Review the HealthSouth 10-K Form (located in a separate file).

After reading through and analyzing this information, respond to the following items:

Examine the expenses incurred by HealthSouth.

Determine which of these would have the most effect on the healthcare costs of the services offered by HealthSouth.

Construct a plan that details how this expense could be adjusted to decrease the cost of services.

Using the 10-K form, list and explain ways that healthcare players are attempting to control costs.

Explain the difference between assets and liabilities that are listed on the facility's financial statements.

Assess why, HealthSouth, as a for-profit facility must calculate return on investments. Explain how this can be difficult for a facility to accurately calculate.

Refer to the Healthcare Reform section in the HealthSouth 10-K Form. Evaluate and describe how healthcare reforms may affect the HealthSouth Corporation.

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 _________________________________________ FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2011 Commission File Number 001-10315 ________________________________________________________ HealthSouth Corporation (Exact Name of Registrant as Specified in its Charter) Delaware 63-0860407 (State or Other Jurisdiction of Incorporation or Organization) (I.R.S. Employer Identification No.) 3660 Grandview Parkway, Suite 200 Birmingham, Alabama 35243 (Address of Principal Executive Offices) (Zip Code) (205) 967-7116 (Registrant's telephone number) _____________________________________________________ Securities Registered Pursuant to Section 12(b) of the Act: Title of each class Common Stock, $0.01 par value Name of each exchange on which registered New York Stock Exchange Securities Registered Pursuant to Section 12(g) of the Act: None _________________________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes No Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of \"large accelerated filer,\" \"accelerated filer,\" and \"smaller reporting company\" in Rule 12b-2 of the Exchange Act. Large accelerated filer Accelerated filer Non-Accelerated filer Smaller reporting company Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes No The aggregate market value of common stock held by non-affiliates of the registrant as of the last business day of the registrant's most recently completed second fiscal quarter was approximately $2.5 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant have been deemed to be affiliates. There were 94,671,611 shares of common stock of the registrant outstanding, net of treasury shares, as of February 15, 2012. DOCUMENTS INCORPORATED BY REFERENCE The definitive proxy statement relating to the registrant's 2012 annual meeting of stockholders is incorporated by reference in Part III to the extent described therein. TABLE OF CONTENTS Page Cautionary Statement Regarding Forward-Looking Statements ......................................................................................... ii PART I Item 1. Item 1A. Item 1B. Item 2. Item 3. Item 4. Business............................................................................................................................................................ Risk Factors...................................................................................................................................................... Unresolved Staff Comments ............................................................................................................................ Properties.......................................................................................................................................................... Legal Proceedings ............................................................................................................................................ Mine and Safety Disclosures............................................................................................................................ 1 13 19 19 21 21 Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities .......................................................................................................................................................... Selected Financial Data .................................................................................................................................... Management's Discussion and Analysis of Financial Condition and Results of Operations........................... Quantitative and Qualitative Disclosures About Market Risk ......................................................................... Financial Statements and Supplementary Data ................................................................................................ Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .......................... Controls and Procedures................................................................................................................................... Other Information............................................................................................................................................. 22 23 26 56 56 56 56 57 Directors and Executive Officers of the Registrant.......................................................................................... Executive Compensation.................................................................................................................................. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters........ Certain Relationships and Related Transactions and Director Independence.................................................. Principal Accountant Fees and Services........................................................................................................... 58 58 58 59 59 Exhibits and Financial Statement Schedules.................................................................................................... 60 PART II Item 5. Item 6. Item 7. Item 7A. Item 8. Item 9. Item 9A. Item 9B. PART III Item 10. Item 11. Item 12. Item 13. Item 14. PART IV Item 15. i CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS This annual report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to, among other things, future events, changes to Medicare reimbursement and other healthcare regulations from time to time, our business strategy, our financial plans, our future financial performance, our projected business results, or our projected capital expenditures. In some cases, you can identify forward-looking statements by terminology such as \"may,\" \"will,\" \"should,\" \"expects,\" \"plans,\" \"anticipates,\" \"believes,\" \"estimates,\" \"predicts,\" \"targets,\" \"potential,\" or \"continue\" or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties, many of which are beyond our control. Any forward-looking statement is based on information current as of the date of this report and speaks only as of the date on which such statement is made. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to, the following: each of the factors discussed in Item 1A, Risk Factors; uncertainties and factors discussed elsewhere in this Form 10-K, in our other filings from time to time with the SEC, or in materials incorporated therein by reference; changes in the regulations of the healthcare industry at either or both of the federal and state levels, including those contemplated now and in the future as part of national healthcare reform and deficit reduction, and related increases in the costs of complying with such changes; reductions or delays in, or suspension of, reimbursement for our services by governmental or private payors, including our ability to obtain and retain favorable arrangements with third-party payors; increased costs of regulatory compliance and compliance monitoring in the healthcare industry, including the costs of investigating and defending asserted claims, whether meritorious or not; our ability to attract and retain nurses, therapists, and other healthcare professionals in a highly competitive environment with often severe staffing shortages and the impact on our labor expenses from potential union activity and staffing recruitment and retention; competitive pressures in the healthcare industry and our response to those pressures; our ability to successfully complete and integrate de novo developments, acquisitions, investments, and joint ventures consistent with our growth strategy, including the realization of anticipated revenues, cost savings, and productivity improvements arising from the related operations; any adverse outcome of various lawsuits, claims, and legal or regulatory proceedings involving us; increased costs of defending and insuring against alleged professional liability and other claims and the ability to predict the costs related to such claims; potential disruptions or incidents affecting the proper operation, availability, or security of our information systems; the price of our common stock as it affects our willingness and ability to repurchase shares under the program discussed further in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, "Executive Overview," of this report; our ability to attract and retain key management personnel; and general conditions in the economy and capital markets. The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements. ii PART I Item 1. Business Overview of the Company General HealthSouth Corporation was organized as a Delaware corporation in February 1984. As used in this report, the terms \"HealthSouth,\" \"we,\" \"us,\" \"our,\" and the \"Company\" refer to HealthSouth Corporation and its consolidated subsidiaries, unless otherwise stated or indicated by context. This drafting style is suggested by the Securities and Exchange Commission and is not meant to imply that HealthSouth Corporation, the publicly traded parent company, owns or operates any specific asset, business, or property. The hospitals, operations, and businesses described in this filing are primarily owned and operated by subsidiaries of the parent company. In addition, we use the term \"HealthSouth Corporation\" to refer to HealthSouth Corporation alone wherever a distinction between HealthSouth Corporation and its subsidiaries is required or aids in the understanding of this filing. Our principal executive offices are located at 3660 Grandview Parkway, Birmingham, Alabama 35243, and the telephone number of our principal executive offices is (205) 967-7116. In addition to the discussion here, we encourage you to read Item 1A, Risk Factors, Item 2, Properties, and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, which highlight additional considerations about HealthSouth. We are the nation's largest owner and operator of inpatient rehabilitation hospitals in terms of revenues, number of hospitals, and patients treated and discharged. In order to focus on this core business and to reduce the excessive amount of debt incurred by the Company's previous management, we completed a strategic repositioning in 2007 when we divested our surgery centers, outpatient, and diagnostic divisions. In 2011, we completed the sale of five of our six freestanding long-term acute care hospitals (\"LTCHs\") and closed the remaining LTCH. For further discussion, see Note 18, Assets and Liabilities in and Results of Discontinued Operations, to the accompanying consolidated financial statements. We operate 99 inpatient rehabilitation hospitals (including 3 hospitals that operate as joint ventures which we account for using the equity method of accounting), 26 outpatient rehabilitation satellite clinics (operated by our hospitals, including one joint venture satellite), and 25 licensed, hospital-based home health agencies. As of December 31, 2011, our inpatient rehabilitation hospitals had 6,461 licensed beds (excluding the 3 hospitals that have 234 licensed beds and operate as joint ventures which we account for using the equity method of accounting). While our national network of inpatient hospitals stretches across 27 states and Puerto Rico, our inpatient hospitals are concentrated in the eastern half of the United States and Texas. For additional detail on our hospitals and selected operating data, see the table in Item 2, Properties, and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, \"Results of Operations.\" In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. Our consolidated Net operating revenues approximated $2.0 billion, $1.9 billion, and $1.8 billion for the years ended December 31, 2011, 2010, and 2009, respectively. For 2011, approximately 92% of our Net operating revenues came from inpatient services and approximately 8% came from outpatient services and other revenue sources (see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, \"Results of Operations\"). During 2011, our inpatient rehabilitation hospitals treated and discharged 118,354 patients. Our inpatient rehabilitation hospitals offer specialized rehabilitative care across a wide array of diagnoses and deliver comprehensive, high-quality, cost-effective patient care services. The majority of patients we serve experience significant physical and cognitive disabilities due to medical conditions, such as strokes, neurological disorders, hip fractures, head injuries, and spinal cord injuries, that are generally non-discretionary in nature and require rehabilitative healthcare services in an inpatient setting. Our team of highly skilled nurses and physical, occupational, and speech therapists working with our physician partners utilize the latest in technology and clinical protocols with the objective of returning patients to home and work. Patient care is provided by nursing and therapy staff as directed by physician orders while case managers monitor each patient's progress and provide documentation and oversight of patient status, achievement of goals, discharge planning, and functional outcomes. Our hospitals provide a comprehensive interdisciplinary clinical approach to treatment that leads to a higher level of care and superior outcomes. 