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The Role of Medicare Reimbursement in Contemporary Hospital Finance

Published online by Cambridge University Press:  24 February 2021

Steven Golub
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Abstract

A hospital, while performing its major function of providing health care, is also viewed as a business. It needs capital from a wide variety of sources, many of which are government regulated. Over the past few years, federal expenditures for Medicare have increased dramatically, as has regulation of hospital revenue sources. Congress enacted the Medicare Prospective Payment System (PPS) to curb hospital cost inflation.

This Note examines historical trends in health care financing and analyzes the Medicare reimbursement system, with emphasis on PPS and its impact on hospital revenues. The Note suggests that hospitals, due to the effects of PPS, will be forced to reduce their levels of financial leverage and will have to look for corporate financial alternatives. PPS may signal a new era in hospital finance. Survival mandates an increased focus on efficient corporate, financial and managerial policies.

Type
Notes and Comments
Information
American Journal of Law & Medicine , Volume 11 , Issue 4 , 1985 , pp. 501 - 527
Copyright
Copyright © American Society of Law, Medicine and Ethics and Boston University 1985

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References

1 “Equity” has been defined as “[t]he net worth of a business consisting of capital stock, capital (or paid-in) surplus, earned surplus (or retained earnings), and occasionally, certain net worth reserves.” J. WESTON & E. BRIGHAM, MANAGERIAL FINANCE 1012 (6th ed. 1978). When an institution is described as “equity-funded,” it relies primarily on these types of investments rather than on short or long term debt for financial needs.

2 W. CLEVERLY, ESSENTIALS OF HOSPITAL FINANCE 167-68 (1978).

3 For a discussion of utility rate setting, see generally Note, Full-Avoided Cost Pricing Under the Public Utility Regulatory Policies Act: “Just and Reasonable” to Electric Consumers?, 69 CORNELL L. REV. 1267 (1984)Google Scholar; Poor, , Utility Rates Pending Judicial Review: A Riddle Wrapped in a Mystery in Illinois, 17 J. MAR. 743 (1984).Google Scholar

4 See infra text accompanying notes 93-96.

5 50 Fed. Reg. 24,457 (1985). This tenfold rise in health care spending outpaced the growth of the general economy. As a result, national health expenditures accounted for 10.8% of gross national product (GNP) in 1983, whereas in 1965, they accounted for only 3.9% of GNP. Id. at 24,458. Health care expenditures are projected to rise to $690 billion by 1993. Office of Statistics and Data Management, Bureau of Data Management and Strategy, Health Care Financing Administration, reprinted in Freeland & Schendler, Health Spending in the 1980's; Integration of Clinical Practice Patterns with Management, HEALTH CARE FINANCING REV. 1, 7 (Spring 1984).

6 Address by William V. Corr, Esq., Counsel, Subcommittee on Health and Environment, House Committee on Energy and Commerce, to Group Health Foundation and the National Health Lawyers Association Luncheon, Washington D.C. (March 1, 1984), cited in Blomquist, , Health Maintenance Organizations and State DRG Hospital Cost Control Programs: The Need for Federal Preemption, 10 AM. J.L. & MED. 1, 20 (1984).CrossRefGoogle Scholar

7 50 Fed. Reg. 24,458 (1985). In 1967, the first full year after adoption of the Medicare system, total federal expenditures for Medicare were $4.5 billion. By 1975, the figure had risen to $15.6 billion and by 1984 to $65 billion. Medicare expenditures are projected to increase to $131.5 billion in 1990. (This figure accounts for recent legislation designed to help contain Medicare costs). Freeland & Schendler, supra note 5, at 11.

8 Social Security Amendments of 1983, Pub. L. No. 98-21, 601-07, 97 Stat. 65 (codified as amended at 26 U.S.C. and 42 U.S.C. (1982)).

9 See infra notes 58-63 and accompanying text for a discussion of current Medicare reimbursement of operating costs, and notes 102-111 and accompanying text for discussion of capital cost reimbursement. In 1984, the Medicare program paid for 28% of all hospital services, a total of $65.6 billion. Levit, Lazenby, Waldo & Davidoff, National Health Expenditures, 1984, HEALTH CARE FINANCING REV. 1,12 (Fall 1985). “Operating costs” are defined by Medicare as “the total cost incurred by [a] provider in operating the institution or facility.” 42 C.F.R. § 405.16(b) (1985). “Capital costs” are costs associated with the purchase and financing of plant and equipment. The Medicare regulations provide a very detailed description of capital-related costs. See 42 C.F.R. § 405.414 (1985).

10 “Financial leverage” is defined as the “ratio of debt to total assets” in a business’ capital structure. J. WESTON & E. BRIGHAM, supra note 1, at 1013. For a discussion of “leverage”, see infra notes 143-151 and accompanying text.

