Medicare Hospital Prospective Payment System
How DRG Rates Are Calculated and Updated 
August 2001 
OEI-09-00-00200 
Office of Inspector General

Office of Evaluation and Inspections

Region IX
 This white paper was prepared under the direction of Paul Gottlober, Regional Inspector 
General. Principal OEI staff included: 
San Francisco  Headquarters

Tim Brady, Project Leader  Tricia Davis, Program Specialist

Barbie Robinson, Lead Analyst

Technical assistance was provided by: 
Centers for Medicare & Medicaid Services, Central Office 
Stephen Phillips, Deputy Director, Division of Acute Care

Amy Gruber, Health Insurance Specialist, Division of Acute Care
 I N T R O D U C T I O N  
When Medicare was established in 1965, Congress adopted the private health insurance sectors 
retrospective cost-based reimbursement system to pay for hospital services. Under this 
system, Medicare made interim payments to hospitals throughout the hospitals fiscal year. At 
the end of the fiscal year, the hospital filed a cost report and the interim payments were 
reconciled with allowable costs which were defined in regulation and policy. Medicares 
hospital costs under this payment system increased dramatically; between 1967 and 1983, costs 
rose from $3 billion to $37 billion annually.1 
In 1982, Congress mandated the creation of a prospective payment system (PPS) to control costs. 
Congress looked at the success of State rate regulation systems in controlling costs and mandated 
the implementation of a prospective payment system model that had been successful in several 
States.2  This system is a per-case reimbursement mechanism under which inpatient admission 
cases are divided into relatively homogeneous categories called diagnosis-related groups 
(DRGs). In this DRG prospective payment system, Medicare pays hospitals a flat rate per case 
for inpatient hospital care so that efficient hospitals are rewarded for their efficiency and 
inefficient hospitals have an incentive to become more efficient. 
Congress gave the Department of Health and Human Services (HHS) primary responsibility for 
setting and updating hospital payment rates under PPS.3  Later, Congress created the Prospective 
Payment Assessment Commission (ProPAC) to participate with HHS in setting and updating the 
DRG rates.4  Since its implementation, the DRG-based prospective payment system and the 
updating processes have experienced continual structural shifts and modifications. The 
processes by which the DRG codes are updated raises considerable issues with significant 
implications for the structure and funding of our national health care system. 
The following White Paper explains the PPS system, examines the process by which DRG codes 
are updated, and identifies the factors influencing the DRG prospective payment and 
classifications systems: 
C  Part I provides a summary of the evolution of the system including a discussion 
on how and why the system was created. 
C  Part II provides an overview of the PPS including examples and illustrations. 
C  Part III explains the processes for updating DRG codes and weights. 
C  Part IV contains a discussion of current issues that merit further consideration. 
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1  PART I: The Evolution of DRGs 
The Retrospective Payment System 
From fiscal years 1967 to 1984, hospitals were paid on the basis of the actual cost for providing 
services to Medicare beneficiaries.5  Under this system, each hospital submitted a report called a 
cost report which itemized expenditures incurred in the hospitals prior accounting period or 
fiscal year. During this period, Federal policy-makers viewed the health care system as 
wasteful, as the inflationary costs from this system were enormous.6  The following table shows 
the increase in total Medicare expenditures from 1967 to 1985: 
Medicare: Enrolled Population and Expenditures 1967 and 19857 
Year  Number of  Percent of 
Enrollees  Expenditures  Health Care 
Expenditures 
1967  19.5 million  $4.7 billion  9.2% 
1985  31.1 million  $72.3 billion  16.9% 
Two factors were blamed for the rapid growth in expenditures: 
1.	 Payment methodologies that paid providers based on their charges for providing services 
and consequently created an incentive to provide more services; 
2.  Increases in costly medical technology.8 
The following table shows Medicare hospital payments from 1967 to 1983.9 
Medicare Hospital Payments (1967 -1983) 
(in Billions) 
40 
$37 
35 
nts  30  $29 
e
m 25 
y $20 
a
P 20 
al  $15 
pit 15  $11 
os 10  $6  $7 
H
5  $3  $4 
0 
1967  1969  1971  1973	 1975  1977  1979  1981  1983 
Year 
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2  From 1970 to 1980, Medicare hospital payments increased by 88 percent. After the 
implementation of the PPS, the rate of growth for Medicare hospital payments steadily declined 
until 1987. In 1987, the administrative payment system was changed. This resulted in an 
increase in the payment rate. Also, in 1987, legislative changes increased the amount of 
