In PYA’s ongoing Medicare Payment Primer series, we have been delving into the fundamentals of cost-based reimbursement, breaking them down into four parts. In this section, we will explore how providers’ source data is used to determine Medicare’s share of cost.
Although most reimbursement is not directly tied to cost reimbursement, understanding these mechanics provides insight into how Medicare works.
Determination of Allowable Costs
Foundational to determining allowable costs is having accurate information—verifiable by qualified auditors—available in sufficient detail to support the cost-finding process. Financial and statistical records should be maintained on a consistent basis, unless changes will result in more accurate cost finding [PRM-I, Chapter 23, Section 2304].
- Trial Balance of Expenses Reconciled to Financial Statements: The provider’s trial balance is the starting point for the cost-finding process. Depending on the complexity of the organization, the trial balance may include many hierarchal reporting levels. For cost reporting and cost-finding purposes, the trial balance used to prepare the cost report must show the salaries and non-salary expenses separately at the cost center level of detail. Cost centers are defined as: An organizational unit, generally a department or its subunit, having a common functional purpose for which direct and indirect costs are accumulated, allocated and apportioned. In addition, those natural expense classifications (e.g., depreciation) and nonallowable cost centers (e.g., research) specifically required by the instructions to be shown on the cost report fall under this definition. The table below shows the relationship between the financial statement “roll up” and the cost report assignment. Note that many individual general ledger (GL) level departments may be assigned to the same Medicare cost report (MCR) line.
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Income Statement |
= |
Cost Report |
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GL Object Codes |
= |
GL Object Codes |
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Split Between Salary and Other Expenses |
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|
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GL Department |
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FS Natural Expense Classes |
= |
MCR Line Assignment |
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Total Expenses |
= |
Worksheet A Totals |
- Reclassifications for Proper Medicare Cost Finding: Reclassifications may be necessary to align the GL department and MCR lines to achieve proper cost finding. Internal financial records may include as departmental expenses items or services that need to be grouped elsewhere for Medicare cost finding. The most common example of this is when general service costs (described later) are assigned to revenue-producing departments when they should be handled through the step-down cost-finding process. Reclassifications often occur to ensure that costs and total charges are properly aligned. This is commonly referred to as the matching principle.
- Adjustments to Align Costs With Medicare Principles of Reimbursement: Adjustments to expenses may be required to remove costs that are “not related to patient care,” as defined in the Provider Reimbursement Manual or by regulation. Other types of adjustments (offsets) may be required to properly account for other operating revenues that may be considered cost recoveries. Since Medicare has specific instructions regarding the treatment of “related party” and physician costs included in the provider’s expenses, adjustments related to these items may also be required. Other types of adjustments may be required depending on specific provider situations.
Allocation
Once total provider expenses have been determined, reclassified to achieve proper matching, and adjusted to align with Medicare principles of reimbursement, the process of cost allocation and apportionment can occur. The Medicare program refers to this as the “step-down cost-finding process.” Under step-down cost finding, any general service cost center (defined below) can be stepped down to any other general service cost center, revenue-generating cost center, or non-reimbursable cost center.
- General Service Versus Revenue-Producing and Other Cost Centers: General service cost centers are operated for the benefit of the institution as a whole [PRM-I Chapter 23, Section 2302.9]. They are often referenced as non-revenue-producing centers or overhead cost centers. In general, the costs in those departments are fixed, rather than varying with patient care volume. These overhead cost centers do not generate any patient care revenue (charges). These departments may result in other operating or non-operating revenue, as those terms may be defined in the accounting standards.
Revenue-producing cost centers may also be referenced as “direct patient care departments.” Unlike the general service cost centers noted above, revenue-producing departments do produce charges, and they exist to render a particular patient care service. They may be classified as routine, special care, sub-provider, or ancillary cost centers. All those terms are defined in the Provider Reimbursement Manual and reflect various forms of direct patient care activity.
Providers often operate programs and services that are not considered related to patient care activities. These are non-reimbursable cost centers. These activities do not generate hospital patient care revenue, and arguably the hospital does not need to operate these programs to deliver effective hospital patient care. These activities still benefit from many of the overhead services. So, for proper cost finding, they are included in the hospital report to receive the appropriate allocation of overhead costs.
- Order of Allocation: Under the step-down method, services rendered by certain non-revenue-producing departments or centers are utilized by certain other non-revenue-producing centers, as well as by the revenue-producing centers. All costs of non-revenue-producing centers are allocated to all centers they serve, regardless of whether these centers produce revenue. The cost of the non-revenue-producing center serving the greatest number of other centers is allocated first. Following the allocation of the cost of the non-revenue-producing center, that center will be considered “closed,” and no further costs are allocated to it. This applies even though it may have received some services from a center whose cost is allocated later. Generally, when two centers render service to an equal number of centers while receiving benefits from an equal number, the center that has the greatest amount of expense should be allocated first [PRM-I, Chapter 23, Section 2306.1].