11 See generally D. YAGGY AND W. ANLYAN, FINANCING HEALTH CARE: COMPETITION VERSUS REGULATION 4-6 (1982).

12 Social Security Act, ch. 531, 49 Stat. 620 (42 U.S.C. § 301 (1982)).

13 Connery-Wagner Labor Relations Act, ch. 372, § 1, 49 Stat. 499 (1935) (current version at 29 U.S.C. §§ 151-166 1982).

14 D. YAGGY & W. ANLYAN, supra note 11, at 4-5.

15 Id. at 5.

16 Id.

17 Id.

18 Id. By 1980, third-party payors paid for nearly 92% of all national health expenditures. P. GRIMALDI & J. MICHELETTI, DIAGNOSIS RELATED GROUPS, A PRACTIONER's GUIDE 7 (1982).

19 Medicare-Health Insurance for the Aged Act, Pub. L. 89-97, 100-02, 79 Stat. 291 (1965) (codified as amended in 42 U.S.C. § 1395 (1982 and Supp. I 1983)).

20 D. YAGGY & W. ANLYAN, supra note 11, at 6.

21 Levitt, Lazenby, Waldo & Davidoff, supra note 9, at 12.

22 Freeland & Schendler, supra note 5, at 1, 51.

23 Kinney, and Lefkowitz, , Capital Cost Reimbursement to Community Hospitals Under Federal Health Insurance Programs, 7 J. HEALTH, POL., POL'Y & LAW 648 (1983).CrossRefGoogle Scholar

24 J. ELROD AND J. WILKINSON, HOSPITAL PROJECT FINANCING AND REFINANCING UNDER PROSPECTIVE PAYMENT 2 (1984). “Capital structure” refers to “[t]he permanent long-term financing of the firm represented by long-term debt, preferred stock, and net worth (net worth consists of capital surplus, and retained earnings.).” J. WESTON & E. BRIGH AM, supra note 1, at 1010.

25 Hospital Survey and Construction Act, Pub. L. No. 79-725, 60 Stat. 1040 (1946) (current version at 42 U.S.C. § 291 (1982)). J. ELROD & L. WILKINSON, supra note 24, at 2.

26 J. ELROD & J. WILKINSON, supra note 24, at 2.

27 Id.

28 Under a system of cost-based reimbursement, hospitals are essentially assured that they will receive payment for all services rendered to patients covered by such insurance plans. Thus, hospitals can avoid cash-flow problems which can be associated with uncertain payment systems.

29 See infra notes 91-92 and accompanying text for a discussion of Medicare capital cost reimbursement.

30 Id.

31 See infra notes 112-38 and accompanying text for discussion of return on equity reimbursement. Proprietary institutions can be organized as sole proprietorships, partnerships, or business corporations and are owned by private profit-seeking investors. Other forms of hospitals include tax-exempt non-profit hospitals, also referred to as “voluntary” and “charitable,” and government hospitals which are tax supported facilities. W. T. BERRIMAN, W. ESSICK & P. BENTIVEGNA, CAPITAL PROJECTS FOR HEALTH CARE FACILITIES 131-32 (1976) [hereinafter cited as W. T. BERRIMAN].

32 W. T. BERRIMAN at 4.

33 The shift in funding sources is illustrated in the following table:

Survey of Sources of Funds for Hospital Construction, Am. Hasp. Ass'n (1968, 1973, 1978, 1981), reprinted in J. ELROD & J. WILKINSON, supra note 24, at 4.

34 Medicare Health Insurance for the Aged Act, Pub. L. No. 89-97, 79 Stat. 291 (1965) (codified as amended at 42 U.S.C. § 1395 (1982 and Supp. I 1983)). THE aged and disabled are defined as those who are entitled to Social Security old age disability insurance benefits. 42 U.S.C. § 1395c (1982); see also 42 U.S.C. § 1382 (1982 and Supp. I 1983).

35 Part A is codified at 42 U.S.C. §§ 1395c—1395i-2; Part B is codified at 42 U.S.C. §§ 1395j—1395w (1982 and Supp. I 1983).

36 42 U.S.C. § 1395d (1982).

37 42 U.S.C. § 1395g (1982 and Supp. I 1983).

38 42 U.S.C. § 1395k (1982).

39 42 U.S.C. § 1395t (1982).

40 Davis & Rowland, Reforming Medicare: A New Approach to Financing 121, 122,printed in Staff of House Committee on Ways and Means, 98th Cong. 1st Sess., Proceedings and Preliminary Papers of the Conference on the Future of Medicare (Comm. Print 1983), cited in Phillips & Wineberg, Medicare Prospective Payment: A Quiet Revolution, 87 W. VA. L. REV. 13, 24 n.67 (1984).

41 50 Fed. Reg. 24,459 (1985).

42 42 U.S.C. § 1395e (1983) (deductibles and co-insurance); 42 U.S.C. § 1395g (payments to providers of services).

43 42 U.S.C. § 1395f(b) (1983) (conditions of and limitations on payment for services— amount paid to provider of services).