reimbursement to hospitals for medical education, capital costs, and disproportionate share 
payments.10  From 1985 to 1990, the payment rate decreased by 52 percent, and from 1990 to 
1995 the payment rate decreased by 37 percent.11 
The Prospective Payment System 
In response to payment growth, Congress adopted a prospective payment system to curtail the 
amount of resources the Federal Government spent on medical care for the elderly and disabled. 
The Social Security Amendments of 1983 mandated the PPS payment system for hospitals, 
effective in October of Fiscal Year 1983.12 
The system was intended to motivate hospitals to change the way they deliver services. With 
DRGs, it did not matter what hospitals charged anymore -- Medicare capped their payments. 
Congress had four chief objectives in creating the PPS: 
1.	 To ensure fair compensation for services rendered and not compromise access to hospital 
services, particularly for the more seriously ill; 
2.	 To ensure that the process for updating payment rates would account for new medical 
technology, inflation, and other factors that affect the cost of providing care; 
3.  To monitor the quality of hospital services for Medicare beneficiaries; and 
4.	 To provide a mechanism through which beneficiaries and hospitals could resolve 
problems with their treatment.13 
Congress gave primary authority for implementing the system to the Centers for Medicare & 
Medicaid Services (CMS), formerly known as the Health Care Financing Administration 
(HCFA). It also assigned responsibilities to outside, independent organizations to ensure that the 
medical profession, hospital industry, and Medicare beneficiaries had the opportunity to provide 
input on the creation and implementation of the system. 
The Role of the Prospective Payment Assessment Commission (ProPAC) 
In 1986, Congress created the ProPAC to participate in setting and updating the DRG rates.14 
This congressional commission was given the responsibility to evaluate the performance of the 
executive and legislative branch on the management of the PPS. The commission was 
comprised of 17 experts in health care delivery, finance, and research who were appointed by the 
Director of the congressional Office of Technology Assessment. 
The ProPAC had two statutory responsibilities: 
1.  To recommend mechanisms for updating hospital payment rates to the Secretary; and 
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3  2.	 To recommend necessary changes in DRGs to the Secretary, including the advisability of 
establishing new DRGs, modifying existing ones, or changing the relative weights.15 
To ensure that ProPAC had the requisite information to perform these responsibilities, Congress 
mandated that ProPAC have access to all relevant information, data, and research. Congress also 
mandated a formal schedule of public communications between ProPAC and the Department 
with respect to the annual updating of hospital payment rates.16  As regulated by the Balanced 
Budget Act of 1997, ProPAC and the Physician Payment Review Commission merged to 
become the Medicare Payment Advisory Commission (MedPAC). The ProPACs statutory 
duties are retained in MedPACs statutory mandates.17 
The Role of Peer Review Organizations 
Congress required HHS to contract with peer review organizations to monitor: 
1.  the validity of diagnostic information supplied by hospitals for payment purposes; 
2.  the completeness, adequacy, and quality of care provided to Medicare beneficiaries; 
3.  the appropriateness of admissions and discharges; and 
4.	 the appropriateness of care in outlier cases in which additional Medicare payments 
were made.18 
The basic responsibility of peer review organizations is to ensure that Medicare hospital services 
are appropriate, necessary, and provided in the most cost effective manner. The peer review 
organizations have considerable power to force hospitals to comply with HHS admission and 
quality standards. They may deny payment to hospitals where abusive practices are found and, 
in some instances, report such practices to HHS for further enforcement action. 
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4  PART II: Developing and Rating DRG Codes 
A key part of PPS is the categorization of medical and surgical services into diagnosis-related 
groups (DRGs). The DRGs bundle services (labor and non-labor resources) that are needed to 
treat a patient with a particular disease. The DRG payment rates cover most routine operating 
costs attributable to patient care, including routine nursing services, room and board, and 
diagnostic and ancillary services.19  The CMS creates a rate of payment based on the average 
cost to deliver care (bundled services) to a patient with a particular disease. The DRG rates do 
not expressly include direct medical education costs, outpatient services, or services covered by 
Medicare Part B.20  For fiscal year 2002, there are 499 DRGs with a prospective price based on 
