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A comparison of the capital structures of


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Journal of Health Care Finance
Journal of Health Care Finance (USPS 048-090) Indexing: JHCF is indexed in Academic
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1 2 3 4 5
Editorial Board

Editors Editors Emeritus


James J. Unland, MBA Judith J. Baker, PhD, CPA
President Partner
The Health Capital Group Resource Group, Ltd.
Chicago, IL Dallas, TX

Paul Gibson, Publisher William O. Cleverley, PhD


Joanne Mitchell-George, Senior Managing Editor Professor
Elizabeth Venturo, Managing Editor Ohio State University
Dom Cervi, Marketing Director Columbus, OH

Editorial Board
Dana A. Forgione, PhD, CPA, CMA, CFE, Janey Elizabeth Simpkin, President, The Lowell Group,
S. Briscoe Endowed Chair in the Business Inc., Chicago, IL
of Health, and Professor of Accounting, Elaine Scheye, President, The Scheye Group, Ltd.,
College of Business, University of Texas at Chicago, IL
San Antonio,TX
Pamela C. Smith, PhD, Associate Professor,
Ellen F. Hoye, MS, Principal, Hoye Consulting Ser- Department of Accounting, The University of
vices, Elmhurst, IL Texas at San Antonio, San Antonio, TX
Daniel R. Longo, ScD, Professor and Director Jonathan P. Tomes, JD, Partner, Tomes & Dvorak,
of Research, ACORN Network Co-Director, Overland Park, KS
Department of Family Medicine, Virginia
Mustafa Z. Younis, Professor of Health Economics &
Commonwealth University, Richmond, VA
Finance, Jackson State University, School of
Kevin T. Ponton, President, SprainBrook Group, Health Sciences, Department of Health Policy &
Hawthorne, NY Management, Jackson, MS
JHCF 39:1, Fall 2012

Contents

1 A Comparison of the Capital Structures of Nonprot and


Proprietary Health Care Organizations
John Trussel

12 A Comparative Analysis of the CVP Structure of Nonprot Teaching


and For-Prot Non-Teaching Hospitals
Li-Lin (Sunny) Liu, Dana A. Forgione, and Mustafa Z. Younis

39 The Economics of Health Care Quality and Medical Errors


Charles Andel, Stephen L. Davidow, Mark Hollander, and David A. Moreno

51 Complicated Billing Requirements Challenge Physical Therapy Industry,


Creating Inefciencies and Confusion
Annette R. Ciavarella

79 Americans with Disability Act: Financial Aspects of Reasonable


Accommodations and Undue Hardship
Sandra K. Collins and Eric P. Matthews

87 A Real Options Approach to Clinical Faculty Salary Structure


Marc J. Kahn and Hugh W. Long
From the EditorAbout This Issue
Once again, this issue of the Journal of James J. Unland, MBA
Health Care Finance is illustrative of the
The Health Capital Group
breadth of topics we cover.
244 South Randall Road, Ste 123
We are always interested in new article ideas Elgin, Illinois 60123
that directly or indirectly relate to health care (800) 423-5157
nance. To submit ideas or articles, please send healthfinancejournal@yahoo.com
an email to: HealthFinanceJournal@yahoo.com.

iv Copyright 2012 CCH Incorporated


A Comparison of the Capital
Structures of Nonprot and
Proprietary Health Care
Organizations
John Trussel

The relative amount of debt used by an organization is an important determination of the organizations
likelihood of nancial problems and its cost of capital. This study addresses whether or not there are any
differences between proprietary and nonprot health care organizations in terms of capital structure.
Controlling for protability, risk, growth, and size, analysis of covariance is used to determine whether
or not proprietary and nonprot health care organizations use the same amount of leverage in their
capital structures. The results indicate that there is no difference in the amount of leverage between the
two institutional types. Although nonprot and proprietary organizations have unique nancing mecha-
nisms, these differences do not impact the relative amount of debt and equity in their capital structures.
Key words: institutional convergence, capital structure, leverage, nonprofit financial management, health
care financial management.

C
apital structure is the relative amount directly and empirically compared the capital
of debt that an organization uses to structures of these two types of institutions.
finance its investment projects and This study focuses on the health care industry,
programs. The relative amount of debt used by in order to eliminate the effects of industry on
an organization is an important determination capital structure. I use a methodology similar
of the organizations likelihood of financial to Kester,4 who compared the capital structure
problems and its cost of capital.1 Therefore, of Japanese and US manufacturing corpora-
capital structure is a critical issue in the finan- tions. Using a sample of 163 US proprietary
cial management of both proprietary and non- health care organizations, this study analyzes
profit organizations. Although nonprofit and the capital structures and compares them
proprietary organizations have unique legal to a sample of 163 US nonprofit health care
characteristics that potentially affect financ- organizations. Specifically, I test the hypoth-
ing, these differences may not impact the rela- esis of institutional convergence on capital
tive amount of debt and equity in their capital structurethat there is no difference in the
structures. This study addresses whether or capital structures of proprietary and nonprofit
not nonprofit health care organizations have organizations.
capital structures similar to proprietary health
care organizations. The results will be of inter-
John Trussel, PhD, CPA, is an Associate Profes-
est to creditors and other stakeholders when
sor of Accounting at the University of West Florida
determining the organizations cost of capital in Pensacola, Florida. His research interests include
and its likelihood of financial problems. accounting and financial management of nonprofit,
Although several studies have addressed governmental, and proprietary organizations. He can
capital structure in publicly traded corpo- be reached at jtrussel@uwf.edu.
rations2 and a few have addressed the issue J Health Care Finance 2012; 39(1):111
in nonprofit organizations,3 no studies have Copyright 2012 CCH Incorporated

1
2 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

The results of this study indicate that DiMaggio and Anheier10 support this view
when capital structure is proxied by leverage and also suggest that organizations of vari-
and is measured as the book value of debt- ous forms (proprietary, nonprofit, and pub-
to-assets, there is no significant difference lic) converge, according to industry, due
between proprietary and nonprofit organi- to these isomorphic and other competitive
zations beyond that which the profitability, pressures. As an example, Gray11 conjec-
risk, growth, and size of the organizations tures that competition makes proprietary
can explain. health care providers more socially respon-
The following section provides a brief sible and nonprofit health care providers
overview of the unique legal characteris- more efficient than they would otherwise be.
tics that potentially affect financing and the Empirical evidence supports Grays hypoth-
capital structure models. The next section esis in the development of the hospital indus-
discusses the hypotheses and methodology try.12 Since institutions seem to converge
for testing. That section is followed with a according to industry, I focus on one broadly
discussion of the empirical results, and the defined industry, health care, in testing the
final section summarizes this article. hypothesis of institutional convergence in
the area of capital structure.
Nonprofit Organizations and Brody focuses on the principal-agent
Capital Structure Models problem and concludes that nonprofit and
for-profit firms bear more resemblance to
Whether or not the capital structures of each other than their organizational differ-
nonprofit and proprietary organizations ences suggest.13 Concentrating on economic
are similar is an empirical issue; however, forces and agency costs, she argues that the
previous research addresses this issue con- two institutions are similar due to internal
ceptually. Some researchers5 suggest that and external constraints, such as resource
there is reason to believe that nonprofit and dependency, institutional isomorphism, and
proprietary organizations behave similarly organizational slack.
from an economic standpoint, while oth- Hansmann14 suggests that the nondistri-
ers6 argue that the legal differences make the bution constraint solves the principal-agent
economics diverge. Research in the area of problem in nonprofit organizations, since
institutional convergence between nonprofit this promise not to distribute profits acts to
and proprietary organizations has become make the nonprofit organization more trust-
increasingly popular since the pioneering worthy. Monitoring costs are eliminated
work of DiMaggio and Powell,7 who discuss as the nonprofit delivers trust goods. In
the isomorphism of organizations in general, contrast to Hansmann,15 Brody16 asserts
and Brody,8 who focuses on the economic that the nondistribution constraint theory of
convergence of nonprofit and proprietary nonprofit organizations cannot effectively
organizations in particular. distinguish between a nonprofit organiza-
DiMaggio and Powell9 argue that organi- tion and a proprietary organization for two
zational change occurs as a result of processes reasons. First, there is information asymme-
that make organizations homogeneous with- try causing external agency costs. The prin-
out necessarily making them more efficient. cipals of a nonprofit organization (donors,
Capital Structures: Nonprofit and Proprietary Health Care Organizations 3

customers, government agencies, etc.) may systems. Third, nonprofit organizations can
not be able to judge the quality of the ser- use the market value (net present value) rule
vices provided by the agents (management), with discount rates determined by outside
and the nonprofit organization may not be capital markets when evaluating investment
able to judge the quality of its services either. opportunities.
Second, there is information asymmetry Fama and Jensen do not explicitly address
caused by internal agency costs between the the issue of capital structure in nonprofit
management (principals) and the employ- organizations, however. To fill this void,
ees (agents) of the nonprofit organization. Wedig, Hassan, and Morrisey19 developed
Brody also claims that the nondistribution a theory of capital structure for nonprofit
constraint does not explain how the public organizations. Their model explains how a
should choose between competing nonprofit nonprofit organization, despite its exemp-
organizations. tion from corporate tax, can indirectly ben-
Bowman17 notes that there are four distinct efit from the tax shields in the municipal
legal characteristics relative to financing bond market. Nonprofit organizations have
behavior that most nonprofit organizations a financial incentive to issue tax-exempt
have when compared with proprietary bonds, since some of the personal tax abate-
organizations. First, nonprofit organizations ment is reflected in the yields of municipal
cannot issue stock nor distribute residual bonds. They argue that a nonprofit organiza-
claims. Second, they have the ability to raise tion can earn an indirect arbitrage by issuing
funds through donations, and the donors low-yield, tax-exempt debt in lieu of internal
can restrict their donated assets. Third, they financing with existing cash flow. Opposing
are not subject to involuntary bankruptcy. this incentive to issue debt, they claim, are the
Fourth, many can sell bonds at tax-exempt factors, such as agency and bankruptcy costs,
rates. He also notes that many hold signifi- that would lead to a reduction in the use of
cant endowment assets, which are typically debt. Thus, similar to proprietary firms, a
less risky than other assets. nonprofit organization has an internal opti-
Fama and Jensen18 provide the founda- mum mix of debt and equity, even though the
tion for financial management in nonprofit choice of issuing stock doesnt exist. From the
organizations. They discuss the relationships nonprofit organizations point of view, equity
among agency, contracting, and ownership is the retention of earnings for future program
in (among others) nonprofit organizations purposes. Empirical tests on a sample of non-
and reach three general conclusions. First, profit hospitals support their hypotheses.
they conclude that the absence of residual The balance between opposing factors
claims avoids certain agency problems and for issuing debt (i.e., the tax benefits versus
explains the dominance of nonprofit organi- agency, bankruptcy, and other such costs)
zations in donor-financed activities. How- espoused by Wedig et al.,20 is the so-called
ever, residual risk still exists and is borne by static trade-off model of capital structure.21
consumers and factors used to produce out- This model stands in contrast to the pecking-
puts. Second, like proprietary organizations, order model, which was advanced by Myers
nonprofit organizations require separation of and Majluf22 and Myers23 building upon
ownership and control in designing decision Donaldson.24 Under this model, firms prefer
4 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

retained earnings (available liquid assets) within an industry are similar. To address this
to debt and debt to equity when financing issue empirically, I test the null hypothesis
investments. Using a sample of 200 nonprofit that there is no difference in the capital struc-
hospitals, Bacon25 finds support for the peck- tures of nonprofit and proprietary health care
ing order model for nonprofit institutions. organizations. The empirical model uses
Bowman26 uses a sample of 1,393 non- cross-sectional data for 163 proprietary
profit organizations from four sectors, and 163 nonprofit health care organizations
including hospitals, and has mixed results from 1995 and is replicated using data from
for tests of the pecking-order and static 2005. The year 1995 was chosen, since the
trade-off models. However, neither he nor accounting rules change significantly for
the other researchers in nonprofit capital nonprofit organizations in the United States
structure (Wedig et al.27 and Bacon28) com- after 1995. These data are drawn from two
pare nonprofit organizations with propri- primary sources. Data for proprietary health
etary organizations in their empirical tests. care organizations are obtained from the
This article extends the research on capital Standard and Poors Compustat database.
structure to compare, directly and empiri- I included all 163 health services organi-
cally, the capital structures of nonprofit and zations (Standard Industrial Code (SIC) of
proprietary organizations. 8000 to 8099) that had all of the necessary
Kester29 is one of the few studies that data to apply the empirical model. I also
directly compares the capital structures of selected a sample of nonprofit health care
two different populations, although both organizations from the Statistics on Income
are proprietary. Using cross-sectional data database of the National Center on Charita-
for 344 Japanese and 452 US manufactur- ble Statistics (NCCS). I included a random
ing companies in 27 different industries, he sample of 163 health care organizations that
tests whether or not the Japanese and the had all of the necessary data. The nonprofit
US manufacturing firms have similar capital health care organizations had codes desig-
structures. Controlling for profitability, risk, nated by the National Taxonomy of Exempt
growth, size, and industry in his empirical Entities (NTEE) that were matched to the
tests, he finds that there may or may not be a SIC health services classifications 8000 to
difference in capital structure, depending on 8099. The NTEE is a comprehensive classi-
how leverage is measured. However, when fication system developed by the NCCS for
there was a difference, it was concentrated in tax-exempt organizations. Only health care
certain industries. This article uses a method- organizations are included to control for the
ology similar to Kesters with a few refine- effects of a specific industry on capital struc-
ments, as discussed below. ture (see Figure 1).
Following Kester,30 each organizations
Data and Methodology leverage is used as a proxy for its capital
structure (the dependent variable). To reduce
Much of the literature discussed above, the amount of variance in the error terms,
including the theory of institutional conver- several covariates are utilized. Again, fol-
gence, suggests that the capital structures lowing Kester,31 these additional independ-
of nonprofit and proprietary organizations ent variables are profitability, risk, growth,
Capital Structures: Nonprofit and Proprietary Health Care Organizations 5

Figure 1. Classications of Health Care Organizationsa

SIC Classification SIC NTEE


Offices and Clinics of Doctors of Medicine Surgical and 8011 E31
Emergency Centers, HMOs
Offices and Clinics of Dentists 8021 E31
Offices and Clinics of Doctors of Osteopathy Offices of Doctors 8031 E31
of Osteopathy
Offices and Clinics of Chiropractors 8041 E31
Offices and Clinics of Optometrists 8042 E31
Offices and Clinics of Podiatrists 8043 E31
Offices and Clinics of Health Practitioners, Mental Health 8049 E50
Practitioners
Skilled Nursing Care Facilities Continuing Care Retirement 8051 E90, E91
Communities
Intermediate Care Facilities Continuing Care Retirement 8052 E90
Communities
Nursing and Personal Care Facilities, NEC Continuing 8059 E90
Care Retirement Communities
General Medical and Surgical Hospitals 8062 E20, E21, E22
Psychiatric Hospitals 8063 E20
Specialty Hospitals 8069 E20, E24
Medical Laboratories Diagnostic Imaging Centers 8071 E31
Dental Laboratories 8072 E31
Home Health Care Services 8082 E92
Kidney Dialysis Centers 8092 E31
Specialty Outpatient Facilities, NEC Family Planning Centers 8093 E30, E32, E40, E42
Health and Allied Services, NEC Blood and Organ Banks 8099 E40, E60, E61, E65,
E70, E86, E99
a
Figure 1 represents the various sub-sectors within the SIC classification of health services organizations
(SIC 80008099). The SIC classifications are matched with the National Taxonomy of Exempt Organiza-
tions (NTEE) codes for nonprofit organizations (National Center of Charitable Statistics 2000). The samples
for this study were drawn from these sub-sectors.

and size. A dummy independent variable 8 GROWTH*TYPE +


will be used to represent the institutional 9 SIZE*TYPE + (1)
type. The full regression model (with obser-
vation subscripts removed) is: Leverage (LEV) is measured as the book
value of total liabilities divided by total assets.
LEV = 0 + 1 ROA + 2 RISK + Profitability (ROA) is defined as the excess of
3 GROWTH + 4 SIZE + 5 TYPE + revenues over expenses scaled by total assets,
6 ROA*TYPE + 7 RISK*TYPE + and is calculated as the average from the
6 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

previous five years. The standard deviation of The second step addresses the equality
the ROA over the previous five years is used as of the intercept terms of the two regression
a proxy of the volatility (RISK) of the return on lines. In testing for the equality of intercepts,
assets. GROWTH was measured as the com- the hypotheses are:
pound average annual rate of growth in rev-
enues over the last five years. SIZE, defined as H0: 5 = 0
the natural log of the previous years revenues,
is included as a proxy for other relevant vari- HA: 5 0
ables, such as information asymmetries and
age.32 Finally, TYPE is a dichotomous dummy If the parameter is insignificant, then the null
variable defined as one, if the organization is cannot be rejected. If the slopes are parallel
nonprofit and zero, otherwise. The interaction and the intercepts are the same, then there
parameters, 69, were included in the full is no evidence to reject the hypothesis that
regression model to express the potential rela- the regression lines are coincident. If this
tionship between the covariates ROA, RISK, is the case, then there is no basis for rejecting
GROWTH, and SIZE and the experimental the hypothesis that nonprofit and proprietary
(dummy) variable TYPE. Bowman33 suggests health care organizations have similar capi-
that the relative amount of endowment assets, tal structures. The results are included in the
defined as investments, be included as a pre- next section.
dictor variable. Inclusion of investments as
a percent of total assets does not change the Results
results significantly. He also suggests remov-
ing investments from the ROA and other cal- Figure 2, panel A, includes the descriptive
culations. This also does not change the tenor and univariate results of the testing using the
of the results. 1995 data. The results using 2005 data are
To test the hypothesis that there is no dif- similar and thus are not shown. Mean ROA
ference in the capital structures of the two for proprietary organizations is significantly
institutions, I use analysis of covariance lower than nonprofit organizations, and they
and proceed in two steps. The first step are also are significantly more risky (RISK)
addresses the equality of the slopes of the than nonprofits. The proprietary organiza-
two regression lines (i.e., nonprofit versus tions grew more than the nonprofit organi-
proprietary). I test for parallelism using zations, but the difference in GROWTH
interaction terms for the dummy variable was not significant. This result is interesting
(TYPE) on each of the covariates. In testing since I assumed that the ability to issue stock
for parallelism, the hypotheses are: would give a growth advantage to the propri-
etary organizations. However, the nonprofit
H0: 6 = 7 = 8 = 9 = 0 organizations were significantly smaller in
SIZE than the proprietary ones, which may
HA: at least one of the parameters is not zero. explain why GROWTH was insignificant. If
the nonprofit organizations were smaller over
If the parameters of the interaction terms are the long run, then the SIZE difference may
insignificant, then the null cannot be rejected. explain why GROWTH was insignificant.
Capital Structures: Nonprofit and Proprietary Health Care Organizations 7

Figure 2. Summary Statisticsa

ROA RISK GROWTH SIZE


Panel A: Descriptive statistics and univariate tests
Proprietary Mean 0.166 0.229 0.261 18.49
(Std. Dev.) (0.341) (1.328) (0.399) (2.241)

Nonprofit Mean 0.101 0.055 0.206 16.95


(Std. Dev.) (0.023) (0.030) (0.867) (1.550)

t-statistic 9.966** 2.150* 0.739 7.947**

Panel B: Pearson correlation coefficients


ROA RISK GROWTH
RISK 0.230**

GROWTH 0.025 0.007

SIZE 0.138* 0.110* 0.033


a
The sample consists of 163 health care organizations that are proprietary and 163 that are nonprofit. The
independent variables are as follows: ROA is the ratio of total revenues less total expenses to total assets;
RISK is the volatility of ROA; GROWTH is the rate of growth of revenues over the last five years; SIZE is the
natural log of revenues; and TYPE is 1 if the organization is nonprofit and zero otherwise.
* Significance at the 0.05 level (two-tailed).
** Significance at the 0.01 level (two-tailed).

The Pearson correlation coefficients are the interaction terms were insignificant, I
included in Figure 2, panel B. The highest focused on the reduced regression model.
correlation is between ROA and RISK Panel A of Figure 4 includes the results of
(0.230). The correlations appear within the reduced regression model, without the
reasonable bounds and should not present interaction parameters. Panel B of Figure 4
a serious threat to the estimation of the includes the parameter estimates. Overall the
regression model. model is significant at the 0.05 level. ROA
The results of the analysis of covariance and RISK are significant at the 0.05 level.
are included in Figures 3 and 4. Figure 3 GROWTH and SIZE are not significant at
includes the full regression model (1), with the 0.05 level. Although not a focus of this
the interaction parameters. The interaction study, the negative sign on ROA supports
terms were included to test for parallelism. the pecking-order model of capital structure.
Since none of the interaction parameters is More importantly, TYPE is insignificant at
significant at the 0.05 level, the null hypoth- the 0.05 level, indicating that the null hypoth-
esis of equal slopes is not rejected, and there esis of equal intercepts cannot be rejected.
is no evidence to reject the hypothesis that Since the regression lines for proprietary
the regression lines for proprietary and and nonprofit health care organizations are
nonprofit organizations are parallel. Since parallel and have the same intercept, there is
8 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 3. Test for Parallelism: Full Modela

Variableb Df Mean Square F p-valuec


Corrected Model 9 5.884 11.596 .001
CONSTANT 1 0.077 0.153 .695
ROA 1 0.747 1.484 .224
RISK 1 0.010 0.020 .888
GROWTH 1 0.008 0.017 .897
SIZE 1 0.004 0.009 .925
TYPE 1 1.029 2.046 .154
d
ROA*TYPE 1 0.156 0.309 .578
RISK*TYPEd 1 0.047 0.095 .759
GROWTH*TYPEd 1 0.050 0.099 .753
SIZE*TYPEd 1 0.524 1.041 .308
2
Adjusted R = 0.229
a
The full ANACOVA model is estimated using a sample of 163 proprietary health care organizations and
163 nonprofit health care organizations.
b
The dependent variable is leverage, the ratio of debt-to-total assets. The independent variables are:
ROA is the ratio of total revenues less total expenses to total assets; RISK is the volatility of ROA; GROWTH
is the rate of growth of revenues over the last five years; SIZE is the natural log of revenues; and TYPE is 1 if
the organization is nonprofit and zero otherwise.
c
All p-values on coefficients are based on one-tailed t-tests, with the exception of the model, the intercept,
TYPE, and the interaction terms, which are based on two-tailed t-tests.
d
The interaction terms are included to test for parallelism. Since the interaction terms are insignificant,
the null hypothesis of equal slopes is not rejected.

no evidence for rejecting the hypothesis that Summary and Conclusions


they are coincident. Thus, there is no evi-
dence that the capital structures (as measured This study addresses whether or not there
by the debt-to-assets ratio) of proprietary and are any differences in the capital structures
nonprofit health care organizations are dif- of proprietary and nonprofit health care
ferent, supporting the theory of institutional organizations. The theory of institutional
convergence on capital structure. Although convergence holds that entities with different
nonprofit and proprietary health care organi- institutional forms have similar characteris-
zations have unique financing mechanisms, tics. That is, even though nonprofit organiza-
these differences do not impact the relative tions have unique legal characteristics when
amount of debt and equity in their capital compared to proprietary organizations, these
structures. Using data from 2005 (results do not cause differences in capital structures.
not shown), the results are similar and thus Although there have been several studies on
robust as to the different time periods. the capital structures of both proprietary
Capital Structures: Nonprofit and Proprietary Health Care Organizations 9

Figure 4. Test for Equality of Intercepts: Reduced Modela

Panel A: Reduced ANACOVA Model

Variableb Df Mean Square F p-valuec


Corrected Model 5 10.347 20.671 .001
CONSTANT 1 0.001 0.002 .963
ROA 1 16.127 32.221 .001
RISK 1 18.972 37.903 .001
GROWTH 1 0.193 0.386 .535
SIZE 1 0.961 1.919 .167
d
TYPE 1 0.016 0.032 .857
Adjusted R2 = 0.233

Panel B: Parameter Estimates

Variable Coefficient Standard Error t p-valuec


CONSTANT 0.010 0.388 0.026 .979
ROA 1.002 0.177 5.676 .001
RISK 0.264 0.043 6.157 .001
GROWTH 0.0363 0.058 0.622 .535
SIZE 0.0315 0.023 1.385 .167
TYPE 1.830 0.102 0.180 .857

a
The reduced model is estimated using a sample of 163 proprietary health care organizations and
163 nonprofit health care organizations.
b
The dependent variable is leverage, the ratio of debt-to-total assets. The independent variables are: ROA is
the ratio of total revenues less total expenses to total assets; RISK is the volatility of ROA; GROWTH is the
rate of growth of revenues over the last five years; SIZE is the natural log of revenues; and TYPE is one
if the organization is nonprofit and zero otherwise. The interaction terms are eliminated, since they were
insignificant (see Figure 3).
c
All p-values on coefficients are based on one-tailed t-tests, with the exception of the model, the intercept,
and TYPE, which are based on two-tailed t-tests.
d
Since the experimental variable TYPE is insignificant, the null hypothesis of equality of intercepts is
not rejected.

and nonprofit organizations, no studies have in the amount of leverage between the two
directly and empirically compared the two. institutional types, supporting the institu-
Controlling for profitability, risk, growth, tional convergence on capital structure.
and size, I use analysis of covariance to The limitations of this study are the limited
determine whether or not the proprietary and time period, the single industry focus, and the
nonprofit organizations use the same amount use of only organizations in the United States.
of leverage (measured as the ratio of debt-to- Due to changes in accounting rules, this study
total assets) in their capital structures. The focused on data from the mid-1990s. How-
results indicate that there is no difference ever, data from the mid-2000s also support
10 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

the hypothesis. Also, to eliminate the impact comparing their structures to those of propri-
of industry on capital structure, only one, etary organizations. The relative amount of
albeit broad, industry was used for testing. debt used by an organization is an important
Further research is needed to expand the determination of the organizations likeli-
time periods of the study and to apply the hood of financial problems and its cost of
tests to other industries and other countries. capital.34 Therefore, capital structure is a
This research contributes to the existing lit- critical issue in the financial management of
erature on capital structure of nonprofits by both proprietary and nonprofit organizations.

