Rate-Setting by Diagnosis Related Groups and Hospital Specialization

Under the system of hospital reimbursement for Medicare patients, hospitals receive a prospectively determined price that varies according to the diagnosis related group (DRG) to which the patient is assigned. Rate-setting by DRG encourages hospitals to specialize in those DRGs for which they have relatively low production costs. This may substantially reduce aggregate hospitalization costs if specializing hospitals are efficient. If, instead, hospitals specialize by treating relatively healthier patients within each DRG, cost savings may be mitigated. The wide variation of patient-specific costs within DRGs promotes the latter kind of specialization and reduces the effectiveness of rate-setting.