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A Critical difference: Contractual allowance vs. bad debt for healthcare providers

06/14/2018  |  By: Jayme Parmakian, CPA, Senior Manager, Tax

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Unlike most other businesses, healthcare providers often deal with multiple parties throughout the billing process, such as patients, 3rd party insurers, and government programs (such as Medicare and Medicaid).  While the interaction and agreements with these parties impact cash collections for services rendered, it’s almost impossible for these providers to be sure how much they will ultimately collect. As such, healthcare providers generally take into consideration two separate categories when estimating ultimate collections – contractual allowances and bad debt allowances. And because of the unique nature of the healthcare business, these providers need to take special care in accounting for them, lest they run into problems with the IRS.

Contractual allowances, also known as contractual adjustments, are the difference between what a provider bills for the service rendered versus what it will contractually be paid (or should be paid) based on the terms of its contracts with third-party insurers and/or government programs. Often the reimbursement amount is lower than the billed amount.

Bad debt allowances, on the other hand, typically represent an estimate for the amount a patient or other payer cannot (or will not) pay of its portion of the bill.

To illustrate these two items, assume ABC Hospital provides a same-day outpatient procedure to Patient A who has healthcare insurance with XYZ Insurance Co. Upon completion of the procedure, ABC Hospital bills XYZ Insurance Co. $8,000 for the value of the services provided to Patient A. Under the terms of the contract/agreement between ABC and XYZ, the agreed-upon amount that should ultimately be reimbursed to ABC Hospital is $5,000. The $3,000 difference represents a contractual allowance. Now assume Patient A is responsible for paying the full $5,000 because she has yet to meet her annual deductible. Based on the historical trends of cash collections from actual patients, ABC Hospital estimates that 20% of such outstanding A/R to be uncollectible. This estimate of $1,000 ($5,000 x 20%) represents a bad debt allowance. While the value of the service provided by ABC Hospital is $8,000, the estimated collection of cash is only $4,000.

As illustrated above, contractual allowances and bad debt allowances are similar in that they represent cash that will likely not be collected. However, they are fundamentally different in that contractual allowances represent adjustments to gross revenue based on true contractual agreements between service providers and insurers/government programs, whereas bad debt allowances are estimates of uncollectible net revenue based on historical patient/payer payment trends.

Allowances for bad debts are not deductible for tax purposes until the related accounts receivable are written off the taxpayer’s books and records as uncollectible after exhausting collection efforts (both internally and through third-party collection agencies). As a result, the IRS wants bad debt allowances clearly separated in tax returns, and lumping them together with contractual allowances may cause the IRS to disallow a deduction for the entire amount.

To ensure proper tax return reporting, providers should make separate line entries for contractual allowances and bad debt allowances when compiling financial information. In arriving at net accounts receivable, the chart of accounts should contain accounts for gross accounts receivables, contractual allowances, and bad debt allowances. In arriving at net patient service revenue, the income statement accounts in the chart of accounts should have accounts for gross patient service revenue, contractual allowances, and bad debt expenses.

Jayme Parmakian is a senior manager in the tax practice at LBMC, a premiere Tennessee-based professional services firm. Contact Jayme at 615-309-2309 or jparmakian@lbmc.com.

A Critical difference: Contractual allowance vs. bad debt for healthcare providers