Chapter 1: Financial Information and the Decision-Making Process Short Answer (provide a short answer to each posed question below) 1. What are the primary responsibilities of the financial manager? 2. What are primary uses of financial information? 3. What is the difference in the financial management responsibilities of the controller and treasurer? 4. What is the objective of investor-owned (for–profit) firms? 5. Is profit maximization the same thing as shareholder wealth maximization? 6. What are the objectives of not-for-profit (NFP) firms? 7. What are the three primary forms of legal business organization? What are some of the advantages and disadvantages of each form? 8. What is the difference in ownership between a sole proprietorship, a partnership, and a corporation? True/False (write true or false below each question) 9. One of the advantages of a nonprofit organization compared with an investor-owned company is that the investor-owned company is subject to federal income taxes. 10. The earnings of a standard (“C”) corporation can be subject to double taxation. 11. Governmental health care organizations are able to raise funds through equity investments. CHAPTER 3 FINANCIAL ENVIRONMENT OF HEALTH CARE ORGANIZATIONS Short Answer 1. What is the main difference between the fee-for-service and capitation reimbursement methods? 2. What is the primary distinction between prospective payment and retrospective payment? True/False 2. Some benefits under Medicare part A include hospital stays, skilled nursing care, and home health care. 3. All outpatient procedures have an assigned Ambulatory Payment Classification (APC) code. 5. A hospital that is caring for a Medicare patient on an inpatient basis generally can increase its reimbursement by providing additional services. 6. A hospital that is caring for a Medicare patient on an outpatient basis generally can increase its reimbursement by providing additional services www.acetxt.com www.acetxt.com ESSENTIALS OF HEALTH CARE FINANCE EIGHTH EDITION William O. Cleverley, PhD Chairman and Founder Cleverley & Associates Worthington, Ohio James O. Cleverley, MHA President Cleverley & Associates Worthington, Ohio www.acetxt.com World Headquarters Jones & Bartlett Learning 5 Wall Street Burlington, MA 01803 978-443-5000 info@jblearning.com www.jblearning.com Jones & Bartlett Learning books and products are available through most bookstores and online booksellers. To contact Jones & Bartlett Learning directly, call 800-832-0034, fax 978-443-8000, or visit our website, www.jblearning.com. Substantial discounts on bulk quantities of Jones & Bartlett Learning publications are available to corporations, professional associations, and other qualified organizations. 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Description: Eighth edition. | Burlington, Massachusetts : Jones & Bartlett Learning, [2018] | Includes bibliographical references and index. Identifiers: LCCN 2016047263 | ISBN 9781284094633 Subjects: | MESH: Costs and Cost Analysis | Financial Management | Health Services—economics Classification: LCC RA971.3 | NLM W 74.1 | DDC 362.11068/1—dc23 LC record available at https://lccn.loc.gov/2016047263 6048 Printed in the United States of America 21 20 19 18 17 10 9 8 7 6 5 4 3 2 1 www.acetxt.com © A1Stock/Shutterstock Contents Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi Content of the Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . vii About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii Contributor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix Chapter 1 Financial Information and the Decision-Making Process. . . . . . . 1 Information and Decision Making. . . . . . . . . . . . . . . . . . . 4 Uses and Users of Financial Information. . . . . . . . . . . . . 5 Financial Organization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Forms of Business Organization. . . . . . . . . . . . . . . . . . . . . 8 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Chapter 2 Billing and Coding for Health Services. . . . . . . . . . . . . . . . . . . . . . . . 11 Generating Healthcare Claims . . . . . . . . . . . . . . . . . . . . . Scheduling and Registration. . . . . . . . . . . . . . . . . . . . . . . Provide Services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Medical Documentation and HIM/Medical Records. . . Charge Entry and Charge Master. . . . . . . . . . . . . . . . . . . Billing and Claims Preparation . . . . . . . . . . . . . . . . . . . . . Claims Editing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Claim Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix 2-A Sample UB-04 Form and Sample CMS-1500 Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 14 14 15 19 25 26 27 27 29 Chapter 3 Financial Environment of Healthcare Organizations . . . . . . . . 31 Financial Viability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sources of Operating Revenue. . . . . . . . . . . . . . . . . . . . . Healthcare Payment Systems . . . . . . . . . . . . . . . . . . . . . . Medicare Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Medicare Payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 34 36 40 41 52 Chapter 4 Legal and Regulatory Environment . . . . . . . . . . . . . . . . . . . 97 Part I. Knowledge of the Law and Regulations Is an Essential Part of Healthcare Financial Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Part II. Primary Regulatory Issues Confronting Healthcare Organizations Today . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Legal Audits and Investigations. . . . . . . . . . . . . . . . . . . 126 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128 Chapter 5 Measuring Community Benefit . . . . . . . . . . . . . . . . . . . . . . . 131 Tax Exemption Status. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Community Benefit Areas. . . . . . . . . . . . . . . . . . . . . . . . . The Community Value Index®. . . . . . . . . . . . . . . . . . . . . Estimating Financial Benefits in Not-for-Profit Healthcare Firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Estimating Financial Benefits Provided by Not-for-Profit Healthcare Firms. . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix 5-A Schedule H Form. . . . . . . . . . . . . . . . . . . 132 133 135 139 142 144 147 Chapter 6 Revenue Determination. . . . . . . . . 151 Payment Methods and Their Relationship to Price Setting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Methods for Controlling Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Generic Principles of Pricing . . . . . . . . . . . . . . . . . . . . . . Price Setting for Healthcare Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Justifying Healthcare Firm Prices. . . . . . . . . . . . . . . . . . Health Plan Contract Negotiation. . . . . . . . . . . . . . . . . Health Plan Payment Schedules. . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 153 154 155 158 163 166 168 iii www.acetxt.com iv Contents Chapter 7 Health Insurance and Managed Care . . . . . . . . . . . . . . . . . 171 Chapter 12 Financial Analysis of Alternative Healthcare Firms. . . . . . . . . . . . . . 285 HMO and Managed-Care Development. . . . . . . . . . . Integrated Delivery Systems . . . . . . . . . . . . . . . . . . . . . . Paying Providers in a Managed-Care Environment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Setting Prices in Capitated Contracts. . . . . . . . . . . . . . Medicare and Medicaid Risk Contracts. . . . . . . . . . . . Legal and Regulatory Issues. . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-Term Care Facilities and Nursing Homes. . . . . Medical Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Health Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172 177 181 183 188 189 190 Chapter 8 General Principles of Accounting. . . . . . . . . . . . . . . . . . . . 195 Financial Versus Managerial Accounting . . . . . . . . . . Principles of Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . Accrual Versus Cash Accounting . . . . . . . . . . . . . . . . . . Fund Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conventions of Accounting. . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 197 203 206 207 207 Chapter 9 Financial Statements . . . . . . . . . . . 211 Organizational Structure. . . . . . . . . . . . . . . . . . . . . . . . . . Balance Sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statement of Operations (Revenues and Expenses). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statement of Changes in Net Assets . . . . . . . . . . . . . . Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix 9-A Case Example Audited Financial Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 213 217 219 220 220 225 286 294 297 301 Chapter 13 Strategic Financial Planning. . . . 