44 See 42 C.F.R. § 405.451 (1985).

45 42 U.S.C. § 1395x (Supp. 1983). See 42 C.F.R. §§ 405.402(c)(l) & 405.421 (1983) (“net” educational costs); 42 C.F.R. §§ 405.401(c)(2) & 405.422 (1983) (research costs over and above usual patient care); 42 C.F.R. §§ 405.402(c)(6) & 405.420 (1983) (bad debts of medicare beneficiaries); 42 C.F.R. § 405.427 (1983) (value of services of related organizations); 42 C.F.R. § 405.424 (1983) (costs of non-paid workers, e.g., members of religious orders); 42 C.F.R. § 405.426 (1983) (compensation of owners); 42 C.F.R. § 405.432 (1983) (certain contract services). Some indirect costs were not reimbursed by Medicare or were treated in a special manner. See 42 C.F.R. §§ 405.402(c)(7) & 405.420 (.1983) (charity care and bad debts of non-Medicare patients); 42 C.F.R. § 405.425 (1983) (discounts and other allowance deducted from allowable costs). Indirect costs also include normal “stand-by” costs incurred in maintaining facilities not in use but needed for emergencies. 42 C.F.R. § 405.402(a)(1983).

46 42 C.F.R. §405.402(c) & (f) (1983). See also 42 C.F.R. §§405.415 & 405.418 (1983) (depreciation); 42 C.F.R. § 405.419 (1983) (interest); 42 C.F.R. § 405.429 (1983) (return on equity). Medicare reimbursement of capital costs is discussed infra notes 90-102 and accompanying text.

47 50 Fed. Reg. 24,459 (1985).

48 Id.

49 Ingelhart, , Health Policy Report—New Jersey's Experiment With DRG Based Hospital Reimbursement, 307 NEW ENG. J. OF MED. 1655, 1657 (1982).Google Scholar The retrospective reimbursement system also provides no incentives to patients to reduce cost or utilization. Under a retrospective reimbursement system, the typical patient directly pays only a small fraction of his or her medical costs, and thus has little incentive to minimize the cost of a prescribed medical treatment. Shostack, Blumberg, Schwartz, & Schroeder, , Fee-For-Service Physician Payment: Analysis of Current Methods and Their Development, 16 INQUIRY 230 (1979).Google Scholar

50 Social Security Amendments of 1972, Pub. L. No. 98-603, 223, 86 Stat. 1393, 50 Fed. Reg. 24,459 (1985).

51 Id.

52 Id.

53 Id.

54 Pub. L. No. 97-248, 96 Stat. 324 (1982).

55 Medicare's prospective payment system, enacted in April 1983, incorporated several objectives:

  • a. Ease of understanding and simplicity of administration and implementation;

  • b. Predictability of payment for hospitals and the Federal government;

  • c. Establishment of the Federal government as a prudent purchaser of services;

  • d. Reduction of administrative burdens on hospitals;

  • e. Provision of rewards for efficient operation; and

  • f. Limitation on beneficiary liability only to those co-insurance and deductible amounts previously mandated by the Congress.

50 Fed. Reg. 24,460 (1985).

56 Social Security Amendments of 1983, Pub. L. No. 98-21, 601-607, 97 Stat. 65, 149 (1983); 42 U.S.C. § 1395ww (1983).

57 A DRG has been defined as “a class of patients defined by medical characteristics, such as primary diagnosis, secondary diagnosis, age, and surgical procedure; representing a consistent amount of resource consumption as measured by some unit (patient days, dollars, etc.).” Finley, Using Diagnosis Related Groups (DRGs) and Hospital Payment: The New Jersey Experience (Office of Tech. Assessment Working Paper, 1983), quoted in 87 W. VA. L. REV. 13, 29-30 (1984).

58 42 C.F.R. § 412.2 (1985); 42 C.F.R. § 412.60 (1985).

59 42 C.F.R. §412.70 (1985).

60 42 C.F.R. § 412.70(a)(l) (1985).

61 For a thorough discussion of the Medicare PPS formulas, see Phillips, & Weinberg, , Medicare Prospective Payment: A Quiet Revolution, 87 W. VA. L. REV. 13, 34 n.146 & 147 (1984)Google Scholar

62 42 C.F.R. § 412.73 (1985). The term “case mix” refers to the relative costliness of treating one type of diagnosis versus another. The case mix index also adjusts for differences in the cost of treatment incurred by capital intensive hospitals with more sophisticated equipment as compared to those incurred by smaller, less capital intensive hospitals.

63 The phase-in is as follows:

42 C.F.R. § 405.474 (1984).

64 42 C.F.R. § 412.80 (1985). The term “outliers” refers to those cases “that have either an extremely long length of stay or extraordinarily high costs when compared to most disharges classified in the same DRG.” 48 Fed. Reg. 39,776 (1983).

65 42 C.F.R. § 412.113(b) (1985) (direct medical education costs); 42 C.F.R. § 412.115(b) (1985) (indirect medical education costs).

66 42 C.F.R. §412.23 (1985).

67 42 C.F.R. § 412.2(d)(l) (1985) (Capital costs are discussed in detail infra notes 102-111 and accompanying text.).

68 42 C.F.R. §§ 412.2(e)(l) & 412.80 (1985).

