As tax-exempt hospitals and health care systems continue to struggle with declining reimbursement, class action lawsuits, property tax exemption and other financial challenges, the stakes are being ratcheted up significantly by recent legislative initiatives at both the federal and state level to impose greater charity care commitments on tax-exempt hospitals, including threatening revocation of economically favorable tax-exempt status. In Illinois and New York, in particular, legislation was recently introduced to impose mandates on the charity care provided by tax-exempt hospitals.

While the Illinois bill has been tabled until a future legislative session, the New York measure was passed and has been signed into law. At the same time, federal legislation may be just around the corner, as Congress continues to scrutinize tax-exempt hospitals and the IRS prepares to launch its latest initiative regarding the community benefits being provided by tax-exempt hospitals. With this as the playing field, hospital leaders, their advisors, investors and rating agencies understandably may feel greater pressure on their financial prospects in months and years to come.

Illinois Legislation

In late January, Illinois Attorney General Lisa Madigan proposed legislation that would impose specific charity care requirements on Illinois hospitals. The Tax-Exempt Hospital Responsibility Act (TEHRA), H.B. 5000, 94th Gen. Assem., Reg. Sess. (Ill. 2006), would require that to maintain their tax-exempt status under Illinois' income, sales and use, service, retailers and property tax codes, all tax-exempt Illinois hospitals must implement charity care policies providing free or substantially discounted care to poor uninsured individuals. Patients having household income up to 150 percent of the federal poverty level would qualify for free care, and hospitals would be prohibited from issuing bills to patients who qualify for this full charity care. (In 2005, the federal poverty level was $9,570 for a single person and $19,350 for a family of four. Accordingly, under the proposed legislation, hospital services would be provided free of charge to a single person earning less than $14,355 in annual income, or to a family of four earning less than $29,025.) In addition, hospitals would be required to provide patients with income between 150 percent and 250 percent of the federal poverty level with deep sliding-scale discounts, such that affected patients could be asked to pay only between 20 and 35 percent of a hospital's costs of providing the services; further, a patient's total bill would be capped at $10,000 per year—thereafter, the patient would become eligible for full charity care. For those patients unable to pay their share of a discounted bill in one payment, hospitals also would be required to offer an interest-free payment plan. Hospitals would have to screen each patient to determine whether he or she is uninsured and would be prohibited from issuing bills to such uninsured individuals until the patient's eligibility for charity care assistance is established according to criteria to be determined by the attorney general. These standards would replace the voluntary guidelines adopted by many Illinois hospitals in 2003, which had provided for free care up to 100 percent of the federal poverty level, and discounts between 100 and 200 percent of the federal poverty level; the voluntary guidelines provided for discounts based on hospital charges, rather than costs.

The most eyebrow-raising aspect of TEHRA, as originally proposed, is a requirement that all tax-exempt hospitals must provide uncompensated care in an amount equal to at least 8 percent of their total operating costs. For these purposes, "uncompensated care" would include charity care, bad debt, Medicaid shortfalls and certain other charitable programs approved in advance by the state. At the time that she announced the new legislation, Attorney General Madigan noted that not a single Illinois hospital would currently meet the 8 percent requirement.

The Illinois Hospital Association (IHA) and its constituency responded to the proposed legislation with the claim that the financial burdens imposed upon hospitals would be "staggering." The IHA cited statistics indicating that Illinois hospitals already provide approximately $1.2 billion in free care annually, plus substantially more (estimated at $3 billion total) in uncompensated services and Medicaid shortfalls. Using 2003 data, the IHA observed that the 133 Illinois hospitals that would be subject to the bill would have been required to provide $739 million more in uncompensated care. With one-third of the state's hospitals already operating at a loss (and 22 having closed in the past decade), a significant portion of the state's health care providers could be pushed into bankruptcy, the IHA predicted. The IHA also predicted that the new requirements could push an additional 45 hospitals, currently operating with a positive margin, into the red. In hearings before the Heath Care Availability and Access Committee of the Illinois House of Representatives and in other public statements, opponents of TEHRA argued that when hospitals lose money, they cannot simply raise prices. Rather, approximately one-half of all hospital care is paid by Medicare and Medicaid in amounts that do not even cover hospitals' costs of providing that care. Thus, hospitals will have to shift the shortfalls to insured patients and private payers. At a time when an increasing number of employers are cutting back on employer-funded health benefits, the already-troubled health care system may well face a crisis of untold proportion—almost certainly exacerbating current concerns with lack of access to health care services—i.e., exactly the problem sought to be addressed by the Illinois legislation.

By late March, TEHRA remained before the Illinois House Rules Committee. After discussions between Attorney General Madigan and the IHA, it was agreed that no further action would be taken on TEHRA during the Spring 2006 legislative session. Rather, the parties agreed to negotiate further and to reintroduce a bill in the Spring 2007 session.

