# Running financial due diligence on a hospital target
A buyer once signed a term sheet on a 200-bed community hospital based on reported EBITDAEBITDAEBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures a company's operating profitability before financing and accounting decisions, used to compare core performance across firms.View full definition → of $18 million. Six months into diligence, the number that mattered was different: after stripping out a disputed Medicare cost-report settlement, unbilled charity care reclassified as revenue, and a pending False Claims Act investigation, sustainable EBITDAEBITDAEBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures a company's operating profitability before financing and accounting decisions, used to compare core performance across firms.View full definition → was closer to $11 million. The price gap was tens of millions. That gap is what financial due diligence exists to find.
Hospitals are unlike most acquisition targets. Their revenue is not a price times quantity. It is a negotiated, regulated, retroactively adjustable number filtered through government payers. This lesson gives you a concrete checklist across four areas: net revenue quality, cost-report exposure, contingent liabilities, and regulatory red flags.
Start with the single most important concept: gross charges are fiction. A hospital's "chargemaster" (its master price list) might show $50,000 for a procedure. Almost no one pays that.
What matters is net patient service revenue (NPSR): gross charges minus contractual allowances (the discounts negotiated with payers) minus bad debt and charity care.
Ask for revenue split by payer:
A target that looks profitable on 55% commercial mix is a different asset at 35% commercial and 45% Medicaid. In the US, Medicaid reimbursement is frequently estimated to cover only around 85 to 90 cents per dollar of cost (varies widely by state, as of 2024 reporting). Confirm the mix trend over 36 months, not a single year.
In Europe, the analysis shifts. In systems like the UK NHS or a German statutory insurance model, tariffs are more centrally set, so the "payer negotiation" risk is lower but the tariff and volume-cap risk (governments capping paid activity) is higher.
Concrete checks:
1. Recompute net-to-gross ratio by service line and compare to prior years. A sudden improvement often means aggressive revenue recognition, not real gains.
2. Days in accounts receivable (AR): how long from service to cash. Rising AR days can hide collectibility problems. A commonly used benchmark is roughly 45 to 55 days for a healthy US hospital (estimate, varies by system).
3. Reserve adequacy: are allowances for doubtful accounts keeping pace with self-pay growth?
Worked example:
Gross charges: $500,000,000
Contractual allowances: -$360,000,000
Charity care: -$25,000,000
Bad debt: -$15,000,000
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Net patient service revenue: $100,000,000
Net-to-gross ratio: 20%If last year the ratio was 20% and this year management reports 24% with no new commercial contract, ask why. That 4 point swing is $20 million of "revenue" that may not be real.
Here is what non-hospital investors miss. US hospitals file an annual Medicare cost report with CMS (the Centers for Medicare & Medicaid Services, the federal agency running Medicare and Medicaid). Certain payments (disproportionate share payments, graduate medical education, wage index adjustments) are based on estimates that are settled years later.
Translation: a hospital can receive cash today that it may have to pay back in 2028.
A hospital carrying $6 million in cost-report reserves may be under-reserved if a wage-index reclassification is pending. Model the downside as a purchase-price adjustment or an escrow.
The public CMS cost-report data files let you benchmark a target against peers before you even sign an NDA. Use them.
Hospitals carry liabilities that standard financials understate.
Medical malpractice exposure is often self-insured or funded through a captive insurer (an insurance subsidiary the hospital owns). Check:
Under-reserved malpractice is a classic hidden hole.
Older nonprofit hospitals may run a defined benefit pension (a plan promising a fixed retirement payout). If underfunded, it transfers to the buyer. Get the latest funded-status disclosure.
The 340B Drug Pricing Program lets qualifying hospitals buy outpatient drugs at deep discounts. It generates real margin, but compliance is audited. A hospital leaning on 340B for profitability faces risk if eligibility or program rules change. Quantify how much EBITDAEBITDAEBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures a company's operating profitability before financing and accounting decisions, used to compare core performance across firms.View full definition → depends on it.
This is the section that separates hospital diligence from generic M&A.
Ask directly: any open CID (Civil Investigative Demand, a DOJ document request signaling a possible FCA case)? Any Corporate Integrity Agreement (a settlement in which the hospital agreed to ongoing government oversight)? A CIA in place changes the risk profile and the price.
Review physician employment and compensation arrangements against fair market value. Over-market comp tied to referral volume is a Stark/AKS landmine. Successor liability means the buyer inherits the exposure.
Confirm current CMS Conditions of Participation status (the rules a hospital must meet to bill Medicare) and accreditation (e.g., Joint Commission). A hospital on a CMS termination track can lose the majority of its revenue overnight.
🎬 [VIDEO: "How Hospitals Get Paid" - youtube.com - a clear plain-English walkthrough of Medicare, Medicaid and commercial reimbursement mechanics]
Knowledge check
1. Why does financial due diligence on a hospital focus on 'sustainable EBITDA' rather than reported EBITDA?
2. A hospital's chargemaster lists $50,000 for a procedure but almost no one pays that amount. What concept does this illustrate for a diligence analyst?
3. Two hospitals report identical net patient service revenue, but one has a much higher share of Medicaid patients. Why should a buyer treat these as different-quality assets?
4. Select ALL correct answers. Which of the following are legitimate reasons a hospital's reported revenue can differ from cash the business will sustainably collect?
Select all the correct answers.
5. Select ALL correct answers. Which items would a diligence analyst investigate as contingent or regulatory risks that could reduce a hospital's value?
Select all the correct answers.
Convert findings into three concrete adjustments to the deal.
1. Quality-of-earnings (QoE) adjustments to EBITDA. Strip out non-recurring items: one-time COVID-era relief funds, a favorable cost-report settlement, gains on asset sales. Rebuild "sustainable" EBITDAEBITDAEBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures a company's operating profitability before financing and accounting decisions, used to compare core performance across firms.View full definition →. In our opening example, reported $18M became $11M.
2. Working capital target. Set a normalized net working capitalnet working capitalWorking capital is the difference between a company's current assets and current liabilities, measuring short-term liquidity and the funds available to run daily operations.View full definition → peg. AR quality is central; overstated AR inflates the peg and the buyer overpays.
3. Escrows and indemnities. Cost-report exposure and open FCA matters are usually handled by escrow (cash held back) or a specific indemnity (seller agrees to cover a defined risk), not a price cut, because the amounts are uncertain.
If you are lending rather than buying, the emphasis shifts to cash flow durability and covenant headroom. A recoupment or FCA settlement can spike a debt-to-EBITDA ratio and breach covenants. Size your headroom against the contingent-liability tail, not just reported numbers.
*This lesson is educational and not investment, legal, or medical advice.*