River Community Hospital

Complete all the reading assignments for this course (all 5 modules) prior to beginning work on this assignment. These readings have a direct relation to the case.
Read Case 24: River Community Hospital (A), Assessing Hospital Performance, on pp 159-160 of Pink and Song (2018) (Links to an external site.).
Write a written report to the hospital’s board of trustees (following APA format) detailing answers to the following:
Interpret the hospital’s statements of cash flows.
Present an overview of the hospital’s financial position using the Du Pont equation as a guide.
Use ratio analysis to identify the hospital’s specific financial strengths and weaknesses. Note: The board is not going to appreciate a lengthy dialogue with too many individual ratios. Focus on key findings and one or two ratios per category – don’t put them to sleep! Also, use graphs or other techniques to summarize the data.
Use operating indicator analysis to identify the operational factors that explain the hospital’s current financial condition.
Summarize your evaluation of the hospital’s financial condition. However, don’t just rehash the numbers; rather, present your views on the potential underlying economic and managerial factors that might have caused any problems that surfaced in the financial and operating analysis.
Make any recommendations that you believe the hospital should follow to ensure future financial soundness.
Prepare your assignment for submission:
Follow all applicable APA Guidelines (Links to an external site.) regarding in-text citations, list of cited references, and document formatting for this paper. Failure to properly cite and reference sources constitutes plagiarism.
The title page and reference list are not included in the page count for this paper.
Proofread your assignment carefully. Improper English grammar, sentence structure, punctuation, or spelling will result in significant point deductions.

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Reference:

For Book Chapters:

Louis Gapenski. (2016). Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition: Vol. Sixth edition. Health Administration Press.

For Pages 159-160 documents:

G. Pink, and P. Song (2018). Gapenski’s cases in healthcare finance, sixth edition: Sixth edition. Health Administration Press.

CHAPTER

201

DEPARTMENTAL COSTING AND COST
ALLOCATION

Introduction

In Chapter 5 we discussed organizational costing, which requires the classification
of costs according to their relationship to volume. In this chapter we introduce
departmental costing, which requires an additional classification of costs—the
relationship between costs and the department being analyzed. In essence, we
will see that some costs are unique to the department, while other costs stem
from resources that belong to the organization as a whole. Once it is recognized
that some costs are organizational in nature rather than department specific, it
becomes necessary to create a system that allocates organizational costs to indi-
vidual departments. For now, we will focus on costing at the department level.
In the next chapter, we will discuss costing (and pricing) of individual service
lines. Although some of this chapter’s material is conceptual in nature, much of
it involves the application of various allocation techniques. Thus, a considerable
portion of the chapter is devoted to examples of cost allocation in different settings

Direct Versus Indirect (Overhead) Costs

Some costs—about 50 percent of a health services organization’s cost struc-
ture—are unique to the reporting subunit and hence usually can be identified

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

• Differentiate between direct and indirect (overhead) costs.
• Explain why proper cost allocation is important to health service

organizations.
• Define a cost driver and explain the characteristics of a good driver

as opposed to a poor one.
• Describe the three primary methods used to allocate overhead

costs among revenue-producing departments.
• Apply cost allocation principles across a wide range of situations

within health services organizations.

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H e a l t h c a r e F i n a n c e202

with relative certainty. To illustrate, consider a hospital’s clinical laboratory
department. Certain costs are unique to the department: for example, the
salaries and benefits for the managers and technicians who work there and
the costs of the equipment and supplies used to conduct the tests. These
costs, which would not occur if the laboratory were closed, are classified as
the direct costs of the department.

Unfortunately, direct costs constitute only a portion of the depart-
ment’s entire cost structure. The remaining resources used by the laboratory
are not unique to the laboratory; the department uses many shared resources
of the hospital as a whole. For example, the laboratory shares the organiza-
tion’s physical space (facilities) as well as its infrastructure, which includes
information systems, utilities, housekeeping, maintenance, medical records,
and general administration. The costs that are not borne exclusively by the
laboratory department are called indirect costs, or overhead costs.

Indirect costs, in contrast to direct costs, are much more difficult to
measure at the department level for the precise reason that they arise from
shared resources—that is, if the laboratory department were closed, the indirect
costs would not disappear. Perhaps some indirect costs could be reduced, but
the hospital would still require a basic infrastructure to operate its remaining
departments. The direct/indirect classification has relevance only at the sub-
unit level; if the unit of analysis is the entire organization, all costs are direct
by definition. Thus, in our Chapter 5 discussion of organizational costing, we
did not have to introduce the concept of direct versus indirect costs.

Note that the two cost classifications (fixed/variable and direct/indirect)
overlay one another. That is, fixed costs typically include both direct and
indirect costs, while variable costs, in most cases, contain only direct costs
(although they can include both direct and indirect costs). Conversely, direct
costs usually include fixed and variable costs, while indirect costs typically
include only fixed costs.

Introduction to Cost Allocation

A critical part of cost measurement at the department level is the assignment,
or allocation, of indirect costs. Cost allocation is essentially a pricing process
within the organization whereby managers allocate the costs of one department
to other departments. Because this pricing process does not occur in a market

Direct cost
A cost that is tied
exclusively to
a subunit, such
as the salaries
of laboratory
department
employees.
When a subunit
is eliminated,
its direct costs
disappear.

Indirect
(overhead) cost
A cost that is
tied to shared
resources rather
than to an
individual subunit
of an organization;
for example,
facilities costs.

1. What is the difference between direct and indirect costs?
2. Give some examples of each type of cost for a hospital’s emergency

services department.

SELF-TEST
QUESTIONS

Cost allocation
The process by
which overhead
costs are assigned
(allocated)
to individual
departments.

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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 8/4/2022 10:22 PM via FRANKLIN UNIVERSITY
AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management,
Sixth Edition
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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 203

setting, no objective standard exists that establishes the price for the transferred
services. Thus, cost allocation within a business must, to the extent possible,
establish prices that proxy those that would be set under market conditions.

What costs within a health services organization must be allocated?
Typically, the overhead costs of the business, such as those incurred by admin-
istrators, facilities management personnel, financial staffs, and housekeeping
and maintenance personnel, must be allocated to those departments that gen-
erate revenues for the organization (generally patient services departments).
The allocation of overhead costs to patient services departments is necessary
because there would be no need for such costs in the first place if there were
no patient services departments. Thus, decisions regarding pricing and service
offerings by the patient services departments must be based on the full costs
associated with each service, including both direct and overhead (indirect)
costs. Clearly, the proper allocation of overhead costs is essential to good
decision making within health services organizations.

The goal of cost allocation is to assign all of the costs of an organiza-
tion to the activities that cause them to be incurred. With complete cost data
accessible in the organization’s managerial accounting system, managers can
make better decisions regarding cost control, what services should be offered,
and how these services should be priced. Of course, the more complex the
managerial accounting system, the higher the costs of developing, implement-
ing, and operating the system. As in all situations, the benefits associated
with more accurate cost data must be weighed against the costs required to
develop such data.

Interestingly, much of the motivation for more accurate cost allocation
systems comes from the recipients of overhead services. Managers at all levels
within health services organizations are under pressure to optimize financial
performance, which translates to reducing costs. Indeed, many department
heads are evaluated, and hence compensated and promoted, primarily on the
basis of profitability, assuming that performance along other dimensions is
satisfactory. For such a performance evaluation system to work, all parties
must perceive the cost allocation process to be accurate and fair because man-
agers are held accountable for both the direct and the indirect costs of their
departments. In other words, department heads are held accountable for the
full costs associated with services performed by their departments.

1. What is meant by the term cost allocation? By the term full costs?
2. What is the goal of cost allocation?
3. Why is cost allocation important to health services managers?

SELF-TEST
QUESTIONS

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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 8/4/2022 10:22 PM via FRANKLIN UNIVERSITY
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Sixth Edition
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H e a l t h c a r e F i n a n c e204

Cost Allocation Basics

To assign costs from one activity to another, two important elements must be
identified: a cost pool and a cost driver. A cost pool is a grouping of similar
costs to be allocated, while a cost driver is the basis upon which the alloca-
tion is made. To illustrate, the costs of a hospital’s housekeeping department
might be allocated to the other departments on the basis of the size of each
department’s physical space. The logic here is that the amount of housekeep-
ing resources expended in each department is directly related to the physical
size of that department. In this situation, total housekeeping costs would be
the cost pool, and the number of square feet of occupied space would be the
cost driver.

When the cost pool amount is divided by the total amount of the cost
driver, the result is the overhead allocation rate. Thus, in the housekeeping
illustration, the allocation rate is the total housekeeping costs of the organiza-
tion divided by the total space (square footage) occupied by the departments
receiving the allocation. This procedure results in an allocation rate measured
in dollar cost per square foot of space used. In the patient services depart-
ments, full (total) costs would include the direct costs of each department
and an allocation for housekeeping services, made on the basis of the amount
of occupied space.

Cost Pools
Typically, a cost pool consists of all of the direct costs of one support depart-
ment. However, if a single support department offers several substantially
different services, and the patient services departments use those services in
different relative amounts, it may be beneficial to separate the costs of that
support department into multiple pools.

For example, suppose a hospital’s financial services department provides
two significantly different services: patient billing/collections and budgeting.
Furthermore, assume that the routine care department uses proportionally
more patient billing/collections services than does the laboratory department,
but the laboratory department uses proportionally more budgeting services
than does the routine care department. In this situation, it would be best to
create two cost pools for one support department. To do this, the total costs
of financial services would be divided into a billing pool and a budgeting pool.
Then, cost drivers would be chosen for each pool and the costs allocated to
the patient services departments as described in the following sections.

Cost

Drivers

Perhaps the most important step in the cost allocation process is the identi-
fication of proper cost drivers. Traditionally, overhead costs were aggregated

Cost pool
A group of
overhead costs to
be allocated; for
example, facilities
costs or marketing
costs.

Cost driver
The basis on
which a cost pool
is allocated; for
example, square
footage for
facilities costs.

Allocation rate
The numerical
value used to
allocate overhead
costs; for example,
$10 per square
foot of occupied
space for facilities
costs.

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across all support departments and then divided by a rough measure of orga-
nizational volume, resulting in an allocation rate of some dollar amount of
generic overhead per unit of volume.

For example, the total inpatient overhead costs of a hospital might be
divided by total inpatient days, giving an allocation rate of so many dollars
per patient day, which is called the per diem overhead rate. If a hospital had
72,000 patient days in 2015 and its total inpatient overhead costs were $36
million, the overhead allocation rate would be $36,000,000 ÷ 72,000 = $500
per patient day (per diem). Regardless of the type of patients treated within an
inpatient services department (adult versus child, trauma versus illness, acute
versus critical care, and so on), the $500 per diem allocation rate would be
applied to determine the total indirect cost allocation for that department.

However, it is clear that not all overhead costs are tied to the num-
ber of patient days. For example, overhead costs associated with admission,
discharge, and billing are typically not related to the number of patient days
but to the number of admissions. Thus, tying all overhead costs to a single
cost driver improperly allocates such costs, which distorts reported costs for
patient services and hence raises concerns about the effectiveness of decisions
based on such costs. In state-of-the-art cost management systems, the various
types of overhead costs are separated into different cost pools, and the most
appropriate cost driver for each pool is identified.

The theoretical basis for identifying cost drivers is the extent to which
costs from a pool actually vary as the value of the driver changes. For example,
does a patient services department with 10,000 square feet of space use twice
the amount of housekeeping services as a department with only 5,000 square
feet of space? The better the relationship (correlation) between actual resource
expenditures at each subunit and the cost driver, the better the cost driver
and the better the resulting cost allocations.

Effective cost drivers possess two important characteristics. First, and
perhaps the less important of the two, is fairness—that is, does the cost driver
chosen result in an allocation that is fair to the patient services departments?
The second, and perhaps more important, characteristic is cost control—that
is, does the cost driver chosen create incentives for departments to use less
of that overhead service?

For example, there is little that a patient services department manager
can do to influence overhead cost allocations if the cost driver is patient days.
In fact, the action needed to reduce patient days might lead to negative finan-
cial consequences for the organization. An effective cost driver will encourage
patient services department managers to take overhead cost reduction actions
that do not have negative implications for the organization. The remainder
of this chapter emphasizes the importance of effective cost drivers, including
several illustrations that distinguish good drivers from poor ones.

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H e a l t h c a r e F i n a n c e206

The Allocation Process
The steps involved in allocating overhead
costs are summarized in Exhibit 6.1, which
illustrates how Prairie View Clinic allocated
its housekeeping costs for 2016. Cost alloca-
tion takes place both for historical purposes,
in which realized costs over the past year
are allocated, and for planning purposes, in
which estimated future costs are allocated
to aid in pricing and other decisions. The
examples in this chapter generally assume
that the purpose of the allocation is for
financial planning and budgeting, so the
data presented are estimated for the com-
ing year—2016.

The first step in the allocation process
is to establish the cost pool. In this case, the
clinic is allocating housekeeping costs, so
the cost pool is the projected total costs of
the housekeeping department—$100,000.
Next, the most effective cost driver must be
identified. After considerable investigation,

Prairie View’s managers concluded that the best cost driver for housekeeping
costs is labor hours—that is, the number of hours of housekeeping services
required by the clinic’s departments is the variable most closely related to the
actual cost of providing these services. The intent here, of course, is to pick
the cost driver that provides the most accurate cause-and-effect relationship
between the use of housekeeping services and the costs of the housekeeping

Industry Practice
Hospitals and Housekeeping Cost Drivers

Most hospitals use square footage to allocate
housekeeping costs. The rationale, of course, is
that a patient services department that is twice
as big as another will require twice the expendi-
ture of housekeeping resources. The advantage
of this cost driver is that it is easy to measure and
does not change very often.

The disadvantage of using square footage
as the cost driver is that some patient services
departments require more housekeeping support
because of the nature of the service, even when
similar-sized spaces are occupied. For example,
emergency departments require more intense
housekeeping services than do neonatal care
units.

Is there a better cost driver available for
allocating housekeeping costs? If so, what is it?
Describe how the “new and improved” cost driver
would work.

Step One: Determine the Cost Pool
The departmental costs to be allocated are for the housekeeping

department, which has total budgeted costs for 2016 of $100,000.
Step Two: Determine the Cost Driver
The best cost driver was judged to be the number of hours of housekeeping

services provided. An expected total of 10,000 hours of such services will
be provided in 2016 to those departments that will receive the allocation.

Step Three: Calculate the Allocation Rate
$100,000÷10,000 hours = $10 per hour of housekeeping services provided.
Step Four: Determine the Allocation Amount
The physical therapy department uses 3,000 hours of housekeeping

services, so its allocation of housekeeping department overhead is
$10×3,000 = $30,000.

EXHIBIT 6.1
Prairie View

Clinic:
Allocation of

Housekeeping
Overhead to
the Physical

Therapy
Department

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 207

department. For 2016, Prairie View’s managers estimate that the housekeep-
ing department will provide 10,000 hours of service to the departments that
will receive the allocation.

Now that the cost pool and cost driver have been defined and measured,
the allocation rate is established by dividing the expected total overhead cost
(the cost pool) by the expected total volume of the cost driver: $100,000 ÷
10,000 hours = $10 per hour of services provided.

The final step in the process is to make the allocation to each depart-
ment. To illustrate the allocation, consider the physical therapy (PT) depart-
ment—one of Prairie View’s patient services departments. For 2016, PT is
expected to use 3,000 hours of housekeeping services, so the dollar amount
of housekeeping overhead allocated to PT is $10 × 3,000 = $30,000. Other
departments within the clinic will also use housekeeping services, and their
allocations would be made in a similar manner—the $10 allocation rate per
hour of services used is multiplied by the amount of each department’s hourly
utilization of housekeeping services. When all departments are considered,
the 10,000 hours of housekeeping services is fully distributed among the using
departments. For any one department, the amount allocated depends on both
the allocation rate and the amount of housekeeping services used.

Key Equation: Allocation Rate

The allocation rate is the rate used to calculate each user department’s
allocation of an overhead cost pool. To illustrate, assume the financial
services department has $1,000,000 in total costs (the cost pool) and
the patient services departments in total generate 500,000 bills (the cost
driver). Then, the allocation rate is $2 per bill:

Allocation rate = Cost pool amount ÷ Cost driver volume
= $1,000,000 ÷ 500,000 bills
= $2 per bill.

1. What are the definitions of a cost pool, a cost driver, and an
allocation rate?

2. Under what conditions should a single overhead department be
divided into multiple cost pools?

3. On what theoretical basis are cost drivers chosen?
4. What two characteristics make an effective cost driver?
5. What are the four steps in the cost allocation process?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e208

Cost Allocation Methods

Mathematically, cost allocation can be accomplished in a variety of ways, and
the method used is somewhat discretionary. No matter what method is chosen,
all support department costs eventually must be allocated to the departments
(generally patient services departments) that create the need for those costs.

The key differences among the methods are how support services pro-
vided by one department are allocated to other support departments. The
direct method totally ignores services provided by one support department to
another. Two other allocation methods address intrasupport department allo-
cations. The reciprocal method recognizes all of the intrasupport department
services, and the step-down method represents a compromise that recognizes
some, but not all, of the intrasupport department services. Regardless of the
method, all of the support costs within an organization ultimately are allo-
cated from support departments to the departments that generate revenues
for the organization.

Exhibit 6.2 summarizes the three allocation methods. Prairie View
Clinic, which is used in the illustration, has three support departments (human

Human Resources

Human Resources
Human Resources

Support Departments

Direct Method

Reciprocal Method

Step-Down Method

Patient Services Departments

Housekeeping

Housekeeping
Housekeeping

Physical Therapy

Physical Therapy
Physical Therapy

Administration

Administration
Administration

Internal Medicine

Internal Medicine
Internal Medicine

EXHIBIT 6.2
Prairie View

Clinic:
Alternative

Cost Allocation
Methods

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 209

resources, housekeeping, and administration) and two patient services depart-
ments (physical therapy and internal medicine).

Under the direct method, shown in the top section of Exhibit 6.2,
each support department’s costs are allocated directly to the patient services
departments that use the services. Thus, none of the support services costs
are allocated to other support departments. In the illustration, both physical
therapy and internal medicine use the services of all three support departments,
so the costs of each support department are allocated to both patient services
departments. The key feature of the direct method—and the feature that makes
it relatively simple to apply—is that no intrasupport department allocations
are recognized. Thus, under the direct method, only the direct costs of the
support departments are allocated to the patient services departments because
no indirect costs have been created by intrasupport department allocations.

As shown in the center section of Exhibit 6.2, the reciprocal method
recognizes the support department interdependencies among human resources,
housekeeping, and administration, and hence it generally is considered to be
more accurate and objective than the direct method. The reciprocal method
derives its name from the fact that it recognizes all of the services that depart-
ments provide to and receive from other departments. The good news is that
this method captures all of the intrasupport department relationships, so no
information is ignored and no biases are introduced into the cost allocation
process. The bad news is that the reciprocal method relies on the simultaneous
solution of a series of equations representing the utilization of intrasupport
department services. Thus, it is relatively complex, which makes it difficult to
explain to department heads and typically more costly to implement.

The step-down method, which is shown in the lower section of Exhibit
6.2, represents a compromise between the simplicity of the direct method and
the complexity of the reciprocal method. It recognizes some of the intrasupport
department effects that the direct method ignores, but it does not recognize
the full range of interdependencies as does the reciprocal method. The step-
down method derives its name from the sequential, stair-step pattern of the
allocation process, which requires that the allocation take place in a specific
sequence. As shown in the exhibit, all the direct costs of human resources first
are allocated to both the patient services departments and the other two sup-
port departments. Human resources is then closed out because all of its costs
have been allocated. Next, housekeeping costs, which now consist of both
direct and indirect costs (the allocation from human resources), are allocated
to the patient services departments and the remaining support department—
administration. Finally, the direct and indirect costs of administration are allo-
cated to the patient services departments. The final allocation from administra-
tion includes human resources and housekeeping costs because a portion of
these support costs has been allocated or “stepped down” to administration.

Direct method
A cost allocation
method in which
all overhead costs
are allocated
directly from
the overhead
departments to the
patient services
departments with
no recognition that
overhead services
are provided to
other support
departments.

Reciprocal method
A cost allocation
method that
recognizes all
of the overhead
services provided
by one support
department to
another.

Step-down
method
A cost allocation
method that
recognizes some
of the overhead
services provided
by one support
department to
another.

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H e a l t h c a r e F i n a n c e21

The critical difference between the step-down and reciprocal methods
is that after each allocation is made in the step-down method, a support depart-
ment is removed from the process. Even though housekeeping and administra-
tion provide support services back to human resources, these indirect costs are
not recognized because human resources is removed from the allocation process
after the initial allocation. Such costs are recognized in the reciprocal method.

Direct Method Illustration

The best way to gain a more in-depth understanding of cost allocation is to
work through several allocation illustrations. We begin with the direct method.
As shown in Exhibit 6.3, Kensington Hospital has three revenue-producing
patient services departments: routine care, laboratory, and radiology. Accoun-
tants often call the patient services departments profit centers, because they
not only incur costs but also create revenues. Conversely, overhead depart-
ments are called cost centers in that they incur costs but create no revenues.

Hospital costs are divided into those costs attributable to the profit
centers (direct costs) and those costs attributable to the support departments
(overhead costs). Of course, the overhead costs are direct costs to the support
departments, but when they are allocated to the patient services departments,
these direct costs become indirect (overhead) costs.

The data show that the revenues for each of the patient services depart-
ments are much greater than their direct costs. Furthermore, Kensington’s
projected total revenues of $27,000,000 exceed the hospital’s projected total
costs of $25,450,000. However, the aggregate revenue and cost amounts
provide no information to Kensington’s managers concerning the true profit-
ability of each patient services department. To determine true profitability by
profit center, the full costs of providing patient services, including both direct
and indirect costs, must be measured. Only then can the hospital’s managers
develop rational pricing and cost control strategies.

As previously discussed, three decisions are required when allocating
costs: how to define the cost pools, what the cost drivers are, and which
method of allocation to use. We begin by illustrating the direct method of cost
allocation. The step-down method is discussed in the Chapter 6 Supplement.

The cost pools (total costs) for the support departments are given in
the lower section of Exhibit 6.3. Financial services costs are $1,500,000;

1. What are the three primary methods of cost allocation?
2. Explain how they differ.
3. Which one do you think is best? Which is the worst?

SELF-TEST
QUESTIONS

Profit center
A business unit
(in our examples,
typically a
department)
that generates
revenues as
well as costs,
and hence its
profitability can be
measured.

Cost center
A business unit
that does not
generate revenues,
and hence only
its costs can be
measured.

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 211

facilities costs equal $3,800,000; housekeeping costs are $1,600,000; gen-
eral administration costs total $4,400,000; and human resources costs equal
$2,550,000. Thus, overhead costs at the hospital total $13,850,000, which
ultimately must be allocated to the hospital’s three patient services depart-
ments. Kensington’s managers believe that little is to be gained by dividing
any of the support departments into multiple cost pools, so each support
department constitutes one cost pool.

The next step in the allocation process is to identify the best cost
drivers for each cost pool. Exhibit 6.4 provides a summary of the support
departments and their assigned cost drivers. Unfortunately, the selection of
cost drivers is not an easy process, and to a large extent the usefulness of the
entire cost allocation process depends on choosing the most effective drivers.
As discussed later, Kensington’s selection of cost drivers, like many selections
made in real-world situations, is somewhat of a compromise between effec-
tiveness and simplicity.

EXHIBIT 6.3
Kensington
Hospital: 2016
Revenue and
Cost Projections

Projected Revenues by Patient Services Department
Routine Care $16,000,000
Laboratory 5,000,000
Radiology 6,000,000
Total revenues $27,000,000

Projected Costs for All Departments
Patient Services Departments (Direct Costs):
Routine Care $ 5,500,000
Laboratory 3,300,000
Radiology 2,800,000
Total costs $ 11,600,000

Support Services Departments (Overhead Costs):
Financial Services $ 1,500,000
Facilities 3,800,000
Housekeeping 1,600,000
General Administration 4,400,000
Human Resources 2,550,000
Total overhead costs $ 13,850,000

Total costs of both patient and support services $25,450,000

Projected profit $ 1,550,000

00_GapenskiReiter (2299).indb 211 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e212

The cost driver chosen for financial services is patient services revenue.
Financial services provides a full range of financial support to the hospital.
The bulk of its efforts are devoted to patient billing and collections, but it is
also involved in financial and managerial accounting, budgeting and report
preparation, and a host of other financial tasks. Tying the allocation of this
support department to the amount of patient services revenues assumes a
strong positive relationship between the amount of financial services provided
to each patient services department and revenues generated by that depart-
ment. Clearly, patient services revenue is a relatively inaccurate cost driver,
and hence the resulting cost allocation has limitations. In the next section,
we discuss the benefits of moving from a poor cost driver to a better one.

The amount of space used (square footage) is the basis for allocating
the costs of facilities. This cost driver is often used by health services organiza-
tions to allocate the initial costs of land, buildings, and equipment as well as
the costs of maintenance and other facilities services. The logic applied here
is that the patient services departments with the most space require the most
facilities and hence the most facilities support. Of course, this assumption
does not always hold. For example, in any year, facilities may be required to
support a special large project for one of the patient services departments,
resulting in costs that far exceed that department’s proportional space utili-
zation. Nevertheless, over the long run at Kensington Hospital, the relative
costs of facilities utilization by the patient services departments track closely
with the space occupied by those departments.

Two of the remaining support departments, general administration
and human resources, also use a relatively poor cost driver, salary dollars. If
radiology has payroll costs that are five times larger than those of laboratory,
radiology will be charged (allocated) five times as much of the costs incurred
by administration and personnel. This cost driver is often used, but in real-
ity it is not very good. Thus, the allocated costs from general administration
and human resources probably do not truly represent the relative amounts of
utilization of these overhead services.

Housekeeping has chosen perhaps the best cost driver—namely, the num-
ber of labor hours of housekeeping services consumed. In many organizations,

Support Services Department Cost Driver

Financial Services Patient services revenue
Facilities Space utilization (square footage)
Housekeeping Labor hours
General Administration Salary dollars
Human Resources Salary dollars

EXHIBIT 6.4
Kensington

Hospital:
Assigned Cost

Drivers

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 213

housekeeping costs are allocated on the basis of square footage, using the
logic that the amount of space occupied by a department accurately reflects
housekeeping efforts and hence costs. This assumption may or may not be
valid, however. In effect, large-space departments may be subsidizing small-
space departments, such as emergency services, where space may be limited
but the intensity of work requires a significant amount of housekeeping ser-
vices. To account for such situations at Kensington Hospital, housekeeping is
using a better cost driver—one that more closely aligns to the actual resources
expended in providing support to the patient services departments.

The development and use of the best cost driver is a cost–benefit issue.
Housekeeping must devote resources to tracking where their workers spend
their time, an effort that would not be required if the cost driver were square
footage. The benefit, of course, is a cost driver that makes it easier for Kens-
ington’s senior managers to hold department heads responsible for both direct
and indirect costs. If the head of the radiology department does not like the
amount of housekeeping costs that are being charged to the department, she
can do something about it: use fewer housekeeping services. With an inferior
cost driver, such as square footage, there is little that patient services depart-
ment heads can do if they do not like the housekeeping allocation. In most
cases, reduction of square footage is not a practical way to deal with excessive
housekeeping costs.

With labor hours consumed as the cost driver, the cost control solution
for patient services department heads is to reduce the amount of housekeep-
ing services used. If all patient services department heads are made to think
this way by having the right incentive system in place, ultimately the hospital
will discover it is as efficient as possible in using housekeeping services. In
the long run, the direct costs of the housekeeping department—currently
$1,600,000—will fall as these services are more efficiently used. In reality, the
secondary benefit of choosing a more effective cost driver is a more equitable
allocation. The primary benefit is that a good cost driver creates an incentive
to use less of the support service, which ultimately leads to lower overhead
costs for the organization.

Exhibit 6.5 contains the initial data necessary for the allocation. The
first column of the exhibit lists the patient services departments. The amounts
of the chosen cost drivers consumed by each patient services department are
listed after that: patient services revenue used for allocating financial services
costs, square footage used for facilities allocations, housekeeping labor hours
used for housekeeping allocations, and departmental salary dollars used for
both general administration and human resources allocations.

If Kensington were using the step-down or reciprocal allocation meth-
ods, the information shown in Exhibit 6.5 would have to include the support
departments because the data would be needed for intrasupport department

00_GapenskiReiter (2299).indb 213 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e214

allocations. By using the direct method, the hospital ignores intrasupport
department dependencies, so the totals indicated at the bottom of each column
reflect only the use of support services by the patient services departments,
to which are allocated all of the support costs.

Exhibit 6.6 divides the dollar amount of each cost pool by the total
amount of each cost driver to derive the allocation rates. For example, the
cost pool (direct costs) for financial services totals $1,500,000, which will be
allocated as indirect (overhead) costs to the patient services departments that
have a total of $27,000,000 in patient services revenues. The allocation rate
for financial services, therefore, is $1,500,000 ÷ $27,000,000 = $0.05556 per
dollar of patient services revenue.

As previously mentioned, the allocation of indirect costs can be viewed
as an internal pricing mechanism. Thus, the heads of the revenue-producing
departments can look at Exhibit 6.6 and see the rate that they are being
charged for support services, which amounts to the following:

• $0.05556 for each dollar of patient services revenue generated for
financial services support.

• $12.64 per square foot of space used for facilities support.

Patient
Services Square Housekeeping Salary
Department Revenues Feet Labor Hours Dollars

Routine Care $16,000,000 199,800 76,000 $ 5,709,000
Laboratory 5,000,000 39,600 6,000 2,035,000
Radiology 6,000,000 61,200 9,000 2,439,000
Total $27,000,000 300,600 91,000 $10,183,000

EXHIBIT 6.5
Kensington

Hospital:
Patient Services

Departmental
Summary Data

Cost Pool Total Allocation
Department (total costs) Cost Driver Utilization Ratea

Financial Services $1,500,000 Patient revenue $27,000,000 $0.05556
Facilities 3,800,000 Square feet 300,600 12.64
Housekeeping 1,600,000 Labor hours 91,000 17.58
General 4,400,000 Salary dollars $10,183,000 0.432
Administration
Human Resources 2,550,000 Salary dollars $10,183,000 0.250

EXHIBIT 6.6
Kensington

Hospital:
Overhead
Allocation

Rates

a $ per unit of the cost driver

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 215

• $17.58 per labor hour consumed for housekeeping support.
• $0.432 per salary dollar paid to department employees for general

administrative overhead.
• $0.250 per salary dollar for human resources support.

If radiology pays a technician $10 an hour in direct labor costs for
each hour the technician works, the department will also be charged 0.432
× $10.00 = $4.32 for general administrative overhead and 0.250 × $10.00 =
$2.50 for human resources overhead, plus additional allocations for financial
services, facilities, and housekeeping support. Having two cost pools, in this
case the general administration and human resources departments, that use
the same cost driver (salary dollars) is not unusual. However, the allocation
rate is different for the two support departments because they have different
cost pool amounts.

The final step in the allocation process is to calculate the actual dol-
lar allocation to each of the patient services departments, which is shown in
Exhibit 6.7. The support departments are listed in the first column, along
with the applicable allocation rate, while the patient services departments are
listed across the top. To illustrate the calculations, consider the routine care
department. It produces $16,000,000 in patient services revenue, and the
overhead allocation rate for financial services is $0.05556 per dollar of patient
services revenue, so the allocation for such support is 0.05556 × $16,000,000
= $888,960. Furthermore, routine care has 199,800 square feet of space; with
a facilities rate of $12.64 per square foot, its allocation for facilities support
is $12.64 × 199,800 = $2,525,472.

The allocations to the routine care department for housekeeping,
general administration, and human resources support shown in Exhibit 6.7
were calculated similarly. The end result is that $8,644,050 out of a total
of $13,850,000 of the indirect (overhead) costs of Kensington Hospital are
allocated to routine care. Routine care also has direct costs of $5,500,000, so
the full (total) costs of the department, including both direct and indirect, are
$8,644,050 + $5,500,000 = $14,144,050. The cost allocations and total cost
calculations for the laboratory and radiology departments shown in Exhibit
6.7 were done in a similar manner.

For general management purposes, understanding the mechanics of the
allocation is less important than recognizing the value of choosing effective cost
drivers. The cost driver for housekeeping services (i.e., the number of service
hours provided) is good in the sense that it reflects the true level of effort
expended by this department in support of the patient services departments.
The patient services department heads are being fairly charged for these services,
and more important, patient services department heads can take actions to lower
the allocated amounts by reducing the amount of housekeeping services used.

00_GapenskiReiter (2299).indb 215 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e216

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00_GapenskiReiter (2299).indb 216 11/11/15 11:00 AM

CHAPTER

THE INCOME STATEMENT AND STATEMENT
OF CHANGES IN EQUITY

Introduction

Financial accounting involves identifying, measuring, recording, and com-
municating in dollar terms the economic events and status of an organization.
This information is summarized and presented in a set of financial statements,
or just financials. Because these statements communicate important informa-
tion about an organization, financial accounting is often called “the language
of business.” Managers of health services organizations must understand the
basics of financial accounting because financial statements are the best way to
summarize a business’s financial status and performance.

Historical Foundations of Financial Accounting

It is all too easy to think of financial statements merely as pieces of paper with
numbers written on them, rather than in terms of the economic events and
physical assets—such as land, buildings, and equipment—that underlie the

Financial
accounting
The field of
accounting that
focuses on the
measurement and
communication
of the economic
events and status
of an entire
organization.

3
Learning Objectives
After studying this chapter, readers will be able to

• Explain why financial statements are so important both to
managers and to outside parties.

• Describe the standard-setting process under which financial
accounting information is created and reported, as well as the
underlying principles applied.

• Describe the components of the income statement—revenues,
expenses, and profitability—and the relationships within and
among these components.

• Explain the differences between operating income and net income,
and between net income and cash flow.

• Describe the format and use of the statement of changes in equity.

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H e a l t h c a r e F i n a n c e76

numbers. If readers of financial statements understand how and why finan-
cial accounting began and how financial statements are used, they can better
visualize what is happening within a business and why financial accounting
information is so important.

Many thousands of years ago, individuals and families were self-contained
in the sense that they gathered their own food, made their own clothes, and
built their own shelters. When specialization began, some individuals or fami-
lies became good at hunting, others at making spearheads, others at making
clothing, and so on. With specialization came trade, initially by bartering one
type of goods for another. At first, each producer worked alone, and trade was
strictly local. Over time, some people set up production shops that employed
workers, simple forms of money were used, and trade expanded beyond the
local area. As these simple economies expanded, more formal forms of money
developed and a primitive form of banking began, with wealthy merchants
lending profits from past dealings to enterprising shop owners and traders
who needed money to expand their operations.

When the first loans were made, lenders could physically inspect bor-
rowers’ assets and judge the likelihood of repayment. Eventually, though,
lending became much more complex. Industrial borrowers were developing
large factories, merchants were acquiring fleets of ships and wagons, and
loans were being made to finance business activities at distant locations. At
that point, lenders could no longer easily inspect the assets that backed their
loans, and they needed a practical way of summarizing the value of those
assets. Also, certain loans were made on the basis of a share of the profits of
the business, so a uniform, widely accepted method for expressing income
was required. In addition, owners required reports to see how effectively their
own enterprises were being operated, and governments needed information
to assess taxes. For all these reasons, a need arose for financial statements, for
accountants to prepare the statements, and for auditors to verify the accuracy
of the accountants’ work.

The economic systems of industrialized countries have grown enormously
since the early days of trade, and financial accounting has become much more
complex. However, the original reasons for accounting statements still apply:
Bankers and other investors need accounting information to make intelligent
investment decisions; managers need it to operate their organizations effi-
ciently; and taxing authorities need it to assess taxes in an equitable manner.

It should be no surprise that problems can arise when translating physi-
cal assets and economic events into accounting numbers. Nevertheless, that
is what accountants must do when they construct financial statements. To
illustrate the translation problem, the numbers shown on the balance sheet
to reflect a business’s assets and liabilities generally reflect historical costs and
prices. However, inventories may be spoiled, obsolete, or even missing; land,

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 77

buildings, and equipment may have current values that are much higher or
lower than their historical costs; and money owed to the business may be
uncollectible. Also, some liabilities, such as obligations to make lease payments,
may not even show up in the numbers. Similarly, costs reported on an income
statement may be understated or overstated, and some costs, such as deprecia-
tion (the loss of value of buildings and equipment), do not even represent
current cash expenses. When examining a set of financial statements, it is best
to keep in mind the physical reality that underlies the numbers and to recog-
nize that many problems occur in the translation process.

The Users of Financial Accounting Information

The predominant users of financial accounting information are those parties
that have a financial interest in the organization and hence are concerned
with its economic status. All organizations, whether not-for-profit or investor
owned, have stakeholders that have an interest in the business. In a not-for-
profit organization, such as a community hospital, the stakeholders include
managers, staff physicians, employees, suppliers, creditors, patients, and even
the community at large. Investor-owned hospitals have essentially the same
set of stakeholders, plus owners. Because all stakeholders, by definition, have
an interest in the organization, all stakeholders have an interest in its financial
condition.

Of all the outside stakeholders, investors, who supply the capital (funds)
needed by businesses, typically have the greatest financial interest in health
services organizations. Investors fall into two categories: (1) owners who sup-
ply equity capital to investor-owned businesses and (2) creditors (or lenders)
who supply debt capital to both investor-owned and not-for-profit businesses.
(In a sense, communities supply equity capital to not-for-profit organizations,
so they, too, are investors.) In general, there is only one category of own-
ers. However, creditors constitute a diverse group of investors that includes
banks, suppliers granting trade credit, and bondholders. Because of their direct
financial interest in healthcare businesses, investors are the primary outside
users of financial accounting information. They use the information to make
judgments about whether to make a particular investment as well as to set

1. What are the historical foundations of financial accounting
statements?

2. Do any problems arise when translating physical assets and
economic events into monetary units? Give one or two
illustrations to support your answer.

SELF-TEST
QUESTIONS

Stakeholder
A party that
has an interest,
often financial,
in a business.
Stakeholders can
be affected by the
business’s actions,
objectives, or
policies.

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H e a l t h c a r e F i n a n c e78

the return required on the investment. (Investor-supplied capital is covered
in greater detail in chapters 11, 12, and 13.)

Although the field of financial accounting developed primarily to meet the
information needs of outside parties, the managers of an organization, including
its board of directors (trustees), also are important users of the information. After
all, managers are charged with ensuring that the organization has the financial
capability to accomplish its mission, whether that mission is to maximize the
wealth of its owners or to provide healthcare services to the community at large.
Thus, an organization’s managers not only are involved with creating financial
statements but also are important users of the statements, both to assess the
current financial condition of the organization and to formulate plans to ensure
that the future financial condition of the organization will support its goals.

In summary, investors and managers are the predominant users of finan-
cial accounting information as a result of their direct financial interest in the
organization. Furthermore, investors are not merely passive users of financial
accounting information; they do more than just read and interpret the state-
ments. Often, they create financial targets based on the numbers reported in
financial statements that managers must attain or suffer some undesirable
consequence. For example, many debt agreements require borrowers to main-
tain stated financial standards, such as a minimum earnings level, to keep the
debt in force. If the standards are not met, the lender can demand that the
business immediately repay the full amount of the loan. If the business fails
to do so, it may be forced into bankruptcy.

Regulation and Standards in Financial Accounting

As a consequence of the Great Depression of the 1930s, which caused many
businesses to fail and almost brought down the entire securities industry, the
federal government began regulating the form and disclosure of information
related to publicly traded securities. The regulation is based on the theory that
financial information constructed and presented according to standardized
rules allows investors to make the best-informed decisions. The newly formed
(at that time) Securities and Exchange Commission (SEC), an independent
regulatory agency of the US government, was given the authority to establish
and enforce the form and content of financial statements. Nonconforming
companies are prohibited from selling securities to the public, so many busi-
nesses comply to gain better access to capital. Not-for-profit corporations that

1. What is a stakeholder?
2. Who are the primary users of financial accounting information?
3. Are investors passive users of this information?

SELF-TEST
QUESTIONS

Securities
and Exchange
Commission (SEC)
The federal
government
agency that
regulates the sale
of securities and
the operations
of securities
exchanges.
Also has overall
responsibility for
the format and
content of financial
statements.

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 79

do not sell securities still must file financial statements with state authorities
that conform to SEC standards. Finally, most for-profit businesses that do not
sell securities to the public are willing to follow the SEC-established guidelines
to ensure uniformity of presentation of financial data. The end result is that all
businesses, except for the smallest, create SEC-conforming financial statements.