69 Social Security Amendments of 1983, Pub. L. No. 98-21, 97 Stat. 152, 157 (1983

70 id.

71 42 C.F.R. § 412.113(b) (1985).

72 42 C.F.R. § 412.115(b) (1985) (additional payments); 42 C.F.R. § 412.118 (1985) (determination of indirect medical education costs).

73 The cost per case in teaching hospitals has been estimated at 13-14% higher than the costs of other hospitals. The current Medicare reimbursement system allows an additional 11.6% payment for teaching hospitals. Schwartz, Newhouse, & Williams, , Is the Teaching Hospital an Endangered Species?, 313 NEW ENG. J. OF MED. 157, 161 (1985).CrossRefGoogle Scholar

74 Special Report, WASHINGTON REPORT ON MEDICINE & HEALTH PERSPECTIVES 3 (McGraw-Hill) (Dec. 23, 1985).

75 In fact, teaching hospitals are anticipating financial problems and merging with multihospital chains. The Year Behind, The Year Ahead, WASHINGTON REPORT ON MEDICINE & HEALTH PERSPECTIVES (McGraw-Hill) (Jan. 6, 1986). Sec infra notes 146-49 and accompanying text for a discussion of corporate reorganizations under PPS.

76 42 C.F.R. § 412.23(a) (1985).

77 42 C.F.R. § 412.23(b) (1985). Reimbursement for intensive rehabilitation services for the treatment by a hospital of one or more of the following conditions is excluded from PPS:

  • (i) stroke

  • (ii) spinal cord injury

  • (iii) congenital deformity

  • (iv) amputation

  • (v) major multiple trauma

  • (vi) fracture of femur (hip fracture)

  • (vii) brain injury

  • (viii) polyarthritis, including rheumatoid arthritis

  • (ix) burns

42 C.F.R. § 412.23(a)(2) (1985). Distinct psychiatric, rehabilitation or alcohol/drug units of general hospitals are reimbursed outside the PPS system on a retrospective reasonable cost basis. Id.

78 42 C.F.R. § 412.23(c) (1985).

79 42 C.F.R. § 412.23(d) (1985).

80 42 C.F.R. §412.23(e) (1985).

81 42 C.F.R. § 412.25 (1985).

82 42 C.F.R. §§ 412.90(a), 412.92 (1985). Sole community hospitals are those which represent the only source of inpatient hospital services reasonably available in a geographic area to Medicare beneficiaries.

83 42 C.F.R. §417.241 (1985).

84 42 C.F.R. §417.241(d) (1985).

85 42 C.F.R. § 417.241 (1985).

86 Levit, Lazenby, Waldo & Davidoff, supra note 9, at 6. See supra notes 75-81 for a listing of services excluded from PPS.

87 Kinney, , Medicare Payment to Hospitals for a Return on Capital: The Influence of Federal Budget Policy on Judicial Decision-Making, 11 J. CONTEMP. L. 453, 457, n. 16 (1985)Google Scholar, citing W. MCCLURE, CONVERSION AND O THE R POLICY OPTIONS TO REDUCE EXCESS HOSPITAL CAPACITY (1978).

88 Kinney, 11 J. CONTEMP. L. 453, 458, n. 18, citing Lightle & Ploman, Hospital Capital Financing Entering Phase Four, 55 HOSPS., 61 (Aug. 1, 1981); Ting & Valiante, Future Capital Needs of Community Hospitals, 1 HEALTH AFFAIRS 14 (Summer 1982), cited in AHA FUTURE CAPITAL REQUIREMENTS OF THE HOSPITAL INDUSTRY 4 n.3 (1982); M. HERNANDEZ, THE CAPITAL STRUCTURE OF THE HOSPITAL INDUSTRY IN THE 80 ‘ S : THE FUTURE OF HEALTH CARE CURRENT POLICIES AND LONG TERM CONSEQUENCES (1981); cited in AHA FUTURE CAPITAL REQUIREMENTS OF THE HOSPITAL INDUSTRY 12 n.7 (1982).

89 Kinney, supra note 87, at 457.

90 Id., citing W. MCCLURE, CONVERSION AND OTHER POLICY OPTIONS TO REDUCE EXCESS HOSPITAL CAPACITY (1978); Kinney, Federal Policy on Hospital Capital Investment: Review and Outlook, HOSPS. T5 (1981); Cohodes 8c Kinkhead, Hospital Capital Formation in the 1980's: Is there a Crisis?, 8 J. HEALTH POL., POL'Y & LAW 164 (1983).

91 Kinney, supra note 87, at 457.

92 Kinney, & Lefkowitz, , Capital Cost Reimbursement to Community Hospitals Under Federal Health Insurance Programs, 7 J. HEALTH POL., POL'Y & LAW 648, 649 (1983).CrossRefGoogle Scholar Hospitals with newer assets benefit from depreciation and interest reimbursement. Hospitals with older assets have probably exhausted these benefits. These older hospitals may be encouraged to invest in newer facilities in order to increase capital reimbursement rates.

93 42 U.S.C.S. § 1320a-l (West 1984).