307 Strategic Planning Process. . . . . . . . . . . . . . . . . . . . . . . . Developing the Financial Plan . . . . . . . . . . . . . . . . . . . . Integration of the Financial Plan with Management Control. . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 314 327 327 Chapter 14 Cost Concepts and Decision Making . . . . . . . . . . . . . . . . . . . . . . 335 Concepts of Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Break-Even Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336 343 348 354 Chapter 15 Product Costing. . . . . . . . . . . . . . . 361 Healthcare Cost Accounting. . . . . . . . . . . . . . . . . . . . . . Relationship to Planning, Budgeting, and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Costing Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Two Required Systems for Healthcare Costing. . . . . Relative Value Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362 364 365 368 371 373 Chapter 10 Accounting for Inflation. . . . . . . . 243 Chapter 16 The Management Control Process . . . . . . . . . . . . . . . . . . . . . . 377 Reporting Alternatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . Uses of Financial Report Information. . . . . . . . . . . . . . Case Example: Williams Convalescent Center. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Essential Elements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Budgeting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . Zero-Base Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benchmarking at the Departmental Level. . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244 246 247 254 378 382 391 392 393 Chapter 11 Analyzing Financial Position. . . . 259 Chapter 17 Cost Variance Analysis . . . . . . . . . 401 Developing an Effective Financial Reporting System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 Case Example: Harris Memorial Hospital. . . . . . . . . . . 264 Summary: Harris Case. . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 Cost Control. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investigation of Variances. . . . . . . . . . . . . . . . . . . . . . . . . Variance Analysis Calculations . . . . . . . . . . . . . . . . . . . . Variance Analysis in Budgetary Settings. . . . . . . . . . . 402 403 406 410 www.acetxt.com Contents Variance Analysis in Managed-Care or Bundled Payment Settings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417 Chapter 18 Financial Mathematics. . . . . . . . . 425 Single-Sum Problems. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426 Annuity Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434 Chapter 19 Capital Project Analysis . . . . . . . . 439 Participants in the Analytical Process. . . . . . . . . . . . . . Classification of Capital Expenditures . . . . . . . . . . . . . The Capital Project Decision-Making Process . . . . . . . . . . . . . . . . . . . . . . . Justification of Capital Expenditures. . . . . . . . . . . . . . . Discounted Cash-Flow Methods. . . . . . . . . . . . . . . . . . Selection of the Discount Rate. . . . . . . . . . . . . . . . . . . . Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440 443 445 447 448 452 453 453 Chapter 20 Consolidations and Mergers . . . . 457 Defining the Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . M&A Activity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overview of Theories of M&A Activity. . . . . . . . . . . . . Factors Affecting M&A Activity. . . . . . . . . . . . . . . . . . . . Why Do Mergers Succeed or Fail?. . . . . . . . . . . . . . . . . Valuations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458 459 462 463 463 464 470 v Chapter 21 Capital Formation. . . . . . . . . . . . . 475 Equity Financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-Term Debt Financing . . . . . . . . . . . . . . . . . . . . . . . Alternative Debt Financing Sources. . . . . . . . . . . . . . . More Recent Developments. . . . . . . . . . . . . . . . . . . . . . Early Retirement of Debt. . . . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477 480 485 490 493 495 Chapter 22 Working Capital and Cash Management. . . . . . . . . . . . . . . . . 503 Cash and Investment Management Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management of Working Capital. . . . . . . . . . . . . . . . . . Short-Term Bank Financing . . . . . . . . . . . . . . . . . . . . . . . Investment of Cash Surpluses. . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505 507 513 514 515 Chapter 23 Developing the Cash Budget . . . . . . . . . . . . . . . . . . . . . . 519 Determining Required Cash and Investment Reserves. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sources and Uses of Cash. . . . . . . . . . . . . . . . . . . . . . . . . Preparing the Cash Budget . . . . . . . . . . . . . . . . . . . . . . . Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520 522 523 526 Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557 www.acetxt.com © A1Stock/Shutterstock Preface This book represents the eighth edition of a book published originally in 1978, entitled Essentials of Hospital Finance. The text has evolved from a book containing seven chapters that dealt largely with understanding and interpreting hospital financial statements into a comprehensive financial text. The Eighth Edition has 23 chapters that cover most of the major areas of financial decision making that healthcare executives deal with on a daily basis. This book has been widely used over the years for many reasons. No other textbook so fully melds the best of current financial theory with the tools needed in day-to-day practice by healthcare managers. The textbook also encompasses virtually the whole spectrum of the healthcare industry, including hospitals, pharmaceutical companies, health maintenance organizations, home health agencies, skilled nursing facilities, surgical centers, physician practices, hospital departments, and integrated healthcare systems. Building on the strong foundation of the previous editions, the Eighth Edition introduces a number of enhancements. We have continued the inclusion of learning objectives at the beginning of each chapter. The learning objectives orient students to the material in the chapter and highlight some particular concepts and skills they should acquire by studying the chapter. Following the learning objectives, each chapter has a real-world scenario, which places the material in the chapter into the context of how the concepts and tools are used in practice. As with previous editions, each chapter concludes with a summary, followed by a large number of problems with related solutions. We believe the application of finance theory to real-world financial vi problems is the best way to accomplish learning. One of the primary enhancements of the Eighth Edition is the addition and updating of supporting data tables that provide tangible benchmarking information for students and practitioners in a larger number of areas. In summary, the chapters are designed to provide a framework for understanding healthcare financial issues as well as resources for implementing appropriate operational strategies. Before discussing the coverage of this book, it is important to understand the objective, which has not changed in more than 30 years. This text is intended to provide a relevant and readable resource for healthcare management students and executives. This is important to understand because Essentials of Health Care Finance is neither a traditional financial textbook nor a traditional management or financial accounting textbook. It attempts to blend the topics of both accounting and finance that have become part of the everyday life of most healthcare executives. This textbook does not provide as much coverage of cost of capital, capital structure, and capital budgeting topics as is present in most financial management textbooks. Essentials of Health Care Finance likewise does not provide major coverage of management control and budgeting systems that are present in most cost accounting and management accounting textbooks. Instead, this text tries to cover those types of financial decisions with which healthcare executives are most likely to be involved and provides the necessary materials to help them understand the conceptual basis and mechanics of financial analysis and decision making as they pertain to the healthcare industry sector. www.acetxt.com © A1Stock/Shutterstock Content of the Book The general basis of financial decision making in any business is almost always built on understanding three critical elements. First, most