Reminiscent of the Halloween movie plot where the villain comes back again and again, another major change in Medicare reimbursement is battering skilled nursing facilities (SNFs). The year 1999 witnessed a rash of SNF bankruptcies following a major change in Medicare reimbursement when the Healthcare Financing Administration began to transition to a prospective payment system for SNF services. The new system paid fixed, pre-determined rates for each day of care — a radical change from the former system of cost-based reimbursement. In the decade that followed, SNF operators experienced a period of relative stability, but it may have been the proverbial calm before the storm. Seismic shifts in funding sources, the consequences of a weakened economy from the Great Recession and other environmental factors may soon produce another wave that could rock the industry.

Reliance on State and Federal Government Insurance Programs

It is a common idiom inside the D.C. Beltway that the Center for Medicare and Medicaid Services Administration (CMS) plays the carnival “Whack-a-Mole” game with SNFs as one of the few ways to slow increasing costs.

SNFs provide care for patients that require constant medical attention, but do not require hospitalization. As Baby Boomers age, the demand for services offered by SNFs will increase dramatically. Likewise, this demand will be exacerbated by the efforts of managed care organizations to move patients out of hospital beds and into lower intensity care settings when medically appropriate. The demand for SNF services remains strong.

However, escalating healthcare costs and the pressures of a weak economy have conspired to make fewer individuals able to afford nursing home costs on their own. For about 85% of all SNF residents, government programs pay all or part of their costs. Medicare, the federally funded and operated health insurance program for qualifying individuals age 65 and older, accounts for about 12% of SNF payments. Medicare only pays for the first 100 days in a skilled nursing facility. Residents must then rely upon Medicaid after the first 100 days. Medicaid is a state-operated health insurance program for disabled and low income individuals. Because Medicaid is partly funded by the states, Medicaid reimbursement is often considered more variable than Medicare. Medicaid accounts for approximately half of nursing home payments. Together, Medicare and Medicaid payments account for nearly two-thirds of all SNF payments.

This heavy reliance upon state and federal government funded insurance programs has left SNFs particularly vulnerable to the vagaries of government reimbursement policies.

Changes in Government Reimbursement

The economic downturn has created unprecedented budgetary pressures at the state and federal level.

On October 1, 2011, the CMS announced an 11.1% cut in federal Medicare reimbursement rates. While SNFs were aware a cut was coming, expectations were for a cut of about half of the actual reduction. This dramatic reduction in Medicare reimbursement translates to a $79 billion reduction over ten years, severely cutting into profit margins in an industry where profit margins are traditionally slim to begin with. IBISworld estimates profit margins for SNFs to be around 3.3%. Publicly traded nursing facility companies collectively have some of the lowest margins in the healthcare sector. Further reductions are certainly possible making the situation potentially far worse.

Industry stock prices plummeted on the news of the Medicare reimbursement cut. Stocks of publicly traded nursing home companies fell by as much as 50% on the first day of trading after the slash in reimbursement rates.

The recently announced cut in Medicare reimbursement for nursing homes looms ominous for nursing home operators and businesses dependent upon them. State governments also face staggering deficits. During budget deficits, many states look to save money by cutting Medicaid reimbursement, directly and immediately impacting cash flow and income at SNFs.

Reductions in reimbursement from government insurance programs leave SNFs with little choice but to try to make up the lost revenue by cutting costs and shifting populations to private payers (i.e., individuals and HMOs, insurers and self-insured employer sponsored plans). The economic downturn has only intensified the pressure on managed care organizations to curb healthcare costs by more aggressively negotiating for pricing discounts with participating healthcare providers, including SNFs, controlling the use of healthcare services, and shifting a greater share of the cost to enrollees in the form of higher deductibles and coinsurance.

Other Threats to SNFs

Despite what should be favorable demographics of an aging Baby Boomer population, the reality is that fewer individuals are able to afford SNF care. Seniors typically sell their homes and use this nest egg to pay for long-term care. The depressed real estate market means seniors are either unable to sell their homes, or unable to sell them for a price that will cover the cost of long-term care, thus many are staying at home.

Exacerbating the problem is the fact that private insurance plans are attempting to curb costs by shifting a greater proportion of the coverage costs to enrollees. As a result, many more people are either avoiding the expense of skilled care or seeking out less skilled care settings such as at-home care or are being cared for by family members.

