prob- lems does it present? And what benefits?
CHAPTER 2
HEALTH CARE FINANCIAL STATEMENTS
Creditors, investors, and governmental and commu-nity agencies often require considerable information to make judgments about the financial performance of health care entities. For instance, to decide whether to lend money to an investor-owned1 home health agency, a lender may want to know how much debt the entity already has, how much cash it has available, and how much profit it is earning. Similarly, to make regulatory decisions, a governmental agency may want to know how much charity or uncompensated care is being provided or what the profit margin is for a group of providers. It is also important for creditors, investors, or grantors to be able to make comparisons between health care entities. For this reason generally accepted accounting principles, whether promulgated by the Financial Accounting Stan- dards Board (FASB) for commercial or not-for-profit entities or by the Governmental Accounting Standards Board (GASB) for governments, prescribe a standard set of basic financial statements. Often these basic statements are supplemented by additional statements and schedules. Due to space constraints, this chapter discusses primarily the statements and the health care–specific reporting requirements set forth by the FASB. The basic financial statements are shown in Exhibit 2.1.
The term basic financial statement applies to each of the statements in Exhibit 2.1 as well as the notes to these statements. The notes to the financial statements include information about all the statements provided and explain in more detail the significant elements. These notes are placed after all the statements. GAAP requires certain disclosure (footnote) information to be presented to give readers of the financial statements a much clearer picture
LEARNING OBJECTIVES
• Identify the basic financial statements for investor-owned health care entities and not-for- profit entities.
• Identify and read the basic financial statements particular to not-for- profit, business-oriented health care entities: the balance sheet, the statement of operations, the statement of changes in net assets, and the statement of cash flows.
Chapter 2 Health Care Financial Statements28
EXHIBIT 2.1 A COMPARISON OF FINANCIAL STATEMENTS FOR INVESTOR- OWNED AND NOT-FOR-PROFIT HEALTH CARE ENTITIES
Financial Statements Used by Investor- Owned Health Care Entities
Financial Statements Used by Not-for- Profit Health Care Entities
Balance sheet Balance sheet Statement of income and comprehensive income (combined statement) or two separate statements: a statement of income and a statement of comprehensive income
Statement of operationsa
Statement of changes in stockholders’ equity Statement of changes in net assetsa
Statement of cash flows Statement of cash flows Notes (footnotes) to the financial statements Notes (footnotes) to the financial statements
aThese are often combined, but since the combined statement is so large, it is often shown on two pages.
than they would have otherwise of the financial position and results of operations of the entity. Financial statements of health care entities are often audited due to financing or regulatory requirements, and it is the auditor’s responsibility to evaluate the presentation of both the statements and the note disclosures. In this way similar entities can be compared, and users of the financial statements can make more informed decisions.
As shown in Perspectives 2.1 and 2.2, organizations’ financial state- ments are of interest not only internally but also externally, to the outside parties that either invest in the organizations or fund them. Because health care entities can be investor-owned, not-for-profit, or governmental, the formats of their statements vary slightly, depending on the accounting principles particular to each business model. Nevertheless, because orga- nizations often compete for the same funding, these formats are relatively consistent. The focus of this text is primarily not-for-profit, business- oriented health care entities, which are referred to hereafter as not-for-profit health care entities.
The Balance Sheet The balance sheet of investor-owned entities presents a summary of the entity’s assets, liabilities, and stockholders’ equity. (Note that stockholders’
The Balance Sheet 29
PERSPECTIVE 2.1 S&P: 2013 WILL TEST NOT-FOR-PROFIT HOSPITALS: HOSPITAL RATINGS WILL REMAIN STEADY THIS YEAR, AGENCY PREDICTS
Standard & Poor’s Ratings Services (S&P) anticipates that its ratings for most U.S. not-for-profit health care providers will remain steady in 2013. This is, in part, due to a cushion that many of them have built over the last several years. S&P, however, expects credit quality trends in 2013 to be less favorable because of pressures that entities will face in 2013:
• Sequestration cuts and other Medicare cuts negotiated later this year
• Increased Affordable Care Act preparation
• Soft utilization trends
• New incentives and penalties for failing to meet value-based purchasing standards
Hospital management has been responsive to changes in the industry that have enabled hos- pitals to maintain positive credit rating metrics for the past two years even though pressures have been mounting. But 2013 will bring even more pressures, and hospitals are turning their strategic and operating priorities to health reform preparations.
