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July 10, 1998

UNIHEALTH, Plaintiff,

The opinion of the court was delivered by: PISANO



 This case concerns a contract dispute between plaintiff, Unihealth, and defendants, U.S. Healthcare, Inc. and The Health Maintenance Organization of New Jersey, Inc. Unihealth represents the Meadowlands Hospital Medical Center, which entered into a "Hospital Services Agreement" with the defendants in 1991. Pursuant to this agreement, Meadowlands Hospital was to provide hospital services to enrollees in U.S. Healthcare's health maintenance organization in exchange for U.S. Healthcare's payment for said services. On November 28, 1995, Unihealth brought this suit against defendants, alleging that defendants breached their contract by failing to make proper reimbursements according to the terms of the contract. A non-jury trial was held before the Court on February 10 and February 11, 1998.

 For the reasons discussed herein, the Court finds that: (1) the repeal of the former governmental hospital billing system (the "DRG system") frustrated the Hospital Services Agreement; (2) a modification of this agreement is necessary to provide an equitable remedy for the parties; and (3) the amounts billed for normal newborn babies are to be included in the 1992 and 1993 reconciliations required under the discount clause of this agreement.

 With reference to plaintiff's claim for 1992 services, the Court orders defendants to pay plaintiff $ 39,374.54, which constitutes payment for hospital services and prejudgment interest. With reference to plaintiff's claim for 1993 services, the Court is not satisfied that either party has provided an appropriate method of reconciliation of their respective positions. Accordingly, the Court refers the case to a Special Master. The Special Master shall assist the parties, through mediation, to arrive at a charging formula that is comparable to the DRG system for the purpose of modifying the discount clause in the parties' agreement. In the event the parties are unable to agree upon a suitable charging mechanism, the Special Master shall receive evidentiary submissions from the parties and shall file a Report and Recommendation as to the appropriate standard for plaintiff's billings. The Court assigns the Special Master to subsequently reconcile the amount, including prejudgment interest, that the defendants owe plaintiff for 1993 hospital services pursuant to this formulated rating system.


 Unihealth, a nonprofit public benefit corporation organized under the laws of the state of California, was the sole corporate member of Meadowlands Hospital Medical Center ("Meadowlands"), which operated a health care facility until March 29, 1994, when operations were ceased. Unihealth then sold certain of its asserts to Liberty Riverside Health Care, Inc. According to the terms of the sale agreement, Meadowlands retained the rights to any claims against the defendant, among others. On August 3, 1995, Meadowlands was dissolved and all of its claims, including the one against defendants, were distributed to Unihealth.

 On April 1, 1991, Meadowlands entered into a "Hospital Services Agreement", ("the Agreement"), with U.S. Healthcare, Inc. and The Health Maintenance Organization of New Jersey, Inc. ("HMO"). *fn1" This agreement provided for the terms by which U.S. Healthcare would pay Meadowlands for services rendered to its members. See Ex. P-1 (the Agreement). Schedule A of the contract describes the services covered under the contract. See id. at pp. 1-2 of Schedule A. According to this schedule, "Maternity Care" service includes "semi-private accommodations in a regular maternity bed for the purpose of delivering a baby; inclusive of daily service and all ancillary services for both mother and child." Id. at p. 1 of Schedule A.

 The Agreement also provides that "fees to be charged by Hospital for Hospital Services rendered to Members shall be as described in Schedule 'B,' attached hereto and by reference made a part of this Agreement." Id. at p. 1. Schedule B provides a table of rates that Meadowlands could charge for various services. See id. at Schedule B. U.S. Healthcare agreed to pay "per diem" rates for all inpatient medical procedures aside from vaginal and caesarean (C-section) deliveries, which were to be paid through a flat-fee "case" rate system. *fn2" See id. Schedule B states that case rates for both vaginal deliveries and C-sections "include[] normal newborn." Id.

 Under the "per diem" rate system, defendants were to pay Meadowlands a fixed daily amount when a patient was in the hospital for that particular procedure. See id. According to calculations made during the negotiation of the Agreement, these per diem rates resulted in significantly lower hospital billings than the billings accrued from the rates that Meadowlands ordinarily charged other patients. See Transcript of February 10, 1998 Proceedings, Volume I ("TI") :50-52. To compensate plaintiff for its potential loss in revenue under such terms, the parties incorporated the following clause, which the Court refers to as "the discount clause," at the bottom of Schedule B:

If the overall discount for all Inpatients exceeds 40% during a calendar year, U.S. Healthcare will reimburse Meadowlands Hospital and Medical Center monies beyond the 40% discount. A reconciliation will be completed by HMO within 180 days of the end of the calendar year.