New York Legislation

The New York bill took a different approach, focusing not on hospitals seeking to maintain tax-exempt status but rather on New York hospitals receiving funds from the state's indigent care pool. Citing a need to ensure consistent treatment throughout the state for patients who are either uninsured or have exhausted their health insurance, the legislation set forth various additional conditions for participation in the state pool.

As of Jan. 1, 2007, participating hospitals must maintain financial assistance policies providing free or discounted care for low-income individuals who are uninsured or for insured individuals who have exhausted their coverage and are unable to pay full charges. Specifically, individuals with incomes below 300 percent of the federal poverty level may not be charged more than the rates that would be paid by the hospital's largest non-governmental payor for the prior year, or by Medicare or Medicaid, for the same services (whichever is greater). Beyond that, patient charges would be further adjusted applying a sliding scale for discounts, with categories of household income in comparison to the federal poverty level. Patients with household incomes of under 100 percent of the federal poverty level could be charged "no more than a nominal payment amount." Patients with household incomes of between 101 percent and 300 percent of the federal poverty guidelines would be subject to a sliding scale, with proportionate increases in this range up to the cap set forth above. The legislation establishes these broad requirements but acknowledges that exceptions may be appropriate in certain cases. Hospitals could develop policies to address exceptions on a case-by-case basis, but such policies must be presented to the New York Department of Health for prior approval.

Unlike the Illinois measure, however, the New York bill did not include an express amount of charity care required to be undertaken by hospitals. The bill was approved by the New York Legislature and signed by Governor George Pataki in April. The New York legislation includes various "teeth" by requiring hospitals to report to the Department of Health within 90 days following the effective date of the legislation (i.e., by the end of March 2007) regarding their current financial assistance practices, and to make additional reports on an ongoing basis.

Federal Outlook

Over the past two years, no fewer than three Congressional committees (including the House Ways and Means Committee, the House Energy and Commerce Committee, and the Senate Finance Committee) and numerous subcommittees have taken upon themselves the task of scrutinizing nonprofit organizations and, in particular, nonprofit health care providers. Congressional leaders have asserted that these inquiries are warranted, given that the legal standards for §501(c)(3) tax-exempt status of health care organizations were established more than 35 years ago. Such standards (which do not impose an express charity care requirement, outside of emergency circumstances) remain largely unchanged still today, although the health care industry has evolved such that today's provider environment bears little resemblance to that which existed when the standards were established.

In testimony before the congressional committees, a number of individuals called into question, among other things, the distinction between nonprofit and for-profit hospitals. At the 40,000-foot level, the common assertion is that nonprofit and for-profit hospitals today are remarkably similar in their operations and practices; the seeming absence of substantial distinctions between the two types has led some civic leaders and others to conclude that there is little basis for allowing nonprofit hospitals to enjoy federal income tax exemption (and the other benefits that flow from §501(c)(3) status, such as the ability to receive tax-deductible contributions and the opportunity to utilize tax-exempt bond financing), while for-profit hospitals pay substantial tax bills.

Witnesses appearing before the congressional committees offered statistics to the effect that while nonprofit hospitals may offer some additional amount of uncompensated care (defined to include both true "charity care" as well as amounts written off as uncollectible) in comparison to for-profit hospitals, the differential is not nearly as large as the public is led to believe. By comparison, governmental hospitals appear to provide substantially greater levels of uncompensated care than either nonprofit or for-profit hospitals. Institutions in all three classes of hospitals (governmental, nonprofit and for-profit) tend to view themselves as providing significant "community benefits," and all tend to report a wide range of programs and services as demonstrating their dedication and service to the communities in which they are located. Critics of nonprofit health care, however, have suggested that the typical "community benefit" measures used in today's health care industry are simply what any business would do to attract customers, enhance its market reputation, or stay in touch with its customer base. Some critics have launched more personal charges as well, to the effect that the boards of nonprofit health care institutions (which by tax law are required to include a majority of independent community leaders) are predominantly comprised of largely uninformed and disconnected businessmen who simply rubber-stamp the decisions of health care executives, including approval of executive compensation and benefits packages that are exorbitant and incompatible with a nonprofit mission.

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With the number of uninsured Americans currently estimated at more than 45 million, the pressure for state and federal legislators to do something is tremendous.

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Although generally outnumbered by critics of nonprofit health care, some representatives of the nonprofit health care sector have come forward to offer a defense. Witnesses before the congressional committees pointed to studies suggesting that nonprofit hospitals are more likely than for-profits to offer certain types of health care services that, although important or even essential, are unprofitable (for example, psychiatric emergency services, home health services, child and adolescent psychiatric care, AIDS treatment, and alcohol and drug treatment). Other studies show that nonprofit hospitals are less market-sensitive than for-profits and are more likely to preserve their facilities and programs during economic downturns. Others commented that while government authorities may be inclined to impose rigid formulas defining a required amount of charity care or community benefit, such standards are intrinsically flawed since "community benefit" is not susceptible to measurement in sheer dollars; for example, certain types of programs and services offered by nonprofits are relatively low-cost, but may have a substantial positive impact on community health.

