Beverly Health & Rehabilitation Services, Inc. v. Metcalf

COURT OF APPEALS OF VIRGINIA

Present: Judges Coleman, Elder and Fitzpatrick
Argued at Richmond, Virginia

BEVERLY HEALTH AND REHABILITATION
SERVICES, INC.
OPINION BY
v. Record No. 1757-96-2 JUDGE LARRY G. ELDER
APRIL 22, 1997
ROBERT C. METCALF, DIRECTOR, VIRGINIA
DEPARTMENT OF MEDICAL ASSISTANCE SERVICES

FROM THE CIRCUIT COURT OF THE CITY OF RICHMOND
Theodore J. Markow, Judge

Peter M. Mellette (Jeannie A. Adams; Crews &
Hancock, on briefs), for appellant.

E. Paige Selden, Assistant Attorney General
(James S. Gilmore, III, Attorney General;
William H. Hurd, Deputy Attorney General;
Siran S. Faulders, Senior Assistant Attorney
General, on brief), for appellee.

Beverly Health and Rehabilitation Services, Inc. (appellant)

appeals the decision of the Circuit Court of the City of Richmond

(circuit court) affirming the decision of the Director of the

Virginia Department of Medical Assistance Services (DMAS) denying

appellant's request for reimbursement from the Medicaid program

of certain depreciation and interest expenses. Appellant

contends that DMAS erroneously reversed a hearing officer's

recommendation and that DMAS' interpretation of applicable

regulations was arbitrary and capricious. For the reasons that

follow, we affirm in part, reverse in part, and remand.
 I.

BACKGROUND

Appellant is a Delaware corporation that operates nursing

facilities, retirement living centers, home health agencies and

pharmacies throughout the United States. Appellant is also a

provider under the Medicaid program who operates several nursing

facilities in Virginia. DMAS is the state agency authorized to

administer Virginia's Medicaid program.
In the years relevant to this appeal, appellant claimed

reimbursement from DMAS for two types of expenses. The first

claim was for interest expense and depreciation related to four

facilities (REIT facilities) leased to appellant by Nationwide

Health Properties, Inc. (Nationwide). The other claim was for

interest expense arising from a revolving line of credit

(revolving debt) that was initially obtained by appellant at its

corporate level. A portion of the interest expense from the

revolving debt was allocated to each of appellant's facilities in

Virginia, and appellant sought reimbursement from DMAS for these

interest expenses.

Following an audit of appellant's cost reports for the years

relevant to this appeal, DMAS adjusted appellant's reports to

exclude these interest expenses and depreciation as allowable

costs under the Medicaid program. The Director of DMAS' Division

of Cost Settlement and Audit held an informal fact finding

conference and upheld these adjustments. Appellant appealed, and

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a hearing officer appointed by DMAS recommended reversing the

adjustments and allowing the reimbursement of the depreciation

and interest expense sought by appellant. Appellant filed

exceptions, and the Director of DMAS (DMAS director) rejected the

hearing officer's recommendation. He held that DMAS was correct

when it adjusted appellant's cost reports to deny reimbursement

to appellant for the depreciation and interest expenses

associated with the REIT facilities and the interest expense

arising from the revolving debt. Appellant appealed, and the

Circuit Court of the City of Richmond affirmed the decision of

the DMAS director.
II.

THE DMAS DIRECTOR'S REVIEW

OF THE HEARING OFFICER'S WRITTEN RECOMMENDATION

Appellant initially contends that the DMAS director's

decision should be reversed on procedural grounds. It argues

that the DMAS director lacked the power to reject the hearing

officer's recommendation because DMAS did not file timely

exceptions. In the alternative, appellant argues that the DMAS

director did not accord sufficient deference to the hearing

officer's factual findings.

