Hospital Organization

Table of contents

Hospitals continue to be the largest segment of the health care industry, measured by economic volume and delivery of a wide range of professional services.

Health Care Services

The different segments of the health care delivery system provide various combinations of services. The specific combination offered depends on a variety factors that prevail in a location, including state and local licensing laws, reimbursement structures, availability of medical personnel and facilities, and the demographic details (such as age and industrial distribution) of the potential patient population.The unique aspect of the health care industry from an audit perspective is the health care delivery system – the revenue cycle. The other cycles are essentially similar to those in manufacturing or selling enterprises. Services are generally described by a six-level classification.

Those levels indicate, but do not strictly define, the type of organization, the level of medical treatment involved, or the severity of, or prognosis for, the medical situation. The levels are:

  1. Preventive – Health education and prevention programs provided by business and other organizations, such as schools and family planning clinics.
  2. Primary – Early detection and routine treatment of health problems, such as are often provided by physicians’ offices, industrial and school health units, and hospital outpatient and emergency departments.
  3. Secondary – Acute care services, typically provided by medical personnel, through hospitals, using elaborate diagnostic and treatment procedures.
  4. Tertiary – Highly technical services, such as for psychiatric and chronic diseases, provided through specialty facilities and teaching hospitals.
  5. Restorative – Rehabilitative and follow-up acre, typically provided by home health agencies, nursing homes, and halfway houses.
  6. Continuing – Long-term, chronic care, typically provided by geriatric day care centers and nursing homes.

The growing economic magnitude of the health care system has led to increased regulatory activities focusing on health care. This increase in regulation interacts with a growing demand for more health care and for increasingly technical and complex methods of providing it. The largest and most evident regulatory activity involves reimbursement by state governments. Other regulatory activities are concerned in varying degrees with the availability and quality of health care.There are continued initiatives by state government to link such regulations to reimbursement in order to enforce compliance. The presence of multiple regulatory systems influences the demand for and the nature of professional accounting services required by health care institutions. Those systems often emphasize reporting requirements, and health care institutions tend to view compliance reporting as a major use of accounting data.

Auditing services in particular are affected because the regulatory agencies rely heavily on the attest activities of the health care institution’s independent accountant.

Structure and Organization

Patient care is the essential function of a hospital. Other vital roles include medical education and research. Recently, many larger general hospitals have become total community health centers, providing a wide range of outpatient services in addition to traditional impatient care. One characteristic of the growth of the health center concept is the emergence of such diverse related organizations as real estate holding companies and medical management companies. These organizations are a response to changes in the reimbursement, regulatory, tax and financial environment facing hospital management. Such nontraditional organizational structures and patterns of activity are needed to provide adequate financial resources to support the delivery of health care by hospitals.

Some observers see these changes as leading to major multihospital systems, so that in the future a few major health entities may control the majority of the hospital beds in the country. Hospitals may be classified by type of ownership and mode of operation, as follows:

  1. Government – Hospitals operated by governmental agencies and providing specialized services to specific groups and their dependents, such as the military, veterans, government employees, the indigent and the mentally ill.
  2. Investor-owned (proprietary) – Hospitals owned by individual proprietors or groups of proprietors or by the public through stock ownership. The objective of such hospitals is to operate for profit.
  3. Voluntary nonprofit – Hospitals operated under the sponsorship of a community, religious denomination, or other nonprofit entity. This is the largest category (in number of hospitals), comprising two major types: teaching hospitals and community hospitals.

a. Teaching hospitals – Generally university-related hospitals, their health care service activities combine education, research and a broad range of sophisticated patient services. Large community hospitals affiliated with medical schools and offering intern and resident programs are also considered teaching hospitals.

b. Community hospitals – Hospitals that traditionally are established to serve a specific area, such as a city, town, or county, and usually offer more limited services than teaching hospitals do. Hospitals may also be categorized by the type of care provided, as short-term (acute), general, long-term general, psychiatric, and other special care. The mode of a hospital’s operation and type of care occur in various combinations, such as government psychiatric or short-term pediatric.

Third-Party Reimbursement Or Payment

A major difference between health care entities and commercial enterprises is that the recipient of health care services – the patient – in most cases does not pay directly for the services.

Instead, payment is made by some other organization. The payment is often referred to as a “third party”. Typically, a hospital’s most significant patient revenue sources are its reimbursement contracts with third parties. In each case, there is an identifiable group of patients whose health care services are paid for, in whole or in part, by the third party. The amount of the reimbursement, as well as the eligible class of patients and other administrative matters, is covered by regulations or contracts. The major third parties are governmental agencies. Of these, the state government is the largest.

Medicard is state-administered third-party reimbursement program designed to underwrite hospital costs of the medically indigent and those eligible for certain types of public welfare. Medicare is a third-party reimbursement program administered by the Health Care Financing Administration of the Department of Health and Human Services. State governments have long been involved in reimbursement for health care services, and their involvement has increased through participation in the Medicard Program. Recently, the continued growth of third-party expenditures for reimbursement has fostered a number of state-based cost control programs.Of increasing importance are a wide variety of controls at the state level, usually referred to by terms such as state rate control. The state government has been quite active in encouraging or supporting such programs. The impact of governmental and commercial third parties on hospital is affected by when the reimbursement or payment is determined and the basis of the reimbursement or payment.

