Medicare Prospective Payment System
Introduction
The Medicare Prospective Payment System (PPS) was introduced by the federal government in October, 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 is classified into a Diagnosis Related Group (DRG) on the basis of clinical information. Except for certain patients with exceptionally high costs (called outliers), the hospital is paid a flat rate for the DRG, regardless of the actual services provided.

Each Medicare patient is classified into a Diagnosis Related Group (DRG) according to information from the Medical Record that appears on the bill:

  • Principal Diagnosis (why the patient was admitted)
  • Complications and Comorbidities (CCs - other secondary diagnoses)
  • Surgical Procedures
  • Age
  • Gender
  • Discharge Disposition (routine, transferred, or expired)

How it Works
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 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 effect reimbursement.

There are over 490 DRG categories defined by the Centers for Medicare and Medicaid Services (CMS, formerly known as HCFA). Each category is designed to be "clinically coherent." In other words, all patients assigned to a DRG are deemed to have a similar clinical condition. The Prospective Payment System 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 incorporate new technologies (e.g. laparoscopic procedures) and refine 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.

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 means that charges were historically twice the average; a DRG with a weight of 0.5000 was half the average.

Top 10 DRGs
The ten highest volume Medicare DRGs represent about 30% of total Medicare patients. Each of these higher volume DRGs represent from about 2% to 6% of total Medicare volume.

  DRG DRG Description % Total Rel Wt
1 127 Heart Failure & Shock 5.99 1.0234
2 089 Simple Pneumonia & Pleurisy Age>17 w/CC1 3.85 1.1447
3 014 Specific Cerebrovascular Disorders except TIA 3.18 1.2056
4 430 Psychoses 3.18 0.9153
5 088 Chronic Obstructive Pulmonary Disease 3.11 1.0067
6 209 Major Joint & Limb Reattachment Procedures, Lower Extremity 2.78 2.3491
7 140 Angina Pectoris 2.33 0.6241
8 182 Esophagitis, Gastroent & Misc Digest Disorders Age>17 w/CC1 2.09 0.7617
9 174 G.I. Hemorrhage w/CC1 2.07 0.9657
10 296 Nutritional & Misc Metabolic Disorders Age>17w/CC1 1.93 0.9313

Note: "CC" signifies a significant complication or comorbidity
Source: Health Care Financing Administration, 1994.

DRG-based Payments
The DRG payment for a Medicare patient is determined by multiplying the relative weight for the DRG by the hospital’s blended rate:

DRG PAYMENT = WEIGHT x RATE

The hospital’s payment rate is defined by Federal regulations and is updated annually to reflect inflation, technical adjustments, and budgetary constraints. There are separate rate calculations for large urban hospitals and other hospitals. There are also technical adjustments for local wage variations, teaching hospitals, and hospitals with a disproportionate share of financially indigent patients.

Management Perspectives
The average DRG weight for all of a hospital’s Medicare volume is called the case mix index (CMI). This index is very useful in analysis since it indicates the relative severity of a patient population and is directly proportional to DRG payments.  When making comparisons among various hospitals or patient groups, the case mix index can be used to adjust indicators such as average charges.  (Case mix adjusted average charges would be actual charges divided by the CMI.  Such adjustments are sometimes referred to as "Average charges for a weight of 1.0000.")

The DRG classification system is a useful tool for managing inpatient quality measurements and operating costs. It groups patients by diagnostic category for analysis and provides several key measurements of resource utilization (e.g. average length of stay vs published national averages).

The Medicare Prospective Payment System was first introduced in 1985 to reimburse hospitals for inpatient operating expense only.  An Outpatient Prospective Patient System was introduced in 2000 to reimburse hospitals based on over 660 Ambulatory Payment Classifications (APCs).