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3.2 ASC 606 five-step model
Publication date: 31 Mar 2023
us Health care guide
ASC 606-10-05-3 describes the core principle regarding the recognition of revenue.
The core principle of this Topic is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
In order to implement that principle, the standard lays out five broad steps:
- Step 1—identify the contract with the customer (see HC 3.2.1)
- Step 2—identify performance obligations (see HC 3.2.2)
- Step 3—determine transaction price (see HC 3.2.3)
- Step 4—allocate transaction price to performance obligations (see HC 3.2.4)
- Step 5—recognize revenue (see HC 3.2.5)
This chapter references excerpts from the AICPA Audit and Accounting Guide, Revenue Recognition (AAG-REV), chapter 7, Health Care Entities. That nonauthoritative interpretive guidance was developed by an AICPA Health Care Revenue Recognition Task Force under the supervision and ultimately approval of the AICPA’s Financial Reporting Executives Committee (FinREC) to assist providers and auditors with understanding the application of ASC 606’s broad principles in the context of health care services transactions.
3.2.1 Step 1 – Identify the contract
The first step is to evaluate a contract’s characteristics to determine whether it should be accounted for using the ASC 606 model. This section discusses Step 1 in the context of health care services transactions. For a comprehensive discussion of the general requirements of Step 1, see RR 2.
For providers, the threshold issue in Step 1 is to identify the party that is the customer in the revenue transaction. As discussed in HC 2.1.3.1, health care service transactions often involve more parties than the traditional buyer and seller. Thus, the key question is whether the customer is the patient that receives the health care services or a third party that negotiates with the provider and establishes the amount that will be paid to the provider for the provision of services.
According to AAG-REV 7.6.46, from the perspective of the provider, the “contract with the customer” relates to the arrangement with the patient. Under that arrangement, the health care entity agrees to provide the services requested by the patient, and the patient agrees to pay for those services. As discussed in HC 2, separate contracts between health care providers and third-party payers that establish negotiated prices for the services (discussed in HC 2.1.4.1) are not “contracts with customers” under ASC 606. Instead, those arrangements are considered in determining the transaction price for the contract between the provider and patient (see HC 3.2.3).
Question HC 3-1
A patient makes an appointment with Physician Associates (PA). The patient has commercial health insurance coverage through Health Plan. During the intake process, patient signs a patient responsibility form in which they acknowledge their responsibility to pay and authorizes Health Plan to make payments directly to PA. PA is a “participating provider” in Health Plan’s provider network.
For purposes of ASC 606, who are the “parties to the contract?”
A patient makes an appointment with Physician Associates (PA). The patient has commercial health insurance coverage through Health Plan. During the intake process, patient signs a patient responsibility form in which they acknowledge their responsibility to pay and authorizes Health Plan to make payments directly to PA. PA is a “participating provider” in Health Plan’s provider network.
For purposes of ASC 606, who are the “parties to the contract?”
PwC response
The fact pattern describes three separate contractual arrangements – an arrangement between patient and PA (the provider), an arrangement between patient and Health Plan, and an arrangement between PA and Health Plan. The arrangement between the patient and PA is the “contract with the customer” for purposes of applying ASC 606.
The separate agreement between PA and Health Plan establishes agreed-upon contractual prices for services that PA may provide to Health Plan’s subscribers. These prices will be a focus of Step 3 (transaction price).
The separate agreement between patient and Health Plan provides that Health Plan will reimburse the patient for an agreed-upon portion of costs it incurs in connection with obtaining medical services specified in the insurance contract. Patient’s assignment of its rights to the payment gives Health Plan the ability to make the payment directly to PA, rather than to patient. The party that is financially responsible—patient or Health Plan—will also be a relevant consideration in Step 3 (transaction price) in determining the consideration to which the entity expects to be entitled in exchange for those services.
The ASC 606 model uses a definition of a “contract” for accounting purposes that is based on common legal definitions of a contract in the United States. Its key elements are described in ASC 606-10-25-2.
A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral, or implied by an entity’s customary business practices.
Accordingly, a contract with a customer must be enforceable by law in order for the rights and obligations to be considered under the ASC 606 model. In determining whether a contract with a patient exists for accounting purposes, providers must consider the five criteria specified in ASC 606-10-25-1.
An entity shall account for a contract with a customer … only when all of the following criteria are met:
- The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
- The entity can identify each party’s rights regarding the goods or services to be transferred.
- The entity can identify the payment terms for the goods or services to be transferred.
- The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).
- It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Criteria (a) through (c) relate to the parties’ rights and obligations under the arrangement. The rights of the parties must be identifiable from the contract; otherwise, the entity will not be able to identify its performance obligations in Step 2 of the process (HC 3.2.2).
The arrangement between the provider and patient does not have to be written; it can be oral or evidenced through established business practices. In accepting the patient’s request to be seen, contacting a patient to establish an appointment, or admitting a patient to an inpatient setting, the provider indicates its willingness to provide services requested by the patient. On the patient’s end, requesting an appointment or presenting themselves for assessment or treatment inherently constitutes a request for services. In addition, patients (or their legal representatives) typically will sign a “patient responsibility form,” which acknowledges the patient’s responsibility to pay for the services, or in some cases may sign a consent form for certain procedures. In situations involving emergency treatment of a patient who is unconscious or otherwise unable to sign a legally enforceable agreement (e.g., a minor), an oral or implied contract may exist based on legal standards and customary health care practices.