Rather than directly manage the process, the SEC designates other
organizations to create and implement the standards system. For the most
part, the SEC has delegated the responsibility for establishing reporting stan-
dards to the Financial Accounting Standards Board (FASB)—a private
organization whose mission is to establish and improve standards of financial
accounting and reporting for private businesses. (The Government Account-
ing Standards Board [GASB] has the identical responsibility for businesses
that are partially or totally funded by a government entity.) Typically, the
guidance issued by FASB, which is promulgated by numbered statements,
applies across a wide range of industries and, by design, is somewhat general
in nature. More specific implementation guidance, especially when industry-
unique circumstances must be addressed, is provided by industry committees
established by the American Institute of Certified Public Accountants
(AICPA)—the professional association of public (financial) accountants. For
example, financial statements in the health services industry are based on the
AICPA Audit and Accounting Guide titled Health Care Entities, which was
published most recently on September 1, 2014.

Because of the large number of statements and pronouncements that
have been issued by FASB and other standard-setting organizations, FASB
combined all of the previously issued standards into a single set called the
FASB Accounting Standards Codification, which became effective on September
15, 2009. The purpose of the codification is to simplify access to accounting
standards by placing them in a single source and creating a system that allows
users to more easily research and reference accounting standards data.

When even more specific guidance is required than provided by the
standards, other professional organizations may participate in the process,
although such work does not have the same degree of influence as codifica-
tion has. For example, the Healthcare Financial Management Association
has established the Principles and Practices Board, which develops position
statements and analyses on issues that require further guidance—for example,
its statement regarding the valuation and financial statement presentation of
charity care and bad debt losses, which was issued in 2006 and revised in 2012.

When taken together, all the guidance contained in the codification
and the amplifying information constitute a set of guidelines called gener-
ally accepted accounting principles (GAAP). GAAP can be thought of as
a set of objectives, conventions, and principles that have evolved through the
years to guide the preparation and presentation of financial statements. In
essence, GAAP sets the rules for the financial statement preparation game.

Financial
Accounting
Standards Board
(FASB)
A private
organization
whose mission
is to establish
and improve
the standards
of financial
accounting and
reporting for
private businesses.

American Institute
of Certified Public
Accountants
(AICPA)
The professional
association of
public (financial)
accountants.

Generally
accepted
accounting
principles (GAAP)
The set of
guidelines that has
evolved to foster
the consistent
preparation and
presentation
of financial
statements.

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H e a l t h c a r e F i n a n c e80

Note, however, that GAAP applies only to the area of financial accounting
(financial statements), as distinct from other areas of accounting, such as
managerial accounting (discussed in later chapters) and tax accounting.

It should be no surprise that the field of financial accounting is typically
classified as a social science rather than a physical science. Financial accounting
is as much an art as a science, and the end result represents negotiation, com-
promise, and interpretation. The organizations involved in setting standards are
continuously reviewing and revising GAAP to ensure the best possible develop-
ment and presentation of financial data. This task, which is essential to economic
prosperity, is motivated by the fact that the US economy is constantly evolving,
with new types of business arrangements and securities being created almost daily.

For large organizations, the final link in the financial statement quality
assurance process is the external audit, which is performed by an independent
(outside) auditor—usually one of the major accounting firms. The results of

the external audit are reported in the audi-
tor’s opinion, which is a letter attached to
the financial statements stating whether or
not the statements are a fair presentation of
the business’s operations, cash flows, and
financial position as specified by GAAP.

There are several categories of opinions
given by auditors. The most favorable, which
is essentially a “clean bill of health,” is called an
unqualified opinion. Such an opinion means
that, in the auditor’s opinion, the financial
statements conform to GAAP, are presented
fairly and consistently, and contain all neces-
sary disclosures. A qualified opinion means
that the auditor has some reservations about
the statements, while an adverse opinion means
that the auditor believes that the statements
do not present a fair picture of the financial
status of the business. The entire audit pro-
cess, which is performed by the organization’s
internal auditors and the external auditor, is
a means of verifying and validating the orga-
nization’s financial statements. Of course,
an unqualified opinion gives users, especially
those external to the organization, more con-
fidence that the statements truly represent the
business’s current financial condition.

Although one would think that the
guidance given under GAAP, along with

For Your Consideration
International Financial Reporting Standards

As the globalization of business continues, it
becomes more and more important for financial
accounting standards to be uniform across coun-
tries. At this time, FASB and the International
Accounting Standards Board (IASB) are working
jointly on convergence, a process to develop a
common set of standards that would be accepted
worldwide. These standards, called International
Financial Reporting Standards (IFRS), ultimately
will be applicable to for-profit businesses in more
than 150 countries, including the United States.
Currently, over 100 countries have adopted IFRS
standards, but not the United States.

Needless to say, a large number of details
must be worked out, and differences between
current US and international standards must be
resolved. Thus, it is expected that total conver-
gence will not occur for a number of years. Also,
the impact of international standards on not-for-
profit organizations is uncertain at this time.

What do you think? Should financial
accounting standards be applicable to for-profit
businesses worldwide as opposed to country
by country? What is the rationale behind your
opinion? Should not-for-profit organizations be
subject to international standards? Support your
position.

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 81

auditing rules, would be sufficient to prevent fraudulent financial statements,
in the early 2000s several large companies, including HealthSouth, which
operates the nation’s largest network of rehabilitation services, were found to
be “cooking the books.” Because the US financial system is so dependent on
the reliability of financial statements, in 2002 Congress passed the Sarbanes-
Oxley Act, generally known as SOX, as a measure to improve transparency in
financial accounting and to prevent fraud. (According to the SEC, transparency
means the timely, meaningful, and reliable disclosure of a business’s financial
information.) Here are just a few of the more important provisions of SOX:

• An independent body, the Public Accounting Oversight Board, was
created to oversee the entire audit process.

• Auditors can no longer provide non-auditing (consulting) services to
the companies that they audit.

• The lead partners of the audit team for any company must rotate off
the team every five years (or more often).

• Senior managers involved in the audits of their companies cannot
have been employed by the auditing firm during the one-year period
preceding the audit.

• Each member of the audit committee shall be a member of the
company’s board of directors and shall otherwise be independent of
the audit function.

• The chief executive officer (CEO) and chief financial officer (CFO)
shall personally certify that the business’s financial statements are
complete and accurate. Penalties for certifying reports that are known
to be false range up to a $5 million fine, 20 years in prison, or both. In
addition, if the financial statements must be restated because they are
false, certain bonuses and equity-based compensation that certifying
executives earned must be returned to the company.

It is hoped that these provisions, along with others in SOX, will deter
future fraudulent behavior by managers and auditors. So far, so good.

1. Why are widely accepted principles important for the measurement
and recording of economic events?

2. What entities are involved in regulating the development and
presentation of financial statements?

3. What does GAAP stand for, and what is its primary purpose?
4. What is the purpose of the auditor’s opinion?
5. What is the purpose of SOX, and what are some of its provisions?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e82

Conceptual Framework of Financial Reporting

Because the actual preparation of financial statements is done by accountants,
a detailed presentation of accounting theory is not required in this book.
However, to better understand the content of financial statements, it is useful
to discuss some aspects of the conceptual framework that accountants apply
when they develop financial accounting data and prepare an organization’s
financial statements. By understanding this framework, readers will be better
prepared to understand and interpret the financial statements of healthcare
organizations.

The goal of financial accounting is to provide information about organi-
zations that is useful to present and future investors and other users in making
rational financial and investment decisions. To achieve this objective, GAAP
specifies recognition and measurement concepts that include four assumptions,
four principles, and two constraints.

Assumptions
Accounting Entity
The first assumption is the ability to define the accounting entity, which
is important for two reasons. First, for investor-owned businesses, financial
accounting data must be pertinent to the business activity as opposed to the
personal affairs of the owners. Second, within any business, the accounting
entity defines the specific areas of the business to be included in the statements.
For example, a healthcare system may create one set of financial statements
for the system as a whole and separate sets of statements for its subsidiary
hospitals. In effect, the accounting entity specification establishes boundaries
that tell readers what business (or businesses) is being reported on.

Going Concern
It is assumed that the accounting entity will operate as a going concern and
hence will have an indefinite life. This means that assets, in general, should be
valued on the basis of their contribution to an ongoing business as opposed to
their current fair market value. For example, the land, buildings, and equipment
of a hospital may have a value of $50 million when used to provide patient
services, but if they are sold to an outside party for other purposes, the value
of these assets might only be $20 million. Furthermore, short-term events
should not be allowed to unduly influence the data presented in financial state-
ments. The going concern assumption, coupled with the fact that financial
statements must be prepared for relatively short periods (as explained next),
means that financial accounting data are not exact but represent logical and
systematic approaches applied to complex measurement problems.

Accounting entity
The entity
(business) for
which a set
of accounting
statements
applies.

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 83

Periodicity
Because accounting entities are assumed to have an indefinite life but users of
financial statements require timely information, it is common to report finan-
cial results on a relatively short periodic basis. The period covered, called an
accounting period, can be any length of time over which an organization’s
managers, or outside parties, want to evaluate operational and financial results.
Most health services organizations use calendar periods—months, quarters,
and years—as their accounting periods. However, occasionally an organization
will use a fiscal year (financial year) that does not coincide with the calendar
year. For example, the federal government has a fiscal year that runs from
October 1 to September 30, and the State of Florida has a fiscal year that
runs from July 1 to June 30. Although annual accounting periods are typically
used for illustrations in this book, financial statements commonly are prepared
for periods shorter than one year. For example, many organizations prepare
semiannual and quarterly financial statements in addition to annual statements.

Monetary Unit
The monetary unit provides the common basis by which economic events are
measured. In the United States, this unit is the dollar, unadjusted for inflation
or deflation. Thus, all transactions and events must be expressed in dollar terms.

Principles
Historical Costs
The historical cost principle requires organizations to report the values of most
assets based on acquisition costs rather than fair market value, which implies
that the dollar has constant purchasing power over time. In other words, land
that cost $1 million 20 years ago might be worth $2 million today, but it is
still reported at its initial cost of $1 million. The accounting profession has
grappled with the inflation impact problem for years but has not yet developed
a feasible solution. The historical cost principle ensures reliable information,
which removes subjectivity, but it does not provide the most current informa-
tion. We should note, however, that some items (primarily security holdings)
are reported at fair market value.

Revenue Recognition
The revenue recognition principle requires that revenues be recognized in the
period in which they are realizable and earned. Generally, this is the period in
which the service is rendered, because at that point the price is known (realiz-
able) and the service has been provided (earned). However, in some instances,
difficulties in revenue recognition arise, primarily when there are uncertainties
surrounding the revenue amount or the completion of the service.

Accounting period
The period
(amount of time)
covered by a
set of financial
statements—
often a year, but
sometimes a
quarter or another
time period.

Fiscal year
The year
covered by an
organization’s
financial
statements.
It usually, but
not necessarily,
coincides with a
calendar year.

Historical cost
In accounting, the
purchase price of
an asset.

Revenue
recognition
principle
The concept that
revenues must be
recognized in the
accounting period
in which they are
realizable and
earned.

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H e a l t h c a r e F i n a n c e84

Expense Matching
The expense-matching principle requires that an organization’s expenses be
matched, to the extent possible, with the revenues to which they are related.
In essence, after the revenues have been allocated to a particular accounting
period, all expenses associated with producing those revenues should be matched
to the same period. Although the concept is straightforward, implementa-
tion of the matching principle creates many problems. For example, consider
long-lived assets such as buildings and equipment. Because such assets—for
example, an MRI machine—provide revenues for several years, the expense-
matching principle dictates that its acquisition cost should be spread over the
same number of years. However, there are many alternative ways to do this,
and no single method is clearly best.

Full Disclosure
Financial statements must contain a complete picture of the economic events
of the business. Anything less would be misleading by omission. Further-
more, because financial statements must be relevant to a diversity of users, the
full-disclosure principle pushes preparers to include even more information in
financial statements. However, the complexity of the information presented
can be mitigated to some extent by placing some information in the notes or
supplementary information sections as opposed to the body of the financial
statements.

Constraints
Materiality
If the financial statements contained all possible information, they would be
so long and detailed that making inferences about the organization would be
difficult without a great deal of analysis. Thus, to keep the statements man-
ageable, only entries that are important to the operational and financial status
of the organization need to be separately identified. For example, medical
equipment manufacturers carry large inventories of materials that are both
substantial in dollar value relative to other assets and instrumental to their core
business, so such businesses report inventories as a separate asset item on the
balance sheet. Hospitals, on the other hand, carry a relatively small amount
of inventories. Thus, many hospitals and other healthcare providers do not
report inventories separately but combine them with other assets. In general,
the materiality constraint affects the presentation of the financial statements
rather than their aggregate financial content (i.e., the final numbers).

Cost–Benefit
There are costs associated with financial statement information for both the
preparers of the statements and the users. Preparers must collect, record, verify,

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 85

and report financial information, while users must analyze and interpret the
information. As a result, financial statements cannot report all possible infor-
mation that every potential user might find relevant. When deciding what
information should be reported, and how that information should be reported,
standards setters and accountants must determine whether the benefits of the
information outweigh the associated costs.

Accounting Methods: Cash Versus Accrual

In the implementation of the conceptual framework discussed in the previous
section, two different methods have been applied: cash accounting and accrual
accounting. Although, as we discuss below, each method has its own set of
advantages and disadvantages, GAAP specifies that only the accrual method
can receive an unqualified auditor’s opinion, so accrual accounting dominates
the preparation of financial statements. Still, many small businesses that do
not require audited financial statements use the cash method, and knowledge
of the cash method helps our understanding of the accrual method, so we
discuss both methods here.

Cash Accounting
Under cash accounting, often called cash basis accounting, economic events
are recognized—put into the financial statements—when the cash transaction

1. Why is it important to understand the basic accounting concepts
that underlie the preparation of financial statements?

2. What is the goal of financial accounting?
3. Briefly explain the following assumptions, principles, and

constraints as they apply to the preparation of financial
statements:
• Accounting entity
• Going concern
• Accounting period
• Monetary unit
• Historical cost
• Revenue recognition
• Expense matching
• Full disclosure
• Materiality
• Cost–benefit

SELF-TEST
QUESTIONS

Cash accounting
The recording of
economic events
when a cash
exchange takes
place.

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H e a l t h c a r e F i n a n c e86

occurs. For example, suppose Sunnyvale Clinic, a large multispecialty group
practice, provided services to a patient in December 2015. At that time, the
clinic billed Florida Blue (Blue Cross and Blue Shield of Florida) $700, the
full amount that the insurer was obligated to pay. However, Sunnyvale did
not receive payment from the insurer until February 2016. If it used cash
accounting, the $700 obligation on the part of Florida Blue would not appear
in Sunnyvale’s 2015 financial statements. Rather, the revenue would be rec-
ognized when the cash was actually received in February 2016.

The core argument in favor of cash accounting is that the most impor-
tant event to record on the financial statements is the receipt of cash, not the
provision of the service (i.e., the obligation to pay). Similarly, Sunnyvale’s costs
of providing services would be recognized as the cash is physically paid out:
Inventory costs would be recognized as supplies are purchased, labor costs
would be recognized when employees are paid, new equipment purchases
would be recognized when the invoices are paid, and so on. To put it simply,
cash accounting records the actual flow of money into and out of a business.

There are two advantages to cash accounting. First, it is simple and easy
to understand. No complex accounting rules are required for the preparation of
financial statements. Second, cash accounting is closely aligned to accounting
for tax purposes, and hence it is easy to translate cash accounting statements
into income tax filing data. Because of these advantages, about 80 percent of
all medical practices, typically the smaller ones, use cash accounting. However,
cash accounting has its disadvantages, primarily the fact that in its pure form
it does not present information on revenues owed to a business by payers or
the business’s existing payment obligations.

Before closing our discussion of cash accounting, we should note that
most businesses that use cash accounting do not use the “pure” method
described here but use a hybrid method called modified cash basis accounting.
The modified statements combine some features of cash accounting, usually to
report revenues and expenses, with some features of accrual accounting, usually
to report assets and liabilities. Still, the cash method presents an incomplete
picture of the financial status of a business and hence the preference by GAAP
for accrual accounting.

Accrual Accounting
Under accrual accounting, often called accrual basis accounting, the economic
event that creates the financial transaction, rather than the transaction itself,
provides the basis for the accounting entry. When applied to revenues, the
accrual concept implies that revenue earned does not necessarily correspond
to the receipt of cash. Why? Earned revenue is recognized in financial state-
ments when a service has been provided that creates a payment obligation
on the part of the payer, rather than when the payment is actually received.

Accrual accounting
The recording of
economic events
in the periods in
which the events
occur, even if
the associated
cash receipts or
payments happen
in a different
period.

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 87

For healthcare providers, the payment obligation typically falls on the patient,
a third-party payer, or both. If the obligation is satisfied immediately, such
as when a patient makes full payment at the time the service is rendered, the
revenue is in the form of cash. In such cases, the revenue is recorded at the
time of service whether cash or accrual accounting is used.

However, in most cases, the bulk of the payment for services comes from
third-party payers and is not received until later, perhaps several months after
the service is provided. In this situation, the revenue created by the service
does not create an immediate cash payment. If the payment is received within
an accounting period—one year, for our purposes—the conversion of revenues
to cash will be completed, and as far as the financial statements are concerned,
the reported revenue is cash. However, when the revenue is recorded (i.e.,
services are provided) in one accounting period and payment does not occur
until the next period, the revenue reported has not been collected.

Consider the Sunnyvale Clinic example presented in our discussion of
cash accounting. Although the services were provided in December 2015, the
clinic did not receive its $700 payment until February 2016. Because Sunnyvale’s
accounting year ended on December 31 and the clinic actually uses accrual
accounting, the clinic’s books were closed after the revenue had been recorded
but before the cash was received. Thus, Sunnyvale reported this $700 of revenue
on its 2015 financial statements, even though no cash was collected. When
accrual accounting is used, the amount of revenues not collected is listed as a
receivable (the amount due to Sunnyvale) in the financial statements, so users
will know that not all reported revenues represent cash receipts.

The accrual accounting concept also applies to expenses. To illustrate,
assume that Sunnyvale had payroll obligations of $20,000 for employees’ work
during the last week of 2015 that would not be paid until the first payday in
2016. Because the employees actually performed the work, the obligation to
pay the salaries was created in 2015. An expense will be recorded in 2015
even though no cash payment will be made until 2016. Under cash basis
accounting, Sunnyvale would not recognize the labor expense until it was
paid, in this case in 2016. But under accrual accounting, the $20,000 will be
shown as an expense on the financial statements in 2015 and, at the same
time, the statements will indicate that a $20,000 liability (or obligation to pay
employees) exists.

1. Briefly explain the differences between cash and accrual
accounting, and give an example of each.

2. What is modified cash basis accounting?
3. Why does GAAP favor accrual over cash accounting?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e88

Recording and Compiling Financial Accounting Data

The ultimate goal of a business’s financial accounting system is to produce
financial statements. However, the road from the recording of basic account-
ing data to the completion of the financial statements is long and arduous,
especially for large, complex organizations. The starting point for the iden-
tification and recording of financial accounting information is a transaction,
which is defined as an exchange of goods or services from one individual or
enterprise to another. To ensure that the transaction is faithfully represented
and verifiable—two qualitative characteristics of useful financial information
under the conceptual framework—each transaction must be supported by
relevant documentation, which is retained for some required length of time.

Once a transaction is identified, it must be recorded, or posted, to an
account, which is a record of transactions for one uniquely identified activity.
For example, under the general heading of cash, separate accounts might be
established for till cash, payroll checks, vendor checks, other checks, and the
like. A large business can easily have hundreds, or even thousands, of separate
primary accounts, which are combined to form the general ledger, plus sub-
sidiary accounts that support the primary accounts. The subsidiary accounts,
which pertain to specific assets or liabilities or to individual patients or ven-
dors, are aggregated to create data for a primary (general ledger) account. For
example, individual patient charges, which are carried in subsidiary accounts,
are aggregated into one or more general ledger revenue accounts.

To help manage the large number of accounts, businesses have a docu-
ment called a chart of accounts, which assigns a unique numeric code to each
account. For example, the till cash account might have the code 1-1000-00,
while the account for checks written might have the code 1-1100-00. The
first 1 indicates that the account is an asset account; the second 1 indicates a
cash account; and the next digit, 0 or 1, indicates the specific cash account.
Further numbers are available should the organization decide to subdivide
either the till cash or the checks-written accounts into subsidiary accounts.
For example, the next digit of the checks-written account might indicate the
purpose of the check: 1 for payroll, 2 for vendor payments, and so on. Because
everyone who deals with the accounts is familiar with the business’s chart of
accounts, transactions can be easily sorted by account code to ensure that they
are posted to the correct account.

Within the system of primary and subsidiary accounts, accounts are
further classified as follows:

• Permanent accounts include items that must be carried from one
accounting period to another. Thus, permanent accounts remain active
until the items in the account are no longer “on the books” of the
business. For example, an account might be created, or opened, to

General ledger
The master
listing of an
organization’s
primary accounts,
which record the
transactions that
ultimately are
used to create
a business’s
financial
statements.

Chart of accounts
A document
that assigns a
unique numerical
identifier to every
account of an
organization.

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 89

contain all transactions related to a five-year bank loan. The account
would remain open to record transactions relating to the loan—say,
annual interest payments—until the loan was paid off in five years, at
which time the account would be closed.

• Temporary accounts are for those items that will automatically be
closed at the end of each accounting period. For example, a business’s
revenue and expense accounts typically are closed at the end of the
accounting period, and then new accounts are opened, with a zero
balance, at the beginning of the next period.

• Contra accounts are special accounts that convert the gross value
of some other account into a net value. As you will see in the next
chapter, there is a contra account associated with depreciation expense,
which accounts for the loss of value of buildings and equipment due to
“wear and tear.”

Each transaction is recorded in an account by a journal entry. The sys-
tem used in making journal entries is called the double entry system because
each transaction must be entered in at least two different accounts—once as
a debit and once as a credit. Such a system ensures consistency among the
financial statements. Because accounts have both debit and credit entries,
they traditionally have been set up in a “T” format and hence are called T
accounts, with debits entered on the left side of the vertical line and credits
entered on the right side. To illustrate the double entry system, assume that
Sunnyvale Clinic receives $100 in cash from a self-pay patient at the time of
the visit. A debit entry would be made in the cash account indicating a $100
receipt, while a credit entry would be made in the equity account indicating
that the business’s value has increased by the amount of the cash revenue.
Note that whether an entry is a debit or a credit depends both on the nature
of the entry (revenue or expense) and the type of account, so these entries
may be counterintuitive to someone not familiar with the double entry system.

Ultimately, the journal entries are verified, consolidated, and reconciled
in a trial balance, and the trial balance is formatted into the business’s financial
statements. Often, the primary means for disseminating this information to
outsiders is the business’s annual report. It typically begins with a descriptive
section that discusses, in general terms, the organization’s operating results over
the past year as well as developments that are expected to affect future opera-
tions. The descriptive section is followed by the business’s financial statements.

Because the actual financial statements cannot possibly contain all rel-
evant information, additional information is provided in the notes section.
For health services organizations, these notes contain information on such
topics as inventory accounting practices, the composition of long-term debt,
pension plan status, the amount of charity care provided, and the cost of
malpractice insurance.

Double entry
system
The system
used to make
accounting journal
entries. Called
double entry
because each
transaction has to
be entered in at
least two different
accounts.

Annual report
A report issued
annually by an
organization to
its stakeholders
that contains
descriptive
information and
historical financial
statements.

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H e a l t h c a r e F i n a n c e90

In addition to the body of the financial statements and the notes sec-
tion, GAAP requires organizations to provide certain supplementary informa-
tion. Other supplementary information may be voluntarily provided by the
reporting organization. For example, a healthcare system may report the rev-
enues of its primary subsidiaries as supplementary data even though the state-
ments focus on the aggregate revenues of the entire system. Because the notes
and supplementary information sections contain a great deal of information
essential to a good understanding of the financial statements, a thorough
examination always considers the information contained in these two
sections.

Income Statement Basics

In this section, we begin our coverage of the four primary financial statements
by discussing the income statement. Then, in a later section, we discuss the
statement of changes in equity. In Chapter 4, the remaining two statements—the
balance sheet and the statement of cash flows—are discussed. Unfortunately,
the names of the statements are not consistent across types of organizations.
We will introduce the alternative names of each statement as it is discussed.

The purpose of our financial accounting discussion is to provide readers
with a basic understanding of the preparation, content, and interpretation of
a business’s financial statements. Unfortunately, the financial statements of
large organizations can be long and complex, and there is significant leeway
regarding the format used, even within health services organizations. Thus, in
our discussion of the statements, we use simplified illustrations that focus on
key issues. In a sense, the financial statements presented here are summaries
of actual financial statements, but this is the best way to learn the basics; the
nuances must be left to other books that focus exclusively on accounting issues.

1. Briefly explain the following terms used in the recording and
compiling of accounting data:
• Transaction
• Account
• Posting
• Chart of accounts
• General ledger
• T account
• Double entry system

2. Why are the notes and supplementary information sections
important parts of the financial statements?

SELF-TEST
QUESTIONS

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 91

Perhaps the most frequently asked, and the most important, question
about a business is this: Is it making money? The income statement summa-
rizes the operations (activities) of an organization with a focus on its revenues,
expenses, and profitability. Thus, the income statement is also called the state-
ment of operations, statement of activities, or statement of revenues and expenses.

The income statements of Sunnyvale Clinic are presented in Exhibit 3.1.
Most financial statements contain two or three years of data, with the most
recent year presented first. The title section tells us that these are annual income
statements, ending on December 31, for the years 2015 and 2014. Whereas
the balance sheet, which is covered in Chapter 4, reports a business’s financial
position at a single point in time, the income statement contains operational
results over a specified period of time. Because these income statements are part
of Sunnyvale’s annual report, the time (accounting) period is one year. Also,
the dollar amounts reported are listed in thousands of dollars, so the $148,118
listed as net patient service revenue for 2015 is actually $148,118,000.

The core components of the income statement are straightforward:
revenues, expenses, and profitability (net operating income and net income).
Revenues, as discussed previously in the section on cash versus accrual account-
ing, represent both the cash received and the unpaid obligations of payers for

Income statement
A financial
statement,
prepared in
accordance with
generally accepted
accounting
principles (GAAP),
that summarizes
a business’s
revenues,
expenses, and
profitability.

2015 2014

Operating Revenues:
Patient service revenue $ 150,118 $123,565
Less: Provision for bad debts 2,000 1,800
Net patient service revenue $ 148,118 $ 121,765
Premium revenue 18,782 16,455
Other revenue 3,079 2,704

Net operating revenues $ 169,979 $140,924

Expenses:
Salaries and benefits $ 126,223 $ 102,334
Supplies 20,568 18,673
Insurance 4,518 3,710
Lease 3,189 2,603
Depreciation 6,405 5,798
Interest 5,329 3,476

Total expenses $ 166,232 $ 136,594
Operating income $ 3,747 $ 4,330
Nonoperating income:
Contributions $ 243 $ 198
Investment income 3,870 3,678
Total nonoperating income $ 4,113 $ 3,876
Net income $ 7,860 $ 8,206

EXHIBIT 3.1
Sunnyvale

Clinic:
Statements of

Operations,
Years Ended
December 31,
2015 and 2014
(in thousands)

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H e a l t h c a r e F i n a n c e92

services provided during each year presented. For healthcare providers, the
revenues result mostly from the provision of patient services. However, in
addition to revenues from patient and patient-related services, some revenues,
designated contributions and investment income in Exhibit 3.1, stem from
donations and securities investments, respectively, and hence have nothing to
do with patient services.

To produce revenues, organizations must incur expenses, which are
classified as operating or capital (financial). Although not separately broken
out on the income statement, operating expenses consist of salaries, supplies,
insurance, and other costs directly related to providing services. Capital costs
are the costs associated with the buildings and equipment used by the orga-
nization, such as depreciation, lease, and interest expenses. Expenses decrease
the profitability of a business, so expenses are subtracted from revenues to
determine an organization’s profitability. Sunnyvale’s income statement reports
two different measures of profitability: operating income and net income.

The income statement, then, summarizes the ability of an organization
to generate profits. Basically, it lists the organization’s revenues (and income),
the expenses that must be incurred to produce the revenues, and the differ-
ences between the two. In the following sections, the major components of
the income statement are discussed in detail.

Revenues

Revenues can be shown on the income statement in several different formats.
In fact, there is more latitude in the construction of the income statement
than there is in that of the balance sheet, so the income statements for differ-
ent types of healthcare providers tend to differ more in presentation than do
their balance sheets. (See problems 3.2 and 3.3, as well as Exhibit 17.1, for
examples of income statements from other types of providers.)

Sunnyvale’s operating revenues section (see Exhibit 3.1) focuses on
revenues that stem from the provision of patient services; in other words,
they derive from operations. As we discuss in a later section, Sunnyvale also
has revenues from contributions and securities investments (nonoperating
income), but because such income is not related to core business activities, it
is reported separately on the income statement.

1. What is the primary purpose of the income statement?
2. In regard to time, how do the income statement and balance sheet

differ?
3. What are the major components of the income statement?

SELF-TEST
QUESTIONS

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 93

The first line of the operating revenues section reports patient service
revenue of $150,118,000 for 2015. The key term here is patient service. This
line contains revenues that stem solely from patient services, as opposed to
revenues that stem from related sources, such as parking fees or food services,
which are reported on a separate line in the operating revenues section. Also,
as discussed later, patient service revenue that stems from capitated patients
may be reported separately. If this is the case, the $150,118,000 reported
by Sunnyvale as patient service revenue includes only revenue from fee-for-
service patients.

Sunnyvale, like all healthcare providers, has a charge description master
file, or chargemaster, that contains the charge code and gross price for each item
and service that it provides. However, the chargemaster price rarely represents
the amount the clinic expects to be paid for a particular service. For example,
the price for a particular service might be $800, while the contract with a
particular payer might specify a 40 percent discount from charges, which would
result in a reimbursement of only $480. In addition to negotiated discounts,
governmental payers such as Medicare and Medicaid reimburse providers a
set amount that often is well below the chargemaster (gross) price.

Because recorded revenue must reflect only amounts that are realizable
(collectible), differences between chargemaster prices and actual reimburse-
ment amounts are incorporated before the revenue is recorded on the patient
service revenue line. Thus, the patient service revenue shown on the income
statement is reported after contractual allowances have been considered and
hence represents the actual reimbursement amount expected.

To add to the complexity of revenue reporting, some services have been
provided as charity care to indigent patients. (Indigent patients are those who
presumably are willing to pay for services provided but do not have the ability
to do so.) Sunnyvale has no expectation of ever collecting for these services, so,
like contractual allowances, charges for charity care services are not reflected
in the $150,118,000 patient service revenue reported for 2015.

Finally, some payments for patient services that are owed, and hence
reported as patient service revenue, will never be collected and ultimately will
become bad debt losses. To recognize that Sunnyvale does not really expect to
collect the entire $150,118,000 patient service revenue reported, the second
entry in the operating revenues section for 2015 lists a $2,000,000 provision
for bad debts. When this amount is subtracted, the result is a net patient ser-
vice revenue of $148,118,000 for 2015. Note the distinction between charity
care and bad debt losses. Charity care represents services that are provided
to patients who do not have the capacity to pay. Typically, such patients
are identified before the service is rendered. Bad debt losses result from the
failure to collect revenues from patients or third-party payers who do have
the capacity to pay.

Patient service
revenue
Revenue that
stems solely from
the provision of
patient services. In
some situations,
may only reflect
revenue from
fee-for-service
patients.

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H e a l t h c a r e F i n a n c e94

A description of policies regarding
discounts and charity care often appears in
the notes to the financial statements. Sunny-
vale’s financial statements include the fol-
lowing two notes:

Revenues. Sunnyvale has entered into agree-

ments with third-party payers, including gov-

ernmental programs, under which it is paid for

services on the basis of established charges,

the cost of providing services, predetermined

rates, or discounts from established charges.

Revenues are recorded at estimated amounts

due from patients and third-party payers for

the services provided. Settlements under reim-

bursement agreements with third-party payers

are estimated and recorded in the period the

related services are rendered and are adjusted

in future periods, as final settlements are

determined. The adjustments to estimated

settlements for prior years are not considered

material and thus are not shown in the financial

statements or footnotes.

Charity care. Sunnyvale has a policy of provid-

ing charity care to indigent patients in emer-

gency situations. These services, which are not

reported as revenues, amounted to $67,541 in

2015 and $51,344 in 2014.

Even though Sunnyvale ultimately
expects to collect all of its reported net
patient service revenue not yet received,

the clinic did not actually receive $148,118,000 in cash payments from fee-
for-service patients and insurers in 2015. Rather, some of the revenue has not
yet been collected. As readers will learn in Chapter 4, the yet-to-be-collected
portion of the net patient service revenue—$28,509,000—appears on the
balance sheet (see Exhibit 4.1) as net patient accounts receivable.

If a provider has a significant amount of revenue stemming from capita-
tion contracts, it is often reported separately in the operating revenues section
as premium revenue. Sunnyvale reported premium revenue of $18,782,000
for 2015. The key difference is that patient service revenue is reported when

Premium revenue
Patient service
revenue that stems
from capitated
patients as
opposed to fee-for-
service patients.

Industry Practice
Revenue Reporting in the “Good Old Days”

About 20 years ago, hospital revenues were
reported differently from today. Back then, the
revenues section would begin with gross patient
services revenue based on chargemaster prices.
In other words, every service provided would
be recorded at its chargemaster price and those
prices would be aggregated to calculate reported
revenues.

Then, the total amount of discounts and
allowances would be listed, followed by the total
amount of charity care provided, and these values
would be subtracted from gross patient service
revenue to obtain net patient service revenue.
In this format, discounts and allowances and
charity care were prominently displayed at the
top of the income statement. Today, however, if
these amounts are listed at all, they typically are
listed in the notes to the financial statements as
opposed to the income statement itself.

Also, the treatment of bad debt losses has
recently changed. Whereas the provision for bad
debts had been listed on the income statement
as an expense, it is now listed as a deduction to
patient service revenue.

What do you think? Is the “old” way or the
current system best? Why do you think GAAP was
changed to report only the net amount expected
to be collected, as opposed to the gross amount
billed? Also, why was the provision for bad debt
losses moved from an expense item to the rev-
enues section?

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 95

services are provided, but premium revenue is reported at the start of each
contract payment period—typically the beginning of each month. Thus, pre-
mium revenue implies an obligation on the part of the reporting organization
to provide future services, while patient service revenue represents an obligation
on the part of payers to pay the reporting organization for services already
provided. Also, different types of providers may use different terminology for
revenues; for example, some nursing homes report resident service revenue.

Most health services organizations have revenue related to, but not
arising directly from, patient services, and Sunnyvale is no exception. In 2015,
Sunnyvale reported other revenue of $3,079,000. Examples of other revenue
include parking fees; nonpatient food service charges; office and concession
rentals; and sales of pharmaceuticals to employees, staff, and visitors.

When all the revenue associated with patient services is totaled, the
amount reported as net operating revenues for 2015 is $169,979,000. This
amount represents the net amount of revenue that stems from a provider’s
core operations—the provision of patient services. Income that results from
noncore activities—primarily contributions and securities investments—will
be reported at the bottom of the income statement.

Expenses

Expenses are the costs of doing business. As shown in Exhibit 3.1, Sunnyvale
reports its expenses in categories such as salaries and benefits, supplies, insur-
ance, and so on. According to GAAP, expenses may be reported using either
a natural classification, which classifies expenses by the nature of the expense,
as Sunnyvale does, or a functional classification, which classifies expenses by
purpose, such as inpatient services, outpatient services, and administrative.

1. What categories of revenue are reported on the income
statement?

2. Briefly, what is the difference between gross patient service
revenue and net patient service revenue?

3. Describe how the following types of revenue are reported on the
income statement:
• Contractual discounts and allowances
• Charity care
• Bad debt losses

4. Is income from securities investments included in the revenue
section? If not, why not?

SELF-TEST
QUESTIONS

Expenses
The costs of doing
business. Or, the
dollar amount of
resources used in
providing services.

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H e a l t h c a r e F i n a n c e96

The number and nature of expense items reported on the income
statement can vary widely depending on the nature and complexity of the
organization. For example, some businesses, typically smaller ones, may report
only two categories of expenses: health services and administrative. Others
may report a whole host of categories. Sunnyvale takes a middle-of-the-road
approach to the number of expense categories. Most users of financial state-
ments would prefer more, as well as a mixing of classifications, rather than less
because more insights can be gleaned if an organization reports revenues and
expenses both by service breakdown (e.g., inpatient versus outpatient) and
by type (e.g., salaries versus supplies). To assist readers, some organizations
present additional detail on expenses in the notes to the financial statements.

Sunnyvale is typical of most healthcare providers in that the dominant
portion of its cost structure is related to labor. The clinic reported salaries and
benefits of $126,223,000 for 2015, which amounts to 75 percent of Sunny-
vale’s total expenses. The detail of how these expenses are broken down by
department or contract, or the relationship of these expenses to the volume or
type of services provided, is not part of the financial accounting information
system. However, such information, which is very important to managers, is
available in Sunnyvale’s managerial accounting system. Chapters 5 through 8
focus on managerial accounting matters.

The expense item titled supplies represents the cost of supplies (pri-
marily medical) used in providing patient services. Sunnyvale does not order
and pay for supplies when a particular patient service requires them. Rather,
the clinic’s manager estimates the usage of individual supply items, orders
them beforehand, and then maintains a supplies inventory. As readers will
see in Chapter 4, the amount of supplies on hand is reported on the balance
sheet. The income statement expense reported by Sunnyvale represents the
cost—$20,568,000—of the supplies actually consumed in providing patient
services for 2015. Thus, the expense reported for supplies does not reflect
the actual cash spent by Sunnyvale on supplies purchased during the year. In
theory, Sunnyvale could have several years’ worth of supplies in its inventories
at the beginning of 2015, could have used some of these supplies without
replenishing the stocks, and hence might not have actually spent one dime
on supplies during 2015.

Sunnyvale uses commercial insurance to protect against many risks,
including property risks, such as fire and damaging weather, and liability risks,
such as managerial malfeasance and professional (medical) liability. The cost
of this protection is reported on the income statement as insurance expense,
which for 2015 amounted to $4,518,000.

Sunnyvale owns all of its land and buildings but leases (rents) much of
its diagnostic equipment. The total amount of lease payments—$3,189,000
for 2015—is reported as lease expense on the income statement. There are

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 97

many reasons that health services organizations lease rather than purchase
equipment, including protection against technological obsolescence. Chapter
18, which is available online, contains more information on leases and how
they are analyzed.

The next expense category, depreciation, requires closer examination.
Businesses require property and equipment (fixed assets) to provide goods and
services. Although some of these assets are leased, Sunnyvale owns most of
the fixed assets necessary to support its mission. When fixed assets are initially
purchased, Sunnyvale does not report their cost as an expense on the income
statement. The reason is found in the expense-matching principle, which dictates
that such costs be matched to the accounting periods during which the asset
produces revenues. A more pragmatic reason for not reporting the costs of
fixed assets when they are acquired is that reported earnings would fluctuate
widely from year to year on the basis of the amount of fixed assets acquired.

To match the cost of fixed assets to the revenues produced by such
long-lived assets, accountants use the concept of depreciation expense, which
spreads the cost of a fixed asset over many years. Note that most people use
the terms cost and expense interchangeably. To accountants, however, the terms
can have different meanings. Depreciation expense is a good example. Here,
the term cost is applied to the actual cash outlay for a fixed asset, while the
term expense is used to describe the allocation of that cost over time.

The calculation of depreciation expense is somewhat arbitrary, so the
amount of depreciation expense applied to a fixed asset in any year generally
is not closely related to the actual usage of the asset or its loss in fair market
value. To illustrate, Sunnyvale owns a piece of diagnostic equipment that it
uses infrequently. In 2014 it was used 23 times, while in 2015 it was used
only nine times. Still, the depreciation expense associated with this equipment
was the same—$7,725—in both years. Also, the clinic owns another piece of
equipment that could be sold today for about the same price that Sunnyvale
paid for it four years ago, yet each year the clinic reports a depreciation expense
for that equipment, which implies loss of value.

Depreciation expense, like all other financial statement entries, is calcu-
lated in accordance with GAAP. The calculation typically uses the straight-line
method—that is, the depreciation expense is obtained by dividing the historical
cost of the asset, less its estimated salvage value, by the number of years of
its estimated useful life. (Salvage value is the amount, if any, expected to be
received when final disposition occurs at the end of an asset’s useful life.) The
result is the asset’s annual depreciation expense, which is the charge reflected
in each year’s income statement over the estimated life of the asset and, as
readers will discover in Chapter 4, accumulated over time on the organization’s
balance sheet. (The term straight line stems from the fact that the deprecia-
tion expense is constant in each year, and hence the implied value of the asset

Depreciation
A noncash charge
against earnings
on the income
statement that
reflects the “wear
and tear” on a
business’s fixed
assets (property
and equipment).

