                             UNITED STATES DISTRICT COURT
                             FOR THE DISTRICT OF COLUMBIA

                                       )
COMMONWEALTH OF VIRGINIA,              )
DEPARTMENT OF MEDICAL                  )
ASSISTANCE SERVICES,                   )
                                       )
              Plaintiff,               )
                                       )
       v.                              )               Civil Action No. 08-573 (RMC)
                                       )
                          1
CHARLES E. JOHNSON, Acting             )
Secretary, U.S. Department of Health & )
Human Services, et al.,                )
                                       )
              Defendants.              )
                                       )

                                   MEMORANDUM OPINION

               Two public hospitals in the Commonwealth of Virginia provide health care services

to a disproportionate share of Medicaid and certain uninsured low-income patients and Virginia

seeks supplemental Medicaid reimbursement from the Centers for Medicare & Medicaid Services

(“CMS”) of the U.S. Department of Health and Human Services (“HHS”). Since 1981, Congress

has provided such supplemental funds to safety-net hospitals that serve large numbers of Medicaid

and other eligible patients. Congress intended these supplemental funds to improve the financial

stability of these “disproportionate share hospitals” (“DSHs”) and to preserve access to health care

services for eligible indigent patients. In this case, Virginia and CMS dispute whether, in the context

of care for the indigent, reimbursable “hospital services” include physician services at these two

public hospitals. Virginia seeks a reimbursement payment of $11,085,181, as the federal share for



       1
         Pursuant to Federal Rule of Civil Procedure 25(d), Charles E. Johnson is substituted as
Acting Secretary for his predecessor, Michael O. Leavitt, Secretary of the U.S. Department of Health
and Human Services.
its payments for physician services in 1997 and 1998 that have been disallowed by CMS. The Court

concludes that HHS’s disallowance of Virginia’s reimbursement payment was proper.

                                       I. BACKGROUND

       A.      Statutory and Regulatory Background

               The Medicaid program (Title XIX of the Social Security Act (“SSA”), 42

U.S.C. § 1396 et seq., also referred to as the “Medicaid Act” or the “Medicaid statute”) was

established in 1965 as a cooperative venture between the federal and state governments to assist

states in providing medical care to eligible individuals. Harris v. McRae, 448 U.S. 297, 301 (1980);

see also Wilder v. Va. Hosp. Ass’n, 496 U.S. 498, 502 (1990); Atkins v. Rivera, 477 U.S. 154, 156

(1986). The primary objective of the Medicaid program is “to furnish (1) medical assistance on

behalf of families with dependent children and of aged, blind, or disabled individuals, whose income

and resources are insufficient to meet the costs of necessary medical services, and (2) rehabilitation

and other services to help such families and individuals attain or retain capability for independence

or self-care.” 42 U.S.C. § 1396. Federal and state governments jointly share the cost of providing

medical care to eligible low-income and disabled individuals. See id.; id. § 1396b.

               Each state administers its own Medicaid program pursuant to a state Medicaid plan

which must be reviewed and approved by the Secretary of HHS. 42 U.S.C. §§ 1396, 1396a. If the

state’s Medicaid plan is approved by the Secretary, the state generally becomes eligible to receive

federal matching funds, or “federal financial participation” (“FFP”) for a percentage of the amounts

“expended . . . as medical assistance under the State plan.” See id. § 1396b(a)(1); see also id.

§ 1396d(b). Federal funding levels are established by a statutory formula which computes

reimbursement rates for each state, based on that state’s federally-approved state plan. See id.


                                                 -2-
§ 1396b. The types of “medical assistance” that are reimbursable by the federal government include,

among others, inpatient hospital services, outpatient hospital services, dental services, prescription

drugs, and physician services (including those furnished in a hospital). Id. § 1396d.

               The Omnibus Budget Reconciliation Act of 1981 (“OBRA 1981”) amended the SSA

to require states to make available supplemental funds to safety-net hospitals that serve large

numbers of Medicaid and other low-income patients with special needs. See Pub. L. No. 97-35,

§ 2173(B)(ii), 95 Stat. 357 (codified at 42 U.S.C. § 1396a(13)(A)(iv)). The intent was to stabilize

the hospitals financially and preserve access to health care services for eligible low-income patients:

                   [s]uch hospitals, especially in urban areas, are often multi-
                   faceted health care institutions, which provide many public
                   health and social services to all residents of their area, in
                   addition to serving as hospitals of last resort for the poor.
                   Their sizable Medicaid populations often require extra
                   social and public health services. In addition, in many areas
                   such hospitals also provide considerable care for indigent
                   persons not eligible for Medicaid, who often have only
                   partial or no health care coverage.

H.R. Rep. No. 97-158, at 295 (1981) (Budget Committee Report discussing provisions eventually

incorporated in Pub. L. No. 97-35), available at AR 01043. Only costs that are not otherwise paid

for by the patient, insurance, another third party, Medicaid, or any other program are eligible for

DSH reimbursement. Such reimbursements are called “payment adjustments.” See 42 U.S.C. §

1396r-4(c).

