The inpatient hospital prospective payment system (PPS), which was established in 1983, uses a preset payment schedule based on a patient’s principal diagnosis at discharge, comorbidities, and complications. The service unit is a patient stay. The fixed payment amounts are intended to cover the average costs of all services, supplies, and elements of care an efficient hospital would need to treat the average patient in a specified diagnosis-related group (DRG). There are 524 distinct DRGs, each of which encompasses “patients with similar clinical problems that are expected to require similar amounts of hospital resources” (MedPAC, 2005a). Some cases will cost the hospital more and others less than actual Medicare payments for a particular diagnosis. While these “bundled” payments are indexed to account for geographic differences in labor and other input costs, all hospitals within an area receive the same base payments for DRGs regardless of quality (Worzala et al., 2003). Hospital-specific adjustments that take the form of a percentage increase in all payments are made for institutions serving a disproportionate share of low-income and uninsured patients and teaching hospitals.
The acute inpatient hospital PPS provides an incentive to manage the costs of inputs needed for care. Hospitals can manage their costs by eliminating unnecessary services, reducing the intensity of services per case, bargaining hard over input prices, shortening lengths of stay, increasing the volume of less complex cases within any particular DRG, and reducing the volume of cases in DRGs for which Medicare’s preset payment does not