COURT OF APPEALS OF VIRGINIA 

Present: Judges Benton, Annunziata and Senior Judge Duff 

Argued at Alexandria, Virginia 

LIFE CARE CENTER OF 

 NEW MARKET 

 OPINION BY 

v. Record No. 2022-96-4 JUDGE JAMES W. BENTON, JR. 

 SEPTEMBER 2, 1997 

DEPARTMENT OF MEDICAL 

 ASSISTANCE SERVICES 

FROM THE CIRCUIT COURT OF SHENANDOAH COUNTY 

Perry W. Sarver, Judge Designate 

 Laura G. Aaron (Mezzullo & McCandlish, on 

briefs), for appellant. 

 E. Paige Selden, Assistant Attorney General 

(James S. Gilmore, III, Attorney General; 

William H. Hurd, Deputy Attorney General; 

Siran S. Faulders, Senior Assistant Attorney 

General, on brief), for appellee. 

 This is an appeal from a circuit court's order affirming a 

decision of the Department of Medical Assistance Services (DMAS), 

which denied reimbursement for certain expenses incurred by Life 

Care Center of New Market. New Market argues that the trial 

judge erred in affirming DMAS's decision to deny reimbursement 

for (1) overhead expenses incurred by Life Care Construction in 

building an addition to the New Market facility, and (2) certain 

interest expenses incurred to finance a loan borrowed to fund the 

construction project. For the reasons that follow, we affirm, in 

part, and reverse, in part, the trial judge's order. 

 I. 

 New Market is a nursing facility in Virginia that is owned 

and operated by Life Care Centers of America. New Market 
 2 

participates in the Medicaid program, which is administered by 

DMAS. As a Medicaid participant, New Market is entitled to file 

a cost report with DMAS and obtain reimbursement for expenses 

incurred in providing health care services to Medicaid 

recipients. Expenses properly incurred in constructing an 

addition to an existing facility may be reimbursed by DMAS. See

Fralin v. Kozlowski, 18 Va. App. 697, 699-700, 447 S.E.2d 238, 

239-40 (1994). 

 In March 1987, New Market obtained a certificate of need to 

construct a forty-two bed addition to its facility. New Market 

received a loan commitment in 1987 and constructed the addition 

in 1988 and 1989. After a field auditor for DMAS denied 

reimbursement for certain overhead and interest expenses incurred 

in the construction project, New Market appealed. 

 During the informal fact finding conference, New Market 

argued that the $73,572 paid to Life Care Construction was 

primarily for overhead expenses. When DMAS questioned New 

Market's methodology for computing overhead and its lack of 

supporting documentation, New Market requested and was granted 

additional time to submit documentation to support its claim for 

overhead costs. Although New Market supplied a summary chart of 

Life Care Construction's fees and expenses for the two years the 

project was under construction, it provided no documentation to 

support the data in the chart. The record indicates that DMAS 

"was concerned that . . . the overhead that was allocated to New 
 3 

Market would have been disproportionate to the overhead that 

would be allocated to other projects that were overseen by Life 

Care Construction." Although James Branham, DMAS's audit 

supervisor, offered to assist New Market in arriving at a 

methodology that would be acceptable to DMAS, New Market did not 

pursue that offer. Instead, New Market prepared a second 

analysis based on revenues because it believed "that was the best 

available information." 

 New Market also argued at the informal fact finding 

conference that because the partnership distributions were a 

customary and legitimate business practice, DMAS erroneously 

disallowed reimbursement for interest on a portion of the loan 

equivalent to those distributions. DMAS asserted that the 

records established that New Market made distributions to the 

partnership accounts from the construction loan proceeds and that 

those loan funds therefore were not reasonably related to the 

delivery of patient care. Following the informal fact finding 

conference, the Director of the Division of Cost Settlement and 

Audit affirmed the original decision. New Market again appealed. 

 A formal hearing was held before a hearing officer appointed 

by the Supreme Court. The primary facts proved at the hearing 

are not in dispute. The testimony at the hearing proved that New 

Market initially entered into a contract with a local 

construction company to build the contemplated addition to New 

Market's facility. Before construction began, however, the 
 4 

principal owner of the construction company died. Life Care 

Centers of America, New Market's owner, then decided to build the 

addition itself and formed for that purpose a new company, Life 

Care Construction. New Market hired Life Care Construction to 

build the addition. DMAS and New Market agree that Life Care 

Construction is a "related party," i.e., that it was under common 

ownership or control with New Market. 