the average resources used in treating patients under the specific DRG.21 
DRG Classification System 
The DRGs classify all human diseases according to the affected organ system, surgical 
procedures performed on patients, morbidity, and sex of the patient.22  The classification also 
accounts for up to eight diagnoses in addition to the primary diagnosis, and up to six procedures 
performed during the stay.23  For example, a trauma patient with broken limbs and organ injuries 
involving multiple body systems would receive a principal diagnosis for the most severe 
condition. The physician also would record additional diagnosis and procedures used to treat 
this patient. 
The Claims Process 
The classification process begins with the physicians documentation of the patients 
principal diagnosis, secondary diagnosis and other factors affecting the patients care or 
treatment (referred to as complications and co-morbidities).24  This information is submitted 
to the hospitals medical records department where a medical record coder assigns diagnostic 
and procedures codes from the International Classification of Diseases, Ninth Revision, 
Clinical Modification (ICD-9). The hospital then sends the data electronically to its fiscal 
intermediary on a claim form known as a UB-92.25  The fiscal intermediary is a private 
company that has contracted with Medicare to process bills and pay claims for Medicare Part 
A services. 
The fiscal intermediary inputs these data into its claims processing system, referred to as the 
Medicare Code Editor. The system is designed to screen all cases and sort out those cases 
that require further review before classification into a DRG. Following this screening 
process, the fiscal intermediary, using an automated algorithm called Grouper, groups all 
discharge cases into one of 25 Major Diagnostic Categories (MDCs) before assigning it to 1 
of the 499 DRGs.26  Most of the MDCs are based on the body system involved and disease 
types. For example, MDC 1 involves diseases and disorders of the nervous system and MDC 
2 involves diseases and disorders of the eye. A few MDCs involve more than one organ 
system. For example, MDC 22 is the classification for burns and involves more than one 
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5  organ system, such as the respiratory and circulatory systems. The fiscal intermediary 
electronically submits a data file (referred to as the Medicare Provider Analysis and Review 
file) to CMS containing all the charge data that has been assigned to each DRG.27 
DRG Weights 
The CMS assigns a unique weight to each DRG. The weight reflects the average level of 
resources for an average Medicare patient in the DRG, relative to the average level of resources 
for all Medicare patients.28  The weights are intended to account for cost variations between 
different types of treatments. More costly conditions are assigned higher DRG weights. For 
example, the fiscal year 2001 DRG weights range from .5422 for a concussion (DRG 32) to 
1.4966 for viral meningitis (DRG 21) to 19.0098 for a heart transplant (DRG 103).29 
Calculating DRG Weights 
The methodology for calculating the DRG weights has been refined over time, but the core 
process remains the same. Patient charges are standardized to remove the effects of regional 
area wage differences, indirect medical education costs, and additional payments to hospitals that 
treat a large percentage of low income patients (referred to as disproportionate share 
payments). Cost of living adjustments are removed for hospitals in Alaska and Hawaii.30  The 
average standardized charge for each DRG is calculated by summing the charges for all cases in 
the DRG and dividing that amount by the number of cases classified in the DRG.31  Statistical 
outliers  those cases outside three standard deviations of the average charge for each DRG, are 
eliminated. The average charge for each DRG is re-computed and then divided by the national 
average standardized charge per case to determine the weighting factor.32 
DRG Payment Factors 
All services provided by the hospital, except physician services, must be furnished by the 
hospital directly or through arrangements with another in order to receive payment under the 
PPS.33  Each hospital knows its payment rate prior to the beginning of its fiscal year. To arrive 
at a basic price for a given service for a particular patient, each Medicare patient discharged by a 
PPS hospital is first assigned to a DRG that has a corresponding DRG weight. The DRG weight 
is multiplied by the hospitals payment rate per case. All hospitals are reimbursed on the basis of 
one of two Federal rates--large urban or other.34  These rates are adjusted to reflect 
differences in prevailing wage rates. 
The DRG payments are further adjusted to take into consideration four factors which are 
considered to reflect more accurately the costs of services provided by hospitals: 
1. Application of a Wage Index

