patient hospital care apportions a provider's total costs among groups served on the basis of the relative number of days of care used. This method, commonly referred to as average per diem cost, does not take into account variations in the amount of service which a day of care may represent and thereby assumes that the patients for whom payment is made on this basis are average in their use of service.

(e) In considering the average per diem method of apportioning cost for use under the program, the difficulty encountered is that the preponderance of presently available evidence strongly indicates that the over-65 patient is not typical from the standpoint of average per diem cost. On the average he stays in the hospital twice as long and therefore the ancillary services that he uses are averaged over the longer period of time, resulting in an average per diem cost for the aged alone, significantly below the average per diem for all patients.

(f) Moreover, the relative use of services by aged patients as compared to other patients differs significantly among institutions. Consequently, considerations of equity among institutions are involved as well as that of effectiveness of the apportionment method under the program in accomplishing the objective of paying each provider fully, but only, for services to beneficiaries.

(g) A further consideration of longrange importance is that the relative use of services by aged and other patients can be expected to change, possibly to a significant extent in future years. The ability of apportionment methods used under the program to reflect such change is an element of flexibility which has been regarded as important in the formulation of the cost reimbursement principles.

(h) An alternative to the relative number of days of care as a basis for apportioning costs is the relative amount of charges billed by the provider for services to patients. The amount of charges is the basis upon which the cost of hospital care is distributed among patients who pay directly for the services they receive. Payment for services on the basis of charges applies generally under insurance programs where individuals are indemnified for incurred expense, a form of health insurance widely held throughout the Nation. Also, charges to patients are commonly a factor in determining the amount of pay

ment to hospitals under insurance programs providing service benefits, many of which pay "costs or charges, whichever is less" and some of which pay exclusively on the basis of charges. In all of these instances, the provider's own charge structure and method of itemizing services for the purpose of assessing charges is utilized as a measure of the amount of services received and as the basis for allocating responsibility for payment among those receiving the provider's services.

(i) An increasing number of thirdparty purchasers who pay for services on the basis of cost are developing methods which utilize charges to measure the amount of services for which they have responsibility for payment. In this approach, the amount of charges for such services as a proportion of the provider's total charges to all patients is used to determine the proportion of the provider's total costs for which the third-party purchaser assumes responsibility. The approach is subject to numerous variations. It can be applied to the total of charges for all services combined or it can be applied to components of the provider's activities for which the amount of costs and charges are ascertained through a breakdown of data from provider's accounting records.

(j) For the application of the approach to components, which represent types of services, the breakdown of total costs is accomplished by "cost-finding" techniques under which indirect costs and nonrevenue activities are allocated to revenue producing components for which charges are made as services are rendered.

[31 F.R. 14809, Nov. 22, 1966]

§ 405.404 Methods of apportionment under title XVIII.

(a) The principles for reimbursement under title XVIII of the act establish two basic methods, either of which may be used at the option of a provider, for the determination of the share of allowable costs for which payment is to be made to the provider.

(b) The first alternative is to apply the beneficiaries' share of total charges, on a departmental basis, to total costs for the respective departments. Use of this department-by-department method will involve determination, by cost-finding methods, of the total costs for each of the institution's departments that are reve

ue-producing; i.e., departments proiding services to patients for which harges are made.

(c) The second alternative is a comination method. Under this method, as pplied to inpatient care, that part of a rovider's total allowable cost which is ttributable to routine services (room, oard, nursing service) is to be apporoned on the basis of the relative numer of patient days for beneficiaries and or other patients; i.e., an average cost er diem basis. The residual part of the rovider's allowable cost, attributable to onroutine or ancillary services, is to be pportioned on the basis of the beneciaries' share of the total charges to atients by the provider for nonroutine ancillary services. The amounts comuted to be the program's share of the wo parts of the provider's allowable osts are then combined in determining he amount of reimbursement under the rogram. Use of the combination methd will necessitate cost finding to deterine the division of the provider's total lowable costs into the two parts, though it would be less involved than or the first alternative, the department7-department method.

(d) It is recognized that many hostals and other providers do not cur-ntly employ methods for ascertaining e cost of the services they produce, ther by departmental or other groupgs of services. Although the use of st finding has become more extensive nong institutions in recent years, for large number of providers use of the >portionment methods under the proam will involve compiling information eeded as a basis for breaking down total sts into departmental costs or beeen routine services and other serves, as would need to be done at the end each accounting year. To avoid an idue burden on providers and to allow aple time for all providers to adopt the st-finding methods needed for the aprtionment methods under the proam, a temporary method may be used,

the option of the provider, for acunting periods ending before January 1968. Under this option, a provider ay employ the combination method of portionment by using an estimated rcentage obtained from the intermediy as the basis for arriving at a division total allowable costs between routine d other services. This estimated peratage basis for division of costs will be cepted in lieu of actual cost finding as

will

(a) The fiscal intermediaries establish a basis for interim payments to each provider. This may be done by one of several methods. Where an intermediary is already paying the provider on a cost basis, the intermediary can adjust its rate of payment to an estimate of the result under the title XVIII principles of reimbursement. Where no organization is paying the provider on a cost basis, the intermediary can obtain the previous year's financial statement from the provider and, by applying the principles of reimbursement, compute or approximate an appropriate rate of payment. The interim payment may be related to the last year's average per diem, or to charges, or to any other ready basis of approximating costs.

