The role of financial information in the healthcare decision-making process

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Financial Information and the Decision-Making Process

LEARNING OBJECTIVES

After studying this chapter, you should be able to do the following:

1 . Describe the importance of financial information in healthcare organizations . 2 . Discuss the uses of financial information . 3 . List the users of financial information and their uses for it . 4 . Describe the financial functions within an organization . 5 . Discuss the common ownership forms of healthcare organizations, along with their advantages and

disadvantages .

REAL-WORLD SCENARIO

In 1946, a small band of hospital accountants formed the American Association of Hospital Accountants (AAHA). They were interested in sharing information and experiences in their industry, which was beginning to show signs of growth. First published in 1947, a small educational journal was created in an attempt to disseminate infor- mation of interest to their members. Ten years later, in 1956, the AAHA’s membership had grown to over 2,600 members. The real growth, however, was still to come with the advent of Medicare financing in 1965.

With the dramatic growth of hospital revenues came an escalation in both the number and functions delegated to the hospital accountant. Hospital finance had become much more than just billing patients and paying invoices. Hospitals were becoming big businesses with complex and varied financial functions. They had to arrange funding of major capital programs, which could no longer be supported through charitable campaigns. Cost accounting and management control were important functions for the continued financial viability of their firms. Hospital accountants soon evolved into hospital financial managers, and so in 1968 the AAHA changed its name to the Hospital Financial Management Association (HFMA).

The hospital industry continued to boom through the late 1960s and 1970s. Third-party insurance became the norm for most of the American population. Patients either received insurance through governmental programs

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CHAPTER 1

The healthcare industry’s expansion is a trend visible even to individuals outside the healthcare sys- tem. The hospital industry, the major component of the healthcare industry, consumes about 6.3% of the gross domestic product; other types of healthcare sys- tems, although smaller than the hospital industry, are expanding at even faster rates. TABLE 1-1 lists the types of major healthcare institutions and indexes their relative size.

Learning Objective 1

Describe the importance of financial information in healthcare organizations .

The rapid growth of healthcare facilities provid- ing direct medical services has substantially increased the numbers of decision makers who need to be familiar with financial information. Effective deci- sion making in their jobs depends on an accurate interpretation of financial information. Many health- care decision makers involved directly in healthcare delivery—doctors, nurses, dietitians, pharmacists, radiation technologists, physical therapists, inhala- tion therapists—are medically or scientifically trained but lack education and experience in business and finance. Their specialized education, in most cases, did not include courses such as accounting. However, advancement and promotion within HCOs increas- ingly entails assumption of administrative duties, requiring almost instant, knowledgeable reading of financial information. Communication with the orga- nization’s financial executives is not always helpful. As

such as Medicare and Medicaid or obtained it as part of the benefit program at their place of employment. Hos- pitals were clearly no longer quite as charitable as they once were. There was money, and plenty of it, to finance the growth required through increased demand and the new evolving medical technology. By 1980, HFMA was a large association with 19,000 members. Primary offices were located in Chicago, but an important office was opened in Washington, DC, to provide critical input to both the executive and legislative branches of government. On many issues that affected either government payment or capital financing, HFMA became the credible voice that policymakers sought.

The industry adapted and evolved even more in the 1980s as fiscal pressure hit the federal government. Hospi- tal payments were increasing so fast that new systems were sought to curtail the growth rate. Prospective payment systems were introduced in 1983, and alternative payment systems were developed that provided incentives for treating patients in an ambulatory setting. Growth in the hospital industry was still rapid, but other sectors of health care began to experience colossal growth rates, such as ambulatory surgery centers. More and more, health care was being transferred to the outpatient setting. The hospital industry was no longer the only large corporate player in health care. To acknowledge this trend, the HFMA changed its name in 1982 to the Healthcare Finan- cial Management Association to reflect the more diverse elements of the industry and to better meet the needs of members in other sectors.

In 2015, HFMA had over 39,000 members in a wide variety of healthcare organizations (HCOs). The daily activities of their members still involve basic accounting issues—patient bills must still be created and collected, payroll still needs to be met—but stra- tegic decision-making is much more critical in today’s environment. It would be impossible to imagine any organization planning its future without financial pro- jections and input. Many HCOs may still be charitable from a taxation perspective, but they are too large to depend upon charitable giving to finance their busi- ness future. Financial managers of healthcare firms are involved in a wide array of critical and complex decisions that will ultimately determine the destiny of their firms.