 Although the discount clause applies where "the overall discount ... exceeds 40%," the term "discount," specifically, the lodestar from which the discount should be assessed, is not referred to or defined anywhere in the Agreement. The correct interpretation of this clause is one of the primary issues in this case. The resolution of this issue determines the amount of payment that the defendants owe under the Agreement for the year of 1993. The second issue is whether amounts billed for normal newborn babies are to be included in the reconciliation required under the discount clause. The resolution of this issue determines the amount of payment the defendants owe for the years of 1992 and 1993. *fn3"

 After the parties executed the Agreement in 1991, they began to perform under it. Plaintiff provided services to U.S. Healthcare members, and submitted bills to U.S. Healthcare for those services. See Exs. P-4, and P-5 (Meadowlands Hospital U.S. Healthcare "Patient Account Inquiry Screens" for the Calender Years of 1992, 1993, respectively). *fn4" U.S. Healthcare, in turn, paid for those services in accordance with the rates contained in Schedule B to the Agreement. See id.

 Although the Agreement required the defendants to calculate the reimbursement due under the discount clause within 180 days of the end of the calendar year, the parties never agreed upon a reconciliation for any year. See Ex. P-1 at Schedule B; Plaintiff's Proposed Conclusions of Law and Findings of Fact ("PF") at p. 19. Furthermore, the defendants never made any payment under the provisions of the discount clause for the years of 1992 and 1993. See Stipulation of Facts ("SF") P 10.

 In its Complaint, plaintiff claims that U.S. Healthcare owes money pursuant to these provisions. Specifically, it charges the defendants with breach of contract, (Count 1), breach of the implied covenant of good faith and fair dealing (Count 2), and unjust enrichment, (Count 3). Plaintiff seeks payment for services rendered in the amount of $ 33,088.32 for the year of 1992, and $ 539,420.40 for the year of 1993. See PF at pp. 45-46. In addition, plaintiff seeks prejudgment interest on its award. See id. pp. 48-50.

 a. The Discount Clause.

 1. The DRG System.

 The negotiation of the Agreement took place in 1991. Since 1979, a regulatory system existed throughout the State of New Jersey that required hospitals to bill for inpatient services at prices set by the New Jersey Department of Health. See N.J.S.A. 26:2H-1 et seq. (now repealed). See SF PP 11-12. This categorization of mandatory charges was based on the "DRG" (the "Diagnostic Related Groups"), which was a classification of all the medical procedures and treatments that could be rendered on an inpatient basis in a hospital. See id. In contrast with the per diem terms of the Agreement between the parties, the statewide DRG system provided for flat service rates, or "case rates." *fn5" A "case rate" is a fixed rate for the entire hospital stay for a patient, regardless of how long that patient stayed in the hospital or the amount of services that were provided. *fn6" See TI:9.

 The starting point for calculating DRG case rates was the "base rate." The "base rate" was presumed to represent the direct cost of care for a patient with a particular condition corresponding to each of the approximately 500 diagnostic related groups. See TI:13-15. The ultimate DRG case rate was determined by adjusting the base rate by several factors. *fn7" See TI:13-22. Because these factors varied, the DRG rates could fluctuate from time to time during the course of a year. *fn8" TI:12.

 Approximately fourteen years after the date of its enactment and two years after the parties entered the Agreement, the New Jersey legislature abolished the DRG rate system, effective January 1, 1993. See SF P 14.

 2. The Charge Master.

 Both before and after the abolition of the DRG system, Meadowlands, like all other hospitals, maintained a "Charge Master." See TI:40. This several hundred paged document was essentially a "big price list" that itemized the prices for all hospital procedures, supplies, medicines, nursing care and staff physician services at Meadowlands. See TI:40, 41. Before the repeal of the DRG system, these prices were "essentially academic," insofar as they appeared on hospital bills but did not factor into the amounts due. TI:42.

 After the abolition of the DRG system, however, Meadowlands based its billing rates on the Charge Master prices. See TI:39. In contrast with the governmentally regulated, fixed rates under the DRG system, the Charge Master rates were determined by the hospital. See TI:44. Consequently, after the abolition of the DRG system, the hospital was free to increase or decrease charges at will, as long as the Charge Master rates were the same for all payers and did not exceed the State-mandated upper limit of profitability. See TI: 45. *fn9"

 According to the defendants' calculations, plaintiff's average rates for medical services increased by more than 65 percent from 1992 to 1993 after the deregulation of hospital charges. See SF at p. 20. These calculations indicate that the average per patient-day amount billed to U.S. Healthcare by plaintiff in 1991, 1992, and 1993 (excluding normal newborn billings) was $ 769, $ 1,049 and $ 1,609, respectively. See id. P 36; D-7, D-8, and D-9.

 3. 1991 Negotiations.

 The sole negotiator of the Agreement on behalf of the defendants was Paul Crespi. See SF P 7. Crespi has been employed by U.S. Healthcare since April 14, 1988, and has acted as its director, assistant vice president, and vice president. See id. P 5; Transcript of February 11, 1998 Proceedings, Volume II ("TII") :5. Joseph Coyle, who was the Vice President of Finance and Chief Financial Officer of Meadowlands in 1991, represented the plaintiff during negotiations. See id. P 8. The testimonies of these individuals at trial were similar; Crespi, who testified after Coyle, virtually adopted Coyle's version of the negotiation proceedings. *fn10" See TII:10, 11.