 Life Care Construction employed a local contractor, Paul 

Thompson, who had a general contractor's license, to act as an 

"on-site daily superintendent" for the project. Life Care 

Construction "acted as owner's representative; it acted as 

developer." According to the testimony, Life Care Construction 

"studied [the project], listened to the operators of Life Care 

Centers of America on the needs of the addition; . . . worked 

with the architect; . . . designed with the architect the 

blueprints, helped design the specifications for the project, 

deciding the equipment, the finishes, [and] worked through the 

process of the blueprints being drawn by the architect firm." 

Life Care Construction also "prepared the liens for all the 

subcontractors, paid the bills, coordinated with equipment 

suppliers, the decorator and operations as it got near the end, 

and then turned the building over to operations when it was 

finished." Most of the contracts with the subcontractors were 

executed by Life Care Construction. 

 New Market's analyst, Randy Martin, who is a certified 
 5 

 

public accountant and an employee of Life Care Centers of 

America, testified that New Market sought reimbursement for the 

overhead costs (or "indirect costs") of the project that were 

billed by Life Care Construction.1

 He testified that the 

indirect costs of Life Care Construction were not separately 

incurred in relation to individual projects and that they had to 

be allocated among all of Life Care Construction's building 

projects. To support New Market's claim for reimbursement, 

Martin proposed two analyses that attempted to isolate the 

indirect costs Life Care Construction incurred in relation to the 

New Market construction project. In those analyses, which were 

based on revenues that Life Care Construction received, Martin 

attempted to eliminate any profits from the analysis because DMAS 

will not permit reimbursement for profits earned by a related 

party. 

 In the first calculation, Martin determined that two percent 

of Life Care Construction's total revenues for the year 

represented profits. Martin then determined the amount of 

profits earned on the New Market project by multiplying by two 

percent the total revenues received from New Market. After 

 1"[O]verhead costs are those that are expended for the 

benefit of the whole business, which by their nature cannot be 

attributed or charged to any particular contract." Altmayer v. 

Johnson, 79 F.3d 1129, 1132 (Fed. Cir. 1996); see also Alvey 

Conveyor Mfg. Co. v. Kansas City Terminal Ry. Co., 203 S.W.2d 

606, 609 (Mo. 1947) ("Overhead . . . includes the continuous 

expense of a business irrespective of the direct costs on 

particular contracts."); Neumiller Farms, Inc. v. Cornett, 368 

So. 2d 272, 276-77 (Ala. 1979). 
 6 

eliminating that amount of profit from the revenues, Martin 

concluded that the resulting figure represented both direct and 

indirect costs. Martin testified that overhead costs represented 

approximately eight percent of the total cost of the New Market 

project. The record does not reveal Martin's methodology for 

arriving at the eight percent figure. 

 Martin testified that this method of computing overhead 

costs has been accepted by Medicare in the past. In addition, he 

testified that DMAS accepted this methodology when used by Total 

Designs, the company that provided furnishings and decorations to 

New Market for the same project. 

 Glen Walker, a certified public accountant licensed in 

Virginia, testified as New Market's expert witness that Martin's 

overhead figure of eight percent was unusually low. He indicated 

that ten percent is a more typical overhead amount on commercial 

construction projects. Walker also testified that the technique 

Martin used to calculate overhead expenses has been used in 

Virginia in the Medicaid program and is generally used 90% of the 

time. 

 In the second calculation, Martin determined the total 

amount of overhead costs billed by Life Care Construction for all 

of its projects that year. Martin then "took the percentage of 

. . . New Market's overhead billings to the total overhead 

billings for those two years and applied that percentage to the 

total [actual] overhead costs to identify . . . approximately 
 7 

$79,000 of overhead that should be allocated to . . . New 

Market." That amount "actually exceed[ed] the billings that . . 

. Life Care Construction made to . . . New Market." Martin 

testified that this method "had been used for Medicare and . . . 

