What Inpatient Prospective Payment Is and How It Works

Inpatient Prospective Payment System (IPPS) is the method Medicare uses to pay hospitals a fixed amount for each inpatient stay, determined before treatment begins rather than after. The hospital receives one lump sum based on the patient's diagnosis and the expected cost to treat it, regardless of how long the patient actually stays or what the actual bill turns out to be. This shifts financial risk to the hospital: if treatment costs less than the set rate, the hospital keeps the difference; if it costs more, the hospital absorbs the loss.

The system has been in place since 1983. Medicare assigns each inpatient admission to a Diagnosis-Related Group (DRG), a classification that bundles similar diagnoses and procedures. The DRG determines the base payment amount, which is then adjusted for the hospital's location, teaching status, and whether the patient qualifies for additional payments (called outliers) if the case is unusually expensive or long.

IPPS applies only to Medicare inpatient hospital stays. Outpatient services, skilled nursing facilities, home health, and hospice operate under different payment systems. Private insurance companies and Medicaid programs may use their own versions of prospective payment or other methods entirely.

Key Takeaways

  • Medicare pays hospitals a fixed amount per inpatient stay based on diagnosis, not on actual length of stay or services delivered.
  • Each admission is assigned to a Diagnosis-Related Group (DRG), which determines the base payment rate for that hospital stay.
  • The payment rate varies by hospital location, whether the hospital is a teaching facility, and the patient's age and comorbidities.
  • Hospitals can receive additional payment (outlier payments) if a case is unusually expensive or the patient stays much longer than the DRG average.
  • IPPS affects only inpatient hospital care covered by Medicare; outpatient and other facility types use separate payment systems.

How DRGs Determine the Payment Amount

When a Medicare patient is admitted to the hospital, the hospital assigns the stay to a DRG based on the primary diagnosis, secondary diagnoses, procedures performed, and patient characteristics like age and sex. Medicare publishes a list of all DRGs and their assigned payment weights each year. A DRG weight is a number that reflects the relative costliness of that diagnosis compared to the average inpatient stay.

The actual dollar payment is calculated by multiplying the DRG weight by a base payment rate set by Medicare for that hospital. The base rate varies by geographic region and by hospital type. A teaching hospital in a high-cost urban area will have a higher base rate than a rural non-teaching hospital, even if both treat the same DRG.

For example, if a DRG has a weight of 1.5 and a hospital's base rate is $5,000, the payment for that admission would be $7,500. A different hospital in a different region with a base rate of $4,000 would receive $6,000 for the same DRG. The patient's insurance status, age, and whether they have Medicare Advantage or Original Medicare does not change the DRG assignment or the base payment — IPPS is the same across all Medicare beneficiaries at a given hospital.

Geographic and Hospital-Specific Adjustments to Payment

Medicare recognizes that the cost of delivering care differs significantly by location and hospital characteristics. The base payment rate is adjusted using several factors that reflect these differences.

Geographic adjustment accounts for regional variation in wages, cost of living, and input prices. A hospital in San Francisco receives a higher adjustment than one in rural Mississippi, even if both treat identical cases. Medicare updates these adjustments annually based on wage data from the Bureau of Labor Statistics.

Teaching status increases payment for hospitals affiliated with medical schools or residency programs. The adjustment is based on the ratio of residents to beds. A major academic medical center receives a substantially higher payment than a community hospital for the same DRG.

Disproportionate share adjustments provide additional payment to hospitals that serve a high percentage of low-income or uninsured patients. The adjustment is calculated using the hospital's Medicaid patient load and uninsured patient load relative to its total patient volume.

Hospitals also receive adjustments for indirect medical education costs (the cost of training residents) and capital costs (depreciation and interest on buildings and equipment). These are calculated separately from the base DRG payment.

Outlier Payments for Unusually Expensive or Long Stays

IPPS includes a safety valve for cases that cost far more than the DRG payment or last much longer than expected. If a hospital's costs for a single case exceed a threshold set by Medicare, the hospital can receive an outlier payment — additional money beyond the base DRG rate.

There are two types of outliers. A cost outlier is triggered when the hospital's documented costs for a case exceed a fixed dollar amount above the DRG payment (the threshold changes each year). A day outlier is triggered when a patient's length of stay exceeds a threshold number of days for that DRG (also set annually by Medicare).

To receive an outlier payment, the hospital must submit detailed cost accounting data showing that the case truly cost more than expected. Medicare reviews the submission and pays a percentage of the excess cost — typically 80 percent of costs above the threshold. The hospital still bears some of the financial risk, which creates an incentive to manage costs even in expensive cases.

Outlier payments are capped each year as a percentage of total IPPS payments. If outlier claims exceed the cap, Medicare reduces the payment percentage for all outliers that year. This means outlier payments are not may provide and can vary year to year.

