Consider the image of the modern hospital: Caring for patients, saving lives -- and struggling to keep its doors open.

The plea of poverty has helped hospitals for years in their efforts to win local good will, attract generous private contributions and, most important, keep the federal money flowing.

Suddenly, that image is being challenged.

The hospital industry was jolted earlier this year when an official of the U.S. Department of Health and Human Services alleged that hospitals are making a killing from Medicare, the huge government health insurance program for 31 million elderly Americans.

Here are some examples, based on the methodology used by Richard P. Kusserow, the HHS inspector general, to reach his conclusions: In Philadelphia, Thomas Jefferson University Hospital, a respected nonprofit teaching institution, was paid $50.5 million for the care of Medicare inpatients. But its costs were only $39 million -- a profit of nearly 23 percent of revenues. In Florida, Orlando Regional Medical Center, a big 1,100-bed hospital, made 13.8 percent in 1985 and 12.4 percent in 1986 on Medicare inpatients.

Those, according to the Kusserow studies, are the tip of the iceberg. The nation's 5,800 community acute-care hospitals cleared profits of about 14.2 percent in 1984 and 15.3 percent in 1985 on their Medicare inpatient operations. And those profits came just as a new system to hold down Medicare costs was being put in place.

The government's Prospective Payment Assessment Commission (PROPAC), in charge of monitoring Medicare costs, came up with similar estimates. The Congressional Budget Office estimated 12 percent for 1984.

In 1984 through '86, said John Warner Jr., a St. Louis-based hospital management consultant, many hospitals "were able to make out like bandits."

Those findings -- combined with the assumption that hospitals make even more on paying patients, and the fact that most hospital profits are tax-exempt -- have led to increasing pressure to cut Medicare payment rates or at least freeze them.

President Reagan has proposed that Medicare rates for 1988 be raised only three quarters of 1 percent, less than one fifth the anticipated increase in the costs of things hospitals buy. The House Ways and Means Committee has been slightly more generous, allowing 1 to 2 percent, depending on hospital location. In the wake of last week's tumultuous stock market, there is additional pressure on the government to reduce spending and balance the federal budget.

Hospitals, on the other hand, contend that the government has it all wrong. Overall, they say, they have been making only 5 to 6 percent, and that includes both Medicare and non-Medicare revenues. If anything, they are losing money on Medicare or making a very small amount on it, largely because caring for elderly patients is full of hidden costs, and Medicare doesn't pay its fair share of charity care, they say. Medicare spending must be increased to keep up with inflation, they insist.

The dispute has left the public -- and even experts -- not knowing who to believe.

"I'm leery of the figures," said Dr. Gerard Anderson, director of the Johns Hopkins Center for Hospital Finance and Management, speaking of the 12-15 percent profit calculations for Medicare inpatient operations. "I don't see anything wrong with the methodology," but the numbers "seem too high. I can't figure out why." The Need to Cut Costs

The origin of the current dispute goes back to the enactment in 1983 of a new payment system for Medicare.

Medicare was enacted in 1965, a national health insurance program for retired and disabled Social Security pensioners.

From the start, it reimbursed hospitals for their costs, so in theory hospitals made no profits on Medicare, except for a return on equity paid to the relatively small number of for-profit hospitals. Costs for which Medicare paid included direct costs of caring for patients, plus a fair share of general hospital overhead, of hospital capital costs and of hospital costs for interns, residents and other student health personnel.

During the 1970s there was a tremendous upsurge in hospital costs generally and in Medicare outlays. Medicare outlays for hospital care increased at rates ranging from 10.2 percent to 28.6 percent a year, jumping from $5.3 billion in 1970 to almost $26 billion in 1980 -- a rate of increase far outstripping the general inflation rate. The government decided that hospitals were making inadequate efforts to control their costs, letting people stay in longer than needed out of sheer inefficiency or because it was convenient to doctors and patients. And Medicare was paying the bill.

So in the 1983 Social Security Act amendments, Congress and the Reagan administration approved a totally different system of paying hospitals for Medicare patients -- called "prospective payment" (PPS). The objective was to force hospitals to cut costs by paying them a fixed amount per Medicare patient -- an amount based on diagnosis -- regardless of how long the patients stayed in the hospital.

The rates vary according to diagnosis, with higher payments for more serious conditions. A craniotomy, or skull surgery (diagnosis group 1), is paid at one rate; an appendectomy (diagnosis group 166) at another; a major joint or limb reattachment (diagnosis group 209) at still another. There are 473 such groups, and special rules for patients who have extremely long stays, called "outliers."

Since the payment is no longer by day but by case, the hospital gets no extra payment if it keeps the patient for extra days or performs added tests of marginal medical usefulness.

At Capitol Hill Hospital here, for example, Medicare recently was paying $4,836 per case for each patient in diagnosis group 127 -- heart failure. This was based on an assumed average stay of 6.8 days. Regardless of whether the patient stayed 5 days, 6.8 days or 10 days, the hospital received $4,836 for treatment of a patient in that diagnosis group.