Source: Adapted from The Advisory Board Company, S&P: 2013 will test not-for-profit hospitals, Daily Briefing, January 08, 2013, www.advisory.com/Daily-Briefing/2013/01/08/S-P-2013-will-test-not-for-profit-hospitals.
PERSPECTIVE 2.2 IRS TARGETS TAX-EXEMPT HOSPITALS: BOND INITIATIVES AND SCRUTINY OF COMMUNITY BENEFITS
The IRS has plans to begin an examination of tax-exempt bonds, including the hospital market this year, according to Bob Griffo, supervisory tax law specialist with the Internal Revenue Service (IRS), who spoke at an American Health Lawyers Association conference in January 2013. During the first year of the program, the IRS plans to examine between 20 to 40 tax- exempt hospitals. After that it will target 100 section 501(c)(3) tax-exempt entities outside the hospital industry. This announcement comes at a time when there have been increases in the number of examinations conducted by the IRS’s Tax-Exempt Bond (TEB) Division as well as an increase in municipal bond disclosures from the Securities and Exchange Commission (SEC).
The IRS’s TEB Division has found significant noncompliance in more than 30 percent of the bond issues it has examined since 2005, resulting in assessments to the entities involved from an average of approximately $873,000 in 2006 to in excess of $359,000 in 2010. The IRS is also launching an initiative to get entities to self-report violations and institute stronger internal controls to monitor compliance. To encourage self-monitoring by the borrowers, the IRS is
Chapter 2 Health Care Financial Statements30
sending out questionnaires to many issuers and asking whether they have adopted policies and procedures to ensure compliance with the tax-exempt bond rules. If an issuer provides answers that do not produce evidence that shows that steps have been taken to monitor compliance, then the IRS will use this to justify a full audit.
In addition, the IRS representative stated that the service will review the community benefit activities of 3,377 tax-exempt hospitals. The purpose of the review is to determine if they meet the requirements for tax exemption. The Affordable Care Act requires the IRS to review the community benefit activity of every hospital at least once every three years. The IRS will look at the hospital’s Form 990 and Schedule H. These reviews are “stealth reviews,” as hospitals will not be advised that they are under review and they will not know when these reviews begin or end.
These initiatives are likely cause for concern for the boards and management of tax-exempt and governmental hospitals, especially those with bond financing.
Source: Adapted from D. K. Anning, V. C. Gross, L. K. Mack, and T. J. Schenkelberg, IRS targeting 3,377 hospitals for community benefit review, November 13, 2012, www.jdsupra.com/legalnews/irs-targeting-3377-hospitals -for-commun-01576.
equity is also called shareholders’ equity. In this text we will use the term stockholders’ equity.) Similarly, the balance sheet of a not-for-profit health care entity presents a summary of the entity’s assets, liabilities, and net assets (see Exhibit 2.2). (These terms and the relationship among them will be discussed in more detail shortly.) The balance sheet is similar to a snap- shot of the entity, for it captures what the entity looks like as of a particular point in time, usually the last day of the accounting period (e.g., quarter or fiscal year). Exhibit 2.3 presents an illustration of a balance sheet and serves as an overview of this section of the chapter.
