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that incentive-based competition-not self-defeating caps-is essential to alleviate escalating costs in the health sector.


We realize that much of the impetus for reform of Medicare-Medicaid stems from increasing Congressional insistence that these programs operate in a manner that is as cost efficient as possible. Replacement of the current, highly inflationary system of retrospective payment would be our primary recommendation for reforming institutional reimbursement.

The Federation of American Hospitals has long favored increased experimentation with prospective payments for hospital services based on negotiated rates or target rates established by a formula. Our association favors a major overhaul of the Medicare-Medicaid reimbursement system for institutional providers; however, we also believe that experimentation on a national basis involving several prospective payment methods is necessary to determine appropriate long range systems.

We generally support the determination of a target rate for routine operating costs as outlined in Section 2 of S. 1470, with the following suggested revisions :

We endorse the general approach of Section 2 which includes economic rewards for efficiency. By establishing a target based on average routine costs, the proposal, as already noted, seeks to inject competition among similar facilities.

The incentive feature of Section 2 should be amended so that the bonus payment is not restricted to 5% of the average routine operating costs. Instead, hospitals whose costs are below the target should be reimbursed for actual costs plus one-half the difference between their costs and the average for their category. Thus a hospital whose costs are $80 per day as opposed to a $100 group average, would receive a bonus payment of $10, rather than $5. We believe that the 5% limit lessens the potential impact of the program and can be deleted without impairing its overall cost effectiveness. Barring this, we recommend that the incentive features of Section 2 be broadened to provide for provider retention of savings of up to 72% of the first $100 of routine operating costs and up to 5% of any excess. This would place even greater emphasis on efficiency by reducing the reward for high cost institutions compared to lower cost facilities. A sliding scale for incentive payments is more equitable because it would make the dollar rewards more uniform for all hospitals.

The legislation provides for an adjustment to the average per diem routine cost for area wage differentials. This is a most important adjustment since payroll costs represent about 55% of total hospital costs. We recommend that the bill be clarified by including a definition of the word area to assure that the adjustment is made for community differentials within states.

The restrictions on reimbursement for those hospitals with routine costs more than 20% above the group average should be more flexible. The exception procedure should assure that no institution is penalized for costs beyond its control. Inefficiency should be penalized but unforeseen or uncontrollable events should be defined and recognized as justifiable causes for cost increases.

Where the restrictions on reimbursement are imposed, the facility should be allowed to charge the program beneficiary for the difference between the reimbursement ceiling and its actual costs. This is particularly important since the bill stipulates that hospitals may not increase their rates to other payors in order to offset Medicare and Medicaid reductions resulting from implementation of the legislation. Without such relief, hospitals would be forced to absorb these extra costs. The rising cost of health care should be a matter of concern-and shared responsibility-to all of us. That includes stimulating public awareness through increased out-of-pocket expenses, and government recognition that someone must pay for increased Medicare-Medicaid benefits.

A major change in this year's bill would exempt from the proposed reimbursement system those states which have effective rate setting agencies with authority over all classes of purchasers. The bill requires that the state program results in lower aggregate Medicare and Medicaid costs than would otherwise be incurred.

An evaluation of the long-range efficacy of such an approach has yet to be completed. In hearings before the Ways and Means Health Subcommittee last

year, an HEW representative acknowledged that it would be at least three more years before the effectiveness could be gauged. We would, therefore, recommend that this exemption for state programs be deleted. If an exemption for state programs is provided, we recommend that only those states with a minimum of two years of experience in rate review prior to enactment of S. 1470 be considered for an exemption. At least that much time would be required to establish a workable system generating sufficient data for the Secretary to review.

Furthermore, the test should not be whether or not the state system results in lower Medicare and Medicaid costs alone, but if the system is expected to result in a long-range reduction in the total cost increases of all classes of purchasers. Otherwise there is an incentive for states to mandate further discounted rates for government subsidized programs, with hospitals forced to absorb the difference.

With regard to the method for determining a group average, we believe that as this average decreases over time due to the incentives incorporated in the bill, it may become too harsh. Ultimately, more and more hospitals could be penalized. To prevent this, we recommend that two years after the program is in place the target per diem be based on the average plus 10%.