See AAG-REV 7.6.05 for additional commentary about the existence of a contract.
Question HC 3-2
Hospital’s practice is to obtain a signed patient consent form prior to performing certain procedures. Patient does not sign a consent form prior to receiving services due to administrative oversight or the procedure did not require a signed consent. Can an enforceable contract exist if the patient has not signed written consent for services?
Hospital’s practice is to obtain a signed patient consent form prior to performing certain procedures. Patient does not sign a consent form prior to receiving services due to administrative oversight or the procedure did not require a signed consent. Can an enforceable contract exist if the patient has not signed written consent for services?
PwC response
Typically, yes. The lack of a written agreement and the fact that the hospital’s policy is to obtain a patient acknowledgement does not necessarily mean that a contract does not exist. However, the hospital will need to consider the individual facts and circumstances to determine if there is an oral or implied contract, including customary business practices. For example, if the patient scheduled the procedure in advance or presented themselves for treatment, the hospital may conclude that there is a legally enforceable oral or implied contract with the patient.
Regarding criterion (c), as long as there is an enforceable right to receive payment in exchange for the goods or services, the transaction price does not need to be expressly stated within the agreement. In fact, in contracts for health care services, the transaction price often differs from the amount that will be billed to the patient, as discussed in HC 3.2.3.
Criterion (d) requires that the contract have commercial substance (that is, the entity must expect its cash flows to change as a result of the services provided). It is closely related to criterion (e), which requires that the provider be able to conclude that it is probable that it will collect the consideration to which it will ultimately be entitled, based on an assessment of the customer’s ability and intent to pay as amounts become due. Often, providers will perform services without knowing whether the patient will be able to pay the bill (or the portion of the bill for which the patient is responsible). When a provider is aware of significant credit risk on the part of a customer at the inception of an arrangement (for example, the individual requesting services is uninsured or underinsured), the health care entity must consider that risk in its evaluation of whether the customer is committed to perform its obligations under the contract (i.e., to pay for services rendered).
As discussed in AAG-REV 7.6.19 and AAG-REV 7.6.43, for purposes of assessing criterion (e), the collectability assessment for patient contracts that are inherently at high risk for non-payment would be made using an estimated transaction price that is reduced by the expected uncollectible amounts. Two important concepts discussed in Step 3 – implicit price concessions (see HC 3.2.3) and the use of a portfolio approach (see HC 3.4.1) – underpin that conclusion. Because the estimated transaction price in these situations typically is based on the lower amounts expected to be collected, such contracts would be deemed to pass criterion (e).
Question HC 3-3
Normally, Hospital’s ability to collect accounts receivable from patients in the uninsured self-pay payer class has been poor (historically, an average of 20% of the total gross charges is collected from this class of patients). Thus, it appears unlikely that Hospital would be able to conclude that it is probable that it will collect all of the consideration to which it is entitled for services to those patients. How is the collectability threshold in ASC 606-10-25-1(e) evaluated in such situations?
Normally, Hospital’s ability to collect accounts receivable from patients in the uninsured self-pay payer class has been poor (historically, an average of 20% of the total gross charges is collected from this class of patients). Thus, it appears unlikely that Hospital would be able to conclude that it is probable that it will collect all of the consideration to which it is entitled for services to those patients. How is the collectability threshold in ASC 606-10-25-1(e) evaluated in such situations?
PwC response
If Hospital provides services to patients that are inherently at high risk for non-payment, the collectability analysis typically would be based on an expectation of performance for a portfolio of high-credit-risk contracts as a whole, rather than on the basis of expectations of collectability from each individual high-credit-risk patient. (If Hospital did not utilize the portfolio approach and instead performed the evaluation for each individual patient, it would be unlikely that the arrangement would qualify as a contract with a customer.)
The collectability assessment for the portfolio would use an estimated transaction price that is based on the expected performance of the portfolio of contracts in the aggregate. Thus, if the entity historically collects 20 cents on the dollar on average for contracts in this portfolio, the transaction price for a portfolio of contracts representing $1 million of charges would be estimated at $200,000. Because the amount expected to be collected will be the same as the expected transaction price, Hospital would conclude that it is probable that the entity will collect the $200,000, and the contracts within the portfolio will pass criterion (e). The logic is that, absent evidence to the contrary, Hospital is just as likely to collect the average amount (in this case, 20 cents on the dollar) from any one patient in the portfolio as another. Example HC 3-3 in HC 3.4.2 illustrates the calculation of the transaction price in such a situation.
3.2.1.1 Identifying the contract’s term
Another important aspect of the contract with the customer is properly identifying its term (duration). For many FFS health care arrangements, the service—a procedure, an office visit, a hospital stay—may be delivered in a finite period of time and identifying the contract term will be straight forward. However, in some long-term care arrangements, such as in-home nursing or skilled nursing services in a facility, identifying the contract term may be more challenging.
For accounting purposes, the contract’s term may differ from the stated term as a result of features such as termination rights and renewal options. Providers will need to carefully evaluate such features to determine how they affect contract duration (that is, the period in which there are enforceable rights and obligations between the parties), as the duration directly impacts the identification of performance obligations and how and when revenue can be recognized under the contract.
Excerpt from ASC 606-10-25-3
An entity shall apply the guidance in this Topic to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations.
For example, if an arrangement is cancellable at the discretion of the patient and without penalty (as is often the case with health services arrangements covering extended periods), the stated contract term is disregarded. For ASC 606 purposes, the contract term extends from inception to the earliest date on which the customer can terminate. Essentially, this becomes a contract for the shorter term, with options to renew.
