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April 25, 1979

HOSPITAL ASSOCIATION OF NEW YORK STATE, INC., Misericordia Hospital Medical Center, Buffalo General Hospital, the Genesee Hospital, and the Mount Sinai Hospital on behalf of themselves and all other nonprofit hospitals which are members of the Hospital Association of New York State, Inc. and which are reimbursed for Medicaid services rendered to hospital patients, Plaintiffs,
Philip L. TOIA, as Commissioner of Social Services of the State of New York, Robert P. Whalen, as Commissioner of Health of the State of New York, Peter Goldmark, as Director of the Budget of the State of New York, Hugh L. Carey, as Governor of the State of New York, and David Mathews, as Secretary of the U. S. Department of Health, Education & Welfare, Defendants

The opinion of the court was delivered by: LASKER

One of the results of the explosion of medical knowledge in the past century has been a radical increase in the expenditure of resources for cure, prevention and research. At least in part because increasingly sophisticated medical processes and techniques are more costly, and because this is an age of developing social programs, a wide variety of regulated plans now exist to finance the care of the sick. In some countries the plans provide comprehensive care of all sickness regardless of the age or economic circumstances of the patient. In this country, the two governmentally financed plans are Medicare (Pub.L. 89-97, Title I, July 30, 1965, which provides health insurance for the aged) and Medicaid (42 U.S.C. § 1396 Et seq.) intended to assist the medically indigent, who are defined by statute as "families with dependent children and . . . aged, blind or disabled individuals, whose income and resources are insufficient to meet the costs of necessary medical services."

This case deals with significant questions arising under the Medicaid statute. To put the issues in perspective a review of the checkered history of the case is necessary.


 Congress enacted the Medicaid statute in 1966 as Title XIX of the Social Security Act (42 U.S.C. § 1396 Et seq.). The program is administered by the states pursuant to statute and regulations of the federal Department of Health, Education and Welfare (HEW). Under § 1396a(a)(13)(D) providers of inpatient hospital services, such as the plaintiffs here, are entitled to reimbursement by the states for the "reasonable cost" of their services, "as determined in accordance with methods and standards . . . reviewed and approved by the Secretary and . . . included in the (state Medicaid plan)." The ultimate cost of Medicaid reimbursement to hospitals is shared equally between the state and the federal government.

 Since 1970, New York State has used a prospective methodology to compute the reimbursable "reasonable costs" of hospitals. The system attempts to predict costs for a forthcoming year and is part of the State Medicaid plan. Normally, at the end of each calendar year, the State publishes reimbursement rates for each hospital group *fn1" for the forthcoming year. However, at the end of 1975, faced with rising hospital costs and its own financial instability, New York took action, by issuance of interim rates which in essence froze the 1975 rates.

 In May, 1976, the plaintiffs, a class consisting of 270 voluntary and public hospitals in New York State, brought this suit claiming that the freeze was illegal because it 1) amended the State plan without approval by the Secretary of HEW as required by 42 U.S.C. § 1396a(a)(13)(D) and 2) deprived them of reimbursement of their "reasonable costs."

 In July, 1976, the State promulgated a revised formula for determining the 1976 rates. The revision included significant changes in the earlier method of computation. In particular, 1) it lowered the ceiling on reimbursable costs for "routine" inpatient services from 110% To 100% Of the average of the costs for the group of hospitals to which the hospital being reimbursed belonged; 2) for the first time it imposed a ceiling (of 100% Of average) on reimbursement for "ancillary" inpatient costs; and 3) it reduced to 90% The earlier 100% Reimbursement of salaries of interns and residents.

 On July 16, 1976, the plaintiffs amended their complaint to specify objections to the new formula and moved to restrain the defendants from implementing the amendments until they were approved by HEW. An injunction granting that relief was issued August 2, 1976.

