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A diagnostic-related group (DRG) is how Medicare (and some health insurance companies) categorize hospitalization costs to determine how much to pay for your hospital stay. Instead of paying for each service you receive, a payment amount is predetermined based on your DRG.
The DRG is based on your primary and secondary diagnoses, other conditions (comorbidities), age, sex, and necessary medical procedures. The system is intended to make sure that the care you need is the care you get, while also avoiding unnecessary charges.
Since the 1980s, the DRG system has included both:
The MS-DRG system is more widely used and is the focus of this article.
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.
Medicare's payment to the hospital under the MS-DRG system is calculated based on the patient's primary diagnosis, up to 24 secondary diagnoses, and up to 25 medical procedures that were performed during the patient's stay. In some cases, the DRG classification also includes the patient's age, sex, and discharge status.
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).
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. As such, the DRG can also be affected by your:
To determine DRG payment amounts, Medicare calculates the average cost of the resources needed to treat people in a particular DRG.
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).
MS-DRGs are used by Original Medicare, and can also be used by Medicare Advantage plans. But Medicare Advantage plans also pay hospitals under various incentive programs, including pay-for-performance and shared savings models.
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.
Medicare's DRG system determines how much a hospital is paid, as we'll discuss in a moment. But in most cases, a DRG won't change the amount that the patient pays in out-of-pocket costs.
For patients with Original Medicare, there's a Part A deductible for each benefit period, which covers the first 60 days of inpatient care. In 2024, the deductible is $1,632. This is the amount the patient pays for the inpatient care, regardless of the DRG, how much the hospital spends to treat the patient, or how much Medicare pays the hospital. (Most Medicare enrollees have supplemental coverage—from Medigap, an employer's plan, or Medicaid—that pays some or all of that deductible.)
For patients with Medicare Advantage, out-of-pocket costs for inpatient care will vary by plan. It depends on the plan's deductible, coinsurance, and out-of-pocket cap as well as how the plan's cost-sharing works (for example, which services are subject to a deductible and coinsurance as opposed to copays).
All Medicare Advantage plans must cap in-network out-of-pocket costs at no more than $8,850 in 2024, although most plans have out-of-pocket caps below this level.
Case-mix complexity is used in tandem with DRGs. The term refers to distinct patient attributes that may affect the cost of care. These include:
Case-mix complexity is generally used to denote patients with a poor prognosis or greater severity of illness, treatment difficulty, or need for intervention.
It factors in complications or comorbidities (CC) and can include hospital-acquired conditions, such as a surgical site infection or a pulmonary embolism following joint-replacement surgery.
To healthcare providers, case-mix complexity refers to the patient’s condition and the type of treatment they need.
To hospital administrators, it indicates the degree of resources needed and how much that will cost.
Insurance regulators use these to determine how much they pay.
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 healthcare costs increased, the government looked for ways to control costs while encouraging hospitals to provide care more efficiently. The DRG system was created, and changed how Medicare pays hospitals.
The DRG payment system encourages hospitals to be more efficient and reduces their incentive to overtreat you. This has both benefits and drawbacks for patient care.
The DRG system is intended to standardize hospital reimbursement and:
For a patient, the DRG system makes it less likely for the hospital to order unnecessary tests.
It can also mean you may be discharged earlier than if the DRG wasn't in place, allowing you to recover in the comfort of your home.
The diagnostic-related grouping system also has its drawbacks. For patients, this includes:
For hospitals, the reimbursement methodology affects the bottom line. As a result, many private hospitals 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.
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.
Hospitals are often eager to open beds for incoming patients. As a result, the hospital may discharge patients to an inpatient rehab facility or home with a visiting nurse service or other home health support.
Discharging patients sooner rather than later helps the hospital 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.