94 42 U.S.C.S. §§ 300k-l— 300k-3 (West 1983).

95 42 U.S.C.S. § 1320a-1(d)(1) (West 1983). See generally Miller, , PSRO Data and Information Disclosure to State Health Regulatory Agencies, 57 B.U.L. REV. 245 (1977).Google Scholar

96 42 U.S.C.S. § 1320a-l(a) (West 1983).

97 Kinney, supra note 87, at 457.

98 Id. at 458 n.88.

99 Id. at 457, 458. Under historical cost depreciation, a given project's depreciable basis is based upon historical cost, which is defined as “the cost incurred by the present owner in acquiring the asset.” 42 C.F.R. § 405.415(b)(l) (1985). Under price-level depreciation, the depreciable basis for a project is its fair market value, defined as “the price that the asset would bring by bona fide bargaining between well-informed buyers and sellers at the date of acquisition.” 42 C.F.R. § 405.415(b)(2) (1985).

100 Kinney, supra note 87, at 458. See infra notes 112-39 for a discussion of Medicare return on equity capital reimbursement. The general argument is that it is unjust that proprietary hospitals are paid a return on equity capital, when not-for-profit hospitals, which employ equity assets, are not permitted a return. Not-for-profit hospitals are denied a substantial source of income from similar investments in capital assets to those made by proprietary hospitals.

101 Kinney, supra note 87, at 458, citing AHA POSITION ON EQUITABLE DETERMINATION OF MEDICARE PROSPECTIVE PRICES (Feb. 1984) (approved by the AHA House of Delegates); AHA REPORT OF THE SPECIAL COMMITTEE ON EQUITY OF PAYMENT FOR NOT-FOR-PROFIT AND INVESTOR-OWNED HOSPITALS (1983); AHA BRIEF AMICUS CURIAE, St. Francis Hospital v. Heckler, 714 F.2d 872 (7th Cir. 1983).

102 Social Security Amendments of 1983, Pub. L. No. 98-21, 97 Stat. 149, 42 U.S.C.A. § 1395ww(A)(4) (West 1983).

103 42 C.F.R. § 405.414(a)(l)-(8) (1985). Return on equity capital to proprietary providers is discussed in greater detail infra notes 111-20 and accompanying text.

104 See, e.g., Department of Health and Human Services Report to Congress required by the Tax Equity and Fiscal Responsibility Act of 1982, Hospital Prospective Payment for Medicare; H.R. REP. NO. 25, 98th Cong., 1st Sess. 138 (1983). (“[C]ontinuing to pay capital based on cost will offer incentives to hospitals to undertake projects which substitute capital costs for labor and other costs included in the DRG payments.“) (cited in Verville, Medicare Rate Setting and its Problems: A Fixed Price per Bundled Product, 6 J. LEG. MED. 85, 86 n.2 (1985)).

105 See generally Verville, supra note 104, at 97. As an example, assume a hospital requires technicians to perform a laboratory test. The hospital receives indirect reimbursement for this cost through.DRG payments. The same hospital may purchase automated laboratory equipment which requires only one operator. The hospital would then receive the same indirect reimbursement through DRG payments, and in addition, would receive capital cost reimbursement for the equipment.

106 See generally Verville, supra note 104, at 97 citing H.R. REP. NO. 25, supra note 104, at 139. See generally supra notes 93-96 and accompanying text for a discussion of certificate-ofneed regulation.

107 Verville, supra note 104, at 97, citing H.R. REP. NO. 25, supra note 104, at 139.

108 Social Security Amendments of 1983, Pub. L. No. 98-21, 97 Stat. 166 (HHS has not yet submitted this report to Congress.).

109 Pub. L. No. 98-21, 97 Stat. 149, see also H.R. REP. NO. 25, supra note 104, at 138.

110 The Prospective Payment Assessment Commission recently issued a report to the Secretary of Health and Human Services. Included in this report were several recommendations regarding Medicare capital cost reimbursement. Those recommendations included:

  1. 1)

    1) Including Capital in the Prospective Payment System Beginning in fiscal year 1987, the secretary should initiate a transition to allinclusive prospective prices that combine operating and capital cost components in a single prospective payment per case for hospitals.

  2. 2)

    2) Capital Payment Method The federal portion of capital payments should be computed as a fixed percentage add-on to the standardized amounts beginning in fiscal year 1987. The Secretary should immediately develop capital components to be added to the hospital market basket. When appropriate data become available, the components of PPS payments should be recomputed to reflect the addition of capital costs. The results of this recomputation should be implemented as soon as possible, but no later than fiscal year 1988.

  3. 3)

    3) Level of Federal Capital Payment

Capital payment should be added to the federal portion of PPS payments for hospital accounting years beginning in fiscal year 1987 at the following levels:

  • a) For building and fixed equipment, projected average Medicare actual capital costs per discharge for fiscal year 1985 trended forward to fiscal year 1987 by an index of construction capital costs.

  • b) For moveable equipment, average actual Medicare capital costs per discharge for hospital accounting years beginning in fiscal year 1983 trended forward to fiscal year 1987 by an index of capital costs.

