and the Secretary of HEW which certifies that this would not cost the Federal Government more than it would otherwise have paid under present law. Does that sound fair to you?

Mr. MCMAHON. Mr. Chairman, I would suggest a couple of modifications to that suggestion. First, when you made reference to the fact that medicare and medicaid might pay where all or a majority of the patients are covered by a rate review program, we have set out in our testimony-I think it is at page 15-some comments by Mr. Elmer Smith, an associate commissioner of Social Security, and Dr. Alice Rivlin that suggests that these rate review programs ought to cover all third parties.

Now as far as the second part of your question goes, the difficulty with having anybody certify that the payment being made would be no more than what would be paid under existing medicare and medicaid is that, Mr. Chairman, once you put into place a State rate review program, clearly it is going to have its impact on the reduction of cost. One that takes place there no one can say that medicare or medicaid is not in a position to be paying less than what would be the case if that kind of process were not in place.

Therefore, we think the basic thing the committee should recognize is that once a State rate review program is put in place, then the mechanics of cost reduction or cost effectiveness, the attention of the hospital on the reduction of cost is already underway. Therefore, it would seem to us that at that time medicare and medicaid have been thoroughly protected because the decision is being made just as you heard from the Governors and the counties. The decision has been made to reduce the rate of increase in costs and medicare and medicaid will have the benefit of those activities.

Senator TALMADGE. Senator Dole.

Senator DOLE. Mr. McMahon, what measures has the Association taken to improve the surplus bed problem in rural hospitals, where we have much of the facility remaining empty while overhead continues to mount. And with reference to that, do you think we might be able to utilize some of those beds for long-term care patients?

Mr. MCMAHON. Senator, we have given our attention to that in a number of ways. We think, and my statement indicates, two things that the committee is looking at that make good sense, one of which is the opportunity to utilize some of those beds for long-term care.

In addition, we have given specific attention over on the next to the last page of the statement to S. 3661 introduced by Senator Laxalt and others. The provision that we understand the subcommittee is locking at, sometimes called the swing bed proposal, would encourage rural hospitals particularly to utilize unused beds for long-term care. In addition, we are looking at other ways to provide for the conversion of facilities not only to long-term care but to other kinds of activities and working on ways to advise hospitals of what help is available for that kind of conversion. It is really a use of the existing facilities in some alternative way that we think will provide a very useful approach to the problem.

Clearly in time, Senator Dole, and the reason why we are reluctant particularly in the rural areas to encourage closure is that population shifts are taking place and as the population grows across the country

Mr. Chairman, on pages 5 and 6 we have touched on several current proposals to limit hospital reimbursement like the administration's 7-percent limit on increases and the budget resolution's reduction in the medicare and medicaid budget of $100 million. I would say we appreciate your efforts, Mr. Chairman, and those of Senator Long to restore those reductions during consideration of the budget resolution and we believe the bill that is the subject of these hearings offers better and fairer approach to the problem.

Now, Mr. Chairman, let me address, if I may, section 10, perhaps the single most important section to hospitals, and I am going to read a paragraph at the bottom of page 6 of the full statement.

Section 10 of your bill proposes significant changes in the Federal reimbursement mechanisms for hospitals, and we have carefully studied these changes. We believe them to be a significant improvement over the existing methodology of section 223 of Public Law 92603, which section 10 is intended to replace. Any system to classify institutions for the purpose of reimbursement on a comparative basis has its difficulties, and we certainly applaud your proposal to remove from the comparison procedure for routine per diem hospital costs a number of elements which are beyond the control of institutions. Clearly, any classification system should be sufficiently sophisticated to separate efficient from inefficient institutions, and our suggestions for modifications of section 10 are designed to protect the efficient ones while motivating the others to increase their effectiveness. We offer the following suggestions which have been set forth in detail on pages 7 to 12 which we believe are necessary to make your proposed incentive system more effective, equitable, and workable, assuring you that we stand ready to participate in further refinements toward the ends that both your committee and we seek.

I will be glad to answer any questions about the specifices in time. but let me only say we think the phasein principle is most important. We hope the exception process could be broadened and we hope the bill can be amended to assure adequate payment for medicaid services.

I would like now to turn, Mr. Chairman and Senator Dole, to page 12. We have an additional, and major, change to offer to section 10. We urge that section 10 be amended to provide that where a State rate review program has been established, either by statute as in Maryland and Connecticut, or voluntarily as in Indiana, which applies to all purchasers of care other than medicare and medicaid, and which is designed to meet the full financial requirements of the hospitals covered by the program, then medicare and medicaid should be required to pay the rates so established.

