United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT
Argued September 2, 1997 Decided January 20, 1998
No. 96-5074
The Kidney Center of Hollywood, et al.,
Appellants
v.
Donna E. Shalala, Secretary,
United States Department of Health and Human Services,
Appellee
Appeal from the United States District Court
for the District of Columbia
(No. 94cv01459)
Eugene A. Massey argued the cause for appellant, with
whom Richard J. Webber was on the briefs.
Janice L. Hoffman, Attorney, U.S. Department of Health
& Human Services, argued the cause for appellee, with whom
Frank W. Hunger, Assistant Attorney General, U.S. Depart-
ment of Justice, Eric H. Holder, Jr., U.S. Attorney at the
time the brief was filed, Harriet S. Rabb, General Counsel,
U.S. Department of Health & Human Services, Robert P.
Jaye, Acting Associate General Counsel, Henry R. Goldberg,
Deputy Associate General Counsel, and Thomas W. Coons,
Attorney, were on the brief.
Before: Wald, Williams, and Ginsburg, Circuit Judges.
Opinion for the Court filed by Circuit Judge Ginsburg.
Ginsburg, Circuit Judge: The ten appellants in this case
provide outpatient kidney dialysis services to patients who
are suffering from end-stage renal disease, or ESRD. They
dispute the amount of money to which they are entitled from
the Secretary of Health and Human Services as reimburse-
ment for medical services rendered under the Medicare pro-
gram. Specifically, the appellants challenge (1) the Secre-
tary's decision that the merger of their parent company with
another corporation was a related-party transaction, such that
certain costs associated with the merger were not reimbursa-
ble under Medicare; and (2) the regulation capping reim-
bursement for "bad debts" at a provider's actual cost of
providing dialysis service, which they claim is inconsistent
with the statutory requirement that Medicare reimburse each
dialysis provider in a prospectively set amount.
The district court upheld the Secretary's decision with
respect both to the merger transaction and to the bad debt
regulation. We agree with the district court that the merger
was a related-party transaction. We reverse the district
court, however, with respect to the validity of the bad debt
regulation because we cannot tell, upon the present record,
whether the regulation is based upon a reasonable interpreta-
tion of the Medicare statute. Therefore we vacate the rule
and remand this matter for the Secretary to provide a more
adequate explanation of her rationale for the rule.
I. Background
Under the Medicare program the Secretary reimburses
providers of ESRD dialysis services at 80% of a prospectively
set rate and the Medicare beneficiary is responsible for the
remaining 20% as a co-payment. See 42 U.S.C.
s 1395rr(b)(2)(A); 42 C.F.R. s 413.170(b)(1), (d) (1996).1 If,
after making reasonable collection efforts, the provider is
unable to collect the 20% co-payment, then the uncollected
amount is considered a "bad debt." 42 C.F.R. s 413.80(b)(1),
(e). At the end of the year the Secretary reimburses the
dialysis provider for bad debts, but she caps total reimburse-
ment per treatment at the particular provider's cost of pro-
viding the service. Id. s 413.170(e)(1).
During the relevant time period (1984-85) National Medical
Care, Inc. owned, either directly or through a subsidiary, the
ten dialysis providers that press this appeal. NMC itself
changed ownership during that period, and the NMC subsid-
iaries reported, as reimbursable Medicare costs, certain costs
associated with the acquisition of their parent company. If
those costs are allowable, then the effect will be to increase
those providers' bad debt cap. The Secretary disallowed the
merger-related costs, however, on the ground that the merger
was between related entities. The NMC subsidiaries then
filed this lawsuit challenging both that determination and the
regulation providing for the cap upon reimbursement of bad
debts.
