. 2
( 21)


Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

For ideas on the future of healthcare in the United States, see
Goldsmith, J. 2000. “How Will the Internet Change Our Health Care System.”
Health Affairs (January/February): 148“156.
Kajander, J., and M. Samuels. 1996. “Future Trends in the Health Care Economy.”
Journal of Health Care Finance (Fall): 17“22.
Morrison, I. 1999. Health Care in the New Millennium. New York: Joseph Wiley &
National Coalition on Health Care. 1997. “How Americans Perceive the Health Care
System: A Report on a National Survey.” Journal of Health Care Finance
(Summer): 12“20.
Nauert, R. C. 2000. “The New Millennium: Health Care Evolution in the 21st
Century.” Journal of Health Care Finance (Spring): 1“14.
Sullivan, J. M. 1992. “Health Care Reform: Towards a Healthier Society.” Hospital
& Health Services Administration (Winter): 519“532.
Taylor, R., and L. Lessin. 1996. “Restructuring the Health Care Delivery System in
the United States.” Journal of Health Care Finance (Summer): 33“60.


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

• Describe the alternative forms of business organization and
• Explain why taxes are important to healthcare ¬nance.
• Brie¬‚y describe the third-party-payer system.
• Explain the different types of payment methods used by payers.
• Describe the incentives created by the different payment methods
and their impact on provider risk.

Fortunately, most of the basic concepts of healthcare ¬nance are independent
of the speci¬c industry and organizational setting. However, some aspects of
healthcare ¬nance are in¬‚uenced by industry setting, while the unique owner-
ship structure of healthcare providers in¬‚uences speci¬c applications of ¬nance
concepts. In this chapter, some background material is presented that creates
the context in which ¬nance is practiced in health services organizations.
The fact that many healthcare businesses are organized as not-for-pro¬t
corporations has a signi¬cant impact on the practice of ¬nance. Thus, the
chapter begins with a discussion of alternative forms of business organization
and ownership. Because ownership affects taxes, tax laws also are brie¬‚y in-
troduced. The chapter ends with a discussion of third-party payers and the
reimbursement methods that they use.

Alternative Forms of Business Organization
Throughout the book, the focus is on business ¬nance”that is, the prac-
tice of accounting and ¬nancial management within business organizations.
There are three primary forms of business organization: proprietorship, part-
nership, and corporation. In addition, there are several hybrid forms. Because
most health services managers work for corporations and because not-for-
pro¬t businesses are organized as corporations, this form of organization is
emphasized. However, many individual medical practices are organized as
22 Healthcare Finance

proprietorships, and partnerships are common in group practices and joint
ventures, so health services managers must be familiar with all forms of busi-
ness organization.

Proprietorships and Partnerships
A proprietorship, sometimes called a sole proprietorship, is a business owned by
one individual. Going into business as a proprietor is easy”the owner merely
begins business operations. However, most cities require even the smallest
businesses to be licensed, and state licensure is required for most healthcare
The proprietorship form of organization is easily and inexpensively
formed, is subject to few governmental regulations, and pays no corporate
income taxes. All earnings of the business, whether reinvested in the business
or withdrawn by the owner, are taxed as personal income to the proprietor.
In general, a sole proprietorship will pay lower total taxes than a comparable,
taxable corporation because corporate pro¬ts are taxed twice”once at the
corporate level and again by stockholders at the personal level when pro¬ts
are distributed as dividends or when capital gains are realized.
A partnership is formed when two or more persons associate to con-
duct a non-incorporated business. Partnerships may operate under different
degrees of formality, ranging from informal oral understandings to formal
agreements ¬led with the state in which the partnership does business. Like a
proprietorship, the major advantage of the partnership form of organization
is its low cost and ease of formation. In addition, the tax treatment of a part-
nership is similar to that of a proprietorship: the partnership™s earnings are
allocated to the partners and taxed as personal income regardless of whether
the earnings are actually paid out to the partners or retained in the business.1
Proprietorships and partnerships have several disadvantages, including
the following:

• Selling their interest in the business is dif¬cult for owners.
• The owners have unlimited personal liability for the debts of the
business, which can result in losses greater than the amount
invested in the business. In a proprietorship, unlimited liability
means that the owner is personally responsible for the debts of the
business. In a partnership, it means that if any partner is unable to
meet his or her pro rata obligation in the event of bankruptcy, the
remaining partners are responsible for the unsatis¬ed claims and
must draw on their personal assets if necessary.
• The life of the business is limited to the life of the owners.

For these reasons, proprietorships and most partnerships are restricted to small
Chapter 2: The Financial Environment

The three disadvantages listed above lead to the fourth, and perhaps
the most important, disadvantage from a ¬nance perspective: the dif¬culty
that proprietorships and partnerships have in attracting substantial amounts
of capital. This is no particular problem for a very small business or when
the owners are very wealthy, but the dif¬culty of attracting capital becomes
a real handicap if the business needs to grow substantially to take advantage
of market opportunities. Thus, many companies start out as sole proprietor-
ships or partnerships but then ultimately convert to the corporate form of

A corporation is a legal entity that is separate and distinct from its owners
and managers. The creation of a separate business entity gives these primary

• A corporation has unlimited life and can continue in existence after
its original owners and managers have died or left the company.
• It is easy to transfer ownership in a corporation because ownership
is divided into shares of stock that can be easily sold.
• Owners of a corporation have limited liability.

To illustrate limited liability, suppose that an individual made an invest-
ment of $10,000 in a partnership that subsequently went bankrupt, owing
$100,000. Because the partners are liable for the debts of the partnership,
that partner could be assessed for a share of the partnership™s debt in addition
to the loss of his or her initial $10,000 contribution. In fact, if the other part-
ners were unable to pay their shares of the indebtedness, one partner would
be held liable for the entire $100,000. However, if the $10,000 had been in-
vested in a corporation that went bankrupt, the potential loss for the investor
would be limited to the $10,000 investment. (However, in the case of small,
¬nancially weak corporations, the limited liability feature of ownership is often
¬ctitious because bankers and other lenders will require personal guarantees
from the stockholders.) With these three factors”unlimited life, ease of own-
ership transfer, and limited liability”corporations can more easily raise money
in the ¬nancial markets than sole proprietorships or partnerships can.3
The corporate form of organization has two primary disadvantages.
First, corporate earnings of taxable entities are subject to double taxation”
once at the corporate level and then again at the personal level, when divi-
dends are paid to stockholders or capital gains are realized. Second, setting
up a corporation, and then ¬ling the required periodic state and federal re-
ports, is more costly and time consuming than what is required to establish a
proprietorship or partnership.
Although a proprietorship or partnership can begin operations without
much legal paperwork, setting up a corporation requires that the founders,
24 Healthcare Finance

or their attorney, prepare a charter and a set of bylaws. Today, attorneys have
standard forms for charters and bylaws on their computers, so they can set up a
“no frills” corporation with modest effort. However, setting up a corporation
remains relatively dif¬cult when compared to a proprietorship or partnership,
and it is still more dif¬cult if the corporation has nonstandard features.
The corporate charter includes the name of the business, its proposed
activities, the amount of stock to be issued (if investor owned), and the num-
ber and names of the initial set of directors. The charter is ¬led with the appro-
priate of¬cial of the state in which the business will be incorporated, and, when
approved, the corporation is of¬cially in existence.4 After the corporation has
been of¬cially formed, it must ¬le quarterly and annual reports with various
governmental agencies.
The bylaws are a set of rules drawn up by the founders to provide
guidance for the governing and internal management of the corporation.
Bylaws include features such as: how directors are to be elected, whether
existing shareholders have the ¬rst right to buy any new shares that the ¬rm
issues, and the procedures for changing the charter or bylaws.
The value of any investor-owned business, other than a very small one,
generally will be maximized if it is organized as a corporation for the following

• Limited liability reduces the risks borne by equity investors (the
owners); with all else the same, the lower the risk, the higher the
value of the investment.
• A business™s value is dependent on growth opportunities, which in
turn are dependent on the business™s ability to attract capital.
Because corporations can obtain capital more easily than other
forms of business can, they are better able to take advantage of
growth opportunities.
• The value of any investment depends on its liquidity, which means
the ease at which it can be sold for a fair price. Because an equity
investment in a corporation is much more liquid than a similar
investment in a proprietorship or partnership, the corporate form of
organization creates more value for its owners.