As shown in Exhibit 2.3, the balance sheet, like each of the other basic statements, contains a heading and then the body of the statement. The heading includes the name of the entity and the date (or point in time) of the balance sheet. The entity name is important because it provides the reader with the name of the specific entity (or group of entities) that is the subject matter of the statement. This is not as trivial as it might seem. A health care entity may produce financial statements that include infor- mation for more than one entity, depending on the degree of ownership, control, or economic interest or any combination of these circumstances. For example, a hospital may issue its own financial statements and also may have its financial data included with a parent’s data. When informa- tion for more than one entity is being summarized, then the report is called
The Balance Sheet 31
EXHIBIT 2.2 OVERVIEW OF MAIN BALANCE SHEET SECTIONS FOR INVESTOR- OWNED AND NOT-FOR-PROFIT HEALTH CARE ENTITIES AND RELATED NOTES
Heading Name of Investor-Owned Entity Balance Sheet Dates
Name of Not-for-Profit Entity Balance Sheet Dates
Body Assets Assets
Current assets Current assets
Noncurrent assets Noncurrent assets
Total assets Total assets
Liabilities Liabilities
Current liabilities Current liabilities
Noncurrent liabilities Noncurrent liabilities
Total liabilities Total liabilities
Stockholders’ equitya Net assetsa
Common stock Unrestricted
Retained earnings Temporarily restricted
Permanently restricted
Total stockholders’ equity Total net assets
Total liabilities and stockholders’ equity
Total liabilities and net assets
Notes Key pertinent information including
Key pertinent information including
• Accounting policies • Payment arrangements with
third parties • Asset restrictions • Property and equipment • Long-term debt • Pension obligations
• Accounting policies • Payment arrangements
with third parties • Asset restrictions • Property and equipment • Long-term debt • Pension obligations
aA major difference between the balance sheet of an investor-owned entity and a not-for-profit health care entity is in the owners’ equity section. For an investor-owned organization, the section is organized to show the stock- holders’ ownership stake in the corporation. For a not-for-profit health care entity, the section is called net assets and is organized to show that a not-for-profit entity is not “owned” by any person. The net asset classes show the degree of donor restriction on the net assets.
EX H
IB IT
2 .3
A N
N O
TA TE
D B
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FO R
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ts , l
ia bi
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at a
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tl e.
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on cu
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ab ili
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. T he
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th er
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: e .g
., de
fe rr
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to p
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on cu
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re so
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s of
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at w
ill b
e us
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ve r p
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th an
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9 N
et a
ss et
s (o
r eq
ui ty
). Th
e as
se ts
o f a
n en
tit y
th at
re m
ai n
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r d ed
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g its
li ab
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s (a
ls o
ca lle
d re
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te re
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to th
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or -im
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a nd
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l s ta
te m
en ts
.
32
The Balance Sheet 33
a consolidated or combined balance sheet, and the names of all the entities being summarized are stated in the notes. The Dunhill Health System financial statement used as an example throughout this chapter is a consolidated statement. Although a subsidiary may issue its own stand- alone financial statements, a parent may not do this because a provision of GAAP is that it must consolidate subsidiaries and other entities where required.
In the statement heading, below the name of the entity, the term Balance Sheet appears, to differentiate this document from the other finan- cial statements. Finally, two years are shown. As mentioned earlier, the balance sheet reports what the entity looks like at a particular point in time, which is the last day of the accounting period (e.g., quarter, half-year, or fiscal year). Two dates are often shown so that the reader can compare two successive periods, although for nonpublic entities this is not required. Public companies are required to present two years of balance sheet information and three years of comparative information for the other statements.
Assets The probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. In many instances assets represent resources that the entity owns. Assets are recorded at their cost, unless donated. In these latter cases they are recorded at fair value at the date of donation.
Key Point The balance sheet reports the entity’s assets, liabilities, and equity at a particular point in time, usually the last day of the accounting period (e.g., quarter or fiscal year). Many small health care entities prepare external facing statements only once a year, although internal statements are prepared more often. Others prepare statements once a quarter that summarize results at that point in time.
The three major sections making up the body of the not-for-profit entity’s balance sheet are assets, liabilities, and net assets (Exhibits 2.2 and 2.3). The balance sheet derives its name from the fact that the assets always equal the sum of the liabilities plus the net assets. (Net assets is called stockholders’ equity in investor-owned health care entities and net assets in not-for-profit health care entities. Hereafter, equity will be referred to as stockholders’ equity for investor-owned health care entities.) The rela- tionship among the three major sections of the balance sheet is expressed by the basic accounting equation:
Assets Liabilities Net Assets= +
In investor-owned entities, the equation becomes
Assets Liabilities Stockholders’ Equity= +
Chapter 2 Health Care Financial Statements34
In Exhibit 2.3, at June 30, 2012, the assets equal $6,580,030, and the liabilities plus the net assets also equal $6,580,030 ($3,711,984 plus $2,868,046), in thousands of dollars.
