The erratic history of the labor/delivery room policy is not the kind of interpretation justifying deference to the Secretary's expertise. The district court therefore did not err when it refused to defer to HHS's interpretation of the labor/delivery room reimbursement policy.

The Secretary argues that the labor/delivery reimbursement policy is sustainable without deferring to the Secretary's expertise because the affidavits presented to the Deputy Administrator and the district court show that the policy works fairly. Reply Brief at 12 n. 15. The Medicare statute gives the Secretary broad authority to determine Medicare reimbursement policy and provides for a system of averaging to aid in the efficient administration of the program. The Secretary also argues that under the averaging system one individual policy is not invalid although the result is that some hospitals are paid less than their full costs. The Secretary maintains that it is reasonable to include ancillary area patients in the routine census count because those patients will ultimately receive routine care within the census period, and also because including those patients in the routine census recognizes that those patients incur routine costs while in the ancillary area.7 The difficulty with the Secretary's interpretation is that it appears to be inconsistent to include ancillary patients in the census count for routine costs they have not incurred, but to exclude ancillary patient costs which they have incurred.

Central to the Medicare reimbursement program is that "reasonable costs" are calculated so that non-Medicare payors do not subsidize the care of Medicare patients. 42 U.S.C. Sec. 1395x(v)(1)(A) (1982). Under PRM Sec. 2345 a routine inpatient day is counted for every inpatient in a hospital at midnight. When a maternity patient is admitted directly to the labor area and remains in that area at midnight, Medicare counts those labor room services not only as inpatient days but also as routine days. Therefore, even though labor/delivery patients have incurred no routine costs and Medicare excludes their labor/delivery costs from routine costs, Medicare apportions routine costs to patients in the labor/delivery area.

As noted by the St. Mary I court, this anomalous result would not occur if patients in the labor/delivery room area were Medicare beneficiaries and used that area in the same proportion as they utilized other services. Id. at 462 n. 8. The court in St. Mary II concluded that because labor/delivery patients are disproportionately non-Medicare patients, "HHS's reimbursement scheme raises the presumption that non-Medicare patients are forced to subsidize the routine costs of other patients, in violation of 42 U.S.C. Sec. 1395x(v)(1)(A)." 760 F.2d at 1315.

Similarly, in this case the Hospital has demonstrated that the class of patients residing in the labor/delivery area at census-taking hour has received no routine care. Therefore, the assumption in the HHS reimbursement scheme that ancillary patients have already received routine care, and as a result can fairly be included in the inpatient count, is not consistent with 42 U.S.C. Sec. 1395x(v)(1)(A)(i).

In addition, HHS's argument that it should be allowed to offset the higher costs incurred by labor/delivery patients ignores the requirement in 42 C.F.R. Sec. 403(d) that weighting not be used. See infra at II. C. On the contrary, HHS appears to argue that whenever Medicare patients underutilize a hospital service on a national basis, HHS may offset the difference that occurs from the underutilization. See Reply Brief at 8. This interpretation is inconsistent with HHS's regulation requiring that the average routine costs per day be the same for all patients. See 42 C.F.R. Sec. 405.403(d) (1980).

The Secretary's offsetting rationale is further at odds with his refusals, affirmed by the courts, to allow hospitals to separate out from the calculation of average per diem costs for general routine services days of care utilized by Medicare patients who utilize far greater amounts of routine care than does the inpatient population in general. Consistent with 42 C.F.R. Sec. 405.452(d)(10) (1980), which specifically excludes "maternity labor rooms," courts have held that the only exception from the averaging principle are "special care units" (SCU's) as defined in the regulation. See Butler County Memorial Hospital v. Heckler, 780 F.2d 352, 356-57 (3d Cir.1985) (citing cases). In those cases, even though the average per diem costs of units exceeded the average per diem costs for general routine services, the Secretary refused to reimburse the hospitals. Yet, HHS in this case is attempting to do what it will not countenance in the "sub-intensive care" cases, offsetting costs premised on a special unit not provided for in its regulations.