I have noted at the top of page 13, Mr. Chairman, our reasons for urging this amendment. We believe they are quite simple. If State rate review programs cover all patients but medicare and medicaid beneficiaries, and the latter pay according to a different formula, it is very likely that some hospital costs will not be met. Moreover, the application of two sets of formulas to two sets of patients may well result in one set of patients subsidizing the care of the other, contrary to the long established principle of Public Law 89-97, which set up medicare and medicaid, which specifically prohibits such subsidization.

Mr. Chairman, that kind of an amendment will not operate as an open door to the Federal Treasury. As a matter of fact, the record of the State rate review programs we are describing is one of moderation of rates of increase in health care costs. We have set forth data on pages 13 to 15 in support of this point. In summary, Mr. Chairman, we believe that this proposed amendment will provide equitable treatment for all third-party payers which will avoid subsidization and will at the same time be effective in moderating increases in hospital costs. We recognize there are details of the amendment to work out and we welcome the opportunity to purchase these details with your committee staff.

Mr. Chairman, on pages 15 to 17 we made comments on sections 2, 4. 6, 7, and 8. Generally our comments are very supportive of your efforts to improve these programs.

If I may direct your attention now to the middle of page 18, I would like to say a word or two about section 12 which would increase the rate of return on net equity allowed for purposes of Federal reimbursement to investor-owned hospitals to twice the average return on the social security trust fund. We support this provision on the principle that a suitable return on investment is necessary to insure that investors will continue to advance capital for investor-owned facilities. In addition, we recommend an adequate margin of revenues over expenses for not-for-profit institutions.

We are now developing the specifics for an adequate margin and will provide these to your committee in the near future. The margin is absolutely necessary to provide working capital, the equity base for future capital expenditures and the undergirding of the risk inherent in prospective payment mechanisms. The advantage of this approach to all third-party payors, including medicare and medicaid, lies in the reduction of interest charges on money which otherwise would be borrowed at high interest rates to meet these requirements and contingencies.

Now, Mr. Chairman, I am going to summarize the comments on section 22 which we have on page 19 of our statement and I want to say that this gives us much concern. We understand the problem, but we believe it suggests the wrong solution. The section as it stands provides that hospital associated physicians would generally be paid on a feefor-service basis for personally performed patient care services. In addition, executive, educational, and administrative functions of these physicians would be paid for in amounts equivalent to salaries customarily paid to similarly competent physicians for such services. We oppose this approach because it would interfere with the management prerogatives of hospital administrators and governing boards. We understand that your committee has identified instances where payments to hospital associated physicians are out of line with payments to other physicians. We have tried to determine a way to deal with the problem, but have not yet been able to find a solution. We know, for example, that percentage arrangements generally provide fair compensation but we do not know how to compare these arrangements with salary arrangements, with fee for service arrangements, or with lease arrangements.

desire of the Congress to permit those developing regulations to have some flexibility in implementing this amendment; however, in recruiting and negotiating with the medical staff, the hospital chief executive officer and/or medical school dean must be able to determine the amount of compensation that Medicare and Medicaid will recognize. Therefore, the Association requests that Congress either modify the proposed amendment to incorporate some specific guidelines for regulations or so specify its intent in hearings and Congressional Reports that those preparing the regulations have a clear and consistent direction for determining a reasonable salary for physicians in employment situations.

Percentage contracts

MISCELLANEOUS REFORMS

Section 20, as the Association understands it, is designed, in part, to eliminate as reasonable charges Medicare and Medicaid recognition of expenses for services or facilities which are determined as a percentage of health service revenues. However, our discussions with many groups of individuals have indicated that there are varying interpretations for this subsection. Therefore, the Association requests that the Subcommittee clearly state the objective of this subsection in its report on this legislation.

Overhead cost controls

Section 40 will require the Secretary to establish regulations for determining the reasonable cost or charges of direct and indirect overhead expenses. This approach is one means of controlling costs; however, it seems to be in direct conflict with the philosophy and purpose underlying the cost ceilings imposed in Section 10. The direct and indirect overhead expense controls specified in this subsection are based on itemizing and controlling individual, rather than aggregate, expenses. The Association believes that simultaneous controls of individual overhead expenses and aggregate cost ceilings places management in an untenable position. To provide efficient and effective services within the cost ceilings, the hospital director needs the administrative flexibility which the overhead controls would diminish. In its consideration of changes, the Assocation strongly recommends that the Subcommittee adopt exclusively a cost control philosophy of cost ceilings rather than a philosophy of both ceiling and line-item controls.