The record establishes that the hearing officer recommended

allowing the costs associated with both the REIT facilities and

the revolving debt and based his recommendation upon the exhibits

and testimony of the parties. The hearing officer did not make

any credibility determinations based on recorded observations of

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the witnesses' demeanor. The DMAS director rejected the hearing

officer's recommendation based on several legal grounds,

including the hearing officer's refusal to qualify a DMAS witness

as an expert, the hearing officer's admission that he did not

review the entire record, his reliance upon informal case

decisions as precedent, and his erroneous application of the

Medicare principles of reimbursement. The DMAS director also

stated that appellant had excepted to the hearing officer's

recommendation while DMAS had failed to file timely exceptions.
Administrative proceedings before DMAS are governed by the

Administrative Process Act (APA), DMAS regulations known as the

"state plan for medical assistance" 1 and applicable federal law.

See Code § 32.1-325.1. Federal regulations require DMAS to:
provide an appeals or exception procedure
that allows individual providers an
opportunity to submit additional evidence and
receive prompt administrative review, with
respect to such issues as the agency
determines appropriate, of payment rates.

42 C.F.R. § 447.253(e). The NHPS satisfies this federal

requirement by providing for two levels of administrative review:

an informal proceeding and a formal hearing. See 12 V.A.C.

§ 30-90-130(III). After DMAS makes an informal decision, the

provider may request a formal hearing. Upon such a request, the

1
The portion of the state plan relevant to the issues in
this case is called the Nursing Home Payment System (NHPS).
Several versions of the NHPS have existed over the years and the
current version is codified at 12 V.A.C. § 30-90-10 et seq.
(1996).

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DMAS director appoints a hearing officer who is authorized to

conduct the formal hearing and to "make a written

recommendation." Id. § 30-90-130(III)(C).

Under the APA, the hearing officer's decision is subject to

agency review in two instances: first, if a party files

"exceptions thereto," Code § 9-6.14:12(D), or second, if:
the agency shall by its procedural
regulations provide for the making of
findings and an initial decision by [a
hearing officer] subject to review and
reconsideration by the agency . . . on its
own motion.

Id. § 9-6.14:12(C). The NHPS authorizes the DMAS director to

broadly review a hearing officer's recommendation. In fact, the

NHPS characterizes the DMAS director's final decision as distinct

from the recommendation of the hearing officer. 12 V.A.C.

§ 30-90-130(III)(E) states that "[t]he director shall notify the

provider of his final decision within 30 business days of the

date of the appointed hearing officer's written recommendation

. . . . " (Emphasis added). Thus, under the NHPS, the
recommendation of a hearing officer is just that -- a

recommendation, and the DMAS director may reexamine all of the

hearing officer's conclusions. Regarding a hearing officer's

factual findings, the DMAS director is required by the APA to

defer to findings in the hearing officer's recommendation that

are "explicitly based on the demeanor of witnesses." Code

§ 9-6.14:12(C).

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 We hold that the DMAS director did not exceed his authority

when he reviewed and rejected the hearing officer's

recommendation. Even though DMAS failed to file timely

exceptions, the DMAS director was empowered to review all of the

hearing officer's conclusions based on both the exceptions filed

by appellant and on his own motion. In addition, contrary to

appellant's assertion, the DMAS director is authorized to reject

the factual findings of the hearing officer that are not based on

the hearing officer's express observations of the demeanor of the

witnesses. In this case, the hearing officer did not state in

his recommendation that any of his factual findings were based

upon his observation of the witnesses' demeanor. Thus, the DMAS

director did not exceed his power to review the hearing officer's

recommendation. 2

III.

INTEREST EXPENSE AND DEPRECIATION RELATED TO REIT FACILITIES

Appellant contends that the DMAS director arbitrarily and

capriciously interpreted Medicaid regulations to reach his

conclusion that the interest expense and depreciation related to

2
Appellant also contends that the DMAS director violated
the APA when he failed to rule upon appellant's exceptions to the
hearing officer's written recommendation. However, the substance
and nature of appellant's exceptions were not included in either
the joint appendix or the record received from the circuit court.
Therefore, we are unable to consider this argument on appeal.
See Jenkins v. Winchester Dep't of Social Servs., 12 Va. App.
1178, 1185, 409 S.E.2d 16, 20 (1991) (stating that "[t]he burden
is upon the appellant to provide [this Court] with a record which
substantiates the claim of error").