How IPPS Affects Hospital Behavior and Patient Care

Because hospitals receive a fixed payment regardless of length of stay or number of services, IPPS creates incentives that differ from fee-for-service payment. Hospitals have a financial incentive to discharge patients as soon as clinically appropriate, since each additional day costs the hospital money without increasing revenue. This has contributed to shorter average lengths of stay in U.S. hospitals since IPPS began.

IPPS also incentivizes hospitals to manage complications and readmissions carefully. If a patient is readmitted within 30 days for a condition related to the original stay, Medicare may reduce or deny payment for the readmission under certain conditions. This has led hospitals to invest in discharge planning, follow-up care coordination, and post-acute care partnerships.

The fixed-payment structure means hospitals must manage their costs to remain profitable. This has driven adoption of clinical pathways, standardized protocols, and efficiency improvements. However, it also creates pressure to minimize services or discharge patients before they are ready, which is why Medicare and accrediting bodies monitor hospital readmission rates and patient safety metrics.

Differences Between IPPS and Other Payment Systems

IPPS applies only to inpatient hospital stays. Other settings and services use different payment methods that may or may not be prospective.

Outpatient hospital services (emergency department, surgery center, imaging) are paid under the Outpatient Prospective Payment System (OPPS), which uses Ambulatory Payment Classifications (APCs) instead of DRGs. The payment logic is similar — a fixed rate based on the type of service — but the groupings and rates are different.

Skilled nursing facilities use the Skilled Nursing Facility Prospective Payment System (SNF PPS), which pays a per-diem rate based on the patient's Resource Utilization Group (RUG). Home health agencies are paid under the Home Health Prospective Payment System (HH PPS) using Home Health Resource Groups (HHRGs). Hospice receives a per-diem payment that varies by level of care.

Physician services are paid under the Medicare Physician Fee Schedule, which is a fee-for-service system with a set payment for each procedure code. Private insurance companies may use their own versions of prospective payment, negotiate rates directly with hospitals, or use other methods entirely. Medicaid varies by state; some states use IPPS-like systems, while others negotiate rates or use different formulas.

How DRGs Are Updated and What Changes Year to Year

Medicare updates the DRG system annually. The Centers for Medicare & Medicaid Services (CMS) reviews hospital discharge data, adjusts DRG weights based on actual costs reported by hospitals, and may create new DRGs or combine existing ones to reflect changes in medical practice.

Each October, CMS publishes the final rule for the upcoming fiscal year (which runs October 1 to September 30). The rule includes the new DRG weights, the base payment rates by region, and any changes to the outlier thresholds or adjustment factors. Hospitals receive notice of their individual base rates and can review how the changes affect their expected revenue.

The DRG system has been criticized for not always reflecting the true cost of care, particularly for complex or rare conditions. Hospitals can request that CMS reconsider a DRG weight if they believe it does not accurately represent the cost of treating that diagnosis. However, individual hospital requests rarely result in changes; updates are made at the system level based on aggregate data.

CMS also periodically makes larger structural changes to the DRG system. In 2007, the system was updated to include comorbidities and complications (called MS-DRGs) to better account for patient complexity. Future updates may incorporate additional factors like social determinants of health or quality metrics.

Frequently Asked Questions

Does IPPS explore to Medicare Advantage plans?

No. Medicare Advantage plans are paid by Medicare on a capitated basis (a fixed monthly amount per enrollee), and they negotiate their own rates with hospitals. However, when a Medicare Advantage patient is admitted to a hospital, the hospital still reports the DRG and length of stay to Medicare for quality monitoring purposes.

Can a patient be charged more if the hospital's actual costs exceed the IPPS payment?

No. Under IPPS, the hospital cannot bill the Medicare patient for the difference between the DRG payment and the hospital's actual costs. The patient is responsible only for their deductible and coinsurance, which are calculated as a percentage of the DRG payment, not the actual bill. If costs exceed the payment, the hospital absorbs the loss.

How does a hospital know what DRG it will be paid for before the patient is discharged?

The hospital assigns the DRG based on the diagnoses and procedures documented during the stay. The assignment is made at discharge or shortly after, when all clinical information is available. The hospital can estimate the DRG early in the stay based on the primary diagnosis, but the final assignment depends on all secondary diagnoses and procedures, which may not be known until discharge.

What happens if a hospital disagrees with the DRG assigned to a patient?

The hospital can appeal the DRG assignment through a formal review process. The hospital submits documentation supporting a different DRG, and a Medicare contractor reviews the medical record. If the appeal is successful, the payment is recalculated. However, most appeals are not successful, and the process can take several months.

Does IPPS payment cover all hospital costs, including physician fees?

No. IPPS pays the hospital for facility costs (room, nursing, equipment, supplies). Physicians bill separately under the Medicare Physician Fee Schedule. The patient may receive separate bills from the hospital and from the radiologist, anesthesiologist, or other physicians who provided services during the stay.