What Is a Diagnosis Related Group (DRG)?

What is a DRG? A diagnostic related group, or DRG, is a way of classifying the costs a hospital charges Medicare or insurance companies for your care. The Centers for Medicare & Medicaid Services (CMS) and some health insurance companies use these categories to decide how much they will pay for your stay in the hospital.

CMS and insurers have created metrics and advanced algorithms to group and classify the services you will likely need, according to your illness, diagnosis, prognosis and other factors involved in your care. There are 25 types of major diagnostic related groups or categories in all.

In this system, Medicare or a private insurer pays a predetermined amount – based on the diagnostic related group – instead of paying for each and every service provided by the hospital.

DRGs apply to hospitals only. Long-term acute care hospitals work under a different payment system, known as the Long-Term Care Hospital Prospective Payment System (LTCH-PPS). Payments are categorized within the Medicare Severity Long-Term Care Diagnostic-Related Groups system, or MS‑LTC‑DRGs.

How DRGs Work

Medicare pays your hospital a pre-set amount for your care, which is based on your DRG or diagnosis. These payments are processed under what is known as the inpatient prospective payment system (IPPS). 

Medicare assigns you to a DRG when you are discharged from the hospital. The diagnostic related group is determined by your primary diagnosis, along with as many 24 secondary diagnoses.

CMS determines what each DRG payment amount should be by looking at the average cost of the products and services that are needed to treat patients in that particular group. Among the factors considered are:

• Primary diagnosis
• Secondary diagnoses
• Comorbidities (other health conditions)
• Necessary medical procedures
• Age
• Gender 

CMS first sets a base rate, which is recalculated every year and released to hospitals, insurers and other health providers.

The base rate is then adjusted to reflect certain factors, such as the area in which the hospital is located. This is because costs like wages for employees differ widely across the country; a nurse in New York City or Los Angeles, for example, is paid a higher wage than a nurse in a smaller city or rural town.

In addition, payments are higher in areas with a high cost of living, such as Hawaii and Alaska. They are also higher for hospitals that treat many patients who lack insurance, and for teaching hospitals that are training future doctors.

Those differences are calculated into the final DRG payment the hospital receives. 

DRGs and Outpatient Services

Medicare DRGs include cost coverage for outpatient services that the hospital or another provider organization that the hospital owns for three days leading up to the hospitalization.

These types of services are covered by Medicare Part B under normal circumstances, but in this case CMS allows the IPPS payments to be covered by Medicare Part A.

Why Were DRGs Created for Medicare?

Up until the 1980s, when the diagnostic related group system was created, hospitals billed Medicare or the private insurance company for every product or service. That meant charging for your daily stay but also for every pain relief pill, medication infusion, bandage, shot, medical device and on and on – even the use of a bedpan.  

Called fee for service, this system encouraged hospitals (and all providers, in fact) to preform every possible test, scan and procedure, and keep patients hospitalized as long as possible, to charge more and increase profits.

This system became untenable as overall health care costs began to skyrocket, beginning in the 1970s. CMS and other health experts created the DRG system to control costs and still provide efficient and effective care.

How DRGs Affect Health Care

The goal of the DRG system is to save on costs. When the hospital spends less than the predetermined DRG payment for a patient’s condition, it makes a profit. Conversely, if it spends more than the DRG payment, it suffers a loss.

Like most complex systems, the DRG payment system has both benefits and problems. 

• One the one hand, the system prods hospitals to increase efficiency and use only the necessary treatments, to keep costs down.
  
  
• On the other hand, some hospitals may attempt to discharge patients as quickly as possible. Critics accuse hospitals of sometimes discharging patients too quickly, before they’re adequately prepared to return home safely. Hospitals do this not only to reduce costs of an individual’s care, but also to “turn over” beds to increase occupancy rates and, thus, income.

CMS is aware of these potential problems, and, in some circumstances, penalizes hospitals financially: 

• If a patient is re-admitted within 30 days–a sign that the patient may have been released too early.
• If it discharges a patient to an inpatient rehab facility or to home with outside health support in order to discharge sooner. In this case, the hospital may have to share part of its DRG payment with that facility or provider.

The DRG system is not perfect, and has presented challenges to providers. Many private hospitals have countered lost revenue by focusing on higher-profit services. Other hospitals have been forced to merge with bigger systems to encourage economies of scale.

The Affordable Care Act included, among many other things, reforms to the Medicare payment system, including Accountable Care Organizations (ACOs) and bundled payment schemes. However, DRGs are still at the heart of Medicare hospital payments.

What is a DRG?: Summary

According to CMS, “The DRGs, as they are now defined, form a manageable, clinically coherent set of patient classes that relate a hospital’s case mix to the resource demands and associated costs experienced by the hospital. DRGs are defined based on the principal diagnosis, secondary diagnoses, surgical procedures, age, sex and discharge status of the patients treated. 

Through DRGs, hospitals can gain an understanding of the patients being treated, the costs incurred and within reasonable limits, the services expected to be required. The classification of patients into DRGs is a constantly evolving process. As coding schemes change, as more comprehensive data is collected or as medical technology or practice changes, the DRG definitions will be reviewed and revised.”¹