Diagnostic Related Grouping and How It Works

System Sets fixed Fee Schedule for Hospital Services

Table of Contents
View All
Table of Contents

A DRG, or diagnostic related group, 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.

This encompasses several metrics designed to classify the resources needed to care for you based on diagnosis, prognosis, and various other factors.

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

Since the 1980s, the DRG system has included an all-payer component for non-Medicare patients plus the MS-DRG system for Medicare patients. The MS-DRG system is more widely used and is the focus of this article. (MS stands for Medicare Severity.)

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.

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.

The DRG can also be affected by the specific procedures that were needed to treat you (since two patients with the same condition might need very different types of care). Your age and gender can also be taken into consideration for the DRG.

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.

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.


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, plus a room charge for each day you were hospitalized.

This encouraged hospitals to keep you for as long as possible and perform as many procedures as possible. That way, they made more money on room charges and billed for more Band-Aids, X-rays, and alcohol swabs.

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 medical procedures involved in your care.

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.

Calculating DRG Payments

To come up with DRG payment amounts, Medicare calculates the average cost of the resources necessary to treat people in a particular DRG, including the primary diagnosis, secondary diagnoses and comorbidities, necessary medical procedures, 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 New York City pays higher wages than a hospital in rural Kansas, for example, and that's reflected in the payment rate each hospital gets for the same DRG. 

For hospitals in Alaska and Hawaii, Medicare even 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 hospitals that treat a lot of uninsured patients and for teaching hospitals.

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).

DRGs Impact on Health Care

The DRG payment system encourages hospitals to be more efficient and takes away their incentive to over-treat you.

However, it's a double-edged sword. Hospitals are now 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 in place that penalize a hospital in certain circumstances if a patient is re-admitted 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 healthcare provider if it discharges a patient to an inpatient rehab facility or with home health support.

Since those services mean you can be discharged sooner, the hospital is eager to use them so 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 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 you 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.

Was this page helpful?
8 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. Acute Care Hospital Inpatient Prospective Payment System.

  3. Centers for Medicare and Medicaid Services. Design and development of the Diagnosis Related Group (DRG).

  4. Centers for Medicare and Medicaid Services. Medicare Learning Network. Acute care hospital inpatient prospective payment system.

  5. Catalyze. Accountable care organizations (ACOs).

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

  7. Centers for Medicare and Medicaid Services. Hospital Readmissions Reduction Program (HRRP) And Hospital-Wide All-Cause Unplanned Readmission Measure.

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

Additional Reading