FASB Staff Q&A Revenue
Excerpt from Question 8: How do customer termination rights and penalties affect the identification of a contract duration?
The staff thinks that paragraph BC391 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), clarifies that customer cancellation rights can be similar to a renewal option. The staff thinks that this would typically be the case when there are no contractual penalties that compensate the other party upon cancellation and when the customer has the unilateral right to terminate the contract for other than cause or contingent events outside the customer’s control.
Similar issues arise for “evergreen” contracts, such as open-ended contracts for residential care. Often, the stated term of the contract between the resident and the skilled nursing facility (SNF) is one month, with automatic renewal unless one of the parties provides notice of termination. However, if the resident has the unilateral right to terminate at any time during the month with no penalty (so the provider’s compensation would be limited to payment for days of service actually provided), the contract actually has a day-to-day term with options to renew. In other words, each day is a separate contract that will automatically renew for another day unless terminated.
Example 7-5-2 and Example 7-5-3 in AAG-REV 7.5.08 illustrate these concepts. See HC 3.2.2.1 for discussion of how termination features and renewal options affect the determination of performance obligations.
3.2.2 Step 2 – Identify the performance obligations in the contract
Under ASC 606, the actions or deliverables for which the customer has contracted are referred to as “performance obligations.” Step 2 in the five-step process is to identify the performance obligation in a contract with the customer.
According to ASC 606-10-25-14, a performance obligation is a promise in a contract to provide the customer with a distinct good or service, a distinct bundle of goods or services, or a series of distinct goods or services that are substantially the same. Some contracts may involve a single performance obligation, while others may include multiple performance obligations. Appropriately identifying the performance obligations directly impacts how and when revenue can be recognized under a contract.
HC 3.2.2.1 (which focuses on identifying distinct bundles of services) and HC 3.2.2.2 (which focuses on a series of repetitive services) consider the aspects of identifying performance obligations that are most relevant to fee-for-service health care services contracts. For a comprehensive discussion of Step 2 considerations, see RR 3.
3.2.2.1 Identifying distinct bundles of services
Health care services contracts typically involve delivery of more than a single good or service to the patient. Delivering health care services normally involves diagnosis, evaluation, and carrying out a plan of care prescribed by a medical professional. Thus, identifying the performance obligation(s) within a health care services contract involves determining (from the perspective of the patient) whether the patient is contracting to purchase an array of individual goods and services in the course of the office visit or inpatient stay (in which case each good or service might represent an individual performance obligation), or instead whether the patient is contracting for the “output” of a process that incorporates those goods and services (for example, diagnosis and treatment for a sore throat; a routine physical examination; a knee replacement).
ASC 606-10-25-19 outlines two criteria that are used to determine whether an individual good or service promised in a contract should be accounted for as a separate performance obligation (i.e., it is “distinct”).
A good or service that is promised to a customer is distinct if both of the following criteria are met:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).
In health care services transactions, criterion (b) typically acts as an initial screen in this evaluation. Its objective is to determine whether the nature of the provider’s promise is to transfer individual goods or services to the patient, or instead to transfer a “combined item” to which those individual goods and services are an input.
ASC 606-10-25-21 provides the overarching principle that is relevant to evaluating criterion (b).
In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable in accordance with paragraph 606-10-25-19(b), the objective is to determine whether the nature of the promise, within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs. Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following:
- The entity provides a significant service of integrating goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. In other words, the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer.
- One or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract.
- The goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfill its promise by transferring each of the goods or services independently.
Factor (a) in ASC 606-10-25-21 describes an interrelationship between promised goods and services that are present in most health care services contracts. Viewed from the patient’s perspective (as required by ASC 606), the individual goods and services are “inputs” that will be used in a process to produce an outcome (i.e., output) for which the patient is contracting. If the patient is contracting for a combined output, the array of goods and services that will be utilized in the process must be combined into a single performance obligation, and consideration of ASC 606-10-25-19(a) becomes irrelevant.
Example HC 3-1 illustrates the application of this guidance to a contract between a hospital and a surgical patient. AAG-REV 7.5.08 provides additional illustrations of this determination for inpatient hospital services (Example 7-5-1) and physician office services (Example 7-5-2).
EXAMPLE HC 3-1
Single performance obligations – combined bundle of goods or services
Single performance obligations – combined bundle of goods or services
Surgeon admits a patient to Hospital for knee replacement surgery. Hospital is responsible for the overall management of the process that accompanies Surgeon’s services, which includes providing (among other things) professional services of employees (e.g., nursing and technicians), a prosthetic joint, surgical instruments, drugs, surgical supplies, anesthesia, a sterile environment, and pre- and post-operative care. The patient remains in the hospital for four days, and the resources required to care for the patient will differ significantly for each day of care (with the most intensive resources required on the day of surgery and the day following surgery).
How many performance obligations are embodied in Hospital’s contract with the patient?
Analysis
In this fact pattern, the bundle of goods and services provided by the hospital represent a single performance obligation. While certain of the promised goods and services might, in theory, be capable of being distinct performance obligations (because the patient could benefit from the goods and services either on their own or together with other readily available resources), Hospital does not make these services available for purchase “a la carte.” Hospital only provides these services as part of a treatment plan prescribed by a medical professional; with the exception of cafeteria meals or hospital-based pharmacy sales, they cannot be individually purchased by an individual. Further, the individual goods and services are not separately identifiable from the overall promise in the contract, which is to provide the setting and care required for replacing the knee; the individual goods or services are simply inputs into that process.