1 Competitive Strengths As the nation's largest owner and operator of inpatient rehabilitation hospitals and with our business focused primarily on those services, we believe we differentiate ourselves from our competitors based on our broad platform of clinical expertise, the quality of our clinical outcomes, the application of rehabilitative technology, and the sustainability of best practices. Our strengths can also be described in the following ways: People. We believe our 22,000 employees, in particular our highly skilled clinical staff, share a steadfast commitment to providing outstanding rehabilitative care to our patients. We also undertake significant efforts to ensure our clinical and support staff maintains the education and training necessary to provide the highest quality rehabilitative care in a cost-effective manner. Quality. Our hospitals provide a broad base of clinical experience from which we have developed best practices and protocols. We believe these clinical best practices and protocols help ensure the delivery of consistently highquality rehabilitative healthcare services across all of our hospitals. We have developed a program called \"TeamWorks,\" which is an operations-focused initiative using identified best practices to reduce inefficiencies and improve performance across a wide spectrum of operational areas. In 2011, we successfully implemented a care management project within TeamWorks and a company-wide campaign to improve the patient experience. We believe these initiatives have enhanced, and will continue to enhance, patient-employee interactions and coordination of care and communication among the patient, the patient's family, the hospital's treatment team, and payors, which, in turn, improves outcomes and patient satisfaction. Efficiency and Cost Effectiveness. Our size helps us provide inpatient rehabilitative healthcare services on a costeffective basis. Specifically, because of our large number of inpatient hospitals, we can utilize proven staffing models and take advantage of certain supply chain efficiencies. We have successfully implemented a TeamWorks marketing initiative to leverage best practices from across our hospitals. In addition, we created and installed a proprietary management reporting system, which aggregates timely data from each of our key business systems into a comprehensive reporting package used by the management teams in our hospitals as well as executive management. This system allows users to analyze data and view reports across the enterprise, region, state, or local levels. Technology. As a market leader in inpatient rehabilitation, we have devoted substantial effort and expertise to leveraging rehabilitative technology. For example, we have developed an innovative therapeutic device called the \"AutoAmbulator,\" which can help advance the rehabilitative process for patients who experience difficulty walking. Technology instituted in our facilities allows us to effectively treat patients with a wide variety of significant physical disabilities. Our commitment to technology also includes information technology, such as the internally-developed management reporting system described above. In addition, we have begun installing a rehabilitation-specific electronic clinical information system that we believe will improve patient care and safety and enhance operational efficiency. In June 2011, we entered into an agreement with a prominent healthcare information technology vendor to complete the company-wide implementation of this system over the next few years. Patients and Demographic Trends Demographic trends, such as population aging, will affect long-term growth in healthcare spending. While we treat patients of all ages, most of our patients are persons 65 and older. We believe the demand for inpatient rehabilitative healthcare services will increase as the U.S. population ages and life expectancies increase. In addition, the number of Medicare patients that qualify for inpatient rehabilitative care under Medicare rules is expected to grow approximately 2% per year for the foreseeable future, creating an attractive market. In our markets specifically, we have estimated the demand for inpatient rehabilitative care is growing at an average of 2.6% per year. We believe these market factors align with our strengths in, and focus on, inpatient rehabilitative care. Unlike many of our competitors that may offer inpatient rehabilitation as one of many secondary services, inpatient rehabilitation is our core business. 2 Strategy We focused our 2011 strategy on these priorities: continuing to provide high-quality, cost-effective care to patients in our existing markets; continuing to expand our services to more patients who require inpatient rehabilitative services by constructing and opportunistically acquiring new hospitals in new markets; and further strengthening our balance sheet through the retirement of our most expensive debt (our 10.75% Senior Notes due 2016). Total discharges grew 5.2% from 2010 to 2011. Our same-store discharges grew 3.3% during 2011 compared to 2010. This growth includes the net expansion of licensed beds in our existing hospitals by 50 beds in 2011. Our quality and outcome measures, as reported through the Uniform Data System for Medical Rehabilitation (the \"UDS\"), remained well above the average for hospitals included in the UDS database, and they did so while we continued to increase our market share throughout 2011. As discussed in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, \"Results of Operations,\" not only did our hospitals treat more patients and enhance outcomes, they did so in a highly cost-effective manner. Our development efforts continued to yield positive results in 2011. Specifically: In March 2011, we received final certificate of need approval from the state of Florida to proceed with building a comprehensive inpatient rehabilitation hospital in Marion County, Florida. Construction on this 40-bed hospital began in the fourth quarter of 2011. In October 2011, we began accepting patients at our newly built, 40-bed hospital in the Cypress area of northwest Houston, Texas. In October 2011, we received final certificate of need approval from the state of Florida to proceed with building a comprehensive inpatient rehabilitation hospital in Martin County, Florida. This 34-bed hospital will be a partnership with Martin Health Systems. Construction on this hospital is expected to begin in the third quarter of 2012. In November 2011, we completed our purchase of substantially all of the assets of Drake Center's two rehabilitation-focused patient care units located in Cincinnati, Ohio. We began accepting patients at this newly remodeled, 40-bed hospital located on Drake's campus in December 2011. In 2011, we fully retired our 10.75% Senior Notes due 2016 and reduced total debt by approximately $257 million. Additionally, we improved our overall debt profile in May 2011 by amending our credit agreement. In that amendment, we: added a $100 million term loan with an initial interest rate of LIBOR plus 2.5%, maturing in May 2016; reduced by 100 basis points each of the various applicable interest rates for any outstanding balance on the revolving credit facility; and reset the maturity date for the revolving credit facility from October 2015 to May 2016. For 2012, we will continue to focus on providing high-quality, cost-effective care while seeking incremental efficiencies in our cost structure. We will also begin company-wide implementation of our new electronic clinical information system in 2012. We believe continued growth in our Adjusted EBITDA and our strong cash flows from operations will allow us to invest in growth opportunities and continue to invest in our core business. We will also consider opportunistic repurchases of our common stock, dividends, and, if warranted, further reductions to our long-term debt (subject to changes in our operating environment). Our growth strategy in 2012 will again focus on organic growth and development activities. We believe the regulatory and reimbursement risks discussed below which we have historically faced and will likely continue to face may present us with opportunities to grow by acquiring or consolidating smaller operations in our highly fragmented industry. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently gain market share, realize better outcomes than our competitors and achieve these results at significantly lower costs. We have also been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2016. We have redeemed our most expensive debt and reduced our interest expense. Most importantly, our 3 balance sheet is strong. Our leverage ratio is within our target range, we have ample liquidity, we continue to generate strong cash flows from operations, and we have flexibility with how we choose to invest our cash. For these and other reasons, we believe we will be in a position to take action should a properly sized and priced acquisition or consolidation opportunity arise. For additional discussion of our strategy, business outlook, and Adjusted EBITDA, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, \"Executive Overview\" and "Liquidity and Capital Resources." Employees As of December 31, 2011, we employed approximately 22,000 individuals, of whom approximately 13,000 were fulltime employees. We are subject to various state and federal laws that regulate wages, hours, benefits, and other terms and conditions relating to employment. Except for approximately 60 employees at one inpatient rehabilitation hospital (about 16% of that hospital's workforce), none of our employees are represented by a labor union. We are not aware of any current activities to organize our employees at other hospitals. We believe our relationship with our employees is good. Like most healthcare providers, our labor costs are rising faster than the general inflation rate. In some markets, the lack of availability of nurses and other medical support personnel has become a significant operating issue facing healthcare providers. To address this challenge, we will continue to focus on improving our recruiting, retention, compensation and benefit programs, and productivity. The shortage of nurses and other medical personnel, including therapists, may, from time to time, require us to increase utilization of more expensive temporary personnel, which we refer to as \"contract labor.\" Competition The inpatient rehabilitation industry is highly fragmented, and we have no single, similar direct competitor. Our inpatient rehabilitation hospitals compete primarily with rehabilitation units, many of which are within acute care hospitals, in the markets we serve. For a list of our markets by state, see the table in Item 2, Properties. Smaller privately-held companies compete with us primarily in select geographic markets in Texas and the West. In addition, there are public companies that own primarily LTCHs but also own or operate a small number of inpatient rehabilitation facilities, one of which manages the operations of inpatient rehabilitation facilities as part of its business model. Because of the attractiveness of the inpatient rehabilitation industry, other providers of post acute-care services may attempt to become competitors in the future. For example, over the past few years, the number of nursing homes marketing themselves as offering certain rehabilitation services has increased even though nursing homes are not required to offer the same level of care, or be licensed, as hospitals. The competitive factors in any given market include the quality of care and service provided, the treatment outcomes achieved, and the presence of physician-owned providers. However, the previously enacted ban on new, or expansion of existing, physicianowned hospitals should limit to some degree that competitive factor going forward. See the \"RegulationRelationships with Physicians and Other Providers\" section below for further discussion. Additionally, for a discussion regarding the effects of certificate of need requirements on competition in some states, see the \"RegulationCertificates of Need\" section below. We rely significantly on our ability to attract, develop, and retain nurses, therapists, and other clinical personnel for our hospitals. We compete for these professionals with other healthcare companies, hospitals, and potential clients and partners. In addition, physicians and others have opened inpatient rehabilitation hospitals in direct competition with us, particularly in states in which a certificate of need is not required to build a hospital, which has occasionally made it more difficult and expensive to hire the necessary personnel for our hospitals in those markets. Federal Deficit Reduction On August 2, 2011, President Obama signed into law the Budget Control Act of 2011, provisions of which will result in an automatic 2% reduction of Medicare program payments for all healthcare providers upon executive order of the President in January 2013. We currently estimate this automatic reduction, known as \"sequestration,\" will result in a net decrease in our Net operating revenues of approximately $32 million annually beginning in 2013. There also continue to be a number of efforts in both the United States Senate and the House of Representatives to address the federal spending deficit by, at least in part, reducing Medicare spending. We cannot predict what alternative or additional deficit reduction initiatives or Medicare payment reductions, if any, will ultimately be enacted into law, or the effect any such initiatives or reductions will have on us. If enacted, such initiatives or reductions would likely be challenging for all providers, would likely have the effect of limiting Medicare beneficiaries' access to healthcare services, and could have an adverse impact on our financial position, results of operations, and cash flows. However, we believe the steps we have taken to reduce our debt and corresponding interest expense obligations coupled with our efficient cost structure should allow us to adjust to or mitigate, at least partially, any potential initiative or payment reductions more easily than many other inpatient rehabilitation providers. 4 Healthcare Reform The healthcare industry always has been a highly regulated industry, and the inpatient rehabilitation sector is no exception. Successful healthcare providers are those who provide high-quality, cost-effective care and have the capabilities to adapt to changes in the regulatory environment. We believe we have the necessary capabilities - scale, infrastructure, and management - to adapt and succeed in a highly regulated industry, and we have a proven track record of being able to do so. On March 23, 2010, President Obama signed the Patient Protection and Affordable Care Act (the \"PPACA\") into law. On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010, which amended the PPACA (together, the \"2010 Healthcare Reform Laws\"). The 2010 Healthcare Reform Laws remain subject to continuing Congressional, regulatory and legal scrutiny, and many aspects of their implementation are still uncertain or subject to judicial challenge. We cannot predict the outcome of any legislation or litigation related to the 2010 Healthcare Reform Laws, but we have been, and will continue to be, actively engaged in the legislative process to attempt to ensure any healthcare laws adopted or amended promote our goal of high-quality, cost-effective care. It should also be noted that in November 2011, the Supreme Court of the United States agreed to hear arguments in the first half of 2012 on, among other issues, the Constitutionality of various provisions of the 2010 Healthcare Reform Laws. However, we cannot predict the ultimate outcome of the Supreme Court ruling. Many provisions within the 2010 Healthcare Reform Laws have impacted or could in the future impact our business, including: (1) reducing annual market basket updates to providers, which are discussed in greater detail below under \"Sources of Revenue - Medicare Reimbursement;\" (2) the possible combining, or \"bundling,\" of reimbursement for a Medicare beneficiary's episode of care at some point in the future; (3) implementing a voluntary program for accountable care organizations (\"ACOs\"); (4) creating an Independent Payment Advisory Board; and (5) modifying employer-sponsored healthcare insurance plans. For further discussion of the potential impacts of the 2010 Healthcare Reform Laws, see Item 1A, Risk Factors. Most notably for us, these laws include a reduction in annual market basket updates to hospitals. In accordance with Medicare laws and statutes, the United States Centers for Medicare and Medicaid Services (\"CMS\") makes annual adjustments to Medicare reimbursement rates by what is commonly known as a \"market basket update.