Division of Health Facilities Evaluation and Licensing

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Report Of The Advisory Commission On Hospitals - 1999

III. Trends in new jersey hospital financial status since 1995

The commission was convened during a period when hospitals faced multiple challenges that, according to widespread reports, were severely affecting financial performance. Information presented to the commission confirmed that there has been a significant decline in the financial condition of New Jersey's 84 not-for-profit acute care hospitals since 1995. The depth and breadth of the decline convinced commission members that systemic factors, in addition to hospital-specific performance issues, were contributing to the financial deterioration. Over the course of its meetings, the commission identified many internal and external factors contributing to the trend.

A. Evidence of financial decline

The commission was provided with three studies that documented the financial deterioration. These included:

  • a study by PricewaterhouseCoopers ("PwC") commissioned by the New Jersey Health Care Facilities Financing Authority ("NJHCFFA") entitled "Assessment of the Fiscal Condition of New Jersey's Acute Care Hospitals;"
  • a report prepared by the New Jersey Hospital Association entitled "Financial Status of New Jersey Hospitals, 1998 Edition;" and
  • data regarding the financial status of urban hospitals prepared by the New Jersey Hospital Alliance.

Copies of the reports or their executive summaries are provided in Appendices C, D and E.

The different reports provided essentially the same picture. According to the PwC study, profit margins dropped from 4.40% in 1995 to 1.76% in 1997 and .55% in 1998. Declines were consistent across all categories of hospitals regardless of teaching status, size, or geographic location. In 1997, 26 hospitals reported net losses from operations. This number increased to 42 in 1998. Other measures of financial performance such as days in accounts receivable, long-term debt to capitalization, and debt service coverage ratio have also deteriorated, although not to the same extent as profitability. And, while all hospitals have been affected, the declines have created a more precarious situation for inner city and urban hospitals, because they were in a weaker financial position.

After reviewing available financial information, the commission concluded that the declines are becoming more widespread and are likely to persist for the foreseeable future. The commission therefore turned its attention to identifying the causes and possible solutions.

B. External and internal factors affecting hospital performance

The state's hospitals face numerous external challenges. The growth of managed care enrollment, reduction in Federal Medicare inpatient and outpatient reimbursement, changes in Medicaid reimbursement, and a large uninsured population are all contributing to the decline in financial performance and are likely to persist into the next decade. Advances in technology and pharmaceuticals allow for more outpatient and non-hospital-based treatments, contributing to the downward pressure on utilization. Lack of alignment between physician and hospital payment incentives makes changing physician practice patterns difficult.

Additionally, internal factors hamper needed change. These include:

  • slower than needed reductions in length of stay, particularly for Medicare patients;
  • persistent excess and misdirected hospital capacity;
  • higher staffing levels than hospitals in other states;
  • lack of alignment between physician and hospital payment incentives, making changes in physician practice patterns difficult to implement;
  • board ambivalence about transitioning a hospital's services or closing facilities to appropriately meet the community's needs while ensuring adequate reimbursement to cover costs; and
  • inadequate education of the general public about changes in health care delivery and reimbursement.

Together these factors have contributed to higher operating costs at New Jersey hospitals when compared to their counterparts nationwide.

C. External factors

1. Growth of managed care

Enrollment in managed care plans increased dramatically after the Legislature repealed New Jersey's Hospital Rate Setting system in 1993. Managed care has grown dramatically as New Jersey employers have found it a viable way to rein in the costs of employees' health benefits. The state's Medicaid program has also turned to managed care as a way to improve access and the quality of services and to control costs. By 1998, approximately 30 percent of the state's population had enrolled in health maintenance organizations, up from just 5 percent in 1993. This percentage would be higher if it included many thousand of others enrolled in preferred provider organizations and other forms of managed care for which data is unavailable.

The growth of managed care has reduced hospitals' revenues in several ways. First, hospitals typically must have a contract with a managed care company to be included in a provider network. Physicians are generally prohibited from admitting patients to hospitals without contracts, except on an emergency basis. The threat of this lost volume creates pressure for hospitals to sign contracts at less than optimum rates.

Most managed care companies pay per diem rather than per admission rates. The rate is negotiated and may not cover the hospital's actual cost for the patient. This situation is exacerbated by the hospitals' general lack of cost accounting systems, without which they cannot determine whether per diem payments cover costs. In addition, managed care companies employ utilization review techniques to eliminate unnecessary services. The threat of payment denial for excess days creates an incentive for hospitals to quickly move patients out of acute care beds. The drop in length of stay in New Jersey hospitals from 7.3 days in 1993 to 5.8 days in 1997 (PwC report) is in large part attributable to these incentives. Since hospitals are often paid on a per diem basis, this decline in length of stay has further reduced hospital revenues. Even with this decline in days, third party payers are expected to press for additional reductions.

