The Impact of the Individual Mandate and Internal Revenue Service Form 990 Schedule H on Community Benefits From Nonprofit Hospitals

Abstract

In response to a growing concern that nonprofit hospitals are not providing sufficient benefit to their communities in return for their tax-exempt status, the Internal Revenue Service (IRS) now requires nonprofit hospitals to formally document the extent of their community contributions.

While the IRS is increasing financial scrutiny of nonprofit hospitals, many provisions in the recently passed historical health reform legislation will also have a significant impact on the provision of uncompensated care and other community benefits.

We argue that health reform does not render the nonprofit organizational form obsolete. Rather, health reform should strengthen the nonprofit hospitals’ ability to fulfill their missions by better targeting subsidies for uncompensated care and potentially increasing subsidized health services provision, many of which affect the public's health.

INTERNAL REVENUE CODE § 501(c)(3) exempts nonprofit hospitals from federal income taxes. Since 1969 the community benefit standard¹ has been the criteria by which the deservedness of tax exemption has been determined.² There is, however, a long-standing debate in both the health policy and economics literatures on whether there is a substantial difference between the actions of for-profit and nonprofit hospitals, with empirical evidence supporting both schools of thought.³ The inconclusive nature of this research helped spur political and legal action regarding community benefit provision by nonprofit hospitals.⁴ In response to this growing concern that nonprofit hospitals are providing insufficient benefits to their communities in return for their tax-exempt status, the Internal Revenue Service (IRS) has revised Form 990 requiring nonprofit hospitals to submit additional detailed financial documentation regarding their community benefit expenditures on Schedule H beginning with 2009 filings.

Simultaneously with tax reform, many provisions in the recently passed health reform legislation⁵ will also significantly impact hospitals and their provision of community benefit activities. Sufficient provision of these services has important implications for the public's health. Former US Surgeon General David Satcher has argued that health reform and, specifically, the reduction in the number of uninsured, is “critical to our achieving the overarching goal of eliminating disparities in health.”^6(p15) Regina Benjamin, the current US Surgeon General, states that “eliminating health disparities should certainly be at the top of our national health agenda.”⁷ Approximately 31% of direct medical costs for minority populations from 2003 to 2006 were excess costs resulting from health inequities.⁸

We explored the potential ramifications of the Patient Protection and Affordable Care Act (PPACA) and the Health Care Education Affordability Reconciliation Act of 2010 (HCEARA) on the level, measurement, and potential change in the composition of hospital community benefits, with regard to the new IRS regulations. We considered whether these legislative changes may further blur the distinction between for-profit and nonprofit hospital behavior and performance and explored the potential public health consequences of eliminating the tax-exempt status of nonprofit hospitals. We used data from Maryland, a state that implemented legislation similar to the recent IRS regulations in 2001, to guide our discussion and evaluate potential effects under these new legislative acts.

LEGISLATIVE BACKGROUND

Recent changes in IRS regulations as well as the PPACA have the potential to affect the amount of community benefit services that nonprofit hospitals supply. This section provides a brief overview of relevant provisions and their potential impact on community benefit provision.

IRS Form 990 and Schedule H

Beginning with the 2009 tax year, hospitals that are tax exempt under Section 501(c)(3) were required to file a newly redesigned IRS Form 990 and the supporting Schedule H. The purpose of this schedule is to “give both the IRS and the public an improved window into the way tax-exempt organizations go about their vital mission.”⁹ Although current IRS regulations require no threshold level of community benefit services that must be offered to maintain tax-exempt status, several thresholds have been suggested,¹⁰ including a 2007 recommendation by the Senate Finance Committee suggesting that a nonprofit hospital should provide charity care and community benefits equal to at least 5% of hospital operating expenses or revenue (whichever is greater).¹¹

Schedule H requires hospitals to report the net value of community benefit services offered in the following areas: charity care and means-tested government programs, community health improvements, health professions education, subsidized health services, community building activities, research, and cash or in-kind contributions to community groups. Table 1 contains definitions and examples of these categories.