Hybrid Forms of Organization
Although the three basic forms of organization”proprietorship, partnership,
and corporation”dominate the overall business scene, several hybrid forms
of organization also are used by businesses. Some of these forms are found in
the health services industry.
Several specialized types of partnerships have characteristics somewhat
different than a standard form of partnership. First, limiting some of the
partners™ liabilities is possible by establishing a limited partnership, wherein
Chapter 2: The Financial Environment

certain partners are designated general partners and others limited partners.
The limited partners, like the owners of a corporation, are liable only for
the amount of their initial investment in the partnership, while the general
partners have unlimited liability. However, the limited partners typically have
no control, which rests solely with the general partners. Limited partnerships
are quite common in real estate and mineral investments; they are not as
common in the health services industry because ¬nding one partner that is
willing to accept all of the business™s risk and a second partner that is willing
to relinquish control is dif¬cult.
The limited liability partnership (LLP) is a relatively new type of part-
nership that is available in many states. In a limited liability partnership, the
partners have joint liability for all actions of the partnership, including per-
sonal injuries and indebtedness. However, all partners enjoy limited liability
regarding professional malpractice because partners are only liable for their
own individual malpractice actions, not those of the other partners. In spite
of limited malpractice liability, the partners are jointly liable for the partner-
ship™s debts.
The limited liability company (LLC) is another new type of business
organization. It has some characteristics of both a partnership and a corpora-
tion. The owners of a LLC are called members, and they are taxed as if they
are partners in a partnership. However, a member™s liability is like that of a
stockholder of a corporation because liability is limited to the member™s initial
contribution in the business. Personal assets are only at risk if the member as-
sumes speci¬c liability such as by signing a personal loan guarantee. Both the
LLP and LLC are new and complex forms of organizations, so setting them
up can be time consuming and costly.
The professional corporation (PC), which is called a professional associ-
ation (PA) in some states, is a form of organization that is common among
physicians and other individual and group practice healthcare professionals. All
50 states have statutes that prescribe the requirements for such organizations,
which provide the usual bene¬ts of incorporation, but do not relieve the par-
ticipants of professional liability. Indeed, the primary motivation behind the
professional corporation, which is a relatively old business form compared to
the LLP and LLC, was to provide a way for professionals to incorporate yet
still be held liable for professional malpractice.
For tax purposes, standard for-pro¬t corporations are called C corpo-
rations. If certain requirements are met, either one or a few individuals can
incorporate but, for tax purposes only, elect to be treated as if the business
were a proprietorship or partnership. Such corporations, which differ only in
how the owners are taxed, are called S corporations. Although S corporations
are similar to LLPs and LLCs regarding taxes, LLPs and LLCs provide more
¬‚exibility and bene¬ts to owners. Many businesses, especially group practices,
are therefore converting to the newer forms.
26 Healthcare Finance

Self-Test 1. What are the three primary forms of business organization, and how do
Questions they differ?
2. What are some different types of partnerships?
3. What are some different types of corporations?

Alternative Forms of Ownership
Unlike other sectors in the economy, not-for-pro¬t corporations play a major
role in the healthcare sector, especially among providers. As we discussed
in Chapter 1, about 60 percent of the hospitals in the United States are
private not-for-pro¬t hospitals. Only 15 percent of all hospitals are investor
owned; the remaining 25 percent are governmental. Furthermore, not-for-
pro¬t ownership is common in the nursing home, home health care, and
managed care industries.

Investor-Owned Corporations
When the average person thinks of a corporation, he or she probably thinks
of an investor-owned, or for-pro¬t, corporation. Larger businesses (e.g., Ford,
IBM, and General Electric) are investor-owned corporations.
Investors become owners of such businesses by buying shares of com-
mon stock in the company. Investors may buy common stock when it is put
up for sale by a company in what is called a primary market transaction. In
such a transaction, the funds raised from the sale go to the corporation.5 After
the shares have been sold by the corporation, they are traded in the secondary
market. These sales typically take place on exchanges, such as the New York
Stock Exchange (NYSE) and the American Stock Exchange (AMEX), or in
the over-the-counter (OTC) market, which is composed of a large number of
dealer/brokers connected by a sophisticated electronic trading system.6 When
shares are bought and sold in the secondary market, the corporations whose
stocks are traded receive no funds from the trades (corporations receive funds
only when shares are ¬rst sold to investors).
Investor-owned corporations may be either publicly held or privately
held. The shares of publicly held companies are owned by a large number of
investors and are widely traded. For example, HCA, which owns and operates
roughly 180 hospitals and has about 500 million shares outstanding, is owned
by some 50,000 individual and institutional stockholders. Another example is
Beverly Enterprises, which owns and operates about 775 nursing homes and
has over 100 million shares outstanding owned by about 8,000 stockholders.
Drug companies such as Merck and P¬zer, and medical equipment manufac-
turers such as St. Jude Medical, which makes heart valves, are all publicly held
Conversely, the shares of privately held (also called closely held) com-
panies are owned by just a handful of investors and are not publicly traded.
Chapter 2: The Financial Environment

In general, the managers of privately held companies are major stockholders.
In regards to ownership and control, therefore, privately held companies are
more similar to partnerships than to publicly held companies. Often, the pri-
vately held corporation is a transitional form of organization that exists for
a short time between a proprietorship or partnership and a publicly owned
corporation in which the motivation to sell shares to the public is driven by
capital needs.
The stockholders (also called shareholders ) are the owners of investor-
owned companies. As owners, they have these basic rights:

• The right of control. Common stockholders have the right
to vote for the corporation™s board of directors, which oversees the
management of the company. Each year, a company™s stockholders
receive a proxy ballot, which they use to vote for directors and to vote
on other issues that are proposed by management or stockholders.
In this way, stockholders exercise control. In the voting process,
stockholders cast one vote for each common share held.
• A claim on the residual earnings of the ¬rm. A corporation sells
products or services and realizes revenues from the sales. To
produce these revenues, the corporation must incur expenses for
materials, labor, insurance, debt capital, and so on. Any excess of
revenues over expenses”the residual earnings ”belong to the
shareholders of the business. Often, a portion of these earnings are
paid out in the form of dividends, which are merely cash payments
to stockholders, or stock repurchases, in which the company buys
back shares held by stockholders. However, management typically
elects to reinvest some (or all) of the residual earnings in the
business, which presumably will produce even higher payouts to
stockholders in the future.
• A claim on liquidation proceeds. In the event of bankruptcy and
liquidation, shareholders are entitled to any proceeds that remain
after all other claimants have been satis¬ed.

In summary, there are three key features of investor-owned corpora-
tions. First, the owners (the stockholders) of the business are well de¬ned
and they exercise control of the ¬rm by voting for directors. Second, the
residual earnings of the business belong to the owners, so management is
responsible only to the stockholders for the pro¬tability of the ¬rm. Finally,
investor-owned corporations are subject to taxation at the local, state, and
federal levels.

