Diagnosis-Related Groups: Why They Failed and What Comes Next
Authored by Rita Numerof, Ph.D. and Michael Ryan, PharmD.
CMS introduced Diagnosis-Related Groups (DRGs) in the early 1980s with the promise of bending the proverbial healthcare cost curve. It was the start of a prospective payment system aimed at ending the ‘usual and customary’ retrospective reimbursement system. Under this new model hospitals were paid a flat rate for treating a patient with a given diagnosis, regardless of the length of stay or actual resource use. The logic was straightforward: fixed payments would discourage overutilization, drive hospitals to become more efficient, and control spending.
DRGs and the communication surrounding their introduction were silent on the role of accountability or linking payment to outcomes that matter. Forty years later, the evidence is clear: DRGs have not delivered on their promise. Instead, they have distorted provider behavior, entrenched inefficiencies, and failed to improve patient outcomes. For business leaders, insurers, and policymakers seeking sustainable healthcare models, it is time to move beyond DRGs and embrace a new framework that aligns payment with value, outcomes, and integrated care.
Why DRGs Represent a Failed Policy
1. Misaligned Incentives
Because of misaligned incentives, instead of rewarding efficiency and paying more for improved health outcomes, DRGs incentivized hospitals to “game” the system to maximize their revenues. They did this through upcoding, the practice of coding patient conditions as more severe than they are and generating volume over value.
While DRGs discourage longer stays, they encourage hospitals to maximize throughput, often leading to higher admission rates and readmissions. In more recent years, CMS introduced readmissions penalties aimed at curtailing such problematic but predictable practices. Where care could be delivered in lower cost settings, often associated with lower reimbursement, many hospitals were reluctant to do so, noting that savings would only accrue to payers, and that they would be further disadvantaged financially.
This has created a system where, too often, financial incentives drive decisions, not patient needs.
2. Quality of Care and Health Outcomes Have Not Improved
Numerous studies have shown that DRGs did little if anything to improve care quality. Mortality rates, complication rates, and long-term outcomes have not meaningfully improved under DRG-based reimbursement. Hospitals are pressured to cut costs, but those cuts often come from staffing, support services, and post-acute care coordination—all areas that directly affect patients. And because hospitals and health systems have been more focused on cost, they have often been reluctant to invest in technologies and new processes that could improve outcomes across the continuum of care.
DRGs focused narrowly on discrete hospital stays. They ignored the broader continuum of care—primary care, prevention, chronic disease management, and post-discharge outcomes. As a result, DRGs continued to reinforce fragmentation rather than integrated care delivery.
3. Failure to Contain Costs While Administrative Complexity and Burden Increase
Healthcare spending in the U.S. has continued to rise dramatically since DRGs were implemented. While DRGs slowed the growth of inpatient spending, they shifted costs elsewhere:
Outpatient services and post-acute care grew as hospitals sought revenue streams outside DRGs.
Administrative costs ballooned as hospitals invested in coding, billing, and compliance systems to maximize reimbursement.
The DRG system created an entire industry around coding, compliance, and auditing. Healthcare systems employ armies of coders and consultants to ensure “accurate” billing, and insurers employ auditors to detect fraud and abuse. This adversarial ecosystem generates waste, rather than value. The net result: system-wide costs keep rising, with little correlation to improved outcomes.
Lessons for Business Leaders and Policymakers
The failure of DRGs underscores a critical truth: you cannot bend the cost curve or improve healthcare outcomes by manipulating reimbursement alone or focusing on narrow slices of care. Payment reform must be tied to delivery reform, and incentives must reward value, not volume or coding precision.
Businesses, as major purchasers of healthcare through employee benefits, have a vested interest in driving these reforms.
The majority of U.S. healthcare spending is driven by chronic conditions like diabetes, heart disease, and obesity. Payment models must reward providers for reducing preventable hospitalizations and keeping people healthy, not just treating acute episodes.
The message is and has been clear. DRGs represent a well-intended but failed policy. To build a sustainable healthcare system, we must move to models that align financial incentives with the health and well-being of patients.
See the original article here.