REFERENCES

1. Jensen, M, Meckling, W, Theory of the Firm: 4. Kester, C, Capital and Ownership Structure:
Managerial Behavior, Agency Costs and A Comparison of United States and Japanese
Ownership Structure, Journal of Financial Manufacturing Corporations, Financial Man-
Economics, 3: 305360 (1976). agement, Spring: 516 (1986).
2. E.g., Toy, N, Stonehill, A, Remmers, L, Wright, 5. E.g., Brody, E, Agents Without Principles: The
R, Beekhuisen, T, A Comparative Interna- Economics Convergence of the Nonprot and
tional Study of Growth, Protability, and Risk For-Prot Organizational Forms, New York
as Determinants of Corporate Debt Ratios in Law School Law Review, 40: 457535 (1996).
the Manufacturing Sector, Journal of Finan- 6. E.g., Bowman, supra, n.3.
cial and Quantitative Analysis, Nov: 875886 7. DiMaggio, P, Powell, W, The Iron Cage
(1974); Baskin, J, An Empirical Investigation Revisited: Institutional Isomorphism and Col-
of the Pecking Order Hypothesis, Financial lective Rationality in Organizational Fields,
Management, Spring: 2635 (1989); Kes- American Sociological Review, 82: 147160
ter, C, Capital and Ownership Structure: A (1983).
Comparison of United States and Japanese 8. Brody, supra, n.5.
Manufacturing Corporations, Financial Man- 9. DiMaggio and Powell, supra, n.7.
agement, Spring: 516 (1986). 10. DiMaggio, PJ, Anheier, HK, The Sociology
3. E.g., Wedig, GJ, Sloan, F., Hassan, M, Mor- of Nonprot Organizations and Sectors,
risey, M, Capital Structure, Ownership and Annual Review of Sociology, 16: 137159
Capital Payment Policy: The Case of Hospi- (1990).
tals, Journal of Finance, 43: 2140 (1988); 11. Gray, BH, Prot, Corporate Change and
Wedig, GJ, Risk, Leverage, Donations, and Accountability in American Health, 20th Cen-
Dividends-in-Kind: A Theory of Nonprot tury Fund (1990).
Financial Behavior, International Review of 12. Starr, P, Medical Care and the Boundaries of
Economics and Finance, 3: 257278 (1994); Capitalist Organization, unpublished manu-
Wedig, GJ, Hassan, M, Morrisey, M, Tax- script, Program on Non-Prot Organizations,
Exempt Debt and the Capital Structure of New Haven: Yale University (1980).
Nonprot Organizations: An Application to 13. Brody, supra, n.5, p. 458.
Hospitals, Journal of Finance, 51: 1247 14. Hansmann, H, The Role of the Nonprot
1283 (1996); Bowman, W, The Uniqueness Enterprise, Yale Law Journal, 89: 835901
of Nonprot Finance and the Decision to Bor- (1980).
row, Nonprofit Management and Leadership, 15. Id.
12(3): 293311 (2002). 16. Brody, supra, n.5.
Capital Structures: Nonprofit and Proprietary Health Care Organizations 11

17. Bowman, supra, n.3. Information Investors Do Not Have, Journal


18. Fama, E, Jensen, M, Separation of Owner- of Financial Economics, 13: 187221 (1984).
ship and Control, Journal of Law and Eco- 23. Myers, S, The Capital Structure Puzzle, Jour-
nomics, 26: 301325 (1983); Fama, E, Jensen, nal of Finance, 39: 575592 (1984).
M, Agency Problems and Residual Claims, 24. Donaldson, G, Corporate Debt Capacity:
Journal of Law and Economics, 26: 327349 A Study of Corporate Debt Policy and the
(1983b); Fama, E, Jensen, M, Organizational Determination of Corporate Debt Capacity,
Forms and Investment Decisions, Journal of Boston: Harvard Business School (1961).
Financial Economics, 14: 101119 (1985). 25. Bacon, P, Do Capital Structure Theories Apply
19. Wedig, GJ, Hassan, M, Morrisey, M, Tax- to Nonprot Hospitals? Journal of the Mid-
Exempt Debt and the Capital Structure of west Finance Association, 21: 8690 (1992).
Nonprot Organizations: An Application to 26. Bowman, supra, n.3.
Hospitals, Journal of Finance, 51: 1247 27. Wedig, et al. (1988), supra, n.3.
1283 (1996). 28. Bacon, supra, n.25.
20. Id. 29. Kester, supra, n.4.
21. Taggart, R, A Model of Corporate Financing 30. Id.
Decisions, Journal of Finance, 32: 1467 31. Id.
1484 (1977). 32. Myers and Majluf, supra, n.22.
22. Myers, S, Majluf, N, Corporate Financing 33. Bowman, supra, n.3.
and Investing Decisions When Firms Have 34. Jensen and Meckling, supra, n.1.
A Comparative Analysis of the CVP
Structure of Nonprot Teaching and
For-Prot Non-Teaching Hospitals
Li-Lin (Sunny) Liu, Dana A. Forgione, and Mustafa Z. Younis

Due to the market turbulence facing the hospital industry, the nancial viability of teaching hospitals
has been severely threatened. Their missions of education, research, and patient care even strengthen
this crisis. Therefore, the objective of this study is to conduct a comparative analysis of the cost, volume,
and prot (CVP) structure between large nonprot urban teaching hospitals and small for-prot rural/
suburban non-teaching hospitals. The following two hypotheses were developed: (1) large nonprot ur-
ban teaching hospitals tend to have higher xed cost, lower variable cost, lower total revenue adjusted
by case mix index (CMI), and lower return on total assets (ROA); and (2) small for-prot rural/suburban
non-teaching hospitals tend to have lower xed cost, higher variable cost, higher total revenue adjusted
by CMI, and higher ROA. Using 117 teaching hospitals and 102 non-teaching hospitals selected from
the Medicare Cost Report database in 2005, the results from multiple regression indicated that large
nonprot teaching hospitals located in urban areas are more likely to have higher xed cost and lower
variable cost. While such cost structure doesnt necessarily affect their total revenue adjusted by CMI,
it does lead to a lower return on hospitals total assets. The results support our hypotheses in terms of
xed cost percentage, variable cost percentage, and ROA, but not total revenue adjusted by CMI. The
results suggest that cost structure is signicantly associated with hospitals performance. Also, as teach-
ing hospitals portfolios of services and programs increase (e.g., provision of uncompensated care to
Medicare and Medicaid patients and doing research), it becomes strategically necessary and critical to
manage the allocation of resources or investments into the xed capital that supports the business. Key
words: CVP structure, teaching hospitals, non-teaching hospitals.

I. Introduction viability of all hospitals, the teaching hospi-


tals are especially affected due to their lack of
Teaching hospitals are facing a highly exposure to a competitive industry and their
uncertain and unpredictable future. The once unusually large and complex organizational
placid and stable industry that allowed teach- and capital infrastructures. Additionally,
ing hospitals to practice academic medicine the existence of several business missions
in a financially secure environment has been
replaced by an extremely turbulent and Li-Lin (Sunny) Liu, PhD, CPA, is Assistant Profes-
competitive marketplace.1 A comprehensive sor in the Department of Accounting and Finance,
review of prior studies regarding Academic College of Business Administration and Public Pol-
Health Centers (AHCs), Academic Medi- icy, California State University, Dominguez Hills.
cal Centers (AMCs), and teaching hospitals Dana A. Forgione, PhD, CPA, CMA, CFE, is the
has indicated that changes in public policy, Janey S. Briscoe Endowed Chair in the Business of
Health and Professor of Accounting in the College of
increases in uncompensated care, growth in Business at the University of Texas at San Antonio,
managed care, increases in input prices, par- San Antonio, Texas.
adox of higher intensity, and drop of oper- Mustafa Z. Younis, is Professor of Health Econom-
ating margins are all key challenges facing ics and Finance, at Jackson Sate University, School
these institutions and derive a turbulent and of Health Sciences, Jackson, Mississippi. He can be
competitive market. reached at Younis99@gmail.com.
As Langabeer2 indicated, although this J Health Care Finance 2012; 39(1):1238
market turbulence threatens the financial Copyright 2012 CCH Incorporated

12
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 13

(i.e., education, research, and patient care) literature regarding challenges facing AHCs,
rather than the singular profit-maximizing AMCs, and teaching hospitals, and the possi-
mission of the industrial organization, poses ble determinants of performance differences
even more critical concerns for the finan- between teaching and non-teaching hospi-
cial viability of the teaching hospitals in tals. Section III provides research design,
extremely turbulent markets.3 including propositions, sample selection,
While the private sector has paid signifi- data source, and research method, and the
cant attention to the links among the envi- final section concludes with a summary of
ronment, strategy, and financial performance expected conclusion, limitations, and possi-
for the industrial organization,4 very little ble future research.
research has focused on the academic teach-
ing hospitals. Consequently, the objective of II. Literature Review
this study is to conduct a comparative analysis
of the cost, volume, and profit (CVP) struc- Challenges Facing AHCs, AMCs, and
ture between large non-profit urban teaching Teaching Hospitals
hospitals and small for-profit rural/suburban
The Association of Academic Health
non-teaching hospitals. Based on an exten-
Centers5 defines an AHC as an allopathic or
sive review of prior literature concerning
osteopathic medical school with at least one
teaching hospitals performance, we hence
or more other health professional schools
develop the following two propositions:
and an associated teaching clinical enter-
prise.6 In other words, an AHC refers to a
1. Large nonprofit urban teaching hospitals
medical teaching institution affiliated with
tend to have lower CMI adjusted vol-
a primary hospital. These institutions have
ume, higher fixed cost, lower variable
three goals:
cost, and lower return on assets (ROA,
profit margin x asset turnover); and
2. Small for-profit rural/suburban non- 1. To provide medical and health educa-
teaching hospitals tend to have higher tion and training;
CMI adjusted volume, lower fixed 2. To conduct research and technological
cost, higher variable cost, and higher innovations; and
ROA. 3. To provide patient care, especially to
populations who are unable to pay.
By obtaining data primarily from the
Medicare Cost Report, we plan to utilize The environment facing AHCs has
the CVP technique to conduct the analy- been described as turbulent,7 endangered,8
sis. Hopefully, the findings can be used to competitive,9 and opportunistic.10 Such a
enhance the decision effectiveness of hospi- dynamic environment exists due to the fol-
tal administrators in selecting their product lowing paradoxical view: on one hand,
mix and designing their CVP structure as AHCs share distinctive competitive advan-
well as financial strategies appropriately. tages as clinical and research hubs in the
The remainder of this article is organized health care sector although they confront
as follows: Section II describes the related increased scrutiny from federal regulators
14 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

to ensure that their clinical services and 5. Paradox of Higher Intensity; and
resident practice patterns are in compli- 6. Drop in Operating Margins.
ance with federal statutes;11 and on the other
hand, reimbursement systems that reward Changes in Public Payment Policy
efficiency have replaced traditional fee- The enactment of the Balanced Budget Act
for-service plans and increased penetration (BBA) of 1997 has reduced both Medicare
by managed care organizations have also and Medicaid payments to teaching hospitals
reversed the financial incentives that were and affected hospital profitability14 and the
previously available under the traditional average length of hospitalization.15 Medicare
fee-for-service system.12 has been a key source of funding for graduate
AMCs are generally defined to include the medical education (GME) which is the train-
medical center, the teaching hospital, and the ing that interns or residents receive follow-
faculty practice plan. Fox et al.13 examined ing medical school.16 From 1990 to 1997, the
the factors influencing AMCs financial per- average US hospital payment-to-cost ratio for
formance. Their analysis showed that AMCs fee-for-service Medicare patients increased
tend to be more expensive than their commu- from 89.2 percent to 103.6 percent. However,
nity counterparts, that there are differences following the enactment of the BBA of 1997,
in the mission and culture of AMCs and Medicare Prospective Payment System (PPS)
managed care organizations, and that AMCs payments were reduced and the Medicare
and managed care are incompatible on sev- hospital payment-to-cost ratio fell to 101.1
eral levels, including distribution of patient percent in 1999.17 In addition to the reduction
revenues, attitudes toward patients, and the of Medicare hospital payments, the provi-
role of primary care physicians. In other sions of the BBA of 1997 also reduced Med-
words, AMCs need to act like multispecialty icaid hospital payments. Most of the change
group practices, to adopt new methods for in Medicaid hospital payments has been
controlling service use, and to encourage attributed to growth in the Medicaid Dispro-
recognition of the costs of medical educa- portionate Share Hospital (DSH) program.18
tion in order to survive in this increasingly This program provides additional funding to
turbulent environment. hospitals serving a relatively large number
Due to the emerging dynamic environ- of indigent patients. From 1990 to 1998, the
ment, all AHCs, AMCs, and teaching hos- Medicaid hospital payment-to-cost ratio for
pitals need to identify the key challenges fee-for-service patients increased from 79.7
facing them so as to position themselves percent to a high of 97.9 percent. However,
more favorably for future survival or suc- following the enactment of the BBA of 1997,
cess. Based on an extensive review of prior the Medicaid hospital payment-to-cost ratio
literature, we thus summarize the possible fell to 96.7 percent in 1999.19
challenges facing them as follows: What are the impacts on AHCs of these
reductions in funding? Guo20 reported that
1. Changes in Public Payment Policy; the reductions in Medicare and Medicaid
2. Increases in Uncompensated Care; funding decreased AHCs revenue and
3. Growth in Managed Care; increased uncompensated care. Alexander
4. Increases in Input Prices; et al.21 indicated that reductions in these
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 15

funding sources adversely affect AHCs reduced fees, which is called uncompen-
mission of providing care to the poor and sated care. The increases in uncompensated
uninsured people. The costly care for care are associated with the growth in the
these patients has contributed to the ris- number of Americans without health insur-
ing uncompensated care of AHCs. Just as ance. The number of uninsured increased
Reuter22 reported, AHCs have the highest from 35.6 million in 1990 to 42.6 million
levels of uncompensated care, accounting in 1999.25 Due to the competitive forces in
for 37 percent of all the uncompensated the health care market, its getting more dif-
care in 1994. Reuter23 indicated that such ficult for hospitals to shift the costs of caring
funding reductions also affect AHCs train- for poor and uninsured patients onto paying
ing and education mission. As he stated in patients. As Bellandi26 reported, the uncom-
his study, programs in GME have more than pensated care represented about 6 percent
doubled from 1970 to 1994. Since Medi- of hospital expenses in 1998. When uncom-
care is the largest payer of GME, AHCs are pensated care reaches a substantial portion
especially vulnerable to government legis- of a hospitals business, it could become a
lations that call for reductions in funding to financial burden.27 Consequently, hospitals
Medicare and Medicaid. that serve large numbers of indigent patients
In addition, Linna et al.24 utilized the sto- need to be subsidized either with public
chastic frontier cost function to estimate the funds or private charities in order to sur-
teaching and research costs of Finnish hospi- vive in competitive markets.28 Federal and
tals and demonstrated that: state governments currently are consider-
ing revisions in payment policies to support
1. The efficiency adjustment had signifi- hospitals that disproportionately serve poor,
cant impact on the marginal and aver- uninsured patients.29
age cost estimates of the teaching and The degrees to access the above-described
research output; and subsidies could be various depending upon
2. The university teaching hospitals were the types of hospitals. For example, public
underfunded with respect to both hospitals and teaching hospitals may be
research and teaching output. particularly affected by changes in these
payment policies because many of them
Their results further suggested that the are located in urban centers and serve large
average rate of teaching and research reim- numbers of low-income patients.30 Espe-
bursement should be approximately 14.6 cially teaching hospitals, they must bal-
percent of the total operating costs in uni- ance their patient care activities with their
versity teaching hospitals. Their findings research and education missions in order
may provide some important implications to to position themselves favorably in the
policymakers when there is a need to initiate market for survival. Moreover, the care of
some policy changes in the future. uninsured patients in teaching hospitals
may even be affected by growth of managed
Increases in Uncompensated Care care during the 1990s. Weissman et al.31
Many hospitals provide health services examined the relation of teaching status
to the uninsured for free or substantially and managed care to changes in market
16 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

share and market concentration and found negative impacts of the proliferation of
the following: managed care. For example, Levey et al.33
indicated that managed care, while affect-
The market share of uninsured patients ing significant cost savings, has at no small
during the 1990s grew at AMC hospitals cost to Americas major teaching hospi-
relative to other hospitals in their ser- tals and their social missions of teaching,
vice areas; and these increases occurred research, and patient care. Also, as more
primarily in areas with high levels of and more consumers enroll in managed
managed care; and care plans, they cannot live by primary
In urban areas, the care of uninsured care alone; in other words, they will, at
patients was twice as concentrated as one time or another, need the kinds of spe-
that of all patients, and the ratio of con- cialized care that only major teaching hos-
centration (uninsured patients vs. all pitals and the specialist physicians trained
patients) was greater in areas with high in such institutions can provide. Guo34
managed care levels than in areas with reported that the growth of managed care
low managed care levels. has affected AHCs in several ways. First,
managed care has initiated cost contain-
ment strategies by seeking to contract with
Growth in Managed Care
health care organizations that offer lower
Managed care here is defined as a system fees. As they are more likely to contract
that either pays hospitals on a capitated basis with non-teaching hospitals that charge
(a per member per month basis) or pays the less for patient care than AHCs, AHCs are
hospitals based on a discounted price. This currently facing increasing price competi-
managed care system includes two types tion. More specifically, while AHCs have
of agreements: one between hospitals and always charged 30 to 40 percent more than
health maintenance organizations (HMOs) non-teaching hospitals to offset their mis-
and the other between hospitals and pre- sion of caring for the poor and uninsured,35
ferred provider organizations (PPOs). As they cannot afford to do so any more under
Fox32 documented, about 30 percent of the managed care. Second, more for-profit
population is enrolled in HMOs and 34 per- health care organizations entering the mar-
cent in PPOs, with only 14 percent remain- ket and integrating also threaten AHCs
ing in traditional fee-for-service plans. survival.
Although managed care may be credited In other words, the growth of managed
with reducing hospital and health care cost care has brought drastic competition, thus
inflation, such financial constraints are also leading to higher AHC costs and lower rev-
blamed for jeopardizing other important enues. Higher costs result from the fact that
hospital objectives, especially teaching hos- AHCs must serve patients with sicker and
pitals primary missions in providing direct more complex needs which non-teaching
patient care, training the US medical work- hospitals are not able to accept. Lower rev-
force, and engaging in medical research. enues result from AHCs inability to compete
Several studies dealing with AHCs or with non-teaching hospitals to secure man-
teaching hospitals have pointed out the aged care contracts.
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 17

Increases in Input Prices Despite the widely held perception that


Shortages of hospital workers, such as AMCs important mission and perceived
nurses, radiology technicians, and pharma- quality advantages have been used to justify
cists, have led to upward pressures on hospi- their higher costs and ensure their inclu-
tal wages.36 This pressure can be even more sion in preferred networks of providers, the
severe for a labor-intensive industry such as Fisher et al.39 study suggests that:
hospitals. As Rodgers et al.37 indicated, an
estimated 38.8 percent of the increase in 1. The challenge facing AMCs is to learn
hospital care spending between 1997 and how to improve both the quality and
2001 has been attributed to labor costs (e.g., efficiency of care; and
wages and benefits). 2. Academic institutions that demonstrate
both high quality and lower long-term
Paradox of Higher Intensity costs will be more likely to compete
successfully in a health care market-
Fisher et al.,38 focusing on patients whose place that is increasingly concerned
initial hospitalization was at one of the 299 about longitudinal efficiency.
hospitals that are members of the Council
of Teaching Hospitals (COTH), examined Drop in Operating Margins
the content, quality, and outcomes of care
According to a study commissioned by
across AMCs that differ by up to 60 percent
the New York Citybased Commonwealth
in the overall intensity of medical services
Fund for the financial performance of AHC
delivered to patients with serious chronic ill-
hospitals, 19942000, the main challenges
nesses. Their findings indicated that:
facing AHCs are the declining operating
margins. This report documents a drop of the
1. Although major US AMCs differ dra- operating margins of 1.4 percent and 2.6 per-
matically in the overall intensity of ser- cent in 2000 for AHCs and major teaching
vices they provide to similar patients, hospitals, respectively. Additionally, among
the increased intensity doesnt appear the several factors contributing to the declin-
to be associated with higher quality of ing financial performance of AHC hospitals,
care or to result in better survival; and the primary two are:
2. Characteristics of the institutions
themselves (or the physicians practic- 1. The decrease in private payer payment-
ing in them) provide the major alter- to-cost ratio; and
native explanation for the differences 2. The amount of resources that AHC
in intensity. hospitals spent in caring for the poor.
With respect to the second finding, one According to this report, since private pay-
factor could be the size of the teaching pro- ers have been less willing than in the past
grams, which is consistent with the findings to support the high costs of AHC hospitals,
of prior studies which have shown that as the the private payer payments as a percentage
size of the teaching programs increases, so of costs have declined from 128.4 percent
does the cost of care. in 1996 to 112.5 percent in 2000.40 Also,
18 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

although public AHC hospitals depend more percentage points in 1998 to 2.3 percent,
on Medicaid as a payment source, which is about half the margin of non-teaching hospi-
different from private AHC hospitals which tals. Dick Knapp, executive vice president of
depend more on Medicare and private pay- the AAMC, evaluated this situation and com-
ers, high levels of uncompensated care have mented that the negative margins reported by
reduced their financial strength.41 a number of major teaching hospitals may be
Moreover, the Association of American partly attributed to the increases in the cost
Medical Colleges (AAMC) predicted on of new drugs, medical devices, information
its Web site in 2000 that nearly 50 percent technology, and labor, as well as the declining
of all AMCs that are major teaching hospi- revenues from managed care, Medicare, and
tals would have negative margins by 2002, Medicaid, due in part to the BBA of 1997.44
compared to only about 25 percent of non- In order to gain a better understanding
teaching and other teaching institutions. of the factors driving such margin differ-
According to the AAMC data, negative ences and to achieve our research objective,
margins for major teaching hospitals would we conducted a comprehensive review of
double between 1996 and 2002 due to the prior studies regarding teaching hospitals
provision of the BBA. Besides, while no performance analysis and categorized our
absolute standard exists, total margins below observations of the possible factors driving
4 percent are thought of as insufficient to differences into the following eight groups:
sustain teaching hospitals. In sum, the enact-
ment of the BBA of 1997 has added consider- 1. Cost differences between teaching and
able financial pressure to an already difficult non-teaching hospitals;
financial environment. As such pressure may 2. Cost differences between urban and
threaten the teaching, research, and indigent rural hospitals;
care missions of teaching hospitals, appropri- 3. Productivity (efficiency) differences
ate policy modifications may be necessary to between teaching and non-teaching
ensure teaching hospitals fulfill their special hospitals;
missions with sufficient financial resources.42 4. Competitive effects (effects of growth
of managed care) on teaching hospitals;
Possible Determinants of Performance 5. Impacts of organizational features on
Differences Between Teaching and teaching hospitals;
Non-Teaching Hospitals
6. Form of ownership;
Due to both public policy changes and 7. Significance of size on teaching hospi-
market reforms, the US health care industry tals performance; and
is facing a number of critical changes. While
8. Margin differences between teaching
all hospitals are seeing less income after
and non-teaching hospitals.
expenses given these changes, major teaching
hospitals are experiencing a particularly tight
financial squeeze. Cost Differences Between Teaching
and Non-Teaching Hospitals
As the Medicare Payment Advisory Com-
mission reported in 2000,43 the total margin Teaching hospital costs are substantially
for major teaching hospitals declined by 2.8 higher than non-teaching hospital costs.45
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 19

For example, Foster46 examined the estima- hospitals and thus incur higher costs. Rosko
tion of the costs of the products of teaching proposed that the possible explanations for
hospitals through a review of the literature this phenomenon may include:
and found that the following factors have
the potential to explain why the costs of the 1. Large size of teaching hospitals;
products of teaching hospitals are greater 2. Educational value of attracting patients
than those of non-teaching hospitals: with a wide variety of diagnoses;51 and
3. Generous indirect medical education
1. Complexity of case mix; payments from Medicare as a subsidy.
2. Severity of illness;
3. Research activity;
4. Use of innovative modes of treatment; Cost Differences Between Urban
and Rural Hospitals
and
5. Teaching of students. An analysis of the 1981 Medicare cost
report data showed that average costs per
In addition, Fosters study suggested the case in rural hospitals were about 40 per-
importance of designing a framework that cent lower than that in urban hospitals.
could determine reliable, standard costs for Even after accounting for differences in
diagnostic case types. Rosko et al.47 and case mix, labor costs, and indirect teaching
Thorpe,48 after controlling for a number of costs, a difference of more than 20 percent
characteristics such as location, patient mix, still remained. Although the urban-rural
and size, reported that major teaching hospi- cost differential has often been attributed
tals may be 30 to 42 percent more expensive to systematic differences in patient sever-
than non-teaching hospitals. ity of illness across hospital groups that
Koenig et al.49 estimated the mission- are not accounted for by the current DRG
related costs of teaching hospitals and system, the results of ODougherty et al.52
found that AHCs and other teaching hos- suggested that most of the cost difference
pitals face higher patient care costs than between urban and rural hospitals is not
non-teaching hospitals, because of their attributable to within-DRG differences in
missions of GME, biomedical research, average patient severity.
and the maintenance of standby capacity Moreover, Thorpe53 investigated the cost
for medically complex patients. More spe- differences between inner city hospitals
cifically, its estimated that total mission- and suburban and rural hospitals and found
related costs were $27 billion in 2002 for that the key sources of cost variation
all teaching hospitals, with GME (includ- include:
ing indirect and direct GME) and standby
capacity accounting for roughly 60 percent 1. The higher costs of treating low-income
and 35 percent of these costs, respectively. patients;
Moreover, Rosko50 indicated that teach- 2. The difference in teaching commitment;
ing hospitals, especially those with substan- 3. Market competition;
tial GME programs, provide larger volumes 4. Higher numbers of emergency room
of uncompensated care than non-teaching patients;
20 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

5. The ratio of forecasted to actual admis- due to the originally relatively high pay-
sions; and ments of both.
6. Wages.
Productivity (Efficiency) Differences
More specifically, the most expensive Between Teaching and
Non-Teaching Hospitals
urban hospitals have costs over 5.3 percent
higher than average and nearly one half of If the productivivty of medical labor is lower
this higher cost can be attributed to large in teaching hospitals, it may be concluded that
teaching programs. In addition, case mix teaching hospitals are less efficient and thus
accounts for about 20 percent of the higher- more costly than their non-teaching coun-
than-average costs; higher salaries and terparts. The evidence can be obtained from
cost-increasing competition for physicians the following examples. First, Lehrer et al.55
explain 25 percent of the higher costs; and found that attending physicians productivity
over 7 percent of these costs can be traced is lower in teaching hospitals than that in non-
to emergency admissions, usually involving teaching hospitals. Second, Kralewski et al.56
poor patients. corroborated Lehrer et al.57 findings by indi-
In October 1983, Medicare changed the cating that productivity of clinical practition-
payment method for inpatient hospital ser- ers is lower in teaching hospitals than that in
vices from retrospective, cost-based reim- non-teaching clinics.
bursement to a PPS, under which Medicare
pays a fixed basic rate for each inpatient Competitive Effects (Effects of Growth of
Managed Care) on Teaching Hospitals
stay. Initially, separate standard rates were
established for urban and rural hospitals due The penetration of managed care could
to the existence of the above-described cost drive increasing price competition for teach-
differential; however, the Omnibus Budget ing hospitals. How does this market competi-
Reconciliation Act of 1990 (OBRA 1990) tion affect teaching hospitals performance?
phased out the separate standard rates for Will such market pressure hinder hospitals
urban and rural hospitals between fiscal year performance or will it result in more effi-
(FY) 1991 and FY 1995. cient hospitals providing the social good of
ODougherty et al.54 assessed the need medical education?
for payment adjustments in a PPS without According to a study by Pardes,58 teach-
separate urban and rural rates and found ing hospitals should become as efficient as
that under a single standardized payment possible via decreasing costs, reducing the
and current-law adjustments, there was a number of medical residents, and providing
need to redistribute payments from rural to more primary care to respond to the growth
urban hospitals. They further suggested that of managed care. Additionally, Grosskopf
although refinements for case mix, outliers, et al.59 assessed the performance of US teach-
and the wage index can make a significant ing hospitals operating in 1995 and found
contribution to avoiding payment dispari- that competition (as measured by the number
ties in a single-rate system, changes in the of managed care contracts per hospital and
adjustments for teaching and disproportion- the number of patients covered by these con-
ate-share (DSH) hospitals are also needed tracts per hospital) has positive effects on the
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 21

teaching hospitals; in other words, as compe- hospital is not required to pay taxes and is
tition increases, so does the teaching hospi- not allowed to distribute earnings. Such non-
tals relative efficiency. Moreover, increased distribution constraint hence creates a dif-
competition leads to higher efficiency with- ferent competitive environment compared
out compromising teaching intensity. to for-profit hospitals. As Property Rights
Rosko60 conducted a panel analysis of cost Theory suggests, the variable of ownership
inefficiency on performance of US teaching form (FP) should be negatively associated
hospitals and found that: with costs and inefficiency. Further, since
teaching hospitals have a much different
1. Decreases in inefficiency are associ- cost structure, regulatory environment, and
ated with the HMO penetration rate mission that is linked closely to research and
and time; and teaching rather than just providing care,62
2. Increases in inefficiency are associated the separation of non-profit versus for-profit
with for-profit ownership status and in addition to teaching versus non-teaching
Medicare share of admissions. hospitals is thus important and necessary for
our analysis.
Impacts of Organizational Features
on Teaching Hospitals Significance of Size on Teaching
Hospitals Performance
Teaching hospitals vary among them-
selves in terms of standards and the severity Despite the general belief that the
of patients case mix. Do such differences increased size of health care organizations
in organizational features matter in account- may reduce costs through economies of
ing for teaching hospitals performance? scale and scope, a review of prior literature
Grosskopf et al.61 used two proxy variables for shows mixed results regarding the existence
standards and case mix to examine this issue: of substantial scale economies in hospitals.63
For example, Carr et al.64 analyzed data on
1. Whether the hospital is a member of the 3,147 US hospitals using the average daily
COTH; and patient census and a quadratic cost function
2. Whether the hospital has a medical and concluded that scale economies existed
school affiliation (MDSCH). and the long-run average cost function
reached a minimum at approximately 190
Their findings indicated that COTH members patients. Lave et al.65 used an elaborate two-
and hospitals with medical school affiliation stage model to estimate a Cobb-Douglas
are relatively less efficient than the hospitals hospital cost function and found that size
without such memberships, and they maintain (defined by number of operating beds) was
higher levels of teaching dedication (the num- negative in sign (economies of scale) but
ber of residents per physician) and intensity insignificant. In other words, if economies
(the number of residents per bed). of scale exist in the hospital industry, they
are not very strong. Bays66 used a quadratic
Form of Ownership
cost function specification for the number of
The difference between for-profit and beds, case mix, and case flow rate for teach-
non-profit hospitals lies in thata non-profit ing and non-teaching hospitals in California.
22 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

