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Assessing the Financial Health of Hospitals
By Jack Needleman, Ph.D.
Editor's Note: Public hospitals, academic medical centers, and other hospitals provide a substantial amount of health care to uninsured, Medicaid, and other vulnerable patients. Although treating such patients may be central to these institutions' core mission, doing so may pose problems for their financial solvency, as much of this care may be uncompensated. In this chapter, Jack Needleman provides an introduction to the basic financial terms, data sources, and measures needed to understand the financial health of safety net hospitals.
Measuring the Financial Health of Safety Net Hospitals
Complications of Assessing Hospital Financial Health
Implementing Common Measures of Financial Status
This chapter describes methods for assessing the financial health of hospitals and safety net institutions. The examples used are drawn principally from hospitals, but the principles and approaches apply to clinics and other safety net providers. The chapter discusses:
- What is meant by financial health of institutions.
- Alternative approaches and measures available to assess hospital financial health.
- How these approaches and measures can be implemented using alternative data.
- Issues and complications in interpreting this data.
The goal of this chapter is to enable the reader to identify potential measures, data sources for implementing these measures, and conceptual and accounting issues in implementing and interpreting these measures. It is not intended to be a primer on accounting or financial management, although accounting and financial management concepts are discussed (Lane, Longstreth, and Nixon, 2001).
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Measuring the Financial Health of Safety Net Hospitals
One definition of the financial health of an institution is its ability to continue to operate as a going concern. There are three dimensions to this ability:
- Revenues and expenses must be in balance.
- Adequate resources (that is, capital) must be available to deliver services and finance operations both in the short and long term.
- The institution must be able to replenish or renew itself.
The first two dimensions are explicitly captured in a variety of measures; the third, ability to renew, is generally inferred from a range of data.
Revenues and Expenses
The first dimension of financial health is that revenues and expenses be in balance. More generally, we should expect that revenues at least match expenses ("break even"), and most financial analysts would expect an institution's revenues to exceed expenses, so as to finance increases in working capital and build funds as a cushion for a financial downturn and for renewal or expansion. The standard measure of profitability is margin:
(Revenues - Expenses)
Hospitals are multiproduct firms, with multiple sources of revenues. They provide inpatient and outpatient health care services, and they may provide other services to those using the hospital (parking, cafeteria, and so on) or to outside organizations (selling laboratory services, laundry, or catering services, for example, to other hospitals or health care providers). Some hospitals are involved in medical or related education, whereas others conduct research. Some receive philanthropy, government subsidies, or interest and investment income that may not be directly tied to any operational activities. Analyzing the margin requires specifying the level at which revenues are being aggregated and allocating expenses to match the revenues.
There are three common measures of margin. The broadest measure is total margin, which is computed as follows:
(Total revenues from all sources - Total expenses)
Total revenues from all sources
The second measure is operating margin. In computing operating margin, only revenues from operational activities, whether patient care or other, are considered, and expenses associated with nonoperating revenues, such as the costs of managing investments, are subtracted from expenses.
The third frequently used measure is patient care margin, the margin on what is considered the core business of the hospital or health care institution. For this measure, only revenues for patient care services are considered, and these are compared with operating costs for patient care services. Revenues are usually recorded separately for each activity that bills for its services (designated as "revenue centers" in most reporting systems), and calculating estimated patient care revenues is relatively straightforward.
Estimating patient care expenses is more difficult. Some expenses are incurred within patient care units, but many expenses, including such activities as housekeeping, utilities, insurance, and central administration, are aggregated at levels above revenue centers, sometimes at the hospital level. These operating expenses must be allocated among patient care and other operations. Cost allocation, while subject to extensive accounting rules, involves a substantial degree of discretion. In addition, outside analysts of hospital performance often must rely on imprecise allocations based on aggregate data available in publicly available sources. Operating expenses might, for example, be allocated to patient care based on the proportion of operating revenues derived from patient care. Margin analysis of a subset of hospital activities may thus have more focus, but may also involve less precision.
The analysis of patient care margins may be further extended to examine the margins from each payer. Although hospitals set up schedules of charges for each service they provide, few insurers pay these rates. The Federal Medicare and State Medicaid programs establish the amounts that they pay by regulation, except in a few places where the Medicaid rates are established through negotiation. Most insurers, particularly those with any volume in a community, will negotiate rates with hospitals. These may be established as a percentage of the charges that hospitals bill, fixed payments per day, per admission, or by diagnosis, or on some other basis. Small insurers who do not have a negotiated rate with a hospital and uninsured patients will be billed the full charges for care received, although the amount actually paid may be subject to individual negotiation.
