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HEALTHCARE
FINANCE
AUPHA
HAP Editorial Board

Frederick J. Wenzel
University of St. Thomas

G. Ross Baker, Ph.D.
University of Toronto

Sharon B. Buchbinder, R.N., Ph.D.
Towson University

Caryl Carpenter, Ph.D.
Widener University

Leonard Friedman, Ph.D.
Oregon State University

William C. McCaughrin, Ph.D.
Trinity University

Thomas McIlwain, Ph.D.
Medical University of South Carolina

Janet E. Porter, Ph.D.
University of North Carolina at Chapel Hill

Lydia Reed
AUPHA

Louis Rubino, Ph.D., FACHE
California State University”Northridge

Dennis G. Shea, Ph.D.
Pennsylvania State University

Dean G. Smith, Ph.D.
University of Michigan

Mary E. Ste¬‚, Ph.D.
Trinity University

Linda E. Swayne, Ph.D.
University of North Carolina”Charlotte

Douglas S. Wake¬eld, Ph.D.
University of Iowa
HEALTHCARE
FINANCE


An Introduction to
Accounting and
Financial Management
Third Edition




Louis C. Gapenski




AUPHA
HAP
Your board, staff, or clients may also bene¬t from this book™s insight. For more
information on quantity discounts, contact the Health Administration Press Mar-
keting Manager at (312) 424-9470.
This publication is intended to provide accurate and authoritative information
in regard to the subject matter covered. It is sold, or otherwise provided, with
the understanding that the publisher is not engaged in rendering professional
services. If professional advice or other expert assistance is required, the services
of a competent professional should be sought.

The statements and opinions contained in this book are strictly those of the author
and do not represent the of¬cial positions of the American College of Healthcare
Executives, of the Foundation of the American College of Healthcare Executives,
or of the Association of University Programs in Health Administration.

Copyright © 2005 by the Foundation of the American College of Healthcare
Executives. Printed in the United States of America. All rights reserved. This book
or parts thereof may not be reproduced in any form without written permission
of the publisher.

09 08 07 06 05 54 3 21

Library of Congress Cataloging-in-Publication Data

Gapenski, Louis C.
Healthcare ¬nance : an introduction to accounting and ¬nancial
management / 3rd ed.
p. cm.
Includes bibliographical references and index.
ISBN 1-56793-232-0 (alk. paper)
1. Health facilities”Finance. 2. Health facilities”Accounting.
I. Title.
RA971.3.G3695 2004
362.1'068'1”dc21 2004054241

The paper used in this publication meets the minimum requirements of American
National Standards for Information Sciences”Permanence of Paper for Printed
Library Materials, ANSI Z39.48-1984. „

Project manager: Jane C. Williams; acquisitions manager: Janet Davis; cover
design: Matt Avery


Health Administration Press Association of University Programs
A division of the Foundation in Health Administration
of the American College of 2000 N. 14th Street
Healthcare Executives Suite 780
One North Franklin Street Arlington, VA 22201
Suite 1700 (703) 894-0940
Chicago, IL 60606
(312) 424-2800
BRIEF CONTENTS




Preface xiii

PART I The Healthcare Environment

1 Introduction to Healthcare Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 The Financial Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

PART II Financial Accounting

3 Financial Accounting Basics and the Income Statement . . . . . . . . 53

4 The Balance Sheet and Statement of Cash Flows . . . . . . . . . . . . . . 87

PART III Managerial Accounting

5 Managerial Accounting Basics, Cost Behavior,
and Pro¬t Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

6 Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

7 Pricing and Service Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

8 Planning and Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

PART IV Basic Financial Management Concepts

9 Time Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

10 Financial Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . 287
PART V Long-Term Financing

11 Long-Term Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

12 Equity Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359

13 Capital Structure and the Cost of Capital . . . . . . . . . . . . . . . . . . . 389

PART VI Capital Investment Decisions

14 The Basics of Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

15 Project Risk Assessment and Incorporation . . . . . . . . . . . . . . . . . . 461

PART VII Other Topics

16 Current Asset Management and Financing . . . . . . . . . . . . . . . . . . 491

17 Analyzing Financial Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

18 Lease Financing and Business Valuation . . . . . . . . . . . . . . . . . . . . . 561

Index 591

About the Author 603
DETAILED CONTENTS




Preface xiii

PART I The Healthcare Environment

1 Introduction to Healthcare Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 3

De¬ning Healthcare Finance, 3; Purpose of the Book, 5; The Role of
Finance in Health Services Organizations, 6; Health Services Settings, 8;
Regulatory and Legal Issues, 14; Organization of the Book, 16; How to
Use This Book, 17

2 The Financial Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Alternative Forms of Business Organization, 21; Alternative Forms of
Ownership, 26; Organizational Goals, 29; Tax Laws, 32; Third-Party
Payers, 34; Managed Care Plans, 37; Alternative Reimbursement
Methods, 39

PART II Financial Accounting

3 Financial Accounting Basics and the Income Statement . . . . . . . . 53

Historical Foundations of Financial Accounting, 54; The Users of Financial
Accounting Information, 55; Regulation and Standards in Financial
Accounting, 56; Basic Concepts of Financial Accounting, 59; Accounting
Methods: Cash Versus Accrual, 62; Recording and Compiling Accounting
Data, 65; Income Statement Basics, 67; Revenues, 69; Expenses, 73; Net
Income, 76; Net Income Versus Cash Flow, 78; Income Statements of
Investor-Owned Firms, 79; A Look Ahead: Using Income Statement
Data in Financial Statement Analysis, 80
4 The Balance Sheet and Statement of Cash Flows . . . . . . . . . . . . . . 87

Balance Sheet Basics, 88; Assets, 90; Liabilities, 96; Equity, 98; Fund
Accounting, 102; The Statement of Cash Flows, 102; Transactions, 106;
Another Look Ahead: Using Balance Sheet Data in Financial Statement
Analysis, 111

PART III Managerial Accounting

5 Managerial Accounting Basics, Cost Behavior,
and Pro¬t Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

The Basics of Managerial Accounting, 121; Cost Classi¬cations: Fixed and
Variable, 123; Cost Behavior, 124; Cost Classi¬cations: Semi-Fixed, 127;
Pro¬t (CVP) Analysis, 128; Breakeven Analysis, 133; Operating
Leverage, 136; Pro¬t Analysis in a Discounted Fee-for-Service
Environment, 138; Pro¬t Analysis in a Capitated Environment, 143; The
Impact of Cost Structure on Financial Risk, 150

6 Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

Direct Versus Indirect (Overhead) Costs, 157; Introduction to Cost
Allocation, 158; Cost Allocation Basics, 159; Cost Allocation
Methods, 162; Direct Method Illustration, 164; The Impact of Changing
Cost Drivers, 171; Step-Down Method Illustration, 174; Activity Based
Costing, 176; Final Thoughts on Cost Allocation, 180

7 Pricing and Service Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

Healthcare Providers and the Power to Set Prices, 188; Price Setting
Strategies, 189; Target Costing, 191; Setting Prices on Individual
Services, 192; Setting Prices Under Capitation, 193; Setting Managed
Care Plan Premium Rates, 201; Using Relative Value Units (RVUs) to Set
Prices, 206; Making the Service Decision (Contract Analysis), 208