A. Statutory and Regulatory Background
The Congress established the ESRD program in s 299I of
the Social Security Amendments of 1972, Pub. L. No. 92-603,
__________
1 After the parties had briefed this case the Secretary amended
and re-numbered some of the relevant regulations. See Medicare
Program; End-Stage Renal Disease (ESRD) Payment Exception
Requests and Organ Procurement Costs, 62 Fed. Reg. 43,657,
43,668-69 (1997). During the fiscal year at issue, 1985, the regula-
tion challenged here was codified at s 405.439(e)(1); it is currently
codified at s 413.170(e)(1), and pursuant to the 1997 amendments
will be codified as amended at s 413.178(a). The 1997 amendments
also changed the numbers of the following sections cited in this
opinion: s 413.170(b)(1) will be codified as amended at s 413.172(a),
and s 413.170(d) will be codified at s 413.176. At the time of the
release of this opinion, title 42 of the 1997 Code of Federal Regula-
tions had not been released. Accordingly, the court will cite to the
1996 version of the regulations (or an earlier version if appropriate).
86 Stat. 1329, 1463-64, by extending Medicare coverage to
patients who have permanent kidney failure and require
either dialysis or a kidney transplant. See Medicare Pro-
grams; End-Stage Renal Disease Program; Prospective Re-
imbursement for Dialysis Services, 47 Fed. Reg. 6,556, 6,556-
57 (1982) (history of ESRD program). Medicare Part A, 42
U.S.C. ss 1395c to 1395i-4, covers inpatient dialysis services
provided by hospitals, while Medicare Part B, 42 U.S.C.
ss 1395j to 1395w-4, covers outpatient dialysis treatments by
hospital-based and independent providers (such as NMC).
Under the Part B reimbursement system in place before
1983 the Secretary paid an independent provider of outpa-
tient services 80% of the provider's "reasonable charge" (up
to $138 per treatment). See 42 C.F.R. pt. 405, subpt. E
(1982); 47 Fed. Reg. at 6,557. The Secretary paid an outpa-
tient hospital-based provider 80% of the "reasonable cost" per
treatment (also subject to a maximum of $138). See 42
C.F.R. pt. 405, subpt. D (1982); 47 Fed. Reg. at 6,557. The
Medicare beneficiary was responsible for the remaining 20%.
See 47 Fed. Reg. at 6,557.
Medicare also treated independent providers and hospital-
based providers differently for the purpose of reimbursing
"bad debts" run up by patients who did not pay their 20%
share. Medicare reimbursed hospital-based facilities for bad
debts as part of the reasonable cost reimbursement system.
See 42 C.F.R. s 405.420 (1982); 47 Fed. Reg. at 6,568. The
Secretary expected independent providers, however, "to ab-
sorb bad debts within the level of their charges." 47 Fed.
Reg. at 6,568.
The cost of the ESRD program rose significantly in the
1970s. Id. at 6,556. In order to contain that cost the
Congress passed the ESRD Program Amendments of 1978,
Pub. L. No. 95-292, 92 Stat. 307 (codified as amended in
scattered sections of 42 U.S.C.), in which it directed the
Secretary to prescribe by regulation methods and procedures
to "determine the costs incurred" by ESRD facilities, and to
"determine, on a cost-related basis or other economical and
equitable basis ... the amounts of payments to be made" for
dialysis services. 42 U.S.C. s 1395rr(b)(2)(B). The second
sentence of this new provision (which was deleted in 1981),
required that the new regulations provide incentives for cost
reduction and set either prospective or target rates. See
Pub. L. No. 95-292, s 2, 92 Stat. at 309.
In 1980 the Secretary proposed to adopt a prospectively
determined reimbursement rate, which the provider "would
retain, even if its costs were below that rate." Medicare
Program; Incentive Reimbursement for Outpatient Dialysis
and Self-Care Dialysis Training, 45 Fed. Reg. 64,008, 64,009
(1980). The Secretary rejected the "target rate" approach
under which there would be a "retroactive adjustment" to the
prospective rate at the end of the year so that the Govern-
ment and the provider would share in any cost savings. The
Secretary believed that this approach would not have the
same incentive for cost reduction as a prospectively set rate.
Id.
In the 1980 proposal the Secretary opined that it was
"appropriate to reimburse the facility for Medicare bad
debts," id. at 64,010, and considered two options for doing so.
The first was to "allow for the payment of bad debts written
off during the year in a special payment at the end of the
year." The second option was not to "allow a specific write-
off of bad debts" but to "include an allowance for bad debts in
the dialysis charge and the calculation of the [prospective]
rate." The Secretary chose the former option because it
"would permit [her] to pay each facility the exact amount of
its bad debts." Accordingly the 1980 proposal did not cap the
amount of bad debt that could be reimbursed per treatment.