Because of the variety of negotiated rates, the profit margin for each payer will differ. Computing these margins requires having the amount of revenue from the payer and the patient care expenses allocated to that payer. Expenses are typically allocated to a given payer based on the proportion of the charges billed to that payer. That is, if based on the nominal schedule of charges (which, as noted above, virtually no one actually pays), Medicaid patients were billed for 10 percent of the total charges, then 10 percent of the patient care expenses would be allocated to Medicaid. Within the hospital, this estimate can be made at the department level, with Medicaid or other payers' share of charges in departments such as laboratory, radiology, and intensive care units being used to allocate the expenses of those departments. However, for those analyzing margin using publicly available data, often only hospital-level aggregate charges are available to make this allocation.
In the analysis of margins described above, the denominator is revenues, and profits or margin is defined as a proportion of revenues. An alternative measure, markup or the markup ratio, is obtained by using the following formula:
(Revenues - Expenses)
This is a direct measure of how much the hospital's earnings exceed or fall short of covering its expenses. For most analysis of safety net institutions, the measure of interest is net markup, based on net revenues, rather than gross markup, based on billed charges.
One factor that can complicate the interpretation of margins and other measures of financial health is the use of accrual accounting for revenues and expenses. A cash accounting system records expenses as they are paid and revenues as they are received. Most organizations use accrual accounting, in which revenues and expenses are charged against the fiscal year to which they apply, rather than the year in which they are incurred. Thus, a payment for insurance made in 1 fiscal year that covers periods of 2 fiscal years will be allocated between the years. Revenues that will be received from Medicare, Medicaid, or other third-party payers will be estimated based on current charges and projected contractual adjustments pending final settlement with the payer, and bad debt and charity write-offs will likewise be estimated, if final payment has not been received. Once a fiscal year is closed, if the revenues or expenses differ from projection, the difference will often be recorded in the current fiscal year rather than restating the earlier year report.
For example, if a hospital has overestimated its Medicare revenues for fiscal year (FY) 2000, and the hospital does not reach a final settlement with the Centers for Medicare & Medicaid Services (CMS) until FY 2002, in FY 2002, it will reduce its Medicare revenues by the difference between the final FY 2000 and estimated FY 2000 Medicare revenues. This difference will be subtracted from its estimate of FY 2002 Medicare revenues.
It is clear from this description that in an accrual system the revenues and expenses both contain estimates. Correcting these estimates as more accurate data become available will change figures in subsequent fiscal years. Furthermore, hospitals exercise control over when corrected data will become available (for example, by seeking to speed or delay settlement with third-party payers) and some discretion over whether the estimates of projected revenues are high or low. Both of these factors can lead to substantial year-to-year swings in margins that are larger than the true year-to-year variations in revenues or expenses.
Measures of Capital and Adequate Resources
Revenues and expenses are reported for a specific time period, generally 1 year, and represent the flow of funds to and from the hospital during that year. They are generally drawn from a revenue and expense or income statement. Other measures present a picture of a hospital's financial health at a given point in time. These include its cash on hand and other assets, both physical (such as plant and equipment) and financial (such as investments and revenues expected but not yet received). They also include its liabilities and debts. The difference between assets and liabilities is the equity in the hospital, and it may be positive (more assets than liabilities) or negative. Assets and liabilities are reported on the hospital's balance sheet.
Both assets and liabilities are classified as short or long term. Short-term assets are cash, those that can be immediately converted to cash, or those, such as accounts receivable, which the hospital expects to have in hand within the next 12 months. Short-term liabilities are those that must be paid within a 12-month period, such as money due to vendors for goods and services received but not yet paid for. Measures of whether a hospital can meet its short-term liabilities are said to determine the hospital's liquidity.
Long-term assets include physical plant and long-term investments. Long-term liabilities are those that will not be paid within the next year but are due after that, such as loans or bonds that will be paid over several years. Whether a hospital can meet its long-term liabilities is said to be a good measure of the institution's solvency.
