What Are Diagnostic-Related Groups?

Fixed fees for services ensure hospital stay costs aren’t run up unnecessarily

A diagnostic-related group (DRG) is how Medicare (and some health insurance companies) categorize hospitalization costs and determine how much to pay for your hospital stay. Rather than pay the hospital for each specific service it provides, Medicare or private insurers pay a predetermined amount based on your diagnostic-related group.

The DRG system was set up to make sure that the care you need is the care you get and that your bill isn’t full of unnecessary charged. Diagnostic-related grouping encompasses several metrics designed to classify the resources needed to care for you based on diagnosis, prognosis, and other factors.

In this article, you’ll learn how to better understand Medicare fees and the impact of diagnostic-related groups.

Smiling medical team in discussion in exam room in hospital
Thomas Barwick / Getty Images

What Are Diagnosis-Related Grouping (DRG) Systems?

Since the 1980s, the DRG system has included both:

  • An all-payer component for non-Medicare patients
  • The Medicare-Severity Diagnostic-Related Group (MS-DRG) system for Medicare patients

The MS-DRG system is more widely used and is the focus of this article.

MS-DRG System

Under Medicare’s DRG approach, Medicare pays the hospital a predetermined amount under the inpatient prospective payment system (IPPS). The exact amount is based on the patient’s DRG or diagnosis.

Long-Term Care

A different system called the Long-Term Care Hospital Prospective Payment System (LTCH-PPS) is used for long-term acute care hospitals. It’s based on different DRGs under the Medicare Severity Long-Term Care Diagnosis-Related Groups system (MS‑LTC‑DRGs).

How Do DRGs Work?

When you’re discharged from the hospital, Medicare will assign a DRG based on the main diagnosis that caused the hospitalization, plus up to 24 secondary diagnoses.

Every person is different, and two patients with the same condition might need very different types of care. That’s why the DRG can also be affected by your:

  • Specific procedures needed to treat you
  • Age
  • Gender

If the hospital spends less than the DRG payment on your treatment, it makes a profit. If it spends more than the DRG payment treating you, it loses money.

What Is the History of the DRG System?

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 bandage, X-ray, alcohol swab, bedpan, and aspirin, plus a room charge for each day you were hospitalized.

This incentivized hospitals to keep you for as long as possible, perform as many procedures as possible, and use more supplies.

As health care costs increased, the government looked for ways to control costs while encouraging hospitals to provide care more efficiently. The DRG system is what resulted.

Starting in the 1980s, DRGs changed how Medicare pays hospitals.

What Are the Benefits of DRG?

The idea is that each DRG encompasses patients with clinically similar diagnoses whose care requires the same amount of resources to treat.

The DRG system is intended to standardize hospital reimbursement. It considers:

  • Where a hospital is located
  • What type of patients are being treated
  • Other regional factors

What Are the Challenges of Medicare and DRG?

The implementation of the DRG system has had its challenges.

The reimbursement methodology affects 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 Is a DRG Calculated?

To come up with DRG payment amounts, Medicare calculates the average cost of the resources needed to treat people in a particular DRG, including:

  • Primary diagnosis
  • Secondary diagnoses
  • Comorbidities
  • Necessary medical procedures
  • Age
  • Sex

This base rate is then adjusted based on various factors, including the wage index for a given area. For example, a hospital in New York City pays higher wages than a hospital in rural Kansas, which is reflected in the payment rate each hospital gets for the same DRG. 

For hospitals in Alaska and Hawaii, Medicare adjusts the non-labor portion of the DRG base payment amount because of the higher cost of living. Adjustments to the DRG base payment are also made for teaching hospitals and hospitals that treat many uninsured patients.

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).

What Is the Impact of DRGs on Health Care?

The DRG payment system encourages hospitals to be more efficient and reduces their incentive to overtreat you. But this isn’t always a good thing.

Discharge Rate

Hospitals are eager to discharge you as soon as possible and are sometimes accused of discharging people before they’re healthy enough to go home safely.

Medicare has rules that penalize a hospital in certain circumstances if a patient is readmitted within 30 days. This is meant to discourage early discharge, a practice often used to increase the bed occupancy turnover rate.

Outpatient Services

In some DRGs, the hospital must share part of the DRG payment with the rehab facility or home healthcare provider if it discharges a patient to an inpatient rehab facility or with home health support.

Those services mean you can be discharged sooner, so the hospital is eager to use them 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 healthcare provider to offset the additional costs associated with those services.

The IPPS payment based on your Medicare DRG also covers outpatient services that the hospital (or an entity owned by the hospital) provided in the three days leading up to the hospitalization.

Outpatient services are typically covered under Medicare Part B, but this is an exception to that rule, as the IPPS payments come from Medicare Part A.

Frequently Asked Questions

  • What is the benefit of diagnostic related groupings?

    The main benefits are increased efficiency, better transparency, and reduced average length of stay.

  • What is the difference between DRG, ICD, and CPT?

    These are all medical codes, but they each have different meanings:

6 Sources
Verywell Health uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Value Health Care Services. What is a Medicare severity-diagnosis related group (MS-DRG)?

  2. Centers for Medicare and Medicaid Services. Design and development of the diagnosis related group (DRG).

  3. Centers for Medicare and Medicaid Services. Medicare payment systems.

  4. Catalyze. Accountable care organizations (ACOs).

  5. Centers for Medicare and Medicaid Services. Hospital-wide all-cause unplanned readmission measure.

  6. Mihailovic N, Kocic S, Jakovljevic M. Review of diagnosis-related group-based financing of hospital careHealth Serv Res Manag Epidemiol. 2016;3:2333392816647892. doi:10.1177/2333392816647892

By Elizabeth Davis, RN
Elizabeth Davis, RN, is a health insurance expert and patient liaison. She's held board certifications in emergency nursing and infusion nursing.