Ultimately, Hospital provides a significant service of integrating the various goods and services into the treatment plan which has been ordered on the patient’s behalf by the physician; therefore, Hospital would conclude there is one performance obligation.
For additional commentary on this determination, see the interpretive guidance beginning at AAG-REV 7.2.01, which discusses general considerations related to identifying the performance obligations in health care contracts, including the notion of “significant integration” of services.
3.2.2.2 Applying the “series guidance”
According to ASC 606-10-25-14, a performance obligation is a promise in a contract to provide the customer with a distinct good or service, a distinct bundle of goods or services, or a series of distinct goods or services that are substantially the same.
At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either:
- A good or service (or a bundle of goods or services) that is distinct
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see paragraph 606-10-25-15).
ASC 606-10-25-14(a) -- identifying distinct bundles of goods or services within a contract—is discussed in HC 3.2.2.1. Sometimes the process associated with a prescribed course of treatment will involve delivering a series of substantially similar treatments – for example, a series of recurring outpatient physical therapy or rehabilitation services. This section discusses accounting considerations related to those situations, which are the topic of ASC 606-10-25-14(b).
Consider a situation when a patient is prescribed a series of six physical therapy visits, and the arrangement between the patient and the physical therapy provider cannot be cancelled by either party. If the guidance in ASC 606-10-25-14(a) were to be applied, the noncancelable arrangement would represent a single contract with six separate performance obligations, which introduces complexities into the accounting.
ASC 606-10-25-14(b) – referred to as the “series guidance” – addresses these situations and, if the characteristics of the individual treatments qualify, significantly simplifies the accounting. It states that a series of distinct goods or services provided over a period of time is viewed as a single performance obligation if the distinct goods or services are substantially the same and have the same pattern of transfer to the customer. When both characteristics are present, application of the “series guidance” is mandatory (not optional). The guidance provides criteria for determining whether a series of distinct goods or services has the “same pattern of transfer.”
Excerpt from ASC 606-10-25-15
A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met:
- Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria…to be a performance obligation satisfied over time.
- …the same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.
For additional information on the “pattern of transfer” and application of the “series guidance” in general, see RR 3.2.2.
The situations discussed above pertain to arrangements that are noncancelable. However, a patient who is prescribed a series of physical therapy visits might decide not to finish the series, and normally there is no penalty should they choose to end treatment early. If an arrangement for a series of services is cancellable at the discretion of the patient and without penalty, the “series guidance” cannot be applied. Consequently, the identification of performance obligations differs in these circumstances. In these situations, the stated contract term is disregarded. Instead, the duration of the arrangement is viewed as a relatively short initial contract term accompanied by a series of renewal options. The initial contract term ends on the earliest date on which the customer can terminate without significant penalty.
Excerpt from ASC 606-10-25-3
An entity shall apply the guidance in this Topic to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations.
In the physical therapy example, the right to terminate the arrangement shortens the term of the contract between the patient and the provider to a single treatment. The additional treatments are viewed as “renewal options” that can be exercised at the patient’s discretion. Therefore, if the patient completes the entire course of treatment, the arrangement would comprise six separate contracts, the initial contract and five renewal contracts.
FASB Staff Q&A Revenue
Excerpt from Question 8: How do customer termination rights and penalties affect the identification of a contract duration?
The staff thinks that paragraph BC391 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), clarifies that customer cancellation rights can be similar to a renewal option. The staff thinks that this would typically be the case when there are no contractual penalties that compensate the other party upon cancellation and when the customer has the unilateral right to terminate the contract for other than cause or contingent events outside the customer’s control.
For health care providers, the concept of a short-term, cancellable contract with “renewal options” is a new accounting concept for healthcare arrangements introduced by ASC 606. Like any option that is a right to buy something in the future for a specified price, renewal options in this context give a customer the right to extend a contract in order to acquire additional goods or services of the same type as those supplied under the original contract (in our example, five options to acquire additional physical therapy visits of the same type as the initial visit). Depending on the specified price of the optional services, the renewal option could provide the patient with a “material right,” which is an additional promise embedded in the contract that would need to be accounted for as a separate performance obligation.
Excerpt from ASU 2014-09 Basis for Conclusions
BC391. A renewal option gives a customer the right to acquire additional goods or services of the same type as those supplied under an existing contract…. A renewal option could be viewed similarly to other options to provide additional goods or services. In other words, the renewal option could be a performance obligation in the contract if it provides the customer with a material right that it otherwise could not obtain without entering into that contract.
According to ASC 606, if the additional services are offered at the “standalone selling price” (that is, the price at which the services would be sold separately to any other customer), then no material right exists. The arrangement has a single performance obligation, which is to provide the services associated with the initial visit.
Excerpt from ASC 606-10-55-43
If a customer has the option to acquire an additional good or service at a price that would reflect the standalone selling price for that good or service, that option does not provide the customer with a material right.
However, if the option gives the patient the right to acquire the services for free or at a discount, a material right may be embedded in the contract. A material right is an option to purchase additional goods or services at a price that is less than what the customer would have paid if they had not entered into the original contract. RR 7.2 provides further information on analyzing whether a price concession provided on future services is a material right that represents a separate performance obligation under the contract.
Excerpt from ASC 606-10-55-42
If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract…. If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.
RR 7 provides additional discussion over accounting for material rights included within a contact.
