Hospital finance model
Estimated effects of Medicare payment rates on a hospital
Community nonprofit · A 300-bed community hospital with a balanced payer mix · annual operating expense of $500 million. Policy scenario modeled: All payers at Medicare.
assumptions/ with that institution's cost report and payroll data.Key findings
- Payment levels. Medicare pays this hospital about 84 cents per dollar of cost. The model estimates that commercial insurers pay about $1.59 per dollar of cost (1.89x Medicare). Under the All payers at Medicare scenario, the model estimates that the hospital would need to reduce its cost base by about 18 percent ($92 million) to break even.
- Determinants of the result. Because commercial revenue is repriced to Medicare rates, revenue after the policy change depends on Medicare's payment-to-cost ratio and the payer mix rather than on the level of commercial prices before the change. Commercial prices determine the size of the decline, not the level at which revenue settles.
- Conventional turnaround. Under the conventional turnaround response scenario, the annual operating gain is $28 million and the operating margin is −15.7 percent. The hospital does not reach break-even. The scenario extends the period before cash is exhausted by about 1.4 years.
- Aggressive restructuring. With every restructuring lever at its base level, the annual operating gain is $68 million and the operating margin is −5.9 percent. The hospital does not reach break-even.
- System redesign. The hospital reaches break-even only under the system redesign scenario (an operating margin of +8.5 percent), which assumes that compensation moves toward international norms, that drug and device prices are regulated, and that payer administrative complexity is eliminated. These changes are beyond the control of a single hospital.
- Policy design. Annual operating income before any response is −$92 million under the All payers at Medicare scenario and −$65 million under single payer, which also moves uninsured patients to Medicare rates. With no cost changes the hospital breaks even at a payment level of 1.45x Medicare; after aggressive restructuring, at 1.12x.
Baseline financial position
The payment-to-cost ratio is the payment the hospital receives from a payer for each dollar of cost incurred to treat that payer's patients. Where the ratio is below 1.00, payments fall short of the cost of care for that payer's patients; where it is above 1.00, payments exceed that cost. Table 1 reports the ratios, revenue, and cost of care by payer at baseline.
Table 1. Baseline revenue, cost of care, and payment-to-cost ratio by payer
| Payer | Share of care | Payment-to-cost ratio | Revenue | Cost of care | Surplus or shortfall |
|---|---|---|---|---|---|
| Medicare | 44% | 0.84 | $185M | $220M | −$35M |
| Medicaid | 19% | 0.80 | $76M | $95M | −$19M |
| Commercial | 29% | 1.59 | $230M | $145M | +$85M |
| Uninsured (self-pay) | 6% | 0.10 | $3.0M | $30M | −$27M |
| Other government | 2% | 0.90 | $9.0M | $10.0M | −$1.0M |
| Other operating revenue | $10.0M | +$10.0M | |||
| Total | 100% | $513M | $500M | +$13M |
Source: Model calculations based on the hospital inputs described in the notes above.
Show baseline cost structure (labor of $280M, 56% of operating expense)
Table 2. Baseline operating expense by category
| Cost line | FTE | Average wage | Annual cost | Share of expense |
|---|---|---|---|---|
| Employed physicians | 110 | $380,000 | $52M | 10.4% |
| NPs / PAs | 70 | $135,000 | $12M | 2.3% |
| Registered nurses | 620 | $98,000 | $75M | 15.1% |
| LPNs, aides, techs | 380 | $48,000 | $23M | 4.5% |
| Pharmacy, lab, imaging, therapy | 330 | $85,000 | $35M | 7.0% |
| Billing, coding, payer admin | 150 | $58,000 | $11M | 2.2% |
| Executives and managers | 90 | $190,000 | $21M | 4.2% |
| IT, HR, finance, quality | 210 | $80,000 | $21M | 4.2% |
| Environmental, food, facilities | 300 | $42,000 | $16M | 3.1% |
| Agency (contract) labor | $15M | 3.0% | ||
| Drugs | $42M | 8.4% | ||
| Devices and implants | $22M | 4.4% | ||
| Medical/surgical supplies | $30M | 6.0% | ||
| Purchased services | $44M | 8.8% | ||
| Billing/insurance vendors | $6.0M | 1.2% | ||
| Malpractice and insurance | $9.0M | 1.8% | ||
| Utilities and facilities | $14M | 2.8% | ||
| Depreciation | $28M | 5.6% | ||
| Interest | $8.0M | 1.6% | ||
| Marketing | $3.0M | 0.6% | ||
| Other expense | $14M | 2.8% | ||
| Total | 2,260 | $500M | 100% |
Source: Model calculations based on the hospital inputs described in the notes above.