Liabilities The probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liabilities can be debts or other obligations: for example, deferred revenue, which is an obligation to provide or deliver goods or services when payment has been received in advance.
Net Assets (or Equity) The assets of an entity that remain after deducting its liabilities (also called residual interest). In a business enterprise the equity is the ownership interest. In a not-for-profit entity, which has no ownership interest, net assets is divided into three classes based on the presence or absence of donor-imposed restrictions— permanently restricted, temporarily restricted, and unrestricted net assets.
Basic Accounting Equation
Assets Liabilities Net Assets or stockholders’ equity= + ( ).
Assets The assets of an entity are the resources it owns. On the balance sheet the assets are divided into two categories, current assets and noncurrent assets. Exhibit 2.4 displays a classified balance sheet, one that presents current and noncurrent assets. Health care entities are required by GAAP to present a classified balance sheet, whereas other not-for-profit health care–related entities are not. There is an exception for continuing care retirement communities. They are permitted to sequence their accounts in liquidity order.
Current Assets Current assets are assets that will be used or consumed within one year (Exhibit 2.4). They help to turn the capacity of the entity (i.e., buildings and equipment) into service. Examples of current assets are
• Cash and cash equivalents
• Investments (unless held for long-term purposes or held in an endow- ment fund)
• Assets limited as to use (current portion)
• Patient accounts receivable, net of allowance for doubtful accounts
• Inventories, prepaid expenses, and other similar assets
Liquidity refers to how quickly an asset can be turned into cash, and current assets are generally listed in liquidity order.
Because of their liquidity, current assets require special internal control procedures to ensure that they are handled appropriately and efficiently. For instance, a generally accepted internal control procedure in health care entities involves the segregation of duties. When duties are segregated, different people are involved in billing, receiving payments, and processing and recording payments, reconciling accounts receivable, calculating the allowance for doubtful accounts, and writing off receivables no longer
The Balance Sheet 35
EXHIBIT 2.4 ASSET SECTION OF THE EXHIBIT 2.3 BALANCE SHEET, EMPHASIS ON CURRENT ASSETS
Dunhill Health System Consolidated Balance Sheet
June 30, 2012 (in thousands)
Assets
Current assets
Cash and cash equivalents $427,368
Investments 1,246,310
Assets limited or restricted as to use, current portion 15,780
Patient accounts receivable, net of allowance for doubtful accounts of $98.6 million
532,715
Estimated receivables from third-party payors 64,077
Other receivables 74,389
Inventories 75,450
Assets held for sale
Prepaid expenses and other current assets 81,233
Total current assets 2,517,322
Assets limited or restricted as to use, noncurrent portion
Held by trustees under bond indenture agreements 28,403
Self-insurance, benefit plans and other 228,732
By Board for capital equipment 1,204,519
By donors 58,753
Total assets limited or restricted as to use, noncurrent portion 1,520,407
Property and equipment, net 2,301,768
Investments in unconsolidated affiliates 73,912
Goodwill 60,322
Intangible assets, net of accumulated amortization of $5.1 million 35,711
Other assets 70,588
Total assets $6,580,030
Chapter 2 Health Care Financial Statements36
Performance Indicator The FASB requires not-for-profit health care entities to include a performance indicator in their statement of operations. The FASB defines it as an intermediate level that reports the results of operations. Note that operations includes both operating and nonoperating items. It is analogous to income from continuing operations or net income in an investor-owned entity.
considered collectible. In addition to the cash handling and processing controls, an entity should have monitoring controls, meaning that an independent party such as a supervisor or manager performs analytical procedures including a comparison of budget to actual, a period to period comparison, and an analysis of dollars per unit (such as patient day or procedure). Without segregation of duties, there is opportunity for error and fraud. Although larger entities are able to segregate duties fairly easily, smaller ones may not have the money to hire more personnel. This is when monitoring on a timely basis becomes more important.