Medicaid [in other] states and was a rather commonly accepted 

method of determining the related party costs." However, he 

added that he had "never had to do this type of [calculation] for 

another DMAS audit" because New Market was Life Care Centers of 

America's only facility in Virginia. Walker, the certified 

public accountant, testified that methods similar to this second 

analysis are used ten percent of the time. 

 Martin testified that he had offered to provide "back-up 

documentation" to support his calculations. However, James 

Branham, the audit supervisor for DMAS, testified that Life Care 

Construction's documents were not made available to him for 

review during the audit. He said that he had only received "some 

compiled financial statements." Branham also testified, however, 

that an analysis that is based upon revenues is "not an 

acceptable basis of allocating costs." He stated that such an 

analysis is inappropriate in related party cases because the 

revenue is not determined in an arms length transaction. Branham 

further testified that although Martin had initially agreed to 

work with him to "develop this cost information" in a manner that 

was "more in accordance with the Medicare and Medicaid 

regulations," Martin did not contact him. 
 8 

 Wendall Gatlin, a senior officer for DMAS, testified that he 

sought the additional documentation because he "wanted to 

determine what services [New Market] received" from Life Care 

Construction. He was concerned that there was a "duplication of 

duties" between Life Care Construction and Thompson, the local 

contractor. 

 On the issue of DMAS's denial of reimbursement for a portion 

of the interest expense incurred in financing the construction 

loan, Martin testified that New Market borrowed $1,200,000 to 

finance the project and that the actual total cost of the project 

was $1,075,474. Because the loan exceeded the actual cost, New 

Market only sought reimbursement of the interest expense for the 

portion of the loan that actually was needed, the $1,075,474 

total cost of the project. 

 Martin testified that DMAS initially disallowed $104,461 of 

the total costs and that a large portion of that amount was the 

overhead cost disallowance. To avoid reimbursing the interest on 

the portion of the loan attributable to an expense DMAS 

disallowed, the total amount of the loan was adjusted to $971,013 

for interest reimbursement purposes. The amount was adjusted 

again to account for a portion of management fees that exceeded 

amounts allowable under the Medicare regulations. DMAS 

determined that the money used to pay the management fees "was 

cash that the facility could have withheld and not paid to the 

management company and used to fund the construction rather than 
 9 

paying it to the management company." In addition, DMAS 

determined that partnership distributions and loans had been made 

in the amount of $263,266. DMAS determined that New Market 

should have used those funds to reduce its need to borrow. 

Finally, the amount of the loan was also adjusted to account for 

expenditures of operating funds made during the construction 

process. DMAS determined that because only $573,923 of the total 

loan was necessary for the project, interest attributable only to 

that portion of the loan would be reimbursed. 

 Based on this evidence, the hearing officer reversed the 

decision to deny the reimbursements and ruled in favor of New 

Market. DMAS then appealed. After review by DMAS's Director, 

DMAS issued a final agency decision that rejected the hearing 

officer's conclusions of law and denied the reimbursements New 

Market sought. On appeal to the circuit court, the trial judge 

affirmed DMAS's ruling as contained in the final agency decision. 

 New Market now appeals. 

 II. 

STANDARD OF REVIEW 

 Recently, this Court specifically addressed the standard of 

review applicable to similar cases. 

 In reviewing decisions by DMAS, an 

appellate court accords great deference to 

both the agency's factual findings and 

interpretation of the laws applicable to "the 

reimbursement due qualified providers for 

their reasonable cost incurred while 

delivering health care services." This Court 

will overturn DMAS' "interpretations of the 

statutes and regulations governing Medicaid 
 10 

and Medicare principles of reimbursement 

. . . only . . . when found to be arbitrary 

and capricious." 

Beverly Health and Rehab. Servs., Inc. v. Metcalf, 24 Va. App. 

584, 592, 484 S.E.2d 156, 160 (1997) (citations omitted). 

 III. 

 CONSTRUCTION COSTS 

 New Market first argues that the trial judge erred in 

affirming DMAS's decision to deny reimbursement of certain 

construction costs. New Market contends that DMAS erroneously 

arrived at its decision without first reviewing New Market's 

supporting documentation. DMAS argues that New Market failed to 

provide adequate supporting documentation and that, therefore, 

the denial of reimbursement was supported by 12 VAC 30-90-110 

(1990). DMAS also argues that New Market's methodology for 

isolating the overhead costs applicable to the New Market project 

was inadequate. 