TABLE 1—

Internal Revenue Service Form 990 Schedule H: Definitions and Examples

Schedule Location	Title	Definition or Example
Part I	Charity care and other community benefits	Programs or activities that provide treatment or promote health and healing as a response to an identified community need
Line 7a	Charity care	Free or discounted services for those who cannot afford to pay and meet the hospital's financial assistance criteria
Line 7b–c	Medicaid and other means—tested government programs	CHIP and other federal, state, and local programs also qualify
Line 7e	Community health improvement services	Extend beyond patient care; do not generate inpatient or outpatient bills (e.g., screenings, support groups, mobile units)
Line 7e	Community benefit operations	Costs associated with planning or operating community benefit programs (e.g., assigned staff, community health assessments)
Line 7f	Health professions education	Programs that result in a degree or certificate or training necessary to be certified; costs for residents or interns
Line 7g	Subsidized health services	Negative margin service; meets an identifiable community need; if no longer offered would be unavailable or fall to the responsibility of another nonprofit or government agency (e.g., emergency room and trauma centers, burn units)
Line 7h	Research	Produces “generalizable knowledge” and funded by tax-exempt sources (e.g., clinical and community health research)
Line 7i	Cash or in-kind contributions to community groups	Receiving group must be engaged in a community benefit activity; in-kind donations may include the indirect cost of space donated to community groups and direct cost of donated food or supplies
Part III: lines 1–9	Community-building activities	Programs that address underlying causes of health problems to improve health status and quality of life (e.g., economic development initiatives, physical improvements such as maintenance of parks and playgrounds, participation in community coalitions)

Note. CHIP = Children's Health Insurance Program.

Source. Internal Revenue Service Instructions for Schedule H¹³; The Catholic Health Association of the United States: A Guide for Planning and Reporting Community Benefit 2008 Edition.¹²

The IRS guidelines, which incorporate the Catholic Health Association guidelines,¹² assist hospitals in the proper classification of their activities. The primary directive is that the activity must respond to an identified community need. Community health improvement services, for example, cannot be provided primarily as a mechanism by which to increase hospital market share. A diabetes education program, therefore, constitutes a community health improvement, whereas marketing material for a hospital's orthopedic program does not. A subsidized health service must not only operate at a financial loss, but it must also meet a recognized community need. For example, a mental health service that serves primarily Medicaid patients that has a high census represents a subsidized health service for community benefit reporting purposes. However, a mental health service for all that has a low census and loses money would not qualify as need was not established. Provision of this service merely represents a poor business decision by the hospital. The IRS, moreover, now explicitly states that the amount reported as charity care is not to include any bad debt expense.¹³ Hospitals must separately report bad debt expense and estimate the amount of bad debt attributable to charity care patients, documenting why some of its bad debt expense should be recognized as a community benefit.

The PPACA and HCEARA implications

Numerous components of the health care legislation have the potential to affect both the level and composition of community benefit provision by nonprofit hospitals.¹⁴ Table 2 provides a summary of these relevant components as well as the category of community benefit likely to be most directly affected.

TABLE 2—

Summary of the Patient Protection and Affordable Care Act and The Health Care Education Affordability Reconciliation Act of 2010 Provisions Affecting Community Benefit Activities

Legislative Provision	Description	Potential Impact on Community Benefit
Title I Subtitle A § 2712	Prohibition of insurance rescissions	Charity care reduction
Title I Subtitle A § 2714 (as amended by § 2301 of the Reconciliation Act)	Dependent coverage extension up to age 26	Charity care reduction
Title I Subtitle B § 1101	Prohibition of denial for pre-existing conditions	Charity care reduction
Title I Subtitle C § 2702	Guaranteed availability of coverage	Charity care reduction
Title I Subtitle C § 2703	Guaranteed renewability of coverage	Charity care reduction
Title I Subtitle F § 5000A (as amended by § 1002 of the Reconciliation Act)	Individual mandate to maintain minimal essential coverage or face financial penalty	Charity care reduction
Title II Subtitle A § 2001	Medicaid expansion to the low-income childless adult population	Charity care reduction; potential increased Medicaid shortfall
Title III Part 1 § 3001	Hospital value-based purchasing: percentage of payment tied to quality	Increases in community health improvement services; community benefit operations; community building activities
Title III Pt III § 3022 and § 3025	Allow accountable care organizations to share in generated cost savings with Medicare; hospital readmission payment reduction program	Increases in community health improvement services; community benefit operations; community building activities
Title IX Subtitle A § 9007a, codified in IRS § 501(r)(3)	Conduct health needs assessment; implementation plan every 3 y	Increase in community benefit operations
Title IX Subtitle A § 9007a, codified in IRS § 501(r)(5)	Charge parity for financial assistance patients	Bad debt; charity care reduction
Title IX Subtitle A § 9007a, codified in IRS § 4959	$50 000 excise tax for failure to comply with IRS § 501(r)	Increase in community benefit operations

