STATEMENT OF MICHAEL D. BROMBERG, DIRECTOR, NATIONAL OFFICES, FEDERATION OF AMERICAN HOSPITALS, ACCOMPANIED BY ROBERT J. SAMSEL, PRESIDENT

Mr. BROMBERG. Thank you, Mr. Chairman. Accompanying me is Mr. Samsel, who, in addition to being our president, is vice president of American Medical International, one of the world's largest hospital management companies. Our association represents 1,050 hospitals with over 111,000 beds. In addition, our member hospital management companies now manage under contract over 165 additional hospitals, including teaching institutions, public, religious and other community nonprofit hospitals.

As taxpaying institutions, investor-owned hospitals have been particularly interested in modern professional management of our Nation's health facilities. S. 1470 recognizes the need to amend the medicare and medicaid programs in order to provide economic incentives for effective and efficient management systems in participating hospitals. We commend the subcommittee chairman for his leadership in proposing these meaningful incentives.

When medicare and medicaid were first enacted 11 years ago, and until quite recently, Congress perceived its role to be one of increasing and assuring access for the elderly and the disadvantaged to quality health care. That public policy decision triggered the demand-pull inflation which is a major reason for these hearings.

Since Government has become the largest single purchaser of health care, the marketplace has become increasingly artificial as Government control over both the supply and demand intensifies.

The hospital industry has been hit with severe inflationary pressures for the past 10 years and in particular, following the expiration of the economic stabilization program in early 1974. Those major pressures included catchup wages in a labor-intensive industry; escalation of prices for the goods and services purchased by hospitals, particularly in food, fuel, and malpractice insurance; a rapidly changing medical technology in which new diagnostic and therapeutic techniques and expensive new equipment are centered in the hospital; inflated material costs for hospital modernization and expansion programs; the increased costs of borrowing capital; increased costs of compliance with Government regulations; and the medicare-medicaid retrospective cost reimbursement formula which provides no incentives for efficient management and fails to meet its fair share of the total financial requirements of hospitals, forcing institutions to shift additional costs to private patients.

This combination of demand-pull and cost-push inflation has created a hospital industry with an annual inflation rate well above the national consumer price index.

HEW has identified three major causes for soaring inflation in the hospital sector of the health industry: unrestrained demand, lack of competition among facilities, and the current system of cost reimbursement. However, instead of addressing those underlying causes of inflation, the administration has opted for an arbitrary ceiling on revenues and capital. In its haste to solve within a few months a

budgetary problem which has been snowballing for 12 years, the administration has developed a scheme which exacerbates all that is wrong with the health care payment system.

There are other crucial issues which the administration plan impinges upon. It is a conflict of interest for government, as the major purchaser of health services, to unilaterally determine the price that it will pay for those services. Furthermore, the scheme, as proposed fails to acknowledge a number of unalterable factors which in large part predetermine hospital costs, and therefore, charges.

For example, hospitals have no legal authority to control such physician-directed, and revenue-determining, factors as length of stay, number of services, and the frequency of admissions.

Nor do we seek such control, because it must be left to the physician, under direction from peer and utilization review boards, to make such decisions. However, an arbitrary cap on revenues ignores physician, not hospital, authority in this area.

The revenue cap also fails to recognize that, minus a cap on the cost of supplies and services, hospitals would be forced to absorb such costs, to the detriment of the quality of care delivered. A ceiling on revenues is price controls on a single industry. It amounts to nothing more than a more stringent version of the phase IV hospital price control program rejected by a prior Congress for sound economic, social, and medical reasons which remain valid today.

In contrast with the administration proposal, the medicare-medicaid reimbursement reform bill reintroduced by Senator Talmadge, represents a major step forward in making these programs more cost efficient. It is an innovative, imaginative plan reflecting an examination of both cause and effect as a necessary adjunct to proposed solutions. The measure correctly presupposes that incentive-based competition— not self-defeating caps-is essential to alleviate escalating costs in the health sector.

We have a number of suggestions on pages 7 through 12 for minor amendments to section 2 of the bill. I will just mention one or two of them.

First, we believe that where a ceiling for reimbursement is imposed, a hospital should be allowed to charge the program beneficiary for the difference between the ceiling and actual costs. This is particularly important since the bill prohibits a shifting of those costs to private patients, and the hospital would have to absorb it otherwise. The rise in cost of care should be a matter of shared responsibility to all, and that includes stimulating public awareness through increased out-ofpocket public participation in the cost of care.

Someone has to pay for medicare and medicaid benefits.

Secondly, we would urge the committee to go very slow and exercise caution in delegating to the States the power to set rates for medicare. We believe that more time is needed to evaluate State ratesetting programs and the bill should be amended to provide that only those States that have 2-year experience in ratesetting prior to the enactment of the bill should be allowed a waiver.

In addition, we would urge that new hospitals less than 3 years old be placed in a special category, or made exempt, because of unusually high start-up costs.