Staff costs include benefits and payroll taxes at 24% of wages.
Effect of Medicare payment rates
Under the All payers at Medicare scenario, the model estimates that commercial revenue would fall by $108 million (47 percent). Medicaid revenue would rise by $3.8 million, because Medicare's payment-to-cost ratio exceeds Medicaid's at this hospital. Costs are held at baseline levels in this step, on the assumption that the same patients receive the same care.
Figure 1. Patient revenue by payer, baseline and at Medicare rates
Single-change equivalents of the gap
The calculations in Table 3 are not response scenarios. They indicate the scale of the $92 million annual gap by showing how large a single type of change would have to be to close it.
Table 3. Size of a single change that would close the gap
| If the only change were | Required magnitude |
|---|---|
| An across-the-board reduction in pay and benefits for all employees | 35% |
| Staff reductions at average cost, with no change in pay | 782 FTE (35% of staff) |
| A reduction in the pay of employed physicians | 1.8 times the entire physician payroll |
| A reduction in the pay of executives and managers | 4.3 times the entire management payroll |
| A reduction in prices paid for drugs, devices, supplies, and purchased services | 64% of all such spending |
| Higher payment rates rather than lower costs | 1.45x Medicare paid by every repriced payer |
Source: Model calculations based on the post-policy cost base.
Duration of cash reserves
The hospital begins with 200 days cash on hand ($258 million). With no response, the model estimates that days cash on hand would fall below the 60-day liquidity covenant in 2.2 years and that cash would be exhausted in 3.1 years. Lenders, rating agencies, and vendors may respond when the covenant is breached rather than when cash reaches zero.
Figure 2. Days cash on hand by year and response scenario
Restructuring levers
The model includes 27 restructuring levers in five groups. Each lever is applied to the cost base that remains after the preceding levers, so annual operating gains are additive without double counting. For example, a compensation reduction applies only to staff who remain employed after workforce changes. Compensation reductions include a turnover offset that returns part of the gross savings through turnover and backfill. Gains from the insurance overhead levers are scaled by the share of payer administrative complexity that the policy scenario removes (50 percent in this scenario).
Figure 3. Annual operating gain by restructuring lever, base level
Table 4. Annual operating gain by restructuring lever and level
| Restructuring lever | Control | Size (low / base / high) | Low | Base | High | Principal risk |
|---|---|---|---|---|---|---|
| Workforce configuration | $11M | $21M | $35M | |||
| Convert agency staff to employees | Hospital | 40% / 60% / 80% | $2.2M | $3.4M | $4.5M | Conversion depends on the hospital's ability to recruit permanent staff, which becomes more difficult if nurse compensation is reduced at the same time. |
| Align clinical staffing with benchmarks | Hospital | 2% / 4% / 7% | $2.5M | $5.0M | $8.8M | Lower staffing levels may increase burnout and adverse events, and nurse staffing laws limit reductions in some states. |
| Shift nursing work from RNs to LPNs and aides | Hospital | 4% / 8% / 15% | $1.4M | $2.9M | $5.3M | Research has associated a lower proportion of registered nurses in the nursing workforce with higher patient mortality and lower quality of care. |
| Substitute NPs and PAs for physicians | Hospital | 5% / 10% / 20% | $1.4M | $2.9M | $5.8M | State scope-of-practice laws limit substitution in some states, and substitution is not appropriate for many procedural specialties. |
| Reduce management layers | Hospital | 8% / 15% / 25% | $1.7M | $3.2M | $5.3M | Reducing management capacity may impair the hospital's ability to carry out the restructuring itself. |
| Automate and consolidate administrative functions | Hospital | 5% / 12% / 20% | $1.4M | $3.2M | $5.4M | Automation requires upfront investment in technology, and savings often materialize later than planned. |
| Insurance overhead | $4.0M | $7.6M | $12M | |||
| Reduce billing and payer administration staff | Policy | 12% / 22% / 32% | $1.3M | $2.4M | $3.5M | Savings depend on payers adopting a common fee schedule and rule set. Coding and compliance functions would remain under any payment system. |
| Reduce billing and collection vendor spending | Policy | 15% / 25% / 35% | $0.9M | $1.5M | $2.1M | Existing vendor contracts may include termination penalties or minimum terms. |
