Despite a shortfall in patient-care revenue for the past 25 years, hospitals turned a profit thanks to investments and other revenue

By Joe Carlson | August 2, 2010

Imagine sneaking a peek at the financial ledgers of your local mechanic and finding out that in the past two decades he had never in any year earned enough money fixing cars to pay the expenses of his repair shop.

Yet on his balance sheet you see he’s turned a healthy profit in every single one of those years. And all around you sits a gleaming new garage with wide repair bays and flat-screen TVs in the waiting room.

Wouldn’t you wonder exactly what this guy is up to?

This is how the world of hospital finance appears to many observers. It’s a paradox that surprises not only outside observers, but also longtime hospital officials themselves. An in-depth Modern Healthcare analysis of statistics published annually by the American Hospital Association finds that in the 25 years since hospital bed counts started declining, the hospital industry as a whole has never earned enough revenue from patients to cover costs.

Yet in that same time hospitals turned an overall profit each year, with net profit margins ranging from nearly 7% in the good years to almost 3% in the lean years, including the deeply recessionary 2008.

Observers within and outside hospitals say there’s only one way that the industry can function without turning a profit from its core business of patient care: non-operating revenue sources. Chiefly, that means investments.

Not-for-profit hospitals, which constitute about four in five hospitals in the AHA survey data, have quietly amassed large portfolios on Wall Street as the philanthropy they once depended on has given way to investments that produced unprecedented fortunes during the 2000s.

Hospital financial officers say that it’s just good business, and that this non-operating funding benefits patients by underwriting uncompensated care and unprofitable services. Revenues from patient care do not cover the expenses of the organization, and that has been consistent, said Caroline Steinberg, vice president for trends analysis at the AHA.

Some healthcare economists, however, say there’s a danger inherent in the disconnect between patient care and hospital finances. Skeptics say that using investment proceeds to balance budgets could hurt patients by driving up systemwide costs to unsustainable levels at a time when even ordinary healthcare costs are too expensive for the average middle-class family.

Basically, the endowment revenue is providing an excuse, so to speak, for not engaging in the difficult cost-cutting that would otherwise be required, said University of Florida at Gainesville professor Louis Gapenski, whose textbook, Healthcare Finance. is in its fourth edition. I’ve always been a firm believer that the best way to ensure long-term financial sustainability is by demonstrating economic viability of your core service.

After 25 years of efficiency movements, the AHA data show that the disconnect between profits and revenue has only grown, as losses on patient care have seemingly little effect on whether the industry records net revenue in excess of expenses.

The ramifications of the unsustainability issue are underscored by the unwelcome reality that within two years the federal treasury will become the source of more than half of all dollars going to the healthcare industry, which, for the most part, does not publish its prices but accounts for nearly one-sixth of all spending in the richest country in the world. Hospitals have long accounted for about one-third of all healthcare spending.

Bill Leaver has watched American healthcare evolve since he began his career running a 25-bed hospital in 1977, and he acknowledged that running a business whose operations are subsidized by investment returns can be a tricky proposition.

Leavertoday president and CEO of Iowa Health System, which owns and manages 23 hospitals across the statesaid hospitals have been forced to find alternate revenue sources over the years to adapt to market demands.

In addition to the perennial patient-care revenue shortfalls, hospitals have had to maintain large pools of cash and investments to support borrowing even larger sums to pay for the elaborate hospital buildings and ever-more sophisticated medical equipment that consumers demand. Other experts also noted that pension and reinsurance funds can add significantly to a hospital or system’s portfolios.

Increasingly, Leaver said, the internal financial architecture of healthcare providers has become a hodgepodge of revenue sources that can easily deflect hospital leaders’ thinking away from communities they are supposed to be serving if they are not careful.

If you become too dependent on investment income, as the market zigs and zags, you are more vulnerable, Leaver said. I think it definitely makes it more challenging from a leadership perspective.

That challenge shows in the audited financials of some of the larger systems, some of which have investor relations sections on their websites. At New York-Presbyterian Hospital, officials recorded a $93 million profit from investments, which accounted for more than half of the provider’s $175 million excess of revenue over expenses in calendar year 2009. But in the prior year, the system lost $92 million on its investments, turning only $12 million in profit on $2.9 billion in revenue.

