CAHs are an outgrowth of the seven-state Essential Access Community Hospital/Rural Primary Care Hospital (EACH/RPCH) program established in 1989. The BBA replaced the EACH/RPCH program with the state- administered Rural Hospital Flexibility Program (the “Flex” Program), which includes the CAH designation. The reimbursement component of the Flex Program is the responsibility of CMS. The Flex Program also includes a grant program that supports hospital participation in the program as well as state emergency medical services systems (EMS), and is the responsibility of the FORHP within the Health Resources and Services Administration (HRSA). The CAH program allows eligible rural hospitals to receive Medicare payments based on their reasonable costs rather than under a PPS. Under the Medicare inpatient PPS, hospitals are generally paid a fixed amount per patient discharge, providing an incentive for hospitals to control their costs to stay under this fixed amount because they can retain the difference between the PPS payment and their costs. Under cost-based reimbursement, hospitals are reimbursed for their reasonable costs, which does not provide the same incentive to control costs, but benefits hospitals whose Medicare costs exceed their PPS payments. In addition to receiving cost-based payment for inpatient services to Medicare beneficiaries, CAHs receive cost-based payment from Medicare for skilled nursing care provided in their swing beds and for outpatient care. To become a CAH, a hospital must meet certain criteria with respect to its location, size, patient census, and patient length of stay (see figure 1). CAHs are also subject to different health and safety regulations, known as “conditions of participation,” from other acute care hospitals. Growth in the number of CAHs has been steady (see figure 2). There is a large concentration of CAHs in the central states, although 45 states had at least one CAH as of September, 2002 (see figure 3). Since the inception of the CAH program, two factors have been important in increasing the number of hospitals qualifying for the designation. First, the length-of stay criterion was changed. Until 1999, patient stays at CAHs were limited to 4 days, after which patients would have to be transferred to another health care facility or discharged. In 1999, the Congress relaxed the criterion to require that CAHs keep their annual average length of stay to no more than 4 days. Second, states have widely utilized their authority to designate hospitals as “necessary providers,” thereby exempting such hospitals from the otherwise applicable CAH criterion that they be more than 35 miles from the nearest hospital. According to the Rural Hospital Flexibility Tracking Project (RHFTP), a little more than half of all CAHs had qualified for the CAH program through state designation rather than by meeting the mileage and location requirements, as of September 2002. Hospitals considering CAH conversion weigh numerous factors in their decision, including the impact on hospital finances and community reaction. Financial impact studies are commonly used to estimate how a hospital’s reimbursement for services would change under CAH status. The financial impact may change as Medicare reimbursements to hospitals changes. For example, Medicare payment for hospital outpatient services shifted in 2000 from cost-based payment to a new PPS for outpatient services. Because CAHs are exempt from this PPS and continue to receive cost-based payment for outpatient services, potential CAHs may factor into their decision the impact of being paid reasonable costs, rather than a fixed PPS payment, for outpatient services. They may also consider the possible reaction from the community and from other health care providers to CAH conversion. Some communities have been reluctant to support a hospital’s conversion because they perceive it as the last step before closure. In other cases, hospital officials reported that their physicians expressed concern that if a hospital became a CAH, they would occasionally be unable to admit patients to it because this would bring the CAH over the patient limit. Clinical research has indicated better outcomes for patients who are appropriately treated in inpatient psychiatric or rehabilitation facilities, such as DPUs, rather than in general acute or post acute care settings. For example, one study concluded that elderly depressed patients who were treated in specialty psychiatric DPUs may have received better treatment for their depression than similar patients who were treated in general medical wards. Another study found better outcomes among stroke patients treated in rehabilitation facilities, such as DPUs, than those treated in nursing homes. As separate sections of hospitals, psychiatric and rehabilitation DPUs are subject to specific Medicare regulations regarding the types of patients they admit and the qualifications of their staff. Psychiatric DPUs may admit only patients whose condition requires inpatient hospital care and are described by a psychiatric principal diagnosis. Rehabilitation DPUs may treat only patients likely to benefit significantly from intensive therapy services, such as physical therapy, occupational therapy, or speech