This Article Abstract Reprint (PDF) Submit a response to this article Alert me when this article is cited Alert me when Comments are posted Alert me if a correction is posted Services E-mail this article to a friend Similar articles in this journal Similar articles in PubMed Alert me to new issues of the journal Add to My Personal Archive Download to Citation Manager Reprints & Permissions Citing Articles Citing Articles via HighWire Citing Articles via ISI Web of Science (4) Citing Articles via Google Scholar Google Scholar Articles by Harrison, M. G. Articles by Montalvo, C. C. Search for Related Content PubMed PubMed Citation Articles by Harrison, M. G. Articles by Montalvo, C. C. Related Collections Hospitals Business Of Health State/Local Issues State/Local Issues - California Related Article

Hospital Finance

The Financial Health Of California Hospitals: A Looming Crisis

Abstract

 
This paper summarizes a Shattuck Hammond Partners study, released in late 2000, that found marked erosion in California hospitals’ financial health. The study examined the revenue and expense dynamics that contributed to this erosion and explored future challenges, some of which are unique to California’s regulatory environment, in the context of the hospital industry’s current financial performance. The study concluded that California hospitals face a potential crisis—defined as the potential nonviability of a large portion of its hospital infrastructure—and explored the policy questions and implications of this situation.

Study methods. The Shattuck Hammond Partners study consisted of a literature review, an analysis of the market, and a data analysis of financial results for 1995–1999. The data were obtained from California’s Office of Statewide Health Planning and Development (OSHPD) and were "cleaned" to exclude hospitals with incomplete reporting. Results from OSHPD’s "selected" data files were analyzed longitudinally on a median and average basis to show trends over the study period. Other literature and data sources were examined to create context. Sources included the Center for Health-care Industry Performance Studies (CHIPS), HCIA/Sachs, and the American Hospital Association (AHA) annual hospital survey.

A Challenging Starting Point

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 
California hospitals function in an environment that poses a greater challenge to financial health than is the case for hospitals elsewhere. One of the most challenging factors is a severe and highly competitive pricing environment for commercial business. This environment is the result of a particularly aggressive combination of factors that influence California hospital revenues: (1) strong business and purchasing alliances, which maintain a high degree of premium pricing pressure on payers; (2) high managed care penetration (54 percent compared with 34 percent nationally) combined with a high concentration of managed care lives among few payers; and (3) competition for premium revenue not only with other hospitals but also with sophisticated, large medical group organizations.¹

Federal budget reductions have exacerbated pricing pressure on California hospitals. As a result of the Balanced Budget Act (BBA) of 1997, Medicare spending changes are estimated to have caused a net reduction of $4.9 billion in Medicare payments to California hospitals over the five-year period beginning in 1997.² HCIA, in a study on the impact of Medicare reductions on hospitals in major metropolitan statistical areas (MSAs), rated five of eight California MSAs as "in danger."³

California hospitals also confront an adverse climate on the expense side of the equation. First, California hospital patients have a higher severity-of-illness rate as measured by the case-mix index (1.34 versus 1.22 nationally in 1999).⁴ Second, California has a higher wage index and thus a higher median salary per hospital full-time equivalent (FTE) ($40,984 versus $32,893 nationally in 1999).⁵ Third, California has a nursing shortage and has the lowest number of nurses per capita in the nation.⁶ Fourth, California has a larger uninsured population than the United States as a whole (20.3 percent versus 15.5 percent).⁷ Given this pricing and expense environment relative to the rest of the nation, it is not surprising to find that median California hospital operating margins are well below national medians (1.65 percent in 1995 and –0.33 percent in 1999 versus 2.8 percent in 1995 and 0.4 percent in 1999 nationally).⁸

Defining Financial Health

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 
A financially "healthy" organization is one that is producing an operating margin sufficient to finance the current and future capital that is required for the maintenance and growth of its business. For most California hospitals, this capital comes from two primary sources: directly from operating cash flow, or indirectly from debt financing.