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H e a l t h c a r e F i n a n c e98

declines evenly—like a straight line—over time.) In 2015, Sunnyvale reported
a depreciation expense of $6,405,000, which represents the total amount of
deprecation taken on all of the clinic’s fixed assets during the year.

In addition to depreciation calculated for financial statement purposes,
which is called book depreciation, for-profit businesses must calculate deprecia-
tion for tax purposes. Tax depreciation is calculated in accordance with IRS
regulations, as opposed to GAAP. Also, note that land is not depreciated for
either financial reporting or tax purposes.

In closing our discussion of depreciation expense, note that deprecia-
tion is a noncash expense, meaning there is no actual payment associated with
the expense. The cash payment was made some time, possibly many years,
before the expense appears on the income statement. The impact of noncash
expenses on a business’s cash flows will be covered in a later section.

The final expense line reports interest expense. Sunnyvale owes or paid its
lenders $5,329,000 in interest expense for debt capital supplied during 2015.
Not all of the interest expense reported has been paid because Sunnyvale typi-
cally pays interest monthly or semiannually, and hence interest has accrued on
some loans that will not be paid until 2016. The amount of interest expense
reported by an organization is influenced primarily by its capital structure,
which reflects the amount of debt that it uses. Also, interest expense is affected
by the borrower’s creditworthiness, its mix of long-term versus short-term
debt, and the general level of interest rates. (These factors are discussed in
detail at different points in later chapters.)

In closing our discussion of expenses, note that many income statements
contain a catchall category labeled “other.” Listed here are general and admin-
istrative expenses that individually are too small to list separately, including
items such as marketing expenses and external auditor fees. Although orga-
nizations cannot possibly report every expense item separately, it is frustrating
for users of financial statement information to come across a large, unexplained

Key Equation: Straight-Line Depreciation Calculation

Suppose Sunnyvale Clinic purchases an X-ray machine for $150,000. Its use-
ful life, according to accounting guidelines, is ten years, and the machine’s
expected value at that time is $25,000. The annual depreciation expense,
calculated as follows, is $12,500:

Annual depreciation expense = (Initial cost − Salvage value) ÷ Useful life
= ($150,000 − $25,000) ÷ 10 years
= $125,000 ÷ 10
= $12,500.

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 99

expense item. Thus, income statements that include the “other” category
often add a note that provides additional detail regarding these expenses.

Operating Income

Although the reporting of revenues and expenses is clearly important, the
most important information on the income statement is profitability. As shown
in Exhibit 3.1, two different profit measures can be reported on the income
statement. (Not all healthcare organizations report both measures. Some report
only the final measure—net income.)

The first profitability measure reported by Sunnyvale Clinic is operat-
ing income, calculated in Exhibit 3.1 as net operating revenues minus total
expenses. The precise calculation is tied to the format of the income statement,
but the general idea of operating income is to focus on revenues and expenses
that are related to operations (the provision of patient services).

Because net operating revenues in Exhibit 3.1 are all related to patient
services, operating income measures the profitability of core operations
(patient services and related endeavors).
Many healthcare providers, especially large
ones, have significant revenues that stem
from non-patient-service-related activi-
ties, so it is useful to report the inherent
profitability of the core business sepa-
rately from the overall profitability of the
enterprise.

Sunnyvale reported $3,747,000 of
operating income in 2015, which means
that the provision of healthcare services and
directly related activities generated a profit
of that amount. Operating income is an
important measure of a healthcare business’s
profitability because it focuses on the core
activities of the business. Some healthcare
businesses report a positive net income (net
income is discussed below) but a negative

1. What is an expense?
2. Briefly, what are some of the commonly reported expense

categories?
3. What is the logic behind depreciation expense?

SELF-TEST
QUESTIONS

Operating income
The earnings
of a business
directly related
to core activities.
For a healthcare
provider, earnings
related to patient
services.

For Your Consideration
Will the Real Operating Income Please
Stand Up?

Who would think it would be hard to measure
operating income? After all, the basic definition is
straightforward: operating revenues minus oper-
ating expenses. Still, different analysts can look
at the same set of revenue and expense data and
calculate different values for operating income.

The problem in calculating operating income
lies primarily in the definition of what constitutes
a provider’s operations (core activities). Here,
there are at least three approaches: Operations
include (1) only patient care activities; (2) patient
care and directly related activities, such as cafete-
ria and parking garage operations; and (3) patient

(continued)

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H e a l t h c a r e F i n a n c e100

operating income (an operating loss). This
situation is worrisome, because a business is
on shaky financial ground if its core opera-
tions are losing money, especially if they do
so year after year.

Note that the operating income
reported on the income statement is defined
by GAAP and represents an estimate of the
long-run operating profitability of the busi-
ness. It has some shortcomings—for one,
it does not represent cash flow—that are
similar to the shortcomings related to net
income discussed in a later section. Still,

measuring the core profitability of a business is critical to understanding its
financial status.

Nonoperating Income

The next section of the income statement lists nonoperating income. As men-
tioned earlier, reporting the income of operating and nonoperating activities
separately is useful. The nonoperating income section of Sunnyvale’s income
statement shown in Exhibit 3.1 reports the income generated from activities
unrelated to the provision of healthcare services.

The first category of nonoperating income listed is contributions. Many
not-for-profit organizations, especially those with large, well-endowed foun-
dations, rely heavily on charitable contributions as an income source. Those
charitable contributions that can be used immediately (spent now) are reported
as nonoperating income. However, contributions that create a permanent
endowment fund, and hence are not available for immediate use, are not
reported on the income statement.

The second category of nonoperating income is investment income,
another type of income on which not-for-profit-organizations rely heavily. It
stems from two primary sources:

1. Healthcare businesses usually have funds available that exceed the
minimum necessary to meet current cash expenses. Because cash earns

1. What is operating income?
2. Why is operating income such an important measure of

profitability?

SELF-TEST
QUESTIONS

Nonoperating
income
The earnings of
a business that
are unrelated to
core activities.
For a healthcare
provider, the most
common sources
are contributions
and investment
income.

care, directly related activities, and government
appropriations. Each definition results in a differ-
ent value for operating income. In general, as the
definition of core operations expands, the value
calculated for operating income increases.

What do you think? Consider the hospital
industry. What activities should be considered
part of core operations? Should hospitals be
required by GAAP to report multiple measures of
operating income, each using a different defini-
tion of core activities?

(continued from previous page)

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 101

no interest, these “excess” funds usually are invested in short-term,
interest-earning securities, such as Treasury bills or money market
mutual funds. Sometimes these invested funds can be quite large—say,
when a business is building up cash to make a tax payment or to start
a large construction project. Also, prudent businesses keep a reserve of
funds on hand to meet unexpected emergencies. The interest earned
on such funds is listed as investment income.

2. Not-for-profit businesses may have a large amount of endowment fund
contributions. When these contributions are received, they are not
reported as income because the funds are not available to be spent.
However, the income from securities purchased with endowment funds
is available to the healthcare organization, and hence this income is
reported as nonoperating (investment) income.

In total, Sunnyvale reported $4,113,000 of nonoperating income for
2015, consisting of $243,000 in spendable contributions and $3,870,000
earned on the investment of excess cash and endowments. Nonoperating
income is not central to the core business, which is providing healthcare services.
Overreliance on nonoperating income could mask operational inefficiencies
that, if not corrected, could lead to future financial problems. Note that the
costs associated with creating nonoperating income are not separately reported.
Thus, the expenses associated with soliciting contributions or investing excess
cash and endowments must be deducted before the income is reported on
the income statement.

Finally, note that the income statements of some providers do not con-
tain a separate section titled nonoperating income. Rather, nonoperating income
is included in the revenue section that heads the income statement. In this
situation, total revenues include both operating and nonoperating revenues.

Net Income

The second profitability measure reported by Sunnyvale Clinic is net income,
which in Exhibit 3.1 is equal to Operating income + Total nonoperating
income. Sunnyvale reported net income of $7,860,000 for 2015: $3,747,000
+ $4,113,000 = $7,860,000. (Not-for-profit organizations use the term excess

1. What is nonoperating income?
2. Why is nonoperating income reported separately from revenues? Is

this always the case?

SELF-TEST
QUESTIONS

Net income
The total earnings
of a business,
including both
operating and
nonoperating
income.

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H e a l t h c a r e F i n a n c e102

of revenues over expenses, but we call this measure net income because that is the
more universally recognized term. Also, one could argue that there are three
profitability measures on Sunnyvale’s income statement: operating income,
nonoperating income, and net income. We wouldn’t object to that position,
but accountants generally view nonoperating income as an entry on the state-
ment rather than a calculated profitability measure.)

Because of its location on the income statement and its importance, net
income is referred to as the bottom line. In spite of the fact that Sunnyvale is
a not-for-profit organization, it still must make a profit. If the business is
to offer new services in the future, it must earn a profit today to produce the
funds needed for new assets. Furthermore, because of inflation, Sunnyvale
could not even replace its existing assets as they wear out or become obsolete
without the funds generated by positive profitability. Thus, turning a profit is
essential for all businesses, including not-for-profits.

What happens to a business’s net income? For the most part, it is rein-
vested in the business. Not-for-profit corporations must reinvest all earnings
in the business. An investor-owned corporation, on the other hand, may return
a portion or all of its net income to owners in the form of dividend payments.
The amount of profits reinvested in an investor-owned business, therefore, is
net income minus the amount paid out as dividends. (Some for-profit busi-
nesses distribute profits to owners in the form of bonuses, which often occurs
in medical practices. However, when this is done, the distribution becomes
an expense item that reduces net income rather than a distribution of net
income. The end result is the same—monies are distributed to owners—but
the reporting mechanism is much different.)

Note that both operating income and net income measure profitability
as defined by GAAP. In establishing GAAP, accountants have created guide-
lines that attempt to measure the economic income of a business, which is a
difficult task because economic gains and losses often are not tied to easily
identifiable events.

Furthermore, some of the income statement items are estimates (e.g.,
provision for bad debt losses) and others (e.g., depreciation expense) do not
represent actual cash costs. Because of accrual accounting and other factors,
the fact that Sunnyvale reported net income of $7,860,000 for 2015 does not
mean that the business actually experienced a net cash inflow of that amount.
This point is discussed in greater detail in the next section.

1. Why is net income called “the bottom line”?
2. What is the difference between net income and operating

income?
3. What happens to net income?

SELF-TEST
QUESTIONS

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 103

Net Income Versus Cash Flow

As stated previously, the income statement reports total profitability (net income),
which is determined in accordance with GAAP. Although net income is an
important measure of profitability, an organization’s financial condition, at least
in the short run, depends more on the actual cash that flows into and out of the
business than it does on reported net income. Thus, occasionally a business will
go bankrupt even though its net income has historically been positive. More com-
monly, many businesses that have reported negative net incomes (i.e., net losses)
have survived with little or no financial damage. How can these things happen?

The problem is that the income statement is like a mixture of apples and
oranges. Consider Exhibit 3.1. Sunnyvale reported net operating revenues of
$169,979,000 for 2015. Yet, this is not the amount of cash that was actually
collected during the year, because some of these revenues will not be collected
until 2016. Furthermore, some revenues reported for 2014 were actually col-
lected in 2015, but these do not appear on the 2015 income statement. Thus,
because of accrual accounting, reported revenue is not the same as cash revenue.
The same logic applies to expenses; few of the values reported as expenses on
the income statement are the same as the actual cash outflows. To make mat-
ters even worse, not one cent of depreciation expense was paid out as cash.
Depreciation expense is an accounting reflection of the cost of fixed assets, but
Sunnyvale did not actually pay out $6,405,000 in cash to someone called the
“collector of depreciation.” According to the balance sheet (see Exhibit 4.1),
Sunnyvale actually paid out $88,549,000 sometime in the past to purchase the
clinic’s total fixed assets, of which $6,405,000 was recognized in 2015 as a cost
of doing business, just as salaries and fringe benefits are a cost of doing business.

Can net income be converted to cash flow—the actual amount of cash
generated during the year? As a rough estimate, cash flow can be thought
of as net income plus noncash expenses. Thus, the cash flow generated by
Sunnyvale in 2015 is not merely the $7,860,000 reported net income, but this
amount plus the $6,405,000 shown for depreciation, for a total of $14,265,000.
Depreciation expense must be added back to net income to get cash flow
because it initially was subtracted from revenues to obtain net income even
though there was no associated cash outlay.

Key Equation: Net Income to Cash Flow Conversion

Because of accrual accounting, net income does not represent an estimate
of the organization’s cash flow for the reporting period. This equation
is used to convert net income to a rough estimate of cash flow: Cash
flow = Net income + Noncash expenses. Because depreciation often is

(continued)

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H e a l t h c a r e F i n a n c e104

Here is another way of looking at cash flow versus accounting income:
If Sunnyvale showed no net income for 2015, it would still be generating
cash of $6,405,000 because that amount was deducted from revenues but not
actually paid out in cash. The idea behind the income statement treatment is
that Sunnyvale would be able to set aside the depreciation amount, which is
above and beyond its cash expenses, this year and in future years. Eventually,
the accumulated total of depreciation cash flow would be used by Sunnyvale
to replace its fixed assets as they wear out or become obsolete.

Thus, the incorporation of depreciation expense into the cost and,
ultimately, the price structure of services provided is designed to ensure the
ability of an organization to replace its fixed assets as needed, assuming that
the assets could be purchased at their historical cost. To be more realistic,
businesses must plan to generate net income, in addition to the accumulated
depreciation funds, sufficient to replace existing fixed assets in the future
at inflated costs or even to expand the asset base. It appears that Sunnyvale
does have such capabilities, as reflected in its $7,860,000 net income and
$14,265,000 cash flow for 2015.

It is important to understand that the $14,265,000 cash flow calculated
here is only an estimate of actual cash flow for 2015, because almost every
item of revenues and expenses listed on the income statement does not equal
its cash flow counterpart. The greater the difference between the reported
values and cash values, the less reliable is the rough estimate of cash flow
defined here. The value of knowing the precise amount of cash generated or
lost has not gone unnoticed by accountants. In Chapter 4, readers will learn
about the statement of cash flows, which can be thought of as an income
statement that is recast to focus on cash flow.

1. What is the difference between net income and cash flow?
2. How can income statement data be used to estimate cash flow?
3. What is depreciation cash flow, and what is its expected use?
4. Why do not-for-profit businesses need to make a profit?

SELF-TEST
QUESTIONS

the only noncash expense, the equation can be rewritten as Cash flow =
Net income + Depreciation. To illustrate, Sunnyvale reported net income
of $8,206,000 and depreciation of $5,798,000 in 2014. Thus, a rough
measure of its 2014 cash flow is $14,004,000:

Cash flow = Net income + Depreciation
= $8,206,000 + $5,798,000
= $14,004,000.

(continued from previous page)

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 105

Income Statements of Investor-Owned Businesses

Our income statement discussion focused on a not-for-profit organization:
Sunnyvale Clinic. What do the income statements for investor-owned businesses,
such as Community Health Systems and Brookdale Senior Living, look like?
The financial statements of investor-owned and not-for-profit businesses are
generally similar except for entries, such as tax payments, that are applicable
only to one form of ownership. Because the transactions of all health services
organizations are similar in nature, ownership plays only a minor role in the
presentation of financial statement data. In reality, more differences exist in
financial statements because of lines of business (e.g., hospitals versus nursing
homes versus managed care plans) than because of ownership.

The impact of taxes and depreciation on net income and cash flow for
for-profit businesses deserves discussion. Exhibit 3.2 contains four income
statements that are based on Sunnyvale’s 2015 income statement presented
in Exhibit 3.1. First, note that the Exhibit 3.2 statements are condensed to
show only total revenues (including nonoperating income); all expenses except
depreciation; depreciation; and net income. Lines for taxable income, taxes,
and cash flow have also been added. The column labeled “Not-for-Profit”
presents Sunnyvale’s income statement assuming not-for-profit status (zero
taxes), so the reported net income and cash flow are the same, as discussed
previously.

Now consider the column labeled “For-Profit A,” which assumes that
Sunnyvale is a for-profit business with a 20 percent tax rate. Here, the clinic

EXHIBIT 3.2
Sunnyvale Clinic: Condensed Income Statements Under Alternative Tax Assumptions, Year
Ended December 31, 2015 (in thousands)

Not-for-Profit
(Tax rate = 0%)

For-Profit A
(Tax rate = 20%)

For-Profit B
(Tax rate = 40%)

For-Profit C
(Tax rate = 40%)

Total revenues
Expenses:

All except
depreciation

Depreciation
Total expenses
Taxable income
Taxes
Net income

Cash flow
(NI + depreciation)

$174,092

$159,827
6,405
$166,232
$ 7,860
0
$ 7,860

$ 14,265

$174,092

$159,827
6,405
$166,232
$ 7,860
1,572
$ 6,288

$ 12,693

$174,092

$159,827
6,405
$166,232
$ 7,860
3,144
$ 4,716

$ 11,121

$174,092

$159,827
0
$159,827
$ 14,265
5,706

$ 8,559

Note: Total revenues = Net operating revenues + Total nonoperating income. NI (net income).

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H e a l t h c a r e F i n a n c e106

must pay taxes of 0.20 × $7,860,000 = $1,572,000, which reduces net income
by a like amount: $7,860,000 − $1,572,000 = $6,288,000. In the next col-
umn, labeled “For-Profit B,” the tax rate is assumed to be 40 percent, which
results in higher taxes of $3,144,000 and a lower net income of $4,716,000.
The impact of taxes on net income is clear: The addition of taxes reduces net
income, and the greater the tax rate, the greater the reduction.

Finally, let’s examine the impact of depreciation and taxes on cash flow
(net income plus depreciation). The right column, labeled “For-Profit C,”
is the same as the “For-Profit B” column, except the depreciation expense is
assumed to be zero rather than $6,405,000. What is the impact of deprecia-
tion expense? Depreciation expense lowers taxable income by a like amount
and hence lowers taxes by T × Depreciation expense, where T is the tax rate.
The amount of taxes saved—0.40 × $6,405,000 = $2,562,000—is called the
depreciation shield. It is the dollar amount of taxes that will not have to be
paid because of the business’s depreciation expense.

Let’s check our work. According to Exhibit 3.2, the taxes due without
depreciation expense are $5,706,000, but with depreciation taxes they are
$3,144,000. Thus, the depreciation expense has saved the business $5,706,000
− $3,144,000 = $2,562,000, which is the amount of the depreciation shield
just calculated. Also, note that the cash flow is higher by the same amount,
so the depreciation expense, which reduces taxes but does not impact cash
flow, has increased cash flow by the amount of the tax reduction (the depre-
ciation shield).

Key Equation: Depreciation Shield

Because depreciation expense reduces taxes, it is said to shield a for-profit
business from taxes, and the amount of taxes saved is called the deprecia-
tion shield. If a business has $500,000 in depreciation expense and pays
taxes at a 30 percent rate, its depreciation shield is $150,000:

Depreciation shield = T × Depreciation expense = 0.30 × $500,000
= $150,000.

1. Are there appreciable differences in the income statements of not-
for-profit businesses and investor-owned businesses?

2. What are the impacts of taxes and depreciation on net income and
cash flow?

3. What is the depreciation shield?

SELF-TEST
QUESTIONS

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 107

Statement of Changes in Equity

As discussed in a previous section, all or some portion of a business’s net income
will be retained in the business. The statement of changes in equity, also
called statement of changes in net assets, is a financial statement that indicates
how much of an organization’s net income will be retained in the business
and hence increase the amount of equity shown on the balance sheet.

Exhibit 3.3 contains Sunnyvale’s statements of changes in equity. Because
we have simplified the financial statements presented in this book to facilitate
understanding, the statements shown here are very basic. In most situations,
the Exhibit 3.3 statements would contain several more lines reflecting transac-
tions that affect the amount transferred to the balance sheet.

Exhibit 3.3 tells us that, in 2015, the entire amount of Sunnyvale’s net
income was retained in the business, hence the equity (net assets) of the clinic
increased from $46,208,000 at the beginning of the year to $54,068,000 at
the end of the year. This can be confirmed by the amount of equity shown
for 2015 in Exhibit 4.1 (see Chapter 4).

To illustrate more complex statements of changes in equity, consider
Exhibit 3.4, which assumes that Sunnyvale is a for-profit entity. Now, some
portion of the earnings (net income) of the business is paid out as dividends.
In 2015, the business had a net income of $7,860,000, but $2,000,000 of this
amount was paid to owners. Thus, only $7,860,000 − $2,000,000 = $5,860,000
is available to increase the balance sheet equity account. Note that, in total, the
2015 ending equity was $54,068,000 − $50,168,000 = $3,900,000 greater in
Exhibit 3.3 than in Exhibit 3.4. The difference is caused by the fact that Sunny-
vale, when assumed to be for-profit, paid out $3,900,000 total in dividends
over 2014 and 2015; hence, the amount retained in the business was reduced
by a like amount. (For simplicity, we did not reduce the net income in Exhibit
3.4 by the amount of taxes that would be paid if Sunnyvale were for-profit.)

Statement of
changes in equity
A financial
statement that
reports how much
of a business’s
income statement
earnings flows to
the balance sheet
equity account.

1. What is the purpose of the statement of changes in equity (net assets)?
2. How does the statement differ between not-for-profit and for-

profit entities?

SELF-TEST
QUESTIONS

2015 2014

Net income $ 7,860 $ 8,206

Equity (net assets), beginning of year 46,208 38,002

Equity (net assets), end of year $54,068 $46,208

EXHIBIT 3.3
Sunnyvale
Clinic: State-
ments of
Changes in
Equity (Net
Assets), Years
Ended Decem-
ber 31, 2015
and 2014 (in
thousands)

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H e a l t h c a r e F i n a n c e108

A Look Ahead: Using Income Statement Data in Financial
Statement Analysis

Chapter 17 discusses in some detail the techniques used to analyze financial
statements to gain insights into a business’s financial condition. At this point,
however, it would be worthwhile to introduce financial ratio analysis—one of
the techniques used in financial condition analysis. In financial ratio analysis,
values found on the financial statements are combined to form ratios that have
economic meaning and help managers and investors interpret the numbers.

To illustrate, total profit margin, usually just called total margin, is
defined as net income divided by total revenues, which includes nonoperating
income. For Sunnyvale Clinic, the total margin for 2015 was $7,860,000 ÷
($169,979,000 + $4,113,000) = $7,860,000 ÷ $174,092,000 = 0.045 = 4.5%.
Thus, each dollar of revenues and income generated by the clinic produced
4.5 cents of profit (i.e., net income). By implication, each dollar of revenues
and income required 95.5 cents of expenses. The total margin is a measure of
expense control; for a given amount of revenues and income, the higher the
net income, and hence total margin, the lower the expenses. If the total margin
for other similar clinics were known, judgments about how well Sunnyvale
is doing in the area of expense control, relative to its peers, could be made.

Sunnyvale’s total margin for 2014 was $8,206,000 ÷ $144,800,000 =
0.057 = 5.7%, so the clinic’s total margin slipped from 2014 to 2015. This
finding should alert managers to examine carefully the increase in expenses
in 2015. In effect, Sunnyvale’s expenses increased faster than its revenues
plus investment income, which resulted in falling profitability as measured by
total margin. If this trend continues, it would not take long for the clinic to
be operating in the red (i.e., losing money).

Finally, let’s take a quick look at Sunnyvale’s operating margin, which
is defined as operating income divided by net operating revenues. For 2015,
Sunnyvale’s operating margin was $3,747,000 ÷ $169,979,000 = 0.022 =
2.2%. Thus, each dollar of operating revenues generated by the clinic produced
2.2 cents of profit (operating income). Because operating margin does not
include noncore revenues (contributions and investment income), it is lower
than Sunnyvale’s total margin, which does include such income.

Total (profit)
margin
Net income divided
by total revenues.
It measures the
amount of total
profit per dollar of
total revenues.

Operating margin
Operating
income divided
by net operating
revenues. It
measures the
amount of
operating profit
per dollar of
operating revenues
and focuses on the
core activities of a
business.

2015 2014

Net income $ 7,860 $8,206

Less: Dividends paid 2,000 1,900

Increase in equity $ 5,860 $6,306

Equity, beginning of year 44,308 38,002

Equity, end of year $50,168 $44,308

EXHIBIT 3.4
Sunnyvale

Clinic:
Statements of

Changes
in Equity

Assuming For-
Profit Status,
Years Ended

December 31,
2015 and 2014
(in thousands)

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 109

A complete discussion of financial ratio analysis can be found in Chapter
17. The discussion here, along with a brief visit in Chapter 4, is merely intended
to give readers a preview of how financial statement data can be used to make
judgments about a business’s financial condition.

1. Explain how ratio analysis can be used to help interpret income
statement data.

2. What is the total profit margin, and what does it measure?

SELF-TEST
QUESTIONS

Key Concepts
Financial accounting information is the result of a process of identifying,
measuring, recording, and communicating the economic events and status
of an organization to interested parties. This information is summarized
and presented in four primary financial statements: the income statement,
the statement of changes in equity, the balance sheet, and the statement
of cash flows. The key concepts of this chapter are as follows:

• The predominant users of financial accounting information are
parties who have a direct financial interest in the economic status
of a business—primarily its managers and investors.

• Generally accepted accounting principles (GAAP) establish the
standards for financial accounting measurement and reporting.
These principles have been sanctioned by the Securities and
Exchange Commission (SEC), developed by the Financial
Accounting Standards Board (FASB), and refined by the American
Institute of Certified Public Accountants (AICPA) and other
organizations.

• The goal of financial accounting is to provide information about
organizations that is useful to present and future investors and
other users in making rational financial and investment decisions.

• The preparation and presentation of financial accounting data
are based on the following set of assumptions, principles, and
constraints: (1) accounting entity, (2) going concern, (3) accounting
period, (4) monetary unit, (5) historical cost, (6) revenue recognition,
(7) expense matching, (8) full disclosure, (9) materiality, and (10)
cost–benefit.

• Under cash accounting, economic events are recognized when
the cash transaction occurs. Under accrual accounting, economic

(continued)

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H e a l t h c a r e F i n a n c e110

events are recognized when the obligation to make payment
occurs. GAAP requires that businesses use accrual accounting
because it provides a better picture of a business’s true financial
status.

• The collection and recording of financial accounting data use
the following concepts: (1) transaction, (2) posting, (3) chart of
accounts, (4) general ledger, (5) double entry, and (6) T account.

• The income statement reports on an organization’s operations over
a period of time. Its basic structure consists of revenues, expenses,
and one or more profit measures.

• Operating revenues are monies collected or expected to be collected
that are related to the core business, namely, patient services.
Operating revenues are broken down into categories such as net
patient service revenue, premium revenue, and other revenue.

• Expenses are the economic costs associated with the provision of
services.

• Nonoperating income reports earnings that are unrelated to patient
services, typically unrestricted contributions and investment
income.

• Operating income focuses on the profitability of a provider’s core
operations (patient services), while net income represents the total
economic profitability of a business as defined by GAAP.

• Because the income statement is constructed using accrual
accounting, net income does not represent the actual amount of
cash that has been earned or lost during the reporting period. To
estimate cash flow, noncash expenses (primarily depreciation) must
be added back to net income.

• The income statements of investor-owned and not-for-profit
businesses tend to look very much alike. However, the income
statements of health services organizations in different lines of
business can vary. The good news is that all income statements
have essentially the same economic content.

• For-profit (taxable) entities must include taxes as an income
statement expense item. Because depreciation expense reduces
operating (taxable) income, and hence a business’s tax liability,
it creates a depreciation shield equal to the tax rate times the
depreciation expense. However, as a noncash expense, depreciation
itself does not reduce cash flow, so the greater the amount of

(continued from previous page)

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 111

In this chapter, we focused on financial accounting basics, the income
statement, and the statement of changes in equity. In Chapter 4, the discus-
sion of financial accounting continues with the remaining two statements: the
balance sheet and statement of cash flows.

Questions

3.1 a. What is a stakeholder?
b. What stakeholders are most interested in the financial condition of

a healthcare provider?
c. What is the goal of financial accounting?
3.2 a. What are generally accepted accounting principles (GAAP)?
b. What is the purpose of GAAP?
c. What organizations are involved in establishing GAAP?
3.3 Briefly describe the following concepts as they apply to the

preparation of financial statements:
a. Accounting entity
b. Going concern
c. Accounting period
d. Monetary unit
e. Historical cost
f. Revenue recognition
g. Expense matching
h. Full disclosure
i. Materiality
j. Cost–benefit

depreciation (and therefore, the depreciation shield), the greater
the cash flow.

• The statement of changes in equity indicates how much of the
total profitability (net income) is retained for use by the reporting
organization.

• Financial ratio analysis, which combines values that are found in
the financial statements, helps managers and investors interpret
the data with the goal of making judgments about the financial
condition of the business.

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H e a l t h c a r e F i n a n c e112

3.4 Explain the difference between cash accounting and accrual
accounting. Be sure to include a discussion of the revenue recognition
and matching principles.

3.5 Briefly describe the format of the income statement.
3.6 a. What is the difference between gross revenues and net revenues?

(Hint: Think about discounts, charity care, and bad debt.)
b. What is the difference between patient service revenue and other

revenue?
c. What is the difference between charity care and bad debt losses?

How is each handled on the income statement?
3.7 a. What is meant by the term expense?
b. What is depreciation expense, and what is its purpose?
c. What are some other categories of expenses?
3.8 a. What is the difference between operating income and net income?
b. Why is net income called “the bottom line”?
c. What is the difference between net income and cash flow?
d. Is financial condition more closely related to net income or to cash

flow?
3.9 a. What is the purpose of the statement of changes in equity?
b. What is its basic format?

Problems

3.1 Entries for the Warren Clinic 2015 income statement are listed below
in alphabetical order. Reorder the data in proper format.

Depreciation expense $ 90,000
General/administrative expenses 70,000
Interest expense 20,000
Investment income 40,000
Net income 30,000
Net operating revenues 410,000
Other revenue 10,000
Patient service revenue 440,000
Provision for bad debts 40,000
Purchased clinic services 90,000
Salaries and benefits 150,000
Total expenses 460,000

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 113

3.2 Consider the following income statement:

BestCare HMO
Statement of Operations

Year Ended June 30, 2015
(in thousands)

Revenue:
Premiums earned $26,682
Coinsurance 1,689
Interest and other income 242
Total revenues $28,613

Expenses:
Salaries and benefits $15,154
Medical supplies and drugs 7,507
Insurance 3,963
Depreciation 367
Interest 385
Total expenses $27,376
Net income $ 1,237

a. How does this income statement differ from the one presented in
Exhibit 3.1?

b. Did BestCare spend $367,000 on new fixed assets during fiscal
year 2015? If not, what is the economic rationale behind its
reported depreciation expense?

c. What is BestCare’s total profit margin? How can it be interpreted?
3.3 Consider this income statement:

Green Valley Nursing Home, Inc.
Statement of Income

Year Ended December 31, 2015
Revenue:
Patient service revenue $3,163,258
Less provision for bad debts (110,000)
Net patient service revenue $3,053,258
Other revenue 106,146
Net operating revenues $3,159,404

(continued)

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H e a l t h c a r e F i n a n c e114

Expenses:
Salaries and benefits $1,515,438
Medical supplies and drugs 966,781
Insurance and other 296,357
Depreciation 85,000
Interest 206,780
Total expenses $3,070,356
Operating income $ 89,048
Provision for income taxes 31,167
Net income $ 57,881

a. How does this income statement differ from the ones presented in
Exhibit 3.1 and Problem 3.2?

b. Why does Green Valley show a provision for income taxes while
the other two income statements do not?

c. What is Green Valley’s total profit margin? How does this value
compare with the values for Sunnyvale Clinic and BestCare?

d. The before-tax profit margin for Green Valley is operating income
divided by total revenues. Calculate Green Valley’s before-tax
profit margin. Why might this be a better measure of expense
control when comparing an investor-owned business with a not-
for-profit business?

3.4 Great Forks Hospital reported net income for 2015 of $2.4 million
on total revenues of $30 million. Depreciation expense totaled $1
million.

a. What were total expenses for 2015?
b. What were total cash expenses for 2015? (Hint: Assume that all

expenses, except depreciation, were cash expenses.)
c. What was the hospital’s 2015 cash flow?
3.5 Brandywine Homecare, a not-for-profit business, had revenues of $12

million in 2015. Expenses other than depreciation totaled 75 percent
of revenues, and depreciation expense was $1.5 million. All revenues
were collected in cash during the year, and all expenses other than
depreciation were paid in cash.

a. Construct Brandywine’s 2015 income statement.
b. What were Brandywine’s net income, total profit margin, and cash

flow?
c. Now, suppose the company changed its depreciation calculation

procedures (still within GAAP) such that its depreciation expense
doubled. How would this change affect Brandywine’s net income,
total profit margin, and cash flow?

(continued from previous page)

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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 115

d. Suppose the change had halved, rather than doubled, the firm’s
depreciation expense. Now, what would be the impact on net
income, total profit margin, and cash flow?

3.6 Assume that Mainline Homecare, a for-profit corporation, had exactly
the same situation as reported in Problem 3.5. However, Mainline
must pay taxes at a rate of 40 percent of pretax (operating) income.
Assuming that the same revenues and expenses reported for financial
accounting purposes would be reported for tax purposes, redo
Problem 3.5 for Mainline.

3.7 Consider Southeast Home Care, a for-profit business. In 2015, its
net income was $1,500,000 and it distributed $500,000 to owners
in the form of dividends. Its beginning-of-year equity balance was
$12,000,000. Use this information to construct the business’s
statement of changes in equity. What is the ending 2015 value of the
business’s equity account?

3.8 Bright Horizons Skilled Nursing Facility, an investor-owned company,
constructed a new building to replace its outdated facility. The new
building was completed on January 1, 2015, and Bright Horizons
began recording depreciation immediately. The total cost of the new
facility was $18,000,000, comprising (a) $10 million in construction
costs and (b) $8 million for the land. Bright Horizons estimated
that the new facility would have a useful life of 20 years. The salvage
value of the building at the end of its useful life was estimated to be
$1,500,000.

a. Using the straight-line method of depreciation, calculate annual
depreciation expense on the new facility.

b. Assuming a 40 percent income tax rate, how much did Bright
Horizons save in income taxes for the year ended December 31,
2015, as a result of the depreciation recorded on the new facility
(i.e., what was the depreciation shield)?

c. Does the depreciation shield result in cash or noncash savings for
Bright Horizons? Explain.

3.9 Integrated Physicians & Associates, an investor-owned company, had
the following general ledger account balances at the end of 2015:

Gross patient service revenue (total charges) $975,000
Contractual discounts and allowances to third-party payers 250,000
Charges for charity (indigent) care 100,000
Estimated provision for bad debts 50,000

a. Construct the revenue section of Integrated Physicians &
Associates’ income statement for the year ended December 31,
2015.

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H e a l t h c a r e F i n a n c e116

b. Suppose the 2015 contractual discounts and allowances balance
reported above is understated by $50,000. In other words, the
correct balance should be $300,000. Assuming a 40 percent
income tax rate, what would be the effect of the misstatement on
Integrated Physicians & Associates’ 2015 reported:
1. Net patient service revenue?
2. Total expenses, including income tax expense?
3. Net income?
For each item (1–3), indicate whether the balance is overstated,
understated, or not affected by the misstatement. If overstated or
understated, indicate by how much.

Resources

American Institute of Certified Public Accountants (AICPA). 2014. Audit and Account-
ing Guide for Healthcare Entities. New York: AICPA.

Bailey, S., D. Franklin, and K. Hearle. 2010. “A Form 990 Schedule H Conundrum:
How Much of Your Bad Debt Might Be Charity?” Healthcare Financial Man-
agement (April): 86–87.

Center for Research in Ambulatory Health Care Administration (CRAHCA). 1996.
Medical Group Practice Chart of Accounts. Englewood, CO: CRAHCA.

Duis, T. E. 1994. “Unravelling the Confusion Caused by GASB, FASB Accounting
Rules.” Healthcare Financial Management (November): 66–69.

———. 1993. “The Need for Consistency in Healthcare Reporting.” Healthcare
Financial Management (July): 40–44.

Giniat, E., and J. Saporito. 2007. “Sarbanes-Oxley: Impetus for Enterprise Risk Man-
agement.” Healthcare Financial Management (August): 65–70.

Healthcare Financial Management Association (HFMA). 2007. “P&P Board Statement
15: Valuation and Financial Statement Presentation of Charity Care and Bad
Debts by Institutional Healthcare Providers.” Healthcare Financial Manage-
ment (January): 94–103.

Heuer, C., and M. K. Travers. 2010. “FASB Issues New Accounting Standards for
Business Combinations.” Healthcare Financial Management (June): 40–43.

Holmes, J. R., and D. Felsenthal. 2009. “Depreciating and Stating the Value of Hos-
pital Buildings: What You Need to Know.” Healthcare Financial Management
(October): 88–92.

Maco, P. S., and S. J. Weinstein. 2000. “Accounting and Accountability: Observations
on the AHERF Settlements.” Healthcare Financial Management (October):
41–46.

00_GapenskiReiter (2299).indb 116 11/11/15 11:00 AM

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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 8/4/2022 10:13 PM via FRANKLIN UNIVERSITY
AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management,
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C h a p t e r 3 : T h e I n c o m e S t a t e m e n t a n d S t a t e m e n t o f C h a n g e s i n E q u i t y 117

Peregrine, M. W., and J. R. Schwartz. 2002. “What CFOs Should Know—and Do—
About Corporate Responsibility.” Healthcare Financial Management (Decem-
ber): 60–63.

Reinstein, A., and N. T. Churyk. 2012. “FASB’s ASU 2011-7 Changes Financial
Statement Reporting Requirements.” Healthcare Financial Management (Feb-
ruary): 40–42.

Seawell, L. V. 1999. Chart of Accounts for Hospitals. Chicago: Probus Publishing.
Valetta, R. M. 2005. “Clear as Glass: Transparent Financial Reporting.” Healthcare

Financial Management (August): 59–66.

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CHAPTER

639

FINANCIAL CONDITION ANALYSIS

Introduction

One of the most important characteristics of a healthcare organization is its
financial condition: Does the business have the financial capacity to perform its
mission? Many judgments about financial condition are made on the basis of
financial statement analysis, which focuses on the data contained in a busi-
ness’s financial statements. Financial statement analysis is applied to historical
data, which reflect the results of past managerial decisions, and to forecasted
data, which constitute the road map for the business’s future. Thus, managers
use financial statement analysis both to assess current condition and to plan
for the future

Although financial statement analysis provides a great deal of important
information regarding financial condition, it fails to provide much insight into
the operational causes of that condition. Thus, financial statement analysis
is often supplemented by operating indicator analysis, which uses operat-
ing data not usually found in an organization’s financial statements—such as
occupancy, patient mix, length of stay, and productivity measures—to help
identify factors that contributed to the assessed financial condition. Through
operating indicator analysis, managers are better able to identify and implement
strategies that ensure a sound financial condition in the future.

Financial
statement
analysis
The process
of using data
contained
in financial
statements to
make judgments
about a business’s
financial condition.

Operating
indicator analysis
The process of
using operating
indicators to
help explain
a business’s
financial condition.

17
Learning Objectives
After studying this chapter, readers will be able to

• Explain the purposes of financial statement and operating indicator
analyses.

• Describe the primary techniques used in financial statement and
operating indicator analyses.

• Conduct basic financial statement and operating indicator analyses
to assess the financial condition of a business.

• Describe the problems associated with financial statement and
operating indicator analyses.

• Describe how key performance indicators (KPIs) and dashboards
can be used to monitor financial condition.

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H e a l t h c a r e F i n a n c e640

Financial condition analysis involves a number of techniques that extract
information contained in a business’s financial statements and elsewhere and
combine it in a form that facilitates making judgments about the organization’s
financial condition and operations. Often the end result is a list of organizational
strengths and weaknesses. In this chapter, several analytical techniques used in
financial condition analyses, some related topics, and the problems inherent
in such analyses are discussed. Along the way, you will discover that financial
condition analysis generates a great deal of data. A significant problem in
assessing financial condition is separating the important from the unimportant
and presenting the results in a simple, easy-to-understand, easy-to-monitor
format. Thus, we close the chapter with some ideas about data presentation.
In addition to the chapter content, the Chapter 17 Supplement discusses four
topics: market value ratios, common size analysis, percentage change analysis,
and economic value added (EVA).

Financial Statement Analysis

As you learned in chapters 3 and 4, generally accepted accounting standards
require businesses to prepare four financial statements: (1) the income state-
ment, (2) the statement of changes in equity, (3) the balance sheet, and (4) the
statement of cash flows. Taken together, these statements give an accounting
picture of an organization’s operations and financial position. Because financial
statement data are well organized and easily understood, such statements pro-
vide a logical starting place for analyzing an organization’s financial condition.