Not-For-Pro¬t Corporations
If an organization meets a set of stringent requirements, it can qualify
for incorporation as a tax-exempt, or not-for-pro¬t, corporation. Tax-exempt
28 Healthcare Finance

corporations are sometimes called nonpro¬t corporations. Because nonpro¬t
businesses (as opposed to pure charities) need pro¬ts to sustain operations,
and because it is hard to explain why nonpro¬t corporations should earn
pro¬ts, the term “not-for-pro¬t” is more descriptive of such health services
Tax-exempt status is granted to businesses that meet the tax de¬ni-
tion of a charitable corporation as de¬ned by Internal Revenue Service (IRS)
Tax Code Section 501(c)(3) or (4). Hence, such corporations are also known
as 501(c)(3) or (4) corporations.7 The tax code de¬nes a charitable organiza-
tion as “ . . . any corporation, community chest, fund, or foundation that is
organized and operated exclusively for religious, charitable, scienti¬c, public
safety, literary, or educational purposes.” Because the promotion of health is
commonly considered a charitable activity, a corporation that provides health-
care services can qualify for tax-exempt status, provided that it meets other
In addition to the charitable purpose, a not-for-pro¬t corporation must
be organized and operated so that it operates exclusively for the public, rather
than private, interest. Thus, no pro¬ts can be used for private gain and no
direct political activity can be conducted. Also, if the corporation is liquidated
or sold to an investor-owned business, the proceeds from the liquidation or
sale must be used for a charitable purpose. Because individuals cannot bene¬t
from the pro¬ts of not-for-pro¬t corporations, such organizations cannot pay
dividends. However, prohibition of private gain from pro¬ts does not prevent
parties, such as managers and physicians, from bene¬ting through salaries,
perquisites, contracts, and so on.
Not-for-pro¬t corporations differ signi¬cantly from investor-owned
corporations. Because not-for-pro¬t ¬rms have no shareholders, no single
body of individuals has ownership rights to the ¬rm™s residual earnings or
exercises control of the ¬rm. Rather, control is exercised by a board of trustees
that is not constrained by outside oversight. Also, not-for-pro¬t corporations
are generally exempt from taxation, including both property and income taxes,
and have the right to issue tax-exempt debt (municipal bonds). Finally, indi-
vidual contributions to not-for-pro¬t organizations can be deducted from tax-
able income by the donor, so not-for-pro¬t ¬rms have access to tax-subsidized
contribution capital. (The tax bene¬ts enjoyed by not-for-pro¬t corporations
are reviewed in a later section on tax laws.)
The ¬nancial problems facing most federal, state, and local govern-
ments have caused politicians to take a closer look at the tax subsidies provided
to not-for-pro¬t hospitals. For example, several bills have been introduced at
the national and state levels that require hospitals to provide speci¬ed amounts
of charity care to retain tax-exempt status. For example, Texas has established
minimum requirements for charity care, which in effect hold not-for-pro¬t
hospitals accountable to the public for the tax exemptions they receive. The
Texas law speci¬es four tests, and each hospital must meet at least one of them.
Chapter 2: The Financial Environment

The test that most hospitals use to comply with the law requires that at least
4 percent of net patient service revenue be used for charity care.
Finally, money-starved municipalities in several states have attacked the
property tax exemption of not-for-pro¬t hospitals that have “neglected” their
charitable missions. For example, tax assessors are ¬ghting to remove property
tax exemptions from not-for-pro¬t hospitals in several Pennsylvania cities after
a recent appellate court ruling supported a school district™s authority to tax a
local hospital that had strayed too far from its charitable purpose. According
to one estimate, if all not-for-pro¬t hospitals had to pay taxes comparable
to their investor-owned counterparts, local, state, and federal governments
would garner an additional $3.5 billion in tax revenues. This explains why tax
authorities in many jurisdictions view not-for-pro¬t hospitals as a potential
source of revenue.
The inherent differences between investor-owned and not-for-pro¬t
organizations have profound implications for many aspects of healthcare ¬-
nance, including organizational goals, ¬nancing decisions (i.e., the choice be-
tween debt and equity ¬nancing and the speci¬c types of securities to issue),
and capital investment decisions. How ownership affects the application of
healthcare ¬nance concepts will be addressed throughout the book.

1. What are the major differences between investor-owned and not-for-
pro¬t corporations?
2. What pressures recently have been placed on not-for-pro¬t hospitals to
ensure that they meet their charitable mission?

Organizational Goals
Financial decisions are not made in a vacuum but with some objective in
mind. Finance goals within an organization clearly must be consistent with,
as well as support, the overall goals of the business. Thus, by discussing
organizational goals, a framework for ¬nancial decision making within health
services organizations is established.

Small Business
In a proprietorship, partnership, or small privately owned corporation, the
owners of the business generally are also its managers. In theory, the business
can be operated for the exclusive bene¬t of the owners. If the owners want
to work very hard to maximize wealth, they can. On the other hand, if every
Wednesday is devoted to golf, no one is hurt by such actions. (Of course, the
business still has to satisfy its customers or else it will not survive.) It is in
large, publicly held corporations, in which owners and managers are separate
parties, that organizational goals become very important to ¬nance.
30 Healthcare Finance

Publicly Held Corporations
From a ¬nance perspective, the primary goal of large investor-owned corpora-
tions is generally assumed to be shareholder wealth maximization, which trans-
lates to stock price maximization. Investor-owned corporations do, of course,
have other goals. Managers, who make the actual decisions, are interested in
their own personal welfare, in their employees™ welfare, and in the good of the
community and of society at large. Still, the goal of stock price maximization is
a reasonable operating objective upon which to build ¬nancial decision rules.
The primary obstacle to shareholder wealth maximization as the goal
of investor-owned corporations is the agency problem. An agency problem
exists when one or more individuals (the principals ) hire another individual or
group of individuals (the agents ) to perform a service on their behalf and then
delegate decision-making authority to those agents. Such a problem occurs
between stockholders and managers of large investor-owned corporations
because the managers typically hold only a very small proportion of the ¬rm™s
stock, and hence they bene¬t relatively little from stock price increases. On
the other hand, managers bene¬t substantially from such actions as increasing
the size of the ¬rm to justify higher salaries and more fringe bene¬ts; awarding
themselves generous retirement plans; and spending too much on of¬ce space,
personal staff, and travel”actions often detrimental to shareholders™ wealth.
Clearly, many situations can arise in which managers are motivated to take
actions that are in their best interests rather than in the best interests of
Shareholders recognize the agency problem and counter it by creating
compensation incentives, such as stock options and performance-based bonus
plans, that encourage managers to act in shareholders™ interests. Additionally,
other factors, such as the threat of takeover or removal, are at work to keep
managers focused on shareholder wealth maximization.
Clearly, managers of investor-owned corporations can have motivations
that are inconsistent with shareholder wealth maximization. Still, suf¬cient
incentives and sanctions are in place to force managers to view shareholder
wealth maximization as their primary goal. Thus, shareholder wealth maxi-
mization is a reasonable goal for ¬nancial decision making within investor-
owned corporations.

Not-For-Pro¬t Corporations
Not-for-pro¬t corporations consist of a number of classes of stakeholders,
which include all parties that have an interest, usually of a ¬nancial nature, in
the organization. For example, a not-for-pro¬t hospital™s stakeholders include
the board of trustees, managers, employees, physicians, creditors, suppliers,
patients, and even potential patients, which may include the entire community.
An investor-owned hospital has the same set of stakeholders plus stockholders,
who dictate the goal of shareholder wealth maximization. While managers of
Chapter 2: The Financial Environment

investor-owned companies have to please primarily one class of stakeholders”
the shareholders”to keep their jobs, managers of not-for-pro¬t ¬rms face
a different situation. They have to try to please all of the organization™s
stakeholders because no single well-de¬ned group exercises control.
Many people argue that managers of not-for-pro¬t corporations do
not have to please anyone at all because they tend to dominate the board of
trustees who are supposed to exercise oversight. Others argue that managers
of not-for-pro¬t ¬rms have to please all of the ¬rm™s stakeholders to a greater
or lesser extent because all are necessary to the successful performance of
the business. Of course, even managers of investor-owned ¬rms should not
attempt to enhance shareholder wealth by treating any other stakeholders
unfairly because such actions ultimately will be detrimental to shareholders.
Typically, the goal of not-for-pro¬t corporations is stated in terms of
a mission statement. For example, here is the current mission statement of
Riverside Memorial Hospital, a 450-bed, not-for-pro¬t acute care hospital:
“Riverside Memorial Hospital, along with its medical staff, is a
recognized, innovative healthcare leader dedicated to meeting the
needs of the community. We strive to be the best comprehensive
healthcare provider through our commitment to excellence.”
Although this mission statement provides Riverside™s managers and employees
with a framework for developing speci¬c goals and objectives, it does not
provide much insight into the goal of the hospital™s ¬nance function. For
Riverside to accomplish its mission, its managers have identi¬ed the following
¬ve ¬nancial goals:

1. The hospital must maintain its ¬nancial viability.
2. The hospital must generate suf¬cient pro¬ts to continue to provide
the current range of healthcare services to the community. This means
that current buildings and equipment must be replaced as they become
3. The hospital must generate suf¬cient pro¬ts to invest in new medical
technologies and services as they are developed and needed.
4. Although the hospital has an aggressive philanthropy program in place, it
does not want to rely on this program or government grants to fund its
5. The hospital will strive to provide services to the community as
inexpensively as possible, given the above ¬nancial requirements.