| Reduce clinician time on payer requirements | Policy | 0.5% / 1.0% / 2.0% | $0.7M | $1.3M | $2.5M | Time freed from administrative tasks produces savings only if it results in fewer positions or additional billable services. |
| Eliminate payer contracting and related marketing | Policy | 1% / 2% / 3% | $0.5M | $1.0M | $1.4M | The reduction in marketing assumes that hospitals no longer compete for commercially insured patients. |
| Reduce claim denials and underpayments | Policy | 0.1% / 0.4% / 0.6% | $0.6M | $1.4M | $2.4M | Medicare also audits and denies claims, so the gain reflects only the difference from current commercial practice. |
| Purchasing | $7.3M | $17M | $37M | |||
| Lower drug acquisition costs | Policy | 5% / 12% / 30% | $2.1M | $5.0M | $13M | The high level assumes international reference pricing. Lower acquisition prices would also reduce 340B program savings for eligible hospitals, an effect the model does not capture. |
| Lower device and implant costs | Hospital | 5% / 12% / 30% | $1.1M | $2.6M | $6.6M | Savings require physicians to agree to standardized products, and the high level assumes price transparency or reference pricing requirements. |
| Lower medical and surgical supply costs | Hospital | 3% / 8% / 15% | $0.9M | $2.4M | $4.5M | Most hospitals already purchase through group purchasing organizations, so many of the most readily available savings have been realized. |
| Renegotiate or insource purchased services | Hospital | 5% / 10% / 18% | $2.2M | $4.4M | $7.9M | Vendors face the same labor cost pressures as hospitals, and multiyear contracts delay savings. |
| Lower malpractice and insurance costs | Policy | 0% / 5% / 20% | $0.0M | $0.5M | $1.8M | The high level depends on enactment of tort reform. |
| Lower utility, lease, and facilities costs | Hospital | 2% / 5% / 10% | $0.3M | $0.7M | $1.4M | This category accounts for a small share of hospital spending, which limits potential savings. |
| Reduce discretionary spending | Hospital | 5% / 10% / 15% | $0.7M | $1.4M | $2.1M | Reductions in training and community programs may affect workforce development and community benefit activities. |
| Capital and footprint | $2.5M | $4.8M | $6.0M | |||
| Defer capital spending | Hospital | 5% / 12% / 20% | $1.4M | $3.4M | $5.6M | Deferral improves cash flow quickly but affects operating income only gradually, and deferred investment in facilities and equipment creates future obligations. |
| Close service lines with the largest losses | Hospital | 2% / 4% / 8% | $1.1M | $1.4M | $0.4M | Closures reduce community access to affected services, and shared overhead costs remain after a service closes. |
| Compensation | $6.0M | $18M | $35M | |||
| Reduce executive and management compensation | Hospital | 10% / 20% / 35% | $1.8M | $3.3M | $4.9M | Executive compensation reductions are often a precondition for broader concessions from staff, but they produce relatively small savings. |
| Reduce employed physician compensation | Market | 5% / 15% / 30% | $2.0M | $5.7M | $9.7M | Physicians generate referrals and admissions. The high level would bring compensation closer to levels in other high-income countries and assumes that all employers in the market make similar reductions. |
| Reduce NP and PA compensation | Market | 0% / 5% / 10% | $0.0M | $0.5M | $1.2M | Reductions may conflict with a strategy of relying more heavily on nurse practitioners and physician assistants. |
| Reduce registered nurse compensation | Market | 0% / 5% / 15% | $0.0M | $2.6M | $6.8M | Nurses may leave bedside practice or the profession, collective bargaining agreements may limit reductions, and higher vacancy rates may increase reliance on agency staff. |
| Reduce allied health and clinical support compensation | Market | 0% / 3% / 8% | $0.0M | $1.3M | $3.3M | Wages for aides and technicians are already close to those in retail and warehouse employment, which gives these workers ready alternatives. |
| Reduce administrative and support staff compensation | Market | 0% / 3% / 8% | $0.0M | $1.0M | $2.3M | Administrative and support skills transfer readily to other industries, which increases the risk of turnover. |
| Reduce employee benefits | Market | 5% / 10% / 20% | $2.2M | $3.9M | $6.4M | Benefit reductions affect all employees at once and may increase turnover across the workforce. |
| All levers | $30M | $68M | $125M | Gap to be closed: $92M |
Source: Model calculations based on the lever assumptions in Appendix A.