His findings showed that case mix and case have lower costs due to affiliation. Further,
flow rate are significant and demonstrate Connor et al.71 reported that hospital merg-
economies of scale but that the size of the ers have had a greater effect on bargaining
hospital (beds) is not significant. However, power than on costs.
the coefficients of the linear and quadratic
terms on size are of the right sign to indicate Margin Differences Between Teaching
economies of scale. and Non-Teaching Hospitals
Yafchak67 utilized the Cobb-Douglas Rosko72 employed a panel design to ana-
production function to empirically esti- lyze changes in performance variables related
mate whether or not larger hospitals have to profitability, volume, and efficiency in a
lower long-run average costs per bed than national sample of major teaching hospitals
smaller hospitals. His results indicated that from 1990 to 1999. Roskos findings demon-
although economies of scale have evolved strated that:
recently for non-teaching and teaching hos-
pitals, the primary market forces that may 1. Average operating margin was negative
be creating economies of scale in the hospi- throughout the 1990s, which was in
tal industry are decreasing revenues due to contrast with the positive mean operat-
lower reimbursement and lower occupancy ing margin for non-teaching hospitals
rates. As reimbursement and occupancy in six years of the last decade;73 and
continue to trend down in the future, Yaf- 2. Major teaching hospitals responded
chak further suggested that hospitals may to financial pressures by downsizing
seek additional economies to survive in inpatient capacity, expanding outpatient
an increasingly competitive and shrinking activity, reducing length of stay, and
industry. Moreover, Rosko,68 in his panel increasing labor productivity.
analysis of major teaching hospitals per-
formance, found that major teaching hospi- As Rosko suggested, the difference in
tals increased their participation in systems, operating margins between major teaching
hoping to reap the benefits of firm-level hospitals and non-teaching hospitals prob-
economies of scale and scope and increased ably reflects the higher cost structures and
bargaining power. Compared to that in pri- greater uncompensated care burdens of
vate major teaching hospitals where the rate major teaching hospitals.
increased from 46 percent to 73 percent, How do teaching hospitals deal with the
this trend was especially apparent in public pressure caused by the higher cost structures
major teaching hospitals that had a 9 per- and greater uncompensated care burden
cent system participation rate in 1990 and a described above? Langabeer74 examined the
40.3 percent rate in 1999. financial and operating data for 100 major US
Contrary to prior studies, Friedman et al.69 teaching hospitals to determine relationships
found that hospitals average costs increase among competitive strategy, market envi-
slightly with an increase in hospital size. ronment, and financial return on invested
Dranove70 studied whether or not system capital. Langabeers findings indicated that
affiliation results in economies of scale the single most significant competitive strat-
and found that systems do not appear to egy for improving financial performance
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 23

was pricing strategy. As Langabeer stated, numbers of emergency room patients,


organizations usually have two options to the ratio of forecasted to actual admis-
increase their margins due to the only two sions, and wages;
components of pricing strategy at a macro 2. Productivity differences;
level: price and cost. The first option is to 3. Competitive effects of growth of man-
charge the same price as their competitors as aged care;
long as they have a substantially lower cost 4. Organizational characteristics such as
advantage. The second option is by charg- whether the hospital is a member of the
ing higher prices than competitors, which COTH and whether the hospital has a
only the high-performing hospitals are able medical school affiliation (MDSCH);
to do. Due to the evolution of managed and
care reform efforts by commercial insurers 5. Ownership form.
and HMOs, teaching hospitals will not be
allowed to exert much control over prices in To elaborate further, large non-profit
the future. Since they are facing increasingly urban teaching hospitals, due to their higher
stricter price competition, their ability to complexity of case mix, greater severity of
charge higher prices, even for higher quality patients illness, greater use of innovative
and better positioned services, could become technology for treatment, missions of edu-
much more difficult. Therefore, Langabeer cation, research, and patient care, provision
further suggested that strategic management of larger volumes of uncompensated care,
of teaching hospitals requires improvement larger size, higher level of teaching commit-
of pricing strategies by focusing on both ments, higher labor cost, lower efficiency,
sides of the price-cost equation; that is, to increasing price competition resulting from
reduce cost or improve internal efficiency growth of managed care, organizational
while maintaining or increasing prices for characteristics (teaching status/affiliation),
services where possible. and non-profit ownership form, tend to
incur higher fixed cost and lower variable
Summary cost, have lower CMI-adjusted volume,
To summarize the above discussion, the and thus create lower ROA, which can be
possible factors driving performance dif- decomposed into two elements: profit mar-
ferences between large non-profit urban gin and asset turnover.
teaching hospitals and small for-profit rural/ On the contrary, small for-profit rural/
suburban non-teaching hospitals may suburban non-teaching hospitals, due to
include: their lower complexity of case mix, less
severity of patients illness, less use of
1. Cost differences resulting from com- innovative technology for treatment, provi-
plexity of case mix, severity of illness, sion of smaller volumes of uncompensated
use of innovative modes of treat- care, smaller size, lower level of teaching
ment, missions of GME, biomedical commitments, lower wages, higher effi-
research and patient care, provision ciency, lower penetration of managed care
of uncompensated care, size, market in their located areas, organizational char-
competition, teaching commitments, acteristics (non-teaching status/affiliation),
24 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

and for-profit ownership form, are prone to III. Research Design


incur lower fixed cost and higher variable
cost, have higher CMI-adjusted volume, Hypotheses
and thus create higher ROA. Based on the foregoing discussion, we
The above elaboration is consistent with developed two hypotheses, as follows:
Langabeers findings75 in product market
and capital investment strategy. As Lang- H 1: Large nonprofit urban teaching hospi-
abeer76 stated, product market strategy in tals tend to have lower CMI adjusted volume,
hospitals equates to a selection of the opti- higher fixed cost, lower variable cost, and
mal patient mix. Langabeers analysis con- lower ROA (profit margin x asset turnover).
firmed that the product market strategy is H 2: Small for-profit rural/suburban non-
one of the most fundamental elements that teaching hospitals tend to have higher CMI
hospital administrators should consider adjusted volume, lower fixed cost, higher
when formulating a strategic plan. Selecting variable cost, and higher ROA (profit margin
the appropriate product market strategy will x asset turnover).
not only enhance pricing strategy but also
boost return on invested capital. More spe- We use the following four cross-sectional
cifically, as hospitals select more complex regression models to test the above two
and specialized procedures, as indicated by hypotheses:
the adjusted CMI index, the expected finan- FC/TC = a0 + a1*Medicare % +
cial performance decreases; the other way a2*Medicaid % + a3*DSH + a4*CMI +
round is also true. a5*RESEAR + a6*GME + a7*OCC +
Additionally, as teaching hospitals port- a8*OUTPAT + a9*RESBED + a10*SYS +
folios of services and programs increase, it a11*TH + error (1)
becomes strategically necessary to manage
the allocation of resources or investments VC/TC = a0 + a1*Medicare % +
into the fixed capital (i.e., property, plant, a2*Medicaid % + a3*DSH + a4*CMI +
and equipment) that supports the business. a5*RESEAR + a6*GME + a7*OCC +
Langabeers findings confirmed that capi- a8*OUTPAT + a9*RESBED + a10*SYS +
tal intensity (the overall level of resources a11*TH + error (2)
invested into the assets of an organization
and the average age of the capital infra- VOL = a0 + a1*Medicare % +
structure) is significantly negatively related a2*Medicaid % + a3*DSH + a4*CMI +
to performance; that is, the more diversi- a5*RESEAR + a6*GME + a7*OCC +
fied product mix teaching hospitals select, a8*OUTPAT + a9*RESBED + a10*SYS +
the more capital they will invest into fixed a11*TH + error (3)
assets, and thus the lower expected return
they will get eventually. ROA = a0 + a1*Medicare % +
Based on the above elaboration, two a2*Medicaid % + a3*DSH + a4*CMI +
hypotheses were thus developed in Section a5*RESEAR + a6*GME + a7*OCC +
III and were tested using the CVP and multi- a8*OUTPAT + a9*RESBED + a10*SYS +
ple regression analysis. a11*TH + error (4)
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 25

Where assets. Based on the discussion in the lit-


erature review section (Section II), all inde-
FC/TC = Fixed cost percentage, pendent variables except OCC and OUTPAT
fixed cost / total operating were expected to have a positive coefficient
cost; in models (1) and a negative coefficient in
VC/TC = Variable cost per- models (2), (3), and (4).
centage, variable cost/ The test variable, TH, is defined as 1 if
total operating cost; a hospital is a teaching hospital, has a non-
Volume = Total revenue, adjusted profit ownership, is located in an urban area,
by case mix index (CMI); and has more than 400 beds, and 0 if not. If a
ROA = Return on assets, net
large nonprofit urban teaching hospital tends
income / total assets;
Medicare % =100*Medicare dischar- to have higher fixed cost, lower variable
ges/total discharges; cost, lower CMI adjusted volume, and lower
Medicaid % =100*Medicaid dischar- ROA, then the coefficient on TH should be
ges/total discharges; positive in model (1) and negative in models
DSH = 1 if a disproportionate (2), (3), and (4).
share hospital, 0 otherwise;
CMI = Medicare CMI;
RESEAR = Research expenditure; Data Source
GME = Graduate medical educa- The study data were obtained from the
tion payments; Medicare Cost Report. The report is not only
OCC = Occupancy rate, 100
one of the most comprehensive data sets
*(patient days/365* licen-
sed beds); available for every hospital in the United
OUTPAT = % of outpatient revenue States that services Medicare patients and
to total revenue; receives federal reimbursement, it also
RESBED = Number of residents captures a variety of hospital income state-
per bed; ments, balance sheets, and operational
SYS = 1 if a system affiliated statistics for the entire hospital and is not
hospital, 0 otherwise; limited to Medicare. Because of this, it can
TH = 1 if a large nonprofit be deemed as one of the best sources avail-
urban teaching hospital, 0 able for national financial data on hospitals
if a small for-profit rural/ and thus was was chosen as our primary
suburban non-teaching data source.
hospital.
The dependent variables are FC/TC, VC/
Sample Selection
TC, VOL, and ROA for each of the above
four models respectively. FC/TC measures The unit of analysis is large teaching hos-
the percentage of fixed cost to total operat- pitals, with a non-profit status and situated in
ing cost; VC/TC measures the percentage an urban area. To achieve the research objec-
of variable cost to total operating cost; VOL tive, a control sample of small non-teaching
measures total revenue adjusted by CMI; and hospitals, with a for-profit status and situated
ROA measures the hospitals return on total in a rural or suburban area, was also chosen.
26 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Hospitals with 400 beds or above are con- CVP analysis is often criticized for having
sidered as large; otherwise, as small. Both some shortcomings, it is pliable enough
sample sets were selected from the Medicare to overcome all of them, if necessary, and
Cost Report for the single year 2005 because desirable, since most of these shortcomings
of the restricted nature of the CVP analysis. are related to its basic underlying assump-
We begin with 2,669 hospitals that have tions. Moreover, its restricted scope can
a fiscal year end dated after July 1, 2005 be broadened with an extended version of
from the Medicare Cost Report database. the basic model designed to mitigate cer-
For those hospitals which filed two medical tain shortcomings.77 As a consequence, it is
reports in year 2005, we keep only the latest believed to be a very useful initial analysis
filing in the sample. Therefore, 370 hospi- of strategic decisions.78
tals were deleted from this procedure. We In addition to its merit of simplicity,
then removed 315 hospitals which did not through the provision of a sweeping finan-
have data for teaching status in the Medi- cial overview of the planning process,79 it
care Cost Report. The remaining 1,984 allows managers to examine the possible
hospitals were partitioned into two sam- effects of a wide array of strategic decisions,
ples: 549 teaching and 1,435 non-teaching including pricing policies, product mixes,
hospitals. The teaching sample includes market expansions or contractions, outsourc-
470 hospitals with a non-profit ownership ing contracts, idle plant usage, discretionary
form. Among this group, 440 hospitals were expense planning, and a variety of other
located in an urban areas and 122 of them important considerations in the planning
had more than 400 beds. From the group of process. The key in CVP analysis would be
122 hospitals, five were deleted due to their target income, which is defined as the mini-
missing value for certain variables. The non- mum net income acceptable for a particular
teaching sample includes 392 hospitals with decision. This minimum income level is for-
a for-profit ownership form. Among this mulated as the product of cost of capital and
group, 102 hospitals were located in either total assets required for a decision. By using
rural or suburban areas and all of them had CVP analysis, a hospital would be able to
fewer than 400 beds. Thus, the final sam- determine if a particular pricing policy and
ple includes 117 teaching hospitals and 102 cost structure strategy might yield at least
non-teaching hospitals. a minimum target income level that would
meet the hospitals cost of capital.
Research Method IV. Results
Due to our objective to compare the
CVP structure of large non-profit urban Figure 1 provides descriptive evidence
teaching hospitals and small for-profit rural/ about the sample hospitals. The mean
suburban non-teaching hospitals, the CVP (median) values of Medicare and Medic-
analysis was conducted to test our hypoth- aid % are 42.90 (38.39) and 16.40 (14.17),
eses. CVP analysis can be seen as one of respectively. On average, 84 percent of the
the most powerful and simplest analytical sample hospitals are qualified to receive
tools in management accounting. Although the disproportionate share payments. The
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 27

Figure 1. Descriptive Statistics (n = 219)

25th 75th
Variable Mean SD Percentile Median Percentile
Medicare % 42.90 42.32 29.06 38.39 47.52
Medicaid % 16.40 13.23 7.32 14.17 21.37
DSH 0.84 0.37 1.00 1.00 1.00
CMI 1.44 0.36 1.11 1.44 1.71
RESEAR 2621433.96 13633160.75 0.00 0.00 102755 .00
GME 2374800.02 3949901.50 0.00 266006.00 3660212.00
OCC 62.93 48.22 40.45 65.97 77.63
OUTPAT 0.39 0.15 0.29 0.37 0.46
RESBED 0.16 0.25 0.00 0.01 0.23
SYS 0.09 0.29 0.00 0.00 0.00
Note: The sample includes 117 teaching hospitals and a control sample of 102 non-teaching hospitals from
the Medicare Cost Report database with a fiscal year end dated after July 1, 2005. For those hospitals which
filed two medical reports in 2005, we keep only the latest filing in the sample. The variables are defined as
follows:

Medicare % = 100 * Medicare discharges / total discharges;


Medicaid % = 100 * Medicaid discharges / total discharges;
DSH = 1 if a disproportionate share hospital, 0 otherwise;
CMI = Medicare case mix index;
RESEAR = Research expenditure;

GME = Graduate medical education payments;

OCC = Occupancy rate, 100 * (patient days / 365 * licensed beds);

OUTPAT = % of outpatient revenue to total revenue;

RESBED = Number of residents per bed;

SYS = 1 if a system affiliated hospital, 0 otherwise.

sample hospitals have a mean (median) per bed is 16 (1) percent. Only 9 percent
CMI of 1.44 (1.44) percent. The average of the sample hospitals are affiliated with a
research expenditures and GME payments medical system.
are 2621433.96 and 2374800.02. The sam- Figure 2 provides results from compari-
ple firms have a mean (median) occupancy sons of the teaching and non-teaching groups
rate of 62.93 (65.97) percent. On average, for the variables included in our regression
39 percent of total revenue is outpatient rev- model. The data show that there are signifi-
enue. The mean (median) ratio of residents cant differences between the two groups in
28 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 2. Mean (Median) Values for Teaching and Non-Teaching Groups

Teaching Group Non-Teaching Group p from T-test


Variable (n = 117) (n = 102) (Mann-Whitney U test)

Medicare % 32.17 55.21 0.00


(32.36) (46.93) (0.00)
Medicaid % 14.44 18.64 0.02
(12.67) (16.55) (0.02)
DSH 0.88 0.79 0.08
(1.00) (1.00) (0.08)
CMI 1.72 1.12 0.00
(1.69) (1.11) (0.00)
RESEAR 4906786.64 0.00 0.01
(23597.00) (0.00) (0.00)
GME 4427106.37 20683.92 0.00
(3360043.00) (0.00) (0.00)
OCC 74.23 49.97 0.00
(76.30) (40.68) (0.00)
OUTPAT 0.32 0.46 0.00
(0.31) (0.46) (0.00)
RESBED 0.29 0.01 0.00
(0.18) (0.00) (0.00)
SYS 0.09 0.10 0.75
(0.00) (0.00) (0.75)

Note: The variables are defined as in Figure 1.

terms of all the control variables considered Panel B shows that the mean (median) pro-
in this study except SYS. portion of variable cost to total operating
Figure 3 provides results from comparisons cost is 0.60 (0.61) for the teaching group;
of the teaching and non-teaching groups the corresponding value is 0.63 (0.64) for the
for the dependent variables included in our non-teaching group. Panel C shows that the
regression model. Panel A shows that the mean (median) value of the CMI adjusted
mean (median) proportion of fixed cost to revenue is 869508287.76 (796109726.64)
total operating cost is 0.40 (0.39) for the for the teaching group; the corresponding
teaching group; the corresponding value value is 46868431.22 (29592191.45) for
is 0.37 (0.36) for the non-teaching group. the non-teaching group. Panel D shows that
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 29

Figure 3. Fixed Cost Percentage, Variable Cost Percentage, CMI Adjusted Volume,
and Return on Total Assets in Teaching and Non-Teaching Samples

Panel A: Fixed Cost Percentage


Teaching Non-Teaching
Sample Sample
Variable ( n = 117) ( n = 102)
Mean 0.40 0.37
S.D. 0.06 0.06
25th percentile 0.35 0.33
Median 0.39 0.36
75th percentile 0.43 0.40

Panel B: Variable Cost Percentage


Teaching Non-Teaching
Sample Sample
Variable ( n = 117) ( n = 102)
Mean 0.60 0.63
S.D. 0.06 0.06
25th percentile 0.57 0.60
Median 0.61 0.64
75th percentile 0.65 0.67

Panel C: CMI Adjusted Volume


Teaching Non-Teaching
Sample Sample
Variable ( n = 117) ( n = 102)
Mean 869508287.76 46868431.22
S.D. 481738752.29 57739581.32
25th percentile 589811528.99 15046089.88
Median 796109726.64 29592191.45
75th percentile 1033368941.96 48650078.94

Panel D: Return on Total Assets


Teaching Non-Teaching
Sample Sample
Variable ( n = 117) ( n = 102)
Mean 0.11 0.19
S.D. 0.48 0.17
25th percentile 0.07 0.08
Median 0.00 0.13
75th percentile 0.02 0.25

Note: This figure presents descriptive statistics about the fixed cost
percentage, variable cost percentage, CMI adjusted volume, and
return on total assets for the teaching and non-teaching samples.
30 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

the mean (median) return on total assets is and GME payments are more likely to have
.11 (.00) for the teaching group; the corre- higher a variable cost percentage, which
sponding value is .19 (.13) for the non-teach- is against our expectation. The coefficient
ing group. Both a T-test of the mean and a for TH is negative and significant, suggest-
Wilcoxon test of the median confirm that ing that large nonprofit teaching hospitals
the two groups are significantly different located in urban areas are more likely to have
(p < .01) in terms of fixed cost percentage, a lower proportion of variable cost to total
variable cost percentage, CMI adjusted vol- operating cost. Or put another way, small
ume, and return on assets. for-profit non-teaching hospitals situated in
rural or suburban areas are more likely to
Regression Results
have a higher proportion of variable cost to
Figure 4 presents the results from the total operating cost.
regression. The dependent variable in Panel The dependent variable in Panel C is the
A is the proportion of fixed cost to total CMI-adjusted revenue. The overall regres-
operating cost. The overall regression is sig- sion is significant (p < .001). Consistent with
nificant (p < .001). Consistent with expecta- expectations, the coefficients for OCC and
tions, the coefficient for RESEAR is positive OUTPAT are positive and significant, indi-
and significant, indicating that hospitals cating that hospitals with a higher occupancy
with higher research expenditures are more rate and higher proportion of outpatient rev-
likely to have a higher proportion of fixed enue to total revenue are more likely to have
cost to total operating cost. The coefficients a higher total revenue adjusted by CMI. The
for CMI and GME are negative and signifi- coefficients for CMI, RESEAR, and GME
cant, indicating that hospitals with higher are positive and significant, indicating that
CMI and GME payments are less likely to hospitals with higher CMI, higher research
have a higher fixed cost percentage, which expenditures, and higher GME payments are
is against our expectation. The coefficient more likely to have higher CMI-adjusted rev-
for TH is positive and significant, suggest- enue, which is against our expectation. The
ing that large nonprofit teaching hospitals coefficient for TH is positive and significant,
located in urban areas are more likely to suggesting that large nonprofit teaching hos-
have a higher proportion of fixed cost to total pitals located in urban areas are more likely
operating cost. to have higher total revenue adjusted by
The dependent variable in Panel B is the CMI, which is also against our expectation.
proportion of variable cost to total operat- The dependent variable in Panel D is the
ing cost. The overall regression is significant return on total assets. The overall regression is
(p < .001). Consistent with expectations, significant (p < .001). Consistent with expec-
the coefficient for RESEAR is negative and tations, the coefficients for Medicaid % and
significant, indicating that hospitals with RESEAR are negative and significant, indicat-
higher research expenditures are more likely ing that hospitals with higher Medicaid per-
to have a lower proportion of variable cost centage and research expenditures are more
to total operating cost. The coefficients for likely to have a lower return on assets. Also
CMI and GME are positive and significant, consistent with expectations, the coefficient
indicating that hospitals with higher CMI for OCC is positive and significant, indicating
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 31

Figure 4. Regression Results

Panel A:
FC/TC = a0 + a1*Medicare % + a2*Medicaid % + a3*DSH + a4*CMI + a5*RESEAR + a6*GME + a7*OCC +
a8*OUTPAT + a9*RESBED + a10*SYS + a11*TH + error
Variable Expected Sign Coefficient T-Statistic p-Value
Constant .467 14.175 <.001
Medicare % + .030 .198 .421
Medicaid % + .082 .866 .193
DSH + .084 1.170 .121
CMI + .394 3.252 <.001
RESEAR + .190 2.572 .005
GME + .187 1.502 .067
OCC .003 .017 .493
OUTPAT .026 .344 .365
RESBED + .108 .848 .198
SYS + .064 .986 .162
TH + .551 4.213 <.001

F = 3.27, p < .001; adjusted R-square = .10

Panel B:
VC/TC = a0 + a1* Medicare % + a2*Medicaid % + a3*DSH + a4*CMI + a5*RESEAR + a6*GME + a7*OCC +
a8*OUTPAT + a9*RESBED + a10*SYS + a11*TH + error
Variable Expected Sign Coefficient T-Statistic p-Value
Constant .533 16.175 <.001
Medicare % .030 .198 .421
Medicaid % .082 .866 .193
DSH .084 1.170 .121
CMI .394 3.252 <.001
RESEAR .190 2.572 .005
GME .187 1.502 .067
OCC + .003 .017 .493
OUTPAT + .026 .344 .365
RESBED .108 .848 .198
SYS .064 .986 .162
TH .551 4.213 <.001

F = 3.27, p < .001; adjusted R-square = .10


Continues on next page...
32 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 4. Regression Results (continued)

Panel C:

VOL = a0 + a1*Medicare % + a2*Medicaid % + a3*DSH + a4*CMI + a5*RESEAR + a6*GME + a7*OCC +


a8*OUTPAT + a9*RESBED + a10*SYS + a11*TH + error

Variable Expected Sign Coefficient T-Statistic p-Value


Constant 654901828.776 5.038 <.001
Medicare % .073 1.066 .144
Medicaid % .029 .670 .252
DSH .039 1.209 .114
CMI .379 6.861 <.001
RESEAR .226 6.695 <.001
GME .271 4.772 <.001
OCC .125 1.642 .051
OUTPAT .063 1.847 .033
RESBED .014 .249 .402
SYS .025 .837 .202
TH .225 3.773 <.001

F = 87.66, p < .001; adjusted R-square = .81

Panel D:

ROA = a0 + a1*Medicare % + a2*Medicaid % + a3*DSH + a4*CMI + a5*RESEAR + a6*GME + a7*OCC +


a8*OUTPAT + a9*RESBED + a10*SYS + a11*TH + error

Variable Expected Sign Coefficient T-Statistic p-Value


Constant .049 .425 .671
Medicare % .028 .775 .219
Medicaid % .049 1.204 .100
DSH .025 .717 .237
CMI .014 .282 .389
RESEAR .778 23.720 <.001
GME .038 .967 .167
OCC + .233 6.403 <.001
OUTPAT + .019 .552 .290
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 33

Figure 4. Regression Results (continued)

Variable Expected Sign Coefficient T-Statistic p-Value


RESBED .018 .460 .323
SYS .033 1.072 .142
TH .081 1.603 .046

F = 76.24, p < .001; adjusted R-square = .79

Note: This figure (including four panels) presents the results from a regression model where the dependent
variable is fixed cost percentage, variable cost percentage, CMI adjusted volume, and return on total assets
for each panel, respectively. The sample includes 117 teaching hospitals and a control sample of 102 non-
teaching hospitals from the Medicare Cost Report database, which have a fiscal year end dated after July 1,
2005. The variables are defined as in Figure 1. p-values are two-tailed.

that hospitals with a higher occupancy rate are fixed cost and lower variable cost. While such
more likely to have a higher return on assets. cost structure doesnt necessarily lead to lower
The coefficient for TH is negative and sig- revenue adjusted by CMI, it indeed results in
nificant, suggesting that large nonprofit teach- lower profit or asset turnover in terms of ROA.
ing hospitals located in urban areas are more On the contrary, small for-profit non-teaching
likely to a have lower return on assets. hospitals located in rural or suburban areas
Overall, the results provide empirical sup- tend to have a lower fixed cost, higher vari-
port to our hypothesis that large nonprofit able cost, and higher profit or asset turnover in
urban teaching hospitals, due to their mis- terms of ROA due to their different features.
sions of research and patient care, provision Langabeer80 stated that product market
of larger volumes of uncompensated care, strategy is one of the most fundamental ele-
larger size, higher level of teaching commit- ments that hospital administrators should
ments, higher labor cost, lower efficiency, consider when formulating a strategic plan.
increasing price competition resulting from In other words, as hospitals select more com-
growth of managed care, teaching status, plex and specialized procedures, the expected
and non-profit ownership form, tend to financial performance decreases; the other
incur a higher fixed cost and lower variable way round is also true. While the results in
cost. Such cost structure doesnt necessarily this study seem not fully consistent with
affect their total revenue adjusted by CMI; those of Langabeer81 in the effects of adjusted
however, it does lead to a lower return on CMI on hospitals performance, the find-
hospitals total assets. ings do indicate that large nonprofit urban
teaching hospitals, because of their larger
V. Conclusion size, nonprofit ownership form, location and
increasing price competition, teaching status,
The empirical results confirm our hypoth- mission of research and patient care, higher
esis that large nonprofit teaching hospitals labor cost and lower efficiency, provision
located in urban areas tend to have a higher of uncompensated care to larger volume of
34 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Medicaid patients, lower occupancy rate, CVP structure between teaching and non-
and lower proportion of outpatient revenue teaching hospitals, without looking at other
to total revenue, are more likely to incur a performance measures such as cash flow
higher fixed cost and thus lower ROA. ratio, bond rating, investment of technol-
The findings suggest that cost structure is ogy, and quality of care. Second, this study
significantly associated with hospitals per- focuses on the analysis of teaching hospitals,
formance. That is, the higher proportion the without looking at AHCs and AMCs. Third,
fixed cost to total operating cost in a hospi- the use of the CVP technique to conduct
tals cost structure, the lower return in terms analysis is subject to the following addi-
of ROA will be expected. The findings also tional limitations:
suggest that as teaching hospitals portfolios
of services and programs increase (e.g., pro- 1. The CVP analysis assumes that
vision of uncompensated care to Medicare changes in volume have no effect on
and Medicaid patients and doing research), elasticity of demand or on the effi-
it becomes strategically necessary and criti- ciency of production factors; that is, it
cal to manage the allocation of resources or ignores the curvilinear nature of total
investments into the fixed capital that sup- revenue and total cost schedules;82
ports the business. In other words, teaching 2. Since CVP analysis is typically
hospitals aiming at improving performance restricted to one time period in each
should attempt to do the following: case, this study only spans the single
year 2000;
1. Adjust their cost structure; 3. The CVP analysis has a somewhat nar-
2. Evaluate the cost-benefit of fulfilling row scope on only sales revenue and
the research mission; operating expenses, which could leave
3. Provide less volume of uncompen- some critical aspects of strategic deci-
sated care or the same volume of sions overlooked;
uncompensated care at higher reim- 4. The CVP analysis doesnt measure the
bursement; and impact of the decision on the hospitals
4. Increase occupancy rate and the pro- wealth;83
portion of outpatient revenue to total 5. The CVP analysis does not incorporate
revenue to achieve their objectives. the effect of asset structure changes
required by the decision;84 and
6. The CVP analysis does not acknowl-
Hopefully, the findings can be used to
edge the risk created by the decision.85
enhance the decision effectiveness of hospi-
tal administrators in selecting their product Fourth, this study does not incorporate the
mix and designing their CVP structure as shift of services from inpatient to outpa-
well as financial strategies, appropriately. tient. Finally, since corporate overhead
costs of system-affiliated hospitals are not
Limitations included in the total cost reported in the
This study doesnt come without limita- Medicare Cost Report data,86 the focus of this
tions. First, this study only compares the study is purely on the individual hospital and
A Comparative Analysis: Nonprofit Teaching and For-Profit Non-Teaching Hospitals 35

not system-affiliated hospitals. As a result, impact of managerial compensation schemes


whether system-affiliated hospitals perform on target profit levels.87 Fourth, due to the one-
better than their counterparts will not be year nature of CVP analysis, future research
evaluated in this article. can employ research techniques other than
CVP to explore the long-term performance
Possible Future Research differences. Fifth, future research can extend
There are some fruitful areas for future the basic model of CVP by entering some
research to pursue. First, future research additional variables such as the dichotomy of
can examine the performance differences variable and fixed assets, cost of capital, the
between teaching and non-teaching hospitals degree of operating leverage or an accounting
in terms of other measures such as cash flow beta risk measure to incorporate the wealth
ratio, bond rating, investment in technology, effects and the risk level imposed by a deci-
and quality of care. Second, future research sion.88 Finally, with available data, future
can extend the analysis to include both AHCs research can conduct a comparative analy-
and AMCs. Third, future research can widen sis of the CVP structure between system-
the scope of the CVP analysis to include the affiliated and non-system-affiliated hospitals.

