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Diagnosis Related Groups (DRGs)

An Estimate of Annual DRG Maintenance Expenses in the US

By:
Sabine Moravi-Bottoli

December 2000

Table of Contents
I.

INTRODUCTION

II. DIFFERENT DRG SYSTEMS

1.
2.
3.
4.
5.
6.
7.

M EDICARE DRGS
REFINED DRGS (RDRGS)
ALL PATIENT DRGS (AP-DRGS)
SEVERITY DRGS (SDRGS)
ALL PATIENT REFINED DRGS (APR-DRGS)
COMPARISON OF THE STRUCTURE OF THE DRG SYSTEMS
INTERNATIONAL REFINED-DRGS (IR-DRGS)

5
5
8
8
10
10
13
14

III. INSTITUTIONS

17

1.
2.
3.
4.

17
18
19
19

DEPARTMENT OF HEALTH AND HUMAN SERVICES

HEALTH CARE FINANCING ADMINISTRATION
M EDICARE PAYMENT ADVISORY COMMISSION
THE UNITED STATES GENERAL ACCOUNTING OFFICE

IV. HCFA FINANCIAL REPORT

20

1.
2.
3.
4.
5.
6.
7.

20
21
23
24
26
27
28

INTRODUCTION
M EDICARE
HCFAS COMBINED STATEMENTS OF FINANCIAL POSIT IONS
COMBINED STATEMENTS OF OPERATIONS
EXPENSES BY OBJECT CLASS
ADMINISTRATIVE EXPENSES
REPORT OF INDEPENDENT AUDITORS ON INTERNAL CONTROL

V. ESTIMATED ANNUAL DRG MAINTENANCE EXPENSES IN THE US

30

1.
2.
3.
4.
5.

30
30
31
31
31

HEALTH CARE FINANCING ADMINISTRATION

3M HIS
M EDICARE PAYMENT ADVISORY COMMISSION
THE UNITED STATES GENERAL ACCOUNTING OFFICE
SUMMARY

VII . REFERENCES

32

I. Introduction
The Diagnosis Related Groups (DRGs) are a patient classification scheme that was originally
developed as a means of relating the type of patients a hospital treats (i.e., its casemix) to the
costs incurred by hospitals. The design and the development of the DRGs began in the late
sixties at Yale University (Fetter, et al, 1980). In 1983, US Congress enacted a DRG based
prospective payment system (PPS) for all Medicare patients. After the enactment of the
Medicare PPS, a number of states and large payors implemented DRG based hospital PPS for
non-Medicare patients. In addition, DRGs have been used as the basis of global budget
allocation and payment in several countries in Europe as well as Australia. (Averill, et al, 1998).
The original purpose of DRGs was to relate the casemix of a hospital to the resource demands
and associated costs experienced by the hospital. DRGs focused exclusively on resource
intensity. With the changes in the US health care system, there has been increased demand
for a patient classification system for applications beyond resource use, cost and payment:

Compare facilities across a wide range of resource and outcome measures

Evaluate differences in inpatient mortality rates

Implement and support critical pathways

Facilitate continuous quality improvement projects

Support internal management and planning systems

Manage capitated payment arrangements. (Averill, et al, 1998)

With the implementation of the Medicare prospective payment system in October 1983, the
responsibility for the maintenance and modification of the DRG definitions became the
responsibility of the Health Care Financing Administration (HCFA).

HCFA updates the

Medicare DRGs on an annual basis. HCFA is one of the operating divisions of the Department
of Health and Human Services (DHHS), the United States government's principal agency for
protecting the health of all Americans and providing essential human services.

This project is about estimated annual DRG maintenance expenses in the US.

Project

methodologies included research of papers, analysis of financial statements, and interviews

with key stakeholders.

Chapter II describes and compares different DRG systems that have been developed in the
US including Medicare DRGs, Refined DRGs, All Patient DRGs, Severity DRGs, All Patient
Refined DRGs, and International Refined DRGs. Chapter III portrays the Department of Health
and Human Services, the Health Care Financing Administration, the Medicare Payment
Advisory Commission, and the United States General Accounting Office. In chapter IV HCFAs
financial statements are analyzed. Chapter V discusses estimated annual DRG maintenance
expenses in the US and provides a conclusion.

II.

Different DRG Systems

DRG technology has experienced an evolutionary development process.

The later

generations of DRG systems have incorporated the improvements made by earlier

generations. DRG systems that have been developed in the US include:

Medicare DRGs

Refined DRGs (RDRGs)

All Patient DRGs (AP-DRGs)

Severity DRGs (SDRGs)

All Patient Refined DRGs (APR-DRGs)

International-Refined DRGs (IR-DRGs)

Each of these DRG systems were created to address specific limitations in the original DRGs.
1. Medicare DRGs
The initial DRG definitions developed at Yale intended to describe all types of patients seen in
an acute care hospital. The DRGs encompassed both the elderly patient populations as well
as the newborn, pediatric and adult populations. However, with the implementation of the
Medicare prospective payment system in October 1983, the responsibility for the
maintenance and modification of the DRG definitions became the responsibility of the
Health Care Financing Administration. HCFA updates the Medicare DRGs on an annual
basis.