               States have discretion in deciding which hospitals receive DSH payments and the

level of funds that those hospitals will receive, see 42 U.S.C. § 1396r-4, although there are certain

limits. First, section 1923(f) of the SSA imposes a specific DSH funding limit (the “State DSH

Allotment”) on each state for each federal fiscal year. See id. § 1396r-4(f)(2). Thus, Congress


                                                 -3-
controls the overall level of federal DSH funding state-by-state. There is no dispute that all of the

DSH payments at issue here were well within the State DSH Allotment set by Congress for the

Commonwealth of Virginia for the respective time frames.

                Second, through the Omnibus Budget Reconciliation Act of 1993 (“OBRA 1993”),

Congress separately limited the amount of DSH payments that can be paid to each DSH hospital for

the uncompensated costs incurred for treating Medicaid beneficiaries and the indigent uninsured.

Pub. L. No. 103-66, § 13621, 107 Stat. 312, 629-33 (1993) (codified at 42 U.S.C. § 1396r-4(g)).

This hospital-specific DSH cap is referred to as the uncompensated care cost limit (the “UCC limit”).

Specifically, the SSA provides that DSH payments cannot exceed:

                the costs incurred during the year of furnishing hospital services (as
                determined by the Secretary and net of payments under this
                subchapter, other than under this section, and by uninsured patients)
                by the hospital to individuals who either are eligible for medical
                assistance under the State plan or have no health insurance (or other
                source of third party coverage) for services provided during the year.

42 U.S.C. § 1396r-4(g)(1)(A). Instead of promulgating regulations to implement the UCC limit

enacted by OBRA 1993, the Health Care Financing Administration (“HCFA”), predecessor to CMS,

issued a letter dated August 17, 1994 to State Medicaid Directors (“1994 CMS Letter”) to provide

guidance on the meaning and effect of the new enactment. See AR 01309. The 1994 CMS Letter

stated, in relevant part, that (1) “the legislative history of this provision makes it clear that States may

include both inpatient and outpatient costs in the calculation of the limit,” and (2) “in defining ‘costs

of services’ under this provision, HCFA would permit the State to use the definition of allowable

costs in its State plan, or any other definition, as long as the costs determined under such a definition

do not exceed the amounts that would be allowable under the Medicare principles of cost



                                                    -4-
reimbursement.” Id. at 01312.2 The 1994 CMS Letter explained that “[t]he Medicare principles

are the general upper payment limit [(“UPL”)] under institutional payment under the Medicaid

program.” Id. CMS concluded that “this interpretation of the term ‘costs incurred’ is reasonable

because it provides States with a great deal of flexibility up to a maximum standard that is widely

known and used in the determination of hospital costs.” Id. Although intending to issue regulations

interpreting the UCC limit that was enacted by OBRA 1993, CMS has not done so to date. See AR

01309 (“Until these regulations are published, this summary represents HCFA’s interpretation of the

new DSH requirements.”).

       B.       Factual Background

                The Commonwealth of Virginia has recognized at least two hospitals within its

borders that have been accorded DSH status: the University of Virginia Hospital (“UVA”) and

Virginia Commonwealth University’s Medical College of Virginia Hospital (“MCVH”) (together,

the “Hospitals”). Each is a teaching hospital and each cares for a disproportionate share of Medicaid

and indigent patients.

                Virginia had a State Medicaid plan in effect during the period relevant to CMS’s

disallowance (i.e., state fiscal years (“SFYs”) 1997 and 1998) which implemented the UCC limit for

these DSHs by providing:

                A payment adjustment during a fiscal year shall not exceed the sum
                of:

                         (a) Medicaid allowable costs incurred during the year less
                         Medicaid payments, net of disproportionate share payment
                         adjustments, for services provided during the year, and



       2
           For ease of reference, the Court will refer to HCFA as CMS.

                                                -5-
                       (b) Costs incurred in serving persons who have no insurance
                       less payments received from those patients or from a third
                       party on behalf of those patients. Payments made by any unit
                       of the Commonwealth or local government to a hospital for
                       services provided to indigent patients shall not be considered
                       to be a source of third party payment.

Id. at 01258, 01287. CMS approved the state plan for both years. “The Department of Medical

Assistance Services (‘DMAS’) administers the Medicaid program in Virginia and is responsible for

DSH payments.” Id. at 00181.

               Pursuant to the quoted plan language, DMAS submitted for payment adjustment the

unpaid costs for physician services to the indigent at both DSHs in SFY 1997 and 1998. When these

costs were subject to a routine audit by the HHS Office of Inspector General (“OIG”), the OIG

concluded that, though Virginia’s DSH payments to the Hospitals “were calculated in accordance

with the State plan,” Virginia should not have included the Hospitals’ costs of physician care in the

UCC calculations. Id. at 00186, 00238. Specifically, by final reports dated April 24, 2003 (“MCVH

Report”) and May 1, 2003 (“UVA Report”) (collectively, the “OIG Reports”), the OIG concluded

that: (1) the physician costs were not incurred by the Hospitals, but were incurred by the physician

practice groups that were separate legal entities; and (2) the physician costs were not allowable

because they were not consistent with Medicare cost principles. See id. at 00186, 00238. The OIG

believed “that the explicit language of the DSH statute, CMS interpretation of the statute, and

Medicare cost principles support our position that . . . physician costs should not be included as part

of [each Hospital’s] UCC.” Id. at 00192 (UVA), 00246 (MCVH). The OIG therefore recommended

that CMS recoup the federal government’s portion of DSH payments attributable to the physician

costs incurred by the Hospitals, which totaled $11,085,181. See id. at 00190 (UVA), 00245



                                                 -6-
(MCVH).

