NHS trusts ended 2016/17 with a reported collective deficit of £791 million. On the face of it that looked like good news – the reported deficit in the accounts had shrunk from £2.5 billion in 2015/16.

Unfortunately neither figure bears much relation to the underlying financial distress of hospitals and other NHS services in England over the last few years, nor to the scale of financial difficulties those organisations continue to face this financial year and beyond.

Underlying deficits

To get to that underlying reality, we first need to consider that the £791 million reported deficit figure for 2016/17 was after non-recurrent savings of £790 million. These were real savings trusts often will have had to bend over backwards to find, but they were nonetheless one - off items that cannot be sustained in the year that followed.

Adding the value of those non-recurrent sticking plasters back onto the reported deficit for 2016/17 brings us to a figure nearer £1.6 billion.

These were purely paper-based changes that served to lessen red faces in Whitehall and Westminster, but did nothing to improve the financial health of hospitals and other providers.

To that we then need to add around £300 million, which is the approximate value of various accounting changes and adjustments. These were purely paper-based changes that served to lessen red faces in Whitehall and Westminster, but did nothing to improve the financial health of hospitals and other providers.

That shifts the underlying deficit figure up to £1.9 billion. Finally, we then need to add the £1.8 billion in extra ‘sustainability’ funding providers received in 2016/17. If that was available every year, on a recurrent and reliable basis, we wouldn’t need to add it towards the deficit. We could just say – as the Department of Health implied when it announced it – that the overspending problem was being reduced in part by increasing provider funding. But – as detailed further below – the £1.8 billion is anything but recurrent and reliable extra funding.

Adding the £1.8 billion then brings us to the full gory sight of an underlying £3.7 billion hole in NHS provider finances by the end of 2016/17. That is to say: by the end of the financial year, providers had effectively spent £3.7 billion more on treating patients than the recurrent funding they had coming in.

The loss making rolls on

That real deficit figure matters, not just as a matter of accurate public record, but even more importantly because the underlying deficit providers ended 2016/17 with was merely the starting point for their financial problems in the current year, 2017/18.

Like any other loss-making business that sells its services or goods for less than it costs to produce them, the deficit or loss doesn't get reset to zero at the start of a new financial year.

That is because the underlying deficit is the gap between how much it costs providers to treat their patients and the amount of funding they receive to deliver that care. The £3.7 billion gap at the end of 2016/17 was equivalent to providers making a 5 per cent loss on every patient they treated. Like any other loss-making business that sells its services or goods for less than it costs to produce them, the deficit or loss doesn't get reset to zero at the start of a new financial year. Unless the business can radically increase its prices or decrease its costs, the loss making rolls on, from the first patient treated (or widget sold) on the first day of the new financial year.

Unfunded inflation

In fact, for NHS providers at least, the scale of the financial problem actually gets worse with the turn of each new year. While the cost of clinical and other supplies and of staff salaries increase annually through inflation, the payments made to providers for each patient they treat do not. Indeed, for each of the five years from 2011/12 to 2015/16, payments were actually cut, year after year in cash terms, leaving providers to absorb all of the cost of inflation and then some. (They didn’t manage it – which is why hospitals and other services are in deficit today.)

This year the payments are being increased, just, by 0.3 per cent. The problem for providers, however, is that inflation is now running at nearer 2.9 per cent, leaving hospitals and other services with a £2.2 billion unfunded increase in their costs.

That unfunded cost of inflation (as it happens, £500 million more than the Government planned, due to NHS inflation currently running at around 0.6 per cent higher than forecast) further exacerbates the scale of the euphemistic ‘financial challenge’ for 2017/18 from the £3.7 billion loss-making position inherited from 2016/17, to £5.9 billion.

Unrealistic demands

The Government has asked NHS providers to turn that £5.9 billion gap between their likely income and underlying costs this financial year into something closer to £3 billion (which, after similar levels of non-recurrent savings to those seen in 2016/17 and another £1.8 billion in dubious temporary funding, will allow the accounts to report a deficit of around £500 million).