Note. IRS = United States Internal Revenue Service.

Source. Democratic Policy Committee Section by Section Analysis of the Affordable Care Act With Changes Made by Title X and Reconciliation.¹⁴

Several elements of the legislation will impact the amount of uncompensated care provided. The most significant, of course, is the individual mandate requiring the majority of citizens to have adequate health insurance by 2014 or face a financial penalty.¹⁵ Furthermore, the legislation extends Medicaid coverage to all individuals (except undocumented immigrants) aged younger than 65 years who have incomes up to 133% of the federal poverty level. The numerous insurance market reforms, such as the ones listed in Table 2, should further act to reduce the size of the uninsured population. As a result, the insured share of the nonelderly population is estimated to rise from 81% in 2010 to 92% by 2019.¹⁶

Given the expected decline in the uninsured population and, hence, the reduced demand or need for charity care, the legislation also calls for the reduction of both Medicare and Medicaid Disproportionate Share Hospital (DSH) payments. There is a planned phase-in of the reduced dollars and the Secretary of the Department of Health and Human Services is instructed to impose the largest reductions on those states that do not target DSH dollars to those hospitals serving indigent patients. It may be that the original goal of the Boren Amendment¹⁷—to incrementally reimburse those hospitals serving disproportionately more low-income and/or uninsured patients—will finally be achieved as payments are more closely aligned with hospitals actually serving these patients.

The PPACA's Medicare and Medicaid payment reforms, which include incentives for accountable care organization formation, payment reductions for readmissions, payment linkages to quality measures, and demonstrations regarding bundled payments, also have the potential to increase the amount of resources devoted to both community health improvement services and community building activities. It is quite plausible that a higher level of health status before the start of care will not only increase the probability of a favorable treatment outcome but may also reduce the cost of care, thereby increasing the cost savings captured by Medicare accountable care organizations.

Section 9007(a) of the PPACA also places additional requirements on nonprofit hospitals regarding their community benefit activities.¹⁸ Internal Revenue Service § 501(r)(3) stipulates that hospitals must conduct a community health needs assessment every 3 years and undertake an implementation strategy to meet any identified needs.¹⁹ Hospitals failing to meet this requirement are subject to a $50 000 excise tax.²⁰ Furthermore, IRS § 501(r)(5) stipulates that hospitals cannot use gross charges to bill patients who qualify for financial assistance and that their rates to these patients should be “based on either the best, or an average of the three best, negotiated commercial rates, or Medicare rates.”²¹ Such charge parity will make it more difficult for hospitals to discourage those that remain uninsured or underinsured from seeking services²² and could markedly reduce the dollar amount of charity care reported by hospitals.

To date, there has been little written that evaluates how the expected reduction in charity care and bad debt under the health care legislation will impact the measurement of community benefits for the purposes of meeting IRS Rev Rul 69–545. Recent studies analyzing the impact of state community benefit laws on the provision of community benefits activities²³ were completed before the passage of the PPACA and the HCEARA. Trade publications focus primarily on proper documentation of community benefit to escape IRS scrutiny.²⁴ Some question whether tax exemption will still be necessary as universal coverage becomes operational.²⁵ Others argue that the IRS revision of Form 990 and creation of Schedule H reflect an IRS attempt to extend the community benefit requirement beyond the criteria listed in IRS Rev Rul 69–545.²⁶ Overall, however, those in the hospital industry believe these legislative changes “signal a more active role for government” and that “more facilities will face challenges to tax-exempt status.”^27(p28)

