Explain whether you agree or disagree with the following comments: It always puzzles me why the cost of healthcare is such a big issue. ?Arent about 60% of
Chapter 1, Short Answer
Explain whether you agree or disagree with the following comments: “It always puzzles me why the cost of healthcare is such a big issue. Aren’t about 60% of our hospitals not-for-profit? That means that about 60% of the healthcare needs out there are being satisfied free of charge through charitable organizations.”
Textbook Question 2.7 Describe the provider incentives under each of the following reimbursement methods:
a. Cost based
b. Charge based (including discounted charges)
c. Per procedure
d. Per diagnosis
e. Per diem
f. Bundled payment
g. Capitation
Textbook Question Question – 1.10
a. What is the primary goal of investor-owned corporations?
b. What is the primary goal of most not-for-profit healthcare corporations?
c. Are there substantial differences between the finance goals of investor-owned and not-for-profit corporations? Explain.
Reference
Louis Gapenski. (2016). Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition: Vol. Sixth edition. Health Administration Press.
CHAPTER
3
HEALTHCARE FINANCE BASICS
Introduction
In today’s healthcare environment, where financial realities play an important role in health services decision making, it is vital that managers at all levels understand the basic concepts of healthcare finance and how these concepts are used to enhance the financial well-being of the organization. In this chapter, we introduce readers to the book, including its purpose, goals, and organi- zation. Furthermore, we present some basic background information about healthcare finance and the health services system. We sincerely hope that this book will be a significant help to you in your quest to increase your profes- sional competency in the important area of healthcare finance.
Before You Begin
Before you begin the study of healthcare finance, here are a few tips about the book that will make the process easier.
1 Learning Objectives After studying this chapter, readers will be able to
• Describe the organization of this book and the learning aids contained in each chapter.
• Define the term healthcare finance as it is used in this book. • Describe the key characteristics of a business. • Discuss the structure of the finance department, the role of finance
in health services organizations, and how this role has changed over time.
• Describe the major players in the health services industry. • List the key operational issues currently faced by healthcare
managers. • Describe the alternative forms of business organization and
corporate ownership and their organizational goals. • Discuss the key elements of healthcare reform and its expected
effect on the provision of health services.
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C o p y r i g h t 2 0 1 6 . H e a l t h A d m i n i s t r a t i o n P r e s s .
A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .
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Healthcare F inance4
Purpose of the Book Many books cover the general topics of accounting and financial management, so why is a book needed that focuses on healthcare finance? The reason is that while all industries have certain individual characteristics, the health services industry is truly unique. For example, the provision of healthcare services is dominated by not-for-profit corporations, both private and governmental, and such entities are inherently different from investor-owned businesses. Also, the majority of payments made to healthcare providers are not made by the indi- viduals who use the services but by third-party payers (e.g., employers, com- mercial insurance companies, government programs). Throughout this book, the ways in which the unique features of the health services industry influence the application of finance principles and practices are emphasized.
This book is designed to introduce students to healthcare finance, which has two important implications. First, the book assumes no prior knowledge of the subject matter; thus, the book is totally self-contained, with each topic explained from the beginning in basic terms. Furthermore, because clarity is so important when concepts are introduced, the chapters have been written in an easy-to-read fashion. None of the topics is inherently difficult, but new concepts often take some effort to understand. This process is made easier by the writing style used.
Second, because this book is introductory, it contains a broad overview of healthcare finance. The good news here is that the book presents virtually all the important healthcare finance principles that are used by managers in health services organizations. The bad news is that the large number of topics covered prevents us from covering principles in great depth or from includ- ing a wide variety of illustrations. Thus, students who use this book are not expected to fully understand every nuance of every finance principle and practice that pertains to every type of health services organization. Nevertheless, this book provides sufficient knowledge of healthcare finance so that readers will be better able to function as managers, judge the quality of financial analyses performed by others, and incorporate sound principles and practices into their own personal finance decisions.
