Medicare and Medicaid Receivables Recoupment or Setoff

Journal Issue

Jun 2002

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The last few years have seen a precipitous rise in the number of bankruptcies filed
by health care providers such as hospitals, clinics, nursing homes, home health
agencies and rehabilitation facilities. In 1997, Congress enacted the Balanced
Budget Act to reform the Medicare system. This act included a new prospective payment
system for Medicare reimbursement. Under the prospective payment system, Congress was
trying to decrease Medicare long-term care payments by $8 billion to $9 billion,
but by its own estimates, it reduced payments to the industry by almost $30
billion. In 1999, Congress enacted the Benefits Improvement and Patient
Protection Act, which restored some of the money to the health care industry. Unless
these enhancements are renewed by Oct. 1, however, they will be phased out, and
the health care industry will be faced with another round of business failures.<a href="#1" name="1a">1</a>

For most health care debtors, Medicare and Medicaid reimbursements constitute a
substantial portion of their income. When Medicare or Medicaid reimbursements are
terminated (or are threatened to be terminated), the tourniquet of bankruptcy often
gives way to massive financial hemorrhaging by the debtor, and hopes of a successful
reorganization or meaningful liquidation by the health care provider are dashed.

Pursuant to the Medicare Act, health care providers that provide services to
Medicare patients are entitled to receive payment for their services.<a href="#2" name="2a">2</a> For a health
care provider to receive Medicare funds, it must enter into a "provider agreement" with
the Centers for Medicare and Medicaid Services (CMS). In order to ensure that the
health care provider is paid promptly, the provider agreement and the Medicare Act
establish a payment system whereby the provider receives periodic payments for its
services on an estimated basis. On an annual basis, the health care provider is
required to file a cost report with an intermediary under contract with CMS. The
intermediary conducts an audit of the cost report and the health care provider. The
audit reveals the precise amount of any underpayment or overpayment made to the health
care provider as part of the estimated periodic payment system. Upon the conclusion
of the audit, a retroactive adjustment is made. To the extent that there are
underpayments owing to the health care provider, the intermediary pays the difference
to the provider. If the health care provider has been overpaid, then the intermediary
can demand immediate repayment of the overage, or as is usually the case, the
intermediary can deduct the overpayments from future estimated monthly reimbursements.
Thus, if a health care provider is overpaid for its Medicare services in 2001,
its estimated monthly payments for 2002 will be reduced to compensate for the
overpayments of the previous year.

This payment system is efficient and practical, and works well outside the bankruptcy
context. However, at the point that a bankruptcy petition is filed and a line is
drawn between pre-petition and post-petition claims, the streamlined reimbursement
system of the Medicare Act becomes a muddied quagmire.

If a Medicare provider agreement is assumed by a debtor pursuant to §365 of the
Bankruptcy Code, then, as a condition of assumption, the debtor is obligated to
cure the default by honoring its pre-petition obligations under the provider agreement.
Consequently, upon the assumption of a Medicare provider agreement, there is no
impediment to the government's ability to offset pre-petition Medicare overpayments against
post-petition Medicare reimbursements. However, because it may be prohibitively
expensive for the debtor to pay such cure amounts<a href="#3" name="3a">3</a> and because claims under an assumed
executory contract are elevated from general unsecured to administrative priority status,<a href="#4" name="4a">4</a>

bankrupt health care providers usually are not eager to immediately assume their provider
agreements. After all, the Bankruptcy Code affords chapter 11 debtors a
substantial period of time—until plan confirmation—to assume or reject executory contracts.
Often, it behooves the debtor to see whether reorganization is feasible before the
debtor assumes and obligates itself to perform under a pre-petition provider agreement.

So what happens when a Medicare provider agreement is not assumed by the debtor
pre-confirmation? Despite non-assumption, the debtor may elect to provide post-petition
Medicare services and seek reimbursement for those services. Does the automatic stay
prohibit the collection of the pre-petition overpayments? Is the government relegated
to the unenviable position of a general unsecured creditor with respect to its
pre-petition claim for overpayments? Or can the government extinguish its pre-petition
debt by setting off against post-petition reimbursements? The courts are split on how
these questions should be answered.