  • c) The proportion attributed to moveable equipment should be the lesser of the 1983 proportion or 40 percent.

Prospective Payment Assessment Commission Report and Recommendations to the Society of Health and Human Services, April 10, 1986, printed in MEDICARE AND MEDICAID GUIDE, Extra Edition, Part I, 32-36 (1986).

111 Health Planning Amendments of 1983: Hearing Before the Subcommittee on Health and the Environment of the House Committee on Energy and Commerce, 98th Cong., 1st Sess. at 8-18 (1983) (testimony of Nancy M. Gordon, Assistant Director for Human Resources and Community Development, Cong. Budget office), cited in 87 W. VA. L. REV. 13, 35 (1984).

112 42 U.S.C.A. § 1395x(v)(l)(B) (West 1983).

113 42 C.F.R. § 405.429(a)(2) (1985).

114 Return on assets can be calculated as follows:

J. LOUDERBACK & G. DOMINIACK, MANAGERIAL ACCOUNTING 608 (2d ed. 1978).

Return on Equity can be calculated as follows:

J. FINNERTY, CORPORATE FINANCIAL ANALYSIS 162 (1986).

115 “Capital structure” refers to the mix of different securities (debt and equity) of an organization. R. BREALY & S. MYERS, PRINCIPLES OF CORPORATE FINANCE 35 (1981). The term “senior securities” refers to preferred stock and bonds, W. CARY & M. EISENBERG, CORPORATIONS: CASES AND MATERIALS 1106 (5th ed. 1980).

116 Provider Reimbursement Manual, Part I, § 1202 MEDICARE & MEDICAID GUIDE (CCH) HH 5762-74 (1983); 42 C.F.R. § 405.429(b)(i)(ii) (1985).

117 See Provider Reimbursement Manual, Part I, § 1218 MEDICARE & MEDICAID GUIDE (CCH) HH 5803-25D (1980) (“Land, buildings or other assets acquired in anticipation of expansion are not includable in equity capital as long as they are not being used in the operation or maintenance of patient care activities.“). Id, at H 5818.

118 Id. at § 1218.2, 11 5810. (Any portion of a provider's general or operating funds invested in income producing activities which are not related to patient care is not includable in the provider's equity capital.). See 42 C.F.R. § 405.429 (A)(l)(1985).

119 Id. at § 1218.3, H 5814. (Where a “provider establishes an account in which amounts representing payments received, or amounts accrued for depreciation expense are deposited, the amounts deposited in this account and the earnings on the funded depreciation which remain in the fund are not includable in equity capital.“).

120 See Provider Reimbursement Manual, Part. I, § 1204 MEDICARE & MEDICAID GUIDE (CCH) 11 5778 (1983).

121 42 C.F.R. § 405.429(a)(ii) (1985).

122 Id.

123 For a discussion of this view, see Kinney, , Medicare Payment to Hospitals, 11 J. CONTEMP. L. 453, 453–62 (1985).Google Scholar

124 Id.

125 42 C.F.R. § 405.429(b) (1985).

126 42 C.F.R. § 405.429(b)(l) (1985).

127 I.R.C. § 167 (1954).

128 I.R.C. § 163 (1954).

129 See, e.g., Hospital Authority of Floyd County v. Schweiker, 522 F. Supp. 569 (N.D. Ga. 1981), aff'd, 707 F.2d 456 (11th Cir. 1983); Saline Community Hospital Association v. Schweiker, 554 F. Supp. 1133 (D. Mich. 1983); Indiana Hospital Association, Inc. v. Schweiker, 544 F. Supp. 1167 (D. Ind. 1982); St. Francis Hospital Center v. Heckler, 714 F.2d 872 (7th Cir. 1983); Washington Hospital Center v. Heckler, 581 F. Supp. 195 (D. D.C. 1984).

130 522 F. Supp. 569 (N.D. Ga. 1981), affd, 707 F.2d 456 (11th Cir. 1983).

131 U.S. Const, amend. V, XIV. 522 F. Supp. at 575.

132 707 F.2d 456 (11th Cir. 1982).

133 544 F. Supp. 1167 (D.C. Ind. 1982).

134 Id. at 1184.

135 714 F.2d 872 (7th Cir. 1983).

136 Id. at 875.

137 id.

138 Kinney, supra note 87, at 476.

139 Id.

140 Kinney, supra note 87, at 477.

141 W. T. BERRIMAN, supra note 31, at 131.

142 Id.

143 “Leverage” refers to the extent to which the capital structure of the entity includes both equity and debt. The leverage effect increases as the proportion of debt relative to equity rises in a given capital structure. See J. WKSTON & E. BKIGHAM,.vx/^rn note 1, at 29, 30; see also J. FINNERTY, supra note 114, at 162-64.

144 See supra note 33 for an analysis of the increasing use of debt financing for hospital projects over the past 20 years.

