Capital update factor: a new era approaches - Capital

Healthcare Financial Management, Feb, 1993 by Paul L. Grimaldi

CAPITAL

For FY92 through FY95, the capital update factor for Medicare reimbursement at the standard Federal rate and hospital-specific rate will be derived from a two-year moving average of the adjusted actual increase in Medicare inpatient capital costs per discharge, net of case-mix growth. For FY93, the update is 6.07 percent based on capital spending increases in FY89 and FY90.(a)

Starting in FY96, the capital update will be derived from an analytical framework that considers changes in the price of the market basket of hospital capital, as well as other factors that influence a hospital's capital spending, such as technological advances and utilization changes.

Capital input price index

The capital input price index (CIPI) will measure changes in the price of a market basket of capital resources that hospitals use to produce inpatient care for Medicare beneficiaries. Calculating the index requires the following items:

* A list of capital cost centers, such as depreciation and interest,

* Cost weights indicating the relative importance of each capital cost center during a given time period, and

* Price index for each capital cost center, ideally from publicly available data derived from valid sampling designs for an extended time frame. One or more indexes may be used to calculate the price change for a particular cost center.

The first column in Exhibit 1 shows that the Health Care Financing Administration (HCFA) has divided the capital-related costs of owner-operated assets into three major categories: depreciation, interest, and other capital expenses (e.g., property taxes and insurance). Depreciation and interest are subdivided into two cost centers: 1) buildings and fixed equipment, and 2) movable equipment.

The second column in Exhibit 1 shows initial relative cost weights. For depreciation and interest, overall and separate "internal" weights are shown for both buildings and fixed equipment and movable equipment.

The fact that depreciation accounts for 65.5 percent of the capital market basket suggests that price increases for this cost center will dominate the CIPI. An accurate price index for depreciation, therefore, is imperative. In contrast, other capital expenses will have little impact on the overall index because together they have a cost weight of only 5 percent.

The preliminary CIPI does not explicitly recognize leases and rentals. Instead, HCFA assumes that, as substitutes for owner-occupied capital, their unit costs will increase at the same rate as the cost of owner-occupied capital. HCFA has indicated, however, that distinct cost components for leases and rentals may be established if the necessary information, including an appropriate price index, can be found.

The third column in Exhibit 1 identifies the price indexes, their sources, and frequency of publication. The indexes are called "price proxies" because, as the fourth column suggests, the capital resources for which the index measures price changes differs from the capital resources comprising the corresponding capital cost center. This difference does not necessarily mean, though, that a price increase based on the proxy will differ from the actual price increase for the cost center.

For Example, calculated increases and actual increases may differ little if the resources needed to produce the proxy items are similar to the resources comprising a cost center. Even if the difference is material, the financial impact would be inconsequential if the cost center has a relatively small cost weight.

The fifth column shows that the same price proxy would apply to both interest cost centers. This price proxy would be a weighted average of two interest rates series with weights of 85 percent and 15 percent. It would be adjusted for any changes in interest amortization patterns, which HCFA is preliminarily assuming to be constant over time across hospitals.

With the exception of other capital expenses, the last column in Exhibit 1 indicates that price changes will be based on moving averages, including a 25-year average for the depreciation of buildings and fixed equipment. Arguably, multiple-year moving averages are justifiable for fixed costs apportioned over long time periods.

Price change

The overall percent change in the CIPI depends on the changes in the prices of the capital inputs and their corresponding relative cost weights.

A price increase may be based on a short-term or long-term moving average. A weight may represent the relative importance of the cost center in one or several past years. Different sets of weights may or may not perceptibly affect the overall CIPI. For instance, the smaller the change in the price increases of different cost centers, the smaller the affect of a change in weights on the CIPI. In the extreme, if the cost weights are identical for all cost centers, the CIPI would be the same regardless of the value of the individual weights.

Because of data and time constraints, HCFA has made many assumptions in order to calculate capital input price increases. For example, HCFA has assumed that the quantity of capital services (e.g., number of x-ray machine hours) per unit of capital stock is constant over time. Also assumed to be constant is the useful life of the capital stock of given categories of assets and the amortization rate for classes of debt instruments. Such assumptions are essential to ensure that increases in the unit cost of capital are due to a "pure" price increase only. If the assumptions were invalid, the percent change in the CIPI would have to be adjusted for the factors other than price that cause unit capital cost to change.