(b) At the end of the period, the actual apportionment, based on the cost finding and apportionment methods selected by the provider, will determine the title XVIII reimbursement for the actual services provided to beneficiaries during the period.

(c) Basically, therefore, interim payments to providers will be made for services throughout the year, with final settlement on a retroactive basis at the end of the accounting period. Interim payments will be made as often as possible and in no event less frequently than once a month. The retroactive payments will take fully into account the costs that were actually incurred and settle on an actual, rather than on an estimated basis.

(d) In addition to the basic procedure for payment to a provider following the submission of bills to the intermediary, payment will be made upon request by the provider on a basis designed to reimburse currently as services are furnished to beneficiaries. The amount of such payment will be computed by the intermediary initially on an estimated basis and periodically adjusted to repre

sent the average level of services unreimbursed by the basic payment procedure. [31 F.R. 14810, Nov. 22, 1966]

§ 405.406 Financial data and reports.

(a) The principles of cost reimbursement will require that providers maintain sufficient financial records and statistical data for proper determination of costs payable under the program. Standardized definitions, accounting, statistics, and reporting practices which are widely accepted in the hospital and related fields are followed. Changes in these practices and systems will not be required in order to determine costs payable under the principles of reimbursement. Essentially the methods of determining costs payable under title XVIII involve making use of data available from the institution's basic accounts, as usually maintained, to arrive at equitable and proper payment for services to beneficiaries.

(b) Costs reports will be required from providers on an annual basis with reporting periods based on the provider's accounting year. In the interpretation and application of the principles of reimbursement, the fiscal intermediaries will be an important source of consultative assistance to providers and will be available to deal with questions and problems on a day-to-day basis. [31 F.R. 14810, Nov. 22, 1966]

§ 405.415 Depreciation: allowance for depreciation based on asset costs.

(a) Principle. An appropriate allowance for depreciation on buildings and equipment is an allowable cost. The depreciation must be:

(1) Identifiable and recorded in the provider's accounting records;

(2) Based on the historical cost of the asset or fair market value at the time of donation in the case of donated assets; and

(3) Prorated over the estimated useful life of the asset using the straightline method or accelerated depreciation under the declining balance or sum-ofthe-years' digits methods.

(b) Definitions-(1) Historical costs. Historical cost is the cost incurred by the present owner in acquiring the asset.

(2) Fair market value. Fair market value is the price that the asset would bring by bona fide bargaining between well-informed buyers and sellers at the date of acquisition. Usually the fair market price will be the price at which

bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition.

(3) The straight-line method. Under the straight-line method of depreciation, the cost or other basis (e.g. fair market value in the case of donated assets) of the asset, less its estimated salvage value, if any, is determined first. Then this amount is distributed in equal amounts over the period of the estimated useful life of the asset.

(4) Declining balance method. Under the declining balance method, the annual depreciation allowance is computed by multiplying the undepreciated balance of the asset each year by a uniform rate up to double the straight-line rate.

(5) Sum-of-the-years' digits method. Under the sum-of-the-years' digits method, the annual depreciation allowance is computed by multiplying the depreciable cost basis (cost less salvage value) by a constantly decreasing fraction. The numerator of the fraction is represented by the remaining years of useful life of the asset at the beginning of each year, and the denominator is always represented by the sum of the years' digits of useful life at the time of acquisition.

(c) Recording of depreciation. Appropriate recording of depreciation encompasses the identification of the depreciable assets in use, the assets' historical costs, the method of depreciation, estimated useful life, and the assets' accumulated depreciation. The Chart of Accounts published by the American Hospital Association and publications of the Internal Revenue Service are to be used as guides for the estimation of the useful life of assets.

(d) Depreciation methods. (1) Proration of the cost of an asset over its useful life will be allowed on the straightline, the declining balance, or the sumof-the-years' digits methods. The provider may choose to use one of the methods on a single asset or group of assets and another method on others. In applying the declining balance or sum-ofthe-years' digits method to an asset that is not new, the undepreciated balance of the asset is to be treated as the cost of a new asset in computing the depreciation.

(2) A provider may change from the straight-line method to an accelerated method or vice versa upon advance approval from the intermediary on a prospective basis with the request being made

Al

on

fore the end of the first month of the ospective reporting period. Only one ch change with respect to a particular set may be made by a provider. (e) Funding of depreciation. ough funding of depreciation is not quired, it is strongly recommended that oviders use this mechanism as a means conserving funds for replacement of preciable assets, and coordinate their anning of capital expenditures with eawide planning activities of commuty and State agencies. As an incentive -r funding, investment income nded depreciation will not be treated as reduction of allowable interest expense. (f) Gains and losses on disposal of ssets. Gains and losses realized from ne disposal of depreciable assets are to e included in the determination of alOwable cost. The extent to which such ains and losses are includable is to be alculated on a proration basis recognizng the amount of depreciation charged under the program in relation to the mount of depreciation, if any, charged or assumed in a period prior to the provider's participation in the program.