In the wake of these hearings, congressional leaders have signaled their intention to offer proposed legislative reforms, including those that are aimed at the nonprofit sector generally (including, but not limited to, hospitals and health care institutions), and those that are aimed at nonprofit health care specifically.

In the former category, the proposed measures vary wildly, with some that are quite far-reaching in their approach. Most proposals, however, consistently focus on enhancing federal and state enforcement mechanisms, substantially modifying and expanding IRS reporting and public disclosure provisions, implementing improved financial oversight, bolstering the quality of governing boards and improving their processes and accountability, and imposing both substantive and procedural standards for executive compensation.

As to nonprofit health care providers specifically, proposals have been presented calling for, among other measures, hard and fast charity care and community-benefit formulas, mandated community-needs assessments, expanded reporting of charity care and community-benefit practices, limitations on the amounts that can be charged to uninsured patients, requirements for medical debt-repayment plans, and constraints on debt-collection practices.

As with all legislative matters, the outlook is necessarily uncertain. In recent months, House and Senate leaders have focused their efforts on certain limited reforms in the nonprofit sector generally, rather than health care institutions specifically. Nonetheless, Senate Finance Committee Chair Charles Grassley (R-Iowa) heightened health care institutions' concerns when in May 2005 he contacted 10 large health care systems, posing extensive inquiries regarding their charity care and community benefit practices. That was followed by inquiries to the Catholic Health Association and the American Hospital Association in early 2006, with those organizations providing responses in April and May, respectively. All of this congressional digging sets the stage for the IRS's newest initiative—an inquiry into the community-benefit practices of tax-exempt hospitals. Specifically, the IRS has indicated that beginning sometime before the end of the government's 2006 fiscal year (i.e., before Sept. 30), it will contact roughly 600 hospitals across the country to learn more about their charity care and community-benefit practices or, as others have expressed, what hospitals are doing to "earn" their tax-exempt status.

Implications for Health Care Financing

The current legislative and regulatory climate has understandably created anxiety in the nonprofit health care sector. Under the proposed Illinois TEHRA legislation and other similar proposals, tax-exempt hospitals would face increased financial pressures in satisfying requirements that a certain percentage of operating costs be applied to uncompensated care, while those entities that were unable to meet the percentage requirement would face the grave possibility of losing their tax-exempt status. Among other things, the loss of tax-exempt status could result in substantial tax liability for hospitals, as well as the acceleration of tax-exempt bond debt that had suddenly lost its tax exempt status. In the case of Illinois, the proposed legislation has already had a tangible impact on health care financing. The IHA predicted that TEHRA's requirements would push many hospitals toward financial instability, causing credit ratings to plunge. In February and March, various investment banks warned that the mandates of the Illinois legislation could result in hospital bond ratings being downgraded, and could substantially reduce hospitals' access to capital. Most notably, Standard and Poor's (S&P) observed that TEHRA "could potentially lead to lower ratings, more expensive access to capital and an inability to maintain state-of-the-art services." S&P warned that hospitals may encounter difficulties in getting bond insurance, thereby increasing the cost of capital and putting more pressure on already-strained margins. Hospitals across the state reported that rating agencies were conducting interviews to determine the practical implications of the legislation. In addition, at least two Illinois hospital bond issuances were put on hold, as insurers expressed concerns regarding the impact of the proposed legislation on future operations. S&P has also noted that "the charity care issue is gaining in importance across the nation because of the growing number of uninsured and underinsured patients, who threaten the margins of not-for-profit health care providers."¹ These circumstances led certain industry advisors to speculate on the prospect of class action lawsuits by bondholders, presumably upset with the loss in bond values, against hospital boards of directors for purported violations of fiduciary duties arising from hospitals' fee structures and their billing and collection practices.

Conclusion

While hospitals in Illinois may be breathing a sigh of relief for now, it is virtually certain that charity care legislation imposing expanded charity care commitments on hospitals will be back in 2007 in Illinois and other jurisdictions. With the number of uninsured Americans currently estimated at more than 45 million, the pressure for state and federal legislators to do something is tremendous. But as the response of the capital markets to Illinois' proposed TEHRA legislation suggests, doing "something" may have serious long-term and unintended consequences on the ability of tax-exempt hospitals and health care providers to gain access to the capital that they need.

Footnotes

1 Shields, Yvette, "Midwest Bond-Watch: Illinois: Charity Bill Warnings," The Bond Buyer, Vol. 355, March 22, 2006.