Private sector NHS partner's operational deficit £2.2m higher than planned, says NAO

However the report, by the National Audit Office (NAO), said that Circle Healthcare had already made "early improvements in some clinical areas" since taking over the hospital. The company was awarded the contract to run Hinchingbrooke Health Care NHS Trust in February.

Head auditor Amyas Morse said that as the agreement was the first of its kind, it was important for the NHS to use its experience in the franchising and early operation of Hinchingbrooke to improve future contracts.

"While Circle has made early improvements in some clinical areas, the company will have to generate savings at an unprecedented level," he said. "The final judgement on the value for money of the franchise will depend on how successfully Circle makes the projected savings and repays the cumulative deficit, while maintaining clinical quality."

The private healthcare provider took over the management of the Cambridgeshire hospital in a 10-year deal, worth £31m in franchise payments, on 1 February after approval from the Department of Health. As part of the arrangement Circle has assumed the financial risks of making the hospital more efficient and for paying off an estimated £39m debt. Clinical and non-clinical services are being provided by the Trust under Circle's management, while staff and assets remain with the NHS.

Circle plans to achieve what the NAO described as an "unprecedented" £311m in projected savings over the life of the franchise, with most of those savings expected to be made in the later years of the 10 year arrangement. The Trust, which has an annual income of around £73m, developed a cumulative deficit of £39m between 2004 and 2008. Under the terms of the franchise agreement, Circle will be responsible for the first £5m of debt over the life of the franchise agreement and will not receive its £31m franchise fee if it is unable to return the Trust to profit. If the deficit exceeds £5m either Circle or the hospital board can apply to have the agreement terminated.

In its report, the NAO said that the hospital's performance against standards for cancer and accident and emergency waiting times had already begun to show signs of improvement since Circle took over. However the Trust had made an additional loss of £4.1m as of the end of September, which was £2.2m higher than Circle had predicted.

Healthcare law expert Barry Francis of Pinsent Masons, the law firm behind Out-Law.com, said that although concerns that the hospital would not make a full financial recovery were "understandable", Circle had taken on responsibility for a hospital which the NHS "could not make work financially"."It would not be reasonable to expect projections to be fully underwritten, and any 'first' is bound to have a different risk profile from any later developments of the model," he said. "Lessons will be learned and levels of comfort increased."

According to the report the strategic health authority (SHA) responsible for the franchising arrangement, NHS East of England SHA, "did not fully consider" the relative risks of bids made for the franchise by Circle and another shortlisted bidder. It concluded that procuring authorities needed to apply "consistent risk adjustments" to ensure that all bidders are treated equally throughout the process and any estimated savings are "realistic".

The report also called on the Department of Health to develop standard terms and conditions for future agreements, and carry out a "formal lessons learned" process with the SHA before considering any similar bids.