St. James Hosp. v. Heckler, s. 84-1478

Citation760 F.2d 1460
Decision Date18 April 1985
Docket Number84-1727,Nos. 84-1478,s. 84-1478
Parties, 9 Soc.Sec.Rep.Ser. 324, Medicare&Medicaid Gu 34,577 ST. JAMES HOSPITAL, Plaintiff-Appellee, v. Margaret M. HECKLER, Secretary of the Department of Health and Human Services, Defendant-Appellant. HUMANA OF ILLINOIS, INC., d/b/a Springfield Community Hospital, Plaintiff-Appellee, v. Margaret M. HECKLER, Secretary of the Department of Health and Human Services, Defendant-Appellant.
CourtUnited States Courts of Appeals. United States Court of Appeals (7th Circuit)

Robert V. Zener, Dept. of Justice, Washington, D.C., for defendant-appellant.

Margaret M. Manning, Baltimore, Md., Thomas H. Brock, Casson, Callagaro, Muliyn, Washington, D.C., for plaintiff-appellee.

Before BAUER and FLAUM, Circuit Judges, and GRANT, Senior District Judge. *

FLAUM, Circuit Judge.

In these consolidated appeals, the Secretary of the Department of Health and Human Services (the "Secretary") seeks reversal of two district court decisions invalidating a regulation promulgated in 1979 under Title XVIII of the Social Security Act, 42 U.S.C. Secs. 1395 et seq. (1982) (the "Medicare Act"). The regulation at issue prescribes a new formula for reimbursing Medicare health care providers for malpractice insurance premiums associated with the care of Medicare patients. 42 C.F.R. Sec. 405.452(a)(1)(ii) (1984) (the "Malpractice Rule"). The district courts below concluded that the Malpractice Rule was invalid because it was arbitrary and capricious and contrary to the Medicare Act and because the Secretary failed to provide an adequate basis and purpose statement. St. James Hospital v. Heckler, 579 F.Supp. 757 (N.D.Ill.1984) (Will, J.); Humana of Illinois, Inc. v. Heckler, 584 F.Supp. 618 (C.D.Ill.1984) (adopting Judge Will's decision). 1 We affirm.

I.
A. The Malpractice Rule

Under the Medicare Act, a health care provider is entitled to government reimbursement for the lesser of the "reasonable cost" of the services it provides for Medicare patients or its "customary charges" with respect to those services. 42 U.S.C. Sec. 1395f(b)(1) (1982). "Reasonable cost" is defined as "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" to be promulgated by the Secretary. 42 U.S.C. Sec. 1395x(v)(1)(A) (1982). The statute further provides that such regulations shall take into account "both direct and indirect costs of providers of services ... in order that ... the necessary costs of efficiently delivering covered services to individuals covered by [Medicare] will not be borne by individuals not so covered, and the costs with respect to individuals not so covered will not be borne by [Medicare]...." Id.

With these directives in mind, the Secretary adopted regulations in 1966 that pooled all of a health care provider's general and administrative ("G & A") costs together and then allocated them among Medicare and non-Medicare patients on the basis of patient hospital usage ("patient utilization ratio"). 31 Fed.Reg. 14,808 (1966) (codified at 20 C.F.R. Part 405, Subpart D (1966)). For example, if Medicare patients constituted 30% of the patient charges at a hospital in a given year, then Medicare reimbursed the hospital for approximately 30% of its G & A costs. G & A costs included a variety of overhead expenses, including billing costs, accounting and legal fees, and all types of insurance premiums. This method of allocating indirect costs remained unchanged from 1966 until promulgation of the Malpractice Rule in 1979.

On March 15, 1979, the Secretary issued the proposed Malpractice Rule for public comment. 44 Fed.Reg. 15,744 (Mar. 15, 1979). The proposed rule removed malpractice insurance premiums from the G & A pool of indirect costs and apportioned them directly based on malpractice loss experience. The stated reason for segregating malpractice insurance premiums from the other G & A costs was that the Medicare program was paying a disproportionate amount of malpractice insurance costs under the old formula. This conclusion was based on "[a] study conducted by an HEW consultant indicat[ing] that malpractice awards for Medicare ... patients are significantly lower in amount than losses for other patient population [sic]." Id. at 15,745. 2 The Secretary attributed the lower awards for Medicare patients to the fact that their income potential and life expectancies are generally less than those of the remainder of the patient population. Id.

