Saline Community Hosp. Ass'n v. Schweiker

• Decision Date: 14 January 1983
• Docket Number: 81-60128.,Civ. A. No. 81-60059
• Citation: 554 F. Supp. 1133
• Parties: SALINE COMMUNITY HOSPITAL ASSOCIATION; Sinai Hospital of Detroit, Plaintiffs, v. Richard S. SCHWEIKER, as Secretary of Health and Human Services, et al., Defendants. W.A. FOOTE MEMORIAL HOSPITAL, INC., Plaintiffs, v. Richard S. SCHWEIKER, et al., Defendants.
• Court: U.S. District Court — Western District of Michigan

554 F. Supp. 1133

SALINE COMMUNITY HOSPITAL ASSOCIATION; Sinai Hospital of Detroit, Plaintiffs, v. Richard S. SCHWEIKER, as Secretary of Health and Human Services, et al., Defendants.

W.A. FOOTE MEMORIAL HOSPITAL, INC., Plaintiffs, v. Richard S. SCHWEIKER, et al., Defendants.

Civ. A. Nos. 81-60059, 81-60128.

United States District Court, E.D. Michigan, S.D.

January 14, 1983.

Honigman, Miller, Schwartz & Cohn, Detroit, Mich., for plaintiffs.

Ellen Ritteman, Asst. U.S. Atty., Detroit, Mich., Jeanne Schulte Scott, Atty., Dept. of Health & Human Services, Washington, D.C., for defendants.

MEMORANDUM OPINION

JOINER, District Judge.

The plaintiffs in this action are three non-profit hospitals that seek declaratory and injunctive relief against the Secretary of Health and Human Services for denying their claim for return on equity capital for the cost reporting year 1979 under the Medicare Act and regulations.

The Medicare Program, begun in the summer of 1966, provides hospital insurance benefits to the elderly and disabled. Under the Medicare Act, 42 U.S.C. §§ 1395 et seq., providers who participate in the program are reimbursed for "the lesser of (A) the reasonable cost of such services... or (B) the customary charges with respect to such services...." 42 U.S.C. § 1395f(b)(1). The program is voluntary in that providers elect to participate and in doing so agree not to bill the Medicare patient for any of the services covered.

Each plaintiff timely filed a cost report for its 1979 fiscal year cost reporting period as required by Medicare regulations, 42 C.F.R. § 405.453(f). After timely filing its cost report, but before the fiscal intermediary had made its final determination of the amount of reimbursement due and before it had issued a notice of program reimbursement, each hospital filed an amended cost report with its fiscal intermediary requesting reimbursement for return on equity capital. In each case, the fiscal intermediary denied the request for reimbursement for this item on the merits. The plaintiffs appealed to the Provider Reimbursement Review Board, which dismissed the appeals on jurisdictional grounds.

This action was filed in April of 1981 and consolidated with a similar case involving W.A. Foote Memorial Hospital in April of 1982. The Secretary filed a motion to dismiss when the case was before Judge Feikens and the motion was denied. A similar motion for summary judgment or, in the alternative, for remand was heard and denied by this court. The Secretary's motion for summary judgment based on the merits of the case was also denied.

The matter was tried and the plaintiff hospitals had an opportunity to present evidence regarding return on equity as a cost. This decision is based on the record in this case and the evidence presented at trial.

The hospitals make two arguments:

1) That return on equity is both a "reasonable" and a "direct or indirect" cost as defined by the act and that the Secretary's regulations prohibiting payment for return on equity to non-profit hospitals causes the hospitals to shift this cost from Medicare patients to non-Medicare patients which is expressly prohibited by the act, 42 U.S.C. § 1395x(v)(1)(A).

2) That denying non-profit hospitals reimbursement for return on equity when proprietary hospitals are allowed this cost violates the Equal Protection Clause of the Fifth Amendment.

Return on Equity and Cost Shifting

The hospitals say that a return on equity capital is a reasonable cost under the Medicare Act and that the Secretary's refusal to reimburse non-profit hospitals for this cost is "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law...." Administrative Procedures Act, 5 U.S.C. § 706.

The Secretary argues that he is precluded from reimbursing non-profit hospitals for this item because it is not an allowable cost under the Medicare Act as evidenced by the legislative history.