Salaries generally represent the largest component of hospital costs. Prevailing salary levels

vary substantially among different areas of the country. Use of a single national or regional

DRG payment for all hospitals, without any consideration of prevailing wages, would

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6  severely penalize hospitals located in high-wage areas and unfairly benefit hospitals located 
in low-wage areas. The CMS adjusts Federal DRG rates to reflect prevailing wages in the 
local area which is defined as either large urban, or other. The CMS publishes annually an 
index of prevailing relative wages for each area. As a result, DRG payments in high-wage 
areas are greater than DRG payments in low-wage areas.35 
2. Indirect Medical Education Costs

Teaching institutions are assumed to have higher costs than other institutions due to extra

tests and procedures performed for teaching purposes and the treatment of more serious

cases. Accordingly, the DRG payments for these hospitals are increased by a percentage

based on the ratio of interns and residents to hospital beds.36

3. Cost Outliers

Medicare makes additional payments for cases with extremely high overall costs, commonly

referred to as cost outliers. The CMS annually establishes the limits that must be met to

qualify for cost outlier payments. If the cost of a particular case exceeds the limits, the

hospital may qualify for a cost outlier payment. Cost outlier payments are not automatic; a

hospital must make a specific request and must identify the actual costs associated with each

outlier case.37

4. Disproportionate Share Payments

Disproportionate share hospitals are hospitals that treat a large percentage of low income

patients, including Medicaid and Medicare beneficiaries. The CMS makes additional

payments to hospitals that qualify to account for the cost of treating this population.38