               Over two years later, after several meetings between representatives of CMS and the

Commonwealth, CMS notified Virginia, by letter dated September 8, 2005, that it was disallowing

$11,085,181 in FFP for Medicaid DSH payments because the Hospitals “overstated their UCC of

furnishing hospital services by including the UCC of independent physician groups.” Id. at 00175.

CMS explained that “[t]he individual physicians that practiced as part of these groups were not

hospital employees” as they “billed separately for their services and had their own Medicaid provider

identification numbers.” Id. at 00175-76. Further, CMS reasoned that because the services provided

by these physician groups “were billed and paid by the State . . . as physician services . . . and not

as hospital services . . .[,] the physician groups are separate entities and their costs should not have

been included with the hospitals’ uncompensated cost of furnishing hospital services.” Id. at 00176.

               On October 7, 2005, Virginia appealed the CMS disallowance to the HHS

Departmental Appeals Board (“DAB”). Id. at 00021. Although it declined to adopt CMS’s

interpretation which would preclude a hospital from including physician costs in a DSH UCC limit

calculation under any circumstances, id. at 00011, the DAB nevertheless upheld the disallowance

because the physician services at issue were not reimbursable “hospital services,” as that term is

defined in the Medicaid statute, id. at 00018. In reaching its conclusion, the DAB first explained that

by designating “hospital services” (which it defined as “inpatient hospital services” and “outpatient

hospital services”) and “physician services” as separate categories of medical assistance, Congress

intended states to treat them “as distinct for coverage, payment, and other program purposes.” Id.

at 00010. Thus, the term “hospital services,” as used in the UCC limit statute, did not include

physician services because the two are designated in the statute as “separate categories of


                                                  -7-
reimbursable medical assistance.” Id. Next, the DAB found “no evidence that Virginia’s Medicaid

program regarded the physician costs at issue here as allowable costs of inpatient hospital or

outpatient hospital services,” id. at 00013 n.11, but rather found that those costs were billed

separately to Medicaid as “physicians’ services.” Id. at 00010. After delineating its interpretation

of the UCC limit, the DAB then concluded that, although Congress “may ‘have failed to speak to

the definition of hospital services with sufficient clarity,’” id. at 00011 (internal citation omitted),

the 1994 CMS Letter placed Virginia on adequate notice of CMS’s statutory interpretation of

“hospital services” prior to making the disallowed DSH payments. Id. at 00012. Finally, the DAB

concluded that the physician costs were not permissible under the terms of the 1994 CMS Letter

which requires that the costs “would be allowable” under Medicare cost reimbursement principles:

                [W]hat seems critical here is not whether the hospital actually elected
                to receive reasonable cost-based payment under Medicare but whether
                the hospital satisfied the critical regulatory conditions—having an
                agreement among all physicians not to bill for services, or having all
                physicians be hospital employees who are precluded from billing as
                a condition of employment—for a valid election. Virginia has not
                alleged or shown that [UVA] and MCVH satisfied those conditions.

Id. at 00015. Since the DAB’s decision (the “DAB Decision”), CMS has reclaimed the disallowed

amount of $11,085,181, plus $884,458 in interest.

                                     II. LEGAL STANDARD

        A.      Summary Judgment

                Under Federal Rule of Civil Procedure 56, summary judgment must be granted when

“the pleadings, depositions, answers to interrogatories, and admissions on file, together with the

affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party

is entitled to a judgment as a matter of law.” Fed. R. Civ. P. 56(c); Anderson v. Liberty Lobby, Inc.,


                                                  -8-
477 U.S. 242, 247 (1986); see also Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986); Diamond v.

Atwood, 43 F.3d 1538, 1540 (D.C. Cir. 1995). “Summary judgment is an appropriate procedure for

resolving a challenge to a federal agency’s administrative decision when review is based upon the

administrative record.” Fund for Animals v. Babbitt, 903 F. Supp. 96, 105 (D.D.C. 1995) (citing

Richards v. Immigration & Naturalization Serv., 554 F.2d 1173, 1177 (D.C. Cir. 1977)). Because

this case involves a challenge to a final agency action, the Court’s review is limited to the

administrative record. Fund for Animals, 903 F. Supp. at 105 (citing Camp v. Pitts, 411 U.S. 138,

142 (1973)). Therefore, this case may be appropriately resolved on cross-motions for summary

judgment.

       B.      The Administrative Procedure Act

               Judicial review of a final determination rendered by a federal agency generally is

governed by the Administrative Procedure Act, 5 U.S.C. § 701 et seq. (“APA”). Thomas Jefferson

Univ. v. Shalala, 512 U.S. 504, 512 (1994). The APA requires a reviewing court to set aside an

agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance

with law.” 5 U.S.C. § 706(2)(A); Tourus Records, Inc. v. DEA., 259 F.3d 731, 736 (D.C. Cir. 2001).