Naturally, an introductory finance book does not contain everything that a healthcare financial manager must know to competently perform his or her job. Nevertheless, the book is useful even for those working in finance positions within health services organizations because it presents an overview of the finance function. Often, when one is working in a specific area of finance, it is too easy to lose sight of the context of one’s work. This book will help provide that context.
Organization of the Book In Alice’s Adventures in Wonderland, Lewis Carroll wrote: “If you don’t know where you are going, any road will get you there.” Because not just any road
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Chapter 1 : Healthcare F inance Basics 5
will ensure that this book meets its goals, the destination has been carefully charted: to provide an introduction to healthcare finance. Furthermore, the book is organized to pave the road to this destination.
Part I, The Healthcare Environment, contains fundamental background material essential to the practice of healthcare finance. In essence, Part I intro- duces the book, provides insights into the uniqueness of the health services industry, and provides additional information on how healthcare providers obtain their revenues. Healthcare finance cannot be studied in a vacuum because the practice of finance is profoundly influenced by the economic and social environment of the industry, including alternative types of ownership and reimbursement methods.
Part II, Financial Accounting, begins the actual discussion of healthcare finance principles and practices. Financial accounting, which involves the cre- ation of statements that summarize a business’s financial status, is most useful for outsiders and for long-term planning and management. In this part, we discuss the format and interpretation of the four primary financial statements.
Part III, Managerial Accounting, which consists of four chapters, focuses on the creation of data used in the day-to-day management and control of a business. Here, the emphasis begins with the overall organization, then it shifts to the subunit (department) level, and finally it reaches the individual service level. The key topics in Part III include costing methods and behavior, profit planning, cost allocation, pricing and service decisions, and financial planning and budgeting.
In Part IV, Basic Financial Management Concepts, the focus moves from accounting to financial management. Here we first cover time value analysis, which provides techniques for valuing future cash flows. The second of the two chapters in this part discusses financial risk and required return. Taken together, these chapters provide readers with knowledge of two of the most important concepts used in financial decision making.
Part V, Long-Term Financing, turns to the capital acquisition process. Businesses need capital, or funds, to purchase assets, and this part examines the two primary types of financing—long-term debt and equity. In addition, the final chapter of Part V provides the framework for analyzing a business’s appropriate financing mix and assessing its cost.
Part VI, Capital Investment Decisions, considers the vital topic of how businesses analyze new capital investment opportunities (capital budgeting). Because major capital projects take years to plan and execute, and because these decisions generally are not easily reversed and will affect operations for many years, their impact on the future of an organization is profound. The two chapters in this part first focus on basic capital investment analysis concepts and then turn to project risk assessment and incorporation.
Part VII, Other Topics, covers two diverse topics. The first chapter in this part discusses the revenue cycle and the management of short-term
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Healthcare F inance6
assets, such as cash and inventories, as well as how such assets are financed. The techniques used to analyze a business’s financial and operating condition are discussed in the book’s final chapter. Health services managers must be able to assess the current financial condition of their organizations. Even more important, managers must be able to monitor and control current operations and assess ways in which alternative courses of action will affect the organiza- tion’s future financial condition.
In addition to the printed text, two chapters are available from the publisher’s website for this book. Chapter 18, Lease Financing and Business Valuation, contains information on leasing and how to value entire businesses, and Chapter 19, Distributions to Owners: Bonuses, Dividends, and Repur- chases, discusses how profits in investor-owned businesses are returned to owners. To access these chapters, visit ache.org/books/HCFinance6.
How to Use This Book As mentioned earlier, the book is designed to introduce students to healthcare finance. The book contains several features designed to make the process as easy as possible.
First, pay particular attention to the Learning Objectives listed at the beginning of each chapter. These objectives provide a feel for the most impor- tant topics in each chapter and what readers should set as learning goals for the chapter.
