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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7 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?




    MACRA will be a game changer for the patient, the physician and our US healthcare economics. And as the bellwether for change, it is likely that Medicaid and other government funded healthcare reimbursement programs will keep a keen eye on the impacts and outcomes of this program for their own brand of adoption.

    At the core of all healthcare access and delivery is the patient. Quality patient care, receiving the right care, from the right healthcare provider, at the right time, and at a cost sharing that makes sense – these are the principles that guide our US healthcare system. The question that is top of mind should be whether patient care can improve under MACRA since the goal is to have the vast majority of CMS funding flow through payment models that reward doctors for the quality of care they deliver, not just how many patients they see.

    The CMS 962-page MACRA proposal outlines the biggest change to Medicare reimbursement since the early-80s introduction of DRGs and is fast-propelling the ongoing transformation of our US healthcare delivery system from fee-for-service (FFS) to value-based payments. This will especially impact those states that still operate in FFS markets.

    Under MACRA, physicians are at the center of this sweeping, evolutionary change that heightens physician’s reporting obligations and requires performance metrics for reimbursement.

    Because Medicare is the largest single payor for most physicians, many physicians in private practice are in a quagmire – how will they meet the first and latter stages of this enactment? This will require physicians to have a greater understanding and engagement with healthcare technology solutions to track patient information to meet MACRA’s reporting requirements.

    A cohort of veteran physicians nationwide, tasked with this new heightened emphasis on digital reporting, may not have the required resources – healthcare technology and personnel – to create these reporting metrics. This may be a stimulus for them to leave private practice or their IPAs to join hospital-owned physician groups to become part of integrated regional or even national care delivery systems.

    MACRA points to the way of what is inevitable — that the tapestry of our healthcare system is going to radically change.

    In the Modern Healthcare article, “Docs face stark choices under new Medicare pay proposal,” CA Bureau Chief Beth Kutscher writes, “The changes have the potential to upend the way medicine is practiced today, accelerating the move toward hospital employment and making the small group practice a thing of the past.”

    The call to action is clear. With the growing financial burden on the US healthcare system to shoulder the responsibility of providing access and delivery to all of our citizens, including Medicare beneficiaries, we do need to come up with effective payment solutions while keeping the patient at the forefront of all we do. We cannot lose sight of two overarching imperatives: maintaining quality healthcare access and delivery, while upholding the time-honored benefits of the traditional patient-physician relationship.

    Henry Loubet
    [CEO – Paladin Healthcare]


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