Discussion: Finance And The Health Care Manager

With the amazing advances in health care in recent decades, one question that continues to stir debate within the political arena and from a personal perspective is: “How to pay for health care” Health care managers must be good stewards of their resources to allow the funds available to do the greatest good for the largest number of people. Health care finance information is critical to assessing the financial condition of an organization, as well as accessing whether the resources being spent are achieving the goals of the organization.

To prepare for this Discussion, select a recent (within 5 years) relevant article from the Walden University library and current information from Centers for Medicare & Medicaid Services, U.S. Department of Health & Human Services, and the Healthcare Financial Management Association, Knowledge Center, that addresses the importance of health care finance information in decision making within the health care setting.

Post a comprehensive response(250-350 words) to the following:

How do health care managers depicted in the article and website information you selected apply the principles of financial management to decisions, to the assessment of the financial condition of an entity or stewardship, or to the assessment of the efficiency, effectiveness, and compliance with organization directives?

Reference to files below:

Cleverley, W., Song, P., & Cleverley, J. (2011). Essentials of health care finance (7th ed.). Sudbury, MA. Jones & Bartlett.

Chapter 1, “Financial Information and the Decision Making Process”

Cleverley, W., Song, P., & Cleverley, J. (2011). Essentials of health care finance (7th ed.). Sudbury, MA. Jones & Bartlett.

Chapter 3, “Financial Environment of Healthcare Organizations”

Chapter 1

Financial Information and the Decision-Making Process

LearnIng ObjeCtIves

After studying this chapter, you should be able to do the following:

1. Describe the importance of financial information in healthcare organizations. 2. Discuss the uses of financial information. 3. List the users of financial information. 4. Describe the financial functions within an organization. 5. Discuss the common ownership forms of healthcare organizations, along with their

advantages and disadvantages.

reaL-WOrLD sCenarIO

In 1946 a small band of hospital accountants formed the American Association of Hospital Accountants (AAHA). They were interested in sharing information and experiences in their industry, which was beginning to show signs of growth. A small educational journal, first pub- lished in 1947, attempted to disseminate information of interest to their members. Ten years later, in 1956, the AAHA’s membership had grown to over 2,600 members. The real growth, however, was still to come with the advent of Medicare financing in 1965.

With the dramatic growth of hospital revenues came an escalation in both the number and functions delegated to the hospital accountant. Hospital finance had become much more than just billing patients and paying invoices. Hospitals were becoming big businesses with complex and varied financial functions. They had to arrange funding of major capital programs, which could no longer be supported through charitable campaigns. Cost accounting and manage- ment control were important functions to the continued financial viability of their firms. Hospital accountants soon evolved into hospital financial managers, and so the AAHA changed its name in 1968 to the Hospital Financial Management Association (HFMA).

The hospital industry continued to boom through the late 1960s and 1970s. Third-party insur- ance became the norm for most of the American population. Patients either received it through governmental programs such as Medicare and Medicaid or obtained it as part of the fringe benefit program at their place of employment. Hospitals were clearly no longer quite as charitable as they once were. There was money, and plenty of it, to finance the growth re- quired through increased demand and the new evolving medical technology. By 1980 HFMA was a large association with 19,000 members. Primary offices were located in Chicago, but


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2 Chapter 1 FinanCial inFormation and the deCision-making proCess

In 2010 HFMA had over 35,000 members in a wide variety of healthcare organizations. The daily activities of their members still involve basic accounting issues— patient bills must still be created and collected, and pay- roll still needs to be met—but strategic decision making is much more critical in today’s environment. It would be impossible to imagine any organization planning its future without financial projections and input. Many healthcare organizations may still be charitable from a taxation perspective, but they are too large to depend on charitable giving to finance their business future. Financial managers of healthcare firms are involved in a wide array of critical and complex decisions that will ultimately determine the destiny of their firms.

This book is intended to improve decision makers’ understanding and use of financial information in the healthcare industry. It is not an advanced treatise in accounting or finance but an elementary discussion of how financial information in general and healthcare industry financial information in particular are inter- preted and used. It is written for individuals who are not experienced healthcare financial executives. Its goal is to make the language of healthcare finance readable and relevant for general decision makers in the healthcare industry. Three interdependent factors have created the need for this book:

1. Rapid expansion and evolution of the healthcare industry

2. Healthcare decision makers’ general lack of business and financial background

3. Financial and cost criteria’s increasing importance in healthcare decisions

The healthcare industry’s expansion is a trend visi- ble even to individuals outside the healthcare system. The hospital industry, the major component of the healthcare industry, consumes about 5% of the gross domestic product; other types of healthcare systems, although smaller than the hospital industry, are ex- panding at even faster rates. Table 1−1 lists the types of major healthcare institutions and indexes their rela- tive size.

LearnIng ObjeCtIve 1

Describe the importance of financial infor- mation in healthcare organizations.

The rapid growth of healthcare facilities providing direct medical services has substantially increased the numbers of decision makers who need to be familiar with financial information. Effective decision making in their jobs depends on an accurate interpretation of financial information. Many healthcare decision mak- ers involved directly in healthcare delivery—doctors, nurses, dietitians, pharmacists, radiation technologists, physical therapists, and inhalation therapists—are medically or scientifically trained but lack education and experience in business and finance. Their special- ized education, in most cases, did not include such courses as accounting. However, advancement and promotion within healthcare organizations (HCOs) in- creasingly entails assumption of administrative duties,

an important office was opened in Washington, DC, to provide critical input to both the execu- tive and legislative branches of government. On many issues that affected either government payment or capital financing, HFMA became the credible voice that policymakers sought.

The industry adapted and evolved even more in the 1980s as fiscal pressure hit the federal government. Hospital payments were increasing so fast that new systems were sought to curtail the growth rate. Prospective payment systems were introduced in 1983, and alterna- tive payment systems were developed that provided incentives for treating patients in an ambulatory setting. Growth in the hospital industry was still rapid, but other sectors of health care began to experience colossal growth rates, such as ambulatory surgery centers. More and more, health care was being transferred to the outpatient setting. The hospital industry was no longer the only large corporate player in health care. To recognize this trend, the HFMA changed its name in 1982 to the Healthcare Financial Management Association to reflect the more diverse elements of the industry and to better meet the needs of members in other sectors.

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Information and Decision Making 3

accurate portrayal. However, few individuals in the healthcare industry today would deny the importance of financial concerns, especially cost. Payment pressures from payers, as described in the scenario at the begin- ning of the chapter, underscore the need for attention to costs. Careful attention to these concerns requires knowledgeable consumption of financial information by a variety of decision makers. It is not an overstatement to say that inattention to financial criteria can lead to excessive costs and eventually to insolvency.

The effectiveness of financial management in any business is the product of many factors, such as envi- ronmental conditions, personnel capabilities, and information quality. A major portion of the total finan- cial management task is the provision of accurate, timely, and relevant information. Much of this activity is carried out through the accounting process. An ade- quate understanding of the accounting process and the data generated by it are thus critical to successful deci- sion making.

InFOrMatIOn anD DeCIsIOn MakIng

The major function of information in general and financial information in particular is to oil the deci- sion-making process. Decision making is basically

requiring almost instant, knowledgeable reading of fi- nancial information. Communication with the organi- zation’s financial executives is not always helpful. As a result, nonfinancial executives often end up ignoring financial information.

Governing boards, which are significant users of financial information, are expanding in size in many healthcare facilities, in some cases to accommodate demands for more consumer representation. This trend can be healthy for both the community and the facili- ties. However, many board members, even those with backgrounds in business, are overwhelmed by finan- cial reports and statements. There are important dis- tinctions between the financial reports and statements of business organizations, with which some board members are familiar, and those of healthcare facili- ties. Governing board members must recognize these differences if they are to carry out their governing mis- sions satisfactorily.

The increasing importance of financial and cost crite- ria in healthcare decision making is the third factor creating a need for more knowledge of financial infor- mation. For many years accountants and others involved with financial matters have been caricatured as individ- uals with narrow vision, incapable of seeing the forest for the trees. In many respects this may have been an

(Projected) 2012 ∗ 2007 ∗ 2003 ∗

Annual Growth Rate, 2007–2012 (%)

Total health expenditures 2,930.7 2,241.2 1,734.9 5.5 Percentage of gross domestic product 18.0 16.2 15.8 Health services and supplies 2746.1 2098.1 1621.1 5.5 Personal health care 2446.3 1878.3 1447.5 5.4 Hospital care 931.7 696.5 527.4 6.0 Physician and clinical 604.5 478.8 366.7 4.8 Dental services 115.8 95.2 76.9 4.0 Home health 85.7 59.0 38.0 7.6 Other professional and personal health 180.7 128.2 99.4 7.1 Prescription drugs 288.8 227.5 174.2 4.9 Other medical products 71.3 61.8 54.5 2.9 Nursing home care 167.8 131.3 110.5 5.0 Expenses for prepayment and administration 213.4 155.7 121.9 6.5 Government public health 86.4 64.1 57.3 6.1 Research and construction 184.5 143.1 111.8 5.2

∗Values are US$ in billions, except for “Percentage of gross domestic product.” Source: Centers for Medicare and Medicaid Services, Office of the Actuary.

Table 1–1 Healthcare Expenditures 2003–2012

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4 Chapter 1 FinanCial inFormation and the deCision-making proCess

Periodic measurement of results in a feedback loop, as in Figure 1−1, is a method commonly used to make sure that decisions are actually implemented according to plan.

As previously stated, results that are forecast are not always guaranteed. Controllable factors, such as fail- ure to adhere to prescribed plans, and uncontrollable circumstances, such as a change in reimbursement, may obstruct planned results.

Decision making is usually surrounded by uncer- tainty. No anticipated result of a decision is guaran- teed. Events may occur that have been analyzed but not anticipated. A results matrix concisely portrays the possible results of various courses of action, given the occurrence of possible events. Table 1−2 provides a results matrix for the sample ASC; it shows that ap- proximately 50% utilization will enable this unit to operate in the black and not drain resources from other areas. If forecasting shows that utilization below 50% is unlikely, decision makers may very well elect to build.

A good information system should enable decision makers to choose those courses of action that have the highest expectation of favorable results. Based on the results matrix of Table 1−2, a good information system should specifically

• List possible courses of action • List events that might affect the expected results • Indicate the probability that those events will

occur • Estimate the results accurately, given an action–

event combination (e.g., profit in Table 1−2)

the selection of a course of action from a defined list of possible or feasible actions. In many cases the actual course of action followed may be essentially no action; decision makers may decide to make no change from their present policies. It should be rec- ognized, however, that both action and inaction rep- resent policy decisions.

