The RAC Reserve Debate

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The question is whether hospitals should establish reserve funds as the government's Recovery Audit Contractor program is rolled out nationally.

Talk to a hospital CFO who's been ambushed in a RAC audit, and the question isn't will he be setting aside a RAC reserve, it's how much did he set aside and what methodology did he use to come up with that figure. Escondido, CA-based Palomar Pomerado Health, with three hospitals, had 413 of its charts audited as part of the RAC Demonstration Project between 2007 and 2008. After much deliberation internally and externally with its audit firm, finance leaders decided to put about one-third of the system's Medicare take-back into a reserve fund.

"We decided on a prudent, modest reserve based on our subjective experience with the demonstration project," says Bob Hemker, chief financial officer. The amount is somewhat conservative and based on the recommendation by outside auditors that "it would be more appropriate to recognize it as revenue and not put as much aside," says Tom Boyle, internal audit officer. Still, he adds, "there are two commas in the dollar amount, so it is sizable."

For everyone else—that is, those who haven't been through a RAC audit—the justification for establishing a reserve isn't as clearly defined, and so the risks of doing so versus taking a wait-and-see attitude are being carefully weighed among hospital leaders and their auditors. "Some say it is such a speculative risk that it shouldn't have the reserve set, while others say, 'No, no look at the record; everybody got pounded and lost money so it is really just how much am I going to lose, not if I am going to lose,'" says Brian Flood, managing director for integrity services with KPMG LLP in Austin, TX.

The fact is with the RAC program so new, hospitals vary widely in their opinions and actions on RAC reserves. "Just because RAC is a national initiative, if there is no investigation or analysis of the issues, or a basis or foundation, many hospitals would have no reserves established because they are not aware of any pending potential issue," says John Dugan, CPA, partner with PricewaterhouseCoopers in Philadelphia. "I would say the majority of hospitals that did have recoveries for previous issues under the RAC either corrected those issues or are in the process of correcting them operationally and still may or may not have an established reserve."

If done incorrectly, setting aside a reserve could create havoc with board members, shareholders, and bond holders because of the potential liability. "In today's economic times, the judges of your financial position are much harsher than they were three years ago, and so you have to be very careful with balancing the reporting of proper financial information versus just simply saying the sky is falling," says Flood. "If you got called on the carpet for doing so, how would you justify setting reserves?"

The right methodology
To set aside a reserve, hospital leaders need to determine a basis, a history, and a rationale, whether it is through their own past RAC audits, their own internal audit exercises, or their own analysis of prior published reports, says Dugan. "Where you have difficulties in the real world is when hospitals establish reserves and there is very little underlying information." It then becomes a general reserve, which is difficult to audit, he adds.

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