Before the Secretary had issued a final rule implementing
the 1978 amendments, however, the Congress amended the
statute again, see Omnibus Budget Reconciliation Act of 1981,
Pub. L. No. 97-35, s 2145, 95 Stat. 357, 799-800 (codified at
42 U.S.C. s 1395rr), requiring the Secretary to adopt a
prospective payment system. See 42 U.S.C. s 1395rr(b)(7).
The Congress also modified sub-paragraph (b)(2)(B) of 42
U.S.C. s 1395rr by deleting the option of target rates and the
requirement that the Secretary promulgate regulations to
implement "appropriate incentives" for efficiency. As amend-
ed this subsection reads:
The Secretary shall prescribe in regulations any methods
and procedures to (i) determine the costs incurred by
providers of services and renal dialysis facilities in fur-
nishing covered services to individuals determined to
have end-stage renal disease, and (ii) determine, on a
cost-related basis or other economical and equitable basis
(including any basis authorized under section 1395x(v) of
this title) and consistent with any regulations promulgat-
ed under paragraph (7), the amounts of payments to be
made for part B services furnished by such providers and
facilities to such individuals.
The section to which reference is made defines "reasonable
costs" as the "costs actually incurred" in providing services;
it also prohibits "cross-subsidization" by requiring that the
Secretary
take into account both direct and indirect costs of provid-
ers of services ... in order that, under the methods of
determining costs, the necessary costs of efficiently deliv-
ering covered services to individuals covered by [Medi-
care] will not be borne by individuals not so covered, and
the costs with respect to individuals not so covered will
not be borne by such insurance program[ ].
42 U.S.C. s 1395x(v)(1)(A).
In the wake of the 1981 amendments the Secretary issued
another notice of proposed rulemaking, in which she said that
her
basic approach is to identify the legitimate costs of what
appear to be economically and efficiently operated dialy-
sis facilities and then, in setting the rates, to make
adjustments to reflect costs or savings attributable to
operation as a hospital-based facility or as an indepen-
dent facility.
47 Fed. Reg. at 6,563. Hence the Secretary audited a sample
of dialysis providers, identified the median cost per treat-
ment, and proposed that the prospective reimbursement rate
be based upon a composite figure reflecting the cost of both
in-facility treatment (for hospital-based and independent facil-
ities) and home dialysis. Id. at 6,561-64.
With respect to bad debts, in contrast, the Secretary
proposed to reimburse both hospital-based and independent
facilities retrospectively, but to cap the reimbursement at
each provider's allowable costs. Id. at 6,568. Apparently the
Secretary believed that the cap upon bad debt reimbursement
was required by the prohibition of cross-subsidization:
Since, under Part A of the Medicare program, costs of
covered services furnished beneficiaries are not to be
borne by individuals not covered by Medicare, the pro-
gram will pay that part of uncollectible deductible and
coinsurance amounts that brings the total of a provider's
reimbursement up to the costs of these services. Con-
versely, since the statute requires that the program pay
only for the costs of services related to care of beneficia-
ries, reimbursement for bad debts is limited in that we
will not pay any amounts that would result in total
reimbursement exceeding a provider's Medicare reason-
able costs.... We considered, and discussed in the 1980
NPRM, the possibility of including an amount for bad
debts in the rate, but have decided against it. Instead,
we plan to pay all dialysis facilities 100 percent of
allowable Medicare bad debts, up to their reasonable
costs, in a separate payment at the end of each facility's
cost accounting period.
Id.
The Secretary adopted the proposed rule with only minor
changes not here relevant. See Medicare Program; End-
Stage Renal Disease Program; Prospective Reimbursement
for Dialysis Services and Approval of Special Purpose Renal
Dialysis Facilities, 48 Fed. Reg. 21,254 (1983). The bad debt
reimbursement provision, which the appellants now challenge,
stated:
HCFA will reimburse each facility its allowable Medicare
bad debts, up to the facility's costs as determined under
Medicare principles, in a single lump sum at the end of
the facility's cost reporting period.