Figure 1−1 shows how information is related to the decision-making process and gives an example to il- lustrate the sequence. Generating information is the key to decision making. The quality and effectiveness of decision making depend on accurate, timely, and relevant information. The difference between data and information is more than semantic: Data become infor- mation only when they are useful and appropriate to the decision. Many financial data never become infor- mation because they are not viewed as relevant or are unavailable in an intelligible form.

For the illustrative purposes of the ambulatory sur- gery center (ASC) example in Figure 1−1, only two possible courses of action are assumed: to build or not to build an ASC. In most situations there may be a continuum of alternative courses of action. For exam- ple, an ASC might vary by size or facilities included in the unit. In this case prior decision making seems to have reduced the feasible set of alternatives to a more manageable and limited number of analyses.

Once a course of action has been selected in the decision-making phase, it must be accomplished. Implementing a decision may be extremely complex. In the ASC example, carrying out the decision to build the unit would require enormous management effort to ensure the projected results are actually obtained.

Figure 1–1 Information in the Decision-Making Process



Decision making

Implementation of decision



Financial forecasts of a proposed ASC

Develop or not develop the ASC

ASC is developed

Significant financial losses occur

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Uses and Users of Financial Information 5

stated goals at a consistent level of activity. Viability is a far more restrictive term than solvency; some HCOs may be solvent but not viable. For example, a hospital may have its level of funds restricted so that it must reduce its scope of activity but still remain solvent. A reduction in payment rates by a major payer may be the vehicle for this change in viability.

Assessment of the financial condition of business enterprises is essential to our economy’s smooth and efficient operation. Most business decisions in our economy are directly or indirectly based on perceptions of financial condition. This includes the largely non- profit healthcare industry. Although attention is usually directed at organizations as whole units, assessment of the financial condition of organizational divisions is equally important. In the ASC example, information on the future financial condition of the unit is valuable. If continued losses from this operation are projected, im- pairment of the financial condition of other divisions in the organization could be in the offing.

Assessment of financial condition also includes con- sideration of short-run versus long-run effects. The rel- evant time frame may change, depending on the decision under consideration. For example, suppliers typically are interested only in an organization’s short-run finan- cial condition because that is the period in which they must expect payment. However, investment bankers, as long-term creditors, are interested in the organization’s financial condition over a much longer time period.


Historically, evaluation of stewardship was the most important use of accounting and financial information systems. These systems were originally designed to prevent the loss of assets or resources through employ- ees’ malfeasance. This use is still very important. In fact, the relatively infrequent occurrence of employee fraud and embezzlement may be due in part to the de- terrence of well-designed accounting systems.

An information system alone does not evaluate the desirability of results. Decision makers must evaluate results in terms of their organizations’ preferences or their own. For example, construction of an ASC may be expected to lose $200,000 a year, but it could provide a needed community service. Weighing these results and determining criteria are purely a decision maker’s responsibilitynot an easy task, but one that can be improved with accurate and relevant information.

LearnIng ObjeCtIve 2

Discuss the uses of financial information.

Uses anD Users OF FInanCIaL InFOrMatIOn

As a subset of information in general, financial in- formation is important in the decision-making process. In some areas of decision making, financial informa- tion is especially relevant. For our purposes, we iden- tify five uses of financial information that may be important in decision making:

1. Evaluating the financial condition of an entity 2. Evaluating stewardship within an entity 3. Assessing the efficiency of operations 4. Assessing the effectiveness of operations 5. Determining the compliance of operation with


Financial Condition

Evaluation of an entity’s financial condition is prob- ably the most common use of financial information. Usually, an organization’s financial condition is equated with its viability or capacity to continue pursuing its

Table 1–2 Results Matrix for the ASC


Alternative Actions 25% Utilization 50% Utilization 75% Utilization

Build unit $400,000 Loss $10,000 Profit $200,000 Profit Do not build unit 0 0 0

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6 Chapter 1 FinanCial inFormation and the deCision-making proCess

For example, development of outpatient surgical centers may reduce costs per surgical procedure and thus create an efficient means of delivery. However, the necessity of those surgical procedures may still be questionable.


Finally, financial information may be used to deter- mine whether compliance with directives has taken place. The best example of an organization’s internal directives is its budget, an agreement between two management levels regarding use of resources for a defined time period. External parties may also impose directives, many of them financial in nature, for the organization’s adherence. For example, rate setting or regulatory agencies may set limits on rates determined within an organization. Financial reporting by the or- ganization is required to ensure compliance.

LearnIng ObjeCtIve 3

List the users of financial information.

Table 1−3 presents a matrix of users and uses of financial information in the healthcare industry. It identifies areas or uses that may interest particular decision-making groups. It does not consider relative importance.


Efficiency in healthcare operations is becoming an increasingly important objective for many decision makers. Efficiency is simply the ratio of outputs to inputs, not the quality of outputs (good or not good) but the lowest possible cost of production. Adequate assessment of efficiency implies the availability of standards against which actual costs may be compared. In many HCOs, these standards may be formally intro- duced into the budgetary process. Thus, a given nurs- ing unit may have an efficiency standard of 4.3 nursing hours per patient day of care delivered. This standard may then be used as a benchmark by which to evaluate the relative efficiency of the unit. If actual employment were 6.0 nursing hours per patient day, management would be likely to reassess staffing patterns.


Assessment of the effectiveness of operations is con- cerned with the attainment of objectives through pro- duction of outputs, not the relationship of outputs to cost. Measuring effectiveness is much more difficult than measuring efficiency because most organizations’ objectives or goals are typically not stated quantita- tively. Because measurement of effectiveness is diffi- cult, there is a tendency to place less emphasis on effectiveness and more on efficiency. This may result in the delivery of unnecessary services at an efficient cost.

Table 1–3 Users and Uses of Financial Information


Financial Condition Stewardship Uses Efficiency Effectiveness Compliance

External Healthcare coalitions X X X Unions X X Rate-setting organizations X X X X Creditors X X X Third-party payers X X Suppliers X Public X X X

Internal Governing board X X X X X Top management X X X X X Departmental management X X

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Financial Organization 7

Not every use of financial information is important in every decision. For example, in approving a HCO’s rates, a governing board may be interested in only two uses of financial information: (1) evaluation of finan- cial condition and (2) assessment of operational effi- ciency. Other uses may be irrelevant. The board wants to ensure that services are being provided efficiently and that the established rates are sufficient to guarantee a stable or improved financial condition. As Table 1−3 illustrates, most healthcare decision-making groups use financial information to assess financial condition and efficiency.

FInanCIaL OrganIZatIOn

It is important to understand the management struc- ture of businesses in general and HCO in particular. Figure 1−2 outlines the financial management struc- ture of a typical hospital.

LearnIng ObjeCtIve 4

Describe the financial functions within an organization.

Financial Executives International has catego- rized financial management functions as either con- trollership or treasurership. Although few HCOs have specifically identified treasurers and control- lers at this time, the separation of duties is important

to the understanding of financial management. The following describes functions in the two categories designated by Financial Executives International, along with an example of the type of activities con- ducted within each of these functions:

1. Controllership (a) Planning for control: Establish budgetary

systems (Chapters 13 and 16) (b) Reporting and interpreting: Prepare financial

statements (Chapter 9) (c) Evaluating and consulting: Conduct cost

analyses (Chapter 14) (d) Administrating taxes: Calculating payroll

taxes owed (e) Reporting to government: Submit Medicare

bills and cost reports (Chapters 2 and 6) (f) Protecting assets: Develop internal control

procedures (g) Appraising economic health: Analyze

financial statements (Chapters 11 and 12) 2. Treasurership (a) Providing capital: Arrange for bond issuance

(Chapter 21) (b) Maintaining investor relations: Assist in

analysis of appropriate dividend payment policy (for-profit firms) (Chapters 20 and 21)

(c) Providing short-term financing: Arrange lines of credit (Chapters 22 and 23)

(d) Providing banking and custody: Manage overnight and short-term funds transfers (Chapters 22 and 23)

Figure 1–2 Financial Organization Chart of a Typical Hospital

Controller Director of Patient

Accounting Director of Material

Management Director of Patient


Director of Financial Reporting and Disbursements

Director of Financial Analysis

Senior Vice-President and Chief Financial


Director of Corporate Compliance and Risk


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8 Chapter 1 FinanCial inFormation and the deCision-making proCess

it operates through the healthcare services it provides. Not-for-profit HCOs must be run as a business, how- ever, to ensure their long-term financial viability. With an annual budget of more than $10 billion, Ascension Healthcare is an example of one of the largest not-for- profit HCOs.

Not-for-profit organizations (described in Sec. 501(c)(3) of the Internal Revenue Code) usually are exempt from federal income taxes and property taxes. In return for this favorable tax treatment, not-for-profit organizations are expected to provide community benefit, which often comes in the form of providing more uncompensated care (vis-à-vis for-profit firms), setting lower prices, or offering services that, from a financial perspective, might not be viable for for-profit firms. In addition to patient revenue in excess of ex- penses, not-for-profits can additionally be funded by tax-exempt debt, grants, donations, and investments by other nonprofit firms.

The primary advantage of the not-for-profit form of organization is its tax advantage. It also typically en- joys a lower cost of equity capital compared with for- profit firms. The main disadvantage of this form of organization is that not-for-profits have more limited access to capital. Nonprofits cannot raise capital in the equity markets.

Although for-profit firms are becoming increasingly prevalent in many sectors of health care, not-for-profits still dominate the hospital sector. About 80% of hospi- tals are not-for-profit. In the future, however, this sector may witness the growth of investor-owned orga- nizations, mainly due to their easier access to capital that will be necessary for adapting to the rapid changes in the healthcare system.

For-Profit Healthcare entities

The main objective of most for-profit firms is to earn profits that are distributed to the investor-owners of the firms or reinvested in the firm for the long-term benefit of these owners. For-profit hospital manage- ment must strike a balance between their fiduciary responsibilities to the owners of the company with their other mission of providing acceptable-quality healthcare services to the community.