In much of this chapter, Riverside Memorial Hospital, a 450-bed not-
for-profit facility, is used to illustrate financial condition analysis. Although a
hospital is being used to illustrate the techniques, they can be applied to any
health services setting. Simplified versions of Riverside’s three primary financial
statements are contained in exhibits 17.1, 17.2, and 17.3. Riverside’s income
statements and balance sheets (exhibits 17.2 and 17.3) will be examined in
later sections when we discuss ratio analysis and other tools that are used to
help interpret the data. For now, our focus is on the statement of cash flows,
which can be interpreted without the aid of additional data or tools.

The statement of cash flows (Exhibit 17.1), first described in Chapter
4, provides such information as whether the firm’s core operations are prof-
itable, how much capital the firm raised and how this capital was used, and
what impact operating and financing decisions had on the firm’s cash position.

The top part shows cash generated by and used in operations during
2015. For Riverside, operations provided $9,098,000 in net cash flow. The
income statement reported $6,474,000 in operating income and $4,130,000
in depreciation, for $10,604,000 in operating cash flow. But as part of its
operations, Riverside invested $1,297,000 in current assets (receivables and

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 641

inventories) and reduced its spontaneous liabilities (payables and accruals) bal-
ance by $209,000. The end result, net cash flow from operations, is $10,604,000
− $1,297,000 − $209,000 = $9,098,000.

The next section of the statement of cash flows focuses on investments in
fixed assets and securities. Riverside spent $4,293,000 on capital expenditures
in 2015. Is that a large or small amount? The top part of the statement of cash
flows reports a depreciation expense for 2015 of $4,130,000, so the hospital
spent only slightly more than its depreciation expense on new fixed assets. Thus,
it is likely that the capital expenditures were more to replace worn-out and
obsolete assets than to add a significant amount of new property and equip-
ment. In addition to fixed-asset investments, Riverside invested $2,000,000 in
short-term securities, for a total cash outflow from investing of $6,293,000.

Riverside’s financing activities, as shown in the third section, high-
light the fact that the hospital received $2,098,000 in nonoperating income
(unrestricted contributions and investment income) and used $2,150,000 +
$3,262,000 + $323,000 = $5,735,000 in cash to pay off previously incurred
long-term debt, short-term debt, and capital lease obligations.

EXHIBIT 17.1
Riverside
Memorial
Hospital:
Statement of
Cash Flows,
Year Ended
December
31, 2015 (in
thousands)

Cash flows from operating activities:
Operating income $ 6,474
Adjustments:
Depreciation 4,130
Increase in accounts receivable (1,102)
Increase in inventories (195)
Decrease in accounts payable (438)
Increase in accrued expenses 229
Net cash flow from operations $ 9,098

Cash flows from investing activities:
Investment in property and equipment ($ 4,293)
Investment in short-term securities ( 2,000)
Net cash flow from investing ($ 6,293)

Cash flows from financing activities:
Nonoperating income $ 2,098
Repayment of long-term debt (2,150)
Repayment of notes payable (3,262)
Capital lease principal repayment (323)
Net cash flow from financing ($ 3,637)

Net increase (decrease) in cash and equivalents ($ 832)

Beginning cash and equivalents 3,09

Ending cash and equivalents $ 2,263

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H e a l t h c a r e F i n a n c e642

When the three major sections are totaled, Riverside had a $9,098,000
− $6,293,000 − $3,637,000 = $832,000 net decrease in cash (i.e., net cash
outflow) during 2015. The bottom of Exhibit 17.1 reconciles the 2015 net
cash flow with the ending cash balance shown on the balance sheet. Riverside
began 2015 with $3,095,000; experienced a cash outflow of $832,000 dur-
ing the year; and ended the year with $3,095,000 − $832,000 = $2,263,000
in its cash and equivalents account, as verified by the value reported on the
balance sheet (Exhibit 17.3).

Riverside’s statement of cash flows shows nothing unusual or alarm-
ing. It does show that the hospital’s operations were inherently profitable, at
least in 2015. Had the statement showed an operating cash drain, Riverside’s
managers would have had something to worry about; if it continued, such
a drain could bleed the hospital to death. The statement of cash flows also
provides easily interpreted information about Riverside’s financing and fixed-
asset investing activities for the year. For example, Riverside’s cash flow from
operations was used primarily to purchase replacement fixed assets, to invest
in short-term securities, and to pay off notes payable and long-term debt.
Again, such uses of operating cash flow do not raise any red flags regarding
the hospital’s financial actions.

Managers and investors must pay close attention to the statement of
cash flows. Financial condition is driven by cash flows, and the statement gives
a good picture of the annual cash flows generated by the organization. An
examination of Exhibit 17.1 (or better yet, a series of such exhibits going back
the last five years and projected five years into the future) would give River-
side’s managers and creditors an idea of whether or not the hospital’s opera-
tions are self-sustaining—that is, whether the business generates the cash flows
necessary to pay its bills, including those associated with the capital employed.
Although the statement of cash flows is filled with valuable information, the
bottom line tells little about the business’s financial condition because operat-
ing losses can be covered by financing transactions such as borrowing or selling
new common stock (if investor owned), at least in the short run.

1. What are the four required financial statements?
2. What type of financial performance information is provided in the

statement of cash flows?
3. What is the difference between net income and cash flow, and

which is more meaningful to a business’s financial condition?
4. Does the fact that a business’s cash position has improved provide

much insight into the year’s financial results?

SELF-TEST
QUESTIONS

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Financial Ratio Analysis

The next step in most financial condition analyses is to examine the business’s
other financial statements. We analyzed Riverside’s statement of cash flows
first because this statement is formatted in a way that facilitates interpretation
without further data manipulation. Now we examine the income statement
and balance sheet. Although these statements contain a wealth of financial
information, it is difficult to make meaningful judgments about financial condi-
tion by merely examining the statements’ raw data. To illustrate, one medical
group practice may have $5,248,760 in long-term debt and interest charges of
$419,900, while another may have $52,647,980 in debt and interest charges
of $3,948,600. The true burden of these debts, and each practice’s ability to
pay the interest and principal due on them, cannot be easily assessed without
additional data analyses, such as those provided by ratio

analysis.

Ratio analysis combines data to create single numbers that have eas-
ily interpreted significance (for our purposes, numbers that measure various
aspects of financial condition). Financial ratio analysis is ratio analysis applied
to the data contained in a business’s financial statements (income statement
and balance sheet). In the case of the debt and interest payments described
above, ratios could be constructed that relate each practice’s debt to its assets
and the interest it pays to the income it has available for payment.

Unfortunately, an almost unlimited number of financial ratios can be
constructed, and the choice of ratios depends in large part on the nature of
the business being analyzed, the purpose of the analysis, and the availability
of comparative data. Generally, ratios are grouped into categories to make
them easier to interpret. In the paragraphs that follow, the data presented in
exhibits 17.2 and 17.3 are used to calculate an illustrative sampling of 2015
financial ratios for Riverside Memorial Hospital, which are then compared
with hospital industry average ratios.

Industry average ratios are available from many sources. For example,
Optum360 publishes an annual almanac that provides hospital industry data
on 76 financial and operating indicator ratios. The ratios are reported in several
groupings, such as by hospital size and geographic location. (For information
about the 2016 edition, visit www.optumcoding.com/Product/43409/.) The
industry average ratios presented in this chapter are for illustrative use only
and hence should not be used for making real-world comparisons.

Note that in a real analysis, many more ratios would be calculated and
analyzed. Also, although a hospital is used to illustrate ratio analysis, the specific
ratios used in any analysis depend on the type of healthcare provider. Some
ratios are more meaningful for hospitals, some for managed care organizations,
some for medical practices, and so on.

Ratio analysis
The process of
creating and
analyzing ratios
from financial
statement and
other data to
help assess
a business’s
financial condition.

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H e a l t h c a r e F i n a n c e644

Profitability Ratios
Profitability is the net result of a large number of managerial policies and deci-
sions, so profitability ratios provide one measure of the aggregate financial
performance of a business.

Total Margin
The total margin, often called the total profit margin or just profit margin,
is net income divided by all revenues, including both operating revenues and
nonoperating income:

Total margin

Net income

Total revenues
=

$8,572
$114,148

= 0.075 = 7.5%.

Industry average = 5.0%.

Note that total revenues are defined as net operating revenues plus
nonoperating income, so Total revenues = $112,050 + $2,098 = $114,148.
Riverside’s total margin of 7.5 percent shows that the hospital makes 7.5
cents on each dollar of revenue. The total margin measures the ability of the

Profitability ratios
A group of ratios
that measure
different
dimensions of
a business’s
profitability.

2015 2014

Revenues:
Patient service revenue $ 106,502 $ 95,398
Less: Provision for bad debts 3,328 3,469
Net patient service revenue $ 103,174 $ 91,929
Premium revenue 5,232 4,622
Other revenue 3,644 6,014

Net operating revenues $ 112,050 $102,565

Expenses:
Nursing services $ 58,285 $ 56,752
Dietary services 5,424 4,718
General services 13,198 11,655
Administrative services 11,427 11,585
Employee health and welfare 10,250 10,705
Malpractice insurance 1,320 1,204
Depreciation 4,130 4,025
Interest expense 1,542 1,521

Total expenses $ 105,576 $ 102,165
Operating income $ 6,474 $ 400
Nonoperating income 2,098 1,995

Net income $ 8,572 $ 2,395

EXHIBIT 17.2
Riverside

Memorial Hos-
pital: State-

ments of Opera-
tions (Income
Statements),
Years Ended

December 31,
2015 and 2014
(in thousands)

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organization to generate revenues from all sources and to control expenses.
With all else the same, the higher the total margin, the lower the expenses
relative to revenues. Riverside’s total margin is well above the industry average
of 5.0 percent, indicating good expense control. How good? The industry
data source also reports quartiles; for total margin, the upper quartile was 8.4
percent, meaning that 25 percent of hospitals had total margins higher than
8.4 percent. Although Riverside’s total margin was better than average, it was
not as good as the top 25 percent of hospitals.

Although industry average figures are discussed in detail later in the
chapter, it should be noted here that the industry average is not a magic number
that all businesses should strive to achieve. Some well-managed businesses will
be above the average, while other good firms will be below it. However, if a
business’s ratios are far removed from the average for the industry, its managers
should be concerned about why this difference occurs. Note also that according
to standard practice, we are calling the comparative data averages, but in real-
ity they are median values. Median values are better for comparisons because
they are not biased by extremely high or low values in the industry data set.

2015 2014

Cash and equivalents $ 2,263 $ 3,095
Short-term investments 4,000 2,000
Net patient accounts receivable 21,840 20,738
Inventories 3,177 2,982
Total current assets $ 31,280 $ 28,815
Gross property and equipment $ 145,158 $140,865
Accumulated depreciation 25,160 21,030
Net property and equipment $ 119,998 $ 119,835

Total assets $ 151,278 $148,650

Accounts payable $ 4,707 $ 5,145
Accrued expenses 5,650 5,421
Notes payable 2,975 6,237
Total current liabilities $ 13,332 $ 16,803
Long-term debt $ 28,750 $ 30,900
Capital lease obligations 1,832 2,155
Total long-term liabilities $ 30,582 $ 33,055
Net assets (equity) $ 107,364 $ 98,792

Total liabilities and net assets $ 151,278 $148,650

EXHIBIT 17.3
Riverside
Memorial
Hospital:
Balance Sheets,
December 31,
2015 and 2014
(in thousands)

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H e a l t h c a r e F i n a n c e646

Riverside’s relatively high total margin could mean that the hospital’s
charges are relatively high, its costs are relatively low, it has relatively high
nonoperating revenue, or a combination of these factors is at play. A thor-
ough operating indicator analysis would help pinpoint the cause, or causes,
of Riverside’s high total margin.

Operating Margin
Another useful margin ratio is the operating margin, which is defined as oper-
ating income divided by patient-related (operating) revenues:

Operating margin =
Operating income

Net operating revenues
=

$6,474
$112,050

= 0.058 = 5.8%.

Industry average = 3.5%.

The advantage of operating margin is that it focuses on core business
activities and hence removes the influence of financial gains and losses, which
are unrelated to operations and often are transitory. Riverside’s total margin
was 7.5 percent, while its operating margin was only 5.8 percent, compared
to the industry average of 3.5 percent. Removing nonoperating income (pri-
marily unrestricted contributions and investment returns) lowers profitability,
but Riverside’s core operations are more profitable than the industry average,
which is good news. Note, though, that the format of many healthcare orga-
nizations’ financial statements makes this ratio difficult to determine without
additional information. Furthermore, the definition of operating margin varies
depending on data availability.

Return on Assets
The ratio of net income to total assets measures the return on total assets, often
just called return on assets (ROA):

Return on assets
Net income
Total assets

$8, 572
$151, 278

0.057 5.7%.

Industry average 4.8%.

= =

Riverside’s 5.7 percent ROA, which means that each dollar of assets
generated 5.7 cents in profit, is well above the 4.8 percent average for the
hospital industry. ROA tells managers how productively, in a financial sense,
a business is using its assets. The higher the ROA, the greater the net income
for each dollar invested in assets and hence the more productive the assets.
ROA measures both a business’s ability to control expenses, as expressed by
the total margin, and its ability to use its assets to generate revenue.

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Return on Equity
The ratio of net income to total equity (net assets) measures the return on
equity (ROE):

Return on equity
Net income
Total equity

$8, 572
$107, 364

0.080 8.0%.

Industry average 8.4%.

= = =

Riverside’s 8.0 percent ROE is slightly below the 8.4 percent industry
average. The hospital was able to generate 8.0 cents of income for each dol-
lar of equity investment, while the average hospital produced 8.4 cents. ROE
is especially meaningful for investor-owned businesses because owners are
concerned with how well the business’s managers are using owner-supplied
capital, and ROE answers this question. For not-for-profit businesses such as
Riverside, ROE tells its board of trustees and managers how well, in financial
terms, its community-supplied capital is being used.

Riverside’s 2015 margin measures and ROA were above the industry
averages, yet the hospital’s ROE is below the average. As we explain later in
the section on Du Pont analysis, this seeming inconsistency is a result of the
hospital’s low use of debt financing.

Liquidity Ratios
One of the first concerns of most managers, and the major concern of a firm’s
creditors, is the business’s liquidity. Will the business be able to meet its cash
obligations as they come due? Liquidity ratios are designed to answer that
question. Riverside has debts totaling more than $13 million (i.e., its current
liabilities) that must be paid off within the coming year. Will the hospital be
able to make these payments? A full liquidity analysis requires the use of a cash
budget, which we discussed in Chapter 16. However, by relating the amount
of cash and other current assets to current obligations, ratio analysis provides
a quick, easy-to-use, rough measure of liquidity.

Current Ratio
The current ratio is calculated by dividing current assets by current liabilities:

= = =
=

Current ratio
Current assets

Current liabilities
$31,280
$13,332

2.3, or 2.3 times.

Industry average 2.0.

The current ratio tells managers that the immediate liquidation of Riv-
erside’s current assets at book value would provide $2.30 of cash for every

Liquidity ratios
Ratios that
measure the ability
of a business to
meet its cash
obligations as they
come due.

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H e a l t h c a r e F i n a n c e648

$1 of current liabilities. If a business is getting into financial difficulty, it will
begin paying its accounts payable more slowly, building up short-term bank
loans (notes payable), and so on. If these current liabilities rise faster than
current assets, the current ratio will fall, and this could spell trouble. Because
the current ratio is an indicator of the extent to which short-term claim obli-
gations are covered by assets that are expected to be converted to cash in the
near term, it is a commonly used measure of liquidity.

Riverside’s current ratio is slightly above the average for the hospital
industry. Because current assets should be converted to cash in the near future,
it is highly probable that these assets could be liquidated at close to their
stated values. With a current ratio of 2.3, the hospital could liquidate current
assets at only 43 percent of book value and still pay off current creditors in
full. (To determine the minimum proportion of current assets that must be
converted to cash to meet current obligations, divide the number 1 by the
current ratio. For Bayside, 1 ÷ 2.3 = 0.43, or 43 percent. This proportion is
confirmed by noting that 0.43 × $31,280,000 = $13,332,000, the amount
of current liabilities.)

Days Cash on Hand
The current ratio measures liquidity on the basis of balance sheet accounts
and hence is a static measure of liquidity. However, the true measure of a
business’s liquidity is whether it can meet its payments as they come due, so
liquidity is more related to cash inflows and outflows than it is to assets and
liabilities. The days-cash-on-hand ratio moves closer to those factors that truly
determine liquidity:

=
= = =
=

Days cash on hand
Cash and equivalents + Short-term investments

(Expenses – Depreciation) / 365

$2,263 + $4,000
($105,576 – $4,130) / 365

$6,263
$277.93

22.5 days.

Industry average 30.6 days.

The denominator of the equation estimates average daily cash expenses
by stripping out noncash expenses (depreciation) from reported total expenses
and then dividing by 365, the number of days in a year. The numerator is the
cash and securities that are available to make those cash payments. Because
Riverside’s days cash on hand is lower than the industry average, its liquidity
position as measured by days cash on hand is worse than that of the average
hospital.

For Riverside, the two measures of liquidity, current ratio and days cash
on hand, give conflicting results. Perhaps the average hospital has a greater
proportion of cash and equivalents and short-term investments in its current

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assets mix than does Riverside. More analysis would be required to make a
supportable judgment concerning Riverside’s liquidity position. Remember,
though, that the cash budget, which we discussed in Chapter 16, is the primary
tool used by managers to ensure liquidity.

Debt Management (Capital Structure) Ratios
The extent to which an organization uses debt financing, or financial leverage,
is an important measure of financial performance for several reasons. First, by
raising funds through debt, owners of for-profit businesses can maintain control
with a limited investment. For not-for-profit organizations, debt financing allows
more services to be provided than if the organization were solely financed with
contributions and earnings. Next, creditors look to equity capital to provide
a margin of safety; if the owners (or community) have provided only a small
proportion of total financing, the risks of the enterprise are borne mainly by
its creditors. Finally, if a business earns more on investments financed with
borrowed funds than it pays in percentage interest, its ROE is increased.

Debt management ratios fall into two categories:

1. Capitalization ratios. These ratios use balance sheet data to determine
the extent to which borrowed funds have been used to finance assets.

2. Coverage ratios. Here, income statement data are used to determine
the extent to which fixed financial charges are covered by reported
profits.

The two sets of ratios are complementary, so most financial statement
analyses examine both types.

Capitalization Ratio 1: Total Debt to Total Assets (Debt Ratio)
The ratio of total debt to total assets (total liabilities and equity), called the
debt ratio, measures the percentage of total capital provided by creditors:

= = =
=

Debt ratio
Total debt
Total assets

$43, 914
$151, 278

0.290, or 29.0%.

Industry average 42.3%.

For this ratio, debt typically is defined as all debt, including current
liabilities. In essence, debt is defined here as everything on the capital side
of the balance sheet except equity. However, as illustrated by the next ratio
discussed, capitalization ratios have several variations, many of which use dif-
ferent definitions of what constitutes debt.

Creditors prefer low debt ratios because the lower the ratio, the greater
the cushion against creditors’ losses in the event of bankruptcy and liquida-
tion. Conversely, owners of for-profit firms may seek high leverage either to

Debt management
ratios
A group of ratios
that measure
the extent of
a business’s
financial leverage
(capital structure).

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H e a l t h c a r e F i n a n c e650

leverage up returns or because selling new stock would mean giving up some
degree of control. In not-for-profit organizations, managers may seek high
leverage to offer more services.

Riverside’s debt ratio is 29.0 percent. This means that its creditors have
supplied somewhat less than one-third of the business’s total financing. Put
another way, each dollar of assets was financed with 29 cents of debt, and
consequently, 71 cents of equity. (The equity ratio is defined as 1 − Debt ratio,
so Riverside’s equity ratio is 71 percent.) Because the average debt ratio for the
hospital industry is more than 40 percent, Riverside uses significantly less debt
than the average hospital. The low debt ratio indicates that the hospital would
find it relatively easy to borrow additional funds, presumably at favorable rates.

Note that the debt-to-equity ratio, defined as Total debt ÷ Total equity,
is a close relative of the debt ratio. These ratios are transformations of one
another and provide the same information but with a different twist. Both
the debt ratio and debt-to-equity ratio increase as a business uses a greater
proportion of debt financing, but the debt ratio rises linearly and approaches
a limit of 100 percent, while the debt-to-equity ratio rises at a faster rate and
approaches infinity. Lenders, in particular, prefer to use the debt-to-equity
ratio rather than the debt ratio because it tells them how much capital credi-
tors have provided to the organization per dollar of equity capital. The higher
this ratio, the riskier the creditors’ position. Other analysts tend to prefer the
debt ratio because it makes it easier to visualize the liabilities and equity mix
on the balance sheet.

Capitalization Ratio 2: Debt-to-Capitalization Ratio
The debt-to-capitalization ratio, which is long-term debt divided by long-term
capital (long-term debt plus equity), focuses on the proportion of debt used
in a business’s permanent (long-term) capital structure. This ratio is also called
the long-term-debt-to-capitalization ratio or just capitalization ratio. (Note
that we have included capital lease obligations in our definition of long-term
debt because such obligations are similar in nature to long-term debt.)

=
+

= =
=

Debt-to-capitalization ratio
Long-term debt

Long-term debt Equity
$30,582

$30,582 + $107,364
0.222, or 22.2%.

Industry average 34.6%.

Many analysts believe that the debt-to-capitalization ratio best reflects
the capital structure of a business. This belief is based on the fact that most
businesses use as much spontaneous free credit (current liabilities less short-term
bank loans) as they can get. Furthermore, short-term interest-bearing debt
typically is used only to fund temporary current asset needs. Thus, the “true”

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 651

capital structure of a business—the one that reflects its target structure—is
best reflected by a ratio that focuses on permanent (long-term) financing.

Riverside’s debt-to-capitalization ratio is 22.2 percent, compared to the
industry average of 34.6 percent. This low use of debt financing in Riverside’s
permanent capital mix confirms the conclusion made earlier that the hospital
has unused debt capacity.

Coverage Ratio 1: Times Interest Earned Ratio
The times interest earned (TIE) ratio is determined by dividing earnings before
interest and taxes (EBIT) by interest charges. EBIT is used in the numerator
because it represents the amount of accounting income that is available to pay
interest expense. For a not-for-profit organization, which does not pay taxes,
EBIT = Net income + Interest expense, whereas for a for-profit business,
EBIT = Net income + Interest expense + Taxes. Riverside’s TIE ratio is 6.6:

= =
+

= =
=

TIE ratio
EBIT

Interest expense
$8, 572 $1, 542

$1, 542
$10,114
$1, 542

6.6.

Industry average 4.0.

The TIE ratio measures the number of dollars of accounting income
(as opposed to cash flow) available to pay each dollar of interest expense. In
essence, it is an indicator of the extent to which income can decline before it
is less than annual interest costs. Failure to pay interest can bring legal action
by the firm’s creditors, possibly resulting in bankruptcy.

Riverside’s interest is covered 6.6 times, so it has $6.60 of accounting
income to pay each dollar of interest expense. Because the industry average TIE
ratio is four times, the hospital is covering its interest charges by a relatively
high margin of safety. Thus, the TIE ratio reinforces the previous conclusions
based on the debt and debt-to-capitalization ratios—namely, that the hospital
could easily expand its use of debt financing.

Coverage ratios are often better measures of a firm’s debt utilization than
capitalization ratios because coverage ratios discriminate between low-interest rate
debt and high-interest rate debt. For example, a medical group practice might
have $10 million of 4 percent debt on its balance sheet, while another might
have $10 million of 8 percent debt. If both practices have the same income and
assets, both would have the same debt ratio. However, the group that pays 4
percent interest would have lower interest charges and hence would be in bet-
ter financial condition than the group that pays 8 percent. This difference in
financial condition is captured by the TIE ratio.

Coverage Ratio 2: Cash Flow Coverage Ratio
Although the TIE ratio is easy to calculate, it has three major deficiencies.
First, leasing is a common form of financing, and the TIE ratio ignores lease

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H e a l t h c a r e F i n a n c e652

payments, which, like debt payments, are contractual obligations. Second,
many debt contracts require that principal payments be made over the life of
the loan, rather than only at maturity. Thus, most organizations must meet
fixed financial charges associated with debt financing besides interest pay-
ments. Finally, the TIE ratio ignores the fact that accounting income, whether
measured by EBIT or net income, does not reflect the actual cash flow avail-
able to meet a business’s fixed payments. These deficiencies are corrected in
the cash flow coverage (CFC) ratio, which shows the amount by which cash
flow covers fixed financial requirements. Here is Riverside’s 2015 CFC ratio
assuming the hospital had $1,368,000 of lease payments and $2,000,000 of
required debt principal repayments:

=
+ +

+ + −

=
+ +

+ + −
= =

T
CFC ratio

EBIT Lease payments Depreciation expense
Interest expense Lease payments Debt principal / (1 )

$10,114 $1, 368 $4,130
$1, 542 $1, 368 $2, 000 / (1 0)

$15, 612
$4, 9

3.2.

Industry average 2.3.

Like its TIE ratio, Riverside’s CFC ratio exceeds the industry standard,
indicating that Riverside is better at covering total fixed payments with cash
flow than is the average hospital. This fact should be reassuring both to credi-
tors and to management as it reinforces the view that Riverside has untapped
debt capacity.

You may be wondering why there is a (1 − T ) term applied to the
debt principal. The reason is that investor-owned firms must make principal
repayments with after-tax dollars and hence must earn more pretax dollars
to both pay taxes and make the principal repayment. The grossed-up amount,
which results from dividing by 1 − T, gives the amount of pretax dollars that
are needed to cover the required principal repayments. Thus, the calculation,
which contains pretax dollars in the numerator, now has pretax dollars in the
denominator and hence is consistent in format.

Asset Management (Activity) Ratios
The next group of ratios, the asset management ratios, is designed to mea-
sure how effectively a business’s assets are being utilized. These ratios help
answer whether the amount of each type of asset reported on the balance
sheet seems reasonable, too high, or too low in view of current (or projected)
operating levels. Riverside and other hospitals must borrow or raise equity
capital to acquire assets. If they have too many assets for the volume of ser-
vices provided, their capital costs will be too high and their profits will be
depressed. Conversely, if the level of assets is too low, volume may be lost or
vital services not offered.

Asset
management
ratios
Financial
statement
analysis ratios
that measure how
effectively a firm
is managing its
assets.

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 653

Fixed Asset Turnover Ratio
The fixed asset turnover ratio, also called the fixed asset utilization ratio, mea-
sures the utilization of property and equipment, and it is the ratio of total
(all) revenues to net fixed assets (property and equipment):

Fixed asset turnover =
Total revenues
Net fixed assets

=
$114,148
$119,998

= 0.95.

Industry average = 2.2.

Note that total revenues include both operating and nonoperating revenues:
$112,050 + $2,098 = $114,148. Also, net fixed assets are listed on the bal-
ance sheet as net property and equipment.

Riverside’s ratio of 0.95 indicates that each dollar of fixed assets gener-
ated 95 cents in total revenue. This value compares poorly with the industry
average of 2.2 times, indicating that Riverside is not using its fixed assets
as productively as is the average hospital. (The lower-quartile value for the
industry is 1.1; thus, Riverside falls in the bottom 25 percent of all hospitals
in its fixed-asset utilization.)

Before condemning Riverside’s management for poor performance, it
should be pointed out that a major problem arises from the use of the fixed asset
turnover ratio for comparative purposes. Recall that most asset values listed on the
balance sheet reflect historical costs rather than current market values. Inflation
and depreciation have caused the values of many assets that were purchased in the
past to be seriously understated. Therefore, if an old hospital that had acquired
much of its plant and equipment years ago is compared to a new hospital with
the same physical capacity, the old hospital, because of a much lower book value
of fixed assets, would report a much higher turnover ratio. This difference in
fixed-asset turnover is more reflective of the inability of financial statements to deal
with inflation than of any inefficiency on the part of the new hospital’s managers.

Total Asset Turnover Ratio
The total asset turnover ratio measures the turnover, or utilization, of all of a
business’s assets. It is calculated by dividing total (all) revenues by total assets:

= = =
=

Total asset turnover
Total revenues

Total assets

$114,148
$151,278

0.75.

Industry average 0.97.

Again, note that total revenues include both operating and nonoperating
revenues.

Each dollar of total assets generated 75 cents in total revenues. River-
side’s total asset ratio is below the industry average, but not as far below as its

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H e a l t h c a r e F i n a n c e654

Comparative and Trend Analyses
When conducting financial ratio analysis, the
value of a particular ratio, in the absence of
other information, reveals almost nothing
about a business’s financial condition. For
example, if it is known that a nursing home
management company has a current ratio of
2.5, it is virtually impossible to say whether
this is good or bad. Additional data are needed
to help interpret the results of this ratio analy-
sis. In the discussion of Riverside’s financial ratios, the focus was on comparative
analysis—that is, the hospital’s ratios were compared with the average ratios for
the industry. Another useful ratio analysis tool is trend analysis, in which the trend
of a single ratio is analyzed over time. Trend analysis gives clues about whether
a business’s financial situation is improving, holding constant, or deteriorating.

It is easy to combine comparative and trend analyses in a single graph
such as the one shown in Exhibit 17.4. Here, Riverside’s ROE (the solid lines)
and industry average ROE data (the dashed lines) are plotted for the past five
years. The graph shows that the hospital’s ROE was declining faster than the
industry average from 2011 through 2014, but that it rose above the industry
average in 2015. Other ratios can be analyzed in a similar manner.Comparative

analysis
The comparison
of key financial
and operational
measures of
one business
with those of
comparable
businesses or
industry averages.
Also called
benchmarking.

Trend analysis
A ratio analysis
technique that
examines the
value of a ratio
over time to see if
it is improving or
deteriorating.

1. What is the purpose of ratio

analysis?

2. What are two ratios that measure profitability?
3. What are two ratios that measure liquidity?
4. What are two ratios that measure debt management?
5. What are two ratios that measure asset management?
6. How can comparative and trend analyses be used to help interpret

a ratio?

SELF-TEST
QUESTIONS

fixed asset turnover ratio. Thus, relative to the industry, the hospital is using
its current assets better than its fixed assets. Such judgments can be confirmed
by examining Riverside’s current asset turnover. In 2015, Riverside’s current
asset turnover ratio (Total revenues ÷ Total current assets) is 3.6, compared
to the industry average of 3.4, so the hospital is slightly above average in its
utilization of current assets.

Days in Patient Accounts Receivable
Days in patient accounts receivable is used to measure effectiveness in manag-
ing receivables. This measure of financial performance, which is sometimes
classified as a liquidity ratio rather than an asset management ratio, has many
names, including average collection period (ACP) and days’ sales outstanding
(DSO). It is computed by dividing net patient accounts receivable by average
daily patient revenue to find the number of days that it takes an organiza-
tion, on average, to collect its receivables. In theory, the denominator of this
ratio should focus on revenues other than immediate cash payments, but this
information generally is unavailable, so net patient services revenue is used.
Also, note that premium and other revenue has not been included in the
calculation because such revenue typically is collected either before or at the
time services are provided, and hence does not affect receivables.

=
= = =
=

Days in patient accounts receivable
Net patient accounts receivable

Net patient service revenue / 365

$21,840
$103,174 / 365

$21,840
$282.67

77.3 days.

Industry average 64.0 days.

Riverside is not doing as well as the average hospital in collecting its
receivables. The lower quartile value is 78.7 days, so a large number of hos-
pitals are doing worse. Still, as was discussed in the revenue cycle section of
Chapter 16, it is important that businesses collect their receivables as soon as
possible. Clearly, Riverside’s managers should strive to increase the hospital’s
performance in this key area.

Average Age of Plant
The average age of plant gives a rough measure of the average age in years of
a business’s fixed assets (net property and equipment):

= = =
=

Average age of plant
Accumulated depreciation

Depreciation expense
$25,160
$4,130

6.1 years.

Industry average 9.1 years.

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 655

Riverside’s physical assets are newer
than those of the average hospital. Thus, the
hospital is offering more up-to-date facilities
than average, and it will probably have fewer
capital expenditures in the near future. On the
other hand, Riverside’s net fixed asset valuation
will be relatively high, which, as pointed out
earlier, biases the hospital’s fixed asset and total
asset turnover ratios downward. This fact raises
serious questions about the interpretation of
the turnover ratios calculated previously.
Comparative and Trend Analyses
When conducting financial ratio analysis, the
value of a particular ratio, in the absence of
other information, reveals almost nothing
about a business’s financial condition. For
example, if it is known that a nursing home
management company has a current ratio of
2.5, it is virtually impossible to say whether
this is good or bad. Additional data are needed
to help interpret the results of this ratio analy-
sis. In the discussion of Riverside’s financial ratios, the focus was on comparative
analysis—that is, the hospital’s ratios were compared with the average ratios for
the industry. Another useful ratio analysis tool is trend analysis, in which the trend
of a single ratio is analyzed over time. Trend analysis gives clues about whether
a business’s financial situation is improving, holding constant, or deteriorating.
It is easy to combine comparative and trend analyses in a single graph
such as the one shown in Exhibit 17.4. Here, Riverside’s ROE (the solid lines)
and industry average ROE data (the dashed lines) are plotted for the past five
years. The graph shows that the hospital’s ROE was declining faster than the
industry average from 2011 through 2014, but that it rose above the industry
average in 2015. Other ratios can be analyzed in a similar manner.Comparative
analysis
The comparison
of key financial
and operational
measures of
one business
with those of
comparable
businesses or
industry averages.
Also called
benchmarking.
Trend analysis
A ratio analysis
technique that
examines the
value of a ratio
over time to see if
it is improving or
deteriorating.
1. What is the purpose of ratio analysis?
2. What are two ratios that measure profitability?
3. What are two ratios that measure liquidity?
4. What are two ratios that measure debt management?
5. What are two ratios that measure asset management?
6. How can comparative and trend analyses be used to help interpret
a ratio?
SELF-TEST
QUESTIONS

For Your Consideration
How Many Ratios Are Enough?

In our discussion of financial statement ratio
analysis, we discussed 14 ratios that are com-
monly used to help interpret financial statement
data. Although that may seem like a lot of ratios,
our discussion just scratched the surface. For
example, one of the most widely used sets of
comparative data for hospitals, the Almanac of
Hospital Financial and Operating Indicators, pub-
lished annually by Optum360, provides data on
more than 30 financial ratios.

Without too much additional work, you could
probably compile a list of 50 financial ratios. Yet
studies have shown that about 90 percent of the
information contained in financial statements can be
uncovered using 10 or so carefully selected ratios.

How many ratios do you think are enough?
Does it matter how the ratios are selected? Is there
a cost to using more ratios than necessary? What
is the disadvantage of generating too much data?

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H e a l t h c a r e F i n a n c e656

Tying the Financial Ratios Together: Du Pont Analysis

Financial ratio analysis provides a great deal of information about a business’s
financial condition, but it does not provide an overview, nor does it tie any of the
ratios together. Du Pont analysis, so named because managers at the Du Pont
Company developed it, provides an overview of a business’s financial condition and
helps managers and investors understand the relationships among several ratios.
The analysis decomposes return on equity, one of the most important measures
of a business’s profitability, into the product of three other ratios, each of which
has an important economic interpretation. The result is the Du Pont equation:

= × ×

ROE Total margin Total asset turnover Equity multiplier
Net income
Total equity

Net income
Total revenues

Total revenues
Total assets

Total assets
Total equity

Du Pont analysis
A financial
statement
analysis tool that
decomposes return
on equity into
three components:
profit margin, total
asset turnover, and
equity multiplier.

Return on Equity (ROE)

Industry

Year Riverside Lower Quartile Median

Upper Quartile

2011 12.5% 2.6% 8.6% 13.3%
2012 10.0 2.5 8.6 13.3
2013 6.7 2.8 7.2 12.0
2014 2.4 4.1 7.2 12.1
2015 8.0 3.8 7.4 12.3

2011 2012 2013 2014 20

Lower Quartile

Median

Upper Quartile
5
10
15

ROE (%)

EXHIBIT 17.4
Riverside
Memorial
Hospital:

ROE Analysis,
2011–2015

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Riverside’s 2015 data are used to illustrate the Du Pont equation:

$8,572
$107,364

$8,572
$114,148
$114,148
$151,278

$151,278
$107,364

8.0% 7.5% 0.75 1.4

5.6% 1.4.

= × ×
= × ×

= ×

In the Du Pont equation, the product of the first two terms on the
right side is return on assets (ROA), so the equation can also be written as
ROE = ROA × Equity multiplier. Riverside’s 2015 total margin was 7.5 per-
cent, so the hospital made 7.5 cents profit on each dollar of total revenue.
Furthermore, assets were turned over (or created revenues) 0.75 times during
the year, so the hospital earned a return of 7.5% × 0.75 = 5.6% on its assets.
This value for ROA, when rounded, is the same as was calculated previously
in our ratio analysis discussion.

If the hospital used only equity financing, its 5.6 percent ROA would
equal its ROE. However, creditors supplied 29 percent of Riverside’s capital,
while the equity holders (the community) supplied the rest. Because the 5.6
percent ROA belongs exclusively to the suppliers of equity capital, which
comprises only 71 percent of total capital, Riverside’s ROE is higher than its
5.6 percent ROA. Specifically, ROA must be multiplied by the equity multi-
plier, which shows the amount of assets working for each dollar of equity
capital, to obtain the ROE of 8.0 percent. This 8.0 percent ROE could be
calculated directly: ROE = Net income ÷ Total equity = $8,572 ÷ $107,364
= 8.0%. However, the Du Pont equation shows how total margin, which
measures expense control; total asset turnover, which measures asset utilization;
and financial leverage, which measures debt utilization, interact to determine
ROE.

Key Equation: Du Pont Analysis

The Du Pont equation decomposes a business’s return on equity (ROE)
into the product of three other ratios:

ROE = Total margin × Total asset turnover × Equity multiplier.

The value of this equation stems from the fact that the total margin mea-
sures expense control, the total asset turnover measures asset utilization,
and the equity multiplier measures debt utilization. Du Pont analysis is
particularly useful when the equation can be compared with both bench-
mark equations and previous years’ results.

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H e a l t h c a r e F i n a n c e658

Riverside’s managers use the Du Pont equation to suggest how to
improve the hospital’s financial condition. To influence the profit margin,
Riverside must increase revenues and/or reduce costs. Thus, the hospital’s
marketing staff can study the effects of raising charges, or lowering them to
increase volume; moving into new services or markets with higher margins;
entering into new contracts with managed care plans; and so on. Furthermore,
management accountants can study the expense items and, while working with
department heads and clinical staff, can seek ways to reduce costs. More specific
ideas regarding actions needed to improve financial condition will be gleaned
from an operating indicator analysis, which is discussed in a later section.

Regarding total asset turnover, Riverside’s analysts, while working with
both clinical and marketing staffs, can investigate ways of reducing investments
in various types of assets. Finally, the hospital’s financial staff can analyze the
effects of alternative financing strategies on the equity multiplier, seeking to
hold down interest expenses and the risks of debt while still using debt to
leverage up ROE.

The Du Pont equation provides a useful comparison between a busi-
ness’s performance as measured by ROE and the performance of an average
hospital. For example, here is the comparative analysis for 2015:

Riverside: ROE = 7.5% × 0.75 × 1.4

= 5.6% × 1.4 = 8.0%.

Industry average: ROE = 5.0% × 0.97 × 1.7

= 4.8% × 1.7 = 8.4%.

The Du Pont analysis tells managers and creditors that Riverside has
a significantly higher profit margin, and thus better control over expenses,
than the average hospital has. However, the average hospital has a better
total asset turnover, and thus Riverside is getting below-average utilization
from its assets. In spite of the average hospital’s advantage in asset utilization,
Riverside’s superior expense control outweighs its utilization disadvantage
because its ROA of 5.6 percent is higher than the industry average ROA of
4.8 percent. Finally, the average hospital has offset Riverside’s advantage in
ROA by using more financial leverage, although Riverside’s lower use of debt
financing decreases its risk. The end result is that Riverside gets somewhat less
return on its equity capital than the average hospital gets.

One potential problem with Du Pont and ratio analyses applied to
not-for-profit organizations, especially hospitals, is that a large portion of their
net income may come from nonoperating sources. If the nonoperating rev-
enues are highly variable and unpredictable, as they often are, return on equity
and the ratios as previously defined may be a poor measure of the hospital’s
inherent profitability. All applicable ratios, as well as the Du Pont analysis,

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could be recast to focus on operations by using operating revenue and operat-
ing income in lieu of total (all) revenues and net income.

Other Analytical Techniques

Besides ratio and Du Pont analyses, two additional financial statement analysis
techniques are commonly used in financial condition analysis. In common
size analysis, all income statement items are divided by total revenues and all
balance sheet items are divided by total assets. Thus, a common size income
statement shows each item as a percentage of total revenues, and a common
size balance sheet shows each account as a percentage of total assets. The
advantage of common size statements is that they facilitate comparisons of
income statements and balance sheets over time and across companies because
they remove the influence of the scale (size) of the business.