Other Special Payment Factors 
In addition to the four factors discussed above, there are other factors considered in calculating 
DRG payments depending on whether the hospital is considered a sole community hospital, a 
Medicare dependent rural hospital, or a regional referral hospital. In each instance, there are 
special payment rules. A hospital may be designated as a sole community hospital if, among 
other things, it is (1) located more than 35 miles from another hospital, (2) the sole source of 
inpatient hospital services in a geographic area, or (3) designated by the Secretary as a critical 
access hospital.39  A Medicare dependent rural hospital is one that depends on Medicare for at 
least 60 percent of its patient days or discharges. A regional referral hospital is one that serves 
as a referral center for other hospitals in its area.40  These hospitals are reimbursed according to 
the payment rate for large urban areas. 
Congress recognized that the DRG system does not adequately capture the costs for some 
specialized hospitals. Accordingly, some hospitals are exempt from the system. These include 
psychiatric, cancer, long-term care, childrens, and rehabilitation hospitals. However, PPS 
systems are currently being developed for rehabilitation and long-term care hospitals.41 
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7  Calculating DRG Payments 
Calculating DRG payments involves a formula that accounts for the adjustments discussed in the 
previous section. The DRG weight is multiplied by a standardized amount, a figure 
representing the average price per case for all Medicare cases during the year. The standardized 
amount is the sum of: (1) a labor component which represents labor cost variations among 
different areas of the country and (2) a non-labor component which represents a geographic 
calculation based on whether the hospital is located in a large urban, or other area. The labor 
component is then adjusted by a wage index.42  If applicable, cost outlier, disproportionate share, 
and indirect medical education payments are added to the payment. 
The following case study illustrates how DRG payments are calculated: 
Payment Case Study 
Sara, a 72 year old widow, fell off of her front porch. An ambulance 
transported her to Generic Hospital, a Medicare-certified hospital in San 
Francisco. She is diagnosed with an open fracture of the left femur 
requiring surgical intervention. In addition, the physician determines from 
her medical history that she has non-insulin dependent diabetes with 
associated peripheral vascular disorder. s
Step 1: Calculating the Standard Rate 
The PPS rate calculation begins with the standardized amounts. The 
standardized amounts are composed of a labor and a non-labor 
component. The large urban rates are used because San Francisco is in 
the large urban category. 
Generic Hospitals Standard Federal Rate this year consists of the two 
categories of base operating costs, adjusted for large urban areas: 
Labor related  $2,809.18 
Non-labor related  $1,141.85 
Step 2: Adjusting for the Wage Index Factor 
The labor-related portion of the standardized amount is adjusted for area 
differences in wage levels by using the wage index factor. The wage 
index is calculated from a cost of living adjustment and earnings by 
occupational category. This year, the wage index for San Francisco is 
1.4193. 
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8  The labor portion of the Standardized Federal Rate is multiplied by the 
wage index factor to adjust Generic Hospitals DRG base rate: 
$2,809.18 x 1.4193 = $3987.07  (adjusted labor rate for San Francisco) 
$3,987.07 + $1,141.85= $5,128.92  Generic Hospitals Adjusted Base 
Rate 
Step 3: Adjusting for the DRG Weight 
The DRG weight reflects the level of treatment expected for an average 
patient in this DRG. The relative weight for the hip and femur 
procedure is 1.8128. This weight is multiplied by the labor and non-
labor components calculated in step 1. 
Based on the ICD-9 codes, this case was classified as surgical MDC 8, 
Hip and Femur Procedure, except that the femur is not a major joint, 
Sara is older than age 17, and she has comorbidities or complications 
(Diabetes). 
($3,987.07 + $1,141.85) x (1.8128) =  $9,297.71 
Step 4: Disproportionate Share Payment 
Medicare-contracted hospitals that provide a disproportionate 
percentage of care to Medicaid or Medicaid eligible patients who are 
not eligible for Medicare Part A may qualify for PPS adjustments. The 
CMS applies this payment adjustment to the Generic Hospitals DRG 
revenue for inpatient operating costs. 
Generic Hospital qualifies as a Disproportionate Share Hospital and 
receives additional funds. This rate is 0.1413. Generics base payment 
rate is multiplied by this rate. 
($9,297.71) x (1+ 0.1413) = $10,611.47 
Step 5: Indirect Medical Education Payment 
Teaching hospitals that have medical residents may receive an added 
payment. This payment is based on the number of full-time equivalent 
residents, number of hospital beds, and number of discharges. The base 
payment rate is multiplied by the adjustment factor for Indirect Medical 
Education plus the Disproportionate Share Hospital (DSH). 
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9  The adjustment factor for Indirect Medical Education is 0.0744. This 
rate is added to the DSH factor plus 1 to give the Hospital an adjustment 
rate of: 
1 + 0.1413 + 0.0744 = 1.2157. 
The payment the hospital can expect to receive for this case is: 