For-profit firms have a wide variety of organization and ownership structures. For-profit firms that buy and sell shares of their company stocks on the open market are referred to as publicly traded companies. A major

(e) Overseeing credits and collections: Establish billing, credit, and collection policies (Chapters 2 and 22)

(f) Choosing investments: Analyze capital investment projects (Chapter 19)

(g) Providing insurance: Managing funds related to self-insurance program

LearnIng ObjeCtIve 5

Discuss the common ownership forms of healthcare organizations, along with their advantages and disadvantages.

FOrMs OF bUsIness OrganIZatIOn

More so than in most other industries, firms in the healthcare industry consist of a wide array of owner- ship and organizational structures. In health care there are four main types of organizations (adapted from the American Institute of Certified Public Accountants Audit and Accounting Guide, Health Care Organiza- tions, 2009):

• Not-for-profit, business-oriented organizations • For-profit healthcare entities

• Investor owned • Professional corporations/professional associa-

tions • Sole proprietorships • Limited partnerships • Limited liability partnerships/limited liability

companies • Governmental HCOs • Non-governmental, nonprofit HCOs

These four main types of firms differ in terms of ownership structure. Additionally, different HCOs re- quire slightly different sets of financial statements.

not-for-Profit, business-Oriented Organizations

Not-for-profit HCOs are owned by the entire com- munity rather than by investor-owners. Unlike its for- profit counterpart, the primary goal of a not-for-profit (also referred to as a nonprofit) organization is not to maximize profits but to serve the community in which

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Forms of Business Organization 9

sole proprietor has total control, there are few govern- ment regulations and no special income taxes, and they are easy and inexpensive to dissolve. Its two main dis- advantages are unlimited liability and limited access to capital.

Partnerships are unincorporated businesses with two or more owners. Group practices of physicians some- times were set up with this form. There are now a wide variety of partnership forms. They are easy to form, are subject to few government regulations, and are not sub- ject to double taxation. On the down side, partnerships have unlimited liability, are difficult to dissolve, and cre- ate potential for conflict among the partners.

In a limited partnership there is at least one general partner who has unlimited liability for the partnership’s debts and obligations. Limited partnerships offer lim- ited liability to the limited partners along with tax flow-through treatment. The disadvantage to limited partnerships is that they require a general partner who remains fully liable for their debts and obligations.

A limited liability company, also called a limited liability partnership, is a business entity that com- bines the tax flow-through treatment characteristics of a partnership (i.e., no double taxation) with the liabil- ity protection of a corporation. In a limited liability company, the liability of the general partner is limited. Limited liability companies are flexible in the sense that they permit owners to structure allocations of in- come and losses any way they desire, as long as the partnership tax allocation rules are followed.

governmental Healthcare Organizations

Governmental HCOs are public corporations, typi- cally owned by a state or local government. They are operated for the benefit of the communities they serve. A variation on this type of ownership is the public benefit organization. Assets (and accumulated earn- ings) of a nonprofit public benefit corporation belong to the public or to the charitable beneficiaries the trust was organized to serve. In 1999, for example, the Nassau County Medical Center, a 1,500-bed healthcare system on Long Island, New York, converted from county ownership to a public benefit corporation. The purpose of the conversion was to give Nassau County Medical Center greater autonomy in its governing board and decision making, so that it could compete more effectively with the area’s large private hospitals and networks.

advantage of being publicly traded is the ability to raise equity capital through the sale of company stocks. Publicly traded firms are subject to reporting require- ments and regulation by the securities and exchange Commission. For-profit firms may also be privately held, meaning the shares of the company are held by relatively few investors and are not available to the general public. Privately held companies also have far fewer reporting requirements by the Securities and Exchange Commission. Large for-profit firms are typically publicly traded. However, there are excep- tions. For example, HCA, Inc. is a national for- profit healthcare services company headquartered in Nashville, Tennessee. Before 2005 HCA was the larg- est publicly traded hospital company. In 2005 HCA was purchased by a private equity firm and converted from a publicly traded to a privately held company. HCA, Inc. remains a privately held company and is still the largest for-profit hospital company, with 163 hospitals and related businesses in 20 states. In its fis- cal year ending December 31, 2008, the company had after-tax income of $673 million.

Both publicly traded and privately held for-profit firms are often referred to as “investor-owned” firms. Investor-owned firms are owned by risk-based equity investors who expect the managers of the corporation to maximize shareholder wealth. Most large for-profit firms use this legal form. Investor-owned firms have a relative advantage in terms of financing. In addition to debt, for-profit firms can raise funding through risk- based equity capital. They enjoy limited liability, but their earnings are taxed at both the corporate level and shareholder level (so-called double taxation). The company pays corporate income tax, and the share- holder pays both tax on dividends paid by the company and gains made on the sale of the company’s stock

A professional corporation, also called a profes- sional association, is a corporate form for professionals who wanted to have the advantages of incorporation. A professional corporation does not, however, shield its owners from professional liability. Professional corpo- rations and professional associations have been widely used by physicians and other healthcare professionals.

sole proprietorships are unincorporated businesses owned by a single individual. They do not necessarily have to be small businesses. Solo practitioner physi- cians often are sole proprietors. There are several ad- vantages to a sole proprietorship: They are easy and inexpensive to set up, there is no sharing of profits, the

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10 Chapter 1 FinanCial inFormation and the deCision-making proCess

In some cases governmental HCOs may have access to an additional revenue source through taxes—an op- tion not available to other not-for-profit HCOs. Similar to other not-for-profits, government HCOs are not able to raise funds through equity investments and are ex- empt from income taxes and property taxes.

Governmental HCOs can face political pressures if their earnings become too great. Rather than reinvest- ing their surplus in productive assets, the hospital might be pressured to return some of the surplus to the community, to reduce prices, or to initiate programs that are not financially advisable.

nonprofit, non–business-Oriented Organizations

Non–business-oriented HCOs perform voluntary services in their communities; accordingly, they are often called voluntary health and welfare organiza- tions. They are tax exempt and rely primarily on pub- lic donations for their funds. Examples include the American Red Cross and the American Cancer Society. Although these types of organizations provide

invaluable services, the financial statements and finan- cial management of these organizations are somewhat different from that of business-oriented firms. Although many of the topics covered in this book are applicable to these firms, these firms are not explicitly covered in this book.


The healthcare sector of our economy is growing rapidly both in size and complexity. Understanding the financial and economic implications of decision making has become one of the most critical areas en- countered by healthcare decision makers. Successful decision making can lead to a viable operation capable of providing needed healthcare services. Unsuccessful decision making can and often does lead to financial failure. The role of financial information in the decision-making process cannot be overstated. It is incumbent on all healthcare decision makers to be- come accounting-literate in our financially changing healthcare environment.

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Chapter 1 Financial Information and the Decision-Making Process
Information And Decision Making
Uses And Users Of Financial
FInancial Organization
Forms Of Business Organization
Chapter 3

Financial Environment of Healthcare Organizations

LEarning ObjECtivEs

After studying this chapter, you should be able to do the following:

1. Describe factors that influence the financial viability of a healthcare organization. 2. Describe the financial environment of the largest segments of the healthcare industry. 3. Discuss the major reimbursement methods used in health care. 4. Discuss the major aspects of Medicare benefits. 5. Describe how Medicare reimburses the major types of providers, and discuss the

implications of these methods for an organization’s resource management.

rEaL-WOrLd sCEnariO

Joshua Douglas, chief financial officer at Marshall Regional Hospital, was exploring an option to convert his hospital to critical access hospital (CAH) status under the Medicare program. The CEO of the hospital, Mikaela Grace, had directed Josh to investigate this possible option at the last hospital board meeting. The hospital has been losing money for the last 4 years, and cash positions have been eroding to the point of possible default on a small debt issue.

Marshall Regional is a 13-bed acute-care hospital with a 10-bed skilled-nursing facility. It is located in a rural area of a western state and is 50 miles from the nearest hospital. The cur- rent economic climate in the region is not good and is not expected to improve in the near future. Because of its low volume, Marshall’s cost per unit for acute inpatient and outpatient procedures is very high. As a result the hospital has been losing large sums of money on its sizable Medicare volume. The situation has only gotten worse since Medicare shifted to pro- spective payment for outpatient services in August 2000. Josh has estimated that his hospital loses 45 cents for every dollar of Medicare payment. Because a high percentage of the local population is elderly, Medicare is the hospital’s largest source of business. Medicare repre- sents 50% of all outpatient revenue and 65% of inpatient revenue. Most inpatient procedures are not complex, and severely ill patients are transferred to a larger hospital 50 miles up the interstate.


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34 Chapter 3 FinanCial environment oF healthCare organizations

Almost any measure of size indicates that the health- care industry is big business. Its proportion of the gross domestic product has been steadily increasing for several decades and now represents approximately 16% of the gross domestic product, with over 2 trillion dollars in expenditures. Paralleling this growth, the pressures for cost control within the system have in- creased tremendously, especially at the federal and state levels for control of Medicare and Medicaid. Healthcare organizations (HCOs) not able to deal ef- fectively with these pressures face an uncertain future. In short, as the expected demand for health services continues to increase during the next several decades as our population ages, successful HCOs must become increasingly cost efficient.

LEarning ObjECtivE 1

Describe factors that influence the financial viability of a healthcare organization.

FinanCiaL viabiLitY

An HCO is a basic provider of health services but is also a business. The environment of an HCO viewed from a financial perspective is depicted in Figure 3–1.

In the long run the HCO must receive dollar pay- ments from the community in an amount at least equal to the dollar payments it makes to its suppliers. In very simple terms, this is the essence of financial viability.

The community in Figure 3–1 is the provider of funds to the HCO. The flow of funds is either directly or indirectly related to the delivery of services by the HCO. For our purposes, the community may be cate- gorized as follows:

1. Patients a. Self-payer b. Third-party payer

• Blue Cross and Blue Shield • Commercial insurance, including managed

care • Medicaid • Medicare • Self-insured employer • Other

2. Nonpatients a. Grants b. Contributions c. Tax support d. Miscellaneous

In most HCOs the greater proportion of funds is derived from patients who receive services directly. The largest percentage of these payments usually comes from third-party sources such as Blue Cross, Medicare, Medicaid, and managed care organiza- tions. In addition, some nonpatient funds are derived from government sources in the form of grants for research purposes or direct payments to subsidized HCOs, such as county facilities. Some HCOs also receive significant sums of money from individuals, foundations, or corporations in the form of contribu- tions. Although these sums may be small relative to

Mikaela Grace had been to a recent seminar and learned that her hospital might be eligible for CAH status. If the hospital was successful in its application for CAH status, it would no longer be paid under prospective payment. Instead, Marshall regional would receive the cost incurred in delivering services to Medicare patients plus 1%. Joshua Douglas estimated that this change in payment could result in a substantial improvement in operating margins and should help the hospital to secure its financial future.