The focus of all DRG modifications instituted by HCFA after 1983 has been on

problems relating primarily to the elderly population. (Averill, et al, 1998)

Section 1886 (d) of the Social Security Act (the Act) sets forth a system of payment for the
operating costs of acute care hospital inpatient stays under Medicare Part A (Hospital
Insurance) based on prospective set rates. Section 1886 (g) of the Act requires the Secretary
to pay for the capital-related costs of hospital inpatient stays under a prospective payment
system. Under these prospective payment systems, Medicare payment for hospital inpatient
operating and capital-related costs is made at predetermined, specific rates for each hospital

discharge. Discharges are classified according to a list of diagnosis-related groups. (Federal

Register, 1999)
Certain specialty hospitals are excluded from the prospective payment systems. Under section
1886(d)(1)(B) of the Act, the following hospitals and hospital units are excluded from the
prospective payment systems: psychiatric hospitals or units, rehabilitation hospitals or units,
childrens hospitals, long-term care hospitals, and cancer hospitals. For these hospitals and
units, Medicare payment for operating costs is based on reasonable costs subject to a hospitalspecific annual limit. (Federal Register, 1999)
HCFA administers the PPS and issues all rules and changes concerning DRGs. Changes to
the hospital inpatient prospective payment systems and fiscal year 2000 rates included
revisions for operating costs and capital related costs to implement changes arising from
HCFAs continuing experience with the systems, changes in the amounts and factors
necessary to determine rates for Medicare hospital inpatient services for operating costs and
capital-related costs, rate-of-increase limits as well as policy changes for hospital and hospital
units excluded from the prospective payment systems. (Federal Register, 1999)
DRGs classify patients into clinically cohesive groups that demonstrate similar consumption of
hospital resources and length-of-stay-patterns. Besides reimbursement, DRGs have two major
functions. The first is to evaluate the quality of care. Since all cases in a DRG are clinically
similar, analysis of treatment protocols, related conditions or demographic distribution can be
done. Critical pathways are designed around DRGs. Benchmarking and outcome analysis
can be launched using the DRG clinical framework. Quality reviews can be performed to
access coding practices and physician documentation. Ongoing education of physicians,
coders, nurses and utilization review personnel can be guided to the results of DRG analysis.
(Schultz, 1998):
Secondly, DRGs assist in evaluating the utilization of services. Each DRG represents the
average resources needed to treat patients grouped to that DRG relative to the national
average of resources used to treat all Medicare patients. The DRG assigned to each hospital
inpatient stay relates to the hospital casemix (i.e. the types of patient the hospital treats). The
casemix index is determined by averaging the DRG relative weights for all hospital inpatients.
Medicare computes the casemix adjustment for each fiscal year based upon the casemix data
received. The casemix index is then used to adjust the hospital base rate, which is a factor in

computing the total hospital payment under the prospective payment system. The formula for
computing the hospital payment for each DRG is as follows:
DRG Relative Weight x Hospital Base Rate = Hospital Payment
The hospital casemix complexity includes the following patient attributes:

Severity of illness

Prognosis

Treatment difficulty

Need for intervention

Resource intensity

However, the purpose of the DRG is to relate casemix to resource utilization only.
Reimbursement is adjusted to reflect the resource utilization and does not take into
consideration severity of illness, prognosis, treatment difficulty or need for intervention.
(Schultz, 1998)
DRGs are assigned using the principal diagnosis, up to eight additional diagnoses, the principal
procedure and up to five additional procedure codes, and age, sex and discharge status. One
DRG is assigned for each inpatient stay.
DRG assignment is based upon the following considerations:

Principal and secondary diagnosis and procedure codes

Sex

Age

Discharge status

Presence or absence of complications and comorbidities (CCs)

Birth weight for neonates.

HCFA has developed a standard list of diagnoses that are recognized as complications and
comorbidities for the DRGs. When these CCs are present as secondary diagnoses, they
would be considered as a complication or comorbidity that may impact DRG assignment.
(Schultz, 1998)
2. Refined DRGs (RDRGs)
During the mid 1980s the Health Care Financing Administration funded a project at Yale
University to revise the use of complications and comorbidities in the Medicare DRGs
(Freeman, et al, 1995). In the Medicare DRGs a secondary diagnosis is considered a CC if it
causes a significant increase in the hospital resource use. For certain types of patients, a
different Medicare DRG is assigned depending on whether or not a CC is present. The Yale
project mapped all secondary diagnoses that were considered a CC in the Medicare DRGs into
136 secondary diagnosis groups each of that was assigned a CC complexity level. For
surgical patients each secondary diagnosis group was assigned to one of four CC complexity
levels, (non CC, moderate CC, major CC, and catastrophic CC). For medical patients each
secondary diagnosis group was assigned to one of three CC complexity levels (non-CC,
moderate or major CC and catastrophic CC). All age splits and CC splits in the Medicare
DRGs were eliminated and replaced by the four subgroups for surgical patients, or the three
subgroups for medical patients. The DRG system developed by the Yale project is referred to
as Refined DRGs or RDRGs.
3. All Patient DRGs (AP-DRGs)
In 1987, the state of New York passed legislation instituting DRG-based prospective payment
system for all non-Medicare patients. The legislation included a requirement that the New York
State Department of Health (NYDH) evaluate the applicability of the Medicare DRGs to a nonMedicare population. The legislation required that the DRGs be evaluated with respect to
neonates and patients with Human Immunodeficiency Virus (HIV) infections. The evaluation
concluded that the Medicare DRGs were not adequate for a non-Medicare population. NYDH
entered into an agreement with 3M Health Information Systems (3M HIS) to research and
develop all necessary DRG modifications. The DRG definitions developed by NYDH and 3M
HIS are referred to as the All Patient DRGs or AP-DRGs.
During the mid 1980's extensive research had been performed independently by the National
Association of Children's Hospitals and Related Institutions (NACHRI) on alternative
approaches to improve the DRG categories for neonates and other pediatric patients. The