In making this inquiry, the reviewing court “must consider whether the [agency’s] decision was

based on a consideration of the relevant factors and whether there has been a clear error of

judgment.” Marsh v. Oregon Natural Res. Council, 490 U.S. 360, 378 (1989) (internal quotations

omitted). At a minimum, the agency must have considered relevant data and articulated an

explanation establishing a “rational connection between the facts found and the choice made.”

Bowen v. Am. Hosp. Ass’n, 476 U.S. 610, 626 (1986); see also Pub. Citizen, Inc. v. FAA, 988 F.2d

186, 197 (D.C. Cir. 1993) (“The requirement that agency action not be arbitrary or capricious


                                                -9-
includes a requirement that the agency adequately explain its result.”). An agency action usually is

arbitrary or capricious if:

                   the agency has relied on factors which Congress has not
                   intended it to consider, entirely failed to consider an
                   important aspect of the problem, offered an explanation for
                   its decision that runs counter to the evidence before the
                   agency, or is so implausible that it could not be ascribed to
                   a difference in view or the product of agency expertise.

Motor Vehicle Mfrs. Ass’n of U.S.v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983); see also

County of Los Angeles v. Shalala, 192 F.3d 1005, 1021 (D.C. Cir. 1999) (“Where the agency has

failed to provide a reasoned explanation, or where the record belies the agency’s conclusion, [the

court] must undo its action.”).3

                As the Supreme Court has explained, “the scope of review under the ‘arbitrary and


        3
          Virginia argues that the APA standard is not the appropriate standard of review in this case.
It contends that where the recipient of a federal grants program is a sovereign, as is the case here, an
agency’s interpretation of a statute is entitled to deference only if the statute is “unambiguous” as
to its requirements. See Pl.’s Mem. in Supp. of Mot. for Summ. J. (“Pl.’s Mem.”) at 17-18 [Dkt.
# 15] (citing Pennhurst State Sch. & Hosp. v. Halderman, 451 U.S. 1, 17 (1981)). Thus, Virginia
asserts that HHS may prevail only if the Medicaid statute “unambiguously” put Virginia on notice
that the hospital costs for the physician services at issue in this case could not be billed as costs for
“hospital services” for which Virginia could rightfully claim federal reimbursement. Pl.’s Mem. at
18. The Pennhurst standard advocated by Virginia is not applicable here. The question in Pennhurst
was “whether Congress . . . imposed an obligation on the States to spend state money to fund certain
rights as a condition of receiving federal moneys” when such a condition was not readily apparent
from the plain language of the statute. 451 U.S. at 18. The Supreme Court concluded that Congress
did not impose that precondition, holding that “if Congress intends to impose a condition on the
grant of federal moneys, it must do so unambiguously . . . .” Id. at 17. Here, the question is not
whether Congress imposed a condition, or rather, an additional condition, on Virginia’s right to
receive federal funds for DSH costs, but rather how an explicit condition, i.e., the UCC limit for
hospital services, should be interpreted. Thus, the “arbitrary [and] capricious” standard is the proper
standard of review in this case. Cf. Massachusetts v. Sec. of HHS, 749 F.2d 89, 95 (1st Cir. 1984)
(“We do not believe that Pennhurst requires that every arguably ambiguous provision conditioning
the receipt of federal funds by a state be construed in the state’s favor. . . . The present case involves
not the imposition of a new condition on the state but the interpretation of the provisions governing
the remedies available to the federal government.”).

                                                  -10-
capricious’ standard is narrow and a court is not to substitute its judgment for that of the agency.”

Motor Vehicle Mfrs. Ass’n, 463 U.S. at 43. Rather, the agency action under review is “entitled to

a presumption of regularity.” Citizens to Pres. Overton Park, Inc. v. Volpe, 401 U.S. 402, 415

(1971), abrogated on other grounds by Califano v. Sanders, 430 U.S. 99 (1977). If the district court

can “reasonably discern” the agency’s path, it should uphold the agency’s decision. Pub. Citizen,

988 F.2d at 197.4

               The Supreme Court set forth a two-step approach to determine whether an agency’s

interpretation of a statute is valid under the APA. Chevron U.S.A. Inc. v. Nat. Res. Def. Council,

Inc., 467 U.S. 837, 842 (1984). This approach, commonly referred to as “Chevron deference,”

requires the court to first look to “whether Congress has spoken to the precise question at issue.”