- Systematic and Rational Allocation Statistical Basis: The step-down method described earlier does result in a systematic and rational allocation basis. It is systematic because once an overhead cost center is stepped down, it is closed out, so there is a degree of finality in the process. The percent of the total allocation statistic attributable to a particular cost center will establish the total share of the overhead cost assigned to that center. It is rational because every overhead cost center can be allocated to all the other cost centers, and the basis of allocation is reasonable and consistent with how cost finding may be developed in other settings.
- Approved allocation basis: Medicare has established approved allocation bases for all the standard overhead MCR lines. Examples include square footage for depreciation and operation of the plant, gross salaries for employee benefits, pounds of laundry for the laundry cost center, etc. Since many of the statistical bases are not financial values, hospitals need to obtain the statistical allocation information from various operating departments to properly complete their cost reports.
- Alternative allocation basis: Hospitals may have more overhead cost centers than recognized in the standard hospital cost report. They may also determine they are unable to obtain the necessary statistical information that could be used as an allocation basis. For example, if a hospital is not able to determine the number of cafeteria meals for each department, an acceptable proxy would be to use the departmental full-time equivalents (FTEs). As another example, a hospital may not be able to determine departmental usage of information technology resources, so those information technology costs may be allocated using accumulated costs. In both examples, the alternative allocation bases would be acceptable. In these situations, the hospital can seek approval from its Medicare Administrative Contractor (MAC) to use an alternative basis. The hospital must demonstrate that the use of the alternative basis (or order) of allocation results in a more sophisticated cost-finding method.
- Operating versus capital cost allocation process: Prior to the inception of the various prospective payment systems, there was not a need to separately identify operating and capital costs. Basically, allowable cost was allowable cost.
When the Inpatient Prospective Payment System (IPPS) was launched, initially only operating costs were subject to the IPPS, and capital costs were still reimbursed on a reasonable cost basis. This necessitated separately identifying capital costs and creating a bifurcated step-down process. The first step-down (B Part I) considers all allowable costs. The second step-down (B Part II) separately identifies the capital costs (depreciation, interest, property insurance, and rental expenses) that are included within the total allowable costs.
Now, the separate capital cost step-down provides information to CMS on the portion of total capital-related costs to be used in the PPS rate updates. Only the IPPS includes a separate element for capital costs. The only other area where capital costs are separately identified includes any Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) hospitals (e.g., children’s hospitals, hospitals located in various U.S. territories, and cancer hospitals).
The graphic representation below illustrates the step-down cost-finding process.
Apportionment
At the conclusion of the step-down cost finding, only fully allocated costs assigned to the revenue-producing cost centers advance through the process as reimbursable costs. The reimbursable costs consist of the direct departmental costs, plus the amounts allocated through the step-down cost finding. The non-reimbursable cost centers also drop off.
- Departmental Cost Finding: As a result of the step-down process, the cost report now identifies the departmental cost for every revenue-producing department. The departmental cost is matched up with the departmental gross charges, split between inpatient and outpatient, with the total reconcilable to the gross patient service revenue per the internal financial statements or trial balance.
- Ratio of Cost to Charges (RCC): The result of the division of departmental costs by the total departmental charges is the RCC. These total departmental ratios are important because these ratios will be multiplied by the departmental Medicare charges, by provider component (acute inpatient, outpatient, behavioral medicine, rehabilitation unit, and skilled nursing facility), to determine the Medicare share of the cost for that department and provider component. Other payers such as Medicaid and commercial insurance could also determine departmental cost using the same cost/charge ratios applied to their specific charges. Prior to the determination of the RCCs, everything in the cost report has been total facility, regardless of the insurer. After the RCCs are established, the balance of the cost apportionment process focuses on just the Medicare activity.
- Determining Medicare Cost: Apportioning costs to Medicare is done separately for each provider component (e.g., inpatient, outpatient, skilled nursing unit, swing beds, inpatient psychiatric unit, inpatient rehabilitation unit, etc.). There are separate cost-reporting schedules designed to accomplish this purpose.
Although RCCs can be determined for any department, Medicare cost-finding principles use a per-diem calculation for the nursing units (general routine care, special care units, sub-provider components). The RCC method is only used for the ancillary departments.
For providers reimbursed under the various prospective payment mechanisms, the consideration of cost may not be as fully relevant as to cost-based entities such as critical access hospitals. However, CMS does use the cost report data to inform future rate setting, so attention to detail is still important.
Resources
Related Insights in our Medicare Payment Primer Series cover:
- The definition of “cost” (Part 3a)
- Provider types and components (Part 3c)
- Other areas dependent on cost report ratios and processes (Part 3d)
If you have questions about any matter related to reimbursement, strategy and transactions, compliance, or valuation, one of our executive contacts would be happy to assist. You may email them below, or call (800) 270-9629.