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the REIT facilities are not allowable costs.

In reviewing decisions by DMAS, an appellate court accords

great deference to both the agency's factual findings and

interpretation of the laws applicable to "the reimbursement due

qualified providers for their reasonable costs incurred while

delivering health care services." Fralin v. Kozlowski, 18 Va.

App. 697, 700-01, 447 S.E.2d 238, 240-41 (1994). This Court will

overturn DMAS' "interpretations of the statutes and regulations

governing Medicaid and Medicare principles of reimbursement . . .

only . . . when found to be arbitrary and capricious." Id. at

701, 447 S.E.2d at 241.

A.

Prior to 1985, appellant leased the REIT facilities from

Kellett Corporation (Kellett). Kellett was not a participant in

the Medicaid program and was not "related" to appellant. In

early September, 1985, Kellett sold the REIT facilities, along

with nineteen other nursing facilities, to appellant. Each REIT

facility had an outstanding mortgage debt attached to it. As

part of the consideration for its purchase, appellant assumed the

mortgages for three of the REIT facilities and paid off the

outstanding debt on the fourth.

On October 25, 1985, Nationwide was incorporated as a real
3
estate investment trust (REIT). At all times relevant to this

3
Nationwide was initially called Beverly Investment
Properties, Inc.

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appeal, appellant owned five percent of Nationwide's issued and

outstanding stock, and the two are "related" for Medicaid

reimbursement purposes. By December 30, 1985, appellant either

paid off or defeased the remaining three mortgages it had assumed

as part of its purchase of the REIT facilities. On December 31,

1985, appellant sold the REIT facilities to Nationwide pursuant

to a "sale/leaseback" transaction. Appellant leased the REIT

facilities from Nationwide during the subsequent fiscal years

relevant to this appeal.
Appellant sought reimbursement from DMAS for the expenses

associated with the REIT facilities. Specifically, appellant

sought reimbursement for depreciation of the facilities on a

"stepped-up" basis equal to the purchase price it paid Kellett

for the REIT facilities. It also sought reimbursement for the

"interest expense" related to the lease payments it made to

Nationwide.

DMAS refused to allow the reimbursement sought by appellant.

Regarding depreciation, DMAS allowed reimbursement to appellant

based on Kellett's basis in the REIT facilities and not

appellant's "stepped-up basis." In upholding this adjustment,

the DMAS director stated that § (A)(5)(b)(9) of the

then-applicable version of the NHPS prohibited appellant from

collecting reimbursement for depreciation on a "stepped-up"

basis. See NHPS § (A)(5)(b)(9) (1982 & Supp. 1984). Section

(A)(5)(b)(9) states:

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 Effective October 1, 1984, the valuation of
an asset of a hospital or long term care
facility which has undergone a change of
ownership on or after July 18, 1984, shall be
the lesser of the allowable cost to the owner
of record, or the acquisition cost to the new
owner.

In the case of an asset not in existence as
of July 18, 1984 the valuation of an asset of
a hospital or long-term care facility shall
be the lesser of the first owner of record,
or acquisition cost to the new owner.

In establishing an appropriate allowance for
depreciation . . . the asset basis to be used
for such computations shall be limited to the
valuation above.

(Emphasis added). The DMAS director reasoned that the REIT

facilities were in existence as of July 18, 1984 and, citing

Black's Law Dictionary, held that the plain, meaning of "owner of

record" is "the owner of title at the time of notice." The DMAS

director concluded that appellant's basis in the REIT facilities

for depreciation purposes was limited to Kellett's basis because

Kellett was the owner of record on July 18, 1984 and its basis in

the REIT facilities was less than the acquisition cost to
appellant. Furthermore, the DMAS director held that the

sale/leaseback transaction between appellant and Nationwide did

not change the allowable reimbursement for depreciation. The

DMAS director reasoned that appellant would continue to be

reimbursed for the allowable depreciation that existed prior to

the sale/leaseback because this transaction was between related

parties.

