Healthcare industry – How Good are your Financial Models?

Financial modeling in the healthcare industry is critical in evaluating capital allocation, ever-changing payments, or other factors. We use models in contract negotiations, valuations, budgeting, capital spending analysis, Certificate of Need, financing, decisions to enter or expand a market, merger/acquisition/divesture, and a host of others. Getting to the right answer is critical to making the right resource allocation. And, if we have a good objective model, we are likely to better understand the risks.

Assumptions and data inputs are constantly changing.  So, let’s acknowledge that on the day after any given forecast model is complete, it will become outdated. The model must be able to look at the upside and downside of any project. As a practical matter, an entity must pick a point in time, use the most current data, make the best assumptions, evaluate the sensitivity, and settle on a model that will require periodic updates. Once the model is ‘final’, there should be two versions, a locked down model, on which decisions were based and a second version to be used as a starting point for the next generation of models for ongoing analysis.

The size and scope of the subject analysis will determine the complexity and flexibility required. Certain models require an extra layer of scrutiny, such as

  • External models including CONs, valuations, financing, litigation, and settlements; or
  • Internal models including transaction evaluation and strategic plans.

So, what makes a good model.

  • Attention to detail – without being burdensome or issues that are immaterial. The complexity of a model can provide a greater degree of comfort and greater accuracy as it is updated. It will also make changes more difficult. Temper the use of overly complex models in smaller projects with fewer critical assumptions.
  • Good input
    • Use as much real-time data as is available rather than historically based assumptions.  Currently, this is harder to do with changes influenced by the pandemic.
    • Test the input – is there a similar service, facility or project that can act as a reasonableness test?
    • Don’t simply adjust actual data to include planned changes, as though the changes are complete. Include only confirmed changes. (See Good Assumptions below)
    • Thoroughly consider what is direct fixed cost to the project. For internal decision making, I prefer to measure the contribution margin or the contribution to the entities overhead. For example, the new housekeeper for expanded space is a direct fixed cost but the overhead of the housekeeping department is not.
  • Good Assumptions –
    • Take time to understand the payor mix and the way in which payors are treating a given group of procedures from a standpoint of coverage requirements, particularly as site neutral payments take hold.
    • Understand how the facility, service line or new technology will be staffed, the related expenses, including which of these expenses are variable versus direct fixed.
    • Understand that even fixed cost can increase if volume moves higher at an aggressive rate, perhaps in a stairstep manner – what is the incremental driver, and which fixed cost is most likely to change in the mid-term?
    • Consider pending or proposed changes as part of the assumptions going forward and not the current baseline.
    • Things never go up or down forever. Don’t get overly optimistic or pessimistic.
  • Where is the sensitivity– As you focus attention on building the model, focus on the assumptions that can make the biggest change in the model.  What is the model most sensitive to – Volume? Payor mix? Payment increases? Inflation? (I will explore sensitivity in more detail in a later post.)
  • Test the model.  Does the model work in a downward fashion (i.e., volumes) as it does in the upward movement? Depending on the nature of fixed cost, a downward movement should cause an accelerated loss, while an upward movement will show accelerated profits. Is there enough contribution margin to allow growth on incremental volume? Or does the potential exist to lose more money on higher volume?
  • Protect from Bias – Finally, and perhaps most important, protect the model from bias. Predetermining the outcome through model assumptions is a recipe for disaster. (I address this in a separate post to follow.)

Some common missteps:

While the use of averages and estimates in a forecast model are inevitable, consider the basis or validity of the averages and estimates. Here are some simple issues that I have run into overtime:

  • A benefit percentage that may not reflect the makeup of the workforce. Fifty percent or more of employee benefits have no correlation to percent of salary because they are a fixed amount per employee, for example, health insurance. Other variables include the level participation in benefits. Not all employees enroll in health insurance or retirement plans. The use of an average percentage, where lower paid employees are disproportionately higher, will understate benefit cost and vice versa.
  • Know your payor base. Too often, a model will use a percentage of charges but historically, charges have changed at a higher rate than payments, resulting in an overstatement of payments. Whenever possible, use as the base payment the actual methodology (e.g., DRG, per diem, per unit, etc.).  The actual methodology, among the largest payors, allows for changes in case mix and volume and a more precise revenue estimate, in the case of potential payor actions. Some issues to consider include changes in volume between Medicare and Medicare Advantage, movement to more narrow networks and site neutral payments.
  • Know what is changing or likely to change. Over the past 10 years, every form of Medicare payment has had some significant adjustment. Using payment data from the year immediately preceding the change may overstate the projections. Such a change recently occurred for the physician RVU.
  • Staffing – Be realistic, particularly with start-ups. Let us assume that the required nursing hours are 10 hours per patient day. We need to add paid time off or paid time outside of patient care. More significant, in a start-up, hours of care might be higher during the ramp up due to minimum staffing requirement.
  • Variable supplies – In one forecast, we saw a situation where the variable supply components were concentrated in three items making up 70 percent all variable cost. One of the items had fluctuated wildly over the past three or four months from interruptions in the supply chain with no recovery in sight. As a result, the average price for the trailing twelve months was understated.

