By MAGGIE MAHAR

Monday, The New York Times reported that the IRS, Congress and state officials have begun taking a close look at nonprofit hospitals, all asking one charged question: Do they really deserve their tax-exempt status?

Some 16% of U.S. hospitals are for-profit—and they pay taxes. Nonprofits, by contrast, have traditionally been tax-exempt.  But now investigators are asking: “Are they really that different from the
for-profits?  Do they provide enough charity care and community service to justify the break?

The short answer is this: To understand the economics of the hospital industry,  you first need to understand that it is in many ways very much like the real estate industry: what matters most is “Location, Location, Location.”

A hospital located in an affluent area will draw well-insured patients. By definition, then, it will provide less charity care because it well see fewer uninsured patients.

This is why for-profit hospitals tend to provide less charitable care: If you’re a corporation you don’t a build a for-profit hospital in a market where you expect that half of your customers won’t be able to pay.  For-profits don’t close their doors to the poor, but they purposefully try to locate areas where they won’t see as many of them.  As well they should: a for-profit corporation’s first obligation is to generate profits for its shareholders.

Non-profit hospitals, on the other hand, began as charitable institutions—often with a religious affiliation—and to this day, many are located in inner cities or poor rural areas where they serve a large uninsured or underinsured population. Traditionally, nonprofit hospitals have operated with a sense of “mission”—to serve the health needs of their community. This is argument  giving them a break on their taxes.

Yet, it’s  worth noting that all nonprofit hospitals are exempt from corporate income taxes as well as state and local property taxes—wherever they are located. Perversely, that exemption is most valuable to those located in the most affluent areas because their income is higher and their property is worth more. As David A. Hyman and William M. Sage point out in the current issue of Health Affairs:

“All else being equal, a hospital that provides little charity care and is located in a “desirable” location (in terms of property values) will receive a much greater financial benefit when its income and property go untaxed than a hospital that provides lots of charity care and is located in an “undesirable” location. Thus, in important respects, current subsidies are ‘upside down’ in the sense that they are worth the most to institutions that are likely to” [provide the least charity care. ]

This brings us directly to the question Congress and the IRS are posing: should nonprofit hospitals be exempt from taxes based simply on their status as nonprofits, or should tax-exempt status be dependent on what they actually do to serve their community?

Here, it’s important to remember that caring for the poor is not the only way that a hospital can contribute to its community. Under the law, a nonprofit can  receive a federal tax exemption, if it is organized and operated exclusively to promote one of the specific purposes set forth in section 501(c)(3) of the Internal Revenue Code—which includes charitable, religions, educational and scientific ends.

Thus an academic medical center which  loses money educating  medical students while also investing in the expensive technologies that it needs to do important scientific research might well be able to justify its tax exempt status even if it treated only a small number of indigent patients. Some hospitals also provide educational  services in their communities—running support groups for diabetic patients for instance, teaching them how to monitor their disease.

How a nonprofit uses any money left over after covering the costs of operation is also important.

A for-profit might distribute those earnings to its shareholders, or invest in something that would generate greater profits going forward: valet parking, for example, might attract more well-insured patients. But to qualify as a non-profit, Hyman and Sage note, a hospital must:
“retain its net earnings and use them to promote the purposes for which the nonprofit was created. “ In other words, a non-profit must plough any surplus back into its “mission.”

Yet in today’s fiercely competitive market, non-profit hospitals sometimes spend their capital in ways that seem to have little to do with mission—and much to do with struggling to take market share away from neighboring hospitals.

In Money-Driven Medicine: The Real Reason Healthcare Costs So Much ( Harper/Collins, May 2006).  I quote the director of a Phoenix-based health foundation describing how resources are allocated in his hometown as local hospitals chase affluent newcomers moving into the city’s “Valley of the
Sun”:

   
“By expanding and modernizing, acute care hospitals are looking to compete with a recent surge in physician-owned hospitals and specialty surgical centers,” he explains. Acute care hospitals fear that these specialty centers will “skim” lucrative business like heart surgery, leaving the general hospitals with the least profitable businesses—burn units, for example, level 3 trauma units or ERS.
   

Fighting to offset potential losses, the nonprofit acute care hospitals are rushing to add beds in the Sun Valley area where a new young, well-educated and well-insured work force is moving in. The foundation director describes a new facility: “It’s like a luxury hotel.”

Every hospital feels that it  must stake their claim in this newly affluent area, he adds, and “the land-rush mentality doesn’t always take into account planning for the community’s needs . . .  When it comes to breaking down the health needs of the population by age and chronic disease in order to try to decide what mix of ambulatory, inpatient and home health care will be required . . . This,” he observes, “Is not the game that hospital executives are in.”

