It's that time of the year again. The hospital industry is screaming that it can't make ends meet and needs higher reimbursement. The government and private insurance payers insist hospitals' comfy profit margins show there's plenty of fat yet to trim.
Heard it all before?
Then hear this: Hospital operating margins dropped 45% in the fourth quarter of 1998 compared with 1997, according to HBS International, a healthcare outcomes management company. It's the largest decline in profitability since HBSI started collecting data in 1993.
Analysts at two other healthcare data companies, HCIA and the Center for Healthcare Industry Performance Studies, confirm this finding, and add that very preliminary results from the first quarter of 1999 show earnings trending farther downhill. Consultants in the field say profitability is declining more sharply than many people realize.
However, an analysis of industrywide financial ratios reveals that the "average" hospital may be less and less representative of the whole.
Instead, a chasm is widening around the median. In recent years the top-performing hospitals have gotten stronger and stronger, while the worst-performers have dropped further and further (See top chart, p. 35). This is a change from the early 1990s, when their performance moved up and down in roughly parallel motion.
"While the financial health of the hospital industry as a whole is excellent at the present time, there are sectors of the industry in which current financial performance is weak, a situation which may signal future closures," ominously notes the 1998-99 Almanac of Hospital Financial and Operating Indicators, published by Columbus, Ohio-based CHIPS.
This conclusion, by center President William Cleverley, starts from the observation that, based on 1997 results, the financial position of the hospital industry as a whole has never been stronger.
In general, economic value added, or EVA, was still increasing strongly in 1997, and hospitals were covering their cost of capital (See chart, p. 36). Hospitals were reducing capital expenditures on property, plant and equipment and adding liquidity.
Yet return on investment has remained flat, indicating that hospitals are not reaping higher profits on the capital expenditures they make. And CHIPS' financial flexibility index, a measure of an organization's ability to control the flow of funds, although improving overall, shows increasing divergence between strong and weak hospitals based on 1997 data. Preliminary 1998 data show the average for the whole industry is declining.
Measuring performance. CHIPS analyzed its database of confidential audited hospital financial returns and defined low-performing and high-performing hospitals according to return on investment and the financial flexibility index. Given a median value for ROI of 10.1%, CHIPS found the bottom quarter of hospitals had ROI values of 7.6% or less, and designated them "low performers." The top quarter had ROI values of 12.6% or more, and were dubbed "high performers."
High performers are hospitals "that appear to do virtually everything right," Cleverley says. Investment in plant and equipment is reasonable, and their robust cash balances yield investment income to beef up the bottom line. These institutions code more aggressively. And they charge premium prices in those few places where they can.
Most important, they are able to control costs across the board. Their lengths of stay, care protocols, use of ancillary services and labor productivity are all better than average.
Low-performance hospitals are just the opposite, and they contend with one extra factor: They may operate in an environment where it's hard to support quality patient care with the revenues available to them.
Cleverley argues that the industry's focus on bottom-line profit or margin has been "myopic."
"The critical issue is the amount of profit earned in relation to the investment employed in the business," he writes. This will affect the future ability of hospitals to meet capital requirements.
Meanwhile, hospitals are aging and will need to replace facilities and equipment. The rise in the age of the physical plant is especially noticeable for the 25% of the hospital industry designated as low performers. To continue to compete, they'll need to renovate and replace items. The critical questions become which hospitals will replace which facilities, and which hospitals, lacking the capital to keep up, will be forced to close?
The squeeze is on. The driver in the coming crunch, healthcare consultants and hospital advocates agree, is the Balanced Budget Act of 1997.
The budget law will have a sizable impact, Cleverley says. If hospitals do not quickly cut their costs to match the decrease in reimbursements resulting from the law, their profitability will take an immediate hit. Those hospitals that are already low performers could be pushed over the edge, he says.
The balanced-budget law went into effect Oct. 1, 1997. Hospitals whose fiscal year ended Sept. 30 or Dec. 31, 1998, will show the full effects of the law on their 1998 Medicare cost reports. For others, the effect will be partially masked.
"Hospitals have to adapt," says Greg Bennett, president of HBSI, based in Bellevue, Wash. They're going to have to change their operating styles, and fast, to make their margins. "If you restrict operating margins of hospitals in general, you restrict their ability in the long term to replace plant, create programs and serve their communities. Most of them have short-term reserves. It's the long run we worry about. Capital formation is the issue here."