Following each major section in a chapter (except the chapter’s Intro- duction), one or more Self-Test Questions are included. As you finish reading each major section, try to provide reasonable answers to these questions. Your responses do not have to be perfect, but if you are not satisfied with your answer, it would be best to reread the section before proceeding. Answers are not provided for the self-test questions, so a review of the section is indicated if you are in doubt about whether your answers are satisfactory.
It is useful for readers to have important equations both embedded in the text to illustrate their use and broken out separately to permit easy identi- fication and review. The Key Equation boxes can be used both for section and chapter review and as an aid to working end-of-chapter problems. In addi- tion, the book contains several types of boxes, such as For Your Consideration and Industry Practice boxes. Each of these boxes presents an important issue relevant to the text discussion and allows readers to pause for a few moments to think about the issue presented, generate opinions, and draw conclusions. Many instructors use these boxes to stimulate in-class discussions.
Within the book, italics and boldface are used to indicate importance. Italics are used whenever a key term is introduced; thus, italics alert readers that a new and important concept is being presented. Boldface indicates terms that are defined in each chapter’s running glossary, which complements the glossary at the back of the book, and is also occasionally used for emphasis.
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Chapter 1 : Healthcare F inance Basics 7
In addition to in-chapter learning aids, materials designed to help read- ers learn healthcare finance are included at the end of each chapter. First, each chapter ends with a summary section titled Key Concepts, which briefly sum- marizes the most important principles and practices covered in that chapter. If the meaning of a key concept is not apparent, you may find it useful to review the applicable section. Each chapter also contains a series of Questions designed to assess your understanding of the qualitative material in the chapter. In most chapters, the questions are followed by a set of Problems designed to assess your understanding of the quantitative material. Additionally, each chapter ends with a set of Resources. The books and articles cited can provide a more in-depth understanding of the material covered in the chapter. Finally, some chapters contain a Chapter Supplement, whose purpose is to present additional information pertaining to topics in the chapter that is useful but not essential.
Taken together, the pedagogic structure of the book is designed to make learning healthcare finance as easy and enjoyable as possible.
Defining Healthcare Finance
What is healthcare finance? Surprisingly, there is no single answer to that question because the definition of the term depends, for the most part, on the context in which it is used. Thus, in writing this book, the first step was to establish the definition of healthcare finance.
We began by examining the healthcare sector of the economy, which con- sists of a diverse collection of subsectors that involve, either directly or indirectly, the healthcare of the population. The major subsectors include the following:
• Health services. The health services subsector consists of providers of health services, including medical practice, hospital, nursing home, home health care, and hospice industries.
• Health insurance. The health insurance subsector, which makes most of the payments to health services providers, includes government programs and commercial insurers as well as self-insurers. Also included here are managed care companies, such as health maintenance organizations, which incorporate both insurance and health services (provider) functions.
1. Why is it necessary to have a book dedicated to healthcare finance?
2. What is the purpose of this book? 3. Briefly describe the organization of this book. 4. What features in the book are designed to make learning easier?
SELF-TEST QUESTIONS
Provider An organization that provides healthcare services (treats patients).
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Healthcare F inance8
• Medical equipment and supplies. These subsectors include the makers of diagnostic equipment, such as X-ray machines; durable medical equipment, such as wheelchairs; and expendable medical supplies, such as disposable surgical instruments and hypodermic syringes.
• Pharmaceuticals and biotechnology. These subsectors develop and market drugs and other therapeutic products.
• Other. This category includes a diverse collection of organizations ranging from consulting firms to educational institutions to government and private agencies.
Most users of this book will become (or already are) managers at health services organizations or at companies such as insurance and consulting firms that deal directly with health services organizations. Thus, to give this book the most value to its primary users, we focus on finance as it applies within the health services subsector. Of course, the principles and practices of finance cannot be applied in a vacuum but must be based on the realities of the current healthcare environment, including how health services are financed. Further- more, insurance involves payment to healthcare providers; much of managed care involves utilization management of providers, either directly or through contracts; and most consulting work is done for providers, so the material in this book is also relevant for managers in industries related to health services.