HHS could have chosen to define labor/delivery room units as SCU's, and therefore come under the exception in 42 C.F.R. Sec. 405.452(d)(10) (1980), but did not do so. See St. Mary II, 760 F.2d at 1319. As a result, to justify its action with an offsetting rationale clearly is invalid because, under the HHS reimbursement and apportionment process, no special reimbursement treatment may be granted to a particular class of patients unless they qualify as SCU's. See John Muir Memorial Hospital, Inc., et al. v. Davis, Nos. C-81-4731 EFL and C-81-4732, slip op. at 4 (N.D.Cal. Aug. 9, 1984). Therefore, the Deputy Administrator's statement that the Hospital is merely unhappy with the effects of the averaging process, Deputy Administrator's Decision at 6, J.A. at 8, simply does not explain what is essentially an irrational interpretation for an unfair modification of the reimbursement formula.

Seven Circuits to date have considered the issue whether the Secretary's reimbursement methodology is rational. Six have expressly ruled against the Secretary and one Circuit has implied that it found the policy to be irrational. Community Hospital of Roanoke v. HHS, 770 F.2d 1257, 1264 (4th Cir.1985); Central DuPage Hospital v. Heckler, 761 F.2d 354, 357 (7th Cir.1985); Beth Israel Hospital v. Heckler, 734 F.2d 90, 92 (1st Cir.1984); Baylor University Medical Center v. Heckler, 730 F.2d 391, 392 (5th Cir.1984) (per curiam); International Philanthropic Hospital Foundation v. Heckler, 724 F.2d 1368, 1371 (9th Cir.1984) (per curiam); St. Mary I, 718 F.2d 474. See also University of Tennessee v. HHS, 737 F.2d 579, 580 (6th Cir.1984) (per curiam) (remanding to district court for consideration in light of St. Mary I ). For the reasons stated above, we too conclude that the method of reimbursement adopted in Sec. 2345 is irrational.

The Secretary presented the affidavits of Doctors Fitzmaurice and Cromwell in order to show that non-Medicare patients incur higher routine costs, once they do receive routine care, than the average patient.8 Therefore, according to the Secretary, counting labor/delivery patients even though they have received no routine services provides the necessary balancing for the later higher costs they incur when they do receive routine services. Appellant's Brief at 23.

The Secretary asserts that this is the first case to consider the data developed in response to the remands ordered by the other Circuits which have confronted this issue.9 He further contends that, while the D.C. Circuit in St. Mary II, 760 F.2d at 1317-19, and the Ninth Circuit in Mount Zion Hospital and Medical Center v. Heckler, 758 F.2d 1346, 1348 (9th Cir.1985), have considered this data, they did not reach the merits, relying instead on the data in connection with their limited remands.

The Secretary's contention as to the validity of the affidavits is contingent upon a finding that there is a rational basis for HHS's labor/delivery room policy. However, the affidavits rest on an evaluation of the entire routine care reimbursement system. The issue before the court is whether the labor/delivery room policy is an irrational method of reimbursement with respect to Sioux Valley Hospital. See 42 C.F.R. Sec. 405.402(b)(3) (1980). Therefore, because they address nationwide patterns of reimbursement and not the labor/delivery room dispute concerning this hospital, the affidavits are of little relevance to the dispute before the court. In addition, the affidavits appear to be irrelevant to this case in light of the fact that the costs they compare are not the specific costs generated by labor/delivery patients, but the more general costs of patients who have been admitted to a routine care bed.

Even assuming that the affidavits are relevant, their impact must be circumscribed as post hoc rationalizations. The affidavits were introduced midway through the administrative process, some ten years after the instant policy had been established. HHS did not rely on these affidavits during the PRRB hearing. Once before the Deputy Administrator, who had reversed numerous previous PRRB decisions without considering the affidavits, HHS produced the evidence it now contends is central to its offsetting rationale to the ten-year-old labor/delivery room policy. The Deputy Administrator stated that the affidavits were "merely further arguments" justifying HHS's position. Deputy Administrator's Decision at 6, J.A. at 8.