system developed by NACHRI was called the Pediatric Modified Diagnosis Related Groups or
PM-DRGs.

The PM-DRGs created many additional DRGs specifically for neonatal and

pediatric patients. As part of the New York DRG evaluation effort, NYDH and 3M HIS
examined the NACHRI neonatal definitions and adopted a modified version of them.
In addition to the changes for the neonatal AP-DRGs, MDC 24 was created for HIV infection
patients. Assignment to MDC 24, it is based on a principal diagnosis of an HIV infection, or a
principal diagnosis of an HIV related complication combined with a secondary diagnosis of an
HIV infection.
Subsequent updates have made additional enhancements to the AP-DRGs. For example, as
demonstrated by the RDRGs some CCs have a greater impact on hospital resource use than
others. The AP-DRGs designate a subset of the CCs as major CCs. These major CCs are
similar to the catastrophic CCs in the RDRGs. In order to avoid significantly increasing the
number of DRGs, major CC AP-DRGs for surgical patients within an MDC and major CC APDRGs for medical patients within an MDC were formed for some MDCs. In total, 60 major CC
AP-DRGs were created. As part of the development of the major CC AP-DRGs, a limited
reevaluation of the CC list was performed.
The AP-DRGs introduced many additional changes to the Medicare DRGs. Some of these
primarily affect pediatric patients while others affect patients of all ages.

The pediatric

modifications include some of the recommendations originally developed by NACHRI as well

as other significant modifications. MDC 25 was added for patients with multiple traumas. In
addition, significant modifications have been made for transplants, long term mechanical
ventilation patients, cystic fibrosis, nutritional disorders, high-risk obstetric care, acute leukemia,
hemophilia, and sickle cell anemia.
Some of the DRG modifications, originally developed in the AP-DRGs, have subsequently
been adopted in the Medicare DRGs. For example, in Version 8.0 of the Medicare DRGs, an
HIV infection MDC was added. However, the Medicare HIV infection MDC consists of three
DRGs and does not discriminate among HIV infection patients at the level of detail contained in
the AP-DRGs.
The AP-DRGs have been updated in January of every year since 1988. (Averill, et al, 1998)

10

4. Severity DRGs (SDRGs)

In 1993, HCFA initiated a re-evaluation of the use of complications and comorbidities within the
Medicare DRGs (Federal Register, 1994). The DRG system developed is referred to as the
severity DRGs of SDRGs (sometimes also referred to as Severity Refined DRGs) or SRDRGs. The re-evaluation excluded the DRGs associated with pregnancy, newborns and
pediatric patients. The major CC list from the AP-DRGs was used to identify an initial list of
major CCs. Using Medicare data the categorization of each secondary diagnoses as a nonCC , non-major CC or a major CC was re-evaluated. The end result was that 111 diagnoses
that were non-CCs in the Medicare DRGs were made a CC, 220 diagnoses that were a CC
were made a non-CC and 395 CCs were considered a major CC. This evaluation differed
from the RDRGs in that both non-CCs and CCs were evaluated and the evaluation was
performed independently for each individual diagnosis as opposed to aggregate secondary
diagnosis groups.
All CC splits in the Medicare DRGs were eliminated plus an additional 24 Medicare DRGs
were merged together. The resulting base DRGs were then subdivided into three, two or no
subgroups based on an analysis of Medicare data.

The result was 84 DRGs with no

subgroups, 124 with two subgroups and 85 with three subgroups. This plus the 63 DRGs not
evaluated resulted in a total of 652 SDRGs.
In SDRGs, a patient is assigned to a subgroup corresponding to the highest level secondary
diagnosis. Like RDRGs, multiple secondary diagnoses at a one level do not cause a patient to
be assigned to a higher subgroup. The categorization of a diagnosis as non-CC, non major
CC or major CC is uniform across the SDRGs and there are no modifications for specific
SDRGs. HCFA published the SDRGs in 1994, but did not establish an implementation date.
They have not been updated by HCFA since the original 1994 release. (Averill, et al, 1998)
5. All Patient Refined DRGs (APR-DRGs)
The All Patient Refined DRGs (APR-DRGs) further refine the basic AP-DRG structure by
adding four subgroups. In contrast to the SDRGs and RDRGs, the initial version of the APRDRGS used the AP-DRGs as the base DRGs instead of the Medicare DRGs. The only
exception was the neonatal MDC for which an entirely new set of base DRGs was developed.
In subsequent updates of the APR-DRGs, the base AP-DRGs have been substantially
modified. All age, CC and major CC distinctions in the AP-DRGs were eliminated and replaced
by two sets of four subgroups. One set of subgroups addresses patient differences relating to