 Effective January 1, 1976, Congress had required states participating in the Medicaid program to consent to suits in federal court by hospitals which claimed that the state was not in compliance with the reimbursement requirements of the statute (see 42 U.S.C. § 1396a(g)). Pursuant to this statute, but under protest, New York had executed a consent to suit. On October 18, 1976, the mandatory waiver of immunity provisions were repealed "effective January 1, 1976." (Pub.L. 95-452) Upon the enactment of the repealing statute, the State moved, under the Eleventh Amendment, to dismiss the suit as to itself. The motion was granted by this court, Hospital Association of New York State, Inc. v. Toia, 435 F. Supp. 819 (S.D.N.Y.1977) Aff'd, 577 F.2d 790 (2d Cir. 1978). The Secretary of HEW concurrently moved to dismiss on the grounds of mootness but that motion was denied since HEW's role in the approval process was found to be "capable of repetition, yet evading review," within the rule of Southern Pacific Terminal Co. v. Interstate Commerce Commission, 219 U.S. 498, 515, 31 S. Ct. 279, 283, 55 L. Ed. 310 (1911); United States v. W. T. Grant Co., 345 U.S. 629, 632, 73 S. Ct. 894, 97 L. Ed. 1303 (1953); and Moore v. Ogilvie, 394 U.S. 814, 816, 89 S. Ct. 1493, 23 L. Ed. 2d 1 (1969).

 Governing Law

 42 U.S.C. § 1396a(a)(13) provides that:

"A State plan for Medical assistance must . . . provide . . . for payment of the reasonable cost of inpatient hospital services . . . in accordance with methods and standards . . . developed by the State and reviewed and approved by the Secretary . . ."

 The Secretary has specified criteria by which the approvability of a state plan is to be determined:

". . . criteria for approval will include:
(a) Incentives for efficiency and economy;
(b) Reimbursement on a reasonable basis: . . .
(d) Assurance of adequate participation of hospitals and availability of hospitals services of high quality to title XIX recipients . . ."
"(a) State plan requirements: A State plan for medical assistance under title XIX of the Social Security Act must: . . .
(2) Provide for payment of the reasonable cost of inpatient hospital services as determined in accordance with methods and standards, consistent with the provisions of section 1122 of the Social Security Act for participating States which shall be developed by the State . . ." (45 C.F.R. 250.30 (1976).

 The hospitals contend that HEW's review and approval of the State plan were arbitrary and capricious in giving inadequate attention to the statutory and regulatory criteria for approval and that HEW's conclusions that the criteria were satisfied were based on clear errors of judgment. See Hospital Association of New York State, Inc. v. Toia, 438 F. Supp. 866 at 879 Et seq. (S.D.N.Y.1977). To understand how the regulatory criteria were applied in reviewing the New York State system, it is necessary to describe how the State computed reimbursement rates in 1976, and how HEW went about reviewing the validity of the plan.

 How the Plan Works

 The prospective reimbursement system works in the following manner. *fn2" In the "base" year, which is two years prior to the payment, or "rate," year, the State compiles the actual inpatient costs for all of its Medicaid hospitals. On the basis of this compilation, the State computes allowable costs (described below), and these are used to determine how much hospitals will be paid at the beginning of the rate year.

 The first step in the derivation of allowable costs is the computation of the average costs (routine and ancillary) that each hospital incurs in treating a Medicaid patient. To obtain this average, the state divides each hospital's total routine costs by its total patient days, and divides each hospital's total ancillary costs *fn3" by total patient discharges.

 Every hospital's average cost is then compared with the average cost of other hospitals in its peer group. *fn4" The comparison yields an average for the entire group, the "group average" (sometimes referred to as the "ceiling"). After the disallowance of costs in excess of the group average, if any, each hospital's allowable costs (routine and ancillary) are, with some additions, "trended forward" to compensate for inflation, and, with the addition of allowable capital costs and the conversion of the total costs to per diem amounts, become the hospital's Medicaid reimbursement rate in the rate year. *fn5"