Gains by level of control
Table 5. Annual operating gain by degree of hospital control
| Aggressive restructuring (base levels) | System redesign (high levels) | |
|---|---|---|
| Within hospital control | $40M | $69M |
| Requires market-wide change | $15M | $30M |
| Requires policy change | $13M | $26M |
| Total | $68M | $125M |
| Gap to be closed | $92M | $92M |
Source: Model calculations based on the lever assumptions in Appendix A.
Compensation levers are classified as dependent on the labor market because a hospital that reduces pay while competitors do not would be likely to lose staff to them. If all hospitals face the same payment rates, the alternative for staff is employment outside health care, which would produce a slower but still material loss of workers.
Response scenarios
Table 6 reports results for the four response scenarios defined in the model, each applied under the All payers at Medicare scenario.
Table 6. Results by response scenario
| Response scenario | Annual operating gain | Cost reduction | Final operating margin | FTE change | One-time cost | Liquidity covenant breached in | Cash exhausted in |
|---|---|---|---|---|---|---|---|
| No response The hospital makes no changes. | $0.0M | 0.0% | −22.4% | +0 | $0.0M | 2.2 years | 3.1 years |
| Conventional turnaround Measures a hospital board would typically approve first, including operational improvements, purchasing savings, and capital discipline, without pay reductions for frontline staff. | $28M | 6.7% | −15.7% | -66 | $5.0M | 3.2 years | 4.4 years |
| Aggressive restructuring All levers at their base levels, including compensation reductions for all staff, changes in skill mix, and service line closures. | $68M | 15.8% | −5.9% | -168 | $11M | not within 10 years | not within 10 years |
| System redesign All levers at their high levels. Compensation moves toward levels in other high-income countries, drug and device prices are regulated, and payer administrative complexity is eliminated. These changes are beyond the control of any single hospital. | $125M | 29.3% | +8.5% | -311 | $18M | not within 10 years | not within 10 years |
Source: Model calculations.
Figure 4. Operating income under aggressive restructuring, from baseline to end state
Figure 5. Operating income under system redesign, from baseline to end state
Figure 6. Operating margin by year and response scenario
Workforce effects
Labor accounts for 56 percent of operating expense, so response scenarios that close a substantial gap generally involve labor costs. Benefits are reduced separately (10 percent under aggressive restructuring and 20 percent under system redesign) and are included in the change in cost. Employment of nursing support staff may rise, because registered nurse hours shift to licensed practical nurses and aides and because agency nurses are converted to employees.
Aggressive restructuring
Table 7. Workforce effects of aggressive restructuring
| Occupational group | FTE, before | FTE, after | Change | Wage, before | Wage, after | Change | Change in cost |
|---|---|---|---|---|---|---|---|
| Employed physicians | 110 | 95 | −14% | $380,000 | $323,000 | −15% | −$15M |
| NPs / PAs | 70 | 80 | +15% | $135,000 | $128,250 | −5% | +$0.8M |
| Registered nurses | 620 | 564 | −9% | $98,000 | $93,100 | −5% | −$11M |
| LPNs, aides, techs | 380 | 408 | +7% | $48,000 | $46,560 | −3% | +$0.5M |
| Pharmacy, lab, imaging, therapy | 330 | 307 | −7% | $85,000 | $82,450 | −3% | −$4.0M |
| Billing, coding, payer admin | 150 | 113 | −25% | $58,000 | $56,260 | −3% | −$3.1M |
| Executives and managers | 90 | 74 | −18% | $190,000 | $152,000 | −20% | −$7.5M |
| IT, HR, finance, quality | 210 | 175 | −17% | $80,000 | $77,600 | −3% | −$4.3M |
| Environmental, food, facilities | 300 | 276 | −8% | $42,000 | $40,740 | −3% | −$1.9M |
| Agency (contract) labor | −$9.2M | ||||||
| Total labor | 2,260 | 2,092 | −7% | −$55M |
Source: Model calculations.