Conclusion – Validate your data. Test the assumptions. Challenge your models.

For more information –

Ken Conner

Conner Healthcare Group

Accounts Receivable Values – Part II Don’t be Surprised

• The value of receivables are estimates. Estimates need to be reasonable and well documented with a combination of historical performance and real time insight.
• Accounts Receivable values directly correlate to Net Revenue and therefore, financial performance, valuation and budgeting.
• The first place to start is with a subsequent payment test. There is no better check on accounts receivable value than to see what was collected.
• For larger organizations, subsequent payment by financial class should be considered.
• Establish a lag report showing the month of service within in the month of collection.
• Large accounts, special collection issues and credit balances can skew value and should be reviewed separately.

First, let’s all acknowledge that the valuation of receivables is a group of estimates based on historical performance, general experience and gut instinct. Estimates can be influences by biases, revenue cycle team performance, expectations both good and bad  and unfortunately, in some cases pressure to report better results. The reporting of financial statements requires timely estimates, whether monthly or at year-end. Time is too short to really dig deep in preparing an estimate each month.  Rather, estimates and assumptions must be an ongoing process. Further, estimates are just that estimates, and they may be high or may be low. But there are consequences to bad estimates. If receivables are overstated in one year the correction will have to be absorbed in the next year’s earnings or future budgets may be based on the higher than actual revenue.
[1]In Part I of this series (click here), we looked at some of the issues leading to errors in the valuation of accounts receivable and revenue recognition. But more importantly than how the errors happen is, how do you monitor accounts receivable values in a current manner.

To address timeliness, calculations supporting estimates need to be planned, tracked over time, constantly considering changing payments from third parties, charge increases, payor mix and collection rates. The supporting calculations should be well documented. Monitoring changes of   receivables composition and variables throughout the year is critical.

Throughout my career, whether it be as a CFO, supporting a financial audit, representing a healthcare entity in a sale or providing buy-side due diligence, the first thing, I checked, was revenue recognition and accounts receivable valuation.

  • As a CFO, I needed to know the status of accounts receivable, not only for financial reporting but to address, weaknesses in the revenue cycle.
  • As an auditor, revenue recognition is the highest area of risk in a healthcare audit.
  • As an adviser to the seller, I wanted to find the overstatement before the buyer to protect my client from unexpected adjustments or find the understatement so that the client got true value.
  • In due diligence, the buyer client expects a thorough review and much like the audit, it was a high-risk area. More than any other area, receivables are a place where the buyer can impact the sales price by identifying overstated revenue.

Subsequent Payment Test

The first place to start is to understand if previous values were reasonable. There is no better check on historical accounts receivable values than to see what was ultimately collected. A subsequent payment test will compare the reported value of receivables to the actual collections, six, nine and twelve months later. Subsequent payment testing will validate methodology or expose errors in estimates and calculations. When used in transactions the testing can confirm historical revenue in a quality of earnings review and minimize post-closing disputes over net working capital.

The challenge is getting good data out of information systems. Accounting professionals looking to do the analysis need to work closely and communicate clearly with the IT group to design the right queries of payment data. Say the hospital year end wants to look back and test accounts receivable estimates from  June 30th. Then, the query needs to contain payments made for dates of service prior to July 1st but collected after June 30th. Defining payments can be tricky, depending on the complexity of the system, clarity of data fields and the strength of the report writer. Somethings that you want to consider in the query:

  • Report the collections by financial class. This will allow a focus on where the estimate may be too high or too low. This also requires consideration of patients changing financial class during the collection cycle.
  • Distinguish payment between the patient or 3rd party payor.
  • Include a review based on the last payment date, to understand the length of time from the date of service to collection and the gap between an insurance payment and a remaining patient liability.
  • The query may filter out patients who were inpatient on the cut-off date. Payments on these accounts may need to be prorated.
  • Evaluate alternative measurement of any outsourced collection service.