 As stated above, in 1976 the amount of the prospective ceiling was set exactly at the average. That is, every hospital was to receive no more than 100% Of the trended, base year group average. This marked a substantial change over 1975, when hospitals' rate year maximum reimbursement was set at 110% Of their peer group's average per diem cost. Furthermore, under the 1976 plan, the 100% Ceiling on prospective payments was applied to both routine and ancillary costs. In 1975, only routine costs had been subjected to the ceiling. Also, the 1976 plan reduced reimbursement of interns' and residents' salaries from 100% To 90%. Finally, the 1976 plan contained an expanded appeals provision, *fn6" which permitted hospitals to recoup, upon a proper showing, the costs that were disallowed as being in excess of the ceiling.

 HEW Review Process and Rationale of Approval

 Pursuant to its statutory and regulatory obligations, HEW reviewed and approved the 1976 amendments (although the approval was issued after they had been put into effect). The review process began shortly after HEW received the amendments, in December, 1975. This review consisted of analysis by the HEW regional staff, as well as correspondence and meetings with both the State and HEW's central office in Washington, D.C. Moreover, although there was no statutory or regulatory obligation to do so, HEW kept the Hospital Association of the State of New York, Inc. ("HANYS") abreast of the amendments being proposed by the State, and solicited and received from HANYS detailed statements, as well as live presentations, of HANYS' views with regard to the proposed changes.

 In its review of the 1976 amendments, HEW focused on the projected "impact" of the lowered ceilings, which, as indicated above, limited prospective reimbursement of routine and ancillary Medicaid costs to 100% Of the group average and disallowed 10% Of the salaries of interns and residents. In an array of tables (PX-1 at 86-120, 162-205, 978-1061, especially, 115-120, 999-1000, 1008-12, 1058-61) the State provided statistics that variously represented the effect of the lowered ceilings by showing: the absolute difference between each hospital's Medicaid costs and the Medicaid ceilings, (the difference is known as the Medicaid Disallowance); that difference expressed as a percentage of the hospital's total inpatient cost, *fn7" and a comparison of the 1975 and 1976 Medicaid reimbursement rates.

 What the State's tables purported to show was that, when expressed in percentage terms, the impact of the lowered ceilings would, for approximately 90% Of the hospitals, be a Medicaid Disallowance of between 0 and 2% Of total inpatient cost. *fn8" (PX-1 at 116) For HEW, this statistic was crucial: there is no dispute that the agency's conclusion that the plan measured up to the statutory and regulatory criteria *fn9" was based on its view that the impact of the 100% Average ceiling was minimal *fn10" and that hospitals that were dissatisfied with their rate of reimbursement could appeal. Seymour Budoff, an Associate Regional Commissioner at the time of approval, broadly summarized HEW's rationale:

". . . to the extent (that) the hospital had costs above the peer group average which it could justify, it would get those costs reimbursed (on appeal) and to the extent that the costs . . . were above the group average . . . and were inefficiently produced . . . the hospital through prudent management would reduce those costs and not have a deficit . . . (I)n the aggregate . . . (the) impact was about two percent of total inpatient cost, which seemed like an attainable goal for the hospitals to reach." (Tr. 2688-89).

 In somewhat more detail, HEW's conclusion was reached in the following manner. First, with regard to its decision that the 1976 plan satisfied the reasonable cost criterion, HEW viewed the amendments as giving rise to a two-phased reimbursement system. The first phase was the prospective one, in which, at the beginning of the rate year, each hospital would receive reimbursement on the basis of 100% Of the base year group average. HEW decided that a plan that, at worst, inflicted a disallowance of 2% Of total inpatient cost provided reimbursement on a reasonable basis. This decision was based on a number of factors. First, to the extent that the disallowance represented a penalty on costs that exceeded a hospital's Peer group's Average cost, HEW viewed the disallowance as a prohibition of inefficient costs (Tr. 762-63, 765, 2261, 2688-89; see also, Id. at 2276, 2311, 2365) which, under the Medicaid statute and regulations, are not subject to reimbursement. HEW considered the conclusion that above-ceiling costs were inefficient to be supported by its judgment that there was universal inefficiency within the hospital industry (Tr. 385-89, 2307, 2697-99; see also, Id. at 2275). Moreover, HEW concluded that whatever the reason a hospital's costs exceeded the ceiling, the State plan provided a safety valve for those hospitals for which imposition of the 100% Average resulted in reimbursement of less than the reasonable cost of their services: they could appeal. In HEW's judgment, the State plan's appeals process gave all hospitals an opportunity to justify their above-average costs; upon a showing that these costs were not the result of inefficiency, hospitals would recoup the amount of the disallowance. HEW believed that it was fair to remit the hospitals to the appeals procedure to recover what, for more than 90% Of the hospitals, was a relatively small sum.

