In these consolidated appeals, the Secretary of Health and Human Services (Secretary) challenges the judgment of two district courts which independently, on the complaints of two sets of hospitals, declared invalid a new regulation, 42 C.F.R. Sec. 405.452(a)(1)(ii) (1984), promulgated by the Secretary that changed the process by which hospitals are compensated for the portion of their malpractice costs attributable to Medicare patients. We agree with the district courts that the regulation is invalid because promulgated in violation of provisions of the Administrative Procedure Act (APA) and the Medicare Act and because, as promulgated, it is arbitrary and capricious. We therefore affirm the determinations of invalidity and remand with directions to enter summary judgment requiring the Secretary to compensate the complaining hospitals under the regulation sought to be superseded.

* Two groups of hospitals, Bedford County Memorial Hospital, et al. (Bedford), and Alexandria Hospital, et al. (Alexandria) sued separately in different district courts challenging a regulation promulgated in 1979 by the Department of Health and Human Services (Secretary). The new regulation, 42 C.F.R. Sec. 405.452(a)(1)(ii), changed the way that the Secretary compensates hospitals for the portion of their malpractice costs attributable to Medicare patients.

Under a prior regulation, which had guided reimbursement since 1966, the Secretary treated malpractice costs as one of many overhead expenses that were pooled by Medicare services providers and reimbursed based on the provider's "utilization ratio," which is a ratio of usage of the hospital by Medicare patients to total patient usage.

The new regulation segregated malpractice costs from general overhead expenses and established a scheme of reimbursement based on actual malpractice claim loss experience of Medicare providers arising from serving Medicare patients.1 The Secretary promulgated the new regulation by notice and comment rulemaking subject to the Administrative Procedure Act (APA), 5 U.S.C. Sec. 553.

Both hospital groups challenged the new regulation on three grounds in district court: (1) the Secretary failed to meet the APA, 5 U.S.C. Sec. 553(c) requirement that an agency provide an adequate statement of basis and purpose for informal rules; (2) the rule is arbitrary and capricious; and (3) the rule is contrary to a provision of the Medicare Act, 42 U.S.C. Sec. 1395x(v)(1)(A).

The Bedford court entered judgment invalidating the rule for lacking an adequate statement of basis and purpose and as constituting arbitrary and capricious rulemaking. Bedford County Memorial Hospital v. Heckler, 583 F. Supp. 367 (W.D.Va.1984). The Bedford court indicated that it would have found the rule to be contrary to the Medicare Act as well had it needed to reach the issue. See id. at 378 & n. 16. The Alexandria court entered a similar judgment in Alexandria Hospital v. Heckler, 586 F. Supp. 581 (E.D.Va.1984). Both courts remanded the hospitals' underlying claims for malpractice cost reimbursement to the Secretary without specifying whether the Secretary was to pay Bedford and Alexandria under the old rule, or instead, was to be permitted to attempt correction of the deficiencies in her rule and be allowed to apply it as corrected.

These appeals by the Secretary followed and were consolidated by us for hearing and decision.

We note at the outset that the challenged regulation has spawned extensive litigation, and that to date, six other circuits have considered challenges to its validity. All but one have found the rule invalid; and the one remanded with expression of doubt as to validity. See DeSoto General Hospital v. Heckler, 766 F.2d 182 (5th Cir.1985) (affirming district court judgment insofar as it invalidated the new rule); Lloyd Noland Hospital and Clinic v. Heckler, 762 F.2d 1561 (11th Cir.1985) (affirming district court judgment invalidating the new rule); St. James Hospital v. Heckler, 760 F.2d 1460 (7th Cir.1985) (affirming district court judgment invalidating the new rule); Humana of Aurora, Inc. v. Heckler, 753 F.2d 1579 (10th Cir.1985) (reversing a district court judgment upholding the new rule); Abington Memorial Hospital v. Heckler, 750 F.2d 242 (3d Cir.1984) (affirming district court judgment invalidating the new rule); and Walter O. Boswell Memorial Hospital v. Heckler, 749 F.2d 788 (D.C.Cir.1984) (raising serious questions regarding the Secretary's rulemaking, but ultimately remanding because the parties failed to submit a complete administrative record for consideration by the district court).