Contract approval

This provision directs the Secretary to establish a program for review and advance approval of "consulting, management, and service contracts" with an annual cost of $10,000 or more. The Association believes this subsection contains several deficiencies. First, as with the overhead controls program, this contract approval amendment is an individual service control rather than an aggregate ceiling control. Once again, the hospital director must try to live within a ceiling at the same time his operational flexibility to do so is reduced. Second, by requiring advance approval of virtually all types of hospital contracts, this amendment shifts operational management authority from the hospital director to the HEW staff. The hospital director and governing board could propose and implement but not decide on courses of action. In effect, DHEW will be managing by contract review significant aspects of the nation's hospitals. Third, by requiring all contracts with an annual payment of $10,000 or more to be approved, the amendment guarantees that DHEW will have to undertake a significant bureaucratic expansion. This $10,000 threshold is so low that the number of contracts requiring approval will be significant. Bureaucracy will mushroom and the resultant costs will be an additional burden on the nation's health expenditures. Fourth, the legislation requires a procedure to determine if the services may appropriately be furnished by contract. Even if government authorities could judge the reasonableness of a contract price and could evaluate the contractor's likely ability to perform the services, the governing board of the institution should retain the right to determine whether it wants a function performed by "in-house" or contract personnel.

If this segment of the proposed Section 40 is intended to ensure that Medicare and Medicaid do not subsidize contracts of questionable value or contracts undertaken with nearly fraudulent intentions, the present provisions do not discriminate between those contracts likely to be undesirable and those which are characteristic of routine hospital operations. Therefore, the Association recommends that this section be re-written to direct the Secretary to control

only those irregular, nearly fraudulent and self-dealing contracts which may be sources of abuse.

Conclusion

In conclusion, the Association expresses its appreciation to the Committee for this opportunity to testify on S. 3205. The Association shares the Committee's objective of improving the Medicare and Medicaid programs, and the Association has offered this testimony on the legislation as a sincere effort to refine and improve the proposed amendments.

Senator TALMADGE. Our next witness is Mr. John Alexander McMahon, president, American Hospital Association, accompanied by Leo J. Gehrig, M.D., senior vice president.

Without objection, your entire statement will be inserted in the record and you may summarize.

STATEMENT OF JOHN

ALEXANDER MCMAHON, PRESIDENT, AMERICAN HOSPITAL ASSOCIATION, ACCOMPANIED BY LEO J. GEHRIG, M.D., SENIOR VICE PRESIDENT

Mr. MCMAHON. Thank you, Mr. Chairman. We will be very brief. Mr. Chairman, as your introduction indicated, I am John Alexander McMahon, president of the American Hospital Association, representing more than 7,000 member institutions and 21,000 personal members.

As you indicated, Dr. Leo Gehrig, senior vice president of the Washington office, is here along with Allen J. Manzano, vice president of the association, on my right and Mr. Irwin Wolkstein, associate director of the Washington office, on my far left.

We appreciate the opportunity to present our views and recommendations and appreciate the inclusion of the entire statement in the record.

Your bill, Mr. Chairman, identifies and addresses a number of important areas, many of which provide for positive reform in the administration of medicare and medicaid. We also appreciate your understanding of the shortcomings of simplistic solutions-like arbritrary caps that have been suggested by others. The full statement indicates that there are certain sections of the bill which we support as they stand. In other areas, while we support the intent, we think that certain changes would be helpful. We have made in our full statement a number of constructive suggestions in response to your invitation for refinement and modification.

Mr. Chairman, on pages 2 to 5 of our full statement we have offered an explanation for the factors in rising health costs, including inflation, the difference in the hospitals' market basket, the effect of malpractice insurance premiums, increases in costs of food and energy in hospitals and the growing population and expanding benefits of the medicaid and medicare programs along with the statutory and regulatory requirements which often add to costs without raising benefits to patients. The statement also indicates that this system is not really out of control, as people suggest, because there are a number of controls Congress has already put in place, like the planning act and like the PSRO's, which this committee had a substantial hand in developing.