Medicare Adopts DRG Prospective Payment System Creating Hospital Profit Incentives for Reduced Care

The Social Security Amendments of 1983 establish Medicare’s Prospective Payment System (PPS), fundamentally transforming hospital economics by replacing cost-based reimbursement with fixed payments based on Diagnosis Related Groups (DRGs). Under the new system, hospitals receive a predetermined amount based on a patient’s diagnosis regardless of actual treatment costs, creating powerful financial incentives to minimize care, discharge patients quickly, and avoid costly procedures.

The Reagan administration promotes the DRG system as a cost-control measure to address Medicare’s escalating expenses, but the reform effectively shifts financial risk from insurers to hospitals while creating perverse incentives. Hospitals that treat patients for less than the DRG payment keep the difference as profit; those exceeding the payment absorb the loss. This structure incentivizes early discharge, reduced testing, and treatment in lower-cost settings, regardless of patient outcomes.

The hospital industry initially opposes prospective payment but recognizes opportunities in the new system. The Federation of American Hospitals, representing for-profit hospital chains, successfully lobbies for favorable payment adjustments. The American Hospital Association negotiates transition provisions that protect hospital revenues during implementation. Both organizations ensure the payment formulas account for teaching hospitals, regional cost variations, and special cases that benefit their members.

Implementation accelerates the transformation of American hospitals into profit-maximizing enterprises. Average length of hospital stays drops precipitously as facilities rush to discharge patients before costs exceed DRG payments. The term “quicker and sicker” enters the healthcare lexicon as critics observe patients leaving hospitals in increasingly fragile conditions. Hospitals respond by expanding profitable outpatient services while reducing inpatient capacity and staffing.

The DRG system catalyzes the for-profit hospital industry’s growth by creating predictable revenue streams attractive to investors. Hospital Corporation of America, Humana, and other chains expand rapidly through the 1980s, applying industrial management techniques to healthcare delivery. The reform establishes the principle that healthcare institutions should operate as profit-seeking enterprises rather than community service organizations, accelerating the corporatization of American medicine.