We are in essential agreement with all the other circuits that have held the regulation invalid on a variety of grounds. On these appeals, we agree with the district courts that the regulation is invalid because of the Secretary's failure to provide an adequate statement of basis and purpose in her rulemaking process. The APA, 5 U.S.C. Sec. 553(c), requires that an agency promulgating an informal rule issue a concise statement of basis and purpose that identifies and addresses major issues raised during the comment period. St. James, 760 F.2d at 1469; Boswell, 749 F.2d at 794. The hospitals contend and we agree that the Secretary's statement failed to address major criticisms of the accuracy and relevance of the Westat study,2 the primary source of malpractice claim data relied on by the Secretary in formulating the new rule, and failed to address alternatives suggested by commenters.

The Secretary contends that it gave an adequate statement in noting that malpractice premium expense had inflated much more rapidly than other overhead items since the beginning of the original practice of pooling malpractice costs with other overhead items. Further, she cites the Westat study as establishing that because of his relatively advanced age, lower life expectancy and reduced income potential, the average Medicare patient represented a lower risk of malpractice claim losses than the average patient in the overall patient population. From this the Secretary had derived the regulation's stated basis that rapidly escalating malpractice costs had now made associated expenses too significant to lump into a crudely allocated overhead pool in which malpractice costs were necessarily then over-allocated to Medicare patients.3 See Bedford, 583 F. Supp. at 379 app.

We agree with the district court that this statement of basis was inadequate in view of the complete failure to address criticisms of the Westat study and alternatives raised by commentators. Accord Lloyd Noland Hospital, 762 F.2d at 1566-67; St. James, 760 F.2d at 1469-70.

One criticism raised by the hospitals' comments went to the heart of the reliability of the Westat study's data and its applicability to the hospitals affected by the new regulation.4 The Westat study included malpractice claims against both doctors and hospitals whereas only claims against hospitals would be relevant in determining whether the old overhead allocation scheme over-allocated malpractice costs to Medicare patients. The hospitals specifically questioned the over-inclusiveness of the data base by pointing out with supporting data that younger patients tend to sue their doctors more than do older patients and that doctor-defendant cases typically produce larger recoveries than do hospital-defendant cases. If that criticism were valid, the inclusion of doctor-defendant cases in the Westat study overstated any existing difference in malpractice risk for hospitals between older Medicare patients and patients in general, and undermined the stated basis for the new regulation segregating malpractice costs from general overhead.5

Because the accuracy and relevancy of the Westat study was thereby made a critical issue in deciding whether to promulgate the new regulation largely on the study's basis, it was essential that the criticism be addressed in the statement of basis; but it was not. In the absence of a valid basis for change of regulation, the Secretary was not free to depart from the longstanding policy of including malpractice costs in overhead. See Motor Vehicle Manufacturers Ass'n v. State Farm Mutual Automobile Insurance Co., 463 U.S. 29, 41-42, 103 S. Ct. 2856, 2865-66, 77 L. Ed. 2d 443 (1983); Humana, 753 F.2d at 1582. Hence, at least the major criticisms of the information forming the basis for the Secretary's rule should have been addressed in the Secretary's statement of basis and purpose.6 See Home Box Office, Inc. v. FCC, 567 F.2d 9, 35-36 (D.C.Cir.1977).

