Diagnostic Related Grouping and How It Works

System Sets fixed Fee Schedule for Hospital Services

A DRG, or diagnostic related grouping, is how Medicare and some health insurance companies categorize hospitalization costs and determine how much to pay for a patient's hospital stay. Rather than paying the hospital for what it spent caring for a hospitalized patient, Medicare pays the hospital a fixed amount based on the patient’s DRG or diagnosis.

If the hospital treats the patient while spending less than the DRG payment, it makes a profit. If the hospital spends more than the DRG payment treating the patient, it loses money.


Years ago, when you stayed in the hospital, the hospital would send a bill to Medicare or your insurance company that included charges for every Band-Aid, X-ray, alcohol swab, bedpan, and aspirin, as well as a room charge for each day you were in the hospital.

This encouraged hospitals to keep you hospitalized for as long as possible and to do as much to you as possible while you were in the hospital. After all, the longer you were in the hospital, the more money the hospital made on room charges. The more procedures you had done while hospitalized, the more Band-Aids, X-rays, and alcohol swabs you used.

As health care costs went up, the government sought a way to control costs while encouraging hospitals to provide care more efficiently. What resulted was the DRG. Starting in the 1980s, DRGs changed how Medicare pays hospitals.

Instead of paying for each day you’re in the hospital and each Band-Aid you use, Medicare pays a single amount for your hospitalization according to your DRG, which is based on your age, gender, diagnosis, and the surgical procedures involved.

Medicare Challenges

The idea is that each DRG encompasses patients who have clinically similar diagnoses, and whose care requires a similar amount of resources to treat. The DRG system is intended to standardize hospital reimbursement, taking into consideration where a hospital is located, what type of patients are being treated, and other regional factors.

The implementation of the DRG system was not without its challenges. The reimbursement methodology has affected the bottom line of many private hospitals, leading some to channel their resources to higher-profit services.

To counter this, the Affordable Care Act (ACA) introduced Medicare payment reforms, including bundled payments and Accountable Care Organizations (ACOs). Still, DRGs remain the structural framework of the Medicare hospital payment system.

How DRG Payments Are Calculated

Medicare starts by calculating the average cost of the resources necessary to treat Medicare patients in a particular DRG. That base rate is then adjusted based on a variety of factors, including the wage index for a given area (a hospital in NYC pays higher wages than a hospital in rural Kansas, for example, and that's reflected in the payment rate that each hospital gets for the same DRG). 

For hospitals in Alaska and Hawaii, even the nonlabor portion of the DRG base payment amount is adjusted by a cost of living factor. There are also adjustments to the DRG base payment if the hospital treats a large number of uninsured patients or if it's a teaching hospital.

The baseline DRG costs are recalculated annually and released to hospitals, insurers, and other health providers through the Centers for Medicare and Medicaid Services (CMS).

Example of How DRGs Work

A simplified version goes like this: Mr. Koff and Mr. Flemm were both admitted to the same hospital for treatment of pneumonia. Mr. Koff was treated and released in two days. Mr. Flemm’s hospitalization lasted 10 days.

Since Mr. Koff and Mr. Flemm have the same diagnosis, they have the same DRG. Based on that DRG, Medicare pays the hospital the same amount for Mr. Koff as it does for Mr. Flemm even though the hospital spent more money providing 10 days of care to Mr. Flemm than providing two days of care to Mr. Koff.

With a DRG, Medicare pays for a hospitalization based on the diagnosis the patient was hospitalized to treat, not based on how much the hospital did to treat the patient, how long the patient was hospitalized, or how much the hospital spent caring for the patient.

In the case of Mr. Koff, the hospital may have made a small profit. The DRG-based payment was probably a little bit larger than the actual cost of Mr. Koff's two-day stay.

In the case of Mr. Flemm, the hospital probably lost money. It surely cost the hospital more to care for Mr. Flemm for 10 days than the DRG-based payment it received. 

Impact of DRGs on Health Care

The DRG system of payment encourages hospitals to become more efficient in treating patients and takes away the incentive for hospitals to over-treat patients. However, this is a double-edged sword as hospitals are now eager to discharge patients as soon as possible and are sometimes accused of discharging patients home before they’re healthy enough to go home safely.

Medicare has rules in place that penalize a hospital if a patient is re-admitted with the same diagnosis within 30 days. This is meant to discourage early discharge, a practice often used to increase the bed occupancy turnover rate.

Additionally, in some DRGs, the hospital has to share part of the DRG payment with the rehab facility or home health care provider if it discharges a patient to an inpatient rehab facility or with home health support.

Since a patient can be discharged from the hospital sooner with the services of an inpatient rehab facility or home health care, the hospital is eager to do so because it's more likely to make a profit from the DRG payment. However, Medicare requires the hospital to share part of the DRG payment with the rehab facility or home health care provider to offset the additional costs associated with those services.

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Article Sources
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  1. Centers for Medicare and Medicaid Services. Medicare Learning Network. Acute care hospital inpatient prospective payment system. Updated February 2019.

  2. Centers for Medicare and Medicaid Services. Design and development of the Diagnosis Related Group (DRG). Updated October 2019.

  3. Catalyze. Accountable care organizations (ACOs). Updated 2019.

  4. Field, RI. Health Care Regulation in America: Complexity, Confrontation, and Compromise. Oxford, England: Oxford University Press; 2006.

  5. Cromwell J, Donoghue S, Gilman BH. Expansion of Medicare's definition of post-acute care transfersHealth Care Financ Rev. 2002;24(2):95–113.

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