$9,297.71 x 1.2157 = $11,303.23 
Step 6: Outlier Payments 
The CMS provides an additional payment for beneficiaries whose 
lengths of stay or costs exceed the threshold rate. 
The hospital cost for Saras care was $9,983.64. She stayed in the 
hospital for 5 days. The hospital was paid $11,303.23 by Medicare. If 
the cost of her care had exceeded the payment rate by $14,050, Generic 
Hospital could request an outlier payment. 
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10  PART III: Updating DRG Classifications and Weights 
Updating the PPS is a complex and lengthy process. It is a two-part process in which CMS has 
primary responsibility for creating or modifying new DRGs and making necessary changes to the 
relative weights, and MedPAC makes recommendations to CMS and Congress on how to update 
the PPS. 
The Social Security Act requires CMS to adjust the DRG classifications and relative weights 
annually.43  Throughout the calendar year, CMS receives comments from the public and other 
interested parties. In December and January, CMS compiles a list of issues to be addressed 
through the updating process. CMS awarded a contract to Minnesota Mining and Manufacturing 
(3M) Corporation, a company specializing in health information systems development to 
maintain and update the DRG classification.44  The 3M Corporation addresses those issues 
related to updating the DRG classification.45  CMS internally handles issues related to updating 
the DRG weights. In May, CMS publishes its proposed updates in the Federal Register for 
public comment. It is required to respond to each comment received. In August, CMS publishes 
its final updates, which are effective in October of that year.46 
The process involves: (1) updating and reclassifying existing DRG codes, as well as creating 
new codes; (2) updating the DRG weights; and (3) adjusting the wage index. The updates are 
performed to account for: 
1.  inflation, hospital productivity and new technology, 
2.  changes in resource consumption due to technology and other factors, and 
3.	 changes in treatment patterns, technology and other factors that may change the use 
of hospital resources.47 
The CMS Process 
CMS reclassifies the DRGs and recalibrates the DRG weights to decide what changes are 
necessary to compensate adequately for costs under PPS. The recalibration and reclassification 
processes are integrally related. The reclassification update occurs first, followed by 
recalibration of the weights. 
Updating DRG Codes 
The process by which the DRG codes are updated is called reclassification. It involves not 
only an assessment of the appropriateness of the DRG assignment within MDCs, but it also 
entails reclassifying the codes to account for new medical technologies and treatment 
patterns. 
The 3M Corporation provides CMS with recommendations for modifications to the DRG 
system including changes to the DRGs based on new ICD-9 codes.48  Using a sample of 
Medicare cases from a 2-year old MedPAR file, 3M performs statistical analyses to 
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11  determine whether potential DRG modifications are warranted. The analyses determine 
whether the cases of patients classified within a DRG have a similar pattern of resource 
intensity and whether they contain similar characteristics based on common organ systems 
(commonly referred to as clinical coherence).49 
Examples of DRG modifications may include adding new MDCs, creating new DRGs, 
redesigning classes of DRGs, or splitting DRGs to increase classification specificity. When 
such modifications are implemented, they are tracked for 2 years to determine whether they 
are appropriate. In 1998, CMS implemented a final rule in which it reclassified the DRGs 
for burn cases to account for the variation in resources associated with the different severity 
levels of burn patients.50  This reclassification was done after a 2-year review of the cases 
within the DRG. The review assessed whether or not changes in resource use were valid. 
Updating DRG Weights 
The process by which the DRG weights are updated is referred to as recalibration. Through 
recalibration, CMS updates the DRG system to account for changes in medical practices, 
technology, and the range of cases within the DRGs (commonly referred to as case 
complexity). Recalibration ensures that the weights accurately reflect the value of resources 
used for each patient classification. The Social Security Act requires CMS to recalibrate the 
DRG weights in a manner that maintains budget neutrality of the total program. Budget 
neutrality requires that the estimated payments for the hospital benefit are not greater or less 
than 25 percent of the payment amounts that would have been payable for the same services 
in Fiscal Year 1984.51 
DRG recalibration follows the reclassification updates. The CMS recalibrates the DRGs 
from bills received from all hospitals that are under PPS. The recalibration process begins 
when all the cases in the Medicare Provider Analysis and Review file are regrouped using 
the DRG reclassification updates. A national standardized average charge is created by 
performing a statistical analysis to remove the differences in area wage levels, indirect 
medical education and disproportionate share hospitals payments and the cost-of-living 
adjustment factor for hospitals in Alaska and Hawaii.52  An average standardized charge is 
calculated by summing the standardized charges for all cases in the DRG and dividing that 