Function of operating margins. Operating margin was used in the study as a primary and "early warning" indicator of financial health. Operating margin is defined as total operating revenue minus total operating expense and thus measures financial performance to the exclusion of nonoperating factors. This single measure of financial performance best reflects the combined underlying business dynamics and trends of the hospital marketplace. It is an "early warning" indicator because it directly and indirectly provides access to the capital required to sustain or grow a business in the future. Later in this paper we review financial ratios that incorporate cash and nonoperating income in the context of credit trends that affect financial health.

When a hospital organization fails to produce an operating margin that is sufficient to fund capital needs, deterioration to a point of nonviability may be slow or rapid depending on a variety of factors. These factors include severity and duration of margin decline, competitive position, size of cash or liquidity position, and the magnitude of capital requirements. Any of these factors, or a combination thereof, can accelerate a weakening of financial health to a point of nonviability, or "crisis." Although generalizing about "healthy" levels of operating margin may be misleading in some circumstances, an industry "rule of thumb" is that an operating margin of 3–5 percent is considered "healthy."

California versus the nation. Systemwide, California’s median hospital operating margins declined into negative territory in 1999, indicating that more than half of California hospitals were losing money from operations that year. The most precipitous decline occurred from 1996 to 1997, with a decline of 1.5 percentage points of a total two-percentage-point drop over the entire five-year period. Between 1995 and 1999 California’s median operating margin was well below comparable national medians. However, the rate of decline in median operating margins was larger nationally than in California (2.4 percentage points nationally versus 1.98 percentage points in California).

Hospital operating margin data were further analyzed by quartile grouping. Most interestingly, the disparity in operating margins between the top- and bottom-performing hospitals widened from 1995 to 1999 for both California and the nation as a whole (Exhibit 1). In 1999 California’s top-quartile hospitals outperformed the nation’s top quartile—a reversal of the 1995 relationship. From 1995 to 1999 California’sbottom-quartilehospitalsfared worse than the nation’s bottom-quartile hospitals. While there was a gap of 10.82 percentage points between the top- and bottom-quartile median California margins in 1995, the gap widened to 13.48 percentage points in 1999.

Revenue, Expense, And Utilization Dynamics

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 
To understand the revenue, expense, and utilization trends that are driving the deterioration in overall California hospital operating margin performance, we gathered key indicators and combined them in Exhibit 2. The exhibit shows adjusted revenue and expense per day and provides discharge statistics, to contrast the competing trends that drive operating margins. These figures have been adjusted to create a "factor" for outpatient revenue (through adjusting days and discharges) and for total case-mix index.

While expenses trended at a rate well below the rate of medical price inflation, prices trended at an even lower rate over 1995–1999, leading to an erosion of operating margin. This finding reinforces the notion that competitive and regulatory forces contained California hospitals’ pricing over the study period. Further, although the California hospital industry has kept per unit cost trends below the rate of inflation, it has not reduced unit costs in this aggressive pricing environment enough to maintain or improve operating margin.

Top- and bottom-quartile California hospitals. As discussed earlier, the median and quartile operating margin analysis showed a widening of the gap between the top and bottom operating margin performers, from 10.82 percentage points to 13.48 percentage points. The rate of margin decline for top- and bottom-quartile hospitals for 1995–1999 showed much disparity, with the top-quartile hospitals declining 1.12 percentage points and the bottom-quartile hospitals, 3.80 percentage points.

It is interesting to note that in 1999 top-quartile hospitals generated 27 percent of California hospital discharges, while the bottom-quartile hospitals generated 17 percent. The study data demonstrated that while the top-quartile hospitals experienced price reductions that surpassed cost reductions, these hospitals were able to maintain a positive operating margin (albeit a declining one). Another characteristic that differentiated the top-quartile hospitals from the average California hospital was the relative mix of business. The top-quartile hospitals had a higher proportion of inpatient acute business and a lower proportion of outpatient business. Trends in revenue and expense per day for the bottom-quartile hospitals followed the same pattern as did those of the top-quartile hospitals: a pricing decline that exceeded the cost 1995–1999 decline.