Another frequently used technique when analyzing financial statements
is percentage change analysis. Here, the percentage changes in the balance
sheet accounts and income statement items from year to year are calculated
and compared. In this format, it is easy to see what accounts and items are
growing faster or slower than others and thus to identify which are under
control and which are out of control.

The conclusions reached in common size and percentage change analyses
generally parallel those derived from ratio analysis. However, occasionally a
serious deficiency is highlighted only by one of the three analytical techniques,
while the other two techniques fail to bring the deficiency to light. Thus, a
thorough financial statement analysis usually consists of a Du Pont analysis to
provide an overview and then includes several different techniques such as
ratio, common size, and percentage change analyses. For illustrations of com-
mon size and percentage change analyses, see the supplement to this
chapter.

1. Explain how the Du Pont equation combines several ratios to
obtain an overview of a business’s financial condition.

2. Why might a focus on operating revenue and operating income be
preferable to a focus on total revenue and net income?

SELF-TEST
QUESTIONS

Common size
analysis
A technique
to analyze a
business’s
financial
statements that
expresses income
statement items
and balance
sheet accounts as
percentages rather
than in dollars.

Percentage
change analysis
A technique
to analyze a
business’s
financial
statements that
expresses the
year-to-year
changes in income
statement items
and balance
accounts as
percentages.

1. What advantage do common size statements have over regular
statements when conducting a financial

statement analysis?

2. What is percentage change analysis, and why is it useful?
3. Which analytical techniques should be used in a complete financial

statement analysis?
SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e660

Operating Indicator Analysis

Operating indicator analysis goes one step beyond financial statement analy-
sis by examining operating variables with the goal of explaining a business’s
financial condition. Like the financial ratios, operating indicators are typically
grouped into major categories to make interpretation easier. For hospitals, the
most commonly used categories are

• profit indicators,
• price indicators,
• volume (utilization) indicators,
• length-of-stay indicators,
• intensity-of-service indicators,
• efficiency indicators, and
• unit cost indicators.

Because of the large number of operating indicators used in a typical
analysis, the indicators cannot be discussed in detail here. However, to give
you an appreciation for this type of analysis, we discuss seven commonly used
hospital operating indicators—one from each category. Note that most of the
data needed to calculate operating indicators are not contained in the financial
statements. More complete data are required for this type of analysis.

Profit per Discharge
Profit per discharge, a profit indicator, provides a measure of the amount of profit
on inpatient services earned per discharge. Note that this measure is “raw” in
the sense that it is not adjusted for case mix, which we discuss later, or local
wage conditions. Often, operating indicators are calculated in both raw and
adjusted forms. In 2015, Riverside’s managerial accounting system reported
$87,740,000 of inpatient service revenue, $84,865,000 of inpatient costs, and
18,281 patient discharges. Thus, Riverside’s profit per discharge was $157:

= =
= =
=

Profit per discharge
Inpatient profit
Total discharges

$87,740,000 – $84,865,000
18,281

$2,875,000
18,281

$157.

Industry average $73.

Compared to the industry average, Riverside’s inpatient services are more
than twice as profitable. It is not uncommon in today’s tight reimbursement

Operating
indicator
A ratio that
focuses on
operating data
rather than
financial data.

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environment for hospitals to lose money (as measured by accounting profit) on
inpatient services. In fact, with an industry average profit per discharge of only $73,
half of the hospitals are making less than $73, which indicates that a significant
percentage of hospitals are losing money on inpatient services. Most, however,
make up the losses with profits from other services or from nonoperating income.

Net Price per Discharge
Net price per discharge, which is one of many price indicators, measures the
average inpatient revenue collected on each discharge. Based on the data
presented in the discussion of the profit-per-discharge indicator, Riverside’s
net price per discharge for 2015 was $4,800:

= = =
=

Net price per discharge
Net inpatient revenue

Total discharges
$87,740,000

18,281
$4,800.

Industry average $5,056.

Riverside collects less per discharge than the average hospital; however,
we have already seen that Riverside makes a profit of $157 on each discharge,
so its inpatient services cost structure must be proportionally even lower than
the industry average. Riverside’s ability to make a profit on each discharge could
be attributed to a lower-than-average case mix, which measures the average
intensity of services provided, or to an aggressive cost management program.

Occupancy Rate (Percentage)
Occupancy rate, one of many volume indicators, measures the utilization of
a hospital’s licensed beds and hence fixed assets. Because overhead costs are
incurred on all assets whether used or not, higher occupancy spreads fixed
costs over more patients and hence increases per patient profitability. Based on
95,061 inpatient days in 2015, Riverside’s occupancy rate was 57.9 percent:

Occupancy rate
Inpatient days

(Number of licensed beds 365)
95, 061

450 365
57.9%.

Industry average 45.4%.

=
×

=
×
=
=

Riverside has a higher occupancy rate than the average hospital and hence
is using its inpatient fixed assets more productively. Note that this conclusion
contradicts the financial statement analysis interpretation of the hospital’s 2015
fixed-asset-turnover ratio. While that ratio is affected by inflation, accounting
convention, and the amount of assets devoted to other functions, the occupancy
rate is not. Hence, it is a superior measure of pure asset utilization, at least
regarding inpatient utilization. On this basis, Riverside’s managers appear to

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H e a l t h c a r e F i n a n c e662

be doing a good job, relative to the industry, of using the hospital’s inpatient
fixed assets. This measure can also be applied to staffed beds. In Riverside’s
case, the two measures of capacity are the same, but some hospitals have fewer
staffed beds than licensed beds.

Average Length of Stay
Average length of stay (ALOS), or just length of stay (LOS), is the number of
days an average inpatient is hospitalized with each admission. ALOS and an
alternative version adjusted for case mix are the sole LOS indicators. Riverside’s
2015 LOS was 5.2 days:

= = =
=

LOS
Inpatient days

Total discharges
95, 061
18, 281

5.2 days.

Industry average 4.7 days.

On average, Riverside keeps its patients in the hospital slightly longer
than the average hospital does. In general, that longer stay is considered to
have a negative impact on inpatient profitability because most hospitals have a
reimbursement mix heavily weighted toward prospective (episodic) payment.
With payment fixed per discharge, lower LOS typically leads to lower costs
and hence higher profitability.

All Patient Case-Mix Index
The all patient case-mix index is one of several intensity-of-service indicators.
The concept of measuring case mix was first applied to Medicare patients;
hence, many hospitals calculate both a Medicare case-mix index and an all
patient case-mix index. Case mix is based on diagnosis; diagnoses requiring
more complex treatments are assigned a higher value. The idea is to be able
to differentiate (on average) between hospitals that provide relatively simple,
and hence low-cost, services from those that provide highly complex and costly
services. Case-mix values assigned to diagnoses are periodically recalibrated,
with the intent of forcing the average hospital to have a case-mix index of 1.0.
In general, case mix is related to size because large hospitals typically offer a
more complex set of services than small hospitals do. Furthermore, case-mix
values tend to be high at teaching hospitals (greater than 1.5) because the
most complex cases often are transferred to such hospitals.

Riverside’s all patient case-mix index was 1.12 for 2015, which is slightly
below the industry average of 1.15. Thus, the patients that Riverside admits
to the hospital require about the same intensity of services that patients at
the average hospital require, which tells us that inpatient revenues and costs
are not influenced by having a patient mix that is either relatively simple to
treat or relatively complex.

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Inpatient FTEs per Occupied Bed
The number of inpatient full-time equivalents (FTEs) per occupied bed is a
measure of workforce productivity and hence is an efficiency indicator. The
lower the number, the more productive the workforce. When the focus is
on inpatient productivity, inpatient FTEs are used. The measure can also be
adapted to outpatient productivity. Needless to say, there are many situations in
a hospital setting in which it is difficult to allocate FTEs to the type of service
provided. With an inpatient workforce of 1,251 FTEs, Riverside’s inpatient
FTEs per occupied bed was 4.8 in 2015:

=
=
×
= =
=

Inpatient FTEs per occupied bed
Inpatient FTEs

Average daily census
1, 251

0.579 450
1, 251
260.55

4.8.

Industry average 5.6.

Note that the average daily census—the number of patients hospitalized
on an average day—was calculated by multiplying Riverside’s occupancy rate
(57.9 percent = 0.579) by the number of licensed beds (450). With higher-
than-average labor productivity, coupled with better fixed-asset utilization, it
is no surprise that Riverside’s inpatient services are more profitable than those
of the average hospital.

Salary per FTE
Salary per FTE, one of the unit cost indicators, provides a simple measure of the
relative cost of the largest resource item used in the hospital industry—labor.
With total salaries of $83,038,613 in 2015 and 2,681 total FTEs, Riverside’s
salary per FTE in 2015 was $30,973:

= = =
=

Salary per FTE
Total salaries
Total FTEs

$83, 038, 613
2, 681

$30, 973.

Industry average $32, 987.

Now, we can see that Riverside’s above-average profitability is enhanced
by both worker productivity and control over wages and benefits.

In a full operating indicator analysis, many more indicators would be
examined in an attempt to identify the operating strengths and weaknesses
that underlie a business’s financial condition. Although operating indicator
analysis has been illustrated using the hospital industry, its concepts can be
applied to any healthcare business, although the indicators would differ. Also,
operating indicators are interpreted in the same way as financial ratios (i.e.,
by performing comparative and trend analyses).

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H e a l t h c a r e F i n a n c e664

Limitations of Financial Ratio and Operating
Indicator Analyses

While financial ratio and operating indicator analyses can provide a great deal
of useful information regarding a business’s operations and financial condi-
tion, such analyses have limitations that necessitate care and judgment. In this
section, some of the problem areas are highlighted.

To begin, many large healthcare businesses operate a number of dif-
ferent services in quite different lines of business, and in such cases it is dif-
ficult to develop meaningful comparative data. This problem tends to make

financial statement and operating indicator
analyses somewhat more useful for provid-
ers with single service lines than for large,
multiservice companies.

Next, generalizing about whether
a particular ratio or indicator is good or
bad is often difficult. For example, a high
current ratio may show a strong liquidity
position, which is good, or an excessive
amount of current assets, which is bad.
Similarly, a high asset turnover ratio may
denote either a business that uses its assets
efficiently or one that is undercapitalized
and simply cannot afford to acquire enough
assets. In addition, firms often have some
ratios and indicators that look good and
others that look bad, which make a firm’s
financial position, strong or weak, difficult
to determine. For this reason, significant
judgment is required when analyzing finan-
cial and operating performance.

Another problem is that different
accounting practices can distort financial

For Your Consideration
Inflation Accounting

Inflation accounting (also called replacement cost
accounting or current cost accounting) describes
a range of accounting systems designed to
correct problems arising from historical cost
accounting under inflation. It was widely used in
the nineteenth and early twentieth centuries but
was mostly replaced by historical cost accounting
in the 1930s after asset values were devastated
by the Great Depression.

Historical cost accounting leads to two basic
problems. First, many of the historical numbers
appearing on financial statements are not eco-
nomically relevant because prices have changed
since they were incurred. Second, the num-
bers on financial statements represent dollars
expended at different points of time. Thus, add-
ing cash of $10,000 held on December 31, 2015,
with a $10,000 cost of land acquired in 1965
makes little sense because inflation has caused
the two amounts to represent significantly

1. What is the difference between financial and operating indicator
analyses?

2. Why is operating indicator analysis important?
3. Describe several metrics commonly used in operating indicator

analysis.
SELF-TEST
QUESTIONS

(continued)

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statement ratio comparisons. For example,
firms can use different accounting conven-
tions to value cost of goods sold and end-
ing inventories. During inflationary periods
these differences can lead to ratio distor-
tions. Other accounting practices, such as
those related to leases, can also create prob-
lems in ratio interpretation.

Finally, inflation effects can distort
balance sheets and income statements.
Numerous reporting methods have been
proposed to adjust accounting statements
for inflation, but no consensus has been
reached on how to do this or even on the
practical usefulness of the resulting data.
Nevertheless, accounting standards encour-
age, but do not require, businesses to dis-
close supplementary data to reflect the
effects of general inflation. Inflation effects
tend to make ratio comparisons over time
for a given business, and across businesses
at any point in time, less reliable than would be the case in the absence of
inflation.

Benchmarking

Most techniques for evaluating financial condition require comparisons to make
meaningful judgments. In the previous examination of selected financial and
operating indicator ratios, Riverside’s ratios were compared to industry aver-
age ratios. However, like managers in most businesses, Riverside’s managers
go one step further—they compare their ratios not only with industry aver-
ages but also with industry leaders and primary competitors. The technique
of comparing ratios against selected standards is called benchmarking, while
the comparative ratios are called benchmarks. Riverside’s managers benchmark

1. Briefly describe some of the problems encountered when
performing financial statement and operating indicator analyses.

2. Explain how inflation effects created problems in the Riverside
illustration.

SELF-TEST
QUESTIONS

Benchmarking
The comparison
of performance
metrics, such as
financial ratios,
of one business
against those of
similar businesses
and industry
averages. Also
called comparative
analysis.

different levels of purchasing power. Under infla-
tion accounting, the $10,000 cash would be
added to the current market value of the land,
say, $50,000, which equalizes the purchasing
power of the two amounts.

During the past 50 years, accounting stan-
dards have encouraged companies to supplement
historical cost-based financial statements with
price level (inflation)–adjusted statements, but
few companies have done so. Additionally, in
the 1970s, the Financial Accounting Standards
Board reviewed a draft proposal that would man-
date price level–adjusted statements. However,
because of stringent opposition from companies,
the proposal was never adopted.

What do you think? Would it be easy to esti-
mate the current values of balance sheet assets?
What are the advantages and disadvantages of
inflation accounting? Should generally accepted
accounting principles be revised to require infla-
tion accounting?

(continued from previous page)

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H e a l t h c a r e F i n a n c e666

against industry averages; against National/GFB Healthcare and Pennant
Healthcare, which are two leading for-profit hospital businesses; and against
Woodbridge Memorial Hospital and St. Anthony’s, which are its primary
local competitors.

To illustrate the concept, consider how Riverside’s analysts present total
margin data to the firm’s board of trustees:

2015 2014
National/GFB 9.8% National/GFB 9.6%
Industry top quartile 8.4 Industry top quartile 8.0
St. Anthony’s 8.0 St. Anthony’s 7.9
Riverside 7.5 Pennant Healthcare 5.0
Industry median 5.0 Industry median 4.7
Pennant Healthcare 4.8 Riverside 2.3
Industry lower quartile 1.8 Industry lower quartile 2.1
Woodbridge Memorial 0.5 Woodbridge Memorial (1.3)

Benchmarking permits Riverside’s managers to easily see where the firm
stands relative to its competition in any given year and over time. As the data
show, Riverside was roughly in the middle of the pack in 2015 with respect to
its primary competitors and two large investor-owned hospital chains, although
its showing was better than the average hospital’s. Its 2014 performance was
significantly worse, so it improved substantially from 2014 to 2015. Although
benchmarking is illustrated with one ratio, other ratios can be analyzed similarly.
Also, for presentation purposes, bar charts are often used with comparative
data that are color coded for ease of recognition and interpretation.

All comparative analyses require comparative data. Such data are avail-
able from a number of sources, including commercial suppliers, federal and
state governmental agencies, and various industry trade groups. Each of these
data suppliers uses a somewhat different set of ratios designed to meet its
own needs. Thus, the comparative data source selected dictates, in a very real
sense, the ratios that will be used in the analysis. Also, there are minor and
sometimes major differences in ratio definitions between data sources—for
example, one source may use a 365-day year, while another uses a 360-day
year. Or one source might use operating values, as opposed to total values,
when constructing ratios. It is very important to know the specific defini-
tions used in the comparative data because definitional differences between
the ratios being calculated and the comparative ratios can lead to erroneous
interpretations and conclusions. Thus, the first task in any ratio analysis is to
identify the comparative data set and the ratios to be used. The second task
is to make sure the ratio definitions used in the analysis match those from the
comparative data set.

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 667

Key Performance Indicators and Dashboards

Financial statement data are usually created on an annual and quarterly basis,
while operating indicator data are generated much more often, even daily.
Furthermore, financial condition analyses produced from this information may
include literally hundreds of metrics (ratios and other measures). Although
annual and quarterly financial condition analyses are always performed, man-
agers need to monitor financial condition on a more regular basis so that
problem areas can be identified and corrective action taken in a timely manner.
However, the type of financial condition analyses described in this chapter
with, say, weekly data would overload managers, and as a result, important
findings could be missed.

To help solve the data overload and timeliness problems, many health-
care businesses use key performance indicators (KPIs) and dashboards. KPIs
are a limited number of financial and operating indicator metrics that measure
performance critical to the success of an organization. In essence, they assess
the current state of the business, measure progress toward organizational goals,
and facilitate prompt managerial action to correct deficiencies.

The KPIs chosen by any business depend on the line of business and
its mission, objectives, and goals. In addition, KPIs usually differ by timing.
For example, a hospital might have a daily KPI of number of net admissions
(admissions minus discharges), while the corresponding quarterly and annual
KPI might be occupancy rate. Clearly, the number of KPIs used must be kept
to a minimum to allow managers to focus on the most important aspects of
financial and operating performance.

Dashboards are a common way to present an organization’s KPIs. The
term stems from an automobile’s dashboard, which presents key information
(e.g., speed, engine temperature, oil pressure) about the car’s performance.
Often, the KPIs are shown as gauges, which allow managers to quickly inter-
pret the indicators. The basic idea here is to allow managers to monitor the
business’s most important financial and operating metrics on a regular basis
(daily for some metrics) in a form that is easy to read and interpret.

Key performance
indicator (KPI)
A financial
statement ratio or
operating indicator
that is considered
by management
to be critical to
mission success.

Dashboard
A format for
presenting a
business’s key
performance
indicators that
resembles the
dashboard of an
automobile.

1. What is a key performance indicator (KPI)? A dashboard?
2. How are KPIs and dashboards used in financial condition

analysis?
SELF-TEST
QUESTIONS

1. What is benchmarking?
2. Why is it important to be familiar with the comparative data set?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e668

Key Concepts
The primary purpose of this chapter is to present the techniques used by
managers and investors to assess an organization’s financial condition. The
main focus is on financial condition as reflected in a business’s financial state-
ments, although operating data are also introduced to explain a business’s
current financial status. The key concepts of this chapter are as follows:

• Financial statement analysis, which is designed to identify a firm’s
financial condition, focuses on the firm’s financial statements.
Operating indicator analysis, which uses data typically found
outside of the financial statements, provides insights into why a
firm is in a given financial condition.

• Financial ratio analysis, which focuses on financial statement data,
is designed to reveal the relative financial strengths and weaknesses
of a company as compared to other companies in the same
industry, and to show whether the business’s financial condition
has been improving or deteriorating over time.

• The Du Pont equation indicates how the total margin, the total
asset turnover ratio, and the use of debt interact to determine the
rate of return on equity. It provides a good overview of a business’s
financial condition.

• Liquidity ratios indicate the business’s ability to meet its short-term
obligations.

• Asset management ratios measure how effectively managers are
using the business’s assets.

• Debt management ratios reveal the extent to which the firm is
financed with debt and the extent to which operating cash flows
cover debt service and other fixed-charge requirements.

• Profitability ratios show the combined effects of liquidity, asset
management, and debt management on operating results.

• Ratios are analyzed using comparative analysis, in which a firm’s
ratios are compared with industry averages or those of another firm,
and trend analysis, in which a firm’s ratios are examined over time.

• In a common size analysis, a business’s income statement and
balance sheet are expressed in percentages. This facilitates
comparisons between firms of different sizes and for a single firm
over time.

• In percentage change analysis, the differences in income statement
items and balance sheet accounts from one year to the next are
expressed in percentages. In this way, it is easy to identify those

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Financial condition analysis has its limitations, but if used with care and
judgment, it can provide managers with a sound picture of an organization’s
financial condition as well as identify those operating factors that contributed
to that condition.

Questions

17.1 a. What is the primary difference between financial statement
analysis and operating indicator analysis?

b. Why are both types of analyses useful to health services managers
and investors?

17.2 Should financial statement and operating indicator analyses be
conducted only on historical data? Explain your answer.

17.3 One asset management ratio, the inventory turnover ratio, is
defined as sales (i.e., revenues) divided by inventories. Why would
this ratio be important for a medical device manufacturer or a
hospital management company?

17.4 a. Assume that Kindred Healthcare and Sun Healthcare Group,
two operators of nursing homes, have fiscal years that end at
different times—say, one in June and one in December. Would
this fact cause any problems when comparing ratios between the
two companies?

b. Assume that two companies that operate walk-in clinics both
had the same December year-end, but one was based in Aspen,
Colorado, a winter resort, while the other operated in Cape
Cod, Massachusetts, a summer resort. Would their locations lead
to problems in a comparative analysis?

items and accounts that are growing appreciably faster or slower
than average.

• Benchmarking is the process of comparing the performance of a
particular company with a group of benchmark companies, often
industry leaders and primary competitors.

• Financial condition analysis is hampered by some serious problems,
including development of comparative data, interpretation of results,
and inflation effects.

• Key performance indicators (KPIs) are a limited number of
metrics that focus on those measures that are most important to
an organization’s mission success. Often, KPIs are presented in a
format that resembles a dashboard.

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H e a l t h c a r e F i n a n c e670

17.5 a. How does inflation distort ratio analysis comparisons, both
for one company over time and when different companies are
compared?

b. Are only balance sheet accounts or both balance sheet accounts
and income statement items affected by inflation?

17.6 a. What is the difference between trend analysis and comparative
analysis?

b. Which is more important?
17.7 Assume that a large managed care company has a low return on

equity (ROE). How could Du Pont analysis be used to identify
possible actions to help boost ROE?

17.8 Regardless of the specific line of business, should all healthcare
businesses use the same set of ratios when conducting a financial
statement analysis? Explain your answer.

17.9 What are key performance indicators (KPIs)? What is a dashboard?

Problems

17.1 a. Modern Medical Devices has a current ratio of 0.5. Which of the
following actions would improve (i.e., increase) this ratio?
• Use cash to pay off current liabilities.
• Collect some of the current accounts receivable.
• Use cash to pay off some long-term debt.
• Purchase additional inventory on credit (i.e., accounts payable).
• Sell some of the existing inventory at cost.

b. Assume that the company has a current ratio of 1.2. Now which
of the above actions would improve this ratio?

17.2 Southwest Physicians, a medical group practice, is just being
formed. It will need $2 million of total assets to generate $3 million
in revenues. Furthermore, the group expects to have a profit margin
of 5 percent. The group is considering two financing alternatives.
First, it can use all-equity financing by requiring each physician to
contribute his or her pro rata share. Alternatively, the practice can
finance up to 50 percent of its assets with a bank loan. Assuming
that the debt alternative has no impact on the expected profit
margin, what is the difference between the expected ROE if the
group finances with 50 percent debt versus the expected ROE if it
finances entirely with equity capital?

17.3 Riverside Memorial’s primary financial statements are presented in
exhibits 17.1, 17.2, and 17.3.

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 671

a. Calculate Riverside’s financial ratios for 2014. Assume that
Riverside had $1,000,000 in lease payments and $1,400,000
in debt principal repayments in 2014. (Hint: Use the book
discussion to identify the applicable ratios.)

b. Interpret the ratios. Use both trend and comparative analyses.
For the comparative analysis, assume that the industry average
data presented in the book are valid for both 2014 and 2015.

17.4 Consider the following financial statements for BestCare HMO, a
not-for-profit managed care plan:

BestCare HMO Statement of Operations and
Change in Net Assets, Year Ended June 30, 2015

(in thousands)
Revenue:
Premiums earned $26,682
Coinsurance 1,689
Interest and other income 242
Total revenues $28,613
Expenses:
Salaries and benefits $15,154
Medical supplies and drugs 7,507
Insurance 3,963
Provision for bad debts 19
Depreciation 367
Interest 385
Total expenses $27,395
Net income $ 1,218

Net assets, beginning of year $ 900
Net assets, end of year $ 2,118

BestCare HMO Balance Sheet,
June 30, 2015 (in thousands)

Assets:
Cash and cash equivalents $2,737
Net premiums receivable 821
Supplies 387
Total current assets $3,945
Net property and equipment $5,924
Total assets $9,869

(continued)

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H e a l t h c a r e F i n a n c e672

Liabilities and Net Assets:
Accounts payable—medical services $2,145
Accrued expenses 929
Notes payable 141
Current portion of long-term debt 241
Total current liabilities $3,456
Long-term debt $4,295
Total liabilities $7,751
Net assets (equity) $2,118
Total liabilities and net assets $9,869

a. Perform a Du Pont analysis on BestCare. Assume that the
industry average ratios are as follows:

Total margin 3.8%
Total asset turnover 2.1
Equity multiplier 3.2
Return on equity (ROE) 25.5%

b. Calculate and interpret the following ratios for BestCare:

Industry Average
Return on assets (ROA) 8.0%
Current ratio 1.3
Days cash on hand 41 days
Average collection period 7 days
Debt ratio 69%
Debt-to-equity ratio 2.2
Times interest earned (TIE) ratio 2.8
Fixed asset turnover ratio 5.2

17.5 Consider the following financial statements for Green Valley
Nursing Home, Inc., a for-profit, long-term care facility:

(continued from previous page)

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 673

Green Valley Nursing Home, Inc., Statement
of Income and Retained Earnings, Year Ended

December 31, 2015
Revenue:
Net patient service revenue $3,163,258
Other revenue 106,146
Total revenues $3,269,404
Expenses:
Salaries and benefits $1,515,438
Medical supplies and drugs 966,781
Insurance 296,357
Provision for bad debts 110,000
Depreciation 85,000
Interest 206,780
Total expenses $3,180,356
Operating income $ 89,048
Provision for income taxes 31,167
Net income $ 57,881

Retained earnings, beginning of year $ 199,961
Retained earnings, end of year $ 257,842

Green Valley Nursing Home, Inc.,
Balance Sheet, December 31, 2015

Assets
Current Assets:
Cash $ 105,737
Marketable securities 200,000
Net patient accounts receivable 215,600
Supplies 87,655
Total current assets $ 608,992
Property and equipment $2,250,000
Less accumulated depreciation 356,000
Net property and equipment $1,894,000
Total assets $2,502,992

(continued)

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H e a l t h c a r e F i n a n c e674

Liabilities and Shareholders’
Equity

Current Liabilities:
Accounts payable $ 72,250
Accrued expenses 192,900
Notes payable 100,000
Current portion of long-term debt 80,000
Total current liabilities $ 445,150
Long-term debt $1,700,000
Shareholders’ Equity:
Common stock, $10 par value $ 100,000
Retained earnings 257,842
Total shareholders’ equity $ 357,842
Total liabilities and shareholders’

equity $2,502,992

a. Perform a Du Pont analysis on Green Valley. Assume that the
industry average ratios are as follows:

Total margin 3.5%
Total asset turnover 1.5
Equity multiplier 2.5
Return on equity (ROE) 13.1%

b. Calculate and interpret the following ratios:

Industry Average
Return on assets (ROA) 5.2%
Current ratio 2.0
Days cash on hand 22 days
Average collection period 19 days
Debt ratio 71%
Debt-to-equity ratio 2.5
Times interest earned (TIE) ratio 2.6
Fixed asset turnover ratio 1.4

c. Assume that there are 10,000 shares of Green Valley’s stock
outstanding and that some recently sold for $45 per share.

(continued from previous page)

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 675

• What is the firm’s price/earnings ratio?
• What is its market/book ratio?

(Hint: These ratios are discussed in the supplement to this
chapter.)

17.6 Examine the industry average ratios given in problems 17.4 and
17.5. Explain why the ratios are different between the managed
care and nursing home industries.

17.7 Recent financial statements for The Heart Hospital are provided
below:

The Heart Hospital, Balance Sheet,
September 30, 2015 (in thousands)

Current assets:
Cash $14,202
Accounts receivable, net 5,918
Medical supplies inventory 1,211
Prepaid expenses and other current

assets 1,429
Total current assets $22,760
Property, plant, and equipment, net $33,769
Other assets 901
Total assets $57,430
Current liabilities:
Accounts payable $ 1,910
Accrued compensation and benefits 2,543
Other accrued liabilities 1,843
Current portion of long-term debt 2,064
Total current liabilities $ 8,360
Long-term debt 21,640
Total liabilities $30,000
Owners’ equity $27,430
Total liabilities and owners’ equity $57,430

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H e a l t h c a r e F i n a n c e676

The Heart Hospital, Statement of Operations,
Year Ended September 30, 2015 (in thousands)

Patient service revenue net of
discounts and allowances $66,962

Provision for bad debt ( 2,457)
Net patient service revenue $64,505

Operating expenses:
Personnel expense $21,707
Medical supplies expense 15,047
Other operating expenses 9,721
Depreciation expense 2,625
Total operating expenses $49,100
Income from operations $15,405
Other income (expenses):
Interest expense ($ 1,322)
Interest and other income, net 159
Total other income (expenses), net ($ 1,163)
Net income $14,242

a. Perform a Du Pont analysis on The Heart Hospital. Assume that
the industry average ratios are as follows:

Total margin 15.0%
Total asset turnover 1.5
Equity multiplier 1.67
Return on equity (ROE) 37.6%

b. Calculate and interpret the following ratios for The Heart
Hospital:

Industry Average
Return on assets (ROA) 22.5%
Current ratio 2.0
Days cash on hand 85 days
Average collection period 20 days
Debt ratio 40%
Debt-to-equity ratio 0.67
Times interest earned (TIE) ratio 5.0
Fixed asset turnover ratio 1.4

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C h a p t e r 1 7 : F i n a n c i a l C o n d i t i o n A n a l y s i s 677

17.8 Refer to the financial statements for The Heart Hospital in Problem
17.7. Prepare a common size balance sheet (where each account is
expressed as a percentage of total assets) and a common size income
statement (where each account is expressed as a percentage of total
revenues). What do the common size balance sheet and income
statement reveal about The Heart Hospital?

(Hint: Common size analysis is illustrated in the supplement to
this chapter.)

Resources

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Sixth Edition
Account: s8879308

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ay
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re
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uc
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i
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an
y
fo
rm
w
it
ho
ut
p
er
mi
ss
io
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fr
om
t
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p
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er
,
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pt
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Sixth Edition
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CHAPTER

HEALTHCARE FINANCE BASICS

Introduction

In today’s healthcare environment, where financial realities play an important
role in health services decision making, it is vital that managers at all levels
understand the basic concepts of healthcare finance and how these concepts are
used to enhance the financial well-being of the organization. In this chapter,
we introduce readers to the book, including its purpose, goals, and organi-
zation. Furthermore, we present some basic background information about
healthcare finance and the health services system. We sincerely hope that this
book will be a significant help to you in your quest to increase your profes-
sional competency in the important area of healthcare finance.

Before You Begin

Before you begin the study of healthcare finance, here are a few tips about
the book that will make the process easier.

1
Learning Objectives
After studying this chapter, readers will be able to

• Describe the organization of this book and the learning aids
contained in each chapter.

• Define the term healthcare finance as it is used in this book.
• Describe the key characteristics of a business.
• Discuss the structure of the finance department, the role of finance

in health services organizations, and how this role has changed
over time.

• Describe the major players in the health services industry.
• List the key operational issues currently faced by healthcare

managers.
• Describe the alternative forms of business organization and

corporate ownership and their organizational goals.
• Discuss the key elements of healthcare reform and its expected

effect on the provision of health services.

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H e a l t h c a r e F i n a n c e4

Purpose of the Book
Many books cover the general topics of accounting and financial management,
so why is a book needed that focuses on healthcare finance? The reason is that
while all industries have certain individual characteristics, the health services
industry is truly unique. For example, the provision of healthcare services is
dominated by not-for-profit corporations, 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 indi-
viduals who use the services but by third-party payers (e.g., employers, com-
mercial insurance companies, government programs). Throughout this book,
the ways in which the unique features of the health services industry influence
the application of finance principles and practices are emphasized.

This book is designed to introduce students to healthcare finance, which
has two important implications. First, the book assumes no prior knowledge
of the subject matter; thus, the book is totally self-contained, with each topic
explained from the beginning in basic terms. Furthermore, because clarity is
so important when concepts are introduced, the chapters have been written
in an easy-to-read fashion. None of the topics is inherently difficult, 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 finance. The good news here is that the book presents virtually
all the important healthcare finance 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 from includ-
ing a wide variety of illustrations. Thus, students who use this book are not
expected to fully understand every nuance of every finance principle and practice
that pertains to every type of health services organization. Nevertheless, this
book provides sufficient knowledge of healthcare finance so that readers will
be better able to function as managers, judge the quality of financial analyses
performed by others, and incorporate sound principles and practices into their
own personal finance decisions.

Naturally, an introductory finance book does not contain everything
that a healthcare financial manager must know to competently perform his
or her job. Nevertheless, the book is useful even for those working in finance
positions within health services organizations because it presents an overview of
the finance function. Often, when one is working in a specific area of finance,
it is too easy to lose sight of the context of one’s work. This book will help
provide that context.

Organization of the Book
In Alice’s Adventures in Wonderland, Lewis Carroll wrote: “If you don’t know
where you are going, any road will get you there.” Because not just any road

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 5

will ensure that this book meets its goals, the destination has been carefully
charted: to provide an introduction to healthcare finance. Furthermore, the
book is organized to pave the road to this destination.

Part I, The Healthcare Environment, contains fundamental background
material essential to the practice of healthcare finance. In essence, Part I intro-
duces the book, provides insights into the uniqueness of the health services
industry, and provides additional information on how healthcare providers
obtain their revenues. Healthcare finance cannot be studied in a vacuum
because the practice of finance is profoundly influenced by the economic and
social environment of the industry, including alternative types of ownership
and reimbursement methods.

Part II, Financial Accounting, begins the actual discussion of healthcare
finance principles and practices. Financial accounting, which involves the cre-
ation of statements that summarize a business’s financial status, is most useful
for outsiders and for long-term planning and management. In this part, we
discuss the format and interpretation of the four primary financial statements.

Part III, Managerial Accounting, which consists of four chapters, focuses
on the creation of data used in the day-to-day management and control of
a business. Here, the emphasis begins with the overall organization, then it
shifts to the subunit (department) level, and finally it reaches the individual
service level. The key topics in Part III include costing methods and behavior,
profit planning, cost allocation, pricing and service decisions, and financial
planning and budgeting.

In Part IV, Basic Financial Management Concepts, the focus moves from
accounting to financial management. Here we first cover time value analysis,
which provides techniques for valuing future cash flows. The second of the
two chapters in this part discusses financial risk and required return. Taken
together, these chapters provide readers with knowledge of two of the most
important concepts used in financial decision making.

Part V, Long-Term Financing, turns to the capital acquisition process.
Businesses need capital, or funds, to purchase assets, and this part examines
the two primary types of financing—long-term debt and equity. In addition,
the final chapter of Part V provides the framework for analyzing a business’s
appropriate financing mix and assessing its cost.

Part VI, Capital Investment Decisions, considers the vital topic of how
businesses analyze new capital investment opportunities (capital budgeting).
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. The two
chapters in this part first focus on basic capital investment analysis concepts
and then turn to project risk assessment and incorporation.

Part VII, Other Topics, covers two diverse topics. The first chapter
in this part discusses the revenue cycle and the management of short-term

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H e a l t h c a r e F i n a n c e6

assets, such as cash and inventories, as well as how such assets are financed.
The techniques used to analyze a business’s financial and operating condition
are discussed in the book’s final chapter. Health services managers must be
able to assess the current financial condition of their organizations. Even more
important, managers must be able to monitor and control current operations
and assess ways in which alternative courses of action will affect the organiza-
tion’s future financial condition.

In addition to the printed text, two chapters are available from the
publisher’s website for this book. Chapter 18, Lease Financing and Business
Valuation, contains information on leasing and how to value entire businesses,
and Chapter 19, Distributions to Owners: Bonuses, Dividends, and Repur-
chases, discusses how profits in investor-owned businesses are returned to
owners. To access these chapters, visit ache.org/books/HCFinance6.

How to Use This Book
As mentioned earlier, the book is designed to introduce students to healthcare
finance. The book contains several features designed to make the process as
easy as possible.

First, pay particular attention to the Learning Objectives listed at the
beginning of each chapter. These objectives provide a feel for the most impor-
tant topics in each chapter and what readers should set as learning goals for
the chapter.

Following each major section in a chapter (except the chapter’s Intro-
duction), one or more Self-Test Questions are included. As you finish 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 satisfied 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 about whether your answers are satisfactory.

It is useful for readers to have important equations both embedded in
the text to illustrate their use and broken out separately to permit easy identi-
fication and review. The Key Equation boxes can be used both for section and
chapter review and as an aid to working end-of-chapter problems. In addi-
tion, the book contains several types of boxes, such as For Your Consideration
and Industry Practice boxes. Each of these boxes presents an important issue
relevant to the text discussion and allows readers to pause for a few moments
to think about the issue presented, generate opinions, and draw conclusions.
Many instructors use these boxes to stimulate in-class discussions.

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 indicates terms
that are defined in each chapter’s running glossary, which complements the
glossary at the back of the book, and is also occasionally used for emphasis.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 7

In addition to in-chapter learning aids, materials designed to help read-
ers learn healthcare finance are included at the end of each chapter. First, each
chapter ends with a summary section titled Key Concepts, which briefly sum-
marizes the most important principles and practices covered in that chapter. If
the meaning of a key concept is not apparent, you may find it useful to review
the applicable section. Each chapter also contains a series of Questions designed
to assess your understanding of the qualitative material in the chapter. In most
chapters, the questions are followed by a set of Problems designed to assess
your understanding of the quantitative material. Additionally, each chapter
ends with a set of Resources. The books and articles cited can provide a more
in-depth understanding of the material covered in the chapter. Finally, some
chapters contain a Chapter Supplement, whose purpose is to present additional
information pertaining to topics in the chapter that is useful but not essential.

Taken together, the pedagogic structure of the book is designed to
make learning healthcare finance as easy and enjoyable as possible.

Defining Healthcare Finance

What is healthcare finance? Surprisingly, there is no single answer to that
question because the definition of the term depends, for the most part, on
the context in which it is used. Thus, in writing this book, the first step was
to establish the definition of healthcare finance.

We began by examining the healthcare sector of the economy, which con-
sists of a diverse collection of subsectors that involve, either directly or indirectly,
the healthcare of the population. The major subsectors include the following:

• Health services. The health services subsector consists of providers
of health services, including medical practice, hospital, nursing home,
home health care, and hospice industries.

• Health insurance. The health insurance subsector, which makes most
of the payments to health services providers, includes government
programs and commercial insurers as well as self-insurers. Also
included here are managed care companies, such as health maintenance
organizations, which incorporate both insurance and health services
(provider) functions.

1. Why is it necessary to have a book dedicated to healthcare
finance?

2. What is the purpose of this book?
3. Briefly describe the organization of this book.
4. What features in the book are designed to make learning easier?

SELF-TEST
QUESTIONS

Provider
An organization
that provides
healthcare
services (treats
patients).

00_GapenskiReiter (2299).indb 7 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e8

• Medical equipment and supplies. These subsectors include the makers
of diagnostic equipment, such as X-ray machines; durable medical
equipment, such as wheelchairs; and expendable medical supplies, such
as disposable surgical instruments and hypodermic syringes.

• Pharmaceuticals and biotechnology. These subsectors develop and
market drugs and other therapeutic products.

• Other. This category includes a diverse collection of organizations
ranging from consulting firms to educational institutions to
government and private agencies.

Most users of this book will become (or already are) managers at health
services organizations or at companies such as insurance and consulting firms
that deal directly with health services organizations. Thus, to give this book
the most value to its primary users, we focus on finance as it applies within
the health services subsector. Of course, the principles and practices of finance
cannot be applied in a vacuum but must be based on the realities of the current
healthcare environment, including how health services are financed. Further-
more, insurance involves payment to healthcare providers; much of managed
care involves utilization management of providers, either directly or through
contracts; and most consulting work is done for providers, so the material in
this book is also relevant for managers in industries related to health services.

Now that we have defined the healthcare focus of this book, the term
finance must be defined. Finance, as the term is used within health services
organizations and as it is used in this book, consists of both the accounting
and financial management functions. (In many settings, accounting and finan-
cial management are separate disciplines.) Accounting, as its name implies,
is concerned with the recording, in financial terms, of economic events that
reflect the operations, resources, and financing of an organization. In general,
the purpose of accounting is to create and provide to interested parties, both
internal and external, useful information about an organization’s operations
and financial status.

Whereas accounting provides a rational means by which to measure a
business’s financial performance and assess operations, financial management
provides the theory, concepts, and tools necessary to help managers make
better financial decisions. Of course, the boundary between accounting and
financial management is blurred; certain aspects of accounting involve decision
making, and much of the application of financial management theory and
concepts requires accounting data.