Managed care has affected hospital financial performance in less obvious ways too. Without rate setting regulations, hospitals now compete with each other for managed care business by offering lower prices or more comprehensive services; either strategy can hurt financial performance. In addition, managed care companies review hospital bills more closely as part of their efforts to eliminate unnecessary services. This scrutiny puts added pressure on the hospitals to document the services provided, generate error-free bills and to ensure that preauthorization is obtained before services are provided. The result has been higher administrative costs, slower payments as bills are reviewed, and denied claims in situations where payers believe the services were not properly documented or were deemed unnecessary.

While New Jersey has legislation and regulations requiring prompt payment of bills, the commission heard conflicting opinions as to whether insurers are adhering to these requirements. A sub-committee, convened to study the issue, concluded that hospitals and payers may misunderstand the rules and that many factors contribute to the slowdown in payments.

Managed care organizations, under pressure from employers to keep premiums as low as possible, themselves face financial problems, which in turn can affect the hospitals. A managed care trade organization reported that New Jersey HMOs lost $250 million since mid-1996. In late 1998 and early 1999, the insolvency of two health maintenance organizations left hospitals with significant unpaid claims. In a presentation to the commission, Randi Reichel, Executive Director of the American Association of Health Plans, predicted continued pressure on hospitals to lower prices as managed care companies work to stabilize their own declining margins. She also suggested that smaller managed care organizations will be merging with larger ones, giving them more leverage in negotiating rates with hospitals.

All the information provided to the commission suggests that the effects of managed care will continue to challenge hospitals in the future. The state's Medicaid program, which has already converted most of the TANF population (mothers and children) from fee-for-service to managed care, expects to move a significant portion of its disabled population into managed care plans in the next two years. Analysis provided in the PwC report from Milliman & Robertson (an actuarial and consulting firm) predicted that utilization will continue to decline and medical denials will increase as New Jersey's use rates fall into line with those of other states with moderate levels of managed care. Managed care companies are expected to broaden their focus from just unnecessary days to unnecessary admissions as well. Therefore, the downward pressure on hospital revenues is expected to worsen.

Estimating the likely dollar impact of continued growth in managed care is difficult. However, the projections provided by PwC using the Milliman & Robertson rates, which assumed only moderate managed care activity, suggest that the state could expect to see a drop of approximately 150,000 non-Medicare patient days per year. The revenue impact of such a decline could be as much as $150 million to $200 million based on average net revenue per day. To the extent that managed care penetration reaches higher levels, the impact could be larger.

2. Federal balanced budget act of 1997 (BBA)

The federal government, in response to budget pressures and reports of double digit positive hospital Medicare margins nationally, moved to restrict the growth of Medicare payments with the passage of the Balanced Budget Act of 1997. The BBA affects Medicare reimbursement in several ways, including:

  • limiting increases in Medicare reimbursement rates to less than the measured level of inflation;
  • reducing capital reimbursement by 17.8% from current levels;
  • reducing Medicare payments to teaching hospitals for graduate medical education
  • reducing Medicare payments to hospitals that provide high levels of care to indigent patients;
  • reducing reimbursement for certain Medicare patients who receive post-acute care services after a hospital stay; and
  • reducing reimbursement to managed care organizations participating in Medicare risk contracting.

The BBA has had, and will continue to have, a dramatic effect on all hospitals.

Unlike the rest of the country, New Jersey's Medicare margins prior to the BBA were barely above break-even (1.9%, the fifth lowest in the country in 1996). The PwC report suggests that an excessive Medicare average length of stay (1.5 days higher than the national average in 1997) and high staffing levels contributed to these relatively low margins. Hospital representatives suggested that another reason for the low margins is that while New Jersey hospitals must pay health care professionals at New York City or Philadelphia wage rates, Medicare reimbursement assumes that state's hospitals compete for personnel in New Jersey's lower cost labor markets. The result is that New Jersey hospitals are being particularly hard hit by the BBA. According to analysis from several sources, by the time the BBA is fully implemented in 2002, the $10.5 billion a year New Jersey hospital industry can expect to see $515 million less in Medicare reimbursement annually than if BBA had not been enacted. The cumulative effect over the five years of the BBA is expected to be nearly $2 billion less in Medicare revenue for New Jersey hospitals.

Through 1998, hospitals have already absorbed about $160 million of the impact and the BBA is, in part, responsible for the breadth of the financial decline in New Jersey hospitals. Like managed care, the impact is expected to be felt for several more years. Unless reversed in whole or in part, by 2002, the BBA will take another $355 million a year out of Medicare reimbursement on top of the amounts already eliminated.