In effect, Riverside™s managers are saying that to achieve the hospital™s
commitment to excellence as stated in its mission statement, the hospital must
remain ¬nancially strong and pro¬table. Financially weak organizations can-
not continue to accomplish their stated missions over the long run. What is
interesting is that Riverside™s ¬ve ¬nancial goals are probably not much differ-
ent from the ¬nance goals of Jefferson Regional Medical Center (JRMC), a
32 Healthcare Finance

for-pro¬t competitor. Of course, JRMC has to worry about providing a return
to its shareholders, and it receives only a very small amount of contributions
and grants. However, to maximize shareholder wealth, JRMC also must re-
tain its ¬nancial viability and have the ¬nancial resources necessary to offer
new services and technologies. Furthermore, competition in the market for
hospital services will not permit JRMC to charge appreciably more for services
than its not-for-pro¬t competitors.

Self-Test 1. What is the difference in goals between investor-owned and not-for-
Questions pro¬t businesses?
2. What is the agency problem, and how does it apply to investor-owned
3. What factors tend to reduce the agency problem?

Tax Laws
The value of any investment”whether the investment is a stock, a bond, or
an entire business”depends on the usable cash ¬‚ows that the investment
is expected to provide to the owner. Because taxes affect usable cash ¬‚ows,
both individuals and managers of for-pro¬t businesses must be concerned
about taxes.
Tax laws are very complicated and are constantly changing. Conse-
quently, covering even the most basic features of our tax laws in an introduc-
tory ¬nance book is impossible. However, what is important is to recognize
that individuals must pay personal (individual) taxes to federal and state (in
most states) authorities that can approach 50 percent of income. Thus, in-
come from proprietorships and partnerships, as well as dividends and capital
gains on stock investments, will be reduced when personal taxes are taken into
To illustrate the effect of personal taxes, assume that an individual™s tax
rate is 35 percent and he or she receives $100 in partnership income. Using
the letter T to represent tax rate, that person must pay T — $100 = 0.35 —
$100 = $35 in taxes on the income, which leaves him or her with only $100
’ $35 = $65 on an after-tax basis. This tax analysis leads to the following
useful equation:

AT = BT ’ (T — BT)
= BT — (1 ’ T),
where AT = after-tax and BT = before-tax. Thus, the after-tax income amount
to the investor is AT = BT — (1 ’ T) = $100 — (1 ’ 0.35) = $100 — 0.65 =
$65. (This equation can be applied to interest rates as well as dollar amounts.
Chapter 2: The Financial Environment

See Problem 2.3 as an example.) Clearly, taxes will in¬‚uence investment deci-
sions, so any differential tax implications on investment alternatives must be
considered in the decision process.
In addition to personal taxes paid by individuals, investor-owned (for-
pro¬t) corporations must pay both federal and state corporate taxes, which
can exceed 40 percent of the corporation™s taxable income. Corporate taxes
are paid on earnings before dividends are distributed, so corporate income
is subject to double taxation”once at the corporate level and again when
stockholders receive dividends or capital gains.
Not-for-pro¬t corporations, for the most part, are not subject to in-
come or property taxes. In addition, such organizations bene¬t from being
able to issue (take on) debt with interest payments that are exempt from per-
sonal taxes. To illustrate the advantage of being able to issue tax-exempt debt,
¬rst consider the bonds issued by Jefferson Regional Medical Center (JRMC),
an investor-owned hospital. Its debt carries an interest rate of 10 percent, so
bond investors receive 0.10 — $100 = $10 in annual interest for every $100
worth of bonds that they own. For a bond investor that pays 40 percent in
federal and state income taxes, each $10 of interest provides the investor with
AT = BT — (1 ’ T) = $10 — (1 ’ 0.40) = $6 of after-tax interest. However,
if the bonds had been issued by Riverside Memorial Hospital, a not-for-pro¬t
corporation, the investor would have to pay no taxes on the interest and hence
would keep the entire $10. If investors truly require a $6 after-tax return,
Riverside can issue debt with an interest rate of only 6 percent and, with all
else the same, investors in the 40 percent tax bracket would be as willing to
buy these bonds as they are the JRMC 10 percent bonds. Thus, the interest
rate that Riverside must set on its debt issues to sell them to investors is lower
than the rate that JRMC must set because of the tax exemption on debt issued
by not-for-pro¬t corporations.
Finally, contributions that individuals make to not-for-pro¬t corpora-
tions are tax deductible to the donor. If John Brooks is in the 40 percent tax
bracket and he donates $1,000 to Riverside Memorial Hospital, his taxable
income would be reduced by $1,000. A reduction in taxable income of this
amount would save John T — $1,000 = 0.40 — $1,000 = $400 in taxes.
Thus, the effective cost of his contribution would only be $600. In effect,
the government will pay John 40 cents for every dollar he contributes. Thus,
not-for-pro¬t corporations have access to a source of ¬nancing that, for all
practical purposes, is not available to investor-owned businesses.
Because of the impact that taxes have on usable earnings of investor-
owned businesses and because not-for-pro¬t ownership has important tax
consequences, tax implications are highlighted and explained as necessary
throughout the book. Still, what is most important now is to recognize that
taxes will play a critical role in many topics to be discussed.
34 Healthcare Finance

Self-Test 1. Why does a ¬nance book have to consider taxes?
Questions 2. Why is the ability to issue tax-exempt debt an advantage for not-for-
pro¬t corporations?
3. What advantage accrues to businesses that qualify for tax-exempt

Third-Party Payers
Up to this point in the chapter, basic concepts about the form and ownership
of healthcare businesses have been considered. A large proportion of the
health services industry receives its revenues not directly from the users of their
services”the patients”but from insurers known collectively as third-party
payers. Because an organization™s revenues are key to its ¬nancial viability,
this section contains a brief examination of the sources of most revenues in
the health services industry. In the next section, the types of reimbursement
methods employed by these payers are reviewed in more detail.
Health insurance originated in Europe in the early 1800s when mutual
bene¬t societies were formed to reduce the ¬nancial burden associated with
illness or injury. Today, health insurers fall into two broad categories: private
insurers and public programs.

Private Insurers
In the United States, the concept of public, or government, health insurance
is relatively new, while private health insurance has been in existence since the
turn of the century. In this section, the major private insurers are discussed:
Blue Cross/Blue Shield, commercial insurers, and self-insurers.

Blue Cross/ Blue Cross/Blue Shield organizations trace their roots to the Great Depres-
Blue Shield sion, when both hospitals and physicians were concerned about their patients™
abilities to pay healthcare bills.
Blue Cross originated as a number of separate insurance programs of-
fered by individual hospitals. At that time, many patients were unable to pay
their hospital bills, but most people, except the very poorest, could afford
to purchase some type of hospitalization insurance. Thus, the programs were
initially designed to bene¬t hospitals as well as patients. The programs were all
similar in structure: Hospitals agreed to provide a certain amount of services
to program members who made periodic payments of ¬xed amounts to the
hospitals whether services were used or not. In a short time, these programs
were expanded from single hospital programs to communitywide, multihos-
pital plans that were called hospital service plans. The American Hospital Asso-
ciation (AHA) recognized the bene¬ts of such plans to hospitals, so a close
relationship was formed between the AHA and the organizations that offered
hospital service plans.
Chapter 2: The Financial Environment

