Preparing for Reimbursement Cuts to Stay on Track for Capital Planning

Lenders will want to know that hospital leaders have a grasp on the legislative landscape

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As political uncertainty has shifted from the Supreme Court's ruling on the constitutionality of the Affordable Care Act (ACA), to the results of the presidential election, to dealing with the "fiscal cliff," one uncertainty that has remained constant for acute care providers is the uncertainty of reimbursement. Despite the doubt regarding the future of reimbursement, many hospitals do not have the luxury of delaying needed capital projects. When pursuing financing for these capital projects, there are steps that providers can take to mitigate the risk of Medicare and Medicaid reimbursement rate cuts.

What Can't Be Controlled
States still face a long and rocky recovery as 30 states have projected budget shortfalls totaling $49 billion for this fiscal year, according to the Center on Budget and Policy Priorities. Medicaid is a large component of a state's expenditures - averaging 13% of state budgets nationwide - and it's becoming even larger. Standard & Poor's Healthcare Economic Composite Index indicates that the average per capita cost of healthcare services covered by Medicaid rose 5.28% in 2011. As a result, Medicaid is a common target for states' budget balancing efforts, leaving many hospitals with an uncertain future. Similarly, Medicare reimbursement rates are also susceptible to cuts as pressure increases for the Federal Government to balance its budget.

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Hospitals are often getting pulled in both directions. Even as reimbursement rates are being cut, Medicaid is becoming more prevalent as a payer source. The Medicaid expansion mandated by the ACA is scheduled to take effect Jan. 1, 2014, and is projected to move an additional 16 million people to Medicaid. Although this increased coverage will "federalize Medicaid," meaning the federal government will bear a majority of the extra costs, the Congressional Budget Office projects that states will still see a 2.8% increase in Medicaid cost due to the expanded enrollment.

What Can Be Controlled Now
First, any lender or government agency providing credit enhancement wants to be convinced that hospital management has a grasp on the state and national legislative landscape. Hospital leadership should be able to discuss how the hospital has been impacted by past changes to the law and what future changes are currently being discussed. Demonstrating that the hospital has a pulse on the developments impacting reimbursement and has been able to navigate reimbursement changes in the past is a key indicator of the strength of the management team when assessing a hospital's credit worthiness.

Lenders and agencies will also likely expect a sensitivity analysis detailing the impact of possible Medicare or Medicaid rate cuts to be completed. The results may be surprising. According to Fitch's sensitivity analysis of all the hospitals it rates, each percentage point cut in Medicare reimbursement rates reduces operating margin by 40 basis points on average.

As with all potential underwriting risks, an obvious mitigation to the risk of reduced reimbursement rates is to decrease the project size and resulting funding request. Project size is often the first topic of discussion with potential investors and agencies. Considering their qualms with the healthcare industry, investors have reduced the targeted leverage points and are now seeking lower loan-to-value ratios. Therefore, an organization should expect construction costs to be heavily scrutinized, especially with reimbursement rate cuts looming on the horizon, when pursuing financing.

What Can Be Controlled in the Future
Lenders and agencies will likely ask to review a hospital's strategic plan to ensure there is a response for industry changes, including reimbursement cuts. A plan that successfully addresses the risk of reimbursement cuts should largely focus on expense-control tactics that a hospital may employ. Be aware that, when compared to the actual financial performance of a hospital's completed financing, expense projections often are understated in the feasibility study while revenue and cash projections are mostly accurate.

Ross Manson, principal at Eide Bailly, a CPA firm dedicated to audit and consulting services, has observed this trend during his 17 years of working with hospital management teams. According to Manson, a hospital needs to make a concerted effort to keep a sharp eye on expenses post-financing even though its balance sheet may be flush with cash.

"When a hospital is pursuing financing for a planned capital project, expenses are often carefully scrutinized by several parties whether it is the hospital's board of directors, a rating agency or potential lenders and investors," Manson says. "The true test for hospital management is to maintain the same expense discipline in the post-closing years when there is not quite as much third-party oversight."

This is indeed a challenging time for healthcare organizations; however, by focusing on a few select items that can be directly controlled now and in the future, a hospital may better prepare to brave the storm of reimbursement rate cuts.

Kevin Laidlaw is an assistant vice president at Lancaster Pollard, an investment banking and mortgage banking firm in Columbus, Ohio. He may be reached at klaidlaw@lancasterpollard.com.

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