Meanwhile nationwide, nonprofits like those in Phoenix may be overbuilding—or at least investing their capital in the wrong areas. As they view for well-heeled customers, they may be putting too much emphasis on cosmetics and bleeding-edge unproven technologies, while investing too little in less visible areas like palliative care, or the information technology that could reduce hospital errors.  

In many regions, nonprofit suburban hospitals are trying to take high-margin business away from big city hospitals. “What we have to do to maintain our position in the market is to keep adding services,” a Westchester hospital CEO explained to New York Magazine a couple of years ago. “That’s the whole reason we’re doing liver transplants.”

“Liver transplants”??

Do the residents of Westchester County need a local hospital doing liver transplants? Just how many would the hospital do? Would patients be better off at a high-volume medical center in Manhattan, where the carpeting might not be as nice, but, research shows, “practice makes perfect”?

These questions didn’t seem to come up. Transplants would raise the nonprofit hospital’s image.
 
And when it comes to enhancing a brand name, sometimes nonprofits seem littler different from for-profits. In Money-Driven Medicine, I quote from a 2005 study in the Archives of Internal Medicine which describes how even academic medical centers trawl for customers with ads like “We Do Botox!” or “FDA Approves Deep Brain Stimulation Therapy for Parkinson’s Disease”
The study pointed out that many of the ads (38%) risked “raising false hopes” by thumping the tub for unproven procedures like “deep brain stimulation for Parkinson’s,” while another 28% were advertising cosmetic procedures. Such ad spending has little to with improving the health of the community, much to do with growing market share.

Yet, with the number of uninsured patients and unpaid bills rising, many nonprofit hospitals find themselves caught between a rock and a hard place. If they can’t bring in the patients willing to pay for private rooms with Jacuzzis in the maternity ward–patients who will be impressed by a waterfall in the lobby and chutney for dinner–they won’t have the money they need to keep the trauma unit open–and serve the larger community. “No [profit] Margin, No Mission” is a favorite saying among hospital CEOs.

Moreover, today’s hospitals are increasingly dependent on the bond market to raise capital. At one time, both government and philanthropists contributed a much larger share of the money hospitals needed to survive, but today, hospitals rely on borrowing by issuing bonds. And, quite understandably, a bondholder’s primary concern is not whether or not the hospital is serving its community, but whether or not he will receive the expected return on his investment. Thus, when bond rating agencies like Standard and Poor’s rate hospital bonds, they can’t give points for charitable care.      

Nevertheless, if we are going to give nonprofits enormous tax exemptions, somebody needs to be keeping an eye on how they are spending their capital.

Two years after the Westchester CEO bragged about his new “product line” (liver transplants) The New York Times reported that a state audit of the very same Westchester hospital showed  “mismanagement, sloppy accounting practices and wasteful spending” which “contributed to staggering financial losses.”  The audit also showed that former executives at the hospital were spending lavishly on things like restaurants, hotels and florists—with scant controls or documentation” even while  “the medical center’s finances were deteriorating.”But while some hospitals should lose their tax breaks, we don’t want to throw out the baby with the bath water by doing away with tax exemptions for all  non-profits.  They are different from for-profits-in ways that are essential to our health care system.   

In the most recent issue of Health Affairs Bradford Gray and Mark Schlesinger very carefully analyze some 162 studies comparing the real-world performance of nonprofit and for-profit hospitals, nursing homes and health plans on a  range of issues and discover that, while they may not be as different as one might expect, the fact is that, on average:

“for-profit organizations more aggressively mark up prices over costs and otherwise maximize revenue. This pattern has been documented among community general hospitals, nursing homes, psychiatric hospitals, drug treatment centers, rehabilitation facilities, and health plans.

“Second, nonprofit organizations appear more trustworthy in delivering services, being less likely to make misleading claims, to have complaints lodged against them by patients, and to treat vulnerable patients differently from other clientele.

“Third, nonprofits are typically the incubators of innovation, using philanthropy and cross-subsidies to finance the development of services for which there is not yet a market.

Moreover, while only about one-quarter of non-profit hospitals provide enough uncompensated care to the poor and uninsured to equal  their  tax benefits, “one  study found that the nonprofit hospitals that were the least involved in free or subsidized treatment were the most engaged in other forms of community” service.

The bottom line is that auditing nonprofits is a good idea, though federal investigators should turn to community experts to find out just how much service a nonprofit offers. Local GPs who work in low-cost clinics, for instance, will know how easy or difficult it is for a Medicaid or uninsured patient to get an appointment with a specialist at a hospital clinic.(And will that patient be seen by residents or a combination of teaching faculty and medical students?) Local educators will know which hospitals are making a contribution to health education in the schools.

Because the hospital industry is all about location, these audits must be done on a local basis, with the community weighing in on decisions. The many ways in which a hospital serves its community are not easy to quantify, and they vary, depending on the needs of the community.

At the same time, it is good for non-profit hospitals to know that they are accountable–and that if they forget their mission, they can (and should) lose that tax exemption.