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How to Treat Capital Costs on the Cost Report [PODCAST]

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The Hospital Finance Podcast

In this episode, we are joined by Andrew Kinnaman, BESLER’s Senior Reimbursement Consultant, to explain what capital costs on the Medicare cost report are, how to report them, and their effect on cost reporting.

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Highlights of this episode include:

  • Defining Capital Costs
  • Best method for reporting
  • Directly assigned versus step-down
  • Downstream effect of capital costs

Mike Passanante: Hi, this is Mike Passanante and welcome back to the award-winning Hospital Finance podcast. Joining me on the podcast today is Andrew Kinnaman, a senior consultant on our reimbursement team here at BESLER to explain what capital costs on the Medicare cost report are, how to report them, and their effect on cost reporting. Andrew, welcome back to the show.

Andrew Kinnaman: Well thank you. It’s a pleasure to be here today.

Mike: Always a pleasure to talk to you. So, Andrew, why don’t we start out by just sort of defining what capital costs are? So, in general terms, how would you define capital costs for cost report purposes?

Andrew: Well thanks, Mike. Yeah. I’m going to use the verbiage from the cost report instructions, to be clear on what the capital-related costs include. Their definition– capital costs are defined as all allowable capital-related costs for land and depreciable assets, with additional recognition of cost for capital-related items and services that are legally obligated by an enforceable contract, also betterment or improvement costs related to capital that are included in capital assets, and capital costs incurred as a result of extraordinary circumstances that can also be included in capital. So that is basically worksheet A capital costs for the definition [through?] the cost report instructions.

Mike: Okay. It seems maybe a little bit vague in nature. Would you be able to expand on this definition for everyone?

Andrew: Yes. I agree. The statement itself does not provide the type of specification that would, in general, be helpful, so let me provide some more context. For cost reporting purposes capital-related expense for most hospitals will include depreciation, lease and rentals for the use of the facilities and/or equipment, possibly interest incurred in acquiring land or depreciation, or depreciable assets used for patient care. And you notice I put in there, “For patient care.” So you may buy land, but if it’s not for patient care, [it?] may not be considered capital for that case. But other costs besides these can also be determined to be capital in nature. So I’m going to spend a brief minute and go over each one of these in a little more detail, as terms of identifying the cost. So depreciation expense is really an accounting method of allocating the cost of a tangible asset over its useful life, and is used to account for declines in value over time. So most of us in finance know what depreciation [is?] and how to treat it, but just as a clear identification, what we’re identifying as depreciation expense that is related for patient care.

Let’s move on to interest expense. It is the cost incurred by an entity for borrowed funds. It represents interest payable on any borrowings, that’d be bonds, loans, convertible debt, or lines of credit. And, again, it should be noted that interest expense incurred to borrowing working capital or for any other purpose than the acquisition of land or depreciable assets used for patient care is not considered capital-related. That doesn’t mean that it’s not allowable expense; it just would not be considered capital-related. Now, in the case of leases and rental of equipment, the fact that the lease or rental is for a depreciable asset is sufficient for consideration as a capital-related item, but there must be a distinction made between the lease of the equipment and the purchases of services. A lease of equipment is considered a capital-related cost, while a purchase of service is considered an operating cost. Generally, for the agreement to be considered a lease or rental, and therefore a capital-related cost, the agreement must convey to the provider the possession, use, and enjoyment of the asset. Now, those are usually the big three that you will see in any given facility, but there are also some additional ones that, if you can identify that they’re for depreciable assets and patient care, including but not limited to property taxes, insurance on property, and license and royalty fees on depreciable assets. I will finish by just stressing that it’s very important for each hospital to identify their own capital-related costs and properly report these amounts on the cost report.

Mike: Well, that really clears things up a little bit, I think, so I appreciate that expanded information there. Andrew, let me ask you this. Once you identify your capital-related costs, what is the best method for reporting these on the cost report?

Andrew: In reality there is no one correct method to reporting these expenses as capital on the cost report. The most important process is making sure that the expense does get reported as capital-related, if the expenses meet that criteria. Now, you may think to yourself this is a very general statement, but let me give you a couple examples here to clarify. So I’m looking at hospital A, and on their general ledger they report depreciation in the administrative department as part of total expense of that department. So we can identify the depreciation expense by the general ledger accounts assigned to this administrative department. Now, that administrative department is grouped to the administrative and general cost center on worksheet A. In this case, for us to have the capital being assigned, we would have to do an A6 reclassification to move that depreciation from worksheet A administrative and general line where we directly assigned it, based off its department, to either capital-related lines 1 for buildings or line 2 for equipment, depending on if the expense can be determined to be either building or equipment-related. So, in other words, in this case, the depreciation expense was really buried inside a administrative account that we had grouped to line 5 of worksheet A, and now we have to identify it and move it through the cost report process.