8 Planning and Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

The Planning Process, 220; Introduction to Budgeting, 223; Budget
Types, 223; Budget Decisions, 226; Constructing a Simple Operating
Budget, 228; Variance Analysis, 231; The Cash Budget, 239
PART IV Basic Financial Management Concepts

9 Time Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

Time Lines, 254; Future Value of a Lump Sum (Compounding), 255;
Present Value of a Lump Sum (Discounting), 259; Opportunity
Costs, 261; Solving for Interest Rate and Time, 263; Annuities, 265;
Perpetuities, 268; Uneven Cash Flow Streams, 269; Using Time Value
Analysis to Measure Financial Returns, 272; Semiannual and Other
Compounding Periods, 276; Amortized Loans, 279

10 Financial Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . 287

The Many Faces of Financial Risk, 288; Introduction to Financial
Risk, 289; Risk Aversion, 290; Probability Distributions, 291; Expected
and Realized Rates of Return, 292; Stand-Alone Risk, 293; Portfolio Risk
and Return, 295; Measuring the Risk of Investments Held in
Portfolios, 304; Portfolio Betas, 309; Relevance of the Risk
Measures, 310; Interpretation of the Risk Measures, 312; The
Relationship Between Risk and Required Return, 312

PART V Long-Term Financing

11 Long-Term Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

The Cost of Money, 325; Common Long-Term Debt Instruments, 327;
Debt Contracts, 331; Bond Ratings, 333; Credit Enhancement, 335;
Interest Rate Components, 335; The Term Structure of Interest
Rates, 339; Debt Valuation, 341

12 Equity Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359

Equity in For-Pro¬t Businesses, 359; Types of Common Stock, 362;
Procedures for Selling New Common Stock, 363; The Market for
Common Stock, 365; Regulation of Securities Markets, 367; The
Investment Banking Process, 369; Equity in Not-for-Pro¬t
Businesses, 371; Common Stock Valuation, 373; Security Market
Equilibrium, 379; Informational Ef¬ciency, 380; The Risk/Return
Trade-Off, 383
13 Capital Structure and the Cost of Capital . . . . . . . . . . . . . . . . . . . 389

Capital Structure Basics, 389; Impact of Debt Financing on Accounting
Risk and Return, 390; Capital Structure Theory, 393; Identifying the
Optimal Capital Structure in Practice, 396; Not-for-Pro¬t Businesses, 398;
Cost of Capital Basics, 399; Cost of Debt Capital, 401; Cost of Equity
Capital, 403; The Corporate Cost of Capital, 412; An Economic
Interpretation of the Corporate Cost of Capital, 414

PART VI Capital Investment Decisions

14 The Basics of Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

Importance of Capital Budgeting, 425; Project Classi¬cations, 426; The
Role of Financial Analysis in Healthcare Capital Budgeting, 427; Overview
of Capital Budgeting Financial Analysis, 428; Cash Flow Estimation, 428;
Cash Flow Estimation Example, 435; Breakeven Analysis, 442;
Pro¬tability (Return on Investment) Analysis, 443; Some Final Thoughts
on Breakeven and Pro¬tability Analyses, 446; Capital Budgeting in
Not-for-Pro¬t Businesses, 446; The Post Audit, 449; Using Capital
Budgeting Techniques in Other Contexts, 450

15 Project Risk Assessment and Incorporation . . . . . . . . . . . . . . . . . . 461

Types of Project Risk, 462; Relationships Among Stand-Alone, Corporate,
and Market Risk, 464; Risk Analysis Illustration, 464; Sensitivity
Analysis, 465; Scenario Analysis, 469; A Subjective Approach to Risk
Assessment, 472; Incorporating Risk Into the Decision Process, 472;
Making the Final Decision, 475; Adjusting Cash Out¬‚ows for Risk, 476;
Subsidiary Costs of Capital, 478; An Overview of the Capital Budgeting
Decision Process, 479; Capital Rationing, 481

PART VII Other Topics

16 Current Asset Management and Financing . . . . . . . . . . . . . . . . . . 491

An Overview of Short-Term Financial Management, 491; Current Asset
Investment and Financing Policies, 493; Cash Management, 498;
Marketable Securities Management, 501; Long-Term Securities
Management, 502; Receivables Management, 503; Supply Chain
Management, 508; Short-Term Financing, 510
17 Analyzing Financial Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

The Statement of Cash Flows, 528; Ratio Analysis, 531; Tying the Ratios
Together: Du Pont Analysis, 542; Other Analytical Techniques, 544;
Market Value Added and Economic Value Added, 545;
Benchmarking, 547; Operating Indicator Analysis, 549; Limitations of
Financial Performance Analysis, 551

18 Lease Financing and Business Valuation . . . . . . . . . . . . . . . . . . . . . 561

Leasing Basics, 561; Tax Effects, 563; Balance Sheet Effects, 565; Lease
Evaluation, 567; Motivations for Leasing, 574; Business Valuation, 578

Index 591

About the Author 603
This page intentionally left blank
PREFACE




S
ome 20 years ago, after years of teaching corporate ¬nance and writing
related textbooks and casebooks, I began teaching healthcare ¬nancial
management in the University of Florida™s joint MBA/MHA program.
The move prompted me to write my ¬rst healthcare ¬nance textbook, Un-
derstanding Health Care Financial Management. The book was designed for
use in health services administration ¬nancial management courses in which
students had prerequisite courses in both accounting and corporate ¬nance.
In general, such courses are case courses, so this book served primarily as a
reference tool when working healthcare ¬nance cases.
In recent years, I expanded my healthcare ¬nance teaching to include
courses in nontraditional and clinician-oriented programs in which students
do not have a formal background in ¬nancial issues. Finance courses in these
programs require a book that provides basic information on foundation topics.
Furthermore, these courses often are part of programs that contain just one
healthcare ¬nance course, so the course must cover both accounting and ¬-
nancial management. In reviewing the books available for use in such courses,
I found some that were strong in accounting and others that were strong in
¬nancial management; however, I could not ¬nd one that gave equal empha-
sis to both components of healthcare ¬nance. This situation prompted me
to write Healthcare Finance: An Introduction to Accounting and Financial
Management.


Concept of the Book
My goal in writing this book was to create a text that introduces students
to the most important principles and applications of healthcare ¬nance, with
roughly equal coverage of accounting and ¬nancial management. Further-
more, because the book is intended for use primarily in clinical and health
services administration programs, in which students are trained primarily for
professional positions within healthcare providers, its focus is on healthcare
¬nance as practiced within such organizations. The examples within the book
are based on such organizations as hospitals, medical practices, clinics, home
xiii
health agencies, nursing homes, and managed care organizations.
xiv Preface



Another consideration in writing the book is that most readers would
be seeing the material for the ¬rst time. Thus, it is very important that the
material be explained as clearly and succinctly as possible. I have tried very
hard to create a book that readers will ¬nd user-friendly”one that they will
enjoy reading and can learn from on their own. If students don™t ¬nd a book
interesting, understandable, and useful, they won™t read it.
The book begins with an introduction to healthcare ¬nance and a
description of the current ¬nancial environment in which providers operate.
From there, it takes students through the basics of ¬nancial and managerial
accounting. Here, my goal is not to turn clinicians or generalist managers into
accountants, but to present those accounting concepts that are most critical
to managerial decision making. The book then discusses the basic foundations
of ¬nancial management before progressing to demonstrate how healthcare
managers can apply ¬nancial management theory and principles to help make
better decisions, where better is de¬ned as decisions that promote the ¬nancial
well-being of the organization. Finally, the book is written under the premise
that providers will be under increasing ¬nancial pressure to provide cost-
effective services. Thus, considerable emphasis is placed on ¬nancial decision
making within a managed care environment.


