Hospitals will need to raise rates, cut costs and implement “transformational” change to combat inflationary-driven pressures that are damaging margins and setting back the sector’s COVID-19 pandemic recovery, according to a Fitch Ratings report.

“Not-for-profit hospital operating margins, which declined during the pandemic, will see further erosion due to ongoing inflationary pressures of elevated labor, supply and capital costs,” analysts Kevin Holloran and Sarah Repucci say in the report.

“Improvement in operating margins from reduced levels will require hospitals to make transformational changes to the business model” over the long term, while in the near- to mid-term they will manage “cost pressures through a combination of rate hikes and relentless, ongoing cost-cutting and productivity improvements,” the report published Tuesday said.

Margins had begun to rebound from early pandemic-related blows caused by rising costs and the halting of some procedures and services in order to manage COVID patients. Those early wounds were also offset by an infusion of federal pandemic relief. Margins have since fluctuated as cases and hospitalizations surge and wane.

Labor shortages and supply chain struggles last year took a toll on margins but those pressures are mounting as inflation has further driven up wages and expenses. Some margins remain materially lower than in 2019.

“The vast majority of our rated credits have strong balance sheets that will offset lower margins for a period of time and allow for operational improvements” but “without more substantial changes to the current business model, or with additional coronavirus surges this fall or winter, this balance sheet cushion could eventually erode, which would lead to negative rating actions,” Fitch said.

Fitch looked back to the late 1970s and early 1980s for an inflationary comparison. Hospital reimbursement was cost-based and increases were passed on to government and private insurer payors. The Medicare payor model implemented in 1983 in response to higher costs was the beginning of reimbursements based on a pre-determined, fixed amount according to diagnosis.

Fitch expects providers will likely attempt to secure much higher rate increases from their commercial payors to counter the combined impact of ongoing COVID cases and inflation. While hospitals could make some headway on that front, they will face pushback. Commercial payors are dealing with similar pressures and have consolidated in recent years, resulting in increased leverage over health systems. Fitch does not expect to see Medicare or Medicaid rate adjustments given federal budget deficits.

Inflationary pressures also will contribute to an ongoing wave of sector consolidation, Fitch said. “Today’s inflation is a key factor pushing more providers to consider consolidation in the sector, as hospitals seek to generate economies of scale and gain skills to enable them to take on additional risk contracts,” Fitch wrote.

One mitigating factor on that front is heightened regulatory scrutiny launched by the Biden administration last year over concerns that consolidation would hurt competition and drive up prices.

All of the pressures combined with the rising interest rate environment as the Federal Reserve seeks to tamp down inflation could impact capital planning. “With increased capital costs, higher debt financing costs due to rising interest rates, and ongoing supply chain disruptions, plans for expansion or renovations will cost more or may be postponed,” Fitch said.

The most recent data from Kaufman Hall, which issues a monthly report on hospital margins, underscores the strains as nearly halfway through the year margins are “cumulatively negative.”

“While we are seeing hospital revenues inch up, it simply is not enough to mitigate the skyrocketing costs of material and labor expenses, resulting in negative operating margins for the nation’s hospitals and health systems,” according to the June 28th report’s author Erik Swanson, a senior vice president of data and analytics at the financial advisory firm. “Hospitals are seeing labor costs increase at every level as they compete with other hospitals and local employers to retain and attract non-clinical staff with higher wages and better benefits.”

The median operating margin was up in May compared to April but down when compared to May 2021 with the year-to-date operating margin index at a negative 0.33%, marking a fifth straight month of cumulative negative operating margins.

Revenues are up as people spend more time outdoors and suffer seasonal injuries leading to emergency room visits, and elective procedures have picked up, but they aren’t keeping pace with expenses, which rose 1.1% from April and 10.7% from May 2021.

The months ahead also remain murky, especially as hospitalizations are spiking due to the now dominant Omicron subvariant BA.5 strain.