POLICY IMPLICATIONS

It will be important to monitor PPACA's impact on both the measurement of community benefit activities as reported on Schedule H and on observed differences between nonprofit and for-profit hospital behavior. Even before passage of the legislation some academics questioned the need for a broad exemption for nonprofit hospitals.²⁸ Maryland hospital data are especially instructive with regard to potential policy implications as this is an all-payer, rate-regulated state with only 1 for-profit hospital. Reimbursement for uncompensated care is also built into hospital rates. Maryland hospitals have been required to report annual community benefit expenditures to the state's Health Services Cost Review Commission in a format very similar to the new IRS requirements since 2001.²⁹

Analysis of the Maryland data revealed the need for the increased oversight of nonprofit hospitals that mandatory Schedule H reporting will provide. Despite the subsidy for charity care, the lack of competition from for-profit hospitals, and a nonprofit mission, there is substantial variation in the amount of community benefit services provided by Maryland hospitals, ranging from a minimum of 1.67% of operating expenses to a maximum of 13% (Table 3). There is only a weak correlation (0.046) between operating income and total community benefit expenditures, despite 34 (77%) hospitals reporting positive operating income. Nineteen hospitals (43%) have operating income exceeding $500 000 and only 31 (70.5%) hospitals meet the 2007 Senate Finance Committee's proposed 5% threshold. We found no statistically significant difference in physical capital (as measured by the number of beds) or financial resources (as measured by operating income) between hospitals meeting this threshold versus those that do not. Indeed, more than 60% of the hospitals that do not meet the 5% threshold have a positive operating income.

TABLE 3—

Net Community Benefit Expenditures Summary Statistics: Maryland Nonprofit Hospitals, 2008

Category	Mean (SD), $	Range, $
Charity care	6 268 434 (8 522 382)	262 900–41 992 000
Health professions education	5 570 295 (14 958 520)	0–83 739 383
Community health services	1 376 751 (1 464 725)	917–622 820
Mission-driven health services	4 027 845 (4 227 628)	0–17 821 729
Community-building activities	379 774 (776 650)	0–4 606 556
Community benefit operations	157 732 (32 945)	0–1 386 176
Research	203 004 (921 002)	0–5 916 900
Cash or in-kind contributions to community groups	370 089 (667 570)	0–4 300 306
Total community benefit expenditures	18 710 713 (27 121 187)	744 358–145 369 791
Total community benefits as a percentage of operating expenses	6.30 (2.80)	1.67–13.0
Operating income	6 367 101 (13 801 930)	−19 527 024–69 647 000

Source. Maryland Health Services Cost Review Commission, Community Benefit Report for fiscal year 2008. Data reported for all private, short-term, acute care hospitals in the state.²⁹

Influence of the Individual Mandate

The individual mandate, payment reforms, and the requirement of nonprofit hospitals to conduct periodic community health needs assessments all have the potential to affect both the level and composition of community benefits as well as their concentration at hospitals in areas or markets with the most need for free or subsidized care.

Under the individual mandate, the number of uninsured is estimated to fall from 49.1 million to 23 million by 2019 resulting in a 25% reduction in uncompensated care spending,³⁰ causing some health care executives to question whether a “community-centered mission” is still necessary.³¹ Charity care is the largest and fastest growing (since 2005) component of Maryland hospitals' community benefit expenditures (Table 4), suggesting that implementation of the legislation will undoubtedly affect the composition of community benefits in the state.

TABLE 4—

Percentage Composition of Net Community Benefit Expenditures: Maryland Nonprofit Hospitals, 2008

Category	Community Benefit Composition, %	Composition Change From 2005, %	Community Benefit as a % of Operating Expenses	Composition Change From 2005, %
Charity care	33.50	3.52	2.42	0.32
Health professions education	29.80	−9.03	2.15	−0.57
Community health services	7.40	0.48	0.53	0.05
Mission-driven health services	21.50	3.33	1.56	0.28
Community-building activities	2.00	0.31	0.15	0.03
Community benefit operations	0.84	0.31	0.06	0.02
Research	1.10	−0.10	0.08	−0.01
Cash or in-kind contributions to community groups	1.98	−0.05	0.14	0.00

