Not-for-Profit Hospitals Hit All-Time-Low Operating Margins: Moody’s

In response to the worsening financial picture, hospitals are emphasizing patient base growth, productivity increases, supply cost control, and drug cost reductions, says one advisor.

Aug. 29—Operating margins for not-for-profit hospitals fell to 1.6 percent in FY17, the lowest level one rating agency has ever found in its tracking.

The Moody’s Investor’s Service analysis of audited FY17 financial statements for 303 free-standing hospitals, single-state health systems, and multistate healthcare systems found “significant income contraction” cut median operating margins from 2.7 percent in 2016.

The decline in median operating margins is off from a recent peak of 3.4 percent in 2015.

In addition, median operating cash flow declined from 9.4 percent in FY16 to 8.1 percent in FY17.

“The significance is that the decline has been happening for two years now and it is at an all-time low,” Rita Sverdlik, a Moody’s analyst, said in an interview. “The general takeaway is that profitability levels are declining.”

The findings echoed a preliminary 10-year analysis of 160 hospitals’ FY17 performance that Moody’s issued in April. In December 2017, Moody’s revised its outlook for the not-for-profit and public healthcare sector from stable to negative.

Driving the Decline

Behind the declining margin growth, according to Moody’s, is a faster decline in the median annual revenue growth rate (from 6.1 percent in 2016 to 4.6 percent in 2017) than the decline in median annual expense growth rate (from 7.1 percent in 2016 to 5.7 percent in 2017).

Drivers behind those expenses include labor shortages and high-cost temporary labor. Revenue is suffering from lower commercial insurance rate increases, a growing share of low-pay governmental payers, and increased supply costs—including drugs.

Moody’s found Medicare payments increased from 44.9 percent of median gross revenue to 45.6 percent, and Medicaid increased from 15 percent to 15.5 percent. The median commercial insurance rate declined to 31.9 percent from 32.6 percent.

“In terms of Medicare revenue and Medicaid revenue, the increases have been below the expense ramp up at hospitals” in recent years, said Steve Valentine, a vice president at Premier.

Another challenge is that volume growth—although still positive—is lower than it was at its 2015 peak.

The declining margin growth is happening nationally, although hospitals in the Northeast and the West are worse off because they were starting from lower margins.

“We are seeing it across all of the regions for very similar reasons,” said Beth Wexler, vice president for Moody’s.

The profitability pressures are especially impacting smaller hospitals. Small and mid-size hospitals face the additional challenges of reduced negotiating power with health plans and greater difficulty attracting clinical staff, said Sverdlik.

The smallest 50 hospitals in the Moody’s analysis averaged no growth in their FY17 operating margins, Sverdlik said.

“A common trend that we have been seeing for a number of years is the fact that smaller hospitals are having greater challenges,” Sverdlik said.  

Such organizations anecdotally have lower staffing ratios, a broader base of entities across which to spread their costs, and fewer Medicaid patients. In addition, they lack the mission-focus of not-for-profit hospitals, Wexler said.

The Moody’s findings differed from national hospital survey findings by the American Hospital Association (AHA), which found aggregate operating margins for all hospitals remained over 6 percent, as of 2016.   

Aaron Wesolowski, vice president of policy research for AHA, said the higher operating margins in their surveys stem from a several factors, including many expenses not appearing at the hospital level for health systems.

 “What we found in terms of trends in recent years is pretty consistent with what we’re seeing in the Moody’s report, which is that total and operating margins are dropping,” Wesolowski said in an interview. Similarly, AHA found Medicare and Medicaid margins also have worsened.

AHA also has found margins have deteriorated to the point where 30 percent of hospitals had overall negative margins by 2016. That tracks with Congressional Budget Office estimates that by 2025 from 40 percent to 50 percent of all hospitals will have negative margins.

“So it is an issue; it makes it increasingly difficult to offer 24-hour care t anybody who walks through the door and to respond to things like emergencies and natural disasters, and to provide the community benefits that are outside of what are seen as the core of hospital services,” Wesolowski said. 

Value, Insurance, Physician Impacts

Hospital finance leaders have been concerned about the negative financial impacts on their organizations from the shift to value-based payment.

Value-based payment is “kind of code for consuming less healthcare,” Valentine said. “Doctors, nurses, and hospitals have been doing what is being asked, which is to have better, more efficient care models in place and that also is helping to reduce utilization. These new payment models by design are also putting some financial stress on hospitals and health systems.”   

Despite a greater focus on value-based payment, the majority of revenue for NFP hospitals and health systems Moody’s rates still primarily comes from fee-for-service payments, Sverdlik said.

“For all of the conversation, it still represents an immaterial proportion of the majority of the rated providers’ revenue base,” Wexler said in an interview. “That doesn’t mean they aren’t beginning to think about more and more risk contracting with real upside and downside risk corridors.”

The bigger negative financial impacts have come when providers have moved into insurance.

“Those experiencing challenges are more the ones who have gone into either owning insurance products or having a financial interest in insurance products,” Wexler said. “Those have been troubling—and meaningfully troubling—to organizations that have gone in that direction.”

Related to the personnel cost challenges, Moody’s has previously found hospitals with larger numbers of employed physicians had experienced margin pressures.

Hospital Responses

In response to the worsening financial picture, hospitals are emphasizing patient base growth, productivity increases, supply cost control, and drug cost reductions.

“Growing market share is the key, although it is very difficult,” Valentine said. “If you have a bigger population base, it helps compensate some for reduced use because you get more volume even though the per-capita use is declining.”

Hospitals are attempting to improve overall productivity by addressing their salaries, wages, and benefits, which generally comprise about 55 percent of their costs, according to Valentine.

A common hospital response to labor costs are large staff cuts, as well as the elimination of duplicate positions after a merger, Valentine said.

“Part of the reason that organizations are merging and coming together is that it helps to eliminate a lot of the duplicate positions and services,” Valentine said.

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Rich Daly is a senior writer/editor in HFMA’s Washington, D.C., office. Follow Rich on Twitter: @rdalyhealthcare