IRS Issues IDD on Contractual Allowance Issues in the Health Care Industry

By Jane Rohrs, CPA, Washington, DC

Editor: David J. Kautter, CPA Ernst & Young LLP

The Service has issued an industry director directive (IDD) (LMSB-04-0807-056) on contractual allowance issues in the health care industry. The IDD provides direction to the field on the efficient use of examination resources relating to the audit of contractual allowances. Specifically, the IDD provides a uniform format and approach for examiners to evaluate potential compliance risk related to contractual allowance issues, outlines the established issue management and oversight process, and introduces an initial set of audit guidelines.


Health care providers primarily derive revenue from providing medical goods and services to patients. The providers generally issue multiple bills for the same services to the patient and third-party payers. Third-party payers include private insurance companies and government payers, such as Medicare and Medicaid.

Providers have standard charges for each specific good sold or service rendered. The standard charge amount is initially recorded as an account receivable on the financial books when the service is rendered or the good is sold. However, providers typically have contractual agreements with most third-party payers regarding the amount that the payer will reimburse for specific goods and services. The discount amount usually differs in contracts between a provider and different payers, and it often differs between different plans offered by the same payer.

A contractual allowance is not a bad debt because the provider was never entitled to collect the difference under the terms of the relevant contract. A provider’s book contractual allowance represents the difference between the amount recorded on its books as a receivable at the time of the initial billing and the estimated net realizable value (NRV) of gross receipts reported for book purposes under generally accepted accounting principles (GAAP). The NRV is not an acceptable method of determining income for tax purposes.

On an income tax return, properly determined contractual allowances would offset gross receipts. The return may report either a net amount of receipts reduced for contractual allowances or total billed amounts with an offsetting reduction for contractual allowances. The reduction will often appear in returns and allowances.

When the provider issues a bill, it has, at a minimum, the following information:

  • The identity of the patient and
    any known third party that may ultimately bear responsibility for some or all of the payment due;
  • The exact nature of the services and medical goods provided;
  • All gross billing information; and
  • All terms of any contract(s) that may or will provide a legal basis for claiming a contractual allowance for the billed amount as accrued income.

The contract terms would be available at all times subsequent to the
date of the applicable contract. Most providers and payers have access to payment calculators that compute expected reimbursements under specific contract terms.

Planning and Examination Guidance

The IDD indicates that contractual allowances will appear on the income tax returns of health care providers who:

  • Bill all goods and services at a standard charge;
  • Enter into contractual arrangements with payers (primarily third-party payers) to accept less than their standard charge in full payment of a bill;
  • Record income at the standard charge; and
  • Use contractual allowances to reduce recorded income.

The IDD advises examiners that contractual allowances may be improper if any of the following indicators are present:

  • Book income is calculated using GAAP/NRV and there is no Schedule M-3 adjustment;
  • Contractual allowances are determined by reference to prior experience, total collection experience, or commingled contractual allowance and bad debt amounts;
  • Contingencies, reserves, or subjective judgments are included in the contractual allowance on the income tax return; or
  • Contractual allowances are calculated with reference to any patient account in which there is no contract in force at the time services are rendered or the contract in force provides for full payment of the standard charge.

Methods That Limit Results to Contractual Allowance

Under Technical Advice Memorandum (TAM) 200619020, a contractual allowance is the difference between the amount billed for a service/good and the amount that the taxpayer may legally collect from the responsible payer under the terms of a legally enforceable contract in existence at the time the service is performed or the good is provided. TAM 200619020 provides that estimates may be used to the extent they determine gross income with reasonable accuracy. The taxpayer must show that the contractual amount used in preparing the return is reasonably accurate, and the field must determine whether the contractual allowances reflected on the taxpayer’s return meet the reasonable accuracy standard.

To determine whether the contractual allowance amount is reasonably accurate, an examiner must first determine whether the taxpayer uses a method that limits its results to the clearly defined contractual allowance definition provided in TAM 200619020. This method would reference specific accounts and contractual terms or provisions. When this method is in use, the examiner may:

  • Accept the method on its face;
  • Evaluate the method further if there are indications it does not produce a reasonably accurate result; or
  • Examine factual or computational components to verify the correct application of an acceptable method.

Methods That Do Not Limit the Results to Contractual Allowance

When a taxpayer uses a method that does not limit its results to the contractual allowance definition in TAM 200619020, the IDD indicates that several examination steps may be required. Examples include the use of a book/GAAP/NRV method with no Schedule M-3 adjustment to correct the method for tax purposes or any method that considers prior experience or total collection experience.

The IDD directs examiners to first determine whether the method produces a reasonably accurate result. The IDD stresses that reviews by internal or external auditors to verify the accuracy of allowances for book purposes do not necessarily verify their accuracy for tax purposes. The review method must be analyzed and verified in accordance with the contractual allowance definition in TAM 200619020.

The examiner may then have to remove impermissible method components, such as contingencies and reserves, to determine the accounts subject to reduction. After those components are eliminated, the examiner must consider whether the method used by the taxpayer to adjust the accounts subject to reduction is permissible. The size and significance of the accounts subject to reduction, in both relative and absolute terms, and the egregiousness of the method will determine whether further examination is necessary. If it is, examiners may use specific accounts and contractual provisions available to the taxpayer at the time services were performed or goods were provided. If the information is not available in the format required for proper testing or review, examiners may use a statistical sample. The IDD also directs examiners to consider using an outside expert if the taxpayer is unwilling or unable to provide the billing expertise required to interpret the information.

If time and resources are limited, examiners may use online payment calculators provided by payers, commercial computer software maintained by the taxpayer, and historical contract experience on a procedure-by-procedure basis (if contract provisions are relatively consistent). The IDD also lists items for which examiners should issue information document requests, including all workpapers and computations that show the contractual allowance computation and the steps taken to arrive at book and tax amounts.

Editor Notes:

David J. Kautter, CPA Ernst & Young LLP Washington, DC

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

If you would like additional information about these items, contact Mr. Kautter at (202) 327-8878 or

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