 The trial judge made the following rulings: 

 It was New Market's responsibility to 

furnish evidence in support of its claim for 

reimbursement for management fees and 

overhead costs. . . . DMAS insisted that New 

Market furnish information on a cost and not 

a revenue basis. After the Informal Fact 

Finding Conference, there was a general 

agreement that the parties would meet for the 

purpose of developing procedures for 

providing cost information and the supporting 

data for such costs. The time for 

accomplishing this was extended by DMAS, and 

New Market's response has been to insist on 

reimbursement on a revenue basis. 

The evidence supports that ruling. 
 11 

 To facilitate the process of auditing health care providers, 

DMAS requires providers to keep and make accessible adequate 

documentation to support their claims for reimbursement. See 12 

VAC 30-90-110 (1990). In relevant part, 12 VAC 30-90-110 

provides as follows: 

 II. Types of records to be maintained. 

Information which must be maintained for the 

duration of the provider's participation in 

the DMAS includes, but is not limited to: 

 * * * * * * * 

 D. Copies of all cost reports filed with 

the DMAS together with supporting financial 

statements. 

 III. Record Availability. The records must 

be available for audits by DMAS staff. Where 

such records are not available, costs shall 

be disallowed. 

(Emphasis added). As pertinent to this case, DMAS would have 

grounds to deny New Market's claim if New Market failed to make 

available its cost reports or supporting financial statements. 

See 12 VAC 30-90-110 (II)(D). 

 The evidence reveals that DMAS sought to audit the financial 

documents that would support New Market's request for 

reimbursement. Branham, the audit supervisor for DMAS who 

oversaw the audit of New Market, testified that "[w]hen [they] 

requested [the documentation], what was furnished were some 

financial statements." Branham stated that he sought more 

detailed information than the "compiled financial statements" 

provided by New Market; he sought documents demonstrating "the 
 12 

various components of [the] . . . costs and the revenue." 

Gatlin, a senior officer for DMAS, testified that the auditors 

"were after the detail of the services" that Life Care 

Construction provided to New Market. Gatlin stated that DMAS 

initially "wanted to determine what services . . . [New Market] 

received" from Life Care Construction. 

 Branham testified that when New Market initially sought 

reimbursement for money paid to Life Care Construction, DMAS 

"questioned the need" for the payment "because they had a general 

contractor, . . . Thompson, who was on-site and was doing . . . a 

lot of the subcontracting." DMAS also questioned "the 

methodology" that New Market used. New Market had only submitted 

a "profit computation" as justification for the fees charged by 

Life Care Construction. DMAS informed New Market that it 

required additional financial documents because New Market had 

merely submitted statements using a "revenue basis" for 

calculating the payment it made to Life Care Construction. 

Branham testified that the Medicaid regulations require that 

providers be reimbursed only for actual costs incurred by related 

parties. He testified that revenue based methodologies are not 

acceptable because related party transactions are "not . . . 

arms-length transaction[s]" and, thus, "revenue[s] can be set at 

whatever the related parties agree." Branham testified that when 

the DMAS auditors requested supporting financial statements for 

the requested reimbursement they only received "compiled 
 13 

financial statements" that did not provide adequate "back-up" 

financial documentation to support New Market's methodology. 

 Branham further testified that at the informal conference 

DMAS informed New Market "that the more appropriate method would 

be to identify all of the various project costs and use that 

basis for allocating the indirect costs or the overhead 

components." Although DMAS believed that it had reached an 

agreement with New Market to develop the cost information, New 

Market did not follow through. Instead, it submitted another 

revenue based proposal. New Market also did not submit financial 

documentation to support the second proposal. 

 Accordingly, we hold that the evidence supports the trial 

judge's finding that New Market failed to meet its burden, under 

12 VAC 30-90-110, to provide documentary evidence to support its 

claim for reimbursement. "Because the trial [judge's] decision 

upholding DMAS's denial of payment to [New Market] is consistent 

with Medicare principles of reimbursement, [the] decision was not 

arbitrary or capricious and must be affirmed." Fralin, 18 Va. 

App. at 705, 447 S.E.2d at 243. 

 IV. 