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 Regarding the lease-related interest expense, DMAS

disallowed reimbursement to appellant for any interest expense

incurred after the sale of the REIT facilities to Nationwide. In

upholding this adjustment, the DMAS director cited § (c) of

Appendix II in the NHPS, which stated:
Interest - Interest expense will be limited
to actual expense incurred by the owner of
the facility in servicing long-term debt
. . . .

NHPS app. II, § (c) (1982). He reasoned that the only long term

debt serviced by appellant in its acquisition of the REIT

facilities from Kellett was the three mortgages it assumed and

paid off or defeased prior to the sale of these facilities to

Nationwide. Because this long term debt ceased to exist,

appellant no longer incurred any "actual interest expense"

related to long term debt that was allowable under the NHPS.

B.

The DMAS director "is authorized to administer [the] state

plan and to . . . expend federal funds therefor in accordance

with applicable federal and state laws and regulations . . . ."

Code § 32.1-325(B). Under the NHPS, DMAS may only reimburse

providers for "those allowable, reasonable cost items which are

acceptable under Medicare principles of reimbursement, except as

modified herein . . . ." NHPS, Introduction (1982). Thus, under

the NHPS, when DMAS considers the reimbursement of an expense

claimed by a provider in a cost report, it must first apply DMAS

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regulations that pertain to the particular expense. If the NHPS

is silent on a particular expense or issue, then DMAS is required

to apply Medicare principles of reimbursement, including those

stated in the Provider Reimbursement Manual. See State Plan

Under Title XIX of the Social Security Act, Attachment

4.19-D(d)(2) (stating that "[t]he determination of allowable

costs will be in accordance with Medicare principles as

established in the Provider Reimbursement Manual . . . except

where otherwise noted in this Plan"). 4
We hold that the DMAS director's denial of appellant's

request to allow depreciation of the REIT facilities on a

"stepped up" basis was based on an arbitrary and capricious

interpretation of the relevant Medicaid regulations.

Specifically, the DMAS director declined to apply federal

regulations defining which facilities were "not in existence" as

of July 18, 1984 for the purposes of determining the allowable

depreciation cost. The DMAS director correctly stated that

§ (A)(5)(b)(9) of the 1982 NHPS applied to the transactions

involving the REIT facilities. However, § (A)(5)(b)(9) is silent

on the issue of which facilities "existed" as of July 18, 1984

4
We have described the Provider Reimbursement Manual (PRM)
as "a guide for intermediaries in applying the Medicare statute
and reimbursement regulations [that] does not have the binding
effect of law or regulation." Fralin, 18 Va. App. at 699 n.2,
447 S.E.2d at 240 n.2. This statement does not describe the
legal effect of the PRM in all cases. In this case, DMAS is
bound by the state plan to apply any relevant provisions of the
PRM when the NHPS is silent on a particular reimbursement issue.

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for purposes of establishing the proper basis of depreciation.

Medicare principles of reimbursement, as stated in Federal

regulations, speak to this issue. 42 C.F.R.

§ 413.134(b)(1)(ii)(B) states that "an asset not in existence as

of July 18, 1984 includes any asset that physically existed, but

was not owned by a hospital or [skilled nursing facility]

participating in the Medicare program as of July 18, 1984."

(Emphasis added).
If the DMAS director had properly applied Medicare

principles of reimbursement as required by the NHPS, he could not

have concluded that appellant's basis of depreciation in the REIT

facilities was limited to Kellett's basis before the facilities

were sold. Although Kellett owned the REIT facilities prior to

July 18, 1984, it did not participate in the Medicare or Medicaid

program. Thus, for the purposes of calculating depreciation

under § (A)(5)(b)(9) of the 1982 NHPS, the REIT facilities were

not in existence as of July 18, 1984. See 42 C.F.R.

