The nursing home industry may be hiding nearly two-thirds of its profits through the use of opaque business practices, based on data from a study of the industry in Illinois, according to new research from Andrew Olenski, assistant professor of economics.
The finding, published in a National Bureau of Economic Research working paper by Olenski and Ashvin Gandhi of UCLA, is cited in the Biden administration’s new regulation implementing a minimum staffing standard for long-term care facilities and is drawing calls for reform from industry advocates and watchdogs.
“A consensus among these groups is that it is widely known that this is going on, but nobody has been able to show it empirically or estimate the magnitude prior to our study,” Olenski said.
'Tunneling' and Related Party Transactions
The nursing home industry purports to be widely unprofitable, with about 50% of firms reporting negative profits in a given year. Yet, despite this largely losing record, the industry has been increasingly attractive to capitalists.
About 70% of firms are for-profit entities, and private equity has been entering the industry at high rates over the past several years.
For an economist such as Olenski, this confluence raised questions: If the industry is so unprofitable, why aren’t firms closing at higher rates, and why is private equity getting involved?
His research found that the true profitability of nursing homes was being misrepresented through “tunneling,” making inflated payments for goods and services to related parties. Related parties are companies held by the same ownership as the nursing home.
“Essentially, owners are moving money from their left pocket to their right, and then showing they have no money in their left pocket,” Olenski said. “Correctly accounting for this activity reveals that the industry is meaningfully more profitable than it appears: About 63% of industry profits are ‘hidden’ through this sort of activity.”
A nursing home trade industry association cited in a recent Forbes article on the findings, said in response: “We do not believe it is common practice to “tunnel” profits to other lines of business….The sad truth is that because long term care is chronically underfunded, ancillary services and related parties sometimes help keep these facilities afloat. These issues are a distraction from the real challenges facing the majority of the long-term care sector.”
How Does Tunneling Work?
The research indicates that the vast majority of tunneling in the nursing home industry occurs within two costs that are reported publicly: real estate and management services.
One common practice the researchers found was for a nursing home to sell its building and land to a real estate company, and then lease the property back. This leaseback practice is legal, and there are some cases in which it might be done for legitimate business purposes, Olenski said.
However, when the real estate company is owned by the same entity that owns the nursing home, the arrangement can be used to hide profits by funneling them to the real estate company, often by paying rents far higher than fair market rate. The nursing home then publicly reports higher costs for rent and decreased profits, while the “hidden” profits continue flowing to the same owners.
The analysis found that, on average, leaseback transactions typically led to higher real estate costs for the nursing homes and in many cases resulted in negative book equity—with their total liabilities eclipsing their total assets. In other words, such transactions left nursing homes with fewer net assets while also paying higher costs for rent than they did to own their properties.
“Why would a firm do this? What benefit is there for the nursing home? It’s very hard to rationalize this from an economic standpoint as anything other than an accounting trick,” Olenski said.
For the management services line item, the researchers also found that nursing homes that outsourced management to related parties also ended up paying more for services than their prior costs for direct management and similarly reported decreased profits.
Tunneling Under the Public Eye
The vast majority of funds flowing through nursing homes come from publicly funded Medicare and Medicaid reimbursements. As such, nursing homes are required to publicly report costs, including real estate and management services, to the federal Centers for Medicare and Medicaid Services (CMS) as well as state offices.
How then, could such practices be occurring under the public eye?
According to Olenski, the nursing home cost data that gets reported to CMS is “infamously noisy.”
“This is because the data are not subject to audit risk, and so nursing homes often leave blank values or put in obviously erroneous data,” he said.
The government has long been reluctant to implement auditing of CMS reports out of fear that doing so would be too resource-intensive.
However, some states have taken steps to ensure more complete and accurate data. Illinois is one such state, which is why the study focused on nursing home data from that state (from the years 2000-2019). The reports Illinois collects include more detailed data from related parties and requires that every related party cost correspond directly to line items that would traditionally be required.
What’s the Damage?
About 75-80% of nursing homes across the sector engage in related-party transactions, including both for-profit and nonprofit entities. In Illinois, the average nursing home that used related party transactions was found to be hiding about $300,000 in profits each year.
With well over 15,000 nursing homes operating in the U.S., the total sum of profits potentially being hidden in a year is in the billions. And the authors believe that the figure calculated from Illinois’ data likely underestimates the problem nationally, given more lax reporting requirements in other states.
The study details that if these hidden profits were instead directed back toward patient care, they could fund an additional 15 minutes of care from a registered nurse per day per patient, or 30 minutes per day from a certified nursing assistant. While those figures may seem low, they would represent an increase of approximately 30% over the current average.
Potential Solutions
With profits being hidden at such a magnitude, drastic measures may seem to be needed. But the authors say that relatively simple steps could make a big difference.
“A first priority is trying to improve the federal reporting of these types of data. Second, it is important to note that it’s important to not only audit nursing homes’ financial data, but the reported costs of any related parties as well,” Olenski said.
While auditing all CMS reports would create a massive burden, the authors believe that selective auditing would nudge nursing homes to submit more accurate data. Just as the remote possibility of an IRS audit keeps most taxpayers honest, the looming threat of a CMS audit would likely encourage nursing homes to be more accurate in their reports.
Another potential step would be to require review of certain consequential transactions, such as related-party leaseback deals. Olenski said he also believes that direct quality regulations, such as the new minimum staffing rule, may be needed.
“For the last two to three decades, the terms of the debate around nursing home reimbursement policy have been that the industry is struggling, can’t afford to hire more nurses and can’t implement higher staffing standards because facilities will close, and therefore reimbursement rate increases are needed,” he said. “These results underscore that this public debate has been off the mark—this industry has not been entirely forthcoming about how profitable they really are, and that is no way to start a discussion of what’s economically feasible.”
Story by Dan Armstrong
Listen to Olenski talk more about his research on the ilLUminate podcast.