Turning to suggested modifications in the exceptions procedures, we would like to recommend that there be an exemption for new hospitals built with required planning approval to recognize the high start up costs as well as higher debt services of a new facility or wing. This exemption is needed because of initially low occupancy rates that push up the average per diem costs of new facilities making it unfair to expect those hospitals to compete with already established facilities. We recommend that new facilities be exempt from the target rate for their first full three fiscal years.

For similar reasons we suggest an exception for sudden and uncontrollable drops in occupancy in an established facility. The Economic Stabilization Program provided such an exception for reductions in occupancy of more than 5%. Another concern is that recognition needs to be given to differences in treatInent modality for psychiatric facilities. The legislation should require the Secretary to take into account the treatment modality of psychiatric hospitals and give recognition to the variation in personnel needs demanded by the different programs.

For example, a psychiatric hospital that has extensive shock treatment modality will have a very different pattern of personnel requirements than a psychiatric facility that has programs which have milieu therapy treatment. Yet these are all accepted and recognized treatment modalities for mental health


We urge the Subcommittee to recommend a "hardship" exception for other "unforeseen and uncontrollable" events which cause significant cost increases. Finally, S. 1470 requires that the Secretary, by a given date, establish "an accounting and uniform functional cost reporting system." Although we assume that this means development of a system of uniform reporting only, we would like to see that language so clarified. The requisite data can be obtained through a uniform reporting system bolstered by uniform definitions of reported costs without imposing a costly and burdensome system of uniform accounting.


We believe that the performance-based reimbursement system outlined in S. 1470 represents a major step in making Medicare and Medicaid more cost efficient. However, it is essentially not a system of prospective rates. We believe that if payments are to be closely related to actual costs, they should be made on a predetermined basis. Therefore, although we favor the implementation of the target rate scheme proposed in S. 1470, we recommend that the Secretary be directed to engage in an intensive program of experimentation along prospective lines. Experimentation on a national basis involving several prospective rate methods is necessary to determine appropriate long range systems.

It is important to understand that because Medicare has not paid its fair share of institutional costs for providing services to program beneficiaries, health facilities have been forced to increase charges to non-government patients. The inflationary impact of Medicare has been felt throughout the health field. By changing the payment system to a predetermined rate, we can begin to reduce the annual inflation rate, but the Medicare program must first acknowledge its obli

gation to pay a fair rate for services rendered. There will, therefore, be no federal budgetary savings in the initial periods of experimentation with prospective rates. There should, however, be an immediate impact on inflation rates in charges to non-government patients as well as long range cost containment for the Medicare program.

The concept of a predetermined rate for specific treatments on a per diem or per admission basis by diagnosis is one example of the type of prospective ratesystem we believe should be developed and tested. Other examples include a negotiated rate; a negotiated discount from billed charges with a negotiated inflation rate for subsequent years; and a rate review process limited to facilities whose rates exceed a percentile of group charges or costs.


We urge the Committee to amend the Medicare law to create a mechanism for the annual determination of a reasonable rate of return on investment. The Medicare rate of return should be equal to investments of comparable risk in other industries.

An adequate rate of return is necessary for a number of reasons, most importantly to: (1) protect the hospital's financial integrity and maintain its credit; (2) to reward investors at a level commensurate with the risk assumed in making their investment; and (3) to attract new capital for maintenance and needed expansion.

In no other industry are income taxes not recognized as an operating expense for purposes of cost based reimbursement or rate of return. By eliminating income taxes as a reimbursable cost, the Department of HEW has effectively reduced the return on equity for investor-owned hospitals to approximately 10% on a pre-tax basis or an after-tax return of approximately 5%.

Investor-owned hospitals must make a fair return on investment in order to be viable, and if the federal government refuses to pay its fair share, this increases the return needed from the private patients, in order to make the overall return acceptable. This is, in effect, an indirect subsidy to the federal government at the expense to private patients needing hospitalization. Such cross-subsidization represents not only a direct violation of the Medicare law, but is a major cause of inflation in the private sector of the health industry.