This text is intended to improve decision makers’ understanding and use of financial information in the healthcare industry. It is not an advanced treatise in accounting or finance but an elementary discussion of how financial information in general and health- care industry financial information in particular are interpreted and used. It is written for individuals who are not experienced healthcare financial executives. Its aim is to make the language of healthcare finance readable and relevant for general decision makers in the healthcare industry.

Three interdependent factors have created the need for this text:

1. Rapid expansion and evolution of the healthcare industry

2. Healthcare decision makers’ general lack of business and financial background

3. Financial and cost criteria’s increasing importance in healthcare decisions

2 Chapter 1 Financial Information and the Decision-Making Process

TABLE 1-1 Healthcare Expenditures 2008–2024*

Type of Expenditure 2008 2010 2012 2014 2016 2024

Hospital care 728 .9 814 .9 898 .5 978 .3 1,087 .3 1,755 .1

Physician and clinical services 486 .5 519 .0 565 .3 615 .0 666 .5 1,034 .8

Other professional services 64 .0 69 .8 76 .8 85 .5 96 .0 155 .4

Dental services 102 .4 105 .4 110 .0 114 .5 123 .5 183 .4

Other health, residential, and personal care

113 .5 128 .5 140 .1 153 .0 167 .1 251 .1

Home health care 62 .3 71 .2 77 .1 81 .9 91 .7 156 .0

Nursing care facilities and continuing care retirement communities

132 .6 143 .0 152 .2 160 .2 176 .1 274 .4

Prescription drugs 242 .7 256 .2 264 .4 305 .1 343 .2 564 .3

Durable medical equipment 34 .9 37 .0 41 .3 44 .2 48 .2 76 .9

Other non-durable medical products

49 .5 51 .2 53 .7 58 .4 62 .6 98 .7

Personal Health Care 2,017.3 2,196.2 2,379.4 2,596.1 2,862.2 4,550.1

Government administration 29 .4 30 .5 34 .2 39 .9 45 .5 82 .2

Net cost of private health insurance 140 .7 152 .3 165 .3 200 .4 235 .4 384 .3

Government public health activities 71 .5 75 .5 74 .8 78 .7 86 .2 137 .7

Health Consumption Expenditures

2,258.9 2,454.5 2,653.6 2,915.3 3,229.3 5,154.2

Research 44 .0 48 .7 48 .0 45 .9 48 .7 72 .0

Structures and equipment 111 .2 101 .0 115 .7 118 .9 124 .7 198 .9

National Health Expenditures 2,414.1 2,604.1 2,817.3 3,080.1 3,402.6 5,425.1

Gross Domestic Product 14,718.6 14,964.4 16,163.2 17,418.9 18,821.2 27,648.0

National Health Expenditures to GDP

16.4% 17.4% 17.4% 17.7% 18.1% 19.6%

Hospital Care to GDP 5.0% 5.4% 5.6% 5.6% 5.8% 6.3%

*Values are in US$ in billions.

Centers for Medicare and Medicaid Services, Office of the Actuary

3Financial Information and the Decision-Making Process

possible or feasible actions. In many cases, the actual course of action followed may essentially be no action; decision makers may decide to make no change from their present policies. It should be recognized, how- ever, that both action and inaction represent policy decisions.

FIGURE 1-1 shows how information is related to the decision-making process and gives an example to illustrate the sequence. Generating information is the key to decision making. The quality and effectiveness of decision making depend on accurate, timely, and relevant information. The difference between data and information is more than semantic: data become information only when they are useful and appropri- ate to the decision. Many financial data never become information because they are not viewed as relevant or are unavailable in an intelligible form.

For the illustrative purposes of the ambulatory surgery center (ASC) example in Figure 1-1, only two possible courses of action are assumed: to build or not to build an ASC. In most situations, there may be a continuum of alternative courses of action. For exam- ple, an ASC might vary by size or by facilities included in the unit. In this case, prior decision making seems to have reduced the feasible set of alternatives to a more manageable and limited number of analyses.

Once a course of action has been selected in the decision-making phase, it must be accomplished. Implementing a decision may be extremely complex. In the ASC example, carrying out the decision to build the unit would require enormous management effort to ensure that the projected results are actually obtained. Periodic measurement of results in a feed- back loop, as in Figure 1-1, is a method commonly used to make sure that decisions are actually imple- mented according to plan.

As previously stated, results that are forecast are not always guaranteed. Controllable factors, such as

a result, nonfinancial executives often end up ignoring financial information.