The following sections discuss specific types of assets.
Cash and Cash Equivalents Cash and cash equivalents are the most liquid current assets (and therefore listed first in Exhibit 2.4). This account is composed of actual money on hand as well as savings and checking accounts. Cash equivalents are short-term investments with an original maturity of three months or less. Examples are money market funds, certificates of deposits, and treasury securities with original maturities of three months or less. This asset group excludes cash that has restrictions or limitations regarding withdrawal or that is to be used for purposes other than current operations.
Liquidity A measure of how quickly an asset can be converted into cash.
Key Point Cash (and cash equivalents) is the most liquid asset on the balance sheet.
Investments The classification of investments depends on how long management intends to hold them and whether or not restrictions or other requirements are absent. Short-term investments often include certificates of deposit, commercial paper, and treasury bills (those with an original maturity of three months or less are included in cash and cash equivalents) and also marketable securities designated as trading securities. Short-term invest- ments allow a health care facility to earn interest on idle cash and, at the same time, provide almost immediate access to cash for unexpected situations.
Investments held for long-term purposes such as endowment funds or those designated by the board for long-term use are not included in short- term investments.
Health care entities frequently invest in alternative investments, such as venture funds and other partnerships or derivative instruments. They
The Balance Sheet 37
may also have investments in other entities as business ventures. These are considered investments when the ownership is less than 50 percent, and the other entities’ financial statements are not required to be consolidated with the investing entity’s due to control. Health care entities may use the equity method to account for investments where the investor has signifi- cant influence but not control. Investments other than equity method investments are required to be marked to fair value, with the unrealized gains and losses included in other comprehensive income when investor owned, or below the performance indicator when not-for-profit. Market- able securities are discussed in greater detail in Chapter Five.
Assets Limited as to Use The cash and short-term investments listed in the current assets section of the balance sheet are generally available for management to use to carry out its responsibilities. In addition, a health care entity may have other cash, marketable securities, or other current assets that can be used only under special conditions. For example, in taking out a loan, a health care entity may agree to set aside an amount of funds equal to six months’ worth of loan payments. Assets limited as to use may be current or noncurrent or have both current and noncurrent portions (as in Exhibit 2.4), depend- ing on how soon they may be liquidated. The assets limited as to use for Dunhill Health System are $15,780 (current portion) and $1,520,407 (non- current portion) (in thousands) in 2012.
Patient Accounts Receivable, Net of Allowance for Doubtful Accounts Gross patient accounts receivable is the amount owed the health care entity at full charges. However, many payors, such as Medicaid, insurance com- panies, large employers, and managed care entities, are given discounts, called contractual allowances. After subtracting contractual allowances and charity care discounts from gross patient accounts receivable, what remains is the patient accounts receivable that the provider has a legal right to collect.
A reserve or allowance is deducted from patient accounts receivable on the balance sheet. It represents an estimate of how much of the entity’s patient accounts receivable are not likely to be collectable. This estimate is called the allowance for doubtful accounts.
Assuming that Dunhill’s gross patient accounts receivable were $735,819, discounts and contractual allowances were $104,504, and allow- ance for doubtful accounts was $98,600, then patient accounts receivable, net of the allowance for doubtful accounts, would be $532,715 (in thou- sands), as shown in Exhibit 2.5.
Charity Care Discounts Discounts from gross patient accounts receivable given to patients who cannot pay their bills and who meet the entity’s charity care policy.
Chapter 2 Health Care Financial Statements38
EXHIBIT 2.5 CALCULATION OF PATIENT ACCOUNTS RECEIVABLE, NET OF ESTIMATED UNCOLLECTIBLES
Account Title Amount (in thousands) Explanation
Gross patient accounts receivable
$735,819 The amount owed to the organization, based on full charges. This amount is not reported on financial statements; because of the discounts and allowances, it does not represent how much the health care organization is really owed.
− Discounts and allowances
−104,504 Includes discounts given to third parties (large-scale purchasers of health care services) and discounts for charity care.
