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For-Profit Enterprise in Health Care. 1986. National Academy Press, Washington, D.C. Response to financial Incentives Among Investor- Owned and Not-for-Profit Hospices: An Analysis Based onCalifornu Data, 1978 1982 Robert V. Pattison This report presents findings from an in- vestigation conducted for the Institute of Med- icine's project on the implications of for-profit organization in health care. The investigation focuses on the dynamic aspects of financial per- formance by the nonprofit (public and private) and investor-owned (independent and "chain") sectors of the hospital industry in California over a 4-year period, from 1977-1978 to 1981- 1982. Data have been examined for 240 acute care, fee-for-service (non-HMO) hospitals in the 76 to 250 bed-size range. The research is an extension and refinement of a study by Pattison and Katz, "Investor- Owned and Not-for-Profit Hospitals: A Com- parison Based on California Data" published on August 11, 1983 in The New England Jour- nal of Medicine. In that study, utilizing Cali- fornia Health Facilities Commission (CHFC) data for 1978-1980 (CHFC Cycle 5), the au- thors analyzed differences in financial pe~for- mance by ownership class among small to midsize urban hospitals. Among the principal findings of that study are the following: There was no evidence that investor-owned (IO) hospitals were more cost effective than nonprofit or public hospitals of comparable size and service complexity. This was true for ei- ther independent or multi-institutional affili- ated (chain) IO hospitals, and was true whether costs (operating expenses) were measured on either a per-day or per-admission basis. The profitability and the growth of IO chain sectors were attributed to an aggressive use of pricing and marketing strategies. There was no evidence that ownership per se was influential in the payer mix of pa Dr. Pattison is Executive V-ice President of He Health Services Research Foundation. 290 tients served (Medicare, Medicaid, and pri- vate pay). Hospital size, location, and type appeared to be the principal factors. Those findings raised questions for further investigation. In particular, issues were raised regarding financial performance over time- the ways in which the IO and not-for-profit sectors of the industry had responded to fi- nancial incentives. It is the purpose of this study to examine these issues. SUMMARY OF PRINCIPAL FINDINGS The principal findings of the current study are; 1. Corroborating our earlier study, no ev- idence was found to support a hypothesis that IO hospitals are more cost effective than their private not-for-profit or public counterparts. Operating costs per discharge were higher and the rate of increase in operating costs over the 4-year period was at least as high for IO as for not-for-profit facilities. 2. Higher operating expenses in IO hospi- tals were attributable to overhead expenses. Administrative and fiscal costs were higher as a percent of operating expenses for the IO than for the not-for-profit sector. 3. For all sectors, capital costs increased at a rate in excess of other operating expenses over the period. This was much more pro- nounced in the IO independent sector than in the others. 4. All of the sectors apparently became more aggressive in their use of pricing strategies, shifting inpatient revenues toward ancillary and away from daily (room and board) services. Not surprisingly, this phenomenon was more pro- nounced in the IO sector, followed by the vol- untary sector, and finally by public hospitals. 5. For nearly all financially important daily

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HOSPITAL RESPONSES TO FINANCIAL INCENTIVES and ancillary services, charges per service unit (prices) were highest in the IO sector and low- est in the public sector. 6. Over the 4-year period, operating mar- gins improved for the IO chains, but remained constant or deteriorated for the other sectors. 7. The mix of patients (Medicare, Medi-Cal, and other) stayed relatively constant within each sector over the period. There was little difference between the voluntary and IO sec- tors. Public hospitals cared for a significantly greater share of Medi-Cal patients and a lesser share of Medicare. Other (private-pay) pa- tients also comprised relatively less of the vol- ume for public hospitals. 8. Public hospitals provided a dispropor- tionately large share of services to Medi-Cal beneficiaries, both inpatient and outpatient. The stringency of Medi-Cal reimbursement during this period adversely affected their ability to maintain break-even or profitable opera- tions. 