Now that we have defined the healthcare focus of this book, the term finance must be defined. Finance, as the term is used within health services organizations and as it is used in this book, consists of both the accounting and financial management functions. (In many settings, accounting and finan- cial management are separate disciplines.) Accounting, as its name implies, is concerned with the recording, in financial terms, of economic events that reflect the operations, resources, and financing of an organization. In general, the purpose of accounting is to create and provide to interested parties, both internal and external, useful information about an organization’s operations and financial status.
Whereas accounting provides a rational means by which to measure a business’s financial performance and assess operations, financial management provides the theory, concepts, and tools necessary to help managers make better financial decisions. Of course, the boundary between accounting and financial management is blurred; certain aspects of accounting involve decision making, and much of the application of financial management theory and concepts requires accounting data.
Accounting The field of finance that involves the measuring and recording of events, in dollar terms, that reflect an organization’s operational and financial status.
Financial management The field of finance that provides the theory, concepts, and tools used by healthcare managers to make financial decisions.
1. What is meant by the term healthcare finance? 2. What is the difference between accounting and financial management?
SELF-TEST QUESTIONS
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Chapter 1 : Healthcare F inance Basics 9
Concept of a Business
This book focuses on finance as practiced within health services businesses, so it is reasonable to ask this question: What is a business? If this question were asked to a group of accountants, the answer probably would involve financial statements, such as the income statement and balance sheet, which we cover in chapters 3 and 4. However, if the question were posed to a group of lawyers, the answer likely would include legal forms of business, which we describe later in this chapter.
From a financial (economic) perspective, a business can be thought of as an entity (its legal form does not matter) that (1) obtains financing (capital) from the marketplace; (2) uses those funds to buy land, buildings, and equip- ment; (3) operates those assets to create goods or services; and then (4) sells those goods or services to create revenue. To be financially viable, a business has to have sufficient revenue to pay all of the costs associated with creating and selling its goods or services.
Although this description of a busi- ness is surprisingly simple, it tells a great deal about the basic decisions that business managers must make. One of the first deci- sions is to choose the best legal form for the business. Then, the manager must decide how the business will raise the capital that it needs to get started. Should it borrow the money (use debt financing), raise the money from owners (or from the community if not- for-profit), or use some combination of the two sources? Next, once the start-up capital is raised, what physical assets (facilities and equipment) should be acquired to create the services that (in the case of healthcare providers) will be offered to patients?
Note that businesses are profoundly different from pure charities. A business, such as a hospital or medical practice, sus- tains itself financially by selling goods or services. Thus, it is in competition with other businesses for the consumer dollar. A pure charity, such as the American Heart Association, on the other hand, does not sell goods or services. Rather, it obtains funds by soliciting contributions and then uses
For Your Consideration Businesses, Pure Charities, and Governmental Entities
A healthcare business relies on revenues from sales to create financial sustainability. For exam- ple, if a hospital’s revenues exceed its costs, cash is being generated that can be used to provide new and improved patient services and the hos- pital can continue to meet community needs. On the other hand, pure charities, such as the Ameri- can Red Cross, rely on contributions for revenues, so the amount of charitable services provided (which typically are free) is limited by the amount of contributions received. Finally, most govern- mental units are funded by tax receipts, so, as with charities, the amount of services provided is limited, but in this case by the taxing authority’s ability to raise revenues. Yet, in spite of differ- ences, all three types of organizations must oper- ate in a financially prudent manner.
What do you think? From a finance perspec- tive, how different are these types of organiza- tions? How does the day-to-day functioning of their respective finance departments vary? Is finance more important in one type of organiza- tion than in another?
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Healthcare F inance10
those funds to supply charitable (free) services. In essence, a pure charity is a budgetary organization in that the amount of contributions fixes its budget for the year.