Patient accounts receivable
631,315 Gross charges less discounts and allowances.
− Allowance for uncollectibles
−98,600 An estimate of how much of patient accounts receivable will likely not be collectible.
Patient accounts receivable, net of estimated uncollectibles
$532,715 The amount expected to be collected.
Inventories, Prepaid Expenses, and Other Current Assets Prepaid expenses and other current assets are presented together in the Dunhill financial statements (Exhibit 2.4), because of their relatively small size. In some entities inventories and prepaid expenses may be grouped together with other assets under the title other current assets. Inventories include the day-to-day supplies used by the entity in the provision of health care services, including food, drugs, office supplies, and medical supplies. A common mistake is to confuse supplies and equipment. Supplies refers to small-dollar items that will be used up or fully consumed within one year or less, such as pharmaceuticals and office supplies. Equipment refers
The Balance Sheet 39
to more expensive items that will be used over a longer period, such as buildings and radiology equipment. These are capitalized and depreciated. Prepaid expenses include items the health care entity has paid for in advance, such as rent and insurance. Although they are not tangible, they are still assets in the form of rights that the entity has purchased. For instance, by paying its rent in advance, the entity has a right to use a build- ing for a specified period. When supplies and prepaid expenses are relatively large amounts, they may be broken out and reported separately rather than grouped together.
Key Point Supplies are sometimes called inventory.
Noncurrent Assets Whereas current assets will be used or consumed within one year, noncur- rent assets will be used or consumed over periods longer than one year (see Exhibit 2.6). Noncurrent assets are relatively costly items that allow the entity to deliver service over time. Whereas current assets require special management attention because of their liquidity and transport- ability, noncurrent assets require special attention because of their cost and the extensive time it takes to plan, acquire, and manage them. Examples of noncurrent assets are
• Assets limited as to use (noncurrent portion)
• Property and equipment, net
• Goodwill
• Other assets
Key Point The terms noncurrent and long-term are often used interchangeably.
Assets Limited as to Use Assets limited as to use are assets whose use is limited by contracts or agreements with outside parties other than donors or grantors (assets such as proceeds of debt issues, funds deposited with a trustee, self-insurance funding arrangements, and statutory reserve requirements). The term also includes assets with limitations placed on them by the entity’s board of directors or trustees. As is illustrated in Exhibit 2.6, Dunhill identifies the
Chapter 2 Health Care Financial Statements40
EXHIBIT 2.6 ASSET SECTION OF THE EXHIBIT 2.3 BALANCE SHEET, EMPHASIS ON NONCURRENT ASSETS
Dunhill Health System Consolidated Balance Sheet
June 30, 2012 (in thousands)
Assets Current assets
Cash and cash equivalents $427,368 Investments 1,246,310 Assets limited or restricted as to use, current portion 15,780 Patient accounts receivable, net of allowance for doubtful accounts of $98.6 million
532,715
Estimated receivables from third-party payors 64,077 Other receivables 74,389 Inventories 75,450 Assets held for sale Prepaid expenses and other current assets 81,233
Total current assets 2,517,322
Assets limited or restricted as to use, noncurrent portion Held by trustees under bond indenture agreements 28,403 Self-insurance, benefit plans and other 228,732 By Board for capital equipment 1,204,519 By donors 58,753
Total assets limited or restricted as to use, noncurrent portion 1,520,407
Property and equipment, net 2,301,768
Investments in unconsolidated affiliates 73,912
Goodwill 60,322
Intangible assets, net of accumulated amortization of $5.1 million 35,711
Other assets 70,588
Total assets $6,580,030
The Balance Sheet 41
assets limited as to use on the face of the balance sheet. However, these items may also be separately presented and not identified with the caption “assets limited as to use.” When the term is used and the items are not separately identified on the face of the statements, they are then described in the notes.