 Crespi testified that U.S. Healthcare's goal in negotiating the Agreement was to contract on a "per diem," as opposed to "case rate," basis. See TII:9. According to Crespi, U.S. Healthcare believed that contracting on a per diem basis would result in lower costs, owing to defendants' "aggressive case management." See id. U.S. Healthcare's additional goal in obtaining a long-term, fixed rate contract with Unihealth was to avoid the fluctuations that took place in the DRG-based rate system. See id. Coyle, in turn, testified that Crespi expressly stated that his purpose in negotiating the Agreement was to attain a per diem, multi-year contract at a fixed rate. See TI:47. Coyle recognized that U.S. Healthcare aimed to establish an agreement with fixed rates, so that it might offer customers "premiums that could be stable for over a several year period." See TI:47-48.

 Coyle testified that Meadowland's goal in negotiating the Agreement was to gain patients who were members of U.S. Healthcare. See TI: 51-52. Prior to the negotiation of this contract, Meadowlands did not have an agreement with the defendants. However, U.S. Healthcare did have a contract with Franciscan Health System, which operated St. Mary's Hospital in Hoboken and is a competitor of Meadowlands. See TI:51-52; 19; TII:8. Coyle testified that U.S. Healthcare referred its patients from Meadowlands to St. Mary's because St. Mary's had a contract with U.S. Healthcare and Meadowlands did not. See TI:51. Consequently, plaintiff was "anxious to get that business back" by contracting with U.S. Healthcare. Id.

 Coyle testified that, during the negotiations, he was nevertheless concerned that accepting the per diem/ maternity case rate terms offered by defendants would result in a financial loss for Meadowlands. See TI:52. Coyle indicated that, "as patients stayed fewer and fewer days," Meadowlands would get a lower percentage of the payment it would ordinarily have received under the DRG case rate. TI:6-7, 12. He based this opinion, in part, on profit calculations he made during earlier negotiations between the parties in 1989. See TI:49, 50. At that time, Coyle analyzed the per diem rates proposed by U.S. Healthcare to calculate whether an agreement would be profitable to Meadowlands. See id. Coyle testified that the 1989 calculations revealed that the aggregate payments of these rates would only total approximately 50 to 60 percent of the payments the hospital would have received for services under the DRG case rate system. See TI:50-51. Under these circumstances in 1989, Meadowlands did not enter into a contract with U.S. Healthcare.

 In 1991, Coyle made additional profit calculations and the parties resumed negotiations. See TI:50. According to Coyle, the 1989 rates were approximately the same as the rates calculated in the 1991 proposal. See id. He testified that, although Meadowlands was willing to suffer some loss to contract with defendants and recapture patients referred to St. Mary's, Meadowlands insisted on placing a limitation on the loss it would incur under the proposed per diem/ maternity case rate system. TI:11-12, 51-52. Voicing these concerns, Coyle suggested in 1991 that the Agreement contain the "discount clause" within Schedule B. See TI:27-28. During negotiations, he explained to Crespi that his purpose in suggesting the clause was "to limit the financial risk of a multiple year contract at predetermined rates, particularly at per diem and case rates that [he] knew were lower than what [plaintiff was] getting paid already." Id. At trial, Crespi acknowledged that he understood Coyle insisted on including a discount clause during the negotiations because "he wanted some protection on his normal revenues." TII:28. U.S. Healthcare, in turn, agreed to this discount clause in exchange for a four year contract. See TII:27-28. *fn11" As a result, U.S. Healthcare drafted the discount clause limiting U.S. Healthcare's overall discount for inpatient services to 40% of the hospital's "normal revenue." TI:30; TII:28.

 During negotiations, however, neither Crespi nor Coyle recall expressly defining the amount of the hospital's "normal revenue," from which the discount would be calculated. See TI:30; TII:22. Nevertheless, both individuals testified that their understanding was that hospital's "normal revenue" corresponded to the current rates under the DRG system. The following discussion during trial addresses Coyle's understanding of the "discount clause" at the time of negotiations:

 Coyle :

"[The discount clause is a l]imitation on the amount of discount to be provided; discount being the difference between the amount that was billed and the amount that was agreed upon within the contract customarily understood to be the discount, and that we wanted to limit that amount over the life of the contract.

 Court :

You're using a phrase, "a discount from the amount that was billed".. . My question to you is: The amount that was billed; by what standard?

 Coyle :

The only standard we had in place at the time was the DRG rate, that was the amount that [sic] the rate-setting system that we were in.

 Court :

So you understood that where it says in the [discount] clause, where it says, "If the overall discount for all in-patients exceeds 40 percent during a calendar year"; did you understand that the words "of the DRG billing rate" were to be incorporated or implied to be included in that sentence?

 Coyle :

Yes, that would have been my understanding, that would have meant that the payment would be at least 60 percent of the DRG billing rate.

 TI31. *fn12" Crespi similarly testified that he understood "the discount for all in-patient rates ... was to apply to the DRG rates ... the discount was to ...

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