11

severity of illness and the second set addresses the risk of mortality. Severity of illness is
defined as the extent of organ system loss of function or physiologic de-compensation, while
risk of mortality is the likelihood of dying. Since severity of illness and risk of mortality are
distinct patient attributes, separate subgroups are assigned to a patient for severity of illness
and risk of mortality. Thus, in the APR-DRG system a patient is assigned three distinct
descriptors:

The base APR-DRG

The severity of illness subgroup

The risk of mortality subgroup

The four severity-of-illness subgroups and the four risk-of-mortality subgroups represent minor,
moderate, major or extreme severity of illness or risk of mortality. The assignment of a patient
to one of these four subgroups takes into consideration not only the specific secondary
diagnoses but also the interaction between secondary diagnoses, age, principal diagnoses,
and the presence of certain non-OR procedures. The assignment of a patient to a subgroup
for each APR-DRG is performed separately for severity of illness and risk of mortality.
The creation of the four levels created the opportunity for a complete revaluation of the
diagnoses categorized as a complication or comorbidity.

With the expansion to four

subclasses, many non-CC diagnoses could be assigned to at least a level of moderate

whereas previously there was not sufficient justification to include them with the heterogeneous
set of diagnoses previously categorized as a CC. Because of this re-evaluation, there were
1693 diagnoses that are considered a non-CC in the AP-DRGs and Medicare DRGs that were
assigned to the moderate, major, or extreme level in the APR-DRGs.

Conversely, 418

secondary diagnoses that are considered a CC were moved to the non-CC (minor) level in the
APR-DRGs.
In the AP-DRGs, the assessment of the severity of illness or risk of mortality of a patient is
specific to the APR-DRG to which a patient is assigned. The determination of the severity of
illness and risk of mortality is disease specific. The significance attributed to a secondary
diagnosis is dependent on the underlying problem. In APR-DRGs the severity or risk of
mortality level of a secondary diagnosis is assigned separately for each base APR-DRG.

12

The most important component of determining the final patient subgroup is the recognition of
the impact of interactions among secondary diagnoses. In APR-DRGs, high severity of illness
and risk of mortality are pri marily determined by the interactions of multiple diseases. Patients
with multiple diseases involving multiple organ systems constitute the patients with a more
extensive disease process who are difficult to treat and who have poor outcomes. In APRDRGs specific combinations of secondary diagnoses interact causing the severity of risk of
mortality subgroup to be increased.
The combination of the base APR-DRG and the final patient severity of illness and risk of
mortality subgroup constitute the complete APR-DRG description of the patient.

For

applications such as evaluating resource-use or establishing patient care guidelines, the APRDRGs in conjunction with the severity of illness subgroup is used. For evaluating patient
mortality, the APR-DRG in conjunction with the risk of mortality subgroup is used.
The subdivision of the 382 base APR-DRGs into the four severity subgroups, combined with
the two error APR-DRGs (i.e., 469, 470), results in 1530 APR-DRGS. The APR-DRGs were a
joint development of 3M HIS and NACHRI.

The APR-DRGs encompass all the DRG

modification developed for the original PM-DRGs plus subsequent NACHRI research. APRDRGs are updated every two years. (Averill, et al, 1998)

13

6. Comparison of the Structure of the DRG Systems

Medicare

SDRGs

DRGs

RDRGs

AP-DRGs

APR-DRGs

version 10.0 version 12.0 version 12.0

version 12.0
Number of base DRG 338

316

367

NA

384

652

1170

641

1350

Multiple Trauma MDC limited

limited

limited

complete

complete

HIV infection MDC

limited

limited

complete

complete

no

limited

complete

complete

no

no

limited

complete

yes

yes

yes

yes

yes

yes

yes

no

no

yes

newborn

no

categories
Number of DRGs

492

limited

Newborn birth-weight no
used
NACHRI

pediatric no

changes
Major (extreme) CCs
Death

used

no
in yes

definition
LOS used in definiti on no

only
CC list reevaluated

no

substantial

no

limited

complete

Multiple CCs

no

no

no

no

yes

3 med., 4 3

recognized
Number of CC
subgroups

surg.

CC subgroup structure variable

variable

relatively

variable

uniform

uniform
Risk of mortality

no

no

no

no

yes

Medicare

Medicare

Medicare

AP-DRGs

subgroup
Base DRGs used

except
neonates
Table: Comparison of the Structure of the DRG Systems (Averill, et al, 1998)

14

7. International Refined-DRGs (IR-DRGs)

The clinical researchers at 3M Health Information Systems recognized that countries have the
following conflicting needs:

A DRG system that is unique to the country

The ability to compare one country to another

Conformity to multiple coding systems

In response, a new classification system was developed.