Governing boards, which are significant users of financial information, are expanding in size in many healthcare facilities, in some cases to accommodate demands for more consumer representation. This trend can be healthy for both the community and the facilities. However, many board members, even those with backgrounds in business, are being overwhelmed by financial reports and statements. There are import- ant distinctions between the financial reports and statements of business organizations, with which some board members are familiar, and those of healthcare facilities. Governing board members must recognize these differences if they are to carry out their govern- ing missions satisfactorily.

The increasing importance of financial and cost criteria in healthcare decision making is the third fac- tor creating a need for more knowledge of financial information. For many years, accountants and others involved with financial matters have been caricatured as individuals with narrow vision, incapable of see- ing the forest for the trees. In many respects, this may have been an accurate portrayal. However, few indi- viduals in the healthcare industry today would deny the importance of financial concerns, especially cost. Payment pressures from payers, as described in the beginning-of-chapter scenario, underscore the need for attention to costs. Careful attention to these con- cerns requires knowledgeable consumption of finan- cial information by a variety of decision makers. It is not an overstatement to say that inattention to finan- cial criteria can lead to excessive costs and eventually to insolvency.

The effectiveness of financial management in any business is the product of many factors, such as environmental conditions, personnel capabilities, and information quality. A major portion of the total financial management task is the provision of accu- rate, timely, and relevant information. Much of this activity is carried out through the accounting process. An adequate understanding of the accounting process and the data generated by it are thus critical to suc- cessful decision making.

▸ Information and Decision Making

The major function of information in general and financial information in particular is to oil the decision-making process. Decision making is basically the selection of a course of action from a defined list of FIGURE 1-1 Information in the Decision-Making Process

SEQUENCING EXAMPLE

Financial forecasts of a proposed ASC

Develop or not develop the ASC

ASC is developed

Significant financial losses occur

Information

Decision making

Implementation of decision

Results

4 Chapter 1 Financial Information and the Decision-Making Process

▸ Uses and Users of Financial Information

As a subset of information in general, financial infor- mation is important in the decision-making process. In some areas of decision making, financial infor- mation is especially relevant. For our purposes, we identify five uses of financial information that may be important in decision making:

1. Evaluating the financial condition of an entity

2. Evaluating stewardship within an entity 3. Assessing the efficiency of operations 4. Assessing the effectiveness of operations 5. Determining the compliance of operation

with directives

Financial Condition Evaluation of an entity’s financial condition is probably the most common use of financial information. Usu- ally, an organization’s financial condition is equated with its viability or capacity to continue pursuing its stated goals at a consistent level of activity. Viability is a far more restrictive term than solvency; some HCOs maybe solvent but not viable. For example, a hospital may have its level of funds restricted so that it must reduce its scope of activity but still remain solvent. A reduction in payment rates by a major payer may be the vehicle for this change in viability.

Assessment of the financial condition of business enterprises is essential to our economy’s smooth and efficient operation. Most business decisions in our economy are directly or indirectly based on percep- tions of financial condition. This includes the largely nonprofit healthcare industry. Although attention is usually directed at organizations as whole units, assessment of the financial condition of organiza- tional divisions is equally important. In the ASC

failure to adhere to prescribed plans, and uncontrol- lable circumstances, such as a change in reimburse- ment, may obstruct planned results.

Decision making is usually surrounded by uncer- tainty. No anticipated result of a decision is guaran- teed. Events may occur that have been analyzed but not anticipated. A results matrix concisely portrays the possible results of various courses of action, given the occurrence of possible events. TABLE 1-2 provides a results matrix for the sample ASC; it shows that approximately 50% utilization will enable this unit to operate in the black and not drain resources from other areas. If forecasting shows that utilization below 50% is unlikely, decision makers may very well elect to build.

A good information system should enable decision makers to choose those courses of action that have the highest expectation of favorable results. Based on the results matrix of Table 1-2, a good information system should, specifically, do the following

■ List possible courses of action. ■ List events that might affect the expected results. ■ Indicate the probability that those events will

occur. ■ Estimate the results accurately, given an action/

event combination (e.g., profit in Table 1-2).

One thing an information system does not do is evaluate the desirability of results. Decision makers must evaluate results in terms of their organizations’ preferences or their own. For example, construction of an ASC may be expected to lose $400,000 per year, but it could provide a needed community service. Weigh- ing these results and determining criteria is purely a decision maker’s responsibility—not an easy task, but one that can be improved with accurate and relevant information.

Learning Objective 2

Discuss the uses of financial information .