Example HC 3-2 illustrates the accounting for a physical therapy program consisting of several distinct but similar services that contains a termination option. Example 7-5-2 and Example 7-5-3 in AAG-REV 7.5.08 provide additional examples for physical therapy and residential skilled nursing facility (SNF) care, respectively. For additional information on customer options (including renewal options), refer to RR 3.5 and RR 7.
EXAMPLE HC 3-2
Outpatient physical therapy services – program of multiple treatments with option for cancellation by patient
Outpatient physical therapy services – program of multiple treatments with option for cancellation by patient
Patient A sees a physician for diagnosis and treatment of an injury. The physician orders six physical therapy sessions for Patient A. Patient A’s insurance company will pay a fixed amount for the therapy services on a per-visit basis, up to the total number of visits ordered by the physician.
Patient A makes an appointment with PT Clinic. PT Clinic provides the initial therapy session and indicates its willingness to provide the entire series of treatments. At any point in the series, Patient A is free to discontinue PT Clinic’s services without penalty (for example, to change to a different physical therapy clinic, or to simply discontinue receiving therapy).
At inception, how many performance obligations are included in the arrangement between PT Clinic and Patient, and what is their nature?
Analysis
This arrangement has a single performance obligation, which is for PT Clinic to provide the services associated with the initial visit.
The key point to consider is that Patient A has discretion as to whether to continue receiving the services from PT Clinic. At any point in the treatment series, Patient A might opt to change to a different physical therapy provider or to discontinue treatment altogether. For purposes of ASC 606, this means that the arrangement between PT Clinic and Patient A contains a termination provision. If Patient A terminates the arrangement, Patient A would have no obligation to pay PT Clinic for any services beyond those actually provided (i.e., there is no penalty for terminating).
Under ASC 606, the enforceable rights and obligations under this arrangement—PT Clinic’s obligation to provide services, and Patient A’s obligation to pay for those services—are limited to the first visit in the series, due to Patient A’s ability to cease further treatment from PT Clinic without penalty. In effect, the arrangement is a contract for a single treatment with renewal options (that is, an option to return five more times) that can be exercised at Patient A’s request. If and when Patient A exercises an option (that is, returns for another treatment), that visit (and any subsequent visits) will each represent a separate, renewable contract. Said differently, if Patient A completes the entire series of treatments, it will involve six separate contracts, each with its own performance obligation.
At the inception of the arrangement, PT Clinic must also evaluate whether Patient A’s option to renew the contract provides Patient A with a material right; if so, the contract would contain an additional performance obligation to stand ready to provide the additional services at a discount if the customer requests them. Under ASC 606, a material right is the right to acquire the additional goods and services at a discounted price. In this fact pattern, because the prices for each succeeding treatment remain the same, the renewal option is not a material right.
Note that if the arrangement had been non-cancellable (e.g., if Patient A were obligated to pay for all six treatments in the series, regardless of whether they actually receive all the services) and each treatment was substantively the same, PT Clinic would have likely concluded that its performance obligation was a series under ASC 606-10-25-14(b). In that case, the entire series of treatments would have been viewed as a single performance obligation recognized over the period that the treatments are performed. PT Clinic would need to determine an appropriate measure of progress for recognizing revenue.
3.2.3 Step 3 – determine the transaction price
Step 3 of the five-step model is to determine the transaction price, which is the amount of consideration to which an entity expects to be entitled in exchange for transferring the promised goods and services under the contract (or portfolio of similar contracts). This represents the amount that will ultimately be recognized as contract revenue.
The determination of the transaction price is often the most complex aspect of a health care provider’s revenue recognition process. This section covers the basics of Step 3. Variable consideration (e.g., implicit price concessions, retroactive price adjustments by government payers) is discussed in depth in HC 3.3, HC 3.4, and HC 3.5. For health care providers, most health care service revenue will have some element of variable consideration.
ASC 606-10-32-2 identifies fundamental principles for establishing the transaction price.
An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.
The notion of “transaction price” is focused on the amount of consideration that the provider expects to be entitled to rather than the amount billed to the patient (or other payers). In many arrangements to provide health care services, the transaction price is often a relatively small fraction of the provider’s overall “gross charges,” as illustrated in Figure HC 3-1.
Figure HC 3-1
Derivation of transaction price -- fee-for-service arrangements
Derivation of transaction price -- fee-for-service arrangements
3.2.3.1 Fixed consideration
In many cases, gross patient charges will be reduced by explicit price concessions, which are explicit reductions in the price for the services. An example is a contractual allowance or contractual adjustment. As discussed in HC 2.1.4.1, health plans will often negotiate discounted rates on behalf of their subscribers, members, or enrollees. The difference between the provider’s established rates for its services and the discounted rate it agrees to accept is often tracked as a contractual allowance (a contra-revenue account) in the underlying accounting records (see HC 2.1.2). Amounts billed to both patients and payers will reflect these explicit, or contractual, price concessions.
Another example of an explicit price concession is a policy discount. This might be an across-the-board discount offered to uninsured patients who do not qualify for charity care; a discount negotiated individually with an uninsured patient; or a courtesy discount provided to a health care entity’s employees. As with contractual discounts and allowances, the difference between gross charges and the amount billable after application of the discount is considered a reduction of the transaction price (reduction of revenue) for the specific contract.