Building on twenty years of

experience in developing classification systems, 3M has designed the new IR-DRGs to provide
the same results in classifying patients regardless of the coding system in use. The new
system allows a particular country to localize IR-DRGs using its own diagnosis and procedure
codes. Furthermore, the IR-DRGs use the concept of severity adjustment (refinement) to
better describe the relative resource demand based on individual patient characteristics.
(Mullin, et al, 2000)
A statistically valid and clinically coherent system must be employed in order to aggregate
patient treatment episodes that are similar in their resource consumption and to explain
variations in resource use. Classification systems developed for the United States, including
the HCFA-DRGs, can be difficult to adapt where the coding systems vary from ICD-9-CM.
Limits on their capacities to fully meet the needs of other countries have recently emerged.
Because of a variety of countries have adapted existing coding and classification systems to
meet their specific requirements, numerous coding and classification systems are used
worldwide.

Many countries have adopted or modified World Health Organizations

International Classification of Diseases 10 th revision (WHO ICD-10) for diagnosis coding in an

effort to meet their own specific needs. Some countries have also developed or modified
existing procedure coding systems for use in their countries to more accurately describe their
medical practices.
Ideally, a classification system specifically designed for use with these various coding systems
would solve these problems. As countries continue to shift from ICD-9 to ICD-10, the ideal
classification system would also group a patient into the same DRG category regardless of the
coding system used. This would make the process of change much easier for hospital
managers.

15

IR-DRGs build upon key design advancements of both the AP-DRGs and APR-DRGs. The
IR-DRGs are designed not only for use as part of a funding system, but also for outcomes
analysis. This would include managing all the data needed for direct and indirect patient care
to compare resource usage across facilities and regions and support local and national health
system management. The system incorporates the concept of refinement through the use of
multiple levels of CCs applied to all individual severity-of-illness subgroups. (Mullin, et al, 2000)
The IR-DRGs consist of 330 base DRGs, each of which will contain three subclass severity
levels, plus two error IR-DRGs for a total of 992 DRGs. Several base categories that were
eliminated from the United States versions of DRGs (because these procedures were being
conducted in ambulatory care facilities rather than acute care hospitals), were returned to the
IR-DRGs. For example, Carpal Tunnel Release, not included in the current U.S. based
systems, was incorporated into IR-DRGs because this procedure is so frequently documented
as an inpatient procedure in international electronic patient records.
A major advantage of the IR-DRG system is the ability to update the classification within the IRDRGs. In addition, an International Advisory Panel will discuss periodic updates of the IR-DRG
grouper, making recommendations and overseeing implementation of updates.
International standards for statistical reporting of computer-based patient data, represented in a
coded form, have many useful applications, including:

Decision-making for direct patient care

Statistical reporting

Funding calculations

Automated decision support

Profiling

Benchmarking

Clinical research

Standards must be developed to support all of these functions. While past systems were
insufficient for application without customized coding schemes to suit some countries and
system operators particular needs, the comprehensive IR-DRG system should be put forward

16

as a possible standard. Further research on the remaining impediments to acceptance of

standards and the efforts to overcome them should be undertaken. (Mullin, et al, 2000)

17

III.

Institutions

To estimate annual DRG maintenance expenses in the US, interviews were performed with
representatives of selected institutions. The following paragraphs provide a brief summary of
these institutions i.e. the Department of Health and Human Services, its operating arm, the
Health Care Financing Administration, the Medicare Payment Advisory Commission, and the
United States General Accounting Office.
1. Department of Health and Human Services
The Department of Health and Human Services is the United States government's principal
agency for protecting the health of all Americans and providing essential human services,
especially for those who are least able to help themselves. DHHS budget for the fiscal year
2000 is US $395 billion; the Department has 61,654 employees.
The Department includes more than 300 programs, covering a wide spectrum of activities.
Some highlights include:

Medical and social science research

Preventing outbreak of infectious disease, including immunization services

Assuring food and drug safety

Medicare (health insurance for elderly and disabled Americans) and Medicaid (health
insurance for low-income people)

Financial assistance for low-income families

DHHS is the largest grant-making agency in the federal government, providing some 60,000
grants per year. DHHS' Medicare program is the nation's largest health insurer, handling more
than 900 million claims per year.
The Department's programs are administered by eleven Health and Human Services operating
divisions:

18

Health Care Financing Administration (Employees: 4,363, FY 2000 Budget: US $325.4

billion)

National Institutes of Health (Employees: 16,673, FY 2000 Budget: US $17.8 billion)

Food and Drug Administration (Employees: 9,009, FY 2000 Budget: US $1.1 billion)

Centers for Disease Control and Prevention (Employees: 7,511, FY 2000 Budget: US $3.0
billion)

Agency for Toxic Substances and Disease Registry (Employees: 412, FY 2000 Budget: US
$70 million)

Indian Health Service (Employees: 14,673, FY 2000 Budget: US $2.4 billion)

Health Resources and Services Administration (Employees: 2,152, FY 2000 Budget: US

$4.8 billion)

Substance Abuse and Mental Health Services Administration (Employees: 686, FY 2000
Budget: US $2.7 billion)

Agency for Healthcare Research and Quality (Employees: 285, FY 2000 Budget: US $205
million)

Administration for Children and Families (Employees: 1,500, FY 2000 Budget: US $36.1
billion)

Administration on Aging (Employees: 147, FY 2000 Budget: US $933 million)

(www.hhs.gov)

