The Role of Medicare Cost Reports and Their Limitations

Medicare Cost Reports

The most widely used and publicly available reports for analyzing hospitals’ costs are the Medicare Cost Reports (MCRs), which hospitals submit to CMS and which CMS publishes as a public data file. These reports are important because CMS uses them, in addition to a base rate and market basket, as the primary input in deciding how much to pay hospitals for inpatient and outpatient procedures. Also, MCRs are the only national data available for all types of providers.

Hospitals report their costs annually to CMS in four broad categories: allowable costs, allocation of overhead costs, ratio of cost to charges, and Medicare’s share of allowable costs. The worksheets crosswalk costs in hospital departments to Medicare cost centers (i.e., more specific categories, also known as “lines”). These “lines” include general service (e.g., housekeeping or plant operations), inpatient routine costs (e.g., surgery or intensive care unit), outpatient routine costs (e.g., clinics or emergency department), and ancillary services (e.g., radiology or laboratory services). Ancillary services are direct costs not tied to room and board, such as operating room fees or radiology. Another way to define ancillary services is services that hospitals provide without knowing in advance whether they will be billed as inpatient or outpatient. In an example presented by the Northern New England chapter of the Health Care Financial Management Association, 36 percent of a hospital’s ancillary costs were paid by Medicare, of which almost all were attributed to outpatient services.

A Cost-Plus System

Medicare’s payment updates are based on a base rate and market basket in combination with the MCRs. However, these reports simply accept systemic cost increases as a feature, not a bug. In training materials for continuing professional education, a large accounting and professional services firm teaches that “auditors typically focus on DSH [Disproportionate Share Hospital payments], bad debts, etc. & pay little or no attention to the cost side” of the prospective payment systems.” Although government auditors are incentivized to audit costs accurately, they do not question whether costs are too high. Medicare pays for capital-related costs via the Capital Prospective Payment System. One early observer of the system noted: “Certainly, in the private sector, it is almost impossible to think of a good or service for which the unit of payment separately identifies capital from the other inputs used in producing the good or service.” Because Medicare pays explicitly to reimburse capital expenditure, hospitals have little incentive to make capital investments efficient.

Last year, the Trump administration made a significant first step to improving MCRs by requiring hospitals to include median MA rates in their reports. There is a generally close correlation between relative payments across diagnosis-related groups in Medicare and commercial plans. Nevertheless, at the margin, there are some services where commercial weights for certain services or bundles are different than Medicare rates, and this represents useful information for Medicare rates better reflecting market conditions and value. The change also creates an opportunity for an eventual divergence such that Medicare is no longer the main driver of inpatient hospital payment rates, particularly as MA penetration increases.

“Relative Efficiency”

The Medicare Payment Advisory Commission (MedPAC) is a congressional agency that provides policy advice to Congress on Medicare payment and health care delivery issues. MedPAC categorizes 13 percent of hospitals as “relatively efficient.” In 2024, these hospitals had a Medicare margin of –1 percent, versus –10 percent overall.

Here, we find a circularity problem: Current levels of efficiency influence the measurement of that efficiency. For example, the group of hospitals that MedPAC labeled “relatively efficient” had standardized costs per unit that were no more than 93 percent of the national median, mortality no more than 89 percent of the national median, and readmissions no more than 93 percent of the national median.

However, being below the median in these metrics does not mean a hospital is efficient—it may only mean it is relatively less inefficient than others. If most hospitals are deeply inefficient (in whatever metric used), then a top-performing hospital may simply be less inefficient rather than actually providing a model for high efficiency.

When taxpayer dollars continue to flow regardless of hospital efficiency and when more dollars flow if inefficiency increases, there is little incentive—especially in comparison to private market actors—for a hospital to try to break free of the pack and improve efficiency.

Inconsistent Financial Reporting

The Healthcare Financial Management Association, a professional society composed of finance professionals associated with hospitals, recently published a caution:

Financial statements, tax/information returns and Medicare cost reports are key information sources for the healthcare industry, but many times they convey seemingly contradictory information, which creates confusion for both management and external stakeholders.

Overall, Hospitals Are Not Unprofitable and Have Low Financial Risk

Types of Cost

Hospital advocates and associations typically argue that hospitals lose money on Medicare and Medicaid. However, this claim flows from the way they choose to measure margin. A more appropriate metric indicates that Medicare patients are, in fact, often profitable, and Medicaid patients are also likely a source of positive net revenue, not a net loss.

Getting to the truth of profit margins comes down to how hospitals allocate costs. Like other businesses, hospital costs are typically sorted into two sets: (1) fixed or variable and (2) direct or indirect. These sets overlap—a cost could be both fixed and indirect or variable and direct.

A fixed cost remains constant regardless of how many services the hospital provides. A variable cost changes in proportion to how many services are provided. For example, a new MRI machine is classified as a fixed cost, whereas drugs administered to patients constitute variable costs. MedPAC estimates that “roughly” 80 percent of hospital costs are variable, implying that 20 percent of costs are fixed.

Direct costs are those that can be more easily tracked to specific services, whereas indirect costs cannot. For example, a nurse fully employed in an emergency department is treated as a direct cost for that department, whereas an administrator over the entire hospital is not. Demonstrating how difficult it can be to categorize direct versus indirect costs, a literature review concluded that between 30 percent and 85 percent of costs can be considered unrelated to patient care (that is, “indirect”), depending on the measurement used.

Some studies rely on the Healthcare Cost Report Information System (a database curated by CMS) to examine costs systemically. However, each study and even each hospital categorizes spending differently, making comparisons challenging. Most recently, a study by Trilliant Health estimated spending on items other than direct patient care amounted to two-thirds of hospitals’ expenses in 2023. This study included management and administration, overhead, home office and affiliates, capital-related, and other operating non-labor-related costs. A previous study—which defined overhead alone as non-patient-related costs such as employee benefits, administrative staff, and capital costs—estimated overhead at 46 percent of total costs in 2010, a proportion unchanged since 1996.