§ 413.134(b)(1)(ii)(B). Instead of analyzing the REIT facilities

under the first paragraph of § (A)(5)(b)(9), the DMAS director

should have applied the second paragraph of § (A)(5)(b)(9), which

states:
In the case of an asset not in existence as
of July 18, 1984 the valuation of an asset of
a hospital or long-term care facility shall
be the lesser of the first owner of record,
or acquisition cost to the new owner.

The REIT facilities did not "exist" until they were acquired by

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appellant. Thus, appellant was the first owner of record and its

basis in the REIT facilities for depreciation purposes should

have been its acquisition cost. Because the DMAS director

declined to apply relevant Medicare principles of reimbursement,

he acted arbitrarily and capriciously when he concluded that

appellant was not entitled to reimbursement for depreciation of

the REIT facilities on a "stepped-up" basis.

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 C.

We also hold that the DMAS director incorrectly applied

Medicaid and Medicare regulations to the interest expense arising

from appellant's lease payments on the REIT facilities but that

the DMAS director reached the right result for the wrong reason.

"We do not hesitate, in a proper case, where the correct

conclusion has been reached but the wrong reason given, to

sustain the result and assign the right ground." Robbins v.
Grimes, 211 Va. 97, 100, 175 S.E.2d 246, 248 (1970).

Although the DMAS director correctly applied § (A)(5)(b)(9)

of the 1982 NHPS to the depreciation of the REIT facilities, the

DMAS director erroneously failed to determine that this section

applies to any interest expense arising from the sale/leaseback

transaction as well. Section (A)(5)(b)(9) states that:
Reimbursement for rental charges in sales and
leaseback agreements shall be restricted to
the . . . interest . . . as computed above
(cost of ownership).

As previously discussed, the REIT facilities did not exist as of

July 18, 1984, and the second paragraph of § (A)(5)(b)(9) applies

to the calculation of the costs of ownership of these facilities.

This paragraph states:
In the case of an asset not in existence as
of July 18, 1984 the valuation of an asset of
a hospital or long-term care facility shall
be the lesser of the first owner of record,
or the acquisition cost to the new owner.

Interest expense regarding leased facilities is defined elsewhere

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in the NHPS as "actual expense incurred by the owner of the

facility in servicing long-term debt . . . ." NHPS app. II,

§ (c) (1982).

Under these provisions of the NHPS, the DMAS director

correctly disallowed appellant any reimbursement for interest

expense arising from its lease payments on the REIT facilities to

Nationwide. Appellant was the "first owner of record" of the

REIT facilities. The record establishes that, prior to the

sale/leaseback transaction with Nationwide, appellant either paid

off or defeased all of the long term debt it assumed pursuant to

its purchase of the REIT facilities from Kellett. Thus, at the

time of the sale/leaseback transaction, appellant no longer

incurred any interest expense arising from its acquisition of the

REIT facilities. Although the record does not establish the

exact amount of interest expense incurred by Nationwide to

acquire the REIT facilities, we can assume that this amount was

greater than the interest expense incurred by appellant at the

time of the sale/leaseback transaction -- zero. Because the

interest expense of "the first owner of record" (appellant) was

less than the interest expense incurred by the subsequent

purchaser/lessor (Nationwide), the DMAS director did not act

arbitrarily and capriciously when he disallowed appellant

reimbursement of any interest expense arising from this

transaction.
Appellant contends that the NHPS was silent on the issue of

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sale/leaseback transactions and that the DMAS director

arbitrarily ignored applicable Medicare principles of

reimbursement. However, as previously discussed, the NHPS

contains a provision that applies to sale/leaseback transactions.

Thus, the DMAS director was not required to apply any other

Medicare principles of reimbursement. In addition, the only

Medicare principle of reimbursement cited by appellant, PRM

§ 110, does not apply to the transaction between appellant and

Nationwide. Section 110 states that it applies only to

sale/leaseback transactions between a provider and a "nonrelated

purchaser." The record establishes that appellant and Nationwide

were related parties at the time of their transaction. We cannot

say that the DMAS director acted arbitrarily or capriciously when

he declined to apply PRM § 110.
IV.