2. Health Care Financing Administration

The Health Care Financing Administration, an operating division of the DHHS provides health
insurance for over 74 million Americans through Medicare, Medicaid and the State Childrens
Health Insurance Program (SCHIP). Medicare, the nation's largest health insurance program,
covers approximately 39 million Americans. Medicare provides health insurance to people age
65 and over and those who have permanent kidney failure and certain people with disabilities.
Medicaid is a jointly funded, Federal-State health insurance program for certain low-income
and needy people. It covers approximately 36 million individuals including children, the aged,

19

blind, and/or disabled, and people who are eligible to receive federally assisted income
maintenance payments. (www.hcfa.gov)
3. Medicare Payment Advisory Commission
The Medicare Payment Advisory Commission (MedPAC) is an independent federal body that
advises the U.S. Congress on issues affecting the Medicare program. It was established by
the Balanced Budget Act of 1997 (P.L. 105-33), which merged the Prospective Payment
Assessment Commission (ProPAC) and the Physician Payment Review Commission (PPRC).
The Commission has 17 members who bring a wide range of expertise in the financing and
delivery of health care services. The Commission is supported by a full-time Executive Director
and a staff of about 30 analysts. Analysts typically have backgrounds in economics, health
policy, public health, or medicine.
The primary outlet for the Commissions recommendations are two reports, required by statute
to be issued on March and June of each year. In addition to these reports, MedPAC advises
the Congress through other avenues, including comments on reports to the Congress by the
Secretary of the Department of Health and Human Services, testimony, formal comments on
proposed regulations, briefings for Congressional staff and (forthcoming) a series of short issue
briefs. (www.medpac.gov)
4. The United States General Accounting Office
The General Accounting Office (GAO) is the investigative arm of Congress. GAO exists to
support the Congress in meeting its Constitutional responsibilities and to help improve the
performance and accountability of the federal government for the American people. GAO
examines the use of public funds, evaluates federal programs and activities, and provides
analyses, options, recommendations, and other assistance to help the Congress make
effective oversight, policy, and funding decisions. In this context, GAO works to continuously
improve the economy, efficiency, and effectiveness of the federal government through financial
audits, program reviews and evaluations, analyses, legal opinions, investigations, and other
services. GAO's activities are designed to ensure the executive branch's accountability to the
Congress under the Constitution and the government's accountability to the American people.
GAO is dedicated to good government through its commitment to the values of accountability,
integrity, and reliability. (www.gao.gov)

20

IV.

HCFA Financial Report

HCFAs financials were analyzed to provide an estimate for annual DRG maintenance
expenses. HCFAs 1997 Financial Report was analyzed since more current financials were
not electronically available at the time this project was written.
1. Introduction
HCFA is the largest purchaser of health care in the world. Medicare and Medicaid outlays 1,
including State funding, represent 33.9 cents of every dollar spent on health care in the United
States -- 59.2 cents of every dollar spent on nursing homes, 47.7 cents of every dollar received
by U.S. hospitals, and 28.5 cents of every dollar spent on physician services. (U.S. Department
of Health and Human Services, 1997)

In addition to establishing rules for eligibility and benefit payments, paying 853 million Medicare
benefits claims, and providing States with matching funds for Medicaid benefits, HCFA carries
out many other important activities i.e. safeguarding the fiscal integrity of the Medicare and
Medicaid programs, assuring the safety of medical facilities, and maintaining the Nations
largest collection of health care data. (U.S. Department of Health and Human Services, 1997)

Outlays are used in the discussions of HCFAs financial activity only when comparable expense data are not available. They refer to the
issuance of checks, disbursement of cash, or electronic transfers of funds made to liquidate an axpense regardless of the fiscal year the service
was provided or the expense was incurred.

21

2. Medicare
Title XVIII of the Social Security Act was established by the Social Security Amendments of
1965. Legislated as a complement to Social Security retirement, survivors, and disability
benefits, Medicare originally covered people aged 65 and over. In 1972, the program was
broadened to cover the disabled, people with end-stage renal disease, and certain others who
elect to purchase Medicare coverage.

Since 1967, Medicare enrollment has increased from 19.5 million to 38.6 million beneficiaries,
a 98 percent increase. The percentage of beneficiaries aged 85 and over has grown from 6.2
percent in 1966 to 11.6 percent in 1995.
Medicare is a combination of two programs, each with its own enrollment, coverage, and
financing--Hospital Insurance and Supplementary Medical Insurance. The Balanced Budget
Act of 1997 (BBA) created a third program called Medicare+Choice that restructures the
Medicare managed care program and, through user fees, provides funding for better consumer
information.
In the Hospital Insurance (HI) Trust Fund, Medicare contractors are paid by HCFA to
process Medicare claims for hospital inpatient services, hospice, and certain skilled nursing
and home health services. Benefit payments made by the Medicare contractors for these
services, as well as administrative costs, are charged to the HI Trust Fund. The financial
statements include HI Trust Fund activities administered by the Department of the Treasury
(Treasury).
In the Supplementary Medical Insurance (SMI) Trust Fund, Medicare contractors are paid by
HCFA to process Medicare claims for physicians, medical suppliers, hospital outpatient

22

services and rehabilitation, end stage renal disease (ESRD), rural health clinics, and certain
skilled nursing and home health services. Benefit payments made by the Medicare contractors
for these services, as well as administrative costs, are charged to the SMI Trust Fund. The
financial statements include SMI Trust Fund activities administered by Treasury.
Department of Health and Human Services, 1997)

(U.S.