(g) Establishment of cost basis on purchase of facility as ongoing operation. In establishing the cost basis for a facility purchased as an ongoing operation after July 1, 1966, the price paid by the purchaser shall be the cost basis where the purchaser can demonstrate that the sale was a bona fide sale and the price did not exceed the fair market value of the facility at the time of sale. The cost basis for depreciation of depreciable assets shall not exceed the fair market value of those assets at the time of sale. If the sale is not demonstrated to be bona fide, the seller's cost basis shall be the cost basis to the purchaser.

[31 FR. 14810, Nov. 22, 1966]

§ 405.416 Depreciation: optional allowance for depreciation based on a percentage of operating costs.

(a) Principle. With respect to all assets acquired before 1966, the provider, at its option, may choose an allowance for depreciation based on a percentage of operating costs. The operating costs to be used are the provider's 1965 operating costs or the provider's current year's allowable costs, whichever are the lower. The percent to be applied is 5 percent starting with the year 1966-67, with such

percentage being uniformly reduced by one-half percent each succeeding year. The allowance based on operating costs is in addition to regular depreciation on assets acquired after 1965; however, when the optional allowance is selected the combined amount of such allowance on pre-1966 assets and the straight-line depreciation on assets acquired after 1965 (including the estimated depreciation on assets held on a rental basis during the current year) may not exceed 6 percent of the provider's allowable cost for the current year.

(b) Definitions-(1) Operating costs. Operating costs are the total costs incurred by the provider in operating the institution or facility.

(2) Allowable costs. Allowable costs are the costs of a provider which are includable under the principles for cost reimbursement; by the application of apportionment methods to the total amount of such allowable costs, the share of a provider's total cost which is attributable to covered services for beneficiaries is determined.

(c) Application. Where a provider has inadequate historical cost records for pre-1966 depreciable assets, the provider may elect to receive an allowance for depreciation on such assets based on a percentage of operating costs. The optional allowance for depreciation for such assets may be used, however, whether or not a provider has records of the cost of pre-1966 depreciable assets currently in use.

(d) Allowance based on a percentage of operating costs. (1) The allowance for depreciation based on a percentage of operating costs is to be computed by applying a specified percentage to a base amount equal to the provider's 1965 total operating costs, without adjustments to these principles or the current year's allowable operating costs, whichever is lower. The percentage to be applied would be five for the reporting period that starts before or during 1966-67, four and one-half for the reporting period that begins during 1967-68, and would so continue to decline annually by equal amounts to become zero in 1976-77.

(2) When used as a base for determining the optional allowance for depreciation, neither the 1965 operating costs nor the current year's allowable

costs are to include any actual depreciation, estimated depreciation on rented depreciable-type assets, allowance in lieu of specific recognition of other costs, or return on equity capital. Such exclusions are to be made only for the purpose of computing the allowance for depreciation based on operating costs. For other purposes, the excluded amounts are recognized in determining allowable costs and for computing the costs of services rendered to the program beneficiaries during the reporting period.

(e) Change to actual depreciation. (1) A provider that elects this allowance may at any time before 1976 change to actual depreciation on all pre-1966 depreciable assets. In such case, this option is eliminated and the provider can no longer elect to receive an allowance for depreciation based on a percentage of operating costs.

(2) Where the provider desires to change to actual depreciation but either has no historical cost records or has incomplete records, the determination of historical cost could be made through appropriate means involving expert consultation with the determination being subject to review and approval by the intermediary.

(f) Determination of optional allowance based on percentage of operating costs illustrated. The following illustrates how the provider would determine the optional allowance for depreciation based on operating costs.

Example No. 1. The provider keeps its records on a calendar year basis. The current year's actual allowable cost and the actual operating cost for 1965 do not include any actual depreciation or rentals on depreciable-type assets. The current year's allowable cost also does not include any allowance in lieu of specific recognition of other costs or return on equity capital.

1 The current year's allowable cost was used in computing the allowance for depreciation based on percentage of operating costs because it was lower than 1965 operating cost.

2 Since the reporting period began during the year 1967-68 (July 1, 1967-June 30, 1968) 42 percent is the percentage to be used. Example No. 2. When the provider pays rent for depreciable-type assets rented prior to 1966, the estimated depreciation on such assets must be deducted from the allowance. The following illustration demonstrates how the allowance is determined.

The provider keeps its records on a calendar year basis. The current year's actual allowable cost and the actual operating cost for 1965 did not include any actual depreciation, allowance in lieu of specific recognition of other costs, or return on equity capital. However, such costs have been adjusted to exclude estimated depreciation on rented depreciable-type assets.

YEAR 1966 Adjusted current year's allowable cost

$1,100,000