Upon Josh’s review of CAH materials, he learned that over 1,300 hospitals in the United States are designated as CAH. Although a number of criteria must be met, it seemed that the hospital would be eligible. It was under the 25-bed maximum, and it was more than 35 miles from the nearest hospital. It also maintained an acute-care length of stay less than 96 hours and had round-the-clock emergency care available. Although there were other criteria, Josh was very optimistic about Marshall’s chances of receiving CAH status, and he prepared a memo to Mikaela Grace recommending that they move forward with an application.

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Sources of Operating Revenue 35

sOurCEs OF OpErating rEvEnuE

Table 3–2 provides a historical breakdown of the relative size of the healthcare industry and its indi- vidual industrial segments. The largest segment is the hospital industry, which absorbs about 31% of all healthcare expenditure dollars (in per capita terms). This percentage has been declining over the last few years and is expected to decline further as other indus- try segments grow more quickly. The physician seg- ment absorbs approximately 21% of total healthcare expenditures; this has been steady in recent years but still represents a modest increase over the prior de- cade when expressed as a percentage of total health- care expenditures. Prescription drugs represent the third largest healthcare segment, reflecting the rapid rise in prescription drug use. Whereas in the past nurs- ing homes represented the third largest healthcare segment, prescription drugs have overtaken nursing homes. Prescription drugs now constitute about 10% of all per capita healthcare expenditures.

Another area experiencing significant growth has been the administration of private health insurance, representing 7% of health expenditures. The once- rapid increases in Medicare spending for skilled nurs- ing facilities (SNFs) have been tempered by the change to prospective payment (explained later in the chapter). Annual growth rates in spending for nursing home care have been cut almost in half in recent years, as providers reacted to the changes in reim- bursement method. Demographic factors, however, still will tend to put upward pressure on national nurs- ing home expenditures. Many people believe that the nursing home segment will grow faster as the popula- tion ages.

Table 3–3 depicts the sources of operating funds for the four largest healthcare segments: hospitals,

the total amounts of money received from patient ser- vices, their importance in overall viability should not be understated. In many HCOs these contributed dol- lars mean the difference between net income and loss.

The suppliers in Figure 3–1 provide the HCO with resources that are necessary in the delivery of quality health care. The major categories of suppliers are the following:

• Employees • Equipment suppliers • Service contractors • Vendors of consumable supplies • Lenders

Payments for employees usually represent the larg- est single category of expenditures. For example, in many hospitals payments for employees represent about 60% of total expenditures. Table 3–1 is an ex- ample of a statement of operations (similar to an in- come statement for a for-profit firm) that shows percentages of revenues and expenses for a hospital. Payments for physicians’ services also represent im- portant financial requirements. In addition, lenders such as commercial banks or investment bankers sup- ply dollars in the form of loans and receive from the HCO a promise to repay the loans with interest accord- ing to a defined repayment schedule. This financial requirement has grown steadily as HCOs have become more dependent on debt financing.

LEarning ObjECtivE 2

Describe the financial environment of the largest segments of the healthcare industry.

Figure 3–1 Financial Environment of Healthcare Organizations Source: Centers for Medicare & Medicaid Services, office of Financial and Actuarial Analysis, Division of

National Cost Estimates. Retrieved from http://www.cms.gov on March 10, 2010.

Suppliers Community HCO





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36 Chapter 3 FinanCial environment oF healthCare organizations

Table 3–1 Statement of Operations for Memorial Hospital, Year Ended 20X7 (000s Omitted)

20X7 %

Unrestricted revenues, gains, and other support: Net patient service revenue $85,502 85.84 Premium revenue 11,195 11.24 Other operating revenue 2,913 2.92

Total operating revenue $99,610 100.0

Expenses Salaries and benefits 40,258 40.41 Medical supplies and drugs 27,542 27.65 Professional fees 16,857 16.92 Insurance 5,568 5.59 Depreciation and amortization 3,952 3.97 Interest 1,456 1.46 Provision for bad debts 1,152 1.16 Other 523 0.53

Total expenses $97,308 97.69

Operating income 2,302 2.31

Investment income 1,846 1.86

Excess of revenues, gains, and other support over expenses 4,148 4.17

Net assets released from restrictions used for purchase of property and equipment

192 0.19

Increase in unrestricted net assets $ 4,340 4.36

Source: Centers for Medicare & Medicaid Services, Office of Financial and Actuarial Analysis, Division of National Cost Estimates.

physicians, prescription drugs, and nursing homes. Dramatic differences in financing among these four segments can be seen easily.

The hospital industry derives more than 50% of its total funding from public sources, largely from Medicare and Medicaid. Of the two, Medicare is by far the larger, representing about 30% of all hospital rev- enue. This gives the federal government enormous control over hospitals and their financial positions. Few hospitals can choose to ignore the Medicare pro- gram because of its sheer size. Another 36% of total hospital funding results from private insurance, largely from Blue Cross, commercial insurance carriers, man- aged care organizations, and self-insured employers. Direct payments by patients to hospitals represent ap-

proximately 3% of total revenue. The implication of this distribution for hospitals is the creation of an oli- gopsonistic marketplace. The buying power for hospi- tal services is concentrated in relatively few third-party purchasers, namely the federal government, the state government, Blue Cross, a few commercial insurance carriers, and some large self-insured employers.

The physician marketplace is somewhat different from the marketplace for hospital services. A much larger percentage of physician funding is derived from direct payments by patients (approximately 10%). Compared with hospital funding, a slightly larger percentage of physician funding results from private insurance sources, largely from Blue Cross and commercial insurance carriers. Physicians derive

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Sources of Operating Revenue 37

Table 3–2 National Healthcare Expenditures

2000 2008

2000–2008 Annual Growth

2019 Projected

2008–2019 Annual Growth

National health expenditures (millions) 1,855,389 2,338,746 6.0% 4,482,696 5.1% Population (millions) 293.2 304.5 0.9% 334.8 0.7%

Per capita expenditures

Hospital care 1,481 2,359 6.0% 4,105 5.2% Physician and clinical services 1,026 1,629 6.0% 2,635 4.5% Prescription drugs 429 769 7.6% 1,367 5.4% Administration and net cost of private

health insurance 291 524 7.6% 957 5.6% Nursing home care 339 455 3.8% 735 4.5% Investment: structures and equipment 225 374 6.6% 663 5.3% Other personal health care 132 224 6.8% 551 8.6% Dental services 220 332 5.3% 539 4.5% Home health care 108 212 8.8% 459 7.3% Government public health activity 153 228 5.1% 419 5.7% Other professional care 139 216 5.7% 369 5.0% Investment: research 91 143 5.9% 272 6.0% Other nondurable medical products 106 128 2.4% 189 3.6% Durable medical equipment 69 87 3.0% 129 3.6%

National health expenditures 4,808 7,681 6.0% 13,389 5.2%

Source: Centers for Medicare & Medicaid Services, Office of Financial and Actuarial Analysis, Division of National Cost Estimates. Retrieved from http://www.cms.gov on March 10, 2010.

Table 3–3 Sources of Health Services Funding: 2008 and Projected 2019

Hospitals Physicians Prescription Drugs Nursing Homes

Source 2008 2019 2008 2019 2008 2019 2008 2019

Private payments (%) 43 38 65 65 63 53 38 33 Private health insurance 36 32 49 47 42 36 7 6 Out-of-pocket payments 3 3 10 11 21 17 27 24 Other private funds 4 3 6 7 0 0 4 4

Government payments (%) 57 62 35 35 37 47 62 67 Medicare 29 33 21 20 22 30 19 21 Medicaid 17 18 7 9 8 10 41 43 Other 10 11 7 6 7 8 3 3

Total payments (%) 100 100 100 100 100 100 100 100

Source: Centers for Medicare & Medicaid Services, Office of Financial and Actuarial Analysis, Division of National Cost Estimates. Retrieved from http://www.cms.gov on March 10, 2010.

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38 Chapter 3 FinanCial environment oF healthCare organizations

In contrast, the typical healthcare firm may have several hundred different contractual relationships with payers, which specify different rates of payment for an identical basket of services. Although different payers may negotiate different rates of payment, the critical distinction is the unit of payment. For exam- ple, some payers pay physicians a discount from their charges, other payers pay on fee schedule, Medicare pays on a relative value scale referred to as the resource-based relative value scale (rbrvs), and some health maintenance organizations may pay on an enrolled or capitated basis. Similar scenarios apply in other sectors of the healthcare industry. Alternative payment units have a different effect on the firm’s financial position and might lead to different conclu- sions with respect to business strategy. It is thus ex- tremely important to understand the financial implications of the various payment units used to pay healthcare firms. Four major payment units are discussed:

1. Historical cost reimbursement 2. Specific services (charge payment) 3. Capitated rates 4. Bundled services

Historical Cost reimbursement

Cost reimbursement was the predominant form of payment for most hospitals and other institutional pro- viders by Medicare until the early 1980s. In addition to Medicare, most state Medicaid plans and a large num- ber of Blue Cross plans paid hospitals on the basis of “reasonable” historical costs. Today, the major payers have abandoned historical cost reimbursement and substituted other payment systems. We provide some discussion of cost reimbursement for two reasons. First, it is used in some limited settings for payment. For example, Medicare still pays on a cost basis for services performed in comprehensive cancer centers and critical-access hospitals (CAHs). Second, some policy analysts have suggested that “regulated cost reimbursement” might be a legitimate way to maintain the quality of patient care.

Two key elements in historical cost reimbursement are reasonable cost and apportionment. reasonable cost is simply a qualification introduced by the payer to limit its total payment by excluding certain catego- ries of cost or placing limits on costs that the payer

approximately 49% of their total funds from this source; the hospital segment derives 36% of total funds from this source. Public programs, although still sig- nificant, are the smallest source of physician funding, representing 35% of total funds. This situation results because more physician services, such as routine phys- ical examinations and many deductible and copayment services, are excluded from Medicare payment.

Similar to the market for physicians, most payments for prescription drugs (42%) come from private insur- ance sources. The impact of Medicare coverage can be clearly seen in Table 3–3. By 2019 projections show that Medicare will be funding 30% of all prescription drug costs. Many state Medicaid plans (which are more than 50% federally funded) do provide prescrip- tion drug benefits. Medicaid represents over 8% of prescription drug payments.

