The Maryland health department responded formally yesterday to allegations of mismanagement within its now-disbanded State Games program by agreeing with most of a state auditor's recommendations to clean up the problems.

The Department of Health and Mental Hygiene's response came in a six-page letter dated Jan. 18 and sent yesterday to the General Assembly's legislative audit division. The unit had issued a blistering report Dec. 21 detailing possible payroll abuse and questioned more than $460,000 in expenditures by the foundation that helped run the annual Olympic-style State Games for the state. The review also called into question the health department's oversight of the program.

The health department's letter noted that many of the corrective steps recommended by the legislative auditor's office already had been taken. For instance, auditors recommended that the health department transfer all responsibility for the state's bid to attract a U.S. Olympic festival in 1993, 1994 or 1995 to another state agency. Gov. William Donald Schaefer (D) announced such a shift last week in his State of the State speech.

State auditors also had recommended that the health department take action to recover money raised or inappropriately spent by the Maryland State Games Foundation Inc. The department's response, signed by Sylvia Hamlett-Law, the director of Maryland's Fiscal Services Administration, said the department had gone to court to successfully put the foundation under the control of a court-appointed receiver. The receiver's job is to inventory the foundation's assets and to try to pay off the foundation's debts.

It is unlikely that the foundation will be able to pay all its obligations. A health department review of the program's expenses found that the foundation might have misspent about $370,000 it received from the state, including money intended for programs to fight drug abuse. The state must try to recover much of that money so it does not run afoul of federal guidelines for spending anti-drug money, the legislative auditor's office warned.

As of Nov. 30, when the legislative auditors reviewed the foundation's accounts, the foundation had additional debts totaling at least $187,196 and a cash balance of $14,198 in its accounts.

"We don't know exactly how much we're owed until the Attorney General's Office finishes its investigation," said William Groseclose, the health department's audit coordinator.

If the foundation cannot repay the money, "we will have to take it from other programs . . . {or} seek specific approval for a budget amendment," Groseclose said.

The legislative auditor's office recommended that state agencies seek General Assembly approval whenever they want to give money to affiliated agencies. The president of the State Games Foundation, James E. Narron, also worked for the health department as director of the State Games program. He has since been dismissed.

Health department officials said they are sympathetic to the auditor's recommendation and said they are considering better ways to keep tabs on affiliated organizations. But the department said requiring General Assembly approval for every transaction to an affiliated agency could create a paperwork nightmare.

"It would make it tough for us to award grants to counties, which might be construed to be an 'affiliated' agency," Groseclose said.

The foundation, however, received its anti-drug money after it had been first routed through the Carroll County health department. Said one state official: "In this case, you possibly were dealing with deceptive management. I don't know how to legislate against that."