Third-party reimbursement systems are either retrospective or prospective. Retrospective refers to third-party reimbursement systems that determine the amount to be paid after the services have been performed.In prospective payment systems, the amount is determined before the services have been performed. Reimbursements or payments are usually based on either the costs (to the hospital) of services performed for eligible patients or the amounts charged by the hospital for such services. The regulations or contracts of the third party contain specific provisions designed to ensure that only certain costs or charges enter into the determination of the reimbursement or payment. There are also provisions to ensure that reimbursement or payment is made only for services to eligible patients.Third-party payers can be expected to continue to refine their approach as the volume of payments increases.

The difference between the hospitals established rates for services rendered and the amounts received or receivable from third-party payers known as a contractual allowance and is shown as a deduction from gross patient revenues on the statement of revenues and expenses.

Payments and Settlements

Under many retrospective reimbursement and prospective payment contracts, the hospital is paid throughout the year on an interim basis.The payment is based on estimates of costs expected to be incurred during the year in serving patients. At the end of the fiscal year, a reimbursement report is filed with each third party, and any difference between the final cost settlements, by providing an independent basis for third-party reliance on the hospital’s accounting records. Reimbursement reports typically include cost-finding calculations that segregate direct costs by cost centers and allocate overhead costs from indirect or nonrevenue-producing centers to revenue-producing centers, using one of several allocation methods.Departments that provide direct patient services such as nursing, laboratory, and radiology are examples of revenue-producing centers, while support or overhead units such as laundry, dietary, and administrative services are typical nonrevenue-producing cost centers. This allocation produces an operating cost for each revenue-producing center, consisting of its direct costs plus its share of indirect costs.

After all costs have been assigned to revenue-producing centers, they are apportioned to the various third-party payers.


Departmental activity or usage statistics are employed in most cost-finding methods used to allocate overhead costs to revenue-producing centers. Some statistics, such as square feet of space, may remain unchanged from prior years. The auditor should, however, inquire whether changes have occurred. Simple observation is helpful; a new wing, department, or floor plan means that statistics must be updated. Certain statistical information is generated by the various transaction cycles. Examples of statistics that are generated in the buying cycle are:

  1. Payroll pesos – Used to allocate employee benefits, health and welfare costs, and other compensation costs.
  2. Hours worked – Used to allocate nursing administration costs and sometimes employee cafeteria costs.
  3. Full-time equivalent employees (FTE) – Sometimes used to allocate employee cafeteria costs.

Other statistics utilized in cost-finding and third-party reimbursement are generated by departmental activity studies and surveys. Examples of such statistics are pounds of laundry, housekeeping hours of service, social service hours, and cost of drugs and medical and surgical supplies issued to nursing stations.Medicare regulations require a study of at least four 2-week periods annually.

Fund Accounting

The audit guide prescribes the use of fund accounting for the external financial statements of nongovernment, not-for-profit hospitals. Fund accounting entails the maintenance of separate or group accounts for hospital resources according to the spending objectives set by donors, other outside sources, or the board of trustees. (Investor-owned hospitals are regarded as business enterprises and report as such. )

Two broad classes of funds are used:

Unrestricted funds, which encompass assets other than those that are restricted, as defined below.Many authorities believe that this class of funds should be referred to as general and that the term unrestricted is misleading, since restrictions other than those imposed by donors or grantors may be placed on assets of these funds. A reserve account maintained under a bond indenture provision is an example of an asset that is included in unrestricted funds but is restricted as to use.

Restricted funds, which encompass assets that are subject to restrictions imposed by specified external parties, that is, donors or grantors. Examples are plant replacement and endowment funds.

Audit Strategy and Risk Assessment

In many ways, the accounting systems and controls that operate in health care institutions are the same as those in any other industry.

Because of regulation by governmental agencies and consumer group pressures, however audit concerns for hospital client is expanded considerably. Those concerns, fee pressures because of the nonprofit nature of many institutions, and competition among firms all create a need for this audit analysis to streamline audit procedures and improve audit efficiency as much as possible. In developing an audit strategy for a hospital engagement, the auditor had a thorough understanding of the patient mix.The geographic location of the hospital, the range of service it provides, and state regulations influence the age, financial status, and insurance coverage of the patient population. In particular, the audit strategy will vary depending on whether the services are rendered on a charge-paying or cost-reimbursement basis. If most of the hospital’s services will be paid on a cost-reimbursement basis; the propriety of costs incurred is a primary concern of the auditor. The accuracy of departmental revenue classification is also important in the cost apportionment process.

The payment is made either directly by the patient or by third parties based on actual charges billed; auditing statistical data and departmental cost classification is deemphasized since those data do not affect revenue. In planning hospital audit, it is important to have an understanding of the hospital’s current financial position and financial trends. Analyzing financial ratios may lead to a fuller understanding of the hospital’s operations and problems than could be obtained from reviewing raw data. It is also helpful to compare the hospital’s operations and financial position with those of the other institutions.Inherent risk in considerations in the health care industry revolves around the third-party reimbursement structure. A key concern is billing procedures, which are complicated by the very significant involvement of third parties.