INTEREST EXPENSE ARISING FROM THE REVOLVING DEBT

Appellant contends that the DMAS director arbitrarily and

capriciously interpreted Medicaid regulations when he denied

reimbursement to appellant for the interest expenses arising from

the portions of the revolving debt allocated to its facilities in

Virginia. We disagree.

A.

The record indicates that on February 18, 1987, appellant

executed a complex, revolving line of credit agreement that had a

$400,000,000 limit. In 1989, appellant borrowed funds from the

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revolving line of credit due to cash flow problems that appellant

was experiencing at many of its facilities across the country.

When it decided to incur this revolving debt, appellant based its

decision on its "total corporate need" and not on the needs of

its individual facilities.

Appellant used its regular accounting practices and

procedures to allocate portions of the interest expense arising

from the revolving debt to each of its Virginia facilities.

Appellant's system of accounting consolidates through monthly

intercompany transfers both its cash accounts and debt accounts

from all of its facilities at the corporate level. After this

consolidation, appellant allocates portions of its cash and debt

accounts to its individual facilities either directly or through

a "home office cost report." Costs, assets, and liabilities

which can be directly identified with a particular facility are

allocated directly, while those that cannot are allocated through

the home office cost report.
In accordance with these accounting procedures, appellant

allocated portions of the interest expense from its revolving

debt to each of its Virginia facilities on a monthly basis in the

years relevant to this appeal. The amount allocated to each

facility was approximate and based on the sum of each facility's

estimated annual supply inventory and the actual amount of fixed

assets purchased by that facility from January, 1988 through the

current month. This sum was multiplied by one percent to obtain

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the amount of interest expense allocated to each facility.

Appellant allocated portions of the revolving debt to its

Virginia facilities without assessing each facility's need for

working capital. Moreover, due to its corporate accounting

procedures, appellant admitted that it was unable to determine

whether or not its Virginia facilities had excess working capital

at the time it allocated the revolving debt.

Appellant sought reimbursement from DMAS for the interest

expense arising from the revolving debt that it allocated to each

of its Virginia facilities. DMAS adjusted appellant's cost

reports to disallow this interest expense. In upholding this

adjustment, the DMAS director cited PRM § 202.1, which states

that interest expense is reimbursable if it is necessary for the

operation or maintenance of a provider's facilities. He then

relied upon PRM § 202.2 and 42 C.F.R. § 413.153 for the

proposition that interest expense is necessary if incurred to

satisfy a "financial need and for a purpose reasonably related to

patient care." Citing PRM § 202.2, the DMAS director also stated

that interest expense is not necessary if the debt from which it

arises created excess working capital for the provider.
The DMAS director then stated that neither the NHPS nor

federal regulations dictate the procedure for calculating a

provider's excess working capital for the purpose of determining

the provider's need to borrow funds. He then held that:
cash flow is an adequate measure of excess
working capital. A nursing facility with

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 sufficient cash flow does not need to borrow
funds to pay for its working capital needs.

Regarding the method for calculating cash flow, the DMAS director

held that the calculation should not rely on generally accepted

accounting procedures (GAAP) and should instead "compare [the

provider's] total revenues with its Medicaid allowable expenses."

DMAS had introduced into evidence a report of the cash flow in

appellant's Virginia facilities based on this method. The report

showed that appellant's Virginia facilities had an aggregate

positive cash flow of several million dollars during the years

relevant to this appeal. Relying on this report, the DMAS

director held that appellant's Virginia facilities had excess

working capital at the time appellant allocated the revolving

debt to them, which rendered the revolving debt unnecessary.

