Understanding the Medicare Prospective Payment System

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Origins of Diagnostic Related Groups

By Dr. David Edward Marcinko; MBA, CMP™


The Medicare Prospective Payment System (PPS) was introduced by the federal government in October, 1 1983, as a way to change hospital behavior through financial incentives that encourage more cost-efficient management of medical care. Under PPS, hospitals are paid a pre-determined rate for each Medicare admission. Each patient was classified into a diagnosis-related group (DRG) on the basis of clinical information. Except for certain patients with exceptionally high costs (“outliers”), the hospital is paid a flat rate for the DRG, regardless of the actual services provided.

Enter the DRGs

Each Medicare patient is classified into a DRG according to information from the medical record that appears on the bill:

  • principal diagnosis (why the patient was admitted);
  • complications and co-morbidities (other secondary diagnoses);
  • surgical procedures;
  • age and patient gender; and
  • discharge disposition (routine, transferred, or expired).

Medical Records DocumentationMedical Records

Diagnoses and procedures must be documented by the attending physician in the patient’s medical record. They are then coded by hospital personnel using ICD-9-CM nomenclature. This is a numerical coding scheme of over 13,000 diagnoses and more than 5,000 procedures. The coding process is extremely important since it essentially determines what DRG will be assigned for a patient. Coding an incorrect principal diagnosis or failing to code a significant secondary diagnosis can dramatically affect reimbursement.

DRG Categories

Originally, there were more than 490 DRG categories defined by the Centers for Medicare and Medicaid Services (CMS, formerly known as the Health Care Financing Administration [HCFA]). Each category was designed to be “clinically coherent.” In other words, all patients assigned to a DRG are deemed to have a similar clinical condition. The PPS is based on paying the average cost for treating patients in the same DRG.  Each year CMS makes technical adjustments to the DRG classification system that incorporates new technologies (e.g., laparoscopic procedures) and refines its use as a payment methodology. CMS also initiates changes to the ICD-9-CM coding scheme. The DRG assignment process is computerized in a program called the “grouper” that is used by hospitals and fiscal intermediaries. It was last significantly updated by CMS in 2006.


Each year CMS also assigns a relative weight to each DRG. These weights indicate the relative costs for treating patients during the prior year.  The national average charge for each DRG is compared to the overall average. This ratio is published annually in the Federal Register for each DRG. A DRG with a weight of 2.0000, for example, means that charges were historically twice the average; a DRG with a weight of 0.5000 was half the average; and so on.


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6 Responses

  1. Did you know that some doctors are trying to remove a provision in the Senate’s latest health bill that would cut Medicare payments to those who administer the most tests and treatments?




  2. Critical Access Hospitals (CAHs)

    Did you know that prospective payment systems like APCs and MS-DRGs are not used by CAHs. Any thoughts?



  3. And now … on the Outpatient Prospective Payment System

    Medicare payments for outpatient services are based on a PPS. Originally, hospitals were paid for outpatient services based on the allowable incurred costs. Section 4523 of the BBA allowed CMS, then known as the Health Care Financing Administration (HCFA), to implement a PPS under Medicare for hospital outpatient services in August 2000.

    Payments are based on a set of relative weights, a conversion factor, and an adjustment for geographic differences in input prices.

    The PPS includes an outlier adjustment for extraordinarily high cost services and “pass-through” payments for new technologies. CMS grouped outpatient procedures into approximately 750 APCs. The APCs group services and items that are clinically similar and use comparable resources. The APC is “bundled,” meaning it encompasses integral services and items with the primary service. The payment is intended to cover the hospital’s operating and capital costs.

    The payment is determined by multiplying the relative weight for the APC by a conversion factor. The APC groups and their relative weights are reviewed annually. CMS updates the conversion factor for inflation using the hospital inpatient market basket index.

    Services provided are assigned current procedural terminology (CPT) codes and classified into APCs, each being assigned a specific payment rate. Hospitals have the ability to bill for various services performed on an individual on a single day.

    However, if there are multiple surgical procedures performed on a single day, the APC payment is subject to discounting.

    From: Robert James Cimasi; MHA, AVA, CMP


  4. More Emphasis on Quality While Reducing Costs if New CMS Head is Confirmed

    Although no official announcement has been made, the White House press office has confirmed that Donald Berwick, MD, president of the Institute for Healthcare Improvement (IHI) and a Harvard Medical School professor, will be Obama’s pick to head the agency. Berwick, a pediatrician by training, served on an advisory commission for patients rights during the Clinton administration and on an Institute of Medicine panel focused on the reduction of medical errors and improved patient safety.

    Boosting quality while reducing costs will be the next administrator’s top priority as the Medicare program is scaled back by more than $400 billion over the next decade, and enrollment in state-run Medicaid programs explodes as a result of the health reform law and double-digit unemployment rates. As a result, the agency’s strategic focus will need to shift to increased use of chronic care management and quality improvement. Industry observers interviewed by Health Plan Week say that makes Berwick an ideal candidate.

    Source: Health Plan Week [4/5/10]


  5. More on Inpatient Prospective Payment Systems

    Dr. Marcinko,

    Did you know that late last week, the Centers for Medicare and Medicaid Services released the fiscal year (FY) 2011 final rule for the inpatient prospective payment systems (IPPS) for acute-care hospitals and long-term acute-care hospitals, and the American Hospital Association (AHA) wasn’t impressed.


    AHA CEO Rich Umbdenstock stated that U.S. hospitals “strongly disagree” with the rule, largely because CMS did not heed industry studies, as well as bipartisan congressional support, that recommended doing away with or reducing a 2.9 percent coding offset to general acute-care hospital payments. Adding further insult to injury, CMS reiterated that the 2.9 percent adjustment represents only half of the 5.8 percent adjustment required to recoup industry overpayments.


    So, what do you and our ME-P readers think?



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