On page 13 of our testimony we discuss the issue of rate of return, which is addressed in section 46 of the bill. We urge the committee to provide for a rate of return equal to industries of comparable risk. That, we believe, should be the test, rather than any single number.

A study was contracted for by us with ICF, Inc., a Washingtonbased consulting firm. The study was released this morning. I would like to leave a copy for insertion in the record, with the permission of the chairman.

Senator TALMADGE. Without objection, so ordered.

[The executive summary of the study referred to follows. The balance of the study was made a part of the official files of the committee.]

AN EVALUATION OF MEDICARE RETURN ON EQUITY PAYMENTS TO INVESTOR-OWNED HOSPITALS

Executive Summary

A. PURPOSE

The purpose of this study is to determine the rates of return on equity (ROES) that the Medicare program should pay to investor-owned hospitals (IOHS) for services to Medicare patients. This report is intended to provide an analytical basis for evaluating changes in the present ROE payment formula under Medicare, and for identifying a range of average ROE levels that is appropriate under any type of reimbursement system, including incentive or prospective reimbursement systems.

This analysis assumes that Congress intended for the Medicare program to pay the full reasonable cost of equity capital, and that the cost of equity capital for IOHS is equivalent to the rate of return earned by investors in industries. of comparable risk. The first assumption is based upon the regulations for the Medicare program, which state that:

"the share of the total institutional cost that is borne by the [Medicare] program is related to the care furnished beneficiaries so that no part of their cost would need to be borne by other patients," and

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"an allowance of a reasonable return on equity capital invested and used in the provision of patient care is allowable as an element of the reasonable cost of covered services to beneficiaries by proprietary providers.'

Implicit in this assumption is the fact that certificate-of-need and Section 1122 capital disallowances, not Medicare ROE payments, represent the Congressionally-mandated approach by which unnecessary hospital investments are prevented. This approach is consistent with the need to ensure the availability of capital to maintain existing hospital investments and to make new investments where Health Systems Agencies authorize them. This approach also ensures that non-profit hospitals and investor-owned hospitals are treated evenhandedly, without regard to their tax status.

The second assumption is based upon the principles that have been established in federal rate-setting proceedings conducted by state public utility commissions and regulatory agencies such as the Federal Communications Commission. Theseprinciples, based primarily upon the 1944 Hope Natural Gas case, state that private businesses which employ their assets in service of the public interest should be paid rates of return which:

Protect their financial integrity;

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Reward their investors at a level commensurate with the risks the investors assumed in making their investment; and,

Permit the companies to attract new capital for purposes of maintaining and expanding their operations.

These principles form the basis for determining appropriate rates of return in virtually every regulated industry, and, therefore, appear to be well-suited to the Medicare program.

120 C.F.R., § 405.402(a).

220 C.F.R., § 405.429 (a).

3 Federal Power Commission vs. Hope Natural Gas Company, 320 U.S. 591 (1944).

B. APPROACH

The basic approach was to examine the financial characteristics of the investorowned hospital industry and to compare the riskiness of IOHS with that of other consumer product and service industries. Using this comparison, we identified other industries of similar risk and established a range of appropriate rates of return on equity for IOHS for the years 1969 through 1975. A range was used rather than a single ROE because it is not possible to measure industry risk precisely.

In order to analyze IOH financial characteristics, we first compiled financial data on ten major hospital management companies whose financial statements are filed annually with the Securities and Exchange Commission. Those companies operate about 42 percent of all IOH beds and over 80 percent of the beds owned by hospital management companies. Hence, they represent a major portion of the IOH industry. In addition, although independent IOHs tend to be smaller, they seem to have risk and return characteristics which are similar to the larger hospital management companies in our sample. As a result, we are confident that our findings can be safely applied to investor-owned hospitals in general.

We next compared the financial data on these ten hospital management companies with similar information on 24 major consumer product and service industries. These comparisons focussed explicitly on the average returns earned by these industries over the 1969-75 period in relation to four measures of risk:

Variability of profit margins, which measures the uncertainty of the earnings in an industry and, thus, the exposure to demand or competitive factors which increase the risk to stockholders;

Financial leverage, which measures the proportion of an industry's capitalization that is financed by debt. Leverage reflects the risk assumed by stockholders because it indicates the extent to which lenders have a prior claim on assets when a default occurs,

Interest coverage, which measures financial risk in terms of the adequacy of firms' profits to cover their interest payments; and,

Stock price volatility (beta values), which indicates investors' overall perception of industry risk as reflected in movements of firm's stock price relative to the stock market average.

Based upon the analysis, we identified those industries which were definitely less risky than the IOH industry over the period to establish an appropriate lower limit on the range of ROES that IOHS should have earned during 1969-75. Then, we identified industries of comparable risk over the period and used the ROES earned by these industries as the basis for an appropriate upper limit on the ROES that IOHS should have earned over the same period.