145 See R. POSNER & K. SCOTT, ECONOMICS OF CORPORATION LAW AND SECURITIES REGULATION 235 (1980); citing Baumol & Malkiel, The Firm's Optimal Debt-Equity Combination and the Cost of Capital, 81 Q.J. ECON. 547, 571 (1967); see also J. FiNNERTY,ju£ra note 114, at 170, 171.

146 See Modigliani and Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM. ECON. REV. 261-297 (1958), reprinted in R- POSNER & K. Scott, supra note 145, at 237.

147 See Modigliani and Miller, supra note 146. The following hypothetical table illustrates how, up to a certain level, the use of debt financing will actually decrease a firm's average cost of capital:

For a discussion of the relationships between leverage and the cost of capital, see V. BRUDNEY & M. CHIRELSTEIN, CASES AND MATERIALS ON CORPORATE FINANCE 401, 402 (2d ed. 1979).

148 Baxter, , Leverage, Risk of Ruin and the Cost of Capital, 22 J. FIN. 395 (1967)Google Scholar, reprinted in R. POSNER & K. SCOTT, supra note 145, at 259.

149 For a discussion of the relationship between variance of earnings and a business’ ability to tolerate debt, see N. Baxter, supra note 148, at 403, reprinted in R. POSNER & K. SCOTT, supra note 145, at 245.

150 For a technical discussion of the relationship between cash flow and debt service obligations, see J. FINNERTY, supra note 114, at 183.

151 R. POSNER AND K. SCOTT, supra note 145, at 259, reprinting Baxter, supra note 148.

152 Bradford, Caldwell and Goldsmith, The Hospital Capital Crisis: Issues for Trustees, 60 HARV. B. R. 64 (Sept.-Oct. 1982).

153 J. ELROD & J. WILKINSON, supra note 24, at 81.

154 Private investors set bond interest rates based on the opinions of bond rating corporations, most significantly Moody's Investors Service, Inc. and Standard & Poor's Corporation. These firms rate bonds based on relative creditworthiness, reviewing past records and anticipated future performance. Key areas addressed include: “debt factors, financial factors, bond security provisions and hospital specific factors … legal provisions, institutional characteristics and market position, medical staff characteristics, and management factors.” J. ELROD & J. WILKINSON, supra note 24, at 82; see also MOODY's INVESTORS SERVICE: RATING HOSPITAL REVENUE BONDS 1 (1984).

155 The “cost of capital” refers to the interest rate an entity must pay on the funds it uses for various purposes in its operations. See generally V. BRUDNEY & M. CHIRELSTEIN, supra note 147, at 380-86.

156 MOODY's INVESTORS SERVICE RATING TRENDS OF HOSPITAL REVENUE BONDS: A FIVE YEAR ANALYSIS 3 (1984), cited in J. ELROD & J. WILKINSON, supra note 24, at 82. For example, “during 1982 and 1983, Standard and Poor's downgraded 84 hospitals, whereas it upgraded only 31.” Id. at 83.

157 J. ELROD & J. WILKINSON, supra note 24, at 83.

158 See generally D. Millikan, S. Foster and R.E. Herzlinger, “Debt Financing for Hospitals,” Harvard Business School, Note 9-178-225 (1979), citedin Cohodes, Hospital Capital Formation in the 1980's: Is there a Crisis? 8 J. HEALTH, POL., POL'Y & L. 164, 167 n.10 (1983).

159 Hospitals with “greater equity bases” rely less on debt financing and more on government grants, philanthropic contributions, investments, and other capital sources which have no repayment obligations.

160 For a technical discussion of the concept of economies of scale, see E. MANSFIELD, MICROECONOMICS: THEORY AND APPLICATIONS, 158-62 (4th ed. 1982).

161 J. ELROD & J. WILKINSON, supra note 24, at 85.

162 A representative from Standard & Poor's summarized its standards as follows:

A hospital's earning performance, financial structure, business mix, and operating efficiency are all a function of management. Management largely determines the hospital's future. The financially and operationally strong organization will continue to prosper. For hospitals, now more than ever, the key to survival, a better credit rating, and access to capital is a strong management team.

J. ELROD & J. WILKINSON, supra note 24, at 85, quoting G. WAGNER, INVESTMENT CAPITAL: ACCESS NOW AND INTO THE FUTURE, SPEECH, STANDARD & POOR's CORP. (1984).

163 Corporate reorganizations fall into three functional categories:

  1. 1)

    1) Combinations, in which two or more corporate entities are merged or consolidated into one;

  2. 2)

    2) Separations, in which a single entity is divided into two or more; and

  3. 3)

    3) Simple adjustments, in which changes take place in an entity's capital structure, but which do not involve a combination or division of business entities.

See W. ANDREWS, FEDERAL INCOME TAXATION OF CORPORATE TRANSACTIONS, 70, 71 (1979).

164 The Internal Revenue Code contains a series of detailed provisions on the tax treatment of corporate reorganizations. In general, these code sections provide for nonrecognition of any gain or loss realized by a corporation or its shareholders as a result of certain readjustments of the corporate structure. See I.R.C. §§ 354, 355, 356, 361, 368 (Supp. 1986).