Now, let’s contrast this to if the expense is not reported in [the?] administrative department, but instead could be directly identified in a designated depreciation department. So, again, let’s go with hospital A on the general ledger reports depreciation in a department that captures only the depreciation as part of the total expense of this department. We can identify the depreciation expense by the general ledger accounts assigned to this depreciation department. That depreciation department is grouped to the capital-related cost centers on worksheet A. In this case, the capital has been assigned to the worksheet A capital line. The only issue that we have remaining is can that depreciation be split between building and equipment? So there’s two distinctions: one is– we both found the expense. One, we had to move it from where it was to the capital lines. In the other case, we know where the expense is, and we can directly assign it to the capital lines. Each way gets the capital cost to where it is; it just depends on how your accounting structure is and where you identify it and how you have to move it. So it should be noted that all capital costs, interest, rent leases, taxes, insurance will probably require this same analysis, and you need to identify [and group?] with possible requirement of reclassification or adjustments of expense on the cost report. One of the important things about this is that– again, reiterating that all these costs could be allowable; it’s determining whether they’re capital or not. So that’s what I wanted to kind of put emphasis on.

Mike: Okay. Gotcha. Andrew, what is the difference of capital costs directly assigned versus step-down for the Medicare cost report?

Andrew: Thanks, Mike. I’m going to go at this with consideration of what I call, “The concept of direct design versus step-down allocation for the capital costs,” and I think of the matching principle; that is a priority of matching the expense with the revenues generated. So let’s go for another example here. A piece of radiology equipment is leased for the purposes of providing imaging services for the radiology department. The equipment, lease expense, and the revenue generated from this is captured in the radiology department, and it is directly assigned to worksheet A, line 54 of radiology. Therefore, I would consider reporting this cost on worksheet B, part 2, column 0, which is directly assigned capital on line 54. Now, let’s [contrast?] that with another one. Let’s go to another capital cost that most facilities incur, and that’s building depreciation. In this case the expense cannot be identified to a single department or area of service, as we did in the example above. In this case, we will report the expense in the capital line of worksheet A and step-down the building depreciation expense to cost report lines using [this?] statistical basis. In many cases this statistical basis is square feet. And by using this allocation basis, the building depreciation expense is allocated to all areas of the hospital based on square feet. Since the expense cannot be directly assigned to a single group or group of Medicare cost report lines, we are using the square feet to allocate these costs.

Mike: Got it. Okay. Different type of a question. In another BESLER presentation we addressed the issue of downstream effects on the cost reporting process. Can you explain what is meant by the downstream effect of capital costs?

Andrew: Mike, yeah. Great question. And, again, we’ve discussed this in other BESLER presentations, and [inaudible] pretty long discussions of this before. What we really talked about here is the concept of [properly?] accounting for the expenses for other worksheets of the cost report. In other words, we’ve identified the expense, we’ve traced through the cost report worksheets, and we have ended up accounting for the expense properly. You know me; I like examples because it makes it clear, so I’m going to give you another example here. A hospital has a family birth center, and all the expenses for the OB– nursery and labor and delivery, are combined into a single accounting department. For Medicare purposes we must separately identify the services. Let’s take an example that we have equipment depreciation and equipment rental expense directly assigned to this cost center or to these services. In addition, we have an A6 reclassification that moves the equipment depreciation from this department to cost report line 2– to capital-related equipment. And for the same example, we have reported the equipment rental of worksheet B, part 2, column 0 as directly assigned capital to the department cost report line.

Well, for the A6 reclassification, regardless of the method we use to choose to allocate the department expense to the different services, in most cases– let’s take the family birth center. We may use revenue or the revenue code as an allocation of the percent to total. Well, the equipment depreciation, once we do this, should be netted out of the department expenses prior to completing the A6 reclassification, because that cost is no longer in that department. So what you’re seeing is that we’ve had that cost in there, we moved it out through a reclassification – therefore that cost is no longer there – but any remaining costs that are still within those departments need to be allocated for the purposes of operating costs. Now, we also talked about B, part 2, column 0, and it’s important to realize that we need to move that expense, which was part of the A6 reclassification, to the other services based on the same allocation method used for the A6 reclassification. Therefore, these two examples are an illustration of the downstream effect of moving expense that were reported on worksheet A and subsequent movement within the cost report worksheets. Hopefully what I’m picturing is that when you’re looking at a cost report, we’re trying to make sure that where the expense starts and where it ends– is that we’ve moved it appropriately, based on the methodologies that we need to have in place to report them.

Mike: Will this have other downstream effects to anything other than expenses?

Andrew: Yeah. Thank you for bringing– the answer is yes. The downstream impact could impact the b1 statistics we are using to step-down the expenses are worksheet B. So in the example we just discussed, we moved the equipment depreciation to line 2, capital-related, but for Medicare purposes some of the depreciation in this department should be stepped-down to other services for which the equipment is being used. So in this case, we assume the statistic is equipment value or dollar value of equipment by department and by cost report line. This statistic, then, should also be allocated in the same manner as the expense so that the allocated expense is ultimately stepped-down to all these other services, based on how we move the expense. So your statistics are following your expenses is what we’re trying to do.

Mike: Thank you for that explanation, Andrew, and for all the great information today. For anyone in our audience that is interested in diving into this topic in a little bit more depth, Andrew has just recently completed a much longer webinar that gets into this. So you can head up to, click on the insights button, go to the reimbursement tab, and you can view a recording of that webinar, as well as get a look at the slides, so we invite you to do that. Andrew, thank you so much for joining us today on The Hospital Finance Podcast.

Andrew: Thank you, Mike.

The Hospital Finance Podcast


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