Philadelphia Reflections

Hospitals' Ratio of Charges to Actual Costs

Apple vs. Apple Corp

Recently it was announced that Apple Corp., the largest corporation in the world, enjoys a 50% profit margin. By contrast, an American hospital seldom makes more than a 5% profit, and many lose money. Even at both extremes, individual products have differing ratios of individual prices to individual costs. Only in the aggregate do they produce a company-wide profit of 50% and 5%, respectively. It is on this aggregate profit and loss that the company is judged, its officers promoted, dividends declared for the stockholders, taxes get assessed, and the value of the company measured by the stock market.

A for-profit company is judged by its profitability, and while most hospitals are run as not-for-profit organizations, the accounting convention for nonprofits is to judge "profitability" by the annual increase (or decrease) in its net assets, essentially the same thing as profits and losses. It is not necessary to examine the little quirks introduced by such things as the ownership of fine art. While a not-for-profit corporation is judged by its profitability rather than its profits, that's also really the same thing. It has been said that fewer than a thousand people in America understand nonprofit accounting, and while it is an important subject, it is just not the one we are discussing.

It is also important for even a layman to understand that government accounting while resembling nonprofit accounting, differs in one important feature: departmental accounting regards money from the general taxpayer fund as an asset, not a liability. Therefore, what we would normally regard as a loss for a government department has two components: any reduction in its assets, and any money from general taxpayer funds. The sum of the two is the loss from operations, and in the case of Medicare, it is about $550 billion a year, plus the decline in assets (in the Medicare Reserve Fund) of another $19 billion. Thus, if Medicare were a business, it would be said it lost $569 billion a year, or about half of its expenditures. If a nonprofit hospital were considered with the same numbers, it would be said to have lost $19 billion, because it has no transfers from general tax revenues.

The only present point is that it is difficult to discuss hospital economics in anything but the same aggregate form which is natural to for-profit entities, so you must look to the increase or decrease in its assets instead of profit and loss. If that premise is accepted, it must also be accepted that internal cost-shifting is not merely a permissible but an essential feature of their accounting. There are no dividends to dispose of excess profits; excess profits must be transferred somewhere and justify the costs of something else. Sometimes, just sometimes, a large vaporous cloud called "indirect overhead" floats around justifying expenditures. And weakening price resistance to them, so it's doubly important to concentrate on indirect costs. Triple, because the accountant has very little idea of the relevance of the indirect cost to the main business of the organization, which in this case is medical care. As soon as you start calling it healthcare, its relevance is even more difficult to define.

A large vaporous cloud called "indirect overhead" floats around justifying expenditures. And weakening price resistance to them.

Although a few corporations existed in the Colonial Period, corporations were not considered important enough to be dealt with at the 1787 Constitutional Convention. As the Industrial Revolution proceeded, that indifference was no longer useful, but a special blockade was created by what emerged as the central organizing principle of the new Constitution. That principle of limited federal powers is most clearly stated in the Tenth Amendment, declaring that any power not specifically assigned to the Federal Government belongs to the states and the people themselves. As a practical matter, corporations are created by state legislatures, and the Union would not have been agreed to without that provision. In spite of the current opinions of Justice Ruth Bader Ginsburg, the enduring force of this provision is illustrated by the difficulties the European Union is having over that same issue -- of limited federal sovereignty. It continues to be true that, if the federal union will not agree to limited federal powers, there will be no union. To explain the point, this must continue to be true of any voluntary union of sovereign states which are unequal in size and strength. A peculiarly American twist to this situation is to give corporations a choice of fifty state corporation statutes, and somehow they gravitate to Delaware by choice. It can be argued that a wide choice of governance rules leads to a selection by merit, but the militarily smallest of states does consistently win the prize. Whether that is an oddity or has something to do with it, remains a puzzle.