\" The reductions in our annual market basket updates began April 1, 2010 and continue through 2019 for each CMS fiscal year, which for us begins October 1, as follows: 2010 0.25% 2011 0.25% 2012-13 0.1% 2014 0.3% 2015-16 0.2% 2017-19 0.75% In addition, beginning on October 1, 2011, the 2010 Healthcare Reform Laws require the market basket update to be reduced by a productivity adjustment on an annual basis. The productivity adjustments equal the trailing 10-year average of changes in annual economy-wide private nonfarm business multi-factor productivity. The productivity adjustment effective from October 1, 2011 to September 30, 2012 is a decrease to the market basket update of 1.0%. We estimate the adjustment effective October 1, 2012 will be a decrease to the market basket update of approximately 1.2%, but we cannot predict it with certainty. The 2010 Healthcare Reform Laws also direct the United States Department of Health and Human Services (\"HHS\") to examine the feasibility of bundling, including conducting a voluntary bundling pilot program to test and evaluate alternative payment methodologies. These voluntary bundling pilot projects are scheduled to begin no later than January 2013 and are limited in scope. In August 2011, the Center for Medicare and Medicaid Innovation within CMS released details for a voluntary Bundled Payments for Care Improvement Initiative. We are currently evaluating whether there may be any appropriate participation opportunities in the bundling initiatives for our hospitals and patients and the hospitals and physicians who refer their patients to our hospitals. Similarly, the 2010 Healthcare Reform Laws required CMS to start a voluntary program by January 1, 2012 for ACOs, in which hospitals, physicians and other care providers develop entities to pursue the delivery of coordinated healthcare on a more efficient, patient-centered basis. Conceptually, ACOs will receive a portion of any savings generated from care coordination as long as benchmarks for the quality of care are maintained. In October 2011, CMS issued the final rules establishing the voluntary ACO program. These rules are extremely complex and remain subject to further refinement by CMS. As with bundling, we are currently evaluating whether there may be any appropriate participation opportunities in the ACO pilots for our hospitals and patients and the hospitals and physicians who refer their patients to our hospitals. Another provision of these laws establishes an Independent Payment Advisory Board that is charged with presenting proposals, beginning in 2014, to Congress to reduce Medicare expenditures upon the occurrence of Medicare expenditures exceeding a certain level. However, due to the market basket reductions that are also part of these laws (as discussed above), 5 certain healthcare providers, including HealthSouth, will not be subject to payment reduction proposals developed by this board and presented to Congress through 2019. While we may not be subject to payment reduction proposals by this board for a period of time, based on the scope of this board's directive to reduce Medicare expenditures and the significance of Medicare as a payor to us, other decisions made by this board may impact our results of operations either positively or negatively. In addition to these factors, the 2010 Healthcare Reform Laws also contain provisions that have required, and will continue to require, modifications to employer-sponsored healthcare insurance plans, including HealthSouth plans. For example, the 2010 Healthcare Reform Laws require employer-sponsored healthcare plans to offer coverage to an employee's dependent children until such dependents attain the age of 26. These laws also eliminate an employer's ability to include a lifetime maximum benefit per participant within its plans. We currently estimate these changes will increase our healthcare plan costs by approximately $1 million annually. Given the complexity and the number of changes in these laws, as well as the implementation timetable for many of them, we cannot predict their ultimate impact. However, we believe the above provisions are the issues with the greatest potential impact on us. We will continue to evaluate and review these laws, and, based on our track record, we believe we can adapt to these regulatory changes. Sources of Revenues We receive payment for patient care services from the federal government (primarily under the Medicare program), managed care plans and private insurers, and, to a considerably lesser degree, state governments (under their respective Medicaid or similar programs) and directly from patients. Revenues and receivables from Medicare are significant to our operations. In addition, we receive relatively small payments for non-patient care activities from various sources. The following table identifies the sources and relative mix of our revenues for the periods stated: For the Year Ended December 31, 2011 2010 2009 Medicare Medicaid Workers' compensation Managed care and other discount plans Other third-party payors Patients Other income Total 72.0% 1.6% 1.6% 19.8% 2.0% 1.2% 1.8% 100.0% 70.5% 1.8% 1.6% 21.3% 2.3% 1.3% 1.2% 100.0% 67.8% 2.2% 1.7% 23.0% 2.6% 1.3% 1.4% 100.0% Our hospitals offer discounts from established charges to certain group purchasers of healthcare services that are included in \"Managed care and other discount plans\" in the table above, including private insurance companies, employers, health maintenance organizations (\"HMOs\"), preferred provider organizations (\"PPOs\") and other managed care plans. Medicare, through its Medicare Advantage program, offers Medicare-eligible individuals an opportunity to participate in a managed care plan. The Medicare Advantage revenues are also included in \"Managed care and other discount plans\" in the table above. Patients are generally not responsible for the difference between established gross charges and amounts reimbursed for such services under Medicare, Medicaid, and other private insurance plans, HMOs, or PPOs but are responsible to the extent of any exclusions, deductibles, copayments, or coinsurance features of their coverage. Collection of amounts due from individuals is typically more difficult than from governmental or third-party payors. The amount of these exclusions, deductibles, copayments, and coinsurance has been increasing each year but is not material to our business or results of operations. Medicare Reimbursement Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons, and persons with end-stage renal disease. Medicare, through statutes and regulations, establishes reimbursement methodologies and rates for various types of healthcare facilities and services, and, from time to time, these methodologies and rates can be modified by CMS. In some instances, these modifications can have a substantial impact on existing healthcare providers. In accordance with Medicare laws and statutes, CMS makes annual adjustments to Medicare payment rates in many prospective payment systems, including the inpatient rehabilitation facility (\"IRF\") prospective payment 6 system (the \"IRF-PPS\") by what is commonly known as a \"market basket update.