In the case of Dunhill Health System in 2012, this category contains several items: the bond trustee is holding $28,403 under Dunhill’s bond indenture agreements, $1,204,519 has been set aside by the board to pur- chase capital equipment, and $228,732 has been set aside to pay for Dunhill’s employee insurance claims under its self-insured benefit plan. In addition, Dunhill combines its assets limited as to use with those that are restricted as to use, so the amount restricted to long-term purposes by donors is $58,753 (in thousands). Notice that the current portion of assets limited as to use (see the section emphasized in Exhibit 2.4) consists of the amounts in these accounts that are converted to cash in the current year. The current portion is not broken out in the same way as the noncurrent portion is.
Investments Most health care entities invest excess funds. Investments in marketable securities that are held by a not-for-profit entity are carried at fair value. This means that in every period, the value of those investments that have not been sold will be adjusted to the amount for which they could currently be sold. While this used to be called market value, the world of investments has become so volatile and complicated that the accounting literature now calls it fair value, defining it as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Although complete discussion of fair value is beyond the scope of this text, the important concept is that the fair value is an exit value, or how much one could expect to receive for the asset. A marketable security is one with a readily determinable fair value. Hospital systems, in particular, will also invest in complex instruments where the value cannot be readily determined by going to an investment pricing service. In those cases the fair value is the result of an estimate by the investment manager (of the hedge fund, limited partnership, etc.), which should be evaluated by management.
Investments held by an investor-owned health care entity are carried at fair value when they are considered trading or available for sale securi- ties. The investment is considered trading when the intent is to sell (or trade) it. The investment is considered available for sale when it is not held
Noncurrent Assets The resources of the entity that will be used or consumed over periods longer than one year.
Chapter 2 Health Care Financial Statements42
for trading. The difference between the two lies in the placement of the unrealized gains and losses. When the securities are considered trading, the unrealized gains and losses go through operations. When they are not trading, they are shown in other comprehensive income. When there are investments in debt securities that will be held to maturity, then they are carried at amortized cost. Not-for-profit entities such as charities and social service organizations are not required to and generally do not use these classifications for investments. However, not-for-profit hospitals, in order to be comparable to their investor-owned counterparts, generally do.
The classification of securities as trading and available for sale is driven by the intent and ability to hold them. Health care entities that use discre- tionary money managers are able to demonstrate the ability to hold the securities but not the intent, since the timing decisions on purchases and sales are made by the money manager. Trading securities are reported as current assets.
Since not-for-profit entities do not have comprehensive income, the unrealized gains and losses on available for sale securities are reported after the performance indicator. Dunhill classifies its investments as current because they are considered trading securities. (See the discussion of the performance indicator later in this chapter.)
Securities include various types of stocks and bonds and are discussed in more detail in Chapter Eight.
Properties and Equipment, Net This category of assets represents the major capital investments in the facility. Three types of assets are included in this category: land, plant, and equipment. Plant refers to buildings (fixed, immovable objects), land refers to property, and equipment includes a wide variety of durable items from beds to CAT scanners. Land, plant, and equipment are recorded on the entity’s books at cost, and over time, plant and equipment are depreciated. Land is not depreciated. Land improvements are depreciated unless there is no way to estimate their useful lives. This may occur when land is being prepared for its intended purpose. Depreciation is an estimate of the extent to which the plant or equipment has been used up during the accounting period. Depreciation is a noncash item.
The word net in properties and equipment, net, means that the total amount of depreciation taken up to this point in time has been subtracted from the original cost. To derive properties and equipment, net, the total amount of depreciation taken since the asset was put into use (called accu- mulated depreciation) is subtracted from the original cost of the asset (called plant and equipment). Assuming the original cost is $4,126,149 and
Depreciation A measure of the extent to which a tangible asset (such as plant or equipment) has been used up or consumed.
Accumulated Depreciation The total amount of depreciation taken on an asset since it was put into use.
The Balance Sheet 43
accumulated depreciation is $1,824,381, then properties and equipment, net, would be calculated as $2,301,768 (in thousands) (Exhibit 2.7).
By convention, plant and equipment are always kept on the books in their own accounts at their original cost until the assets are modified or sold. Similarly, the total amount of depreciation is kept in a separate account, accumulated depreciation. In this way, those looking at the balance sheet are always able to know (1) the original cost of the assets, (2) how much they have been depreciated, and (3) their current book value (origi- nal cost less depreciation). More detail is available in the notes.