Id. If so, the court ends its inquiry. Id. But, if the statute is ambiguous or silent, the second step

requires the court to defer to the agency’s position, so long as it is “based on a permissible

construction of the statute.” Id. at 843; Sea-Land Servs., Inc. v. Dep’t of Transp., 137 F.3d 640, 645

(D.C. Cir.1998) (holding that “[Chevron] deference comes into play of course, only as a consequence

of statutory ambiguity, and then only if the reviewing court finds an implicit delegation of authority

to the agency”).     In applying Chevron, the Supreme Court has held that “administrative



       4
          For a court to have jurisdiction under the APA, the challenged agency action must be final.
Cobell v. Norton, 240 F.3d 1081, 1095 (D.C. Cir. 2001). A final agency action “(1) marks the
consummation of the agency’s decisionmaking process – it must not be of a merely tentative or
interlocutory nature; and (2) the action must be one by which rights or obligations have been
determined or from which legal consequences will flow.” Domestic Secs., Inc. v. SEC, 333 F.3d.
239, 246 (D.C. Cir. 2003) (internal quotations omitted). The final agency action at issue in this case
is the DAB Decision upholding the disallowance; that decision is the only one that is presently under
review. See 42 C.F.R. § 430.42; cf. id. § 405.1877(a)(4) (explaining that where the Administrator
sets forth a final decision, only that decision is subject to judicial review, not the agency decision
below which was reversed, affirmed, or modified by the Administrator).

                                                -11-
implementation of a particular statutory provision qualifies for Chevron deference when it appears

that Congress delegated authority to the agency generally to make rules carrying the force of law, and

that the agency interpretation claiming deference was promulgated in the exercise of that authority.”

United States v. Mead Corp., 533 U.S. 218, 226-27 (2001). Indeed, “judgment about the best

regulatory tools to employ in a particular situation is . . . entitled to considerable deference from the

generalist judiciary.” W. Union Int’l v. FCC, 804 F.2d 1280, 1292 (D.C. Cir. 1986). There is no

question here but that Congress entrusted the Secretary of HHS with the responsibility of

administering the Medicare and Medicaid programs. See Methodist Hosp. of Sacramento v. Shalala,

38 F.3d 1225, 1229 (D.C. Cir. 1994). Thus, the Secretary’s construction of the complex statutory

scheme governing these programs is frequently entitled to deference. See id. (“[T]he court takes

special note of the tremendous complexity of the Medicare statute. That complexity adds to the

deference which is due to the Secretary’s decision.”); see also Thomas Jefferson Univ., 512 U.S. at

512.

                                           III. ANALYSIS

                This case boils down to a dispute over the nature of the “hospital services” that are

subject to DSH reimbursement pursuant to section 1923(g)(1)(A) of the SSA (codified at 42 U.S.C.

§ 1396r-4(g)(1)(A)) and further described in the 1994 CMS Letter. Defendants assert:

                As the term “hospital services” is used in the Medicaid statute’s
                description of “medical assistance,” and as it is explicitly defined in
                the legislative history, it is clear that the costs incurred in furnishing
                “hospital services” mean the costs incurred in furnishing “inpatient
                hospital services” and “outpatient hospital services.” HHS has, in its
                contemporaneous interpretation of the phrase “cost incurred of
                furnishing hospital services,” adopted the legislative history confining
                the DSH payment to the costs of “inpatient” and “outpatient” hospital
                services.


                                                  -12-
Defs.’ Mem. in Supp. of their Combined Mot. for Summ. J. & Opp’n to Pl.’s Mot. for Summ. J.

(“Defs.’ Mem.”) at 2. HHS insists that neither “inpatient hospital services” nor “outpatient hospital

services” includes the physician services provided to uninsured patients at the two public Virginia

hospitals. Id. Because the statute is dense and Defendants state their position in clear English, the

Court quotes liberally from Defendants’ brief:

               First, it is clear that under the Medicaid statute, “physician services”
               are not synonymous with “hospital services,” nor are “physician
               services” simply a subset of “inpatient” or “outpatient” hospital
               services. Instead, the complex Medicaid statute treats these terms
               differently and, indeed, provides different parameters for what the
               states may include within each of these categories. Therefore, while
               the Medicaid program may permit a state to decide, and then
               categorize, some services rendered by physicians in their hospitals as
               “inpatient” or “outpatient” services, it does not categorically fold all
               services rendered by a physician into the costs of inpatient or
               outpatient hospital services. Pursuant to the Medicaid statute, the
               states are required to properly categorize services provided in the
               state under its Medicaid plan, and the states are given flexibility under
               the Medicaid program in doing so, as long as they follow the
               parameters and conditions set forth under the statute and regulations.
               The state Medicaid plan is, after all, the vehicle through which a state
               obtains all federal funding for its expenditures under its Medicaid
               program. Thus, the Medicaid statute makes clear that “physician
               services” and “inpatient” and “outpatient hospital services” are
               distinct categories of service, and that it is incumbent upon the states
               to cover and appropriately categorize any given service in their state
               Medicaid plans. Virginia did not cover the types of services rendered
               by physicians here in its Medicaid plan as an inpatient or outpatient
               “hospital service.” Therefore, it cannot now claim these costs as
               costs of “hospital services” for DSH payment purposes. Under the
               Medicaid statute, Virginia’s argument fails.

               Second, the Secretary’s interpretation of the [DSH] requirements and
               the administrative record in this case make clear that the physician
               costs are not allowable for DSH payment purposes. The Secretary
               has read the DSH provision as limiting allowable costs to inpatient
               and outpatient hospital costs, as defined and covered by the state


                                                 -13-
                plan. However, Virginia did not authorize or cover in its state
                Medicaid plan the types of services at issue as “inpatient” or
                “outpatient” hospital services. Indeed, for the very same types of
                services provided to Medicaid and Medicare patients, Virginia
                separately billed the federal government for, and was reimbursed for,
                these services as “physician services” and did not bill for them as part
                of the hospitals[’] inpatient or outpatient hospital service rate.
                Notwithstanding Virginia’s own treatment of these services as
                “physician services” rather than “inpatient hospital services” or
                “outpatient hospital services,” Virginia now wants HHS and this
                Court, to void Virginia’s prior choices and rewrite [the] Virginia state
                [Medicaid] plan using a definition and categorization of certain
                services that would maximize Medicaid payment to the state.