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The Economics of Health Care
Quality and Medical Errors
Charles Andel, Stephen L. Davidow, Mark Hollander, and David A. Moreno

Hospitals have been looking for ways to improve quality and operational efciency and cut costs for nearly
three decades, using a variety of quality improvement strategies. However, based on recent reports, ap-
proximately 200,000 Americans die from preventable medical errors including facility-acquired conditions
and millions may experience errors. In 2008, medical errors cost the United States $19.5 billion. About 87
percent or $17 billion were directly associated with additional medical cost, including: ancillary services,
prescription drug services, and inpatient and outpatient care, according to a study sponsored by the Society
for Actuaries and conducted by Milliman in 2010. Additional costs of $1.4 billion were attributed to in-
creased mortality rates with $1.1 billion or 10 million days of lost productivity from missed work based
on short-term disability claims. The authors estimate that the economic impact is much higher, perhaps
nearly $1 trillion annually when quality-adjusted life years (QALYs) are applied to those that die. Using
the Institute of Medicines (IOM) estimate of 98,000 deaths due to preventable medical errors annually in
its 1998 report, To Err Is Human, and an average of ten lost years of life at $75,000 to $100,000 per year,
there is a loss of $73.5 billion to $98 billion in QALYs for those deathsconservatively. These numbers
are much greater than those we cite from studies that explore the direct costs of medical errors. And if the
estimate of a recent Health Affairs article is correctpreventable death being ten times the IOM estimate
the cost is $735 billion to $980 billion. Quality care is less expensive care. It is better, more efcient, and
by denition, less wasteful. It is the right care, at the right time, every time. It should mean that far fewer
patients are harmed or injured. Obviously, quality care is not being delivered consistently throughout US
hospitals. Whatever the measure, poor quality is costing payers and society a great deal. However, health
care leaders and professionals are focusing on quality and patient safety in ways they never have before
because the economics of quality have changed substantially. Key words: medical errors, quality, patient
safety, quality-adjusted life year, QALY, Joint Commission, Institute of Medicine, Society of Actuaries, Milli-
man, efficiency, Medicare, accountable care organizations (ACOs), facility-acquired condition, cost savings.

H
ospitals have been looking for ways
Charles Andel, MBA, BSRT, is Manager of Radiology
to improve quality and operational Quality and Compliance at Loyola University Medical
efficiency and cut costs for nearly Center and a graduate of Loyola University Chicagos
three decades, using a variety of quality Quinlan School of Business MBA in Healthcare Manage-
improvement strategies. The Joint Commis- ment program. He may be reached at cjandel@lumc.edu.
sion implemented its Agenda for Change Stephen L. Davidow, MBA, APR, is a health care market-
in 1986 to improve the systems, processes, ing and communications professional with a strong focus
on quality and patient safety. He is a graduate of Loyola
and, ultimately, the outcomes of care. How-
University Chicagos Quinlan School of Business MBA in
ever, there has not been widespread adop- Healthcare Management program. He may be reached at
tion of these principles, in part because the stephen@davidowcommunciations.com or 708-284-2300.
incentives were not substantial enough to Mark Hollander, MBA, is a financial manager at the
overcome the inertia of many hospital cul- Department of Veterans Affairs and graduate of Loyola
tures and the US payment system. How- University Chicagos Quinlan School of Business MBA
ever, those hospitals and health systems in Healthcare Management program.
that overcame that inertia have experienced David A. Moreno, MBA, is a biotechnology business ana-
lyst and graduate of the Loyola University Chicagos Quin-
tremendous improvement in quality, finan-
lan School of Business MBA in Healthcare Management
cial performance, patient safety, and patient program. He may be reached at dmoreno@gmail.com.
satisfaction. In a recent interview on PBSs
Nightly Business Report,1 Dr. Mark Chas- J Health Care Finance 2012; 39(1):3950
sin, The Joint Commissions president and Copyright 2012 CCH Incorporated

39
40 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

CEO, said that only about a quarter of the extension taxpayers, billions of dollars
nations 6,000 hospitals are involved in (1) preventable readmissions and (2) health
some sort of quality improvement effort. care facilityacquired conditions, such as
Preventable medical harm has been an infections. Before we discuss the new incen-
ongoing and vexing problem. Quality and tive system, lets explore how widespread
patient safety expert Dr. Lucian Leape medical errors are and how much they cost.
from the Harvard School of Public Health,
estimated more than 25 years ago that the
problems human toll equaled 300 jumbo How Big a Problem Is Quality
and Patient Safety?
jets crashing every year in the United States.
Thats nearly one a day. If that were the case, In 1999, the US Institute of Medicine
the US aviation industry would have been (IOM) issued its landmark report, To Err
shut down until a solution was found. Yet, Is Human, which stated that up to 98,000
interestingly, the Medicare program over all Americans died as a result of preventable
these years reimbursed hospitals regardless medical errors in US hospitals (see Figure 1),
of outcome. In fact, there are ICD-9 billing and up to one million more patients experi-
codes for specific errors. enced some type of preventable error.2 An
In a perversion of the fee-for-service sys- error is defined as an act that produces a pre-
tem, hospitals fared better financially when ventable adverse outcome compared to the
patients needed follow-up care after an error natural progression of disease that leads to
occurred. A hospital was encouraged by injury or death.3
the payment system to harm a patient just The Centers for Disease Control and Pre-
enough without killing him or her and per- vention more recently noted that another
form some additional services, for which 100,000 Americans die from infections.4 A
it received additional payments. Not much quarter of Medicare beneficiaries admitted
incentive to improve care or save Medicare to a hospital are victims of medical harm,
money. Of course, no hospitals leader- according to a December 2010 report from
ship consciously decided to hurt patients to the Office of the Inspector General (and
make more money, but the system did not thats only patients age 65 and above or those
encourage and reward better and more effi- on disability). Approximately 5,000 ben-
cient care. eficiaries per month suffer a never event,
Recent national health reform legislation and 180,000 die from medical errors annu-
(the Patient Protection and Accountable Care ally.5 Newer studies from Health Affairs in
Act or PPACA) has several quality improve- April 2011 suggest that the rate of prevent-
ment provisions including restructuring the able harm may be up to ten times higher than
way health care is delivered in the United IOM estimates.6 Although 12 years have
States through accountable care organiza- passed since the IOM report, experts are still
tions (ACOs) and value-based purchasing. having a difficult time developing a concrete
The Centers for Medicare & Medicaid Ser- picture of the problem but clearly the toll is
vices (CMS) has for the first time said it will high in terms of death, injury, and loss.
stop reimbursing hospitals for two major An even greater challenge may be estimat-
problems that cost the government, and by ing the economic impact poor quality and
The Economics of Health Care Quality and Medical Errors 41

Figure 1. Leading Causes of Death in United States

1. Heart Disease 599,413


2. Cancer 567,628
3. Chronic Lower Respiratory Disease 137,353
4. Stroke 128,842
5. Accidents (Unintentional Injuries) 118,021
Preventable Medical Harm (Medical Errors) 98,000
6. Alzheimers Disease 79,003
7. Diabetes 68,705
8. Influenza/Pneumonia 53,692
9. Nephritis/Nephrosis 48,935
10. Intentional Self-Harm (Suicide) 36,909

Sources: CDC Web site, FastStats: Leading Causes of Death (Jan. 2012); National Vital Statistics
Report, Deaths Final Data for 2009, vol. 60, no. 3; and for 98,000 statistic, IOM Report, To Err Is
Human (1998).

unsafe care has in the United States because level? What is the value of a human life and
there are so many factors involvedloss of that persons relationship with his or her
life or functionality, lost wages, impact on family members and, more broadly, in rela-
family and dependents, law suits, inefficient tion to the patients community? Ask those
and wasteful care as a result of poor facility family members and the answer is incalcu-
operations, etc. lable. Although difficult to measure because
Much of the national discussion about the value of an individual life is not exact,
quality and patient safety focuses on the we have applied an economic approach
direct medical costs associated with poor using quality-adjusted life years (QALYs) in
care. The studies that we explore in this an attempt to develop one answer. Based on
article do just that and that seems to be the the IOM figure of 98,000 deaths each year
bulk of the leading literature on the subject. with an estimate of ten lost years of life at
However, there is a significant human cost $75,000 to $100,000 per year, there is a loss
for the loss of human life or the impact it of $73.5 billion to $98 billion in QALYs for
has on patients who are injured and must those deathsconservatively. These numbers
live with disability for the remainder of their are much greater than those we cite from
lives. The focus of the health reform legisla- studies that explore the direct costs of medi-
tion is on cost savings to the government by cal errors. And if the estimate of a recent
improving care. Of course, the side benefit is Health Affairs article is correctpreventable
fewer harmed patients. death being ten times the IOM estimatethe
It is easy to forget when reviewing study cost is $735 billion to $980 billion.7
after study, that what we are talking about are The various estimates on medical errors
patientsreal peopleand their families. point out several failures of the US health care
What does poor quality care cost on a human system. The recently enacted health reform
42 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

legislation has many provisions to improve entire US health care system may be too
the quality and efficiency of care provided difficultand certainly not an estimate for
to Medicare beneficiaries.8 In this article, which one can budget. If PPACA is success-
we explore several studies and estimates of ful in providing health insurance and access
the economic impact preventable medical to care to 32 million more Americans, invar-
errors have on the US health care system. iably there will be a numerical increase in
Although there is no meaningful estimate as medical errors if nothing is done to improve
to how much cost savings can be achieved quality of care.
through better care under changes outlined in
The Economics of Medical Errors
the PPACA, we will discuss the significance
of these studies and some anecdotal exam- In 2008, medical errors cost the United
ples of hospitals or health systems that have States $19.5 billion. About 87 percent or $17
improved their care and experienced signifi- billion were directly associated with addi-
cant cost savings. In this article we explore tional medical cost, including: ancillary ser-
different ways improved quality may help vices, prescription drug services, and inpatient
reduce costs of the US health care delivery and outpatient care, according to a study spon-
system. Quality improvement is a major fac- sored by the Society for Actuaries and con-
tor in the PPACA legislations efforts to reign ducted by Milliman in 2010. Additional costs
in costs in federal expenditures for health care. of $1.4 billion were attributed to increased
We also explore the incentives and disincen- mortality rates with $1.1 billion or ten million
tives for better quality care and what behavior days of lost productivity from missed work
changes among health care providers can be based on short-term disability claims.11
expected, both for facilities and individual The report analyzed claims data to extrap-
professionals, to achieve better quality care. olate an estimated 6.3 million medical
Under PPACA, hospitals and other provid- injuries. Of those it is believed that, conserv-
ers that deliver poor or substandard care will atively, 1.5 million medical injuries were
no longer be able participate in the Medicare preventable errors. The study concluded that
and Medicaid programs.9 Medicare is a sub- the most significant errors were easily pre-
stantial source of income for nearly every ventable if better policies and practices were
hospital, nursing home, and physician, so the followed. Opportunity savings of 19.5 bil-
impact could be significant. lion would be available.
We did not find specific analyses of the For medical errors to be in the top ten
proposed quality provisions economic causes of death we must reflect on the value
impact in the Congressional Budget Office we put on life, as medical errors are easily
(CBO) scoring for the PPACA legislation,10 preventable and caused by simple negligence.
or in analyses by the Kaiser Family Foun- Milliman also reviewed two previous major
dation, the Alliance for Health Reform, nor studies, which attempted to estimate the eco-
the Heritage Foundation. No one questions nomic impact of medical errors. The first was
the fact that health care can be made better the Harvard Medical Practice Study,12 which
in terms of operational efficiency and higher estimated that all types of medical injuries
quality. However, developing a meaning- totaled approximately $3.8 billion in New
ful estimate for expected savings across the York in 1984, $50 billion nationally.
The Economics of Health Care Quality and Medical Errors 43

The second study, Costs of Medical Inju- An additional 21 percent feel that a moder-
ries in Utah and Colorado,13 reviewed a ate negative impact has occurred. Those sur-
representative sample of 14,732 randomly veyed conveyed concern over medication
selected discharges from 1992 and estimated safety, new purchasing procedures, equip-
total costs for errors to be $662 million in ment lifespan, facility maintenance, prop-
1996 dollars$308 million of that was erly qualified staff, and staff shortages.16
related to preventable medical errors. Extrap- Those surveyed stated that medication
olated nationally, that is approximately $37.6 safety was still the number one problem
billion for all medical errors and $17 billion and explained its causes. First the elimina-
for preventable errors. That studys authors tion or reduction in time spent by key safety
categorize medical errors into five areas: personnel such as medication safety officers
was reported by over 42 percent surveyed,
1. Operative; coupled with 33 percent reporting less clini-
2. Drug-related; cal pharmacist involvement in patient care
3. Diagnostic or therapeutic; units specifically. Intensive care units and a
4. Procedure-related; and new level of risk adverse behavior starts to
5. Other. appear. The reduction has also affected allot-
ted time for nurse education, a key area of
Postoperative complications were the most concern as more facilities use more part-time
expensive, accounting for 35 percent of costs or registry nurses whose integration into the
for medical errors and 39 percent of costs for health institution medication administration
preventable medical errors. There are many procedures is not adequate. This has led to
ways to measure errors and the economic drug administration short cuts and missed
impact. The National Quality Forum and safety steps all increasing the risk of harm or
National Priorities Partnership talks about the death to patients.
$21 billion cost of medication errors.14 Cit- New purchasing procedures refer to
ing the New England Healthcare Institute, the purchasing of multi-dose medications
inpatient preventable medication errors cost instead of single dose vials and syringes.
approximately $16.4 billion, while outpatient Yes, Sams Club and Costco have their place
medication errors cost $4.2 billion, according in the medical market as medical institu-
to the Center of Information Technology.15 tions look to cut cost with bulk medication.
This has increased the number of medication
The Economys Impact on errors fivefold. The opposite effect, medica-
Quality and Patient Safety
tion shortages, is occurring as facilities try
Although there is no definitive evidence to limit supply cost of fast-expiring medica-
that the recent recession is having an impact tions that are normally expensive and not
on health care quality and patient safety, often utilized.
it may be having an affect. A recent study Next is the investment in medical equipment
of over 800 nurses, administrators, and and technology. Life cycles for equipment
physicians revealed that 20 percent believe are being extended as institutions try to limit
a large impact on patient and staff safety has or cancel plans to purchase expensive new
occurred due to the recession and its fall out. technology. This becomes one of the biggest
44 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

problems as stagnation in purchasing new will have a significant impact on its ability
technology slows or stops both development to survive.
and research. Hospital profits are not ade-
quate for re-invest in the technology areas
Quality: Solutions
that are not covered under PPACA. New
hospitals, remodeling, and design improve- Quality and patient safety have histori-
ments have come to a halt as credit and cash cally been a secondary issue for the majority
flow have slowed. Americas rural and inner of the nations approximately 6,000 hospi-
city hospitals are antiquated at best and are tals. Of course, there have been visionary
a point of contention as they are not suited leaders who have seen quality, operational
for best care practices and are in a state of excellence, and patient care as inextricably
ill repair. linked. They provide examples for the rest
of the country. In 1986, The Joint Com-
mission launched its Agenda for Change
Designing for Quality
initiative to introduce quality improvement
Stepping back from health reforms spe- philosophy into its accreditation process.
cific focus on preventable readmissions It was also a way to encourage US hospi-
and facility-acquired conditions, quality is tals to adopt these principles in order to
a much broader field and incorporates the improve health care operations, quality, and
safe design of medical facilities. According ultimately, patient safety. The PPACA legis-
to the Agency for Healthcare Research and lation and the financial penalties associated
Quality, there is a correlation between how with poor care makes quality job one to
a hospital is designed and quality of care borrow a slogan from Ford Motor Company
and outcomes. New health care construc- in the 1990s.
tion over the next ten years is expected to Besides providing better care, improved
be $250 billion.17 Evidence-based design quality under the legislation is expected
and incorporating it into hospital best prac- to be a major force in efforts to bend the
tices (Lean and Six Sigma)18 is expected to cost curve for Medicare, as well as private
reduce medical waste, improve quality out- insurance. Given the size of the Medicare
comes, reduce medical errors, and improve program, the focus on quality will have a
patient and employee satisfaction while significant ripple effect throughout the
instilling a culture of safety. Improvements entire US health system. But how much
include noise suppression, additional light- money is at stake?
ing (sunlight when possible), nature areas, Rather than try to determine an exact fig-
and music. The additional $12 million19 ure, we will review a number of reports that
in upgrades per facility are expected to be explore the economic impact of quality health
recovered within 12 months through opera- care and discuss the work and achievement
tional savings and increased revenue. Given of three leading hospitals and health systems
the state of the economy and ongoing staff that have implemented significant quality
shortages, information that provides trans- improvement efforts. Two institutions have
parency about hospital performance and how received the prestigious Malcolm Baldrige
it is linked to a hospitals reimbursement Award for Quality with only ten other US
The Economics of Health Care Quality and Medical Errors 45

hospitals the first being SSM Healthcare in patients and assume the responsibility for
St. Louis in 2002.20 patients from hospitals that do not meet the
standard. This situation has the potential to
alter market leadership quickly.
Incentives and Penalties for Quality Care
Brad Bowman, Director of the Health
Historically, the Medicare program paid Care Advisory Practice at Pricewaterhouse-
for whatever services health care provid- Coopers suggested that detailed quality
ers charged, including provider errors. That performance data that identifies a poor per-
has been changing in recent years and in an forming hospital in a three or four hospital
effort to improve quality of care and reduce town, would put the hospital at a signifi-
costs to the Medicare program, CMS will no cant disadvantage especially when the local
longer reimburse providers for preventable media publicizes the information.22
hospital readmissions. The initial focus will By 2017, up to 6 percent of hospital
be on heart attack, heart failure, and pneumo- diagnosis-related group payments will be
nia. Hospitals will see their reimbursement at-risk based on quality performance meas-
rates go down for high rates of readmissions. ures. Voluntary quality reporting will begin
Fines or penalties will start at one percent in 2011, something entirely new for physi-
and reach 3 percent over the next three years. cians who accept Medicare patients. Physi-
Recognizing that hospitals need to do a bet- cians will receive one percent bonuses going
ter job of reducing hospital-acquired condi- down to 0.5 percent by 2014. By 2015, there
tions such as infection, the government will will be a 1.5 percent penalty and by 2016, it
fine hospitals with the highest rates, one per- will be 2 percent. And for the first time, start-
cent. Given the low average operating mar- ing in 2015, physicians will see mandatory
gin of 5 percent for US hospitals,21 those that individual performance reports published on
provide poor quality care will have difficulty the CMS Web site, as has been done for hos-
staying in business. In fact, those that do not pitals and nursing homes.23
improve and meet the national requirements Although the governments plans seem
will lose their ability to care for Medicare logical, the question remains, will the pen-
patients. To turn up the heat a bit, Medicare alty/incentive approach work? The approach
has said it will publicize which hospitals is not based on a demonstration project or
are performing well and those that are not. past experience. However, there is evidence
Depending on what actually happens, poor that at least physicians are responsive when
quality and the governments active public their personal compensation is tied to per-
notification could damage institutional repu- formance. In a study conducted at the Uni-
tations and be the dominant force in shifting versity of Illinois at Chicago that used a
market position or leadership. four-year sample of 59 physicians and 1.1
Although Medicare does not reimburse million encounters, a network of primary
at the same level as most private insurance, care clinics shifted from salary to a com-
it is a significant portion of most hospitals pensation plan with a lower salary and
business, so a loss of it would be disastrous. piece rates for encounters and procedures.
Those hospitals that provide quality care Physicians increased the number of patient
will continue to be eligible to treat Medicare encounters from 11 to 61 percent. They were
46 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

paid between $22 and $30 for each outpa- sector delivery reform that is working.
tient visit. The authors also noted that physi- Twenty models are included in the statute
cians of all medical specialties increased the but it allows for unlimited possibilities. To
number of procedures done to one per visit support these types of initiative, $10 bil-
reimbursed at $5 per procedure. The authors lion is provided over ten years. Under the
found that physicians respond strongly to Center, a new federal Coordinated Health
even to marginal incentives when it is tied to Care Office has been established to help
their overall compensation.24 Whether CMS improve the coordination of care for benefi-
penalties will motivate health care providers ciaries who are eligible for both Medicare
to deliver better quality and less expensive and Medicaid (known as dual-eligible).26
care remains to be seen. The study suggests
it doesnt take much to change certain physi- Leading Examples of Hospitals and
cian practice patterns. Health System Improving Quality
In a study published in Medical Care
Intermountain Healthcare
and Review, Blue Cross and Blue Shield
of Michigan implemented a pay-for- Since 1988, Intermountain Healthcare,
performance program composed of just over based in Salt Lake City, Utah, has been
$22 million in incentive payments to hos- applying quality improvement techniques
pitals plus a 5 percent administrative cost. to health care delivery that were developed
Almost 25,000 patients had better care and by W. Edwards Deming at the end of World
had from 733 to 1,701 QALYs depending on War II, and adopted throughout Japanese
the effectiveness of care provided. Based on industry.
the study results, a QALY was estimated to Brent James, Director of Intermountain
be $12,967 to $30,081, much less than most Healthcares Institute for Health Care Deliv-
generally accepted estimates.25 ery Research, wrote in Health Affairs that
Clearly, incentives can have an impact on quality improvement methods were applied
how physicians and hospitals deliver care to reduce rates of elective induced labor,
and what care they provide. Will the penal- unplanned caesarean sections, and admis-
ties be the right motivation to improve health sions to newborn intensive care units. He
care? There may be other proven ways to estimated that the initiative saved $50 million
improve the care that can be replicated dollars annually. Nationally, it would save
around the country. $3.5 billion.27
Another initiative focused on improving
Center for Medicare and Medicaid the operation of mechanical ventilators that
Innovation were used in treating acute respiratory dis-
Given that the PPACA legislations goal tress syndrome. As a result, they improved
is to reduce cost and improve efficiency adherence to the guideline and reduced vari-
and quality, the Center for Medicare and ation from 59 percent to 6 percent within
Medicaid Innovation was established in four months. Patient survival increased from
2011 to test innovative payment and service 9.5 percent to 44 percent. Physician time
delivery models. The Center will fund pro- involved in care dropped in half and the total
jects at a local level building upon private cost of care dropped by 25 percent.
The Economics of Health Care Quality and Medical Errors 47

In 1995, Intermountain analyzed its cost Another important measure of quality is


savings from 65 such initiatives and found ICU ventilator-associated pneumonia. In 2006
$30 millionapproximately 2 percent of they had no cases. In 2007 and 2008 they had
its total clinical operations. These interven- one case per 1,000, which translated to one
tions were only applied in one local practice. case per year. In 2009 and 2010 they had no
Intermountain estimated that if this initiative cases. Using data from Thomson-Reuters, the
was applied to the entire health system, there hospital dropped their actual/expected mor-
would be total savings of $100 million to tality ratio significantly.
$150 million, approximately 6 to 10 percent Although already below what was expected
of annual clinical costs. As a result of these for a hospital of their type based on acuity
findings, Intermountain developed a strate- (Level-1 trauma center) in 2003 (0.74), it
gic plan to apply these methods throughout dropped to 0.25 in 2010. That translates to
the health system. more than 550 patients living than would
In a separate White Paper, Intermountain have otherwise have died. The last statistic
Healthcares CEO, Charles Sorenson, MD, shared was an 83 percent decrease in medi-
notes that the United States could reduce cal liability insurance expense. A specific
national health care spending by as much dollar amount was not shared during the
as 40 percent if Intermountains operational presentation or in an interview, but the sav-
and clinical processes were used as a bench- ings were reported to be in the millions.
mark and adopted nationwide.28 This is based
on research by Dartmouths Paul Wennberg
who focused on variation in medical care Poudre Valley Health System
practices nationally. At the same meeting, Priscila Nuwash,
President of the Center for Performance
Excellence at Poudre Valley Health System
Advocate Good Samaritan Hospital
(PVHS), Fort Collins, Texas, discussed their
Downers Grove, Illinoisbased Advocate quality efforts, which also were recognized
Good Samaritan Hospital is nationally rec- by a Baldrige Award.30
ognized for the quality of its operations and Again, while not specific on financial sav-
care. It won the Malcolm Baldrige Award for ings, two of PVHSs hospitals are doing better
Quality in 2010. Tamara Schaefer, Director of than competitors on HCAHPS data (federal
Patient Safety, recently presented at the 2011 patient satisfaction data). In other PVHS
Chicagoland Patient Safety Summit29 and dis- patient satisfaction data examining customer-
cussed the importance of a culture of patient focused outcomes, PVHS had nine years of
safety on improving care. Although she did consistent improvement. Also, staff voluntary
not discuss the hospitals performance on spe- turnover rates dropped from 19 percent to
cific Partnership for Patients goals, she made approximately 7 percent from 2000 to 2010.
a good case for improving quality. From There was a slight up tick the last year with
February of 2009 to April 2011, the hospital the opening of a new hospital.
increased hand washing from 30 percent to Another interesting sign of PVHSs im-
almost 100 percentone of the major ways proved quality is the 59 percent increase in
to reduce facility-acquired infections. health system discharges from 2000 to 2010
48 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

compared to 15 percent for their competi- settlements are made when appropriate to
tion. PVHS experienced only a 19 percent help the patients and their families begin
increase in population growth in their home the healing process. These analyses are also
county compared to 40 percent growth in used to change systems and the way pro-
their competitors home county. Obviously, cedures are done in order to prevent recur-
a number of factors can affect these num- rences. Besides being the right thing to do
bers but the increase in discharges is attrib- and helping those affected, a byproduct of
uted, in part, to the improved quality of this approach is that UICs medical liability
services. PVHS also uses Thomson-Reuters insurance costs have dropped 53 percent.
data and they fall in the nations top 10 per- This approach is being evaluated further
cent of hospitals for risk-adjusted mortality. through a $3 million Agency for Healthcare
An interesting measure was their financial Research and Quality demonstration pro-
flexibility index from Ingenix. It examines ject administered by UICs Institute among
total margin, return on investment, replace- ten Chicago-area hospitals. Some legal and
ment viability, equity financings, days of patient safety experts think this approach
cash on hand, cash flow to total debt, and may be an alternative to tort reform, which
average age of plant. Although the trend has been struck down twice in Illinois by the
line shows some ups and downs, from 2001 states Supreme Court.31
to 2010, they improved from approximately
7 percent to over 12 percent while locally
and nationally there have been decreases. Conclusion

Quality care is less expensive care. It is


University of Illinois at Chicago better, more efficient, and by definition, less
Medical Center
wasteful. It is the right care, at the right time,
Historically, medical professionals have every time. It should mean that far fewer
been uncomfortable with the idea of admit- patients are harmed or injured. Obviously,
ting that a mistake has been made or harm quality care is not being delivered consistently
has been caused from an action they have throughout US hospitals. Although recently
taken. They fear increased medical liability enacted health reform legislation does not
costs, giving attorneys ammunition, censure, require hospitals to implement comprehen-
and public rebuke. Counter to this tradi- sive quality improvement and patient safety
tional way of thinking is the University of programs, incorporating operational quality
Illinois at Chicago (UIC) Medical Center. improvement programs involving Lean or
It has focused on developing a culture of Six Sigma have had a significant affect at
patient safety. In fact, through its Institute Intermountain Healthcare, Advocate Good
for Patient Safety Excellence, its philosophy Samaritan Hospital, Poudre Valley Health
has become an international model. Errors System, and the University of Illinois at
are quickly identified, disclosed to patients Chicago Medical Center. Interestingly,
or their families, root-cause analyses are developing a culture of safety and quality
conducted, and the results are shared with also can improve medical liability insur-
those who have been affected, and financial ance costs although thats not the primary
The Economics of Health Care Quality and Medical Errors 49

motivator for improving care. The Society says, then that cost could be $735 billion
of Actuaries/Milliman report showed that to $980 billionalmost $1 trillion annu-
medical errors cost the United States $19.5 ally. Whatever the measure, poor quality
billion in direct medical costs. Other studies is costing payers and society a great deal.
show the cost to be much higher. Looking at Time will tell if the Medicare programs
the totality of a human life, our own conserv- incentives will make the difference. How-
ative calculation shows that medical errors ever, health care leaders and professionals
cost $73.5 billion to $98 billion in QALYs are focusing on quality and patient safety
and if applied to the most recent estimate in in ways they never have before because
Health Affairs that says preventable medi- the economics of quality have changed
cal harm is ten times what the IOM report substantially.