At first glance, it seems that the automatic stay of §362 would prohibit the
recovery of pre-petition overpayments—which are simply pre-petition claims—from
post-petition Medicare receivables. Even the setoff provisions of §553 are of no
avail to CMS, since that provision disallows setoff when the respective claims span
the pre-petition/post-petition line. However, in an attempt to skirt the limitations
imposed by §362, CMS has successfully argued that the right to credit pre-petition
Medicare overpayments against post-petition Medicare reimbursements is founded on the
doctrine of recoupment, an equitable exception to the automatic stay that allows
post-petition payments due to a debtor to be applied against pre-petition debt owed
by the debtor.

Generally speaking, recoupment is the setting off of an obligation arising from the
"same transaction" as the plaintiff's cause of action, strictly for the purpose of
abatement or reduction of such claim. As explained by one court, "[t]he doctrine is
justified on the grounds that where the creditor's claim against the debtor arises from
the same transaction as the debtor's claim, it is essentially a defense to the
debtor's claim against the creditor rather than a mutual obligation, and application of
the limitation on setoff in bankruptcy would be inequitable."<a href="#5" name="5a">5</a> Thus, the distinction
between setoff and recoupment is that recoupment requires not only that the claims be
mutual (as in setoff), but also that the claims arise from the same transaction or
occurrence that gave rise to the liability sought to be enforced by the debtor.

The first appellate court to consider the applicability of the recoupment doctrine
to post-petition Medicare reimbursements was the Third Circuit in In re University
Medical Center.<a href="#6" name="6a">6</a> In that case, a chapter 11 debtor operated its hospital as a
debtor-in-possession for three months before finally closing its doors and ceasing its
operations. CMS then sought to recoup pre-petition overpayments against post-petition
Medicare reimbursements, and the debtor filed an adversary proceeding arguing that the
withholding of post-petition reimbursements to recover amounts overpaid violated the
automatic stay of §362. The debtor also sought turnover of the post-petition
reimbursements pursuant to §§542 and 543. The bankruptcy court and the district
court both held that the failure to turn over the post-petition reimbursements was a
violation of the automatic stay.

On appeal, the Third Circuit first considered the argument of CMS that because
the debtor operated under its Medicare provider agreement for a period of three months,
the provider agreement was assumed by the debtor for purposes of §365. The court
rejected this argument, holding that formal court approval is a prerequisite to a
debtor's assumption of an executory contract.

Turning to the question of recoupment, the court reviewed the applicable Medicare
regulations, noting that the relevant regulations state that each providers' cost year
is subject to a distinct annual audit, following the submission of a separate cost
report for each fiscal year. According to the Third Circuit, "[t]hese regulations
indicate that reimbursement payments made for any one year arise from transactions wholly
distinct from reimbursement payments made for subsequent years."<a href="#7" name="7a">7</a> The court continued:

<blockquote>
For the purposes of recoupment, a mere logical relationship is not enough: The
"fact that the same two parties are involved, and that a similar subject matter
gave rise to both claims...does not mean that the two arose from the same
transaction." Rather, both debts must arise out of a single, integrated
transaction so that it would be inequitable for the debtor to enjoy the benefits
of that transaction without also meeting its obligations. Use of this stricter
standard for delineating the bounds of a transaction in the context of recoupment
is in accord with the principle that this doctrine, as a non-statutory,
equitable exemption to the automatic stay, should be narrowly construed.<a href="#8" name="8a">8</a>
</blockquote>

The court went on to determine that the post-petition reimbursements were independently
determinable and were due for services completely distinct from those reimbursed during
prior years. As explained by the court,

<blockquote>
The relationship between HHS and a Medicare provider entails transactions that
last over an extended period. However, each of these transactions begins with
services rendered by the provider to a Medicare patient, includes payment to
the provider, and concludes with HHS's recovery of any overpayments. Recovery
of the 1985 overpayments, therefore, is the final act of the transactions
that began in 1985. [The debtor's] 1988 post-petition services were the
beginning of transactions that would stretch into the future, but they were not
part of the 1985 transactions.<a href="#9" name="9a">9</a>
</blockquote>

Accordingly, the Third Circuit held that CMS had violated the automatic stay by
withholding the debtor's post-petition reimbursements and applying them to pre-petition
overpayments, and directed that the post-petition reimbursements be turned over to the
debtor.