financial decisions are based on the use of accounting information. It is difficult to make intelligent decisions without having at least a basic understanding of accounting information. The user does not need to be a CPA, but it is essential to have a little understanding of what accounting is and is not. Second, all business units operate within an industry. The healthcare industry is a huge, complex industry that in many areas is unlike any other industry. Unless the student has an appreciation for these critical differences, major mistakes can be made. Finally, both accounting and finance are, in many ways, subsets of economics. The principles of economics form the conceptual basis upon which many types of business decisions are made. Chapter 1 provides an introduction to the role of information in decision making. Chapter 2, “Billing and Coding for Health Services,” recognizes the increasing importance that billing and coding play in financial decision making. Chapter 3 provides detailed information about the economic environment of healthcare firms. Specific coverage of payment methods for all types of providers, from hospitals to physicians, is included. Much of Chapter 3 was rewritten for this edition because payment rules are constantly changing. This edition covers current Medicare prospective payment systems for outpatient, home health, and skilled nursing facilities. Chapter 4 provides coverage of the numerous legal and regulatory provisions that affect today’s healthcare manager. Chapter 5, “Measuring Community Benefit,” provides expanded coverage of a topic that has gained more attention with the recent passage of healthcare reform. Nonprofit healthcare providers increasingly are being asked to document the community benefits they provide to their communities. Chapter 6, “Revenue Determination,” devotes specific attention to pricing and managed-care contract negotiations. Extensive coverage of managed care, its definition, concepts, organizational structures, and its financial implications is included in Chapter 7 and woven throughout the remainder of the text. Managed-care contracting is covered extensively in this edition along with coverage of “bundled payments.” Chapters 8, 9, and 10 cover financial reporting for healthcare firms. Specific discussions of accounting jargon are included. Perhaps of more importance, the accounting terms are related to healthcare issues, such as self-insurance of professional liability. Chapters 11, 12, and 13 cover financial analysis and financial planning. Chapter 11 has been thoroughly revised to reflect the best analytical tools and techniques available for financial statement analysis. Chapter 12 provides specific coverage of healthcare firms other than hospitals. Comparative financial and operating benchmark values are included for hospitals, and benchmark values are included for hospitals, health maintenance organizations, nursing homes, and medical groups. These benchmark values are used later to evaluate the financial position of a number of different kinds of healthcare firms. Chapters 14 through 16 cover cost finding, pricing, break-even analysis, and budgeting, and other managerial-care examples and concepts have been added in this edition. This edition also features more extensive coverage of relative value units. Chapter 17 includes material on the application of variance analysis techniques to both healthcare providers and payers. Chapters 18 through 21 include coverage of capital budgeting, consolidations, valuation, and ­capital formation topics as they pertain to healthcare firms. Special attention is given to capital formation in both taxable and voluntary nonprofit situations. Chapter 20 covers the increasingly important ­topics of consolidations, mergers, and acquisitions. In that chapter we offer detailed coverage of several ­valuation techniques. Chapter 21 includes extensive coverage of sources of capital used by healthcare providers, especially tax-exempt revenue bonds. Chapters 22 and 23 cover the topics of working capital management and cash budgeting. Building from the practical educational approach of prior editions, we believe that the enhancements made to the text will provide students and practitioners with a greater understanding of financial application in the complex and changing healthcare industry. vii www.acetxt.com © A1Stock/Shutterstock About the Authors William O. Cleverley, PhD, is the chairman and founder of Cleverley & Associates, which was started in January 2000. Before forming Cleverley & ­Associates, Dr. Cleverley was the president and founder of CHIPS (Center for Healthcare Industry Performance Studies). United Healthcare acquired the firm in March 1998, and Dr. Cleverley remained on staff as a part-time employee until December 1999. Dr. Cleverley is also professor emeritus at The Ohio State University where he taught courses in healthcare finance starting in 1973. Dr. Cleverley was the original author of Essentials of Healthcare Finance in 1978. In addition, he has authored over 250 articles on healthcare financial issues in a wide variety of both academic and professional journals. James O. Cleverley, MHA, is the president of Cleverley & Associates, where he has worked since viii September 2003. Mr. Cleverley consults with hospital and healthcare organizations to identify financial and operating opportunities, as well as related strategies for performance improvement. Before joining the firm, he directed a statewide health services program for a medical association. Mr. Cleverley has authored over 50 books and articles dealing with healthcare financial analysis and application, including the annual Community Value Index® hospital survey, the State of the Hospital Industry, and Essentials of Health Care Finance. He is a two-time recipient of the Healthcare Financial Management Association’s Yerger/Seawell Best Article award. Mr. Cleverley received his master of health administration from The Ohio State University in 2004. He received his bachelor of science in business administration from The Ohio State University in 1999. www.acetxt.com © A1Stock/Shutterstock Contributor Peter A. Pavarini, Esq. Squire, Sanders & Dempsey, LLP Columbus, Ohio ix CHAPTER 1 Financial Information and the Decision-Making Process LEARNING OBJECTIVES After studying this chapter, you should be able to do the following: 1. 2. 3. 4. 5. Describe the importance of financial information in healthcare organizations. Discuss the uses of financial information. List the users of financial information and their uses for it. Describe the financial functions within an organization. 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. First published in 1947, a small educational journal was created in an attempt 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 management control were important functions for the continued financial viability of their firms. Hospital accountants soon evolved into hospital financial managers, and so in 1968 the AAHA changed its name to the Hospital Financial Management Association (HFMA). The hospital industry continued to boom through the late 1960s and 1970s. Third-party insurance became the norm for most of the American population. Patients either received insurance through governmental programs Opener image: © A1Stock/Shutterstock 1 2 Chapter 1 Financial Information and the Decision-Making Process such as Medicare and Medicaid or obtained it as part of the 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 required 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 an important office was opened in Washington, DC, to provide critical input to both the executive 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 alternative 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 acknowledge 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. In 2015, HFMA had over 39,000 members in a wide variety of healthcare organizations (HCOs). The daily activities of their members still involve basic accounting issues—patient bills must still be created and collected, payroll 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 HCOs may still be charitable from a taxation perspective, but they are too large to depend upon 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 text 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 interpreted and used. It is written for individuals who are not experienced healthcare financial executives. Its aim 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 text: 1. 2. 