9. During the time period studied, the principal acquisition targets for the IO chains in California were independent IO hospitals. 10. As compared to nonacquired facilities, the IO independent hospitals acquired were typically older, more depreciated, unprofita- ble facilities with higher than average uncol- lectable charges. Following acquisition, A. 1 .1-. . ~ 291 respectively determined costs, and most pri- vate payers paid billed charges. We examined data for short-term, acute care, fee-for-service (non-Kaiser) hospitals of be- tween 76 and 250 beds. This selection method eliminated teaching hospitals; large, complex facilities; small and rural hospitals; and spe- cialty hospitals or those with a long-term-care emphasis. Four subsectors of the sample were analyzed: voluntary not-for-profit (including religious and secular), public (including city/ county and district), IO independent, and IO chain hospitals. As Table 1 illustrates, the method provided a relatively homogeneous sample in terms of bed size, occupancy, and length of stay. Fur- thermore, the sample included most of the California hospitals owned by the large, inves- tor-owned national management companies (referred to in this report as IO chains). RESULTS General Observations Table 1 reflects major structural changes in the California hospital industry. While the to tal number of hospitals and beds in the sample remained almost constant over the 4-year pe riod (a net decline of 11 hospitals and 1,210 pronely unproved, bad debts were re- beds, or 5 and 3 percent, respectively), this duced, and the accounting value of assets, debt, was not true within individual ownership cat equity, and capital expenses increased dra- egories. The greatest growth, either in abso matically. lute or percentage terms, was in the IO chain 11. The major source of capital for the ac- sector, which experienced a net increase of quisition of hospitals by the IO chains was not seven hospitals and 1,066 beds. The greatest ownership (or equity) capital, but new long- decrease was in the IO independent sector, term debt. which experienced a decrease of 14 hospitals and 1,795 beds. This suggests that the growth of the IO chain sector was due principally to acquisitions of IO independent hospitals, rather than either voluntaries or publics. A detailed analysis of the data revealed this to be true. We identified nine hospitals acquired by the major national management companies at some time during the 4-year period studied. All nine were acquired from independent IO hospitals or from a small, regional multi-institutional system. (A discussion of these hospitals as a separate group follows in a later section of this paper. ) Beds per hospital changed very little for any DATA BASE AND METHODS Our analysis is based on CHFC annual dis- closure data. Three CHFC reporting cycles were analyzed: Cycle 3 (fiscal years ending between June 30, 1977 and June 29, 1978), Cycle 5 (1979-1980), and Cycle 7 (1981-19821. The 4 years examined in this study were those preceding the implementation of revolution- ary changes in hospital reimbursement in Cal- ifornia. [During the time period covered by the study, reimbursement for both Medicare and Medi-Cal inpatient services was based on ret

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292 FOR-PROFIT ENTERPRISE IN HEALTH CARE TABLE 1 General Characteristics of Hospitals in the Study Ownership Category Investor-Owned Investor-Owned CyclelVanable Alla Voluntary Public Independent Chain Cycle 3 (1977-1978) Number of hospitals242105335945 Beds35,37216,0165,2217,7896,346 Inpatient days (1,000s)7,8043,8031,2301,4391,333 Discharges (1,000s)1,276610193241231 Beds/hospital146153158132141 Occupancy (%)6065655158 Length of stay (days)6.16.26.46.05.8 Cycle 5 (1979-1980) Number of hospitals236107324651 Beds34,76316,7834,9135,9517,116 Inpatient days (l,OOOs)7,6163,9371,1911,0451,442 Discharges (l,OOOs)1,230624187177242 Beds/hospital147157154129140 Occupancy (%) Length of stay (days)6.26.36.45.96.0 Cycle 7 (1981-1982) Number of hospitals231100344552 Beds34,16215,2835,4735,9947,412 Inpatient days (1,000s)8,1134,0161,4911,0641,547 Discharges (1,000s)1,388677246185280 Beds/hospital148153161133143 Occupancy (%)6572754957 Length of stay (days)5.85.96.15.75.5 aIncludes general acute care, non-Kaiser (HMO) hospitals between 76 and 250 beds. Of the sectors during the time period studied. For the most recent year (1981-1982), it ranged from a low of 133 in the IO independent hos- pitals to a high of 161 in the public hospitals. Occupancy rates improved