Intended Market and Use
The book is not targeted for speci¬c types of educational programs. Rather,
it is designed to teach students, in one course, the fundamental concepts
of healthcare ¬nance, including both accounting and ¬nancial management,
with emphasis on provider organizations. Thus, the book can be used in a
wide variety of settings: undergraduate and graduate programs, traditional
and executive programs, on-campus and distance learning programs, and even
independently for self-improvement.
The key to the book™s usefulness is not the educational program but
the focus of the course. If the course is a stand-alone course designed to
cover both healthcare accounting and ¬nancial management, the book will
¬t. In fact, the book can be easily used across a two-course healthcare ¬nance
sequence, especially in modular programs where each course is two credit
hours. Typically, such a sequence begins with an accounting course and ends
with a ¬nancial management course. This book, supplemented by cases (and
possibly readings), would work well in such a sequence. The ideal casebook
for use here is Cases in Healthcare Finance by Louis C. Gapenski, which is
part of Health Administration Press™s healthcare ¬nance series. The casebook
contains 30 cases that focus on the topics contained in this textbook, along
with six ethics minicases that can be used to highlight ethical issues in a
healthcare ¬nance setting.
xv
Preface



The book should also be useful to practicing healthcare professionals
who, for one reason or another, must increase their understanding of health-
care ¬nance. Such professionals include clinicians who have some management
responsibilities as well as line managers who now require additional ¬nance
skills. Finally, many members of ¬nancial staffs, especially those who work
exclusively in a single area, such as patient accounts, would bene¬t from hav-
ing a broader understanding of ¬nance principles and hence would ¬nd this
book useful.


Changes in the Third Edition
Since the publication of the second edition of this book, I have used it nu-
merous times in various settings. In addition, I have received many comments
from users at other universities. The overall reaction of students, other profes-
sors, and the marketplace in general has been overwhelmingly positive”every
comment received indicates that the basic concept of the book is sound. Even
so, nothing is perfect, and the healthcare environment is evolving at a dizzying
pace. Thus, many changes have been made to the book; the most important
of which are listed here:

• The book was updated and clari¬ed throughout. Particular care was
taken to include the most recent information on reimbursement
and to update the real-world examples. In addition, there is no
doubt that text material improves as it is repeatedly edited. Like all
books, the second edition had some “rough spots,” and
considerable effort was expended to improve these discussions.
• New sections have been added that deal with the Sarbanes-Oxley
Act and the revenue cycle.
• In addition, the variance analysis coverage has been changed to
separate the analysis into revenue and cost sides.
• Most importantly, the book was “cut and trimmed” as necessary to
create a better ¬‚ow of material. Over time, textbooks tend to “gain
weight” as new material is added. However, a large book is usually
not a better book, because many students get overwhelmed before
they are able to grasp the key concepts.
• The lecture presentation software was updated and improved based
on continuous usage and suggestions from adopters and students
alike.

All in all, these changes improve the quality and value of the book without
affecting its basic concept and approach to learning.
xvi Preface



Ancillary Materials
Two important teaching aids accompany this book. These materials can be ob-
tained through the Health Administration Press web site www.ache.org/pubs/
hc¬n3.cfm. For access information, please email hap1@ache.org.

• Instructor™s Manual. A comprehensive manual is available to
instructors who adopt the book. The manual includes a sample
course outline and solutions to the end-of-chapter questions and
problems.
• Lecture Presentation Software. A set of PowerPoint© slides that
cover all the essential issues contained in each chapter is also
available. Concepts, graphs, tables, lists, and calculations are
presented in about 40 slides per chapter, much as an instructor
might do on a blackboard. However, the slides are more crisp,
clear, and colorful, and can be displayed on a screen almost
instantaneously. Furthermore, hard copies of the slides can be
provided to students for use as lecture notes. Many instructors will
¬nd these slides useful, either as is or as customized to best meet
the situation at hand.


Acknowledgments
This book re¬‚ects the efforts of many people. First and foremost, I would like
to thank Mark Covaleski of the University of Wisconsin, who made signi¬-
cant contributions to the accounting content of the book. In fact, without
his materials, advice, and counsel, the book could not have been written. In
addition, Anna McAleer of Arcadia University (formerly Beaver College) pro-
vided many useful comments for improving both the text and the Instructor™s
Manual.
Colleagues, students, and staff at the University of Florida provided in-
spirational support, as well as more tangible support, during the development
and class testing of the text. Last, but certainly not least, the Health Admin-
istration Press staff was instrumental in ensuring the quality and usefulness of
the book.


Errors in the Book
In spite of the signi¬cant effort that has been expended by many individuals
on this book, it is safe to say that some errors exist. In an attempt to create
the most error-free and useful book possible, I strongly encourage both in-
structors and students to write me at the address below with comments and
suggestions for improving the book. I certainly welcome your input.
xvii
Preface



Conclusion
In the environment faced by healthcare providers today, good ¬nance is more
important than ever to the economic well-being of the enterprise. Because of
its importance, managers of all types and at all levels should be thoroughly
grounded in ¬nance principles and applications; but this is easier said than
done. I hope that Healthcare Finance: An Introduction to Accounting and Fi-
nancial Management will help you understand the ¬nance problems currently
faced by healthcare providers and, more importantly, that it will provide guid-
ance on how best to solve them.

Louis C. Gapenski, Ph.D.
Box 100195
Health Science Center
University of Florida
Gainesville, Florida 32610“0195

September 2004
This page intentionally left blank
PAR T



I
The Healthcare Environment
This page intentionally left blank
CHAP TER



1
INTRODUCTION TO
HEALTHCARE FINANCE

Learning Objectives
After studying this chapter, readers will be able to:

• De¬ne the term healthcare ¬nance as it is used in this book.
• Discuss the role of ¬nance in health services organizations and how
this role has changed over time.
• Describe the major players in the health services industry.
• Describe the organization of this book and the learning aids
contained in each chapter.

Introduction
In today™s healthcare environment, where ¬nancial realities play an important
role in business decision making, it is vital that managers at all levels under-
stand the basic concepts of healthcare ¬nance and how these concepts are
used to enhance the ¬nancial well-being of the organization. In this chapter,
we introduce readers to the book, including its goals and organization. Fur-
thermore, we present some basic background information about the health
services system. We sincerely hope that this book will be a signi¬cant help
to you in your quest to increase your professional competency in the very
important area of healthcare ¬nance.

De¬ning Healthcare Finance
What is healthcare ¬nance? Surprisingly, there is no single answer to that
question because the de¬nition of healthcare ¬nance depends, for the most
part, on the context in which the term is used. Thus, in writing this book, our
¬rst step was to decide how to de¬ne “healthcare ¬nance.”
We began by examining the healthcare sector of the economy, which is
second in size only to the real estate sector and consists of a diverse collection
of industries that involve, either directly or indirectly, the healthcare of the
population. The major industries in the healthcare sector include:

• Health services. The health services industry consists of providers
of health services such as medical practices, hospitals, clinics,
3
nursing homes, and home health care agencies.
4 Healthcare Finance



• Health insurance. The health insurance industry includes
government programs and commercial insurers as well as
self-insurers.
• Managed care. Managed care includes organizations such as health
maintenance organizations (HMOs) that incorporate both
insurance and health services (provider) functions.
• Medical equipment and supplies. These industries include the
makers of durable medical equipment, such as diagnostic
equipment and wheel chairs, and expendable medical supplies, such
as disposable surgical instruments and bandages.
• Pharmaceuticals and biotechnology. These industries develop
and market drugs and other therapeutic products.
• Other. This category includes a diverse collection of businesses
ranging from consulting ¬rms to educational institutions to
government and private research agencies.