 As for the requirement that the State plan provide for "adequate participation of hospitals" and the availability of "services of high quality," HEW concluded that since, participation and quality of care had been excellent, under the prior plan, the minimal impact would neither drive hospitals away from the Medicaid program nor force a significant reduction in the quality of service.

 With regard to incentives for efficiency and economy, HEW concluded that once it received notice of its projected, rate year payments and its disallowance (if any), a hospital would institute measures to trim unnecessary "fat" from its costs.

 Plaintiffs' Attack on HEW's approval

 In particular, the hospitals challenge (1) HEW's reliance on the State's "impact tables," which, they claim, were generated by an incorrect formula and (2) HEW's approval of the appeals system, which is said to have been inchoate at the time the State presented it for agency review. Other objections to HEW's approval are that:

to the extent that the agency's approval was based on a presumption of industry-wide inefficiency, the presumption was both impermissible and unfounded,
both the methods used to construct peer groups (from which the per diem group average was computed) and the statistical formula for determining the group average were faulty; the impact tables excluded cost data from hospitals belonging to the New York City Health and Hospitals Corporation ("HHC"),
the cut in reimbursement of interns' and residents' salaries was thoughtlessly made and thoughtlessly endorsed,
use of the 100% Ceiling would, over a period of years, create a continuously declining rate of reimbursement, and
the State's failure to submit the plan to the State medical advisory committee ("MAC") prior to presenting it to HEW should have warranted HEW's rejection of the amendments. *fn11"
The Legal Framework of the Case
Before proceeding to findings with respect to plaintiffs' claims, it is necessary to define the legal framework within which the findings are made, and, to this end, a certain amount of procedural history must be recited.
The hospitals' pleadings in this action contained allegations against both the State and HEW. Against the State, it was claimed that the 1976 plan was substantively inadequate; and, as has been discussed above, the charge against HEW was that its review and approval procedures had been faulty.
The case against the State was ultimately dismissed as moot. Memorandum opinion of November 17, 1978, Aff'd, Hospital Association of New York State, Inc. v. Toia, 577 F.2d 790 (2d Cir. 1978). The case against HEW was retained: against the agency's argument that the Secretary's approval was a matter committed to agency discretion (and therefore, judicially unreviewable), we ruled that the manner in which the Secretary reached the decision to approve was a proper subject for judicial review, Hospital Association of New York State, Inc. v. Toia, supra, 438 F. Supp. at 868-69, and that the approval methods were capable of repetition but evading review. Southern Pacific Terminal Company v. Interstate Commerce Commission, 219 U.S. 498, 515, 31 S. Ct. 279, 55 L. Ed. 310 (1911). The decision that the manner of approval was judicially reviewable was based primarily on the existence of agency regulations, 45 C.F.R. 250.30(a)(2)(ii), that listed explicit criteria *fn12" to be considered in the approval process; it was proper for the court to determine whether the Secretary had considered the criteria (and whether his consideration was adequate) in reaching his decision to approve the plan.
The parties were informed, both orally (at numerous pretrial conferences) and by way of opinion issued in connection with plaintiffs' motion for summary judgment and defendant's motion to dismiss, that in the case against HEW, the merits of the 1976 plan long since altered and the correctness of the Secretary's conclusions about that plan were not at issue: *fn13" the sole issue which remained for trial was whether HEW had properly discharged its statutory and regulatory obligations in reaching its conclusions.