3. Uninsured population

Health care for New Jersey's substantial uninsured population, approximately 16 percent in 1998 according to the federal Census Bureau imposes considerable costs on hospitals. A subset of the uninsured population is eligible for charity care. As the cost of health care has continued to rise (albeit at lower rates than in the early 1990s), the cost of charity to New Jersey hospitals has also risen, from $337 million in 1993 to $483 million in 1999. The committee also heard anecdotal information regarding the impact that a growing undocumented population is having on charity care costs.

Fortunately, New Jersey remains one of relatively few states which provides some reimbursement to private hospitals for charity care. The state has two subsidy funds that, in 1998, provided $320 million in payments for charity care and another $203 million in hospital relief funds to facilities that treat a high proportion of special needs patients (e.g. AIDS, low birth weight babies, tuberculosis).

In spite of the fact that $80 million was added to these two funds in 1998 charity care presents a continuing problem to hospitals. First, funding is not keeping pace with increases in charity care. For hospitals with high levels of charity care, the combination of the two subsidies helps offset the costs of bad debt (which hospitals suggest is often really undocumentable charity care, much of which comes from admissions through emergency rooms). As the burden of charity care increases, however, more bad debt is left uncovered. Second, because the subsidies are funneled to high charity care hospitals, 18 hospitals receive no subsidies for charity care. Although the levels of charity care are not rising as quickly at these hospitals, they are still experiencing an increasing charity care burden in addition to the other financial pressures.

4. Certificate of need

Traditionally, New Jersey had a comprehensive Certificate of Need program that regulated the addition of beds and services. Throughout the 1990s, the state has been incrementally exempting certain services from certificate of need requirements. In its current form, the Certificate of Need program may exacerbate the financial pressures on some hospitals, although in other cases it has worked to strengthen financially vulnerable hospitals. Eliminating certificate of need requirements for certain services has exposed hospitals to more market pressures as they compete with other hospitals and health care providers for patients. On the other hand, the remaining certificate of need regulations prevent hospitals from competing for certain services which they believe will strengthen their financial position. The commission also heard evidence that profitable outpatient services that once were provided by hospitals are now rendered in physician offices and other outpatient settings. Regulatory barriers may exist which constrain hospitals from developing timely and cost-effective ambulatory care services. In 1998, the Legislature created a Certificate of Need commission to determine which services, if any, should remain subject to certificate of need regulations. This commission, which is looking at the implications for quality as well as finances, will conclude its deliberations by year-end.

5.advances in medical technology and pharmaceuticals

Hospitals have also been affected by changes in medical technology that make it possible to perform many profitable surgical procedures on an outpatient basis. For example, the ambulatory surgery centers in New Jersey grew from 16 in 1996 to 40 in 1999, an increase of 250 percent. Drug therapies for conditions such as diabetes and cardiovascular diseases have also reduced the need for hospitalization. These improvements in technology and pharmaceuticals have also increased costs for hospitals, and they are growing at a significantly faster rate than other costs.

D. Internal factors

1. Length of stay

The PwC report indicated that while New Jersey's average length of stay for non-Medicare patients was consistent with national averages, the length of stay for Medicare patients was 1.5 days higher than the national average. This longer length of stay results in approximately 600,000 extra patient days for which the hospitals receive no revenue under Medicare's fixed payment per admission reimbursement system. Estimates of the added cost of these days range from $200 million to $600 million. The magnitude of these added costs suggests that reducing length of stay for Medicare patients could be a way for hospitals to cope with continuing reductions to Medicare revenues resulting from the BBA.

The commission heard many reasons for the state's high length of stay. Some suggested that New Jersey's Medicare population may be older and sicker than in other states and that a higher length of stay is inevitable, although many disputed this claim. A New Jersey Hospital Association study concluded that New Jersey patients are not older or sicker than patients in other states. Others note that physicians are paid by Medicare for each day a Medicare patient remains hospitalized and that this fee-for-service payment system works against hospital efforts to reduce lengths of stay. Many suggested a lack (as well as regulatory obstacles to the utilization) of post-acute care placement alternatives as the primary reason. Clearly, reducing Medicare length of stay will be a difficult task for hospital management to address without help from other players in the health care delivery system.

2. Excess capacity

On any given day, as many as 50% of New Jersey's 30,000 licensed acute care beds are unoccupied and that percentage is likely to increase as managed care and pressure to reduce Medicare length of stay continue to bring down the state's hospital use rates. Counting only staffed beds (hospitals set staffing levels based on the number of beds expected to be in use, not the number of licensed beds), the occupancy rate statewide is just 67%. This oversupply of beds is the root cause of many of the problems that contribute to the weak financial condition of the New Jersey hospital industry. For example, pressure to fill empty beds puts hospitals at a disadvantage in negotiating rates with payers and the widespread availability of beds means that physicians have no incentives to shorten the length of stay of their patients. Most importantly, the oversupply means that the industry is not generating enough revenue to adequately cover its fixed costs.