"Reasonable cost" is defined in 42 U.S.C. § 1395x(v)(1)(A), which provides in part:

The reasonable cost of any services shall be the cost actually incurred, excluding therefrom any part of incurred cost found to be unnecessary in the efficient delivery of needed health services, and shall be determined in accordance with regulations establishing the method or methods to be used, and the items to be included, in determining such costs for various types or classes of institutions, agencies, and services; ... Such regulations shall (i) take into account both direct and indirect costs of providers of services (excluding therefrom any such costs, including standby costs, which are determined in accordance with regulations to be unnecessary in the efficient delivery of services covered by the insurance programs established under this subchapter) in order that, under the methods of determining costs, the necessary costs of efficiently delivering covered services to individuals covered by the insurance programs established by this title will not be borne by individuals not so covered.

At present the Secretary does not reimburse non-profit hospitals for return on equity. Under the regulations, return on equity is an allowable cost for proprietary providers only. 42 C.F.R. § 405.429.

Return on equity capital is a return on the capital assets or capital investment of an organization. Equity is the excess of assets over liabilities.

The hospitals presented expert testimony that a reasonable return on equity is a cost for businesses generally, and all hospitals in particular, for a variety of reasons. First, return on equity is necessary as a reserve to provide for future capital investment. Depreciation paid by Medicare only reflects the original cost of investment, and is not sufficient to cover the additional expense of replacing capital assets caused by inflation. Unless a hospital is able to generate a return on equity it cannot replace capital assets without incurring debt. The example given by Professor Silver, witness for the plaintiff, was a $100 asset at a 15% inflation rate. In ten years it would cost $400 to replace the asset. In order to maintain capital intact, the hospital must have the additional $300 of equity returned. Even if the hospital invested the funds it obtained for depreciation, this would not be sufficient to provide the $300 needed because of varying interest rates and because depreciation is spread over the useful life of the asset and recovered accordingly.

Second, return on equity is necessary to allow hospitals to enter the debt market and borrow funds to finance capital investment. This is because lenders require that borrowers have significantly more money generated from their operations than the minimum necessary to cover repayment of indebtedness. This margin is called debt service coverage. Professor Silver testified that lenders require hospitals seeking financing in the bond market to demonstrate that they have sufficient revenues to repay the debt, allowing some margin for error. All of this is translated into a figure referred to as the debt coverage ratio. The ratio is obtained by subtracting expenses from revenue and dividing the excess by the premium plus the interest on the debt.

Mr. Michael Hernandez, plaintiff's expert on investment banking and Vice President of Kidder, Peabody & Company, testified that the minimum average coverage ratio for hospitals able to get financing in the bond market, which is the relevant market for non-profit hospitals, is now 2.1 to 1. The ratio affects the hospital's bond rating which in turn affects the marketability of the hospital's bonds and ultimately its ability to raise capital. Return on equity represents a substantial portion of debt service coverage and, consequently, affects the coverage ratio and resultant bond rating. Mr. Hernandez testified that reducing return on equity to zero would make it extremely unlikely that a hospital could get financing.

Mr. Hernandez also testified that hospitals which have a high percentage of revenue derived from Medicare tend to receive a lower bond rating, i.e., the investment community views the hospital's bonds as being a less sound investment. This is partly due to the fact that Medicare does not pay return on equity.

Third, even hospitals financing investment out of conventional operations need return on equity to provide a "risk premium" to cover the possibility of lower revenues or higher costs than predicted in their financial projections.

The problem of inflation and replacing existing assets is further compounded by the need to make the institution more efficient through capital expenditures and the need to compete in attracting physicians and patients by providing quality care. The ability to compete is related to the ability to keep up with technological advances in health care delivery. Technological advances also make it often impossible to replace a particular asset with an equivalent item at an equivalent cost.

The debt service coverage problem is aggravated by the fact that the ratio of debt to capital expenditures for non-profit, acute care hospitals has risen from 40% in 1968 to 71% in 1980. It is estimated that this figure will increase to 81% in 1989. Therefore, hospitals which cannot maintain a sufficient debt service coverage ratio will be unable to finance 80% of their capital needs. Mr. Hernandez estimated that, if conditions remain the same, in ten years one-half of the hospitals would be unable to borrow.

Charitable contributions accounted for only 6.5% of the total amount spent for construction for non-profit hospitals in 1979 and the percentage figure appears to be decreasing. Contributions, as well as being sporadic and undependable, tend to be for new capital and to be directed toward specific uses and, therefore, do not assist with the return on equity problem, since return on equity relates to existing capital. Further, Mr. Hernandez projected that the combined funds available to...