A second major flaw in the Secretary's statement of basis and purpose was the failure to address the alternative advanced by the hospitals of creating separate insurance pools for Medicare and non-Medicare patients. Normally, the failure to discount alternatives would not invalidate a rule because an agency need not pick a theoretical best solution for a problem, but rather, need only implement a reasonable solution. See Mourning v. Family Publications Service, Inc., 411 U.S. 356, 369, 93 S. Ct. 1652, 1660, 36 L. Ed. 2d 318 (1973). However, the Medicare statute, 42 U.S.C. Sec. 1395x(v)(1)(A), expressly requires the Secretary to consider the practices of national organizations in determining how to reimburse costs. It is undisputed that the Secretary's new reimbursement system based on five year loss history at each hospital is not used by any national organization, yet the hospitals' alternative represents a typical risk pooling scheme used by insurers. In view of the statute, rejection of an alternative that comports with usual practices is a major issue that should have been addressed in the Secretary's statement.7

Hence we find the Secretary's rule to be invalid for failure to adhere to the statement of basis and purpose requirement of the APA, 5 U.S.C. Sec. 553(c). See APA, 5 U.S.C. Sec. 706(2)(D). However, in order fully to assess the regulation's impact and determine appropriate relief, we continue into the issues of whether the rule is arbitrary and capricious and contrary to law.

Agency action is arbitrary and capricious if the agency relies on factors that Congress did not intend for it to consider, entirely ignores important aspects of the problem, explains its decision in a manner contrary to the evidence before it, or reaches a decision that is so implausible that it cannot be ascribed to a difference in view. Motor Vehicle, 463 U.S. at 43, 103 S.Ct. at 2866. We find that the rule in issue is arbitrary and capricious because the Secretary failed to consider important aspects of the malpractice cost reimbursement problem and implemented a system that is so implausible that it does not represent reasonable administration of the Medicare program. Accord Lloyd Noland Hospital, 762 F.2d at 1567-68; St. James, 760 F.2d at 1465-69.

The first flaw in the Secretary's rulemaking was the failure to consider problems regarding the accuracy and relevancy of the Westat study. Concededly, nothing in the Medicare Act requires the Secretary to treat malpractice costs as a part of overhead; however, the practice of reimbursing the costs under the overhead formula was entrenched at the time of the Secretary's rulemaking and could not be changed without justification. See Motor Vehicle, 463 U.S. at 41-42, 103 S.Ct. at 2865-2866. The Westat study, as discussed supra, was the primary factual basis for the Secretary's justification for changing the reimbursement rule, and in addition, was used in setting the actual reimbursement rate for hospitals that lack a five year malpractice loss history. Hence, the accuracy and relevancy of the Westat study was critical to the rulemaking, and the Secretary ignored an important aspect of the reimbursement problem in ignoring problems of over-inclusiveness of the Westat data base.8

Even had the Secretary justified the departure from prior practice, the rule in issue would be arbitrary and capricious because we find it contrary to the evidence and an implausible strategy for more fairly allocating malpractice expenses. The rule bases reimbursement solely on the loss history of the providing hospital, or if the individual hospital lacks a five year loss history, on a national figure derived from the Westat study.9 However, for hospitals protecting themselves with malpractice insurance, approximately forty percent of every premium dollar reflects the administrative expenses incurred by insurance companies rather than dollars paid out on malpractice claims. The Secretary gives no explanation of how a reimbursement formula based solely on loss experience fairly accounts for the portion of premium expenses that represent fixed costs of insurance coverage unrelated to the loss history of particular groups of patients.10

Since the Secretary's purpose in promulgating the rule was to more fairly allocate malpractice costs, the adopted system based solely on loss history is contrary to evidence that a large part of premium expense reflects administrative costs. The system therefore cannot be expected to result in fair allocation of malpractice costs, and is arbitrary and capricious.