amount by the number of cases classified in the DRG. Cases above or below the average 
standardized charge by a specified amount (statistical outliers) are eliminated. After 
eliminating the statistical outliers, the average charge for the DRG is then re-computed and 
divided by the national average standardized charge to determine the relative weight for each 
DRG.53 
Updating the Wage Index 
The CMS is required to make annual updates to the wage index.54  This process involves 
adjustments to the standardized amounts in hospital wages in different geographic areas 
throughout the country. The standardized amounts are adjusted by a factor that reflects the 
relative hospital wage level in a given geographic area compared to the national average 
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12  hospital wage level.55  The CMS must base the updates on several factors, which include a 
survey of wages and wage-related costs of short-term, acute care hospitals. The survey 
measures the salaries, paid hours of employment by occupational category, home office 
costs and hours, and certain contract labor costs and hours. The update to the wage index 
excludes the wages and wage-related costs for skilled nursing facility and home health 
services as well as the wages for other provider areas which are not subject to PPS.56 
Medicare Payment Advisory Committees Process 
MedPACs (formerly ProPAC) involvement in the updating process is mandated by statute.57 
The Commission has 17 members (appointed by the Comptroller General of the General 
Accounting Office) who bring a wide range of expertise in the financing and delivery of health 
care services. The Commission is supported by a full-time executive director and a staff of 
approximately 30 analysts. Analysts typically have backgrounds in economics, health policy, 
public health or medicine.58  The Commissions recommendation process begins in June when it 
meets to set its policy agenda for the coming year. During the summer months, Commission 
staff conduct research on the issues set forth in its policy agenda. Beginning in September, the 
Commission begins a series of 2 day public meetings to discuss the results of its research and to 
formulate recommendations to CMS and Congress.59 
The Commission releases its recommendations in two reports, which are required by statute to be 
issued in March and June of each year. MedPACs recommendations may involve specific 
issues related to the DRG updating process or more global considerations related to PPS and 
Medicare payment policy. The MedPAC does not embark upon a systematic review nor does it 
use the CMS methodology to update DRG classification and weighting factors. Through its 
reporting and recommendation processes, it conducts broader analysis related to Medicare 
payment. Over the years, MedPAC has (1) looked at issues related to improving the quality of 
care, (2) made recommendations for developing prospective payment systems for various 
provider categories, and (3) suggested ways to improve payments for end-stage renal diseases 
services. Recently, however, the MedPAC has focused on specific issues pertaining to the DRG 
updating process. 
MedPACs June 2000 Recommendations for Updating PPS 
In its June 2000 report to Congress, MedPAC specifically outlined recommendations for 
updating and refining the DRG classification and weighting methodologies. MedPAC 
recommended updating the system by: 
1.	 changing the DRG definitions to account more completely for severity differences 
among patients, 
2.  altering the methods currently used to calculate the DRG weights, and 
3.  changing the method of financing extra payments for outlier cases.60 
The MedPAC recommended refinement of the DRG definitions and relative weights to 
improve payment accuracy. It recommended that CMS adopt the All Patient Refined 
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13  Diagnosis Related Groups patient classification system. This system differs from the current 
DRG system in how information about patients secondary diagnoses is reported on hospital 
claims. It also recommended calculating the DRG weights using hospital-specific relative 
values. 
The MedPAC maintains that the use of refined DRGs and weights based on hospitals 
relative values would more accurately reflect the relative costliness of typical cases in each 
DRG. It conducted an evaluation of its proposed changes and the current DRG classification 
and weighting system.61 
The CMS Response to MedPACs Recommendations 
CMS responds to MedPACs recommendations in the same manner that it responds to the 
general publics comments  through the public comment process in the Federal Register. 
CMS systematically responds to each MedPAC recommendation. Some of the 
recommendations are implemented, others are not. Some of MedPACs recommendations 
would require legislative changes which are beyond CMS control.  In response to 
MedPACs June 2000 recommendation that the Secretary should adopt the All Patients 
Refined Diagnosis Related Groups, CMS agreed that this change would reduce discrepancies 
between payments and costs, but declined to adopt such a change because it would not be 
able to predict with accuracy how such a change may affect coding behavior. Furthermore, 
CMS believes that such a change would require specific legislative authority.62 
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14  PART IV: Issues for Consideration 
Previous Issues Considered by the Office of Inspector General 
Over the years the Office of Inspector General has studied numerous issues related to the DRG-