The financial benefits of eliminating the excess beds will depend on how the supply of beds is reduced. Reducing the inpatient capacity of all facilities by 30 percent to 50 percent might improve the hospitals' bargaining position with payers and put pressure on physicians to reduce lengths of stay. However, that approach would leave fixed costs relatively unchanged and would not dramatically improve the financial condition of hospitals. In fact, the steady decrease in the number of staffed beds in the state since deregulation (approximately 5,000 beds, a 17% decline) does not seem to have helped financial performance to date.

Closing entire hospitals, as opposed to across-the-board downsizing, offers much more potential for improving the financial condition of the state's hospitals as a whole. Remaining hospitals will gain additional patients and will likely be able to treat them without significantly increasing their fixed costs. For example, many hospitals will treat these new patients in previously vacant beds. Therefore, the cost of treating new patients at these hospitals will be less than the new revenues they will receive. As outlined in the chart in Appendix F, the industry could handle the expected demand for services with as much as $1 billion less in fixed costs. Put another way, eliminating the excess capacity by closing hospitals rather than across the board downsizing could increase revenues to remaining hospitals by as much as $1 billion without any aggregate increase in payments. While the commission believed that the underlying assumptions of this analysis were reasonable, some members cautioned that this figure may be overstated.

When a facility needs to close, the hospital and its community face a new set of obstacles, including enormous political and community pressures to remain open. Hospital trustees worry about the welfare of the community the hospital serves, the people it employs, and the debts for which it is obligated. The host community and its leaders worry about the health care needs of their residents and the economic impact on their region. Physicians worry about where they will practice their profession. In addition, nurses and other health care professionals worry about the loss of employment and adequate staffing to ensure quality of care. These issues are very difficult to deal with even when there is an orderly, planned closure process. When a hospital closes suddenly, as in the case of a bankruptcy, they become almost impossible to address in a constructive way. Without assistance in addressing the broad range of issues, hospital management may not be able to bring about a managed downsizing of the system.

3. Mergers and acquisitions

In anticipation of, and in reaction to, the impending changes in the health care market, some hospitals have merged or consolidated with other hospitals or have entered into affiliation agreements, hoping to capture a larger market share, reduce costs and improve their bargaining position with payers. Many of these mergers are still relatively new, but results to date have been mixed. Some hospitals reported they were able to reduce administrative costs through mergers and consolidations. Others reported little savings due to differences in business and clinical protocols, incompatible computer systems, and community and physician opposition to change in the delivery system. Perhaps most telling is, despite the merger activity since deregulation and the reduction in staffed beds, the number of hospital physical plants in operation has only decreased by three. Reducing staffed beds, consolidating clinical services, and eliminating duplicative administrative functions appear to be necessary but insufficient to accomplish system-wide savings that the anticipated reductions in utilization will require. Many agreed that significant savings from mergers may come only when entire facilities are actually closed or converted to other uses. Commission members also noted that clinical consolidation is difficult unless the facilities are geographically close. Outside experts presented similar information about the impact of mergers and acquisitions in other parts of the country to date.

4. High Costs

New Jersey hospitals cost more to treat patients than their regional and national counterparts. PwC found that New Jersey's average cost per admission (adjusted for the types of cases seen and wage differences) was $6,214 in 1997 compared with $5,257 for hospitals in the region and $5,892 for urban hospitals nationwide. Much of the variance results from higher staffing levels for the volume of patients seen. In 1997, New Jersey hospitals used 4.73 full time staff per occupied bed compared to 4.56 nationwide and 4.2 for the region. PwC estimated that New Jersey hospitals could save $50 million in salary and fringe benefits for each one- percent reduction in staffing per occupied bed.

5. Education

Educated boards and competent management are also important in ensuring that essential services will be available. The commission was dismayed to learn that some hospitals cannot identify profitability by payer or product line. Ability to track costs varies greatly among hospitals and can contribute to difficulties in negotiating adequate managed care rates. In addition, many hospitals are unable to track the differences between hospital charges and contract rates and therefore cannot accurately value accounts receivable and expected revenue from these receivables. Further, some hospital boards and physicians underestimate the critical need to reduce length of stay to maintain financial viability.

Education of key policy makers is also needed. Understandably, local officials get very involved when there is an initiative to close or convert hospitals in their communities. Better and earlier dialogue to discuss the gravity of the situation and to identify realistic options open to the key stakeholders is of paramount importance. Lastly, resistance on the part of hospital boards to face the realities of the changing health care environment is hampering efforts to improve the financial condition of hospitals. Declining utilization means that closure of some acute care facilities is inevitable and attempts to keep unneeded hospitals open weakens all hospitals and jeopardizes the quality of health care provided in the state.


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