therapy. Both types of DPUs must provide a specified range of services and employ clinical staff with specialized training. The Congress has required that CMS develop PPSs for both inpatient rehabilitation and inpatient psychiatric providers, including DPUs, to replace the payment methodology established by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under TEFRA, providers that had been exempted from the inpatient PPS, including inpatient rehabilitation and psychiatric hospitals and DPUs, receive the lesser of either their average cost per discharge or a provider-specific target amount. In 2002, a PPS was implemented for inpatient rehabilitation. Because a PPS for inpatient psychiatric providers has yet to be implemented, psychiatric DPUs continue to be paid under TEFRA. The financial incentives associated with TEFRA payments differ from those associated with cost-based payment. Under TEFRA, Medicare payments are capped by a provider’s target amount, giving hospitals an incentive to restrain costs. By contrast, hospitals such as CAHs, which are paid their reasonable costs, have less incentive to restrain costs because their payments can increase as their costs increase. Most existing CAHs prior to their conversion had more beds in fiscal year 1999 than CAHs are allowed. Most were likely able to reduce their bedsize to 15 (or 25 with swing beds) to become CAHs without adjusting their patient volume because their average patient census of 4.8 was generally well below the CAH limit of 15 (see table 1). Likewise, potential CAHs, on average, exceeded CAH bedsize limits in fiscal year 1999 and had a patient census well below 15. To meet the CAH limit, existing CAHs, on average, had to reduce their bedsize by less than potential CAHs would have had to if they had sought CAH status. Most existing CAHs prior to their conversion and potential CAHs were below the CAH length-of-stay limit. In fiscal year 1999, existing CAHs prior to their conversion generally experienced greater losses on their inpatient and outpatient Medicare services than did potential CAHs (see table 2), and therefore had greater financial incentive to seek conversion. A small majority, 55 percent, of existing CAHs experienced losses on inpatient Medicare services, while more than 60 percent of potential CAHs experienced gains. Nearly all hospitals in both groups experienced losses on their Medicare outpatient services. Across all revenue sources, existing CAHs prior to their conversion experienced a 0.3 percent median loss, while potential CAHs experienced a 1.8 percent median gain. The effective ban on CAHs operating DPUs may have contributed to the disparity between urban and rural areas in the availability of inpatient psychiatric and rehabilitation services in fiscal year 1999. Twenty-five existing CAHs had to close their DPU as part of becoming CAHs. Of the 93 potential CAHs that operated a DPU (one-seventh of all potential CAHs), about half lost money on their Medicare inpatient and outpatient services, giving them a financial incentive to convert. If, however, the other financial benefits associated with the DPU exceeded their combined losses on inpatient and outpatient services, these potential CAHs would have had a countervailing incentive to stay under the PPS, rather than close their DPU and convert. Some rural hospital administrators told us that, even when it was financially advantageous to seek CAH status, they were reluctant to close their DPU because it was needed to maintain access to psychiatric or rehabilitation services in the community they serve. While allowing hospitals to convert to CAH status and retain their DPU would alleviate this concern, extending cost-based reimbursement to DPUs operated by CAHs diminishes the incentives for efficiency that are inherent in PPS payments. If DPU patient stays and beds were counted against current CAH limits without any adjustment, nearly all potential CAHs with DPUs would have exceeded either the bedsize or length of stay limit in fiscal year 1999. The closure of 25 DPUs by hospitals that needed to relinquish their DPU as part of becoming a CAH may have contributed to the lower availability of inpatient psychiatric and rehabilitation services in rural areas. Inpatient psychiatric and rehabilitation providers are concentrated in urban areas, and DPUs are least common among smaller rural hospitals. Only 8 percent of rehabilitation beds and 17 percent of psychiatric beds were located in rural areas in fiscal year 1999, while about 25 percent of Medicare beneficiaries live in rural areas. In fiscal year 1999, 14 percent (93) of potential CAHs operated a DPU. By comparison, 37 percent of larger rural hospitals operated a DPU, and 53 percent of urban hospitals operated a DPU. DPUs may be less common in rural areas due to the challenge of finding the resources needed to open a DPU. Hospital representatives and officials from rural health organizations said the difficulty in finding the specialized staff required to operate a DPU likely prevents many small rural hospitals from opening a DPU. In fiscal year 1999, nearly half the potential CAHs with a DPU experienced net gains on their combined inpatient and outpatient payments for Medicare services (see table 3).