New York-Presbyterian officials have tried in recent years to move away from subsidizing operations with investment earnings, a system spokeswoman said.

At Catholic Health Initiatives in Denver, where officials recently reclassified investment income as a separate line item on its operating revenue balance sheet, heavy investment losses of $709 million accounted for the lion’s share of the system’s $508 million loss in the fiscal year ended June 30, 2009.

Investment performance placed a significant strain on available capital spending; however, this highlighted the need to drive better operating performance to become less dependent on investment earnings to support both operating and capital investment activities, CHI officials wrote in their audited financial statements. In a written statement, CHI said those losses stemmed from the recession and that its investment portfolio performance has improved over the past year. The improvement should be reflected in its financial statements for fiscal 2010, according to the CHI statement.

It’s not that hospitals don’t make any profits from their operations. Income from running cafeterias, gift shops, parking lots and other regular operations that don’t fluctuate like investments do have led the industry to turn a 3% operating profit in the past 17 years. But as a subset of operating income, patient revenue doesn’t pay the bills, the statistics show.

The good Samaritan?

Once upon a time hospitals set up shop in communities to take care of unhealthy people. They received exemptions from nearly all taxes and even charitable donations from community benefactors to support vital operations such as providing emergency care regardless of ability to pay.

While this image of the good Samaritan still arguably holds sway in the public eye today, it smacks headlong into the business realities that came to pass 25 years ago and remain in effect.

Think hospitals stay open to serve the sick and poor? Consider the case of St. Vincent’s Hospital-Manhattan in New York. Last spring the 511-bed hospital closed its doors after 161 years when none of the surrounding health systems would agree to buy the struggling Catholic facility, which had $1 billion in liabilities on its books and an emergency room case mix that included 47% Medicaid recipients.

Despite their image as charitable organizations, hospitals have been closing at a rate of 30 a year since 1983, many in rural and inner-city areas, while those that remain have joined up with larger corporate systems, maximizing their profits.

The AHA data show that modern hospitals have posted an average net profit margin of 4.9% over the past 25 years, placing them below resorts and casinos (7.8%) and above grocery stores (0.9%) in terms of profitability, based on the most recent industrywide figures from 2006.

Administrators don’t typically use terms such as profit in public since most hospitals are tax-exempt and therefore forbidden by law to pay dividends. But hospitals in California earn more revenue than Hollywood, and the largest private employer in New York City is New York-Presbyterian Hospital.

Experts say the factors that led to the changeover from social service organizations to large businesses can be traced to 1983, the year when economic forces that drove an uninterrupted expansion of bed count in U.S. hospitals since World War II were finally overcome by mandates for efficiency, causing the number of beds to peak at just over 1 million before starting a 25-year descent.

The sky has been falling for 25 years, said Glenn Melnick, a healthcare economist at the University of Southern California and a consultant for California-based think tank RAND Corp.

Two developments in 1983 are widely cited for putting hospitals in the fiscally defensive posture that they still occupy today, and both changes were spurred on by the severe double-dip recessions of 1981 and 1982.

Amid the extreme economic stress of the recessions, U.S. employers began to take a hard look at one of healthcare’s most expensive line items, inpatient hospital care, with an eye toward reducing it by managing the care being authorized by insurers. The number of inpatient admissions actually peaked in the U.S. in 1981, the AHA data show.

The federal government, meanwhile, took steps to stabilize its Medicare costs in the wake of the recession by kicking off the prospective payment revolution, standardizing how hospitals’ largest single payer would reimburse them for care. Under the new system, Medicare no longer paid hospitals’ allowable charges that varied widely among hospitals, but rather switched to standardized payments based on DRGs of patients.

In the decade that preceded DRGs and managed care, hospital revenue grew by 15% a year. In the 25 years afterward, hospitals’ total revenue grew by 7% annually on average.

Hospitals closed 1% of their beds each year since 1983, even though the U.S. population grew by 30% in that time.

A second wave of financial stressors hit in the 1990s, with the advent of commercial managed careHMOs and PPOsalong with federal efforts to reduce Medicare payments in the Balanced Budget Act of 1997.

Hospitals again adapted. A wave of corporate consolidation created larger health systemsand far larger pools of assets and investments to managein the process, consolidating hospitals’ market presence and building clout in price negotiations with commercial insurers.