This issue whether the Secretary had properly considered the relevant criteria was designated one of "procedure," and the designation was intended to underscore our refusal to review the merits of the State plan. To a certain extent, both parties have misapprehended our earlier rulings on this point.
In its post-trial brief, the government argues that the only question before the court is:
"the narrow procedural issue: whether HEW violated the Administrative Procedure Act or the Due Process clause by failing to adhere to a required procedural mandate, such as opportunity to be heard, etc." (HEW Brief at 190) *fn14"
The government goes on to argue that since the Secretary's approval constitutes informal decision making as opposed to adjudication or rule making (See 5 U.S.C. §§ 553, 554, 556, 557), the Administrative Procedure Act does not impose any procedural standards on the Secretary. Neither, claims the government, do the Medicaid Act or the regulations thereunder. Finally, HEW argues that the due process clause of the Fifth Amendment does not apply (HEW Brief at 218, citing Langevin v. Chenango Court, 447 F.2d 296, 300-302 (2d Cir. 1971)) and that in any event, the hospitals did not press the due process claim at trial. *fn15"
Satisfied that all relevant procedures were complied with and pointing out that the court may not impose additional procedures and then sanction the agency for not having followed them, Vermont Yankee Nuclear Power Corp. v. Natural Resources Defense Council, Inc., 435 U.S. 519, 98 S. Ct. 1197, 55 L. Ed. 2d 460 (1978), *fn16" the government urges that there is no basis for overturning the Secretary's actions.
In sum, HEW's argument is as follows:
1. This court earlier ruled that the only issue against HEW was a narrow one of procedural due process.
2. No procedural due process claims may be asserted against the Secretary because none of the applicable statutes or regulations imposes any procedural due process requirements upon the Secretary's approval.
3. Vermont Yankee precludes imposition by the court of any additional procedural requirements.
Despite its internal consistency, the government's argument on this point is incorrect because it ignores what was specified as the single remaining issue in the case (in which HEW is the sole remaining defendant): whether the Secretary's approval was based on due consideration of the criteria established by the C.F.R. Accordingly, the question for decision is whether the Secretary's actions were "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." 5 U.S.C. § 706(2)(A). *fn17" Judged by this standard, the issue is whether the agency acted without taking account of all "relevant factors, and whether there has been a clear error of judgment," Citizens to Preserve Overton Park, Inc. v. Volpe, infra, 401 U.S. at 416, 91 S. Ct. at 824; United States v. Nova Scotia Food Products Corp., 568 F.2d 240, 251 (2d Cir. 1977); Hooker Chemicals & Plastics Corp. v. Train, 537 F.2d 620, 630-31 (2d Cir. 1976); American Meat Institute v. Environmental Protection Agency, 526 F.2d 442, 453 (7th Cir. 1975); Hanly v. Mitchell, 460 F.2d 640, 648 (2d Cir.), Cert. denied, 409 U.S. 990, 93 S. Ct. 313, 34 L. Ed. 2d 256 (1972), or whether it acted on the basis of scant consideration. See Hempstead Bank v. Smith, 540 F.2d 57, 60 (2d Cir. 1976); Chelsea Neighborhood Associations v. United States Postal Service, 516 F.2d 378, 387 n. 23 (2d Cir. 1975). *fn18"
For their part, plaintiffs largely ignored, both at trial and in the post-trial briefs, the question whether the steps taken by HEW conformed to the requirements of the statute and the regulations. Instead, the merits of the State plan became the focus, with HEW's action a shell under which an attack on the merits could be made. Thus, the plaintiffs argued and attempted to prove that HEW was "wrong" in approving the plan because the plan was inadequate. From there, the adequacy of the plan was put to test. Whether the agency was right or wrong is not the object of review. *fn19" The matter for determination is ...

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