Most users of this book will become (or already are) managers at health
services organizations, or at companies such as insurance companies, managed
care organizations, and consulting ¬rms that deal directly with such organiza-
tions. Thus, to create a book that has the most value to its primary users, we
focus on ¬nance as it applies within the health services industry. Of course, the
principles and practices of ¬nance cannot be applied in a vacuum but must be
based on the realities of the current healthcare environment, including how
healthcare services are ¬nanced. Furthermore, insurance involves payment to
healthcare providers; much of managed care involves utilization management
of healthcare providers, either directly or through contracts; and most con-
sulting work is done for providers; so the material in this book is also relevant
for managers in other industries related to health services.
Now that we have de¬ned the healthcare focus of this book, the term
¬nance must be de¬ned. Finance, as the term is used within the health services
industry, and as used in this book, consists both of the accounting and ¬nancial
management functions. (In many settings, accounting and ¬nancial manage-
ment are separate disciplines.) Accounting, as its name implies, concerns the
recording, in ¬nancial terms, of economic events that re¬‚ect the operations,
resources, and ¬nancing of an organization. In general, the purpose of ac-
counting is to create and provide to interested parties, both internal and exter-
nal, useful information about an organization™s ¬nancial status and operations.
Whereas accounting provides a rational means by which to measure a
business™s ¬nancial performance and assess operations, ¬nancial management,
or corporate ¬nance, provides the theory, concepts, and tools necessary to help
managers make better ¬nancial decisions. Of course, the boundary between
accounting and ¬nancial management is blurred; certain aspects of accounting
involve decision making, and much of the application of ¬nancial management
theory and concepts requires accounting data.
5
Chapter 1: Introduction to Healthcare Finance




Self-Test
1. What is meant by the term healthcare ¬nance?
Questions
2. What is the difference between accounting and ¬nancial management?



Purpose of the Book
Many books cover the general topics of accounting and ¬nancial management,
so why is a book needed that focuses on health services ¬nance? The reason is
that while all industries have certain individual characteristics, the health ser-
vices industry is truly unique. For example, the provision of healthcare services
is dominated by not-for-pro¬t organizations, both private and governmental,
and such entities are inherently different from investor-owned businesses. Also,
the majority of payments made to healthcare providers are not made by the
individuals who use the services but by third-party payers (e.g., an employer,
commercial insurance company, or government program). Throughout the
book, the ways in which the unique features of the health services industry
in¬‚uence the application of ¬nance principles and practices are emphasized.
This book is designed to introduce students to healthcare ¬nance,
which has two important implications. First, the book assumes no prior knowl-
edge of the subject matter; thus, the book is totally self-contained, with each
topic explained from the beginning in basic terms. Furthermore, because clar-
ity is so important when concepts are ¬rst introduced, the chapters have been
written in an easy-to-read fashion. None of the topics are inherently dif¬cult,
but new concepts often take some effort to understand. This process is made
easier by the writing style used.
Second, because this book is introductory, it contains a broad overview
of healthcare ¬nance. The good news here is that the book presents virtually all
the important healthcare ¬nance principles that are used by managers in health
services organizations. The bad news is that the large number of topics covered
prevents us from covering principles in great depth or including a wide variety
of application illustrations. Thus, students that use this book are not expected
to fully understand every nuance of every ¬nance principle and practice that
pertains to every type of health services organization. Nevertheless, this book
provides a suf¬cient knowledge of healthcare ¬nance so that readers will be
able to function better as managers, judge the quality of ¬nancial analyses
performed by others, and incorporate sound principles and practices into
personal ¬nance decisions.
Naturally, an introductory ¬nance book does not contain everything
that a healthcare ¬nancial manager must know to competently perform his
or her job. Nevertheless, the book is useful even for those working in ¬nancial
positions because it presents an overview of the ¬nance function. Often, when
working in speci¬c areas of ¬nance, it is too easy to lose sight of the context
of one™s work. This book will help provide that context.
6 Healthcare Finance




Self-Test 1. Why is it necessary to have a book dedicated to healthcare ¬nance?
Questions 2. What is the purpose of the book?


The Role of Finance in Health Services Organizations
The primary role of ¬nance in health services organizations, as in all businesses,
is to plan for, acquire, and utilize resources to maximize the ef¬ciency and
value of the enterprise. The two broad areas of ¬nance”accounting and ¬-
nancial management”are separate functions at larger organizations, although
the accounting function usually is carried out under the direction of the or-
ganization™s chief ¬nancial of¬cer (CFO) and hence falls under the overall
category of ¬nance.
In general, ¬nance activities include:

• Planning and budgeting. First and foremost, business ¬nance
involves evaluating the ¬nancial effectiveness of current operations
and planning for the future. Budgets play an important role in this
process.
• Financial reporting. For a variety of reasons, it is important for
businesses to record and report to outsiders the results of
operations and current ¬nancial status. This is typically
accomplished by a set of ¬nancial statements.
• Capital investment decisions. Although more important to senior
management, managers at all levels must be concerned with the
capital investment decision process. Such decisions, which are called
capital budgeting decisions, focus on the acquisition of land,
buildings, and equipment. They are the primary means by which
businesses implement strategic plans, and hence they play a key role
in a business™s ¬nancial future.
• Financing decisions. All organizations must raise capital to buy
the assets necessary to support operations. Such decisions involve
the choice between internal and external funds, the use of debt
versus equity capital, the use of long-term versus short-term debt,
and the use of lease versus conventional ¬nancing. Although senior
managers typically make ¬nancing decisions, these decisions have
rami¬cations for managers at all levels.
• Working capital management. An organization™s current, or
short-term, assets, such as cash, marketable securities, receivables,
and inventories, must be properly managed both to ensure
operational effectiveness and to reduce costs. Generally, managers
at all levels are involved, to some extent, in short-term asset
management, which is often called working capital management.
7
Chapter 1: Introduction to Healthcare Finance



• Contract management. In today™s healthcare environment, health
services organizations must negotiate, sign, and monitor contracts
with managed care organizations and third-party payers. The
¬nancial staff typically has primary responsibility for these tasks, but
managers at all levels are involved in these activities and must be
aware of their effects on operating decisions.
• Financial risk management. Many ¬nancial transactions that take
place to support the operations of a business can, themselves,
increase the business™s risk. Thus, an important ¬nance activity is to
control ¬nancial risk.