3. Rapid expansion and evolution of the healthcare industry Healthcare decision makers’ general lack of business and financial background Financial and cost criteria’s increasing importance in healthcare decisions The healthcare industry’s expansion is a trend visible even to individuals outside the healthcare system. The hospital industry, the major component of the healthcare industry, consumes about 6.3% of the gross domestic product; other types of healthcare systems, although smaller than the hospital industry, are expanding at even faster rates. TABLE 1-1 lists the types of major healthcare institutions and indexes their ­relative size. Learning Objective 1 Describe the importance of financial information 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 makers involved directly in healthcare delivery—doctors, nurses, dietitians, pharmacists, radiation technologists, physical therapists, inhalation therapists—are medically or scientifically trained but lack education and experience in business and finance. Their specialized education, in most cases, did not include courses such as accounting. However, advancement and promotion within HCOs increasingly entails assumption of administrative duties, requiring almost instant, knowledgeable reading of financial information. Communication with the organization’s financial executives is not always helpful. As 3 Financial Information and the Decision-Making Process TABLE 1-1 Healthcare Expenditures 2008–2024* Type of Expenditure 2008 2010 2012 2014 2016 2024 Hospital care 728.9 814.9 898.5 978.3 1,087.3 1,755.1 Physician and clinical services 486.5 519.0 565.3 615.0 666.5 1,034.8 64.0 69.8 76.8 85.5 96.0 155.4 Dental services 102.4 105.4 110.0 114.5 123.5 183.4 Other health, residential, and personal care 113.5 128.5 140.1 153.0 167.1 251.1 62.3 71.2 77.1 81.9 91.7 156.0 Nursing care facilities and continuing care retirement communities 132.6 143.0 152.2 160.2 176.1 274.4 Prescription drugs 242.7 256.2 264.4 305.1 343.2 564.3 Durable medical equipment 34.9 37.0 41.3 44.2 48.2 76.9 Other non-durable medical products 49.5 51.2 53.7 58.4 62.6 98.7 2,017.3 2,196.2 2,379.4 2,596.1 2,862.2 4,550.1 29.4 30.5 34.2 39.9 45.5 82.2 Net cost of private health insurance 140.7 152.3 165.3 200.4 235.4 384.3 Government public health activities 71.5 75.5 74.8 78.7 86.2 137.7 2,258.9 2,454.5 2,653.6 2,915.3 3,229.3 5,154.2 44.0 48.7 48.0 45.9 48.7 72.0 111.2 101.0 115.7 118.9 124.7 198.9 2,414.1 2,604.1 2,817.3 3,080.1 3,402.6 5,425.1 14,718.6 14,964.4 16,163.2 17,418.9 18,821.2 27,648.0 16.4% 17.4% 17.4% 17.7% 18.1% 19.6% 5.0% 5.4% 5.6% 5.6% 5.8% 6.3% Other professional services Home health care Personal Health Care Government administration Health Consumption Expenditures Research Structures and equipment National Health Expenditures Gross Domestic Product National Health Expenditures to GDP Hospital Care to GDP *Values are in US$ in billions. Centers for Medicare and Medicaid Services, Office of the Actuary 4 Chapter 1 Financial Information and the Decision-Making Process a result, nonfinancial executives often end up ignoring f­ inancial 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 facilities. However, many board members, even those with backgrounds in business, are being overwhelmed by financial reports and statements. There are important distinctions between the financial reports and statements of business organizations, with which some board members are familiar, and those of healthcare facilities. Governing board members must recognize these differences if they are to carry out their governing missions satisfactorily. The increasing importance of financial and cost criteria in healthcare decision making is the third factor creating a need for more knowledge of financial information. For many years, accountants and others involved with financial matters have been caricatured as individuals with narrow vision, incapable of seeing the forest for the trees. In many respects, this may have been an 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 beginning-of-chapter scenario, 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 environmental conditions, personnel capabilities, and information quality. A major portion of the total financial management task is the provision of accurate, timely, and relevant information. Much of this activity is carried out through the accounting process. An adequate understanding of the accounting process and the data generated by it are thus critical to successful decision making. ▸▸ Information and Decision Making The major function of information in general and financial information in particular is to oil the ­decision-making process. Decision making is basically 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 essentially be no action; decision makers may decide to make no change from their present policies. It should be recognized, however, that both action and inaction represent policy decisions. FIGURE 1-1 shows how information is related to the decision-making process and gives an example to illustrate 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 information only when they are useful and appropriate to the decision. Many financial data never become information because they are not viewed as relevant or are unavailable in an intelligible form. For the illustrative purposes of the ambulatory surgery 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 example, an ASC might vary by size or by 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 that the projected results are actually obtained. 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 SEQUENCING EXAMPLE Information Financial forecasts of a proposed ASC Decision making Develop or not develop the ASC Implementation of decision ASC is developed Results Significant financial losses occur FIGURE 1-1 Information in the Decision-Making Process Uses and Users of Financial Information 5 TABLE 1-2 Results Matrix for the ASC Possible Events (Utilization Percentages) Alternative Actions 25% Usage 50% Usage 75% Usage Build the ASC $400,000 loss $10,000 profit $200,000 profit Do not build the ASC 0 profit 0 profit 0 profit failure to adhere to prescribed plans, and uncontrollable circumstances, such as a change in reimbursement, may obstruct planned results. Decision making is usually surrounded by uncertainty. No anticipated result of a decision is guaranteed. 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 approximately 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, do the following ■■ ■■ ■■ ■■ 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). One thing an information system does not do is 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 $400,000 per year, but it could provide a needed community service. Weighing these results and determining criteria is 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 information is important in the decision-making process. In some areas of decision making, financial information is especially relevant. For our purposes, we identify five uses of financial information that may be important in decision making: 1. 2. 3. 4. 5. Evaluating the financial condition of an entity Evaluating stewardship within an entity Assessing the efficiency of operations Assessing the effectiveness of operations Determining the compliance of operation with directives Financial Condition Evaluation of an entity’s financial condition is probably the most common use of financial information. Usually, an organization’s financial condition is equated with its viability or capacity to continue pursuing its stated goals at a consistent level of activity. Viability is a far more restrictive term than solvency; some HCOs maybe 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 nonprofit 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 6 Chapter 1 Financial Information and the Decision-Making Process example, information on the future financial condition of the unit is valuable. If continued losses from this ­operation are projected, impairment of the financial condition of other divisions in the organization could be in the offing. Assessment of financial condition also includes consideration of short-run versus long-run effects. The relevant time frame may change, depending on the decision under consideration. For example, suppliers typically are interested only in an organization’s short-run financial 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. Stewardship 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 employees’ 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 deterrence of well-designed accounting systems. Efficiency 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 introduced into the budgetary process. Thus a given nursing 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 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. Effectiveness Assessment of the effectiveness of operations is concerned with the attainment of objectives through production 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 quantitatively. Because measurement of effectiveness is difficult, 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. 