That would require providers to cut their costs by 4.3 per cent in the year – fresh off the back of cutting them by 3.7 per cent in 2016/17 and by 3.6 per cent in 2015/16.

Those prior year levels of efficiency savings tell us two things: first, that we have already had several years where the level of efficiency extracted from hospitals and other services has run far higher than the 2 per cent level government and regulator reviews have found reasonable. This implies that much if not all of the ‘low hanging fruit’ has already been picked. Second, 4.3 per cent is significantly higher than anything that has been achieved in recent years. It is, most likely, impossible.

Our modelling at the Nuffield Trust suggests an underlying deficit by the end of 2017/18 nearer £3.5 billion – only slightly smaller than the position in 2016/17 because the vast bulk of recurrent efficiency savings trusts make this year will be needed to offset that whopping £2.2 billion in unfunded inflation.

Prospects for the years that follow are not much better. Even if providers continue to make historically very high levels of efficiency (around 3.3 per cent, year after year) we expect them to end 2020/21 with an underlying deficit of between £2 billion and £3.7 billion (our wide range here reflects uncertainties around the official forecast for NHS inflation).

When £1.8 billion isn’t £1.8 billion

What, then, are the alternatives? The NHS commissioning bodies (clinical commissioning groups locally, and NHS England nationally) who fund providers cannot afford to pay them any more for each patient they treat: after five successive years of balancing their own books only by making year-on-year cuts to the prices they paid providers, commissioners are now struggling to cope with even the 1 per cent price increase in 2016/17 and the 0.3 per cent increase this year.

The Government, of course, tries to imply it has already fixed the problem by giving providers an extra £1.8 billion in ‘sustainability funding’.

But there is a major catch to that ‘extra’ funding: trusts are forbidden to use it to increase their spending. Instead they must use it to improve their ‘bottom line’ – that is, to reduce their reported deficit or boost their reported surplus, all with the aim of reducing the overall reported net deficit.

That meant that in 2016/17, £715 million of the £1.8 billion was not spent on patient care at all, but had to be used instead to create surpluses in provider accounts.

But there is a major catch to that ‘extra’ funding: trusts are forbidden to use it to increase their spending. Instead they must use it to improve their ‘bottom line’ – that is, to reduce their reported deficit or boost their reported surplus, all with the aim of reducing the overall reported net deficit.

The reason is clear: providers cannot be allowed to use the £1.8 billion to increase their spending on patient care because if they do so, they will need it for every year that follows. The DH cannot tolerate that, because it desperately needs to spend it elsewhere.

This is not simply because of the need to invest in service transformation about which we hear so much, but because the fundamentals are so desperate. Overall funding is growing at just 2.5 per cent a year, in cash terms, leaving NHS commissioners struggling to cope with an annual increase in demand for NHS care of 3 per cent, let alone fund any contribution to inflation for providers on top of that.

Who can cover the costs?

The official response to this is that commissioners will cope with just a 2.5 per cent increase in cash because they will cut annual growth in demand for hospital care to around 2 per cent. But there is little sign so far that is happening, let alone evidence that it would be desirable: growth in demand for services is not just made up of people getting sicker, but also by increasing medical sophistication that allows the NHS to improve care quality and outcomes.

It is worth noting then that the cost to the public purse of increasing NHS funding to eliminate the provider deficit, while still extracting significant levels of annual efficiencies, would not be unmanageable. Our estimates suggest around £5.5 billion extra would be needed in 2020/21 above existing plans – for a total of £138.6 billion that year. That would see health spending as a proportion of Gross Domestic Product stay more or less constant with the level it is today (around 7.3 per cent) rather than fall, as under plans, to around 7 per cent.

The level of financial distress within NHS providers at present may be catastrophic, but it seems the solution may not be.