DRG- efficiency and quality

Every week during a summer you might find a summary from a book called Diagnosis Related Groups in Europe, available HERE.

DRG-based hospital payment and efficiency

Diagnosis-related groups (DRGs) were first used to pay hospitals in 1983 under the Medicare Program in the United States. This development was born out of a need to move away from an approach to hospital financing based on fee-for-service payments, which was seen as inherently inefficient and increasingly expensive. Since then, DRG-based hospital payment has been widely adopted internationally with the explicit objective of improving efficiency, principally because of its three overarching strengths, summarized here:

1.       DRG-based hospital payment offers greater transparency in the financing of health care.

2.       Payments are based on patient characteristics. Fundamental to effective DRG-based hospital payment is an accurate description of the type of patients treated (casemix).

3.       DRG-based hospital payment is a form of ‘yard stick competition’, designed to encourage greater efficiency in the absence of market competition.


‘Efficiency’ is a widely used term that can have various meanings. Economists make distinctions between technical, cost- and allocative efficiency.

Technical efficiency is defined as maximizing output for given input levels or, in this context, treating as many patients as possible given the resources available. Hospitals are cost-efficient when they minimize costs for any given output level. Allocative efficiency can be defined for both outputs and inputs. The optimal output mix depends on the value of each output, which requires judgments to be made on the relative values of an appendectomy operation, a heart bypass, and all other health care interventions. The optimal mix of inputs depends on the relative price of each input type, such as the salaries of doctors and nurses. Alongside these economic terms, reference is often made to things thought to be indicative of efficient behavior, which – in the hospital sector – might include the number and type of patients treated, unit costs, and length of stay, for example. The extent to which DRGs contribute to achieving these forms of efficiency depends on how they are used for payment purposes.

Yard stick competition is designed to encourage providers to reduce their costs in contexts in which they face limited competitive pressure. Yard stick competition is effective when regulated prices are virtually independent of an individual provider’s costs. Ideally, prices should reflect the supply costs of efficient providers, determined across all providers within the same industry.

Hospital payment models

The role of DRG-based hospital payment, we compare the three main forms of provider payment models used in hospital financing:  

1.       cost-based reimbursement (also known as fee-for-service payment),

2.       the global budget model,

3.       DRG-based payment.

With cost-based reimbursement, payments to hospitals are based on the cost incurred by each patient. The main method of cost control is to specify a price list that details the unit payment for each ‘item of service’ (for example, medication, X-ray, procedure). Hospitals must therefore provide itemized bills for every patient treated, but there is no incentive to limit what treatments they provide per insured patient.

Cost control is one of the key advantages of global budget arrangements, which have been used in many European health care systems, at least if the budget constraint is credible and binding, and separation exists between a payer. This division has traditionally been present in social health insurance systems and, since the 1990s, increasingly also in tax-funded systems. A fixed payment is agreed in advance for a target level of activity – often specified at the specialty level.

There are two key features of DRG-based hospital payment. (1) Activity is described using DRGs rather than by specialty.  (2) The reimbursement per DRG is to a large extent fixed in advance, as patient characteristics (especially the main diagnosis) determine the DRG category with its fixed ‘price’.

The three models offer different incentives for achieving objectives relating to activity levels, expenditure control, quality of care, and the three types of efficiency.

DRG-based hospital payment performs better than cost-based reimbursement regarding expenditure control, but not as well as global budgets. The potential for quality improvement under a DRG-based hospital payment system may be dependent on whether payments are adjusted for quality of care. Where DRG-based hospital payment provides a fixed price per unit of activity, hospitals are incentivized to increase activity and minimize cost and, therefore, to improve technical efficiency. While cost-based reimbursement also encourages increased activity, there is no motivation to minimize inputs/costs. DRG-based hospital payment may offer incentives to improve allocative and cost-efficiency by encouraging providers to consider the prices and amount of inputs they use. It may also promote an efficient allocation of outputs if prices reflect their relative value but, in practice, most jurisdictions still base prices on costs. Nevertheless, overall, DRG-based hospital payment is likely to provide stronger incentives for efficiency compared to either of the alternatives.

DRG-based hospital payment systems have the potential to enhance efficiency in the delivery of hospital services, more so than other hospital payment models. This is because there are clear incentives for hospitals to work harder. After all, they are paid according to the number of patients they treat, as well as to control their costs because the prices they face are set independently of their costs. These payment characteristics encourage providers to improve their technical and cost-efficiency and to seek allocative efficiency in their choice of input mix. In theory, DRG-based hospital payment can be used to support allocative efficiency in the overall mix of outputs produced by the hospital sector as a whole. This requires the price attached to each DRG to reflect its societal value. In practice, though, DRG prices are based on costs in almost all countries, so the pursuit of allocative efficiency in this sense has not been a feature of DRG-based hospital payment policy.


