MARCH 12, 2014

U.S. PUBLIC FINANCE

SECTOR COMMENT

Two-Midnight Rule Will Reduce Revenue for Most Hospitals

Effective October 2013, the two-midnight rule for acute care hospitals classifies most hospital visits under 48 hours as outpatient cases. Previously, inpatient status was largely determined by medical necessity. We expect the rule change will weaken hospital operating profitability in calendar year 2014 because it will lower Medicare reimbursement for these cases. Although the rule change will affect all acute care hospitals, the impact will not be uniform across the not-for-profit hospital sector. Key observations: Reimbursement difference between inpatient and outpatient cases will decrease profits: On average, the rule could cause revenue reduction averaging $3,000 to $4,000 per case. Two-midnight rule will accelerate trend of inpatient care shifting to outpatient: The rule will result in significant growth in observation stays in 2014, pressuring hospital revenues. Hospitals with short lengths of stay will be most affected: Smaller community hospitals with low average lengths of stay and less complex cases are most at risk. Reimbursement change will impact hospitals with high proportion of inpatient care: Profitability will suffer as the high fixed costs of inpatient care are spread over a smaller base of inpatients. Small hospitals lack adequate staff to adapt to new rule: More resources are needed to implement administrative and operating changes caused by the rule. Fewer RAC claims provide a silver lining: The rule could reduce recovery auditor contractor (RAC) reviews of hospital admissions practices, offering some financial relief.

Table of Contents:
LOWER REIMBURSEMENT WILL LOWER PROFIT DUE TO FIXED COST STRUCTURE TWO-MIDNIGHT RULE WILL ACCELERATE TREND OF INPATIENT CARE SHIFTING TO OUTPATIENT HOSPITALS WITH SHORT LENGTHS OF STAY MOST AFFECTED LOWER REVENUE WILL AFFECT ALL HOSPITALS WITH HIGH PROPORTION OF INPATIENT CARE SMALL HOSPITALS LACK ADEQUATE STAFF TO ADAPT TO NEW RULE FEWER RAC CLAIMS PROVIDE A SILVER LINING MOODYS RELATED RESEARCH

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Analyst Contacts:
SAN FRANCISCO +1.415.274.1708

Daniel Steingart, CFA +1.949.429.5355 Assistant Vice President - Analyst daniel.steingart@moodys.com NEW YORK Lisa Martin Senior Vice President lisa.martin@moodys.com +1.212.553.1653 +1.212.553.1423

Kendra M. Smith +1.212.553.4807 Managing Director - Public Finance kendra.smith@moodys.com

Over the next two years, we expect hospitals to adapt by adjusting care protocols for the most frequent diagnoses impacted by the rule, and by opening dedicated units to treat these patients. Over the last few years, some hospitals have opened lower-cost, separate observation units to care for patients that dont meet the qualifications for inpatient admission but require treatment. This has the potential to lower costs for certain groups of patients.

U.S. PUBLIC FINANCE

Lower Reimbursement Will Lower Profit Due to Fixed Cost Structure

We expect the rule change to negatively impact financial performance for most hospitals during calendar year 2014. The reimbursement differential between an inpatient admission and outpatient case varies according to a variety of factors. On average, inpatient cases are reimbursed at a far higher rate -- two to three times higher -- than outpatient cases. The rule could decrease revenues on average by $3,000 to $4,000 per case. However, the cost of treating these patients will initially remain the same. In many cases, the patient is treated in the same unit and is not aware they are being cared for on an outpatient basis.

Two-Midnight Rule Will Accelerate Trend of Inpatient Care Shifting to Outpatient

We expect the two-midnight rule to accelerate the now well-established trend of inpatient admissions converting to outpatient status (see Exhibit 1) and observation stays at most hospitals continuing to grow in 2014. The shift from inpatient admissions to outpatient status over the last several years, is due to a variety of factors, including Medicare reviews of medical necessity for inpatient stays and changing modalities of care that require fewer inpatient stays. The two-midnight rule adds to these pressures.
EXHIBIT 1

Two-Midnight Rule Will Exacerbate Trend of Declining Admissions and Growing Observation Stays
Admissions Growth Rate 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 (est) Observation Stays Growth Rate

Source: Moodys

Hospitals with Short Lengths of Stay Most Affected

Low acuity community hospitals are highly exposed to this rule change. These hospitals tend to have a greater share of medical cases often resulting in short hospital stays, but still consuming significant resources from tests, drugs and other inpatient hospital care. Under the new rule, shorter hospital stays are likely to convert from inpatient cases to lower-paying outpatient cases. Diagnoses that fall into this category typically involve chest pain and gastrointestinal issues and risk conversion to outpatient status. Hospitals with low average lengths of stay and lower acuity are typically smaller and lower- rated (see Exhibit 2), with less financial flexibility to absorb reduced revenue under the new the rule.

