Bad Debt Expense Defined & How To Calculate Bad Debt Expense

Realistically, some level of bad debt expense is unavoidable in financial operations. Hospitals recognize this and have developed procedures to account for unpaid medical bills. Small amounts of bad debt are negligible. However, large amounts can greatly impact a hospital’s operating budget.

Understanding and monitoring bad debt is essential. It helps hospitals make budgetary decisions and analyze revenue recovery efforts. Hospitals can prioritize patient care and satisfaction when bad debt is managed properly.

How Does Bad Debt Happen?

Bad debt happens when a patient cannot or will not pay their bills. There are many reasons for this:

• A patient who won’t pay may have experienced provider negligence or be disputing an invoice. They might not pay because they feel generally dissatisfied with their care.

• A patient who can’t pay may be experiencing problems like:
  • Personal financial hardships
  • Bankruptcy
  • Financial crises
  • Economic downturns

Sometimes, patients have faced limited in-network options. They might even lack awareness of financial assistance programs.

• You might have a patient who doesn’t realize they need to pay. This can result from lax collection processes and a lack of communication on the provider’s end.

• An insured patient who pays may still run into billing, coding or registration errors on behalf of the hospital. There may also be misunderstandings between the provider and the insurance company. Neither of these circumstances is the patient's fault, but they can still result in bad debt.

What is a Bad Debt Expense?

Bad debt expense is also called “write-offs.” It is the accounts receivables (A/R) that providers can't collect from patients or insurance companies. This issue arises after the rendering of medical services. The account is not immediately considered bad debt. It becomes bad debt after unsuccessful collection attempts.

In hospitals, bad debt is uncompensated care that creates a financial loss for the hospital. It must be reported accurately. Bad debt at higher levels weakens financial health. The result is fewer resources, poor care, and lower patient satisfaction.

How Do You Find Bad Debt Expense?

When does bad debt officially become bad debt? The answer depends on hospital policy. Every organization should have a defined policy explaining when debt should be written off. For example, if collections called the customer five times with no answer and sent three email reminders, and 90 days have passed, the account may be classified as bad debt.

This policy is important to avoid overstating revenue and generate a better picture of financial health. It should be examined and updated annually for accuracy.

How to Calculate Bad Debt Expense?

There are two main ways of calculating bad debt expense: 

• The direct write-off method
• The allowance method.

Note that the direct write-off method is usually less accurate. However, it is easier than the allowance method. Most hospitals and businesses employ the allowance method in their calculations.

Bad Debt Expense Formula: Direct Write-Off Method

In the direct write-off method, the amount of the unpaid invoice deemed bad debt is charged directly as a bad debt expense. The invoice is removed from accounts receivable. Bad debt is debited, and AR is credited. No other accounts are involved.

This method is useful for small amounts of unpaid debt. However, it does not follow accounting principles. These state that an expense must be recorded when the transaction occurs, such as when the patient is billed for service. It should not be recorded when the payment (or, in this case, lack of payment) is made.

Theoretically, a hospital could report income in AR one year and a bad debt expense the next year, even though they were part of the same transaction. Because of this, direct write-offs are not the most accurate way of calculating bad debt, but they are quick and easy.

Bad Debt Expense Formula: Allowance Method

In the allowance method, bad debts are anticipated before they occur. Entries are adjusted based on expected losses at the end of each accounting period.

First, the hospital estimates bad debt losses at the start of the period. Then, income and corresponding bad debt are recorded at the same time. The bad debt expense is debited. Meanwhile, a contra-asset account called “allowance for doubtful accounts” is credited. At the end of the year, unpaid AR is zeroed out. Anything deemed officially uncollectible is debited from the contra-asset account, and AR is credited.

This method allows for more accurate records documented closer to the actual transaction time. It takes more effort than the direct write-off method but is more precise and widely accepted in best-practice accounting.

How to Estimate Bad Debt Expense?

You may notice that the allowance method relies on an estimate of anticipated losses. Hospitals estimate bad debt expense to derive this number in two ways: 

• The bad debt percentage method
• The AR aging method

Accounts Receivable Aging Method

The AR aging method assigns a percentage of the likelihood of collection to each account depending on its age. These estimates are based on hospital historical data related to the likelihood of collection. But generally, an account is less likely to be paid the longer it remains unpaid.

First, the hospital divides accounts into categories based on age, i.e., 0-30 days, 31-60 days, 61-90 days, and past 90 days. Then, each account is placed into the correct category. Staff determines the total AR in each category. Then, they apply percentages to calculate the overall anticipated bad debt in percentage.

For example, a hospital receives $100,000 in AR in one month. They calculate the likelihood of failed collection at 1%. $1,000 of this amount will be allocated to the “allowance for doubtful accounts” contra-asset account.

Bad Debt Percentage

The second method of calculating anticipated bad debt is bad debt percentage. This method analyzes historical data to find average total past losses. This number is then divided by the total average AR over the same period. This number is the amount of anticipated bad debt as a percentage of income. 

Like the AR aging method, this number is multiplied by anticipated income, and the resulting amount is put into a contra-asset account. 

Note the inverse of this method, called the percentage of AR method, helps calculate estimated bad debt in dollars. Simply multiply the estimated bad debt percentage by the total AR within that same date range.

How to Understand & Utilize Bad Debt Ratio

Hospitals and health systems can use the bad debt ratio to understand better how much bad debt is too much. This number is calculated by dividing total bad debt by net AR. 

The resulting number provides insights into important elements like: 

• Cash flow
• Collection efficiency
• Revenue recovery efforts
• Overall financial health 

Higher ratios are unideal. If your ratio keeps climbing, your accounting and collections teams need to act. Causes behind an increasing bad debt ratio include:

• Lax collection policies
• Unclear collection policies
• Poor revenue recovery solutions
• Poor payment processing solutions
• Poorly trained staff

By monitoring this ratio, hospitals can maintain better cash flow to provide better care and achieve higher levels of patient satisfaction.

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