Analysis of nursing home capital reimbursement systems

Health Care Financing Review, Spring, 1991 by Heidi Boerstler, Tom Carlough, Robert E. Schlenker

Introduction

Although capital costs represent a small portion of overall nursing home costs (around 10 percent) (Cohen and Holahan, 1986), the way in which such costs are reimbursed by State Medicaid programs can significantly affect the longrun financial viability of existing nursing homes as well as the perceived attractiveness of new investments (Baldwin, 1984). This, in turn, can affect the overall supply of nursing home beds and the access to care for Medicaid recipients. A major concern of policymakers is that more favorable capital reimbursement is likely to increase the cost of nursing home care to already strained State budgets. Nevertheless, with an aging population, decreasing acute care lengths of stay, occupancy rates in excess of 90 percent, and relatively old facilities, policies that promote an adequate supply of acceptable quality facilities within State budget constraints are essential to meet the increasing demand for nursing home care. Capital-reimbursement policies are one important part of this overall situation.

States vary considerably in their approach to capital reimbursement. These variations can be broadly categorized into traditional and nontraditional methods. The major traditional approaches base reimbursement for capital costs on the historical cost of long-term assets. They typically reimburse for depreciation, interest expense, and lease payments; and they sometimes include the payment of a return on equity. Various limits are often applied to these reimbursement elements. Another traditional approach used by some States is a flat rate methodology, in which capital costs are not treated separately but instead are included as part of an overall facility reimbursement rate that is the same for all or for a group of nursing homes.

In contrast to the traditional approaches, an increasing number of States are using an innovative approach to payment for capital costs called "fair rental." Although fair-rental systems vary considerably among themselves, all estimate the current value of capital assets as the basis for payment of a fee for capital, that is, an imputed fair-rental amount. States currently utilizing a fair-rental approach include Mayrland, West Virginia, Minnesota, Colorado, and Florida (Boerstler, Carlough, and Schlenker, 1988).

Several drawbacks are inherent in the traditional cost-based systems. In particular, such systems usually reimburse for interest costs on mortgages and for estimated depreciation. Typically, depreciation-reimbursement amounts exceed principal payments on mortgages in the early loan years, so owners experience a positive cash flow. However, over time, principal payments increase to eventually exceed depreciation reimbursement. The resulting negative cash flows create incentives for nursing home owners to refinance, sell, or sell-leaseback; and most such actions increase reimbursement amounts and costs to the state. Such actions also create considerable instability in nursing home ownership, and they can have adverse effects on the quality of care (Baldwin and Bishop, 1984; Bishop, 1980; Cohen and Holahan, 1986; Spitz, 1982).

The fair-rental approaches are often advocated as eliminating the disadvantages of the traditional payment method, by paying amounts that are more in line with the current value of the nursing home. Such a payment strategy, it is argued, is fairer to nursing home owners; and it reduces incentives for destabilizing financial actions (such as frequent resale or refinancing). However, fair-rental systems are also assumed to cost more in State funds (Baldwin and Bishop, 1984; Bishop, 1980; Cohen and Holahan, 1986; Spitz, 1982).

To examine these and related issues, three representative nursing home capital-reimbursement systems are analyzed herein in terms of after-tax cash flow to the investor, cost to the State, and rate of return to the investor.

Specifically, the objective of this analysis was to contrast the traditional cost-based, capital-reimbursement approach with the fair-rental approach in terms of facilitating adequate access to care for Medicaid recipients by encouraging investors to provide an adequate supply of nursing home beds while, at the same time, constraining State Medicaid costs. The focus of the analysis was on differences in outcomes between representative cost-based and fair-rental approaches, not on specific State systems. A limited number of situations were examined, and results are therefore not intended to provide a comprehensive assessment of each capital-reimbursement approach or its affect on all types of facilities.

The focus of this study was on owner-operator, proprietary facilities. The intent was to analyze some of the financial differences between cost-based and fair-rental, capital-reimbursement systems from the points of view of the owner-investor and of the State. Thus, the variables included in the model were primarily financial rather than ownership related. Although a significant number of nursing homes are nonprofit organizations, most are proprietary. Also, most are owned rather than leased. Capital reimbursement of leased facilities and of nonprofit facilities are issues suggested for investigation in future studies. (1)