Empirical evidence is mixed in terms of the extent to which DRG-based hospital payment has improved efficiency. This is partly because of cross-country heterogeneity in how DRG-based hospital payment systems are operated.

It is generally agreed that DRG-based hospital payment affects indicators of efficiency, such as activity and length of stay, although the same caveats apply. Unintended consequences may include skimping (on quality), cost-shifting, patient selection, or up-coding to higher-priced DRGs.

DRGs and quality

Quality of care is a multidimensional concept, covering effectiveness, safety, accessibility, and responsiveness of care but there is no agreement on how these should be measured. A useful and widely used approach is the one conceptualized by Donabedian, that describes quality measures as being either structure-, process- or outcome-oriented in nature. Structural measures – such as qualification of medical staff or equipment levels – may represent conditions for the delivery of a given quality of health care, but they are not sufficient to ensure an appropriate care process. Process measures should be based on clinical evidence of the effectiveness of the process concerned and consistent with current professional knowledge. Thus, process indicators may be more vulnerable to ‘gaming’ than outcome or structure measures.

The way prices are set will have a significant impact on the cost-efficiency effort of providers and, consequently, on quality.

It appears that in most countries in which a DRG-based hospital payment system is introduced, the monitoring and reporting of care quality remain inadequate.

 Unintended adverse effects of DRG-based hospital payment systems on care quality could potentially be avoided by modifying the incentives of the payment system. If the payer/purchaser wants to improve the quality of care, payments need to be adjusted in a way that rewards hospitals for the additional costs/effort involved in raising quality. Furthermore, that the form of the payment contract should take into account the type of provider. Different options exist for adjusting DRG-based hospital payment systems based on the quality of care. Simplified, there are three options:

1.       the hospital level,

2.       the level of a DRG-or all DRGs for one condition,

3.       the individual patient level.

Under the first option, total hospital income could be adjusted based on hospital-level quality indicators.

Under the second option, when patient-level data are available on outcomes and/or treatment process(es), payments can be adjusted for certain DRGs based on the quality of all patients treated within that DRG. The aim is to encourage a medical practice that is considered to be ‘good quality’ by moving away from pricing simply based on average observed costs per episode.

The third option is to adjust payments for individual patients based on the quality of their treatment, independent of the DRG to which they are allocated. This requires reliable indicators of patient outcomes. Developing such indicators is not always straightforward, as attributing a certain patient outcome to provider behavior can be controversial. Indicators for bad (or good) quality, on which such penalties (or rewards) are based, will thus need to be very robust and subject to as little controversy as possible.

Of course, it is also possible to have a system that combines different approaches, for example, quality adjustments at the patient level with a global payment/adjustment for quality at the hospital level. However, an essential prerequisite for any quality-based payment adjustments to the hospital payment system is the availability of information on the quality of care.

DRG-based payment systems may represent risks for the quality of care, but may also provide opportunities for quality improvements. The introduction of DRGs has increased transparency and has facilitated the comparison and standardization of care. The pressure for efficiency introduced by DRG-based payment systems might help to improve the organization of care, accelerate the adoption of technology, and hence improve quality. Nevertheless, hospitals can also skimp on quality as a way of saving costs by manipulating the services/care provided to patients. Technology adoption rates may decelerate if new technologies do not induce cost savings. At the same time, these potential adverse effects are not inevitable consequences of DRG-based hospital payment and can be addressed by carefully designing the payment scheme.

Despite the widespread introduction of DRG-based hospital payment systems since the early 2000s, the available research evaluating the systems’ impact on care quality and patient outcomes is too limited to draw any firm conclusions. The limited evidence so far does not suggest that the introduction of DRG- based hospital payment had a significant impact on patient outcomes.

DRG-based hospital payment provides an opportunity to better measure the quality of care in hospitals. Thus, it becomes possible to improve quality by providing explicit incentives for higher quality procedures/treatments, penalizing ‘poor-quality care’, or granting funds for improving patient outcomes. This requires continuous refinement of data and indicators for monitoring the quality of care. In many countries, information on patient outcomes and process quality is not routinely collected. However, if financing arrangements become more sophisticated, the demand for and supply of information regarding the quality of health care will surely increase.