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August 30, 1984

NEW YORK CITY HEALTH AND HOSPITALS CORPORATION, Plaintiff, against MARGARET HECKLER, as Secretary of the United States Department of Health and Human Services, CESAR A. PERALES, as Commissioner of Social Servies of the State of New York, DAVID AXELROD, as Commissioner of Health of the State of New York, and MICHAEL FINNERTY, as Director of the Budget of the State of New York, Defendants.

The opinion of the court was delivered by: CONNER



 NewYork City Health and Hospitals Corporation ("HHC"), which operates fourteen New York City hospitals, commenced the instant action against the Secretary of the Department of Health and Human Services ("the Secretary") and various New York State officials ("the State Defendants") challenging the method by which the State calculated the 1982 Medicaid reimbursement rate paid to three HHC's hospitals. Specifically, plaintiff seeks declaratory and injunctive relief that would invalidate use of a specific component of the New York State Plan for Medical Assistance ("the State Plan").

 This is the second such action brought by HHC. The first action, which challenged the validity of the same provision on a variety of grounds similar to those presented here, followed a tortuous procedural path leading ultimately to a dismissal by Judge Brieant of this Court. See New York City Health and Hospitals Corp. v. Blum, et al., No. 80 Civ. 5495 (CLB) (slip op. July 6, 1981), appeal dismissed, 678 F.2d 392 (2d Cir. 1982), on remand, No. 80 Civ. 5495 (CLB) (slip op. July 21, 1982). That dismissal was subsequently affirmed by the Court of Appeals for the Second Circuit. 708 F.2d 880 (2d Cir. 1983). Because the framework and operation of the complex State Plan have been described in considrable detail in the various opinions cited above, some familiarity with the prior proceedings is presumed.


 The State of New York has elected to participate in the Medicaid program, through which the federal government contributes funds to assist states in providing health care for the poor. Pursuant to the Medicaid Act, 42 U.S.C. §§ 1396 et seq., hospitals that offer care to Medicaid-eligible patients receive reimbursement funded jointly by federal and state authorities. Each participating state is required to adopt a State Plan for Medical Assistance, which establishes a methodology for determining a reimbursement rate. These plans must be approved by the Secretary and must provide for payments that are "reasonable and adequate to meet costs which must be incurred by efficiently and economically operated facilities." 42 U.S.C. §§ 1396A(a)(13)(A).

 New York's State Plan, set forth at 10 N.Y.C.R.R. Part 86-1, is prospective in nature. In other words, the per diem rate that each hospital receives for treating Medicaid patients is determined in advance, on the basis of a formula derived from the costs actually incurred by that hospital in a previous year. The year in which the hospital renders services is referred to as the "rate year"; the year from which the costs are analyzed to compute the rate-year payments is the "base year." The instant action involves reimbursement rates established for services rendered in rate year 1982. The per diem rate was derived from costs incurred in base year 1980.

 A. The State Plan

 New York's in-patient hsopital reimbursement methodology was designed to provide a workable procedure for determining which of a hospital's base year costs are attributable of efficient and economical operations and which are attributable to inefficiency and waste. This determination is used to predict with a reasonable degree of accuracy the costs each hospital will incur during the rate year if it is efficiently and economically operated. Anderman Aff. at P6.

 Computation of 1982 payment rates under the State Plan involved several steps that may be summarized, briefly and simply, as follows: First, the State recorded the total actual costs that each hospital incurred in base year 1980. From this figure, amounts in excess of certain cost ceilings were subtracted; the remainder represented the hospital's reimbursable costs. These costs were multiplied by an inflation factor, and the adjusted total was then divided by the number of patient-days the hospital recorded in the base year. This yielded a per diem amount that each hospital was to receive for each day of inpatient service it rendered to Medicaid patients in the rate year.

 At issue here is the validity of one of the three ceilings placed on base-year costs. As explained in greater detail in the opinions cited above, participating hospitals were placed in peer groups for purposes of calculating average costs. To the extent that a given hospital exceeded 105% of the peer group average in providing "routine" and "ancillary" services in the base year, *fn1" the difference was disallowed in calculating the rate year reimbursement figure. HHC does not challenge the routine or ancillary cost limitations; it challenges instead a third ceiling that was designed to eliminate costs attributable to excessively prolonged hospitalizations in the base year. The limitation imposed under the challenged provision of the State Plan is referred to as the "length of stay" or "LOS" ceiling.

 The LOS disallowance represents the difference between each hospital's average length of stay and an average length of stay calculated for the hospital's peer group. Base year patient data for each hospital were collected and patients were categorized according to such factors as age, diagnosis and the presence or absence of surgery. An average length of stay for each of the categories was then computed. This was the hospital's "actual average LOS," and it was compared with the peer group average, or "expected average LOS" for each category. A given hospital was deemed to have had a LOS excess in the base year to the extent that its actual average exceeded its expected average by more than one-half day.

 The figure obtained above represented the average over-stay of each patient, and was multiplied by the number of patients to yield the total number of excess days for the base year. That number was multiplied by the average routine per diem cost incurred by the hospital in the base year, to obtain the excess cost figure. Thus, the LOS disallowance reduced each hospital's total actual base-year costs by the amount of the routine costs associated with excessive patient days.

 In addition to establishing this reimbursement methodology, the 1982 State Plan provides an appeal procedure under which hospitals have an opportunity to justify base-year costs that been deemed excessive and have therefore been excluded from the rate year per diem reimbursement figure. The procedure, which is set forth in 10 N.R.C.R.R. §§ 86-1.16 and 86-1.17, affords hospitals a more individualized review of their base-year costs than is feasible at the time rates are established under the general formula. Upon a proper showing that the hospital's peculiar patient mix or case mix caused all or part of the cost in excess of the ceilings, or upon a showing that the hospital has brought its actual average LOS within one-half day of the expected average for any consecutive twelve-month period between the base year and the rate year, a retrospective recomputation of the per diem rate is performed by the Department of Health ("DOH"). Final determinations rendered on the rate appeals are reviewable in state ...

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