The FASB requires that whenever events or changes in circumstances indicate that the carrying value of a long-lived asset or asset group may not be recoverable, its value must be reduced by an impairment loss. This can occur when there is a downturn in the economy that affects the real estate market. It can also happen when a facility is no longer being used for its intended purpose and there is not a market for it that will cover its cost minus accumulated depreciation.
For example, inpatient volumes may decline and the board of a small community hospital may decide that the facility should be used for outpa- tient services only. In this instance the facility would be grouped with other assets and liabilities at the lowest level for which identifiable cash flows are measured, and compared to the fair value of the asset group. This type of evaluation takes specialized skills and use of a valuation specialist is recom- mended when the entity does not have the expertise in-house.
EXHIBIT 2.7 CALCULATION OF PROPERTIES AND EQUIPMENT, NET
Account Title Amount (in thousands) Explanation
Properties and equipment
$4,126,149 The original cost of the land, plant, and equipment.
− Accumulated depreciation
−1,824,381 An estimate of the amount by which the assets have been used up, which is equal to the total amount of depreciation taken since the organization acquired the assets; by convention, plant and equipment depreciate, land does not.
Properties and equipment, net
$2,301,768 The original cost minus the amount by which the assets have been depreciated (used up).
Chapter 2 Health Care Financial Statements44
Other Assets Other assets is a catchall account used for noncurrent assets not included in the other categories of noncurrent assets.
Goodwill Goodwill is the term used for what an entity is buying in an acquisition when it pays cash and assumes liabilities in excess of the fair value of the assets acquired. Goodwill represents the future earnings power of the acquired entity. Goodwill is no longer amortized. However, it must be evaluated for impairment every year.
Liabilities The preceding section focused on how assets are presented on the balance sheet. We now turn to a discussion of the liabilities of a health care entity. Liabilities are probable sacrifices of economic benefits. Although it is tempting to describe liabilities as what an entity owes to its creditors, some liabilities, such as a malpractice reserve, are simply an estimate. As with assets, liabilities are divided into two categories: current and noncurrent (see Exhibit 2.8).
Current Liabilities Current liabilities are the financial obligations (or current portion of mal- practice or other reserves) that, due to their contractual terms, are expected to be paid within one year. Common account categories include
• Current portion of long-term debt
• Accounts payable and accrued expenses (including payroll)
• Estimated third-party payor settlements
• Other current liabilities
Each of these accounts is discussed below.
Current Portion of Long-Term Debt This account contains the amount of the entity’s long-term debt that is expected to be paid off within one year. For example, if a home health agency has executed a five-year note payable, the principal amount due this year is reported in this account. The remainder is listed under noncur- rent liabilities. This information is sometimes reported in the account notes payable, which reports the amount of short-term (less than one year) obli- gations for which a formal note has been signed.
Current Liabilities Financial obligations due within one year.
The Balance Sheet 45
EXHIBIT 2.8 LIABILITIES SECTION OF THE EXHIBIT 2.3 BALANCE SHEET (IN THOUSANDS)
Liabilities and net assets 2012
Current liabilities
Commercial paper $55,008 Short-term borrowings 511,301 Current portion of long-term debt 17,052 Accounts payable 182,390 Accrued expenses 145,688 Salaries, wages, and related liabilities 237,921 Estimated payables to third-party payors 146,092 Other current liabilities 72,377
Total current liabilities 1,367,829
Long-term debt, net of current portion 1,254,717
Self-insurance reserves 237,960
Accrued pension and retiree health costs 603,877
Other long-term liabilities 247,601
Total liabilities $3,711,984
Accounts Payable and Accrued Expenses Accounts payable are obligations to pay suppliers who have sold the health care entity goods or services on credit. Accrued expenses are expenses that arise in the normal course of business that have not yet been paid. Included in this category are salaries, wages, and interest. Sometimes accrued expenses are presented in separate accounts, such as
• Salaries and wages payable
• Interest payable
Key Point Accrued expenses are liabilities and are reflected in the balance sheet.
