Medicare Inpatient Prospective Payment System

The Medicare Inpatient Prospective Payment System (IPPS) 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 IPPS, hospitals are paid a pre-determined rate for each Medicare admission.  Each patient is classified into a diagnostic category (MS-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 MS-DRG, regardless of the actual services provided.

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

  • Principal Diagnosis (why the patient was admitted)
  • Complications and Comorbidities (other secondary diagnoses)
  • Surgical Procedures
  • Age
  • Gender
  • Discharge Destination (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 MS-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 740 DRG categories defined by the Centers for Medicare and Medicaid Services (CMS. Each category is designed to be "clinically coherent." In other words, all patients assigned to a MS-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 MS-DRG.

Each year CMS makes technical adjustments to the MS-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 MS-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 MS-DRG. These weights indicate the relative costs for treating patients during the prior year. The national average charge for each MS-DRG is compared to the overall average. This ratio is published annually in the Federal Register for each MS-DRG. An MS-DRG with a weight of 2.0000 means that charges were historically twice the average; an MS-DRG with a weight of 0.5000 was half the average.

Top 10 MS-DRG
The ten highest volume Medicare MS-DRGs represent about 30% of total Medicare patients. Each of the 10 highest volume MS-DRG represent from about 2.1% to 4.6% of total Medicare volume.

  MS-DRG MS-DRG Description % Total Rel Wt
1 470 Major joint replacement or reattachment of lower extremity w/o MCC 4.6% .9871
2 885 Psychoses 4.5% .7783
3 871 Septicemia w/o MV 96+ hours w MCC 3.0% 1.7484
4 945 Rehabilitation w CC/MCC 2.9% .1005
5 392 Esophagitis, gastroent & misc digest disorders w/o MCC 2.8% .7121
6 194 Simple pneumonia & pleurisy w CC 2.8% .0235
7 291 Heart failure & shock w MCC 2.4% .2585
8 292 Heart failure & shock w CC 2.3% .0134
9 690 Kidney & urinary tract infections w/o MCC 2.1% .8000
10 641 Nutritional & misc metabolic disorders w/o MCC 2.1% .7248

Note: "CC" signifies a significant complication or comorbidity. "MCC" signifies a major CC.
Source: MedPAR, FY 2008 (early release for discharges during first nine months), Short-term acute care hospitals only.

MS-DRG-based Payments
The MS-DRG payment for a Medicare patient is determined by multiplying the relative weight for the MS-DRG by the hospital's blended 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. There are also adjustments applied to certain types of transfers for some MS-DRG.

Management Perspectives
The average MS-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 MS-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 MS-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 Inpatient Prospective Payment System was first introduced in 1985 and the patient classification system was totally revised for the federal fiscal 2008 beginning October 1, 2007. This revision was designed to better adjust for severity of illness. (At about the same time, CMS also changed the method of calculating relative weights to base them on allocated costs instead of charges.) An Outpatient Prospective Patient System was introduced in 2000 to reimburse hospitals based on over 660 Ambulatory Payment Classifications (APCs).