MARCH 12, 2014

SECTOR COMMENT: TWO-MIDNIGHT RULE WILL REDUCE REVENUE FOR MOST HOSPITALS

U.S. PUBLIC FINANCE

EXHIBIT 2

Lower Rated Hospitals Exposed Due to Lower Acuity and Length of Stay
Medicare Case Mix Index 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 All Ratings Aa A Baa Below Baa 4.5 4.4 4.3 4.2 Average Length of Stay (Days) 4.9 4.8 4.7 4.6

Source: Moodys

Lower Revenue Will Affect All Hospitals With High Proportion of Inpatient Care
Hospitals that depend on inpatient care for the majority of operating profit, regardless of size, will see reduced profit from the rule change. Due to high fixed costs, small fluctuations in patient volume can significantly impact profitability as outpatient care generates less revenue per case than inpatient. Tertiary hospitals and academic medical centers will also be impacted. Although they have fewer lowacuity cases as a share of overall patient volume, they are predominantly focused on inpatient care. Because their cost base is typically higher than community hospitals, the conversion of patients to outpatient will result in greater losses on a per case basis. Hospitals that perform a large number of surgeries on an inpatient basis will be less affected by the change. Many inpatient surgeries are on the CMS Inpatient Only list, which requires certain procedures be performed and billed on an inpatient basis, even if the patient is only in the hospital for one night.

Small Hospitals Lack Adequate Staff to Adapt to New Rule

We expect smaller hospitals with less integrated medical staffs and fewer support resources to have greater difficulty adapting to the rule change than larger hospitals. The two midnight rule does not automatically convert all short stay admissions to outpatient status and requires appropriate physician documentation. Patients that are expected to be in the hospital for more than 48 hours, but are subsequently discharged early will qualify for inpatient reimbursement so long as the admitting physician properly documents that the admission was initially warranted. Ensuring proper documentation is unlikely to be a challenge for larger hospitals with well integrated medical staffs and additional administrative resources. However, smaller hospitals may find it harder to implement documentation changes with thinner medical and support staffs.

MARCH 12, 2014

SECTOR COMMENT: TWO-MIDNIGHT RULE WILL REDUCE REVENUE FOR MOST HOSPITALS

U.S. PUBLIC FINANCE

Fewer RAC Claims Provide A Silver Lining

Although the two-midnight rule is negative for hospitals, it could lessen the financial pinch from recovery auditor contractor (RAC) reviews. RACs audit hospital Medicare claims and can claw back overpayments for improper admissions. Over the last few years, RACs have reviewed the medical records of many short-stay admissions, looking for admissions not medically necessary. The reviews have contributed to the industry-wide shift from inpatient to outpatient care and resulting lost revenue. The two-midnight rule could provide some relief from RAC reviews by substituting a strict rule set for the ambiguity involved in borderline cases.

MARCH 12, 2014

SECTOR COMMENT: TWO-MIDNIGHT RULE WILL REDUCE REVENUE FOR MOST HOSPITALS

U.S. PUBLIC FINANCE

Moodys Related Research

Industry Outlook:

2014 Outlook US Not-for-Profit Hospitals, November 2013 (160569) US Not-for-Profit Hospital 2012 Medians Show Balance Sheet Stability Despite Weaker Performance, August 2013 (157417)

Median report:

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

MARCH 12, 2014

SECTOR COMMENT: TWO-MIDNIGHT RULE WILL REDUCE REVENUE FOR MOST HOSPITALS

U.S. PUBLIC FINANCE

Report Number: 165866

Author Daniel Steingart, CFA Production Associate Vikas Baisla

Editor David Goetzl

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MARCH 12, 2014

SECTOR COMMENT: TWO-MIDNIGHT RULE WILL REDUCE REVENUE FOR MOST HOSPITALS