The Medicare Severity Diagnosis Related Group (MS-DRG) is a classification system used by the Centers for Medicare & Medicaid Services (CMS) to manage the reimbursement of inpatient hospital services under Medicare Part A. Instead of paying for every service and supply, the MS-DRG system groups patients with similar clinical conditions and expected resource needs into a single category. A fixed payment amount is assigned to this category, standardizing how hospitals are paid for comparable patient stays. This structure promotes efficiency in care delivery while ensuring hospitals are compensated based on the complexity and severity of the patient’s illness.
Understanding the Prospective Payment System
The establishment of the MS-DRG system fundamentally changed healthcare financing by moving away from the previous “fee-for-service” or retrospective cost-based model. Before this shift, hospitals were paid for the actual costs incurred and services rendered, which often led to rapidly escalating healthcare expenses. The more a hospital spent, the more it was paid, creating little motivation for efficiency.
In response to this unsustainable cost inflation, Congress mandated a change to a Prospective Payment System (PPS) for inpatient hospital stays, introducing Diagnosis-Related Groups (DRGs) to set fixed payments. The PPS dictates that hospitals receive a predetermined, fixed payment for a patient’s entire hospital stay based on the assigned MS-DRG, regardless of the actual length of stay or the total volume of services consumed. This fixed-rate structure successfully flipped the financial incentive for hospitals. Hospitals must now manage resources effectively, as any cost incurred above the fixed payment results in a loss, thereby promoting efficiency.
The Patient Grouping Mechanism
Assigning a patient to a specific MS-DRG is a complex clinical coding process that occurs after the patient is discharged, using information from the medical record. The assignment begins with the patient’s Principal Diagnosis (PDx), the condition chiefly responsible for the hospital admission. This PDx determines the initial Major Diagnostic Category (MDC), which broadly groups conditions related to a major body system.
The MS-DRG system then uses several other factors to refine the grouping and determine the severity level of the case. These factors include procedures performed, the patient’s age, discharge status, and Secondary Diagnoses—all other conditions present upon admission or developed during the stay.
These secondary diagnoses are classified into two severity levels: Complication/Comorbidity (CC) and Major Complication/Comorbidity (MCC). A CC significantly increases the resources needed for treatment, while an MCC represents an even greater level of severity and resource consumption. A patient with no qualifying secondary diagnoses is classified as “Non-CC.”
This three-tiered severity adjustment is the “MS” component of the system. For most conditions, the initial PDx is split into three distinct MS-DRGs based on the presence of an MCC, a CC, or neither. This ensures that hospitals treating sicker patients with more complex conditions receive a proportionally higher fixed payment.
Calculating Fixed Reimbursement
Once the patient is grouped into a specific MS-DRG, the payment calculation translates this clinical classification into a dollar amount using two primary financial components.
The first component is the Relative Weight (RW), a numerical value assigned to every MS-DRG that reflects the average resource intensity and cost required to treat patients in that group compared to the average case overall. A common, simple case is assigned an RW near 1.0, while a highly complex case might have an RW of 3.0 or higher.
The second primary component is the Hospital Base Rate (HBR), the standardized dollar amount set by Medicare for a hospital. This rate is a hospital-specific value tailored to account for geographic differences, primarily through a wage index adjustment reflecting local labor costs.
The basic payment formula is the product of these two components: MS-DRG Payment = Relative Weight × Hospital Base Rate. This calculation is further modified by hospital-specific adjustments, such as those for teaching hospitals (Indirect Medical Education, or IME) or hospitals that serve a disproportionate share of low-income patients (Disproportionate Share Hospital, or DSH). These adjustments ensure the final payment accurately reflects both the clinical complexity of the case and the operational realities of the specific facility.
Operational Impact on Hospitals
The MS-DRG system profoundly influences how hospitals operate, creating two major pressures on hospital administration and clinical staff.
The first is the intense focus on Clinical Documentation Improvement (CDI), which ensures the medical record accurately reflects the patient’s severity of illness and all resources utilized. Since the final MS-DRG assignment—and therefore the payment—is based solely on the documentation, a missed or poorly described secondary diagnosis can result in a significant underpayment. Hospitals must dedicate resources to CDI teams who work with physicians to ensure all conditions, especially CCs and MCCs, are documented clearly.
This documentation pressure directly impacts the hospital’s Case Mix Index (CMI), which is the average RW of all its patients. A higher CMI indicates a sicker patient population and leads to higher overall Medicare reimbursement.
The second major operational consequence is the incentive to manage the utilization of hospital resources, including the patient’s Length of Stay (LOS). Since the hospital receives a fixed payment regardless of how long the patient stays, the system encourages efficient, high-quality care that minimizes unnecessary tests and services. Hospitals must streamline care pathways to safely discharge patients as quickly as clinically appropriate.