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Northwest Hospital Inc. v. Hospital Service Corp.

decided*fn*: August 25, 1982.


Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 75 C 2803 -- Milton I. Shadur, Judge.

Cummings, Chief Judge, Swygert, Senior Circuit Judge, and Cudahy, Circuit Judge.

Author: Cudahy

CUDAHY, Circuit Judge.

This case involves the proper treatment, under the Medicare program, of interest payments made by a non-profit Medicare provider to three individuals affiliated with the provider. The Secretary of Health and Human Services (the "Secretary") disallowed these payments on the grounds that the applicable Medicare regulations prohibited reimbursement for all interest incurred on "indebtedness established with lenders or lending organizations[] related through control, ownership, or personal relationship to the borrower." 42 C.F.R. § 405.419(c) (1976). The provider appealed to the district court, which reversed in part. For the reasons stated below, we affirm the judgment of the district court.


This case arises under Title XVIII of the Social Security Act (the "Act"), which established the federally funded health insurance program commonly known as "Medicare." 42 U.S.C. § 1395 et seq. (1976). Part A of the Medicare program, which is funded out of social security taxes, provides "hospital insurance" for the aged and certain disabled individuals. Under Part A, the federal government reimburses eligible hospitals, nursing facilities, and home health agencies for the "reasonable costs" of covered services provided to Medicare beneficiaries in accordance with a Congressionally established scheme. 42 U.S.C. § 1395d (1976).

A hospital may become a Medicare provider, and thus become eligible for federal reimbursement, by filing an agreement with the Secretary of Health and Human Services. 42 U.S.C. § 1395cc. Medicare providers are reimbursed for their services either by the Secretary or, more commonly, by certain private organizations acting as fiscal intermediaries pursuant to contract with the Secretary. 42 U.S.C. § 1395h. As part of their fiscal responsibilities, these intermediaries are required to ascertain the amount of reimbursement which accurately reflects the "reasonable cost" of the Medicare services provided by an eligible health care institution. A final calculation as to reimbursable costs is made annually, at the close of the provider's fiscal year, and is based upon a "cost report" that each provider is required to file. 42 C.F.R. § 405.406(b).

Upon receipt of a provider's cost report, the fiscal intermediary is required to analyze the reported data, undertake any necessary audits and inform the provider, through a written Notice of Program Reimbursement, of the amount of Medicare reimbursement to which it is entitled. 42 C.F.R. § 405.1803. If the provider is not satisfied with this determination, and the total amount in controversy is at least $10,000, the provider may request a hearing before the Provider Reimbursement Review Board (PRRB). 42 U.S.C. § 1395 oo (a); 42 C.F.R. § 405.1835. Within 60 days after a PRRB decision, the Secretary, on her own motion, may reverse, affirm or modify that decision. 42 U.S.C. § 1395 oo (f) (1). Pursuant to the applicable provisions of the Administrative Procedure Act, 5 U.S.C. § 701 et seq., the provider may then seek review of the agency's final decision in federal district court. 42 U.S.C. § 1395 oo (f) (1).

Plaintiff-appellee Northwest Hospital became a participating Medicare provider on July 1, 1966. At that time, Northwest Hospital was a for-profit corporation with three stockholders. Prior to the date on which Northwest Hospital became a Medicare provider, the three stockholders had begun the process of transforming Northwest Hospital from a for-profit to a not-for-profit corporation. In an effort to obtain not-for-profit status, these three individuals, together with four other persons, formed a new corporation in early 1966. On January 27, 1966, these seven trustees of the new corporation authorized the execution of a purchase agreement for all outstanding stock of Northwest Hospital. The purchase price was to be $5,000,000, of which $100,000 would be cash, with the balance to be financed by the issuance of unsecured subordinated 15-year promissory notes payable to the three stockholders of the old for-profit corporation, with interest at 4% per annum. The purchase agreement was also conditioned on the new corporation's receiving a favorable ruling on its request for tax exempt status.

On December 20, 1967, plaintiff-appellee was notified of a favorable ruling from the Internal Revenue Service on its request for tax exempt status. On December 27, 1967, the new corporation, by its Board of Trustees, authorized the purchase of the old for-profit hospital on the terms described above. By January 2, 1968, the new corporation had acquired the stock of Northwest Hospital, liquidated the former hospital corporation and begun business as a non-profit institution. The new corporation, however, continued to use the name "Northwest Hospital," and retained essentially the same management structure as the former for-profit corporation.

In its cost report for the reporting period ending April 30, 1974, Northwest Hospital included among its eligible Medicare costs depreciation expenses based upon the five million dollar purchase price of the former for-profit hospital. In addition, Northwest Hospital included among its reimbursable expenses, interest payments made on the 15-year promissory notes used to finance that purchase. Hospital Service Corporation, the fiscal intermediary responsible for monitoring Northwest Hospital's Medicare expenses, objected to these and several other cost items. On February 12, 1976, the PRRB held a hearing on the issues that were still in dispute between the provider and the intermediary.*fn1 On March 30, 1976, the PRRB rendered its decision on the two issues relevant to this appeal as follows:

Issue No. 1

The Provider is not entitled to depreciation expenses based on the fair market value of the assets of the former Provider. Rather the depreciation expense must be based on the historical cost of the assets to the former Providers.

Issue No. 2

The Provider is entitled to deduct interest expense on the notes that were given in exchange for the stock of the former Provider, but only to the extent they apply to the historical costs of the assets to the former Provider and not the interest expense on the full amount of the notes as claimed by the Provider.

On May 28, 1976, the Commissioner of Social Security,*fn2 affirmed the PRRB's resolution of Issue #1, but ruled, on Issue #2, that Northwest Hospital was not entitled to reimbursement for any of the interest paid to the three former stockholders of the for-profit hospital. The Commissioner based his decision, in part, on 45 C.F.R. § 405.419(c), which provides that to qualify as an allowable Medicare cost,

interest expense must be incurred on indebtedness established with lenders or lending organizations not related through control, ownership, or personal relationship to the borrower. . . . Thus, interest paid by the provider to partners, stockholders, or related organizations of the provider would not be allowable. . . .*fn3

The Commissioner found that the current provider and the former for-profit stockholders were "related parties" within the meaning of this and other Medicare regulations and, therefore, that no portion of the ...

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