The Inpatient Prospective Payment System (IPPS) is the primary method the U.S. Medicare program uses to reimburse hospitals for inpatient stays. This system fundamentally shifted the financial relationship between the government and healthcare providers, moving away from paying for every service a hospital delivered. IPPS establishes a fixed, predetermined amount for an entire hospital stay based on the patient’s condition, rather than the actual costs incurred by the hospital. This approach was designed to encourage hospitals to manage their resources more effectively and promote cost consciousness in healthcare delivery.
The Historical Context of Prospective Payment
The IPPS was introduced to curb rapidly escalating healthcare expenditures under the previous system. Before 1983, Medicare used a “retrospective” payment model, or fee-for-service, where hospitals were reimbursed for all reasonable costs incurred during a patient’s stay. This structure provided no incentive for efficiency and rewarded hospitals for increasing the volume and cost of services, contributing significantly to inflation in Medicare spending.
Congress passed the Social Security Amendments of 1983 to curb these rising costs and introduce financial predictability. These amendments mandated the creation of the IPPS, transforming Medicare’s payment mechanism into a prospective model. Under this new system, the payment amount is set before the patient is admitted, offering both the government and hospitals a predictable payment structure. This transition successfully brought the growth of Medicare hospital inpatient costs under control.
The Core Payment Mechanism Using DRGs
The central component of the IPPS is the Diagnosis-Related Group (DRG) system, which classifies inpatient stays to determine the fixed payment amount. DRGs group stays that are clinically similar and require comparable hospital resources. A patient is assigned a specific DRG based on their principal diagnosis, secondary diagnoses, surgical procedures, age, sex, and discharge status.
The final payment calculation begins with a national standardized operating payment amount, representing the average cost of treating a patient across all hospitals. This national rate is adjusted for two main factors: the complexity of the case and the hospital’s geographic location. The complexity is captured by the DRG relative weight, which reflects the average resources required for that specific DRG compared to the average case overall.
The payment formula multiplies the standardized amount by the DRG weight, resulting in a fixed dollar amount for the case. This amount is further refined to account for local market variations in labor costs. The labor-related portion of the payment is adjusted by a wage index specific to the hospital’s geographic area, ensuring hospitals in high-wage areas receive a higher payment to account for increased operating costs.
Additional adjustments can be made to the base payment for specific circumstances. Hospitals that treat a disproportionately high percentage of low-income patients receive the Disproportionate Share Hospital (DSH) adjustment. Hospitals with approved medical residency programs also receive an Indirect Medical Education (IME) adjustment to offset the indirect costs associated with teaching. Finally, a hospital may receive an outlier payment if the patient’s case is extraordinarily costly, which protects the facility from catastrophic financial losses.
What Facilities and Services IPPS Covers
The IPPS primarily applies to acute care hospitals, covering the operating and capital costs associated with inpatient stays for Medicare beneficiaries. It pays for the “bundle” of services provided during a single admission, including nursing care, most supplies, and ancillary services. More than three-quarters of the nation’s inpatient acute-care hospitals are paid under this system.
Not all facilities or services are paid under the IPPS, as many are covered by different prospective payment systems. Facilities explicitly excluded include psychiatric hospitals and units, rehabilitation facilities and units, and long-term care hospitals. These specialized hospitals are reimbursed under their own distinct prospective payment systems, such as the Inpatient Rehabilitation Facility Prospective Payment System (IRF PPS).
Critical access hospitals (CAHs), which are small, rural facilities, are also exempt from IPPS. CAHs are instead reimbursed based on their reasonable costs, a throwback to the pre-IPPS cost-based model. All outpatient services, including emergency department visits that do not result in an inpatient admission, are paid under a separate system called the Outpatient Prospective Payment System (OPPS).
Financial Incentives and Hospital Operations
The fixed payment structure of the IPPS fundamentally alters financial incentives for hospitals, driving them toward greater efficiency and careful resource management. Since the hospital receives the same predetermined payment regardless of the length of stay or resources consumed, it creates an incentive to deliver care for less than the fixed rate. If a hospital’s costs for a case are lower than the IPPS payment, the hospital keeps the difference, resulting in an operating gain.
Conversely, if a hospital’s costs exceed the fixed payment, it incurs a financial loss. This mechanism encourages administrators to reduce unnecessary testing, minimize the length of stay, and standardize care protocols to avoid wasteful spending. This focus on efficiency has prompted hospitals to develop sophisticated internal resource management and cost-tracking systems. The shift also transforms service lines that were once “revenue centers” under the old system into “cost centers” that must be managed tightly.
Beyond efficiency, the IPPS incorporates quality incentives that directly affect a hospital’s payment. Programs such as the Hospital Value-Based Purchasing (VBP) program and the Hospital-Acquired Condition (HAC) Reduction Program adjust the base payment based on performance metrics. Hospitals face financial penalties for high rates of readmissions or complications, motivating them to improve the quality of care and coordinate post-discharge services. This system encourages hospitals to view the entire episode of care as part of their financial responsibility.