Typical Transactions, Internal Controls, And Audit Tests Patient Revenue Cycle

The major source of revenues in a hospital is services provided to patients. Revenue was recorded, at hospital’s established rate, on the accrual basis at the time services are performed. Patient service revenues are recorded separately by source (laboratory revenues) and by patient type (inpatient or outpatient).Additionally, the source of payment of each patient is essential information that was captured by the accounting system. Hospitals generally billed inpatients after completion of a patient’s stay in the hospital. The actual amount received by the hospital may vary depending on contractual arrangements between the hospital and the patient or a third-party payer. Services rendered to private-paying patients are billed at the established rates, except that courtesy allowances may be granted to doctors, employees, or members of religious orders and charity allowances may be granted as determined by patient needs and hospital policy.To understand the hospital’s patient revenue cycle, the auditor should become familiar with the various functions and departments that may serve patients and should also understand how those functions and departments relate to accounting for patient revenue.

Substantive Tests Of Accounts Receivable

Hospital receivables have several characteristics not normally found in receivables of commercial organizations. First, full-rate charges to patients for services received may be settled for an amount less than the full rate because of contractual arrangements with third-party payers courtesy, charity, or other policy discounts.In addition, large amounts of receivables are paid by third-parties, and payment may be made by a single payer or combination of payers (e. g. , commercial insurance, Medicare, Medicard, workers’ compensation and the patient. ) Since a patient may have more than one insurer, it is possible for duplicate payments to be made on the patient’s account. This results in credit balances in accounts receivable, which are characteristic of hospitals with aggressive billing procedures.

The auditor should review the components of these credit balances, and if they are significant, consider reclassifying them. Since the hospital must refund duplicate payments, the auditor should review controls over issuance and use of refund checks to determine that they are for valid credit balances and that they are payable to the proper payee. In most hospitals, accounts receivable are classified according to the patient’s billing status, generally using the following categories: •Inpatient:Admitted but not discharged (commonly referred to as “in-house patients”) Discharged but not billed (accounts awaiting final or “late” charges, or unbilled as a result of a backlog in billing procedures – which might indicate a control weakness) Discharged and billed •Outpatient: Unbilled Billed These categories of inpatients and outpatients may be expanded further to indicate private-paying status or third-party responsibility for payment. The existence and accuracy of accounts receivable are normally tested by reviewing subsequent cash receipts.The validity of admitted-but-not discharged patient receivables can be tested by comparing accounts with the daily census report or by relying on compliance tests of admitting function. Confirming balances with patients may be difficult, and the auditor should consider confirming other items, such as number of days spent in the hospital, types of insurance coverage, or, at least, the policy number and insurance company. This information confirms that the patient was in the hospital.

Negative confirmations generally produce adequate results for the “self-pay” or patient portion of the bill.Typical responses for the third-party portion state that the patient believes the bill will be paid by the insurance company or that the patient is unable to confirm because of insufficient information.

Nonpatient Revenues

Revenues from sources other than patient charges consist of interest on invested funds, unrestricted gifts and grants, transfers from restricted funds, and expenditures of restricted fund assets for the benefit of unrestricted (general) funds. Audit steps for material nonpatient revenues should include, but not limited to: •Confirming investment activity with banks or an external trustee. Reviewing date and documents underlying gifts, grants, and bequests, such as board minutes, correspondence, and acknowledgement receipts. •Reviewing research or grant documentation. •Confirming pledges (or otherwise obtaining satisfaction as to their existence) and evaluating their collectability.

Buying Cycle

Payroll. Hospital employees may be classified as professional and nonprofessional. Examples of professional staff are registered nurses and licensed vocational nurses. Nonprofessional employees include orderlies, housekeeping and maintenance personnel, and kitchen staff.Control over both professional and nonprofessional time is critical since salary costs constitute a significant portion of hospital costs. Generally, the same payroll audit procedures used in other organizations of comparable size also apply to hospitals. Compliance testing of total payroll costs should include tests of controls over classification of costs by department, which is important for purposes of reimbursement and also for cost reporting.

Misclassification of a reimbursable cost to a no reimbursable cost center could result in failure to receive reimbursement for that cost.The auditor typically reviews the appropriateness of the account distribution and traces amounts to the payroll register or distribution summaries. Those registers or summaries are tested for mathematical accuracy and then agreed to the appropriate general ledger accounts. Other Expenses. Hospital expenses are typically classified by departmental function (such as nursing services and laboratory services). Proper classification of costs by department is important for financial statement purposes as well as cost reporting and reimbursement .The auditor should test the propriety of the general ledger account distribution by reference to purchasing documentation.

Fixed Assets. Controls over the acquisition of property, plant, and equipment by a hospital should be the same for a commercial enterprise. Some hospital departments own and use expensive, highly specialized equipment, such as nuclear magnetic resonance devices. Department heads should, of course, but that involved in capital budgeting and purchasing decisions, but that involvement should not extend to overriding controls that have been instituted for purchases generally.

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