Also, businesses are different from governmental agencies such as local public health departments. In general, governmental agencies do not receive revenues by selling services or by soliciting contributions. Rather, the reve- nues are derived from taxing the populations that benefit from the govern- mental services, so providing additional services typically uses resources with- out generating additional income. Thus, like a pure charity, a governmental agency has a budget that is fixed, but by appropriations rather than by contributions.
The Role of Finance in Health Services Organizations
The primary role of finance in health services organizations, as in all busi- nesses, is to plan for, acquire, and use resources to maximize the efficiency and value of the enterprise. As we discuss in the next section, the two broad areas of finance—accounting and financial management—are separate functions in larger organizations, although the accounting function usually is carried out under the direction of the organization’s chief financial officer and hence falls under the overall category of finance.
In general, finance activities include the following:
• Planning and budgeting. First and foremost, healthcare finance involves evaluating the financial effectiveness of current operations and planning for the future. Budgets play an important role in this process.
• Financial reporting. For a variety of reasons, it is important for businesses to record and report to outsiders the results of operations and current financial status. This is typically accomplished by a set of financial statements.
• Capital investment decisions. Although capital investment is more important to senior management, managers at all levels must be concerned with the capital investment decision-making process. Decisions that result from this process, which are called capital budgeting decisions, focus on the acquisition of land, buildings, and equipment. They are the primary means by which businesses
1. From a financial perspective, briefly describe a business. 2. What is the difference between a business and a pure charity?
Between a business and a governmental agency?
SELF-TEST QUESTIONS
Budget A detailed plan, in dollar terms, of how a business and its subunits will acquire and utilize resources during a specified period of time.
Financial statements Statements prepared by accountants that convey the financial status of an organization. The four primary statements are the income statement, balance sheet, statement of changes in equity, and statement of cash flows.
Capital budgeting The process of analyzing and choosing new long-term assets such as land, buildings, and equipment.
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Chapter 1 : Healthcare F inance Basics 11
implement strategic plans, and hence they play a key role in an organization’s financial future.
• Financing decisions. All organizations must raise capital to buy the assets necessary to support operations. Such decisions involve the choice between internal and external funds, the use of debt versus equity capital, the use of long-term versus short-term debt, and the use of lease versus conventional financing. Although senior managers typically make financing decisions, these decisions have ramifications for managers at all levels.
• Revenue cycle and current accounts management. Revenue cycle management includes the billing and collections function, while current accounts management involves the organization’s short-term assets, such as cash and inventories, and short-term liabilities, such as accounts payable and debt. Such functions and accounts must be properly managed both to ensure operational effectiveness and to reduce costs. Generally, managers at all levels are involved to some extent in revenue cycle and current accounts management.
• Contract management. In today’s healthcare environment, health services organizations must negotiate, sign, and monitor contracts with managed care organizations and third-party payers. The financial staff typically has primary responsibility for these tasks, but managers at all levels are involved in these activities and must be aware of their effects on operating decisions.
• Financial risk management. Many financial transactions that take place to support the operations of a business can themselves increase the business’s risk. Thus, an important finance activity is to control financial risk.
These specific finance activities often are summarized by the four Cs: costs, cash, capital, and control. The measurement and minimization of costs is vital to the financial success of any business. Rampant costs, as compared to revenues, usually spell doom for any business. A business can be profitable but still face a crisis due to a shortage of cash. Cash is the “lubricant” that makes the wheels of a business run smoothly—without it, the business grinds to a halt. Capital represents the funds used to acquire land, buildings, and equipment. Without capital, businesses would not have the physical resources needed to provide goods and services. Finally, a business must have adequate control mechanisms to ensure that its capital is being wisely employed and its physical resources are protected for future use.
In times of high profitability and abundant financial resources, the finance function tends to decline in importance. Thus, at the time when most healthcare providers were reimbursed on the basis of costs incurred, the role of
Capital The funds raised by a business that will be invested in assets, such as land, buildings, and equipment, that support the organizational mission.
Four Cs A mnemonic for the basic finance activities: costs, cash, capital, and control.
Cost A resource use as
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