System redesign
Table 8. Workforce effects of system redesign
| Occupational group | FTE, before | FTE, after | Change | Wage, before | Wage, after | Change | Change in cost |
|---|---|---|---|---|---|---|---|
| Employed physicians | 110 | 81 | −27% | $380,000 | $266,000 | −30% | −$26M |
| NPs / PAs | 70 | 89 | +28% | $135,000 | $121,500 | −10% | +$1.2M |
| Registered nurses | 620 | 494 | −20% | $98,000 | $83,300 | −15% | −$26M |
| LPNs, aides, techs | 380 | 429 | +13% | $48,000 | $44,160 | −8% | −$0.1M |
| Pharmacy, lab, imaging, therapy | 330 | 287 | −13% | $85,000 | $78,200 | −8% | −$8.0M |
| Billing, coding, payer admin | 150 | 95 | −37% | $58,000 | $53,360 | −8% | −$4.8M |
| Executives and managers | 90 | 63 | −30% | $190,000 | $123,500 | −35% | −$12M |
| IT, HR, finance, quality | 210 | 153 | −27% | $80,000 | $73,600 | −8% | −$7.5M |
| Environmental, food, facilities | 300 | 258 | −14% | $42,000 | $38,640 | −8% | −$3.7M |
| Agency (contract) labor | −$12M | ||||||
| Total labor | 2,260 | 1,949 | −14% | −$99M |
Source: Model calculations.
Sensitivity of results to policy design
A policy of paying Medicare rates can take several forms. Whether Medicaid and uninsured patients are included, whether payers also adopt a common set of rules, and how quickly rates are reduced each change the results, in some cases by more than individual restructuring levers.
Table 9. Final operating margin by policy scenario and response scenario
| Policy scenario | Operating income before response | No response | Conventional turnaround | Aggressive restructuring | System redesign | Cash exhausted in (no response) |
|---|---|---|---|---|---|---|
| Commercial capped at Medicare Commercial insurers pay Medicare rates but retain their own coverage rules and administrative processes. Medicaid and uninsured patients are unaffected. | −$95M | −23.6% | −17.5% | −8.2% | +5.8% | 2.9 years |
| All payers at Medicare Commercial insurers and Medicaid pay Medicare rates under a common fee schedule. Uninsured patients are unaffected. | −$92M | −22.4% | −15.7% | −5.9% | +8.5% | 3.1 years |
| All payers, 5-year phase-in Identical to the all-payer scenario, except that payment rates decline to Medicare levels in equal steps over five years. | −$92M | −22.4% | −15.7% | −5.9% | +8.5% | 5.6 years |
| Single payer at Medicare All residents are covered, and care is paid for at Medicare rates under a single set of rules. Patient volume increases by 3 percent. | −$65M | −14.6% | −7.3% | +2.6% | +16.8% | 4.4 years |
Source: Model calculations.
Break-even payment level
Table 10. Payment level, as a multiple of Medicare, at which the hospital breaks even
| Break-even payment level | |
|---|---|
| No cost changes | 1.45x |
| After conventional turnaround | 1.32x |
| After aggressive restructuring | 1.12x |
Source: Model calculations.
The model estimates that, combined with aggressive restructuring, a payment level of 1.12x Medicare would allow this hospital to break even. A payment level of 1.00x Medicare would not be sufficient under that response scenario.
Results for the illustrative hospital types
Table 11 compares five illustrative hospital types, which are not actual institutions. All five share one cost structure scaled to size and differ in payer mix and reserves. In these results, hospitals with the largest commercial share experience the largest decline in operating margin, and hospitals with smaller reserves exhaust cash sooner even where the decline in margin is smaller.