Capital costs can be accounted for in two ways. One is by measuring the cash spent to pay for the capital, or the schedule of payments. The second is by measuring depreciation, which is an estimate of the wear and tear or proportion of useful life of the asset that has been consumed. The two sets of charges need not match over time. For example, if a piece of equipment has a useful life of 10 years and is bought with cash, the equipment will be entered as an asset at its full price, and the cash used to purchase the equipment will be drawn down from the cash on the balance sheet. If the hospital depreciates equipment using straight line accounting methods, each year for 10 years it will record one-tenth of the price as a depreciation charge on its revenue and expense statement, and reduce the asset's value on its balance sheet by one-tenth of the purchase price. After 10 years, the asset will have no balance sheet value, even if the hospital continues to use it. In this case, the cash outflow and the charges for the equipment on the revenue and expense statement do not match, with the cash outlay preceding the depreciation charges of the equipment on the revenue and expense statement.
If the hospital borrows the money to pay for the equipment, with one-tenth of the principal due each year, the cash out will match the depreciation. If the hospital takes a loan that defers the principal payments to later years, the depreciation will be higher than the actual cash outlays in the early years and lower in the later years. Level payment loans, in which the payment is fixed for the entire loan period, with interest payments higher and principal payments lower in the early years, lead to depreciation being higher than actual cash outlays for principal in those early years, and are a common form of loan for large equipment and physical plant.
Because depreciation and cash outlays for capital need not match over time, it is critical to consider both depreciation-based measures and cash or cashflow-based measures in examining the institution's financial health. A hospital with large level-payment loans will have more cash coming in and larger margins on a cash flow basis than it appears on its revenue and expense statement. At the same time, it will have long-term liabilities to repay principal that will be larger than later depreciation charges, and a depreciation-based projection may underestimate the hospital's cash needs. If the institution treats the cash coming in early in this cycle as discretionary income, it may be short of funds to fully pay the loan in later years.
Hospitals differ in scale. A 1,000-bed hospital will have both higher anticipated receipts and more that it owes to vendors than a 100-bed hospital. To accommodate the differences in scale, measures of financial health based on assets and liabilities (like margins) are presented as ratios that can be consistently interpreted across hospitals of different sizes. Many financial ratios and several publications such as the Ingenix Almanac of Hospital Financial & Operating Indicators (Petrie, 2003) present data on the average and range of these indicators for hospitals of different size, ownership, location, and so forth.
Ability of the Hospital to Renew Itself
Financial indicators examine current or recent financial performance, including the ability to pay for current operations and existing capital. They do not look forward to assess the ability to finance future operations or replace capital. In general, higher margins and more free cash flow indicate a stronger financial position and imply a greater ability to finance expansion. Other ratios, described in accounting texts, that also provide an indication of ability to finance additional capital or replace existing physical plant include: Free Operating Cash Flow to Revenue, Free Operating Cash Flow, Growth Rate in Equity, Debt Service Coverage, Equity Financing Ratio, and Replacement Viability Ratio. Credit ratings can also provide an independent assessment of the ability of the hospital to obtain and pay off debt.
Cash flow figures prominently on the list above and in the solvency measures. Cash is necessary to pay for operations and capital. Financially strong institutions will generate the cash they need to sustain themselves through operations. Financially weak institutions will generate cash through either explicit borrowing or implicit borrowing by lengthening the time they take to pay their bills. If depreciation is larger than principal payments because principal payments are being deferred, financially strong institutions will build reserves to cover these future outlays. Financially weak institutions will not build these reserves. Assessing these issues requires examining cash flows of hospitals the sources and uses of funds on a cash basis.
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Complications of Assessing Hospital Financial Health
There are several dimensions to hospitals and health care institutions that complicate assessing their financial health. Some of these are general issues, affecting both safety net and non-safety net providers, whereas others are specific to assessing the financial status of safety net hospitals.
Common Problems in Assessing Hospital Financial Health
Assessing hospital financial health can be problematic because of the mix of operations, the multilevel nature of the modern hospital, the mix of payers, and the mix of ownership. Each of these problems is addressed in greater detail below.
Mix of Operations
As noted, hospitals are multiproduct entities, often providing inpatient and outpatient care, and sometimes providing long-term patient care, education, and research. Each of these activities has its own stream of revenues, whereas the production costs for many activities are joint. Management decisions about what areas to expand or contract, which can be critical for safety net providers facing tight financial circumstances, often are influenced by assessments of which activities are profitable and which are losing money. These decisions are very sensitive to the allocation of expenses to specific activities. As noted, there is substantial discretion in the allocation of expenses, particularly those not incurred in a specific patient care or revenue center.