165 See supra text accompanying notes 93-96 for a discussion of CON programs.

166 Linter has identified five sources of increase in the aggregate market value of merging firms. They are:

  1. 1)

    1) Gains from favorable tax treatments;

  2. 2)

    2) Gains from greater leverage and or lower borrowing costs due to size;

  3. 3)

    3) Gains from merging imperfectly correlated income streams to preserve expected returns with reduced risk;

  4. 4)

    4) Gains from changes in accounting approaches; and

  5. 5)

    5) Automatic increases in earnings per share from price-earnings ratio differences.

Linter, Expectations, Mergers and Equilibrium in Purely Competitive Securities Markets, AMER. L. REV. 101 (1971), reprinted in V. BRUDNEY & M. CHIRELSTEIN, supra note 147, at 509.

167 Cohades, , Hospital Capital Formation in the 1980's: Is There a Crisis?, 8 J. HEALTH, POL., POL'Y & L. 164, 167 (1983).Google Scholar

168 Id.

169 For a discussion of dividend policy, see generally Miller, & Modigliani, , Dividend Policy, Growth, and the Valuation of Shares, 34 J. Bus. 411–433 (1961)CrossRefGoogle Scholar; Black, , The Dividend Puzzle, 2 J. PORTFOLIO MAN. 5–8 (1976)CrossRefGoogle Scholar; Black, & Scholes, , The Effects of Dividend Yield and Dividend Policy on Common Stock Price and Returns, J. FIN. ECON. 1–22 (1974).CrossRefGoogle Scholar All reprinted in R. POSNER & K. SCOTT, ECONOMICS OF CORPORATION LAW AND SECURITIES REGULATION (1980).

170 Cohades, supra note 167, at 170. “Net lease financing” is a tax shelter device involving a “long-term lease (usually 20 to 25 years) under which the tenant agrees to pay a fixed minimum rent and also all operating expenses, including real estate taxes, insurance, utilities, and cost of repairs and maintenance.” R. NESSEN, THE REAL ESTATE BOOK 260 (1983). “Wrap-around mortgaging” involves:

‘a second mortgage securing a promissory note, the face amount of which is the sum of the existing first mortgage liability plus the cash or equity advanced by the lender. The wrap-around borrower must make payments on the first mortgage debt to the wrap-around lender, who, as required by the wrap-around agreement, must in turn make payments on the first mortgage debt to the third party, the first mortgagee. If the wrap-around mortgagee should fail to perform his obligation to pay off the first mortgage, the wrap-around agreement normally gives the non-defaulting mortgagor the right to pay the interest and principal owing on the first mortgage, reducing his wrap-around obligation pro tanto.’

G. NELSON & D. WHITHAN, REAL ESTATE FINANCE LAW 297 (2d edition 1985), quoting Comment, The Wrap-Around Mortgage: A Critical Inquiry, 21 UCLA L. REV. 1529, 1529–30 (1974).Google Scholar

‘Floating-issues’ are securities which do not carry a fixed rate of interest but instead, one which varies depending upon existing market rates. See BLACK'S LAW DICTIONARY 328 (5th ed. 1983). ‘Letters of credit’ are ‘instrumens by which a bank substitutes its own credit for that of individuals, firms or corporations, to the end that. . . trade may be more safely, economically and expeditiously conducted.’ G. MUNN's ENCYCLOPEDIA OF BANKING AND FINANCE 519 (7th banks and the larger life insurance companies to corporations unable or unwilling to run the risks of captial market underwriting of new capital for such purposes as increase in working capital, purchase of equipment or other fixed assets, and other capital purposes. . . . Term loans are characterized by regular periodic amortization of a fixed principal amount, followed large “balloon” final maturity, usually in the last year. Interest rates are graduated according to the serial maturities, and on the average for the full term compare with capital market flotations of similar maturity.” G. MUNN's ENCYCLOPEDIA OF BANKING AND FINANCE 892 ed. 1973).

171 Cohades, supra note 167, at 170.

172 See, e.g., Omenn, & Conrad, , Sounding Board-Implications of DRGs for Clinicians, 311 NEW ENG. J. OF MED. 1314 (1984)CrossRefGoogle Scholar (noting that DRGs encourage surgical over medical treatment); Bendix, “Demarketing” Speech Embroiled in Controversy, 12 MODERN HEALTH CARE 21 (Jan. 1982) (discussing AHA comments on discouraging “unprofitable” patients). Cf. Understanding Massachusetts’ New Hospital Law, STAYING ALIVE 1, 11 February 1983 (noting refusal to care for indigents under the Massachusetts cost control program).

173 In a medical malpractice tort case, in arriving at a relevant standard of care, professional custom is dispositive, so that negligence is often predicated on deviance from custom. See generally EPSTEIN, GREGORY, & KALVEN, CASES AND MATERIALS ON TORTS, 196-98 (4th ed. 1984). At least one author has recognized the possibility of a lessened standard of care resulting from financial measures. Comment, California Negotiated Health Care: Implications for Malpractice Liability, 21 S.D.L. Rev. 455, 464 (1984).Google Scholar