The nursing home segment receives almost no fund- ing from private insurance sources. The major public program for nursing homes is Medicaid, not Medicare. However, the federal government pays more than 50% of all Medicaid expenditures. Medicare payments to nursing homes are largely restricted to skilled nursing care, whereas most Medicaid payments to nursing homes are for intermediate-level (custodial) care.

LEarning ObjECtivE 3

Discuss the major reimbursement methods that are used in health care.

HEaLtHCarE paYMEnt sYstEMs

One of the most important financial differences be- tween healthcare firms and other businesses is the way in which their customers or patients make payment for the services they receive. Most businesses have only one basic type of payment: billed charges. Each cus- tomer is presented with a bill that represents the prod- uct of the quantity of goods or services received and their appropriate prices. Some selective discounting of the price may take place to move slow inventory dur- ing slack periods or to encourage large-volume orders. The basic payment system, however, remains the same: a fixed price per unit of service that is set by the business, not the customer.

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Healthcare Payment Systems 39

(CMS)- 1450 or Uniform Bill 2004 (UB-04). Physician bills are often submitted on a CMS-1500. A sample of both the UB-04 and the CMS-1500 are presented in Appendix 2–A. Both forms are designed by the CMS and are standards for claims submission that are re- quired by most payers.

Many medical and surgical procedures often have an assigned code designated as either current proce- dural terminology (CPT, developed and maintained by the American Medical Association) or Healthcare Common procedure Coding system (HCPCS, devel- oped and maintained by the CMS). Supply and phar- maceutical items do not usually have CPT codes but may have specific HCPCS codes, although most do not have either. The example UB-04 in Appendix 2–A consolidates individual charges for specific services by departmental or revenue code. Note that there is no listing of specific services in this bill because the ser- vices are consolidated to a revenue code level. If the patient or their insurance plan requested a detailed bill, then the specific services provided would be listed.

Payers who pay on a specific-service basis usually fall into three categories. First, they could be patients who do not have any insurance coverage or lack cover- age for the procedures performed. These patients are usually responsible for the total billed charges repre- sented on the claim. Second, the patients could have coverage from an insurance firm that does not have any formal contract with the provider. In the absence of a contract, the patient and/or his or her carrier is responsible for the entire billed charges. This often happens when a provider that is out of the carrier’s network treats a patient. Third, some insurance firms negotiate contracts with providers on a discounted- charge basis. The carrier agrees to make payment based on the total billed charges for the claim but at something less than 100%.

Payment for specific services has several important implications for financial management. First, revenue from specific services may represent the major source of profit for many healthcare firms. In these situations pricing or rate setting becomes an important policy (rate setting is addressed in Chapter 6). Second, the firm’s rate structure should be based on projected vol- ume and cost. Any unexpected deviation from the projections may require pricing changes. If these changes are not made, there could be a significant ef- fect on the firm’s cash flow.

deems reasonable. Examples of costs often defined as unreasonable and therefore not reimbursable are costs for charity care, patient telephones, and nursing educa- tion. Apportionment refers to the manner in which costs are assigned or allocated to a specific payer such as Medicaid. For example, assume that a nursing home has total reasonable costs of $10 million, which repre- sent the costs of servicing all patients. If Medicaid is a historical cost reimbursement payer, an allocation or apportionment of that $10 million is necessary to de- termine Medicaid’s share of the total cost. Quite often, the apportionment is related to billed charges. For ex- ample, if charges for services to Medicaid patients were $3 million and total charges to all patients were $15 million, then 3/15 or 20% of the $10 million cost would be apportioned to Medicaid.

Several important financial principles of cost reim- bursement should be emphasized. First, cost reim- bursement can insulate management somewhat from the financial results of poor financial planning. New clinical programs that do not achieve targeted volume or exceed projected costs may still be viable because of extensive cost reimbursement. This assumes that the payer does not regard the costs as unreasonable. Second, cost reimbursement can often be increased through careful planning, just as taxes can often be reduced through tax planning. The key objective is to maximize the amount of cost apportioned to cost pay- ers subject to any tests for reasonableness.

specific services

Most healthcare firms have some master price list that identifies the appropriate charge for a defined unit of service. These master price lists are often re- ferred to as charge description masters. The charges that are applicable for specific services may bear no relationship to amounts actually paid. For example, a hospital may have charges for a patient categorized as Medicare severity-diagnosis related group (MS-DRG) #293 (Heart Failure and Shock) for $15,000, but Medicare could determine that the applicable rate of payment was $4,000. Although the charges for spe- cific services of $15,000 are recorded on the patient’s bill, the actual charges for specific services are not the basis for payment.

Most institutional providers such as hospitals and nursing homes record their charges for specific ser- vices on a Centers for Medicare & Medicaid Services

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40 Chapter 3 FinanCial environment oF healthCare organizations

incremental basis. This simply means that manage- ment is interested in the change in costs and change in revenue that result if the contract is signed. The firm’s cost accounting system should be able to define the incremental costs likely to be incurred in a given con- tract so they can be compared with the incremental revenue likely to result from the contract.

bundled services

Many payment plans used to pay healthcare provid- ers in today’s environment could be classified as bun- dled services arrangements. A bundled services payment plan has two key features. First, payments to the provider are not necessarily related to the list of specific services provided the patient and identified in the UB-04 or the CMS-1500. Instead, payment is grouped into a mutually exclusive set of service cate- gories. For example, hospitals are paid by some health- care plans on a per diem (meaning per day) or per case payment rate. Both are examples of bundled service payment. Second, bundled services arrangements have a fixed fee specified per unit of service. For example, in the per diem arrangement, revenue from treating a patient is equal to the length of stay times the negoti- ated per diem rate.

Medicare has developed bundled services payment plans for most healthcare providers. We discuss some of these plans in detail later in this chapter. Medicare’s pay- ment methods have a profound impact on the rest of the industry because they tend to become the standard for payment by many health plans. For example, Medicare pays physicians on an RBRVS basis, which is often used as the payment basis by many healthcare plans with one slight wrinkle. Most often, these plans will not pay 100% of Medicare’s rates but some greater or lesser percent- age, such as 110% of RBRVS. Table 3–4 presents the unit of payment used by Medicare in a variety of health- care sectors.

Capitated rates

Capitated rates represent a rare and declining type of payment for many healthcare providers. In some re- spects a capitated rate is a form of bundled service be- cause the unit of payment is the enrollee. A medical group, hospital, or some association of providers may agree to provide some or all healthcare services for enrollees during a specified period of time. Most often the provider agrees to pay only for specific services they perform. For example, a cardiology group might agree to provide all cardiology services to an employer or a health maintenance organization for a fixed fee per member per month. It is rare that a single healthcare provider will agree to provide for all medical services to an enrolled population. When this does occur, the term “global capitation” is used to describe the nature of the contractual relationship. Global capitation rates are very uncommon because most healthcare firms are not in a position to control all healthcare costs. Capitation arrangements were more common in the mid-1990s and have been declining since that point.

In a capitated payment environment, financial plan- ning and control are critical—even more critical than in a bundled services payment situation. In a capitated payment arrangement the provider is responsible not only for the costs of services provided but also their utilization. Changes in either costs or utilization can have a dramatic effect on profitability. Unexpected increases in costs are not usually a basis for contract renegotiation. It is imperative therefore that manage- ment knows the cost of providing a unit of service re- quired in the contract. For example, if the negotiated rate is to provide all hospital services to subscribers of a health maintenance organization for a fixed fee per subscriber (or capitation), the hospital must know both the utilization and the cost per unit of the required services. Sometimes management may assess the financial desirability of a capitation contract on an

Table 3–4 Medicare Payment Units for Healthcare Sectors

Healthcare Sector Payment Unit

Hospital inpatient Medicare Severity-Diagnosis Related Groups (MS-DRGs) Hospital outpatient Ambulatory patient classifications (APCs) Physicians Resource-Based Relative Value Scale (RBRVS) Skilled Nursing Facilities (SNFs) Resource utilization groups (RUGs) Home health agencies Home health resource groups (HHRGs)

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Medicare Benefits 41

Medicare benefits are provided to three categories of individuals. Far and away the largest single group is the aged, beneficiaries over 65 years of age. The second group consists of disabled individuals, and the third group includes people with end-stage renal disease.

There are two primary ways that Medicare benefi- ciaries may receive care through the system. The most popular method is the so-called traditional or original plan. In this plan Medicare beneficiaries can go to any hospital, doctor, or specialist that accepts Medicare to receive care. The second method is a Medicare man- aged care plan (e.g., Medicare Advantage). Under this method beneficiaries are enrolled in a private health- care plan or health maintenance organization, and they are usually limited in terms of the providers that they can visit for care to those included in the plan’s net- work. Usually, Medicare managed care plans provide a wider range of benefits, such as routine physicals and prescription drugs, to offset their restricted networks.

Benefits under Part A include hospital stays, skilled nursing care, hospice care, and some home health ser- vices. Under Part A there is a deductible, which means the patient is responsible for this dollar amount before any payment by Medicare. In 2010 the hospital de- ductible was $1,100. Coinsurance arrangements also exist under Part A coverage. Patients who stay beyond 60 days in a hospital were required to pay $275 per day in 2010. Patients in SNFs had no deductible but were required to pay an additional $137.50 per day for lengths of stay between 21 and 100 days.

Benefits under Part B include a wide range of services, such as doctor’s fees, hospital outpatient services, clinical laboratory tests, durable medical equipment, and a number of other preventive medical services. There was a $155 deductible for medical ser- vices received under Part B in 2010. Part B benefits also require a coinsurance payment in many cases. This coinsurance is 20% of approved amounts. This coinsurance amount can be no less than 20% of the total payment due (although it can be larger) to the provider of services, which includes Medicare’s pay- ment and the coinsurance. For example, Medicare may determine that total payment for ambulatory payment classification (APC) #83 (Coronary Angioplasty) is $3,500. The required coinsurance on this claim may be $1,750 as set by Medicare, which represents 50% of the total payment (which is greater than 20%).

Part D, the Medicare drug plan, was initiated on January 1, 2006. Medicare beneficiaries have the ability

Healthcare providers who are paid under bundled service arrangements need to understand and monitor their costs of production. A bundled service unit is simply a set of specific services that may be grouped or classified into a bundled unit of some kind. Total cost of producing the bundled services unit is therefore a product of two factors.