Using the same dataset, a more recent study covering 2011-2022 looked at the narrower category of administrative and general costs. Unlike overhead, which includes costs allocated to specific departments, these costs exclude costs not attributable to specific departments. The study found that administrative and general expenses amounted to 20 percent of all expenses in urban hospitals and 17 percent in rural hospitals in 2022. Little changed over the years. Although they do not use standard definitions of costs not associated with direct patient care, these studies agree those costs have increased at about the same rate as costs for patient care, indicating no productivity growth.

The IRS regulates executive compensation in tax-exempt entities through its private inurement doctrine and related rules, which are designed to ensure that tax-exempt entities’ resources are not spent to benefit insiders. Nevertheless, median executive compensation rose by 23.4 percent from 2018 to 2022 at 20 tax-exempt hospitals randomly selected from across the United States. The increase was not uniform. For example, compensation in the Mayo Clinic’s executive suite increased from $148 million to $159 million (just under 8 percent), while compensation at the Cleveland Clinic increased by 25 percent from $91 million to $116 million. On the other hand, executive compensation at the much smaller New England Baptist Hospital in Boston almost tripled from $6 million to $18 million.

Mean CEO compensation at 1,113 tax-exempt hospitals rose from $996,000 to $1.3 million from 2012 through 2019 (with the 2012 amount in 2019 dollars), an increase of more than 30 percent, while registered nurse wages increased only 2.3 percent. Of this growth, 44.5 percent came from across-the-board base pay increases, 28.5 percent from more generous rewards for managing larger systems, and 27.0 percent from hospitals actually becoming larger or more profitable. Remarkably, hospital quality improvements declined as a factor determining CEO pay during the period.

The problem is not the high pay itself but why the pay is high: CEO compensation at tax-exempt hospitals is mostly driven by the organizations’ size, profits, revenues, and growth, not any metric of quality or community benefit. Although these outcomes are appropriate for investor-owned corporations, they are not appropriate for tax-exempt hospitals that are supposed to be organized for community benefit.

Hospitals’ increases in overhead costs—brought on in part by the need to deal with ever-increasing complexity and larger consolidated enterprises as a share of total costs—will be an important topic in the discussion below of how Medicare payments also subsidize inefficiency.

Charity Care, Bad Debt, Uncompensated Care, and Unreimbursed Care Are Small—While Debt Collections Rise

Another challenge to delving into hospital finances is the categorization of charity care and bad debt. Charity care is care for which hospitals do not expect reimbursement. Bad debt is made up of out-of-pocket patient expenses (co-payments and deductibles) that are not paid. Hospitals report these purported costs separately on their MCRs. Charity care is used to preserve a hospital’s tax-exempt status, while bad debt is care that a hospital expected to be compensated for and thus does not count as charity care. CMS sums the components of charity care and bad debt into two categories: (1) uncompensated care, which includes charity care, non-Medicare bad debt, and non-reimbursable Medicare bad debt; and (2) unreimbursed care, which includes unpaid services to self-pay or charity or Medicaid patients (the difference between the amount Medicaid paid and the cost to treat Medicaid patients). In 2023, charity care comprised almost $31 billion and bad debt $51 billion. Uncompensated care amounted to $43 billion and unreimbursed care almost $37 billion.

However, these are not total losses: Hospitals have flexibility in reporting these data and have an obvious incentive to report the highest costs possible. Also, Medicare reimburses hospitals for some uncompensated care. Further, tax-paying hospitals, which have no obligation to provide charity care, allocate a similar or greater share of operating expenses to charity care as tax-exempt hospitals do. As a share of total hospital operating costs, charity care represents only a small fraction—raising questions about whether the value of hospitals’ tax exemptions and subsidies is commensurate with the level of uncompensated care they provide.

Tax-Exempt Hospitals Have Artificially Low Financing Costs

Nearly three-quarters of privately operated community hospitals (71 percent) benefit from tax-exempt status. Although they do not provide more charity care than tax-paying hospitals do, their status allows them to escape corporate income tax as well as some state and local taxes, including property taxes. A recent estimate indicated that this will reduce federal tax revenue by roughly $260 billion over 10 years, starting in 2024. Exemption from state and local taxes more than doubles the break, amounting to $37.4 billion in 2021 alone.

Further, interest payments from tax-exempt hospitals are free of income tax to investors. This allows them to issue debt at significantly lower rates than taxable corporations can. At the beginning of February 2026, tax-exempt borrowers could issue debt at an interest rate 1.66 percentage points lower than the rate for taxable borrowers.

The Challenges of Measuring Hospital Profitability

Hospitals are similar to hotels or airlines in the following sense: profitability depends on what is being measured. Prices for hotel rooms or flights are highly variable because the marginal cost of putting a guest in a room or a passenger in a seat is low relative to the total cost of operating the hotel or airline. However, in the long run, the hotel or airline must cover its fixed costs, too. Because price-sensitive consumers rent hotel rooms and buy airline tickets, hotels and airlines have incentives to develop business plans that reduce fixed costs over time. Unlike hotels or airlines, however, hospitals face little competitive pressure to reduce fixed costs over time because administered prices, favorable political treatment, and subsidies and other government advantages adjust upward as reported costs rise, insulating hospitals from the productivity discipline that governs other capital-intensive industries.

MedPAC examines two measures of profitability that include revenues from all payers: total margin and operating margin, as well as measures specific to Medicare (See Table 2).