In fact, the average cost to Capitol Hill was closer to $6,000 per patient in diagnosis group 127 because the average length of stay was about 10 days, according to chief financial officer Clarence Osborne. So the hospital actually lost money on these patients.

But many other hospitals, such as Philadelphia's Thomas Jefferson, made profits by reorganizing operations, reducing lengths of stay or cutting staff in order to drive costs down. Jefferson and other nonprofit hospitals put their surplus revenues into improving or expanding services or facilities.

Some have charged that the payment levels were set too high in the first place, either by mistake, or as a necessary concession to hospitals to assure passage of the plan.

Overall, though, most observers agree that the new system, designed to hold down hospital costs and therefore Medicare outlays, has worked. The growth of Medicare outlays for hospitals dropped to 4.15 percent in 1986, in part because of the new system. "The Medicare prospective payment system has helped to reduce the cost of inpatient care compared to what it would have been otherwise," said Medicare administrator William L. Roper on June 23.

Ironically, however, the new system also allowed hospitals to make visible profits on Medicare inpatients for the first time. Spurred by the new system, many pushed costs down below the level of the fixed payments, thereby gaining profits -- even though the total costs to Medicare were less than they would have been under the old system.

Challenging the Estimates

The 12- to 15-percent profits hospitals are said to be earning off of Medicare would make corporate America look like paupers. For example, the Chrysler Corp. in 1986, the third-best year in its history, enjoyed a profit of only 10.3 percent of sales revenues, and that was before taxes.

But according to many health economists and hospital industry spokesmen, those huge Medicare profits are an illusion. What's more, they say, even if the Medicare profits were real, other costs far outweigh them.

The Kusserow figures, these observers say, overlook the following key points: Outpatient costs and overhead. The estimates do not include separate Medicare payments for capital, direct costs for training interns, residents and other personnel, or outpatient operations -- all of which are reimbursed at cost and thus produce no profits. Hidden costs. Hospital officials argue that the Medicare PPS payments do not have factored into them Medicare's fair share of some major costs, thereby making Medicare costs appear lower and profits higher: malpractice insurance; extra nursing costs for the aged; certain other nursing costs; fund-raising costs; the costs of TV and phones provided free in some hospitals to Medicare patients.

Jefferson's Mark Richards said, "Medicare's share of our patient days is one third," and therefore, he argues, Medicare should pay one third of the hospital's malpractice premiums. But "I calculate the Medicare payment only covers 13 percent of malpractice costs," he says.

William Haire, president and chief executive officer of Capitol Hill, said, "While I'm not sure I can quantify it, there is no doubt in my mind, based on 17 years of experience, that the nursing and other costs for many Medicare patients, particularly where there is a large concentration of low-income patients, are higher than for other patients." Low-income patients often are in poorer general physical health because of lifelong poor nutrition and inadequate health care, and are hit harder by a given illness.

Hospitals strongly believe that if all these costs were properly allocated, Medicare profits would appear much lower. Henry Bachofer, vice president of the American Hospital Association, contended in an interview that if costs were properly allocated, average hospital profits nationwide on Medicare inpatients would be seen as only a few percent, perhaps zero, in 1984-85.

Orlando's chief financial officer, Garry Singleton, agreed, saying he would calculate that Orlando actually lost 8 percent on Medicare inpatients in 1986, rather than making over 12 percent.

And Ron Kovener, vice president of the Health Care Financial Management Association, an organization of 25,000 hospital and nursing home financial officers of various types, in a survey of 650 hospital financial officers, found they calculated their real profit margins on all Medicare operations at only 5.3 percent in 1985, 4.5 percent in 1986 and 1.5 percent in 1987. Charity care. Hospitals spend billions -- $6.3 billion in 1985, for which no one pays them back -- on charity care of low-income non-Medicare patients and on care of patients who come into the hospital intending to pay but do not. About 1,000 mainly urban hospitals bear most of the burden of these charity and bad debt cases.

In the Medicare cost calculations made by Kusserow, the Congressional Budget Office and PROPAC, virtually none of this uncompensated care is attributed to Medicare. All of it is ultimately treated as a cost of the non-Medicare sector of hospital operations.

The reason is that Medicare simply does not pay for uncompensated care of non-Medicare patients or even of Medicare patients, except for about $200 million a year from failure of Medicare patients to pay their $520 deductible and certain copayments.

Historically, hospitals have always run a system of cross-subsidies, charging more to the patients who can afford it in order to cover their uncompensated costs for those who can't.

Kovener and others argue that costs for the poor are a social cost and there is no rational reason why one payer, the Medicare program, should be absolved of responsibility for these patients, with the whole social burden dumped on private payers.

For individual hospitals, uncompensated care can make a huge difference. For fiscal 1988, Capitol Hill Hospital has projected charity costs of $2.5 million and bad debt of $2.8 million, a major reason its net profit margin on all non-Medicare and Medicare operations has been projected at only $758,000, about 1.7 percent.