3.2.3.2 Variable consideration
Variable consideration also has to be evaluated when determining the transaction price. In healthcare, variable consideration can be significant and can include reductions to gross charges (such as those due to implicit price concessions or payer recoupments), or increases in the transaction price (such as those due to payer refunds). Variable consideration is discussed more extensively in HC 3.3, with an overview of the concepts provided below.
Implicit price concessions differ from explicit price concessions in that they typically are not specific to individual patients and also because they are not contractually specified or determinable at the inception of the contract. They arise because the portion of bills for which patients are responsible (either through deductibles and coinsurance, or because patients are uninsured) often carries a high risk of uncollectibility, and providers often perform services without knowing whether patients will be able to pay. Thus, in order to determine transaction price pursuant to the principle in ASC 606 of “the amount that the provider expects to be entitled to,” amounts that are not expected to be collectible from patients will reduce the transaction price “up front” rather than being treated as bad debt expense.
This upfront reduction of revenue differs from the handling of uncollectible customer amounts in most other industries. In healthcare, the provider is not extending credit to the patients in the traditional sense; instead, they are providing services despite knowing that the patient may not be able (or willing) to pay. Because the entity does not know at inception how much will be collected (or will remain uncollected) from specific patients, implicit price concessions are not “pushed down” to individual patient accounts (that is, they are not reflected in patient bills) but instead, are estimated on a portfolio basis by class of patient (see HC 2.1.4) and reduce aggregate patient care revenues. For internal record-keeping purposes, these estimated implicit price concessions can be thought of similar to an allowance for doubtful accounts (bad debt reserve) and will periodically be updated based on actual collections experience. Implicit price concessions are discussed further in HC 3.3.1.
Payer recoupments and refunds are another form of variable consideration that will affect transaction price. Any compensation that a provider expects to have to return to a government payer, such as Medicare and Medicaid, must be estimated at the time services are provided and excluded from the transaction price. Under the existing regulatory framework, those payers retain rights to perform post-payment reviews that may result in denials of claims previously paid or retroactively adjust compensation through other means (e.g., settlement or reduction of future claim payments). The potential for such adjustments must be estimated and excluded from revenue in the periods that the related services were provided as discussed in HC 3.3.2.
3.2.3.3 Non-revenue transactions
Gross patient charges utilized in determining the transaction price exclude charges related to charity care services provided. As discussed in HC 5.2.1, charges associated with charity care services do not qualify for recognition as revenue. Thus, arrangements involving charity care services do not represent a contract with a customer because a provider does not expect to be entitled to any compensation for these services (see AAG-REV 7.6.15).
3.2.3.4 Significant financing components included in contracts
In some contracts within the scope of ASC 606, payments by or on behalf of customers are received either significantly before or significantly after the seller provides the goods or services. Sometimes contracts are structured in this manner in order to provide financing to one of the parties (either explicitly or implicitly). For example, a customer might make a large upfront payment that provides financing to the seller (in lieu of the seller obtaining financing from an outside lender). Alternatively, a seller that allows the customer to pay significantly in arrears might be financing the customer’s purchase. In either of these situations, the contract would contain a financing component that might need to be identified and separated from the revenue transaction as either interest income (if the seller allows the customer to pay in arrears) or interest expense (if the customer pays in advance). The assessment of whether a financing component exists and if so, whether it is “significant” under the guidance in ASC 606-10-32-15 through ASC 606-10-32-19 is a matter of judgment and is based on the facts and circumstances of each contract (see RR 4.4).
Providers often receive compensation either before or significantly after the services were provided. For example, as discussed at HC 3.5, they might receive notices of third-party settlement adjustments or risk-sharing bonuses or penalties months (or years) after the services were provided to the patients. In addition, they might offer extended payment plans to uninsured self-pay patients that span months or years. In evaluating these situations in light of the guidance for identifying a significant financing component, providers should consider the following unique aspects of health care service transactions.
- Amounts due to/due from government payers
At any given time, providers may have substantial amounts that are due to or due from Medicare or Medicaid (for example, in connection with estimated cost report adjustments/settlements or in connection with government risk-sharing programs that can provide incentive payments or claw back funds under penalties). Sometimes, these amounts may not be settled until several years after the periods in which the related health care services were provided to patients. However, as neither the health care entity nor the payer in these situations intend to provide the other party with financing and, pursuant to ASC 606-10-32-17(b), a substantial amount of the consideration promised is variable and the timing of payment varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the provider or the patient, such lags between the time the services are provided to patients and the time payment is received (or made) by the government do not give rise to a significant financing component.
The payment terms for services provided to Medicare and Medicaid patients are established under separate contractual arrangements entered into between the government program and the provider, under which the government program controls the timing and amount of payments. The payment terms are not negotiated as part of the contract between the provider and the patient, which is the focus of the significant financing component analysis for ASC 606 purposes. - Receivables from patient contracts with implicit price concessions
Typically, a financing component in receivables arises from a seller’s offer (implicit or explicit) to finance a customer’s purchase of goods or services. Prior to extending the offer to finance, the seller will have evaluated the customer’s credit standing, and the seller will expect compensation (interest income) for providing the service.
In the health care industry, however, providers often perform services without knowing whether the patient will be able (or willing) to pay the portion of the bill for which they are responsible. Such services give rise to implicit price concessions, as discussed in HC 3.3. Providers would be unlikely to offer a patient financing (and expect interest income) in situations where they do not expect to be able to collect the full amount of the receivables; thus, financing would not have been contemplated when the terms of the arrangement were established with the patient.