 INTEREST EXPENSE 

 New Market sought reimbursement for interest expenses it 

incurred to finance the construction loan. DMAS found that 

portions of the loan were unnecessary and denied reimbursement 

for the interest that accrued on those portions of the loan. 
 14 

 Under the Nursing Home Payment System, "cost shall include 

actual allowable . . . interest." NHPS § 2.1 (A) (1989-1991). 

All costs, including interest, must be necessary and reasonable. 

See NHPS App. I, § 1.1 (A) (1989-1991). As the NHPS does not 

define "necessary" and "reasonable," we must look to the Medicare 

principles of reimbursement as set forth in the Provider 

Reimbursement Manual for guidance. See Beverly, 24 Va. App. at 

594, 484 S.E.2d at 161. "Necessary and proper interest on both 

current and capital indebtedness is an allowable cost." Prov. 

Reimb. Man., Part 1, § 200 (1968). "To be allowable under the 

Medicare program, interest must be . . . necessary and proper for 

the operation, maintenance, or acquisition of the provider's 

facilities." Prov. Reimb. Man., Part 1, § 202.1 (1968). 

"Necessary means that the interest [must] be incurred on a loan 

made to satisfy a financial need of the provider . . . ." Prov. 

Reimb. Man., Part 1, § 202.2 (1983).2

Interest Incurred to Pay Management Fees

 The record reveals that DMAS reduced the amount of the loan 

for which it would pay the interest expense in part to account 

for management expenses New Market incurred. No authority 

supports that reduction. DMAS made the adjustment on the ground 

that because related party management fees are not reimbursable, 

the management fees should not have been incurred; rather, New 

 

 2§ 202.2 has been amended since 1983; however, the 1983 

version is applicable to the cost reports for 1989, 1990, and 

1991 involved in this case. 
 15 

Market should have used those funds to reduce its need to borrow. 

 DMAS misapplies the law. To determine whether interest for 

a loan is reimbursable, the relevant inquiry is the necessity for 

the loan. See Prov. Reimb. Man., Part 1, § 202.1 (1968). 

Whether DMAS will reimburse a given expenditure is a different 

question than whether an expenditure is necessary. DMAS does not 

reimburse all expenditures made by providers that are necessary 

for the ongoing operation of their facilities. Thus, regardless 

of whether DMAS would reimburse New Market for related party 

management fees, the interest on the loan is reimbursable so long 

as the management fees were a necessary expense incurred in 

operating New Market's health care facility. 

 At the evidentiary hearing, Martin described the management 

services as "accounting services, data processing services, risk 

management services, [and] . . . general overall supervision." 

No evidence was offered at the hearing that would tend to show 

that the management services were not a necessary expense of the 

health care facility. Accordingly, we hold that the trial judge 

erred in affirming DMAS's decision to deny reimbursement for 

interest on the portion of the loan that was equivalent to the 

amount of management fees paid by New Market. 

Partnership Distributions

 DMAS determined that the amount of the loan necessary for 

New Market's project should be reduced by $263,266, the amount of 

the partnership distributions made between 1987 and 1989. DMAS 
 16 

reasoned that New Market had those funds available and could have 

used them to reduce its need to borrow. Thus, DMAS found that 

$263,266 of the loan was not "necessary." 

 New Market argues that under Pioneer Hosp. v. The Travelers 

Ins. Co., 1983-1 Medicare & Medicaid Guide, New Developments 

(CCH) Para. 32,400 (PRRB Jan. 7, 1983), DMAS's consideration of 

the partnership distributions was erroneous. We agree. In 

Pioneer, the Provider Reimbursement Review Board held that when 

determining whether a loan was "necessary" for interest 

reimbursement purposes, the availability of funds and 

distributions to partners after the loan was made are not 

relevant. Rather, a reviewing tribunal should only consider the 

provider's financial condition as it existed at the time the loan 

was made. Therefore, we hold that DMAS erred in using the 

partnership distributions made after the loan commitment as a 

basis for reducing the amount of interest it would reimburse. 

 Accordingly, we affirm the trial judge's decision to uphold 

DMAS's denial of reimbursement for the related party overhead 

expenses. However, we reverse the remainder of the decision and 

remand the case to the trial judge. The trial judge shall remand 

the case to DMAS to remove the interest deductions it imposed on 

account of the management fees and partnership distributions. 

 Affirmed in part, reversed in part, 

and remanded.