considerably for both the voluntaries and publics over the pe- nod, increasing respectively from 65 to 72 per- cent and from 65 to 75 percent. This increase came mostly between the finch and sixth cycles. For the IO sector, this figure worsened slightly. Lengths of stay declined for all sectors. The figure was lowest for the IO chains (5.5 days) and highest for the publics (6.1 days). Overall hospital case-mi2` intensity and acuity mea- sures were not available, so it is not possible to say whether the increased lengths of stay in the voluntaries and publics were attribut- able to a more severe case load. Profitability and Grown The two most wiclely used measures of prof- itability are operating margin (profits ex- pressed as a percent of revenues) and return on equity (profits expressed as a percent of owners' investment). By either of these two measures, the IO chain sector was the most profitable and the public sector the least. Table 2 reveals that operating margins, de- fined here as net operating revenues divided by total operating revenues, were highest for the IO chains, followed in order by the vol- untaries, IO independents, and publics. Pub- lic hospitals consistently operated at a loss, and this loss worsened over the period, from 11 percent in 1977-1978 to 14 percent in 1981- 1982. These operating losses were recovered principally by public subsidies. Interestingly, margins remained constant or deteriorated for

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HOSPITAL RESPONSES TO FINANCIAL INCENTIVES TABLE 2 Profitability, Assets, and Growth Ownership Category 293 Investor-OwnedInvestor-Owned Year/Variable All VoluntaryPublicIndependentChain 1977-1978 Operating margin .02.03- .11.02.08 Return on equity .08.08.oSa.08.12 Accounting age of facility (yrs) 6.06.27.84.64.7 Invested capital (assets) per bed61,278 68,597 57,249 34,109 79,467 Net plant, property, and equipment per bed32,163 38,878 29,559 13,691 40,028 1979-1980 Operating margin.02 .03 - .09 .03 .06 Return on equity.10 .10 .06 .25 .16 Accounting age of facility (yes)6.0 6.4 7.3 5.0 4.2 Invested capital (assets) per bed75,740 86,829 74,388 40,852 79,694 Net plant, property, and equipment per bed40,231 49,006 39,210 15,916 40,572 1981-1982 Operating margin Retwn on equity Accounting age of facility (yrs) Invested capital (assets) per bed Net plant, property, and equipment per bed49,491 Percent growth ([year period Dom EYE 6130177-6129178 to EYE 6130181-6129182) Number of beds Total invested capital (assets) Invested capital per bed Net plant property and equipment per bed .01 .13 5.9 96,108 .03 .13 6.3 112,771 57,802 - .14 .05 7.8 90,208 47,991 51 57 53 57 65 64 58 48 62 .01 .10 4.2 59,382 24,857 -23 34 74 81 aReturn on equity is not a useful measure for public hospitals because many fail to report equity. all but the IO chains, in which they increased from 8 to 10 percent. The margins for the chains in 1981-1982 were 10 times the average for the cohort of hospitals studied. Further attesting to the profitability of the national IO chain hospitals is the figure on return on equity. This increased dramatically for these hospitals, from 12 percent to 27 per- cent. Return on equity improved for all sectors .10 .27 4.0 95,392 53,383 17 40 20 33 except for the publics. (The reader is cau- tioned, however, that this measure has little validity for public hospitals, which frequently do not report equity capital on their balance sheets.) In the previous study, based only on 1979- 1980 data, net income (after tax profit) per discharge was highest for the voluntaries, fol- lowed in order by the IO chains, publics, and

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294 IO indspc;~-'ents. Analysis of the three time periods reveals a different pattern for 1977- 1978 and 1981-1982, with the IO chains high- est, followed respectively by the voluntaries, publics, and IO independents. This figure showed little change for the publics over the 4-year period, rising by only $3 or 9 percent. However, for the IO chains, the growth was substantial, rising by $100 over the period or a percentage increase of 149 percent. The accounting age of facility figures dem- onstrates that investment in depreciable assets was talking place relatively silo,' rapidly in the investor-ow~led sector than in the not-for-profit. The age of these facilities' assets fell a little over 4.5 years to just slightly over 4 years. During the same time, the age of not-for-prof- its increased slightly or remained the same. Accounting age is computed by dividing ac- cumulated depreciation by annual deprecia- tion. It is an