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What does non-profit status really mean?

By Samuel H. Steinberg, Ph.D.

This is an area of hospital knowledge where jargon gets in the way of real understanding. The confusion results from the need of hospitals and health systems to meet technical and legal requirements to be classified a non-profit, charitable entity (also frequently called a 501-C-3 organization for the relevant section of the IRS code), while conducting business in a way that looks just like that of any for-profit company. The Internal Revenue Service determines the requirements for an organization to be classified as a non-profit, but, as we shall discuss, it does not completely regulate the manner in which the organization conducts its business affairs.

Non-profits make up the majority of our nation’s hospitals and must meet a long list of governmental regulations. The most important, for our purposes, is the hospital’s use of its profit, or any excess of revenues over expenses, for the benefit of the hospital. For-profit companies may use their profits to distribute monies to their owners or shareholders, and they can also reinvest that profit into the business. Non-profits only have the latter choice, that is, they must invest all profits into the business.

Charity Care

Confusing already, right? How can there be profit in a non-profit? Some hospitals use terms such as I did above – excess of revenues over expenses, and net margin are some of the favorites used – but we are really talking about profit. Most importantly, nonprofits, like any other business entity, seek to have a profit; that profit just does not go to shareholders. Hospitals are also asked to provide some level of charitable care to the communities they serve. These two requirements – turning back any profit for use by the hospital and providing care to the uninsured and underinsured – are the key determinants of a hospital’s non-profit status. Not well understood is the fact that the level of charitable care required is, at best, confused at all levels of government, even the local townships, so that there is no clear definition of how much free care is appropriate. Hospitals include many things in their determination of charity care: discounts to indigent patients, allowances for unpaid care from Medicare and Medicaid; even public health and education programs. Unfortunately, the IRS has neither defined what charity care is nor delineated specific required levels of charitable care. In fact, the federal rules that explain the requirements for achieving and maintaining non-profit status have not been updated significantly since 1969.

Business Practices

Non-profit hospitals perform all the tasks of any business: they build facilities, purchase equipment and supplies, pay salaries and benefits, and even merge with or purchase other hospitals. While physicians and others may question why nonprofits can do some things, such as pay large salaries to their executives, they can and do conduct all the activities of any business.

The most controversial area currently is that of salaries and bonuses for hospital leaders. High salaries were certainly not always the case, but recent years have seen an explosion in income levels as administrators have convinced many boards that their responsibilities equal those of executives in any business. Not everyone agrees, obviously, and the IRS says one million dollars annually is too much, regardless of the size of the organization, but this area remains cloudy and can be the cause of some disharmony in hospitals.

Rising health care costs during the past several decades has also caused many in our society to urge hospitals to be more businesslike in their dealings, however, we appear to remain puzzled as to exactly how businesslike society really means. Employers, who pay much of the health care bill in the United States, want to see their costs decline and view it as anti-competitive to have rising health care costs affect the pricing of their products and services. Some practices, such as using aggressive bill collectors to pursue people who have no health insurance, or charging whatever the market will bear for a service may be very businesslike, but are certainly controversial. There are, in fact, several class action suits across the country against hospitals that have used these practices. It remains difficult to determine what business practices are acceptable for nonprofit hospitals and which ones are not.

Tax Exempt Status

The most important benefits of non-profit status are exemption from paying most taxes and the ability to utilize tax-exempt debt, thereby reducing the cost of borrowing money for capital items. It is exactly this coming together of non-profit status and tax exemption that has caused the most concerns in recent years.

As both for-profit and non-profit organizations conduct their business affairs in a similar fashion, governmental officials, political leaders and academics have started to question why some non-profit organizations should receive a tax exemption. The most contentious issues include hospitals using aggressive collection techniques for collecting past-due bills from uninsured patients, as well as hospitals competing with small businesses in their area for such things as restaurant services or pharmacies. As a result of this, as well as because of the concerns regarding high salaries, some localities have pressed hospitals to pay real-estate taxes on the value of their land just like other businesses situated there. Some members of Congress have held hearings addressing this matter, and lawsuits have been filed, both by municipal governments seeking tax payments, and hospitals looking to counter this push.

Implications for Physicians

For-profit companies benefit their stockholders through the value of their ownership of shares of stock and through the distribution of dividends. Non-profit hospitals turn back all money left after the payment of expenses to the hospital for the benefit of the organization. After that, all hospitals seem to behave in a very similar fashion to their for-profit cousins. The long-held belief that a non-profit, charitable organization meant lower salaries and a workforce dedicated to the mission of the hospital, while still operative for large numbers of people, has given way for some to a perception of well-paid staff and managers who install commonly held business practices and operate the hospital as a normal business entity.

Adding to the complexity is a recent trend regarding the development of single specialty hospitals, either for-profit and non-profit, designed to capture profitable segments of health care business, such as ambulatory surgery services or cardiology services. Many of these entities have some or all physician ownership and are often accused of skimming off the best and most profitable health care activities. Clearly, this remains a situation begging for more clarity and agreement.

So what does this mean for the practicing physician? My advice is to not waste time and energy worrying about the technical differences between for-profit and non-profit hospitals and health systems. Assume they all act the same regarding the patient care process, all conduct their business practices in a similar fashion, and all hold their managers to the same high standards of performance. Whether they answer to shareholders or to the community they serve, in today’s challenging business environment, they must all function with great efficiency and effectiveness. If your hospital cannot convince you of its adherence to best practices and standards and does not meet your needs for taking care of your patients, find another hospital to practice at and do not worry about whether it is a for-profit or not!

Samuel H. Steinberg, Ph.D., FACHE, is Associate Consultant with Health Strategies & Solutions, a national health care management consulting firm.

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