In the early years, several states ruled that the sale of hospital services by
prepayment did not constitute insurance, so the plans were exempt from reg-
ulations governing insurance companies. However, the legal status of hospital
service plans clearly would be subject to future scrutiny unless their status was
formalized. The states, one by one, passed enabling legislation that provided
for the founding of not-for-pro¬t hospital service corporations that were ex-
empt both from taxes and from the capital requirements mandated for other
insurers. However, state insurance departments had”and continue to have”
oversight over most aspects of the plans™ operations. The Blue Cross name
was of¬cially adopted by most of these plans in 1939.
Blue Shield plans developed in a manner similar to that of the Blue
Cross plans, except that the providers were physicians instead of hospitals and
the professional organization was the American Medical Association (AMA)
instead of the AHA. Today, roughly 40 Blue Cross/Blue Shield (Blues) or-
ganizations exist, some of which offer only one of the two plans, but most
offer both plans. The Blues are organized as independent corporations, but
all belong to a single national association that sets standards that must be met
to use the Blue Cross/Blue Shield name.
Historically, the Blues have been not-for-pro¬t corporations that en-
joyed the full bene¬ts accorded to that status, including freedom from taxes.
In 1986, however, Congress eliminated the Blues™ tax exemption on the
grounds that they operated commercial-type insurance activities. However,
the plans were given special deductions, which resulted in taxes that are gen-
erally less than those paid by commercial insurance companies. In spite of the
1986 change in tax status, the national association continued to require all
Blues to operate entirely as not-for-pro¬t corporations, although they could
establish for-pro¬t subsidiaries. In 1994, however, the national association
lifted its traditional ban on member plans becoming investor-owned compa-
nies. Since that time, 14 plans have converted to for-pro¬t status.

Commercial health insurance is issued by life insurance companies, by casu- Commercial
alty insurance companies, and by companies that were formed exclusively to Insurers
write health insurance. Commercial insurance companies can be organized
either as stock or mutual companies. Stock companies are shareholder owned
and can raise capital by selling shares of stock just like any other for-pro¬t
company. Furthermore, the stockholders assume the risks and responsibilities
of ownership and management. A mutual company has no shareholders; its
management is controlled by a board of directors elected by the company™s
policyholders. Regardless of the form of ownership, commercial insurance
companies are taxable entities.
Commercial insurers moved strongly into health insurance following
World War II. At that time, the United Auto Workers (UAW) negotiated the
¬rst contract with employers in which fringe bene¬ts were a major part of the
contract. Like the Blues, the majority of individuals with commercial health
36 Healthcare Finance

insurance are covered under group policies with employee groups, professional
and other associations, and labor unions.

Self-Insurers The third major form of private insurance is self-insurance. An argument can
be made that all individuals who do not have some form of health insurance are
self-insurers, but this is not technically correct. Self-insurers make a conscious
decision to bear the risks associated with healthcare costs and then set aside
funds to pay future costs as they occur. Individuals are not good candidates for
self-insurance because they face too much uncertainty concerning healthcare
expenses. On the other hand, large groups, especially employers, are good
candidates for self-insurance. Today, most large groups are self-insured. For
example, employees of the State of Florida are covered by health insurance that
is administered by Blue Cross/Blue Shield of Florida, but the actual bene¬ts
to plan members are paid directly by the state. Blue Cross/Blue Shield is paid
to administer the plan, but the state bears all risks associated with cost and
utilization uncertainty.
Many ¬rms today are even going one or two steps further in their self-
insurance programs. For example, Digital Equipment Corporation, a major
computer maker, negotiates discounts directly with hospitals and physicians
and self-administers its program. Others, such as Deere & Company, a farm
implements manufacturer, have set up company-owned subsidiaries to provide
healthcare services to their employees. These companies believe that they
can lower healthcare costs by applying the kind of management attention to
healthcare that they do to their core businesses.

Public Insurers
Government is a major insurer as well as a direct provider of healthcare
services. For example, the government provides healthcare services directly
to qualifying individuals through the Department of Veterans Affairs (VA),
Department of Defense (DOD), and Public Health Service (PHS) medical
facilities. In addition, the government either provides or mandates a variety
of insurance programs such as worker™s compensation and TRICARE (health
insurance for uniformed service members and families). In this section, how-
ever, the focus is on the two major government insurance programs: Medicare
and Medicaid.

Medicare Medicare was established by the federal government in 1966 to provide med-
ical bene¬ts to individuals age 65 and older. Medicare consists of two separate
coverages: Part A provides hospital and some skilled nursing home coverage;
Part B covers physician services, ambulatory surgical services, outpatient ser-
vices, and other miscellaneous services. Part A coverage is free to all persons
eligible for social security bene¬ts. Individuals who are not eligible for social
security bene¬ts can obtain Part A medical bene¬ts by paying premiums into
the program. Part B, which requires a monthly premium, is optional to all
Chapter 2: The Financial Environment

individuals who have Part A coverage. About 97 percent of Part A participants
purchase Part B coverage.
The Medicare program falls under the Department of Health and
Human Services (DHHS), which creates the speci¬c rules of the program
on the basis of enabling legislation. Medicare is administered by an agency
under DHHS called the Centers for Medicare and Medicaid Services (CMS).
CMS has eight regional of¬ces that oversee the Medicare program and ensure
that regulations are followed. Medicare payments to providers are not made
directly by CMS but by contractors at state or local level called intermediaries
for Part A payments and carriers for Part B payments.9

Medicaid began in 1966 as a modest program to be jointly funded and Medicaid
operated by the states and the federal government that would provide a
medical safety net for low-income mothers and children and for elderly, blind,
and disabled individuals who receive bene¬ts from the Supplemental Security
Income (SSI) program. Congress mandated that Medicaid cover hospital and
physician care, but states were encouraged to expand on the basic package of
bene¬ts either by increasing the range of bene¬ts or extending the program to
cover more people. States with large tax bases were quick to expand coverage
to many groups, while states with limited abilities to raise funds for Medicaid
were forced to construct more limited programs. A mandatory nursing home
bene¬t was added in 1972.
Over the years, Medicaid has provided access to healthcare services
for many low-income individuals who otherwise would have no insurance
coverage. Furthermore, Medicaid has become an important source of revenue
for healthcare providers, especially for nursing homes and other providers that
treat large numbers of indigent patients. However, Medicaid expenditures
have been growing at an alarming rate, which has forced both federal and
state policymakers to search for more effective ways to improve the program™s
access, quality, and cost.

1. What are some different types of private insurers?
2. Brie¬‚y, what are the origins and purpose of Medicare?
3. What is Medicaid, and how is it administered?

Managed Care Plans
Managed care plans strive to combine the provision of healthcare services
and the insurance function into a single entity. Traditionally, such plans have
been created by insurers who either directly own a provider network or create
one through contractual arrangements with independent providers. Recently,
however, providers in some areas have banded together to form integrated
38 Healthcare Finance

delivery systems (IDSs ) that are capable of offering both insurance and health-
care services.
One type of managed care plan is the health maintenance organization
(HMO). HMOs are based on the premise that the traditional insurer/provider
relationship creates perverse incentives that reward providers for treating pa-
tients™ illnesses while offering little incentive for providing prevention and
rehabilitation services. By combining the ¬nancing and delivery of compre-
hensive healthcare services into a single system, HMOs theoretically have as
strong an incentive to prevent as to treat illnesses.
Because of the many types of organizational structures, ownership, and
¬nancial incentives provided, HMOs vary widely in cost and quality. HMOs
use a variety of methods to control costs. These include limiting patients
to particular providers by using gatekeeper physicians who must authorize
any specialized or referral services, using utilization review to ensure that
services rendered are appropriate and needed, using discounted rate schedules
for providers, and using payment methods that transfer some risk to providers.
In general, services are not covered if bene¬ciaries bypass their gatekeeper
physician or use providers that are not part of the HMO.
The federal Health Maintenance Act of 1973 encouraged the develop-
ment of HMOs and created a great deal of interest in the concept by provid-
ing federal funds for HMO-operating grants and loans. In addition, the Act
required larger employers that offer healthcare bene¬ts to their employees
to include a federally quali¬ed HMO as a healthcare alternative, if one was
available, in addition to traditional insurance plans.
Another type of managed care plan, the preferred provider organiza-
tion (PPO), evolved during the early 1980s. PPOs are a hybrid of HMOs and
traditional health insurance plans that use many of the cost-saving strategies
developed by HMOs. PPOs do not mandate that bene¬ciaries use speci¬c
providers, although ¬nancial incentives are created that encourage members
to use those providers that are part of the provider panel, which are those
providers that have contracts (usually at discounted prices) with the PPO. Un-
like HMOs, PPOs do not require bene¬ciaries to use pre-selected gatekeeper
physicians who serve as the initial contact and authorize all services received.
In general, PPOs are less likely than HMOs to provide preventive services and
they do not assume any responsibility for quality assurance because enrollees
are not constrained to use only the PPO panel of providers.
HMOs and PPOs grew rapidly in numbers and size during the 1980s
and 1990s. Hybrids of HMOs and PPOs continue to develop. For example,
exclusive provider organizations (EPOs) are PPO-like plans that require mem-
bers to use only participating providers but do not designate a speci¬c gate-
keeper. Also, point of service (POS) plans permit enrollees to obtain services
either from within the HMO panel or to bear higher out-of-pocket costs to
obtain services outside the panel.
Chapter 2: The Financial Environment