In 1997, the D.C. Circuit Court of Appeals authored an opinion rejecting
the Third Circuit's analysis in University Medical Center, determining that
post-petition Medicare reimbursements can be recouped against pre-petition overpayments.
In U.S. v. Consumer Health Services of America Inc.,<a href="#10" name="10a">10</a> a chapter 11 debtor
operated its home health care business for a year before converting to chapter 7.
The chapter 7 trustee submitted a claim for reimbursement for Medicare services
performed during the period that the debtor was operating under chapter 11. The
government brought a motion before the bankruptcy court requesting that the court affirm
its right to recoup pre-petition overpayments against post-petition receivables. The
court determined that the government should be allowed to recoup the amounts owed,
basing its decision on the language of a Medicare statute that provides as follows:

<blockquote>
The secretary shall periodically determine the amount which should be paid under
this part to each provider of services with respect to the services furnished by
it, and the provider shall be paid, at such time or times as the secretary
believes appropriate (but not less often than monthly) and prior to audit or
settlement...the amounts so determined, with necessary adjustments on account
of previously made overpayments or underpayments.<a href="#11" name="11a">11</a>
</blockquote>

The Consumer Health Services court criticized the Third Circuit for overlooking the
plain language of this statute, maintaining that the Third Circuit assumed that the
amount due on post-petition services was to be determined by the regulations detailing
how much a provider normally gets paid for the services rendered.

<blockquote>
Only then, after that determination, did the [Third Circuit] inquire into
whether the prior overpayments could be deducted from the amount due... [W]e
disagree with the premise that the "amount due" should be calculated with reference
to the fee schedule set out in the regulations. That fee schedule only
determines what "should be paid;" the amount actually due under the statute is
the amount which "shall be paid"—which includes necessary adjustments for prior
overpayments.<a href="#12" name="12a">12</a>

</blockquote>

The Consumer Health Services court concluded its analysis by stating:

<blockquote>
Unlike the Third Circuit, we do not think the frequency of the audit
appropriately defines the "transaction." The audit is simply the mechanism by
which the intermediary determines whether and by how much it ought to adjust
subsequent periodic payments to a particular provider... An audit is nothing
more than a snapshot in time—whether it is monthly, annual or decennial is, in
our view, irrelevant.

In determining whether the pre-petition and post-petition services should be
thought of as one transaction, the key to us is the Medicare statute. Since
it requires the secretary to take into account pre-petition overpayments in order
to calculate a post-petition claim—as we have described above—Congress rather
clearly indicated that it wanted a provider's stream of services to be considered
one transaction for purposes of any claim the government would have against the
provider.<a href="#13" name="13a">13</a>
</blockquote>

In 2000, the Ninth Circuit followed the lead of the D.C. Circuit and
held that the government could recoup pre-petition overpayments against post-petition
Medicare reimbursements. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re TLC Hospitals Inc., 224 F.3rd 1008
(9th Cir. 2000)</a>.

The Third Circuit, the D.C. Circuit and the Ninth Circuit are the only
circuit appeals courts to have considered the issue of whether Medicare overpayments can
be recouped against post-petition reimbursements. However, a number of lower courts
have considered this issue with a slight majority allowing recoupment to some
degree.<a href="#14" name="14a">14</a>

<blockquote><blockquote>
<hr>
<big><center>
Courts will need to balance the legitimate interest
of the government to repayment with the equally
legitimate right of the debtor to attempt to
reorganize.
</center></big>
<hr>
</blockquote></blockquote>

One case that is of particular interest is <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Healthback LLC, 226 B.R.
464 (Bankr. W.D. Okla. 1998)</a>. In that case, the court's decision that
recoupment should not be allowed was heavily influenced by the fact that the debtor
was still operating and that an order allowing the government to recoup pre-petition
overpayments would cause the destruction of the debtor as a viable business entity,
leaving hundreds of employees without jobs and thousands of patients without adequate
medical care. The court explained:

<blockquote>
The doctrine of recoupment is an equitable doctrine. But equity goes both ways.
In this matter, the harm to both parties must be balanced. If the secretary
is granted her request...then there is little doubt that the debtor will
cease to exist. Thus, the harm to the debtor, its 200 employees, patients
and creditors will be the highest degree of harm possible. On the other hand,
if the debtor is granted its remedy, the harm to the Department of Health
and Human Services will only be a delay in the accounting and recovery of any
overpayments. The harm to the debtor clearly and unequivocally outweighs any
inconvenience to the Department of Health and Human Services.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 476</a>. In order to soften the impact of its decision, the court pointed
to the fact that the debtor was not attempting to discharge the overpayments made by
the Department of Health and Human Services, but was only seeking to forestall
accounting for the alleged overpayments and for "breathing room" to effect reorganization.
The court explained:

<blockquote>
Indeed, the debtor, at the hearing, merely asked that the current withholdings
be released to facilitate survival and rehabilitation of the debtor as a business
entity, which is the purpose of a chapter 11 case. Only later in this case
would it be proper for this court to undertake any determination of the
dischargeability of these overpayments to the debtor from the Department of
Health and Human Services as "debts."
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; In effect, the Healthback court required the government to relinquish its bird
in hand (i.e., the post-petition Medicare reimbursements) for a bird in the
bush, and hope that the debtor would be sufficiently solvent to be able to fully
satisfy the pre-petition overpayments at some later date.

Unlike the circuit court decisions in University Medical Center, Consumer Health
Services and TLC Hospitals, where each debtor ceased doing business, Healthback
involved the situation where the debtor was still operating and providing necessary
medical services to the local community. Faced with the specter of closing a community
hospital, it is understandable why a court may be inclined to hold that recoupment
should not be allowed.

<h3>Conclusion</h3>

Medicare and Medicaid receivables are the lifeblood of most health care businesses.
If the government is allowed to recoup, then at best, it will control the
reorganization of such a debtor. At worst, it can prohibit the reorganization by
cutting off the blood supply. Courts will need to balance the legitimate interest of
the government to repayment with the equally legitimate right of the debtor to attempt
to reorganize.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> For an in-depth look at the current financial state of the health care industry, see the Health Care Industry Market Update,
available at <a href="http://www.cms.hhs.gov" target="window2">www.cms.hhs.gov</a>, the web site for the Centers for Medicare and Medicaid Services (CMS), formerly known as the Healthcare
Financing Administration, or HCFA. <a href="#1a">Return to article</a>

<a name="2">2</a> For the sake of simplicity, this article will focus principally on Medicare reimbursement procedures. Medicare is a
government-sponsored health care insurance program for individuals who have certain disabilities or are over the age of 65. Medicaid is
essentially health care for indigent individuals. Medicaid regulations generally echo those of the Medicare Act, but can vary from state to
state. One important distinction between Medicare provider agreements and some states' Medicaid participation agreements is that some Medicaid
participation agreements are only valid for a year and must be renewed annually. Conversely, Medicare provider agreements tend to be perpetual
and continue from year to year. <a href="#2a">Return to article</a>

<a href="3">3</a> A related problem is that it is often impossible to tell the amount of any Medicare overpayments that may be owed under a given
provider agreement. <a href="#3a">Return to article</a>

<a name="4">4</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re South Motor Co. of Dade County, 161 B.R. 532, 546 (Bankr. S.D. Fla. 1993)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re University Medical Center, 973 F.2d 1065, 1079-80 (3rd Cir. 1992.)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 1035 (3rd Cir. 1992)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1080</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1081</a> (quoting <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Schweiker, 739 F.2d 870, 875 (3rd Cir. 1984)</a>). <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1081-82</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 390 (D.C. Cir. 1997)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1395g(a)</a> (emphasis added). <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 394</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 395</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re AHN Homecare LLC, 222 B.R. 804 (Bankr. N.D. Texas 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Southern Institute
for Treatment and Evaluation Inc., 217 B.R. 962 (Bankr. S.D. Fla. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CDM Management Services Inc., 226
B.R. 195 (Bankr. S.D. Ind. 1997)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Visiting Nurse Association of Tampa Bay Inc., 121 B.R. 114 (M.D.
Fla. 1990)</a>; but see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Healthback LLC, 226 B.R. 464 (Bankr. W.D. Okla. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re First American
Healthcare of Georgia Inc., 208 B.R. 985 (S.D. Ga. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Tidewater Memorial Hospital Inc., 106 B.R.
876 (E.D. Va. 1989)</a>. <a href="#14a">Return to article</a>

Journal Authors

Daniel C. Bruton

Thomas W. Waldrep

Journal Date

Saturday, June 1, 2002 - 12:00

Bankruptcy Rule

2002