Accounting
The field of finance
that involves
the measuring
and recording of
events, in dollar
terms, that reflect
an organization’s
operational and
financial status.

Financial
management
The field of finance
that provides the
theory, concepts,
and tools used
by healthcare
managers to make
financial decisions.

1. What is meant by the term healthcare finance?
2. What is the difference between accounting and financial management?

SELF-TEST
QUESTIONS

00_GapenskiReiter (2299).indb 8 11/11/15 11:00 AM

C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 9

Concept of a Business

This book focuses on finance as practiced within health services businesses, so
it is reasonable to ask this question: What is a business? If this question were
asked to a group of accountants, the answer probably would involve financial
statements, such as the income statement and balance sheet, which we cover in
chapters 3 and 4. However, if the question were posed to a group of lawyers,
the answer likely would include legal forms of business, which we describe
later in this chapter.

From a financial (economic) perspective, a business can be thought of
as an entity (its legal form does not matter) that (1) obtains financing (capital)
from the marketplace; (2) uses those funds to buy land, buildings, and equip-
ment; (3) operates those assets to create goods or services; and then (4) sells
those goods or services to create revenue. To be financially viable, a business
has to have sufficient revenue to pay all of the costs associated with creating
and selling its goods or services.

Although this description of a busi-
ness is surprisingly simple, it tells a great
deal about the basic decisions that business
managers must make. One of the first deci-
sions is to choose the best legal form for the
business. Then, the manager must decide
how the business will raise the capital that it
needs to get started. Should it borrow the
money (use debt financing), raise the money
from owners (or from the community if not-
for-profit), or use some combination of the
two sources? Next, once the start-up capital
is raised, what physical assets (facilities and
equipment) should be acquired to create
the services that (in the case of healthcare
providers) will be offered to patients?

Note that businesses are profoundly
different from pure charities. A business,
such as a hospital or medical practice, sus-
tains itself financially by selling goods or
services. Thus, it is in competition with
other businesses for the consumer dollar.
A pure charity, such as the American Heart
Association, on the other hand, does not sell
goods or services. Rather, it obtains funds
by soliciting contributions and then uses

For Your Consideration
Businesses, Pure Charities, and
Governmental Entities

A healthcare business relies on revenues from
sales to create financial sustainability. For exam-
ple, if a hospital’s revenues exceed its costs, cash
is being generated that can be used to provide
new and improved patient services and the hos-
pital can continue to meet community needs. On
the other hand, pure charities, such as the Ameri-
can Red Cross, rely on contributions for revenues,
so the amount of charitable services provided
(which typically are free) is limited by the amount
of contributions received. Finally, most govern-
mental units are funded by tax receipts, so, as
with charities, the amount of services provided is
limited, but in this case by the taxing authority’s
ability to raise revenues. Yet, in spite of differ-
ences, all three types of organizations must oper-
ate in a financially prudent manner.

What do you think? From a finance perspec-
tive, how different are these types of organiza-
tions? How does the day-to-day functioning of
their respective finance departments vary? Is
finance more important in one type of organiza-
tion than in another?

00_GapenskiReiter (2299).indb 9 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e10

those funds to supply charitable (free) services. In essence, a pure charity is a
budgetary organization in that the amount of contributions fixes its budget
for the year.

Also, businesses are different from governmental agencies such as local
public health departments. In general, governmental agencies do not receive
revenues by selling services or by soliciting contributions. Rather, the reve-
nues are derived from taxing the populations that benefit from the govern-
mental services, so providing additional services typically uses resources with-
out generating additional income. Thus, like a pure charity, a governmental
agency has a budget that is fixed, but by appropriations rather than by
contributions.

The Role of Finance in Health Services Organizations

The primary role of finance in health services organizations, as in all busi-
nesses, is to plan for, acquire, and use resources to maximize the efficiency and
value of the enterprise. As we discuss in the next section, the two broad areas
of finance—accounting and financial management—are separate functions in
larger organizations, although the accounting function usually is carried out
under the direction of the organization’s chief financial officer and hence falls
under the overall category of finance.

In general, finance activities include the following:

• Planning and budgeting. First and foremost, healthcare finance
involves evaluating the financial 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 financial status. This is typically accomplished by a set of
financial statements.

• Capital investment decisions. Although capital investment is more
important to senior management, managers at all levels must be
concerned with the capital investment decision-making process.
Decisions that result from this process, which are called capital
budgeting decisions, focus on the acquisition of land, buildings,
and equipment. They are the primary means by which businesses

1. From a financial perspective, briefly describe a business.
2. What is the difference between a business and a pure charity?

Between a business and a governmental agency?

SELF-TEST
QUESTIONS

Budget
A detailed plan,
in dollar terms, of
how a business
and its subunits
will acquire and
utilize resources
during a specified
period of time.

Financial
statements
Statements
prepared by
accountants
that convey the
financial status of
an organization.
The four primary
statements are the
income statement,
balance sheet,
statement of
changes in equity,
and statement of
cash flows.

Capital budgeting
The process of
analyzing and
choosing new
long-term assets
such as land,
buildings, and
equipment.

00_GapenskiReiter (2299).indb 10 11/11/15 11:00 AM

C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 11

implement strategic plans, and hence they play a key role in an
organization’s financial 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 financing. Although senior managers
typically make financing decisions, these decisions have ramifications
for managers at all levels.

• Revenue cycle and current accounts management. Revenue cycle
management includes the billing and collections function, while
current accounts management involves the organization’s short-term
assets, such as cash and inventories, and short-term liabilities, such
as accounts payable and debt. Such functions and accounts must be
properly managed both to ensure operational effectiveness and to
reduce costs. Generally, managers at all levels are involved to some
extent in revenue cycle and current accounts management.

• 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 financial 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 financial transactions that take
place to support the operations of a business can themselves increase
the business’s risk. Thus, an important finance activity is to control
financial risk.

These specific finance activities often are summarized by the four Cs:
costs, cash, capital, and control. The measurement and minimization of costs
is vital to the financial success of any business. Rampant costs, as compared
to revenues, usually spell doom for any business. A business can be profitable
but still face a crisis due to a shortage of cash. Cash is the “lubricant” that
makes the wheels of a business run smoothly—without it, the business grinds
to a halt. Capital represents the funds used to acquire land, buildings, and
equipment. Without capital, businesses would not have the physical resources
needed to provide goods and services. Finally, a business must have adequate
control mechanisms to ensure that its capital is being wisely employed and its
physical resources are protected for future use.

In times of high profitability and abundant financial resources, the
finance function tends to decline in importance. Thus, at the time when most
healthcare providers were reimbursed on the basis of costs incurred, the role of

Capital
The funds raised
by a business that
will be invested
in assets, such as
land, buildings,
and equipment,
that support the
organizational
mission.

Four Cs
A mnemonic for
the basic finance
activities: costs,
cash, capital, and
control.

Cost
A resource use
associated with
providing or
supporting a
specific service.

those funds to supply charitable (free) services. In essence, a pure charity is a
budgetary organization in that the amount of contributions fixes its budget
for the year.
Also, businesses are different from governmental agencies such as local
public health departments. In general, governmental agencies do not receive
revenues by selling services or by soliciting contributions. Rather, the reve-
nues are derived from taxing the populations that benefit from the govern-
mental services, so providing additional services typically uses resources with-
out generating additional income. Thus, like a pure charity, a governmental
agency has a budget that is fixed, but by appropriations rather than by
contributions.
The Role of Finance in Health Services Organizations
The primary role of finance in health services organizations, as in all busi-
nesses, is to plan for, acquire, and use resources to maximize the efficiency and
value of the enterprise. As we discuss in the next section, the two broad areas
of finance—accounting and financial management—are separate functions in
larger organizations, although the accounting function usually is carried out
under the direction of the organization’s chief financial officer and hence falls
under the overall category of finance.
In general, finance activities include the following:
• Planning and budgeting. First and foremost, healthcare finance
involves evaluating the financial 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 financial status. This is typically accomplished by a set of
financial statements.
• Capital investment decisions. Although capital investment is more
important to senior management, managers at all levels must be
concerned with the capital investment decision-making process.
Decisions that result from this process, which are called capital
budgeting decisions, focus on the acquisition of land, buildings,
and equipment. They are the primary means by which businesses
1. From a financial perspective, briefly describe a business.
2. What is the difference between a business and a pure charity?
Between a business and a governmental agency?
SELF-TEST
QUESTIONS
Budget
A detailed plan,
in dollar terms, of
how a business
and its subunits
will acquire and
utilize resources
during a specified
period of time.
Financial
statements
Statements
prepared by
accountants
that convey the
financial status of
an organization.
The four primary
statements are the
income statement,
balance sheet,
statement of
changes in equity,
and statement of
cash flows.
Capital budgeting
The process of
analyzing and
choosing new
long-term assets
such as land,
buildings, and
equipment.

00_GapenskiReiter (2299).indb 11 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e12

finance was minimal. The most critical finance function was cost identification
because it was more important to account for costs than it was to control them.
In response to payer (primarily Medicare) requirements, providers (primarily
hospitals) churned out a multitude of reports both to comply with regulations
and to maximize revenues. The complexities of cost reimbursement 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 activi-
ties, most finance work focused on bureaucratic functions.

In recent years, however, providers have been redesigning their finance
functions in recognition of the changes that have occurred in the health ser-
vices industry. Although billing and collections remain important, to be of
maximum value to the enterprise today the finance function must support
cost containment efforts, third-party payer contract negotiations, joint venture
decisions, and integrated delivery system participation. In essence, finance
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 finance function, but there are no
unimportant functions in healthcare organizations. Senior executives must
understand a multitude of other functions, such as operations, marketing,
facilities management, and human resource management, in addition to finance.
Still, all business decisions have financial implications, so all managers—whether
in operations, marketing, personnel, or facilities—must know enough about
finance to properly incorporate any financial implications into decisions made
within their own specialized areas.

The Structure of the Finance Department

The size and structure of the finance department within health services organiza-
tions depend on the type of provider and its size. Still, the finance department
within larger provider organizations generally follows the model described here.

The head of the finance department holds the title chief financial officer
(CFO) or sometimes vice president–finance. This individual typically reports
directly to the organization’s chief executive officer (CEO) and is respon-
sible for all finance activities within the organization. The CFO directs two
senior managers who help manage finance activities. First is the comptroller
(pronounced, and sometimes spelled, “controller”), who is responsible for

1. What is the role of finance in today’s health services
organizations?

2. How has this role changed over time?
3. What are the four Cs?

SELF-TEST
QUESTIONS

00_GapenskiReiter (2299).indb 12 11/11/15 11:00 AM

C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 13

accounting and reporting activities such as routine budgeting, preparation of
financial statements, payables management, and patient accounts management.
For the most part, the comptroller is involved in those activities covered in
chapters 3 through 8 of this text.

Second is the treasurer, who is responsible for the acquisition and man-
agement of capital (funds). Treasurer activities include the acquisition and
employment of capital, cash and debt management, lease financing, financial
risk management, and endowment fund management (within not-for-profits).
In general, the treasurer is involved in those activities discussed in chapters
11 through 17 of this text.

Of course, in larger organizations, the comptroller and treasurer have
managers with responsibility for specific functions, such as the patient accounts
manager, who reports to the comptroller, and the cash manager, who reports
to the treasurer.

In very small businesses, many of the finance responsibilities are com-
bined and assigned to just a few individuals. In the smallest health services
organizations, the entire finance function is managed by one person, often
called the business (practice) manager.

Health Services

Settings

Health services are provided in numerous settings, including hospitals, ambu-
latory care facilities, long-term care facilities, and even at home. Before 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 controlled a single type of healthcare
facility, such as hospitals or nursing homes. Over time, however, many health
services organizations have diversified and become vertically integrated through
either direct ownership or contractual arrangements.

Most readers of this text are familiar with health services settings either
through previous courses or by working in the field. For those readers who
have not had exposure to health services settings, the Chapter 1 Supplement
provides additional information.

1. Briefly describe the typical structure of the finance department
within a health services organization.

SELF-TEST
QUESTION

1. Name a few settings in which health services are provided.
SELF-TEST
QUESTION

00_GapenskiReiter (2299).indb 13 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e14

Current Managerial Challenges

In recent years, the American College of Healthcare Executives (ACHE) has
surveyed CEOs regarding the most critical concerns of healthcare manag-
ers. Financial concerns have headed the list of challenges on every survey
conducted since the survey began in 2002. When asked to rank their specific
financial concerns, CEOs put reimbursement at the forefront, with Medicaid,
Medicare, and bad debt losses as their top payer concerns. (Reimbursement
is discussed in Chapter 2.)

In a survey of healthcare CFOs conducted by the Healthcare Finan-
cial Management Association, they reported that their most pressing issue
was balancing clinical and financial issues—in essence, determining how to
improve financial performance without having a negative impact on clinical
performance. Other issues of concern included improving the revenue cycle
(billing and collecting on a timely basis) and developing different ways to
access (raise) capital.

Taken together, the results of these surveys confirm the fact that finance
is of primary importance to today’s healthcare managers. The remainder of
this book is dedicated to helping you confront and solve these issues.

Alternative Legal Forms of Businesses

Throughout this book, the focus is on business finance—that is, the practice
of accounting and financial management within business organizations. There
are three primary legal forms of business organization: proprietorship, partner-
ship, and corporation. In addition, there are several hybrid forms. Because
most health services managers work for corporations and because not-for-
profit businesses are organized as corporations, this form of organization is
emphasized. However, some medical practices are organized as proprietor-
ships, and partnerships and hybrid forms are common in group practices and
joint ventures, so health services managers must be familiar with all forms of
business organization.

Proprietorships
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

1. What are some important issues facing healthcare managers
today?

SELF-TEST
QUESTION

Proprietorship
A simple form of
business owned by
a single individual.
Also called sole
proprietorship.

00_GapenskiReiter (2299).indb 14 11/11/15 11:00 AM

C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 15

smallest businesses to be licensed, and state licensure is required for most
healthcare professionals.

Partnerships
A partnership is formed when two or more persons associate to conduct a
business that is not incorporated. Partnerships may operate under different
degrees of formality, ranging from informal oral understandings to formal
agreements filed with the state in which the partnership does business. Both
the proprietorship and partnership forms of organization are easily and inex-
pensively formed, are subject to few governmental regulations, and pay no
corporate income taxes. All earnings of the business, whether reinvested in
the business or withdrawn by the owner(s), are taxed as personal income to
the proprietor or partner.

Proprietorships and partnerships have several disadvantages, including
the following:

• Selling their interest in the business is difficult 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 obligation in the event of bankruptcy, the remaining partners are
responsible for the unsatisfied claims and must draw on their personal
assets if necessary.

• The life of the business is limited to the life of the owners.
• It is difficult for proprietorships and partnerships to raise large

amounts of capital. This is no particular problem for a very small
business or when the owners are very wealthy, but the difficulty of
attracting capital becomes a real handicap if the business needs to grow
substantially to take advantage of market opportunities.

Corporations
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
advantages:

• 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 sold.

• Owners of a corporation have limited liability.

Partnership
A nonincorporated
business entity
that is created
by two or more
individuals.

Corporation
A legal business
entity that is
separate and
distinct from
its owners (or
community) and
managers.

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H e a l t h c a r e F i n a n c e16

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 partners
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 invested in
a corporation that went bankrupt, the potential loss for the investor would
be limited to the $10,000 initial investment. (However, in the case of small,
financially weak corporations, the limited liability feature of ownership is often
fictitious 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 financial markets than can sole proprietorships or partnerships.

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. Second, setting up a
corporation, and then filing the required periodic state and federal reports,
is more costly and time consuming than what is required to establish a pro-
prietorship or partnership.

Setting up a corporation requires that the founders, 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. In addition, several companies offer online
services that help with the incorporation process. Still, setting up a corporation
remains relatively difficult when compared to a proprietorship or partnership,
and it is even more difficult if the corporation has nonstandard features, such
as multiple classes of stock.

Hybrid Forms of Organization
Although the three basic forms of organization—proprietorship, partnership,
and corporation—historically have dominated the overall business scene, sev-
eral hybrid forms of organization have become quite popular in recent years.

In general, the hybrid forms are designed to limit owners’ liability with-
out having to fully incorporate. For example, in a limited liability partner-
ship (LLP), the partners have joint liability for all actions of the partnership,
including personal 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 part-
ners. In spite of limited malpractice liability, the partners are jointly liable for
the partnership’s debts. Other hybrid forms of organization include limited
liability companies (LLCs), professional corporations (PCs), and professional
associations (PAs).

Limited liability
partnership (LLP)
A partnership form
of organization
that limits the
professional
(malpractice)
liability of its
partners.

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Alternative Corporate Ownership

In the previous section, we discussed alternative legal forms of businesses.
Now, we turn our attention to the two alternative ownership forms of cor-
porations: for-profit and not-for-profit. Unlike other sectors in the economy,
not-for-profit corporations play a major role in the healthcare sector, especially
among providers. For example, about 60 percent of the hospitals in the United
States are private, not-for-profit hospitals. Only 15 percent of all hospitals are
investor owned; the remaining 25 percent are governmental. Furthermore,
not-for-profit ownership is common in the nursing home, home health care,
hospice, and health insurance industries.

Investor-Owned Corporations
When the average person thinks of a corporation, he or she probably thinks
of an investor-owned, or for-profit, corporation. For example, Ford, IBM,
and Microsoft are investor-owned corporations. In health services, corporations
such as HCA and Community Health Systems are examples of large for-profit
hospital systems; Kindred Healthcare and Emeritus Senior Living are examples
of long-term care providers; Select Medical and HealthSouth offer rehabilitation
services; and MEDNAX offers pediatric services. Individuals become owners
of for-profit corporations by buying shares of common stock in the company.

The stockholders (also called shareholders) are the owners of investor-
owned corporations. As owners, they have two 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 firm. 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—belongs to the shareholders
of the business. Often, a portion of these earnings is paid out in the

Investor-owned
(for-profit)
corporation
A corporation
that is owned by
shareholders who
furnish capital and
expect to earn a
return on their
investment.

1. What are the three primary forms of business organization, and
how do they differ?

2. What is the purpose of hybrid forms?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e18

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. (See
Chapter 19, which is available online at ache.org/books/HCFinance6,
for more information about how corporate earnings are distributed to
shareholders.)

When compared to not-for-profit corporations (discussed below), three
key features make investor-owned corporations different. First, the owners
(stockholders) of the corporation are well defined and exercise control of the
business 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 profitability of the firm. Finally, investor-owned corporations are subject
to various forms of taxation at the local, state, and federal levels.

Not-for-Profit Corporations
If an organization meets a set of stringent requirements, it can qualify for
incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt
corporations are sometimes called nonprofit corporations. Because nonprofit
businesses (as opposed to pure charities such as the American Red Cross) need
profits to sustain operations, and because it is hard to explain why nonprofit
corporations should earn profits, the term not-for-profit is more descriptive of
such health services corporations. Examples of not-for-profit health services
corporations include the Kaiser Foundation, Catholic Health Initiatives, and
the Mayo Clinic Health System.

Tax-exempt status is granted to corporations that meet the tax definition
of a charitable organization as defined 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. The tax code defines a charitable organization
as “any corporation, community chest, fund, or foundation that is organized
and operated exclusively for religious, charitable, scientific, public safety, liter-
ary, or educational purposes.” Because the promotion of health is commonly
considered a charitable activity, a corporation that provides healthcare services
can qualify for tax-exempt status, provided that it meets other requirements.

In addition to the charitable purpose, a not-for-profit corporation must
be organized and run so that it operates exclusively for the public, rather than
private, interest. Thus, no profits 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 charitable purposes. Because individuals cannot benefit

Tax-exempt
(not-for-profit)
corporation
A corporation that
has a charitable
purpose, is tax
exempt, and has
no owners. Also
called nonprofit
corporation.

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from the profits of not-for-profit corporations, such organizations cannot pay
dividends. However, prohibition of private gain from profits does not prevent
parties, such as managers and physicians, from benefiting through salaries,
perquisites, contracts, and so on.

Not-for-profit corporations differ significantly from investor-owned
corporations. Because not-for-profit firms have no shareholders, no single
body of individuals has ownership rights to the firm’s residual earnings or
exercises control of the firm. Rather, control is exercised by a board of trustees
that is not constrained by outside oversight, as is the board of directors of a
for-profit corporation, which must answer to stockholders. Also, not-for-profit
corporations are generally exempt from taxation, including both property
and income taxes, and have the right to issue tax-exempt debt (municipal
bonds). Finally, individual contributions to not-for-profit organizations can
be deducted from taxable income by the donor, so not-for-profit firms have
access to tax-subsidized contribution capital.

For-profit corporations must file annual income tax returns with the
IRS. The equivalent filing for not-for-profit corporations is IRS Form 990,
titled “Return of Organization Exempt from Income Tax.” Its purpose is to
provide both the IRS and the public with financial information about not-
for-profit organizations, and it is often the only source of such information.
It is also used by government agencies to prevent organizations from abusing
their tax-exempt status. Form 990 requires significant disclosures related to
governance and boards of directors. In addition, hospitals are required to file
Schedule H to Form 990, which includes financial information on the amount
and type of community benefit (primarily charity care) provided, bad debt
losses, Medicare patients, and collection practices. IRS regulations require not-
for-profit organizations to provide copies of their three most recent Form 990s
to anyone who requests them, whether in person or by mail, fax, or e-mail.
Form 990s are also available to the public through several online services.

The financial problems facing most federal, state, and local governments
have caused politicians to take a closer look at the tax subsidies provided to
not-for-profit hospitals. For example, several bills have been introduced in
Congress that require hospitals to provide minimum levels of care to the
indigent to retain tax-exempt status. Such efforts by Congress prompted the
American Hospital Association (AHA) in 2007 to publish guidelines for char-
ity care that include (1) giving discounts to uninsured patients of “limited
means”; (2) establishing a common definition of “community benefit,” which
encompasses the full range of services provided to the population served; and
(3) improving “transparency,” or the ability of outsiders to understand a busi-
ness’s governance structure and policies, including executive compensation.

Likewise, officials in several states have proposed legislation that man-
dates the minimum amount of charity care to be provided by not-for-profit

Form 990
A form filed by
not-for-profit
organizations
with the Internal
Revenue Service
that reports
on governance
and charitable
activities.

Schedule H
An attachment
to Form 990 filed
by not-for-profit
hospitals that
gives additional
information
on charitable
activities.

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H e a l t h c a r e F i n a n c e20

hospitals and the types of billing and collec-
tions procedures applied to the uninsured.
For example, Texas has established mini-
mum requirements for charity care, which
hold not-for-profit hospitals accountable
to the public for the tax exemptions they
receive. The Texas law specifies four tests,
and each hospital must meet at least one of
them. The test that most hospitals use to
comply with the law requires that at least
4 percent of net patient service revenue be
spent on charity care. Also, Ohio legislators
have held hearings to discuss whether a law
should be passed requiring Ohio’s not-for-
profit hospitals to make “payments in lieu
of taxes,” or PILOTS.

Finally, money-starved municipalities
in several states have attacked the property
tax exemption of not-for-profit hospitals
that have “neglected” their charitable mis-
sions. For example, tax assessors are fighting
to remove property tax exemptions from
not-for-profit hospitals in several Pennsylva-
nia cities after an appellate court ruling sup-
ported the Erie 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-profit hospi-
tals 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 estimate explains why tax authorities
in many jurisdictions are pursuing not-for-
profit hospitals as a source of revenue.

The inherent differences between
investor-owned and not-for-profit organi-
zations have profound implications for many

elements of healthcare financial management, including organizational goals,
financing decisions (i.e., the choice between debt and equity financing and the
types of securities issued), and capital investment decisions. Ownership’s effect
on the application of healthcare financial management theory and concepts is
addressed throughout the text.

For Your Consideration
Making Not-for-Profit Hospitals Do Good

Many people have criticized not-for-profit hos-
pitals for not “earning” their charitable exemp-
tions. In one of the latest relevant court rulings,
in 2010 the Illinois Supreme Court concluded that
Provena Covenant hospital, located in Urbana,
Illinois, was not a charitable institution for prop-
erty tax purposes. The court’s opinion reasoned
that the primary use of the hospital property was
providing medical services for a fee, while char-
ity means providing a gift to the community. The
opinion further pointed out that (1) the charity
care being provided was subsidized by payments
from other patients; (2) many patients granted
partial charity care still paid enough to cover
costs; and (3) the hospital’s community benefit
activities, such as a residency program and an
education program for emergency responders,
also benefited the hospital and thus were not
truly gifts to the community. Thus, the hospital
property was not in charitable use.

Most not-for-profit hospitals today are, of
course, primarily supported by payments for
services rather than by charitable contributions.
Under the opinion’s reasoning, the property tax
exemption may well be hard to maintain. How-
ever, a partial dissent by two justices suggests
that this case is not the end of the story. The dis-
sent argues that the plurality opinion impinges
on the legislative function of setting specific stan-
dards for tax exemption, and the issue should be
settled by legislative action rather than by courts.

What do you think? Should not-for-profit
hospitals lose their property tax or income tax
exemptions? Should legislatures set standards
that hospitals must meet to maintain their tax-
exempt status? If so, how might such standards
be specified?

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 21

Organizational Goals

Healthcare finance is not practiced in a vacuum; it is practiced with some
objective in mind. Finance goals within an organization clearly must be con-
sistent with, as well as supportive of, the overall goals of the business. Thus,
by discussing organizational goals, a framework for financial decision making
within health services organizations can be established.

Small Businesses
In a small business, regardless of its legal form, the owners generally are also
its managers. In theory, the business can be operated for the exclusive benefit
of the owners. If the owners want to work very hard to get rich, they can.
On the other hand, if every Wednesday is devoted to golf, no outside owner
is hurt by such actions. (Of course, the business still has to satisfy its custom-
ers or it will not survive.) It is in large, publicly held corporations, in which
owners and managers are separate parties, that organizational goals become
important to the practice of finance.

Publicly Held Corporations
From a finance perspective, the primary goal of large investor-owned corpo-
rations is generally assumed to be shareholder wealth maximization, which
translates to stock price maximization. Investor-owned corporations do, of
course, have other goals. Managers, who make the actual decisions, are inter-
ested in their own personal welfare, in their employees’ welfare, and in the
good of the community and society at large. Still, the goal of stock price
maximization is a reasonable operating objective upon which to build financial
decision-making rules.

Not-for-Profit Corporations
Corporations consist of a number of classes of stakeholders, which include all
parties that have an interest, usually of a financial nature, in the organization.
For example, a not-for-profit hospital’s stakeholders include the board of
trustees; managers; employees; physician staff; 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,

1. What are the major differences between investor-owned and not-
for-profit corporations?

2. What pressures recently have been placed on not-for-profit
hospitals to ensure that they meet their charitable mission?

3. What are the purpose and content of IRS Form 990?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e22

who dictate the goal of shareholder wealth maximization. While managers
of investor-owned companies have to please primarily one class of stakehold-
ers—the shareholders—to keep their jobs, managers of not-for-profit firms
face a different situation. They have to try to please all of the organization’s
stakeholders because no single well-defined group exercises control.

Many people argue that managers of not-for-profit corporations do not
have to please anyone at all because they tend to dominate the boards of trustees
that are supposed to exercise oversight. Others argue that managers of not-for-
profit corporations have to please all of the business’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 corporations should not

attempt to enhance shareholder wealth by
treating other stakeholders unfairly, because
such actions ultimately will be detrimental
to shareholders.

Typically, the goal of not-for-profit
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-profit acute
care hospital:

Riverside Memorial Hospital, along with its

medical staff, is a recognized, innovative health-

care leader dedicated to meeting the needs of

the community. We strive to be the best com-

prehensive healthcare provider through our

commitment to excellence.

Although this mission statement pro-
vides Riverside’s managers and employees
with a framework for developing specific
goals and objectives, it does not provide
much insight into the goal of the hospital’s
finance function. For Riverside to accom-
plish its mission, its managers have identified
the following five financial goals:

1. The hospital must maintain its
financial viability.

2. The hospital must generate sufficient
profits to continue to provide the
current range of healthcare services

For Your Consideration
Does the Finance Function

Differ Among Providers?

Readers of this book understand the difference
between for-profit and not-for-profit providers.
Not-for-profit providers have a charitable mission,
while for-profits are in business to make money
for owners. Furthermore, all not-for-profit earn-
ings must be reinvested in the enterprise, while
some (or all) profits of for-profit health services
businesses may be returned to owners in the
form of dividends or stock repurchases. Although
many studies have tried to assess which type of
ownership is better for patients, no consensus
has been reached.

But what about the finance function? That
is, what about the day-to-day activities of opera-
tional managers and the finance staff? Are these
appreciably different at not-for-profit providers
than at for-profit providers? What about different
types of providers—say, medical group practices
versus hospitals? If those activities differ, might
you benefit from taking two healthcare finance
courses—one for investor-owned providers and
another for not-for-profit providers? Or should
separate healthcare finance courses be offered
for different types of providers, for example, one
for hospitals and another for nursing homes?

What do you think? Is the finance function at
not-for-profit providers appreciably different from
that at for-profit providers, or is there an appre-
ciable difference between types of providers? If
there are differences, what are they?

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to the community. This means that current buildings and equipment must
be replaced as they become obsolete.

3. The hospital must generate sufficient profits 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 operations.

5. The hospital will strive to provide services to the community as
inexpensively as possible, given the above financial requirements.

In effect, Riverside’s managers are saying that to achieve the hospital’s
commitment to excellence as stated in its mission, the hospital must remain
financially strong and profitable. Financially weak organizations cannot con-
tinue to accomplish their stated missions over the long run.

What is interesting is that Riverside’s five financial goals are probably
not much different from the financial goals of Jefferson Regional Medical
Center (JRMC), a for-profit 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 retain its financial viability and have the financial resources necessary
to offer new services and technologies. Furthermore, competition in the market
for hospital services does not permit JRMC to charge appreciably more for
services than its not-for-profit competitors.

Healthcare Reform and Finance

The Patient Protection and Affordable Care Act (ACA) of 2010 has been
called the most significant healthcare legislation since Medicare and Medicaid
in 1965. The law, which was enacted on March 23, 2010, was designed to
provide all US citizens and legal residents with access to affordable health
insurance, to reduce healthcare costs, and to improve care and quality. This
legislation puts in place comprehensive health insurance exchanges to expand
coverage, hold insurance companies accountable for product cost and quality,
lower costs across the system, guarantee more choices, and enhance the qual-
ity of care—all of which are intended to transform the US healthcare system
and make it more sustainable.

The ACA has numerous major aims. However, the central goal is to
expand healthcare coverage through shared responsibility between government,

1. What is the difference in goals between investor-owned and not-
for-profit businesses?

SELF-TEST
QUESTION

00_GapenskiReiter (2299).indb 23 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e24

individuals, and employers. This involves requiring all US citizens and legal
residents to have health insurance coverage, which may be obtained through
health insurance exchanges at an “affordable” cost if the individual does not
have health insurance available from other sources.

Some of the benefits of the ACA include free preventive care, the ban-
ning of preexisting-condition coverage limitations, prescription discounts for
seniors, extended coverage for young adults, lifetime coverage on most benefits,
prevention of coverage cancellation by insurers, transparency on increases in
insurance premium rates, and patient selection (rather than insurer assignment)
of primary care doctors from the provider network.

The major implications of the ACA for health insurance are addressed
in Chapter 2, while the major implications for the delivery of healthcare ser-
vices, and hence healthcare finance, are discussed in the following sections.

Accountable Care Organizations
One of the ways the ACA seeks to decrease healthcare costs and increase
quality is by encouraging providers to form accountable care organizations
(ACOs). An ACO is a network of physicians, other clinicians, and hospitals
and clinics that shares responsibility for providing coordinated care to patients.
Providers in an ACO not only are jointly accountable for the health of their
patients but also receive financial incentives to cooperate and reduce costs by
avoiding unnecessary tests and procedures, eliminating duplication of services,
and coordinating patient care.

An ACO can take one of many forms, such as the following:

• An integrated delivery system that has common ownership of hospitals
and physician practices and uses electronic health records, offers team-
based care, and makes available resources to support cost-effective care

• A multispecialty group practice that has strong affiliations with
hospitals and contracts with multiple health plans

• A physician–hospital organization that is a subset of a hospital’s medical
staff and that functions like a multispecialty group practice

• An independent practice association composed of individual physician
practices that come together to contract with health plans

• A virtual physician organization that sometimes includes physicians in
rural areas

ACOs are paid through the traditional fee-for-service system (see Chapter
2); however, they are offered bonuses as an incentive to reduce the cost of care.
Doctors and hospitals have to meet specific quality benchmarks that focus on
prevention and careful management of patients with chronic diseases. In other
words, providers get paid more for keeping patients healthy and out of the
hospital. If an ACO is unable to save money, it could be liable for the costs

Accountable care
organization (ACO)
A network of
healthcare
providers joined
together for
the purpose of
increasing patient
service quality and
reducing costs.

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C h a p t e r 1 : H e a l t h c a r e F i n a n c e B a s i c s 25

of the investments made to improve care; it also may have to pay a penalty if
it does not meet performance and cost-savings benchmarks.

Medical Homes
A medical home (or patient-centered medical home) is a team-based model of
care led by a personal physician who provides continuous and coordinated care
throughout a patient’s lifetime with the goal of maximizing health outcomes.
The medical home is responsible for providing all of a patient’s healthcare
needs or appropriately arranging care with other qualified professionals. This
includes the provision of preventive services, treatment of acute and chronic
illnesses, and assistance with end-of-life issues. It is a model of practice in which
a team of healthcare professionals, coordinated by a personal physician, works
collaboratively to ensure coordinated and integrated care, patient access and
communication, quality, and safety. The medical home model is independent
of the ACO concept, but it is anticipated that ACOs will provide an organi-
zational setting that facilitates implementation of the model.

Supporters of the model claim that it will allow better access to health-
care, increase patient satisfaction, and improve health. Although the develop-
ment and implementation of the medical home model is in its infancy, its key
characteristics at this time are the following:

• Personal physician. Each patient has an ongoing relationship with
a personal physician trained to provide first-contact, continuous, and
comprehensive care.

• Whole-person orientation. The personal physician is responsible
for providing all of a patient’s healthcare needs or for appropriately
arranging care with other qualified professionals. In effect, the personal
physician leads a team of clinicians who collectively take responsibility
for patient care.

• Coordination and integration. The personal physician coordinates
care across specialists, hospitals, home health agencies, nursing homes,
and hospices.

• Quality and safety. Quality and patient safety are ensured by a care-
planning process, evidence-based medicine, clinical decision–support
tools, performance measurement, active participation of patients
in decision making, use of information technology, and quality
improvement activities.

• Enhanced access. Medical care and information are available at all
times through open scheduling, expanded hours of service, and new
and innovative communications technologies.

• Payment-for-value methodologies. It is essential that payment
methodologies recognize the added value provided to patients.
Payments should reflect the value of work that falls outside of

Medical home
A team-based
model of care
led by a personal
physician
who provides
continuous and
coordinated care
throughout a
patient’s lifetime
with a goal of
maximizing health
outcomes.

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H e a l t h c a r e F i n a n c e26

face-to-face visits, should support adoption and use of health
information technology for quality improvement, and should recognize
differences in the patient populations treated within the practice.

Industry Consolidation
The ACA is driving the consolidation of healthcare organizations. It has accel-
erated health systems’ acquisition of hospitals and hospitals’ acquisition of
physician practices, and that trend is likely to continue for many years. With
the greater focus on clinical integration, quality of care, and changing reim-
bursement methodologies, healthcare organizations are seeking to restruc-
ture healthcare delivery to operate more efficiently and improve coordination
between patients and providers. Healthcare organizations are looking to gain a
competitive advantage from combining assets, staff, and resources. Consolida-
tion not only provides organizations access to capital, economies of scale, and
market share but also may lead to improvement in patient care by making it
easier to share patient information, adhere to clinical practice guidelines (thus
reducing variations in care), and access high-quality specialist physicians.

Population Health
The ACA is moving providers toward the population health management
approach to care provision. The goal of population health management is to
shift from focusing on treating illness to maintaining or improving health. The
idea is to prevent costly illnesses when possible and hence avoid unnecessary
care, which is encouraged by reimbursement models such as capitation, payment
bundling, and shared savings (discussed in Chapter 2). Instead of just provid-
ing preventive and chronic care when patients come in for acute problems,
ACOs track and monitor the health status of the entire patient population,
requiring greater use of health information technology. The keys to success
in population health management are greater awareness of the health status
of the population and proactive intervention to reduce the use of provider
resources and to achieve the best population outcomes.

Clinical Integration
A fundamental component to achieving the goals of the ACA is clinical inte-
gration. Clinical integration aims to coordinate patient care across conditions,
providers, settings, and time to achieve care that is safe, timely, effective,
efficient, and patient focused. New payment models and advances in health
information systems are used to facilitate the transition to the clinical integra-
tion model and to manage the continuum of care for patients. Provider pay-
ments are tied to results for quality, access, and efficiency with the objective of
establishing coordination between hospitals and physicians. Health informa-
tion technology aims to capture patient information and make it accessible

Population health
management
The concept that
the health of all
individuals is
improved when
the health of the
entire population
is improved.

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to authorized providers at the point of care. Complete patient information
facilitates optimal treatment strategies and reduces the chance of medication
errors and conflicting treatment plans. There will be requirements for new
and more comprehensive policies and procedures that protect patient privacy
and that guarantee the security of data that are transferred between patients,
caregivers, and organizations.

Data Analytics
The emergence of ACOs and an increased emphasis on collaboration between
clinicians and on quality patient care are making it necessary for healthcare
organizations to invest in integrated information systems technology to collect
large quantities of patient and provider data (so-called big data). Data ana-
lytic systems are capable of analyzing large amounts of patient data to better
understand clinical processes and to identify problems and opportunities for
improvement in the provision of healthcare services. New, complex informa-
tion technology will facilitate analysis of care coordination, patient safety, and
utilization of healthcare services.

Staffing Shortages
The ACA is expected to increase the number of patients who can access the
healthcare system. Healthcare organizations will see an influx of formerly
uninsured patients now seeking care because they have insurance or better
coverage. As a result, the demand for healthcare professionals—especially
physicians, nurse practitioners, and physician assistants—will likely increase.
The ACA is also driving changes in hospital staffing by emphasizing preven-
tion and value-based care, creating demand for primary care providers, emer-
gency physicians, clinical pharmacists, and health information technology and
data specialists. Some professional and industry associations are predicting
that current shortages of various healthcare staff will worsen in the face of this
growing demand. The ACA has identified several strategies to increase the
supply of health professionals (including primary care physicians), such as
scholarships and flexible loan repayment programs to help fund their educa-
tion. However, many healthcare organizations likely will face great competition
for some healthcare staff.

1. What is the primary purpose of healthcare reform?
2. Will reform have a greater impact on insurers or providers?
3. What is an accountable care organization (ACO), and what is it

designed to accomplish?
4. What is the medical home model, and what is its purpose?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e28

Key Concepts
This chapter provided an introduction to healthcare finance. The key
concepts of this chapter are as follows:

• The term healthcare finance, as it is used in this book, means the
accounting and financial management principles and practices used
within health services organizations to ensure the financial well-
being of the enterprise.

• A business maintains its financial viability by selling goods or
services, while a pure charity relies solely on contributions.

• The primary role of finance in health services organizations, as in
all businesses, is to plan for, acquire, and use resources to maximize
the efficiency and value of the enterprise.

• Finance activities generally include (1) planning and budgeting, (2)
financial reporting, (3) capital investment decisions, (4) financing
decisions, (5) revenue cycle and current accounts management, (6)
contract management, and (7) financial risk management. These
activities can be summarized by the four Cs: costs, cash, capital, and
control.

• The size and structure of the finance department within a
health services organization depend on the type of provider and
its size. Still, the finance department within a larger provider
organization generally consists of a chief financial officer (CFO),
who typically reports directly to the chief executive officer (CEO)
and is responsible for all finance activities within the organization.
Reporting to the CFO are the comptroller, who is responsible
for accounting and reporting activities, and the treasurer, who is
responsible for the acquisition and management of capital (funds).

• In larger organizations, the comptroller and treasurer direct
managers who have responsibility for specific functions, such as the
patient accounts manager, who reports to the comptroller, and the
cash manager, who reports to the treasurer.

• In small health services organizations, the finance responsibilities
are combined and assigned to one individual, often called the
business (practice) manager.

• All business decisions have financial implications, so all managers—
whether in operations, marketing, personnel, or facilities—must
know enough about finance to incorporate those implications into
their own specialized decision-making processes.

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• Healthcare services are provided in numerous settings, including
hospitals, ambulatory care facilities, long-term care facilities, and
even at home.

