2015 Outlook: Nonprofit Healthcare Organizations

By Adam Cole, CPA, Cortney Marcin, and Patrick Pilch, CPA, MBA

Pressures to perform and transform, merge, acquire or consolidate, and protect are building and converging on nonprofit healthcare organizations. As such, 2015 promises to be a seminal year for these organizations and the communities they serve.

According to the American Hospital Association’s 2013 Hospital Statistics, there are about 5,686 hospitals in the U.S., 2,904 of which are nongovernment nonprofit community hospitals and 1,010 are tax-exempt state and local government community hospitals.The pressure to perform and transform is informed by numerous data points that are combining to make the current operating model structure unsustainable:

  • The Medicare Payment Advisory Commission’s 2014 Data Book shows a demonstrable decline in Medicare inpatient and outpatient margins from 2002 to 2012. For that period, the overall hospital Medicare margin decreased from 2.2 percent to a negative 5.4 percent
  • Modern Healthcare analyzed earnings for approximately 200 hospitals and health systems and included a mix of nonprofit and investor-owned through 2013. The study revealed a shrinking of margins for all hospitals to 3.1 percent in 2013.
  • A Moody’s report on operating margins of nonprofit hospitals and health systems for 2013 showed overall operating margin deterioration to 2.2 percent.
  • Moreover, the typical hospital’s payer mix is 40 percent Medicare. This year, 8 percent of Medicare payments to hospitals will be value- or risk-based. Moreover, in February, Health and Human Services (HHS) announced a goal of tying 30 percent of existing fee-for-service Medicare payments to value-based payment models such as Accountable Care Organizations (ACOs) or bundled payment models by the end of 2016, and ultimately 90 percent of all traditional Medicare payments by 2018.

The trend is accelerating, and makes the current operating model structure unsustainable. The credit rating agencies know this. For the third consecutive year, the three major credit rating agencies all forecast a negative outlook for the nonprofit healthcare and hospital sector. They pointed to declining cash flows from operations because of lower revenues associated with the shift to risk-based reimbursement from volume-driven fee-for-service reimbursement, coupled with the rising costs of operations. The agencies also anticipate further rating downgrades due to the continuing challenges associated with the implementation of the Affordable Care Act (ACA).

The shift away from traditional fee-for-service to value-based payments has been underway for some time through various innovation models, and has accelerated under the ACA. The acceleration has been the result of a greater emphasis being placed on overall population health, preventative care, reductions in hospital admissions and readmissions, and providing services in lower cost of care settings to reduce overall costs.

Adding to the uncertainty is the upcoming U.S. Supreme Court decision in the King vs. Burwell case, which may overturn the ACA’s provision for insurance coverage purchased through federally operated state exchanges.

One might ask, “have similar dynamics occurred in other industries?” The resultant tipping point faced by the healthcare industry is similar to that faced by another capital-intensive industry in the late 20th century: U.S. steel. In that emblematic case study, new, more nimble competitors eroded the country’s global market advantage by introducing more modern methods and technologies. A flurry of capital restructuring and operational redesign followed, and the industry ultimately shifted to more efficient mini-mills structures. By the 1980s, the rush of competition not only forced the shutdown of aging mills, but also began to threaten some of the more thinly capitalized new entrants.

We posit that 2015’s outlook for nonprofit healthcare organizations will reflect a similar dynamic; nonprofit hospitals will need to access the right capital aligned with the new—and different—operating and delivery models, and they must monitor and adapt to outside factors that will impact access to this capital, as well as their operations and reimbursements. New regulations and stressed government budgets threaten access to grants and tax-exempt bonds, and even tax-exempt status itself. Compliance will be critical in the face of these evolving requirements and new scrutiny.

Typically, for nonprofit healthcare organizations, capital is provided through tax-exempt bond financing, charitable contributions through foundation development and, occasionally, government or private grants. Tax-exempt bond financing represents the primary source of capital. Rates for these borrowings are lower than their taxable comparables, but easy access to such financing is challenging given both a negative outlook for reimbursement and the sector, as well as and the need for more efficient capital and scale to redesign nonprofit healthcare organizations. The need for capital has accelerated mergers and acquisitions and consolidation activity. For the last several years, this activity has been robust among nonprofit hospitals and within the social service sector. In addition to traditional M&A activity, nonprofit healthcare organizations have been pursuing risk sharing arrangements through ACOs, bundled payment arrangements and managed care contracts. Other capital arrangements through joint ventures with Real Estate Investment Trusts (REITs) also create access to new sources of capital. We expect these activities to continue, and even accelerate.

Potential regulatory changes may place nonprofit healthcare organizations’ tax exempt status at risk in two important ways.

First, in return for tax-exempt status, federal law requires nonprofit health systems to provide services to the poor and uninsured/underinsured, as well as to provide community benefits to the general public. The ACA contains a provision that requires hospitals to make “reasonable efforts” to assess whether patients qualify for financial assistance before taking an aggressive step like filing a lawsuit. This provision has bipartisan support in Congress. Recent news reports suggest that the government intends to enforce this provision in the form of significant penalties to those organizations that appear to cross the line. While a loss of tax exempt status has not yet happened under this provision, it remains highly possible this provision will impact the tax exempt status of organizations that do not comply.

Secondly, billions of dollars in tax exemptions granted to nonprofit hospitals are being challenged by regulators and politicians as federal, state and municipal budgets have been strained significantly since the recession. Nonprofit healthcare organizations need to ensure that they are in compliance with the new provisions of the ACA, as well as state and local regulations, in order to protect their nonprofit status.

There are myriad additional regulatory and compliance requirements taking effect in 2015, including notable changes impacting federal funding as affected by the Office of Management and Budget’s (OMB) new Uniform Guidance. The guidance is the most comprehensive set of changes to occur to the OMB regulations in decades, and will impose more consistent guidelines on both grant recipients and organizations issuing grants to sub-recipients, which is more common with certain healthcare funding arrangements. Compliance will be critical in the face of these evolving requirements and new scrutiny.

So, what should nonprofit healthcare organizations consider for 2015 and beyond?

1.   Understand your cost of care and cost of operations.
This is often easier said than done. Care delivery is complex, and fragmented outcomes are disassociated from financial and market analytics. There is much market opportunity to reposition nonprofit healthcare organizations for the future sustainability.

2.   Understand your investment thesis.
Nonprofit healthcare CFOs can take a page from global corporations whose CFOs must evaluate their enterprises from a portfolio perspective. In the same way that steel industry CFOs redeployed capital into new mini-mill models, so too can healthcare providers examine their assets in terms of ROI. Reduce or moderate investment in lower ROI assets in favor of aligning investments with higher-ROI businesses in emerging or growing markets or assets. Think care design and new risk-based models.

3. Understand your market and your “customer.”
Nonprofit healthcare leaders need to understand the implications of the risk shifts from payer to provider to consumer, as well as the opportunities for investing in a customer-focused relationship. Understanding the market need through visual analytics will serve nonprofit healthcare organizations well in redesigning their models around the population they serve. Tapping into best practices from consumer focused industries will be helpful.

4. Understand who you are and what your organization means.
Do you have the vision, leadership, appropriate resources, ideas, capital and partners to mitigate the risks and take advantage of the opportunity for your organization? Each CFO must ask himself or herself: “Where are the gaps? Can we execute the change?”

5. Understand what your future state could look like—the art of the possible.
Look to the future and assess what will be the successful models in five or 10 years, taking into account the first four recommendations.

The next step is to get started!
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2015). Copyright © 2015 BDO USA, LLP. All rights reserved. www.bdo.com