23

3. HCFAs combined statements of financial positions

Source: U.S. Department of Health and Human Services, 1997

24

4. Combined Statements of Operations

25

Source: U.S. Department of Health and Human Services, 1997

In 1997, HCFA's expenses total US $309 billion. Administrative expenses of US $3 billion are
less than one percent of the total. HCFA has approximately 4,000 Federal employees, but
carries out many important operational activities through third parties: (1) 22,000 employees at
65 Medicare contractors have primary responsibility for processing Medicare claims, providing
technical assistance to providers and servicing beneficiaries needs, including responding to
inquiries; (2) 34,000 State employees have primary responsibility for administering Medicaid;
(3) 6,000 State employees have primary responsibility for inspecting hospitals, nursing homes,
and other facilities to ensure that health and safety standards are met; and (4) 1,600
employees at 53 Peer Review Organizations conduct a wide variety of quality improvement
programs to ensure quality of care provided to Medicare beneficiaries. The Social Security
Administration (SSA), the Railroad Board, and other Federal agencies also provide thousands
of other staff, either full or part time, who support Medicare and/or Medicaid operations.
Of HCFA's approximately 4,000 Federal employees, about 1,380 work in 10 regional offices
around the country providing direct services to Medicare contractors, State agencies,
providers, beneficiaries, and the general public. Approximately 2,620 of HCFA's employees
work in Baltimore and Washington, D.C., providing funds to Medicare contractors; writing
policies and regulations; developing more efficient operating systems; setting payment rates;

26

managing programs to fight fraud, waste, and abuse; monitoring contractor performance;
developing and implementing customer service improvements; and assisting States and
Territories with Medicaid and other issues. (U.S. Department of Health and Human Services,
1997)
5. Expenses by Object Class

Source: U.S. Department of Health and Human Services, 1997

27

6. Administrative Expenses
Note 14: Administrative Expenses (Dollars in Millions)

Source: U.S. Department of Health and Human Services, 1997

For purposes of financial statement presentation, administrative costs are considered
expenses to the Medicare trust funds when outlayed by Treasury although some funds may
have been used to pay for assets such as property and equipment. In this regard, SSA
reported US $49.5 million of Property and Equipment, (Net) attributable to the Medicare
program as of September 30, 1997. This amount is not included in HCFA's Combined
Statement of Financial Position as assets related to the Medicare program. However, funds
withdrawn from the trust funds by SSA during FY 1997 to pay for this activity are included in
this section as an administrative expense to the Medicare program. The SSA administrative
costs are reported to HCFA by Treasury. These expenses are also reported by SSA on their
FY 1997 Annual Financial Statement. . (U.S. Department of Health and Human Services,
1997)

28

HCFA's administrative costs have been allocated to the Medicare and Medicaid
programs based on the HCFA cost allocation system. Administrative costs allocated to the
Medicare program include US $1.2 billion paid to Medicare contractors to carry out their
responsibilities as HCFA's agents in the administration of the Medicare program.

HCFA's administrative costs are less than one percent of total expenditures. In the past, HCFA
has been placed in a difficult position because the agency's resources have been straight-lined
(in constant dollars) while the scope and magnitude of the programs it administers increased.
This was caused by the budget scoring rules which totally separated mandatory and
discretionary spending, with Medicare and Medicaid benefit dollars being on the mandatory
side, while the money used to administer these programs was on the discretionary side. Thus,
while the benefit payments were growing, the dollars available to administer them were not.
Actions to remedy this situation have resulted in a variety of funding mechanisms. Most of
HCFA's claims payment and management oversight operations are funded through an annual
appropriation; certain quality control functions, primarily the Peer Review Organizations and the
Medicare Integrity Programs, are funded through direct trust fund draws; and numerous other
activities are funded through a variety of user fees. In 1997, administrative expenses were US
$2,899 million.
User fees are currently collected to fund the activities related to the survey and certification of
laboratories under Clinical Laboratory Improvement Amendments (CLIA), sales of data from
HCFA's numerous data bases, and sales of Freedom of Information Act (FOIA) material.
Unless set by statute, these fees are set to cover the costs of doing business and are
reassessed at least every two years. Income received from user fees in 1997 ranged from
slightly under US $200,000 for FOIA to more than US $30 million for CLIA. Beginning in 1998,
comparative information developed to enhance beneficiary choices will be disseminated under
the Managed Care plus Choice provision. This will be funded from a legislatively mandated
user fee collected monthly from each managed care organization. (U.S. Department of Health
and Human Services, 1997)
7. Report of Independent Auditors on Internal Control
The report of Independent Auditors on Internal Control at HCFA includes information related to
the financial management systems that were found not to comply with the requirements
(Brown, 1997):

29

The HCFA does not have an integrated accounting system to capture expenditures at the
Medicare contractor level.

The HCFAs process for preparing annual financial statements is manually intensive,
involving a series of spreadsheets that incorporate general ledger data as well as Treasury
information, contractor information, and adjustments determined by HCFA.

30

V.