Defs.’ Mem. at 3-4 (emphases added). Virginia contends that both “inpatient hospital services” and

“outpatient hospital services” are separately defined in regulations to include physician services, Pl.’s

Statement of Material Facts as to Which There is No Genuine Issue ¶ 12 [Dkt. # 15-2], and that its

inclusion of these physician services in its UCC fully comported with Medicare principles.

                It is useful to remember that the final agency decision that is challenged here is the

DAB Decision and not the 1994 CMS Letter. As the DAB itself acknowledged, Congress did not

speak to the meaning of “hospital services,” as used in section 1923(g)(1)(A) of the SSA, with

clarity. See AR 00011. Given its agreement that the statute is dense and provides no clarity here,

the Court will move directly to step two of the Chevron analysis, i.e., whether the DAB’s position

was “based on a permissible construction of the statute.” 467 U.S. at 843. The DAB held that

“hospital services” did not encompass the physician services that Virginia reported as reimbursable

DSH costs, and that the 1994 CMS Letter gave Virginia adequate notice of that interpretation.

Although not immediately obvious, the Court concludes that both holdings are permissible and

reasonable interpretations of the statute and the 1994 CMS Letter and are entitled to deference here.

                First the DAB recognized that “the services of physicians are often provided in


                                                  -14-
hospitals and might reasonably be considered a subset or component of hospital services in that

ordinary sense.” AR 00008 (emphasis in original). Virginia wishes it had stopped there but the

DAB concluded the sentence by finding that “the context surrounding section 1923(g) indicates that

Congress intended the term ‘hospital services’ to have a technical or specialized legal meaning.”

Id. This conclusion was certainly within the authority of the DAB to reach and, given the complexity

of the Medicare and Medicaid statutes, it is reasonable and entitled to deference. In opposition,

Virginia would cut the DSH program from its moorings in Medicaid/Medicare and have it be a

stand-alone, plain English provision of extra federal monies to hospitals that serve a disproportionate

share of the uninsured poor. Pl.’s Reply at 2 (“[A]lthough the DSH program is found within the

Medicaid statute, it is a different funding mechanism subject to completely different reimbursement

and reporting standards.”). Presumably, CMS could have so interpreted the program when it issued

the 1994 CMS Letter but as long ago as then, it is clear that the agency chose a different path and

tied reimbursement to “the amounts that would be allowable under the Medicare principles of cost

reimbursement.” AR 01312 (emphasis added). The argument that the DSH program is separate and

apart from the rest of the statute is a non-starter.

                Second, the DAB did in fact interpret the DSH payment provisions, and in particular,

the term “hospital services,” in light of the broader Medicaid statute. The DAB explained that the

Medicaid statute “provides that a DSH payment (or ‘payment adjustment’) constitutes an

‘appropriate increase in the rate or amount of payment’ for ‘inpatient hospital services.’” AR 00009

(citing 42 U.S.C. § 1396r-4(a)(1)(B)). It concluded that “[t]his statement suggests that Congress did

not intend DSH payments to offset all of the costs that might be incurred by a DSH in addressing

the medical needs of indigent patients, but only those costs of providing what might properly be


                                                  -15-
classified as ‘hospital services’ for Medicaid purposes.” AR 00009 (emphasis in original). The

conclusion was buttressed in part by the fact that “‘[i]npatient hospital services,’ ‘outpatient hospital

services,’ and ‘physicians’ services’ are listed in section 1905(a) [of the SSA] as distinct categories

of medical assistance” and are reported separately on the Medicaid Quarterly Statement of

Expenditures (“QSE”). Id. at 00008-00009; see also id. at 0009 n.8 (citing La. Dep’t of Human

Servs., DAB No. 1772 (2003) (DAB interpreted the House Conference Report accompanying OBRA

1993 as showing an “inten[t] to limit the amount of funds that can be claimed as DSH payment

adjustments for hospital services, rather than expand the types of medical assistance that can be

claimed.”) (emphasis in original)). Interpreting the Medicaid Act is certainly within the purview of

the DAB and its permissible interpretation is entitled to deference.

                Third, the DAB relied on the Medicare Prescription Drug, Improvement, and

Modernization Act of 2003, Pub. L. No. 108-173, 117 Stat. 2431, which “directs states to submit an

independent audit verifying that ‘[o]nly the uncompensated care costs of providing inpatient hospital

and outpatient hospital services . . . are included in the calculation of the hospital-specific limits

under such subsection.” See AR 00009 (citing 42 U.S.C. § 1396r-4(j)(2)(C)) (emphasis in original).