Ascension Health, the nation’s largest nonfederal not-for-profit health system by patient revenue, last year hired its first chief investment officer, who manages the 77-hospital system’s investments, which included $5.4 billion in daily and weekly liquidity and another $2 billion in longer-term investments as of April.

Healthcare organizations as a rule have been slow to adopt some of the more proven creative financing techniques available today, Ascension President and CEO Anthony Tersigni said in a news release announcing the investment chief job. Our intention is to take advantage of all the opportunities available to us in a responsible, thoughtful way in order to help us achieve our mission.

Melnick, the USC professor, said reliance on investments to subsidize operations can drive up hospital pricing, especially after recessions. It tends to contribute to price inflation, he said. If I spend more this year because I can afford it, and everyone else does the same to compete with me, then next year when I go into negotiations that price basis will factor into negotiations.

Robert Zirkelbach, spokesman for America’s Health Insurance Plans, said some of the commercial insurers that are members of the association have been reporting price increases of as much as 40% or 50% in some parts of the country recently.

A January article in Health Affairs concluded that price increases, not increased utilization, tend to account for most of the growth in healthcare spending after major recessions. This finding indicates that relatively severe recessions may have more immediate and profound impacts on healthcare spending growth, the article’s authors wrote.

Although the 4.3% growth in health spending by individual households in 2008 was lower than in prior years, the article also noted that wages grew only 2.7% on average that year. Despite the overall slowdown in national health spending growth, increases continue to outpace growth in the resources available to pay for it, the authors wrote.

The invisible counterweight

Hospitals’ investment holdings are often virtually invisible to the external world.

Neither the AHA nor the Healthcare Financial Management Association keeps even a rough tally of the total amount of cash and investment assets held by hospitals, leaving observers to extrapolate from known data.

For instance, if the 367 hospitals in California were representative of the nation, then, based on data reported to state officials there, U.S. hospitals might hold $875 billion in total assets, which include investments, cash, real estate and equipment. Or using the figures for 2,229 hospitals reported as part of the annual Modern Healthcare Hospital Systems Survey for 2009 (June 7, p. 18), U.S. hospitals would be holding about $950 billion in total assets.

Whatever the figure, observers say there’s no denying healthcare’s reliance on investment income, which acts like a counterweight hidden inside an old window frame, helping the user lift a burden that appears lighter than it actually is.

Randy Fuller, the director of thought leadership at the HFMA, is among the people who do not believe that hospitals’ reliance on investments to make up for patient-revenue shortfalls is a good thing. We recognize that the cost trend is simply not sustainable for the long term in this, he said.

But taking away investment income to force hospitals to make the tough decisions they don’t have to is also not the answer, he said: I’m not sure I buy into the theory that the more fiscal distress you put the industry in, the better off you’re going to be. That’s a little like the old concept of twisting the dragon’s tail. I would rather see it done in a more thoughtful way.

Almost invariably, industry insiders say one major component of that solution is to increase Medicare and Medicaid payments, which cover only 85% or less of the actual cost of care provided to the government insurance patients.

The AHA data show, however, that hospitals were not turning a profit on patient care long before the Balanced Budget Act of 1997 slashed federal reimbursements to where they are today, although the years after the law did see far higher shortfalls on patient revenue.

The hospital executives who agreed to interviews said they were surprised by the AHA figures on the patient-revenue shortfall because they seemed to not portray the industry that they understand from the inside. (AHA and HFMA officials both confirmed the findings.)

Kyle DeFur, president of Ascension’s largest acute-care facility, 772-bed St. Vincent Indianapolis Hospital, said that in the long run a hospital leadership team ought to focus on operating marginsnot net margins, which include investment incomeif they want to run a hospital sustainably.

To remain sustainable, a hospital should typically shoot for an operating margin of 4% to 6%, DeFur said.

As an industry, hospitals during the past 17 years have recorded an average operating margin of 3.4%, the AHA statistics show (all 25 years of data were not published for that statistic).

If a health system or a hospital was focused on net income as opposed to operating income, I think that is dangerous, because that fluctuates up and down, DeFur said. The reality is the financial health of a hospital is determined by its operating income, and so that’s what we focus on. We spend very little time talking about net income, because that’s not something you can control.