Id. at 21,278 (currently codified at 42 C.F.R. s 413.170(e)(1)
(1996)). In the preamble to the Final Rule the Secretary
justified the cap upon reimbursement for bad debts, as she
had in the 1982 NPRM, solely by reference to the statutory
prohibition of cross-subsidization. 48 Fed. Reg. at 21,273.
The Secretary also clarified the process by which bad debts
will be reimbursed: the Secretary subtracts the provider's
revenue, including both the 80% payment and any co-payment
or deductible actually collected, from its reasonable cost, in
order to determine the provider's "unrecovered costs." If the
provider has made reasonable efforts to recover these
amounts, then the program pays the lesser of the provider's
unrecovered costs or the amount of the uncollected coinsur-
ance and deductible.
B. The Transaction
In April 1984 NMC entered into negotiations with W.R.
Grace & Co. regarding the possibility of Grace's acquiring
NMC through an exchange of stock. Eventually the parties
agreed to structure the transaction as a leveraged buy-out.
The parties met on July 23 to negotiate the terms of such a
deal in which Grace and certain members of NMC's manage-
ment would participate. These so-called "Management In-
vestors" included Dr. Constantine L. Hampers, Chairman and
CEO, as well as certain senior officers and directors.
When the parties had tentatively agreed upon a price of
$19.50 per share of NMC, Dr. Hampers presented the trans-
action to NMC's board of directors. The board instructed
Dr. Hampers to continue negotiations and appointed a com-
mittee of independent directors to evaluate the proposal and
to make a recommendation to the full board. The indepen-
dent directors retained their own legal counsel and invest-
ment bankers.
In August the parties agreed to a final price of $19.25 per
share. After obtaining various changes to the form of the
transaction the independent directors recommended the
merger to the full NMC board, which approved, as did the
shareholders of NMC.
Pursuant to the merger agreement, NMC (called "Old
NMC") was acquired through the use of two newly formed
entities, NMC Holding Corporation and its wholly owned
subsidiary, NMC Acquisition Corporation. In December
1984 Old NMC was first acquired by and then merged with
NMC Acquisition. The resulting company in turn merged
with NMC Holding in June 1985 and the surviving corpora-
tion changed its name to National Medical Care, Inc. ("New
NMC"). By January 1990, five years after the merger, Grace
had acquired all of the shares of New NMC.
At its formation in 1984 the voting securities of NMC
Holding were owned 49.99% by Grace, 37.20% by the Man-
agement Investors, and 12.81% by the so-called Physicians
Group, which was made up of medical directors of NMC's
dialysis facilities. Grace received options permitting it to
purchase additional shares sufficient to give it 65% of the
voting securities. Most of the money NMC Holding used to
buy Old NMC came from bank borrowings ($315 million) and
from the sale of NMC Holding stock to Grace ($65 million),
with the Management Investors contributing only about $2
million through the purchase of NMC Holding stock. The
Management Investors and Grace could each chose four of
the eight directors of NMC Holding. Several officers and
directors of Old NMC occupied the same positions with NMC
Holding.
C. Procedural History
For fiscal year 1985 the NMC providers claimed as allow-
able Medicare costs certain expenses relating to the transac-
tion between Old NMC and NMC Holdings, including depre-
ciation of tangible assets, amortization of intangible assets,
and interest for financing the purchase of these assets. The
fiscal intermediary, a private entity that the Secretary en-
gages to determine the amounts payable to Medicare provid-
ers, see 42 U.S.C. s 1395h, disallowed some of these costs.
The NMC providers appealed that decision to the Provider
Reimbursement Review Board. The PRRB held that the
two-step merger between Old NMC and NMC Holding did
not involve related entities and that most of the expenses the
NMC providers incurred in connection with the merger were
therefore reimbursable. Upon further appeal the Adminis-
trator of the HCFA, acting on behalf of the Secretary, held
that the merger was between related parties and therefore
disallowed all relevant costs.
The NMC providers filed suit in the district court challeng-
ing the regulation capping reimbursement for bad debts and
the Secretary's final decision that Old NMC and NMC Hold-
ing were related entities. The court granted the Secretary's
and denied NMC's motion for summary judgment. The court
held the regulation was not "arbitrary and capricious" in
violation of the Administrative Procedure Act, and was rea-
sonable under the two-step analysis of Chevron U.S.A. Inc. v.
Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
As to the related-party issue, the court held that the Secre-
tary's decision that Old NMC and NMC Holding were related
entities is supported by substantial evidence, and in particular
by the role of the Management Investors in the transaction.
II. Analysis
We review the Secretary's Medicare reimbursement deci-
sions pursuant to the standards of the Administrative Proce-
dure Act. See 42 U.S.C. s 1395oo(f)(1). The NMC providers
claim that (1) the Secretary's determination that Old NMC
and NMC Holding were related by control is not supported
by substantial evidence; and (2) the regulation governing bad
debt reimbursement is (a) not in accordance with law, under
the standards of Chevron steps one and two, and (b) arbitrary
and capricious.
A. The Merger Issue
The NMC providers claim that the 1984-85 change in the
ownership of NMC did not involve a related-party transaction
within the meaning of the Medicare regulations. Therefore,
they maintain, the Secretary should have permitted them to
include the costs associated with the merger in their 1985 cost
reports, thereby increasing the amount for which they could
be reimbursed under the bad debt cap.
In general, depreciation and interest costs incurred in the
acquisition of assets used to provide covered services are
allowable Medicare costs. 42 C.F.R. ss 413.134(a),
413.153(a)(1) (1996). Depreciation must be based upon the
present owner's "historical cost" of acquiring the asset. Id.
s 413.134(a)(2), (b)(1). When a Medicare provider is pur-
chased by another organization the regulations permit the
acquiring organization, for the purpose of calculating its
allowable Medicare costs, to "revalue" the assets of the
acquired provider up to the acquiring organization's cost of
purchasing the assets. See id. s 413.134(g).
The regulations governing reimbursement of the cost of
providing services to Medicare beneficiaries state that
costs applicable to services, facilities, and supplies fur-
nished to the provider by organizations related to the
provider by common ownership or control are includable
in the allowable cost of the provider at the cost to the
related organization.
Id. s 413.17(a). This rule is intended to prevent related
parties from using transfer prices to inflate the cost of their
inputs. See Biloxi Regional Med. Ctr. v. Bowen, 835 F.2d
345, 349-50 (D.C. Cir. 1987). The rule also provides that a
party is "related to the provider" if "the provider to a
significant extent ... has control of or is controlled by the
organization furnishing the services, facilities, or supplies."
42 C.F.R. s 413.17(b)(1) (1996). Control is, in turn, defined
as "the power, directly or indirectly, significantly to influence
or direct the actions or policies of an organization or institu-
tion." Id. s 413.17(b)(3). The Secretary's guidance on the
meaning of the regulation elaborates:
The term "control" includes any kind of control, whether
or not it is legally enforceable and however it is exercisa-
ble or exercised. It is the reality of the control which is
decisive, not its form or the mode of its exercise.
U.S. Dep't of Health & Human Services, Medicare Provider
Reimbursement Manual, Part I, s 1004.3, reprinted in 1
Medicare & Medicaid Guide (CCH) p 5700 (Nov. 1994) (here-
inafter the Manual).
The appellants do not dispute that if the NMC merger was
a related-party transaction, then the costs associated with the
merger are not reimbursable by the Secretary. The question
over which the parties are divided is whether the transaction
between Old NMC and NMC Holding was in fact between
related parties within the meaning of the regulations. The
Secretary's decision that Old NMC and NMC Holding were
related by control must be upheld if it is supported by
substantial evidence in the record. 5 U.S.C. s 706(2)(E); see
also Biloxi Regional Med. Ctr., 835 F.2d at 349 n.13.
There certainly is substantial evidence in the record sup-
porting the Secretary's anterior determination that the Man-
agement Investors had the power significantly to influence
the actions of both Old NMC and NMC Holding. That
finding is itself sufficient to support the Secretary's conclu-
sion that the firms were related by control. Because the
Management Investors held key positions on the board and in
the management of Old NMC, they were clearly in a position
to influence the board to recommend, and the shareholders of
Old NMC to approve, the transaction.