REFERENCES

1. Oct. 14, 2011. May Be Ten Times Greater Than Previously


2. For 98,000 statistic, To Err Is Human: Building Measured, Health Affairs, Project Hope,
a Better Health System, Institute of Medicine Bethesda, MD (Apr. 2011).
(IOM), National Academy Press, Washington, 7. Id.
DC (1999); CDC Web site, FastStats: Leading 8. The Staff of The Washington Post, Landmark:
Causes of Death, http://www.cdc.gov/nchs/ The Inside Story of Americas New Health
fastats/lcod.htm/, last updated: Jan. 27, 2012, Care Law and What It Means for Us All,
accessed Aug. 30, 2012; National Vital Statis- Public Affairs Reports (2010).
tics Report, Deaths Final Data for 2009, vol. 60, 9. Id.
no. 3, http://www.cdc.gov/nchs/data/nvsr/ 10. Elmendorf, DW, CBOs Analysis of Major
nvsr60/nvsr60_03.pdf. Health Care Legislation Enacted in March
3. Shreve, J, et al., The Economic Measurement 2010, Congressional Budget Ofce, State-
of Medical Errors, sponsored by Society of ment before the subcommittee on Health,
Actuaries Health Section, prepared by Milli- Committee on Energy and Commerce, US
man Inc., Schaumburg, IL (June 2010). House of Representatives, Washington, DC
4. Klevens, RM, et al., Estimating Health-Care (Mar. 30, 2011).
Associated Infections and Deaths in U.S. 11. Shreve, supra, n.3.
Hospitals, 2002: U.S. Pubic Health Service, 12. Brennan, TA, et al., Incidence of Adverse
Public Health Reports, Association of Schools Events and Negligence in Hospitalized
of Pubic Health, Washington, DC (Mar.-Apr. Patients: Results from the Harvard Medical
2007), http://www.cdc.gov/ncidod/dhqp/ Practice Study I, New England Journal of
pdf/hicpac/infections_deaths.pdf. Medicine, 324:370376 (1991).
5. Levinson, DR, Adverse Events in Hospitals: 13. Thomas, EJ, Costs of Medical Injuries in Utah
National Incidence Among Medicare Bene- and Colorado, Inquiry, 36: 255264 (Fall 1999).
ciaries, Ofce of Inspector General, Depart- 14. Preventing Medication Errors: A $21 Billion
ment of Health and Human Services (Nov. Opportunity, Compact Action Brief: A Road-
2010), http://oig.hhs.gov/oei/reports/oei-06- map for Increasing Value in Health Care,
09-00090.pdf. National Priorities Partnership, convened by
6. Classen, DC, et al., Global Trigger Tool the National Quality Forum, Washington, DC
Shows That Adverse Events in Hospitals (Dec. 2010).
50 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

15. Id. 25. Nahra, TA, Effectiveness of Hospital Pay-for-


16. ISMP Survey: Economy Having Negative Performance Incentives, Medical Care and
Impact on Medication Safety, Oncology Times, Review, Sage Publications: Thousand Oaks, CA.
32(3) (Feb. 10, 2010). The online version of this article can be found at:
17. Transforming Hospitals: Designing For Safety http://mcr.sagepub.com/content/63/1_suppl/
and Quality U.S. Department of Health and 49S DOI: 10.1177/1077558705283629
Human Services, Agency for Health Care (Jan. 18, 2006, online supplement Feb. 2006).
Research and Quality, www.ahrq.gov, AHRQ 26. Landmark, supra, n.8.
Pub. No. 07-0076-1 (Sept. 2007). 27. James, BC, Savitz, LA, How Intermountain
18. SSMHC First Health-Care Recipient of 2002 Trimmed Health Care Costs Through Robust
Malcolm Baldrige National Quality Award. Quality Improvement Efforts, Health Affairs,
SSM Healthcare Web site news release, (2011): doi:10.1377/hlthaff.2011.0358http://
accessed Oct. 22, 2011, update unknown, content.healthaffairs.org/content/
http://www.ssmhc.com/internet/home/ early/2011/05/17/hltaff.2011.0358.full.html.
ssmcorp.nsf/6ca2af2859f73db98625710800 28. Sorenson, CW, Healthcare in the U.S. and
6dce97/671952c33f1a497f862573ec003a5 Utah: A Clinicians Perspective, An Inter-
76b?OpenDocument. mountain Healthcare white paper, Salt Lake
19. Thomson-Reuters, Hospital Operating Trends City, Utah (2011).
Quarterly, Aug. 2011, accessed Oct. 22, 2011, 29. Schaeffer, T, Presentation: Lifesaving Leadership:
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com/content/healthcare/pdf/articles/hosp_ of Patient Safety, Chicagoland Patient Safety
oper_trends_quarterly_aug_2011. Summit, held at UIC Forum (Sept. 15, 2011).
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21. Kavilanz, P, US to Hospitals: Clean Up Excellence in Service: Is Pursuing Safety and
Your Act, CNNMoney Web site, posted Quality the Pathway to Baldrige? Chica-
Apr. 29, 2010, accessed October 22, 2010, goland Patient Safety Summit, held at UIC
http://money.cnn.com/2010/04/29/news/ Forum (Sept. 15, 2011).
economy/healthreform_hospital_fines/. 31. McDonald, T, Presentation: Protecting Patients
22. Landmark, supra, n.8. and Supporting Staff: The Seven Pillars Dem-
23. Id. onstration Project, Chicagoland Patient Safety
24. Shreve, supra, n.3. Summit, held at UIC Forum (Sept. 15, 2011).
Complicated Billing Requirements
Challenge Physical Therapy Industry,
Creating Inefciencies and Confusion
Annette R. Ciavarella

This article is designed to explain the subtle differences between the reimbursement requirements for
coverage of physical therapy services in physician-based settings under the Medicare Benet Policy
Manual Chapter 15Covered Medical and Other Health Services.1 These billing challenges have a
profound nancial impact on the physical therapy industry.2 This article includes: (1) a general back-
ground of the reasons surrounding the increased regulations in the physical therapy industry; (2) general
denitions within the physical therapy industry; (3) a discussion of the confusing and complicated bill-
ing requirements for physical therapy services; (4) a discussion of the incident to billing requirements
within the physical therapy billing requirements; (5) an explanation of differing rules or policies within
the physical therapy billing requirements; and (6) a discussion of why these rules regarding physical
therapy billing requirements are essential to the delivery of quality of care within the physical therapy
industry. Key words: physical therapy, billing requirements.

General Background of the Reasons Office of Counsel to the Inspector General. The
Surrounding the Increased Regulations Work Plan includes projects planned in each
in the Physical Therapy Industry of the departments major entities and projects
related to issues among all departmental pro-
The Office of Inspector General (OIG) has grams.9 With the continuation of improper
been closely scrutinizing payments for phys- billing procedures within the large physi-
ical therapy services since 2002 when it dis- cal therapy industry (see Appendices A
covered improper billing.3 The OIGs reports and B), therapy services, and review of
indicated more than 90 percent of claims payments were once again reviewed on the
submitted to the Medicare program during OIG fiscal year 2011 Work Plan,10 and are
the first six months of 2002, failed to meet once more slated for review on the 2012
Medicares requirements for payments when Work Plan11 (see Appendix C).
therapy services were provided in a physi-
cians office, resulting in $136 million worth Definitions
of improper payments paid by Medicare
(see Figure 1).4 Although fraud requires Qualified Professional
the intent to deceive or misrepresent,5 abuse
only involves receipt of payment for items There are several definitions within the
or services for which there is no entitlement Medicare Benefit Policy Manual that warrant
to that payment.6 This discovery of improper discussion. Under the Manual, a qualified
payments was the catalyst for the subsequent professional means a physical therapist
increased regulations for physical therapy
services.7 Annette R. Ciavarella, LLM, JD, CFE, CHC, is
The OIG uses a Work Plan8 to address President and CEO of Healthcare Compliance
various projects during the fiscal year by the Professionals, LLC.
Office of Audit Services, Office of Evaluation J Health Care Finance 2012; 39(1):5178
and Inspections, Office of Investigations, and Copyright 2012 CCH Incorporated

51
52 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 1. Improper Payments for Physical Therapy Billed by Physicians

Sample Projected
Allowed Services Allowed Amount
Type of Error Services Amount (Percent) (Millions)
Not medically necessary 18 $455.65 26% $33.0
Undocumented:
Nonresponse 14 466.58 * *
Missing documentation 9 209.56 * *
Total undocumented 23 $676.14 34% $49.0
Incomplete/No plan of care:
Incomplete plan of care 23 $802.40 34% $58.2
No plan of care 16 $397.50 24% $28.8
Total incomplete/no plan of care 39 $1,199.90 57% $87.0
Overlapping errors (Both not medically
(18) ($455.65)> <26%> <$33.0>
necessary and incomplete/no plan of care)
Total 62 $1,876.04 91% $136.0

Source: Medical Review of Physical Therapy Billed by Physicians January to June 2002.
*Indicates the n for that cell is too small to reliably project. Totals may not equal the sum of individual rows due
to rounding, in HHS OIG semi-annual report on fraud and abuse, May 1, 2006, http://oig.hhs.gov/oei/reports/
oei-09-02-00200.pdf.

[and] may also include physical therapist and consequently cannot provide billable
assistants (PTAs) when working under the therapy services to Medicare.17 If the PTA
supervision of a qualified therapist, within is not properly supervised, and claims are
the scope of practice allowed by state law.12 submitted for reimbursement to any federal
(See Appendix D for State Practice Acts.) health care program, these claims would be
This rule establishes the supervision require- improper and any monies paid by the federal
ments for a PTA to be reimbursed for services health care program, would need to be re-
by Medicare.13 According to Medicares def- paid to that program, and could also include
initions, a PTA only meets the requirements civil monetary penalties (CMPs).18
of a qualified professional, thereby allow-
ing those services to be properly billed to and Covered Physical Therapy Services
reimbursed by Medicare, when that therapist
is supervised by a qualified therapist.14 Medicares definitions dictate what physi-
The supervision by the physical therapist cal therapy services are in fact covered and
must also take place in the same room as the therefore reimbursable.19 The Manual defines
PTA.15 PTAs must be supervised because covered physical therapy services as skilled
they do not perform initial evaluations of rehabilitative services, which are medically
the patients or develop treatment plans.16 necessary and reasonable and necessary skilled
Therefore, if a PTA is not being supervised, procedures provided by a qualified profes-
that PTA is not a qualified professional sional within the scope of his or her practice.20
Complicated Billing Requirements Challenge Physical Therapy Industry 53

A Tennessee physical therapy organization 2. Services that can be furnished by PTAs


was held to have violated the federal False without a supervising therapist are not
Claims Act for improperly billing Medicare rehabilitative and therefore not reason-
for physical therapy services which were not able or necessary.29
medically necessary, and was ordered to pay
$1.8 million.21 On May 2, 2012, a nationwide The Medicare Benefit Policy Manual
takedown by Medicare Fraud Strike force is quite clear: a PTA must be supervised.30
operations22 resulted in charges against 107 If a PTA is unsupervised, then those ser-
individuals, including physical therapists.23 vices are considered non-rehabilitative and
Their alleged participation in Medicare fraud thereby not reimbursable under Medicare.31
schemes involved approximately $452 million Moreover, the type, or level, of supervision
in false billing.24 These individuals allegedly required for covered services under Medi-
participated in schemes to submit claims that care depends on the following:
were either medically unnecessary or never
provided.25 These indictments should remind 1. The location of the PTA; and
those criminals that they risk prosecution and 2. The employment arrangement,32 which
prison time every time they submit a false is discussed later in this article.
claim.26
Medicare explains, Rehabilitative therapy Billing Confusion
occurs when the skills of a therapist are
necessary to safely and effectively furnish Establishing Billing Privileges
a recognized therapy service.27 Medicare
To bill Medicare directly, Medicare
adds the following emphasis:
requires every physical therapist (PT) to
Services that can be safely and effec- enroll as a private practitioner.33 The
tively furnished by PTAs with- PT is then referred to as a therapist in
out the supervision of therapists are not private practice (TPP).34 To qualify to
rehabilitative therapy services. If at any bill Medicare directly as a TPP, every PT
point in the treatment of an illness it must also be employed in one of the fol-
is determined that the treatment is not lowing practice categories:
rehabilitative, or does not legitimately
require the services of a qualified pro- an unincorporated solo practice, unin-
fessional the services will no longer corporated partnership, unincorpo-
wbe considered reasonable and neces- rated group practice, physician
sary. Services that are not reasonable or group or groups that are not profes-
necessary should be excluded from cov- sional corporations [PCs], if allowed
erage under 1862(a)(1) of the Act.28 by state and local law.35 Physician
These points reinforce the following group practices may employ TPP
facts: if state and local law permits this
employee relationship. For purposes
1. Unsupervised PTAs are not qualified of this provision, a physiciangroup
professionals; and practice is defined as one or more
54 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

physicians enrolled with Medicare more than the employment arrangement,


who may bill as one entity.36 and are insufficient research to determine
proper billing procedures.45
To clarify, if PTs want to obtain and retain The OIG inquiries associated with Medi-
billing privileges with Medicare to bill directly care payments for physical therapy direct
for their services, they must first: that more research is needed than query-
ing peers.46 Comparisons with peers require
1. Complete the CMS-855-I application;37 specific details, including the site of that
and employment arrangement as well as the type
2. Choose the private practitioner option of employment arrangement; specific super-
on the application when enrolling.38 vision requirements must be investigated.47

The therapist will then be issued a National Supervision Requirements


Provider Identifier (NPI), the unique iden-
tification number for health care providers, As detailed above, if the therapist is
which enables them to bill Medicare directly employed in a physician group practice, and
for their services.39 The therapist must also wants to bill Medicare directly for services
be employed in one of the above practice performed, then that therapist must enroll
types, all of which have different supervi- with Medicare as a TPP.48 However, if the
sion requirements,40 and are discussed later TTP practice does not enroll as a Medi-
in this article. Therefore, if the therapist was care provider, then that therapist may not
employed by an incorporated41 physician bill Medicare directly, and must then be
group practice, or partnership,42 or an institu- directly supervised (direct supervision is
tional setting (e.g., skilled nursing facility), discussed later in this article) by an enrolled
then that therapist would not be permitted to therapist (the same requirements for a PTA,
directly bill Medicare (see Figure 2).43 as noted earlier).49 These direct supervi-
This is why merely comparing billing sion requirements apply only in the private
practices and supervision procedures with practice setting and only for therapists and
peers is insufficient.44 Comparisons with their assistants.50 Supervision requirements
peers require specific details, which include differ within other sites of service, and are
Figure 2. Employment Billing Categories

Employment Category Having the Employment Category NOT Having


Ability to Bill Medicare Directly the Ability to Bill Medicare Directly
Unincorporated solo practice Incorporated physician group practice
Unincorporated partnership Incorporated physician partnership
Unincorporated group practice Incorporated group(s)
Physician group(s) that are not PCs, if permitted Hospital
by state and local law
Skilled nursing facility
Complicated Billing Requirements Challenge Physical Therapy Industry 55

often at the core of the confusion, and ulti- state practice requirements are more strin-
mately, civil monetary penalties (CMPs).51 gent, in which case those requirements
The OIG, through the Secretary of Health must be followed.57 General supervision
and Human Services (HHS), is authorized to requires the physicians direction and con-
seek CMPs, as well as, exclusion from partic- trol over the services performed.58 Although
ipation in all federal health care programs.52 it is not necessary for the physician to be
There was a very recent False and Fraudu- present during the treatment, that physician
lent Claims CMPs case with the OIG.53 This remains ultimately responsible for the treat-
case involved a physician from Mississippi ment as well as for the maintenance of any
who agreed to settle his case for $25,500 equipment.59 Direct supervision requires
for allegedly submitting improper claims to the presence of the physician in the actual
Medicare by failing to directly supervise the office building, though not necessarily in
physical therapy services.54 Another recent the treatment room, and immediately avail-
case came out of Minnesota.55 The organiza- able to render assistance during treatment if
tion in this case had been submitting false necessary.60 Presence of the physician in the
Medicare and Medicaid claims for over treatment room is required under personal
three years due to either: supervision.61 See Figure 3.62
The supervision requirements in Figure
1. Unsupervised physical therapy ser- 3 are related to a therapist wishing to bill
vices; or Medicare directly for his or her services,
2. Physical services that were not per- using the therapists own NPI. Adding to
formed at all.56 the already confusing billing requirement,
Medicare has additional billing require-
General supervision, is required for ments related to a therapist wishing to bill
PTAs in all settings except private practice Medicare using the employers NPI, rather
(which requires direct supervision), unless than the therapists own NPI.63

Figure 3. Supervision Requirements

Supervision
Site of Service Requirement Physical Presence Requirement
Outpatient hospital General PT presence not required on premises
Nursing facility General PT presence not required on premises
Comprehensive outpatient General PT presence not required on premises
rehabilitation facilities
Outpatient rehabilitation facilities General PT presence not required on premises
Home health agencies General PT presence not required on premises
PT in private practice Personal PT present in the same room
Physician office (Incident to) Direct Physician present in the office suite
Physician office Personal PT present in the same room
56 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Incident To Requirements provided incident to services of a physical


therapist.73
Incident to rules were developed by PTAs may not bill incident to either the
Medicare to reimburse non-physician provider physical therapists service or the physicians
services that were incident to a physicians service.74 However, if a physical therapist
service.64 When a physical therapist who has and PTA are both employed by a physician
acquired his or her own NPI provides services group, then the services of the supervised
in the physicians group practice where that PTA may be billed by the physician group
therapist is employed, but that therapist bills as physical therapy services (using the physi-
using the physicians group practice NPI for cal therapists NPI), if the physical therapist
the services provided by the therapist, rather is enrolled with Medicare.75 It is necessary
than using the therapists own NPI, then all to learn and understand these incident to
enrolled therapists must bill incident to the requirements because they are mandatory
enrolled physicians services, though this is billing requirements for reimbursement under
not the typical billing practice.65 In this situ- Medicare guidelines as well as for some com-
ation, the rules for both physical therapy ser- mercial payers.76
vices as well as the confusing incident to Medicares incident to billing procedure
billing must be followed.66 is often required by private third-party pay-
The OIG reports, mentioned earlier, deter- ers (e.g., managed care organizations, private
mined that a portion of the improper pay- insurance carriers) that often do not credential
ments they discovered was due to physicians physical therapists as providers in their group
improperly billing under the complicated contracts.77 Many third-party payers are also
and confusing incident to rule.67 Inaccu- Medicare Parts C and D payers (a program
rate incident to billing is one reason physi- through which organizations contract with the
cal therapy services are on OIGs 2012 Work Centers for Medicare & Medicaid Services
Plan.68 The OIG is also investigating whether (CMS) to provide coverage of health care ser-
incident to billing is vulnerable to overu- vices to Medicare beneficiaries78) and as such
tilization [which consequently exposes] must follow Medicare guidelines,79 includ-
Medicare beneficiaries to care that does not ing incident to requirements, regardless of
meet professional standards of quality.69 whether that particular patient is a Medicare
To qualify for reimbursement under beneficiary.80 The incident to billing proce-
Medicares incident to rules, the supervis- dure is quite complex with several steps.81
ing physician must be on the premises on the A non-physician provider is billing inci-
day and time of services, immediately avail- dent to a physician-providers services.82
able to render assistance if needed, and be Incident to services are defined as those
documented as such in the patient record.70 services that are furnished incident to a phy-
Auditors and investigators will compare both sicians professional services in the phy-
the physicians and therapists schedules to sicians office, which must meet certain
determine billing integrity.71 As previously requirements as follows:83
mentioned, incident to services only apply
to billing incident to the services of phy- Services must be part of the patients
sicians.72 There is no coverage for services normal course of treatment, during which
Complicated Billing Requirements Challenge Physical Therapy Industry 57

a physician personally performed an The caregiver providing the service


initial service and remains actively must represent a direct financial
involved in the course of treatment.84 expense to the physician-provider
The physician does not need to be phys- (e.g., a W-2 or leased employee, an
ically present in the patients treatment independent contractor); and
room while these services are provided, The caregiver providing the service
but the physician must provide direct must be directly supervised by the
supervision, i.e., the physician must physician-provider.
be present in the office suite to render The physician directly supervis-
immediate assistance, if necessary.85 ing the auxiliary personnel need
The availability of the physician not be the same physician upon
by telephone does not constitute whose professional service the
direct supervision.86 incident to service is based.
Documentation should include the es- If the physician is in a group prac-
sential requirements for incident to tice, any physician of the group
service. may be present in the office to
The physician is not required to see the supervise (see specifics immedi-
patient each time the non-physician ately below).87
practitioner treats the patient.
There must be subsequent services by Medicare rules for incident to a physi-
the physician of a frequency that reflects cians service provided within a physician
the physicians continuing active par- group practice are generally the same as the
ticipation in and management of the rules listed above, with a few differences:88
course of treatment.
These services must be all of the fol- 1. A physician (or a number of physi-
lowing: cians) is physically present in the facil-
An integral part of the patients treat- ity to perform medical (rather than
ment course; administrative) services at all times the
Commonly rendered without charge [group] is open;
or included in the physicians bill 2. Each patient is under the care of a
[i.e., relatively insignificant supplies [group] physician; and
and services that are not separately 3. The non-physician services are under
payable by Medicare; or, under other medical supervision.89
circumstances, the supply or service
would already be included in the Therefore, the physician ordering a particu-
physicians bill]; lar service need not be the physician who is
Of a type commonly furnished in a supervising the service in a group practice.90
physicians office or clinic (clinic In a group practice, direct supervision by a
includes a physician group practice physician may be the responsibility of several
but not an institutional setting); physicians on the premises.91 Thus, medical
Provided by a caregiver qualified to management of all services provided in the
provide the service; group practice is assured.92 Hence, services
58 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

performed by non-physician personnel are the therapist is billing for his or her services
protected even though those services are per- as incident to one of the group physicians
formed in another department of the group services, the claim form will be completed
practice.93 The direct supervision require- differently.106
ments for a group practice are no different.94 For those practices that have implemented
Direct supervision of a physical therapist electronic medical records, how to properly
by a physician in an office setting requires electronically document incident to ser-
the physician to be present in the office vices would be as follows:
suite.95 Although Medicare does not specifi-
cally define what a suite is, it has indicated The physician who ordered the physical
that a suite means the same office building therapy service should have his or her
where a physician is immediately available information included on every line of
to furnish assistance and direction through- service in the 2420E loop;
out the performance of the procedure if so The supervising physicians informa-
needed.96 These requirements do not oblige tion should be included in loop 2310E;
the physician to be present in the same room The rendering provider would be the
while the procedure or service is performed.97 treating physical therapist and his or her
The physician need only be in the same information should be included in loop
office building.98 Direct supervision should 2420D.107
not be confused with Medicares general
or personal supervision requirements.99 The supervising physician will now be
Under general supervision, the physician identified on the CMS 1500 claim form in
is not even required to be in the building.100 the lower left corner of the page, and his
Even if physicians successfully comprehend or her NPI will be indicated on that same
the previously listed incident to require- form in the center of the page. The physical
ments (which the OIG report indicates other- therapist would not be listed on the form at
wise101), they may still encounter confusion all. However, the supervising physical ther-
when submitting the actual claims.102 apist is still documented in the electronic
medical record by following the procedures
above.
Dealing with Claim Forms
A therapist with his or her own Medicare
NPI, employed in a physician group, typi- Differing Rules or Policies
cally bill services as his or her own, using
the therapists NPI, with the therapist iden- Confusion Between Reimbursement
tified on the claim.103 Physician and other Differences
qualified professional provider services are There is further confusion when it comes
filed on the CMS 1500 claim form.104 The to reimbursement rates for physical therapy
therapists are then identified on the CMS (PT) services. PT services are reimbursed at
1500 claim form in the lower left corner of 100 percent of the applicable physician fee
the page, and their NPI is indicated on that schedule,108 (up to the $1,860 therapy cap
form in the center of the page.105 However, if established in 2010109). This reimbursement
Complicated Billing Requirements Challenge Physical Therapy Industry 59

is the same as nurse practitioners (NPs) only between TPPs and NPs are just a few of the
when their services are billed under the phy- sources contributing to the confusion sur-
sicians NPI as incident to that physicians rounding billing requirements for physical
services.110 The NP is reimbursed only at 85 therapy services. When conflicting messages
percent of the fee schedule amount when are sent by different organizations, this leads
those services are billed under the NPs to even more confusion.
NPI and not as incident to a physicians
service.111 This percentage differential does American Physical Therapy
not exist for physical therapists.112 PTs are Association
always reimbursed at 100 percent of the phy-
Medicare indicates that the American
sician fee schedule.113
Physical Therapy Association (APTA)
Signature Requirement Differences guidelines may be utilized; however, they
may be used as guidelines only, and not as
There is another significant difference
policy.121 Medicare goes on to clarify that
between billing requirements for TPPs
whenever a differing policy or law exists that
and NPs regarding progress note signature
is more stringent than Medicare rules, it is
requirements. Rehabilitative services must
the more stringent policy or rule that must be
include a written plan of treatment from the
followed.122 Medicare repeatedly mentions
provider in the progress report.114 The plan
that the more stringent policy or law must
of care must include the type, frequency,
be met,123 indicating that whenever there is
and duration of the services, as well as the
a harsher policy or law, that more strin-
diagnosis and goals the provider hopes to
gent regulation must be followed, regard-
accomplish.115 The progress report provides
less of whether the stricter rule is a state
justification for the medical necessity of
law or the Medicare regulation.124 Some of
this plan of treatment.116 The determination
the confusion surrounding the supervision
of the necessity of the services provided is
requirements originates directly with the
based on the documentation in the treatment
presentation of the rules in the Medicare
notes and progress report.117 The signature
Benefit Policy Manual.
indicates the ownership of that documenta-
As noted earlier, a physical therapist
tion (i.e., the medical decision-making).118
employed within a group medical practice
For Medicare payment purposes, informa-
is a therapist in private practice.125 This can
tion required in progress reports shall be
be very confusing to physical therapists,
written by a clinician who either provides or
especially if seeking assistance from the
supervises the services, or by the therapist
individual State Practice Act. The APTA
who provides the services and supervises
also indicates that the requirements for
a PTA.119 Medicare does require the super-
supervision and direction of PTAs are based
vising physician to sign the progress notes,
on several considerations, which include:
written by the NP, for services billed inci-
dent to that physicians service; however,
Medicare does not require the supervising 1. Site of service (group practice, institu-
physician to sign the progress reports writ- tional, etc.);
ten by the TPP.120 The above differences 2. The use of personnel;
60 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

3. The education, experience, and skill of Rules: Essential to Quality of Care


the PTA;
4. The patients criticality, acuity, stabil- The above rules are indeed quite compli-
ity, and complexity; and cated. It is understandable to think that the
5. Federal regulations.126 complication can lead to confusion regarding
accurate billing procedures. It may be difficult
PTs must therefore look to three major for providers to appreciate the importance of
governmental bodies to discern physical the above rules and regulations. Providers may
therapy billing requirements: also be feeling production financial pressures.
However, these regulations were designed to
1. APTA; protect the health of all Americans,128 i.e., to
2. The State Practice Act; and obtain the highest quality of care for patients.
3. CMS. Quality of care is dependent on patient safety.
And patient safety within organizations is
However, the safest course is to comply dependent on people and staff to adhere to
with Medicare rules, because governing the appropriate principles and rules in the face
bodies can vary.127 of production pressures.129
Ratio of PTAs to PTs: By CMS Region (1999)

0.50

0.45

0.40
0.38
0.35
0.35
0.31
0.30
0.27 0.27
0.25 0.25
0.25

PTA to PT Ratio
0.20
0.17

0.15
0.11
0.10

0.05
By CMS Region (1999)

0.00
Total Atlanta Boston Chicago Denver Philadelphia San Francisco Seattle New York
Note: PT is physical therapist; PTA is physical therapist assistant.
Appendix A. Ratio of PTAs to PTs:

Source: Urban Institute analysis of 1999 State Occupation Employment and Wage Estimates, US Department of
Labor.
Complicated Billing Requirements Challenge Physical Therapy Industry
61
62

Distribution of PTs and PTAs: By Setting (2001)