In times of high pro¬tability and abundant ¬nancial resources, the ¬-
nance function tends to decline in importance. Thus, when most healthcare
providers were reimbursed on the basis of costs incurred, the role of ¬nance
was minimal. At that time, the most critical ¬nance function was cost account-
ing because it was more important to account for costs than it was to control
them. In response to payer (primarily Medicare) requirements, providers (pri-
marily hospitals) churned out a multitude of reports both to comply with
regulations and to maximize revenues. The complexities of cost reimburse-
ment meant that a large amount of time had to be spent on cumbersome
accounting, billing, and collection procedures. Thus, instead of focusing on
value-adding activities, most ¬nance work focused on bureaucratic functions.
In recent years, however, providers have been redesigning their ¬-
nance functions to recognize the changes that have occurred in the health
services industry. Although billing and collections remain important, to be of
maximum value to the enterprise today the ¬nance function must support
cost-containment efforts, managed care and other payer contract negotia-
tions, joint venture decisions, and integrated delivery system participation.
In essence, ¬nance must help lead organizations into the future rather than
merely record what has happened in the past.
In this book, the emphasis is on the ¬nance function, but there are
no unimportant functions in health services organizations. Senior executives
must understand a multitude of functions such as marketing, facilities man-
agement, and human resource management in addition to ¬nance. Still, all
business decisions have ¬nancial implications, so all managers”whether in
operations, marketing, personnel, or facilities”must know enough about ¬-
nance to properly incorporate any ¬nancial implications into decisions made
within their own specialized areas.


Self-Test
1. What is the role of ¬nance in today™s health services organizations?
Questions
2. How has this role changed over time?
8 Healthcare Finance



Health Services Settings
Healthcare services are provided in numerous settings, including hospitals,
ambulatory care facilities, long-term care facilities, and even at home. Prior
to the 1980s, most health services organizations were freestanding and not
formally linked with other organizations. Those that were linked tended to be
part of horizontally integrated systems that control a single type of healthcare
facility such as hospitals or nursing homes. Recently, however, many health
services organizations have diversi¬ed and become vertically integrated either
through direct ownership or contractual arrangements.

Hospitals
Hospitals provide diagnostic and therapeutic services to individuals who re-
quire more than several hours of care, although most hospitals are actively
engaged in ambulatory services as well. To ensure a minimum standard of
safety and quality, hospitals must be licensed by the state and undergo inspec-
tions for compliance with state regulations. In addition, most hospitals are
accredited by the Joint Commission on Accreditation of Healthcare Organiza-
tions (JCAHO). JCAHO accreditation is a voluntary process that is intended
to promote high standards of care. Although the cost to achieve and maintain
compliance with standards can be substantial, accreditation provides eligibil-
ity for participation in the Medicare program, and hence most hospitals seek
accreditation.
Recent environmental and operational changes have created signi¬cant
challenges for hospital managers. For example, many hospitals are experienc-
ing decreasing admission rates and shorter lengths of stay, resulting in excess
capacity. At the same time, hospitals have been pressured to give discounts
to managed care plans, to limit the growth in patient charges, and to assume
greater risk in their contracts with third-party payers. Because of the changing
environmental, as well as increasing cost-containment pressures, the number
of hospitals (and beds) has declined in recent years.
Hospitals differ in function, length of patient stay, size, and owner-
ship. These factors affect the type and quantity of assets, services offered, and
management requirements and often determine the type and level of reim-
bursement. Hospitals are classi¬ed as either general acute care facilities or
specialty facilities. General acute care hospitals provide general medical and
surgical services and selected acute specialty services. General acute care hos-
pitals are short-stay facilities and account for the majority of hospitals. Specialty
hospitals, such as psychiatric, children™s, women™s, rehabilitation, and cancer,
limit admission of patients to speci¬c ages, sexes, illnesses, or conditions. The
number of psychiatric and rehabilitation hospitals has grown signi¬cantly in
the past few decades because of the increased needs created by substance abuse
as well as increased government reimbursement for such services.
Hospitals vary in size from fewer than 25 beds to more than 1,000
9
Chapter 1: Introduction to Healthcare Finance



beds; general acute care hospitals tend to be larger than specialty hospitals.
Small hospitals, those with fewer than 100 beds, tend to be located in rural
areas. Many rural hospitals have experienced ¬nancial dif¬culties in recent
years because they have less ability than larger hospitals to lower costs in
response to ever-tighter reimbursement rates. Most of the largest hospitals
are academic health centers or teaching hospitals, which offer a wide range of
services, including tertiary services.1
Hospitals are classi¬ed by ownership as private not-for-pro¬t, investor
owned, and governmental. Governmental hospitals, which make up 25 percent
of all hospitals, are broken down into federal and public (nonfederal) entities.
Federal hospitals, such as those operated by the military services or the Depart-
ment of Veterans Affairs, serve special purposes. Public hospitals are funded
wholly or in part by a city, county, tax district, or state. In general, federal and
public hospitals provide substantial services to indigent patients. In recent
years, many public hospitals have converted to other ownership categories”
primarily private not-for-pro¬t”because local governments have found it in-
creasingly dif¬cult to fund healthcare services and still provide other necessary
public services. In addition, the inability of politically governed organizations
to respond quickly to the changing healthcare environment contributed to
many conversions as managers tried to create organizations that are more re-
sponsive to external change.
Private not-for-pro¬t hospitals are nongovernment entities organized
for the sole purpose of providing inpatient healthcare services. Because of
the charitable origins of U.S. hospitals and a tradition of community service,
roughly 80 percent of all private hospitals (60 percent of all hospitals) are
not-for-pro¬t entities. In return for serving a charitable purpose, these hos-
pitals receive numerous bene¬ts, including exemption from federal and state
income taxes, exemption from property and sales taxes, eligibility to receive
tax-deductible charitable contributions, favorable postal rates, favorable tax-
exempt ¬nancing, and tax-favored annuities for employees.
The remaining 20 percent of private hospitals (15 percent of all hos-
pitals) are investor owned. This means that they have owners (typically share-
holders) that bene¬t directly from the pro¬ts generated by the business. His-
torically, most investor-owned hospitals were owned by physicians, but now
most are owned by large corporations such as HCA, which owns about 180
hospitals, and Tenet Healthcare, which owns about 110 hospitals. Unlike not-
for-pro¬t hospitals, investor-owned hospitals pay taxes and forgo the other
bene¬ts of not-for-pro¬t status. However, investor-owned hospitals typically
do not embrace the charitable mission of not-for-pro¬t hospitals. Despite the
expressed differences in mission between investor-owned and not-for-pro¬t
hospitals, not-for-pro¬t hospitals are being forced to place greater empha-
sis on the ¬nancial implications of operating decisions than in the past. This
trend has raised concerns in some quarters that many not-for-pro¬t hospitals
are now failing to meet their charitable mission. As this perception grows,
10 Healthcare Finance



some people now argue that these hospitals should lose some, if not all, of the
bene¬ts associated with their not-for-pro¬t status.
Hospitals are labor-intensive because of their need to provide contin-
uous nursing supervision to patients, in addition to the other services they
provide through professional and semiprofessional staffs. Physicians petition
for privileges to practice in hospitals. While they admit and provide care to
hospitalized patients, physicians, for the most part, are not hospital employ-
ees and hence are not directly accountable to hospital management. However,
physicians retain a major responsibility for determining which hospital services
will be provided to patients and how long patients are hospitalized, so physi-
cians play a critical role in determining a hospital™s costs and revenues and
hence its ¬nancial condition.