The Management Investors also had the ability significant-
ly to influence NMC Holding. They had the power to appoint
four of the eight members of the board and they held at NMC
Holding essentially the same management and board posi-
tions that they had held with Old NMC. As a group they
owned 37.20% of the voting securities of NMC Holding, and
together with the Physician's Group--i.e. managers employed
by the separate NMC facilities--controlled 50.01% of the
voting shares. That the Management Investors were able to
retain their positions and to come out owning a sizable
portion of the voting securities of NMC Holding, while con-
tributing only a small portion of the purchase money (approx-
imately $2 million), further supports the inference that they
controlled NMC Holding.
In addition, the chief negotiator for Old NMC (Dr. Ham-
pers) was also one of the Management Investors in NMC
Holding. He was essentially negotiating on both sides of the
transaction. In fact, he signed the Merger Agreement on
behalf of all three parties--Old NMC, NMC Holding, and
NMC Acquisition. There is, therefore, substantial evidence
to support the Secretary's conclusion that the acquisition of
Old NMC was a transaction between related parties.
The appellants raise several arguments in an attempt to
avoid this conclusion. First, they argue that the Secretary's
interpretation of the related-party rule runs afoul of this
court's decision in PIA-Asheville, Inc. v. Bowen, 850 F.2d
739, 741 (D.C. Cir. 1988), where we invalidated as unrealistic
and therefore arbitrary the Secretary's rule that a two-step
merger is per se a related-party transaction. The appellants
contend that in this case the Secretary "artificially treated
NMC Holding rather than Grace as the acquiring party and
failed to analyze the transaction as a whole to determine if
the purchase price for the NMC shares was the result of an
arm's-length transaction." Indeed, they suggest that Grace
and Old NMC had agreed upon the purchase price before
NMC Holding even existed; therefore the focus of the inqui-
ry should be upon the relationship between Grace and Old
NMC--two parties that clearly were not related.
The appellants err in thinking PIA-Asheville helps their
cause; the Medicare provider in that case came to be con-
trolled by a previously unrelated company through a two-step
acquisition, which the court held should be treated as a single
integrated transaction. In this case a group of individuals
with a significant stake in the acquiring company were in
control of the acquired company. In any event, to the extent
that the appellants' argument goes to the validity of the
Secretary's interpretation of the rule defining a "related
party," the Secretary's reasonable interpretation is entitled to
our deference. See, e.g., Marymount Hosp., Inc. v. Shalala,
19 F.3d 658, 661 (D.C. Cir. 1994). The Secretary interpreted
the definition to require an examination of the relationship
between the seller and the actual buyer--hardly an unreason-
able interpretation of the rule.
Although Old NMC and Grace may have originally contem-
plated that Grace would be the buyer through an exchange of
stock, in the actual transaction NMC Holding was the buyer.
NMC Holding was owned by the Management Investors and
the Physicians' Group as well as by Grace; indeed, Grace did
not own even a controlling interest in NMC Holding. More-
over, the appellants' suggestion that the acquisition price
"was negotiated between Grace and NMC at arm's length at
a time when they were clearly unrelated" is contrary to the
evidence. Dr. Hampers and representatives of Grace dis-
cussed price on only one occasion prior to the parties' decision
to structure the transaction as a leveraged buy-out. Most of
the price negotiations took place after the parties had decided
that the Management Investors would be participating in the
leveraged buy-out through NMC Holding. By that point Dr.
Hampers was dealing on both sides of the transaction, not at
arm's length.
Second, the appellants argue that even if the transaction is
viewed as one between NMC Holding and Old NMC, there
was no control relation because NMC Holding could not
control the decision of the Old NMC shareholders to approve
the transaction. The appellants also point out that the inde-
pendent directors, whom the Management Investors did not
control, approved the transaction.
The appellants' implicit reliance upon the "fairness" of the
transaction--as reflected in the participation of the indepen-
dent directors--is insufficient to undermine the Secretary's
conclusion. As long as the parties are related, fairness is
irrelevant: the Secretary need not show that the terms of
their transaction are unfair, see Stevens Park Osteopathic
Hosp., Inc. v. United States, 633 F.2d 1373, 1379 (Ct. Cl.