imprecise measure, and does not distinguish between investment in new con- struction and equipment or acquisition of an existing facility by a new owner. Thus, the purchase of relatively older IO independent hospitals by the IO chains would have the ef- fect of reducing the accounting age of each of the two sectors, as these more depreciated facilities were acquired and depreciation schedules reestablished subsequent to the change in ownership. The growth in total assets was highest in the publics, followed by the voluntaries, IO chains, and IO independents. However, an exami- nation of growth in assets per bed yields quite different results. IO independents become the highest (74 percent) and IO chains the lowest (20 percent). This phenomenon, closely re- lated to that discussed in the preceding par- agraph, occurs because the IO chains were acquiring relatively older and more depre- ciated IO independent hospitals. Thus, as those older hospitals' beds and assets were removed from the books of the IO independent sector and added to those of the IO chain sector (at a value reIRecting the acquisition price), the growth rate in assets per bed increased for the former and decreased for the latter. Whereas in 1977-1978 the IO chain hospi- tals had the greatest investment in assets per bed, by 1981-1982, investment was highest for the voluntaries. This was due to the high rate FOR-PROFIT ENTERPRISE IN HEALTH CARE of growth in the voluntary sector. It is also interesting to compare the publics with the IO chains. In 1977-1978, public hospitals' assets per bed were only 72 percent of the IO chains. Because of the rate of investment in the public sector, this figure had risen to 95 percent by 1981-1982. Thus, the public and voluntary hospitals in this group, even though somewhat older, became as heavily "capitalized" as the IO chain hospitals, and significantly more so than the IO independents. Pricing Strategies The growth of the IO chains has been at- tributed to the aggressive and successful use of pricing and marketing strategies rather than to economies of scale or centralization, which would have been reflected in lower cost per day or per discharge. This study confirms this finding and Farther demonstrates that (1) over the time period studied, all ownership sectors adopted a more aggressive pricing structure, and (2) the IO chains were the leaders in adop- tion of these strategies. Gross patient revenues (patient charges) were highest for the IO chains, followed by IO in- dependents, voluntaries, and publics (Table 3~. For 1977- 1978, IO chain charges were 114 percent of the group mean, and by 1981-1982, this had risen to 117 percent. In contrast, pub- lic hospitals' average charges were 86 percent of the group mean in 1977-1978, but had fallen to 82 percent by 1981-1982. As revealed in Table 4, the increase in the ratio of inpatient ancillary to daily service charges indicates that all sectors adopted a pricing strategy in which ancillary services be- came relatively more important as a revenue source when compared to daily (room and board) services. Two factors can explain this: 1. The decrease in length of stay for all sec- tors, which may indicate either a more intense case mix or more intense treatment modali- ties, andlor 2. A more aggressive pricing strategy in which an increasing proportion of revenues are generated from the services win relatively less price-elastic demand (inpatient ancillary ser- vices).

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HOSPITAL RESPONSES TO FINANCIAL INCENTIVES TABLE 3 Charges, Deductions, Expenses, and Profits Her Adiusted Discharge 295 Ownership Category Year/Variable 1977-1978 All Voluntary Public Investor-Owned Investor-Owned Independent Chain Gross patient charges 1,7771,7081,5361,9082,022 Deductions 231200198248328 Net patient revenue 1,5451,5081,3371,6601,694 Operating expense 1,5431,4921,5121,6431,576 Net income (profit) after tax 4755391468 1979-1980 Gross patient charges 2,3662,2552,0452,5272,783 Deductions 390314357394608 Net patient revenue 1,9771,9401,6882,1332,175 Operating expense 1,9691,9141,8952,0992,046 Net income (profit) after tax ~7082535165 1981-1982 Gross patient charges 3,0122,8942,4623,3993,527 Deductions 571495486625797 Net patient revenue 2,9412,3991,9762,7752,730 Operating expense 2,4392,3702,3042,7712,458 Net income (pro~t) after tax 991124225168 Percent increase (4-year period from EYE 6130177-6129178 to FYE 6130181-6129182) Gross patient charges Deductions Net patient revenue Operating expense Net income (profit) after tax 70 147 58 58 110 69 147 59 59 106 60 145 48 52 9 