• Recent surveys of health services executives confirm the fact that
healthcare managers view financial concerns as the most important
current issue they face.

• The three main forms of business organization are proprietorship,
partnership, and corporation. Although each form of organization
has its own unique advantages and disadvantages, most large
organizations, and all not-for-profit entities, are organized as
corporations.

• Investor-owned corporations have stockholders who are the owners
of the corporation. As owners, stockholders have claim on the
residual earnings of the corporation. Investor-owned corporations
are fully taxable.

• Charitable organizations that meet certain criteria can be
organized as not-for-profit corporations. Rather than having a well-
defined set of owners, such organizations have a large number
of stakeholders who have an interest in the organization. Not-for-
profit corporations do not pay taxes; they can accept tax-deductible
contributions, and they can issue tax-exempt debt.

• In lieu of tax filings, not-for-profit corporations must file Form
990, which reports on an organization’s governance structure and
community benefit services, with the Internal Revenue Service.

• From a financial management perspective, the primary goal of
investor-owned corporations is shareholder wealth maximization,
which translates to stock price maximization. For not-for-profit
corporations, a reasonable goal for financial management is to
ensure that the organization can fulfill its mission, which translates
to maintaining financial viability.

• Healthcare reform is federal legislation that was signed into law
in 2010 and is expected to have a significant impact on health
insurers and providers.

• Accountable care organizations (ACOs) are a method of integrating
local physicians with other members of the healthcare community
and rewarding them for controlling costs and improving quality.

• A medical home (or patient-centered medical home) is a team-based
model of care led by a personal physician who provides continuous
and coordinated care throughout a patient’s lifetime to maximize
health outcomes.

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H e a l t h c a r e F i n a n c e30

In the next chapter, we continue the discussion of the healthcare environ-
ment, with emphasis on health insurance and reimbursement methodologies.

Questions and Problems

1.1 Briefly describe the purpose and organization of this book and the
learning tools embedded in each chapter.

1.2 a. What are some of the industries in the healthcare sector?
b. What is meant by the term healthcare finance as used in this

book?
c. What are the two broad areas of healthcare finance?
d. Why is it necessary to have a book on healthcare finance as

opposed to a generic finance book?
1.3 What is the difference between a business and a pure charity?
1.4 a. Briefly discuss the role of finance in the health services industry.
b. Has this role increased or decreased in importance in recent years?
1.5 What is the structure of the finance department within health services

organizations?
1.6 a. (Hint: the material reviewed in this question is covered in the

Chapter Supplement.) Briefly describe the following health services
settings:

• Hospitals
• Ambulatory care
• Home health care
• Long-term care
• Integrated delivery systems

b. What are the benefits attributed to integrated delivery systems?
1.7 What are the major current concerns of healthcare managers?
1.8 What are the three primary forms of business organization? Describe

their advantages and disadvantages.
1.9 What are the primary differences between investor-owned and not-

for-profit corporations?
1.10 a. What is the primary goal of investor-owned corporations?

b. What is the primary goal of most not-for-profit healthcare
corporations?

c. Are there substantial differences between the finance goals of
investor-owned and not-for-profit corporations? Explain.

1.11 Briefly describe the main provisions of healthcare reform and its
implications for the practice of healthcare finance.

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1.12 Describe the primary features of accountable care organizations
(ACOs) and medical homes. What benefits are attributed to them?

Resources

For a general introduction to the healthcare system in the United States, see
Barton, P. L. 2010. Understanding the U.S. Health Services System. Chicago: Health

Administration Press.
Shi, L., and D. A. Singh. 2013. Essentials of the U.S. Health Care System. Burlington,

MA: Jones and Bartlett Learning.

For the latest information on events that affect health services organizations, see
Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

For ideas on the future of healthcare in the United States and other information
pertinent to this chapter, see
Bisognano, M. 2011. “Finance is Key to Achieving Quality and Cost Goals.” Health-

care Financial Management (April): 68–71.
Giniat, E. J. 2009. “Finance Needs to Sit at the Head Table.” Healthcare Financial

Management (May): 80–82.
Kim, C., D. Majka, and J. H. Sussman. 2011. “Modeling the Impact of Healthcare

Reform.” Healthcare Financial Management (January): 51–60.
Lee, J. G., G. Dayal, and D. Fontaine. 2011. “Starting a Medical Home: Better Health

at Lower Cost.” Healthcare Financial Management (June): 71–80.
Mulvany, C. 2011. “Medicare ACOs No Longer Mythical Creatures.” Healthcare

Financial Management (June): 96–104.
Nguyen, J., and B. Choi. 2011. “Accountable Care: Are You Ready?” Healthcare

Financial Management (August): 92–100.
Reynolds, M. 2011. “Managing the Risks of Accountable Care.” Healthcare Financial

Management (July): 49–56.
Selvam, A. 2013. “Reform Unease Fading Among CEOs: But Financial Challenges

Remain Top Concern in ACHE’s Annual Survey.” Modern Healthcare (Janu-
ary 14): 22–23.

Smith, P. C., and K. Noe. 2012. “New Requirements for Hospitals to Maintain Tax-
Exempt Status.” Journal of Health Care Finance (Spring): 16–21.

Song, P. H., S. D. Lee, J. A. Alexander, and E. E. Seiber. 2013. “Hospital Ownership
and Community Benefit: Looking Beyond Uncompensated Care.” Journal of
Healthcare Management (March/April): 126–42.

For current information on how the Internet affects health and the provision of
health services, see Journal of Medical Internet Research, www.jmir.org.

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http://www.jmir.org

CHAPTER SUPPLEMENT

1 HEALTH SERVICES SETTINGS
Introduction

Health services are provided in numerous settings, including hospitals, ambu-
latory care facilities, long-term care facilities, and even at home. Before 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 controlled a single type of healthcare
facility, such as hospitals or nursing homes. Recently, however, many health
services organizations have diversified and become vertically integrated either
through direct ownership or contractual arrangements.

Settings

Hospitals
Hospitals provide diagnostic and therapeutic services to individuals who require
more than several hours of care, although most hospitals are actively engaged in
ambulatory (walk-in) services as well. To ensure a minimum standard of safety
and quality, hospitals must be licensed by the state and undergo inspections
for compliance with state regulations. In addition, most hospitals are accred-
ited by The Joint Commission. Joint Commission accreditation is a voluntary
process that is intended to promote high standards of care. Although the cost
to achieve and maintain compliance with Joint Commission standards can be
substantial, accreditation provides eligibility for participation in the Medicare
program, and hence most hospitals seek accreditation.

Recent environmental and operational changes have created significant
challenges for hospital managers. For example, many hospitals are experiencing
decreasing admission rates and shorter lengths of stay, which result in excess
capacity. At the same time, hospitals have been pressured to give discounts
to private third-party payers, governmental payments have failed to keep up
with the cost of providing services, and indigent care and bad debt losses
have increased. Because of the changing payer environment and resultant
cost containment pressures, the number of hospitals (and beds) has declined
in recent years.

Hospitals differ in function, average length of patient stay, size, and
ownership. These factors affect the type and quantity of assets, services offered,

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and management requirements and often determine the type and level of
reimbursement. Hospitals are classified as either general acute care facilities
or specialty facilities. General acute care hospitals, which provide general medi-
cal and surgical services and selected acute specialty services, are short-stay
facilities and account for the majority of hospitals. Specialty hospitals, such as
psychiatric, children’s, women’s, rehabilitation, and cancer facilities, limit admis-
sion of patients to specific ages, sexes, illnesses, or conditions. The number of
specialty hospitals has grown significantly in the past few decades because of
the increased need for such services.

Hospitals vary in size, from fewer than 25 beds to more than 1,000
beds; general acute care hospitals tend to be larger than specialty hospitals.
Small hospitals, those with fewer than 100 beds, usually are located in rural
areas. Many rural hospitals have experienced financial difficulties 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. (Tertiary care is highly specialized and
technical in nature, with services for patients with unusually severe, complex,
or uncommon problems.)

Hospitals are classified by ownership as private not-for-profit, 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 US
Department of Veterans Affairs, serve special populations.

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-profit—because local
governments have found it increasingly difficult 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 has contributed to many conversions as managers try to create
organizations that are more responsive to external change.

Private not-for-profit hospitals are nongovernmental entities organized
for the sole purpose of providing inpatient healthcare services. Because of the
charitable origins of US hospitals and a tradition of community service, roughly
80 percent of all private hospitals (60 percent of all hospitals) are not-for-profit
entities. In return for serving a charitable purpose, these hospitals receive
numerous benefits, 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 financing,
and tax-favored annuities for employees.

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The remaining 20 percent of private hospitals (15 percent of all hospitals)
are investor owned. This means that they have owners (typically shareholders)
that benefit directly from the profits generated by the business. Historically,
most investor-owned hospitals were owned by physicians, but now most are
owned by large corporations such as HCA, which owns about 160 hospitals;
Community Health Systems, which owns about 130 hospitals; and Tenet
Healthcare, which owns about 80 hospitals.

Unlike not-for-profit hospitals, investor-owned hospitals pay taxes and
forgo the other benefits of not-for-profit status. However, investor-owned
hospitals typically do not embrace the charitable mission of not-for-profit
hospitals. Despite the expressed differences in mission between investor-owned
and not-for-profit hospitals, not-for-profit hospitals are being forced to place
greater emphasis on the financial implications of operating decisions than in the
past. This trend has raised concerns in some quarters that many not-for-profit
hospitals are now failing to meet their charitable mission. As this perception
grows, some people argue that these hospitals should lose some, if not all, of
the benefits associated with their not-for-profit status.

Hospitals are labor intensive because of their need to provide continu-
ous 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 employees
and hence are not directly accountable to hospital management. However,
physicians retain a major responsibility for determining which hospital services
are provided to patients and how long patients are hospitalized, so physicians
play a critical role in determining a hospital’s costs and revenues and hence
its financial condition.

Ambulatory (Outpatient) Care
Ambulatory care, also known as outpatient care, encompasses services provided
to noninstitutionalized patients. Traditional outpatient settings include medical
practices, hospital outpatient departments, and emergency departments. 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 offer
patients increased amenities and convenience compared with hospital-based
services and, in many situations, provide services at a lower cost than hospitals
do. 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

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hospitalization because of the complexity, intensity, invasiveness, or risk associ-
ated with certain procedures can now be treated in outpatient settings. In addi-
tion, third-party payers have encouraged providers to expand their outpatient
services through mandatory authorization for inpatient services and by pay-
ment mechanisms that provide incentives to perform services on an outpatient
basis. Finally, fewer entry barriers to developing outpatient services relative to
institutional care exist. Ordinarily, ambulatory facilities are less costly and less
often subject to licensure and certificate-of-need regulations (exceptions are
hospital outpatient units and ambulatory surgery centers).

As outpatient care consumes an increasing portion of the healthcare
dollar and as efforts to control outpatient spending are enhanced, the tra-
ditional role of the ambulatory care manager is changing. Ambulatory care
managers historically have focused on such routine management tasks as bill-
ing, collections, staffing, scheduling, and patient relations, while the owners,
often physicians, have tended to make the more important business decisions.
However, reimbursement changes and increased affiliations with insurers and
other providers 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 finance decisions.

Long-Term Care
Long-term care entails the provision of healthcare services, as well as some
personal services, 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,
specifically 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 needed services. Long-term care is a
hybrid of healthcare services and social services; 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 provided under the supervision of a physician and must include 24-hour
daily nursing care. Intermediate care facilities (ICFs) are intended for individu-
als who do not require hospital or SNF care but whose mental or physical
conditions require daily continuity of one or more medical services. Residen-
tial care facilities are sheltered environments that do not provide professional

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healthcare services and thus for which most health insurance programs do not
provide coverage.

Nursing homes are more abundant than hospitals and are smaller, with
an average bed size of about 100 beds, compared with about 170 beds for
hospitals. Nursing homes are licensed by states, and nursing home administra-
tors 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 they are for licensure requirements.

The long-term care industry has experienced tremendous growth in
the past 50 years. Long-term care accounted for only 1 percent of healthcare
expenditures in 1960, but by 2010 it accounted for about 6 percent of expen-
ditures. Further demand increases are anticipated, as the percentage of the US
population aged 65 or older increases, from less than 15 percent in 2013 to a
forecasted 20 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 being developed 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, less generous Medicare payment system.

Integrated Delivery Systems
Many healthcare experts have extolled the benefits of providing hospital care,
ambulatory care, long-term care, and business support services through a single
entity called an integrated delivery system. The hypothesized benefits 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 (e.g.,

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.

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• 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 defined population,
including chronic disease management and health improvement
programs. Many of these population-based efforts typically are not
offered by stand-alone providers.

• Incentives can be created that encourage all providers in the system
to work together for the common good of the system, which has the
potential to improve quality and control costs.

Although integrated delivery systems can be structured in many different
ways, the defining characteristic of such systems is that the organization has the
ability to assume full clinical responsibility for the healthcare needs of a defined
population. Because of current state laws, which typically mandate that the
insurance function be assumed only by licensed insurers, integrated delivery
systems typically contract with insurers rather than directly with employers.
Sometimes, the insurer, often a managed care plan, is owned by the integrated
delivery system itself, but generally it is separately owned. In contracts with
managed care plans, the integrated delivery system often receives a fixed pay-
ment per plan member and hence assumes both the financial and clinical risks
associated with providing healthcare services.

To be an effective competitor, integrated delivery systems must minimize
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 concept is
frequently used to control utilization and hence costs. While hospitals continue
to be centers of technology, integrated delivery systems have the incentive to
shift patients toward lower-cost settings. Thus, clinical integration among the
various providers and components of care is essential to achieving quality, cost
efficiency, and patient satisfaction.

1. What are some different types of hospitals, and what trends are
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.

SELF-TEST
QUESTIONS

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CHAPTER

HEALTHCARE INSURANCE AND
REIMBURSEMENT METHODOLOGIES

Introduction

For the most part, the provision of healthcare services takes place in a unique
way. First, often only a few providers of a particular service exist in a given
area. Next, it is difficult, if not impossible, to judge the quality of competing
services. Then, the decision about which services to purchase is usually not
made by the consumer but by a physician or some other clinician. Also, full
payment to the provider is not normally made by the user of the services but
by a healthcare insurer. Finally, for most individuals, health insurance from
third-party payers is totally paid for or heavily subsidized by employers or
government agencies, so many patients are partially insulated from the costs
of healthcare.

This highly unusual marketplace for healthcare services has a profound
effect on the supply of, and demand for, such services. In this chapter, we
discuss the concept of insurance, the major providers of healthcare insurance,
and the methods used by insurers to pay for health services.

2
Learning Objectives
After studying this chapter, readers will be able to

• Explain the overall concept of insurance, including adverse
selection and moral hazard.

• Briefly describe the third-party payer system.
• Explain the different types of generic payment methods.
• Describe the incentives created by the different payment methods

and their impact on provider risk.
• Describe the purpose and organization of managed care plans.
• Explain the impact of healthcare reform on insurance and

reimbursement methodologies.
• Explain the importance and types of medical coding.

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H e a l t h c a r e F i n a n c e40

Insurance Concepts

Healthcare services are supported by an insurance system composed of a wide
variety of insurers of all types and sizes. Some are investor owned, while oth-
ers are not-for-profit or government sponsored. Some insurers require their
policyholders, who may or may not be the beneficiaries of the insurance, to
make the policy payments, while other insurers collect partial or total payments
from society at large. Because insurance is the cornerstone of the healthcare
system, an appreciation of the nature of insurance will help you better under-
stand the marketplace for healthcare services.

A Simple Illustration
To better understand insurance concepts, consider a simple example. Assume
that no health insurance exists and you face only two medical outcomes in
the coming year:

Outcome Probability Cost
Stay healthy 0.99 $ 0
Get sick 0.01 20,000

Furthermore, assume that everyone else faces the same medical out-
comes at the same odds and with the same associated costs. What is your
expected healthcare cost—E(Cost)—for the coming year? To find the answer,
we multiply the cost of each outcome by its probability of occurrence and
then sum the products:

E(Cost) = (Probability of outcome 1 × Cost of outcome 1)
+ (Probability of outcome 2 × Cost of outcome 2)
= (0.99 × $0) + (0.01 × $20,000)
= $0 + $200 = $200.

Now, assume that you, and everyone else, make $20,000 a year. With
this salary, you can easily afford the $200 “expected” healthcare cost. The
problem is, however, that no one’s actual bill will be $200. If you stay healthy,
your bill will be zero, but if you are unlucky and get sick, your bill will be
$20,000. This cost will force you, and most people who get sick, into personal
bankruptcy.

Next, suppose an insurance policy that pays all of your healthcare costs
for the coming year is available for $250. Would you purchase the policy, even
though it costs $50 more than your expected healthcare costs? Most people
would. In general, individuals are risk averse, so they would be willing to pay
a $50 premium over their expected costs to eliminate the risk of financial

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ruin. In effect, policyholders are passing to the insurer the costs associated
with the risk of getting sick.

Would an insurer be willing to offer the policy for $250? If an insurance
company sells a million policies, its expected total policy payout is 1 million
times the expected payout for each policy, or 1 million × $200 = $200 mil-
lion. If there were no uncertainty about the $20,000 estimated medical cost
per claim, the insurer could forecast its total claims precisely. It would col-
lect 1 million × $250 = $250 million in health insurance premiums; pay out
roughly $200 million in claims; and hence have about $50 million to cover
administrative costs, create a reserve in case realized claims are greater than
predicted by its actuaries, and make a profit.

Basic Characteristics of Insurance
The simple example of health insurance we just provided illustrates why indi-
viduals would seek health insurance and why insurance companies would be
formed to provide such insurance. Needless to say, the concept of insurance
becomes much more complicated in the real world. Insurance is typically
defined as having four distinct characteristics:

1. Pooling of losses. The pooling, or sharing, of losses is the heart of
insurance. Pooling means that losses are spread over a large group of
individuals so that each individual realizes the average loss of the pool
(plus administrative expenses) rather than the actual loss incurred.

In addition, pooling involves the grouping of a large number of
homogeneous exposure units—people or things having the same risk
characteristics—so that the law of large numbers can apply. (In statistics,
the law of large numbers states that as the size of the sample increases,
the sample mean gets closer and closer to the population mean.) Thus,
pooling implies (1) the sharing of losses by the entire group and (2)
the prediction of future losses with some accuracy.

2. Payment only for random losses. A random loss is one that is
unforeseen and unexpected and occurs as a result of chance. Insurance
is based on the premise that payments are made only for losses that are
random. We discuss the moral hazard problem, which concerns losses
that are not random, in a later section.

3. Risk transfer. An insurance plan almost always involves risk transfer.
The sole exception to the element of risk transfer is self-insurance,
which is the assumption of a risk by a business (or an individual) itself
rather than by an insurance company. (Self-insurance is discussed in a
later section.) Risk transfer is transfer of a risk from an insured to an
insurer, which typically is in a better financial position to bear the risk
than the insured because of the law of large numbers.

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H e a l t h c a r e F i n a n c e42

4. Indemnification. The final characteristic of insurance is indemnification
for losses—that is, reimbursement to the insured if a loss occurs. In
the context of health insurance, indemnification takes place when the
insurer pays the insured, or the provider, in whole or in part for the
expenses related to an insured’s illness or injury.

Adverse Selection
One of the major problems facing healthcare insurers is adverse selection.
Adverse selection occurs because individuals and businesses that are more
likely to have claims are more inclined to purchase insurance than those that
are less likely to have claims. For example, an individual without insurance
who needs a costly surgical procedure will likely seek health insurance if she
can afford it, whereas an individual who does not need surgery is much less
likely to purchase insurance. Similarly, consider the likelihood of a 20-year-old
to seek health insurance versus the likelihood of a 60-year-old to do so. The
older individual, with much greater health risk due to age, is more likely to
seek insurance.

If this tendency toward adverse selection goes unchecked, a dispropor-
tionate number of sick people, or those most likely to become sick, will seek
health insurance, and the insurer will experience higher-than-expected claims.
This increase in claims will trigger a premium increase, which only worsens
the problem, because the healthier members of the plan will seek insurance
from other firms at a lower cost or may totally forgo insurance. The adverse-
selection problem exists because of asymmetric information, which occurs
when individual buyers of health insurance know more about their health
status than do insurers.

In today’s world of health reform, ushered in by the Patient Protection
and Affordable Care Act (ACA; introduced in Chapter 1), which requires insur-
ers to take on patients regardless of preexisting conditions, the best strategy
for healthcare insurers to combat adverse selection is to create a large, well-
diversified pool of subscribers. If the pool is sufficiently large and diversified,
the costs of adverse selection can be absorbed by the large number of enrollees.

Moral Hazard
Insurance is based on the premise that payments are made only for random
losses, and from this premise stems the problem of moral hazard. The most
common case of moral hazard in a casualty insurance setting is the owner who
deliberately sets a failing business on fire to collect the insurance. Moral hazard
is also present in health insurance, but it typically takes a less dramatic form;
few people are willing to voluntarily sustain injury or illness for the purpose
of collecting health insurance. However, undoubtedly there are people who
purposely use healthcare services that are not medically required. For example,
some people might visit a physician or a walk-in clinic for the social value of

Adverse selection
The problem faced
by insurance
companies
because
individuals who
are more likely
to have claims
are also more
likely to purchase
insurance.

Moral hazard
The problem faced
by insurance
companies
because
individuals are
more likely to use
unneeded health
services when they
are not paying the
full cost of those
services.

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human companionship rather than to address a medical necessity. Also, some
hospital discharges might be delayed for the convenience of the patient rather
than for medical purposes.

Finally, when insurance covers the full cost or most of the cost of
healthcare services, individuals often are quick to agree to an expensive MRI
(magnetic resonance imaging) scan or other high-cost procedure that may not
be necessary. If the same test required total out-of-pocket payment, individuals
would think twice before agreeing to such
an expensive procedure unless they clearly
understood the medical necessity involved.
All in all, when somebody else is paying
the costs, patients consume more healthcare
services.

Even more insidious is the impact
of insurance on individual behavior. Indi-
viduals are more likely to forgo preventive
actions and embrace unhealthy behaviors
when the costs of not taking those actions
will be borne by insurers. Why stop smoking
if the monetary costs associated with cancer
treatment are carried by the insurer? Why
lose weight if others will pay for the adverse
health consequences likely to result?

The primary weapon that insurers
have against the moral hazard problem is
coinsurance, which requires insured indi-
viduals to pay a certain percentage of eligible
medical expenses—say, 20 percent—in
excess of the deductible amount. (Insurers
also use copayments, which are similar to
coinsurance but are expressed as a dollar
amount: $20 per primary care visit, for
example.) To illustrate coinsurance, assume
that George Maynard, who has employer-
provided medical insurance that pays 80
percent of eligible expenses after the $100
deductible is satisfied, incurs $10,000 in
medical expenses during the year. The
insurer will pay 0.80 × ($10,000 − $100)
= 0.80 × $9,900 = $7,920, so George’s
responsibility is $10,000 − $7,920 = $2,080.
The purposes of coinsurance and copay-
ments are to reduce premiums to employers

For Your Consideration
Who Should Pay for Health Services?
Users or Insurers?

One of the most confounding questions that
arises when discussing healthcare services is
who should bear the responsibility for payment.
Should the patient be responsible, or should
some third party such as the government or an
insurance company foot the bill?

Many people argue that when individuals
bear the cost of their own healthcare, they will be
responsible consumers and only pay for neces-
sary services. In addition, they will choose pro-
viders on the basis of cost and quality and hence
create the incentive for providers to offer better
yet less expensive services. It is estimated that
this action alone would reduce total healthcare
costs in the United States by some 20–30 per-
cent, or even more.

Other people argue that individuals can-
not make rational decisions regarding their
own healthcare because they do not sufficiently
understand the nature of illness and injury. Fur-
thermore, there is insufficient information about
provider quality and costs available to guide
individuals to good decisions. Finally, individuals
would skimp on routine preventive healthcare
services to save money, which would create
healthcare problems down the road and ulti-
mately lead to higher future costs.

What do you think? Should individuals be
held more responsible for their own costs of
healthcare services? What about the arguments
stated above? Is there some way of balancing the
need for more consumerism in healthcare service
purchases with the need to protect individuals
against the very high costs of many services?

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H e a l t h c a r e F i n a n c e44

and to prevent overutilization of healthcare services. Because insured individuals
pay part of the cost, premiums can be reduced. Additionally, by being forced
to pay some of the costs, insured individuals will presumably seek fewer and
more cost-effective treatments and embrace a healthier lifestyle.

Third-Party Payers

Up to this point in the chapter, we have focused on basic insurance concepts
because 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 critical to its financial viability, this section contains a brief examination of
the sources of most revenues in the health services industry. In the next sec-
tion, the reimbursement methodologies employed by these payers are reviewed
in more detail.

Health insurance originated in Europe in the early 1800s when mutual
benefit societies were formed to reduce the financial burden associated with
illness or injury. Since then, the concept of health insurance has changed
dramatically. 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 early 1900s. In this section, the major private insurers are discussed: Blue
Cross/Blue Shield, commercial insurers, and self-insurers.

Blue Cross/Blue Shield
Blue Cross/Blue Shield organizations trace their roots to the Great Depression,
when both hospitals and physicians were concerned about their patients’ ability

1. Briefly explain the following characteristics of insurance:
a. Pooling of losses
b. Payment only for random losses
c. Risk transfer
d. Indemnification

2. What is adverse selection, and how do insurers deal with the
problem?

3. What is the moral hazard problem, and how do insurers mitigate
the problem?

SELF-TEST
QUESTIONS

Third-party payer
A generic term
for any outside
party, typically
an insurance
company or a
government
program, that
pays for part or
all of a patient’s
healthcare
services.

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to pay healthcare bills. One example is Florida Blue (formerly Blue Cross and
Blue Shield of Florida), which offers healthcare insurance to individuals and
families, Medicare beneficiaries, and business groups that reside in Florida.

Blue Cross originated as a number of separate insurance programs
offered by individual hospitals. At that time, many patients were unable to
pay their hospital bills, but most people, except the poorest, could afford to
purchase some type of hospitalization insurance. Thus, the programs were
initially designed to benefit 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 fixed amounts to the
hospitals whether services were used or not. In a short time, these programs
were expanded from single hospital programs to community-wide, multihos-
pital plans that were called hospital service plans. The Blue Cross name was
officially adopted by most of these plans in 1939.

Blue Shield plans developed in a manner similar to Blue Cross plans,
except that the providers were physicians instead of hospitals. Today, there
are 37 Blue Cross/Blue Shield (“the Blues”) organizations. Some offer only
one of the two plans, but most offer both plans. The Blues are organized as
independent corporations, including some for-profit entities, but all belong
to a single national association that sets standards that must be met to use
the Blue Cross/Blue Shield name. Collectively, the Blues provide healthcare
coverage for more than 100 million individuals in all 50 states, the District
of Columbia, and Puerto Rico.

Commercial Insurers
Commercial health insurance is issued by life insurance companies, by casu-
alty insurance companies, and by companies that were formed exclusively to
offer healthcare insurance. Examples of commercial insurers include Aetna,
Humana, and UnitedHealth Group. All commercial insurance companies are
taxable (for-profit) entities. Commercial insurers moved strongly into health
insurance following World War II. At that time, the United Auto Workers
negotiated the first contract with employers in which fringe benefits were a
major part of the contract. Like the Blues, the majority of individuals with
commercial health 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. Although it might
seem as if all individuals who do not have some form of health insurance are
self-insurers, this is not the case. Self-insurers make a conscious decision to
bear the risks associated with healthcare costs and then set aside (or have
available) funds to pay future costs as they occur. Individuals, except the very

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H e a l t h c a r e F i n a n c e46

wealthy, 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, the costs of which are paid directly by the state.
Florida Blue is paid a fee to administer the plan, but the state bears all risks
associated with cost and utilization uncertainty.

Public Insurers
Government is a major insurer as well as a direct provider of healthcare services.
For example, the federal government provides healthcare services directly to
qualifying individuals through the medical facilities of the US Department of
Veterans Affairs; the US Department of Defense and its TRICARE program
(health insurance for uniformed service members and their families); and the
Public Health Service, part of the US Department of Health and Human Ser-
vices (HHS). In addition, government either provides or mandates a variety of
insurance programs, such as workers’ compensation. In this section, however,
the focus is on the two major government insurance programs: Medicare and
Medicaid.

Medicare
Medicare was established by Congress in 1965 primarily to provide medical
benefits to individuals aged 65 or older. About 50 million people have Medi-
care coverage, which pays for about 17 percent of all US healthcare services.

Over the decades, Medicare has evolved to include four major coverages:
(1) Part A, which provides hospital and some skilled nursing facility cover-
age; (2) Part B, which covers physician services, ambulatory surgical services,
outpatient services, and other miscellaneous services; (3) Part C, which is
managed care coverage offered by private insurance companies and can be
selected in lieu of Parts A and B; and (4) Part D, which covers prescription
drugs. In addition, Medicare covers healthcare costs associated with selected
disabilities and illnesses, such as kidney failure, regardless of age.

Part A coverage is free to all individuals eligible for Social Security ben-
efits. Individuals who are not eligible for Social Security benefits can obtain
Part A medical benefits by paying monthly premiums. Part B is optional to
all individuals who have Part A coverage, and it requires a monthly premium
from enrollees that varies with income level. About 97 percent of Part A
participants purchase Part B coverage, while about 20 percent of Medicare
enrollees elect to participate in Part C, also called Medicare Advantage Plans,
rather than Parts A and B. Part D offers prescription drug coverage through
plans offered by private companies. Each Part D plan offers somewhat differ-
ent coverage, so the cost of Part D coverage varies widely.

Medicare
A federal
government health
insurance program
that primarily
provides benefits
to individuals aged
65 or older.

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The Medicare program falls under HHS, which creates the specific rules
of the program on the basis of enabling legislation. Medicare is administered
by an agency in HHS called the Centers for Medicare & Medicaid Services
(CMS). CMS has eight regional offices that oversee the Medicare program
and ensure that regulations are followed. Medicare payments to providers are
not made directly by CMS but by contractors for 12 Medicare Administrative
Contractor (MAC) jurisdictions.

Before we close our discussion of Medicare, note that many private
insurers offer coverage called Medicare supplement insurance, or Medigap. Such
insurance is designed to help pay some of the healthcare costs that traditional
Medicare does not cover, such as copayments, coinsurance, and deductibles.
In addition, some Medigap policies offer coverage for services that Medicare
doesn’t include, for example, medical care when traveling outside of the United
States. When an individual buys Medigap coverage, Medicare will first pay
its share of the Medicare-approved amount for covered costs, and then the
Medigap policy pays its share.

Medicaid
Medicaid began in 1966 as a modest program to be jointly funded and 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 benefits 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 benefits either by
increasing the range of benefits 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 benefit 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 cover-
age. 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.

Medicaid
A federal and
state government
health insurance
program that
provides benefits
to low-income
individuals.

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

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e48

Managed Care Plans

Managed care plans strive to combine the provision of healthcare services
and the insurance function into a single entity. Traditional plans are created
by insurers who either directly own a provider network or create one through
contractual arrangements with independent providers.

One type of managed care plan is the health maintenance organiza-
tion (HMO). HMOs are based on the premise that the traditional insurer–
provider relationship creates perverse incentives that reward providers for
treating patients’ illnesses while offering little incentive for providing preven-
tion and rehabilitation services. By combining the financing and delivery of
comprehensive healthcare services into a single system, HMOs theoretically
have as strong an incentive to prevent illnesses as to treat them. However,
from a patient perspective, HMOs have several drawbacks, including a limited
network of providers and the assignment of a primary care physician who
acts as the initial contact and authorizes all services received from the HMO.

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 beneficiaries use specific
providers, although financial incentives are created that encourage members
to use those providers that are part of the provider panel—those providers
that have contracts (usually at discounted prices) with the PPO. Furthermore,
PPOs do not require beneficiaries to use preselected gatekeeper physicians. In
general, PPOs are less likely than HMOs to provide preventive services and
do not assume any responsibility for quality assurance because enrollees are
not constrained to use only the PPO panel of providers.

In an effort to achieve the potential cost savings of managed care
plans, most insurance companies now apply managed care strategies to their
conventional plans. Such plans, which are called managed fee-for-service plans,
use preadmission certification, utilization review, and second surgical opinions
to control inappropriate utilization.

Although the distinctions between managed care and conventional
plans were once quite apparent, considerable overlap now exists in the strate-
gies and incentives employed. Thus, the term managed care now describes a
continuum of plans, which can vary significantly in their approaches to provid-
ing combined insurance and healthcare services. The common feature in man-
aged care plans is that the insurer has a mechanism by which it controls, or
at least influences, patients’ utilization of healthcare services.

Managed care
plan
A combined effort
by an insurer and a
group of providers
with the purpose
of both increasing
quality of care and
decreasing costs.

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

SELF-TEST
QUESTIONS

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Healthcare Reform and Insurance

The ACA introduced a number of provisions to expand insurance coverage
and improve insurance affordability and access. Here are some of the act’s
provisions that focus on healthcare insurance.

Insurance Standards
A number of new insurance standards have been specified in the ACA. In
terms of coverage, these include the following:

• Children and dependents are permitted to remain on their parents’
insurance plans until their twenty-sixth birthday.

• Insurance companies are prohibited from dropping policyholders if
they become sick and from denying coverage to individuals due to
preexisting conditions.

• Individuals have a right to appeal and request that the insurer review
denial of payment.

In terms of costs, the standards include the following:

• Insurers are required to charge the same premium rate to all applicants
of the same age and geographic location, regardless of preexisting
conditions or sex.

• Insurers are required to spend at least 80 percent of premium dollars
on health costs and claims instead of on administrative costs and
profits. If the insurer violates this standard, it must issue rebates to
policyholders.

• Lifetime limits on most benefits are prohibited for all new health
insurance plans.

In terms of care, the standards include the following:

• All plans must now include essential benefits, such as ambulatory
patient services; emergency services; hospitalization; maternity and
newborn care; mental health and substance use disorder services;
prescription drugs; laboratory services; preventive and wellness services;
chronic disease management; and pediatric services, including oral and
vision care.

• Preventive services, such as childhood immunizations, adult vaccinations,
and basic medical screenings, must be available to patients free of
charge.

• Individuals are permitted to choose a primary care doctor outside the
plan’s network.

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• Individuals can seek emergency care at a hospital outside the health
plan’s network.

Individual Mandate
All eligible individuals (US citizens and legal residents) who are not covered
by an employer-sponsored health plan, Medicaid, or Medicare are required
to have a health insurance policy. If they do not maintain minimum essential
coverage for themselves and their dependents, they face tax penalties assessed
by the Internal Revenue Services at the end of each tax year.

Health Insurance Exchanges
Health insurance exchanges (HIEs) are an important part of ensuring that
healthcare access is available to all Americans and legal immigrants. People who
have no employer-sponsored insurance, the unemployed, or the self-employed
can purchase coverage through an exchange. HIEs are online marketplaces
where people can research and review their options and purchase health insur-
ance. It is estimated that more than 10 million people are using HIEs to buy
healthcare insurance coverage. To ensure price transparency, all participating
insurance companies are required to post on HIEs the rates for their various
health insurance plans. This mandate permits individuals and businesses shop-
ping for insurance to compare all plans and rates side by side and select plans
that are affordable and meet their needs.

There are different types of HIEs. Public exchanges are created by
state or federal government and are open to both individuals seeking personal
insurance and small-group employers seeking insurance for their workers. All
plans listed on an HIE are required to offer core benefits—called essential
health benefits—such as preventive and wellness services, prescription drugs,
and hospital stays. Private exchanges, on the other hand, are created by private-
sector firms, such as health insurance companies. Private HIEs are expected
to increase in number over time as more employers offer defined healthcare
contribution plans (discussed in a later section in this chapter) to their employ-
ees, who then must purchase health insurance on their own.

Medicaid Expansion
One of the provisions of the ACA is the expansion of Medicaid. Nearly all US
citizens and legal residents between the ages of 19 and 64 who have house-
hold incomes below 133 percent of the federal poverty level now qualify for
Medicaid. This expansion benefits childless adults who previously did not
qualify for Medicaid regardless of their income level as well as low-income
parents who previously did not qualify even if their children did qualify. As a
result, it is estimated that an additional 16 million people will receive cover-
age through Medicaid.

Health insurance
exchange (HIE)
An online
marketplace
created primarily
by the states
or the federal
government that
insurers use to
post plan details
and consumers
use to purchase
healthcare
insurance.

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Originally, under the ACA, Medicaid expansion was mandatory for all
states; states that did not comply were to be penalized by the federal govern-
ment. However, the US Supreme Court ruled that states can opt out of the
Medicaid expansion, leaving this decision to participate in the hands of the
state’s leaders. As of 2015, 31 states have participated in the Medicaid expan-
sion program. The managed Medicaid market may be an area of high growth
potential for insurance companies as more states move Medicaid beneficiaries
into managed care plans.

High-Deductible Health Plans
Many individuals are now choosing high-deductible health plans (HDHPs) for their
health insurance coverage. HDHPs are growing in popularity because they are
among the least expensive options available on HIEs. In fact, the rate of enrollment
in HDHPs has more than doubled since 2009. These plans have low premiums
and high deductibles and are linked with savings accounts established to pay for
healthcare services. HDHPs aim to provide individuals more control over their
healthcare expenditures and hence may offer an incentive to control healthcare costs.

New Insurance Markets
Before health reform, the health insurance industry focused on selling group
plans to employers. Now it must re-create itself to cater to an entirely new,
huge market of individual consumers. Many insurers have little idea how
costly it is to provide coverage to these new customers, many of whom are
not working and have not been insured for a long time (or even at all). One
of the biggest challenges that insurance companies will face is attempting to
accurately price and administer these plans without dramatic premium increases.
Another problem is that the newly insured often need education about how
to use their health plan effectively and how to access different types of care.

Focus on Chronic Care
As insurers and providers continue to partner in new accountable care orga-
nizations (ACOs), the shared savings programs will likely increasingly focus
on consumers with chronic conditions. That means implementing more patient-
centered medical homes that aim to manage chronic conditions with specific
care pathways that address behavioral health needs and decrease hospital admis-
sions and emergency department visits. ACOs and medical homes will also
increasingly make use of personal health coaches, who motivate patients on a
one-on-one basis and help coordinate patient care with all caregivers.

1. Briefly describe the impact of the ACA on health insurance.
2. What is a health insurance exchange (HIE)?

SELF-TEST
QUESTIONS

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Generic Reimbursement Methodologies

Regardless of the payer for a particular healthcare service, only a limited
number of payment methodologies are used to reimburse providers. Payment
methodologies fall into two broad classifications: fee-for-service and capita-
tion. In fee-for-service payment, of which many variations exist, the greater
the amount of services provided, the higher the amount of reimbursement.
Under capitation, a fixed payment is made to providers for each covered life,
or enrollee, that is independent of the amount of services provided. In this
section, we discuss the mechanics, incentives created, and risk implications of
alternative reimbursement methodologies.

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

Cost-Based Reimbursement
Under cost-based reimbursement, the payer agrees to reimburse the provider
for the costs incurred in providing services to the insured population. Reim-
bursement is limited to allowable costs, usually defined 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 final reconciliation is made
after the contract period expires and all costs have been processed through
the provider’s managerial (cost) accounting system.

During its early years (1966–1982), Medicare reimbursed hospitals on
the basis of costs incurred. Now most hospitals are reimbursed by Medicare,
and other payers, using a per diagnosis prospective payment system (see the
later subsection on this topic). However, critical access hospitals, which are small
rural hospitals that provide services to remote populations that do not have
easy access to other hospitals, are still reimbursed on a cost basis by Medicare.

Charge-Based Reimbursement
When payers pay billed charges, or simply charges, they pay according to a rate
schedule established by the provider, called a chargemaster. To a certain extent,
this reimbursement system places payers at the mercy of providers in regards
to the cost of healthcare services, especially in markets where competition is
limited. In the early days of health insurance, all payers reimbursed providers
on the basis of billed charges. Some insurers still reimburse providers accord-
ing to billed charges, but the trend for payers is toward other, less generous
reimbursement methods. If this trend continues, the only payers that will be

Fee-for-service
A reimbursement
methodology that
provides payment
each time a service
is provided.

Capitation
A reimbursement
methodology that
is based on the
number of covered
lives as opposed
to the amount of
services provided.

Cost-based
reimbursement
A fee-for-service
reimbursement
method based on
the costs incurred
in providing
services.

Charge-based
reimbursement
A fee-for-service
reimbursement
method based
on charges
(chargemaster
prices).

Chargemaster
A list of all items
and services
provided by a
health services
organization
containing their
gross (list) prices.

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expected to pay billed charges are self-pay, or private-pay, patients. Even then,
low-income patients often are billed at rates less than charges.