In an effort to achieve the potential cost savings of managed care plans,
insurance companies have started to apply managed care strategies to their
conventional plans. Such plans, which are called managed fee-for-service plans,
are using pre-admission certi¬cation, utilization review, and second surgi-
cal opinions to control inappropriate utilization. Although the distinctions
between managed care and conventional plans were once quite apparent, con-
siderable overlap now exists in the strategies and incentives employed. Thus,
the term managed care now describes a continuum of plans, which can vary
signi¬cantly in their approaches to providing combined insurance and health-
care services. The common feature in managed care plans is that the insurer has
a mechanism by which it controls, or at least in¬‚uences, patients™ utilization
of healthcare services.

1. What is meant by the term managed care?
2. What are some different types of managed care plans?

Alternative Reimbursement Methods
Regardless of the payer for a particular healthcare service, only a limited num-
ber of payment methods are used to reimburse providers. Payment methods
fall into two broad classi¬cations: fee-for-service and capitation. In fee-for-
service payment methods, of which many variations exist, the greater the
amount of services provided, the higher the amount of reimbursement. Un-
der capitation, a ¬xed payment is made to providers for each covered life, or
enrollee, that is independent of the amount of services provided. In this sec-
tion, we discuss the mechanics, incentives created, and risk implications of
alternative reimbursement methods.

Fee-for-Service Methods
The three primary fee-for-service methods of reimbursement are cost based,
charge based, and prospective payment.

Under cost-based reimbursement, the payer agrees to reimburse the provider Cost-Based
for the costs incurred in providing services to the insured population. Reim- Reimbursement
bursement is limited to allowable costs, usually de¬ned as those costs directly
related to the provision of healthcare services. Nevertheless, for all practical
purposes, cost-based reimbursement guarantees that a provider™s costs will
be covered by payments from the payer. Typically, the payer makes periodic
interim payments (PIPs) to the provider, and a ¬nal reconciliation is made
after the contract period expires and all costs have been processed through
the provider™s managerial accounting system. During the early years (1966“
1982), Medicare reimbursed hospitals on the basis of costs incurred.
40 Healthcare Finance

Charge-Based When payers pay billed charges, they pay according to the schedule of charge
Reimbursement rates established by the provider. To a certain extent, this reimbursement sys-
tem places payers at the mercy of providers in regards to the cost of healthcare
services, especially in markets where competition is limited. In the very early
days of health insurance, all payers reimbursed providers on the basis of billed
charges. Some insurers still reimburse providers according to billed charges,
but the trend for payers is toward other, less-generous reimbursement meth-
ods. If this trend continues, the only payers that will be expected to pay billed
charges are self-pay, or private-pay, patients.
Some payers that historically have reimbursed providers on the basis of
billed charges now pay by negotiated, or discounted, charges. This is especially
true for insurers that have established managed care plans such as HMOs and
PPOs. HMOs and PPOs, as well as some conventional insurers, often have
bargaining power because of the large number of patients that they bring to a
provider, so they can negotiate discounts from billed charges. Such discounts
generally range from 20 to 30 percent, or even more, of billed charges.

Prospective In a prospective payment system, the rates paid by payers are determined by
Payment the payer before the services are provided. Furthermore, payments are not
directly related to either reimbursable costs or billed charges. Here are some
common units of payment used in prospective payment systems:

• Per procedure. Under per procedure reimbursement, a separate
payment is made for each procedure performed on a patient.
Because of the high administrative costs associated with this method
when applied to complex diagnoses, per procedure reimbursement
is more commonly used in outpatient than in inpatient settings.
• Per diagnosis. In the per diagnosis reimbursement method, the
provider is paid a rate that depends on the patient™s diagnosis.
Diagnoses that require higher resource utilization, and hence are
more costly to treat, have higher reimbursement rates. Medicare
pioneered this basis of payment in its diagnosis related group (DRG)
system, which it ¬rst used for hospital reimbursement in 1983.
• Per day (per diem). If reimbursement is based on a per diem rate,
the provider is paid a ¬xed amount for each day that service is
provided, regardless of the nature of the services. This type of
reimbursement is applicable only to inpatient settings. Note that
per diem rates can be strati¬ed. For example, a hospital may be paid
one rate for a medical/surgical day, a higher rate for a critical care
unit day, and yet a different rate for an obstetrical day. Strati¬ed per
diems recognize that providers incur widely different daily costs for
providing different types of care.
• Global pricing. Under global pricing, payers pay a single
Chapter 2: The Financial Environment

prospective payment that covers all services delivered in a single
episode, whether the services are rendered by a single or by multiple
providers. For example, a global fee may be set for all obstetric
services associated with a pregnancy provided by a single physician,
including all prenatal and postnatal visits, as well as the delivery. For
another example, a global price may be paid for all physician and
hospital services associated with a cardiac bypass operation.

Capitation Method
Up to this point, the prospective payment methods presented have been fee-
for-service methods”that is, providers are reimbursed on the basis of the
amount of services provided. The service may be de¬ned as a visit, a diagnosis,
a hospital day, or in some other manner, but the key feature is that the
more services that are performed, the greater the reimbursement amount.
Capitation, although a form of prospective payment, is an entirely different
approach to reimbursement and hence deserves to be treated as a separate
category. Under capitated reimbursement, the provider is paid a ¬xed amount
per covered life per period (usually a month) regardless of the amount of
services provided. For example, a primary care physician might be paid $15
per member per month for handling 100 members of an HMO plan.
Capitation payment, which is used primarily by managed care plans,
dramatically changes the ¬nancial environment of healthcare providers. It has
implications for ¬nancial accounting, managerial accounting, and ¬nancial
management. A discussion of how capitation, as opposed to fee-for-service re-
imbursement, affects healthcare ¬nance is provided throughout the remainder
of this book.

Provider Incentives
Providers, like individuals or other businesses, react to the incentives created
by the ¬nancial environment. For example, individuals can deduct mortgage
interest from income for tax purposes, but they cannot deduct interest pay-
ments on personal loans. Loan companies have responded by offering home
equity loans that are a type of second mortgage. The intent is not that such
loans would be used to ¬nance home ownership, as the tax laws presumed,
but that the funds would be used for other purposes, including paying for
vacations and purchasing cars or appliances. In this situation, tax laws created
incentives for consumers to have mortgage debt rather than personal debt,
and the mortgage loan industry responded accordingly.
In the same vein, it is interesting to examine the incentives that alter-
native reimbursement methods have on provider behavior. Under cost-based
reimbursement, providers are given a “blank check” in regards to acquiring
facilities and equipment and incurring operating costs. If payers reimburse
providers for all costs, the incentive is to incur costs. Facilities will be lavish
and conveniently located, and staff will be available to ensure that patients are
42 Healthcare Finance

