Many U.S. hospitals provide charity care to financially disadvantaged patients without the expectation of getting paid for their services. Nonprofit hospitals receive a sizable tax exemption — estimated at almost $25 billion in 2015 (using 2011 data) and likely much larger now — that is largely intended to subsidize the costs of this charity care.
But the relationship between providing charity care and obtaining a tax exemption is far from direct, and many nonprofit hospitals do not provide enough charity care to justify their exemptions.
A study published today in Health Affairs, co-authored by one of us (G.B.), used Medicare cost reports from 2018 to study hospitals’ charity care. For every $100 in total spending, nonprofit hospitals provided $2.30 in charity care, while for-profit hospitals provided $3.80. More than one-third of nonprofit hospitals (36%) provided less than $1 of charity care for every $100 in total expenses.
Are these nonprofit hospitals earning their tax exemptions?
The legal requirements for a hospital to be exempt from paying taxes are straightforward: A nonprofit hospital must be organized and operated exclusively to promote one of the purposes specified in section 501(c)(3) of the Internal Revenue Code, including charitable, religious, educational, and scientific purposes. Section 501(c)(3) offers not only exemption from paying federal taxes, but state taxes and local property taxes as well. It also provides the ability to receive tax-deductible contributions and to issue tax-exempt bonds, which lower the cost of borrowing.
These provisions date back to the first Internal Revenue Code, adopted in 1913 after the enactment of the 16th Amendment. Over the years, the Internal Revenue Service has issued guidance interpreting this language. For example, in a 1956 revenue ruling, the IRS required a hospital to operate “to the extent of its financial ability for those not able to pay for the service rendered” and prohibited a hospital from denying care to patients who are unable to pay for it.
U.S. hospitals were originally funded by religious groups and philanthropists and staffed primarily by volunteers. They almost exclusively served indigent people. These institutions’ obvious charitable pursuits — to relieve the suffering of the poor, the distressed, and the underprivileged — rightly justified their tax-exempt status.
Over time, the market for hospital services has become far more competitive and commercial. Hospitals now receive far more money from insurers’ and patients’ payments than from philanthropic contributions. Some nonprofit hospitals have engaged in price gouging, employed aggressive debt collection practices, and used various means to stifle competition. Nonprofit hospitals compete aggressively with one another and with for-profit firms. All of these changes erode the argument for providing tax exemptions to nonprofit hospitals.
In fairness, the standard for receiving a tax exemption is not limited to providing charity care. In 1969, the IRS replaced the original charity care standard with the current community benefit standard. The promotion of health is now considered a charitable purpose, with hospitals judged by whether they are providing a “community benefit.” The IRS has identified eight categories of community benefit, such as the extent of any payment shortfall from Medicaid and other means-tested government programs, and community health improvement efforts, but many of these categories are squishy, easy to game, or are, at best, contestable measures of community benefit.
Among these eight categories, only charity care demonstrates voluntary and proactive activities that can be objectively measured and fairly compared across hospitals. Charity care also helps protect working-class and low-income Americans from overwhelming medical debt, and relieves taxpayers from what might otherwise become governmental burdens. But even here, for-profit hospitals also provide charity care, and many of them in aggregate provide more charity care than nonprofit hospitals in the same area.
The high cost of providing a tax exemption to nonprofit hospitals is compounded by the fact the subsidy is poorly targeted — it is worth more to financially successful hospitals located in wealthy areas, which face little demand for charity care. In 2017, the top 5% of nonprofit hospitals (by overall net income) were responsible for more than half of the overall earnings of all nonprofit hospitals, but provided only about 20% of overall charity care.
What about for-profit hospitals? The tendency is to view them as unsavory interlopers and nonprofit hospitals as the virtuous baseline. Yet based on the new Health Affairs study, for-profit hospitals in aggregate provided 65% more charity care than nonprofits per $100 in total expenses without receiving any subsidies for doing so. For-profit hospitals also pay federal, state, and local (property) taxes, while nonprofit hospitals do not.
Perhaps it is time we start viewing for-profit hospitals as the virtuous baseline and nonprofit hospitals as the unsavory freeloaders.
Automatic tax exemption for nonprofit hospitals is a long-standing but poorly targeted policy that has outlived its sell-by date. In its current form, tax exemption provides no assurance that nonprofit hospitals will behave in accordance with their charitable mission. If nonprofit hospitals are unwilling to provide sufficient charity care to justify the amount of their current tax exemption, there is no reason we should deprive local communities of the property tax revenues that allow them to fund local schools, parks, and other public services.
If we truly want to encourage hospitals to do the right thing, we should tie the value of the subsidy to the amount of charity care that is provided — whether it is provided by a nonprofit or for-profit hospital.
Ge Bai is an associate professor of accounting at Johns Hopkins Carey Business School and associate professor of health policy and management at Johns Hopkins Bloomberg School of Public Health. David A. Hyman is a professor of health law and policy at Georgetown University Law Center, and author of “Overcharged: Why Americans Pay Too Much For Health Care” (Cato Institute, 2018).