1980); cf. Biloxi Regional Med. Ctr., 835 F.2d at 350; West
Seattle Gen. Hosp., Inc. v. United States, 674 F.2d 899, 904
(Ct. Cl. 1982), and the parties may not show that they were
fair. Nor does the Old NMC shareholders' having final
authority to approve the transaction mean that Old NMC and
NMC Holding were not in fact related by common control.
Such control may obtain in fact "whether or not it is legally
enforceable." Manual s 1004.3, supra, at p 5700.
In sum, there is overwhelming evidence in the record that
the Management Investors had the power "significantly to
influence or direct the actions or policies" of both the buyer
and the seller. Therefore, the Secretary's decision that the
two parties were related by control is supported by substan-
tial evidence.
B. Cap Upon Reimbursement for Bad Debts
The appellants claim that the rule capping reimbursement
for bad debt at the provider's cost of service is inconsistent
with the statute and therefore invalid under the familiar tests
of Chevron U.S.A. Inc. v. Natural Resources Defense Coun-
cil, Inc., 467 U.S. 837 (1984). The appellants also maintain
that the regulation is arbitrary and capricious and therefore
invalid under 5 U.S.C. s 706(2)(A).
Under Chevron step one the court asks "whether Congress
has directly spoken to the precise question at issue," Chevron,
467 U.S. at 842; if so, then we "must give effect to the
unambiguously expressed intent of Congress." Id. at 843. If
the Congress has not addressed the issue, however, then
under Chevron step two we must determine whether the
agency's interpretation of the statute is reasonable. Id.
The NMC providers argue that the bad debt reimburse-
ment regulation fails under Chevron because (1) the Congress
required a prospective-rate system, whereas the cap upon
reimbursement for bad debts is based upon a retrospective
calculation; and (2) the Congress intended to provide an
incentive for increased efficiency in the provision of dialysis
services, whereas the cost limitation upon reimbursement for
bad debts reduces the provider's incentive to hold down its
costs.
We conclude that the regulation passes muster under Chev-
ron step one because the statute does not speak directly to
the question of bad debt. The statute generally requires the
Secretary to pay 80% of a prospectively determined rate.
See 42 U.S.C. ss 1395rr(b)(2)(A) & (b)(7). No provision in
the statute, however, specifically addresses how bad debt is to
be reimbursed; indeed, there is no clear requirement in the
statute that bad debt be reimbursed at all. Therefore, we
must defer to the Secretary's interpretation unless it is
unreasonable.
We are unable confidently to evaluate the reasonableness of
the Secretary's statutory interpretation under Chevron step
two, however, because the Secretary has provided an incoher-
ent justification for her decision to cap reimbursement for
bad debts. The only statutory authorization the Secretary
relied upon in the rulemaking record for her decision to cap
reimbursement for bad debts is the prohibition of cross-
subsidization in 42 U.S.C. s 1395x(v). In the preamble to the
final rule the Secretary decided to cap reimbursement for bad
debts at the provider's reasonable cost because "the statute
requires that [Medicare] pay only for the costs of services
related to care of beneficiaries." 48 Fed. Reg. at 21,273.
Before this court counsel for the Secretary understandably
wants to present a different account of the Secretary's rea-
soning. The Secretary's brief thus suggests that the cap
upon bad debt reflects the balance she struck between the
prohibition of cross-subsidization and the statutory require-
ment that Medicare pay 80% and beneficiaries pay 20% of the
prospective rate. She argues that historically Medicare reim-
bursed providers for their bad debts based upon the Secre-
tary's statutory mandate to avoid cross-subsidization. When
the Congress amended the statute to require a prospective
payment system it retained, in the section directing the
Secretary to promulgate regulations governing the rate to be
paid for dialysis services (s 1395rr(b)(2)(B)), the express
cross-reference to the provision defining reasonable cost and
prohibiting cross-subsidization (s 1395x(v)). That is, the stat-
ute permitted the Secretary to set the rate upon "any basis
authorized under" s 1395x(v), which apparently would include
a rate based upon "reasonable cost" and the prohibition of
cross-subsidization. Because the Secretary based the pro-
spective rate upon reasonable cost principles, she argues, "it
makes perfect sense" that she chose to cap bad debt at cost in
order to comply with the prohibition of cross-subsidization.