Using these ROE estimates, we examined how the present Medicare costreimbursement formula could be modified to provide appropriate rates of return. Specifically, we analyzed the impact of alternative Hospital Trust Fund multiplier values on Medicare ROES over the 1969-75 period and evaluated the use of alternatives to the interest rate on bonds purchased by the Hospital Trust Fund.

C. FINDINGS AND CONCLUSIONS

1. The IOH industry faces above average financial and business risk in comparison to other consumer product and service industries.-Using measures of the variability of profit margins, financial leverage, interest coverage, and stock price volatility, we found that IOHS face risks which are viewed by investors and bankers to be similar to those of industries in the second highest quartile of risk (see Table 1 on page 7). These industries include broadcasters, brewers, shoe manufacturers, food processors, leisure industries and dairy products. Although some claim that providing care to Medicare patients entails less financial risk than providing care to private patients, we could find no support for that claim among those who provide capital to all types of hospitals.

2. To achieve ROEs commensurate with this risk, the IOH industry should have earned rates of return on equity between 11 and 16 percent over the 1969-75 period.-Average after-tax Medicare ROES during this period ranged from 4.7 to 6.3 percent, and overall hospital ROES averaged between 10.0 and 12.2 percent over these years. The Standard and Poor's 400-stock average over this period was 12.3 percent. Hence, IOH earnings were in the low range of appropriate ROES for their

risk, and Medicare paid a substantially smaller share for equity costs than other hospital patients (see Table 2 on page 7). This share was even below the ROES earned in low risk regulated industries such as electric utilities. Thus, non-Medicare patients subsidized the use of hospital services by Medicare patients to the extent of the difference.

3. Under the Medicare ROE formula, return on equity payments should have been based upon a 3.7 Hospital Trust Fund multiplier rather than the current 1.5 multiplier.—A multiplier equal to 3.7 would have yielded IOH rates of return on equity which were commensurate with their risk during each year of the 1969-75 period. If Medicare recognized taxes as an allowable cost, then the corresponding appropriate Trust Fund multiplier should have been 2.0. In 1976, the use of a multiplier of 3.7 would have increased total Medicare costs (net of taxes) by about $28 million or less than 0.3 percent of total Medicare program costs.

4. Medicare disallowances of certain unavoidable hospital expenses or investments can produce effective Medicare ROEs which are below the appropriate nominal rates identified above.-Consequently, higher Hospital Trust Fund multipliers might be needed to ensure that effective ROES are commensurate with the ROES in similar risk industries. Such unavoidable costs disallowed by Medicare include income taxes, routine SEC registration costs, and other stock maintenance costs. If such disallowances represent three percent of total costs attributable to Medicare, then a Trust Fund multiplier equal to 5.1 rather than 3.7 would have been required to provide the appropriate average ROEs during 1969–75. Medicare equity disallowances include denial of fair market value assessments of IOH land used for hospital expansion and of hospitals acquired through the exchange of stock. When three percent of the value of such investments is disallowed by Medicare, then the Trust Fund multiplier needed to provide appropriate ROES during 1969-75 would have been 3.8.

5. Medicare ROE payments in the indicated range would allow IOHs to reduce non-Medicare patient charges by at least two percent, or reduce the amount of debt capital employed by some IOHs.-By eliminating the current subsidy of Medicare patient expenses by other payors, hospital charges could be reduced on average by about two percent without reducing overall IOH profits. In areas where third-party cost-reimbursement covers a larger than average proportion of all patients, non-Medicare charges could be reduced even more. Alternatively, these ROE payments could permit IOHS to raise additional equity and thereby reduce some of the risk created by the use of large amounts of debt. The higher Medicare ROES might thus tend to be offset by the lower interest rates and payments which result from a less risky capital structure. Under certain circumstances, this return to a more balanced capital structure would produce lower total capital costs.

6. Under alternative Medicare reimbursement systems, IOHs should still receive ROEs which on average are consistent with the 11 to 16 percent returns.— Although our analysis focussed specifically on changes under the present Medicare cost-reimbursement system, most experts agree that Medicare reimbursement should be reformed to promote greater efficiency among hospitals. If a different reimbursement approach is adopted through legislation or changes in DHEW policy, then the new approach should still provide a target average industry ROE of at least 11 to 16 percent, because the IOH industry continues to face the same business and financial risks as before. Indeed, a new reimbursement system could actually increase industry risk. This seems to have occurred in other regulated industries that are naturally competitive, such as airlines and nursing homes.

7. Future analysis should focus upon three key factors which affect the determination of appropriate ROEs for investor-owned hospitals.—Specifically, future work should focus upon :

The degree to which certain unallowable costs and investments are simply unavoidable in IOH operations and thus may unreasonably reduce the effective return on equity;

The potential impact on return on equity and capital structure of alternative Medicare reimbursement proposals; and,

The degree to which full payment of IOH debt costs and partial payment of equity costs affects total costs of capital and the resulting capital structure.

These factors are important in the establishment of an appropriate regulatory policy for hospital reimbursement and were simply beyond the scope of this study.