Accounting for Health Care Organizations

Each type of not-for-profit organization tends to retain some unique elements of financial reporting that have evolved over the years. Voluntary health and welfare organizations, must report a statement of functional expenses. Probably the most distinctive version of not-for-profit accounting belongs to health-care organizations.

From a quantitative perspective, the providers of health-care services have many thousands of institutions in oper­ation throughout the United States; virtually every city and town has hospitals, nursing homes, and medical clinics. The large number of these enterprises is not surprising; health-care expen­ditures now make up more than 15 percent of the gross national product in this country. Because of society’s focus on health care, a wide array of organizations including for-profit endeavors, governmental operations, and not-for-profit entities have emerged.

One major factor influencing the financial reporting of health-care organizations is the presence of third-party payors such as insurance companies, Medicare, and Medicaid. These organizations, rather than the individual patient, pay all or some of the cost of medical services that the patient receives. Because of the significant monetary amounts involved, third-party payors have historically sought reliable financial data, especially concerning the sources of revenue and the costs of patient care.

Accounting for Patient Service Revenues:

The largest source of health-care revenues normally is patient services. For example, the Lucile Packard Children’s Hospital of the Stanford Medical Center reported in 2005 that $444 million of its total revenue of $481 million came from net patient service revenue. These amounts include fees for surgery, nursing services, medicine, laboratory work, X rays, blood, housing, food, and so forth.

Reductions in Patient Service Revenues:

For a variety of reasons, health-care entities often receive much less in total payment than the amount they normally charge for specific patient services. Bad debts and other fee reductions can be significant. However, to provide complete financial data about their operations, these organizations initially record revenues at standard rates. Then they report each of the various reductions in a specified manner to best reflect these activities.

Assume, as an illustration, that patient charges for the current month at a local hospital total $750,000. Of this amount, $170,000 is due from patients, and the remaining $580,000 was billed to third-party payors- Medicare, Medicaid, and various insurance companies.

Regard­less of expected receipts, the hospital initially should record these revenues through the fol­lowing journal entry:

This hospital reports the entire $750,000 as patient service revenue although complete collec­tion is doubtful. This approach is considered the best method of allowing the health-care orga­nization to monitor activities during the period.

To continue this example, assume that the hospital estimates that $20,000 of the patient receivables will be uncollectible. Furthermore, not-for-profit hospitals and other similar enti­ties often make no serious attempt to collect amounts that indigent patients owe. In many cases, these facilities were originally created to serve the poor. Assume, therefore, that another $18,000 of the accounts receivable will never be collected because several specific patients earn incomes at or below the poverty level.

Thus, to mirror these anticipated reductions, the hospital records two additional entries. As the following shows, the handling of the two reductions is not the same. The bad debts create an expense as in a for-profit business, but the revenue and receivable for the charity care are removed entirely so that no financial reporting is shown. If the work was performed with no intention to seek collection, no basis exists for recognizing either a receivable or a revenue.

Contractual Agreements with Third-Party Payors:

The adjustments in the preceding entries reflect amounts that the entity will not collect from patients. Such organizations make an additional reduction in connection with receivables due from third-party payors. Organizations such as insurance companies and Medicare often estab­lish contractual arrangements with health-care providers stipulating that they will pay set rates for specific services. The entity agrees, in effect, to accept as payment in full an amount that the third-party payor computes as reasonable (based normally on the average cost within the locality in which the service was rendered).

For example, a note to the 2006 financial statements for Duke University explains that the Duke University Health System (DUHS) has agreements with third-party payors that provide for payments to DUHS at amounts that gen­erally are less than established rates. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges and per diem payments. Accordingly, net patient service revenue is reported at the estimated net realizable amounts from patients, third-party payors, and others for services rendered.

Thus, although a health care entity charges a patient $3,000, for example, it might collect only $2,700 (or some other total) from a third-party payor if the lower figure is determined to be an appropriate cost. The entity must write off the remaining $300, which is commonly referred to as a contractual adjustment.

Because of the current cost of health care, contractual adjustments can be huge. For exam­ple, Duke University’s 2006 financial statements indicate that the receivable balances shown by DUHS “are reported net of allowances for contractual adjustments and uncollectible accounts of $228,305,000.” This reduction was roughly equal to the remaining receivable that was reported.

An alternative method of determining the amount to be paid is known as a prospective pay­ment plan. Under this system, reimbursement is based not on the cost of the health services being provided but on the diagnosis of the patient’s illness or injury.

Thus, if a patient has a broken leg, for example, the health care entity would be entitled to a set reimbursement regard­less of the actual expense incurred. Such plans were developed in an attempt to encourage a reduction in medical costs because the facility collects no additional amount if a patient remains in a hospital longer than necessary or receives more expensive treatment.

The health-care entity should estimate and recognize these reductions in the same period that it earns the patient service revenue. The hospital probably does not anticipate collecting the entire $580,000 billed to third-party payors. Assume, for illustration purposes, that this hospital projects receiving only $420,000 of the $580,000 charge.

To establish a proper value for the hospital’s revenues, the entity must record another $160,000 adjustment:

The AICPA audit and accounting guide requires that entities show bad debts as expenses rather than as reductions to patient service revenues. Furthermore, revenues and related charity care deductions are not recorded at all if the health-care entity has no inten­tion of collecting. Finally, contractual adjustments reduce patient service revenues but do not appear explicitly on the financial statements.

Rather, patient service revenues are shown on the statement of activities as a net figure after removing all such reductions. Because the entity has little chance of collecting the entire balance, reporting total revenues could mislead readers.