Assisted living facilities, which offer greater autonomy for their residents than SNFs, continuing care retirement communities offering a continuum of long term care for the elderly, and expanding home healthcare options are each contributing to declines in SNF use.

The problems for SNFs are further intensified by changes in government policy. The Balanced Budget Act Amendment of 1997, which aimed to reduce Medicare spending on SNFs through the introduction of a prospective payment system, also gave the states the power to mandate enrollment in managed care plans for individuals that wish to receive Medicaid coverage for nursing home services. Some states have responded by requiring the most expensive Medicaid patients to enroll in managed care plans. Managed care plans, by definition, seek to cut costs through the negotiation of discounts from participating healthcare providers.

Changes brought about by the 2010 healthcare reform legislation have added to the woes of SNFs. The Patient Protection and Affordable Care Act (PPACA) makes federal dollars available to fund programs promoting more at-home care. This also has the effect of shifting care away from SNFs. As a result of these changes, the patients who do arrive at SNFs are often the frailest and the most expensive to care for. This creates an adverse selection problem for SNFs; there are increasingly fewer relatively health residents to offset the frailer, more costly residents.

Beginning in fiscal year 2015, the hospitals with the top 25% of rates of hospital acquired conditions (HACs) for certain high-cost and common conditions will be subject to a payment penalty under Medicare. The Patient Protection and Affordable Care Act requires that the Health and Human Services Secretary submit a report to Congress by January 1, 2012 about expanding that reduced reimbursement policy to other healthcare providers including SNFs. While this is not a direct cut to reimbursement, it strongly suggests potential cuts in the future as well as increased costs for SNFs to avoid financial penalties.

Existing Financial Problems

Profit margins for the SNF industry have historically been slim. Profitability is affected by patient census, sources of payment and reimbursement, and the acuity level of patients. As discussed above, none of these aspects are working in the SNF’s favor. Not surprisingly, over the past five years, the number of SNF companies has declined 3.1% annually and the number of facilities has decreased 3.3%. If more cuts in government payments are made, many predict the industry will have zero or negative profit margins further pressuring the for-profit sector.

Despite some deleveraging over the past two years, SNF debt levels remain high. A sampling of 12 companies in the assisted living facilities industry reveals an average net debt to EBITDA ratio of about 6.6x[1]. SNFs often incur uncollectable fees as a result of unpaid Medicare co-payments for care rendered. Unpaid Medicare payments are typically incurred by the poorest and frailest patients that are dually eligible for Medicare and Medicaid coverage. Nearly all of SNF co-payments are uncollectible since they are owed by state governments, which increasingly are choosing not to pay them to solve their own financing shortfalls.

Also contributing to the woes of SNFs is their high operating costs. Like the NBA, the largest cost is employee-related. Like the NBA, nursing is a highly skilled profession and there is a significant shortage. Unlike the NBA, state regulators have established minimum staffing requirements for SNFs in an effort to assure quality. Staffing the mix of skilled and unskilled employees needed to run SNF’s is difficult and turnover is high, resulting in recurring costly training of new workers. The increase in patient acuity increases direct care, which increases wage expenses to meet minimum care requirements.

To deal with escalating employee benefit costs, SNFs may reduce benefits or shift costs to employees, further pressuring staffing issues. If the scarcity of nurses and aides disrupts the ability of SNFs to provide a high quality of care, patients who have choices available to them will likely turn to alternative healthcare providers, or to punitive government regulators, thereby escalating the vicious cycle of meeting quality of care standards in the face of declining census.

In order to stay competitive with alternative care providers, it is important for SNFs to have up-to-date facilities and technologies but these often take second priority in the face of reduced reimbursement and increased day-to-day care requirements.

A Zero Sum Game

In the end, it is a zero sum game for SNFs with downward spiraling tendencies. Reduced government program funding must be made up for in some other manor. Unfortunately, the only other sources of funding for SNFs are private pay patients who are now less able and less willing to absorb the cost of skilled nursing care. With few if any alternative sources of revenue, costs get cut. SNFs are caught in a catch-22 situation; they cannot attract private payers without adequate and attractive facilities, but they are unable to afford those. SNF’s reliance on an unsustainable capital structure promises a new wave of distressed M&A or bankruptcies that will redefine the industry.

Jeffrey R. Manning is managing director of the Special Situations Practice at BDO Capital Advisors, LLC, a middle-market investment bank. He can be reached at [email protected].

Jerry Shapiro is a managing director at BDO Consulting Corporate Advisors. He can be reached at [email protected]