Figure 7. Operating margin by hospital type under the All payers at Medicare scenario
Table 11. Operating margin by hospital type and response scenario
| Hospital | Operating expense | Commercial share | Commercial payment relative to Medicare | Baseline | At Medicare rates | Conventional | Aggressive | Redesign | Cash exhausted in (no response) |
|---|---|---|---|---|---|---|---|---|---|
| Community nonprofit A 300-bed community hospital with a balanced payer mix | $500M | 29% | 1.89x | +2.5% | −22.4% | −15.7% | −5.9% | +8.5% | 3.1 years |
| Academic medical center A large teaching hospital with high-acuity patients and research and teaching costs | $2.00B | 30% | 1.73x | +3.0% | −16.8% | −10.3% | −0.8% | +13.0% | 4.4 years |
| High-commercial suburban A hospital in an affluent service area where nearly half of care is commercially insured | $600M | 46% | 1.68x | +9.0% | −18.9% | −12.4% | −2.8% | +11.2% | 5.1 years |
| Urban safety net A hospital serving a large share of Medicaid and uninsured patients, with relatively little commercial revenue | $700M | 12% | 2.37x | −1.0% | −14.6% | −8.2% | +1.1% | +14.8% | 1.9 years |
| Rural critical access A 25-bed critical access hospital paid by Medicare at 101 percent of cost, less sequestration | $40M | 22% | 1.32x | 0.0% | −4.7% | −4.1% | −3.2% | −1.6% | 5.2 years |
Source: Model calculations based on the illustrative hospital inputs.
The critical access hospital is modeled as paid by Medicare at cost, so a reduction in its costs also reduces its Medicare-rate revenue. Cost reductions therefore improve its operating margin by less than they do for the other hospital types.
Uncertainty
Sensitivity to individual assumptions
Each bar in Figure 8 shows the final operating margin under aggressive restructuring when one assumption is changed and all others are held at their central values.
Figure 8. Final operating margin under aggressive restructuring, changing one assumption at a time
Variation in outcomes across lever sizes
The model simulated 3,000 restructurings. In each, every lever was drawn independently between its low and high level (most likely at the base level), and Medicare's payment-to-cost ratio varied within a narrow range. The median final operating margin across simulations is −4.0 percent. The hospital reaches break-even in 7 percent of simulations when compensation reductions are included and in 0 percent when they are excluded.
Figure 9. Distribution of final operating margin across simulated restructurings
Limitations
The results should be interpreted in light of several limitations.
- The inputs for the illustrative hospitals are round benchmarks rather than data for actual institutions. The commercial payment-to-cost ratio is solved from the baseline operating margin (1.89x Medicare for this hospital). Studies of employer plans report higher ratios for the services they cover; higher ratios would increase the estimated decline in revenue without changing the level at which revenue settles.
- The model does not estimate the effects of restructuring on quality of care, patient outcomes, or patient volume. Lower staffing, a smaller share of registered nurses, and closed service lines may have clinical consequences, some of which would return as costs through readmissions, penalties, or liability.
- Labor market responses are represented by fixed turnover offsets rather than by a model of labor supply. Actual turnover responses are likely to be nonlinear, and a large reduction in physician pay has no domestic precedent against which to calibrate.
- Supplier responses to lower hospital revenue are not modeled. If revenue falls across the hospital sector, drug, device, and staffing vendors would face similar pressure, which could either increase purchasing savings or lead some suppliers to exit.
- Projections are in constant dollars and exclude debt principal repayment, philanthropy, and investment portfolio policies. Estimates of the duration of cash reserves are therefore indicative.
- Supplemental payment programs, including 340B, disproportionate share hospital payments, graduate medical education payments, and Medicaid supplemental payments, are reflected in payment-to-cost ratios rather than modeled separately.
- All illustrative hospitals share one cost structure scaled by size; an actual academic medical center or critical access hospital has a different staffing mix.
- Medicare Advantage is treated as equivalent to traditional Medicare.
Generated 2026-11-12 by run.py. Changing the values in assumptions/*.yaml and rerunning the program changes the results above.