JOURNAL

30%
OF

25.5%
25%
22.8%
21.7%

20% 19.7%

17.1%

15%
13.8%13.8% PT
PTA

Share of PTs / PTAs


12.0%
HEALTH CARE FINANCE/FALL 2012

10.1%
10%
8.7%
7.6%
7.2%

5.0% 5.1% 5.2%


5% 4.7%

0%
Private Acute Outpatient Skilled Rehabilitation Home/ Colleges/ Other
and PTAs: By Setting (2001)

practice hospital facility nursing hospital home care secondary


(inpatient) facility schools
Appendix B. Distribution of PTs

Note: PT is physical therapist; PTA is physical therapist assistant; other includes health/wellness facilities, industry,
research centers, and other unspecified settings.
Source: Urban Institute summary of American Physical Therapy Association fall 2001 survey of members and non-
members (n = 4,898 PT respondents; n = 3,413 PTA respondents).
Complicated Billing Requirements Challenge Physical Therapy Industry 63

Appendix C. OIG 2012 Work Plan


Every year, the Office of Inspector Gen- is in the Social Security Act, 1861(s)
eral (OIG) within the Department of Health (2)(A). Medicare requires providers to
and Human Services (DHHS) publishes its furnish such information as may be nec-
Work Plan, a description of issues targeted essary to determine the amounts due to
for government attention during the upcom- receive payment. (Social Security Act,
ing fiscal year. For FY 2012, the OIG has 1833(e).) (OEI; 00-00-00000; expected
multiple issues in its Work Plan that are of issue date: FY 2013; new start)
importance to physical therapists. The issues
include: Physicians: Impact of Opting Out of
Medicare (New)Review the extent
Physicians: Incident-To Services to which physicians are opting out of
(New)Review of physician billing Medicare and determine whether phy-
for incident-to services to determine sicians who have opted out of Medi-
whether payment for such services had care are submitting claims to Medicare.
a higher error rate than that for non- We will also examine whether specific
incident-to services. We will also assess areas of the country have seen higher
CMSs ability to monitor services billed numbers of physicians opting out and
as incident-to. Medicare Part B pays its potential impact on beneficiaries.
for certain services billed by physicians Physicians are permitted to enter into
that are performed by non-physicians private contracts with Medicare benefi-
incident to a physician office visit. ciaries. (Social Security Act, 1802(b).)
A 2009 OIG review found that when As a result of entering into private con-
Medicare allowed physicians billings tracts, physicians must commit that they
for more than 24 hours of services in a will not submit a claim to Medicare for
day, half of the services were not per- any Medicare beneficiary. (OEI; 07-11-
formed by a physician. We also found 00340; expected issue date: FY 2012;
that unqualified non-physicians per- work in progress)
formed 21 percent of the services that
physicians did not perform personally. Independent Therapists: Outpatient
Incident-to services represent a pro- Physical Therapy ServicesReview
gram vulnerability in that they do not of outpatient physical therapy services
appear in claims data and can be iden- provided by independent therapists to
tified only by reviewing the medical determine whether they were in com-
record. They may also be vulnerable pliance with Medicare reimbursement
to overutilization and expose Medicare regulations. Previous OIG work has
beneficiaries to care that does not meet identified claims for therapy services
professional standards of quality. Medi- provided by independent physical thera-
cares Part B coverage of services and pists that were not reasonable, medically
supplies that are performed incident to necessary, or properly documented. Our
the professional services of a physician focus is on independent therapists who
64 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

have a high utilization rate for outpatient Part B payments to physicians and sup-
physical therapy services. Medicare will pliers. We will determine whether pay-
not pay for items or services that are ment system controls are in place to
not reasonable and necessary. (Social identify such payments and assess the
Security Act, 1862(a)(1)(A).) Docu- effectiveness of those controls. Medi-
mentation requirements for therapy care Part B services must be reason-
services are in CMSs Medicare Benefit able and necessary (Social Security Act,
Policy Manual, Pub. 100-02, Ch. 15, 1862(a)(1)(A)), adequately documen-
220.3. (OAS; W-00-11-35220; vari- ted ( 1833(e)), and provided consist-
ous reviews; expected issue date: FY ent with Federal regulations (42 CFR,
2012; new start) 410). A high cumulative payment is
an unusually high payment made to an
Comprehensive Outpatient Reha- individual physician or supplier, or on
bilitation FacilitiesReview national behalf of an individual beneficiary, over
Medicare utilization patterns for Com- a specified period. Prior OIG work has
prehensive Outpatient Rehabilita- shown that unusually high Medicare
tion Facility (CORF) services, identify payments may indicate incorrect billing
CORFs in high-utilization areas, and or fraud and abuse. (OAS; W-00-12-
determine whether they meet basic 35605; various reviews; expected issue
Medicare requirements. Medicare paid date: FY 2012; new start)
about $61 million for 35,000 benefi-
ciaries who received CORF services in Medicare Payments for Part B
2009. Previous OIG work identified Claims with G ModifiersReview
CORF services that did not meet Medi- Medicare payments made from 2002
care reimbursement standards because to 2010 for claims on which providers
they were not medically necessary or used certain modifier codes indicat-
lacked documentation that they were ing that Medicare denial was expected.
provided. OIG has also raised concern We will determine the extent to which
about potentially inappropriate rental Medicare paid claims having such mod-
arrangements between physician land- ifiers. We will also identify providers
lords and CORFs. Federal regulations and suppliers with atypically high bill-
require that CORFs maintain locations ing related to the modifiers. Providers
that provide safe and sufficient space for may use GA or GZ modifiers on claims
the scope of all services offered (42 CFR they expect Medicare to deny as not rea-
485.62). We will conduct site visits of sonable and necessary. (CMSs Claims
CORFs. (OEI; 05-10-00090; expected Processing Manual.) They may use GX
issue date: FY 2012; work in progress) or GY modifiers for items or services
that are statutorily excluded. A recent
Physicians and Other Suppliers: High OIG review found that Medicare paid
Cumulative Part B Payments (New) for 72 percent of pressure-reducing
Review payment systems controls that support surface claims with GA or GZ
identify high cumulative Medicare modifiers, amounting to $4 million in
Complicated Billing Requirements Challenge Physical Therapy Industry 65

potentially inappropriate payments. that consistently submitted claims found


(OEI; 02-10-00160; expected issue to be in error in a 4-year period. In this
date: FY 2012; work in progress) review, we will select the top error-
prone providers based on expected dol-
Payments for Services Ordered or lar error amounts and match selected
Referred by Excluded Providers providers against the National Claims
Review the nature and extent of Medi- History file to determine the total dol-
care payments for services ordered or lar amount of claims paid. We will then
referred by excluded providers (those conduct a medical review on a sample
who have been barred from billing fed- of claims. Providers must submit accu-
eral health care programs) and examine rate claims for services provided to
CMSs oversight mechanisms to iden- Medicare beneficiaries. (CMSs Medi-
tify and prevent payments for such ser- care Claims Processing Manual, Pub.
vices. No payments shall be made for 100-04.) (OAS; W-00-11-35565; vari-
any items or services furnished, ordered, ous reviews; expected issue date: FY
or prescribed by excluded individuals or 2012; new start)
entities. (Social Security Act, 1128
and 1156, and 42 CFR 1001.1901.) Payments for Physical, Occupational,
(OEI; 00-00-00000; expected issue and Speech Therapy Services (Med-
date: FY 2013; new start) icaid)Determine the extent to which
payments for Medicaid physical, occu-
Medical Claims Review at Selected pational, and speech therapy services
ProvidersReview Medicare Part A comply with State standards and limits
and Part B claims submitted by error- on coverage. Previous OIG studies found
prone providers to determine their that some therapy services provided
validity, project our results to each pro- under Medicare were billed incorrectly.
viders population of claims, and rec- Through a review of selected States, we
ommend that CMS request refunds on will determine whether Medicaid has
projected overpayments. Previous OIG similar program integrity issues. States
work illustrated a methodology for may provide physical, occupational,
identifying error-prone providers using and speech therapy services to Medic-
CMSs Comprehensive Error Rate Test- aid beneficiaries pursuant to the Social
ing (CERT) Program data. Using this Security Act, 1905(a), and regulations
methodology, we identified providers at 42 CFR 440.110.130
66
Appendix D. State Practice Acts
Supervision Requirements for PTAs
JOURNAL
OF

Supervision
State Requirement Definition Regulation

Alabama Under the The board shall not issue any rules or regulations that require a PTA to be within sight Tit. 34, ch. 24, art.
direction of a of a consulting PT or a PT supervisor while working under the direction of that PT or 5, 34-24-193
registered PT issue any rules, regulations, or orders inconsistent with 34-24-217(b).
Alaska Periodic on-site The PT shall be available for consultation with the PTA that may be provided by tel- Art. 4, 510, 12
at least once per ephone, verbally, or in writing. ACC, 54.510(e)
month
Arizona General The supervising PT is on call and is readily available via telecommunications when the Ch. 19, art. 1,
supervision PTA is providing treatment interventions. 32-2001, AZ State
Legislature
Arkansas Direct supervision The supervising PT is on-site and available for Consultation. Arkansas State
HEALTH CARE FINANCE/FALL 2012

Bd of Practice
Act, 17-93-101,
1(B)(2)
California Adequate The supervising PT shall be readily available in person or by telecommunication to the 1398.44 of the
supervision PTA at all times while the PTA is treating patients. The supervising PT shall provide PT Regulations
periodic on-site supervision and observation of the assigned patient care rendered by
the PTA.
Colorado Direct supervision Supervision that is on the premises where any such unlicensed individuals are Colorado Revised
practicing. Statutes, Tit. 12,
art. 41-113(1)
Connecticut (Continuous: for The overseeing of or the participation in the work of a PTA by a licensed physical (Continuous: for
graduates of for- therapist, including, but not limited to: (A) continuous availability of direct communica- graduates of for-
eign PT schools) tion between the PTA and a licensed PT; (B) availability of a licensed PT on a regularly eign PT schools:
Direct and imme- scheduled basis to: (i) review the practice of the PTA; and (ii) support the PTA in the 20-70a)
diate supervision performance of the PTAs services; and (C) a predetermined plan for emergency situ- Ch. 376,
ations, including the designation of an alternate licensed PT in the absence of the 20-66(3);
regular licensed PT. 20-70(2)(b)(1)
Supervision
State Requirement Definition Regulation
Delaware Direct supervision A licensed PT shall be on the premises; and evaluations and progress notes shall be Tit. 24, Del. C.
co-signed by the supervising, licensed PT. In relation to a PTA with less than one year of 2611(a)
experience, a PT shall be on the premises at all times and see each patient. In relation to
a PTA with one year or more of experience, the supervising PT must see the patient at
least once every sixth treatment day, and the PTA must receive on-site, face-to-face super-
vision at least once every 12th treatment day. The supervising PT must have at least one
year of clinical experience. The PT must be available and accessible by telecommunica-
tions to the PTA during all of the PTAs working hours. All supervision must be documented.
District of Direct supervision The PT is physically present and immediately available for direction and supervision. Ch. 12,
Columbia The PT will have direct contact with the patient/client during each visit that is defined as 3-1212.04(C)
all encounters with a patient/client in a 24-hour period. Telecommunications does not
meet the requirement of direct supervision.
Florida Direct supervision Except in a case of emergency, direct supervision requires the physical presence of the FL statute
licensed PT for consultation and direction of the actions of a PT or PTA who is practic- 486.021(9)
ing under a temporary permit and who is a candidate for licensure by examination.
Georgia Direct supervision PT must be on the premises at all times. 43-33-13.1
Hawaii Direct supervision The supervisor shall be present in the same building as the person being supervised Ch. 461J-3(e)
and available for consultation and assistance.
Idaho A licensed PT shall supervise and be responsible for patient care given by PTAs and 54-2218(1)
supportive personnel.
Illinois General supervi- General: The PT must maintain continual contact with the PTA including periodic per- 225 ILCS 90/2
sion for PTAs sonal supervision and instruction to insure the safety and welfare of the patient.
Direct supervi-
sion for students
Indiana Direct supervision The supervising PT or physician at all times shall be available and under all circumstances 25-27-1
shall be absolutely responsible for the direction and the actions of the person supervised
when services are performed by the PTA or holder of a temporary permit issued under IC
25-27-1-8(d). For the holder of a temporary permit issued under IC 25-27-1-8(d), unless the
supervising PT or physician is on the premises to provide constant supervision, the holder
of a temporary permit shall meet with the PT or physician at least once each working day
to review all patients treatments. This meeting must include the actual presence of the PT
or physician and the holder of a temporary permit. The patients care shall always be the
responsibility of the supervising PT or physician. Reports shall be countersigned by the PT
Complicated Billing Requirements Challenge Physical Therapy Industry

or physician who may enter remarks, revision, or additions. With respect to the supervision
of PTAs under IC 25-27-1-2(c), unless the supervising PT or physician is on the premises
to provide constant supervision, the PTA shall consult with the supervising
67

Continued ...
68
State Practice Acts Continued...

Supervision
State Requirement Definition Regulation
JOURNAL

PT or physician at least once each working day to review all patients treatments. The
supervising PT or physician shall examine each patient not less than: (1) every 14 days
OF

for inpatients in either a hospital or comprehensive rehabilitation facility; (2) the earlier
of every 90 days or 6 physical therapy visits for patients in a facility for the mentally
retarded (MR) and developmentally disabled (DD) and school system patients; and
(3) the earlier of every 30 days or every 15 physical therapy visits for all other patients;
to review patients treatment and progress. If this daily consultation is not face-to-face,
the PT or physician may not supervise more than the equivalent of 3 full-time PTAs. A
consultation between a supervising PT or a physician and the PTA may be in person,
by telephone, or by a telecommunications device for the deaf (TDD), so long as there is
interactive communication concerning patient care.
Iowa Under direction PTA works under the direction and supervision of a licensed PT 148A.6(2)
and supervision
Kansas Personal Oversight by a PT or PTA acting under the direction of the PT who is on-site and imme- Ch. 65, KS
supervision diately available to the support personnel. Statutes
HEALTH CARE FINANCE/FALL 2012

Kentucky Not specified


Louisiana Supervising A supervising PT shall be readily accessible by beeper or telephone and available to 2418F(2)(c)
the patient by the next scheduled treatment session upon request of the patient or PTA.
Maine Direction Continuing verbal and written contact by a PT with a PTA including periodic on-site Tit. 32, ch. 45,
supervision adequate to ensure the safety and welfare of the patient. 3111 (2)
Maryland Direct supervision A licensed PT is personally present and immediately available within the treatment area Tit. 10, 13-206,
to give aid, direction, and instruction when physical therapy procedures or activities are ch. 04.02
performed.
Massachusetts Direct supervision PT must be physically present in the facility. Ch. 112, 23 A-D
Michigan Not specified
Minnesota Direct supervision Is available for in-person intervention while treatment is provided. 148.6402
Mississippi Direct, on-site Face-to-face oversight by a licensed PT at regular intervals, as prescribed in regulations 73-23-33 (f)
supervision adopted by the board, of the services provided to a patient by a licensed PTA
Missouri Direct, on-site No licensed PT shall have under his or her direct supervision more than 4 full-time 334.506(7);
supervision equivalent PTAs. 334.650(2)
Supervision
State Requirement Definition Regulation
Montana Supervision The licensed PT must make an on-site visit to the client at least once for every 6 37-11-105
visits made by the PTA or once every two weeks, whichever occurs first. The PT may
not concurrently supervise more than 2 full-time PTAs, 4 PT aides, or two assistants
and two aides. This supervision does not require the presence of the PTA. A student
requires on-site supervision.
Nebraska General supervi- General supervision: either on-site or by means of telecommunication. 71-1370; 71-1368
sion: PTA Direct supervision: The PT must be physically present and immediately available and
Direct supervi- does not include supervision provided by means of telecommunication.
sion: Students
Nevada Immediate A person is present and immediately available within the treatment area to give aid, NRS 640.016
supervision direction, and instruction to the person he or she is supervising.
New IV. A PTA shall III. Direct personal supervision: the PT or the PTA is physically present and immedi- 328-A:2, III-V;
Hampshire work under a ately available to direct and supervise tasks that are related to patient/client manage- A:11, IV-V
PTs general ment. The direction and supervision is continuous throughout the time these tasks
supervision. are performed. Telecommunications does not meet the requirement of direct personal
A PTA shall supervision.
document care IV. Direct supervision means that the PT is physically present and immediately avail-
provided and able for direction and supervision. The PT will have direct contact with the patient/cli-
shall report to a ent during each visit that is defined as all encounters with a patient/client in a 24-hour
supervising PT period. Telecommunications does not meet the requirement of direct supervision.
any status in a V. General supervision means that the PT is not required to be on-site for direction and
patient requiring supervision, but must be available at least by telecommunications.
a change in the
plan of care. The
supervising PT
shall review and
co-sign all notes
during each
reevaluation.
V. A PT aide shall
work under the
direct personal
Complicated Billing Requirements Challenge Physical Therapy Industry

supervision of a
PT or a PTA.
69

Continued ...
70
State Practice Acts Continued...

Supervision
State Requirement Definition Regulation
New Jersey Direct supervision The PT must be present on-site, readily available to respond to any consequence 13:39A-2.1
JOURNAL

regarding a patients treatment or a patients reaction to the treatment occurring during


OF

any treatment procedure.


New Mexico Supervision (A) A PT may not be responsible for the direction and supervision of more than 2 full- 16.20.7.8
time PTAs, or 2 FTEs (full-time equivalency totaling 80 work hours per week) requiring
supervision, including temporary PT, temporary PTAs, and licensed PTAs.
(B) A PT may supervise 2 or more PTAs provided combined FTEs do not exceed more
than 80 hours per week.
(C) When supervising another licensee, a PT planning an absence from work (vacation,
leave of absence, continuing education) must arrange for another PT to supervise the
licensee in his or her place.
(D) A PT supervising a temporary licensee must notify the New Mexico PT licensing
board, in writing, when he or she is no longer responsible for supervision of a tempo-
rary licensee.
(E) The referring PT must hold documented conferences with the PTA regarding the patient.
HEALTH CARE FINANCE/FALL 2012

New York Direct personal Direct: Same room 6738; 6741


supervision: PTAs On-site: Same building
On-site supervi-
sion: Students
North On-site supervi- On-site supervision means the supervising licensee is present in the department or facil- 90-270.24 (5);
Carolina sion: PT aides ity where services are provided, is immediately available to the person being supervised, 90-270.31(a);
Immediate super- and maintains continued involvement in aspects of treatment sessions in which students 21 NCAC
vision: PTAs completing clinical requirements or PT aides are involved in components of care. 48A.0105(8);
Immediate supervision means that the PT must be immediately available directly or by 21 NCAC
telecommunication to a PTA supervising a PT aide or student. 48C.0102(h)
North Dakota Direct supervision: Direct: The PT is physically present on the premises and immediately available for Tit. 61.5, art.
PT aide direction and supervision. The PT will have direct contact with the patient during each 61.5-05-01-02; 04
On-site visit. Telecommunications does not meet this requirement.
supervision: PTA On-site: The PT is on-site and present in the facility where the services are provided, is
immediately available to the person being supervised, and maintains continued involve-
ment in appropriate aspects of each treatment session in which supportive personnel
are involved in components of care.
Supervision
State Requirement Definition Regulation
Ohio Supervision: PTA PTA: A PTA may only be supervised by a PT and may not be supervised by 4755-27-04(C)
Direct supervi- any other person, including those persons licensed to practice in any other (2); 4755-27-
sion: Student profession. 04(D)(2)
Student: The PT is on-site and available to immediately respond to the needs
of the patient. The PT shall have direct contact with the patient during each visit.
Oklahoma Direct or general General: The responsible supervision and control of the practice of the licensed 435:20-7-1
supervision: PTA PTA by the supervising PT. The supervising therapist is regularly and routinely
Immediate on-site, and every 3 months will provide a minimum of 1 co-treatment of face-to-face,
supervision: real-time interaction with each PTA providing services with his or her patients
PT aides These co-treatments will be documented in the medical record and on a supervision
log, which is subject to inspection. When not on-site, the supervising therapist is
on call and readily available physically or through direct telecommunication for
consultation.
On-site or direct: The PT is continuously on-site and present in the department or
facility where services are provided, is immediately available to the person being
supervised, and maintains continued involvement in appropriate aspects of each
treatment session in which assistive personnel are involved in components of care.
Oregon Supervision and (5) Supervise means to provide the amount of personal direction, assistance, advice, Admin. Rules
direction: PTA and instruction necessary to reasonably assure that the supervisee provides the Ch. 848; Div. 20;
Direct, on-site patient competent PT services, given the supervisors actual knowledge of the 848-020-
supervision: supervisees ability, training and experiences. Additionally, supervision of: (a) A 0000(5)(a)
PT aides treatment-related task requires that the supervising PT or PTA be in the same building
and within sight or earshot of the aide who is performing the treatment-related task,
such that the supervising PT or PTA is immediately available at all times to provide
in person direction, assistance, advice, or instruction to the aide or the patient. A PT
may delegate supervision of an aide to a PTA.
Pennsylvania Direct, on-prem- The physical presence of a PT on the premises so the PT is immediately available to 40.1
ise supervision provide supervision, direction, and control.
Rhode Island Supervision The PT is at all times responsible for supportive personnel and students. 5-40-1
Complicated Billing Requirements Challenge Physical Therapy Industry

Continued ...
71
72
State Practice Acts Continued...

Supervision
State Requirement Definition Regulation
JOURNAL

South On-site PT must be (1) continuously on site; (2) present in the department or facility where 40-45-20(2)
Carolina supervision services are being performed; (3) immediately available to assist in the services being
OF

performed; and (4) maintain continued involvement in appropriate aspects of each treat-
ment session where the supervisee is treating the patient.
South Dakota Supervision Supervision is the responsibility of the PT to observe, direct, and review the work, SL 1996, ch. 231,
records, and practice of PTA to ensure the patient, the PT, and the PTA that good and 2, 36-10-18.2
safe treatment is rendered.
Tennessee Supervision: PTA PTA: The supervising PT will be readily available to the PTA being supervised. When 63-13-103(10);
On-site super- the PTA is practicing in an offsite setting, the supervising PT will be immediately 63-13-103(11)
vision: Aides, accessible by telecommunications; patient conferences will be regularly scheduled and
students documented.
Aides/students: The PT or PTA must (1) be continuously on-site and present in the
department or facility where services are being performed; (2) be immediately available
to assist; and (3) maintain continued involvement in appropriate aspects of each treat-
HEALTH CARE FINANCE/FALL 2012

ment session in which a component of treatment is being performed by the supervisee.


Texas Supervision: PTA PTAs: The PT must be on call and readily available when PT services are being 322.3(b)(2);
On-site supervi- provided. 322.3(14)
sion: PT aides Aides: The PT is on the premises and readily available to respond.
Utah General supervi- PTAs: The PT must be immediately available in person, by telephone, or by electronic 58-24(b)-
sion: PTAs communication to assist the PTA. 102(4), (8);
On-site super- Aides/students: the therapist must be continuously present at the facility where the 58-24b-401(2);
vision: aides, person is providing services; immediately available to assist the person; and regularly 58-24b-404
students involved in the services being provided by the person.
Vermont Supervision: Aides: the PT will be readily available to the PTA. When the PTA is practicing in an off- 26-38-2086(2)
PTAs site setting, the PT will be immediately accessible by telecommunications.
On-site supervi-
sion: aides
Supervision
State Requirement Definition Regulation
Virginia Direct supervi- Direct: A PT or PTA must be physically present and immediately available and is fully 54.1-3479(C);
sion: student responsible for the PT services being performed. Cannot supervise more than 3 train- VA Bd of PT131
General supervi- ees at any one time.
sion: PTAs General: A PT shall be available for consultation.
Washington Direct supervi- Direct: The PT must (a) be continuously on-site and present in the department or facility RSW: 18.74.130,
sion: students, where assistive personnel or holders of interim permits are performing services; (b) 150, 180
aides, PTAs be immediately available to assist the person being supervised in the services being
Indirect supervi- performed; and (c) maintain continued involvement in appropriate aspects of each treat-
sion: PTAs ment session in which a component of treatment is delegated to assistive personnel.
May only supervise 2 assistants at a time.
Indirect: The supervisor is not on the premises, but has given either written or oral
instructions for treatment of the patient and the patient has been examined by the PT at
such time as acceptable health care practice requires and consistent with the particular
delegated health care task.
West Virginia General supervi- General: The PT must be available at least by telecommunications. 30.20-2(h);
sion: PTAs Direct: The physical presence of the PT in the immediate treatment area where the 16-1-2.2
Direct supervi- treatment is being rendered.
sion: Aides Immediate treatment area: the area within the PTs direct line of sight or within audible
distance of the PT and the ability of the PT to immediately respond to calls for
assistance from the patient or PT aide.
Wisconsin Direct supervi- Direct: PT must provide direct, on-premises supervision on a daily basis; have primary 448.56(6); 8.
sion: PTAs, aides, responsibility for patient care rendered by supervisee; and be available at all times for PT 5.01 and .02
students consultation. There may not be more than 2 PTAs or 4 aides being supervised at one
General supervi- time.
sion: PTAs General: There may not be more than four PTAs or four aides being supervised at
one time.
Wyoming On-site super- PT must be continuously present in the facility where the supervised services are 33-25-101(a)(9)
vision: aides, provided, is immediately available to the person being supervised, and maintains
students continued involvement in each treatment session.
Complicated Billing Requirements Challenge Physical Therapy Industry
73
74 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

REFERENCES

1. http://www.cms.gov/Regulations-and- 13. http://www.aota.org/DocumentVault/


Guidance/Guidance/Manuals/downloads// Surveys/LCD-Outpatient.aspx.
bp102c15.pdf. The rules discussed in this 14. http://www.cms.gov/manuals/Downloads/
article also apply to Occupational Therapists bp102c15.pdf, 220 - Coverage of Outpa-
and Occupational Therapists Assistants. tient Rehabilitation Therapy Services (Physi-
2. HHS OIG semi-annual report on fraud and cal Therapy, Occupational Therapy, and
abuse, May 1, 2006, http://oig.hhs.gov/oei/ Speech-Language Pathology Services) Under
reports/oei-09-02-00200.pdf. Medical Insurance (Rev. 88, Issued: 05-07-
3. HHS OIG semi-annual report on fraud and 08, Effective: 01-01-08, Implementation:
abuse, May 1, 2006, http://oig.hhs.gov/oei/ 06-09-08), A; http://www.aota.org/Document
reports/oei-09-02-00200.pdf. Vault/Surveys/LCD-Outpatient.aspx.
4. HHS OIG semi-annual report on fraud and 15. 42 C.F.R. 410.32(b)(3)(iii), 410.60(c)(2).
abuse, May 1, 2006, http://oig.hhs.gov/oei/ 16. Report to Congress: Standards for Supervision
reports/oei-09-02-00200.pdf. of PTAs and the Effects of Eliminating the Per-
5. One has committed fraud if one know- sonal PTA Supervision Requirement on the
ingly and willfully executes or attempts to Financial caps for Medicare Therapy Services,
execute a scheme to defraud any health- http://www.cms.gov/TherapyServices/
care benet program or to obtain by means downloads/61004ptartc.pdf.
of false or fraudulent pretenses, representa- 17. http://www.aota.org/DocumentVault/
tions, or promises any of the money or prop- Surveys/LCD-Outpatient.aspx.
erty owned by any healthcare benet 18. http://oig.hhs.gov/fraud/enforcement/
program, Health Insurance Portability and cmp/index.asp.
Accountability Act 1996 (18 U.S.C., Ch. 63, 19. http://www.cms.gov/Regulations-and-
1347). Guidance/Guidance/Manuals/downloads//
6. CMS Glossary, http://www.cms.hhs.gov; bp102c15.pdf.
http://www.medicare.gov. 20. http://www.cms.gov/Regulations-and-
7. HHS OIG semi-annual report on fraud and Guidance/Guidance/Manuals/downloads//
abuse, May 1, 2006, http://oig.hhs.gov/oei/ bp102c15.pdf; http://www.cms.gov/manuals/
reports/oei-09-02-00200.pdf. Downloads/bp102c15.pdf, Rehabilitative Ther-
8. http://oig.hhs.gov/reports-and-publications/ apy (220.2 - Reasonable and Necessary Outpa-
workplan/index.asp#current. tient Rehabilitation Therapy Services), C.
9. http://oig.hhs.gov/reports-and-publications/ 21. Benchmark Physical Therapy to pay $1.8
workplan/index.asp#current. Million for improper Medicare Billings
10. OIG Archives, http://oig.hhs.gov/reports-and- (6/30/10), Benchmark violated the federal FCA
publications/archives/workplan/index.asp. by submitting claims for PT services which
11. http://oig.hhs.gov/reports-and-publications/ were not medically necessary (http://www.
archives/workplan/2012/Work-Plan-2012. chattanoogan.com/2010/6/30/178983/
pdf. Benchmark-Physical-Therapy-To-Pay-
12. http://www.cms.gov/manuals/Downloads/ 1.8.aspx).
bp102c15.pdf, 220 - Coverage of Outpa- 22. http://www.justice.gov/opa/pr/2012/
tient Rehabilitation Therapy Services (Physi- May/12-ag-568.html. Cases are being inves-
cal Therapy, Occupational Therapy, and tigated by Medicare Strike Force Teams, FBI
Speech-Language Pathology Services) Under agents, HHS-OIG and State Medicaid Fraud
Medical Insurance (Rev. 88, Issued: 05-07- Control Units.
08, Effective: 01-01-08, Implementation: 23. http://www.justice.gov/opa/pr/2012/May/
06-09-08), A. 12-ag-568.html.
Complicated Billing Requirements Challenge Physical Therapy Industry 75

