How a DRG Determines How Much a Hospital Gets Paid

Medicare and certain private health insurance companies pay for hospitalizations of their beneficiaries using a diagnosis-related group (DRG) payment system. This article will explain how the DRG system works, and how it determines the payment amounts that hospitals receive.

When you've been admitted as an inpatient to a hospital, that hospital assigns a DRG when you're discharged, basing it on the diagnosis you received and the treatment that you needed during your hospital stay. The hospital gets paid a fixed amount for that DRG, regardless of how much money it spent treating you.

If a hospital can effectively treat you for less money than Medicare pays for your DRG, then the hospital makes money on that hospitalization. If the hospital spends more money caring for you than Medicare gives it for your DRG, then the hospital loses money on that hospitalization.

What Does DRG Mean?

DRG stands for diagnosis-related group. Medicare's DRG system is called the Medicare severity diagnosis-related group, or MS-DRG, which is used to determine hospital payments under the inpatient prospective payment system (IPPS). It's the system used to classify various diagnoses for inpatient hospital stays into groups and subgroups so that Medicare can accurately pay the hospital bill.

The idea behind DRGs is to ensure that Medicare reimbursements adequately reflect "the fundamental role which a hospital’s case mix (the type of patients the hospitals treats, and the severity of their medical issues) plays in determining its costs" and the number of resources that the hospital needs to treat its patients.

The diagnoses that are used to determine the DRG are based on ICD-11 codes or ICD-10 codes (the ICD-11 codes went into effect in 2022, but some areas are still using ICD-10 codes). Additional codes were added to that system in 2021 and 2022, to account for the COVID-19 pandemic, and a 20% MS-DRG add-on payment was added during the pandemic when hospitals treated COVID-19 patients.

DRGs have historically been used for inpatient care, but the 21st Century Cures Act, enacted in late 2016, required the Centers for Medicare and Medicaid Services to develop some DRGs that apply to outpatient surgeries. These are required to be as similar as possible to the DRGs that would apply to the same surgery performed on an inpatient basis.

Medicare and private insurers have also piloted new payment systems that are similar to the current DRG system, but with some key differences, including an approach that combines inpatient and outpatient services into one payment bundle. In general, the idea is that bundled payments are more efficient and result in better patient outcomes than fee-for-service payments (with the provider being paid based on each service that's performed).

Figuring Out How Much Money a Hospital Gets Paid for a Given DRG

In order to figure out how much a hospital gets paid for any particular hospitalization, you must first know what DRG was assigned for that hospitalization. In addition, you must know the hospital’s base payment rate, which is also described as the "payment rate per case." You can call the hospital’s billing, accounting, or case management department and ask what its Medicare base payment rate is.

Each DRG is assigned a relative weight based on the average amount of resources it takes to care for a patient assigned to that DRG. You can look up the relative weight for your particular DRG by downloading a chart provided by the Centers for Medicare and Medicaid Services following these instructions:

1. Go to the CMS payment systems webpage.
2. Scroll down to "FY 2024 Final Rule and Correcting Amendment Tables" (note that this is for Fiscal Year 2024)
3. Download Table 5 ("MS-DRGs, Relative Weighting Factors and Geometric and Arithmetic Mean Length of Stay").
4. Open the file that displays the information as an Excel spreadsheet (the file that ends with “.xlsx”).
5. The column labeled “weights” shows the relative weight for each DRG.

The average relative weight is 1.0. DRGs with a relative weight of less than 1.0 are less resource-intensive to treat and are generally less costly to treat. DRGs with a relative weight of more than 1.0 generally require more resources to treat and are more expensive to treat. The higher the relative weight, the more resources are required to treat a patient with that DRG. This is why very serious medical situations, such as organ transplants, have among the highest DRG weight.

How a Hospital’s Base Payment Rate Works

The base payment rate is broken down into a labor portion and a non-labor portion. The labor portion is adjusted in each area based on the wage index. The non-labor portion varies for Alaska and Hawaii, according to a cost-of-living adjustment.

Since healthcare resource costs and labor vary across the country and even from hospital to hospital, Medicare assigns a different base payment rate to each and every hospital that accepts Medicare.

For example, a hospital in Manhattan, New York City probably has higher labor costs, higher costs to maintain its facility, and higher resource costs than a hospital in Knoxville, Tennessee. The Manhattan hospital probably has a higher base payment rate than the Knoxville hospital.

Other things that Medicare factors into your hospital’s blended rate determination include whether or not it’s a teaching hospital with residents and interns, whether or not it’s in a rural area, and whether or not it cares for a disproportionate share of the poor and uninsured population. Each of these things tends to increase a hospital’s base payment rate.

Each October, Medicare assigns every hospital a new base payment rate. In this way, Medicare can tweak how much it pays any given hospital, based not just on nationwide trends like inflation, but also on regional trends. For example, as a geographic area becomes more developed, a hospital within that area may lose its rural designation.

In 2020, the Centers for Medicare and Medicaid Services approved 24 new technologies that are eligible for add-on payments, in addition to the amount determined based on the DRG.

Are Hospitals Making or Losing Money?

After the MS-DRG system was implemented in 2008, Medicare determined that hospital-based payment rates had increased by 5.4% as a result of improved coding (i.e., not as a result of anything having to do with the severity of patients' medical issues).

So Medicare reduced the base payments rates to account for this. But hospital groups contend that the increase due to improved coding was actually only 3.5% and that their base rates had been reduced by too much with an expected $41.3 billion loss in hospital revenue from 2013 to 2028.

Hospitals in rural areas are especially struggling. More than 150 rural hospitals closed from 2005 to 2019, another 18 hospitals in 2020, and 19 hospitals from 2021 to 2023, nine of them in 2023. The Center for Healthcare Quality and Payment Reform reported in 2023 that as many as a third of rural hospitals, more than 600 facilities, remain at risk of closing in the near future.

Rural hospitals are not the only ones at risk. The pandemic triggered a workforce shortage in the healthcare industry and hospitals across the board had to pay more for contract labor and staffing to fill in those gaps. Rising rates of inflation have also increased non-labor expenses, i.e., the cost of drugs, medical equipment and supplies, building maintenance, sanitation, information technology and cybersecurity, and even food. Altogether, the American Hospital Association estimates these factors increased hospital spending to the point that more than half of hospitals had negative margins at the end of 2022.

The challenge is how to ensure that some hospitals aren't operating in the red under the same payment systems that put other hospitals well into the profitable realm. That's a complex task, though, involving more than just DRG-based payment systems, and it promises to continue to be a challenge for the foreseeable future.

Summary

When a patient with Medicare (or many types of private insurance) is hospitalized, a diagnostic related category (DRG) code is assigned based on the patient's condition. There are numerous factors that go into determining the DRG for each patient, and each DRG has a different relative weight, depending on the resources that are generally needed to provide care for someone with that DRG.

Each hospital also has a blended base rate, which is based on a variety of factors, including location, patient demographics, whether it's a teaching hospital, etc. The relative weight of the DRG is multiplied by the hospital's base rate to determine how much the hospital will be paid for that patient.

A Word From Verywell

Although there's a complex formula that determines how much a hospital gets paid for each patient, you don't have to know the details of exactly how it works. From a patient perspective, the most important details are ensuring that the hospital is in-network with your health plan, and understanding how your health plan's cost-sharing works.

An inpatient stay will generally result in having to pay your deductible, and maybe meeting your plan's annual out-of-pocket cap. You'll want to understand how much those expenses are, so that you're not caught off guard when the bills arrive.