DRG codes, or Diagnosis-Related Group codes, are a classification system that sorts every hospital inpatient stay into one of roughly 760 payment categories. Each category groups patients who have similar diagnoses, underwent similar procedures, and typically consume a comparable level of hospital resources. Medicare and many private insurers use these codes to determine how much a hospital gets paid for each admission, rather than billing for every individual service provided during a stay.
How DRG Codes Work
When you’re discharged from a hospital, medical coders review your chart and assign diagnosis and procedure codes using the ICD-10 coding system. A hospital can report a principal diagnosis, up to 24 additional diagnoses, and up to 25 procedures performed during the stay. All of that information feeds into software called a “grouper,” which processes the codes and assigns a single DRG that represents the entire hospitalization.
The grouper doesn’t just look at your primary diagnosis. It evaluates whether you had complications or additional conditions (called comorbidities) that made your care more complex. These secondary diagnoses fall into two tiers: complications or comorbidities (CC) and major complications or comorbidities (MCC). A patient admitted for pneumonia who also has sepsis will land in a higher-severity DRG than a patient admitted for pneumonia alone, because the expected resource use is greater.
This tiered structure is why the current system is formally called MS-DRGs, short for Medicare Severity Diagnosis-Related Groups. Many DRGs come in sets of two or three versions reflecting different severity levels for the same basic condition or procedure.
How Hospitals Get Paid
Each DRG carries a relative weight, a number that reflects how costly that type of case is compared to the average Medicare inpatient stay. A straightforward vaginal delivery might carry a weight near 0.7, while a heart transplant with complications could carry a weight above 25. The higher the weight, the more the hospital is reimbursed.
The actual dollar amount is calculated by multiplying the DRG’s relative weight by a base payment rate. That base rate is then adjusted for local wage differences using a geographic wage index, so a hospital in Manhattan and a hospital in rural Kansas receive different amounts even for the same DRG. Additional adjustments may apply for factors like readmission rates or new technologies used during care.
This is fundamentally different from fee-for-service billing, where hospitals charge separately for every lab test, medication, imaging scan, and day in the bed. Under DRG-based payment, the hospital receives a fixed amount per admission. If the hospital spends less than that amount delivering care, it keeps the difference. If it spends more, it absorbs the loss.
Why DRGs Were Created
Before 1983, Medicare reimbursed hospitals based on whatever costs they reported. This gave hospitals little incentive to control spending. The Social Security Amendments of 1983 changed that by establishing a prospective payment system, where payment rates based on DRGs replaced the old cost-based model. The law required the Secretary of Health and Human Services to create a classification of inpatient discharges by diagnosis-related groups and a methodology for computing group-specific payment rates.
The system was designed to relate the types of patients a hospital treats (its “case mix”) to the costs the hospital actually incurs. Since then, DRG-based payment has been adopted by countries around the world as a tool for controlling healthcare spending.
Effects on Hospital Stays and Costs
Because hospitals receive a flat payment per admission, DRGs create a financial incentive to deliver care efficiently. Unnecessary tests, redundant procedures, and prolonged stays all eat into a hospital’s margin without increasing reimbursement. Research across multiple hospital types and departments has found that DRG implementation reduces average length of stay by about two days and lowers overall hospitalization costs, while shifting resources toward the procedural services patients actually need.
For patients, this generally means shorter hospitalizations. It also means hospitals are motivated to discharge you as soon as you’re medically stable rather than keeping you an extra day “just in case.” Critics have raised concerns that this pressure could lead to premature discharges, which is one reason readmission penalties exist. Hospitals with excessive 30-day readmission rates see their base DRG payments reduced.
Case Mix Index: How DRGs Shape a Hospital’s Profile
A hospital’s Case Mix Index (CMI) is the average DRG weight across all its Medicare discharges. It’s calculated by adding up the relative weights for every discharge and dividing by the total number of discharges. A hospital that handles a high volume of complex surgeries and critically ill patients will have a higher CMI than a community hospital that primarily manages straightforward medical admissions.
CMI matters because it serves as a proxy for how sick a hospital’s patients are and how many resources their care demands. Research at a large academic medical center found a 61% positive correlation between DRG weights and actual hospitalization expenses, confirming that the weighting system, while imperfect, reasonably tracks real-world costs. Hospitals track their CMI closely because it directly determines revenue and is used in benchmarking against peer institutions.
DRGs vs. Outpatient Payment Systems
DRGs apply only to inpatient hospital stays. If you visit an emergency room, have outpatient surgery, or receive care at a hospital clinic without being formally admitted, a different system kicks in. Outpatient hospital services under Medicare are paid through the Outpatient Prospective Payment System, which uses Ambulatory Payment Classifications (APCs) instead of DRGs. APCs work on a similar principle of grouping services into payment categories, but they’re structured around individual procedures and services rather than entire hospital stays. Medicare also maintains separate prospective payment systems for other care settings like skilled nursing facilities, home health, and inpatient rehabilitation.
How DRGs Are Updated
CMS revises the DRG system annually through the Inpatient Prospective Payment System (IPPS) final rule. Each fiscal year brings updates to relative weights, changes to which diagnosis codes qualify as CCs or MCCs, additions of new diagnosis and procedure codes, and removal of outdated ones. The FY 2025 rule, for example, included updated MS-DRG grouper logic, revised wage index values, and new tables detailing additions and deletions to both the CC and MCC lists. Hospitals, coders, and billing departments must implement these changes every October 1 when the new fiscal year begins.
These annual updates mean that the same clinical scenario can be classified and reimbursed differently from one year to the next, which is why healthcare organizations invest heavily in keeping their coding staff trained and their billing software current.