Virginia's system for regulating adult homes does not adequately protect residents with serious mental health or medical needs, a legislative watchdog agency said yesterday.

The report by the Joint Legislative Audit and Review Commission recommends overhauling the way the state licenses the 470 adult homes in Virginia. The homes house 18,000 to 20,000 people with mental or physical disabilities.

The report also said the procedure the state uses to determine reimbursement to adult homes that care for indigent residents does not accurately determine the cost of caring for and housing adult home residents. Many residents are former mental patients discharged from state hospitals.

Last year, state and local payments covering about 5,700 adult home residents through Virginia's auxiliary grants program totaled $15.5 million.

The report is the result of a follow-up to a study of the adult home industry carried out by the review commission's staff in 1979.

Of the original study's 13 major recommendations, two had been fully implemented. Those required the state fire marshal to inspect adult homes and for the state Department of Social Services, which regulates the adult home industry, to issue provisional licenses for limited periods.