Last year, in a case filed in the U.S. District Court for the District of Columbia, Humana of South Carolina, Inc. v. Mathews, Civil Action No. 75-0302, the court ruled that the Secretary of HEW must establish new guidelines for the determination of an appropriate rate of return on equity capital for investor-owned hospitals participating in the Medicare program. Humana contended that the current formula of one and one-half times the trust fund yield does not reimburse the reasonable cost of providing services insofar as a return on equity capital is such a cost and therefore, hospitals are forced to raise their charges to private paying patients. The court held that such cross-subsidization directly violates 42 U.S.C. 1395x (v) (1) (A), the law governing the Medicare program. The court directed the Secretary of HEW to make "a detailed study of the various factors affecting the economics of the proprietary hospital industry” in order to enable the Secretary to determine the actual level of return needed to provide a reasonable return on equity and avoid cross-subsidization.

The Federal Power Commission, the Civil Aeronautics Board, the Federal Maritime Commission, the Interstate Commerce Commission and the Federal Communications Commission all recognize that federal income taxes represent a proper service cost in determining a just and reasonable rate of return.

Although S. 1470 attempts to correct this inequity by raising the allowable return to twice the rate on current hospital insurance trust fund investments until 1981 when it returns to the current 11⁄2 times, we believe that this is still insufficient. Section 46 would in effect increase the rate of return from 5% after taxes to 7% after taxes. That proposed increase would still fail to make the rate of return equal to investment of comparable risk.

The Federation recently contracted with ICF, Inc., a Washington based consulting firm, for an in-depth study of rates of return on equity in industries comparable to the investor-owned hospital industry. The study has just been completed and copies will be furnished to the Committee Members and staff. The summary of findings by ICF includes the following conclusions:

1. For comparable risk industries, the estimated range of an after tax return on equity was between 11.0% and 16.0%.

2. For investor-owned hospitals, this range implies a multiplier of 3.7 of the Hospital Insurance Trust Fund rate, rather than the 2.0 in the proposed legislation.

3. Depending upon the level of Medicare cost adjustments which represent necessary costs of doing business but unallowable by Medicare, the multiplier required to achieve reasonable returns for investors would be between 5.2 and 8.6. We urge you to consider these alternative approaches to improve the current Medicare rate of return on investment:

(1) Provide for an annual determination by the Secretary of a return equal to rates of return on investments in industries of comparable risk;

(2) Recognize income taxes as an allowable cost of doing business, reimbursable under Title XVIII; or

(3) Increase the current formula to at least 3.7 times the trust fund yield.


Section 4 of S. 1470 provides that Medicare and Medicaid reimbursement of both capital and direct operating costs would be prohibited when a capital expenditure has not met with specific approval. We support this as a valid means of strengthening the health planning law in a manner which will effectively restrain increasing costs. We believe that it should be up to individual HSAS, working to meet the needs of the communities they oversee, to decide what new capital expenditures are justified. This is in marked contrast to the Administration's proposed dollar ceiling on capital expenditures on a state wide basis according to population, coupled with a fixed ratio of four beds per 1,000 individuals or occupancy of 80%

We do not, however, support the provision in S. 1470 which requires unanimous approval of a proposed capital expenditure when it involves an SMSA which crosses state boundaries. Although the other jurisdictions should certainly be actively consulted, the decision regarding approval should ultimately be left to the state in which the proposed expenditure will actually be made. That HSA should be equipped with sufficient data to accurately gauge the need-based on current and projected utilization trends-of the proposed project. It would be too cumbersome a process for approval to be secured from secondary jurisdictions and political stalemates could jeopardize needed health expenditures.

Finally we recommend an amendment requiring certificate of need agencies to solicit competitive applications for needed services, equipment, and facilities to stimulate competition and lower costs.


The Federation supports that provision of the bill which encourages closing or converting underutilized beds or services by including in the hospital reasonable cost payment, reimbursement for costs associated with closure or conversion. However, in the case of for-profit hospitals, only increased operating costs would be recognized; capital costs would be disallowed.