It is disconcerting to consider that the Affordable Care Act may have upset a minute of healthcare regulations, originally finely balanced on the need to run a hospital with reasonable business latitude. After all, it is impossible to follow society's mission if a hospital cannot itself determine some indirect costs. Once a hospital reaches even moderate size of two hundred beds, almost any product of a hardware store, department store, or supermarket could plausibly be required to run it. Business supplies, school supplies, parking, and building maintenance are required, as are architects, lawyers, and electricians. Once you go down this list, you might constrain approval to buy supplies and equipment that sound as though they belong in a hospital, but one hospital reported its largest single expense was heating oil, closely followed by ice cream. Somehow, every item must be connected in some way to a service which can be charged for, which is an accountant's trick for establishing what is a legitimate expense. Sometimes this is pretty hard to do; a hospital needs a hammer, but how do you assign the cost of the hammer to some item which is legitimately charged for? It soon becomes evident that the assignment of indirect costs is always going to be a little questionable, but always absolutely essential. In the early days of hospital cost accounting, it was reasonable to aggregate the indirect costs of each department and assign them to the direct costs of that department.

From this evolves the concept of a cost-to-charge ratio. Reasonable uniformity in the ratio of charges to costs within departments, or between various departments, assures that cross-subsidy between insurance companies and patient classes is fairly uniform. Without that check, complaints between competitors would be immediate. Essentially, this sort of system depends on equal justice being applied, at least in a general sense. When equal justice is impossible, the accounting department can only rely on intuition and overall balance. Outside regulatory agencies can compare the cost/charge ratio in one hospital's operating room with that of some comparable institution. The first step in such comparisons is to compare the institution-wide ratio with its peer group. If that doesn't produce a reasonable result, the analysis can go down to individual departments to individual tests and procedures, until the source of a wide discrepancy can be isolated. At that point, questions can be asked, and a reasonable conclusion reached. But that was forty years ago. When charges are submitted for an electrocardiogram totaling several hundred dollars, and drugs at several times the retail price in a neighboring pharmacy, this sort of analysis is fruitless because it leads to ridiculous results. It is time to agree that a reasonable pattern of only direct costs can be typically and quickly laid out. On the whole, it can be judged that it is indirect costs which become very hard to follow by the usual step-down process. Therefore, it seems reasonable to pass over direct costs quickly, and go straight to the indirect costs, judging them on their separate merits. Apparently, It really does not matter what charge they have been assigned to; what matters is whether they are legitimate. Outliers can be dealt with individually. What is important is for community representatives to assess, is whether the bulk of general overhead costs can be justified for a community, whether the bulk of CEO salaries suits community expectations, or whether landscaping costs unsettle community opinion.

The main reason for having health insurance is to protect yourself from being fleeced.

Jonathan E. Rhoads, M.D.

This all sounds pretty dry and boring, so let's look at something more exciting. Let's notice that in Medicare's own analysis, the ratio of average charges to average audited costs, or the hundred commonest diagnostic groups, in every section of every region, is four hundred percent greater than the audited cost. In plainer language, the charge reported and billed is 400% greater than the cost, which would be eight times the profit margin of Apple, Inc. if it were paid. It's not paid, but the mystery continues as to why hospitals keep on billing for so much more than they know Medicare will pay. The comparatively small variation in this markup suggests there is a reason unrelated to unreimbursed care since the variation in bad debts is likely to be much greater between hospitals. But the sad consequence is that the poorest people in the country, those without health insurance, get billed -- and vigorously dunned -- for amounts they of all people cannot afford. Another viewpoint was offered by an elderly surgeon, after whom an entire hospital pavilion has been named, that "The main reason to have health insurance is to protect yourself against being fleeced."

Unfortunately, it is just this sort of needed commentary which is most questionable on a constitutional or political science level. It is not at all certain that consumer groups or third-party insurance groups have a right to be dictating salary levels, or whether an institution needs a new HVAC system. It is far from clear that a government of limited federal powers has any right at all to be dictating local hospital indirect expenditures. When Medicare was only one of several dominant payers in a hospital, they did acquire a sort of legitimacy when they insisted on equal treatment with other payers. Now that Federal Laws of uncertain shape, mandate universal coverage of uncertain form, it becomes legitimate to ask whether the format of filling in the coverage gaps can stretch the Constitution into assuming the total administrative control which the Constitution seems to prohibit. As these new regulations get actual implementation, more and more people will acquire "standing" by sustaining a provable personal injury. It remains to be seen, where that will lead.

Originally published: Wednesday, June 12, 2013; most-recently modified: Tuesday, May 21, 2019