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. Additionally, many
conventional insurers 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 50 percent, or even
more, of billed charges. The effect of these discounts is to create a system
similar to hotel or airline pricing, where there are listed rates (chargemaster
prices for providers, and rack rates or full fares for hotels and airlines) that
few people pay.

Prospective

Payment

In a prospective payment system, the rates paid by payers are established by
the payer before the services are provided. Furthermore, payments are not
directly related to either costs or chargemaster rates. 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 first used for hospital inpatient reimbursement in 1983.

• Per day (per diem). If reimbursement is based on a per diem
payment, the provider is paid a fixed amount for each day that service
is provided, regardless of the nature of the service. Note that per diem
rates, which are applicable only to inpatient settings, can be stratified.
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 obstetrics day. Stratified per diems recognize that providers incur
widely different daily costs for providing different types of care.

• Bundled. Under bundled payment, payers make a single prospective
payment that covers all services delivered in a single episode, whether
the services are rendered by a single provider or by multiple providers.
For example, a bundled payment may be made for all obstetric services

Prospective
payment
A fee-for-service
reimbursement
method that
is established
beforehand by the
third-party payer
and, in theory, not
related to costs or
charges.

Per diem payment
A fee-for-service
reimbursement
method that pays
a set amount for
each inpatient day.

Bundled (global)
payment
The fee-for-service
payment of a
single amount
for the complete
set of services
required to treat a
single episode.

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H e a l t h c a r e F i n a n c e54

associated with a pregnancy provided by
a single physician, including all prenatal
and postnatal visits as well as the delivery.
For another example, a bundled payment
may be made for all physician and
hospital services associated with a cardiac
bypass operation. Finally, note that, at the
extreme, a bundled payment may cover
an entire population. In this situation,
the payment becomes a global payment,
which, in effect, is a capitation payment
as described in the next section.

Capitation
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 pro-
vided. The service may be defined as a visit,
a diagnosis, a hospital day, an episode, 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 fixed 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, dra-
matically changes the financial environment of healthcare providers. It has implica-
tions for financial accounting, managerial accounting, and financial management.
Discussion of how capitation, as opposed to fee-for-service reimbursement,
affects healthcare finance is provided throughout the remainder of this book.

For Your Consideration
Creating the Proper Provider Incentives

An article in the Wall Street Journal (February 18,
2015, page A1) describes how one patient in a
Kindred Healthcare long-term care hospital was
discharged after 23 days of treatment for compli-
cations from a previous knee surgery. According
to family members, the timing of his release did
not appear to be related to any improvement in
his medical condition. However, it did result in a
higher reimbursement that the hospital received
for his stay.

According to billing documents, Kindred
collected $35,887.79 from Medicare for his treat-
ment, the maximum amount it could earn for
treating patients with his condition. Under Medi-
care’s reimbursement rules, if the patient had
left the hospital one day earlier, Kindred would
have received a per diem rate that would have
resulted in a total payment of roughly $20,000. If
he had stayed longer than 23 days, the hospital
likely would not have received any additional
reimbursement other than the $35,887.79 single
payment for an “extended” stay.

What do you think? What incentives are
created for providers under the reimbursement
method used by Medicare for long-term (as
opposed to acute care) hospitals? Can you think
of a payment system that would encourage long-
term care hospitals to discharge patients at the
appropriate time?

1. Briefly explain the following payment methods:
• Cost based

SELF-TEST
QUESTIONS

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Provider Incentives Under Alternative Reimbursement
Methodologies

Providers, like individuals and businesses, react to the incentives created by the
financial environment. For example, individuals can deduct mortgage interest
from income for tax purposes, but they cannot deduct interest payments 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
always be used to finance home ownership, as the tax laws assumed, but that
the funds could be used for other purposes, including paying for vacations
and purchasing cars or appliances. In this situation, tax laws created incen-
tives 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 regard 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
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 and hence lead to higher revenues.

Under charge-based reimbursement, providers have the incentive to
set high charge rates, which lead 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 churn-
ing—creating more visits, ordering more tests, extending inpatient stays, and

• Charge based and discounted charges
• Per procedure
• Per diagnosis
• Per diem
• Bundled
• Capitation

2. What is the major difference between fee-for-service
reimbursement and capitation?

SELF-TEST
QUESTIONS

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H e a l t h c a r e F i n a n c e56

so on. Charge-based reimbursement does encourage providers to contain costs
because (1) the spread between charges and costs represents profits, and the
more the better, and (2) lower costs can lead to lower charges, which can
increase volume. Still, the incentive to contain costs is weak because charges
can be increased more easily than costs can be reduced. Note, however, that
discounted charge reimbursement places additional pressure on profitability
and hence increases the incentive for providers to lower costs.

Under prospective payment reimbursement, provider incentives are
altered. First, under per procedure reim-
bursement, the profitability of individual
procedures varies depending on the rela-
tionship between the actual costs incurred
and the payment for that procedure. Provid-
ers, usually physicians, have the incentive to
perform procedures that have the highest
profit potential. Furthermore, the more pro-
cedures the better, because each procedure
typically generates additional profit. The
incentives under per diagnosis reimburse-
ment are similar. Providers, usually hospitals,
will seek patients with those diagnoses that
have the greatest profit potential and dis-
courage (or even discontinue) those services
that have the least potential. Furthermore,
to the extent that providers have some flex-
ibility in selecting procedures (or assigning
diagnoses) to patients, an incentive exists to
up code procedures (or diagnoses) to ones
that provide the greatest reimbursement.

In all prospective payment methods,
providers have the incentive to reduce costs
because the amount of reimbursement is
fixed 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 profitable. However,

For Your Consideration
Value-Based Purchasing

Value-based purchasing rests on the concept
that buyers of healthcare services should hold
providers accountable for quality of care as well
as costs. In April 2011, HHS launched the Hospital
Value-Based Purchasing program, which marks
the beginning of a historic change in how Medi-
care pays healthcare providers. For the first time,
3,500 hospitals across the country are being
paid for inpatient acute care services based on
care quality, not just the quantity of the services
provided.

“Changing the way we pay hospitals will
improve the quality of care for seniors and save
money for all of us,” said former HHS Secretary
Kathleen Sebelius. “Under this initiative, Medi-
care will reward hospitals that provide high-
quality care and keep their patients healthy. It’s
an important part of our work to improve the
health of our nation and drive down costs. As
hospitals work to improve quality, all patients—
not just Medicare patients—will benefit.” The ini-
tial measures to determine quality focus on how
closely hospitals follow best clinical practices and
how well hospitals enhance patients’ care experi-
ences. The better a hospital does on its quality
measures, the greater the reward it will receive
from Medicare.

What do you think? Should providers be
reimbursed based on quality of care? How should
“quality” be measured? Should the additional
reimbursement to high-quality providers be
obtained by reductions in reimbursement to low-
quality providers?

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as mentioned previously, hospitals have the incentive to reduce costs during
each day of a patient stay.

Under bundled pricing, providers do not have the opportunity to be
reimbursed 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 making the diagnosis, taking x-rays, setting the fracture, removing the cast,
and so on. The rationale for unbundling is usually to provide more detailed
records of treatments rendered, but often the result is higher total charges for
the parts than would be charged for the entire package. Also, bundled 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
treatment. Such a joint view of cost containment may be more effective than
each provider separately attempting to minimize its treatment costs because
lowering costs in one phase of treatment could increase costs in another.

Finally, capitation reimbursement totally changes the playing field by
completely reversing the actions that providers must take to ensure financial
success. Under all fee-for-service methods, the key to provider success is to
work harder, increase utilization, and hence increase profits; under capitation,
the key to profitability 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.

Medical Coding: The Foundation of Fee-for-Service
Reimbursement

Medical coding, or medical classification, is the process of transforming
descriptions of medical diagnoses and procedures into code numbers that
can be universally recognized and interpreted. The diagnoses and procedures
are usually taken from a variety of sources within the medical record, such
as doctor’s notes, laboratory results, and radiological tests. In practice, the
basis for most fee-for-service reimbursement is the patient’s diagnosis (in the

1. What are the provider incentives created under fee-for-service
reimbursement? Under capitation?

SELF-TEST
QUESTION

Medical coding
The process of
transforming
medical diagnoses
and procedures
into universally
recognized
numerical codes.

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H e a l t h c a r e F i n a n c e58

case of inpatient settings) or the procedures performed on the patient (in the
case of outpatient settings). Thus, a brief background on clinical coding will
enhance your understanding of the reimbursement process.

Diagnosis Codes
The International Classification of Diseases (most commonly known by the
abbreviation ICD) is the standard for designating diseases plus a wide variety of
signs, symptoms, and external causes of injury. Published by the World Health
Organization, ICD codes are used internationally to record many types of
health events, including hospital inpatient stays and death certificates. (ICD
codes were first used in 1893 to report death statistics.)

The codes are periodically revised; the most recent version is ICD-10.
However, US hospitals are still using a modified version of the ninth revision,
called ICD-9-CM, where CM stands for Clinical Modification. The ICD-9 codes
consist of three, four, or five digits. The first three digits denote the disease
category, and the fourth and fifth digits provide additional information. For
example, code 410 describes an acute myocardial infarction (heart attack), while
code 410.1 is an attack involving the anterior wall of the heart. (However, the
conversion to ICD-10 codes will occur October 1, 2015, although hospitals
will not be penalized if they continue to use ICD-9 codes for one additional
year. The conversion process is consuming and costly because there are more
than five times as many individual codes in ICD-10 as in ICD-9. Of course, the
information provided by the new code set will be more detailed and complete.)

In practice, the application of ICD codes to diagnoses is complicated
and technical. Hospital coders have to understand the coding system and the
medical terminology and abbreviations used by clinicians. Because of this
complexity, and because proper coding can mean higher reimbursement from
third-party payers, ICD coders require a great deal of training and experience
to be most effective.

Procedure Codes
While ICD codes are used to specify diseases, Current Procedural Terminol-
ogy (CPT) codes are used to specify medical procedures (treatments). CPT
codes were developed and are copyrighted by the American Medical Associa-
tion. The purpose of CPT is to create a uniform language (set of descriptive
terms and codes) that accurately describes medical, surgical, and diagnostic
procedures. CPT and its corresponding codes are revised periodically to reflect
current trends in clinical treatments. To increase standardization and the use
of electronic health records, federal law requires that physicians and other
clinical providers, including laboratory and diagnostic services, use CPT for
the coding and transfer of healthcare information. (The same law also requires
that ICD codes be used for hospital inpatient services.)

International
Classification of
Diseases (ICD)
codes
Numerical codes
for designating
diseases plus a
variety of signs,
symptoms, and
external causes of
injury.

Current Procedural
Terminology (CPT)
codes
Codes applied to
medical, surgical,
and diagnostic
procedures.

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To illustrate CPT codes, there are ten codes for physician office visits.
Five of the codes apply to new patients, while the other five apply to established
patients (repeat visits). The differences among the five codes in each category
are based on the complexity of the visit, as indicated by three components: (1)
extent of patient history review, (2) extent of examination, and (3) difficulty
of medical decision making. For repeat patients, the least complex (typically
shortest) office visit is coded 99211, while the most complex (typically lon-
gest) is coded 99215.

Because government payers (Medicare and Medicaid) as well as other
insurers require additional information from providers beyond that contained
in CPT codes, an enhanced version called the Healthcare Common Proce-
dure Coding System (HCPCS, commonly pronounced “hick picks”) was
developed. This system expands the set of CPT codes to include nonphysi-
cian services and durable medical equipment such as ambulance services and
prosthetic devices.

Although CPT and HCPCS codes are not as complex as the ICD codes,
coders still must have a high level of training and experience to use them cor-
rectly. As in ICD coding, correct CPT coding ensures correct reimbursement.
Coding is so important that many businesses offer services, such as books,
software, education, and consulting, to hospitals and medical practices to
improve coding efficiency.

Specific Reimbursement Methods

There are many specific reimbursement methods in use today. Typically, the
methods differ from one insurer to another. In addition, insurers use differ-
ent methods for different types of providers and services, such as hospitals
versus physicians or even hospital inpatients versus outpatients. In this sec-
tion, we discuss the specific methods used by Medicare to reimburse hospitals
for inpatient services and physicians for all services. We discuss other specific
reimbursement methods used by Medicare in the chapter supplement.

Hospital Inpatient Services
The Medicare inpatient prospective payment system (IPPS) is a prospective
payment methodology based on an inpatient’s diagnosis at discharge. It starts
with two national base payment rates (operating and capital expenses), which

Healthcare
Common
Procedure Coding
System (HCPCS)
A medical coding
system that
expands the CPT
codes to include
nonphysician
services and
durable medical
equipment.

1. Briefly describe the coding system used in hospitals (ICD codes)
and medical practices (CPT codes).

2. What is the link between coding and reimbursement?

SELF-TEST
QUESTIONS

Inpatient
prospective
payment system
(IPPS)
The method, based
on diagnosis,
that Medicare
uses to reimburse
providers for
inpatient services.

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H e a l t h c a r e F i n a n c e60

are then adjusted to account for two factors that affect the costs of providing
care: (1) the patient’s condition and treatment and (2) market conditions in
the facility’s geographic location (Exhibit 2.1).

Discharges are assigned to one of 751 Medicare severity diagnosis-related
groups (MS–DRGs), which designate the diagnoses of patients with similar
clinical problems and, hence, who are expected to consume similar amounts
of hospital resources. Each MS–DRG has a relative weight that reflects the
expected cost of inpatients in that group. The payment rates for MS–DRGs
in each local market are determined by adjusting the base payment rates
to reflect the local input price level and then multiplying them by the rela-
tive weight for each MS–DRG. The operating and capital payment rates are
increased for facilities that operate an approved resident training program

+ +

Adjusted for geographic

factors

Adjusted for case mix

Adjustment for transfers

Policy adjustments for
hospitals that qualify

If case is
extraordinarily

costly

Wage
index
≥ 1.0

Wage
index
≤ 1.0

Indirect
medical

education
payment

Disproportionate
share payment

Full
LOS

Short LOS and
discharged

to other acute
IPPS hospital
or post-acute

care*

Operating
base

payment

rate

Adjusted
base

payment
rate

Per case
payment

rate

Payment**

High-
cost

outlier
(payment

+
outlier

payment)

Per
diem

payment
rate

Hospital
wage
index

Adjusted
base
payment
rate

MS–DRG

Patient characteristics

69.6%
adjusted
for area
wages

62%
adjusted
for area
wages

Principal diagnosis
Procedure
Complications and comorbidities

Non-labor-

related
portion

Base rate
adjusted

for
geographic

factors

MS–DRG
weight

EXHIBIT 2.1
Medicare

Hospital Acute
Inpatient

Services
Payment

System

Note: MS–DRG (Medicare severity diagnosis-related group), LOS (length of stay), IPPS (inpa-
tient prospective payment system). Capital payments are determined by a similar system.

* Transfer policy for cases discharged to post-acute care settings applies for cases in 275
selected MS–DRGs.

** Additional payment made for certain rural hospitals.

Source: Reprinted from MedPAC. 2014. “Hospital Acute Inpatient Services Payment System.”
Figure 1. Revised October. www.medpac.gov/documents/payment-basics/hospital-acute-
inpatient-services-payment-system-14 .

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or that treat a disproportionate share of
low-income patients. Rates are reduced for
various transfer cases, and outlier payments
are added for cases that are extraordinarily
costly to protect providers from large finan-
cial losses due to unusually expensive cases.
Both operating and capital payment rates
are updated annually.

The IPPS rates are intended to cover
the costs that reasonably efficient provid-
ers would incur in providing high-quality
care. If the hospital is able to provide the
services for less than the fixed reimburse-
ment amount, it can keep the difference.
Conversely, if a Medicare patient’s treat-
ment costs are more than the reimburse-
ment amount but do not meet the definition
of an outlier, the hospital must bear the
loss.

Physician Services
Medicare pays for physician services using a
resource-based relative value scale (RBRVS)
system. In the RBRVS system, payments
for services are determined by the resource
costs needed to provide them as measured by
weights called relative value units (RVUs).
RVUs consist of three components: (1) a
work RVU, which includes the skill level and
training required along with the intensity
and time required for the service; (2) a practice expense RVU, which includes
equipment and supplies costs as well as office support costs, including labor;
and (3) a malpractice expense RVU, which accounts for the relative risk and
cost of potential malpractice claims. To illustrate, the (total) RVU is 0.52 for
a minimal office visit, 1.32 for an average office visit, and 3.06 for a compre-
hensive office visit. Furthermore, the average office visit RVU is composed
of a work RVU of 0.67, a practice expense RVU of 0.62, and a malpractice
expense RVU of 0.03.

The RVU values then are adjusted to reflect variations in local input
prices, and the total is multiplied by a standard dollar value—called the con-
version factor—to arrive at the payment amount. Medicare’s payment rates
may also be adjusted to reflect provider characteristics, geographic

Relative value unit
(RVU)
A measure of the
amount of resources
consumed
to provide a
particular service.
When applied
to physicians, a
measure of the
amount of work,
practice expenses,
and liability costs
associated with a
particular service.

Industry Practice
Using RVUs for Physician Compensation

Traditionally, there have been a number of ways of
estimating physician productivity when tying com-
pensation to performance. For many years, productiv-
ity was measured by volume-based metrics such as
number of patients seen or amount of revenue billed.
Today, however, physician productivity measures and
compensation models are rapidly moving toward
models based on relative value units (RVUs).

Work RVUs, which are one of three components
of RVUs, measure the relative level of time, skill, train-
ing, and intensity required of a physician to provide a
given service. As such, they are a good proxy for the
training required and volume of work expended by a
physician in treating patients. A routine well-patient
visit, for example, would be assigned a lower RVU
than an invasive surgical procedure would. Given this
relative scale, a physician seeing two or three com-
plex or high-acuity patients per day could accumulate
more RVUs than a physician seeing ten or more low-
acuity patients per day. Thus, the nature of the work,
rather than number of patients or billings, is being
measured and hence used for compensation levels.

According to the Medical Group Manage-
ment Association (MGMA), well over half of all
physicians are compensated, at least in part, on
the basis of productivity as measured by work
RVUs. Usually, work RVUs are combined with other
productivity and quality measures in determining
productivity and compensation, but there is little
doubt that work RVUs have the dominant role.

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H e a l t h c a r e F i n a n c e62

designations, and other factors. The provider is paid the final amount, less
any beneficiary coinsurance (Exhibit 2.2).

Healthcare Reform and Reimbursement Methods

In addition to improving healthcare delivery through focusing on access and
quality, the ACA has significantly changed the way providers are reimbursed.
The key reforms include a move from a fee-for-service model to a prospective
payment model, which may include bundled payments or capitation. These
new payment methods aim to move reimbursement from that based on the
amount of services provided (volume) to that based on value and better
outcomes.

1. Briefly describe the method used by Medicare to reimburse for
inpatient services.

2. Explain the method used by Medicare to reimburse for physician
services.

SELF-TEST
QUESTIONS

+ +× × × ×

Complexity
of service

and expenses

Geographic
factors

Provider type Geographic Service type

Payment

Adjusted
for:

Conversion

factor

Payment
modifier

Adjusted
fee schedule

payment
rate
Adjusted
fee schedule
payment
rate

Total RVUs from physician fee schedule

Policy adjustments (multiplicative)

Work
RVU

PE
RVU

PLI
RVU

PLI
GPCI

PE
GPCI

Work
GPCI

(decreases)

Nonphysician Nonparticipating HPSA bonus
Primary

care
Major surgical

procedures

(increases) (increases)

EXHIBIT 2.2
Medicare
Physician

Services
Payment
System

Note: RVU (relative value unit), GPCI (geographic practice cost index), PE (practice expense), PLI
(professional liability insurance), HPSA (health professional shortage area). This figure depicts
Medicare payments only. The fee schedule lists separate PE RVUs for facility and nonfacility
settings. Fee schedule payments are reduced when specified nonphysician practitioners bill
Medicare separately, but not when services are provided “incident to” a physician.

Source: Reprinted from MedPAC. 2014. “Physician and Other Health Professionals Payment
System.” Figure 1. Revised October. http://medpac.gov/documents/payment-basics/physician-
and-other-health-professionals-payment-system-14 .

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C h a p t e r 2 : H e a l t h c a r e I n s u r a n c e a n d R e i m b u r s e m e n t M e t h o d o l o g i e s 63

The new payment methods are specifically designed to accomplish the
following:

• Encourage providers to deliver care in a high-quality, cost-efficient
manner

• Support coordination of care among multiple providers
• Adopt evidence-based care standards and protocols that result in the

best outcomes for patients
• Provide accountability and transparency
• Discourage overtreatment and medically unnecessary procedures
• Eliminate or reduce the occurrence of adverse events
• Discourage cost shifting

The sections that follow describe a few of the important implications
for provider payments.

Value-Based Purchasing
Value-based purchasing (VBP) is a Medicare initiative that rewards acute care
hospitals with incentive payments for providing high-quality care to Medicare
beneficiaries, which should lead to better clinical outcomes for all hospital-
ized patients. The amounts of these payments are based on how closely the
institution followed best clinical practices, how well it enhanced patients’ care
experiences, how well it achieved quality goals, and how much it improved on
each measure compared to its performance during the baseline period. Note
that some VBP programs are paired with shared savings programs (discussed
later) to reward cost reduction as well as quality of care.

Quality-Based Clinician Compensation
In addition to VBP for hospitals, the ACA requires Medicare to factor quality
into payments for physicians and most other clinicians. Quality-based com-
pensation is part of Medicare’s effort to shift medicine away from the volume-
based focus, where clinicians are paid for each service regardless of quality.
Clinicians can earn additional compensation based on the quality of care they
provide to their patients. Bonuses and penalties are calculated on the basis
of performance on quality measures, which vary by specialty. As with VBP
programs for hospitals, quality-based clinician reimbursement programs can
be paired with shared savings programs.

Shared Savings Programs
Shared savings is an approach to reducing healthcare costs and, potentially, a
mechanism for encouraging the creation of ACOs. Under shared savings, if
a provider reduces total healthcare spending for its patients below the level

Value-based
purchasing (VBP)
An approach
to provider
reimbursement
that rewards
quality of care
rather than
quantity of care.

00_GapenskiReiter (2299).indb 63 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e64

that the payer expected, the provider is then rewarded with a portion of the
savings. The benefits are twofold: (1) The payer spends less than it would oth-
erwise, and (2) the provider gets more revenue than it expected. The savings
can arise from the more efficient, cost-effective use of hospital or outpatient
services that enhance quality, reduce costs over time, and improve outcomes.
It can be applied to hospital episodes of care, including physician services, or
to physician office care.

New Bundled Payment Models
Bundled payment models are a form of fee-for-service reimbursement in which
a single sum covers all healthcare services related to a specific procedure. The
objective of bundled payments is to promote more efficient use of resources
and reward providers for improving the coordination, quality, and efficiency
of care. If the cost of services is less than the bundled payment, the physicians
and other providers retain the difference. But if the costs exceed the bundled
payment, physicians and other providers are not compensated for the difference.

In some circumstances, an ACO may receive the bundled payment and
subsequently divide the payment among participating physicians and providers.
In other situations, the payer may pay participating physicians and provid-
ers independently, but it may adjust each payment according to negotiated
predefined rules to ensure that the total payments to all the providers do not
exceed the total bundled payment amount. This type of reimbursement is
called virtual bundling. For providers, the challenges of bundled payments
include determining who owns the episode of care and apportioning the pay-
ment among the various providers.

Readmission Reduction Program
With the passage of the ACA, Medicare now has the authority to penalize
hospitals if they experience excessive readmission rates compared to expected
levels of readmission. The readmissions are based on a 30-day readmission
measure for heart attack, heart failure, and pneumonia.

Hospital-Acquired Conditions
In a relatively new initiative, hospitals will be penalized by Medicare for hospital-
acquired conditions. Hospital-acquired conditions include bedsores, infections,
complications from extended use of catheters, and injuries caused by falls.
Hospitals will face a 1 percent reduction in Medicare inpatient payments for
all discharges if they rank in the top 25 percent of hospital-acquired conditions
for all hospitals in the previous year.

1. Briefly describe the impact of the ACA on payments to providers.
SELF-TEST
QUESTION

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C h a p t e r 2 : H e a l t h c a r e I n s u r a n c e a n d R e i m b u r s e m e n t M e t h o d o l o g i e s 65

Key Concepts
This chapter covers important background material related to healthcare
insurance and provider reimbursement. The key concepts of this chapter
are as follows:

• Health insurance is widely used in the United States because
individuals are risk averse and insurance firms can take advantage of
the law of large numbers.

• Insurance is based on four key characteristics: (1) pooling of
losses, (2) payment for random losses, (3) risk transfer, and (4)
indemnification.

• Adverse selection occurs when individuals most likely to have claims
purchase insurance while those least likely to have claims do not.

• Moral hazard occurs when an insured individual purposely sustains a
loss, as opposed to a random loss. In a health insurance setting, moral
hazard is more subtle, producing such behaviors as seeking more
services than needed and engaging in unhealthy behavior because the
costs of the potential consequences are borne by the insurer.

• Most provider revenue is not obtained directly from patients but
from healthcare insurers, known collectively as third-party payers.

• Third-party payers are classified as private insurers (Blue Cross/
Blue Shield, commercial, and self-insurers) and public insurers
(Medicare and Medicaid).

• Managed care plans, such as health maintenance organizations
(HMOs), strive to combine the insurance function and the
provision of healthcare services.

• Third-party payers use many different payment methods that fall
into two broad classifications: fee-for-service and capitation. Each
payment method creates a unique set of incentives and risk for
providers.

• When payers pay billed charges, they pay according to a schedule of
rates established by the provider called a chargemaster.

• Negotiated charges, which are discounted from billed charges, are
used by insurers with sufficient market power to demand price
reductions.

• Under a cost-based reimbursement system, payers agree to pay
providers certain allowable costs incurred when providing services
to the payers’ enrollees.

(continued)

00_GapenskiReiter (2299).indb 65 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e66

Because the managers of health services organizations must make finan-
cial decisions within the constraints imposed by the economic environment,
the insurance and reimbursement concepts discussed in this chapter will be
used over and over throughout the remainder of the book.

• In a prospective payment system, the rates paid by payers are
determined in advance and are not tied directly to reimbursable
costs or billed charges. Typically, prospective payments are made
on the basis of the following service definitions: (1) per procedure,
(2) per diagnosis, (3) per diem (per day), or (4) bundled pricing.

• Capitation is a flat periodic payment to a physician or another
healthcare provider; it is the sole reimbursement for providing
services to a defined population. Capitation payments are generally
expressed as some dollar amount per member per month, where
the word member typically refers to an enrollee in some managed
care plan.

• Medical coding is the foundation of fee-for-service reimbursement
systems. In inpatient settings, ICD codes are used to designate
diagnoses, while in outpatient settings, CPT codes are used to
specify procedures.

• Medicare uses the inpatient prospective payment system (IPPS) for
hospital inpatient reimbursement. Under IPPS, the amount of the
payment is determined by the patient’s Medicare severity diagnosis-
related group (MS–DRG).

• To provide some cushion for the high costs associated with severely
ill patients within each diagnosis, IPPS includes a provision for
outlier payments.

• Physicians are reimbursed by Medicare using the resource-based
relative value scale (RBRVS). Under RBRVS, reimbursement
is based on relative value units (RVUs), which consist of three
resource components: (1) physician work, (2) practice expenses, and
(3) malpractice insurance expenses. The RVU for each service is
multiplied by a dollar conversion factor to determine the payment
amount.

• The ACA is having a significant impact on health insurance and on
the way providers are reimbursed. More people now have access
to insurance coverage, and the new provider payment methods
emphasize value and patient outcomes over volume.

(continued from previous page)

00_GapenskiReiter (2299).indb 66 11/11/15 11:00 AM

C h a p t e r 2 : H e a l t h c a r e I n s u r a n c e a n d R e i m b u r s e m e n t M e t h o d o l o g i e s 67

Questions

2.1 Briefly explain the following characteristics of insurance:
a. Pooling of losses
b. Payment only for random losses
c. Risk transfer
d. Indemnification
2.2 What is adverse selection, and how do insurers deal with the

problem?
2.3 What is the moral hazard problem?
2.4 Briefly describe the major third-party payers.
2.5 a. What are the primary characteristics of managed care plans?
b. Describe different types of managed care plans.
2.6 What is the difference between fee-for-service reimbursement and

capitation?
2.7 Describe the provider incentives 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. Bundled payment
g. Capitation
2.8 What medical coding systems are used to support fee-for-service

payment methodologies?
2.9 Briefly describe how Medicare pays for the following:
a. Inpatient services
b. Physician services

2.10 What are some features of the ACA that affect healthcare insurance
and reimbursement?

Resources

For the latest information on events that affect the healthcare sector, see Modern
Healthcare, published weekly by Crain Communications Inc., Chicago.

Other resources pertaining to this chapter include

00_GapenskiReiter (2299).indb 67 11/11/15 11:00 AM

H e a l t h c a r e F i n a n c e68

Beagle, J. T. 2010. “Episode-Based Payment: Bundling for Better Results.” Healthcare
Financial Management (February): 36–39.

D’Cruz, M. J., and T. L. Welter. 2010. “Is Your Organization Ready for Value-Based
Payments?” Healthcare Financial Management (January): 64–72.

———. 2008. “Major Trends Affecting Hospital Payment.” Healthcare Financial
Management (January): 53–60.

Harris, J., I. Elizondo, and A. Isdaner. 2014. “Medicare Bundled Payment: What Is
It Worth to You?” Healthcare Financial Management (January): 76–82.

Kentros, C., and C. Barbato. 2013. “Using Normalized RVU Reporting to Evaluate
Physician Productivity.” Healthcare Financial Management (August): 98–105.

Kim, C., D. Majka, and J. H. Sussman. 2011. “Modeling the Impact of Healthcare
Reform.” Healthcare Financial Management (January): 51–60.

Mulvany, C. 2013. “Insurance Market Reform: The Grand Experiment.” Healthcare
Financial Management (April): 82–88.

———. 2010. “Healthcare Reform: The Good, the Bad, and the Transformational.”
Healthcare Financial Management (June): 52–57.

Patton, T. L. 2009. “The IRS’s Version of Community Benefit: A Look at the Rede-
signed Form 990 and New Schedule H.” Healthcare Financial Management
(February): 50–54.

Pearce, J. W., and J. M. Harris. 2010. “The Medicare Bundled Payment Pilot Program:
Participation Considerations.” Healthcare Financial Management (September):
52–60.

Ronning, P. L. 2011. “ICD-10: Obligations and Opportunities.” Healthcare Financial
Management (August): 48–51.

Saqr, H., O. Mikhail, and J. Langabeer. 2008. “The Financial Impact of the Medicare
Prospective Payment System on Long-Term Acute Care Hospitals.” Journal
of Health Care Finance (Fall): 58–69.

Shoemaker, P. 2011. “What Value-Based Purchasing Means to Your Hospital.” Health-
care Financial Management (August): 61–68.

Tyson, P. 2010. “Preparing for the New Landscape of Payment Reform.” Healthcare
Financial Management (December): 42–48.

Wilensky, G. R. 2011. “Continuing Uncertainty Dominates the Healthcare Landscape.”
Healthcare Financial Management (March): 34–35.

Williams, J. 2013. “A New Model for Care: Population Management.” Healthcare
Financial Management (March): 69–76.

Woodson, W., and S. Jenkins. 2010. “Payment Reform: How Should Your Organiza-
tion Prepare?” Healthcare Financial Management (January): 74–79.

00_GapenskiReiter (2299).indb 68 11/11/15 11:00 AM

CHAPTER SUPPLEMENT

2ADDITIONAL MEDICARE PAYMENT
METHODS

Introduction

In Chapter 2, we discussed the inpatient prospective payment system (IPPS)
and the resource-based relative value scale (RBRVS) system used by Medicare
to reimburse hospitals for inpatient services and physicians for all services. In
this supplement, we provide information on the other primary reimbursement
methods used by Medicare.

Outpatient Hospital Services

The outpatient prospective payment system (OPPS) is essentially a fee schedule.
The unit of payment under the OPPS is the individual service as identified by the
Healthcare Common Procedure Coding System (HCPCS), which contains codes
for about 6,700 distinct services. Medicare groups services into ambulatory pay-
ment classifications (APCs) on the basis of clinical and cost similarity. Each APC
has a relative weight that measures the resource requirements of the service and
is based on the median cost of services in that APC. The Centers for Medicare &
Medicaid Services (CMS) sets payments for individual APCs using a conversion
factor that translates the relative weights into dollar payment rates with adjustments
for geographic differences in input prices. Hospitals also can receive additional
payments in the form of outlier adjustments for extraordinarily high-cost services
and pass-through payments for selected new technologies (Exhibit S2.1).

Ambulatory Surgery Centers

Medicare pays for surgery-related facility services provided in ambulatory sur-
gery centers (ASCs) based on the individual surgical procedure. Each of the
nearly 3,600 approved procedures is assigned an APC from the same payment
groups as used for hospital outpatient services. The relative weights for most
procedures in the ASC payment system are the same as the relative weights used
in the OPPS. Like the OPPS, the ambulatory surgical center payment system
sets payments for individual services using a conversion factor and adjustments
for geographic differences in input prices. Note that the payment for facilities
services is separate from the payment for physician services.

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ap
te
r

2
S

u
p
p
le
m
en
t

Inpatient Rehabilitation Facilities

Inpatient rehabilitation facilities are paid predetermined, per discharge rates
based primarily on the patient’s condition (diagnoses, functional and cognitive
status, and age) and market area wages. Discharges are assigned to one of 92
intensive rehabilitation categories called case-mix groups (CMGs), which are
groups of patients with similar clinical problems. Within each of these CMGs,
patients are further categorized into one of four tiers on the basis of comor-
bidities, with each tier having a specific payment that reflects the costliness of
patients in that tier relative to others in the CMG.

Psychiatric Hospital Services

Medicare uses the inpatient psychiatric facility prospective payment system for
psychiatric hospital services, which is based on a per diem rate plus additional
payments for ancillary services and capital costs. A base per diem payment is
adjusted to account for cost-of-care differences related to patient character-
istics, such as age, diagnosis, comorbidities, and length of stay, and facility
characteristics, such as local wages, geographic location, teaching status, and
emergency department status.

+ + + +× =

Hospital
wage
index

APC

Payment
Conversion

factor
High-
cost
outlier
(payment
+
outlier
payment)

Adjusted for
geographic factors

Payment adjusted for
complexity of service

Policy adjustments for
hospitals that qualify

If patient is
extraordinarily costly

60%
adjusted
for area
wages

40%
non-labor-

related
portion

Measures
resource

requirements
of service

Conversion
factor

adjusted for
geographic

factors

APC
relative
weight

7.1%
add-on

for
rural
SCHs

Hold
harmless
for cancer

and
children’s
hospitals

EXHIBIT S2.1
Medicare

Outpatient
Hospital
Services
Payment

System

Note: APC (ambulatory payment classification), SCH (sole community hospital). The APC is the
service classification system for the outpatient prospective payment system. Medicare ad-
justs outpatient prospective payment system payment rates for 11 cancer hospitals so that the
payment-to-cost ratio (PCR) for each cancer hospital is equal to the average PCR for all hospitals.

Source: Reprinted from MedPAC. 2014. “Outpatient Hospital Services Payment System.” Figure 1.
Revised October. www.medpac.gov/documents/payment-basics/outpatient-hospital-services-
payment-system .

00_GapenskiReiter (2299).indb 70 11/11/15 11:00 AM

http://www.medpac.gov/documents/payment-basics/outpatient-hospital-services-payment-system

71C h a p t e r 2 S u p p l e m e n t : A d d i t i o n a l M e d i c a r e P a y m e n t M e t h o d s
C

h
ap

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S

u
p

p
lem

en
t

Skilled Nursing Facility Services

Medicare uses a prospective payment system for skilled nursing facilities (SNFs)
that pays facilities a predetermined daily rate for each day of care, up to 100
days. The rates are expected to cover all operating (nursing care, rehabilitation
services, and other goods and services) and capital costs that efficient facilities
would incur in providing SNF services. Various high-cost, low-probability ancil-
lary services are covered separately. Patients are assigned to one of 66 categories,
called resource utilization groups (RUGs), on the basis of patient characteristics
and services used that are expected to require similar resources. Nursing and
therapy weights are applied to the base payment rates of each RUG. Daily base
payment rates are also adjusted to account for geographic differences in labor costs.

Home Health Care Services

Medicare uses a prospective payment system that pays home health agen-
cies a predetermined rate for each 60-day episode of home health care. If
fewer than five visits are delivered during a 60-day episode, the home health
agency is paid per visit, by visit type. Patients who receive five or more visits
are assigned to one of 153 home health resource groups, which are based on
clinical and functional status and service use as measured by the Outcome and
Assessment Information Set (OASIS). The payment rates are adjusted to reflect
local market input prices and special circumstances, such as high-cost outliers.

Critical Access Hospitals

The Balanced Budget Act of 1997 created a new category of hospitals called
critical access hospitals (CAHs), which operate primarily in rural areas. Each of
the approximately 1,300 CAHs is limited to 25 beds, and patients are limited
to a four-day length of stay. The limited size and short length-of-stay require-
ments are designed to encourage CAHs to focus on providing inpatient and
outpatient care for common, less complex conditions while referring more
complex patients to larger, more distant hospitals. Unlike most other acute care
hospitals (which are paid using prospective payment systems), Medicare pays
CAHs on the basis of reported costs. As of this writing, each CAH receives 99
percent of the costs it incurs in providing outpatient, inpatient, laboratory, and
therapy services and post-acute care. The cost of treating Medicare patients is
estimated using cost accounting data from Medicare cost reports. The purpose
of the different reimbursement system for CAHs is to enhance the financial
performance of small rural hospitals and thus reduce hospital closures.

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Hospice Services

Medicare pays hospice providers a daily rate for each day a beneficiary is enrolled
in the hospice program, regardless of the amount of services provided, even on
days when no services are provided. The daily payment rates are intended to
cover costs of providing services included in patients’ care plans. Payments are
made according to a fee schedule for four different categories of care: routine
home care, continuous home care, inpatient respite care, and general inpatient
care. The four categories of care differ by the location and intensity of the
services provided, and the base payments for each category reflect variation
in expected input cost differences.

Ambulance Services

Medicare pays for ambulance services using a dedicated fee schedule, which
has set rates for nine payment categories of ground and air ambulance trans-
port. Historical costs are used as the basis to establish relative values for each
payment category. These relative values are multiplied by a dollar amount
that is standard across all nine categories and then adjusted for geographic
differences. This amount is added to a mileage payment to arrive at the total
ambulance payment amount. Medicare payments for ambulance services may
also be adjusted by one of several add-on payments based on additional geo-
graphic characteristics of the transport.

00_GapenskiReiter (2299).indb 72 11/11/15 11:00 AM

PART

II
FINANCIAL ACCOUNTING

Part I discusses the unique environment that creates the framework for the
practice of healthcare finance. Now, in Part II, we begin the actual coverage
of healthcare finance by discussing financial accounting, which involves the
preparation of a business’s financial statements. These statements are designed
to provide pertinent financial information about an organization both to its
managers and to the public at large.

The coverage of financial accounting extends over several chapters.
Chapter 3 begins the coverage with an introduction to basic financial account-
ing concepts and an explanation of how organizations report financial perfor-
mance, specifically revenues, expenses, and profits. Then, in Chapter 4, the
discussion is extended to the reporting of financial status, which includes an
organization’s assets, liabilities, and equity. In addition, Chapter 4 covers the
way in which organizations report cash flows. Finally, note that Chapter 17 is
related to financial accounting in that it also discusses financial statements, but
the focus is on how interested parties use financial statement data to assess the
financial condition of an organization. That material has purposely been placed
at the end of the book because the nuances of financial statement analysis can
be better understood after learning more about the financial workings of a
business. Part II and Chapter 17, taken together, will provide readers with a
basic understanding of how financial statements are created and used to make
judgments regarding the operational status and financial condition of health
services organizations.

00_GapenskiReiter (2299).indb 73 11/11/15 11:00 AM

00_GapenskiReiter (2299).indb 74 11/11/15 11:00 AM

CHAPTER

THE INCOME STATEMENT AND STATEMENT
OF CHANGES IN EQUITY

Introduction

Historical Foundations of Financial Accounting

Financial
accounting
The field of
accounting that
focuses on the
measurement and
communication
of the economic
events and status
of an entire
organization.

3
Learning Objectives
After studying this chapter, readers will be able to

• Explain why financial statements are so important both to
managers and to outside parties.

• Describe the standard-setting process under which financial
accounting information is created and reported, as well as the
underlying principles applied.

• Describe the components of the income statement—revenues,
expenses, and profitability—and the relationships within and
among these components.

• Explain the differences between operating income and net income,
and between net income and cash flow.

• Describe the format and use of the statement of changes in equity.

00_GapenskiReiter (2299).indb 75 11/11/15 11:00 AM

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