While this later-passed law bolsters the DAB’s decision, it is cold comfort to Virginia, which

incurred these physician costs and submitted them for reimbursement in the late 90s, well before the

prescription drug benefit became part of Medicare.

                The DAB concluded:

                In view of these circumstances, it is clear that the term “hospital
                services” in section 1923(g)(1)(A) refers to the categories of medical
                assistance identified in section 1905(a) as “inpatient hospital
                services” and “outpatient hospital services.” By designating “hospital
                services” and “physicians’ services” as separate categories of


                                                  -16-
                reimbursable medical assistance, Congress intended states to treat
                them as distinct for coverage, payment and other program purposes.

AR 00010. To this rather curiously broad statement, the DAB added a footnote:

                We express no view about whether (or to what extent, if any) the
                statute permits a state Medicaid program to cover or pay for a
                particular service furnished by a physician as a “hospital service”
                rather than as a “physician’s service.” We emphasize only that a
                service cannot be classified as both a hospital and a physician’s
                service.

Id. at 00019 n.9. But see 42 C.F.R. § 415.160 (allowing teaching hospitals to elect to have physician

services covered as “hospital services” if certain conditions are met).5

                Finally, the DAB declared:

                A cost may not be included in the calculation of the DSH payment
                limit unless it is the cost of a service that is covered and paid for
                under the state plan as a “hospital service.” . . . Virginia has
                acknowledged that the services in question, when provided to
                Medicaid recipients, were billed to Medicaid as “physicians’
                services.”

AR 00010 (emphasis in original). Because physician services rendered to Medicaid patients are

reported as “physicians’ services” on Virginia’s QSE, the DAB disallowed inclusion of “physician

services” as part of “hospital services” when provided to indigent patients. Id. It is difficult to find




        5
          Of course, it is just those examples of “physician services” being properly reimbursed as
a part of “hospital services” upon which Virginia relies. See Pl.’s Reply at 22 (citing AR 01338,
Audit of California’s Medicaid Inpatient Disproportionate Share Hosp. Payment for Kern Med. Ctr.,
State Fiscal Year 1998 (Sept. 17, 2002)); AR 01402, Audit of California’s Medicaid Inpatient
Disproportionate Share Hosp. Payments for L.A. County Hosps., State Fiscal Year 1998 (May
2003)); see also 60 Fed. Reg. 61483, 61484-85 (Nov. 30, 1995) (“nurse-midwife services are similar
to physician services in that they may be billed in their own distinct category or alternatively may
be billed under other categories such as hospital or clinic services.”).

                                                 -17-
irrationality in this analysis.6

                While the DAB’s interpretation fully met the APA’s standards, nothing issued by

CMS was ever as clear as the DAB Decision under review. Recognizing that its statutory

interpretation had never before been articulated, the DAB looked to the 1994 CMS Letter to see if

Virginia had received fair warning that the category “hospital services” was so limited. This is

where Virginia loses its case, its common-sense arguments notwithstanding.

                As noted by the DAB, the 1994 CMS Letter directs states to determine a hospital’s

uncompensated costs by using the “‘definition of allowable costs in its State plan, or any other

definition [of allowable costs], as long as the costs determined under such a definition do not exceed

the amounts that would be allowable under Medicare principles of cost reimbursement.’” Id. at

00012 (emphasis in original) (internal citation omitted). The DAB explained that although the 1994

CMS Letter does not use the precise terms “inpatient hospital services” or “outpatient hospital

services,” nonetheless the Letter “state[d] that a hospital’s ‘cost of services’ includes both inpatient

and outpatient costs.” Id. The terms “inpatient and outpatient are used in the Medicaid statute and

regulations only with reference to ‘hospital services’ or ‘nursing facility’ services.” Id. Further, the

1994 CMS Letter provided that “the determination of a hospital’s allowable costs would be subject

to the upper payment limit (UPL) regarding ‘institutional payment.’ In 1994, the relevant UPLs for


        6
          CMS urged the DAB to adopt an interpretation, “‘which CMS says is ‘consistent with the
statutory design and longstanding regulatory policy,’ [that would] preclude[] a hospital from
including physician costs in the DSH payment limit calculations under any circumstances.” AR
00011 (internal citation omitted) (emphasis in original). The DAB declined to adopt such an
interpretation because Virginia did not have timely notice, the interpretation appears no where in the
Federal Register or other agency pronouncements, and, as late as October 2003, CMS officials
“expressed the view that physician costs could be included in the payment limit calculation under
some circumstances.” Id.; see also 42 C.F.R. § 415.160 (allowing physician services to be reported
as “hospital services” under certain circumstances).

                                                 -18-
‘institutional’ payments were caps on payments for ‘inpatient hospital services’ and ‘outpatient

hospital services.’” Id. (citing C.F.R. §§ 447.253(b), 447.272, 447.321). The DAB therefore

concluded that:

               From these elements of the 1994 CMS Letter, it should have been
               clear to Virginia, when it made the disallowed DSH payments, that
               a cost could be included in the calculation of a hospital’s DSH
               payment limit only if it was an “allowable” cost (for payment or
               reimbursement purposes) of an inpatient hospital or outpatient
               hospital service under the state’s Medicaid program or relevant
               Medicare cost reimbursement policies.