Source. Maryland Health Services Cost Review Commission, Community Benefit Report for fiscal year 2008²⁹; The percentage change in the composition from 2005 calculated using data provided in Grey and Schlesinger.³²

The net effect of the individual mandate on the amount of charity care provided by nonprofit hospitals, however, is indeterminate and will require empirical study. Nonprofit hospitals will still provide uncompensated care as an estimated 8% of the population will still lack meaningful coverage by 2019³³ resulting in an estimated uncompensated care expenditure of $46.6 billion.³⁴ There will always be persons transitioning between insured and uninsured status, those who refuse to take up subsidized insurance, and noncitizens who will remain unaffected by the legislation's expansion of coverage. It is plausible that a further concentration of charity care will occur and that hospitals located in inner-city areas with high poverty may not see demand for charity care decrease.³⁵ There is preliminary evidence for this possibility as Maryland hospitals that meet the Senate Committee's 5% threshold are located in counties with a statistically significant greater number of people with income below the poverty level consistent with other research that posits location is an important determinant of demand for and supply of community benefits. For only some nonprofit hospitals, therefore, charity care has the potential to become a smaller component of community benefit, increasing the importance of other community benefit activities in the measurement and determination of adequate provision.

For those nonprofit hospitals that see a reduced demand for uncompensated care, total revenue may actually increase if the cost of treating the newly insured is fully reimbursed. This would enable the hospital to enhance its offerings of community benefit services beyond uncompensated care,³⁶ as an increase in cash flow and lower debt levels have been linked to higher levels of uncompensated care.³⁷ Consequently, some nonprofit hospitals may substantially change the composition of their community benefit provision, away from charity care, and toward other components of community benefit: community health improvement, community building activities, community health operations, or subsidized health services.

Of these categories, subsidized health services exhibit the greatest potential for hospital behavior to differ by ownership status and for this behavior to have significant public health consequences. The legislation mandates that nonprofit hospitals perform periodic community health needs assessments, which should increase resources devoted to community benefit operations. Payment reform efforts in the legislation, by contrast, are similar to many private sector pay-for-performance initiatives.³⁸ As episodic payment and risk-adjusted capitation continue to replace traditional fee for service, all hospitals will have the incentive to increase their provision of community health improvement or community building services in an effort to either improve health status before the beginning of an episode of care or reduce costs under universal payment.

Potential Legislative Changes

This potential convergence in behavior suggests that the IRS may have to give more weight to the provision of subsidized health services, which, by definition, have a negative margin, in determining adequacy of community benefits, especially in areas where the individual mandate results in high insurance coverage. Our analysis of Maryland data indicated that increased oversight with regard to subsidized health services may be warranted. Although these services currently represent an average of 21.5% of total community benefit expenditures, which has increased since 2005, further review finds considerable variation among this state's nonprofit hospitals (Table 4). Two hospitals (4.5%) reported no mission-driven services. Six hospitals (13.6%) reported mission-driven services comprising less than 10% of their community benefit expenditures, and 2 hospitals (4.5%) reported more than 95% of total community benefit expenditures as mission-driven services.

Sufficient provision of mission-driven services is critical as many of these unprofitable services directly influence public health. Standard management theory would suggest that a for-profit firm will face more pressure than does a nonprofit firm to divest unprofitable services.³⁹ Existing empirical research, in addition, finds that nonprofit hospitals are more likely to offer unprofitable services than are for-profit hospitals.⁴⁰ For example, nonprofit hospitals admit seriously mentally ill patients from the emergency room more frequently than do for-profit hospitals.⁴¹ For-profit drug treatment providers are not as likely as nonprofit providers to provide the comprehensive services necessary for successful drug abuse treatment.⁴² Nonprofit hospitals are also more likely than for-profit hospitals to provide AIDS services, alcohol and drug outpatient programs, psychiatric emergency services, and obstetrical care as well as operate an emergency room and trauma center.⁴³ Furthermore, these are also high-use services among the uninsured and poor.⁴⁴

