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    Timothy Smith, CPA, ABV

    Series: Examining Losses in Health System Physician Practices

    As we continue to examine the unique operating environment of health system physician practices, another potential contributor to practice losses emerges. Intercompany accounting practices for hospitals and physician practices within a health system may overstate practice costs, and thereby contribute to practice losses. There are two types of intercompany transactions that frequently serve to inflate practice operating costs, while conversely understating hospital or corporate operating expenses. These cost-shifting areas include:


    • Employed physicians providing services to hospital departments
    • Shared corporate services allocated or charged to physician practices

    Employed physicians in health system practices commonly provide medical directorship, call coverage, and clinical comanagement services to affiliated hospitals within the system. Shifting of hospital costs to physician practices occurs when employed physicians provide professional services to hospitals without the practice receiving an intercompany payment or credit for the value of the services that benefited the hospital.

    We can trace the cost shifting by following the money trail. Generally, the physician compensation for these professional services is paid through the employment agreement, and thus, the compensation cost is recorded on the books of the practice. The benefits costs for the physician is also usually charged to the practice. Some portion of the benefits cost, however, is allocable to the compensation for providing hospital services. In addition, the employed physician’s malpractice insurance may also cover any liability associated with these services. In some cases, other practice resources may also be used in providing the services. Yet, the costs for these resources is similarly charged to practice expenses.

    While the costs for providing these hospital-related services is recorded on the books of the practice, many health systems do not record an intercompany transaction allocating these practice costs back to the hospital receiving the services. The net result of this omission is to shift hospital operational costs to the physician practice. In other words, the practice bears the cost of hospital departmental expenses, thereby distorting the real economics of both the physician practice and the hospital. This accounting distortion may result in a loss for the practice or contribute to higher losses, when combined with other factors.

    It is interesting to contrast how the cost of professional services are handled when independent practice physicians provide the services. In these cases, it is common for the hospital to enter into a professional services agreement (“PSA”) at fair market value (“FMV”) rates with the independent doctors. This FMV rate will include an appropriate level of compensation for the cost of the services, including physician compensation, benefits, malpractice, and other costs (where applicable). The cost of these PSAs is typically charged to the appropriate hospital department and is reported in the hospital’s overall operating expenses. Thus, the hospital’s operating costs are accurately reported to include all resources used in providing patient care.

    The second area for cost shifting involves corporate shared services. Many health systems provide various administrative and support services to their physician practices through corporate functions or departments. Examples include legal, accounting, HR, compliance, IT, revenue cycle, facilities, treasury, tax, managed care contracting, and senior or executive management oversight. Two cost issues can arise when physician practices utilize such services, and the cost of these services are charged to the practice on an allocation basis.

    First, some of the costs for shared services may relate solely to hospital operations and requirements, but, nonetheless, the practices are charged a share of these costs as part of an overall allocation of corporate services. In addition, allocations of cost may not be indicative of actual usage by physician practices within the organization, due to the allocation base or formula used.

    Second, physician practices may be allocated costs for corporate services that they could readily obtain at cheaper rates from third-party contractors. The health system, however, elects to perform these functions in-house, rather than outsource them on a less expensive basis. Indeed, such insourcing may help spread corporate general and administrative costs over a larger allocation base, creating economies of scale for the hospitals in the system while driving up costs for the practices.

    (Conversely, some health systems may not allocate the full cost of corporate services to their practices. In this case, practice operating expenses are understated rather than overstated.)

    When it comes to practice losses that result from poorly designed intercompany accounting practices, there’s actually a simple solution: Record all intercompany transactions at FMV rates!

    In the case of physicians providing services to hospitals, the best practice is to record an intercompany “payment” for these services at FMV. The payment is recorded on the hospital’s books as an expense and as a revenue item on the practice’s books. Doing so ensures the cost of the hospital-related services are reported on the hospital’s books and not the practice’s. Using FMV rates is the best way to account for the value of the services. If calculated correctly, FMV will reflect the appropriate cost for the practice resources used in providing the services.
    Similarly, the cost of corporate services provided to practices should be charged at FMV rates. In this way, the appropriate amount of expense is charged to the practice relative to the value of the services provided. Any inefficiencies and skewed cost allocations due to the intermingling of hospital and practice requirements is taken out of the costs charged to the practice. In other words, the economic impact of health system decisions and considerations to centralize and share corporate services among affiliated entities is not borne by the practice. This approach also ensures that any excessive costs for corporate shared services that exceed FMV are reported at the corporate level, not the practice.

    In our next article, we’ll examine how the conversion of practice ancillaries to hospital outpatient department services contributes to practice losses.

    Click the following to read previous articles in the series:

    Physician practice losses: A tale of two owners

    Physician practice losses: Why physician-owned practices break even or make a profit

    Physician practice losses: Why losses are typical in health system practices

    Physician practice losses: Losses from revenue issues in health system practices

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