Hospital Operating Margins in Limbo as Investments Drive Profitability

Business & Financial Planning

The dichotomy of hospital financial news is puzzling. Just today, I saw a headline about a hospital turning a profit for the first time in four years. That article was immediately followed by another one listing nearly 100 hospitals that are closing departments or ending services due to poor financial performance.

The central question remains: Are hospital financials improving? As we’ll discuss, the answer continues to depend on the selected profitability measure.

Consistent with previous blog posts in this series (see July 2023 and Oct. 2022), we’ll break our analysis down into two distinct measures of profitability: operating income and net income. As a reminder, a hospital operating margins are focused solely on core operations, whereas net income provides a comprehensive view of the hospital’s profitability after considering all financial activities. The key difference for hospitals is typically the inclusion of investment income or losses in net income.

The Rebound in Operating Profits Has Stalled

According to S&P Global, the annual median health system operating margin ranged from 2.2 to 3.6 percent in the decade leading up to the COVID-19 outbreak. Subsequently, this margin dipped to 1.2 percent in 2020 before recovering to 2.5 percent in 2021. As expense inflation surged, 2022 marked the first full year with a negative median operating margin.

Recovery since then has been uneven at best. A quarterly breakdown of 2022 and 2023 is shown in the chart below.[1] The median health system operating margin improved throughout 2022 but remained negative until the fourth quarter. Thus far in 2023, the median operating margin improved in the second quarter but declined in the first and third quarters. Regardless, the quarterly margins all remain well below the pre-COVID, 10-year lows of 2.2 percent.

Though median margins are now hovering just above break-even for the industry as a whole, recovery is far from certain at the organization level. In fact, the 125 largest U.S. systems remain almost evenly split between operating profits and losses. The most recent quarter saw a significant drop in systems reporting an operating profit, though every quarter of 2023 has been better than the year-earlier period. As fourth quarter numbers come out, we’ll be watching closely to see if the third quarter decline was an aberration – or a warning sign for 2024.

Similar to our July analysis, widespread operating losses continue to be a cause for worry – especially as many systems continue to experience expense growth that outstrips revenue growth. Ascendient has seen negative margins off and on for more than 20 years in our client engagements, but never has the phenomenon been this widespread or this persistent.

Ongoing operating losses are simply not sustainable for the US healthcare system, but we’re not seeing any clear trend toward improvement. In fact, less than half (only 36 percent) of health systems saw operating income improve in the third quarter of 2023.

Investment Income Drives Net Income

Leaders have some degree of control over hospital operating margins. From services to salaries to supplies, there are thousands of levers for fine-tuning revenues and expenses. But if one thing is clear from the chart below, it’s that investment income is the key driver of net income at health systems – and markets are entirely beyond any leader’s control.

Look what happened in just the last two quarters. In the second quarter of 2023, the Dow Jones was up 3.4%, the S&P 500 increased 8.3%, and the Nasdaq increased 12.8%, allowing nearly all health systems to report net income regardless of operational results. Unfortunately, the reliance on investment income swung the pendulum in the opposite direction in the third quarter of 2023, when the Dow Jones was down 2.6%, the S&P 500 was down 3.6%, and the Nasdaq was down 4.1%. These market declines resulted in investment losses at 66% of health systems – and not surprisingly, almost exactly the same percentage of systems experienced net losses in the quarter.

What to Expect for Q4 2023 Financial Statements

Operating Income: Though operating margins are running below their historic average, it appears that revenues and expenses continue to stabilize. We expect this trend to continue into the fourth quarter.

Net Income: Investments are expected to positively drive hospital bottom lines in the fourth quarter of 2023 when the Dow Jones was up 12.5%, the S&P 500 was up 11.2%, and the Nasdaq was up 13.6%. This suggests another period of investment income driving strong net income to close out 2023. 

Conclusion

The examination of hospital operating margins exposes a delicate balance between recovery and continued challenges. While the median operating margin reflects a fragile return to positivity, the persistence of operating losses for a significant portion of health systems raises red flags. The impact of investment income on net income further complicates the scenario, showcasing health system’s reliance on or vulnerability to market fluctuations. The uncertain terrain calls for a closer examination of financial strategies and a more comprehensive approach to ensure the financial wellbeing of healthcare institutions.

Research support provided by Stephenie Fahy, senior financial analyst

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[1] All charts based on Ascendient analysis of quarterly financial statements from the largest US health systems. Although health systems utilize a variety of fiscal years, our analysis focused on distinct three-month periods.  Q1 refers to January 1 – March 31.  Q2 refers to April 1 – June 30.  Q3 refers to July 1 – September 30. Q4 refers to October 1 – December 31.