Ambulatory (Outpatient) Care
Ambulatory care, also known as outpatient care, encompasses services pro-
vided to noninstitutionalized patients. Traditional outpatient settings include
medical practices, hospital outpatient departments, and emergency rooms. In
addition, the 1980s and early 1990s witnessed substantial growth in nontradi-
tional ambulatory care settings such as home health care, ambulatory surgery
centers, urgent care centers, diagnostic imaging centers, rehabilitation/sports
medicine centers, and clinical laboratories. In general, the new settings of-
fer patients increased amenities and convenience compared to hospital-based
services and, in many situations, provide services at a lower cost than hospi-
tals. For example, urgent care and ambulatory surgery centers are typically
less expensive than their hospital counterparts because hospitals have higher
overhead costs.
Many factors have contributed to the expansion of ambulatory services,
but technology has been a leading factor. Often, patients who once required
hospitalization because of the complexity, intensity, invasiveness, or risk asso-
ciated with certain procedures can now be treated in outpatient settings. In
addition, third-party payers have encouraged providers to expand their outpa-
tient services through mandatory authorization for inpatient services and by
payment mechanisms that provide incentives to perform services on an outpa-
tient basis. Finally, fewer entry barriers to developing outpatient services rel-
ative to institutional care exist. Ordinarily, ambulatory facilities are less costly,
less often subject to licensure and certi¬cate-of-need regulations (exceptions
are hospital outpatient units and ambulatory surgery centers), and generally
are not accredited. (Licensure and certi¬cate-of-need regulation are discussed
in detail in the next major section.)
As outpatient care consumes an increasing portion of the healthcare
dollar, and efforts to control outpatient spending are enhanced, the tradi-
tional role of the ambulatory care manager is changing. Ambulatory care man-
agers historically have focused on such routine management tasks as billing,
collections, staf¬ng, scheduling, and patient relations, while the owners, of-
11
Chapter 1: Introduction to Healthcare Finance



ten physicians, have tended to make the more important business decisions.
However, reimbursement changes, including a new Medicare payment sys-
tem and increased managed care af¬liations, are requiring a higher level of
management expertise. This increasing environmental complexity, along with
increasing competition, is forcing managers of ambulatory care facilities to
become more sophisticated in making business decisions, including ¬nance
decisions.

Long-Term Care
Long-term care entails healthcare services, as well as some personal services,
provided to individuals who lack some degree of functional ability. It usually
covers an extended period of time and includes both inpatient and outpatient
services, which often focus on mental health, rehabilitation, and nursing home
care. Although the greatest use is among the elderly, long-term care services
are used by individuals of all ages.
Long-term care is concerned with levels of independent functioning,
speci¬cally activities of daily living such as eating, bathing, and locomotion.
Individuals become candidates for long-term care when they become too
mentally or physically incapacitated to perform necessary tasks and when their
family members are unable to provide the services needed. Long-term care is
a hybrid of healthcare services and social services, and nursing homes are a
major source of such care.
Three levels of nursing home care exist: (1) skilled nursing facilities,
(2) intermediate care facilities, and (3) residential care facilities. Skilled nursing
facilities (SNFs) provide the level of care closest to hospital care. Services must
be under the supervision of a physician and must include 24-hour daily nurs-
ing care. Intermediate care facilities (ICFs) are intended for individuals who
do not require hospital or SNF care but whose mental or physical conditions
require daily continuity of one or more medical services. Residential care fa-
cilities are sheltered environments that do not provide professional healthcare
services, and thus for which most health insurance programs do not provide
coverage.
Nursing homes are more abundant than hospitals and are also smaller,
with average bed size of about 100 beds, compared with about 170 beds
for hospitals. Nursing homes are licensed by states, and nursing home ad-
ministrators are licensed as well. Although the Joint Commission accredits
nursing homes, only a small percentage participate because accreditation is
not required for reimbursement, and the standards to achieve accreditation
are much higher than licensure requirements.
The long-term care industry has experienced tremendous growth in the
past three decades. Long-term care accounted for only 1 percent of healthcare
expenditures in 1960, but by 2000 it accounted for over 8 percent. Further
demand increases are anticipated, as the percentage of the U.S. population
65 and older increases from less than 16 percent in 2000 to a forecasted 20
12 Healthcare Finance



percent in 2030. The elderly are disproportionately high users of healthcare
services and are major users of long-term care.
Although long-term care is often perceived as nursing home care,
many new services are developing to meet society™s needs in less-institutional
surroundings such as adult day care, life care centers, and hospice programs.
These services tend to offer a higher quality of life, although they are not
necessarily less expensive than institutional care. Home health care, provided
for an extended time period, can be an alternative to nursing home care for
many patients, but it is not as readily available as nursing home care in many
rural areas. Furthermore, third-party payers, especially Medicare, have sent
mixed signals about their willingness to adequately pay for home health care.
In fact, many home health care businesses have been forced to close in recent
years as a result of a new, and less generous, Medicare payment system.

Integrated Delivery Systems
Many healthcare experts have extolled the bene¬ts of providing hospital care,
ambulatory care, long-term care, and business support services through a
single entity called an integrated delivery system. The hypothesized bene¬ts
of such systems include the following:

• Patients are kept in the corporate network of services (patient
capture).
• Providers have access to managerial and functional specialists (for
example, reimbursement and marketing professionals).
• Information systems that track all aspects of patient care, as well as
insurance and other data, can be developed more easily, and the
costs to develop them are shared.
• Linked organizations have better access to capital.
• The ability to recruit and retain management and professional staff
is enhanced.
• Integrated delivery systems are able to offer payers a complete
package of services (“one-stop shopping”).
• Integrated delivery systems are better able to plan for and deliver a
full range of healthcare services to meet the needs of a de¬ned
population, including chronic disease management and health
status improvement programs. Many of these population-based
efforts typically are not offered by stand-alone providers.
• Incentives that encourage all providers in the system to work
together for the common good of the system can be created, which
has the potential to both improve quality and control costs.

Although integrated delivery systems can be structured in many differ-
ent ways, the de¬ning characteristic of such systems is that the organization
13
Chapter 1: Introduction to Healthcare Finance



has the ability to assume full clinical responsibility for the healthcare needs of
a de¬ned population. Because of current state laws, which typically mandate
that the insurance function can be assumed only by licensed insurers, inte-
grated delivery systems typically contract with managed care plans rather than
directly with employers. Sometimes, the managed care plan is owned by the
integrated delivery system itself, but generally it is separately owned. In con-
tracts with managed care plans, the integrated delivery system often receives
a ¬xed payment per plan member and hence assumes both the ¬nancial and
clinical risks associated with providing healthcare services.
To be an effective competitor, integrated delivery systems must mini-
mize the provision of unnecessary services because additional services create
added costs but do not necessarily result in additional revenues. Thus, the
objective of integrated delivery systems is to provide all needed services to its
member population in the lowest cost setting. To achieve this goal, integrated
delivery systems invest heavily in primary care services, especially prevention,
early intervention, and wellness programs. The primary care gatekeeper con-
cept is frequently used to control utilization and hence costs. While hospitals
continue to be centers of technology, integrated delivery systems have the in-
centive to shift patients toward lower cost settings. Thus, clinical integration
among the various providers and components of care is essential to achieving
quality, cost ef¬ciency, and patient satisfaction.
One of the most common types of integrated delivery system is the
physician hospital organization (PHO), which is a separate organization formed
by a hospital and a physician group to provide contracted healthcare services
to managed care plans and, when permitted, directly to employers. The PHO
must provide utilization and quality management, physician credentialing,
claims processing, marketing, and revenue distribution for the system. An-
other common type is the management service organization (MSO), which is a
hospital-based organization that provides physician billing and medical group
management services. Some of the larger integrated systems are a combina-
tion of PHOs, MSOs, and managed care organizations, which can provide all
clinical services as well as the insurance function. Most of these large systems
were developed by hospitals, but others were started by health plans or by
large physician group practices.
In spite of the hypothesized bene¬ts of integration, executives of health-
care systems have found it more dif¬cult than they originally envisioned to
manage large, diverse enterprises. This dif¬culty has been especially true when
hospitals or health systems have acquired physician practices. In many cases,
the ¬nancial and patient care gains predicted were not realized and some of
the integrated delivery systems that were formed in the 1990s have broken
up. Today, it is not clear whether or not large integrated health systems are
better suited for success than are smaller, more-focused organizations. Only
time will tell.
14 Healthcare Finance