The proposed rule removed malpractice insurance premiums from the G & A pool and instead reimbursed those costs by dividing the losses paid to Medicare patients by the total paid malpractice losses, and then multiplying that ratio times malpractice insurance costs. Id. The ratio was to be calculated for both the cost year at issue and the four preceding years. The Secretary selected a single provider's five-year malpractice loss ratio as the relevant measure on the theory that "the estimated malpractice losses paid in future periods are closely related to past malpractice losses paid." Id. Hospitals with no malpractice loss experience for the relevant five-year period were required to obtain an actuarial estimate of Medicare's share of current malpractice costs from an independent actuary, insurance company, or broker. Id.

The Secretary received nearly 600 comments on the proposed rule. 3 The comments were submitted by health care institutions, consumers, accounting firms, insurance companies, actuaries, health care consultants, physicians and nurses, and Medicare beneficiaries. All comments received were opposed to the proposed rule and recommended its complete withdrawal. 44 Fed.Reg. 31,641 (June 1, 1979). There were seven major criticisms of the proposed rule: (1) the inequity of removing malpractice premiums from the G & A pool while retaining in the pool other costs incurred principally for Medicare patients, (2) providers' anticipated cash flow problems due to erratic reimbursement patterns as the paid-loss ratio fluctuates from year to year, (3) the increased likelihood that hospitals would fraudulently treat malpractice claims by Medicare patients, (4) the statistical invalidity of the Westat study, (5) the fact that malpractice insurance protects hospitals' assets and thus benefits all patients equally, (6) the fact that insurance companies set premiums on the basis of an overall assessment of risk, without allocating the risk among different types of patients, and (7) the complexity and expense of the additional accounting required by the proposed rule.

Notwithstanding the many adverse comments, the Secretary issued the final Malpractice Rule on June 1, 1979. 44 Fed.Reg. 31,641 (originally codified at 42 C.F.R. Sec. 405.452(b)(1)(ii)). The only change to the proposed rule was the formula to be used for providers with no malpractice loss experience. Instead of the actuarial estimate required in the proposed rule, the final rule calculated reimbursement for these providers on the basis of the national ratio of malpractice awards paid to Medicare patients to the malpractice awards paid to all patients. Id. at 31,642. This national ratio, set at 5.1% for the first year based on the Westat study, was to be recalculated each year in light of the previous year's data. 4

B. The Hospitals

Plaintiff-appellees St. James Hospital and Humana of Illinois, Inc. ("Humana") are both health care providers as defined in the Medicare Act. See 42 U.S.C. Sec. 1395x(u) (1982). For its cost year ending in 1980, St. James Hospital's overall Medicare patient utilization ratio was 30%. Under the new Malpractice Rule, however, Medicare only reimbursed 20.11% of its malpractice insurance premiums. The amount of denied Medicare reimbursement at issue is $24,159.

On June 3, 1981, St. James sought a hearing on its malpractice reimbursement determination before the Provider Reimbursement Review Board ("PRRB" or the "Board") pursuant to 42 U.S.C. Sec. 1395oo(a) (1982). The Board held that it had no jurisdiction to review the validity of the Malpractice Rule and therefore, pursuant to statute, certified the question for appeal to the federal district courts. 42 U.S.C. Sec. 1395oo(f)(1) (1982). On appeal, Judge Will held that the Secretary failed to provide an adequate basis and purpose statement for the Malpractice Rule and that the Rule was arbitrary and capricious and not in compliance with the requirements of the Medicare Act. St. James Hospital v. Heckler, 579 F.Supp. at 767. St. James Hospital's motion for summary judgment was accordingly granted. Id.

The Malpractice Rule's impact on Humana was even greater than its effect on St. James Hospital. Humana's Medicare patient utilization ratio was 49.38% for cost year 1980, yet its reimbursement under the Malpractice Rule was zero. Humana received no Medicare reimbursement because it had only paid a single $750 malpractice award in the relevant five-year period and the recipient of that award was a non-Medicare patient. The amount of denied Medicare reimbursement at issue for Humana is approximately $37,000. On appeal to the district court, Judge Ackerman adopted Judge Will's opinion holding the Malpractice Rule invalid and granted Humana's motion for summary judgment. Humana of Illinois, Inc. v. Heckler, 584 F.Supp. 618, 619 (C.D.Ill.1984).

II.

In assessing the validity of the Malpractice Rule on appeal, we will address three separate, although somewhat interrelated, questions. The first question is whether the Secretary's action was substantively "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law," under the judicial review provisions of the Administrative Procedure Act ("APA"), 5 U.S.C. Secs. 551-559, 701 et seq. (1982). 5 U.S.C. Sec. 706(2)(A) (1982). The second inquiry is whether the Rule complies with the procedural...

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