Once the subsequent payment testing is complete, objectively consider what was different about the actual results and the original estimates, one or more financial classes, changes related to a particular payor, declines in patient liability, higher denial rates among a payor(s), shifts between inpatient and outpatient, increases or decreases in the use of a particular service.

Monitoring in “Real Time” –

Understand that as charges are increased contractual adjustments go up and as payments increase contractuals go down. Knowing how and when to change collection percentage assumptions is critical to maintaining good estimates.

Establish a lag report as an ongoing monthly report. A lag report will track collections matching the month of collection to the month of revenue, calculating completion rates compared to the original estimate. The lag report allows the provider to develop expectations on how quickly claims are collected and how long the run-out or completion process is. For example, what is the expected and actual completion percentage at 30, 60, 90 days? The lag report can be done for receivables in total or for specific payor classes.

By updating a lag report monthly, the healthcare entity is effectively creating both a rolling look-back at subsequent payments and developing a rolling average collection rate based on the age of an account.

The lag report is especially useful when evaluating the receivables of a cash basis entity. Cash basis providers do not maintain estimates of accounts receivable value. A lag report allows the buyer to estimate receivables being acquired based on the historical time to completion.

Keep Receivables as Clean as Practical –

Resolving accounts quickly provides, not only more timely cash but, a clearer picture of what is collectible or what is not collectible. Resolving charity patients quickly is one way to get a clearer picture. All healthcare providers, for-profit or not-for-profit, can benefit from clearing out bona fide charity patients as quickly as possible. Qualified charity patients pay little or nothing, clog up the system, consume resources and inflate receivables. A strong charity program with timely resolution is not only a compliance issue for not-for-profits but will reduce the potential for misstatement from charity accounts and identify non-charity accounts that require immediate collection efforts. Timely addressing charity patients will improve reporting and impact payment based on Medicare Cost Report Schedule S-10.

The same is true of determining when an account is uncollectible and should be written-off to bad debt or transferred to a collection agency to be separately monitored.

Credit balances can understate the value of receivables but may also alter the calculation of contractual adjustments or bad debt allowances. A credit balance arises from an overpayment (almost always due back at 100%) or a misposting (almost always worth nothing). These two extremes distort the value of account receivable, net of contractuals and uncollectibles. For example, assume that a refund of $1,000 is due and included in a financial class with 50% collectability. By including the credit balance in accounts receivable, the impact on the adjustment is to understate the contractual by $500. Consider what the impact would be, if credit balances are $100,000 or more. It is strongly suggested that whatever the methodology used to estimate receivables, the estimates should be based on accounts receivables excluding any credit balances.

Adjusting to Account Specific Conditions

The subsequent payment test and the use of a lag report are the first steps to understanding the collectability of accounts receivable. But there are some accounts that by their very nature have a long collection cycle or other factors. Some areas of accounts receivable may be better evaluated on an account by account basis. Large disputed or delayed collection account skew results.  It may be appropriate to exclude or track these large accounts separately in adjustment calculation.

Consider some of the following issues as either adjustments to any estimate or requiring separate consideration:

  • Denials of coverage for medical necessity – Early monitoring of these will also allow the entity to engage the payor, the patient or the clinical service lines to reduce the issue going forward.
    • Payor practices.
    • Large accounts.
    • Type of denial.
  • Legal claims where there may be third party liability –
    • Nature of the claim.
    • Other available coverage and subjugation rights.
  • Patients paying over time
    • Consider aging from date of last payment to identify accounts not paying as promised.
    • Monitor compliance based on original balance, size of periodic payment, use of automatic draft.
  • Chapter 13 bankruptcies and expected recoveries
  • Out-of-network claims –
    • Nature of service – emergency or elective can affect the payor view of coverage.
    • Fairness of payor payment rates and success resolving with payors.
  • Unique arrangements with 3rd parties, particularly newer arrangements in the evolving use of value-based payments.

Receivables will always require monitoring and verification. Regular monitoring of receivables will identify no only changes to the contractual adjustment but issues affecting collectability.  Even the best methodology can vary due to changes in payor mix, case mix, staff turnover, contract updates, local economies and 3rd party behavior.

NOTE: This article is focused on the practical aspects of measuring collectability. It does not attempt to address issues related to new accounting standards on revenue recognition. You should consider reviewing revenue recognition standards with your auditor or other accounting professional.

For questions or help in reviewing these or other complex healthcare financial issues, contact us at

[1] Changes in accounting estimates are recorded in the period that they are corrected. Accounting errors will give rise to a restatement of a prior year. The year to year changes in estimates are not errors. Errors are and should be a rare occurrence. However, occasionally an estimate is so bad that it is an error.

