In this research, I study the effect of changes in Medicare payments, introduced in the Balanced Budget Act of 1997, on the financial condition of non-profit hospitals. Non-profit hospitals are a very important part of the healthcare delivery system in US. Medicare patients constitute the single largest segment of their revenue sources. Understanding the consequence of the changes in reimbursement on the hospital finances is relevant in framing future revisions of Medicare payments.

BBA was introduced to control the growing federal budget deficit. The most important instrument for the cutback in government expense came in the form of reduction in Medicare outlays. Some of the changes introduced in Medicare payment policy had direct consequences on reimbursement received by hospitals. I look at the cumulative effect of the changes introduced in the BBA through the following steps: First, I identify the important financial and operational factors which explain the majority of the variation in the performance of non-profit hospitals. Subsequently, I study the changes in those measures, before and after the BBA. Additionally, I look at the effect of the changes on capital use and cost of capital faced by these hospitals that can be attributed to the policy change.

I obtain financial and operational information for the hospitals mainly from the Hospital Cost Reports maintained by the Center for Medicare and Medicaid Services. To evaluate the cost of capital, I use data on new issues in municipal bond market from the Thomson Financial SDC Platinum database.

My key observation is the importance given to the use of capital by non-profit hospitals. Even though BBA adversely affected their profitability, the hospitals did not lower their use of capital. Neither did they cut back on the use of debt to finance their new investments. These were despite the fact that the declining financial conditions resulted in higher cost of borrowing for the hospitals. Acknowledging the importance of the use of debt capital is critical, for future policy changes, as the study also finds that it is the single most important determinant of the variation in the performance of non-profit hospitals.