Self-Test 1. What are some different types of hospitals, and what trends are
Questions occurring in the hospital industry?
2. What trends are occurring in outpatient and long-term care?
3. What is an integrated delivery system?
4. Do you think that integrated delivery systems will be more or less
prevalent in the future? Explain your answer.


Regulatory and Legal Issues
Entry into the health services industry is heavily regulated. Examples of such
regulation include licensure, certi¬cate of need, rate setting, and review pro-
grams. In addition, legal issues, especially malpractice, are prominent in dis-
cussions of healthcare cost control.
States require licensure of certain healthcare providers in an effort to
protect the health, safety, and welfare of the public. Licensure regulations
establish minimum standards that must be met to provide a service. Many
types of providers are licensed, including whole facilities, such as hospitals
and nursing homes, as well as individuals, such as physicians, dentists, and
nurses. Facilities that are licensed must submit to periodic inspections and
review activities. Such reviews have focused more on physical features and
safety and less on patient care and outcomes, although some progress is being
made in these areas. Thus, licensure has not necessarily ensured that the public
will receive quality services. Critics of licensure contend that it is designed
more to protect providers than to protect consumers. For example, licensed
paramedical professionals are required to work under the supervision of a
physician or dentist, and thus it is impossible for the paramedical professions
to compete with physicians or dentists. Despite the limitations of licensure, it
is probably here to stay.
Certi¬cate of need (CON) legislation was enacted by Congress in 1974
in an effort to control increasing healthcare costs. States were required to
conduct healthcare planning, and a logical extension of this planning was to
require providers to obtain approval based on community need for construc-
tion and renovation projects that either relate to speci¬c services or exceed a
de¬ned cost threshold. This attempt to control capital expenditures by con-
trolling expansion and preventing duplication of services lasted less than a
decade before the Reagan administration began to downplay CON regulation
and to promote cost controls through competition, although CON regulation
still exists in about 75 percent of the states.
Critics of CON regulation argue that it does not provide as much con-
trol over capital expenditures as originally envisioned and it increases health-
care costs by forcing providers to incur additional administrative costs when
new facilities are needed. Perhaps the biggest criticism of CON regulation is
15
Chapter 1: Introduction to Healthcare Finance



that it creates a territorial franchise for services that it covers; that is, it makes
it dif¬cult for new entities to enter markets, even though the new businesses
may be more cost ef¬cient and offer better patient care than the existing ones.
In addition to CON regulation, cost containment programs were en-
acted in many states at the time when most health services reimbursement was
based on costs. By the late 1970s, nine states had mandatory cost containment
programs, and many other states had voluntary programs or programs that did
not mandate compliance. The primary tool for cost containment programs is
the rate review system. Three types of systems have been used: (1) detailed
budget reviews with approval or setting of rates; (2) formula methods, which
use in¬‚ation formulas to set target rates; and (3) negotiated rates involving
joint decision making between the provider and the rate setter. Some states
that use rate review systems have reduced the rate of increase in healthcare
costs below the national average, while others have failed. However, rate re-
view, as a sole means of cost containment, has been criticized because it does
not address the issue of demand for healthcare services.
Healthcare services are subject to many other forms of regulation.
For example, pharmacy services are regulated by state and federal laws, and
radiology services are highly regulated because of the handling and disposal of
radioactive materials. The costs of complying with regulation are not trivial.
The CEO of a 430-bed hospital estimated that the cost of dealing with
regulatory agencies, including third-party payers, is about $8 million annually,
requiring a staff of 140 full-time workers to handle the process.
The primary legal concern of health services providers is professional
liability. Malpractice suits are the oldest forms of quality assurance in the
U.S. healthcare system, and such suits now are used to an extreme extent.
Many people believe that the United States is facing a malpractice insurance
crisis. Total malpractice premiums, which have doubled in the last ten years,
have been passed on to healthcare purchasers. Some specialist physicians pay
malpractice premiums of more than $100,000 per year, and each month
U.S. courts manage approximately 20,000 new malpractice suits, with awards
averaging $300,000 for cases that go to trial. Although providers have been
successful in achieving some tort reforms, malpractice litigation continues to
be perceived as inef¬cient because it diverts resources to lawyers and courts
and creates disincentives for physicians to practice high-risk specialties and for
hospitals to offer high-risk services. In addition, such litigation encourages
the practice of defensive medicine in which physicians overutilize diagnostic
services in an effort to protect themselves.
Although professional liability is the most visible legal concern in health
services, the industry is subject to many other legal issues, including those
typical of other industries such as general liability and antitrust issues. Finally,
healthcare providers are confronted with unique ethical issues such as the right
to die or to prolong life, which are often resolved through the legal system.
16 Healthcare Finance




Self-Test 1. What are some forms of regulation used in the health services industry?
Questions 2. What is the most pressing legal issue facing healthcare providers today?


Organization of the Book
In Alice in Wonderland, Lewis Carroll wrote: “Any road will do if you don™t
know where you are going.” Because not just any road will ensure that this
book meets its goals, the destination has been carefully charted: to provide
an introduction to healthcare ¬nance. Furthermore, the book is organized to
best pave the road to this destination.
Part I (The Healthcare Environment) contains fundamental back-
ground materials essential to the practice of healthcare ¬nance. Chapter 1
introduces the book, while Chapter 2 provides additional insights into the
uniqueness of the health services industry. Healthcare ¬nance cannot be stud-
ied in a vacuum because the practice of ¬nance is profoundly in¬‚uenced by the
economic and social environment of the industry, including alternative types
of ownership, taxes, and reimbursement methods.
Part II (Financial Accounting) begins the actual discussion of health-
care ¬nance principles and practices. Financial accounting, which involves the
creation of statements that summarize a business™s ¬nancial status, is most
useful for managing at the organizational (aggregate) level. In Chapter 3, ¬-
nancial accounting concepts and the income statement are discussed, while in
Chapter 4 the balance sheet and statement of cash ¬‚ows are reviewed.
Part III (Managerial Accounting), which consists of Chapters 5 through
8, focuses on the creation of data used in the day-to-day management and
control of a business. Here, the focus changes from the aggregate organization
to sub-unit (department) level management. The key topics in Part III include
cost behavior, pro¬t planning, cost allocation, pricing and service decisions,
and planning and budgeting.
In Part IV (Basic Financial Analysis Concepts), the focus moves from
accounting to ¬nancial management. Chapter 9 covers time value analysis,
which provides techniques for valuing future cash ¬‚ows, and Chapter 10
presents ¬nancial risk and required return”two of the most important con-
cepts in ¬nancial decision making.
Part V (Long-Term Financing) turns to the capital acquisition process.
Businesses need capital, or funds, to purchase assets, and in Chapters 11
and 12 the two primary types of ¬nancing”long-term debt and equity”
are examined. These chapters not only provide descriptive information about
securities and the markets in which they are traded but also discuss security
valuation. Chapter 13 provides the framework for analyzing the appropriate
mix of capital ¬nancing and assessing its cost to the business.
In Part VI (Capital Investment Decisions), the vital topic of how busi-
nesses analyze new capital investment opportunities (or capital budgeting)
17
Chapter 1: Introduction to Healthcare Finance