It appears that nonprofit hospital management⁴⁵ recognizes its public health role. As one CEO stated,

we provide many services that are not self-sustaining, such as pediatrics, subspecialties, and mental health. We would never consider not providing those services because there would be no one else to provide them.^46(p365)

They further acknowledged that a decreased uncompensated care burden will enable them

to provide community benefit in other ways, such as more support to federally qualified health clinics or working in community health education.^47(p369)

This increased spending has the potential to significantly improve public health because

high rates of return have been demonstrated for community level interventions to reduce the high risk behaviors that promote chronic diseases, which accounts for two-thirds of all deaths in the United States and a higher percentage of deaths among the most disadvantaged groups.^48(p205)

The IRS, moreover, may have to not only pay careful attention to both the level and composition of community benefits but also consider expanding the types of activities that fulfill the community benefit obligation once all provisions of the legislation are fully implemented and hospitals have an opportunity to alter their behavior in response to the incentives contained in the legislation. An expansion, although potentially necessary, may not help identify activities that are unique to nonprofit providers. For example, all hospitals will have the incentive to offer services that involve transitioning poor or near-poor to Medicaid or insurance exchanges and coordinating care with the remaining safety net providers in the community (e.g., public health departments, community health centers, or Title X providers) either to maximize revenue or to minimize costs. Those involved in the demonstrations that bundle payment will have incentives to coordinate care in the community with Medicaid physicians or safety net providers.

By contrast, however, there is evidence that nonprofits may provide additional community benefit services, not currently recorded on Schedule H, but that should be recognized. For example, recent research finds that nonprofit hospitals are more likely to admit seriously mentally ill patients seen in the emergency room than are for-profit hospitals, leading some to argue for allowing treatment of the underinsured, seriously mentally ill, to fulfill community benefit obligations.⁴⁹ As a nonprofit hospital CEO stated when discussing a hospital program involving development of a medical home for all patients, not just government-sponsored:

It's unfortunate that none of these are being counted as part of our community benefit because they really are part of it. Community benefit is evolving and its definition needs to reflect that evolution. Hopefully government at all levels will begin to see it the way we do.^50(p370)

CONCLUSIONS

Preliminary analysis of Maryland hospital community benefits data illustrates the need for continued oversight of nonprofit hospitals regarding the appropriate level of expenditure necessary for tax exemption. Mandatory Schedule H filing will enable regulators to both determine patterns in the community benefit provision of nonprofit hospitals and monitor change as the individual mandate and other provisions in the health reform legislations become fully operational.

It also appears that a uniform expenditure threshold will not result in an adequate matching of benefit with community need. Rather, regulators should more closely link tax-exempt status to nonprofit hospital behavior in relation to the specific needs of a hospital's local community. The requirement in the PPACA that tax-exempt hospitals complete a community needs assessment every 3 years should make such a linkage possible and help to reduce community and health disparities.

As episodic payment and risk-adjusted capitation continue to replace traditional fee-for-service payment, all hospitals will have an incentive to increase their provision of community health improvements or community building services in an effort to either improve health status before the beginning of an episode of care or reduce costs under universal payment. This potential convergence in behavior suggests that the IRS may have to give more weight to the provision of subsidized health services, which, by definition, have a negative margin, in determining adequacy of community benefit, especially in areas where the individual mandate results in high insurance coverage.

A reduction in the number of uninsured has the potential to provide nonprofit hospitals with the necessary resources to provide additional mission-driven (subsidized) services, allowing them to truly distinguish themselves from for-profit providers. We argue, therefore, that there is still a meaningful role for the nonprofit hospital because “[t]he services available through community benefit programs are designed to respond to unmet public health needs.”^51(p11) Although the composition of community benefit services may change, tax-exempt status is still necessary to ensure sufficient provision of unprofitable services and those related to preventable diseases. Such preventative services have the potential to address the pressing public health problems of diabetes, obesity, and asthma.⁵² Because of the importance of these services to public health promotion, the empirical evidence indicating that nonprofit hospitals are more likely to provide these services, and the correlation between provision of these services and the hospital's financial strength, health reform does not render the nonprofit organizational status obsolete. Rather, health reform should strengthen the ability of the nonprofit hospital to fulfill its mission and serve the local community.