Even when providers enter into arrangements with uninsured self-pay patients that provide extended payment terms over periods greater than one year, the purpose of those arrangements is to enhance the provider’s chances of collecting consideration from the patient (and minimizing the amount to be written off), not to provide the patient with financing. Consequently, the arrangement to provide health care services to the patient is not considered to contain a significant financing component in these situations.
However, if the provider assesses credit prior to providing services and extends credit to the patient (for example, for some self-pay elective procedures), then it would be appropriate for the provider to evaluate whether the arrangement contains a significant financing component. If the provider concludes the arrangement contains a significant financing component, it would need to separate it from the health care services revenue (refer to RR 4.4).
For additional information on healthcare-specific considerations related to evaluating financing components, see AAG-REV 7.6.63 through AAG-REV 7.6.67 and AAG-REV 7.6.105. The “Financing Component” subsection of AAG-REV 7.7.59 provides illustrative disclosures.
3.2.4 Step 4 – allocate the transaction price
As discussed at HC 3.2.2, most health care services contracts promise to provide a bundle of goods and services that represent a single distinct performance obligation. When a contract contains a single performance obligation, Step 4 is irrelevant (i.e., no allocation of the transaction price is required), and the health care entity proceeds directly to Step 5 – recognize revenue (HC 3.2.5).
However, if the contract contains more than one distinct performance obligation, the transaction price determined in Step 3 must be allocated to each of the distinct performance obligations in the contract based on the relative standalone selling price of the goods and services being provided to the patient. The best evidence of a standalone selling price is the price an entity charges for that good or service when sold in similar circumstances to similar customers. For components that aren’t normally sold separately (as is often the case in health care fee-for-service arrangements), guidance on estimating standalone selling prices is provided in ASC 606-10-32-32 to ASC 606-10-32-35.
For a comprehensive discussion of Step 4 considerations, see RR 5.
3.2.5 Step 5 – recognize revenue
The final step of the ASC 606 model is to recognize revenue when (or as) the entity satisfies a performance obligation by transferring the goods or services promised in the contract.
An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.
From a health care service provider’s point of view, the concepts of “transferring control” and “obtaining control” may seem counterintuitive, as the service provider is not delivering a tangible product. However, conceptually, a service also transfers an asset (i.e., a benefit) to the customer, even if that benefit is consumed immediately.
A customer might “obtain control” of the benefits over time (as/while the entity is performing), or at a point in time (when the entity’s performance is complete). This determination must be made at the inception of the contract and is made from the perspective of the customer. According to ASC 606-10-25-24, in order to conclude that a performance obligation is satisfied over time, it must meet one or more specified criteria. If the performance obligation does not meet any of those criteria, it is satisfied at a point in time.
For each performance obligation identified…, an entity shall determine at contract inception whether it satisfies the performance obligation over time (in accordance with paragraphs 606-10-25-27 through 25-29) or satisfies the performance obligation at a point in time (in accordance with paragraph 606-10-25-30). If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.
As noted in HC 3.2.3, healthcare arrangements may involve multiple payment streams (for example, from the patient, from the third-party payer at the time of service, from the third-party payer in the course of settling the cost report, incentive payments). Regardless of the amount, timing, and variety of payers, all payment streams included in the transaction price pursuant to Step 3, including estimates for variable consideration, are recognized according to the timing of satisfaction of the performance obligation based on the identified measure of progress. Refer to HC 3.3.1.2 and HC 3.3.2 for discussion over subsequent adjustments to the transaction price.
A performance obligation is satisfied over time if it meets one or more criteria specified in ASC 606-10-25-27.
Excerpt from ASC 606-10-25-27
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs...
- The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced…
- The entity’s performance does not create an asset with an alternative use to the entity…, and the entity has an enforceable right to payment for performance completed to date…
AAG-REV 7.5.08 provides several illustrative examples of applying the notion of “transfer of control” in the context of health care services. In cases when the patient is receiving clinical care (e.g., inpatient hospital, outpatient physician, physical therapy, skilled nursing), because the patient simultaneously receives and consumes the benefits provided by the health care provider (criterion (a)), the performance obligations are typically satisfied over time, even when the time from start to finish is very short. In many cases, the time frame for recognition over time may be so short that there will be no substantive difference between point-in-time versus over-time recognition. In situations when the patient is not present when the services are provided (for example, clinical lab tests performed on samples provided by the patient), the determination of the pattern of control transfer may be less straightforward. These situations may involve consideration of criterion (b) or criterion (c) considering, for example, the hypothetical implications of another entity having to step in partway through the contract to fulfill the remaining performance obligation to the customer (see RR 6.3.1), or whether the customer would be obligated to pay for the work performed to date if it cancelled the contract for a reason other than nonperformance (see RR 6.3.3).
Example HC 3-3 illustrates application of the “transfer of control” guidance for clinical lab tests.
EXAMPLE HC 3-3
Laboratory revenue recognized at a point in time or over time
Laboratory revenue recognized at a point in time or over time
A patient visits an outpatient clinical lab (Lab A) for a blood test ordered by her physician. A lab technician draws a blood sample and provides patient with the expected time frame for the test results to be provided to the ordering physician. Lab A is entitled to payment upon completion of the test. If Lab A is unable to complete the test (if, for example, the sample drawn is found to be inadequate), it is not entitled to payment for its performance up to that point.
Is Lab A’s performance obligation satisfied at a point in time or over time?