given “deluxe” treatment. Furthermore, as in billed charges reimbursement,
services that may not truly be required will be provided because more services
lead to higher costs, which leads to higher revenues.
Under charge-based reimbursement, providers have the incentive to
set high charge rates, which leads to high revenues. However, in competitive
markets, there will be a constraint on how high providers can go. But, to the
extent that insurers, rather than patients, are footing the bill, there is often
considerable leeway in setting charges. Because billed charges is a fee-for-
service type of reimbursement in which more services result in higher revenue,
a strong incentive exists to provide the highest possible amount of services. In
essence, providers can increase utilization, and hence revenues, by churning ”
creating more visits, ordering more tests, extending inpatient stays, and so on.
Although charge-based reimbursement does encourage providers to contain
costs, the incentive is weak because charges can be more easily increased than
costs can be reduced. Note, however, that discounted charge reimbursement
places additional pressure on pro¬tability and hence creates increased incentive
for providers to lower costs.
Under prospective payment reimbursement, provider incentives are al-
tered. First, under per procedure reimbursement, the pro¬tability of individual
procedures will vary depending on the relationship between the actual costs
incurred and the payment for that procedure. Providers, usually physicians,
have the incentive to perform procedures that have the highest pro¬t poten-
tial. Furthermore, the more procedures the better because each procedure
typically generates additional pro¬t. The incentives under per diagnosis re-
imbursement are similar. Providers, usually hospitals, will seek patients with
those diagnoses that have the greatest pro¬t potential and discourage (or even
discontinue) those services that have the least potential. Furthermore, to the
extent that providers have some ¬‚exibility in assigning diagnoses to patients,
an incentive exists to upcode diagnoses to another one that provides greater
In all prospective payment methods, providers have the incentive to
reduce costs because the amount of reimbursement is ¬xed and independent
of the costs actually incurred. For example, when hospitals are paid under
per diagnosis reimbursement, they have the incentive to reduce length of
stay and hence costs. Note, however, when per diem reimbursement is used,
hospitals have an incentive to increase length of stay. Because the early days
of a hospitalization typically are more costly than the later days, the later days
are more pro¬table. However, as mentioned previously, hospitals have the
incentive to reduce costs during each day of a patient stay.
Under global pricing, providers do not have the opportunity to be re-
imbursed for a series of separate services, which is called unbundling. For
example, a physician™s treatment of a fracture could be bundled, and hence
billed as one episode, or it could be unbundled with separate bills submitted
for diagnosis, x-rays, setting the fracture, removing the cast, and so on. The
Chapter 2: The Financial Environment

rationale for unbundling is usually to provide more detailed records of treat-
ments rendered, but often the result is higher total charges for the parts than
would be charged for the entire package. Also, global pricing, when applied
to multiple providers for a single episode of care, forces involved providers
(e.g., physicians and a hospital) to jointly offer the most cost-effective treat-
ment. Such a joint view of cost containment may be more effective than each
provider separately attempting to minimize its treatment costs because lower-
ing costs in one phase of treatment could increase costs in another.
Finally, capitation reimbursement totally changes the playing ¬eld by
completely reversing the actions that providers must take to ensure ¬nancial
success. Under all fee-for-service methods, the key to provider success is to
work harder, increase utilization, and hence increase pro¬ts; under capitation,
the key to pro¬tability is to work smarter and decrease utilization. As with
prospective payment, capitated providers have the incentive to reduce costs,
but now they also have the incentive to reduce utilization. Thus, only those
procedures that are truly medically necessary should be performed, and treat-
ment should take place in the lowest cost setting that can provide the appro-
priate quality of care. Furthermore, providers have the incentive to promote
health, rather than just treat illness and injury, because a healthier population
consumes fewer healthcare services.

Financial Risks to Providers
A key issue facing providers is the impact of various reimbursement methods
on ¬nancial risk. For now, think of ¬nancial risk in terms of the effect that the
reimbursement methods have on pro¬t uncertainty”the greater the chance
of losing money, the higher the risk. (Financial risk is discussed in detail in
Chapter 10.)
Cost- and charge-based reimbursement are the least risky for providers
because payers more or less ensure that costs will be covered, and hence pro¬ts
will be earned. In cost-based systems, costs are automatically covered, and a
pro¬t component typically is added. In charge-based systems, providers typi-
cally can set charges high enough to ensure that costs are covered, although
discounts introduce uncertainty into the reimbursement process.
In all reimbursement methods except cost-based, providers bear the
cost-of-service risk in the sense that costs can exceed revenues. However, a pri-
mary difference among the reimbursement types is the ability of the provider
to in¬‚uence the revenue/cost relationship. If providers set charge rates for
each type of service provided, they can most easily ensure that revenues ex-
ceed costs. Furthermore, if providers have the power to set rates above those
that would exist in a truly competitive market, charge-based reimbursement
could result in higher pro¬ts than cost-based reimbursement.
Prospective payment adds a second dimension of risk to reimbursement
contracts because the bundle of services needed to treat a particular patient
may be more extensive than that assumed in the payment. However, when the
44 Healthcare Finance

prospective payment is made on a per procedure basis, risk is minimal because
each procedure will produce its own revenue. When prospective payment is
made on a per diagnosis basis, provider risk is increased. If, on average, patients
require more intensive treatments, and for inpatients a longer length of stay
(LOS), than assumed in the prospective payment amount, the provider must
bear the added costs.10
When prospective payment is made on a per diem basis, even when
strati¬ed, one daily rate usually covers a large number of diagnoses. Because
the nature of the services provided could vary widely, both because of varying
diagnoses as well as intensity differences within a single diagnosis, the provider
bears the risk that costs associated with the services provided on any day exceed
the per diem rate. However, patients with complex diagnoses and greater
intensity tend to remain hospitalized longer, and per diem reimbursement
does differentiate among different LOSs, but the additional days of stay may
be insuf¬cient to make up for the increased resources consumed. In addition,
providers bear the risk that the payer, through the utilization review process,
will constrain LOS and hence increase intensity during the days that a patient
is hospitalized. Thus, under per diem, compression of services and shortened
LOS can put signi¬cant pressure on providers™ pro¬tability.
Under global pricing, a more inclusive set of procedures, or providers,
are included in one ¬xed payment. Clearly, the more services that must be
rendered for a single payment”or the more providers that have to share a
single payment”the more providers are at risk for intensity of services.
Finally, under capitation, providers assume utilization risk along with
the risks assumed under the other reimbursement methods. The assumption
of utilization risk has traditionally been an insurance, rather than a provider,
function. In the traditional fee-for-service system, the ¬nancial risk of pro-
viding healthcare is shared between purchasers and insurers. Hospitals, physi-
cians, and other providers bear negligible risk because they are paid on the
basis of the amount of services provided. Insurers bear short-term risk in that
payments to providers in any year can exceed the amount of premiums col-
lected. However, poor pro¬tability by insurers in one year usually can be offset
by premium increases to purchasers the next year, so the long-term risk of ¬-
nancing the healthcare system is borne by purchasers. Capitation, however,
places the burden of short-term utilization risk on providers.
When provider risk under different reimbursement methods is dis-
cussed in this descriptive fashion, an easy conclusion to make is that capitation
is by far the riskiest to providers, while cost- and charge-based reimbursement
are by far the least risky. Although this conclusion is not a bad starting point
for analysis, ¬nancial risk is a complex subject, and its surface has just been
scratched. One of the key issues throughout the remainder of this book is ¬-
nancial risk, so readers will see this topic over and over. For now, keep in mind
that different payers use different reimbursement methods. Thus, providers
Chapter 2: The Financial Environment

can face con¬‚icting incentives and differing risk, depending on the predomi-
nant method of reimbursement.
In closing, note that all prospective payment methods involve a trans-
fer of risk from insurers to providers that increases as the payment unit moves
from per procedure to capitation. The added risk does not mean that providers
should avoid such reimbursement methods; indeed, refusing to accept con-
tracts with prospective payment provisions would be tantamount to organi-
zational suicide for most providers. However, providers must understand the
risks involved in prospective payment arrangements, especially the effect on
pro¬tability, and make every effort to negotiate a level of payment that is
consistent with the risk incurred.

1. Brie¬‚y explain the following payment methods:
• Cost-based
• Charge-based and discounted charges
• Per procedure
• Per diagnosis
• Per diem
• Global
• Capitation
2. What is the major difference between fee-for-service reimbursement
and capitation?
3. What provider incentives are created under each of the payment
methods previously listed?
4. Which of these payment methods carries the least risk for providers?
The most risk? Explain your answer.