California Hospital Credit Trends

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 
An analysis of median credit ratios for the top and bottom quartiles of hospitals by operating margin revealed some important findings. California’s best-performing hospitals (on an operating margin basis) experienced a decline in credit strength over the 1995–1999 period, with declining debt-service coverage and cash at the same time that leverage was increasing (Exhibit 3). Bottom-quartile hospitals also showed credit deterioration to levels that, based upon the 1999 data, would likely keep these hospitals from borrowing in the public capital markets.

Credit trends can be analyzed by examining credit-rating upgrade and downgrade trends as well as outlook distribution (Exhibit 4). Of S&P’s rated California hospital organizations, 30 percent carried a "negative outlook" qualifier or were on credit watch with negative implications (that is, they were being evaluated for negative reasons).¹⁰ Moody’s ratings were 38 percent qualified by "negative outlook," and California had the second-highest percentage of hospitals downgraded of any state.¹¹

Moody’s noted a variety of market dynamics that could have a future negative impact on California hospital credits: (1) strong leverage of managed care organizations relative to hospital providers in pricing negotiations; (2) strong business alliances maintaining pricing pressure on payers and providers; (3) competition from large, sophisticated medical groups combined with market disruption caused by widespread physician-practice bankruptcies; (4) deferred capital spending and looming seismic-retrofit requirements creating a need for more leverage "while it is becoming more difficult to predict the adequacy of future earnings to support incremental debt"; and (5) labor shortages in nursing and information system technology resulting in increased costs and exacerbated by A.B. 394 (minimum nurse staffing requirements). Moody’s also noted that heavy union activity could contribute to cost pressure.

S&P generally cited the same credit issues as Moody’s did and observed that "credit deterioration, and weakened income statement performance for hospitals and healthcare systems in California has been pervasive and more extreme than the industry as whole." S&P also noted that "at current levels, cash flow generation for a high percentage of California hospitals is insufficient to finance any significant increase in capital expenditures."

Regulatory And Legislative Burden

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 
In addition to federal and state budget uncertainties, which may produce adverse pressure on Medicare, Medi-Cal (California Medicaid), and disproportionate-share hospital (DSH) funding, California hospitals face some legislative requirements that will apply strong additional financial pressure. Among these are A.B. 394 (legislating minimum nurse staffing ratios) and S.B. 1875 (mandating that hospitals create computerized physician order entry systems by 1 January 2005). However the legislation that has garnered the greatest attention is S.B. 1953. Costs will include retrofitting, business interruption, and, in many cases, complete hospital replacement. Although no definitive cost estimates are available, unpublished sources suggest that more than half of California’s beds may be affected, at a cost in the tens of billions of dollars.

California Hospitals’ Financial Health

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 
The Shattuck Hammond Partners study concluded that the financial health of California hospitals is seriously eroding. It suggested that the combination of a highly competitive marketplace and a heavy regulatory/legislative financial burden might result in widespread hospital closures. At a minimum, it is unlikely that many of California’s bottom-quartile hospitals will continue to be financially viable in the future. Patterns of closure appear to be somewhat unpredictable based on "type."

Policy issues and implications. California legislators and community leaders can choose to be proactive or reactive. A proactive pathway would mean that government would initiate community health planning discipline to ensure access to high-quality hospital care. A reactive pathway would allow market forces (in combination with legislative requirements) to shape California’s future hospital system. The role of state government in this scenario would be to develop funding mechanisms to support hospitals that provide critical access to vulnerable populations.

But no matter what the pathway, many of the overarching policy issues are the same. For example, (1) What do population and demo-graphic projections tell us about future demand for hospital services? (2) How will evolving medical and information technology influence the hospital of the future? (3) How will financial factors and physician practice patterns influence the size and design of the hospital of the future? (4) How will consumers and employers shape demand for hospital care?