24. Ibid. bp102c15.pdf ( 230.4: Services Furnished


25. Ibid. by a Therapist in Private Practice).
26. Ibid, FBI Assistant Attorney General Breuer. 35. Federal law does permit this employment
27. http://www.cms.gov/manuals/Downloads/ arrangement. The Federal self-referral, Stark
bp102c15.pdf, Rehabilitative Therapy Law, and anti-kickback statutes as well as
(220.2 - Reasonable and Necessary Outpa- Medicare payment policies all permit physi-
tient Rehabilitation Therapy Services), C. cians to employ and to refer patients to physical
28. http://www.cms.gov/manuals/Downloads/ therapists within their group practice. Federal
bp102c15.pdf, 220 - Coverage of Out- laws clearly draw an important distinction
patient Rehabilitation Therapy Services between prohibited referrals and legitimate
(Physical Therapy, Occupational Therapy, employment relationships. Referrals, 1877
and Speech-Language Pathology Services) [42 U.S.C. 1395nn] (b)(2). Additionally, it is
Under Medical Insurance (Rev. 88, Issued: important to determine if such an arrangement
05-07-08, Effective: 01-01-08, Implementa- is permitted under individual state law.
tion: 06-09-08), A, emphasis added. 36. http://www.cms.gov/manuals/Downloads/
29. LCD for Outpatient Physical and Occu- bp102c15.pdf (230.4: Services Furnished
pational Therapy Services (http://www. by a Therapist in Private Practice). See
aota.org/DocumentVault/Surveys/LCD- provider enrollment at www.cms.hhs.gov/
Outpatient.aspx); Comments and Responses MedicareProviderSupEnroll, Pub. 100-08,
Regarding Draft Local Coverage Deter- Medicare Program Integrity Manual, chapter
mination: Outpatient Physical and Occu- 10, section 12.4.14; American Physical Ther-
pational Therapy Services, http://www. apy Association; Culver, L, Understanding
cms.gov/medicare-coverage-database/ APTA Positions on the Use of Personnel, Mag-
lcd_attachments/26884_33/Outpatient_ azine of Physical Therapy, 8(9): 2833 (2000).
Physical_Occupational_Therapy_Services_ 37. Healthcare Payment Systems, An Introduction,
Comm_Resp_art_pub_Jul_08.pdf. Duane C. Abbey, p. 83.
30. http://www.cms.gov/Regulations-and- 38. http://www.cms.gov/Regulations-and-
Guidance/Guidance/Manuals/downloads// Guidance/Guidance/Manuals/downloads//
bp102c15.pdf. bp102c15.pdf ( 230.4: Services Furnished
31. LCD for Outpatient Physical and Occu- by a Therapist in Private Practice).
pational Therapy Services (http://www. 39. http://www.cms.gov/NationalProvIdentStand/.
aota.org/DocumentVault/Surveys/LCD- 40. http://www.cms.gov/Regulations-and-
Outpatient.aspx); Comments and Responses Guidance/Guidance/Manuals/downloads//
Regarding Draft Local Coverage Deter- bp102c15.pdf ( 230.4: Services Furnished
mination: Outpatient Physical and Occu- by a Therapist in Private Practice).
pational Therapy Services, http://www. 41. An organization that has led articles of
cms.gov/medicare-coverage-database/ incorporation with the Secretary of State.
lcd_attachments/26884_33/Outpatient_ 42. An organization that has registered their
Physical_Occupational_Therapy_Services_ Statement of Partnership Authority with the
Comm_Resp_art_pub_Jul_08.pdf. Secretary of State.
32. http://www.cms.gov/Regulations-and- 43. http://www.cms.gov/Regulations-and-
Guidance/Guidance/Manuals/downloads// Guidance/Guidance/Manuals/downloads//
bp102c15.pdf ( 230.4: Services Furnished bp102c15.pdf (section 230.4: Services Fur-
by a Therapist in Private Practice). nished by a Therapist in Private Practice).
33. http://www.cms.gov/Regulations-and- 44. http://oig.hhs.gov/oei/reports/oei-09-02-
Guidance/Guidance/Manuals/downloads// 00200.pdf.
bp102c15.pdf ( 230.4: Services Furnished 45. http://oig.hhs.gov/oei/reports/oei-09-02-
by a Therapist in Private Practice). 00200.pdf.
34. http://www.cms.gov/Regulations-and- 46. http://oig.hhs.gov/oei/reports/oei-09-02-
Guidance/Guidance/Manuals/downloads// 00200.pdf.
76 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

47. http://oig.hhs.gov/oei/reports/oei-09-02- supervisory visit at least once every 30 days


00200.pdf. or more frequently if required by state or
48. http://www.cms.gov/manuals/Downloads/ local laws or regulation.
bp102c15.pdf, 230.4 - Services Furnished 58. 42 C.F.R. Ch. IV (10-1-03 Edition), 410.32(b)
by a Therapist in Private Practice (TPP), (Rev. (3)(i).
106, Issued: 04-24-09, Effective: 07-01-09, 59. Ibid.
Implementation: 07-06-09), A. 60. 42 C.F.R. Ch. IV (10-1-03 Edition), 410.32(b)
49. http://www.cms.gov/manuals/Downloads/ (3)(ii).
bp102c15.pdf, 230.4 - Services Furnished 61. 42 C.F.R. Ch. IV (10-1-03 Edition), 410.32(b)
by a Therapist in Private Practice (TPP), (Rev. (3)(iii).
106, Issued: 04-24-09, Effective: 07-01-09, 62. http://www.cms.gov/TherapyServices/
Implementation: 07-06-09), B. downloads/61004ptartc.pdf.
50. Ibid. 63. http://www.cms.gov/manuals/Downloads/
51. http://www.cms.gov/Regulations-and- bp102c15.pdf, 230.5 Physical Therapy
Guidance/Guidance/Manuals/downloads// Services Provided Incident to the Services of
bp102c15.pdf (section 230.4: Services Fur- Physicians and Non-Physician Practitioners
nished by a Therapist in Private Practice). (NPP), (Rev. 36, Issued: 06-24-05, Effective:
52. http://oig.hhs.gov/fraud/enforcement/ 06-06-05, Implementation: 06-06-05).
cmp/index.asp. 64. S.S. Act 1862; 42 U.S.C. 1395y.
53. http://oig.hhs.gov/fraud/enforcement/ 65. http://www.cms.gov/manuals/Downloads/
cmp/false_claims.asp. bp102c15.pdf, 230.5 Physical Therapy
54. Ronald V. Myers, Sr., M.D. (Myers), Missis- Services Provided Incident to the Services of
sippi, agreed to pay $25,500 for allegedly Physicians and Non-Physician Practitioners
violating the Civil Monetary Penalties Law. (NPP), (Rev. 36, Issued: 06-24-05, Effective:
The OIG alleged that Myers caused improper 06-06-05, Implementation: 06-06-05).
claims to be submitted to Medicare from 66. Ibid.
Select Care, Inc. and Primary Physical Medi- 67. HHS OIG semi-annual report on fraud and
cine, Inc., for physical therapy and related abuse, May 1, 2006, http://oig.hhs.gov/oei/
health care items or services that Myers did reports/oei-09-02-0200.pdf.
not personally render or did not directly 68. PT in Motion News Now, HHS to Investi-
supervise (2-22-12); http://oig.hhs.gov/fraud/ gate Incident To Billing in 2012 (Oct. 13,
enforcement/cmp/false_claims.asp. 2011), http://www.apta.org/PTinMotion/
55. Star Tribune, Whistleblower gets green light NewsNow/2011/10/13/OIGWorkPlan/.
to build false-claims case, by Dan Brown- 69. h t t p : / / w w w. a p t a . o r g / P T i n M o t i o n /
ing (2/24/12), http://www.startribune.com/ NewsNow/2011/10/13/OIGWorkPlan/.
local/140316793.html. 70. 42 C.F.R. 410.27(f).
56. Star Tribune, Whistleblower gets green light 71. This list is a reminder of what to include when
to build false-claims case, by Dan Brown- responding to a third partys request for ther-
ing (2/24/12), http://www.startribune.com/ apy records: http://www.palmettogba.com/
local/140316793.html. Palmetto/Providers.nsf/files/Responding_
57. http://www.cms.gov/Regulations-and- to_an_Request_for_Outpatient_Therapy_
Guidance/Guidance/Manuals/downloads// Records_Checklist.pdf/$FIle/Responding_
bp102c15.pdf (section 230.4: Services Fur- to_an_Request_for_Outpatient_Therapy_
nished by a Therapist in Private Practice); In Records_Checklist.pdf.
clinics, rehabilitation agencies, and public 72. http://www.cms.gov/manuals/Downloads/
health agencies, 42 C.F.R. 485.713 indi- bp102c15.pdf, 1861(s)(2)(A) of the Social
cates that when a PTA provides services, Security Act, 42 C.F.R. 410.10(b), 410.26,
either on or off the organizations premises, Pub. 100-02, ch. 15, 60.
those services are supervised by a quali- 73. Ibid.
ed physical therapist who makes an onsite 74. Ibid.
Complicated Billing Requirements Challenge Physical Therapy Industry 77

75. https://www.cms.gov/manuals/Downloads/ 92. CMS Manual System, Pub. 100-02 Medicare


bp102c15.pdf, 230.5. Benet Policy, http://www.hcca-physician-
76. Goseld, A, The Ins and Outs of Incident-To conference.org/past/2004/302/CMS%20
Reimbursement, Family Practice Manage- Manual%20System.pdf.
ment,(Nov.Dec.2001);http://www.aafp.org/ 93. h t t p s : / / w w w . c m s . g o v / m a n u a l s /
fpm/2001/1100/p23.html. Downloads/bp102c15.pdf, 230.5.
77. Ibid. 94. 42 C.F.R. 410.32(b)(3)(ii).
78. http://www.medicare.gov/navigation/ 95. 42 C.F.R. 410.32(b)(3)(ii).
medicare-basics/medicare-benefits/part-c. 96. 42 C.F.R. 410.32(b)(3)(ii).
aspx?AspxAutoDetectCookieSupport=1. 97. http://www.cms.gov/manuals/Downloads/
79. http://www.medicare.gov/navigation/ bp102c15.pdf.
medicare-basics/medicare-benefits/part-c. 98. CMS Manual System, Pub. 100-02 Medicare
aspx?AspxAutoDetectCookieSupport=1. Benet Policy, http://www.hcca-physician-
80. http://www.medicare.gov/navigation/ conference.org/past/2004/302/CMS%20
medicare-basics/medicare-benefits/part-c. Manual%20System.pdf.
aspx?AspxAutoDetectCookieSupport=1. 99. General supervision means the procedure
81. Medicare Carriers Manual Claims Process, is furnished under the physicians overall
http://www.cms.gov/Regulations-and- direction and control, but the physicians
G u i d a n c e / G u i d a n c e / Tr a n s m i t t a l s / presence is not required during the per-
downloads//R1764B3.pdf. formance of the procedure. Under general
82. Medicare Carriers Manual Claims Process, supervision, the training of the non-physi-
http://www.cms.gov/Regulations-and- cian personnel who actually perform the
G u i d a n c e / G u i d a n c e / Tr a n s m i t t a l s / diagnostic procedure and the maintenance
downloads//R1764B3.pdf. of the necessary equipment and supplies are
83. http://www.cms.gov/manuals/Downloads/ the continuing responsibility of the physi-
bp102c15.pdf, 60.1, 60.2 and 60.3. cian (42 C.F.R. 410.32(B)(3)(i)); and
84. Medicare Carriers Manual Claims Process, Personal supervision means a physician
http://www.cms.gov/Regulations-and- must be in attendance in the room during
G u i d a n c e / G u i d a n c e / Tr a n s m i t t a l s / the performance of the procedure (42 C.F.R.
downloads//R1764B3.pdf. 410.32(b)(3)(iii)).
85. http://www.cms.gov/manuals/Downloads/ 100. 42 C.F.R. 410.32(B)(3)(i).
bp102c15.pdf, 60.1, 60.2 and 60.3. 101. HHS OIG semi-annual report on fraud and
86. 42 C.F.R. 410.26. abuse, May 1, 2006, http://oig.hhs.gov/oei/
87. http://www.cms.gov/Regulations-and- reports/oei-09-02-00200.pdf.
Guidance/Guidance/Manuals/downloads// 102. Goseld, supra, n.76.
bp102c15.pdf. 103. http://www.cms.gov/Regulations-and-
88. http://www.cms.gov/Regulations-and- Guidance/Guidance/Manuals/downloads//
Guidance/Guidance/Manuals/downloads// bp102c15.pdf.
bp102c15.pdf. 104. Healthcare Payment Systems, An Introduc-
89. http://www.cms.gov/Regulations-and- tion, Duane C. Abbey, p. 5.
Guidance/Guidance/Manuals/downloads// 105. Medicare Benet Policy Manual CMS Pub.
bp102c15.pdf. 100-2, 60.1.
90. Medicare Carriers Manual Claims Process, 106. CMS Billing and Coding Guidelines, http://
http://www.cms.gov/Regulations-and- www.cms.gov/medicare-coverage-database/
G u i d a n c e / G u i d a n c e / Tr a n s m i t t a l s / lcd_attachments/32007_1/120811_00153_
downloads//R1764B3.pdf. L32007_OPHTH026_CBG_010112.pdf.
91. CMS Manual System, Pub. 100-02 Medicare 107. CMS Billing and Coding Guidelines, http://
Benet Policy, http://www.hcca-physician- www.cms.gov/medicare-coverage-database/
conference.org/past/2004/302/CMS%20 lcd_attachments/32007_1/120811_00153_
Manual%20System.pdf. L32007_OPHTH026_CBG_010112.pdf.
78 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

108. CMS Internet Only Manual (IOM) Pub- 119. Ibid.


lication 100-04, Chapter 12, Section 120. http://www.cms.gov/manuals/Downloads/
30.6.1.b, and 100-02 http://www.cms.gov/ bp102c15.pdf, 220.3, D.
Regulations-and-Guidance/Guidance/ 121. http://www.cms.gov/manuals/Downloads/
Manuals/downloads//clm104c12.pdf. bp102c15.pdf, 220 - Coverage of Outpa-
109. CHC Medicare Explained Health Law Pro- tient Rehabilitation Therapy Services (Physi-
fessional Series, Wolters Kluwer Law & cal Therapy, Occupational Therapy, and
Business, p. 143 (2010). Speech-Language Pathology Services) Under
110. CMS Internet Only Manual (IOM) Publication Medical Insurance (Rev. 88, Issued: 05-07-
100-04, Chapter 12, Section 30.6.1.b, and 08, Effective: 01-01-08, Implementation:
100-02http://www.cms.gov/Regulations-and- 06-09-08).
Guidance/Guidance/Manuals/ 122. Ibid.
downloads//clm104c12.pdf. 123. http://www.cms.gov/Regulations-and-
111. CMS Internet Only Manual (IOM) Publication Guidance/Guidance/Manuals/downloads//
100-04, Chapter 12, Section 30.6.1.b, and bp102c15.pdf.
100-02 http://www.cms.gov/Regulations- 124. Ibid.
and-Guidance/Guidance/Manuals/ 125. http://www.cms.gov/Regulations-and-
downloads//clm104c12.pdf. Guidance/Guidance/Manuals/downloads//
112. http://www.cms.gov/Regulations-and- bp102c15.pdf ( 230.4: Services Furnished
Guidance/Guidance/Manuals/downloads// by a Therapist in Private Practice).
clm104c12.pdf. 126. Culver, supra, n.36.
113. CMS Internet Only Manual (IOM) Publication 127. Goseld, supra, n.76.
100-04, Chapter 12, Section 30.6.1.b, and 128. http://www.hhs.gov/about/.
100-02 http://www.cms.gov/Regulations- 129. Youngberg, BJ, Principles of Risk Manage-
and-Guidance/Guidance/Manuals/ ment and Patient Safety, Jones & Bartlett
downloads//clm104c12.pdf. Learning, LLC: p. 11 (2011).
114. 42 C.F.R. 410.61. 130. http://www.fearonlevine.com/Resource.
115. Ibid. aspx?id=7ca3287d-efe3-48a8-9be5-
116. h t t p s : / / w w w. c m s . g o v / R e g u l a t i o n s - ee38a3ae3f64, http://oig.hhs.gov/reports-
and-Guidance/Guidance/Transmittals/ and-publications/archives/workplan/2012/
downloads//R88BP.pdf. Work-Plan-2012.pdf.
117. Ibid. 131. http://www.dhp.state.va.us/PhysicalTherapy/
118. Ibid. pt_faq.htm.
Americans with Disability Act:
Financial Aspects of Reasonable
Accommodations and
Undue Hardship
Sandra K. Collins and Eric P. Matthews

The Americans with Disability Act (ADA) is a signicant piece of discrimination legislation that merits
ongoing managerial exploration. This civil rights legislature indicates that employers are expected to
provide reasonable accommodations to employees with reported disabilities. The statute also indicates
that employers can refuse to offer a reasonable accommodation if doing so creates an undue hard-
ship on the organization. However, health care managers should exercise extreme caution when using
undue hardship as a defense against providing reasonable accommodations to employees with
disabilities. This point should be duly noted by health care managers given that studies indicate that
lawsuits alleging disability discrimination are on the rise. This is unfortunate given the costs of reasonable
accommodations are typically miniscule. Key words: American Disability Act (ADA), reasonable
accommodations, undue hardship, disability discrimination.

T
he Americans with Disability Act consideration. Health care managers may
(ADA) is a challenging piece of find it helpful to make offering disabled
legislation for managers in every
industry to fully understand. Ambiguous
Sandra K. Collins, MBA, PhD, is an associate
terms such as reasonable accommodation professor and program director of the Health Care
and undue hardship may make it diffi- Management Program at Southern Illinois Univer-
cult for health care managers to accurately sity Carbondale. She has approximately 18 years
and uniformly apply the principles of this of experience in the management of health care
paramount civil rights law. Although the related facilities and has authored numerous publi-
cations concerning human resource management and
legislation can be perplexing, health care
aspects in the health care field. She lectures at the
managers should carefully explore the stat- state, national, and international level on a variety
ute given that the number of cases alleging of management related topics and can be reached at
disability-related discrimination may be on skcollin@siu.edu.
the rise.1 Eric P. Matthews, PhD, is an assistant professor and
As the ADA laws are somewhat vague, program director of the Radiography Program in
conducting an in-depth exploration may still the College of Applied Sciences and Arts, Southern
Illinois University Carbondale (SIU). He has taught
leave health care managers perplexed as to
within the School of Allied Health at SIU for nine
the expectations of the statute. Reasonable years; he has over 19 years of experience in diagnos-
accommodation and undue hardship are two tic imaging, ranging from large trauma centers and
fundamental aspects within the ADA statute teaching hospitals to outpatient imaging facilities.
which health care managers should fully He has published a wide range of articles and given
understand. Increasing awareness of these numerous presentations on topics ranging from medi-
cal history to modern medical ethics and law.
topics is perhaps a positive step in assur-
ing their organizations and employees are J Health Care Finance 2012; 39(1):7986
given appropriate levels of protection and Copyright 2012 CCH Incorporated

79
80 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

workers an equal employment opportunity were necessary and have worked diligently
while simultaneously guarding their organi- to introduce more protective mechanisms for
zations from unsavory and costly legal con- those with disabilities.6 In 2008, the Act was
sequences their goal.2 further revised providing more emphasis on
the episodic illnesses that are expected to
A Historical Overview of ADA accompany the influx of soldiers returning
home from the current war.7 The ADA obvi-
Overseen by the Equal Employment ously continues to remain an evolving work
Opportunity Commission (EEOC), the in progress.
ADA specifically forbids employers from The ADA is often criticized because it
discriminating against people with disabili- lacks the type of specificity that provides
ties if they are otherwise qualified for the employers with solid guidance pertaining
position. ADA protection is afforded to all to legal compliance. Allegations of discrim-
aspects of employment including the appli- ination based on disability are reviewed by
cation process, employee selection and hir- the EEOC on a case-by-case basis so as to
ing, compensation, training, disciplining, allow qualified individuals with disabilities
promotion, and termination.3 Also known to compete for a variety of positions. Yet,
at Title VII and/or the Civil Rights Act of the vagueness of the ADA makes it difficult
1964, originally legislation on the issue of for health care managers to know exactly
discrimination sought to ensure that every- how to comply with ADA regulations.8
one, (without discrimination based on race,
color, religion, gender, or national origin),
would be given the right to pursue the work Legal Issues Surrounding Disabilities
of their choice. Segregating and classifying
employees or applicants which prevented Health care managers will find it nec-
them from equal employment opportunities essary to appropriately consider the vast
were specifically addressed and forbidden array of complexities that are associated
in Title VII legislation.4 with ADA legislature. This may include an
Those with disabilities were mentioned in intense review of departmental policies and
a peripheral fashion within the Title VII leg- procedures which are linked to all applica-
islation, but the Rehabilitation Act of 1973 ble employment transactions. These range
brought forth more specifications in greater from employee recruitment and job descrip-
detail. The Rehabilitation Act became a cat- tions to the disciplining and termination of
alyst to address perceptions associated with employees. The entire employment process
employing disabled workers. It also paved should be closely evaluated to assure the
the way for stricter guidelines and conse- absence of discriminatory practices.9
quences to be imposed against employ- Adhering to the guidelines provided by
ers who discriminated against those with the ADA in terms of employing individu-
disabilities.5 als with disabilities is a vital management
Since then, the ADA has undergone mul- competency for any health care manager
tiple revisions. In 1990, legislators again since the health care field accounted for
deemed that further amendments to Title VII more than 13 million jobs in 2004 and is
ADA: Financial Aspects of Reasonable Accommodations and Undue Hardship 81

expected to provide over 19 percent of all of the job. Examples might include
new jobs between 2004 and 2014.10 There- changing the counter height for indi-
fore, an exploration of the most paramount viduals using wheelchairs or designing
and significant expectations regarding the computer keyboards that allow for var-
employment of individuals with disabilities iations of hand/arm position or move-
is a necessary action health care managers ment; and
should initiate. Among the most relevant 3. Provide equal access to workers with
issues for managers to fully grasp in terms disabilities in terms of benefits and
of the ADA are the legal responsibilities sur- privileges of employment.13 For exam-
rounding reasonable accommodations and ple, the salary for a position should be
undue hardship.11 based on areas such as the individuals
skill and abilities, experience, educa-
Reasonable Accommodation tion, and knowledge. It should not
be based on disability. Therefore, an
When a disabled employee is not capa- employee with a disability should not
ble of performing the functions of his or her be offered a lower salary than that of
job, the ADA requires that employers find another non-disabled employee if their
a reasonable accommodation for the disa- positions are comparable.
bled worker if he or she is otherwise quali-
fied for the position. The term reasonable The ADA would expect for employers to
accommodation means altering the job create a reasonable accommodation for an
environment or the application method so individual with a disability who is otherwise
that a qualified individual is still capable of qualified for the job.14 Being qualified to per-
doing the job and therefore is provided an form a job means that the individual must
equal employment opportunity. Reason- satisfy the vital skills, experience, education,
able accommodation guidelines given in the and other job related qualifications of the
ADA statute include: position with or without a reasonable accom-
modation. If there is a portion of the job that
1. Modification of application methods the individual cannot perform due to his or
so as to make sure disabled workers her disability, it is paramount that the health
have an equal opportunity to engage care manager be able to effectively demon-
in the competitive job market. Exam- strate why that portion of the position can-
ples of this might include providing not be modified and is truly job related and/
interpreters to assist in the interview or consistent with business necessity. The
process for those with hearing impair- EEOC seemingly scrutinizes these claims
ments to make sure any questions or heavily. In essence, it is not prudent for
statements within the application pro- health care managers to overlook employ-
cess are absent discriminatory intent or ing a disabled employee because he or she
perception;12 cannot enter the data into the computer fast
2. Modification of the physical require- enough if that skill is not a requisite neces-
ments of the position so disabled sity of the position. Health care managers
individuals can perform the functions need to be able to legally defend any and all
82 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

job requirements which are associated with of the job as a whole or a restructuring of the
each position.15 job assignments and duties, to the modifica-
However, there are no protections in the tion of work schedules or equipment. The
ADA afforded to those with disabilities that accommodations need not be cost prohibitive
are not otherwise qualified for the position. or difficult.19
In other words, just because an individual
applies for the position and he or she happens Undue Hardship
to have a disability, a health care manager Under the ADA, an employer can be par-
does not have to hire that individual if he or doned from the expectations associated with
she is not otherwise qualified for the position reasonable accommodation if the employer
in question. Too many times, those in charge can demonstrate that it creates an undue
of the hiring process make irrational employ- hardship on the organization.20 Undue hard-
ment related decisions because they are fear- ship, another elusive term in the ADA legis-
ful of discrimination allegations. If the health lation, has been successful as a defense for
care manager can clearly document that the employers when the reasonable accommo-
individual is not qualified for the job, then dation creates a significant organizational
he or she can more easily demonstrate that the expense. Criteria for this defense indicates
disabled individual was not selected for the that the reasonable accommodation must be
position due to factors other than the disabil- either exceedingly difficult to implement,
ity. The ADA only offers protection for dis- cause extensive organizational disruption,
crimination if the hiring manager refuses to or create a significant change to the mission
hire someone because of his or her disability. and/or operations of the organization.21
There was no intention in the statute to indi- Using the undue hardship defense should
cate that employers are required to hire any not be entered into lightly by astute health
unqualified person regardless of disability.16 care managers. The following data demon-
Although the aforementioned guidelines strate the estimated costs of providing rea-
are helpful, deciding exactly what an employ- sonable accommodation from the employers
ers responsibility is in terms of reasonable perspectives:
accommodation is still challenging. The foun-
dational premise is that if the cost of the rea- 46 percent of reasonable accommoda-
sonable accommodation does not outweigh tions resulted in no cost to the employer;
the benefit of having the disabled employee, 45 percent of reasonable accommoda-
then the ADA would provide protection if the tions resulted in a one-time median cost
reasonable accommodation is refused by the of $500;22
employer.17 The ADA mandates employers 14 percent of employers indicate the
look for avenues by which to meet organi- cost of providing reasonable accommo-
zational requirements and consideration for dation was more costly than they origi-
the disabled worker.18 Since there is latitude nally anticipated;23
in what a reasonable accommodation might 50 percent of employers indicate
be, it really is only limited by the imagination the cost of providing a reasonable
and creativity of the health care manager. It accommodation was exactly what or
could range anywhere from the modification even less than originally anticipated.24
ADA: Financial Aspects of Reasonable Accommodations and Undue Hardship 83