We believe that regardless of ownership, hospitals should have both their capital and increased operating costs associated with closure or conversion recognized. To differentiate on the basis of ownership raises serious constitutional questions. If there are two hospitals located in a community-one a non-profit the other investor-owned-and the community believes that the investor-owned facility should be closed or converted to another use, the provision as presently stated provides no incentive for the investor-owned hospital to acquiesce. After all, no facility can be expected to shut down and retire its debt without benefit of patient income. The question should be "What is best for the community?" Then all costs connected with closing or converting the facility-regardless of ownership should be recognized.

This provision is essentially experimental, limiting transitional allowances to only fifty hospitals per year for the first two years of operation. The Secretary would review all recommendations forwarded by the Hospital Transitional Allowance Board; however, there would be no appeal to the Secretary's final decision. We recommend that when the program becomes more than experimental, these decisions become subject to judicial review.

In addition, we recommend that total hospital closures be given priority under this voluntary program. Little or no dollar savings will be realized from closing some beds within an institution, but significant savings can be realized if an entire facility is purchased for fair value and closed.


Insofar as control of physician reimbursement is concerned, we can understand the desire to discourage potential abuse or excessive payments by limiting the reimbursement for certain hospital based physicians. However, we believe that the actual method of payment-be it fixed fee, or percentage, lease, or direct billing arrangements-should be left to the discretion of hospital management. By restricting payments to a fixed fee, many rural areas might be unable to attract the services of these specialists.

We would not, however, be opposed to screens being applied to the final result of the hospital physician negotiations using a technique similar to the 75th percentile of the prevailing payment levels in the area.

Finally, there should be a "grandfather" clause covering all contracts made prior to enactment of S. 1470 between hospitals and hospital based physicians.


We are pleased to note that Section 40 has been modified substantially, deleting last year's requirement that all contracts of $10,000 or more be approved in advance by the Secretary. This modification reflects an awareness of the chaos that such a provision would have caused in the daily administration of a facility.

However, Section 40 still provides that no cost or charge will be considered reasonable for purposes of reimbursement under Titles XVIII or XIX if it represents a commission or finder's fee or an amount payable under rental or lease arrangement where payment is based on a percentage arrangement. The Federation objects to this provision which covers consulting and management contracts for the same reasons it rejects the restrictions imposed on contracts with hospital based physicians. We believe that these are matters properly left to the discretion of the hospital's administrator and Board of Trustees.

Section 2 of the bill precludes the need for the kind of line-by-line budget examination proposed in Section 40. Under the proposed target rate, the concern is properly with the total costs, not with all the individual components that go into that final figure. Hospitals are given incentives to come in under the target rate, or at the very least make sure that their per diem routine operating costs do not exceed 120% of the average rate determined for their category. This factor in itself serves to prohibit the negotiation of contracts that are excessive. We, therefore, recommend that Section 40 be deleted altogether from S. 1470.


We believe that the stated purpose of Section 20 of S. 1470-to make better and more flexible use of underutilized hospital beds in rural areas by permitting their conversion to long-term care beds with appropriate reimbursement-is an excellent one. We would suggest, however, that this provision be amended to delete the requirement that limits the section to hospitals with less than fifty beds. Since a certificate of need would be required prior to conversion, planning authorities would not be faced with a surplus of long-term care beds. Therefore, we do not think that the potential success of this provision should be blunted by the currently suggested fifty bed limitation.


Turning lastly to the area of administrative reforms, the Federation shares Senator Talmadge's concern that the new Health Care Financing Administration may be guilty of furthering, rather than alleviating, the bureaucratic superstructure controlling the health sector.

We would suggest that in re-examining the purpose and proposed organization of such an Administration under Section 30 of S. 1470, that consideration be given to placing it under the direct supervision of the Assistant Secretary for Health or creating an Under Secretary for Health, rather than an Assistant Secretary for Health Care Financing. With the exception of the Secretary himself, the Assistant Secretary-or Under Secretary-for Health, should be the top spokesman and policy maker for departmental health policy. The position of Assistant Secretary for Health Care Financing could serve to undermine this authority.

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