Because the revolving debt was unnecessary, the DMAS director

held that any interest expense arising from it was not an

allowable cost.
B.
We hold that the DMAS director's interpretation of Medicaid

and Medicare regulations pertaining to the reimbursement of

interest expense arising from the revolving debt was not

arbitrary and capricious. The 1986 NHPS, which applies to the

interest expense on the revolving debt, provides little guidance

on reimbursement for loans that provide working capital to a

facility. Appendix I of the NHPS contains a list of "allowable

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expenses" that includes interest expense other than that incurred

to purchase a building or equipment. See NHPS app. I,

§ 2.1(D)(19) (1986). The NHPS also states that in order for this

interest expense to be "allowable," it must be, among other

things, necessary. NHPS app. I, § 1.1(A) (1986). However, the

NHPS does not indicate which interest is "necessary" and which is

not. Because the NHPS is silent, the DMAS director was required

to apply Medicare principles of reimbursement.
Medicare principles of reimbursement support the DMAS

director's conclusion that interest expense is unnecessary, and

therefore not allowable, if it is incurred by a provider to

finance a debt that creates "excess" working capital at the

facility claiming it as an expense. First, the federal

regulation cited by the DMAS director permits reimbursement to a

provider for "necessary and proper interest on both current and

capital indebtedness." 42 C.F.R. § 413.153(a)(1). This federal

regulation also states that interest expense is "necessary" only

if it is "[i]ncurred on a loan made to satisfy a financial need

of the provider. Loans that result in excess funds . . . would

not be considered necessary." Id. at § 413.153(b)(2). PRM

§ 202.2, also cited by the DMAS director, states that "when

borrowed funds create excess working capital, interest expense on

such borrowed funds is not an allowable cost."

The only aspect of the DMAS director's interpretation that

is not supported by the relevant authorities on Medicaid

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reimbursement is the method he adopted for measuring excess

working capital at a provider's facility. Both state and federal

regulations and the PRM provide no guidance on this issue. The

DMAS director held that whether or not a provider's facility has

excess working capital should be determined by calculating its

cash flow during the relevant cost reporting period.

Furthermore, the DMAS director held that the measurement of cash

flow should not follow GAAP but should instead be calculated by

subtracting a provider's allowable expenses under the Medicaid

program from its total revenues. The DMAS director reasoned that

this method prevents a provider from shifting interest expenses

incurred in the care of non-Medicaid patients to the Medicaid

program. He explained that this method of calculating cash flow

is superior to the GAAP method because it establishes whether the

borrowing by the provider was necessary to enable the provider to

care for its patients who are Medicaid beneficiaries.
We conclude that the DMAS director's method for calculating

excess working capital was not arbitrary and capricious because

it is consistent with general Medicare principles of

reimbursement. Medicare principles state that one of the

purposes of methods to determine reimbursable costs is to

segregate costs incurred to treat program beneficiaries from

costs incurred to treat patients not covered by the program. See

42 C.F.R. § 413.9(b)(1).
The determination of reasonable cost of
services must be based on the cost related to

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 the care of Medicare beneficiaries.
Reasonable cost includes all necessary and
proper expenses incurred in furnishing
services . . . . However, if the provider's
operating costs include amounts not related
to patient care . . . such amounts will not
be allowable . . . .

Id. at § 413.9(c)(3). The DMAS director's method for calculating

excess working capital furthers this purpose of the Medicare

principles of reimbursement and is thus not arbitrary and

capricious. In light of DMAS' recognized expertise in

determining the reimbursement due to providers under the Medicaid

program, we will not substitute our own judgment for that of

DMAS. See Fralin, 18 Va. App. at 701, 447 S.E.2d at 240-41. In

addition, the DMAS director's holding that the revolving debt

allocated by appellant to its Virginia facilities was not

"necessary" because these facilities had excess working capital

is supported by credible evidence in the record.

For the foregoing reasons, we affirm in part and reverse in

part the circuit court's affirmance of the DMAS director's

decision. We remand this case to the circuit court for further
proceedings consistent with this opinion.
Affirmed in part, reversed in part,
and remanded.

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