It is useful to think of two categories of expenses. The first is direct expenses incurred in specific revenue centers related to the production of the services of each center. These might include nurses salaries, supplies, laboratory, drug, radiology, and therapist services. The second category is expenses incurred in running the institution that cannot be tied directly to specific patients, but which must be allocated to patient care. These include utilities, housekeeping, employee benefits, administration, physical plant, and equipment costs. These are the costs most subject to allocation.
In addition to the distinction between costs incurred directly in the revenue center and overhead costs that must be allocated to revenue centers, a distinction must also be drawn between costs that vary directly with the volume of services and those that are fixed and will be incurred at a given level regardless of volume. Drug costs or floor nursing will vary directly with volume; ward clerks, housekeeping costs, and central administration will not. (The distinction is not rigid. Some costs that are fixed in the short term can be adjusted in the long term by reorganizing care. For example, in the short term, housekeeping costs may be fixed by the number of units open. If volume falls and the hospital can close units, housekeeping can be reduced.)
Economists distinguish between marginal costs, the costs that must be incurred to treat one additional patient, and fixed costs. To remain a going concern, an institution must cover both its marginal and fixed costs from all its revenues. But profitability judgments about individual services can differ depending on whether the service is covering its marginal costs or its marginal costs plus its allocated share of fixed or indirect costs.
The Multilevel Nature of the Modern Hospital
In addition to being multiproduct firms, hospitals are multilevel organizations. Some hospitals are parts of chains or systems that own several institutions. The chain or parent company may provide services to the hospital and charge back for these. Analyzing operating costs under these circumstances, the hospital may look low in some areas, simply because these expenses are incurred by the parent organization and high in areas such as central administration if the charges are assigned to these cost centers.
Likewise, many nonsystem hospitals now either directly own affiliates or are owned by a holding company that also owns affiliated organizations. These organizations may include physician practices or physician office buildings, home health agencies, managed care organizations, or entities that self-insure the hospital, among other activities. These affiliated organizations may charge the hospital for services or may be charged by the hospital for services. The financial arrangements can influence the relative profitability of the different entities, including the hospital. Assets, including those to support charity care, may be owned or held by the parent organization, rather than the hospital. Financial data and an integrated financial report may not be available for the overall operation.
Mix of Payers
Hospital patients may have insurance from Medicare, Medicaid, private insurers, or health maintenance organizations, or have no insurance and be responsible for their own hospital bills. Each third-party payer establishes either unilaterally or through negotiation the basis on which it pays hospitals. For some payers, the approaches are straightforward—they pay a fixed amount per admission or per day or a percentage of charges. For others, notably Medicare and Medicaid, the payment rules can be complex. Furthermore, special revenue streams from Medicare and Medicaid, such as funds for disproportionate share payments or for medical education, may be recorded in financial reports in nonstandard places.
Mix of Ownership
Hospitals can be owned by for-profit corporations or partnerships, nonprofit corporations, or government at the local, State, or Federal level. Each type of ownership can lead to variations in accounting and financial reporting. For-profit hospitals are typically in multihospital systems, and the problems cited above with respect to central system versus hospital-level charging are relevant for analyzing expenses.
Government ownership and organization also can lead to unique financial and operating arrangements. In for-profit and nonprofit hospitals, physicians are most likely not employed by the hospital. Although this is also the case for many government-owned facilities, in many cases the physicians practicing at these hospitals will be employees of the local government. They can be organized into a separate entity that bills for their services, or they can be employees of the hospitals with their costs built into the hospital's costs and revenues for their services credited to the hospital as well. In this latter case, both the expenses and revenues per patient will appear higher in the government hospital.
It can also be the case that some expenses associated with the hospital do not appear in the hospital financial reports. When government bonds are used to finance capital construction, for example, all the assets of the hospital may not be reported on available hospital financial reports. Likewise, pension liability for hospital employees may not be carried on the hospital financial statements, but rather on the statements of universities or government entities with which the hospital is affiliated.
Problems Specific to the Safety Net: Accounting for Care for Those Who Cannot Pay for Themselves
As noted, government hospitals, especially those owned by city or county governments, may be subject to special accounting treatment that leaves some of their costs unreported on their revenue and expense statement or balance sheet, or results in apparently higher expenses. In addition to these issues, safety net hospitals vary widely in how they account for charity care and the funds they receive to help pay for such care.