• Services provided • Cost per unit of services provided

First, the set of specific services that comprises a bundled unit forms the basis for the cost computation. It is important to recognize, however, that the set of services may not always be fixed. For example, home health firms are paid on a 60-day episode of care basis. The number of specific visits per episode is not neces- sarily fixed. In some cases there may be 30 individual case visits to the patient in the 60-day episode, whereas in other cases 45 individual visits may be necessary. Second, the cost of producing each of the specific ser- vices that comprises the bundled unit is multiplied times the number of units required. Whether 30 or 45 visits of care are required, management must control the unit cost of individual visits by monitoring the productivity of nursing staff. Management’s overall objective is to minimize the total cost of production, which means keeping total units of service provided at a minimum and producing each unit of service at an efficient level of cost. Naturally, all this must happen within a quality-of-care constraint.

LEarning ObjECtivE 4

Discuss the major aspects of Medicare benefits.

MEdiCarE bEnEFits

Medicare has three basic benefit programs for its beneficiaries: Part A, Part B, and a prescription drug benefit, Part D. Part A, or hospital insurance, typically is provided free to all beneficiaries if they have 40 or more covered quarters of Medicare employment. Part B, or Medical insurance, usually requires a monthly payment by the beneficiary. In 2010 this pay- ment was $96.40 per month for most beneficiaries.

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42 Chapter 3 FinanCial environment oF healthCare organizations

The basis of PPS payment is the DRG system devel- oped by Yale University, which takes all possible diag- noses from the International Classification of Diseases, 9th revision, Clinical Modification (ICD-9-CM) sys- tem and classifies them into 25 major diagnostic cate- gories based on organ systems. These 25 categories are further broken down into distinct medically meaning- ful groupings or DRGs. Medicare contends that the resources required to treat a given DRG entity should be similar for all patients within a DRG category. However, in federal fiscal year 2008, DRGs were ex- panded to account for patient acuity. The number of DRGs increased significantly as a result. At the time of publication, the total number of MS-DRGs was 746. (Appendix 3−A lists 746 MS-DRGs.)

Total payments to a hospital under Medicare can be split into the following elements (see Figure 3−2):

• Prospective payments • DRG operating payment • DRG capital payment

• Reasonable cost payments

The MS-DRG operating payment results from the multiplication of the hospital dollar rate and the spe- cific case weight of the MS-DRG. Appendix 3−A provides the most recent case weight for the 746 MS- DRGs. The case weight for MS-DRG 001, Heart Transplant with MCC, is 24.8548. This measure indi- cates that in terms of expected cost, MS-DRG 001 would cost about 25 times more than the average case. A specific value is assigned to each of the 746 MS- DRGs.

The dollar rate is broken down into labor and nonla- bor components. The labor component is adjusted for cost of living. Table 3−5 provides hypothetical rates that might be defined by Medicare.

Every hospital in the United States has a wage index value assigned to it. That wage index is multiplied by the labor component of the Medicare standardized payment to yield the DRG operating payment. If we

to choose from a variety of plan providers that fall into two categories: a prescription drug plan (covering drugs only) or Medicare advantage plan (covering medical services and drugs). Both plan types have differing costs and benefits for beneficiaries, although some basic re- quirements are stipulated by the government.

Many Medicare beneficiaries purchase additional insurance from private insurance firms to pay for de- ductibles and coinsurance amounts that exist in the Medicare program. This coverage is often referred to as supplemental or Medigap coverage and may also provide limited coverage for other healthcare services. For a more complete picture of specific benefits under the Medicare program, you might visit Medicare’s website, www.medicare.gov.

LEarning ObjECtivE 5

Describe how Medicare reimburses the major types of providers, and discuss the implications of these methods for an organi- zation’s resource management.

MEdiCarE paYMEnts

Hospital inpatient

Medicare pays hospitals for inpatient care on a bundled services unit basis referred to as a prospective payment system (pps). Medicare officially launched PPS on October 1, 1983. All hospitals participating in the Medicare program are required to participate in PPS, except those excluded by statute:

• Children’s hospitals • Distinct psychiatric and rehabilitation units • Hospitals outside the 50 states • Hospitals in states with an approved waiver • CAHs

PPS provides payment for all hospital nonphysician services provided to hospital inpatients. This payment also covers services provided by outside suppliers, such as laboratory or radiology units. Medicare makes one comprehensive all-inclusive payment to the hospi- tal, which is then responsible for paying outside sup- pliers or nonphysician services.

Table 3–5 Hypothetical Medicare Rates According to Hospital Status


Labor Non-labor $3,500 $1,600

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Medicare Payments 43

as a disproportionate share payment. Outlier pay- ments are additional payments for patients who use an unusually large amount of resources. We discuss their computation shortly.

There is still a portion of the total Medicare payment that is related to reasonable cost, as shown in Figure 3–2. Costs that are still paid on this basis are:

• Direct medical education costs • Kidney acquisition costs • Bad debts for copayments and deductibles (reim-

bursed at 70%)

There is a national standardized federal payment rate for capital costs that is similar to the national rates for labor and nonlabor costs discussed earlier. In 2010 the federal rate for capital costs was $430.20. This rate would be adjusted for the following factors:

• Geographical adjustment, using the wage index to impute higher costs to higher wage areas

• Case mix, using the MS-DRG relative weight • Disproportionate share adjustment • Indirect medical education • Outlier adjustments (the adjustment is much

lower than before, to recognize the presumed fixed-cost nature of capital costs)

assume that a hospital has a wage index of 1.2509, its DRG operating payment for DRG 001 would be calcu- lated as follows:

Payment = DRG weight × [(labor amount × wage index) + nonlabor amount]

Payment = 24.8548 [($3,500 × 1.2509) + $1,600] = $148,586

This dollar payment may be further increased by additional payments to cover the following areas:

• Indirect medical education • Disproportionate share • Outlier payments

The add-on to a teaching hospital is referred to as an indirect medical education adjustment. This allow- ance is related to the numbers of interns and residents at the hospital and the hospital’s bed size. The allow- ance is over and above salaries paid to interns and resi- dents, which are already covered as a reasonable cost. The additional payment is meant to cover the additional costs that the teaching hospital incurs in the treatment of patients. A separate payment is also provided to a hospital that treats a large percentage of Medicaid and Medicaid-eligible patients. This payment is referred to

Figure 3–2 Breakdown of Medicare Inpatient Payments to a Hospital

Medicare Payment

Prospective portion Reasonable cost

Indirect medical

education Bad debts Kidney


Graduate medical

education DRG capitalDRG

operating Cost


Case weight

Hospital dollar rate

Wage index

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44 Chapter 3 FinanCial environment oF healthCare organizations

the median payment by category in 2008 for all U.S. hospitals for a MS-DRG with a case weight of 1.00.

There are a number of ways that a hospital can try to increase its total payment under Medicare inpatient PPS payment rules. For example, it can try to get the hospital reclassified to a higher wage index, document bad debts better on Medicare patients, change its ratio of residents to beds to increase its indirect medical education payment, and change the MS-DRG assign- ment. Far and away the most likely source of increased payment is MS-DRG reclassification. MS-DRGs are assigned by a software package referred to as a grou- per. That grouper assigns a MS-DRG based on the patient’s age, the principal diagnosis, procedures per- formed, and secondary diagnosis. In many cases missed secondary diagnoses can cost the hospital sig- nificant amounts of reimbursement.

MS-DRG 179 (Respiratory Infections) carries a MS-DRG weight of 1.0088, whereas MS-DRG 195 (Simple Pneumonia and Pleurisy) carries a weight of 0.7095. For a hospital with an average payment of $5,000 per case weight of 1.000, a patient erroneously assigned to MS-DRG 195 instead of MS-DRG 179 would cost the hospital $1,497 [$5,000 × (1.0088 – 0.7095)]. What would cause a patient with an assign- ment of MS-DRG 195 to be moved to MS-DRG 179? Very simply, is there a specified cause for the pneumo- nia? For example, if the physician identified salmo- nella as the bacterial cause, the patient could be legitimately coded as MS-DRG 179. Medical record coders must be on the alert for this information in the physician’s note and other documents, and physicians must be educated about the importance of accurate documentation.

There are literally hundreds of situations like this within a hospital. The importance of accurate coding cannot be overstated in today’s payment environment. On the other hand, hospitals should seek to accurately code and not overcode to maximize reimbursement. Hospital executives who intentionally upcode may fall under the government’s fraud-and-abuse regulations, which can impose severe civil and criminal penalties.


Beginning in January 1992 Medicare began paying for physician services using a new RBRVS. This new payment system replaced the old reasonable-charge method that had been the basis for physician payment

As an illustration, assume that we wish to calculate capital payment for MS-DRG 001 when the federal payment rate for capital was approximately $430.20. We also assume our hospital is in a large urban area with a geographical adjustment factor of 1.194. Please note that a hospital’s geographical adjustment factor and its wage index are not usually the same. We as- sume that no other adjustments are applicable. The amount of payment would be as follows:

Capital payment = DRG wt. × [standard amount × geographical adjustment factor]

Capital payment = 24.8548 × [$430.20 × 1.194] = $12,767

We now conclude our discussion of Medicare MS- DRG payment with the incorporation of the outlier adjustment. An additional payment for a cost outlier is made when the actual cost of the case exceeds MS- DRG payment by $23,140, the 2010 required amount. To determine whether this threshold is met, one must define actual costs for the specific case under consid- eration. Costs are defined using the hospitals overall ratio of cost to charges. For example, a claim with $100,000 of charges in a hospital with a ratio of cost to charges of 0.75 would have a designated cost of $75,000. If this cost were above the threshold, Medicare would make payment at 80% of the difference. The reason that Medicare does not pay 100% of the differ- ence relates to the concept of marginal cost. Medicare believes that additional costs incurred to treat outlier patients are not 100% of average cost.