PPS including reports on: 
C(cid:32) Overpayments for patient transfers under the PPS system; 
C(cid:32) Improper Medicare payments to hospitals for nonphysician outpatient services; 
C(cid:32) Monitoring of DRG upcoding; 
C(cid:32) Monitoring of hospital payments for specific DRGs; and 
C(cid:32) The effects of the PPS on access to skilled nursing facilities. 
Current Issues for Consideration 
Factors such as technology development, access to and timeliness of information, and the coding 
of the DRGs have an impact on the future of PPS. The following issues have been identified as 
areas for further consideration: 
1.  Do annual updates adequately reflect changes in technology? 
2.	 Does CMS 2-year forecasts of the market basket of costs adequately adjust for 
inflation? 
3.	 Do current review processes adequately verify the validity of diagnostic information 
supplied by providers? 
4.  Are the non-MedPAR data sources adequate for updating the DRGs? 
5.	 Does the budget neutrality requirement constrain CMS ability to update the DRG 
classifications and weights? 
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15  Endnotes 
1. Centers for Medicare & Medicaid Services, Medicare: Estimated Hospital Insurance 
Disbursements Calendar Year 1966-2000, Center for Medicare & Medicaid Services, Office of 
the Actuary (2000). 
2. Thompson, D., Diers, D, Nursing Resources, in DRGs Their Design and Development 121 (R. 
Fetter ed., 1991). 
3. Social Security Act , 42 U.S.C.1395ww(e)(5)(A) (Supp. 1985). 
4. Pub. L. 105-33, Title IV 4022(c), 111 Stat. 355 1395(b)(6) (1997). 
5. Pub. L. No. 89-87, 102(a), 79 Stat. 286 (codified as amended at 42 U.S.C. 1395(f)(b), 
1395x(v) (1982 and Supp. 1985). 
6. Knowles, J. ed., Doing Better and Feeling Worse: Health in the United States (1977). 
7. Center for Medicare & Medicaid Services, Health Care Fin. Rev., 1-9 (1996). 
8. Office of Technology and Assessment, Medical Technology Under Proposals to Increase 
Competition in Health Care, 22-38 (1982). See also, Olson, M. ed. A Synthesis of the Empirical 
Evidence, A New Approach to the Economics of Healthcare (1981). 
9.United States Government Printing Office, Medicare and Health Care Chartbook (1997). 
10.Correspondence Memo with Clare McFarland of the Centers for Medicare and Medicaid 
Services, in Baltimore, MD (June 12, 2001). 
11.United States Government Printing Office, Pre- 1975 to 1995 CPI From Historical Statistics 
of the United States (1997). 
12. Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248 101, 96 Stat. 33-36 
(codified as amended at 42 U.S.C. 1395ww(a)-(c) (Supp. 1985)). 
13. See generally H.R. REP. NO. 25, 98th Cong., 1st Sess. 132 (1983), S. REP. NO. 23 98th 
Cong., 1st Sess. 111 (1983). 
14. Social Security Amendments of 1983, Pub. L. No 98-21, 601(e), 97 Stat. 65 (codified as 
amended at 42 U.S.C. 1395ww(e)(2) (Supp. 1985). 
15. 42 U.S.C. 1395ww(e)(2), (6)(A),6(B) (Supp. 1985). 
16. Social Security Act, 42 U.S.C. 1395ww(e)(2), (6)(A), (6)(B) Supp. (1985). 
17. Pub.L. 105-33, Title IV 4022(c), III Stat. 355 1395(b)(6) (1997). 
)))))))))))
16  18. Peer Review Improvement Act of 1982, Pub. L. No. 97-248 141-150, 96 Stat. 381. 
19. 42 CFR 412.20(a) (2000). 
20. 42 CFR 412.2(e), 412.115. (2000). 
21. Medicare Program; Changes to the Hospital Inpatient Prospective Payment System and 
Fiscal Year 2001 Rates, 65 Fed. Reg. 47025, 47154 (Aug. 1, 2000). 
22. 42 C.F.R. 412.60(a)-(c) (2000). 
23. See 65 Fed. Reg. 47025 (Aug. 1, 2000). 
24. Id. 
25. Telephone Interview with Amy Gruber, Health Insurance Specialist, Centers for Medicare & 
Medicaid Services, in Baltimore, MD (Apr. 27, 2001). 
26. 65 Fed. Reg. 47025, 47057 (Aug. 1, 2000). 
27. Id. 
28. 64 Fed. Reg. 41489, 41491 (Jul. 30, 1999). 
29. Id. 
30. 42 C.F.R. 412.62(d)(1)-(4)(g) (2000). 
31. 64 Fed. Reg. 41489, 41498 (Jul. 30, 1999). 
32. Id. 
33. 42 C.F.R. 412.50(c) (2000). 
34. 42 C.F.R. 412.62(f)(i)-(iii). 
35. 42 C.F.R. 412.60. 
36. 42 C.F.R. Parts 412, 413. 
37. 42 C.F.R. 412.84, 412.86. 
38. 42 C.F.R. 412. 
39. 42 C.F.R. 412.92-102. 
40. Id. 
41. See generally 42 C.F.R. 412.23. 
)))))))))))
17  42. 42 C.F.R. 412, 413. 
43. 42 C.F.R. 412.10(a). 
44. See, Health Care Financing Administration Awards Contract to 3M for Maintenance and 
Update of the Diagnosis Related Groups and Related Software Systems at, 
http://www.3M.com/market/healthcare/his/us/news/news-archive/june_1999.html. 
45. Telephone Interview with Amy Gruber, Program Analyst, Centers for Medicare & Medicaid 
Services, in Baltimore, MD (Apr. 27, 2001). 
46. Id. 
47. 42 C.F.R. 412.60(e). (2000). 
48. Telephone Interview with Amy Gruber, Program Analyst, Centers for Medicare & Medicaid 
Services, in Baltimore, MD (Apr. 27, 2001). 
49. 42 C.F.R. 412.10(b)(1) (2000). 
50. 64 Fed. Reg. 41489, 41494 (Jul. 30, 1999). 
51. 42 U.S.C. 1395ww (2000). 
52. 42 C.F.R. 412.62(h)(i) (2000). 
53. 64 Fed. Reg.41489, 41499 (Jul. 30, 1999). 
54. 42 U.S.C. 1886(d)(3)(E) (1993). 
55. 65 Fed. Reg. 47055, 47070 (Aug. 1, 2000). 
56. Id. 
57. Social Security Act, 42 U.S.C. 1805(a) (1997). 
58. Pub. L. 105-33, Title IV 4022(c), 111 Stat. 355 1395(b)(6) (1997). 
59. Medicare Payment Advisory Commission, Report to Congress: Improving Medicares 
Payment for Inpatient Care and for Teaching Hospitals, at 54 (June 2000). 
60. Id. 
61. Id. 
62. Medicare Program; Changes to the Hospital Inpatient Prospective Payment System and 
Fiscal Year 2001 Rates, 65 Fed. Reg. 47025, 47103 (Aug. 1, 2000). 
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