How Hospitals Get Paid a Fixed Price Per Case: DRGs and Activity-Based Funding

A diagnosis-related group (DRG) pays a hospital a single preset price for an entire admission, fixed by the patient's diagnosis and procedure category rather than by the tests, drugs, and bed-days that end up on the bill. If the hospital treats the case for less than that price, it keeps the difference. If it spends more, it swallows the loss. This is the heart of activity-based funding, and it reshapes what a hospital has reason to do: it rewards treating each case leanly, but it also rewards admitting more patients and coding each one as richly as the chart will support.

Key points#

• A DRG is a fixed price for a whole case, not a running tab of individual services.
• It shifts the cost risk from the payer to the hospital, which is what makes it a spending-control tool.
• The same design that rewards efficiency also rewards more admissions and more favorable coding (upcoding).
• A 2024 ten-country review found many high-income systems now deliberately reducing how much hospital income flows through DRGs, rather than scrapping them.

The idea: one price for the whole case#

Think of two ways a restaurant could charge you. One is an itemized bill where every side, refill, and garnish is a separate line. The other is a fixed-price menu: you pay one number for the meal, and the kitchen decides how to deliver it within that price. Hospital payment has moved, imperfectly, from the first model toward the second.

Under older cost-based and fee-for-service arrangements, a hospital was paid for the inputs it used. More tests, more days, and more line items meant more revenue. The flaw is obvious in hindsight: the payment rises whenever more is done, whether or not the extra activity helped the patient. A DRG replaces that running tab with a set price attached to a clinical category, so a routine appendectomy or hip replacement is worth a predetermined amount regardless of how many individual items the care generates.

The consequence that matters most is where the financial risk lands. Fee-for-service puts the cost risk on the payer, because every additional service is reimbursed. A fixed price per case puts that risk on the hospital, because anything spent above the set price is the hospital's loss. That single reversal is what turns a payment method into a lever for controlling spending.

Where the model came from#

The United States confronted the open-ended-bill problem directly in 1983, when Medicare replaced cost reimbursement with the Inpatient Prospective Payment System. According to the Centers for Medicare and Medicaid Services, each admission is now sorted into a clinical group, the hospital receives a predetermined rate for that group, and unusually costly outlier cases are handled separately. The underlying DRG classification had been developed at Yale in the early 1970s and was first used at scale by New Jersey before Medicare adopted it nationwide.

Most other high-income countries later built their own versions, keeping the basic logic while retuning the categories and price weights to local costs. Milstein and Schreyogg's 2007 account of the system's origins (and the wave of adoption that followed) shows how a tool designed to restrain one country's inpatient spending became a near-standard template for hospital funding across wealthy health systems.

The incentives it creates#

A prospective price per case produces one incentive that policymakers generally want. If the payment is fixed, the hospital has a direct reason to skip duplicate tests, shorten stays that run longer than necessary, and standardize care around what works. As a side benefit, DRGs create a shared vocabulary, so what different hospitals do and what it costs become comparable in a way an itemized bill never allowed.

Two other incentives sit right beside that one, and they are the reason DRG systems always come wrapped in audits and rules.

The first is volume. Efficiency within a case is rewarded, but so is the count of cases. When each admission carries its own price, the plainest way to raise revenue is to admit and treat more patients. The payment formula has no way of its own to judge whether that added activity was clinically warranted.

The second is coding. Because the price attaches to how a case is classified, the same patient can land in a better-paid group when the record emphasizes a more complex diagnosis or a qualifying complication. This is where the well-documented phenomenon of upcoding appears. Analyzing roughly 145 million French hospital stays, a 2021 study found that moving to a finer DRG classification produced an upcoding-learning effect that gradually shifted funding between hospital types even though the care being delivered had not changed. Where a lever exists, some organizations learn to pull it.

Neither incentive requires bad faith. Both fall out of the simple act of paying by classified activity, which is exactly why these systems are paired with coding rules, audits, and volume monitoring.

Why systems are rebalancing the model#

The 2024 review in Health Policy by Milstein and Schreyogg, which asks pointedly whether this is the end of an era, traced a consistent pattern across the ten high-income countries it examined. Rather than abandoning activity-based funding, these systems are diluting and supplementing it in a few recurring ways:

• Lowering the DRG share, so a smaller slice of inpatient income depends on per-case activity, with fixed budgets or population-based elements blended in to soften the volume pull.
• Protecting small and rural hospitals, which cannot hit the case volumes a per-case price assumes, through supplementary payments or exemptions from the standard structure.
• Paying by episode, bundling a single price for a full care pathway instead of a separate price per admission, which discourages splitting one episode into several billable events.
• Steering suitable care toward lower-cost settings such as day surgery or outpatient clinics rather than the inpatient ward.

The review frames this as a shift away from rewarding activity and efficiency alone toward a broader set of goals that includes quality and care coordination. It is candid that the evidence on whether these reforms actually improve quality or reduce spending is mixed, and that candor is the useful part. No payment model is simply correct, because every method rewards whatever it can measure and stays blind to whatever it cannot. Fee-for-service rewards the volume of services; a fixed price per case rewards the volume of cases and cleaner-looking codes; a global budget rewards staying under budget, which can shade into doing less. Reform is less a search for a flawless design than a choice about which distortions a system is willing to watch and manage.

If you are trying to read a hospital-financing debate, the practical move is to ask what a given rule actually pays for, and therefore what it encourages without anyone saying so. A DRG pays for a classified case, so it nudges toward more cases and tidier codes. Seeing that makes the current reforms legible not as a rejection of activity-based funding but as an effort to blunt its sharpest edges.