At Orlando, according to chief financial officer Singleton, the hospital lost $18 million in fiscal 1985 on uncompensated care but still managed an overall profit of $13 million or 10 percent of revenues. But in 1986 uncompensated care jumped to $25 million and net profit plunged to 5.5 percent.

So if hospitals are profiting from Medicare, the argument goes, that's fine; the money is needed to cover these nonpaying patients anyway.

In a counter-argument, Rep. Fortney H. (Pete) Stark (D-Calif.), chairman of the House Ways and Means subcommittee on Medicare, in a meeting with reporters recently, said many hospitals are already recouping this money through their tax-exempt status. He said this saves them huge amounts of money, which, he guessed, more than compensates most, though not all, of them for charity care losses.

More Competition

If the belt-tightening pressure on hospitals were coming just from Medicare, hospitals might be less sensitive about charges that they are cashing in on the federal insurance plan. But, in fact, hospitals are feeling the heat from all sides in an increasingly competitive health care environment.

The assumption that paying customers are a lucrative source of revenue is being challenged.

In recent years hospital stays and admissions have been dropping, even outside the Medicare area. Part of the reason is that private employers and insurance firms have been pressing very heavily to reduce their costs for health care for their employes, and, according to Willis Goldbeck of the Washington Business Group on Health, "They are even reordering the way health care is delivered."

Goldbeck said they are ordering utilization reviews to make sure doctors don't hospitalize patients unnecessarily and keep them in longer than necessary. They are forcing services like minor surgery to be delivered in less costly settings outside the hospital, such as non-hospital-related ambulatory surgery and medical test centers and doctors' office, and they are shifting dying patients to hospices.

St. Louis-based hospital management consultant Warner said that in many states where he does consulting, "They have outpatient one-day maternity. It used to be a five-day vacation . . . {Doctors} are doing cataracts in their offices, all surgery, orthopedics, urology. If it only requires a local anesthetic, they're moving to an outpatient setting."

These cost-cutting pressure have helped to reduce inpatient business, cutting adult lengths of stay from 7.4 days in 1976 to 6.6 in 1986. Hospital admissions have also fallen. Twelve years ago, 75 percent of all community hospital beds were filled daily; by 1986 the occupancy rate was 63.4 percent, which means that of nearly 1 million staffed hospital beds, 350,000 are empty each day.

As a result, hospitals, fighting for occupants, are giving sharp discounts off their ostensible rates. Payers may get anywhere up to 20 percent off, depending on the volume of patients they channel to the hospital. Blue Cross often pays only costs plus a small bit over.

Dr. Edward Zalta, who heads CAPP CARE, a management organization that works for insurance companies, said his group obtains discounts often of "20 to 33 percent below usual billed charges . . . We bring you additional patients, you give us a preferential volume discount."

Kovener estimated that no more than 20 percent of all payers of hospital bills actually pay full charges (the equivalent of list price) any more. These payers are individuals who pay out of their own pockets or are insured by health insurance firms that do not have enough patients in any individual hospital to give them the market leverage to negotiate discounts.

Through it all, though, hospitals overall have clearly done better recently on combined Medicare and non-Medicare operations than in the late 1970s, when their profits were only 3 to 4 percent annually. The recent combined Medicare and non-Medicare margins -- 5.2 percent in 1986 including money from fund drives as well as patient care -- compare quite favorably with those earlier years and also with many other businesses. For example, in 1984, the operating profits of all U.S. corporations were 2.9 percent on revenues. Manufacturing corporations did 4.3 percent. This is before payment of federal and state income taxes.

The Looming Battle

Are hospitals getting rich off Medicare? It's hard to be sure yet. Some government agencies like the CBO have predicted that the large ostensible margins on Medicare PPS operations will continue for the next few years. Medicare officials and hospital spokesmen have a more negative view -- in part because in the years since the PPS system started, Congress has never raised annual rates under the system enough to match inflation, and in part because they fear cost-cutting efforts have reached the point of diminishing returns.

Jefferson's Richards estimates that because of these factors, the hospital, which overall made 7.8 percent on care of all patients, both Medicare and non-Medicare in 1986, the best year in its history, will make only 2.1 percent in 1988. Inclusion of all non-patient and non-operating revenues from fund drives and endowments would still leave the 1988 figure at under 3 percent.

"What worries me is that our data show profits will be down very low next year," said Michael D. Bromberg, executive director of the Federation of American Health Systems, an organization of for-profit hospitals. "It's not productive to argue about whose data were correct two and three years ago."

But that is what Congress may be thinking about as it debates the "budget reconciliation bill," laying out how much Medicare will be allowed to increase the rates it pays to hospitals in 1988. Both the Senate Finance and House Ways and Means Committees, as well as the White House, are thinking of hospital rate increases far below the expected rise in the costs of the things hospitals must buy. There is tremendous pressure on Congress to cut the deficit, and pressing down on Medicare hospital payments is one politically appealing method -- a lot more appealing than charging the patients more for various medical services.

The thought is that even if Medicare profits are not as high as the Kusserow study estimated, and even if overall profits are only in the 5 percent range, it is still possible for hospitals to squeeze a bit more fat out of their operations.