Thus far, California’s legislature has not taken major steps to address legislative matters affecting its hospitals. In its 2001 session the legislature pondered but failed to act on alternative proposals to alter S.B. 1953 deadlines and provide potential funding support. There is a relative lack of health care information to support decision making for California hospitals. Yet failure to address strong market forces could have detrimental results, forcing hospital closures and threatening the timely provision of service to Californians.

Editor's Notes

 
Mark Harrison is managing director and Cecilia Montalvo is vice-president of Shattuck Hammond Partners, a health care investment banking firm in San Francisco.

NOTES

Top A Challenging Starting Point Defining Financial Health Revenue, Expense, And... California Hospital Credit... Regulatory And Legislative... California Hospitals' Financial... NOTES

 

1. InterStudy Competitive Edge 9.2. (St. Paul: InterStudy, 1999); and L. Martin, "California Hospitals Face the Nation’s Most Complex and Dynamic Health-care Market," Moody’s Investors Service Special Comment (November 2000): 4.
2. The BBA and Balanced Budget Refinement Act (BBRA) data are from the Congressional Budget Office, "Preliminary Estimate of Medicare, Medicaid, and SCHIP Balanced Budget Refinement Act of 1999" and "Budgetary Implications of the Balanced Budget Act of 1997"; and Centers for Medicare and Medicaid Services (MEDPAR 1998, HCRIS Database, Inpatient PPS Impact File—Final 2000, Provider Specific File—Final 2000, and Outpatient PPS Impact File).
3. HCIA, "The BBA and a Guide to Hospital Performance," PRNewswire, via News Edge Corporation, 24 June 1999.
4. Center for Healthcare Industry Performance Studies (CHIPS), Almanac of Hospital Financials and Operating Indicators, 2001 ed. (Ingenix Publishing Group, 2000).
5. Ibid.
6. U.S. Department of Health and Human Services, Health Resources and Services Administration, 1996.
7. U.S. Census Bureau, "Percent of People without Health Insurance Coverage throughout the Year by State (3-year average), 1997 to 1999," Table E, Health Insurance Coverage, September 2000, <www.census.gov/prod/2000pubs/p60-211.pdf> (29 October 2001).
8. California data are from California’s Office of Statewide Health Planning and Development, Hospital Disclosure Reports (Sacramento: OSHPD, 1995–1999. National data are from CHIPS, Almanac of Hospital Financials and Operating Indicators, 2001 ed.
9. Martin, "California Hospitals"; and T. Good and L. Zukerman, "California Health Care Facing Near-Term Credit Volatility," Standard and Poor’s Credit Week Municipal (11 December 2000): 10.
10. Good and Zukerman, "California Health Care," 10.
11. Martin, "California Hospitals," 1.

                      What's this?

Related Article

• Margo Denke
  Voting With Our Forks
  Health Affairs, July/August 2002; 21(4): 293-294.
  [Extract] [Full Text] [PDF]
   
  

This article has been cited by other articles:

				J. W. Selsky, J. Goes, and O. N. Baburoglu Contrasting Perspectives of Strategy Making: Applications in 'Hyper' Environments Organization Studies, January 1, 2007; 28(1): 71 - 94. [Abstract] [PDF]

				J. Zwanziger and N. Khan Safety-Net Activities and Hospital Contracting with Managed Care Organizations Med Care Res Rev, December 1, 2006; 63(6_suppl): 90S - 111S. [Abstract] [PDF]

				D. Delia, A. Hall, T. Prinz, and J. Billings What Matters to Low-Income Patients in Ambulatory Care Facilities? Med Care Res Rev, September 1, 2004; 61(3): 352 - 375. [Abstract] [PDF]

				L. G. Sandy Homeostasis without Reserve -- The Risk of Health System Collapse N. Engl. J. Med., December 12, 2002; 347(24): 1971 - 1975. [Full Text] [PDF]