\" Each year, the Medicare Payment Advisory Commission (\"MedPAC\"), an independent Congressional agency that advises Congress on issues affecting Medicare, makes payment policy recommendations to Congress for a variety of Medicare payment systems including the IRF-PPS. Congress is not obligated to adopt MedPAC recommendations, and, based on outcomes in previous years, there can be no assurance Congress will adopt MedPAC's recommendations in a given year. We cannot predict the adjustments to Medicare payment rates Congress or CMS may make in the future. Congress, MedPAC, and CMS will continue to address reimbursement rates for a variety of healthcare settings. For example, the 2010 Healthcare Reform Laws require that CMS establish new quality data reporting for all IRFs to begin in fiscal year 2014 and failure to comply will result in a reduction of 2% in the market basket update for the applicable fiscal year for any hospital found not in compliance with the reporting requirements. Additionally, the Budget Control Act of 2011 and its sequestration provision will result in a reduction of 2% in Medicare payment rates for all healthcare providers upon executive order of the President in January 2013. Any downward adjustment to rates, or another pricing roll-back, for the types of facilities we operate could have a material adverse effect on our business, financial position, results of operations, and cash flows. On January 16, 2009, CMS approved final rules that require healthcare providers to update and supplement diagnosis and procedure codes to the International Classification of Diseases 10th Edition (\"ICD-10\"), effective October 1, 2013, and make related changes to the formats used for certain electronic transactions, effective January 1, 2012. We have made the necessary changes to the formats used for certain electronic transactions and are currently making the other required changes to our systems to accommodate the adoption of ICD-10. We expect to be in compliance on a timely basis. Although this adoption process may result in some disruptions to the billing process and delays in the receipt of some payments, we do not believe there will be a material impact on our business. We will continue to monitor this implementation carefully. A basic summary of current Medicare reimbursement in our primary service areas follows: Inpatient Rehabilitation Hospitals. As discussed above, our hospitals receive fixed payment reimbursement amounts per discharge under IRF-PPS based on certain rehabilitation impairment categories established by HHS. In order to qualify for reimbursement under IRF-PPS, our hospitals must comply with various Medicare rules and regulations including documentation and coverage requirements, or specifications as to what conditions must be met to qualify for reimbursement. These requirements relate to, among other things, preadmission screening, post-admission evaluations, and individual treatment planning that all delineate the role of physicians in ordering and overseeing patient care. With IRF-PPS, our hospitals retain the difference, if any, between the fixed payment from Medicare and their operating costs. Thus, our hospitals benefit from being high-quality, cost-effective providers. Under IRF-PPS, CMS is required to adjust the payment rates based on a market basket index, known as the rehabilitation, psychiatric, and long-term care hospital market basket. The market basket update is designed to reflect changes over time in the prices of a mix of goods and services provided by rehabilitation hospitals and hospital-based inpatient rehabilitation units. The market basket uses data furnished by the Bureau of Labor Statistics for price proxy purposes, primarily in three categories: Producer Price Indexes, Consumer Price Indexes, and Employment Cost Indexes. Over the last several years, changes in regulation governing inpatient rehabilitation reimbursement have created challenges for inpatient rehabilitation providers. Many of these changes have resulted in limitations on, and in some cases, reductions in, the levels of payments to healthcare providers. For example, on May 7, 2004, CMS issued a final rule, known as the \"75% Rule,\" stipulating that to qualify as an inpatient rehabilitation hospital under the Medicare program a facility must show that a certain percentage of its patients are treated for at least one of a specified and limited list of medical conditions. Under the 75% Rule, any inpatient rehabilitation hospital that failed to meet its requirements would be subject to prospective reclassification as an acute care hospital, with lower acute care payment rates for rehabilitative services. On December 29, 2007, the Medicare, Medicaid and State Children's Health Insurance Program (SCHIP) Extension Act of 2007 (the \"2007 Medicare Act\") was signed, setting the compliance threshold at 60% instead of 75% and allowing hospitals to continue using a patient's secondary medical conditions, or \"comorbidities,\" to determine whether a patient qualifies for inpatient rehabilitative care under the rule. The long-term impact of the freeze at the 60% compliance threshold is positive because it allowed patient volumes to stabilize. In another example, the 2007 Medicare Act included an elimination of the IRF-PPS market basket adjustment for the period from April 1, 2008 through September 30, 2009 causing a reduction in the pricing of services eligible for Medicare reimbursement to a pricing level that existed in the third quarter of 2007, or a Medicare pricing \"roll-back,\" which resulted in a decrease in actual reimbursement dollars per discharge despite increases in costs. On July 22, 2010, CMS released its notice of final rulemaking for the fiscal year 2011 IRF-PPS. This rule was effective for Medicare discharges between October 1, 2010 and September 30, 2011. The pricing changes in this rule included a 2.5% market basket update that was reduced to 2.25% under the requirements of the 2010 Healthcare Reform Laws discussed above, as well as other pricing changes that impacted our hospital-by-hospital base rate for Medicare reimbursement. 7 On July 29, 2011, CMS released its notice of final rulemaking for the fiscal year 2012 IRF-PPS (the \"2012 Rule\"). This rule is effective for Medicare discharges between October 1, 2011 and September 30, 2012. The pricing changes in this rule include a 2.9% market basket update that has been reduced by 0.1% to 2.8% under the requirements of the 2010 Healthcare Reform Laws discussed above, as well as other pricing changes that impact our hospital-by-hospital base rate for Medicare reimbursement. The productivity adjustment effective October 1, 2011 is a decrease to the market basket update of 1.0%. Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the rule's release and incorporates other adjustments included in this rule, we believe the 2012 Rule will result in a net increase to our Medicare payment rates of approximately 1.6% beginning October 1, 2011. We estimate the to-be-determined productivity adjustment effective October 1, 2012 will be a decrease to the 2013 market basket update of approximately 1.2%. Although reductions or changes in reimbursement from governmental or third-party payors and regulatory changes affecting our business represent one of the most significant challenges to our business, our operations are also affected by coverage rules and determinations. Medicare providers like us can be negatively affected by the adoption of coverage policies, either at the national or local level, that determine whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. Current CMS coverage rules require inpatient rehabilitation services to be ordered by a qualified rehabilitation physician and be coordinated by an interdisciplinary team. The interdisciplinary team must meet weekly to review patient status and make any needed adjustments to the individualized plan of care. Qualified personnel must provide required rehabilitation nursing, physical therapy, occupational therapy, speechlanguage pathology, social services, psychological services, and prosthetic and orthotic services. CMS has also noted that it is considering specific standards governing the use of group therapies. For individual claims, Medicare contractors make coverage determinations regarding medical necessity which can represent more restrictive interpretations of the CMS coverage rules. We cannot predict how future CMS coverage rule interpretations or any new local coverage determinations will affect us. Pursuant to legislative directives and authorizations from Congress, CMS developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. These audits are in addition to those conducted by existing Medicare contractors. Some contractors are paid a percentage of the overpayments recovered. One type of audit contractor, the Recovery Audit Contractors ("RACs"), began post-payment audit processes in late 2009 for providers in general. The RACs receive claims data directly from Medicare contractors on a monthly or quarterly basis and are authorized to review claims up to three years from the date a claim was paid, beginning with claims filed on or after October 1, 2007. These RAC audits have initially focused on coding errors. CMS is currently expanding the program to medical necessity reviews for inpatient rehabilitation hospitals. The 2010 Healthcare Reform Laws extended the RAC program to Medicare, Parts C and D, and Medicaid. In 2011, we responded to a limited number of RAC audit requests, and to date, those audits have resulted in some overpayment and underpayment determinations, with a net underpayment determination of less than $1,000. On November 15, 2011, CMS announced that starting January 1, 2012, the RAC program will be expanded to include a three-year demonstration project for prepayment review of Medicare fee-for-service claims. This demonstration project will identify specific diagnosis codes for review, and the RAC contractors will review the selected claims to determine if they are proper before payment has been made to the provider. The project will be implemented in 11 states, including Florida, California, Texas, Louisiana, Illinois, Pennsylvania, Ohio, and Missouri in which we operate. CMS has delayed implementation of the prepayments review demonstration until June 1, 2012. CMS has also established contractors known as the Zone Program Integrity Contractors ("ZPICs"). These contractors are successors to the Program Safeguard Contractors and conduct audits with a focus on potential fraud and abuse issues. Like the RACs, the ZPICs conduct audits and have the ability to refer matters to the United States Department of Health and Human Services Office of Inspector General (the "HHS-OIG") or the United States Department of Justice. Unlike RACs, however, ZPICs do not receive a specific financial incentive based on the amount of the error. As a matter of course, we undertake significant efforts through training and education to ensure compliance with coding and medical necessity coverage rules. Despite our belief that our coding and assessment of patients is accurate, audits may lead to assertions that we have been underpaid or overpaid by Medicare or submitted improper claims in some instances, require us to incur additional costs to respond to requests for records and defend the validity of payments and claims, and ultimately require us to refund any amounts determined to have been overpaid. We cannot predict when or how these programs will affect us. Outpatient Services. Our outpatient services are primarily reimbursed under Medicare's physician fee schedule. By statute, the physician fee schedule is subject to annual automatic adjustment by a sustainable growth rate formula that has resulted in reductions in reimbursement rates every year since 2002. However, in each instance, Congress has acted to suspend or postpone the effectiveness of these automatic reimbursement reductions. For example, under the CMS notice of final rulemaking for the physician fee schedule for calendar year 2012, released on November 1, 2011, a statutory reduction of 8 27.4% would have been implemented. However, Congress passed on December 23, 2011, and President Obama signed into law, an extension of the current Medicare physician fee schedule payment rates from January 1, 2012 through February 29, 2012, and again in February 2012, they acted to extend the current Medicare physician reimbursement rates through December 31, 2012, further postponing the statutory reduction. If Congress does not again extend relief as it has done since 2002 or permanently modify the sustainable growth rate formula by January 1, 2013, payment levels for outpatient services under the physician fee schedule will be reduced at that point by more than 27%. We currently estimate that a 27% reduction, before taking into account our efforts to mitigate these changes, which would likely include closure of additional outpatient satellite clinics, would result in a net decrease in our Net operating revenues of approximately $8 million annually. However, we cannot predict what action, if any, Congress will take on the physician fee schedule and other reimbursement matters affecting our outpatient services or what future rule changes CMS will implement. Medicaid Reimbursement Medicaid is a jointly administered and funded federal and state program that provides hospital and medical benefits to qualifying individuals who are unable to afford healthcare. As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodologies and coverage policies from state to state. Many states have experienced shortfalls in their Medicaid budgets and are implementing significant cuts in Medicaid reimbursement rates. Additionally, certain states control Medicaid expenditures through restricting or eliminating coverage of certain services. Continuing downward pressure on Medicaid payment rates could cause a decline in that portion of our Net operating revenues. However, for the year ended December 31, 2011, Medicaid payments represented only 1.6% of our consolidated Net operating revenues. Managed Care and Other Discount Plans All of our hospitals offer discounts from established charges to certain large group purchasers of healthcare services, including Medicare Advantage, managed care plans, private insurance companies, and third-party administrators. Managed care contracts typically have terms of between one and three years, although we have a number of managed care contracts that automatically renew each year (with pre-defined rate increases) unless a party elects to terminate the contract. While some of our contracts provide for annual rate increases of three to five percent and our average rate increase in 2011 was 3.4%, we cannot provide any assurance we will continue to receive increases. Our managed care staff focuses on establishing and renegotiating contracts that provide equitable reimbursement for the services provided. Cost Reports Because of our participation in Medicare, Medicaid, and certain Blue Cross and Blue