TABLE 1-2 Results Matrix for the ASC

Possible Events (Utilization Percentages)

Alternative Actions 25% Usage 50% Usage 75% Usage

Build the ASC $400,000 loss $10,000 profit $200,000 profit

Do not build the ASC 0 profit 0 profit 0 profit

Uses and Users of Financial Information 5

difficult, there is a tendency to place less emphasis on effectiveness and more on efficiency. This may result in the delivery of unnecessary services at an efficient cost. For example, development of outpatient surgical centers may reduce costs per surgical procedure and thus create an efficient means of delivery. However, the necessity of those surgical procedures may still be questionable.

Compliance Finally, financial information may be used to deter- mine whether compliance with directives has taken place. The best example of an organization’s internal directives is its budget, an agreement between two management levels regarding use of resources for a defined time period. External parties may also impose directives, many of them financial in nature, for the organization’s adherence. For example, rate-setting or regulatory agencies may set limits on rates determined within an organization. Financial reporting by the organization is required to ensure compliance.

Learning Objective 3

List the users of financial information and their uses for it .

TABLE 1-3 presents a matrix of users and uses of financial information in the healthcare industry. It identifies areas or uses that may interest particular decision-making groups. It does not consider relative importance.

Not every use of financial information is import- ant in every decision. For example, in approving a HCO’s rates, a governing board may be interested in only two uses of financial information: (1) evaluation of financial condition and (2) assessment of opera- tional efficiency. Other uses may be irrelevant. The board wants to ensure that services are being provided efficiently and that the rates being established are sufficient to guarantee a stable or improved financial condition. As Table 1-3 illustrates, most healthcare decision-making groups use financial information to assess financial condition and efficiency.

▸ Financial Organization It is important to understand the management struc- ture of businesses in general and HCOs in particular. FIGURE 1-2 outlines the financial management struc- ture of a typical hospital.

example, information on the future financial condi- tion of the unit is valuable. If continued losses from this operation are projected, impairment of the finan- cial condition of other divisions in the organization could be in the offing.

Assessment of financial condition also includes consideration of short-run versus long-run effects. The relevant time frame may change, depending on the decision under consideration. For example, sup- pliers typically are interested only in an organiza- tion’s short-run financial condition because that is the period in which they must expect payment. However, investment bankers, as long-term creditors, are inter- ested in the organization’s financial condition over a much longer time period.

Stewardship Historically, evaluation of stewardship was the most important use of accounting and financial informa- tion systems. These systems were originally designed to prevent the loss of assets or resources through employees’ malfeasance. This use is still very import- ant. In fact, the relatively infrequent occurrence of employee fraud and embezzlement may be due in part to the deterrence of well-designed accounting systems.

Efficiency Efficiency in healthcare operations is becoming an increasingly important objective for many decision makers. Efficiency is simply the ratio of outputs to inputs, not the quality of outputs (good or not good) but the lowest possible cost of production. Adequate assessment of efficiency implies the availability of stan- dards against which actual costs may be compared. In many HCOs, these standards may be formally intro- duced into the budgetary process. Thus a given nurs- ing unit may have an efficiency standard of 4.3 nursing hours per patient day of care delivered. This standard may then be used as a benchmark to evaluate the rel- ative efficiency of the unit. If actual employment were 6.0 nursing hours per patient day, management would be likely to reassess staffing patterns.

Effectiveness Assessment of the effectiveness of operations is con- cerned with the attainment of objectives through pro- duction of outputs, not the relationship of outputs to cost. Measuring effectiveness is much more difficult than measuring efficiency because most organiza- tions’ objectives or goals are typically not stated quan- titatively. Because measurement of effectiveness is

6 Chapter 1 Financial Information and the Decision-Making Process

TABLE 1-3 Users and Uses of Financial Information

Uses of Financial Information

Users Financial Condition

Stewardship Efficiency Effectiveness Compliance

External

Healthcare coalitions X X X

Unions X X

Rate-setting organizations X X X X

Creditors X X X

Third-party payers X X X

Suppliers X X

Public X X X

Internal

Governing board X X X X X

Top management X X X X X

Departmental management X

FIGURE 1-2 Financial Organization Chart of a Typical Hospital

Controller Director of Patient

Accounting Director of Material

Management Director of Patient

Registration

Director of Financial Reporting and Disbursements

Director of Financial Analysis

Senior Vice-President and Chief Financial

Officer

Director of Corporate Compliance and Risk

Management

Learning Objective 4

Describe the financial functions within an organization .