Low-performance hospitals lack the cash and investments to finance the kinds of improvements they need to keep up with the star performers.
Most at risk in this new environment are smaller urban hospitals with aging plants, thin margins, paltry cash reserves and existing debt. Without significant turnarounds in the near future, Cleverley notes, they will have to close or merge with stronger neighbors.
Rural hospitals, too, are at risk, but if the hospital is clearly necessary to its community, a mechanism will be found to save it, Cleverley says.
The marginal provider in an overbedded big-city market has no such essential public purpose.
"I would not want to be CEO of a small urban hospital," says Steve Hatch, a consultant with Arista Associates, a healthcare consulting firm in Northbrook, Ill.
Often they're not viewed in the larger community as among the premium providers, which makes them even more vulnerable.
Payers, including the government, "would love to see these hospitals go away," Hatch says. Yet the large, prosperous urban hospitals want to keep them around, "lest the very patient base that's so debilitating to the small hospital get foisted onto the large hospital."
Jay Williams, another Arista consultant and former hospital chief executive officer, points out that small urban hospitals have been squeezed not just by their own internal difficulties but by the growing competitiveness of the name-brand major medical centers. "You see them building outreach facilities, bringing on physician practices and moving out in the communities," he says.
The smaller community hospitals have been relying on their network of primary-care physicians all along and have never offered more complex services. But as minor surgeries and routine diagnostic admissions move to outpatient settings, the community hospitals' stock in trade is drying up. The big guys are poaching the primary-care physician practices to support their specialists and tertiary offerings.
So you're not going to need as many traditional hospitals, Williams concludes.
A real-life example. Take a drive around Chicago and you start to see how this plays out in real life. The Windy City is one of the most traditional healthcare settings in the U.S., overbedded and happy. In an insurance market dominated by PPO products, Chicago's HMOs haven't been able to strong-arm hospitals into granting ruinous discounts. Rambling red-brick facilities of 100 to 250 beds dot the city's neighborhoods.
A handful of major medical centers get most of the publicity and the philanthropy. Foremost among them at the moment is Northwestern Memorial Hospital, a shining example of the best practices that Cleverley is talking about.
Northwestern offers the highest levels of tertiary and quaternary care with a Medicare case-mix index of 1.69. Plus it confers all the amenities of a lakefront location in a luxury shopping district. Its medical staff is drawn from the faculty of Northwestern University Medical School.
It was licensed for 622 beds in 1997. Of patient days at the hospital, 36% are Medicare patients and 16% are Medicaid.
And its financial statements gleam like the bracelets in Tiffany's windows across Michigan Avenue. The hospital is so rich that in the fiscal year ended Aug. 31, 1997, its investment income of $56 million topped its operating income of $51 million, on net patient revenues of $415 million. The hospital's net assets that year rose $178 million, to $946 million, according to a CHIPS profile of its Medicare cost reports. It discharged 26,578 patients that year and had 829 days' cash on hand. Its total margin was 21.6%.
Flush with cash and every other good thing, Northwestern built itself a new hospital. Opened last month, the $580 million, 448-bed edifice offers near breathtaking splendors.
About eight miles to the west, at the opposite extreme, is Loretto Hospital, adjacent to the Eisenhower Expressway on the city's rough and tumble West Side. A stand-alone community hospital in a minority neighborhood, Loretto has 184 beds and an unremarkable range of services. It does no transplants, no open-heart procedures, no burn treatments, no obstetrics, no rehabilitation and no therapeutic radiation. All of these would be profit centers in a larger hospital. Loretto's Medicare case-mix index is 1.31.
Loretto discharged 3,026 patients in the year ended June 30, 1997, according to the most recent Medicare cost report CHIPS has on file. Medicare patients accounted for 54% of patient days, Medicaid for 33%. Thus, the hospital is extremely vulnerable to the federal government's decreases in Medicare reimbursements and to the state of Illinois' recent introduction of Medicaid managed care.
Loretto had operating income of $63,196 that year on net patient revenues of $32.4 million. In 1996 it lost $1.6 million, and in 1995 it made just $563,000. It reported no investment income or nonoperating revenues. It had 56 days' cash on hand.