Shield plans, we are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require the submission of annual cost reports covering the revenue, costs, and expenses associated with the services provided by our inpatient hospitals to Medicare beneficiaries and Medicaid recipients. These annual cost reports are subject to routine audits which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. These audits are used for determining if any under- or over-payments were made to these programs and to set payment levels for future years. Medicare also makes retroactive adjustments to payments for certain low-income patients after comparing subsequently published statistical data from CMS to the cost report data. We cannot predict what retroactive adjustments, if any, will be made, but we do not anticipate such adjustments would have a material impact on our financial position, results of operations, and cash flows. Regulation The healthcare industry in general is subject to significant federal, state, and local regulation that affects our business activities by controlling the reimbursement we receive for services provided, requiring licensure or certification of our hospitals, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and controlling our growth. Our facilities provide the medical, nursing, therapy, and ancillary services required to comply with local, state, and federal regulations, as well as, for most facilities, accreditation standards of The Joint Commission (formerly known as the Joint Commission on Accreditation of Healthcare Organizations) and, for some facilities, the Commission on Accreditation of Rehabilitation Facilities. We maintain a comprehensive compliance program that is designed to meet or exceed applicable federal guidelines and industry standards. The program is intended to monitor and raise awareness of various regulatory issues among employees and to emphasize the importance of complying with governmental laws and regulations. As part of the compliance program, we 9 provide annual compliance training to our employees and encourage all employees to report any violations to their supervisor, or a toll-free telephone hotline. Licensure and Certification Healthcare facility construction and operation are subject to numerous federal, state, and local regulations relating to, among other things, the adequacy of medical care, equipment, personnel, operating policies and procedures, acquisition and dispensing of pharmaceuticals and controlled substances, infection control, maintenance of adequate records and patient privacy, fire prevention, and compliance with building codes and environmental protection laws. Our hospitals are subject to periodic inspection and other reviews by governmental and non-governmental certification authorities to ensure continued compliance with the various standards necessary for facility licensure. All of our inpatient hospitals are currently required to be licensed. In addition, hospitals must be certified by CMS to participate in the Medicare program and generally must be certified by Medicaid state agencies to participate in Medicaid programs. Once certified by Medicare, hospitals undergo periodic on-site surveys in order to maintain their certification. All of our inpatient hospitals participate in the Medicare program. Failure to comply with applicable certification requirements may make our hospitals ineligible for Medicare or Medicaid reimbursement. In addition, Medicare or Medicaid may seek retroactive reimbursement from noncompliant facilities or otherwise impose sanctions on noncompliant facilities. Non-governmental payors often have the right to terminate provider contracts if a facility loses its Medicare or Medicaid certification. The 2010 Healthcare Reform Laws added new screening requirements and associated fees for all Medicare providers. The screening must include a licensure check and may include other procedures such as fingerprinting, criminal background checks, unscheduled and unannounced site visits, database checks, and other screening procedures prescribed by CMS. We have developed operational systems to oversee compliance with the various standards and requirements of the Medicare program and have established ongoing quality assurance activities; however, given the complex nature of governmental healthcare regulations, there can be no assurance Medicare, Medicaid, or other regulatory authorities will not allege instances of noncompliance. A determination by a regulatory authority that a facility is not in compliance with applicable requirements could also lead to the assessment of fines or other penalties, loss of licensure, and the imposition of requirements that an offending facility takes corrective action. Certificates of Need In some states and U.S. territories where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory bodies under a \"certificate of need\" or \"CON\" law. As of December 31, 2011, approximately 49% of our licensed beds are located in states or U.S. territories that have CON laws. CON laws often require a reviewing agency to determine the public need for additional or expanded healthcare facilities and services. These laws generally require approvals for capital expenditures involving inpatient rehabilitation hospitals, if such capital expenditures exceed certain thresholds. In addition, CON laws in some states require us to abide by certain charity care commitments as a condition for approving a certificate of need. Any time a CON is required, we must obtain it before acquiring, opening, reclassifying, or expanding a healthcare facility or starting a new healthcare program. We potentially face opposition any time we initiate a certificate of need project or seek to acquire an existing facility or CON. This opposition may arise either from competing national or regional companies or from local hospitals or other providers which file competing applications or oppose the proposed CON project. Opposition to our applications may delay or prevent our future addition of beds or hospitals in given markets or increase our costs in seeking those additions. The necessity for these approvals serves as a barrier to entry and has the potential to limit competition, including in markets where we hold a CON and a competitor is seeking an approval. We have generally been successful in obtaining CONs or similar approvals when required, although there can be no assurance we will achieve similar success in the future. False Claims The federal False Claims Act prohibits the knowing presentation of a false claim to the United States government and provides for penalties equal to three times the actual amount of any overpayments plus up to $11,000 per claim. In addition, the False Claims Act allows private persons, known as \"relators,\" to file complaints under seal and provides a period of time for the government to investigate such complaints and determine whether to intervene in them and take over the handling of all or part of such complaints. Because we perform thousands of similar procedures a year for which we are reimbursed by Medicare and 10 other federal payors and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties under the False Claims Act. Many states have also adopted similar laws relating to state government payments for healthcare services. The 2010 Healthcare Reform Laws amended the federal False Claims Act to expand the definition of false claim, to make it easier for the government to initiate and conduct investigations, to enhance the monetary reward to relators where prosecutions are ultimately successful, and to extend the