Financial Executives International has cate- gorized financial management functions as either

controllership or treasurership. Although few HCOs have specifically identified treasurers and controllers at this time, the separation of duties is important to the understanding of financial management. The fol- lowing describes functions in the two categories des- ignated by Financial Executives International, along

Financial Organization 7

are three main types organizations (adapted from the American Institute of Certified Public Accountants’ Audit and Accounting Guide Health Care Organiza- tions, 2015):

■ Not-for-profit, business-oriented organizations ■ For-profit healthcare entities

• Investor-owned • Professional corporations/professional asso-

ciations • Sole proprietorships • Limited partnerships • Limited liability partnerships/limited liability

companies ■ Governmental healthcare organizations

These three main types of firms differ in terms of ownership structure. Additionally, different HCOs require slightly different sets of financial statements.

Not-for-Profit, Business-Oriented Organizations Not-for-profit HCOs are owned by the entire com- munity rather than by investor–owners. Unlike its for-profit counterpart, the primary goal of a not-for- profit (also referred to as a nonprofit) organization is not to maximize profits, but to serve the community in which it operates through the healthcare services it provides. Not-for-profit HCOs must be run as a business, however, in order to ensure their long-term financial viability. With an annual budget of more than $20 billion, Ascension Healthcare is an example of one of the largest not-for-profit HCOs.

Not-for-profit organizations (described in Sec. 501(c)(3) of the Internal Revenue Code) usually are exempt from federal income taxes and property taxes. In return for this favorable tax treatment, not-for-profit organizations are expected to provide community benefit, which often comes in the form of providing more uncompensated care (vis-à-vis for-profit firms), setting lower prices, or by offering services that, from a financial perspective, might not be viable for for- profit firms. In addition to patient revenue in excess of expenses, not-for-profits can additionally be funded by tax-exempt debt, grants, donations, and invest- ments by other nonprofit firms.

The primary advantage of the not-for-profit form of organization is its tax advantage. It also typically enjoys a lower cost of equity capital compared with for-profit firms. The main disadvantage of this form of organization is that not-for-profits have more limited access to capital. Nonprofits cannot raise capital in the equity markets.

with an example of the type of  activities conducted within each of these functions:

1. Controllership (a) Planning for control: Establish bud-

getary systems (Chapters 13 and 16) (b) Reporting and interpreting: Prepare

financial statements (Chapter 9) (c) Evaluating and consulting: Conduct

cost analyses (Chapter 14) (d) Administrating taxes: Calculating

payroll taxes owed (e) Reporting to government: Sub-

mit Medicare bills and cost reports (Chapter 2 and 6)

(f) Protecting assets: Develop internal control procedures

(g) Appraising economic health: Analyze financial statements (Chapters 11 and 12)

2. Treasurership (a) Providing capital: Arrange for bond

issuance (Chapter 21) (b) Maintaining investor relations: Assist

in analysis of appropriate dividend payment policy (for-profit firms) (Chapters 20 and 21)

(c) Providing short-term financing: Arrange lines of credit (Chapters 22 and 23)

(d) Providing banking and custody: Manage overnight and short-term funds transfers (Chapters 22 and 23)

(e) Overseeing credits and collections: Establish billing, credit, and collec- tion policies (Chapters 2 and 22)

(f) Choosing investments: Analyze cap- ital investment projects (Chapter 19)

(g) Providing insurance: Managing funds related to self-insurance program

Learning Objective 5

Discuss the common ownership forms of healthcare organizations, along with their advantages and disadvantages .

▸ Forms of Business Organization

More so than in most other industries, firms in the healthcare industry consist of a wide array of owner- ship and organizational structures. In health care, there

8 Chapter 1 Financial Information and the Decision-Making Process

corporate level and the shareholder level (so-called double taxation). The company pays corporate income tax and the shareholder pays both tax on dividends paid by the company and gains made on the sale of the company’s stock.

A professional corporation (PC), also called a professional association (PA), is a corporate form for professionals who wanted to have the advantages of incorporation. A PC does not, however, shield its owners from professional liability. PCs and PAs have been widely used by physicians and other healthcare professionals.

Sole proprietorships are unincorporated busi- nesses owned by a single individual. They do not nec- essarily have to be small businesses. Solo practitioner physicians often are sole proprietors. The main advan- tages are easy and inexpensive to set up, no sharing of profits, total control, few government regulations, no special income taxes, and that they are easy and inexpensive to dissolve. Its two main disadvantages are unlimited liability and limited access to capital.

Partnerships are unincorporated businesses with two or more owner

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