78 152 67 69 75 74 143 61 56 149 aAdjusted discharges are the total discharges times the ratio of total patient revenue (inpatient and outpatient) to inpatient revenue. Despite the shift across all sectors, however, the intersectoral differences were still ex- treme, with the most aggressive use of this strategy employed by the IO chains, and the least aggressive by the publics. It is tempting to speculate that the profitability and financial solvency of public hospitals could have been improved by a more vigorous adoption ofthese pricing strategies. However, it is unlikely that the public hospitals could successfully have employed these strategies given their rela- tively small proportion of patients covered by insurance plans that paid billed charges. The relative importance of outpatient charges was virtually unchanged over time for each of the four ownership categories. As a percent of inpatient charges, outpatient charges were twice as high for the publics as for IO hospitals, with voluntaries close to the IO sector and signifi- cantly below the publics. Public hospitals care for relatively more Medi-Cal patients (see Ta- ble 5~. This accounts for much of the observed difference since :\Iedi-Cal patients consume relatively more outpatient services than the population at large. Tables 6 and 7 demonstrate the differences in pricing strategies on a service-specific basis. The importance of individual ancillary services to the hospitals' revenues is illustrated by the example of pharmacy, which comprised 9 per- cent of patient charges in 1981-1982, or almost half the revenues generated by medical/sur- gical daily services. Pharmacy ranged in im- portance from a low of 6 percent in the public

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296 FOR-PROFIT ENTERPRISE IN HEALTH CARE TABLE 4 Charge Structure: Ratios of Daily Service, Inpatient Ancillary, and Outpatient Charges Ownership Category Year/Ratio Investor-Owned Investor-Owned All Voluntary Public Independent Chain - 1977-1978 Inpatient ancillary/ daily services charges 1.18 1.07 0.92 1.44 Outpatient/inpatient charges 0.19 0.19 0.33 0.14 1979-1980 Inpatient ancillary/ daily services charges 1.27 1.25 Outpatient/inpatient charges 0.19 0.19 1981-1982 Inpatient ancillary/ daily services charges 1.43 1.33 Outpatient/inpatient charges 0.19 0.19 1.42 0.15 0.103 1.56 0.33 0.14 1.08 1.70 0.33 0.14 1.56 0.15 1.81 0.13 hospitals to a figure approximately double that, 12 to 13 percent in the IO sector. Charges per unit of service for nearly all services were uniformly higher in the IO sec- tor than in either the voluntary or public hos- pitals. Again, comparisons of individual services between the IO and public hospitals reveal extreme differences. Operating Expenses Table 3 confirms that operating expenses per adjusted discharge in 1981-1982 were highest for the IO independents, followed re- spectively by the IO chains, voluntaries, and publics. For all four sectors, this figure rose by 58 percent over the 4-year period. This is the equivalent of an average annual com- pounded rate of about 12 percent. The rate of increase was highest for IO independents (69 percent) and lowest for publics (52 percent). Gross patient charges increased by 70 percent, equivalent to an average annual increase of 14 percent. The range was from a low of 60 per- cent Publics) to a high of 74 percent (IO chains). These increases in charges, however, did not translate directly into increases in patient rev- enues, as deductions from revenue (which in- clude Medicare and Medi-Cal contractual allowances as well as charity care, bad debts, and other contractual allowances) increased by 147 percent. Because of these deductions, the growth in net patient revenues (amounts ac- tually received for the provision of care) almost exactly matched the growth in operating ex- penses in the voluntaries and IO indepen- dents. For the publics, revenues grew 4 percent slower than expenses, and for the IO chains the situation was reversed, with revenues growing 5 percent faster than expenses. In Table 8, we examined data for the major expense categories of research, education, general service (costs associated with laundry, dietary, housekeeping, etc.), fiscal services (accounting), administrative services (admin- istration, taxes), and daily and ancillary ser- vices (e.g., costs associated with pursing services aIld ancillary departments). For the IO sector, fiscal and administrative costs (which include, in the case of the IO chains, allocated home office costs) totaled between 28 and 30 percent of operating expenses. For the not-for-profit sector, these costs were 22 to 24 percent. The IO chains, in support of their claims of increased efficiencies (as reflected, for exam- ple, in lower ratios of employees (full-time equivalents or FIEs) per discharge, incurred expenses for general services and daily and ancillary services equal to $1,745 per adjusted discharge in 1981-1982. These costs amounted