Loretto had net assets of negative $4.9 million, a highly unusual situation deriving from its total liabilities of $19 million and total assets of $14.1 million. It's been living in negative balance territory for at least three years. However, with the external financial hits now buffeting the hospital, it's questionable how long Loretto can survive at a total margin of 0.2%.
"Without external equity support, they're in a difficult situation," Cleverley says.
On the critical list. If the gap between low performers like Loretto and high performers like Northwestern continues to widen, what will happen to the hospital industry?
Unless the low performers turn around fast, "they will go out of business," Cleverley says. "No question about that."
As these hospitals are unable to finance upgrades in equipment and their physical plant, physicians will gradually stop referring to them, and patients will drift away.
Would that be a bad thing if they closed?
Not necessarily, analysts say. There's so much excess capacity, especially in urban areas, that a failure here and there won't jeopardize access to care. The redistribution of patients to nearby hospitals would have a beneficial effect on surviving providers, by increasing their revenues substantially with only a marginal increase in costs. The surviving hospitals won't have to spend as much to treat those patients as the failing hospital does.
The hospitals to watch, Cleverley says, are those with razor-thin cash and investment balances and heavy debt loads. As their profitability declines, they'll be unable to service the debt. They'll either run into the arms of a white knight, or fail.
However, the market in white knights is also drying up. Andy Ward, national partner in charge of healthcare regulatory services for the New York office of PricewaterhouseCoopers, says strong providers are no longer willing to merge with their weaker brethren. They have their own profitability issues to worry about, plus the impact of the balanced-budget law. For that reason, Ward expects the number of hospital closures to rise this year.
Cleverley thinks a more likely scenario is a "regression to the mean." Organizations tend to self-correct over time. The big, rich hospitals will grow lackadaisical, and their performance will decline. Meanwhile, some small struggling hospitals will get their acts together and somehow boost profits.
That said, "I do think you will see an increase in the number of hospitals that file for bankruptcy within a couple of years," Cleverley adds.
But don't forget that the ultimate determinant of hospital success or failure lies with management, Cleverley says. "You can make a bad situation a whole lot better, and maintain a superior position if you pay attention to the basics."
An analysis by Baltimore-based HCIA squares with Cleverley's prediction. Kenneth Sypal, a HCIA senior analyst, looked at recent operating results of non-elite hospitals in Chicago at MODERN HEALTHCARE's request. Taken as a whole, the 16 community hospitals of fewer than 250 beds "are not getting crushed relative to the nation," Sypal finds. "They're kind of flat, a slight downward trend from 1995 to 1998."
In 1998, however, Northwestern Memorial started to see its profitability decline, Sypal reports, to $2,693 net income per adjusted staffed bed from $2,820 in 1997. For the 16 community hospitals, net income per bed rose, to $295 per bed from $270 per bed in the previous year. Their cash-flow margins, though, decreased in percentage terms. (The 1998 cost reports are not yet publicly available.)
Yet there's a danger in taking 1997 and 1998 financial results as guides to the present, Ward says. The financial condition of hospitals is deteriorating so rapidly that "there may be some surprises for people" in the current fiscal year. It's not just the balanced-budget law but increases in receivables and rising denials from insurers that are hitting hospital bottom lines.
If Congress is relying on data from 1997 to make decisions on Medicare reimbursements during the next five years, it may be getting a false reading, he says.
Ward suggests that the widening gulf between the haves and have-nots is already an outdated concept. Financial returns from the second half of 1998 and the beginning of 1999 show declining profits for everybody, so the gap is not widening but narrowing.
Jordan Melick, a hospital credit analyst with Fitch IBCA in New York, says the declines in operating results are attributable not just to downward pressure from Medicare and managed-care payers. Hospital-owned physicians practices are continuing to generate much larger losses than predicted. And bad-debt expenses are rising, in some cases because of changes in state programs, he says.
Ward also reminds hospital financial managers that the smallest reductions in Medicare payments occurred in the first year of the balanced-budget law. The subtractions increase in each of the succeeding four years of the act.
But there's still another reason nobody should count out the marginal low performers just yet, says Jean Chenoweth, a vice president at HCIA: "Hospitals have been known to survive forever on virtually nothing."