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. Compliance Finally, financial information may be used to determine 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 organization is required to ensure compliance. Learning Objective 3 List the users of financial information and their uses for it. 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. 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 financial condition and (2) assessment of operational efficiency. Other uses may be irrelevant. The board wants to ensure that services are being provided efficiently and that the rates being established 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 structure of businesses in general and HCOs in particular. FIGURE 1-2 outlines the financial management structure of a typical hospital. Financial Organization 7 TABLE 1-3 Users and Uses of Financial Information Uses of Financial Information Users Financial Condition Stewardship Efficiency Effectiveness Compliance External Healthcare coalitions X X X Unions X X Rate-setting organizations X X X Creditors X X X Third-party payers X X X Suppliers X Public X X X X X Internal Governing board X X X X X Top management X X X X X Departmental management X Learning Objective 4 Describe the financial functions within an organization. Financial Executives International has categorized financial management functions as either controllership or treasurership. Although few HCOs have specifically identified treasurers and controllers 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 Senior Vice-President and Chief Financial Officer Controller Director of Financial Reporting and Disbursements Director of Patient Accounting Director of Patient Registration Director of Financial Analysis FIGURE 1-2 Financial Organization Chart of a Typical Hospital Director of Corporate Compliance and Risk Management Director of Material Management 8 Chapter 1 Financial Information and the Decision-Making Process with an example of the type of activities conducted within each of these functions: 1. 2. 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 (Chapter 2 and 6) (f) Protecting assets: Develop internal control procedures (g) Appraising economic health: Analyze financial statements (Chapters 11 and 12) 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) (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 ownership and organizational structures. In health care, there are three main types organizations (adapted from the American Institute of Certified Public Accountants’ Audit and Accounting Guide Health Care Organizations, 2015): ■■ ■■ ■■ Not-for-profit, business-oriented organizations For-profit healthcare entities • Investor-owned • Professional corporations/professional associations • Sole proprietorships • Limited partnerships • Limited liability partnerships/limited liability companies Governmental healthcare organizations These three main types of firms differ in terms of ownership structure. Additionally, different HCOs ­ require slightly different sets of financial statements. Not-for-Profit, Business-Oriented Organizations Not-for-profit HCOs are owned by the entire community rather than by investor–owners. Unlike its for-profit counterpart, the primary goal of a not-forprofit (also referred to as a nonprofit) organization is not to maximize profits, but to serve the community in which it operates through the healthcare services it provides. Not-for-profit HCOs must be run as a business, however, in order to ensure their long-term financial viability. With an annual budget of more than $20 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 by offering services that, from a financial perspective, might not be viable for forprofit firms. In addition to patient revenue in excess of expenses, 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 enjoys 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. Forms of Business Organization While for-profit firms are becoming increasingly prevalent in many sectors of health care, n ­ ot-for-­profits still dominate the hospital sector. About 80% of ­hospitals are not-for-profit. In the future, however, this sector may witness the growth of ­investor-owned organizations, owing mainly 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 management must strike a balance between their fiduciary responsibilities to the owners of the company and 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 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 requirements and regulation by the Securities and Exchange Commission (SEC). 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 few reporting requirements to the SEC. Large for-profit firms are typically publicly traded. However, there are exceptions. For example, HCA, Inc. is a national for-profit healthcare services company headquartered in Nashville, Tennessee. Prior to 2005, HCA was the largest publicly traded hospital company. In 2005, HCA was purchased by a private equity firm and converted from a publicly traded to privately held company. HCA, Inc. returned to publicly traded status in 2010 and remains the largest forprofit hospital company, with 16 hospitals and 43,275 licensed beds. In its fiscal year ending December 31, 2015, the company had after-tax income of $2.1 billion. 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 9 corporate level and the shareholder level (so-called double taxation). The company pays corporate income tax and the shareholder pays both tax on dividends paid by the company and gains made on the sale of the company’s stock. A professional corporation (PC), also called a professional association (PA), is a corporate form for professionals who wanted to have the advantages of incorporation. A PC does not, however, shield its owners from professional liability. PCs and PAs 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 physicians often are sole proprietors. The main advantages are easy and inexpensive to set up, no sharing of profits, total control, few government regulations, no special income taxes, and that they are easy and inexpensive to dissolve. Its two main disadvantages are unlimited liability and limited access to capital. Partnerships are unincorporated businesses with two or more owners. Group practices of physicians sometimes were set up using 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 subject to double taxation. On the downside, partnerships have unlimited liability, are difficult to dissolve, and create potential for conflict among the partners. In a limited partnership (LP) there is at least one general partner who has unlimited liability for the LP’s debts and obligations. LPs offer limited liability to the limited partners along with tax flow-through treatment. The disadvantage to LPs is that they require a general partner who remains fully liable for the LP’s debts and obligations. A limited liability company (LLC), also called a limited liability partnership (LLP), is a business entity that combines the tax flow through treatment characteristics of a partnership (i.e., no double taxation) with the liability protection of a corporation. In an LLC, the liability of the general partner is limited. LLCs are flexible in the sense that they permit owners to structure allocations of income and losses any way they desire, so long as the partnership tax allocation rules are followed. Governmental Healthcare Organizations Governmental HCOs are public corporations, typically 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 10 Chapter 1 Financial Information and the Decision-Making Process organization. Assets (and accumulated earnings) 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 (NCMC), 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 NCMC 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. In some cases, governmental HCOs may have access to an additional revenue source through taxes— an option 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 they are exempt from income taxes and property taxes. Governmental HCOs can face political pressures if their earnings become too great. Rather than reinvesting 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. ▸▸ SUMMARY The healthcare sector of our economy is growing rapidly in both size and complexity. Understanding the financial and economic implications of decision making has become one of the most critical areas encountered 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 become accounting-literate in our financially changing healthcare environment. ASSIGNMENTS 1. Only in recent years have hospitals begun to develop meaningful systems of cost accounting. Why did they not begin such development sooner? 