Analysis
Lab A’s performance obligation would be satisfied (and revenue recognized) at a point in time. Lab A’s performance obligation is to provide the results to the ordering physician. In determining its conclusion, Lab A would evaluate its performance obligation against the criteria in ASC 606-10-25-27;
- Because the patient is not present while the test is being performed, the patient is not able to consume the benefits as the lab is performing the test. Further, if Lab A is unable to complete the test, a replacement lab would likely need to reperform the work, rather than using the work already performed by Lab A. These factors indicate that control of the benefit does not transfer to the patient as the work is performed and thus, criterion (a) is not met.
- Criterion (b) is not met because no tangible or intangible asset is created by Lab A’s work that is controlled by the patient.
- If the contact is terminated prior to completion (for example, the sample drawn from the patient is inadequate and testing cannot be performed), Lab A would not have an enforceable right to payment for the work completed to date. Thus, criterion (c) would not be met.
Because none of the criteria for recognition over time are met, Lab A’s performance obligation would be satisfied (and revenue recognized) at a point in time, which is when the testing process is complete and the results are delivered to the patient’s physician for communication to the patient.
For more information on the general rules for determining whether a performance obligation is satisfied over time or at a point in time, see RR 6.3.
3.2.5.1 Performance obligations– measuring progress toward completion
When a performance obligation meets one or more of the criteria in ASC 606‑10‑25‑27 (and thus, will be satisfied over time), a health care entity will need to determine a measure of progress toward completion of that performance obligation to determine how much revenue should be recognized at a reporting date that occurs between the inception of the arrangement and the complete satisfaction of the performance obligation.
For each performance obligation satisfied over time… an entity shall recognize revenue over time by measuring the progress toward complete satisfaction of that performance obligation. The objective when measuring progress is to depict an entity's performance in transferring control of goods or services promised to a customer (that is, satisfaction of an entity's performance obligation).
Progress is evaluated using either an output method or an input method, whichever best depicts the pattern of transfer of control of the goods or services. For a general discussion of the considerations in selecting an appropriate measure of progress, see RR 6.4. Health care providers will often use input methods, which evaluate progress (and thus the measure of revenue) based on the amount of resources consumed towards satisfying the performance obligation. One common input method – often referred to as the “cost-to-cost” method – uses the ratio of costs incurred at any point to total estimated costs of completing the performance obligation to measure the extent of progress toward completion (sometimes referred to as “percentage-of-completion”). Health care entities often use a variation of this method, which uses gross patient charges (rather than actual costs of delivery) as a proxy for measuring the consumption of resources (i.e., costs) used in treating patients. In an inpatient hospital stay, for example, progress towards completion of the performance obligation might reasonably be measured by comparing cumulative gross charges incurred as of an interim measurement date to the total expected gross charges for the entire inpatient stay. For additional information on the rationale for using gross charges as a measure of resource consumption, see HC 2.1.2. For additional commentary and examples on measuring progress, see Example 7-5-1 in AAG-REV 7.5.08.
In practice, many providers do not estimate total expected gross charges for the entire stay and instead use a “shortcut” to estimate revenue at any point in time over the period of performance. This process is often applied when the overall transaction price is not easily determinable before the patient is discharged. Many providers have determined that gross charges are an appropriate measure of progress, have assigned patients into financial classes, and use portfolio data by financial class to estimate the transaction price for patients; these determinations allow for the use of a streamlined formula to estimate revenue. The streamlined formula is to multiply gross charges to date by the discount factor for the financial class to which the patient has been assigned.
Example HC 3-4 illustrates application of the “transfer of control” guidance in a hospital’s contract for health care services.
EXAMPLE HC 3-4
Revenue recognized over time – inpatient hospital stay
Revenue recognized over time – inpatient hospital stay
Surgeon admits a patient to Hospital for knee replacement surgery on June 29, 20X1 (Day 1). Hospital is responsible for the overall management of the process that accompanies Surgeon’s services, which includes providing (among other things) professional services of employees (e.g., nursing and technicians), a prosthetic joint, surgical instruments, drugs, supplies, anesthesia, a sterile environment, and pre- and post-operative care.
Hospital has determined that all of the goods and services provided to the patient associated with the knee replacement surgery represent a single performance obligation (see Example HC 3-1).
The patient’s total gross charges during the four-day stay were $10,000, incurred as follows: Day 1, $2,000; Day 2, $4,000; Day 3, $3,000; Day 4, $1,000. Patient has commercial insurance coverage, and Hospital has determined that 55% of the transaction price ($5,500) will be collectible based on the negotiated rates with the insurer and the financial classification of the patient.
Hospital has a June 30 fiscal year-end. How should revenue be recognized for this contract in Hospital’s 20X1 financial statements?
Analysis
Based on the guidance in ASC 606-10-25-27(a), the performance obligation should be accounted for over time because the patient simultaneously receives and consumes the benefits from the transfer of goods or services as the care is provided. Assume that Hospital considers various input and output methods and determines that it will measure progress toward complete satisfaction of the performance obligation.
The amount of revenue recognizable as of June 30, 20X1 is determined by multiplying the transaction price by the measure of the progress at the end of day on June 30, 20X1 (i.e., Day 2): $6,000 cumulative gross charges through end of Day 2 divided by $10,000 total expected gross charges for the stay is 60%, multiplied by the transaction price of $5,500 yields revenue of $3,300.
Using the streamlined formula, Hospital could also estimate its revenue at the end of Day 2 by multiplying the cumulative gross charges to date ($6,000) by the percentage of total expected consideration from this payer class (55%), which would also be $3,300.
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