Estimated Annual DRG Maintenance Expenses in the US

This project is about annual DRG maintenance expenses in the US. With the implementation
of the Medicare prospective payment system in October 1983, the responsibility for the
maintenance and modification of the DRG definitions became responsibility of the Health Care
Financing Administration. DRGs are being used to reimburse for operating costs of acute care
hospital inpatient stays under Medicare Part A (Hospital Insurance). 3M HIS updates the DRG
system on an annual basis on behalf of HCFA. Annual maintenance expenses not only exist
for HCFA but also for hospitals and health plans. This report focuses only on the HCFA side
since hospital and health plan expenses were not captured in the past and therefore, cannot be
estimated.
In 1997, total Medicare Trust Fund Administrative Expenses were US$ 2.8 billion. HCFAs
administrati ve costs are less than one percent of total expenditures of US $308 billion. Total
hospital insurance administrative expenses were US $1.3 billion in 1997.
Due to a lack of available data on annual DRG maintenance expenses, interviews with
representatives of HCFA, 3M HIS, MedPac, and GAO were conducted on the requested
subject.
1. Health Care Financing Administration
A representative of HCFA stated we dont have that level of detail. HCFA would not be able
to break out financials to a level that was necessary to report annual DRG maintenance
expenses. HCFAs activity-based costing would not allow that level of detail. It was pointed
out that annual expenses to maintain the DRG system could account for a small fraction
(approximately 10-20%) of the total hospital insurance administrative expenses of US $1.3
billion. Based on that conversation, estimated annual DRG maintenance expenses could be
anywhere between US $130 and 260 million.
2. 3M HIS
A representative of 3M HIS indicated that approximately 12 persons from 3M HIS are
constantly working on the maintenance of the DRG system on behalf of HCFA. Maintenance
includes an ongoing process to capture comments from hospitals, to ensure clinical
appropriateness, and statistical appropriateness. Also, underlying coding systems (ICD-9-CM

31

in the US) and policy changes needed to be considered when discussing DRG maintenance
expenses. The representative was not familiar with the contractual specifics between HCFA
and 3M HIS regarding HCFAs expenses for services provided by 3M.
Overall, it was estimated that annual DRG maintenance expenses could be up to US $1.3
billion. This estimate might be overstated but would include everything that goes into DRGs
i.e. coding systems, DRG maintenance provided by 3M, policy changes, etc.
3. Medicare Payment Advisory Commission
A representative from MedPac pointed out that reimbursement under Medicare Part A not only
included hospitals compensated with DRGs but also hospitals that were excluded from a PPS,
skilled nursing facilities (SNF), and home health. Reimbursement with DRGs could account for
65% of Medicare Part A.
Therefore, annual DRG maintenance expenses could be up to 65% of the total hospital
insurance administrative expenses of US $ 1.3 billion. The amount could be US $ 845 million.
4. The United States General Accounting Office
A representative from GAO indicated that she would not be aware of any studies that had been
done on annual DRG maintenance expenses in the US. She believed that those expenses
could be up to US $ 1.3 billion.
5. Summary
Interviews with representatives of HCFA, 3M HIS, MedPac, and GAO were conducted on
annual estimated DRG maintenance expenses in the US. Based on these interviews, these
expenses could be in a range of US $130 million and 1.3 billion.

32

VII

. References

Averill, R, Muldoon, J, Vertrees, J, Goldfield, N, Mullin, R, Fineran, E, Zhang, M, Steinbeck, B,

Grant, T, "The Evolution of Casemix Measurement Using Diagnosis Related Groups (DRGs),
HIS Research Report, 5-98, 1998, pp. 1 -40.
Brown, J, Inspector Generals Report on the HCFA Financial Statements for FY 1997, pp. 3436
Federal Register, Vol. 16, No. 106, June 2, 1995, Pg. 29209
Federal Register, Vol. 64, No. 146, July 30, 1999, pp. 41490-41491
Fetter, R, Shin, Y, Freeman,J, Averill, R, Thompson, J, "Case Mix Definition by DiagnosisRelated Groups", Medical Care,, Vol. 18, No.2, pp. 1-53.
Freeman, J, Fetter, R, Hayong, P, Schneider, K, Lichenstein, Hughes, J, Bauman, W, Duncan,
C, Freeman, D, Palmer, G, "Diagnosis Related Group Refinement with Diagnosis- and
Procedure-Specific Comorbidities and Complications", Medical Care, Vol. 33, No. 8, pp. 806827.
Mullin, R, Vertrees, J, Freedman, R, Castoni, R, Mann, K, Case-Mix Analysis Across Patient
Populations and Boundaries: A Refined Classifi cation System Designed Specifically for
International Use, Working Paper 15/09/00, 3M Health Information Systems, 2000, pp. 1 -8
Schultz, D, 1999 St. Anthonys DRG Guidebook, 1999, pp. intro-3 intro-8
U.S. Department of Health and Human Services, Health Care Financing Administration,
Financial Report Fiscal Year 1997, pp. 1-127

Internet Sources:
www.dhhs.gov: U.S. Department of Health and Human Services
www.gao.gov: United States General Accounting Office

33

www.hcfa.gov: Health Care Financing Administration

www.medpac.gov: The Medicare Payment Advisory Commission