2. Your hospital has been approached by a major employer in your market area to negotiate a preferred provider arrangement. The employer is seeking a 25% discount from your current charges. Describe a structure that you might use to summarize the financial implications of this decision. Describe the factors that would be critical in this decision. 3. What type of financial information should be routinely provided to board members? SOLUTIONS AND ANSWERS 1. Prior to 1983, most hospitals were paid actual costs for delivering hospital services. With the introduction of Medicare’s prospective payment system for inpatient care in 1983 and outpatient care in 2000, hospitals now receive prices based on diagnosis-related groupings and ambulatory patient classifications that are fixed in advance. Cost control and, therefore, cost accounting are critical in a fixed-price environment. The expansion of managed care has further restricted revenue and fostered greater interest in costing. 2. This problem could be set up in a results matrix (see Table 1-2). The two actions to be charted are to accept or to reject the preferred provider arrangement opportunity. Possible events would center on the magnitude of volume changes, for example, to lose 1,000 patient days or to gain 500 patient days. A key concern in estimating the financial impact would be the hospital’s incremental revenue and incremental cost positions. In short, how large would the revenue reduction and cost reduction be if significant volume were lost? Actuarial gains or losses of business would be functions of the hospital’s market position. 3. Board members do not need to see detailed financial information that relates to their established plans to ensure that the plans are being met. If significant deviations have occurred more details may be necessary to take corrective action or to modify established plans. References Nicholson, S., Pauly, M. V., Burns, L. R., Baumritter, A., & Asch, D. A. (2000). Measuring community benefits provided by forprofit and nonprofit hospitals. Health Affairs, 19(6), 168. CHAPTER 2 Billing and Coding for Health Services LEARNING OBJECTIVES After studying this chapter, you should be able to do the following: 1. 2. 3. 4. 5. Describe the revenue cycle for healthcare firms. Understand the role of coding information in healthcare organizations in claim generation. Define the basic characteristics of charge masters. Define the two major bill types used in healthcare firms. Appreciate the role of claims editing in the bill submission process. REAL-WORLD SCENARIO Riley Ilene, the Chief Financial Officer of Campbell Hospital, was concerned by the reduction in revenue during the last 3 months. The revenue reduction was most pronounced in the outpatient arena and represented a 15% reduction from prior-year levels. Loss of this revenue had eroded Campbell’s already thin operating margins, and the hospital was now operating with losses. Riley’s first thought was that volume may be down from prior-year levels. She asked her controller, Michael Dean, to report on comparative volumes for last year and this year. Michael’s report showed that total numbers of outpatient visits were actually above last year. Furthermore, the increases in volumes appeared relatively uniform across all product line groupings. Riley then directed Michael to review “revenue and usage” summaries for the current year and last year. A revenue and usage summary would show the quantity of items billed by charge code and payer. The summaries would also break out the volumes by inpatient and outpatient areas. After reviewing these data Michael reported back to Riley with some startling news. Volumes for several procedures in the hospital’s “charge master” were well below prior-year levels. Specifically, the numbers of drug administration codes that are reported when an injectable or infusible drug is administered were well below prior-year levels. This was surprising because the number of injectable and infusible drugs had actually increased. Opener image: © A1Stock/Shutterstock 11 12 Chapter 2 Billing and Coding for Health Services Riley thought she had discovered the problem and reported back to her CEO, Meredith Lynn. However, Meredith asked Riley whether this could have caused the revenue reduction. Meredith believed that a heavy percentage of the hospital’s payment was related to either case payment for inpatients or APC (ambulatory patient classification) groups for outpatients. Meredith believed that these bundled payments would not be impacted by a failure to document the drug administration procedures. Riley said that this was a good point and she would do some additional research and report back to Meredith. Riley found that Medicare provides separate payment for the drug administration procedure when performed in outpatient visits. The average loss for the undocumented procedure codes appeared to average about $150 per occurrence. Riley also found that many of their commercial payers paid on a discount from billed charge basis. Failure to report these procedures for these payers would result in lost revenue. The only remaining task was to discover why charges for drug administration procedures for outpatient procedures were not being recorded. Learning Objective 1 Describe the revenue cycle for healthcare firms. Healthcare firms are for the most part businessoriented organizations. Their ultimate financial survival depends on a consistent and recurring flow of funds from the services they provide to patients. Without an adequate stream of revenue these firms would be forced to cease operations. In this regard, healthcare firms are similar to most business entities that sell products or services in our economy. FIGURE 2-1 depicts the stages involved in the revenue cycle for a healthcare firm. The critical stages in the revenue cycle for healthcare firms are the provision and documentation of services to the patient, the generation of charges for those services, the preparation of a bill or claim, the submission of the bill or claim to the respective payer, and the collection of payment. A simple review of the six stages of the revenue cycle in Figure 2-1 hides the significant degree of complexity involved in revenue generation for healthcare providers. No other industry in our nation’s economy experiences the same level of billing complexity that most healthcare firms face. Part of this complexity is related to the nature and importance of the services provided. Regulation is also a factor that further complicates documentation and billing for healthcare services. Finally, the existence of different payment methods and rates for multiple payers further complicates the revenue cycle for most healthcare firms. Payment complexity is addressed in Chapter 3. ▸▸ Generating Healthcare Claims FIGURE 2-2 provides more detail to the steps and processes involved in the actual generation of a healthcare bill or claim. The process and steps mirror those in Figure 2-1 except additional detail unique to healthcare firms is included. The process often begins with the collection of information about the patient before the delivery of services in the patient registration function. Information about the patient, including address, date of birth, and insurance data, is collected to facilitate bill preparation after services are provided. Once Provide Services Document Services Establish Charges Prepare Claim/Bill Submit Claim Learning Objective 2 Receive Payment Understand the role of coding information in healthcare organizations in claim generation. FIGURE 2-1 Revenue Cycle Generating Healthcare Claims 13 Patient Registration Provide Services Medical Documentation Charge Entry Medical Records Chargemaster Billing System Claims Prepared Claims Edited Claims Submitted to Payers Payment Received FIGURE 2-2 Detailed Revenue Cycle services have been provided, data from that encounter(s) flow into two areas: medical documentation and charge capture. Although the primary purpose of the data accumulated in the medical record may be related to clinical decision making, a substantial proportion of the information may also be linked to billing. For example, the assignment of diagnosis and procedure codes within the medical record by physicians plays a key role in diagnosis-related group (DRG) assignment. Many healthcare payers provide payment for inpatient care related to a DRG-constructed assignment. Data in the medical record are also the primary source for documenting the provision of services. For example, if a patient’s bill listed a series of drugs used by the patient but the medical record did not show those drugs as being used, the claim would not be supported. The primary linkage between the claim and the medical record is related to the documentation of specific services provided and their reporting in a series of clinical codes. We explore the categories of coding and their importance to billing shortly. Data from the provision of services also flow directly to billing through the capture of charges. The 14 Chapter 2 Billing and Coding for Health Services posting of charges to a patient’s account is usually accomplished through the issuance and collection of “charge slips” in a manual mode or through direct order entry or bar code readers in an automated system. The critical link here is the firm’s price list, often referred to as its “charge master” or charge description master (CDM). The CDM is simply a list of all items for which the firm has established specific prices. In a hospital setting it is not unusual to find more than 20,000 items on its charge master. Information from the medical record and the charge master then flow into the actual claim. For most healthcare firms there are two basic categories of claims: the Uniform Bill 2004 (UB-04) and the Centers for Medicare and Medicaid Services (CMS) 1500. The UB-04 is the claim form used by most hospitals to report claims for both inpatient and outpatient services. The CMS-1500 is used primarily for physician and professional claims. Appendix 2-A provides samples of these two claim forms. The final step before actual claim submission is claims editing. Although all healthcare firms may not perform this step, for many it is critical. During this editing process several key areas are reviewed. First, does the claim have enough information to trigger payment by the patient’s payer? For example, perhaps the claim is missing the patient’s social security number or healthcare plan identification number. Second, does the claim meet logical standards and is it complete? For example, a claim may have a charge for laboratory panel but no charge for a blood draw to collect the sample. Editing is critical for accurate and timely payment by third-party payers. Now that we have a general overview of how the revenue cycle works to generate a claim to receive payment, we will discuss the various stages (Figure 2-2) in more detail. ▸▸ Scheduling and Registration In most cases a patient or their representative provides a basic set of information regarding the patient before the actual delivery of services. In a physician’s office this may be done just before performance of medical services. For an elective hospital inpatient admission, it may be done a week or more before admission. A number of clinical and financial sets of information are collected at this point. From the financial perspective, three activities are especially important in the billing and collection process. Perhaps the most important activity is insurance verification. If the patient has indicated they have third-party insurance coverage, it is important to have this coverage verified from the payer. The patient may also have secondary coverage from another health plan. Verification of that coverage is also critical to accurate and timely billing. The critical piece of information to collect from the patient in this regard is their health plan identification number, which may sometimes be their social security number. Queries to the health plan before service can validate the type of coverage provided by the health plan and the eligibility of the patient for the scheduled service. In today’s environment insurance verification is often done online. Sometimes prior approval for elective services is required by the health plan before a claim can be submitted. This prior verification is often referred to as precertification. Information regarding coverage for large governmental programs such as Medicare and Medicaid is often not needed because the benefit structure is standardized. It is important, however, to verify the existence of current coverage. The second activity in registration is often related to the computation of copayment or deductible provisions that may be applicable for the patient. Once insurance coverage has been determined, it is usually possible to calculate the required amount that may still be due from the patient. For example, a Medicare patient without supplemental coverage may report to a hospital for a scheduled computed tomography. It is possible for the registration staff to calculate the amount of copayment due by the patient. The registration staff can then advise the patient regarding the amount of payment due and try to make arrangements for payment at the point of service. The third activity in this registration process relates to financial counseling. Patients who have no coverage may be eligible for some discount through the healthcare firm’s charity care policy. Any residual that may still be due can be discussed with the patient, and financing may be arranged before the point of service. It is also possible that an uninsured patient may be eligible for some governmental programs, especially Medicaid. Staff at the healthcare firm can advise the patient regarding eligibility and help them to complete the necessary documents required for coverage. It is important to note that the reasons for delays in payment to the provider are often the result of inaccurate information or inappropriate processes in the scheduling and registration phase. ▸▸ Provide Services As services are being provided to the patient, information is being recorded. Some of this information will require additional human interaction to generate an Medical Documentation and HIM/Medical Records appropriate claim. This information will be reviewed and processed through the Medical Documentation and Health Information Management (HIM)/Medical Records phases of the revenue cycle. This information will eventually meet up with data that has been recorded electronically and does not require additional professional review (collected through charge entry and the charge master). Let’s first discuss the areas that will require additional professional review. ▸▸ Medical Documentation and HIM/Medical Records Information regarding the services provided to the patient is recorded in the patient’s medical record. Critical pieces of information contained in that record are used in the billing process and are communicated to the payers to trigger payment. The Health Insurance Portability and Accountability Act (HIPAA) of 1996 designated two specific coding systems to be used in reporting to both public and private payers: 1. 2. International Classification of Diseases. As of October 1, 2015, version 10 is the edition used in the United States. Healthcare Common Procedure Coding System (HCPCS) HIPAA requires that two categories of information be reported to payers: diagnosis codes and procedure codes. The ICD-10 has sets of codes that provide information for both diagnoses and procedures. For diagnosis codes, ICD-10-CM (Clinical Modification) is utilized and for procedure codes, ICD-10PCS (Procedure Coding System). ICD-10-CM is the United States’ clinical modification of the ICD10 code set created by the World Health Organization. ICD-10-PCS is maintained and updated by CMS. This coding system is primarily used in the United States. The HCPCS provides information in the procedure area but does not provide information regarding diagnoses. HIPAA therefore requires 15 that ICD-10 codes be used for diagnosis reporting for all healthcare providers, including hospitals and physicians. ICD-10 procedure codes are required for procedure reporting for hospital inpatients, whereas HCPCS codes are used for procedure reporting by hospitals for outpatient services and also by physicians (TABLE 2-1). ICD-10-CM reflects a significant improvement over ICD-9-CM. ICD-10-CM is an expanded code set to include health-related conditions and offer a higher level of specificity by including separate codes for laterality and additional characters for greater detail. The ICD-10-CM code set can be three to seven characters in length, compared to ICD-9 diagnosis codes, which comprise three digits that may be followed by a decimal point with up to two additional digits. Each code in ICD-10-CM provides greater specificity at the sixth and seventh character level. The hierarchical structure