Diagnostic Related Grouping and How It Works

A DRG, or diagnostic related group, 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 each specific service that was provided, Medicare or a private insurer will pay the hospital a predetermined amount based on the patient's Diagnostic Related Group. This encompasses a variety of metrics designed to classify the resources needed to care for a given patient based on diagnosis, prognosis, and various other factors.

Since the 1980s, the DRG system has included an all-payer component for non-Medicare patients, as well as the MS-DRG system for Medicare patients. The MS-DRG system is more widely used, and is what we'll focus on with this article. Under Medicare's DRG approach, Medicare pays the hospital a predetermined amount under the inpatient prospective payment system (IPPS), with the exact amount based on the patient’s DRG or diagnosis. [A different system, called the Long-Term Care Hospital Prospective Payment System (LTCH-PPS) is used for long-term acute care hospitals, based on different DRGs under the Medicare Severity Long-Term Care Diagnosis-Related Groups system, or MS‑LTC‑DRGs.]

When a patient is discharged from the hospital, Medicare will assign a DRG based on the main diagnosis that caused the hospitalization, plus up to 24 secondary diagnoses. The DRG can also be affected by the specific procedures that were needed to treat the patient (since two patients with the same condition might need very different types of care). And the patient's age and gender can also be taken into consideration for the DRG.

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.

Background

If you were hospitalized before the DRG system was introduced in the 1980s, 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.

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.

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, which includes the primary diagnosis, secondary diagnoses and comorbidities, medical procedures necessary to treat the patient, and the patient's age and gender. 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.

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.

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.

The IPPS payment based on a Medicare patient's DRG also covers outpatient services that the hospital (or an entity owned by the hospital) provided to the patient in the three days leading up to the hospitalization. Outpatient services are normally covered under Medicare Part B, but this is an exception to that rule, as the IPPS payments come from Medicare Part A.