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HOSPITAL RESPONSES TO FINANCIAL INCENTIVES TABLE 5 Deductions from Revenue as a Percent of Total Patient Charges Ownership Category 297 Year/Variable Investor-Owned Investor-Owned All Voluntary Public Independent Chain - 1977-1978 Medicare contractual allowance 7 6 4 7 9 Medi-Cal contractual allowance 3 3 5 3 3 Charity O O O O O Bad debt 2 2 2 2 2 Other 1 1 2 1 2 Toed deductions 13 12 13 13 16 1979-1980 Medicare contractual allowance 9 8 5 9 13 Medi-Cal contractual allowance 4 3 5 3 4 Charity O O 1 0 0 Bad debt 2 2 3 3 2 Over 1 1 3 1 3 Total deductions 16 14 17 16 1981-1982 Medicare contractual allowance 10 10 6 10 14 Medi-Cal contractual allowance 5 4 6 4 5 Charity O O 1 0 0 Bad debt 3 2 6 3 2 Other 1 1 1 1 2 Total deductions 19 17 20 18 23 to $1,801 for the voluntaries. Thus, the IO chains experienced savings of $56 per adjusted discharge in these two categories. These savings may represent efficiencies at the hospital level. However, fiscal and admin- istrative costs were $119 less in the voluntaries than in the IO chains. The net effect was a savings of $63 per discharge in the voluntaries. The same analysis holds for a comparison that includes the publics and IO independents. Patient Selection Tables 5 and 9 reveal intersectoral differ- ences in the relative importance of Medicare, Medi-Cal and private-pay patients. Part A of Table 8, which provides information on the percentage of charges by payer category, is the best indication of the volume of services con- sumed by each category. It reveals that public hospitals cared for a disproportionately high share of Medi-Cal patients and a dispropor- tionately low share of Medicare. This was true for all years. There was relatively little differ- ence between the other sectors. Medicare contractual allowances are a re- flection of (1) the percent of patient care pro- vided to Medicare beneficiaries and (2) the spread between charges and allowable costs (as determined by the Medicare fiscal inter- mediary). For each of the three cycles studied, these allowances were highest for the IO chains, followed by IO independents, voluntaries, and publics. As a percent of total charges, Medi-Cal con- tractual allowances were highest for the pub

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Daily services Medicallsurgical acute 191 Medicallsurgical intensive 298 FOR-PROFIT ENTERPRISE IN HEALTH CARE TABLE 6 Important Daily and Ancillary Charges as a Percentage of Total Patient Charges, 1981-1982 Ownership Category Investor-Owned Investor-Owned All Voluntary Public Independent Chain Year/Vanable Daily services Medical/surgical acute Psychiatric acute Obstetrics acute 22 24 20 20 4 2 3 2 Medical/surgical intensive care 4 4 Coronary intensive care 2 2 2 Total daily servicesa 35 37 36 Ancillary services Clinical labs Pharmacy Diagnostic radiology Surgery l 4 1 32 8 7 7 11 9 7 6 13 6 6 5 65 63 64 68 Central service and supply 6 Emergency Inhalation therapy Total ancillary servicesa 4 5 6 5 3 3 3 _ 19 4 31 9 12 4 6 9 3 4 69 aIndividual service figures do not equal total figure because minor services are not included in the table. lies, followed respectively by the IO chains, then the voluntaries arid IO independents. The reason for this difference was the relatively greater percent of Medi-Cal patients served in public hospitals as well as the greater per cent of revenues derived from outpatient ser- vices. (Medi-Cal paid for outpatient services according to a fee schedule, which was lower Man accounting costs for most hospitals and significantly lower than billed charges.) TABLE 7 Patient Charges per Unit of Servicea for Important Daily and Ancillary Services, 1981-1982 Ownership Category Investor-Owned Investor-Owned Year/Variable All Voluntary Public Independent Chain 192 180 200 care 464 463 419 479 486 Ancillary services Clinical labs 0.98 0.92 0.71 1.24 1.19 Pharmacy 49.34 40.20 22.18 84.11 85.14 Diagnostic radiology 7.28 6.90 7.43 8.92 6.79 Surgery 4.65 4.43 3.53 6.07 5.22 Central service and supply 32.26 24.95 16.21 44.00 58.85 Emergency 46.80 44.41 41.96 57.49 52.65 Inhalation therapy 16.46 17.78 12.79 16.10 16.98 aUnits of service are defined by the California Health Facilities Commission.