is similar, where the first three characters are the category of the codes and all codes with the same category have similar traits. For example, all ICD-10-CM codes that start with I50 (letter I followed by number 50) represent heart failure. Additional characters further specify the patient’s exact condition. For example, I50.31 refers to acute diastolic (congestive) heart failure. TABLE 2-2 provides a listing of the top 10 inpatient diagnoses reported by participating hospitals in 2015. ICD-10-PCS codes are used to report hospital inpatient procedures. ICD-10-PCS codes are challenging, yet flexible. ICD-10-PCS codes each have a unique definition and procedures are assigned to only one code, unlike ICD-9 procedure codes. The process of constructing procedure codes in ICD-10-PCS is logical and consistent. The ICD-10-PCS code set has expanded to always include seven characters, whereas the ICD-9 procedure codes could be three to four digits long with a decimal point placed after the second digit. To represent an open right heart catheterization (previously ICD-9 procedure code 37.21), one would consult section 4 (measurement and monitoring), body system A (physiological systems), root operation TABLE 2-1 HIPAA-Designated Coding Inpatient Outpatient Provider Diagnosis Procedure Diagnosis Procedure Professional ICD-10-CM CPT/HCPCS ICD-10-CM CPT/HCPCS Facility ICD-10-CM ICD–10-PCS ICD-10-CM CPT/HCPCS 16 Chapter 2 Billing and Coding for Health Services TABLE 2-2 2015 Primary Diagnosis Frequency Dx1 Definition Frequency Percentage of Total Z3800 Single liveborn infant, delivered vaginally 26,558 6.6% A419 Sepsis, unspecified organism 15,732 3.9% Z3801 Single liveborn infant, delivered by cesarean 12,953 3.2% J189 Pneumonia, unspecified organism 6,456 1.6% N179 Acute kidney failure, unspecified 5,719 1.4% O3421 Maternal care for scar from previous cesarean delivery 5,560 1.4% I214 Non-ST elevation (NSTEMI) myocardial infarction 5,264 1.3% J441 Chronic obstructive pulmonary disease w (acute) exacerbation 5,262 1.3% I5023 Acute on chronic systolic (congestive) heart failure 3,889 1.0% N390 Urinary tract infection, site not specified 3,711 0.9% Courtesy of Cleverley & Associates 0 (measurement), body part 2 (cardiac), approach 0 (open), function/device N (sampling and pressure), and qualifier 6 (right heart). The final code selection would be 4A020N6. TABLE 2-3 shows a listing of the top 10 inpatient ICD-10 procedure codes reported by participating hospitals in 2015. ICD-10 diagnosis and procedure codes are very important in the assignment of a DRG. DRG TABLE 2-3 2015 Primary Procedure Frequency Px1 Definition Frequency Percentage of Total 10E0XZZ Delivery of Products of Conception, External Approach 20,305 8.0% 10D00Z1 Extraction of POC, Low Cervical, Open Approach 13,464 5.3% 3E0234Z Introduction of Serum/Tox/Vaccine into Muscle, Perc Approach 13,100 5.1% 0VTTXZZ Resection of Prepuce, External Approach 10,578 4.1% 02HV33Z Insertion of Infusion Dev into Sup Vena Cava, Perc Approach 4,630 1.8% 4A023N7 Measure of Cardiac Sampl and Pressure, L Heart, Perc Approach 4,490 1.8% 30233N1 Transfuse Nonaut Red Blood Cells in Periph Vein, Perc 4,003 1.6% 0SRC0J9 Replace of R Knee Jt with Synth Sub, Cement, Open Approach 3,799 1.5% 0SRD0J9 Replace of L Knee Jt with Synth Sub, Cement, Open Approach 3,795 1.5% 5A1D60Z Performance of Urinary Filtration, Multiple 3,463 1.4% Courtesy of Cleverley & Associates Medical Documentation and HIM/Medical Records payment is widely used by many payers, especially Medicare. Coding therefore has a critical link to provider payment. TABLE 2-4 provides a list of the top 10 DRGs reported by Medicare in fiscal year (FY) 2015. Physicians and other clinical professionals use HCPCS codes for reporting both inpatient and outpatient procedures. HCPCS codes are also used by facilities for reporting outpatient procedures; however, they use ICD-10-PCS procedure codes for reporting inpatient procedures. There are two tiers used in HCPCS coding, Level I and Level II. Level I codes are referred to as current procedure terminology (CPT) codes; these codes have been developed and maintained by the American Medical Association. Level I and CPT are used interchangeably to describe these sets of codes. Six main categories of CPT codes are currently used: ■■ ■■ ■■ ■■ ■■ ■■ Evaluation and Management (99201 to 99499) Anesthesia (01000 to 01999) Surgery (10021 to 69979) Radiology (70010 to 79999) Pathology and Laboratory (80047 to 89398) Medicine (90281 to 99607) The five-digit CPT code may also contain a “modifier” that is a two-digit numeric or alphanumeric code that may provide additional information essential to process a claim. For example, modifier 91 is used to indicate that a laboratory procedure was repeated. TABLE 2-5 provides a list of the top 10 hospital outpatient CPT codes reported to Medicare in FY 2015. Level II HCPCS codes were developed by CMS to report services, supplies, or procedures that were not present in the Level I (CPT) codes. There are two groups within the Level II HCPCS codes: permanent and temporary. Permanent codes are five-digit codes that begin with an alpha character. TABLE 2-6 provides a list of the top 10 Level II permanent HCPCS codes reported to Medicare in FY 2015 for hospital outpatients. Level II temporary HCPCS codes are used to meet a temporary need for a new code. These codes are also five-digit codes that begin with an alpha character. These codes can exist for a long time, but they may be replaced with a permanent code. TABLE 2-7 provides a list of the top 10 Level II temporary HCPCS codes reported to Medicare in FY 2015 for hospital outpatients. HCPCS/CPT codes have a significant effect on provider payment for both facilities and physicians. CPT codes are often linked to fee schedules for many physicians by a large number of payers, which makes coding by medical groups especially critical. CPT TABLE 2-4 2015 Public Data: DRG Frequency DRG Definition 871 Frequency Percentage of Total Septicemia or severe sepsis w/o MV 96+ hours w MCC 698,326 5.2% 470 Major joint replacement or reattachment of lower extremity w/o MCC 648,919 4.8% 291 Heart failure and shock w MCC 305,874 2.3% 292 Heart failure and shock w CC 273,563 2.0% 392 Esophagitis, gastroent and misc digest disorders w/o MCC 265,473 2.0% 872 Septicemia or severe sepsis w/o MV 96+ hours w/o MCC 212,543 1.6% 683 Renal failure w CC 210,497 1.6% 690 Kidney and urinary tract infections w/o MCC 208,193 1.5% 194 Simple pneumonia and pleurisy w CC 203,574 1.5% 190 Chronic obstructive pulmonary disease w MCC 199,499 1.5% Courtesy of Cleverley & Associates 17 18 Chapter 2 Billing and Coding for Health Services TABLE 2-5 2015 Public Data: CPT Frequency CPT Definition Frequency Percentage of Total 36415 Drawing blood 33,143,861 8.2% 85025 Automated hemogram 23,390,665 5.8% 80053 Comprehen metabolic panel 20,227,551 5.0% 85610 Prothrombin time 12,772,008 3.1% 80048 Metabolic panel total Ca 11,100,899 2.7% 93005 Electrocardiogram, tracing 9,100,359 2.2% 80061 Lipid panel 8,984,219 2.2% 84443 Assay thyroid stim hormone 7,585,005 1.9% 84484 Assay of troponin, quant 6,198,958 1.5% 85027 Automated hemogram 6,134,892 1.5% Courtesy of Cleverley & Associates TABLE 2-6 2015 Public Data: Level II (Permanent) Frequency Level II (Perm) Definition Frequency Percentage of Total J0878 Daptomycin injection 46,996,523 8.2% J1442 Inj, filgrastim g-csf 1 mcg 26,933,441 4.7% J2704 Inj, propofol, 10 mg 23,561,098 4.1% J1756 Iron sucrose injection 21,799,458 3.8% J1453 Fosaprepitant injection 18,895,315 3.3% J2405 Ondansetron HCl inj 1 mg 16,283,351 2.8% J0897 Denosumab injection 15,014,923 2.6% J0881 Darbepoetin alfa, inj, non-ESRD, 1 mcg 14,266,565 2.5% J0583 Bivalirudin 13,296,583 2.3% J0131 Acetaminophen injection 13,242,289 2.3% Courtesy of Cleverley & Associates and Level II HCPCS codes are also used by Medicare to define payment for many hospital outpatient services in the ambulatory patient classification (APC) system. Learning Objective 3 Define the basic characteristics of charge masters. Charge Entry and Charge Master 19 TABLE 2-7 2015 Public Data: Level II (Temporary) Frequency Level II (Temp) Definition Frequency Percentage of Total Q9967 LOCM 300–399 mg/ml iodine, 1 ml 80,292,567 54.1% G0463 Hospital outpt clinic visit 25,487,287 17.2% Q0138 Ferumoxytol, non-ESRD 13,707,635 9.2% Q9966 LOCM 200–299 mg/ml iodine, 1 ml 4,527,896 3.1% Q9963 HOCM 350–399 mg/ml iodine, 1 ml 2,318,546 1.6% G0378 Hospital observation per 2,111,162 1.4% G0277 Hbot, full body chamber, 30 m 1,737,553 1.2% Q9965 LOCM 100–199 mg/ml iodine, 1 ml 1,692,373 1.1% Q9958 HOCM
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