is considered. Because major capital projects take years to plan and execute,
and because these decisions generally are not easily reversed and will affect
operations for many years, their impact on the future of an organization is
profound. Chapter 14 focuses on basic concepts, while Chapter 15 discusses
risk assessment and incorporation.
Part VII contains three chapters. In Chapter 16, the management of
short-term assets is reviewed, including cash, receivables, and inventories as
well as how such assets are ¬nanced. The techniques used to analyze a busi-
ness™s ¬nancial and operating condition are discussed in Chapter 17. Health
services managers must be able to assess the current ¬nancial condition of their
organizations. Even more important, managers must be able to monitor and
control current operations and to assess ways in which alternative courses of
action will affect the organization™s future ¬nancial condition. Finally, Chapter
18 covers two unrelated topics: lease ¬nancing and business valuation.



Self-Test
1. Brie¬‚y, what is the organization of this book?
Question

How to Use This Book
As mentioned earlier, the overriding goal in creating this book is to provide
an easy-to-read, content-¬lled introductory text on healthcare ¬nance. This
book contains several features designed to assist in learning the material.
First, pay particular attention to the LEARNING OBJECTIVES listed
at the beginning of each chapter. These objectives provide a feel for the most
important topics in each chapter and what readers should set as learning
goals for that chapter. After each major section, except the Introduction, one
or more SELF-TEST QUESTIONS are included. As you ¬nish reading each
major section, try to provide reasonable answers to these questions. Your
responses do not have to be perfect, but if you are not satis¬ed with your
answer, it would be best to reread the section before proceeding. Answers are
not provided for the self-test questions, so a review of the section is indicated
if you are in doubt whether or not your answer is satisfactory.
Within the book, italics and boldface are used to indicate importance.
Italics are used whenever a key term is introduced; thus, italics alert readers
that a new and important concept is being presented. Boldface is solely used
for emphasis; thus, the meaning of a boldfaced word or phrase has unusual
signi¬cance to the point under discussion.
In addition to in-chapter learning aids, materials designed to help read-
ers learn healthcare ¬nance are included at the end of each chapter. First, each
chapter ends with a summary section titled KEY CONCEPTS, which very
brie¬‚y summarizes the most important principles and practices covered in that
chapter. If the meaning of a key concept is not apparent, you may ¬nd it useful
18 Healthcare Finance



to review the applicable section. Each chapter also contains a series of QUES-
TIONS designed to assess your understanding of the qualitative material in
the chapter. The questions are followed by a set of PROBLEMS designed to
assess your understanding of the quantitative material.
Finally, each chapter ends with a set of REFERENCES. The books and
articles cited here can provide a more in-depth understanding of the material
covered in the chapter. Taken together, the pedagogic structure of the book
is designed to make the learning of healthcare ¬nance as easy and enjoyable
as possible.


Key Concepts
This chapter provided an introduction to healthcare ¬nance. The key
concepts of this chapter are:
• The term healthcare ¬nance, as it is used in this book, means the
accounting and ¬nancial management principles and practices used within
health services organizations to ensure the ¬nancial well-being of the
enterprise.
• The primary role of ¬nance in health services organizations, as in all
businesses, is to plan for, acquire, and utilize resources to maximize the
ef¬ciency and value of the enterprise.
• Finance activities generally include the following: (1) planning and
budgeting, (2) ¬nancial reporting, (3) capital investment decisions,
(4) ¬nancing decisions, (5) working capital management, (6) contract
management, and (7) ¬nancial risk management.
• All business decisions have ¬nancial implications, so all managers”
whether in operations, marketing, personnel, or facilities”must know
enough about ¬nance to incorporate its implications into their own
specialized decision processes.
• Healthcare services are provided in numerous settings, including hospitals,
ambulatory care facilities, long-term care facilities, and even at home.
• Hospitals differ in function (general acute care versus specialty), patient
length of stay, size, and ownership (governmental versus private and,
within the private sector, for-pro¬t versus not-for-pro¬t ).
• Ambulatory care, also known as outpatient care, encompasses services
provided to noninstitutionalized patients. Outpatient settings include
medical practices, hospital outpatient departments, ambulatory surgery
centers, urgent care centers, diagnostic imaging centers,
rehabilitation/sports medicine centers, and clinical laboratories.
• Home health care brings many of the same services provided in ambulatory
care settings into the patient™s home.
• Long-term care entails healthcare services that cover an extended period of
time, including inpatient, outpatient, and home health care, often with a
focus on mental health, rehabilitation, or nursing home care.
19
Chapter 1: Introduction to Healthcare Finance



• The de¬ning characteristic of an integrated delivery system is that the
organization assumes full clinical, and in certain cases ¬nancial,
responsibility for the healthcare needs of the covered population.
• Entry into the health services industry has been heavily regulated.
Examples of regulation include licensure, certi¬cate of need, and rate
setting and review programs.
• Legal issues, such as malpractice, are prominent in discussions about
controlling healthcare costs.

In the next chapter, the discussion of the healthcare environment is contin-
ued, moving to more ¬nance-related topics such as forms of organization,
reimbursement, and taxes.


Questions
1.1 a. What are some of the industries in the healthcare sector?
b. What is meant by the term healthcare ¬nance as used in this book?
c. What are the two broad areas of healthcare ¬nance?
d. Why is it necessary to have a book on healthcare ¬nance as opposed
to a generic ¬nance book?
1.2 a. Brie¬‚y discuss the role of ¬nance in the health services industry.
b. Has this role increased or decreased in importance in recent years?
1.3 a. Brie¬‚y describe the following health services settings:
• Hospitals
• Ambulatory care
• Home health care
• Long-term care
• Integrated delivery systems
b. What are the bene¬ts attributed to integrated delivery systems?
1.4 What role does regulation play in the health services industry?
1.5 What is the primary legal issue facing providers today?
1.6 Describe the organization of the book and the learning tools embedded
in each chapter.


Note
1. Tertiary care is highly specialized and technical in nature for patients with
unusually severe, complex, or uncommon problems.


References
For a general introduction to the healthcare system in the United States, see
Barton, P. L. 2003. Understanding the U.S. Health Services System. Chicago: Health
Administration Press.
20 Healthcare Finance



Lee, P. R., and C. L. Estes. 2003. The Nation™s Health. Sudbury, MA: Jones and
Bartlett.
Long, M. J. 1998. Health and Healthcare in the United States. Chicago: Health
Administration Press.
Williams, S. J., and P. R. Torrens. 2002. Introduction to Health Services. Albany, NY:
Delmar Publishers.

For the latest information on events that affect health services organizations, see
Medical Bene¬ts, published semimonthly by Kelly Communications, Inc., Charlottes-
ville, VA.

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