To give the reader some idea of payment composi- tion for an average U.S. hospital, Table 3–6 presents

Table 3–6 Median Medicare Payment for U.S. Hospitals, MS-DRG Case Weight of 1.00: 2008

Category Median Payment

DRG operating payment $ 4,771 DRG capital payment 476 Indirect medical education 153 Disproportionate share 577 Coinsurance and deductible 632 Outlier payments 294 Other 43 Total $ 6,946

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Medicare Payments 45

The entire amount will come from the patient di- rectly. No check will be sent to the physician from Medicare. The final total payment could be allocated as follows:

Medicare payment to patient (0.8 × $95.00) $76.00

Patient’s copayment (0.2 × $95.00) 19.00

Additional patient payment 14.25

Total payment to physician $109.25

The nonparticipating physician can also choose to accept assignment on a case-by-case basis. The advan- tage realized with assignment is that Medicare will now pay the physician directly for its portion of the bill. The disadvantage is that the physician must accept the fee schedule for nonparticipating physicians, which is only 95% of the fee approved for participating phy- sicians. In the example above, the nonparticipating physician who agreed to accept assignment on this patient would receive the following payments:

Medicare payment to physician (0.8 × $95.00) $76.00

Patient’s co-payment (0.2 × $95.00) 19.00

Total payment to physician $ 95.00

The participating physician would receive $100.00 for this service because of the higher approved-fee schedule. Of the total $100.00 in payment, $80.00 would come directly from Medicare and $20.00 from the patient as the copayment portion.

At the present time there are Medicare payment rates for more than 10,000 physician services usually broken out by CPT or HCPCS code. There are specific values for those codes that vary by region; presently there are distinct values for each of the Medicare car- rier localities. These payment rates result from the multiplication of three relative values and regional cost indexes. For every procedure there are three compo- nents that together reflect the cost of a particular pro- cedure:

1. Work: This factor represents not only physician time involved but also skill levels, stress, and other factors.

2. Practice expense: This factor represents nonphysician costs, excluding malpractice costs.

3. Malpractice: This factor represents the cost of malpractice insurance.

since the inception of the Medicare program in the 1960s. Medicare pays the lesser of the actual billed charge or the fee-schedule amount.

From Medicare’s perspective, physicians are cate- gorized as participating or nonparticipating physicians. A participating physician is one who agrees to accept Medicare’s payment for a service as payment in full and will bill the patient for the copayment portion only. The copayment portion is usually 20% of the charge. As an example, assume that a patient received a service from a physician who had an approved fee schedule of $100.00. The participating physician re- ceives $80.00 directly from Medicare and then bills the patient for $20.00, which represents the copayment portion of the bill. If the physician’s bill for the service was only $80.00, Medicare would pay 80%, or $64.00, and the patient would be billed 20%, or $16.00. A par- ticipating physician agrees to accept assignment on each and every Medicare patient that he or she treats.

A nonparticipating physician can choose to ac- cept assignment on a case-by-case basis. Although this arrangement initially might seem advantageous, there are several major drawbacks. First, a nonpartici- pating physician has a lower fee schedule. The limit- ing charge is equal to 95% of the approved fee schedule. If the physician in the illustration just dis- cussed were nonparticipating, the amount of the Medicare payment would be $95.00, not $100.00. This difference may not seem all that important if the physician can recover any of the difference from the patient. However, Medicare has placed some limits on the amount that a nonparticipating physician can re- cover from the patient. Medicare sets a maximum fee for a nonparticipating physician equal to 115% of the approved fee for nonparticipating physician, which is already only 95% of the approved fee schedule for a participating physician.

A simple illustration may help to better explain this narrative. Assume that a nonparticipating physician provides services to a patient in the amount of $200.00, but Medicare’s approved schedule for a participating physician is only $100.00. How much can the physi- cian collect? The answer depends on whether the phy- sician accepts or rejects Medicare assignment. First, assume that the physician rejects assignment. The maximum amount that can be collected from this ser- vice is as follows:

$109.25 = [0.95 × $100] × 1.15

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46 Chapter 3 FinanCial environment oF healthCare organizations

may be paid for more than one APC for an encounter. Not all hospital outpatient procedures have an assigned APC code; some procedures are paid on a fee-schedule basis such as lab tests, and others may not be paid at all because they are considered incidental services, such as some drugs and medical supply items.

The Balanced Budget Act also changed the way beneficiary coinsurance is determined for the services included under the PPS. A coinsurance amount is ini- tially calculated for each APC based on 20% of the national median charge for services in the APC. The coinsurance amount for an APC will not change until such time as the amount becomes 20% of the total APC payment. In addition, no coinsurance amount can be greater than the hospital inpatient deductible in a given year. This is a major change for Medicare and means that the total burden of payment shifts more to Medicare in the future. A similar change for physician payment was made in 1992.

Both the total APC payment and the portion paid as coinsurance amounts are adjusted to reflect geographi- cal wage variations using the hospital wage index. It is assumed that 60% of the total payment is labor related and thus subject to the wage-index adjustment. Each APC is assigned a relative weight and then that weight is multiplied times the current conversion factor to determine total payment. This same methodology framework is used throughout most of Medicare’s pay- ment plans.

To illustrate the details discussed, assume that APC #80 (Left Heart Catheterization) has a relative weight of 39.81 when the national conversion rate is $67.40. The total amount paid for this APC is $2,683 (39.81 × $67.40). We further assume that Medicare has set the national coinsurance for APC #80 at $839. To adjust actual payment for a hospital with a wage index of 1.200, the following computations are made to adjust total payment and coinsurance payment:

Total Payment = [0.60 × $2,683 × 1.200] + [0.40 × $2,683] = $3,005

Coinsurance = [0.60 × $839 × 1.200] + [0.40 × $839] = $940

Table 3–8 illustrates the Medicare payment for a specific outpatient claim taken from a hospital-submit- ted UB-04 on a patient who had a left heart cardiac catheterization. The example claim shows that total payment for this claim is $2,750.90, with $844.24

Each individual relative value is then multiplied by a region-specific set of price indexes. To illustrate this adjustment, the weighted value for excision of neck cyst (CPT # 42810) for Los Angeles is presented in Table 3–7. To determine the payment rate for this pro- cedure in Los Angeles, the index-adjusted relative value is multiplied by a conversion factor. If we as- sume that the conversion factor is $40.00, the approved charge for excision of neck cyst in Los Angeles is $309.20 (7.73 × $40.00).

Medicare also differentiates the payment by the set- ting in which the procedure was performed. If the procedure was performed in a facility setting (gener- ally a hospital, SNF, or ambulatory surgery center), the amount allowed for practice expense is reduced from what it would be if the procedure was performed in a nonfacility setting. For example, the allowed practice expense weight for excision of neck cyst in a facility setting is 3.55, but if the procedure was performed in a nonfacility setting, the allowed weight is 5.73. The rationale for these differences is related to the addi- tional payment that Medicare would make to the facil- ity. A procedure performed in a hospital involves a payment to the hospital as well as to the physician.

Hospital Outpatient

The Balanced Budget Act of 1997 directed CMS to implement a prospective payment system (PPS) under Medicare for hospital outpatient services. All services paid under the new PPS are classified into groups called ambulatory payment classifications (APCs). Services in each APC are similar clinically and in terms of the re- sources they require. A payment rate is established for each APC. Depending on the services provided, hospitals

Table 3–7 Components of Price Adjustment for Excision of Neck Cyst in Los Angeles


Geographical Cost Index for Los Angeles Product

Work 3.25 1.043 3.39 Practice expense 3.55 1.144 4.06 Malpractice 0.29 0.954 .28

Total 7.73

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Medicare Payments 47

50% of the cost of the APC that is above 175% of the actual APC payment. However, in addition to meeting the 175% provision, cost must also exceed a fixed dol- lar threshold of $2,175 (fiscal year 2010 amount) plus the APC payment. For example, if an APC had a total payment, including the coinsurance, of $1,000 and the estimated cost of the APC was $4,000, then Medicare would pay an additional $1,125 [0.50 × ($4,000 – $1,750)]. Please recognize that the cost of the APC does include incidental services or “N”-status items, which makes it important to include these items and to charge for them even if Medicare does not recognize them as APC or fee-schedule items.

Resource management under APC reimbursement is more difficult than it is under DRGs because payment is not fixed. In a DRG payment environment, once the patient is classified, cost minimization is the optimal financial strategy because payment does not increase if additional services are provided. In an APC payment situation, payments may increase when more services are provided. Management must determine from a fi- nancial perspective whether the marginal revenue of additional services is greater than the marginal cost of providing those services.

coming from the patient as coinsurance. A large num- ber of the items are coded as “N” or incidental services that are packaged into the APC rate. Many of these procedures are either imaging procedures or injections that are considered to be a part of CPT 93510 (Left Heart Catheterization). This procedure has a “T” status indicator code, which indicates it is discounted at 50% if another “T”-coded procedure was performed. In our example, there is no other “T”-coded procedure pres- ent in the claim, so the procedure is not discounted. When multiple “T”-coded procedures are performed, the highest-value procedure is paid at 100%, but all other “T”-coded procedures are paid at 50%. The lab procedures are all coded as “A,” which in this case means they are clinically diagnostic laboratory ser- vices that are paid from a fee schedule with no coinsur- ance payments.

There are other examples of “A”-coded procedures, and these are described in Table 3–9. The ECG is coded as an “X” procedure, which implies it is an an- cillary service.

It is also important to note that Medicare provides additional payments to hospitals for outliers. Outlier payments are made on an APC basis and are equal to

Table 3–8 Example Medicare Payment for Outpatient Left Heart Cardiac Catheterization: APC Reimbursement, APC # 80

Revenue Code Description HCPCS Units Total Charges Status Code

APC Total Payment Copayment

300 Lab 80051 1 $27.42 A $10.05 $0 301 Lab 82565 1 7.42 A 7.34 0 301 Lab 84520 1 6.46 A 5.65 0 305 Lab 85027 1 20.77 A 9.27 0 305 Lab 85730 1 14.21 A 8.60 0 460 Pulmonary 94760 1 16.46 N 0 0 481 Cath lab 93510 1 1711.17 T 2,683.43 838.92 481 Cath lab 93539 1 607.79 N 0 0 481 Cath lab 93540 1 607.79 N 0 0 481 Cath lab 93543 1 1288.48 N 0 0 481 Cath lab 93545 1 607.79 N 0 0 481 Cath lab 93555 1 718.29 N 0 0 481 Cath lab 93556 1 718.29 N 0 0 636 Drugs J7040 1 7.13 N 0 0 710 Recovery 6 373.13 N 0 0 730 ECG 93005 1 60.74 X 26.56 5.32

$6,793.34 $2,750.90 $844.24

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48 Chapter 3 FinanCial environment oF healthCare organizations

skilled nursing Facilities

As you can see from our discussion of Medicare payments for hospital inpatient, hospital outpatient, and physician services, Medicare payment is a com- plex set of rules. Medicare has paid SNFs on a pro- spective basis since July 1, 1998. The rate is a per diem rate that is calculated to include the costs of all ser- vices, including routine, ancillary, and capital. Per diem payments for each admission are case-mix ad- justed using a resident classification system known as resource utilization groups iii (RUG III). At the time of publication, an updated version (RUG IV) had been proposed for implementation in 2011. As with most CMS payments, the actual payment amounts are ad- justed for differences in cost of living by the hospital wage index on the labor portion of the payment.

