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Community Hospital of Chandler Inc. v. Sullivan

filed: July 10, 1992.


Appeal from the United States District Court for the District of Arizona. D.C. No. 89-1942-PHX-EHC. Earl H. Carroll, District Judge, Presiding. Original Opinion Reported at,

Before: Betty B. Fletcher, Dorothy W. Nelson, Ferdinand F. Fernandez, Circuit Judges. Opinion by Judge D.w. Nelson.

Author: Nelson


D.W. NELSON, Circuit Judge:


Until 1984, Chandler Community Hospital operated in a single-story, 46-bed, small-scale facility. That year, the original facility was closed down and the operation was transferred to a brand-new, four-story, 120-bed, state-of-the-art facility that had been constructed at a nearby location. The new facility was renamed "Chandler Regional Hospital," but it kept the same licenses as the old facility; it was also owned and operated by the same individuals. The new facility had substantially higher per-patient operating costs than the old facility.

This case raises two questions. First, we must decide whether, for the purpose of calculating Medicare reimbursements, the Secretary of Health and Human Services' ("the Secretary") determination that the new facility is not a "new hospital" within the meaning of 42 C.F.R. § 412.74(a)(1) frustrates the Congressional intent behind the Medicare Act. Second, we must determine whether, if the interpretation of the new hospital regulation was valid, the Secretary was nonetheless required, under 42 U.S.C. § 1395ww(b)(4)(A), to otherwise adjust Chandler's reimbursement rate to take into consideration the radical shift in its operating costs.

We hold that neither 42 C.F.R. § 412.74(a)(1) nor the Secretary's interpretation of that regulation to exclude Chandler from characterization as a new hospital frustrate Congressional intent. However, we find that the Secretary erred in not adjusting Chandler's base year costs as required by 42 U.S.C. § 1395ww(b)(4)(A). Therefore, we reverse the district court and remand this case so that the Secretary may have an opportunity to determine whether and to what extent Chandler is entitled to adjustments under that provision.


Overview of the Medicare Program

In 1983, Congress amended the Social Security Act to change the way it reimburses hospitals for the costs of treating Medicare patients. Before 1983, hospitals were reimbursed according to the actual costs they expended in treating each Medicare patient. Concluding that this cost-based system was inefficient because hospitals had no incentive to provide services at lower costs, Congress introduced the Prospective Payment System (PPS). Under PPS, hospitals receive a fixed, standard amount for each Medicare inpatient they treat. The amount of the payment is adjusted for each patient by using "diagnosis-related groups" (DRGs), a classification system based on the patient's condition and treatment. This amount is theoretically equal to the "average" cost per patient. Hospitals receive the per patient DRG amount no matter how much each spends on a given patient. Hospitals that treat patients for less than the DRG amount get "rewarded," while hospitals that spend more than the DRG amount must absorb the excess costs.

Recognizing that the PPS system might create financial disruption for hospitals accustomed to cost-based reimbursement, Congress designated a four-year transition period to help hospitals ease into the new system. For those four years, Congress based a hospital's reimbursement on a formula incorporating both the PPS payment amount and an amount reflecting that particular hospital's past operating costs (the hospital-specific portion - "HSP"). Congress directed the Secretary to base the HSP on a hospital's costs for a "base-year" period of twelve months ending on or before September 30, 1983. Congress further directed that the HSP share of the formula be gradually reduced to zero over the course of the four-year transition period; correspondingly, the PPS amount was to rise to 100 percent.

Congress recognized that for a small number of hospitals, such as new hospitals, there would be no historical cost experience from which to calculate the HSP. Although Congress passed no statute directly addressed to hospitals falling in this category, the legislative history indicates that Congress intended that the Secretary "make appropriate provision for applying a prospective payment system." H.R. Rep. No. 25, 98th Cong., 1st Sess. 137, reprinted in 1983 U.S. Code Cong. & Admin. News 219, 356. Accordingly, the Secretary issued 42 C.F.R. § 412.74(a). This regulation defines "new hospitals" as follows:

(a) For purposes of this section, a new hospital is a hospital that meets either of the following requirements:

(1) The hospital -

(i) Is newly participating in the Medicare program (under previous and present ownership); and

(ii) Does not have a 12-month cost reporting period ending before September 30, 1983.

(2) The hospital is under new ownership and can document to the satisfaction of its intermediary that -

(i) Its base period reflects previous ownership and control under which the hospital's operation was deliberately phased out in expectation ...

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