AR 00012. Given the DAB’s reasoned explanation, the Court cannot say that the DAB acted

arbitrarily or capriciously in concluding that Virginia should have been on notice that the costs

incurred by the Hospitals for physician services could not be included in the calculation of the DSH

payment limit because those costs were not “allowable” under its state plan or under Medicare

principles of cost reimbursement. See id.

               To rebut this conclusion, Virginia protests that under Medicare principles, physician

services are allowed as part of hospital services at teaching hospitals, for which both Hospitals

qualify. Indeed, CMS regulations provide:

               (a) Scope. A teaching hospital may elect to receive payment on a
               reasonable cost basis for the direct medical and surgical services of
               its physicians in lieu of fee schedule payments that might otherwise
               be made for these services.7

               (b) Conditions. A teaching hospital may elect to receive these


       7
         Reimbursement on a reasonable cost basis is a retrospective payment system that was once
the common payment method for Medicare for both physicians’ and hospital costs. See 42 C.F.R.
Part 413. Now, “[t]he statute requires that the prospective payment rate serve as total Medicare
payment for inpatient operating costs for all items and services furnished other than physicians’
services.” 48 Fed. Reg. 39,752, 39,761 (Sept. 1, 1983). The prospective payment system generally
employs a predetermined rate of payment for a given patient diagnosis. Id. at 39,754.

                                               -19-
               payments only if –

                       (1) The hospital notifies its intermediary in writing of the
                       election and meets the conditions of either paragraph (b)(2) or
                       paragraph (b)(3) of this section;

                       (2) All physicians who furnish services to Medicare
                       beneficiaries in the hospital agree not to bill charges for these
                       services; or

                       (3) All physicians who furnish services to Medicare
                       beneficiaries in the hospital are employees of the hospital and,
                       as a condition of employment, are precluded from billing for
                       their services.

               (c) Effect of election. If a teaching hospital elects to receive
               reasonable cost payment for physician direct medical and surgical
               services furnished to beneficiaries –

                       (1) Those services and the supervision of interns and residents
                       furnishing care to individual beneficiaries are covered as hospital
                       services, and

                       (2) The intermediary pays the hospital for those services on a
                       reasonable cost basis under the rules in § 415.162. (Payment for
                       other physician compensation costs related to approved GME
                       programs is made as described in § 413.78 of this chapter.)

               (d) Election declined. If the teaching hospital does not make this
               election, payment is made –

                       (1) For physician services furnished to beneficiaries on a fee
                       schedule basis as described in part 414 subject to the rules in
                       this subpart, and

                       (2) For the supervision of interns and residents as described
                       in §§ 413.75 through 413.83.

42 C.F.R. § 415.160. Payment for physician services is normally made on a “fee schedule basis,”

which pays standard rates based on a uniform set of factors – see 56 Fed. Reg. 59625 (Nov. 5, 1991);

42 C.F.R. Part 415; 60 Fed. Reg. 63126 (Dec. 8, 1995) – but 42 C.F.R. § 415.160 provides an


                                                 -20-
exception which allows a teaching hospital, under certain circumstances, to seek reimbursement for

physician services on a “reasonable cost basis” instead of a “fee schedule basis.” If a teaching

hospital complies with the applicable conditions and elects to receive “reasonable cost payment for

physician . . . services,” those physician services will be covered as “hospital services” for purposes

of Medicare reimbursement. Id. § 416.160(c).

                Inasmuch as the 1994 CMS Letter instructed that states could seek reimbursement

using the “definition of allowable costs in its State plan, or any other definition,” see AR 00012

(emphasis added), Virginia argues that it used the definition from 42 C.F.R. § 415.160, that all of

its physicians giving care to the indigent had formally agreed not to bill on a fee schedule basis for

that care, and, therefore, that the DAB erred when it sustained the disallowance. But Virginia shaves

the definition that is in 42 C.F.R. § 415.160, omitting the requirement that “[a]ll physicians who

furnish services to Medicare beneficiaries in the hospital agree not to bill charges for these services.”

42 C.F.R. § 415.160(b)(2) (emphasis added). Its physicians who provided care to indigent patients

agreed not to bill charges for those services, but the physicians treating patients covered by Medicare

billed on the normal fee schedule method. Because it did not fulfill the requirements of 42 C.F.R.

§ 415.160, Virginia’s costs for physician services to the indigent were not “covered as hospital

services,” and therefore were not “allowable” under Medicare cost principles; hence, they could not

be submitted for federal reimbursement. See AR 00014-15.

                                        IV. CONCLUSION

                For the foregoing reasons, the Court concludes that the DAB’s decision disallowing

the claim for federal DSH payment for Virginia’s costs of providing “physician services” to the

uninsured at the two Hospitals is grounded in a permissible interpretation of the Medicaid statute and


                                                  -21-
must therefore be upheld. Accordingly, the Court will grant Defendants’ motion for summary

judgment [Dkt. # 16] and will deny Plaintiff’s motion for summary judgment [Dkt. # 15]. A

memorializing order accompanies this Memorandum Opinion.



Date: March 25, 2009                                             /s/
                                                  ROSEMARY M. COLLYER
                                                  United States District Judge




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