An administrative agency's policy cannot be justified merely after-the-fact. See Citizens to Preserve Overton Park v. Volpe, 401 U.S. 402, 419, 91 S. Ct. 814, 825, 28 L. Ed. 2d 136 (1971). In this case, HHS did not consider the arguments it raises by way of the affidavits until recently, and only then in response to the holdings of courts that its policy is irrational. The sole purpose for submitting the affidavits is to justify a policy that HHS should have considered ten years ago. It is not therefore surprising that courts have invalidated the HHS affidavits on this basis. See St. Mary II, 760 F.2d at 1315, 1319; John Muir Hospital, slip op. at 4.

Furthermore, HHS's contention that the affidavits contain evidence that maternity and pediatric patients consume more routine care once they are admitted to a routine bed, therefore justifying an adjustment to the Medicare reimbursement, amounts to a violation by HHS of its own regulations. 42 C.F.R. Sec. 405.452(d)(7) (1980) provides the method of computing the "average cost per diem for general routine services." Section 452(d)(7) states that the average cost per diem for general routine services is computed "by dividing the total allowable inpatient cost for routine services by the total number of inpatient days of care * * *." Id. There is nothing in this computation which allows for the weighting of days spent in various sub-units of the general routine areas. Rather, 42 C.F.R. Sec. 405.403(d) (1980) expressly states that inpatient days are not to be weighted in this manner. Section 403(d) states in part:

This method, commonly referred to as the average per diem cost, does not take into account, variations in the amount of services which a day of care may represent and thereby assumes that patients for whom payment is made on this basis are average in their use of service.

By attempting for the first time in 1984 to argue that the weighting of labor/delivery room patients is needed to offset the higher routine costs they incur once they are admitted to the Hospital, HHS has contravened the clear language of its regulation.

The district court therefore correctly concluded that the affidavits were insufficient to support the Secretary's policy. For these same reasons it would not have been appropriate for the district court to remand this case to the PRRB to test the merits of the affidavits.10 The data collected in the Fitzmaurice and Cromwell affidavits cannot salvage what is an irrational policy, and a remand would serve little purpose other than to delay the inevitable result this court would reach.

The Secretary also argues that the district court exceeded its authority when it ordered HHS to recompute the Hospital's reimbursement for the subsequent cost reporting years 1982-83. Agencies should be free, even when they err, to work out their own problems without the interference of the courts. In most cases, agency tribunals should be permitted to develop the factual record upon which decisions should be based. See Weinberger v. Salfi, 422 U.S. 749, 765, 95 S. Ct. 2457, 2466, 45 L. Ed. 2d 522 (1975). However, when an administrative appeal would be futile and little more than a formality, exhaustion will not be required. See United States v. Blair, 321 U.S. 730, 736, 64 S. Ct. 820, 823, 88 L. Ed. 1039 (1944). The futility exception to the exhaustion requirement applies when there is nothing to be gained other than an agency decision adverse to the plaintiff. See West v. Bergland, 611 F.2d 710, 714-20 (8th Cir.1979), cert. denied, 449 U.S. 821, 101 S. Ct. 79, 66 L. Ed. 2d 23 (1980); B. Schwartz, Administrative Law Sec. 8.31, at 505-07 (2d ed. 1984).

Further development at the administrative level will not be necessary. The Hospital has submitted a claim for payment of the disputed costs for 1982-83, which the Intermediary then denied. The PRRB on January 13, 1986 reversed the decision of the Intermediary, and on March 12, 1986 the Deputy Administrator reversed the PRRB. The pattern is clear. Little would be gained by insisting on the administrative process playing itself out. The Secretary has been unable to controvert that the labor/delivery room policy is irrational with regard to cost reporting year 1981. There is no reason to believe that we would reach a different result for 1982-83. Therefore, we conclude that the district court did not err in requiring that the Secretary reimburse the Hospital for cost reporting years 1982-83.

For the reasons stated above, we affirm the decision of the district court.