One of the key services safety net hospitals and other institutions provide is care for those who cannot fully pay for their own care. This may include the uninsured and those who have insurance but whose insurance has substantial deductibles or coinsurance or will not pay for needed services. It may not include all the uninsured, as the uninsured who can afford it may be expected to pay for some or all of their care. There is a clear distinction drawn in principle between charity care, which is rendered to patients with no expectation that they will pay, and bad debt, which is care rendered with an expectation of payment but for which no payment was received. Analysis of hospital financial reports indicates, however, that this distinction is blurred in practice. Some hospitals report virtually no bad debt; others virtually no charity care. As a result, analysts have routinely added these two amounts together to create an estimate of "uncompensated care," care for which the hospital receives no direct payment from the patient or third-party insurer.
Safety net hospitals may have a variety of potential sources to fund such care. They may receive grants, special program funds, or general subsidies from government entities. They may receive contributions from the public or from private organizations to provide such care, or may have received capital contributions to create an endowment to fund such care. In the absence of such funding streams, they will use profits earned on other patients ("cost shifting") or profits from other operations to underwrite such care.
Hospitals vary widely in how they report subsidies or grants and how they charge the costs of charity care against these funding streams. Among the options are:
- Treat the funds as the equivalent of a third-party payer. Charging the care of specific patients against these funds would reduce the level of charity or bad debt reported by the hospital.
- Report charity and bad debt as incurred. This option consists of three possible reporting methods:
- Report the subsidies and grants as another source of patient care revenues.
- Report the subsidies and grants as other operating revenue, but not patient care revenue. Relative to the approaches above, patient care margins will be lower under this approach but operating and total margins will be the same.
- Report subsidies or funds from endowment or contributions as nonoperating revenue. Relative to the approaches above, patient care margins and operating margins will be lower, but total margins will be comparable.
The choice of approach is partly driven by how closely the funding is tied to specific patients. California, for example, is one of a substantial number of States that require hospitals to submit an annual financial and statistical report. The report includes a revenue and expense statement. In the revenue statement, hospitals report gross patient care revenues, deductions from those revenues to estimate net patient care revenues, and nonoperating revenues. Separate schedules provide for reporting charges by revenue center for a selected group of payers. In the current version of the report, provisions for bad debt and charity discounts are reported as deductions from patient care revenue. In the same schedule, Medicaid disproportionate share payments for hospitals providing high levels of care for the uninsured and restricted donations and subsidies for charity care are to be reported as credits augmenting patient care revenues. County allocations of tax revenues and general county appropriations, by contrast, are reported as nonoperating revenues.
Even within a single reporting system, hospitals vary in which treatment they use. As part of a reform of Medicaid in California in the 1980s, the State ended its provision of Medicaid for adults on general assistance and sent the funds that were being spent on the program to counties as block grants to serve the same population. The State, which collects financial data from each hospital did not change its reports, and hospitals appear to have accounted for funds it received through this source as another source of patient care revenue, option 2. In 1993, the State changed the reporting form to add the county indigent care programs to the list of programs for which revenues, patient days, and admissions were to be reported. Some, but not all, county hospitals in the State attributed care for all their uninsured patients to this program. They reported no charity care, although in the past they had reported substantial amounts. The net burden of these patients needed to be estimated by subtracting the billed charges for the indigent care program from the reported revenues. Other county hospitals, however, continued to report substantial charity write-offs.
Accounting rule changes have also led to variations in how hospitals report charity and bad debt. Currently, on their audited statements, hospitals will add bad debt and charity care to their expenses and not report charges for this care as part of their gross patient care revenue. In the past, and in many current State reporting systems, the charges for charity and bad debt were included in gross patient care revenue, and then explicit write-offs were reported for bad debt and charity. This change in accounting does not change margins where the denominator is net revenues, since these charges would be netted out in any case. However, it can bury estimates of charity care and bad debt in footnotes to the accounting statement. In addition, markups will appear lower, since the revision raises the amount being reported as expenses.
For those trying to assess the financial health of safety net hospitals, two implications can be drawn from the discussion above. First, understanding the sources of data being analyzed and the institution being studied is critical. Hospital financial reports, even those standardized by external regulators, leave hospitals with substantial discretion in completing the report. Constructing meaningful financial data requires an understanding of how the institution has exercised its discretion in reporting standard elements like charity care and bad debt and whether the institution has unique variations in its expenses, such as having a large salaried physician staff or capital expenses paid by other entities.
Second, because of the limitations noted above, conducting longitudinal analysis that looks at change over time within the same institution is advisable. As the example of the change in reporting in California makes clear, it is still necessary to examine the reporting closely. But longitudinal analysis can allow the analyst to examine trends and large year-to-year changes in a given line item and can provide a warning that reporting may have changed.
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