Executive Compensation in Healthcare

Healthcare executive compensation requires attentiveness to all the stakeholders of the organization, especially as the rules may change in the blink of an eye.

Healthcare organizations today find themselves in a vortex of competing priorities, making leadership difficult at best. Governing officials are taking red pens to policies established just eight years ago. Local governments threaten the funding of Medicaid and other programs that support our organizations. The public desires greater price and financial transparency in the wake of greater cost-sharing pressures and soaring premiums.

This environment also makes hiring skilled leadership for organizations extremely difficult. Not only must we find leaders who can help us navigate through these difficult times, we must be extremely diligent in deciding how to compensate them.

Whether your organization is a medical clinic, for-profit hospital, nonprofit hospital or integrated health system, executive compensation is a complex issue. Determining compensation for leaders of a healthcare organization requires taking three competing realms into consideration.

1. What are the needs of the executive? Your organization must compensate its leaders adequately to attract talent who can lead the organization effectively.
2. What are the needs of your patients? Your organization must take the public and patients’ perception of its leaders’ compensation into account.
3. What are the tax implications? All healthcare organizations must ensure that executive compensation does not trigger tax penalties with the IRS.

All three areas are equally important and can have consequences for a healthcare organization if not addressed by following certain guidelines when determining how to compensate its leaders.

Attracting skilled healthcare leadership has become increasingly difficult for healthcare organizations. Despite the growth of MHA and healthcare-specific MBA programs across the United States, the number of experienced healthcare executives continues to shrink.

Many healthcare executives are approaching retirement age or choosing to retire early in the face of the continuously changing landscape of healthcare policy. Organizations then face pressure to either find experienced leaders who can navigate the current healthcare landscape or to train leaders from the ranks of recent MHA and MBA program graduates. Either is an expensive proposition.

As a result, healthcare organizations find themselves in a seller’s market. The shrinking numbers of trained leaders have driven healthcare leadership salaries to increase faster than the salaries of most other industries. In rural communities, the pressure to increase leadership compensation can be even higher. Healthcare organizations find themselves competing for executives and, as a result, must compensate them accordingly in order to attract skilled leaders, placing upward pressure on executive compensation for healthcare organizations.

The public is facing a two-fold setback related to healthcare costs. Healthcare insurance premiums are increasing at a furious rate driven by increasing costs to insurers and political drivers such as the discontinuation of the risk corridor and cost-sharing reduction programs. Similarly, the public’s out-of-pocket healthcare costs are increasing rapidly due to the rise of high deductible health plans and overall cost-sharing increases. As patient out-of-pocket costs increase, there is an increased pressure for cost transparency from healthcare providers.

Oftentimes, the public starts with the compensation of an organization’s leadership. For nonprofit healthcare organizations, these amounts are published on their 990 tax forms, making them an easy target when the public wants to understand why their costs are going up.

We have also seen a marked increase in news stories regarding the publicly reported salaries of healthcare leaders. These stories can undermine an organization’s mission in the minds of the very people needed to support it. When the public believes a healthcare organization overpays its leaders, public support, patient visits and admissions may decrease.

The need for public transparency places downward pressure on executive compensation in healthcare organizations.

The tax realm of executive compensation is changing rapidly. Congress is poised to pass legislation to rewrite the tax code, reducing taxes on corporations and many individuals. To help pay for these tax cuts, Congress is reducing or eliminating some of the deductions and safe harbors healthcare organizations have previously used to pay for the compensation that attracts their top executives.

The current tax code prohibits a public, for-profit corporation from deducting compensation to a covered employee in excess of $1 million per year. Currently, the $1 million deduction limit does not apply to performance-based compensation.

The tax bills passed by both the House and Senate would repeal the performance-based compensation exception. For corporations that rely on performance-based compensation for their top executives, this change will limit the deductions for executive compensation and may increase the organization’s tax bill. This may encourage for-profit corporations to consider new avenues for executive compensation.

Not-for-profit organizations can also expect significant tax changes related to executive compensation under the tax bills recently passed by the House and Senate. This new legislation would create a new 20 percent excise tax on the sum of compensation paid to any covered employee over $1 million plus the amount of any excess parachute payment paid to any covered employee. Covered employees are considered to be the top five highest-compensated employees in a tax year and any covered employee from previous tax years. This new tax would be imposed on the employer.

There are other changes for nonprofit organizations. Currently disqualified persons and organization managers who knowingly participate in an excess benefit transaction may be subject to excise taxes under the intermediate sanction rules of Section 4958 of the Internal Revenue Code. Organizations in danger of entering into an excess benefit transaction can use the rebuttal presumption of prudence to enter into an excise tax safe harbor by:

1. Ensuring the compensation was approved in advance by an authorized body of the organization comprised entirely of individuals who did not have a conflict of interest.
2. Ensuring the authorized body relied upon appropriate comparability data prior to approving the executive’s compensation.
3. Ensuring the authorized body adequately and concurrently documented the basis for approving the compensation.

The tax bill passed by the Senate removes the safe harbor and the rebuttable presumption of prudence. It imposes a 10 percent excise tax on the employer on the excess benefit. The steps above would be the minimum standards of due diligence an organization must take to ensure they did not trigger the excise tax. The Senate bill does not create a new safe harbor.

Other changes to the current excise taxes imposed on the executive and those that determined the compensation are expected to change as well. Aldrich will provide updates as the final bill is reconciled and passed by the House and Senate.

What is clear is that the tax rules regarding executive compensation for both for-profit and not-for-profit organizations are changing. Healthcare organizations must stay abreast of these changes as the House and Senate reconcile their bills. Excise taxes levied upon healthcare organizations take precious dollars away from patient care and may limit an organization’s ability to attract skilled leaders.

In order to navigate the tricky waters of executive compensation, we recommend the following to all healthcare organizations regardless of potential tax code changes:

1. Have a formal process and committee that determines and approves executive compensation for your organization.
2. Ensure that the process is in no way influenced by the executives whose compensation is being considered, including subordinate employees and family members.
3. Know your data. Use public and custom compensation surveys of like executives at similar organizations to ensure your decision is defensible to the executive, the public and the IRS.
4. Always follow a formal process to determine the appropriate compensation before making a decision to prevent blessing a compensation decision after the offer has been accepted.
5. Document all processes, meetings and compensation decisions adequately and contemporaneously so that the executive, the public and the IRS fully understand how the decision was made.
6. Where appropriate, publish appropriate information about the compensation process.
7. Use a consultant to help your organization manage the compensation process, provide appropriate comparisons and ensure that your organization respects all three realms of the executive compensation process.

By following these guidelines, healthcare organizations can hire skilled executives while preventing public backlash and harsh tax penalties.

Aldrich Advisors provides executive compensation services to many industries, including healthcare. To learn how we can help you and your organization, contact us here.