With these percentages in mind, it is pos- involved with the litigation of a disability-
sible to understand why claims of undue related discrimination case could easily
hardship may be heavily scrutinized by the result in a six-figure expense. Remedies for
EEOC. Therefore, it is seemingly obvious violations under the ADA can range from
that the largest percentage of reasonable reinstatement and retroactive promotion of
accommodations should be relatively feasi- the employee, back pay, and attorney fees.
ble in terms of cost. Undue hardship might Punitive damages have even been awarded
be a difficult case to prove given the afore- in some extreme cases.31 This is perhaps why
mentioned statistics.25 This should motivate failing to properly identify an employee cov-
health care managers to accurately consider ered by the ADA is listed as the number one
reasonable accommodations for disabled costly return-to-work mistake made by some
workers and help them realize that reason- employers in the United States.32
able accommodations may not be all that
cost prohibitive. The most common forms of Identifying Disabilities
reasonable accommodation include:
There are numerous disabilities that may
Modifications to the physical work be protected under ADA legislation. Charges
environment;26 of disability discrimination have been filed
Changes to the employees work sched- the most for disabilities associated with the
ule;27 or following:
Purchasing a product or piece of equip-
ment (often a one-time purchase).28 Bad backs;
Neurological impairments;
When considering the cost factors associ- Emotional and/or psychological impair-
ated with providing reasonable accommo- ments; and
dation, it may also be wise for health care Physical impairments affecting the heart,
managers to consider the benefits of offer- vision, and/or hearing.
ing reasonable accommodations to disabled
employers. The typical benefits include: Although those are the most common,
even conditions such as high blood pressure,
The capacity to retain valuable em- allergies, morbid obesity, cosmetic disfigure-
ployees; ments, anatomical loss, and significant color
Increased levels of employee productivity; blindness have been considered disabilities
Improved collegial interaction and over- and afforded protection under the ADA. Fur-
all company morale; and thermore, protection for those with paraple-
Increased levels of overall organiza- gia, epilepsy, and HIV or AIDS, can also be
tional productivity.29 considered as a disability along with numer-
ous other conditions.33
The monetary value of these benefits, The ADA provides the following guide-
although potentially intangible and difficult lines to assist in identifying disabilities:
to calculate, could well exceed any costs of
implementing reasonable accommodations 1. A physical or mental impairment which
for disabled workers.30 Furthermore, the fees restricts one or more of lifes major
84 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

activities in a significant way. Major receive protection under the ADA for her
life activities may consist of taking care disability-related issues.37
of ones self, completing physical tasks, Another example the EEOC provides
walking, running, seeing, hearing, regarding disability involves an employee
speaking, breathing, learning, think- who fractures his back. He provides his
ing, sitting, standing, reaching, lifting, employer with a physicians release which
concentrating, sleeping, or interacting instructs the employer that the individual is
with others.34 to refrain from any form of lifting for approx-
2. A historical file or record which can imately six weeks. However, the physician
confirm and verifies the individuals indicates the individual is expected to make
specific impairment. This includes a full recovery and be able to resume his nor-
conditions such as cancer, heart dis- mal job duties without any restrictions at the
ease, or mental disorders.35 end of this timeframe. Due to the short-term
3. The individual is perceived to have nature of this employees condition, which
an impairment. The ADA has certain is not substantially limiting, he would most
conditions that it has determined may likely not be able to receive protection under
be considered disabilities although the the ADA for his condition.38
individual may not have challenges The ADA also provides a list of those con-
with the performance of his or her ditions that are not considered to be disabili-
daily life activities. These are typically ties. Conditions distinctively excluded from
impairments that the public perceives ADA shelter include the following:
to be disabilities, such as something
like a disfigurement due to severe Homosexuality and bisexuality. The
burns caused by a fire. The mere per- ADA excludes these issues as disabili-
ception of disability may subject the ties, but there may be some state and
individual to disability discrimination local legislation that affords protection
even though the individual can func- against discrimination due to sexual
tion like those absent a disability.36 orientation;39
Gender-identity disorders that are not
Two examples, as provided by the EEOC, created by a physical impairment or dis-
offer guidance that may prove helpful in order related to sexual behavior such as
terms of distinguishing between a condition transvestitism or trans-sexualism;40
the ADA would consider a disability and Voyeurism;41
one that would not be considered a disabil- Compulsive gambling, pyromania, klep-
ity. The first example involves an employee tomania;42
with multiple sclerosis. The disease causes Certain disorders resulting from current
her to experience chronic and episodic illegal drug usage such as psychoactive
weakness. As her disease intensifies, she substance abuse;43 and
finds it difficult to stand or walk for days Drug addicts who are not longer
or weeks, often forcing her to be dependent dependent and demonstrate no further
on a wheelchair. Considered substantially drug issues are not considered disabled
limited, this individual would most likely under the ADA.44
ADA: Financial Aspects of Reasonable Accommodations and Undue Hardship 85

Conclusion is to provide equal employment opportuni-


ties to those with disabilities while protect-
The ADA is a complex and legally ing their organizations from allegations of
charged piece of legislation that continues disability discrimination.45 Understanding
to evolve with the needs of the workforce. foundational expectations of the ADA, such
Elusive and vaguely defined, the guide- as reasonable accommodation and undue
lines provided by the ADA allow health hardship, may be a positive beginning. Cost
care managers to begin a close evalua- factors often may be of little to no organiza-
tion of the expectations associated with tional expense; however, the consequences
employing individuals with disabilities. of neglecting or misunderstanding ADA
The goal for astute health care managers legislation may be astronomical.46

REFERENCES

1. Fallon, LF, Jr., McConnell, CR, Human at http://www.eeoc.gov/facts/health_care_


Resource Management in Health Care: Princi- workers.html.
ples and Practice, Jones and Bartlett: Sudbury, 11. Collins, supra, n.1.
MA (2007); Collins, SK, The Americans with 12. Id.; Reasonable Accommodation Procedures,
Disability Act (ADA): How Reasonable Is accessed on Jan. 6, 2010 at http://www.
Reasonable Accommodation? in The Health da.usda.goc/oo/target/subjects/at/addlcap/
Care Managers Legal Guide, 5170, McCo- foreword.htm.; Gary Dressler, Human Resource
nnell, CR, Ed. (2010). Management, 9th Ed., Upper Saddle River, NJ:
2. Collins, supra, n.1. Prentice Hall (2003).
3. Id.; Jones, NL, The Americans with Disabili- 13. Collins, supra, n.1; Reasonable Accommoda-
ties Act (ADA): Overview, Regulations, and tion Procedures, supra, n.12.
Interpretations, New York: Novinka Books 14. Collins, supra, n.1; United States and National
(2003). Rehabilitation Hospital, Answers to Ques-
4. Supra, n.1. tions Commonly Asked by Hospitals and
5. Id. Health Care Providers: ADA, the Americans
6. Collins, supra, n.1, Good News: ADA with Disabilities Act (ADA) (1994).
Amendments Cant Be Invoked Retroactively, 15. US and National Rehabilitation Hospital,
Minnesota Employment Law, 2009, accessed supra, n.14.
Oct. 15, 2009 at http://www.thehrspecialist. 16. Collins, supra, n.1; Id.
com/artivle.aspx?articleid=28699. 17. Dressler, supra, n.12.
7. Id. 18. Collins, supra, n.1; US and National Rehabili-
8. Collins, supra, n.1; Jones, supra, n.3. tation Hospital, supra, n.14.
9. Collins, supra, n.1; McConnell, CR, Umikers 19. Collins, supra, n.1; McConnell, supra, n.9;
Management Skills for the New Health Care Dressler, supra, n.12.
Supervisor, 4th Ed., Boston: Jones and Bartlett 20. Collins, supra, n.1; McConnell, supra, n.9;
(2006). Fisher, R, Evaluating Social Policy (1995).
10. Questions and Answers About Healthcare 21. Collins, supra, n.1; McConnell, supra, n.9;
Workers and the Americans with Disabili- Fisher, supra, n.20; United Nations Gen-
ties Act (Q&A) (Dec. 14, 2009), accessed eral Assembly (UN), Concept of Reasonable
86 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Accomodation, accessed on Jan. 6, 2010 at 30. Hernandez et al., supra, n.22; Blanck, PD,
http://www.unorg/esa/socdev/enable/rights/ Communicating the Americans with Dis-
ahc7bkgrndra.htm. abilities Act, Transcending Compliance: 1996
22. Ofce of Disability Employment Policy Follow-Up report on Sears, Roebuck and
(ODEP), Making Workplace Accommoda- Co., Iowa City, Iowa (1996).
tions: Reasonable Cost, Big Benets (2009); 31. Kuhn, D, Stout, D, Reducing Your Workforce:
Hernandez, B, McDonald, K, Lepera, N, Sho- What You Dont Know Can Hurt You, Strate-
hana, TM, Wang, A, Levy, J, Moving Beyond gic Finance, 85(11), 4045 (2004).
Misperceptions: The Provision of Workplace 32. Ring, K, 10 Costly Return-to-Work Mistakes,
Accommodations, J. of Social Work in Disabil- Buildings, 104 (4), 4244 (2010).
ity & Rehabilitation, 8(3/4): 189204 (2009). 33. Collins, supra, n.1; The SHRM Learning Sys-
23. UN, supra, n.21; Hernandez et al., supra, tem: Workforce Planning and Employment:
n.22. Module 2 (2005).
24. Hernandez et al., supra, n.22; Dixon, K, 34. Fried, B, Fottler, M, Human Resources in
Kruse, D, VanHorn, C, Restricted Access: A Healthcare: Managing for Success, (3rd Ed.)
Survey of Employers About People with Dis- (2008).
abilities and Lowering Barriers to Work, John 35. Id.
J. Heldrich Center for Workforce Develop- 36. Reasonable Accommodation Procedures,
ment, New Brunswick, New Jersey (2003). supra, n.12; The SHRM Learning System, supra,
25. Collins, supra, n.1; Goldstein, T, Simonds, n.33.
C, Sanders, C, Succeeding Together: Peo- 37. Q&A, supra, n.10.
ple with Disabilities in the Workplace, 38. Id.
accessed on Jan. 6, 2010 at http:www.csun. 39. Collins, supra, n.1; Fried and Fottler, supra,
edu/~sp20558/dis/reasonable.html. n.34.
26. Supra, n.24. 40. Fried and Fottler, supra, n.34.
27. Id. 41. Collins, supra, n.1; Dressler, supra, n.12.
28. Hernandez et al., supra, n.22; Hendricks, DJ, 42. Supra, n.39.
Batiste, L, Hirsh, A, Cost and Effectiveness of 43. Id.
Accommodations in the Workplace: Prelimi- 44. Id.
nary Results of a Nationwide Study, Disabil- 45. Collins, supra, n.1.
ity Studies Quarterly, 25(4) (2005). 46. ODEP, supra, n.22; Kuhn and Stout, supra,
29. Supra, n.22. n.31; Ring, supra, n. 32.
A Real Options Approach to
Clinical Faculty Salary Structure
Marc J. Kahn and Hugh W. Long

One can use the option theory model originally developed to price nancial opportunities in security
markets to analyze many other economic arrangements such as the salary structures of clinical faculty
in an academic medical center practice plan. If one views the underlying asset to be the portion (labeled
salary) of the economic value of the collections made for the care provided patients by the physician,
then a salary guarantee can be considered a put option provided the physician, the guarantee having
value to the physician only when the actual salary earned is less than the salary guarantee. Similarly,
within an incentive plan, a salary cap can be thought of as a call option provided to the practice plan
since a salary cap only has value to the practice plan when a physicians earnings exceed the cap.
Further, based on analysis of prior earnings, the Black-Scholes options pricing model can be used both
to price each option and to determine a nancially neutral balance between a salary guarantee and a
salary cap by equating the prices of the implied put and call options. We suggest that such analysis is
superior to empirical methods for setting clinical faculty salary structure in the academic practice plan
setting. Key words: physician salary, real option theory, Black-Scholes.

F
inancial derivatives, as suggested by transactions in the context of derivative-
their name, are derived from under- equivalents brings an important perspective
lying assets, either real (physical) or to risk management.
financial, and in complex contemporary mar- The value of a derivative depends on the
kets can be combined and compounded in a value of the underlying asset. Fire insur-
dizzying array of interactive layers. Deriva- ance is a very basic example of a derivative.
tives such as collateralized mortgage obliga- The value of a fire insurance policy depends
tions and credit default swaps are currently on the value of the remaining asset (house)
viewed with disdain because of their associa- after a house fire. If the fire damage is exten-
tion with the recent economic crisis where sive, the insurance policy has a high value.
they magnified various financial risks imbed- If the fire damage is trivial, the policy may
ded in the reckless design or creation of the be virtually worthless. Using the fire insur-
underlying assets (e.g., no-down-payment ance example, derivatives can be thought
mortgages to persons having little income), of as insurance or hedges against adverse
and their subsequent concentration in indi- economic conditions. Two basic financial
vidual financial institutions (e.g., AIG). derivatives routinely traded in organized
Ironically, the original intent of derivatives
was to provide many market participants Marc J. Kahn, MD, MBA, is the Sr. Associate Dean
with opportunities to reduce risk. When at Tulane University School of Medicine and a Pro-
derivatives are viewed in the light of their fessor in the Department of Medicine. He can be
risk-reduction potential, they are an impor- reached at mkahn@tulane.edu.
tant vehicle for understanding the manage- Hugh W. Long, PhD, JD, is a Professor at Tulane
ment of risk in organizations in general, and University School of Public Health and Tropical Med-
icine in the Department of Global Health Systems and
in certain aspects of the health care and med-
Development.
ical care sector in particular.
Derivatives are an important part of every- J Health Care Finance 2012; 39(1):8796
day financial transactions and viewing such Copyright 2012 CCH Incorporated

87
88 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

markets are put and call options. The theory was developed. Real option analy-
owner (holder) of a put option has the right sis was originally applied to capital budg-
(but not the obligation) during a particular eting (the acquisition or liquidation of
period of time to sell (put) the underlying real (physical) assets), but now extends
asset at a predetermined price to the writer to the analysis of any financial opportunity
of the option (or the writers successor); the that can be described consistent with the
owner (holder) of a call option has the right assumptions of the options model. Hence,
(but not the obligation) during a particular not only real asset management, but also
period of time to buy (call) the underlying management of liquid assets, working capi-
asset at a predetermined price from the writer tal, contracts, and financing are all poten-
of the option (or the writers successor). tial candidates for this type of analysis and
Because of these rights of sale or pur- valuation. Such opportunities have been
chase, options have an intrinsic value (price) valued traditionally by taking into account
related to the actual market value (price) of the profitability of the arrangement, con-
the underlying asset. Although several meth- verting accrual accounting numbers into
ods have been used to value (price) options, cash flows, and adjusting for the differen-
the Fischer Black and Myron Scholes pric- tial timing of cash flows by calculating their
ing model published in 19731 building on present values using the cost of capital and
work by Robert Merton, is the most widely required rates of return. Real options are an
accepted. (That work was recognized in alternative to using net present value analy-
1997 by the award of the Nobel Prize in Eco- sis, particularly in situations where the vari-
nomics to the two surviving members of the ability in the cash flows of the underlying
trio, Robert Merton and Myron Scholes). asset is difficult, largely beyond the con-
Any asset can be the underlying asset for trol of management. Although both meth-
an option, and the attractiveness of options ods can be used in the health care setting,
lies in the fact that the market value (price) real options have seldom been described
of the underlying asset varies through time, in decisions made in departments of aca-
including in particular the period of time dur- demic medicine.2 In this article, we use real
ing which an option on that asset is in effect. option theory to describe academic faculty
That underlying assets price (value) vari- salary models with particular attention to
ability can reflect myriad factors, but when salary guarantees and caps, and use the
all is said and done, the owner of that asset Black-Scholes model to predict the price of
and potential buyers of that asset are bearing guaranteed salaries and salary caps.
the risk that whenever the time comes to buy
or sell that asset, the value may be higher or
lower (which could be either a good thing or Methods
a bad thing depending upon which side of a
Model Description
potential transaction one is on).
The term real applied to options analy- Figure 1 shows the typical payoff for the
sis refers to the use of option pricing theory holder of a put option on a share of common
to value financial opportunities other than stock. As shown in the figure, a put option
the traded stocks and bonds for which the has no value for the holder as long as the
A Real Options Approach to Clinical Faculty Salary Structure 89

Figure 1. Payoff for a Put Option


Note that the payoff is $0 for share price (ST) greater than the
strike price (K). Payoff is only positive when ST is less than K.

Payoff

ST

Strike Price
(K)

share price (ST) is above the exercise price option only has value when the share price
(K) of the put. For example, if the exercise is higher than the strike price. For example,
price is $100 and the share price is $120, a call option representing the right to buy
then the put has no value since the holder of the share for $100 only has value when the
the put would not sell the share to the writer share price is greater than $100. At that point,
of the put for $100 when it could be sold the holder of the call option can purchase the
in the open market for $120. On the other asset at a price less than market value.
hand, if the share price is $80 with the same Clinical faculty physician salaries at
exercise price of $100, then the put is worth academic medical centers, like most sala-
$20 as the put allows the holder of the option ries of professionals, are strongly influ-
to sell the share for $100 despite the actual enced by the supply of and demand for the
share price being only $80. particular talents needed for the position.
Figure 2 shows the same analysis for a They are also rationally related to the eco-
call option. Contrary to a put option, a call nomic value of the medical care delivered
90 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 2. Payoff for a Call Option


Note that the payoff is $0 for share price (ST) less than the strike price (K).
Payoff is only positive when ST is greater than K.

Payoff

ST

Strike Price
(K)

by the physician, particularly that portion the center or the physician. These would
of the value the employing academic medi- include, to mention just a few:
cal center can realize. In particular, that
portion is what the faculty practice plan The demographic and epidemiological
can collect, largely from claims filed with characteristics of the area from which
third parties and to a degree from billings patients are drawn;
to patients, for the care delivered. Viewed The mix of actual CPT codes delivered;
as an asset, this value of what will be col- The mix of those patients payers (e.g., fee-
lected for the care delivered can be highly for-service, capitated; Medicare, Medic-
variable, depending on many factors, very aid, Tricare, workers compensation, etc.;
few of which are controllable by either Aetna, the Blues, United Health, etc.);
A Real Options Approach to Clinical Faculty Salary Structure 91

Which services are covered and which payoff represented by the difference between
are not; the guarantee (put) and the actual calculated
Changes in payment rates through time salary (share price). Because a salary guaran-
(e.g., varying deductibles and copay- tee provides a potential benefit to the physi-
ments; and cian, it can be priced. Importantly, the price of
Expectations regarding the delivery of a salary guarantee put option is not merely the
uncompensated care. difference between the salary guarantee and
previous earnings. Rather, because earnings
Hence, if the cost of practice and profes- vary over time, the price of the put option is
sional liability were estimated to be, for partially dependent on the volatility of both
example, 55 percent of collections, the sal- productivity and collections, which can be
ary of a clinical faculty physician might be estimated from past experience and used to
set at an amount equal to approximately 45 generate the statistical likelihood that the phy-
percent of expected collections for the care sicians calculated salary will be less than the
expected to be delivered by the physician. salary guarantee, and that value (to the phy-
Fixing the salary at an expected amount, sician) can be calculated using mathematical
of course, creates risks for both the physi- principles that are part of option theory.
cian and the faculty practice plan because of In our model, a salary cap can be thought
the variability in the expected amount that of as a call option. In financial terms, the
may be available to collect and the amount physician has written (is short) the call
that may actually be collected. and the practice plan is long. The call
Reflecting the fact of these risks, it is com- option provides a benefit to the employer
mon for clinical faculty physician salaries to as it places a maximum value on the poten-
include both salary guarantees and salary caps. tial compensation provided the physician.
Suppose then that the underlying asset, The employer can call the underlying
using our example, is the medical care pro- asset (the economic value of the collections
ductivity of the physician, the value of which from the physicians care activity) at the cap
is defined as 45 percent of collections. A guar- amount even if (and only if) the calculated
anteed minimum annual salary can be thought salary exceeds that amount. As with a salary
of as a put option on that underlying asset. guarantee, the price (representing here the
More specifically, in finance terms, a physi- value of the cap to the employer) of the sal-
cian with a salary guarantee is long on the ary cap can be calculated using mathemati-
put and the faculty practice plan has written cal principles that are part of option theory.
(is short) the same option, meaning that the According to the Black-Scholes option pric-
physician can, at the end of the year, sell to the ing model, put and call options can be priced
practice plan the physicians productivity for in a manner that depends on five variables:
the year at the set minimum price, regardless
of its defined value. As such, if the calculated The share price (calculated salary);
value of the physicians earnings exceed the The exercise price of the option (salary
guarantee, the put has no payoff. Contrarily, guarantee or cap in our model);
if the calculated value of the physicians ser- The continually compounded risk-free
vices is less than the guarantee, the put has a interest rate;
92 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 3. Equations Used in the Salary Real Options Pricing Model

Volatility Formula

1 n
(x )
2
volatility = x
n 1 i =1 i

x = natural log of cash flow returns (ln (earnings month 2/earnings month 1))
x = mean natural log of cash flow returns
n = number of intervals (11 for a 12 month period)

Black-Scholes Model
c = S0N(d1)KerTN(d2)

p= KerT N (d2 ) S0 N (d1 )

d1 =
(
ln(S0 K )+ r + 2 T
2
)
T
d2 = d1 T

N(x) = cumulative probability distribution function for a standardized normal distribution to be less than x
p = put option price
c = call option price
K = strike price (salary guarantee)
So = Stock Price (earned salary prior year)
r = continuously compounded risk-free interest rate (3% in our model)
= volatility of prior earnings
T = time to maturity (one year for salary guarantee)

The time to maturity of the option (one D. Also included in Figure 4 are the annual
year in our model); and totals of earned salary, the volatility thereof
The volatility of the stock (volatility of calculated per the formula in the Figure 3,
prior calculated salary in our model). and the price of a $150,000 salary guaran-
tee (put option) calculated from the Black-
The Black-Scholes model is most com- Scholes model. Our model predicts the price
monly used by financial experts to price of the salary guarantee to be highest for phy-
options traded on the Chicago Board sician A. This is intuitive since physician A
Options Exchange. Both the Black-Scholes has a salary guarantee that is much higher
model and a simple method for calculating than the physician Cs total calculated sal-
volatility of physician-calculated salaries ary the previous year. Physicians B and C,
are provided in Figure 3. both have earnings during the prior year
that exceed the guaranteed salary. However,
Results even though physician C had higher earn-
ings the prior year, the price of his guaran-
Figure 4 shows monthly earned salaries teed salary is higher than that calculated for
for four theoretical physicians, A, B, C, and physician B. This is because the monthly
A Real Options Approach to Clinical Faculty Salary Structure 93

Figure 4. Monthly Earnings for Four Physicians (A, B, C, and D)


Guaranteed salary is $150,000 for each example. Monthly earnings
are derived as random numbers between $10,000 and $16,000.

Physician As Physician Bs Physician Cs Physician Ds


Time Period
Earned Salary Earned Salary Earned Salary Earned Salary
July $13,968 $15,058 $11,364 $12,032

August $10,423 $11,058 $15,719 $12,300

September $13,400 $10,308 $10,632 $12,400


October $10,895 $12,040 $12,728 $12,004

November $11,007 $12,884 $11,999 $12,543

December $12,017 $14,035 $14,499 $12,578

January $10,826 $15,044 $13,002 $12,222

February $14,246 $10,265 $15,337 $12,378

March $10,715 $10,191 $10,203 $12,007

April $12,265 $14,317 $15,470 $12,068

May $11,426 $15,656 $14,672 $12,309

June $10,151 $15,064 $13,870 $12,223

Total $141,339 $155,920 $159,495 $147,064

Volatility 18.95% 19.36% 25.42% 2.32%

Put price $5,190.19 $745.88 $887.34 $13.25

Salary cap having


$159,387.97 $178,725.64 $189,143.80 $153,426.53
value equal to put

earnings for the prior year for physician C makes stocks and bonds less desirable. In
are more volatile. Somewhat paradoxically, contrast, physician D has the lowest salary
options have a higher price as the volatility volatility among the examples. As such,
of the underlying asset (earnings) increases physician Ds salary guarantee is not only
because volatility adds to the likelihood that the lowest of the four, but, in particular, is
the option will be in the money. less than that of physician A in spite of the
This positive relationship between vola- fact that physician D had higher actual earn-
tility and price is unique for options. Stocks ings than physician A.
and bonds tend to have a lower price with Since the value of the put option (salary
increased volatility, since price uncertainty guarantee) accrues to the physician and the
94 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

Figure 5. Collection Volatilities Calculated for Tulane University


Medical Group by Department

Department Calculated Volatility


Family Medicine 11.9%
Internal Medicine 23.6%
Neurology 33.1%
Obstetrics/Gynecology 16.4%
Pediatrics 24.4%
Psychiatry 57.7%
Surgery 23.8%

value of the call option (salary cap) accrues guarantees to physicians, the risk is shifted
to the practice plan, an equitable arrange- from the clinician to the plan. When the plan
ment would equate the values of the two is large, having clinicians from many differ-
options. Using simple algebra and the Black- ent departments, the risk becomes diversi-
Scholes model for the price of a call option, fied when shifted to the plan. As such, the
the salary cap that would have a call option risk is less subject to fluctuations in indi-
price identical to that of the put option (sal- vidual earnings. This diversification of risk
ary guarantee) is also shown in Figure 4. is similar to an individual investor having a
Although the previous discussion involves portfolio of diverse investments in order to
theoretical earnings, we have used actual protect against market fluctuations that may
account collection data from the Tulane Uni- have great impact on any single investment.
versity Medical Group to calculate collection Although clinical faculty salary guar-
volatilities for individual departments (Fig- antees have a value and can be priced as
ure 5). As shown in the Figure 5, the actual shown by our analysis, physicians are sel-
volatilities vary by specialty. Specialties with dom charged for this benefit. This results
business with more seasonality have higher in financial tension. Obviously, the cost of
volatility. Primary care specialties like family a salary guarantee must be balanced with
medicine have lower volatility due to the rela- another source of revenue to prevent deficit
tively constant nature of their income streams. financing. We suggest three possible scenar-
ios that could be used to resolve this tension.
Conclusions Likely, in many instances, a faculty prac-
tice incentive plan may in effect balance the
Why salary guarantees exist as a part of put option provided the physician as a salary
a compensation plan is a fundamental ques- guarantee with a call option that the physi-
tion. On the surface, a salary guarantee can cian provides back to the faculty plan in the
be used as an enticement to get a physician form of a salary cap. As shown in our prior
to join a practice. From a financial per- analysis, a salary cap provides a direct ben-
spective, when a practice plan offers salary efit to the practice plan since any earnings
A Real Options Approach to Clinical Faculty Salary Structure 95

over the cap are kept by the plan. In options a physicians salary guarantee is easily met
terms, the call option of a salary cap is in and therefore the put option has little value.
the money for the practice plan when the Finally, the tension created by salary guar-
physician earns more than the cap. Although antees may be relieved if the price of the
not typically calculated as such, within a fac- option is paid from sources other than clini-
ulty practice plan, it is likely that a combina- cal income. Such would be the case if reve-
tion of puts and calls in the form of salary nues from tuition, endowment, philanthropy,
guarantees and salary caps balances out to or research were used to support the clini-
avoid fiscal deficits. cal enterprise. In fact, it is not uncommon to
As shown in Figure 4, to remain financially use hospital revenues from graduate medical
neutral, physician A would have the lowest education to support physician salaries.3
salary cap since physician A has the lowest A recent report has suggested that among
earnings during the prior year and the most medical school tenured faculty in clinical
expensive put option. In contrast, physician departments, 44 percent have a salary guar-
C would have the highest salary cap based antee linked to tenure.4 In this report, the
on earnings from the previous year and high majority of the salary guarantee represented
volatility of prior earnings. In short, the cost a guaranteed base salary. Further, the num-
of the salary guarantee to the practice plan ber of medical schools offering a guaran-
can be balanced by the benefit of a salary cap teed salary has been decreasing over time.5
and option theory can be used to calculate In addition to issues related to the rules for
the exact salary cap that would provide the clinical faculty in obtaining tenure, we sug-
same risk (same option price) as the salary gest that some of the erosion of salary guar-
guarantee. As an investment tool, balancing antees among clinical faculty is due to the
the benefit of a put option with the price of inherent cost of a salary guarantee for the
a call option is called a zero premium col- medical school, and difficulties in estimat-
lar. A zero premium collar allows an investor ing these costs. We suggest that our analysis
to hedge against losses with the put that is in is a reasonable step in estimating such costs.
effect paid for with the limitation in value pro- Our analysis must be considered in the con-
vided by the call. Because the put and call are text of the limitations of the Black-Scholes
priced identically, the result is a financially analysis. First, Black-Scholes bases future
neutral position as shown in our salary model. expectations on prior events. Specifically,
Another possible resolution to the tension our analysis is based on monthly earnings
provided by a salary guarantee would be if for the year prior (although longer histori-
the salary guarantee is significantly less that cal horizons could also be used). Second, the
the physicians historical earnings. From a Black-Scholes equation works very well for
finance perspective, the price of an option fluctuations in share price (monthly salary)
decreases as the likelihood that the option that are incremental and smooth. In fact, the
will be in the money decreases. For exam- equations stem from mathematical equations
ple, a physician with a salary guarantee of used to describe the transfer of heat across
$150,000 who has historically earned well a solid where small areas become heated in
over $200,000 has not been provided with a an incremental fashion. As such, our model
very costly option. We suggest that at times, would become more precise if weekly or
96 JOURNAL OF HEALTH CARE FINANCE/FALL 2012

daily salary were used rather than monthly have been described in such terms.6 We sug-
earnings. In fact the exponential function gest that analysis like ours can provide a
(ex) contained in the Black-Scholes equation mathematical basis for the implementation
implies changes that are small and continu- of an incentive plan that includes salary guar-
ous. Black-Scholes works less well when antees and caps. We further suggest that our
changes are large and sudden. We suggest analysis is superior to salary predictions that
that fluctuations in clinical faculty earnings are merely empirical.
are typically smooth. Only with sudden cata- Real option theory can be used to assess
strophic events such as disability-causing the medical school practice plan cost of sal-
physician illness, near total disruption of a ary guarantees and the model presented can
health care system, or closure of a sole facil- be used to balance such costs with the finan-
ity providing care would this analysis falter. cial benefit of a salary cap. We suggest that
Although academic physician salary struc- such analysis can provide a reliable estimate
ture has not been described previously in of salary projections and would be useful
the literature in terms of real options theory, for institutional physician salary modeling
managed care contracting and regulation within incentive plans.

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Reasoning in Healthcare: An Integrative Evolution of Faculty Appointment and Tenure
Approach and Synopsis, Journal of Health- Policies and U.S. Medical Schools, Acad.
care Management, 52: 170186 (2007). Med., 82: 281289 (2007).
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