Accounting Losses and Accounts Receivable – Part I; Why am I always surprised?


Understanding Challenges in Accounts Receivables Valuation

Every year I can count on seeing reports of hospital experiencing substantial losses. But every year, I am still surprised by the reporting of the losses, going back two, three, four or more years and linked to an overstatement of accounts receivable and net patient revenue. I am surprised because I expect someone in accounting, revenue cycle or with the audit firm to question the value of accounts receivable as various ratios or benchmarks get further out of line or the variance from actual cash collections grow to a point that they are material.

Estimating the value of receivables has always been and will continue to be a challenge to hospitals and other healthcare entities, but complexity is not an excuse for missing the value by so much or for so long.

There are a variety of issues involved in the valuation of accounts receivable, starting with the contractual adjustment. Charges are well above the third-party payments. In my own case, a recent outpatient surgery had charges that were six times more than the managed care payment. Add to that, my deductible was more than $5,000, just figuring out how much to expect on one account is a challenge. My one account was hardly measurable in the total revenues of a 400-bed hospital. But it is not just one contract but four to eight major managed care plans and a host of smaller plans accessing discounts through a variety of fee schedules, Medicare, Medicare Advantage, Medicaid, Champus, Charity, Worker’s comp and so on.

And, contractual rates are always changing. Each time a hospital raises charges a new contractual rate needs to be established. The same goes for including increases from payors, either renegotiated contracts or regulatory adjustments to payments, in the case of Medicare.

Contractual adjustments are getting more complex, as hospitals diversify or expand into physician practices and a variety of outpatient services. And what happens as value-based purchasing, in multiple structures, become a bigger part of the puzzle.

Beyond the contractual, the accounts also need to be assessed for

  • Bad debt allowances.
  • Charity write-offs.
  • Disputes with payors including coverage, medical necessity and primary responsibility.
  • Delays in payment related to accurate patient information, including the responsibility.
  • Changes in payor mix or clinical service mix.
  • A variety of other adjustments unique an entity or service.

Adding to the challenge will be an increase in value-based payment systems.

At the end of the day, hospital management is responsible for the accuracy of the financial statements and responsible for developing a good system for tracking and estimating the value of accounts receivable. Over the course of my career as a hospital CFO, healthcare practice leader in a regional CPA firm and independent consultant, I have seen a host of methods for measuring receivables: good; bad; and ugly. Some have been very detailed and actively monitored to look for changes or delays in payment by financial class or specific payors. Others are basic and seem to rely only on the age of the accounts or a historical collection percentage. Others have used a variety of complex formulas that change over time, are not timely updated or that perpetuate an error from prior period. After layering onto calculation method, the subjective estimate of what is expected by management, the assigned value can vary from the actual value. For example:

  • Built-in contractual estimates (not based on actual fee schedule) at the time of billing that were and never trued up to the actual contractual.
  • Simple failure to understand payment arrangements with third parties in developing estimates.
  • Failure to update payment percentages for changes in charges and payments.
  • Locking in an adjustment ‘floor’ at year-end, such that the error is perpetuated into future periods.
  • Attempts to calculate a single ‘average’ contractual across multiple billing entities in multiple states with different payors.
  • Overly optimistic expectations on the ability to collect denials or patient balances, particularly high deductibles.
  • The value of accounts receivable is masked by large credit balances which act to reduce the net value of receivables.
  • Not separating non-hospital revenue cycle from traditional hospital revenue, such as the steady increase in hospital owned physician practice or with the new off-site regulations, imaging centers and other outpatient offerings unintentionally overstate or understate the value of accounts receivable.
  • Errors arising from simple lack of experience and knowledge.
  • Overreliance on past practices.
  • A belief (perhaps hope) that things are better than the numbers show.

You may ask, why doesn’t the audit firm identify these problems sooner? The experienced healthcare audit firms do a very good job of assessing revenue and receivables by both challenging and educating clients. But some hospitals will fall through the cracks, for one reason or another:

  • The audit firm has limited healthcare audits and performs the audit without significant healthcare experience staff on the engagement.
  • The methodology and analysis remain the same year over year, such that the auditor becomes too comfortable or too close to the process.
  • A strong management team takes a strong position supporting the recorded balance, rationalizing delays in payment, contract issues, billing delays or impact of computer conversions.

So how does a healthcare entity protect itself against errors in revenue recognition and accounts receivable valuation – The fact is this is complicated and even the best organization with experience staff can make a mistake or get too comfortable. Creating checks and balances on the estimates is the best defense.

For a discussion testing and monitoring receivables look for Part II – Don’t Be Surprised