We reject the Secretary's attempt in this litigation to
articulate a new justification for the cap upon bad debt. The
record does not support the Secretary's contention that she
engaged in a balancing of the kind she describes. The
Secretary acknowledges that her balancing is "not detailed"
in the rulemaking record, but we do not think it is even
implicit.
More important, we conclude that the Secretary's explana-
tion for the cap upon bad debt reimbursement that is in the
record is inconsistent with the prospective rate scheme of the
statute. A prospective payment rate based upon the median
provider's cost per treatment by definition overcompensates
some Medicare providers and undercompensates others. In-
sofar as the Secretary reimburses some providers more than
their actual cost of treating Medicare beneficiaries, she is
effectively subsidizing services for non-beneficiaries--at least
as contemplated by the Congress in s 1395x(v)(1)(A). Con-
versely, if the Secretary reimburses other providers less than
their actual costs, then those providers will shift costs to non-
beneficiaries--again, at least so far as the statute is con-
cerned.2
Nonetheless, with respect to bad debt the Secretary sug-
gested in the preamble to the final rule that the prohibition of
cross-subsidization required her to cap reimbursement at the
individual provider's actual cost. The rulemaking record,
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2 We are aware of no reason to believe that a Medicare provider
that is overcompensated by Medicare would take the occasion to
subsidize its non-Medicare patients; nor can we imagine why a
Medicare provider that is undercompensated would continue to
participate in the Medicare program. The Congress appears to
have assumed in s 1395x(v)(1)(A), however, that just such cost-
shifting would occur. As neither party to this case takes issue with
that premise, nor shall we.
however, provides no clear rationale for why the statute
requires her to consider the prohibition of cross-subsidization
in reimbursing for bad debt, when the requirement of the
statute that she set a prospective rate is itself inconsistent
with the prohibition of cross-subsidization. Until the Secre-
tary provides such an explanation we cannot conclude that the
prohibition of cross-subsidization justifies the cap upon bad
debt reimbursement.
The appellants also argue that the cap upon reimbursement
for bad debts is arbitrary and capricious because there is not
a similar cap upon reimbursement for bad debts under Part
A, which applies to dialysis treatments provided to hospital
inpatients. See 42 C.F.R. s 412.115(a) (1996). The Secretary
counters that the section of the Medicare statute creating the
Part A prospective payment system, 42 U.S.C. s 1395ww,
does not authorize her to draw upon the prohibition of cross-
subsidization in s 1395x(v).
The appellants' argument further highlights the difficulty
with the Secretary's reliance upon the prohibition of cross-
subsidization as the sole justification for the cap upon reim-
bursement for bad debt. If, as the Secretary argues, the only
statutory basis for reimbursing bad debt is the prohibition of
cross-subsidization, then she must not be authorized to reim-
burse bad debt under Part A because Part A does not refer to
the prohibition of cross-subsidization.
In sum, the Secretary's only explanation for the cap upon
reimbursement for bad debt is the necessity to avoid cross-
subsidization, but a prospective rate scheme necessarily en-
tails a certain amount of cross-subsidization. Because the
Secretary's explanation of the rule is inadequate, we cannot
evaluate whether the Secretary's interpretation of the statute
is reasonable within the meaning of Chevron step two. For
the same reason, we cannot resolve the appellants' argument
that the cap upon reimbursement for bad debt is severable
from the rest of the regulation. Accordingly, we vacate the
rule and remand this matter for the Secretary either to
provide a more adequate explanation of the bad debt cap or to
jettison it.
III. Conclusion
We hold that: (1) The Secretary's decision that the merger
between Old NMC and NMC Holding was a related-party
transaction is supported by substantial evidence; but (2) the
Secretary has not adequately justified the rule capping reim-
bursement for bad debts, as a result of which her order
adopting the rule is arbitrary and capricious. At the same
time we are unable to evaluate whether the Secretary's
interpretation of the statute is permissible under Chevron
step two. Therefore, we vacate and remand this matter for
further proceedings not inconsistent with this opinion.
So ordered.