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HOSPITAL RESPONSES TO FINANCIAL INCENTIVES TABLE 8 Operating Expense Structure as a Percentage of Total Operating Expenses Ownership Category 299 Investor-Owned Investor-Owned Year/Expense Category All Voluntary Public Independent Chain 1977-1978 Research O O O O O Education 0 0 2 0 0 General service 14 IS 15 13 13 Fiscal service 7 7 8 6 7 Administrative 20 18 16 25 22 Daily and ancillary service 59 60 59 56 58 1979-1980 Research 0 0 0 0 0 Education 0 0 2 0 0 General service 14 15 IS 13 13 Fiscal service 7 7 8 6 7 Administrative 19 17 IS 23 22 Daily and ancillary service 60 61 60 59 58 1981-1982 Research O O O O O Education 1 0 2 0 0 General service 13 14 14 12 12 Fiscal service 5 4 5 4 6 Administrative 21 20 17 26 22 Daily and ancillary service 61 62 61 58 59 Finally, the previous study noted the ab- sence of charity care provided by this cohort of hospitals. Table 10 confirms that finding. However, broadening the definition of uncom- pensated care to include bad debts as well as charity reveals the public hospitals to be sig- nificantly more involved in this effort, with allowances equal to 7 percent of total charges in 1981-1982, compared to 3 percent in the nearest sector. This figure rose from 2 percent in 1977-1978, when publics were identical to the other sectors, and was accounted for en- tirely by an increase in the bad debt compo- nent. The data do not reveal whether this was due to the recession environment during 1981- 1982 or to less aggressive management of ac- counts receivable, but it is clear that bad debts became a significant problem for the public hospitals over the period. Hospitals That Changed Ownership During the Period Our previously published study based on a single year's data (1979-1980) left unanswered two critical questions: What were the financial characteristics of hospitals acquired by the IO chains during the preprospective payment sys- tem environment? What financial changes did these hospitals undergo in the years imme- diately following acquisition? We were able to identify definitively nine hospitals which, during our study period, went from IO independent (freestaD ding) to IO chain status through acquisition. While a sample of nine is ail insufficient number upon which to base sweeping conclusions, the comparison of these hospitals with their other IO colmter- parts, presented in Table 10, is instructive. The table presents comparative figures for 1977- 1978 and 1981-1982 for IO hospitals that re- mained independent throughout the period, IO independent hospitals acquired by a na- tional chain at some time dunng the period,

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300 TABLE 9 Patient Mix and Contractual Allowances Ownership Category - FOR-PROFIT ENTERPRISE IN HEALTH CARE Investor-Owned Investor-Owned Year/VanableAll Voluntary Public Independent Chain Part A: Percent of Gross Patient Charges by Payer Class 1977-1978 Medicare 37 40 29 35 38 Medi-Cal 16 13 27 16 14 Other 47 47 44 50 48 1981-1982 Medicare 41 44 31 41 43 Medi-Cal 16 14 29 13 13 Other 43 42 40 46 44 Part B.: Contractual Allowances as Percent of Charges to Each Payer 1977-1978 Medicare 1816 13 19 25 Medi-Cal 21211 19 20 25 Other 75 9 7 7 All payers 1312 13 13 16 1981-1982 Medicare 2523 18 24 32 Medi-Cal 2829 20 27 40 Other 107 21 9 8 All payers 1917 20 17 23 Part C: Percent of Net Patient Revenues by Payer Class 1977-1978 Medicare 35 38 29 32 34 Medi-Cal 14 12 25 14 13 Over 51 51 45 53 53 1981-1982 Medicare 38 41 32 37 38 Medi-Cal 14 12 28 12 10 Other 48 47 40 51 52 and IO hospitals owned by a chain throughout the 4-year period. The table reveals that Pre-acquisition, the purchased hospitals were somewhat older, under-capitalized facil- ities as compared to either the nonacquired IO independents or previously acquired IO chain hospitals. They were unprofitable, incurring after- tax losses of $1.38 per day. This is compared to daily profits of $3.00 for the independents and $11.72 for the chains. Their losses were attributable at least in part to three factors: (1) low occupancy rates (48 percent), (2) high daily expenses ($286 ver- sus $274 for each of the other groups), and (3) a relatively high level of uncollectable ac- counts (2.7 percent of billed charges). Investment per bed was the lowest of the three subsectors and, correspondingly, these hospitals were carrying little debt. Of course, given their unprofitability, low occupancy, and relatively high cost, they would not have been attractive prospects for lenders.