Key Concepts
In this chapter, important background material was presented that will be
used throughout the remainder of the book. The key concepts of this
chapter are:
• The three main forms of business organization are the proprietorship,
partnership, and corporation. Although each form of organization has its
own unique advantages and disadvantages, most large organizations, and
all not-for-pro¬t entities, are organized as corporations.
• Investor-owned corporations have stockholders who are the owners of the
corporation. Stockholders exercise control through the proxy process in
which they elect the corporation™s board of directors and vote on matters
of major consequence to the ¬rm. As owners, stockholders have claim on
the residual earnings of the corporation. Investor-owned corporations are
fully taxable.
46 Healthcare Finance

• Charitable organizations that meet certain criteria can be organized as
not-for-pro¬t corporations. Rather than having a well-de¬ned set of owners,
such organizations have a large number of stakeholders who have an
interest in the organization. Not-for-pro¬t corporations do not pay taxes;
they can accept tax-deductible contributions, and they can issue
tax-exempt debt.
• From a ¬nancial management perspective, the primary goal of
investor-owned corporations is shareholder wealth maximization, which
translates to stock price maximization. For not-for-pro¬t corporations, a
reasonable goal for ¬nancial management is to ensure that the
organization can ful¬ll its mission, which translates to maintaining
¬nancial viability.
• An agency problem is a con¬‚ict of interests that can arise between principals
and agents. One type of agency problem that is relevant to healthcare
¬nance is the con¬‚ict between the owners of a large for-pro¬t corporation
and its managers.
• The value of any income stream depends on the amount of usable, or
after-tax, income. Thus, tax laws play an important role in ¬nancial
management decisions.
• Most provider revenue is not obtained directly from patients but from
healthcare insurers that are known collectively as third-party payers.
• Third-party payers are classi¬ed as private insurers (Blue Cross/Blue
Shield, commercial, and self-insurers) and public insurers (Medicare and
• Managed care plans, such as health maintenance organizations (HMOs),
strive to combine both the insurance function and the provision of
healthcare services.
• Third-party payers use many different payment methods that fall into two
broad classi¬cations: fee-for-service and capitation. Each payment method
creates a unique set of incentives and risk for providers.

Because the managers of health services organizations must make ¬nancial
decisions within the constraints imposed by the economic environment, these
background concepts will be used over and over throughout the remainder of
the book.

2.1 What are the three primary forms of business organization? Describe
their advantages and disadvantages.
2.2 What are the primary differences between investor-owned and
not-for-pro¬t corporations?
2.3 a. What is the primary goal of investor-owned corporations?
b. What is the primary goal of most not-for-pro¬t healthcare
Chapter 2: The Financial Environment

c. Are there substantial differences between the ¬nance goals of
investor-owned and not-for-pro¬t corporations? Explain.
d. What is the agency problem?
2.4 a. Why are tax laws important to healthcare ¬nance?
b. What three major advantages do tax laws give to not-for-pro¬t
2.5 Brie¬‚y describe the major third-party payers.
2.6 a. What are the primary characteristics of managed care plans?
b. Describe different types of managed care plans.
2.7 What is the difference between fee-for-service reimbursement and
2.8 Describe provider incentives and risks under each of the following
reimbursement methods:
a. Cost-based
b. Charge-based (including discounted charges)
c. Per procedure
d. Per diagnosis
e. Per diem
f. Global pricing
g. Capitation

2.1 Assume that Provident Health System, a for-pro¬t hospital, has $1
million in taxable income for 2004, and its tax rate is 30 percent.
a. Given this information, what is the ¬rm™s net income? (Hint: net
income is what remains after taxes have been paid.)
b. Suppose the hospital pays out $300 thousand in dividends. A
stockholder receives $10 thousand. If the stockholder™s tax rate on
dividends is 15 percent, what is the after-tax dividend?
2.2 A ¬rm that owns the stock of another corporation does not have to pay
taxes on the entire amount of dividends received. In general, only 30
percent of the dividends received by one corporation from another are
taxable. The reason for this tax law feature is to mitigate the effect of
triple taxation, which occurs when earnings are ¬rst taxed at one ¬rst
¬rm, then its dividends paid to a second ¬rm are taxed again, and ¬nally
the dividends paid to stockholders by the second ¬rm are taxed yet again.
Assume that a ¬rm with a 35 percent tax rate receives $100 thousand in
dividends from another corporation. What taxes must be paid on this
dividend and what is the after-tax amount of the dividend?
2.3 John Doe is in the 40 percent personal tax bracket. He is considering
investing in HCA bonds that carry a 12 percent interest rate.
a. What is his after-tax yield (interest rate) on the bonds?
b. Suppose Twin Cities Memorial Hospital has issued tax-exempt bonds
48 Healthcare Finance

that have an interest rate of 6 percent. With all else the same, should
John buy the HCA or the Twin Cities bonds?
c. With all else the same, what interest rate on the tax-exempt Twin
Cities bonds would make John indifferent between these bonds and
the HCA bonds?
2.4 Jane Smith currently holds tax-exempt bonds of Good Samaritan
Healthcare that pay 7 percent interest. She is in the 40 percent tax
bracket. Her broker wants her to buy some Beverly Enterprises taxable
bonds that will be issued next week. With all else the same, what rate
must be set on the Beverly bonds to make Jane interested in making a
2.5 George and Margaret Wealthy are in the 48 percent tax bracket,
considering both federal and state personal taxes. Norman Briggs,
the CEO of Community General Hospital, has been aggressively
pursuing the couple to contribute $500 thousand to the hospital™s
soon-to-be-built Cancer Care Center. Without the contribution, the
Wealthy™s taxable income for 2005 would be $2 million. What impact
would the contribution have on the Wealthy™s 2005 tax bill?

1. A tax-exempt corporation can be one partner of a partnership. In this situation,
pro¬ts allocated to the tax-exempt partner are not taxed, but those allocated to
taxable partners are subject to taxation.
2. Although most partnerships are small, there are some very large businesses that
are organized as partnerships or as hybrid organizations. Examples include the
major public accounting ¬rms and many large law ¬rms.
3. Financial markets bring together people and businesses that need money
with other people and businesses that have funds to invest. In a developed
country such as the United States, a great many ¬nancial markets exist. Some
markets deal with debt capital and others with equity capital, some deal with
short-term capital and others with long-term capital, and so on. How ¬nancial
markets operate and their bene¬t to health services organizations are discussed
throughout the book.
4. Over 60 percent of corporations in the United States are chartered in
Delaware, which over the years has provided a favorable governmental and legal
environment for corporations. A ¬rm does not have to be headquartered or
conduct business operations in its state of incorporation.
5. Stock sales are discussed in much more detail in Chapter 12.
6. The OTC market is also known as NASDAQ, which stands for National
Association of Securities Dealers Automated Quotation (System).
7. This entire chapter could easily be ¬lled with the details of obtaining and
maintaining tax-exempt status, but that is not the purpose of this book. Enough
information is provided to show the ways in which not-for-pro¬t status has an
impact on ¬nancial decisions, but the details concerning tax-exempt status are
left to outside readings or other courses.
Chapter 2: The Financial Environment

8. Note that ordinary income, which consists primarily of wages and income
distributed from proprietorships and partnerships, is taxed at higher rates
than income from dividends or capital gains that result from corporate stock
ownership. (A capital gain is realized when stock is sold at a price greater than the
purchase price.) For example, in 2004 an individual investor in the 35 percent
tax bracket for ordinary income would pay only 15 percent taxes on income
from dividends and capital gains.
9. CMS had planned to consolidate the processing of Medicare claims at regional
processing centers in late 1997. The new system, called the Medicare Transaction
System, was designed to standardize claims processing by creating one national
system. The intent was to permit hospitals to ¬le Medicare claims”mostly in
electronic format”directly to CMS. Other functions such as audits, customer
service, and medical reviews would continue to be performed by intermediaries.
However, the contract for the system was terminated because of gigantic cost
overruns, and CMS has had to go back to the drawing board.
10. Most per procedure payment systems contain outlier clauses, whereby providers
receive additional reimbursement when costs are far above average for a particular
patient. However, such extra payments typically do not cover the full amount of
the cost differential.

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