There are seven major categories of patients under RUG III with 53 distinct payment categories, as shown in Table 3–10. Patients are assigned to one of the pay- ment categories by a “RUG III grouper” based on six key determinants:

• Number of minutes per week needed for rehabili- tation services

• Number of different rehabilitation disciplines needed

Table 3–9 Status Codes

Indicator Service Status

A clinical laboratory, ambulance, physical & occupational therapy fee schedule B non-recognized codes not paid C inpatient procedure not paid D discontinued codes not paid E non-allowed item or service not paid F acquisition of corneal tissue reasonable cost G current drug / biological pass-through additional payment H device pass-through additional payment K non-pass-through drug / biological APC rate L vaccine reasonable cost N incidental service packaged P partial hospitalization paid per diem S significant procedure APC rate T significant procedure, reduced when multiple APC rate V clinic or ED visit APC rate X ancillary service APC rate Y non-implant DME not paid under OPPS

• Specific treatments received • Resident’s ability to perform activities of daily

living • ICD-9 diagnoses • Resident’s cognitive performance

To properly classify residents, SNFs must complete resident assessments on the 5th, 14th, 30th, 60th, and 90th days after admission. These forms are extensive and require another layer of administrative support to properly record and report to CMS.

To see how the payment system operates, let us as- sume that a rehabilitation patient has been categorized

Table 3–10 Number of Payment Categories for Major RUG III

Major RUG III Group Number of Payment Categories

Rehabilitation 23 Extensive services 3 Special care 3 Clinically complex 6 Impaired cognition 4 Behavioral problems 4 Reduced physical function 10

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Medicare Payments 49

including the most ill, should ensure that all beneficia- ries have access to home health services for which they are eligible.

The home health PPS is composed of six main fea- tures:

1. 60-Day episode. The unit of payment under HHA PPS is for a 60-day episode of care. An agency receives half of the estimated base payment for the full 60 days as soon as the fiscal intermediary receives the initial claim. This estimate is based on the patient’s condition and care needs (case-mix assignment). The agency receives the residual half of the payment at the close of the 60-day episode unless there is an applicable adjustment to that amount. The full payment is the sum of the initial and residual percentage payments, unless there is an applicable adjustment. This split-percentage payment approach provides reasonable and balanced cash flow for HHAs. Another 60-day episode can be initiated for longer-stay patients.

2. Case-mix adjustment. After a physician prescribes a home health plan of care, the HHA assesses the patient’s condition and likely skilled nursing care, therapy, medical, and social services and home health aide service needs at the beginning of the episode of care. The assessment must be done for each subsequent episode of care a patient receives. A nurse or therapist from the HHA uses the Outcome and Assessment

as “ultra high with treatment minimum of 720 minutes per week.” Payment per day for this patient is com- puted as shown in Table 3–11. The rates used in this example are updated over time as most Medicare rates are adjusted to reflect inflation.

Home Health agencies

The Balanced Budget Act of 1997 called for the development and implementation of a PPS for Medicare home health services to be implemented October 1, 2000. Under prospective payment, Medicare pays home health agencies (HHAs) a predetermined base payment. The payment is adjusted for the health condi- tion and care needs of the beneficiary. The payment is also adjusted for the geographical differences in wages for HHAs across the country. The adjustment for the health condition, or clinical characteristics, and service needs of the beneficiary is referred to as the case-mix adjustment. The home health PPS provides HHAs with payments for each 60-day episode of care for each beneficiary. If a beneficiary is still eligible for care after the end of the first episode, a second episode can begin; there are no limits to the number of episodes a beneficiary who remains eligible for the home health benefit can receive. Although payment for each epi- sode is adjusted to reflect the beneficiary’s health con- dition and needs, a special outlier provision exists to ensure appropriate payment for those beneficiaries who need the most expensive care. Adjusting payment to reflect the HHA’s cost in caring for each beneficiary,

Table 3–11 Components of Payment Under RUG III Categorization of “Ultra High plus Extensive Services, High (RUX)”

Category Dollar Amount

Nursing Care $261.42 Occupational, Physical, and Speech Therapies 233.19 Capital and General and Administrative 70.22

Total Allowed per Diem $564.83 x Labor % .75922 Labor per Diem $428.83 x Wage Index .9907 Labor Adjusted per Diem $424.84 Non-labor per Diem 136.00 Case-Mix Adjusted per Diem $560.84

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50 Chapter 3 FinanCial environment oF healthCare organizations

Information Set (OASIS) instrument to assess the patient’s condition. (All HHAs have been using OASIS since July 19, 1999.) OASIS items describing the patient’s condition and the expected therapy needs (physical, speech- language pathology, or occupational) are used to determine the case-mix adjustment to the standard payment rate. This adjustment is the case-mix adjustment. Eighty case-mix groups, or home health resource groups, are available for patient classification using three classification criteria: clinical severity, functional severity, and service utilization severity. The Home Health Resource Grouping system in the proposed rule uses data from a large-scale case-mix research project conducted between 1997 and 1999.

3. Outlier payments. Additional payments are made to the 60-day case-mix-adjusted episode payments for beneficiaries who incur unusually large costs. These outlier payments are made for episodes whose imputed cost exceeds a threshold amount for each case-mix group. The amount of the outlier payment is a proportion of the amount of imputed costs beyond the threshold. Outlier costs are imputed for each episode by applying standard per-visit amounts to the number of visits by discipline (skilled nursing visits, or physical, speech-language pathology, occupational therapy, or home health aide services) reported on the claims. Total national outlier payments for home health services annually are no more than 5% of estimated total payments under home health PPS.

4. Adjustments for beneficiaries who require only a few visits during the 60-day episode. The proposed home health PPS has a low-utilization payment adjustment for beneficiaries whose episodes consist of four or fewer visits. These episodes are paid the standardized, service- specific, per-visit amount multiplied by the number of visits actually provided during the episode. For 2010 Table 3–12 shows the national payments unadjusted for wage index for HHA’s that submit quality data.

5. Adjustments for beneficiaries who experience a significant change in their condition. When a beneficiary experiences a significant change in condition during the 60-day episode not envisioned in the original physician’s plan of

care and original case-mix assignment, a significant change in condition adjustment can occur. A significant change in condition adjustment requires a new payment amount be determined. The significant change in condition payment adjustment occurs within a given 60-day episode.

6. Adjustments for beneficiaries who change HHAs. The home health PPS includes a partial episode payment adjustment. A new episode clock is triggered when a beneficiary elects to transfer to another HHA or when a beneficiary is discharged and readmitted to the same HHA during the 60-day episode. The partial episode payment provides a simplified approach to the episode definition that takes into account key intervening health events in a patient’s care. The partial episode payment allows the 60-day episode clock to end and a new clock to begin if a beneficiary transfers to another HHA or is discharged but returns because of a decline in his or her condition to the same HHA within the 60-day episode. When a new 60-day episode begins, a new plan of care and a new assessment are necessary. The original 60-day episode payment is proportionally adjusted to reflect the length of time the beneficiary remained under the agency’s care before the intervening event. The new episode is paid an initial episode payment of one-half of the new case-mix group, and the 60-day clock is restarted.

To illustrate the actual payment determination for an episode of care under the HHA PPS program, assume that a patient has been classified as 0 severity for clinical, 1 severity for functional, and 2 severity for

Table 3–12 National HHA Payments Unadjusted for Wage Index

Discipline Per-Visit Rate

Home health aide $51.28 Medical social service 181.51 Occupational therapy 124.64 Physical therapy 123.81 Skilled nursing 113.23 Speech pathology 134.53

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Summary 51

within different segments of the healthcare industry are affected by changes in payment arrangements in different ways.

Healthcare entities also depend quite heavily on a very limited number of key clients for most of their operating funding. Their largest client is often the fed- eral government or the state government. Doing busi- ness with the government involves a significant amount of reporting to ensure compliance and adherence to governmental regulations. Moreover, because the fed- eral government is such a large purchaser of services, a thorough understanding of the nature and implica- tions of the Medicare payment system’s rules and regulations is a must for effective management of an HCO. Important differences exist in setting rates and bundling services between hospital inpatient and out- patient care, physician services, SNFs, and home health care. Each system has differing implications for the management of resources by the HCO.

The revenue function of a typical healthcare entity is usually much more complex than that of a compara- bly sized non-healthcare business. Organizations can have vastly different revenue structures, depending on the segments of the healthcare industry in which they are active. Government commands enormous influ- ence as a purchaser of healthcare services and main- tains complex payment systems. Because payment arrangements are determined primarily by the payer, an effective healthcare administrator must have a firm understanding of the various systems, both public and private, that exist. Yet, although HCOs may be com- plex from a financial perspective, they are still busi- nesses. Their financial viability requires the receipt of funds in amounts sufficient to meet their financial requirements.

services utilization (C0F1S2). Payment for this patient under the PPS program is calculated as follows:

National standardized payment rate $2,320.89

Case weight × 1.5769

Case-mix adjusted payment $3,659.81

This amount is then adjusted for the actual wage index of the provider. Under the HHA PPS program, 77.7% of the payment is assumed to be labor related, whereas the remaining 22.3% is assumed to be nonlabor. Actual payment for a provider with a wage index of 1.2000 is $4,228.54:

[$3,659.81 × 0.777 × 1.2000] + [$3,659.81 × 0.223] = $4,228.54


Compared with most businesses, HCOs are finan- cially complex. Not only do they provide a large num- ber of specific services, but their individual services often also have different effective price structures. Services may be bundled in different ways to deter- mine prices, according to the agreements in place with each specific payer. One customer may choose to pay on the basis of cost, whereas another may pay full charges. Prices may be determined prospectively or may be capitated for broad scopes of care. This varia- tion in payment patterns creates problems in the estab- lishment of prices for products and services. Indeed, the revenue function of a typical healthcare entity is usually much more complex than that of a comparably sized non-healthcare business. Further, organizations

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Chapter 3 Financial Environment of Healthcare Organizations
Sources Of Operating Revenue
Healthcare Payment Systems
Medicare Payments

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