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HOSPITAL RESPONSES TO FINANCIAL INCENTIVES TABLE 10 Comparison of Financial Indicators, Investor-Owned Hospitals, 1977-1978 and 1981-1982 301 1977-1978 1981-1982 Variable Independent Acquired Chain Independent Acquired Chain Number of hospitals5094545943 Occupancy (%)514858495059 A6cer-tax profits per day3.00- 1.3811.124.3923.7032.00 Bad debts (% of charges)2.42.71.63.20.22.6 Inpatient charges per day ($)317334351591631639 Total expenses per day ($)274286274482467441 Capital costs per day ($)121123345539 Assets per bed ($)34,40132,56579,46759,38298,83294,687 Debt per bed ($)10,9917,76734,83223,845s7, 67838,684 Accounting age (yrs)4.64.84.74.22.74.3 About 2.5 years following acquisition, on average, a dramatic turnaround became evi- dent. This group's average daily profits not only recovered, but rose to $23.70. This com- pares to $4.39 for those hospitals remaining independent throughout the period. ~ This increase in profitability was not at- tributable to filling empty beds; occupancy rates remained almost the same, rising only to SO percent. A significant factor in their turnaround was the extraordinary drop in bad debts to only 0.2 percent of total charges. Unfortunately, data do not reveal whether this decrease was due exclusively to more aggressive manage- ment of accounts receivable, or whether pol- icies were instituted to deny all but emergency services to unsponsored patients (those with- out private insurance or government program coverage). The companies appear to have instituted operating cost efficiencies. Daily expenses for this group, which were $12 more than the non- acquired hospitals in 1977-1978, became $15 less than the still-independent hospitals in 1981- 1982. The accounting value of assets per bed increased Tom $32,565 in 1977-1978 to $98,832 4 years later. A significant share ofthis increase was the revaluation of assets to fair market value (typically acquisition cost) upon change of ownership. Another part was due to new construction and equipment added after ac- quisition. A detailed analysis of each hospital's books would be necessary to reveal the im- portance of each. These new asset values were financed principally by additional debt. In 1977-1978, the debt-to-asset ratio (obtained by dividing debt per bed by assets per bed) was 0.24 for this group compared with 0.32 and 0.44 for the independent and chain groups, respec- tively. By 1981-1982 this ratio had risen to 0.58 for this group compared with 0.40 and 0.41 for the independent and chain groups, respec- tively. Partly as a consequence of this new debt, capital costs rose from 4 percent of total ex- penses to 12 percent. This figure includes de- preciation expenses on the newly revalued facility as well as interest costs on the debt. These observations are consistent with in- tuitive and anecdotal evidence regarding pur- chases of independent IO hospitals by the chains during the late 1970s and early 1980s. The policy implications are less clear, especially as Me hospital industry enters a new financial environment in which the targets for acqui- sition appear increasingly to be more complex, larger teaching facilities. CONCLUDING STATEMENT The results of this study confirm most of the findings of our previous study (and others, e.g., those of Lewin and Associates and the Florida Cost Containment Board). In addition, these

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302 results, by demonstrating the more vigorous response of the IO sector to the previous cost- based incentives reimbursement system, help to shed light on what we may expect in the new reimbursement environment being im- plemented in California and in may other parts of the United States. If the IO sector, as demonstrated in our analysis, is quickest to respond to these new incentives, we may expect its growth to con- tinue or even to accelerate. Until now, targets for acquisition in California have been con- fined primarily to smaller, independent, IO hospitals. However, we may expect to see ac- quisitions occur among larger, complex, teach FOR-PROFIT ENTERPRISE IN HEALTH CARE ing facilities as these institutions find themselves in financial difficulty. These facilities have tra- ditionally borne much of the burden of pro- vision of"unprofitable" services and care of unsponsored patients. Whether these services will continue to be provided and these patients to be sewed at historical levels is unclear. ACKNOWLEDGMENTS This analysis was supported by a grant from the James Irvine Foundation, San Francisco, California. The author wishes to acknowledge with gratitude the assistance of Piruz Alemi.