In addition to finding the rule arbitrary and capricious, we find it contrary to law. Accord St. James, 760 F.2d at 1470-73. The Medicare Act requires that the Secretary administer the program so that costs of treating Medicare patients will not be borne by non-Medicare patients. 42 U.S.C. Sec. 1395x(v)(1)(A). By basing reimbursement of malpractice costs solely on loss history, the Secretary has failed to take account of administrative expenses, a disproportionate share of which will be borne by non-Medicare patients under the Secretary's system.11 Hence, the Secretary's failure to provide for the problem of cross subsidization of administrative costs is contrary to law as well as arbitrary and capricious.

The rule is also contrary to law in that the Secretary did not consider alternatives more closely paralleling the practices of other national organizations.12 No national organization determines the cost of malpractice coverage solely on individual hospital loss experience. Rather, similar hospitals are pooled as risks, and other factors such as administrative costs are factored in.

Moreover, the Secretary's failure to consider national practice has led to implementation of a system that appears likely to lead to unfair and illogical results. For instance, a hospital with no loss experience for five years would receive less reimbursement on insurance premium cost than a hospital with a loss experience if many of the claims involved Medicare patients.13 Two hospitals with precisely the same level of claims against them could be subject to widely varying reimbursement rates depending upon whether the hospital's claims happened to be skewed towards Medicare or non-Medicare patients.14

It thus appears clear that this regulation does not reward safe hospitals, treat similarly situated hospitals similarly, nor allow hospital planners to anticipate the level of reimbursement that they will receive from year to year. The Medicare Act, 42 U.S.C. Sec. 1395x(v)(1)(A) expressly requires the Secretary to take national practices into account, and the failure to do so is contrary to law and arbitrary and capricious, especially in view of the unfair and illogical results to which it obviously might lead.

Hence, we agree with the district courts that the Secretary's rulemaking suffered from procedural as well as serious substantive flaws. In our view, the Secretary did not comport with explicit directives of the Medicare Act, proceeded in the face of grave questions regarding the accuracy and relevancy of critical data, and neglected even to consider the obvious flaw in its proposed system for the allocation of administrative costs. With the seriousness of the deficiencies of the Secretary's rulemaking in mind, we turn to the issue of appropriate relief for the hospital petitioners in this case.

Both district courts found the Secretary's rule invalid and remanded to the Secretary, but neither made clear whether the remand was to be for further rulemaking procedures or payment based on the old formula. We hold that the proper relief is to remand all claims properly before the district courts for payment under the old rule. Accord, Desoto General, 766 F.2d at 186; Lloyd Noland Hospital, 762 F.2d at 1569.

The Secretary contends that she should have the opportunity to correct any deficiencies in the rule by further rulemaking.15 The hospitals contend that since the Secretary's new rule is invalid, reimbursement should be ordered under the old scheme, which utilized the general overhead formula. While retroactive rulemaking designed to cure defects in regulatory schemes should sometimes be permitted, this should only occur when the public interest in retroactively curing the defect outweighs the harm to private interests resulting from invalid first instance rulemaking. See Daughters of Miriam Center for the Aged v. Mathews, 590 F.2d 1250, 1260 & n. 27 (3d Cir.1978).

In balancing the interests in this case, the relatively serious deficiencies in the rulemaking and extensive subsequent proceedings that would be required weigh against allowing a retroactive rulemaking. Moreover, only a few years of payments are in question. The hospitals have a legitimate interest in a timely resolution of reimbursement issues that, in view of the deficiencies noted above, outweighs the public interests that could be advanced by a remand for further rulemaking with all reimbursement suspended in the interval.

Hence we find that the appropriate relief for claims properly before the district courts is to remand for entry of decrees directing payment forthwith under the old overhead formula. On remand, the district courts should determine which claims have been properly presented in accordance with 42 U.S.C. Sec. 1395oo and remand to the Secretary with instructions consistent with this opinion.

Having determined that the district courts correctly found the Secretary's regulation, 42 C.F.R. Sec. 405.452(a)(1)(ii) invalid, we affirm the judgments below. We remand to the district courts for issuance of orders clarifying the relief to be granted to the hospital petitioners.

SO ORDERED.